1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 - -------------------------------------------------------------------------------- FORM 10-K (MARK ONE) [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2000 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 No. 000-23877 - ------------------------------------------------------------------------------- HERITAGE COMMERCE CORP (Exact name of registrant as specified in its charter) CALIFORNIA 77-0469558 (State or other jurisdiction of incorporation (I.R.S. Employer or organization) Identification No.) 150 ALMADEN BOULEVARD SAN JOSE, CALIFORNIA 95113 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (408) 947-6900 Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: COMMON STOCK (NO PAR VALUE) NASDAQ (Title of class) (Name of each exchange on which registered) 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of 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. [X] The aggregate market value of the stock held by non-affiliates of the Registrant, based upon the closing price of its common stock on March 28, 2001 on the Nasdaq National Market was $9.00. As of March 28, 2001, 11,076,965 shares of the Registrant's common stock (no par value) were outstanding. DOCUMENTS INCORPORATED BY REFERENCE PARTS OF FORM 10-K INTO WHICH DOCUMENTS INCORPORATED INCORPORATED - ------------------------------------------ ------------------------------------ Definitive proxy statement for the Company's 2001 Annual Meeting of Shareholders to be filed within 120 days of the end of the fiscal year ended December 31, 2000. Part III 1
2 HERITAGE COMMERCE CORP INDEX TO ANNUAL REPORT ON FORM 10-K FOR YEAR ENDED DECEMBER 31, 2000 Page ---- PART I Item 1 Business 3 Item 2 Properties 16 Item 3 Legal Proceedings 17 Item 4 Submission of Matters to a Vote of Security Holders 17 PART II Item 5 Market for the Registrant's Common Equity and Related Stockholder Matters 18 Item 6 Selected Financial Data 21 Item 7 Management's Discussion and Analysis of Financial Condition and Results of Operations 23 Item 7A Quantitative and Qualitative Disclosures About Market Risk 38 Item 8 Financial Statements and Supplementary Data 39 Item 9 Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 39 PART III Item 10 Directors and Executive Officers of the Registrant 40 Item 11 Executive Compensation 40 Item 12 Security Ownership of Certain Beneficial Owners and Management 40 Item 13 Certain Relationships and Related Transactions 40 PART IV Item 14 Exhibits, Financial Statement Schedules, and Reports on Form 8-K 41 2
3 PART I ITEM 1 - BUSINESS GENERAL Heritage Commerce Corp (the "Company") is registered with the Board of Governors of the Federal Reserve System ("FRB") as a Bank Holding Company under the Bank Holding Company Act ("BHCA"). The Company was organized in 1997 to be the holding Company for Heritage Bank of Commerce ("HBC"). In 1998 the Company also became the holding Company for Heritage Bank East Bay ("HBEB"); in January 2000 the Company became the holding Company for Heritage Bank South Valley ("HBSV"); and in October 2000 the Company became the holding Company for Bank of Los Altos ("BLA"). HBC, HBEB, HBSV, and BLA are sometimes collectively referred to herein as the "Banks". On February 21, 2000, a 10 percent stock dividend was paid to shareholders of record as of February 7, 2000. Accordingly, all historical financial information has been restated as if the stock dividend had been in effect for all periods presented. New Branches and Subsidiaries The Company's primary strategy is to establish de novo banks, branches, or representative offices in contiguous geographic areas. By virtue of each subsidiary's local ownership, management, and decision making, the Company hopes to benefit from the continuing trend in the banking industry towards merger and consolidation. The Company's, as well as the Banks', business strategy and promotional activities emphasize service and responsiveness to local needs. On December 22, 1998, HBC received authorization from the California Department of Financial Institutions to open a full service branch in the city of Morgan Hill, California. HBC's Board of Directors saw this geographic expansion as a continuation into HBC's primary market area, Santa Clara County, since Morgan Hill has a high concentration of potential clients with banking service requirements similar to those of HBC's current client mix. HBC opened the branch on March 1, 1999. On January 18, 2000, HBSV commenced business as a California state-chartered commercial bank and a subsidiary of the Company in the premises previously occupied by the Morgan Hill branch of HBC. On May 9, 2000, the Company signed a definitive merger agreement with Western Holdings Bancorp, holding Company of Bank of Los Altos ("BLA"). The agreement provided for shareholders of Western Holdings Bancorp to receive shares of Heritage Commerce Corp stock in a tax free exchange. The estimated value of the merger at signing was approximately $40.9 million based on Heritage Commerce Corp's closing price of $10.875 on May 9, 2000. On August 24, 2000, both companies received shareholder approval to merge. The merger, which was accounted for as a pooling of interests, was completed on October 1, 2000. Bank of Los Altos, a privately held full service commercial bank with two branches in Los Altos and one in Mountain View now operates as a wholly owned subsidiary of Heritage Commerce Corp. Unless otherwise noted, the information contained herein has been restated on a historical basis as if the Companies had been combined for all periods presented. General Banking Services The Company's customer base consists primarily of small to medium-sized businesses and their owners, managers, and employees residing in Santa Clara, Alameda, and Contra Costa counties. Businesses served include manufacturers, distributors, contractors, professional corporations/partnerships, and service businesses. The Company had approximately 14,600 deposit accounts at December 31, 2000. The Company offers a range of loans, primarily commercial, including real estate, construction, Small Business Administration (SBA), inventory and accounts receivable, and equipment loans. The Company also accepts checking, savings, and time deposits; NOW and money market deposit accounts; and provides travelers' checks, safe deposit, and other customary non-deposit banking services. The Company issues VISA and MasterCard credit cards through the Independent Bankers Association. The Company does not have a trust department. 3
4 HBC's main and executive offices and the Company's offices are located at 150 Almaden Boulevard, San Jose, California 95113. In addition, HBEB is located at 3077 Stevenson Blvd., Fremont, California 94538, HBSV is located at 18625 Sutter Drive, Morgan Hill, California 95037, and BLA is located at 4546 El Camino Real, Los Altos, California 94022. See Item 2 -"PROPERTIES." The Company's primary market area is Santa Clara, Alameda, and Contra Costa counties. The Company serves a secondary market consisting of the South Bay portion of the San Francisco Bay area and portions of other counties contiguous to its primary market area. Recent management change On June 15, 2000, John E. Rossell resigned as president and chief executive officer of the Company. As a result, Brad L. Smith, chairman of the Company, assumed the role of chief executive officer of the Company and acting president of Heritage Bank of Commerce, and Richard Conniff, a director of the Company and president of Heritage Bank East Bay, assumed the role of president and chief operating officer of the Company. The Company incurred a $630,000 after tax charge from this change in management in 2000. COMPETITION The banking and financial services business in California generally, and in the Company's market areas specifically, is highly competitive. The increasingly competitive environment is a result primarily of changes in regulation, changes in technology and product delivery systems, and the accelerating pace of consolidation among financial services providers. The Company competes for loans, deposits and customers for financial services with other commercial banks, savings and loan associations, securities and brokerage companies, mortgage companies, insurance companies, finance companies, money market funds, credit unions, and other non-bank financial service providers. Many of these competitors are much larger in total assets and capitalization, have greater access to capital markets and offer a broader array of financial services than the Company. In order to compete with the other financial services providers, the Company principally relies upon local promotional activities, personal relationships established by officers, directors, and employees with its customers, and specialized services tailored to meet its customers' needs. In those instances where the Company is unable to accommodate a customer's needs, the Company seeks to have those services provided in whole or in part by its correspondent banks. See Item 1 - "BUSINESS - Supervision And Regulation." SUPERVISION AND REGULATION General Bank holding companies and banks are extensively regulated under both federal and state law. This regulation is intended primarily for the protection of depositors and the deposit insurance fund and not for the benefit of stockholders of the Company. Set forth below is a summary of certain laws which relate to the regulation of the Company and the Banks. The description does not purport to be complete and is qualified in its entirety by reference to the applicable laws and regulations. As a registered bank holding Company, the Company is subject to the supervision of, and to regular inspection by, the FRB. Historically the activities of bank holding companies such as the Company have been limited by the BHCA to banking, managing or controlling banks, furnishing services to or performing services for their subsidiaries, or any other activity which the FRB deems to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. In making such determinations, the FRB is required to consider whether the performance of such activities by a bank holding Company or its subsidiaries can reasonably be expected to produce benefits to the public such as greater convenience, increased competition, or gains in efficiency that outweigh the possible adverse effects, such as undue concentration of resources, decreased or unfair competition, conflicts of interest, or unsound banking practices. Generally, bank holding companies are required to give notice to or obtain prior approval from FRB to engage in any new activity or to acquire more than 5% of any class of voting stock of any bank. For discussion of recent expansion of the powers of bank holding companies, see "Financial Services Modernization Legislation" below. The Company is also a bank holding Company within the meaning of Section 3700 of the California Financial Code. As such, the Company and its subsidiaries are subject to examination by, and may be required to file reports with, the California Department of Financial Institutions (the "Department"). 4
5 The Company's common stock is registered with the Securities and Exchange Commission ("SEC") under the Securities Exchange Act of 1934, as amended (the "Exchange Act"). As such, the Company is subject to the information, proxy solicitation, insider trading, and other requirements and restrictions of the Exchange Act. Deposit accounts at the Banks are insured by the Federal Deposit Insurance Corporation (FDIC), which currently insures deposits to a maximum of $100,000 per depositor. For this protection, the Banks pay a semi-annual assessment and are subject to the rules and regulations of the FDIC pertaining to deposit insurance and other matters. HBC, HBEB, HBSV, and BLA are California state-chartered bank and members of the Federal Reserve System. State banks chartered in California that are members of the Federal Reserve System are subject to regulation, supervision and regular examination by the Department and by the Federal Reserve Board. The regulations of the Department and the FRB govern most aspects of the Banks' business, including reporting requirements, activities, investments, loans, borrowings, certain check-clearing activities, branching, mergers and acquisitions, reserves against deposits, and other areas. Financial Services Modernization Legislation The Gramm-Leach-Bliley Act of 1999 (the "Financial Services Modernization Act") became effective March 11, 2000. The Financial Services Modernization Act repeals the two provisions of the Glass-Steagall Act: Section 20, which restricted the affiliation of Federal Reserve Member Banks with firms "engaged principally" in specified securities activities; and Section 32, which restricts officer, director, or employee interlocks between a member bank and any Company or person "primarily engaged" in specified securities activities. In addition, the Financial Services Modernization Act also contains provisions that expressly preempt any state law restricting the establishment of financial affiliations, primarily related to insurance. The general effect of the law is to establish a comprehensive framework to permit affiliations among commercial banks, insurance companies, securities firms, and other financial service providers by revising and expanding the BHCA framework to permit a holding Company system to engage in a full range of financial activities through a new entity known as a Financial Holding Company. "Financial activities" is broadly defined to include not only banking, insurance, and securities activities, but also merchant banking and additional activities that the Federal Reserve, in consultation with the Secretary of the Treasury, determines to be financial in nature, incidental to such financial activities, or complementary activities that do not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally. Generally, the Financial Services Modernization Act: - - Repeals historical restrictions on, and eliminates many federal and state law barriers to, affiliations among banks, securities firms, insurance companies, and other financial service providers; - - Provides a uniform framework for the functional regulation of the activities of banks, savings institutions, and their holding companies; - - Broadens the activities that may be conducted by national banks, banking subsidiaries of bank holding companies, and their financial subsidiaries; - - Provides an enhanced framework for protecting the privacy of consumer information; - - Adopts a number of provisions related to capitalization, membership, corporate governance, and other measures designed to modernize the Federal Home Loan Bank system; - - Modifies the laws governing the implementation of the Community Reinvestment Act ("CRA"); and - - Addresses a variety of other legal and regulatory issues affecting both day-to-day operations and long-term activities of financial institutions. 5
6 In order for the Company to take advantage of the ability to affiliate with other financial services providers, the Company must become a "Financial Holding Company" as permitted under an amendment to BHCA. To become a Financial Holding Company, the Company would file a declaration with the FRB, electing to engage in activities permissible for Financial Holding Companies and certifying that it is eligible to do so because all of its insured depository institution subsidiaries are well-capitalized and well-managed. In addition, the FRB must also determine that each insured depository institution subsidiary of the Company has at least a "Satisfactory" CRA rating. The Company currently meets the requirements to make an election to become a Financial Holding Company. The Company's management has not determined at this time whether it will seek an election to become a Financial Holding Company. The Company is examining its strategic business plan to determine whether, based on market conditions, the relative financial conditions of the company and its subsidiaries, regulatory capital requirements, general economic conditions, and other factors, the Company desires to utilize any of the expanded powers provided in the Financial Services Modernization Act. The Financial Services Modernization Act also permits national banks to engage in expanded activities through the formation of financial subsidiaries. A national bank may engage, subject to limitations on investment, in activities that are financial in nature, other than insurance underwriting, insurance Company portfolio investment, real estate development, real estate investment, or merchant banking, which may only be conducted through a subsidiary of a Financial Holding Company. Financial activities include all activities permitted under new sections of the BHCA or permitted by regulation. A national bank seeking to have a financial subsidiary, and each of its depository institution affiliates, must be "well-capitalized" and "well-managed." The total assets of all financial subsidiaries may not exceed the lesser of 45% of a bank's total assets, or $50 billion. A national bank must exclude from its assets and equity all equity investments, including retained earnings, in a financial subsidiary. The assets of the subsidiary may not be consolidated with the bank's assets. The bank must also have policies and procedures to assess financial subsidiary risk and protect the bank from such risks and potential liabilities. The Financial Services Modernization Act provides that designated federal regulatory agencies, including the FDIC, the FRB, the OCC and the SEC, are to publish regulations to implement certain provisions of the Act. These agencies have cooperated in the release of rules that establish minimum requirements to be followed by financial institutions for protecting the privacy of financial information provided by consumers. The FDIC's rule, which would establish privacy standards to be followed by state nonmember banks such as the Banks, requires a financial institution to (i) provide notice to customers about its privacy policies and practices, (ii) describe the conditions under which the institution may disclose nonpublic personal information about consumers to nonaffiliated third parties, and (iii) provide a method for consumers to prevent the financial institution from disclosing information to nonaffiliated third parties by "opting out" of that disclosure. The Financial Services Modernization Act also includes a new section of the Federal Deposit Insurance Act governing subsidiaries of state banks that engage in "activities as principal that would only be permissible" for a national bank to conduct in a financial subsidiary. It expressly preserves the ability of a state bank to retain all existing subsidiaries. Because California permits commercial banks chartered by the state to engage in any activity permissible for national banks, HBC, HBEB, HBSV, and BLA will be permitted to form subsidiaries to engage in the activities authorized by the Financial Services Modernization Act, to the same extent as a national bank. In order to form a financial subsidiary, the bank must be well-capitalized, and the bank would be subject to the same capital deduction, risk management and affiliate transaction rules are applicable to national banks. The Company and the Banks do not believe that the Financial Services Modernization Act has had or will have a material adverse effect on our 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 and the Banks face from larger institutions and other types of companies offering financial products, many of which may have substantially more financial resources than the Company and the Banks. 6
7 Limitations on Dividends The Company's ability to pay cash dividends is dependent on dividends paid to it by the Banks. Under California law the holders of common stock of the Company are entitled to receive dividends when and as declared by the Board of Directors, out of funds legally available therefor, subject to certain restrictions. A California corporation such as the Company may make a distribution to its shareholders if its retained earnings will equal at least the amount of the proposed distribution. California law further provides that in the event sufficient retained earnings are not available for the proposed distribution a corporation may nevertheless make a distribution to its shareholders if, after giving effect to the distribution, it meets two conditions, which generally stated are as follows: (i) the corporation's assets must equal at least 125% of its liabilities; and (ii) the corporation's current assets must equal at least its current liabilities or, if the average of the corporation's earnings before taxes on income and before interest expense for the two preceding fiscal years was less than the average of the corporation's interest expense for such fiscal years, then the corporation's current assets must equal at least 125% of its current liabilities. Most bank holding companies are unable to meet this test. The payment of cash dividends by the Company depends on various factors, including the earnings and capital requirements of itself and its subsidiaries, and other financial conditions. The primary source of funds for payment of dividends by the Company to its shareholders will be the receipt of dividends and management fees from the Banks. The Company has no present intention of paying cash dividends in the foreseeable future. The legal ability of the Banks to pay dividends is subject to restrictions set forth in the California banking law and regulations of the FDIC. No assurance can be given that the Banks will pay dividends at any time. For restrictions applicable to the Banks, see Item 5 - - "MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS - Dividends." Safety and Soundness Standards The federal banking agencies have adopted guidelines establishing standards for safety and soundness. The guidelines are designed to assist the federal banking agencies in identifying and addressing potential safety and soundness concerns before capital becomes impaired. The guidelines set forth operational and managerial standards relating to internal controls, information systems and internal audit systems, loan documentation, credit underwriting, interest rate exposure, earnings, asset quality, asset growth, and compensation, fees and benefits. The guidelines establish the safety and soundness standards that the agencies use to identify and address problems at insured depository institutions before capital becomes impaired. If an institution fails to comply with a safety and soundness standard, the appropriate federal banking agency may require the institution to submit a compliance plan. Failure to submit a compliance plan or to implement an accepted plan may result in enforcement action. "Source Of Strength" Policy According to FRB policy, bank holding companies are expected to act as a source of financial strength to each subsidiary bank and to commit resources to support each such subsidiary. Capital Adequacy Guidelines Federal banking agencies have adopted risk-based capital guidelines for insured banks and bank holding companies. These guidelines require a minimum risk-based capital ratio of 8%, with at least 4% in the form of "Tier 1" capital. Tier 1 capital consists of common equity, non-cumulative perpetual preferred stock, trust preferred securities, and minority interests in the equity accounts of consolidated subsidiaries and excludes goodwill. "Tier 2" capital consists of cumulative perpetual preferred stock, limited-life preferred stock, mandatory convertible securities, subordinated debt and (subject to a limit of 1.25% of risk-weighted assets) general loan loss reserves. The guidelines make regulatory capital requirements more sensitive to the differences in risk profiles among banking institutions, take off-balance sheet items into account when assessing capital adequacy and minimize disincentives to holding liquid low-risk assets. In addition, the regulations may require some banking institutions to increase the level of their common shareholders' equity. Banking regulators have also instituted minimum leverage ratio guidelines for financial institutions. The leverage ratio guidelines require maintenance of a minimum ratio of 3% Tier 1 capital to total assets for the most highly rated bank holding Company organizations. Institutions that are less highly rated, anticipating significant growth, or subject to other significant risks will be 7
8 required to maintain capital levels ranging from 1% to 2% above the 3% minimum. The following table presents the capital ratios of the Company computed in accordance with applicable regulatory guidelines and compared to the standards for minimum capital adequacy requirements under the FDIC's prompt corrective action authority as of December 31, 2000: <TABLE> <CAPTION> December 31, 2000 ----------------------------------------------------------------------- Actual For Capital Adequacy Purposes ----------------------------------------------------------------------- Amount Ratio Amount Ratio ----------------------------------------------------------------------- <S> <C> <C> <C> <C> Total risk-based capital/risk-weighted assets $88,409,000 11.7% $60,451,000 (greater than or equal to) 8.0% Tier 1 capital/risk-weighted assets $78,982,000 10.5% $30,088,000 (greater than or equal to) 4.0% Tier 1 capital / average assets $78,982,000 9.3% $33,971,000 (greater than or equal to) 4.0% </TABLE> Federal banking agencies, including the FRB and the FDIC, have adopted regulations implementing a system of prompt corrective action pursuant to the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"). The regulations establish five capital categories based on the capital measures indicated below: <TABLE> <CAPTION> Total Risk-Based Tier 1 Risk-Based Tier 1 CAPITAL CATEGORY Capital Ratio Capital Ratio Leverage Ratio ------------------------------------------------------------------------------------------ <S> <C> <C> <C> Well capitalized 10.0% 6.0% 5.0% Adequately capitalized 8.0% 4.0% 4.0% Undercapitalized less than 8.0% less than 4.0% less than 4.0% Significantly undercapitalized less than 6.0% less than 3.0% less than 3.0% Critically undercapitalized(1) N/A N/A N/A ------------------------------------------------------------------------------------------ </TABLE> (1) Tangible equity to total assets less than 2.0% The regulations establish procedures for classification of financial institutions within the capital categories, filing and reviewing capital restoration plans required under the regulations and procedures for issuance of directives by the appropriate regulatory agency, among other matters. See Item 1 - - "BUSINESS - Supervision and Regulation - Prompt Corrective Action." The appropriate federal banking agency, after notice and an opportunity for a hearing, is authorized to treat a well capitalized, adequately capitalized or undercapitalized insured depository institution as if it had a lower capital-based classification if it is in an unsafe or unsound condition or engaging in an unsafe or unsound practice. Thus, an adequately capitalized institution can be subject to the restrictions on undercapitalized institutions (provided that a capital restoration plan cannot be required of the institution) described below and an undercapitalized institution can be subject to the restrictions applicable to significantly undercapitalized institutions described below. See Item 1 - "BUSINESS - Supervision And Regulation - Prompt Corrective Action." An insured depository institution cannot make a capital distribution (as broadly defined to include, among other items, dividends, redemptions and other repurchases of stock), or pay management fees to any person who controls the institution, if thereafter it would be undercapitalized. The appropriate federal banking agency, however, may (after consultation with the FDIC) permit an insured depository institution to repurchase, redeem, retire or otherwise acquire its shares if such action (i) is taken in connection with the issuance of additional shares or obligations in at least an equivalent amount and (ii) will reduce the institution's financial obligations or otherwise improve its financial condition. An undercapitalized institution is also generally prohibited from increasing its average total assets. An undercapitalized institution is also generally prohibited from making any acquisitions, establishing any branches or engaging in any new line of business except in accordance with an accepted capital restoration plan or with the approval of the FDIC. In addition, the appropriate federal banking agency is given authority with respect to any undercapitalized depository institution to take any of the actions it is required to or may take with respect to a significantly undercapitalized institution as described below if it determines "that those actions are necessary to carry out the purpose" of FDICIA. The federal banking agencies have adopted a joint agency policy statement to provide guidance on managing interest rate risk. The statement indicated that the adequacy and effectiveness of a bank's interest rate risk management process and the level of its interest rate exposures are critical factors in the agencies' evaluation of the bank's capital adequacy. If a bank has material weaknesses in its risk management process or high levels of exposure relative to its capital, the agencies will direct it to take corrective action. Such directives may include recommendations or directions to raise additional capital, strengthen management expertise, improve management 8
9 information and measurement systems, reduce level of exposure or some combination of these actions. The federal banking agencies have issued an interagency policy statement that, among other things, establishes certain benchmark ratios of loan loss reserves to certain classified assets. The benchmark set forth by such policy statement is the sum of (i) 100% of assets classified loss; (ii) 50% of assets classified doubtful; (iii) 15% of assets classified substandard; and (iv) estimated credit losses on other assets over the upcoming 12 months. This amount is neither a "floor" nor a "safe harbor" level for an institution's allowance for loan losses. Insurance Premiums and Assessments Pursuant to FDICIA, the FDIC has developed a risk-based assessment system, under which the assessment rate for an insured depository institution will vary according to the level of risk incurred on its activities. An institution's risk category is based upon whether the institution is well capitalized, adequately capitalized or less than adequately capitalized. Each insured depository institution is also to be assigned to one of the following "supervisory subgroups": group A, B or C. Group A institutions are financially sound institutions with few minor weaknesses; Group B institutions are institutions that demonstrate weaknesses which, if not corrected, could result in significant deterioration; and Group C institutions are institutions for which there is a substantial probability that the FDIC will suffer a loss in connection with the institution unless effective action is taken to correct the areas of weakness. The FDIC assigns each Bank Insurance Fund (BIF) member institution an annual FDIC assessment rate, summarized below (assessment figures are expressed in terms of cents per $100 in deposits): <TABLE> <CAPTION> Capital Category Group A Group B Group C ------------------------------------------------------------------- <S> <C> <C> <C> Well capitalized 0(1) 3 17 Adequately capitalized 3 10 24 Undercapitalized 10 24 27 ------------------------------------------------------------------- </TABLE> (1) Subject to a statutory minimum assessment of $2,000 per year (which also applies to all other assessment risk classifications). At December 31, 2000, HBC's, HBEB's, HBSV's, and BLA's assessment rates were all equivalent to that of a well capitalized, group A institution. Pursuant to the Economic Growth and Paperwork Reduction Act of 1996 (the "Paperwork Reduction Act"), at January 1, 1997, the Banks began paying, in addition to their normal deposit insurance premium as a member of the BIF, an assessment that is used toward the retirement of the Financing Corporation bonds ("FICO Bonds") issued in the 1980s to assist in the recovery of the savings and loan industry. Members of the Savings Association Insurance Fund ("SAIF"), also pay an assessment, which generally has been calculated at a higher rate than the assessment paid by banks. Under the Paperwork Reduction Act, the FDIC is not permitted to establish SAIF assessment rates that are lower than comparable BIF assessment rates. Effective January 1, 2000, the rate paid to retire the FICO Bonds became equal for members of the BIF and the SAIF. The Paperwork Reduction Act also provided for the merging of the BIF and the SAIF by January 1, 1999 provided there were no financial institutions still chartered as savings associations at that time. However, as of January 1, 1999, there were still financial institutions chartered as savings associations. In February 2000 the FDIC announced that it was refining the system by which it assesses the risks that are presented to the deposit insurance fund by certain financial institutions. The refinements are intended to identify institutions with a typically high-risk profiles from among those institutions in the best-rated premium category, and to determine whether there are unresolved supervisory concerns regarding the risk-management practices of those institutions. The FDIC is concerned about institutions that exhibit characteristics such as rapid asset growth (especially when concentrated in potentially risky, high-yielding lending areas), significant concentrations in high-risk assets, and recent changes in business mix. The FDIC has noted that although such institutions may be well-capitalized and exhibit good earnings when the economy is strong, they often experience deteriorating financial conditions when economic conditions are less favorable. As a result, institutions whose practices are determined to exhibit risky traits under the refined risk assessment system will be assessed higher insurance premiums. The impact of these new rules on the Banks cannot be predicted. 9
10 Prompt Corrective Action The FDIC has authority: (1) to request that an institution's regulatory agency take enforcement action against it based upon an examination by the FDIC or the agency, (2) if no action is taken within 60 days and the FDIC determines that the institution is in an unsafe or unsound condition or that failure to take the action will result in continuance of unsafe or unsound practices, to order the action against the institution, and (3) to exercise this enforcement authority under "exigent circumstances" merely upon notification to the institution's appropriate regulatory agency. This authority gives the FDIC the same enforcement powers with respect to any institution and its subsidiaries and affiliates as such institution's appropriate regulatory agency has with respect to those entities. An undercapitalized institution is required to submit an acceptable capital restoration plan to its appropriate federal banking agency. The plan must specify (i) the steps the institution will take to become adequately capitalized, (ii) the capital levels to be attained each year, (iii) how the institution will comply with any regulatory sanctions then in effect against the institution, and (iv) the types and levels of activities in which the institution will engage. The banking agency may not accept a capital restoration plan unless the agency determines, among other things, that the plan "is based on realistic assumptions, and is likely to succeed in restoring the institution's capital" and "would not appreciably increase the risk . . . to which the institution is exposed". A requisite element of an acceptable capital restoration plan for an undercapitalized institution is a guaranty by its parent holding Company that the institution will comply with such capital restoration plan. Liability with respect to this guaranty is limited to the lesser of (i) five percent of the institution's assets at the time when it became undercapitalized and (ii) the amount necessary to bring the institution into capital compliance with "all capital standards applicable to [it]" as of the time when the institution fails to comply with the plan. The guaranty liability is limited to companies controlling the undercapitalized institution and does not affect other affiliates. In the event of a bank holding Company's bankruptcy, any commitment by the bank holding Company to a federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to priority of payment over the claims of other creditors, including the holders of the Company's long-term debt. FDICIA provides that the appropriate federal regulatory agency must require an insured depository institution that (i) is significantly undercapitalized or (ii) is undercapitalized and either fails to submit an acceptable capital restoration plan within the time period allowed by regulation or fails in any material respect to implement a capital restoration plan accepted by the appropriate federal banking agency to take one or more of the following actions: (i) sell enough shares, including voting shares, to become adequately capitalized; (ii) merge with (or be sold to) another institution (or holding Company), but only if grounds exist for appointing a conservator or receiver; (iii) restrict certain transactions with banking affiliates as if the "sister bank" exception to the requirements of Section 23A of the Federal Reserve Act did not exist; (iv) otherwise restrict transactions with bank or non-bank affiliates; (v) restrict interest rates that the institution pays on deposits to "prevailing rates" in the institution's "region"; (vi) restrict asset growth or reduce total assets; (vii) alter, reduce or terminate activities; (viii) hold a new election of directors; (ix) dismiss any director or senior executive officer who held office for more than 180 days immediately before the institution became undercapitalized, provided that in requiring dismissal of a director or senior executive officer, the agency must comply with certain procedural requirements, including the opportunity for an appeal in which the director or officer will have the burden of proving his or her value to the institution; (x) employ "qualified" senior executive officers; (xi) cease accepting deposits from correspondent depository institutions; (xii) divest certain non-depository affiliates which pose a danger to the institution; (xiii) be divested by a parent holding Company; and (xiv) take any other action which the agency determines would better carry out the purposes of the prompt corrective action provisions. In addition to the foregoing sanctions, without the prior approval of the appropriate federal banking agency, a significantly undercapitalized institution may not pay any bonus to any senior executive officer or increase the rate of compensation for such an officer without regulatory approval. Furthermore, in the case of an undercapitalized institution that has failed to submit or implement an acceptable capital restoration plan, the appropriate federal banking agency cannot approve any such bonus. Not later than 90 days after an institution becomes critically undercapitalized, the appropriate federal banking agency for the institution must appoint a receiver or a conservator, unless the agency, with the concurrence of the FDIC, determines that the purposes of the prompt corrective action provisions would be better served by another course of action. Any alternative determination must be documented by the agency and reassessed on a periodic basis. Notwithstanding the foregoing, a receiver must be appointed after 270 days unless the FDIC determines that the institution has a positive net worth, is in compliance with a capital plan, is profitable or has a sustainable 10
11 upward trend in earnings and is reducing its ratio of non-performing loans to total loans and the head of the appropriate federal banking agency and the chairperson of the FDIC certify that the institution is viable and not expected to fail. The FDIC is required, by regulation or order, to restrict the activities of such critically undercapitalized institutions. The restrictions must include prohibitions on the institution's doing any of the following without prior FDIC approval: entering into any material transactions not in the usual course of business; extending credit for any highly leveraged transaction; engaging in any "covered transaction" (as defined in Section 23A of the Federal Reserve Act) with an affiliate; paying "excessive compensation or bonuses"; and paying interest on "new or renewed liabilities" that would increase the institution's average cost of funds to a level significantly exceeding prevailing rates in the market. Brokered Deposits A bank cannot accept brokered deposits (defined to include payment of an interest rate more than 75 basis points above prevailing rates) unless (i) it is well capitalized or (ii) it is adequately capitalized and receives a waiver from the FDIC. A bank that cannot receive brokered deposits also cannot offer "pass-through" insurance on certain employee benefit accounts unless certain specified procedures are followed. In addition, a bank that is "adequately capitalized" may not pay an interest rate on any deposits in excess of 75 basis points over certain prevailing market rates. There are no such restrictions on a bank that is "well capitalized." Federal Reserve Borrowings The FRB may not make advances to an undercapitalized institution for more than 60 days in any 120-day period without a viability certification by a federal banking agency or by the Chairman of the FRB after an examination by the FRB. If an institution is deemed critically undercapitalized, an extension of FRB credit cannot continue for more than five days without demand for payment unless the FRB is willing to accept responsibility for any resulting loss to the FDIC. As a practical matter, this provision is likely to mean that FRB credit will not be extended beyond the limitations in this provision. Potential Enforcement Actions; Supervisory Agreements Banks and their institution-affiliated parties may be subject to potential enforcement actions by the FRB, the FDIC or the Office of the Comptroller of the Currency (OCC) for unsafe or unsound practices in conducting their businesses, or for violations of any law, rule or regulation or provision, any consent order with any agency, any condition imposed in writing by the agency or any written agreement with the agency. Enforcement actions may include the imposition of a conservator or receiver, cease-and-desist orders and written agreements, the termination of insurance of deposits, the imposition of civil money penalties and removal and prohibition orders against institution-affiliated parties. Interstate Banking Interstate Banking and Branching. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (Riegle-Neal Act) authorizes interstate banking and interstate branching, subject to certain state options. - Interstate acquisition of banks became permissible in all states on and after September 29, 1995; state law cannot vary this rule. However, states may continue to prohibit acquisition of banks that have been in existence less than five years and interstate chartering of new banks. - Interstate mergers of affiliated or unaffiliated banks became permitted after June 1, 1997, unless a state adopted legislation before June 1, 1997 to "opt out" of interstate merger authority, provided any limitations do not discriminate against out-of-state banks. Only Texas opted out. - Interstate acquisitions of branches are permitted to a bank only if the law of the state where the branch is located expressly permits interstate acquisition of a branch without acquiring the entire bank. - Interstate de novo branching is permitted to a bank only if a state has adopted legislation to "opt in" to interstate de novo branching authority. 11
12 Limitations on Concentrations. An interstate banking application may not be approved if the applicant and its depository institution affiliates would control more than 10% of insured deposits nationwide or more than 30% of insured deposits in the state in which the bank to be acquired is located. These limits do not apply to mergers solely between affiliates. States may waive the 30% cap on a nondiscriminatory basis. Nondiscriminatory state caps on deposit market share of a depository institution and its affiliates are not affected by the regulation. Agency Authority. A bank subsidiary of a bank holding Company can be authorized to receive deposits, renew time deposits, close loans, service loans and receive payments on loans as an agent for a depository institution affiliate without being deemed a branch of the affiliate. Banks are not permitted to engage, as agent for an affiliate, in any activity as agent that it could not conduct as a principal, or to have an affiliate, as its agent, conduct any activity that it could not conduct directly, under federal or state law. Host State Regulation. The Riegle-Neal Amendments Act of 1997 amended federal law to provide that branches of state banks that operate in other states will be governed in most cases by the laws of the home state, rather than the laws of the host state. Exceptions are that a host state may apply its own laws of community reinvestment, consumer protection, fair lending and interstate branching. Host states cannot supplement or restrict powers granted by a bank's home state. The amendment will assure state-chartered banks with interstate branches uniform treatment in most areas of their operation. Community Reinvestment Act. Community Reinvestment Act (CRA) evaluations are required for each state in which an interstate bank has a branch. Interstate banks are prohibited from using out-of-state branches "primarily for the purpose of deposit production." Federal banking agencies have adopted regulations to ensure that interstate branches are being operated with a view to the needs of the host communities. Foreign Banks. Foreign banks are able to branch to the same extent as U.S. domestic banks. Interstate branches acquired by foreign banks are subject to the CRA to the extent the acquired branch was subject to the CRA before the acquisition. California Law: California has enacted state legislation in accordance with authority under the Riegle-Neal Act. This state law permits banks headquartered outside California to acquire or merge with California banks that have been in existence for at least five years, and thereby establish one or more California branch offices. An out-of-state bank may not enter California by acquiring one or more branches of a California bank or other operations constituting less than the whole bank. The law authorizes waiver of the 30% limit on state-wide market share for deposits as permitted by the Riegle-Neal Act. The law also authorizes California state-licensed banks to conduct certain banking activities (including receipt of deposits and loan payments and conducting loan closings) on an agency basis on behalf of out-of-state banks and to have out-of-state banks conduct similar agency activities on their behalf. Tie-in Arrangements and Transactions with Affiliated Persons A bank is prohibited from 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, a bank may not condition an extension of credit on a promise by its customer to obtain other services provided by it, its holding Company or other subsidiaries (if any), or on a promise by its customer not to obtain other services from a competitor. Directors, officers and principal shareholders of the Company, and the companies with which they are associated, may conduct banking transactions with the Company in the ordinary course of business. Any loans and commitments to loans included in such transactions must be made in accordance with applicable law, on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other persons of similar creditworthiness, and on terms not involving more than the normal risk of collectibility or presenting other unfavorable features. Community Reinvestment Act Pursuant to the Community Reinvestment Act of 1977, the federal regulatory agencies that oversee the banking industry are required to use their authority to encourage financial institutions to help meet the credit needs of the local communities in which such institutions are chartered, consistent with safe and sound banking practices. 12
13 When conducting an examination of a financial institution such as the Bank, the agencies assess the institution's record of meeting the credit needs of its entire community, including low- and moderate-income neighborhoods. This record is taken into account in an agency's evaluation of an application for creation or relocation of domestic branches or for merger with another institution. Failure to address the credit needs of a bank's community may also result in the imposition of certain other regulatory sanctions, including a requirement that corrective action be taken. The federal banking agencies determine a bank's CRA rating by evaluating its performance on lending, service, and investment tests, with the lending test as the most important. The tests are to be applied in an "assessment context" that is developed by the agency for a particular institution. The assessment context takes into account demographic data about the community, the community's characteristics and needs, the institution's capacities and constraints, the institution's product offerings and business strategy, the institution's prior performance, and data on similarly situated lenders. Since the assessment context is developed by the regulatory agencies, a particular bank will not know until it is examined whether its CRA programs and efforts have been sufficient. Larger institutions are required to compile and report certain data on their lending activities in order to measure performance. Some of this data is also required under other laws, such as the Equal Credit Opportunity Act. Small institutions (those institutions with less than $250 million in assets) are now being examined on a "streamlined assessment method." The streamlined method focuses on the institution's loan to deposit ratio, degree of local lending, record of lending to borrowers and neighborhoods of differing income levels, and record of responding to complaints. Large and small institutions have the option of being evaluated for CRA purposes in relation to their own pre-approved strategic plan. Such a strategic plan must be submitted to the institution's regulator three months before its effective date and be published for public comment. Environmental Regulation Federal, state, and local regulations regarding the discharge of materials into the environment may have an impact on the Company. Under federal law, liability for environmental damage and the cost of cleanup may be imposed on any person or entity who is an owner or operator of contaminated property. State law provisions impose substantially similar requirements. Both federal and state laws provide generally that a lender who is not actively involved in contaminating a property will not be liable to clean up the property, even if the lender has a security interest in the property or becomes an owner of the property through foreclosure, provided certain conditions are observed. The Economic Growth Act includes protection for lenders from liability under the Comprehensive Environmental Response, Compensation, and Liability Act of 1980. The Economic Growth Act specifies the actions a lender may take with respect to lending and foreclosure activities without incurring environmental cleanup liability or responsibility. Typical contractual provisions regarding environmental issues in the loan documentation and due diligence inspections will not lead to lender liability for cleanup, and a lender may foreclose on contaminated property, so long as it merely maintains the property and moves to divest it at the earliest possible time. Under California law, a lender generally will not be liable to the State for the cost associated with cleaning up contaminated property unless the lender realized some benefit from the property, failed to divest the property promptly, caused or contributed to the release of the hazardous materials, or made the loan primarily for purposes of investing in the property. The extent of the protection provided by both the federal and state lender protection statutes depend on their interpretation by administrative agencies and courts. The Company cannot predict whether it will be adequately protected for the types of loans made by it. In addition, the Company is still subject to the risks that a borrower's financial position will be impaired by liability under the environmental laws and that property securing a loan made by the Company may be environmentally impaired and not provide adequate security for the Company. The Company attempts to protect its position against environmental risks by performing prudent due diligence. Environmental questionnaires and information on the use of toxic substances are requested as part of its underwriting procedures. The Company lends based on its evaluation of the collateral, net worth of the borrower, and the borrower's capacity for unforeseen business interruptions or risks. 13
14 Limitation on Activities FDICIA prohibits state chartered-banks and their subsidiaries from engaging, as principal, in activities not permissible by national banks and their subsidiaries, unless the bank's primary federal regulator determines the activity poses no significant risk to the BIF and the state bank is and continues to be adequately capitalized. Similarly, state bank subsidiaries may not engage, as principal, in activities impermissible by subsidiaries of national banks. This prohibition extends to acquiring or retaining any investment, including those that would otherwise be permissible under California law. The State Bank Parity Act, eliminates certain disparities between California state chartered banks and federally chartered national banks by authorizing the Commissioner to address such disparities through a streamlined rulemaking process. The Commissioner has taken action pursuant to the Parity Act to authorize, among other matters, previously impermissible share repurchases by state banks, subject to the prior approval of the Commissioner. In November 1996, the OCC issued final regulations permitting national banks to engage in a wider range of activities through subsidiaries. "Eligible institutions" (those national banks that are well-capitalized, have a high overall rating and a satisfactory CRA rating, and are not subject to an enforcement order) may engage in activities related to banking through operating subsidiaries after going through a new expedited application process. In addition, the new regulations include a provision whereby a national bank may apply to the OCC to engage in an activity through a subsidiary in which the bank itself may not engage. In determining whether to permit the subsidiary to engage in the activity, the OCC will evaluate why the bank itself is not permitted to engage in the activity and whether a Congressional purpose will be frustrated if the OCC permits the subsidiary to engage in the activity. The State Bank Parity Act may permit state-licensed banks to engage in similar new activities, subject to the discretion of the Commissioner. State Bank Sales of Non-Deposit Investment and Insurance Products Securities activities of state non-member banks, as well as the activities of their subsidiaries and affiliates, are governed by guidelines and regulations issued by the securities and financial institution regulatory agencies. These agencies have taken the position that bank sales of alternative investment products, such as mutual funds and annuities, raise substantial bank safety and soundness concerns involving consumer confusion over the nature of the products offered, as well as the potential for mismanagement of sales programs which could expose a bank to liability under the antifraud provisions of federal securities laws. Accordingly, the agencies have issued guidelines that require, among other things, the establishment of a compliance and audit program to monitor a bank's mutual funds sales activities and its compliance with applicable federal securities laws; the provision of full disclosures to customers about the risks of such investments, including the possible loss of the customer's principal investment; and the conduct of securities activities of bank subsidiaries or affiliates in separate and distinct locations. In addition, the guidelines prohibit bank employees involved in deposit-taking activities from selling investment products or giving investment advice. Banks are also required to establish a qualitative standard for the selection and marketing of the investments offered by the bank, and to maintain appropriate documentation regarding the suitability of investments recommended to bank customers. California state-licensed banks have authority to engage in the insurance business as an agent or broker, but not as an insurance underwriter. Change in Senior Executives or Board Members Certain banks and bank holding companies are required to file a notice with their primary regulator prior to (i) adding or replacing a member of the board of directors, or (ii) the employment of or a change in the responsibilities of a senior executive officer. Notice is required if the bank or holding Company is failing to meet its minimum capital standards or is otherwise in a "troubled condition", as defined in FDIC regulations, has undergone a change in control within the past two years, or has received its bank charter within the past two years. 14
15 Impact of Economic Conditions and Monetary Policies The earnings and growth of the Company will be affected by general economic conditions, both domestic and international, and by the monetary and fiscal policies of the United States Government and its agencies, particularly the FRB. One function of the FRB is to regulate the national supply of bank credit in order to mitigate recessionary and inflationary pressures. Among the instruments of monetary policy used to implement those objectives are open market transactions in United States Government securities, changes in the discount rate on member bank borrowings and changes in reserve requirements held by depository institutions. The monetary policies of the FRB have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future. However, the effect, if any, of such policies on the future business and earnings of the Company cannot be accurately predicted. Legislation and Proposed Changes 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 agencies. Typically, the intent of such legislation is to strengthen the banking industry, even if it may on occasion prove a burden on management's plans. No prediction can be made as to the likelihood of any major changes or the impact such changes might have on the Company. EMPLOYEES At December 31, 2000, the Company employed 216 persons, primarily on a full-time basis. The Company's employees are not represented by any union or collective bargaining agreement and the Company believes its employee relations are satisfactory. 15
16 ITEM 2 - PROPERTIES HBC's main and executive offices and the Company's offices are located at 150 Almaden Boulevard, San Jose, California 95113. HBEB is located at 3077 Stevenson Blvd., Fremont, California 94538. HBSV is located at 18625 Sutter Blvd., Morgan Hill, California 95037. BLA's main office is located at 4546 El Camino Real, Los Altos, California 94022. The main office at 150 Almaden Boulevard, San Jose, California, is leased under a non-cancelable operating lease with a non-affiliated third party with terms, including renewal options, ranging from 5 to 14 years. The primary operating area consists of approximately 13,500 square feet of space comprising the entire usable ground floor and a portion of the second floor of a 15-story class-A office building in downtown San Jose. This space also serves as the main office of HBC. The lease arrangement for the primary operating area is a "partial gross lease" for 15 years commencing June 8, 1996 and expiring February 28, 2010. The monthly rent under the lease for the first five-year term is $21,465. During the second five-year term the monthly rent increases to $25,515 and will increase to 95 percent of fair rental value starting from year eleven until the term expires. Provisions of the lease include the right to early termination after 120 months. In addition, the Company leased approximately 1,255 square feet of space contiguous to the primary operating area for meetings, staff training and marketing events. The lease for this additional space commenced January 1, 1997 and expires December 31, 2001. The monthly rent for this additional space is $2,259. In August 1997, the Company leased an area on the second floor of Heritage's main office containing approximately 2,175 square feet of space. The monthly rent is $4,024 until May 31, 2001, when the monthly rent will increase to $4,785 for the following five-year period. The rent for the period from May 31, 2006 until the end of the lease will be 95 percent of fair rental value at that time. The lease for this additional space is coterminous with the original lease. In June of 1998, the Company leased space at 100 Park Center Plaza, Suite 300, consisting of approximately 5,623 square feet of space. The rent started at $11,527 for the first year and ends at $12,651 in the last year of the lease. The lease will terminate on May 31, 2003. In February 1998, Heritage leased space for HBEB's primary office at 3077 Stevenson Blvd., Fremont, California, consisting of 6,590 square feet of space in a stand-alone office building. The lease, which commenced February 1, 1998, is for a ten-year period expiring January 2008. The rent for the first twelve-month period is $13,180 per month, and the rent increases annually thereafter by 4%. Also in March of 1999, the Company entered into an agreement to lease 7,260 square feet of office space for HBSV's primary office in a one-story building consisting of 26,353 square feet, located at 18625 Sutter Boulevard in Morgan Hill, California. The commencement date of the lease was November 1, 1999 with monthly rent payments beginning at $11,447, subject to adjustments every 36 months thereafter based on the percentage increase in the consumer price index as defined in the lease agreement. The term of the lease is 15 years, expiring on October 31, 2014. In September of 1999, the Company entered into an agreement to sublease approximately 2,700 square feet of office space in a one-story multi-tenant building located at 310 Hartz Avenue in Danville, California in order to relocate HBEB's San Ramon office. The commencement date of the sublease was September 15, 1999, with monthly rent payments beginning at $7,025, subject to annual increases of 4%. The term of the sublease is approximately 7 1/2 years, expiring on December 31, 2007. In April of 2000, the Company leased the third floor of 150 Almaden Boulevard, San Jose, California consisting of 12,824 square feet. The lease will expire on February 28, 2010, coterminous with the lease for the main office. Rent payments, which will begin in October of 2000, will be $42,319 per months, subject to annual increase of 3%. The main office for Bank of Los Altos is located at 4546 El Camino Real, Los Altos, California. The Bank executed the lease of approximately 7,900 square feet of space in April 1995, to expire in April 2005, with options to renew at that time. The lease calls for annual consumer price index adjustments between 2% and 5%. Current monthly rent at this facility is $14,723. 16
17 Bank of Los Altos owns a two-story, 2,800 square feet office building near downtown Los Altos, California, at 477 S. San Antonio Road. The building was sold in December 2000. The San Antonio branch of BLA is located at 369 S. San Antonio Road, Los Altos, California. The lease covers approximately 3,500 square feet and has a ten year term from October 1998 through September 2008, with options to renew available at that time. Current monthly rent is $13,665 and increases 4% each year. The Mountain View branch of BLA is located at 175 El Camino Real, Mountain View, California. The lease is for approximately 4,800 square feet and has a ten year term from August 1998 through July 2008, with options to renew available at that time. The lease calls for annual consumer price index adjustments between 3% and 6%. Current monthly rent is $11,297. Refer to Note 10 of the Company's Consolidated Financial Statements, beginning on page F-1 of this Report on Form 10-K, for additional information on rent expense. ITEM 3 - LEGAL PROCEEDINGS In 1992 and for a period prior thereto, a former officer and director of Bank of Los Altos served as a director of Pacific National Financial Company (PNFC), a Canadian corporation, when a PNFC subsidiary was Bank of Los Altos's parent company. In December 1998, Bank of Los Altos received a request for indemnity from the former officer under an indemnity agreement entered into by Bank of Los Altos in December 1992. The request for indemnity relates to three complaints filed in July 1998 naming the former officer and seven other former directors of PNFC and seeks damages of $166 million ($Canadian 240 million) arising from their role as PNFC directors. The largest of the three actions alleges that the defendants breached their fiduciary duties to PNFC, resulting in its 1992 bankruptcy. The former officer has requested that Bank of Los Altos pay for his defense and indemnify him in connection with such actions. Although Bank of Los Altos has reserved its rights under the indemnity agreement, it has conditionally agreed to be responsible for payment of the former officer's defense costs. Following service of the complaints in December, 1998, Bank of Los Altos has been informed by counsel that there has been no effort to prosecute the cases by the plaintiffs or any communications from plaintiffs stating an intent to proceed with the litigation. Based on the representations of the former officer and discussions with legal counsel, management and the Board of Directors of the Company and Bank of Los Altos have no reason to believe that the indemnification will result in any material effect on the financial statements of the Company. ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There was no submission of matters to a vote of security holders during the fourth quarter of the year ended December 31, 2000. 17
18 PART II ITEM 5 - MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's Common Stock is listed on the Nasdaq National Market under the symbol "HTBK." Everen Securities, Hoefer & Arnett, Incorporated, Sutro & Co., Incorporated and Van Kasper & Company have acted as market makers for the Common Stock. These market makers have committed to make a market for the Company's Common Stock, although they may discontinue making a market at any time. No assurance can be given that an active trading market will be sustained for the Common Stock at any time in the future. The information in the following table for 2000 and 1999 indicates the high and low bid prices for the Common Stock, based upon information provided by the Nasdaq National Market as restated on a historical basis to reflect the merger with Western Holdings Bancorp, which closed in October 2000 as a pooling of interests as if the Companies had been combined for all periods presented. These quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions. <TABLE> <CAPTION> HIGH LOW -------------------- <S> <C> <C> 2000 Fourth Quarter $10.25 $ 8.75 Third Quarter 11.34 10.14 Second Quarter 11.66 9.98 First Quarter 13.40 10.83 1999 Fourth Quarter $13.07 $10.99 Third Quarter 12.65 10.64 Second Quarter 14.99 8.67 First Quarter 16.05 10.66 </TABLE> Listed amounts are adjusted to reflect (i) a 3-for-2 stock split paid on February 19, 1999 to shareholders of record as of February 5, 1999, and (ii) a 10 percent stock dividend which was paid on February 21, 2000 to shareholders of record as of February 7, 2000. HBC's stock was exchanged on a share for share basis with the stock of the Company following the formation of the Company as the bank holding Company for HBC in February 1998. As of February 15, 2001, there were approximately 1,100 holders of Common Stock. DIVIDENDS Under California law, the holders of common stock of a bank are entitled to receive dividends when and as declared by the Board of Directors, out of funds legally available therefor. The California Banking Law provides that a state-licensed bank may not make a cash distribution to its shareholders in excess of the lesser of the following: (i) the bank's retained earnings, or (ii) the bank's net income for its last three fiscal years, less the amount of any distributions made by the bank to its shareholders during such period. However, a bank, with the prior approval of the Commissioner of the Department of Financial Institutions ("Commissioner"), may make a distribution to its shareholders of an amount not to exceed the greater of (i) a bank's retained earnings, (ii) its net income for its last fiscal year, or (iii) its net income for the current fiscal year. In the event that the Commissioner determines that the shareholders' equity of a bank is inadequate or that the making of a distribution by a bank would be unsafe or unsound, the Commissioner may order a bank to refrain from making such a proposed distribution. The FDIC and the Commissioner have authority to prohibit a bank from engaging in business practices that are considered to be unsafe or unsound. Depending upon the financial condition of a bank and upon other factors, the FDIC or the Commissioner could assert that payments of dividends or other payments by a bank might be such an unsafe or unsound practice. The FRB has similar authority with respect to a bank holding Company. 18
19 For regulatory restrictions on payment of dividends by the Company, see Item 1- "BUSINESS - Regulation and Supervision - Limitations on Dividends." HBC paid a cash dividend to the Company in 1998. To date, the Company has not paid cash dividends. It is the current policy of the Company to retain earnings to increase its capital to support growth. Payment of cash dividends in the future will depend upon the Company's earnings and financial condition and other factors deemed relevant by management. Accordingly, it is likely that no cash dividends from the Company will be paid in the foreseeable future. In January 1999, the Company's Board of Directors declared a 3 for 2 stock split payable to shareholders of record as of February 5, 1999. The Company accounted for the transaction by restating all share information to reflect the effect of the split. The payable date of the split was February 19, 1999. In January 20, 2000, the Company's Board of Directors declared a 10% stock dividend payable to shareholders of record as of February 7, 2000. The payable date of the dividend was February 21, 2000. The Company accounted for the transaction by decreasing retained earnings and increasing the common equity by an amount equal to the fair value of the additional shares issued which was $9,272,000 based on the closing price of $14.50 per share as of January 20, 2000. MANDATORILY REDEEMABLE CUMULATIVE TRUST PREFERRED SECURITIES OF SUBSIDIARY GRANTOR TRUST Heritage Capital Trust I Heritage Capital Trust I is a Delaware business trust formed by Heritage Commerce Corp for the purpose of issuing Company obligated mandatorily redeemable cumulative trust preferred securities. During the first quarter of 2000, Heritage Capital Trust I issued 7,000 Trust Preferred Securities with a liquidation value of $1,000 per security to the Company for gross proceeds of $7,000,000. The entire proceeds of the issuance were invested by Heritage Capital Trust I in $7,000,000 aggregate principal amount of 10.875% subordinated debentures due 2030 (the Subordinated Debentures) issued by the Company. The Subordinated Debentures represent the sole assets of Heritage Capital Trust I. The Subordinated Debentures mature on March 8, 2030, bear interest at the rate of 10.875%, payable semi-annually, and are redeemable by the Company at a premium beginning on or after March 8, 2010 based on a percentage of the principal amount of the Subordinated Debentures as stipulated in the Indenture Agreement, plus any accrued and unpaid interest to the redemption date. The Subordinated Debentures are redeemable at 100 percent of the principal amount plus any accrued and unpaid interest to the redemption date at any time on or after March 8, 2020. The Trust Preferred Securities are subject to mandatory redemption to the extent of any early redemption of the Subordinated Debentures and upon maturity of the Subordinated Debentures on March 8, 2030. The Subordinated Debentures bear the same terms and interest rates as the Trust Preferred Securities. Holders of the trust preferred securities are entitled to cumulative cash distributions at an annual rate of 10 7/8 % of the liquidation amount of $1,000 per security. The Company has the option to defer payment of the distributions for a period of up to five years, as long as the Company is not in default in the payment of interest on the Subordinated Debentures. The Company has guaranteed, on a subordinated basis, distributions and other payments due on the trust preferred securities (the Guarantee). The Guarantee, when taken together with the Company's obligations under the Subordinated Debentures, the Indenture Agreement pursuant to which the Subordinated Debentures were issued and the Company's obligations under the Trust Agreement governing the subsidiary trust, provide a full and unconditional guarantee of amounts due on the Trust Preferred Securities. 19
20 Heritage Statutory Trust I Heritage Capital Statutory Trust I is a Delaware business trust formed by Heritage Commerce Corp for the purpose of issuing Company obligated mandatorily redeemable cumulative trust preferred securities. During the third quarter of 2000, Heritage Capital Statutory Trust I issued 7,000 Trust Preferred Securities with a liquidation value of $1,000 per security to the Company for gross proceeds of $7,000,000. The entire proceeds of the issuance were invested by Heritage Capital Statutory Trust I in $7,000,000 aggregate principal amount of 10.60% subordinated debentures due 2030 (the Subordinated Debentures) issued by the Company. The Subordinated Debentures represent the sole assets of Heritage Capital Statutory Trust I. The Subordinated Debentures mature on September 7, 2030, bear interest at the rate of 10.60%, payable semi-annually, and are redeemable by the Company at a premium beginning on or after September 7, 2010 based on a percentage of the principal amount of the Subordinated Debentures as stipulated in the Indenture Agreement, plus any accrued and unpaid interest to the redemption date. The Subordinated Debentures are redeemable at 100 percent of the principal amount plus any accrued and unpaid interest to the redemption date at any time on or after September 7, 2020. The Trust Preferred Securities are subject to mandatory redemption to the extent of any early redemption of the Subordinated Debentures and upon maturity of the Subordinated Debentures on September 7, 2030. The Subordinated Debentures bear the same terms and interest rates as the Trust Preferred Securities. Holders of the trust preferred securities are entitled to cumulative cash distributions at an annual rate of 10.60 % of the liquidation amount of $1,000 per security. The Company has the option to defer payment of the distributions for a period of up to five years, as long as the Company is not in default in the payment of interest on the Subordinated Debentures. The Company has guaranteed, on a subordinated basis, distributions and other payments due on the trust preferred securities (the Guarantee). The Guarantee, when taken together with the Company's obligations under the Subordinated Debentures, the Indenture Agreement pursuant to which the Subordinated Debentures were issued and the Company's obligations under the Trust Agreement governing the subsidiary trust, provide a full and unconditional guarantee of amounts due on the Trust Preferred Securities. For financial reporting purpose, the Subordinated Debentures and related trust investments in the Subordinated Debentures have been eliminated in consolidation and the Trust Preferred Securities are included in the consolidated balance sheet. Under applicable regulatory guidelines all of the Trust Preferred Securities currently qualify as Tier I capital. 20
21 ITEM 6 - SELECTED FINANCIAL DATA The following table presents a summary of selected financial information that should be read in conjunction with the Company's consolidated financial statements and notes thereto included under Item 8 - "FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA." SELECTED FINANCIAL DATA(1) <TABLE> <CAPTION> AT AND FOR YEAR ENDED DECEMBER 31, - ------------------------------------------------------------------------------------------------------------------------------- (Dollars in thousands, except per share amounts and ratios) 2000 1999 1998 1997 1996 - ------------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> INCOME STATEMENT DATA: Interest income $ 67,921 $ 45,418 $ 38,193 $ 24,533 $ 16,552 Interest expense 25,101 15,398 12,048 7,071 4,954 ----------- ------------ ----------- ----------- ------------ Net interest income before provision for probable loan losses 42,820 30,020 26,145 17,462 11,598 Provision for probable loan losses 3,159 2,198 1,806 1,330 830 ----------- ------------ ----------- ----------- ------------ Net interest income after provision for probable loan losses 39,661 27,822 24,339 16,132 10,768 Non interest income 2,877 6,051 3,178 2,129 1,904 Non interest expenses 34,060 26,598 21,744 14,202 10,337 ----------- ------------ ----------- ----------- ------------ Income before income taxes 8,478 7,275 5,773 4,059 2,335 Provision for income taxes 3,049 2,606 2,267 1,224 221 ----------- ------------ ----------- ----------- ------------ Net income $ 5,429 $ 4,669 $ 3,506 $ 2,835 $ 2,114 ============ ============ ============ ============ ============= PER SHARE DATA(2): Basic net income(3) $ 0.51 $ 0.47 $ 0.39 $ 0.34 $ 0.27 Diluted net income(4) $ 0.49 $ 0.43 $ 0.35 $ 0.31 $ 0.24 Book value(5) $ 6.01 $ 5.45 $ 4.45 $ 3.74 $ 3.49 Weighted average number of shares outstanding - basic 10,607,584 9,885,036 8,990,769 8,399,174 7,773,121 Weighted average number of shares outstanding - diluted 11,108,329 10,922,977 9,916,907 9,185,147 8,724,335 Shares outstanding at period end 10,939,124 9,737,739 9,433,773 8,406,121 8,133,542 BALANCE SHEET DATA: Investment securities $ 110,802 $ 74,819 $ 127,217 $ 118,988 $ 102,504 Net loans 601,130 394,729 332,862 194,076 124,254 Allowance for probable loan losses 9,651 6,511 5,069 3,270 2,180 Total assets 846,224 677,233 581,404 394,122 261,948 Total deposits 738,186 601,420 509,916 355,728 225,652 Other borrowed funds 18,000 12,000 22,500 3,500 --- Trust Preferred securities 14,000 --- --- --- --- Total shareholders' equity 65,733 56,544 41,991 31,474 28,392 SELECTED PERFORMANCE RATIOS: Return on average assets(6) 0.70% 0.79% 0.74% 0.91% 0.94% Return on average equity 9.07% 9.68% 9.60% 9.58% 8.76% Net interest margin 5.95% 5.56% 6.03% 6.10% 5.71% Average net loans as a percentage of average deposits 75.44% 71.88% 62.35% 58.28% 49.57% Average total shareholders' equity as a percentage of average total assets 7.69% 8.15% 7.68% 9.46% 10.76% SELECTED ASSET QUALITY RATIOS(7): Net loan charge-offs to average loans ---% 0.20% ---% 0.14% 0.04% Allowance for loan losses to total loans 1.58% 1.62% 1.50% 1.66% 1.75% CAPITAL RATIOS(8): Tier 1 risk-based 10.5% 11.3% 9.4% 13.4% 18.5% Total risk-based 11.7% 12.5% 10.5% 14.7% 19.8% Leverage 9.3% 8.5% 7.3% 8.3% 10.7% </TABLE> 21
22 Notes: 1) All amounts have been restated on a historical basis to reflect the merger with Western Holdings Bancorp, which closed in October 2000, as a pooling of interests as if the Companies had been combined for all periods presented. 2) All share figures are adjusted to reflect (i) a 10% stock dividend paid to shareholders of record as of February 5, 1996; (ii) a 5% stock dividend paid to shareholders of record as of February 5, 1997; (iii) a 3-for-2 stock split paid to shareholders of record as of August 1, 1997; (iv) a 3-for-2 stock split paid to shareholders of record as of February 5, 1999; (v) a 10% stock dividend paid to shareholders of record as of February 7, 2000. 3) Represents net income divided by the average number of shares of common stock outstanding for the respective period. 4) Represents net income divided by the average number of shares of common stock and common stock-equivalents outstanding for the respective period. 5) Represents shareholders' equity divided by the number of shares of common stock outstanding at the end of the period indicated. 6) Average balances used in this table and throughout this Annual Report are based on daily averages. 7) Nonperforming assets consist of nonaccrual loans, loans past due 90 days or more, restructured loans, and other real estate owned. As of December 31, 2000, the Company had no nonperforming assets. As of December 31, 1999, the Company had $1,402,000 in nonperforming assets. As of December 31, 1998, the Company had $1,354,000 in nonperforming assets. As of December 31, 1997 and 1996, the Company had no nonperforming assets. 8) The Risk-Based and Leverage Capital ratios are defined in Item 1 - "BUSINESS - Supervision And Regulation - Capital Adequacy Guidelines." 22
23 ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Certain matters discussed or incorporated by reference in this Annual Report on Form 10-K including, but not limited to matters described in this section are forward looking statements that are subject to risks and uncertainties that could cause actual results to differ materially from those projected. RESULTS OF OPERATIONS OVERVIEW On January 20, 2000, the Company's Board of Directors declared a 10% stock dividend payable to shareholders of record on February 7, 2000. On January 27, 1999, the Company's Board of Directors declared a 3-for-2 stock split effective for shareholders of record on February 5, 1999. All outstanding and weighted average share amounts presented in this report have been restated to give effect to this activity. In addition, all amounts have been restated on a historical basis to reflect the merger with Western Holdings Bancorp and its wholly owned subsidiary, Bank of Los Altos, which closed in October 2000, as a pooling of interests as if the Companies had been combined for all periods presented. For the year ended December 31, 2000, consolidated net income was $5,429,000, or $0.49 per diluted share compared to $4,669,000, or $0.43 per diluted share and $3,506,000, or $0.35 per diluted share for the years ended December 31, 1999 and 1998, respectively. For the year ended December 31, 2000, consolidated net income, excluding merger-related costs of $2,026,000, net of tax, was $7,455,000, or $0.67 per diluted share. Costs associated with acquisition of Western Holdings Bancorp primarily included professional fees, costs of regulatory filings, payments under certain change of control provisions, and systems conversion expenses. The increase in 2000 over 1999 was primarily a result of the growth in the level of earning assets, funded by new deposits as well as to improvements in the Company's mix of earning assets in favor of higher yielding assets, such as loans. The increase in 1999 over 1998 was primarily attributable to the sale of the Internet credit card business and the mix and the growth in earning assets funded by new deposits at favorable rates. Average interest earning assets for 2000 were up 32% over 1999. The increase was primarily attributable to growth in loans, which had higher yields than other interest earning assets. As a result, the average rate on interest earning assets increased to 9.43% in 2000, up from 8.40% in 1999 and 8.80% in 1998. Average interest bearing liabilities for 2000 were also up 33% over 1999, with the increase primarily attributable to growth in interest bearing demand deposits, savings, and money market accounts and time deposits. The Company's average rate paid on interest bearing liabilities increased to 4.75% in 2000, up from 3.88% in 1999 and 3.96% in 1998. As a result, net interest margin was 5.95% in 2000, compared to 5.56% in 1999 and 6.03% in 1998. Total noninterest income was $2,877,000 in 2000, compared to $6,051,000 in 1999, and $3,163,000 in 1998. Noninterest income in 2000 included $716,000 in service charges and other fees, and a $778,000 increase in the value of Corporate Owned Life Insurance. Noninterest income in 1999 included $1,576,000 in revenue from the origination of credit cards for an unaffiliated financial institution, and a $969,000 gain on sale of securities. The credit card origination agreement terminated in 1999 and was not renewed. The Company, as a policyholder of a life assurance company, received a one-time pre-tax gain of $530,000 in 1999 as a result of the demutualization of that company. Total noninterest expense was $34,060,000 in 2000, compared to $26,598,000 in 1999, and $21,744,000 in 1998. The increase in 2000 over 1999 was primarily in salaries and benefits, up 21%, as a result of the payment of severance costs related to a change in management and an increase in the number of employees to support the growth of the Company. The Company also incurred $3,164,000 of merger-related costs in 2000 associated with the merger with Western Holdings Bancorp. 23
24 Total assets as of December 31, 2000 were $846,224,00, an increase of $168,991,000, or 25%, from $677,233,000 as of December 31, 1999. Total deposits as of December 31, 2000 were $738,186,000, an increase of $136,766,000, or 23%, from $601,420,000 as of December 31, 1999. Total portfolio loans as of December 31, 2000 were $610,781,000, an increase of $209,541,0000, or 52%, compared to $401,240,000 as of December 31, 1999. The Company's allowance for probable loan losses was $9,651,000, or 1.58%, of total loans as of December 31, 2000. This compares with an allowance for probable loan losses of $6,511,000, or 1.62%, of total loans at December 31, 1999. As of December 31, 2000, non-performing assets, comprised of nonaccrual loans, loans past due 90 days or more and still accruing, troubled debt restructuring and other real estate owned, were zero, compared to $1,402,000 as of December 31, 1999 and $1,354,000 as of December 31, 1998. The Company's shareholders' equity at December 31, 2000 was $65,733,000, compared with $56,544,000 as of December 31, 1999, a 16% increase, which reflects net earnings in 2000, the exercise of stock options and the change in the unrealized gain/loss on securities available-for-sale. Book value per share was $6.01 as of December 31, 2000, compared to $5.45 as of December 31, 1999. The Company's leverage capital ratio increased to 9.3% at December 31, 2000, primarily due to the growth in the Company and the additional Tier I capital from the $14.0 million of trust preferred securities issued in 2000, from 8.5% at December 31, 1999 and 7.3% at December 31, 1998. Return on average equity for the year ended December 31, 2000 was 9.07%, compared to 9.68% for 1999 and 9.60% for 1998. The decrease in 2000 from 1999 was due to the effect of the $2.0 million in merger-related costs, net of tax, for the merger with Western Holdings Bancorp in 2000. The increase in 1999 over 1998 was the result of the increased earnings offset by the increase in average equity of $11,631,000 primarily as a result of the stock offering completed in 1999. Return on average assets in 2000 decreased to 0.70% from 0.79% in 1999. Return on average assets was 0.74% in 1998. NET INTEREST INCOME AND NET INTEREST MARGIN The following table presents the average amounts outstanding for the major categories of the Company's balance sheet, the average interest rates earned or paid thereon, and the resulting net yield on average interest earning assets for the periods indicated. Average balances are based on daily averages. <TABLE> <CAPTION> Year Ended December 31, ------------------------------------------------------------------------------------------------ 2000 1999 1998 ------------------------------------------------------------------------------------------------ Interest Average Interest Average Interest Average Average Income/ Yield/ Average Income/ Yield/ Average Income/ Yield/ (Dollars in thousands) Balance Expense Rate Balance Expense Rate Balance Expense Rate - ----------------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> <C> <C> <C> ASSETS: Loans, gross(1) $537,317 $ 56,709 10.55% $380,686 $ 36,742 9.66% $270,410 $ 28,625 10.59% Investment securities(2) 102,541 6,254 6.10% 93,271 5,305 5.69% 132,224 7,954 6.02% Federal funds sold 80,073 4,958 6.19% 66,937 3,371 5.04% 31,263 1,614 5.16% -------- -------- -------- -------- -------- -------- Total interest earning assets $719,931 $ 67,921 9.43% $540,894 $ 45,418 8.40% $433,897 $ 38,193 8.80% -------- -------- -------- -------- -------- -------- Cash and due from banks 35,429 25,520 27,554 Premises and equipment, net 6,803 6,723 5,665 Other assets 17,026 18,864 8,375 -------- -------- -------- Total assets $779,189 $592,001 $475,491 ======== ======== ======== LIABILITIES AND SHAREHOLDERS' EQUITY: Deposits: Demand, interest bearing $ 55,616 $ 1,014 1.82% $ 39,996 $ 717 1.79% $ 27,628 $ 610 2.21% Savings and money-market 228,336 9,496 4.16% 186,112 6,107 3.28% 165,437 5,644 3.41% Time deposits, under $100,000 73,058 4,273 5.85% 58,423 2,969 5.08% 33,154 1,762 5.32% Time deposits, $100,000 and over 151,275 8,701 5.75% 86,963 4,201 4.83% 67,646 3,444 5.09% Brokered deposits 10,544 690 6.55% 8,812 508 5.76% 3,826 225 5.88% Other borrowings 9,617 927 9.64% 16,893 896 5.30% 6,836 363 5.31% -------- -------- -------- -------- -------- -------- Total interest bearing liabilities $528,446 $ 25,101 4.75% $397,199 $ 15,398 3.88% $304,527 $ 12,048 3.96% -------- -------- -------- -------- -------- -------- Demand deposits 183,422 141,250 129,445 Other liabilities 7,433 5,295 4,988 -------- -------- -------- Total liabilities 719,301 543,744 438,960 Shareholders' equity 59,888 48,257 36,531 -------- -------- -------- Total liabilities and shareholders' equity $779,189 $592,001 $475,491 ======== ======== ======== Net interest income / margin $ 42,820 5.95% $ 30,020 5.56% $ 26,145 6.03% ======== ======== ======== </TABLE> 24
25 (1) Yields and amounts earned on loans include loan fees of $4,065,000, $2,819,000 and $2,074,000 for the years ended December 31, 2000, 1999, and 1998. Nonaccrual loans of zero, $1,402,000 and $1,354,000 for the years ended December 31, 2000, 1999 and 1998 are included in the average balance calculations above. (2) Interest income is reflected on an actual basis, not a fully taxable equivalent basis and does not include a fair value adjustment. Net interest income for the year ended December 31, 2000 was $42,820,000, an increase of $12,800,000, or 43%, over the $30,020,000 reported for 1999. Net interest income for 1999 increased $3,875,000, or 15%, over the $26,145,000 reported for 1998. The increase in 2000 over 1999 occurred primarily as a result of growth in the Company's earning assets augmented by the overall increase in yields on earning assets, funded by the increases in demand, savings, and time deposits. The Company's average interest earning assets were $719,932,000 in 2000, up $179,038,000, or 33%, from the average $540,894,000 for 1999. The increase in 1999 over 1998 was primarily a result of the growth that occurred in earning assets offset by the decrease in yields, primarily on loans. The Company's average interest earning assets were up $106,997,000, or 25%, in 1999 from the average of $433,897,000 for 1998. The net yield on interest earning assets in 2000 was 9.43%, compared to 8.40% in 1999, and 8.80% in 1998. The following tables show the changes in interest income resulting from changes in the volume of interest earning assets and interest-bearing liabilities and changes in the average rates earned and paid. The total change is shown in the column designated "Net Change" and is allocated in the columns to the left, for the portions attributable to volume changes and rate changes that occurred during the period indicated. Changes due to both volume and rate have been allocated to the change in volume. <TABLE> <CAPTION> Years Ended December 31, 2000 versus 1999 1999 versus 1998 ---------------------------------------------------------------------------- Increase (Decrease) Due to Change In: Increase (Decrease) Due to Change In: Average Average Net Average Average Net (Dollars in thousands) Volume Rate Change Volume Rate Change - ---------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> INTEREST EARNING ASSETS: Loans, gross $ 16,531 $ 3,436 $ 19,967 $ 10,643 $ (2,526) $ 8,117 Investment securities 565 384 949 (2,216) (433) (2,649) Federal funds sold 813 774 1,587 1,797 (40) 1,757 - ---------------------------------------------------------------------------------------------------------------- Total interest earning assets $ 17,909 $ 4,594 $ 22,503 $ 10,224 $ (2,999) $ 7,225 ================================================================================================================ INTEREST BEARING LIABILITIES: Demand, interest bearing $ 285 $ 12 $ 297 $ 221 $ (114) $ 107 Savings and money-market 1,756 1,633 3,389 679 (216) 463 Time deposits, under $100,000 856 447 1,303 1,284 (77) 1,207 Time deposits, $100,000 and over 3,699 802 4,501 933 (176) 757 Brokered deposits 113 69 182 287 (4) 283 Other borrowings (702) 733 31 533 --- 533 - ----------------------------------- -------- -------- -------- -------- -------- -------- Total interest bearing liabilities $ 6,007 $ 3,696 $ 9,703 $ 3,937 $ (587) $ 3,350 - ----------------------------------- -------- -------- -------- -------- -------- -------- Net interest income $ 11,902 $ 898 $ 12,800 $ 6,287 $ (2,412) $ 3,875 ================================================================================================================ </TABLE> PROVISIONS FOR PROBABLE LOAN LOSSES The provision for probable loan losses represents the current period expense associated with maintaining an appropriate allowance for credit losses. The loan loss provision and level of allowance for each period is dependent upon many factors, including loan growth, net charge-offs, changes in the composition of the loan portfolio, delinquencies, management's assessment of the quality of the loan portfolio, the valuation of problem loans and the general economic conditions in the Company's market area. Periodic fluctuations in the provision for loan losses result from management's assessment of the adequacy of the allowance for probable loan losses; however, actual loan losses may vary from current estimates. For 2000, the provision for probable loan losses was $3,159,000, up $961,000 (or 44%) from $2,198,000 for 1999. The increase in the provision for 2000 and 1999 reflected the overall growth in the loan portfolio, the change in the mix of loans, and the Company's policy of making provisions to the allowance for probable loan losses. The provision for 1999 was up $392,000, or 22%, from $1,806,000 for 1998. 25
26 The allowance for probable loan losses represented 1.58%, 1.62%, and 1.50% of total loans at December 31, 2000, 1999, and 1998, respectively. See "Allowance for Probable Loan Losses" on page 33 for additional information. NONINTEREST INCOME The following table sets forth the various components of the Company's noninterest income: <TABLE> <CAPTION> Increase (Decrease) ----------------------------------------------------------------- -------------------- Years Ended December 31, 2000 versus 1999 1999 versus 1998 ----------------------------------------------------------------- -------------------- (Dollars in thousands) 2000 1999 1998 Amount Percent Amount Percent - ------------------------------------------------------------------------------------------------------------------------ <S> <C> <C> <C> <C> <C> <C> <C> Other investments $ 778 $ 429 $ 226 $ 349 81% $ 203 90% Service charges and other fees 716 560 407 156 28% 153 38% Servicing income 236 1,903 316 (1,667) (88%) 1,587 502% Gain on sale of Internet credit card portfolio 60 289 --- (229) (79%) 289 ---% Gain on sale of shares of demutualized life assurance company 47 530 --- (483) (91%) 530 ---% Gain on sale of securities 44 969 792 (925) (95%) 177 22% available-for-sale Gain on sale of deposits 16 240 --- (224) (93%) 240 ---% Gain on sale of loans --- 262 435 (262) (100%) (173) (40%) Other income 980 869 1,002 111 13% (133) (13%) --------------------------------------------- -------- Total $ 2,877 $ 6,051 $ 3,178 $(3,174) (52%) $ 2,873 90% ============================================= ======== </TABLE> Noninterest income for the year ended December 31, 2000 was $2,877,000, compared to $6,051,000 for 1999 and $3,178,000 for 1998. The decrease in 2000 from 1999 was primarily due to $1,576,000 in servicing income from the origination of credit cards for an unaffiliated financial institution in 1999, which was terminated in 1999, and a $969,000 gain on sale of securities available-for-sale recognized in 1999, compared to a $44,000 gain on sale of securities available-for-sale recognized in 2000. The decrease in gain on sale of loans was primarily due to the decrease in the level of sales of SBA loans in 2000, compared to 1999 reducing gains by $90,000. The Company, as a policyholder in a life assurance company, received a one-time pre-tax gain of $530,000 in 1999 as a result of the demutualization of that company while the Company had $47,000 such gain in 2000. The increase in other investments income in 2000 of $349,000 was primarily due to the increase in the Company's investment in certain life insurance contracts. The increase in 1999 over 1998 was primarily due to the increase in servicing income from credit cards services, gain on sale of securities, and the gain from the demutualization in 1999 over 1998. NONINTEREST EXPENSES The following table sets forth the various components of the Company's noninterest expenses: <TABLE> <CAPTION> Increase (Decrease) ------------------------------------------------- Years Ended December 31, 2000 versus 1999 1999 versus 1998 ------------------------------------------ -------------------------------------- (Dollars in thousands) 2000 1999 1998 Amount Percent Amount Percent - ------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> <C> Salaries and benefits $17,477 $14,493 $10,941 $ 2,984 21% $ 3,552 32% Merger-related costs 3,164 --- --- 3,164 ---% --- ---% Occupancy 2,399 2,034 1,424 365 18% 610 43% Professional fees 1,861 1,659 1,041 202 12% 618 59% Client services 1,839 1,527 2,426 312 20% (899) (37%) Furniture and equipment 1,528 1,676 1,184 (148) (9%) 492 42% Advertising and promotion 1,029 1,113 1,001 (84) (8%) 112 11% Loan origination costs 1,011 539 449 472 88% 90 20% Stationery & supplies 388 300 247 88 29% 53 21% Telephone expense 359 208 172 151 73% 36 21% All other 3,005 3,049 2,859 (44) (1%) 190 7% ----------------------------------------- -------- Total $34,060 $26,598 $21,744 $ 7,462 28% $ 4,854 22% ========================================= ======== </TABLE> 26
27 The following table indicates the percentage of noninterest expenses in each category: <TABLE> <CAPTION> Years Ended December 31, - ------------------------------------------------------------------------------------------------ (Dollars in thousands) 2000 % of Total 1999 % of Total 1998 % of Total - ------------------------------------------------------------------------------------------------ <S> <C> <C> <C> <C> <C> <C> Salaries and benefits $17,477 52% $14,493 54% $10,941 50% Merger-related costs 3,164 9% --- ---% --- ---% Occupancy 2,399 7% 2,034 8% 1,424 7% Professional fees 1,861 6% 1,659 6% 1,041 5% Client services 1,839 5% 1,527 7% 2,426 11% Furniture and equipment 1,528 4% 1,676 6% 1,184 5% Advertising and promotion 1,029 3% 1,113 4% 1,001 5% Loan origination costs 1,011 3% 539 2% 449 2% Stationery & supplies 388 1% 300 1% 247 1% Telephone expense 359 1% 208 1% 172 1% All other 3,005 9% 3,049 11% 2,859 13% - ------------------------------------------------------------------------------------------------ Total $34,060 100% $26,598 100% $21,744 100% ================================================================================================ </TABLE> Noninterest expenses for the year ended December 31, 2000 were $34,060,000, up $7,462,000, or 28%, from $26,598,000 for the year ended December 31, 1999, and up $4,854,000, or 22%, in 1999 from $21,744,000 for the year ended December 31, 1998. The overall increase in noninterest expenses reflects the growth in infrastructure to support the Company's loan and deposit growth, the opening of Heritage Bank South Valley, and the merger costs related to Western Holdings Bancorp. The increase in salaries and benefits expenses was primarily attributable to an increase in the number of employees and a $630,000 after tax severance charge due to the change in management in 2000. The Company employed 216 people at December 31, 2000, up 13 from 203 employees at December 31, 1999. The Company had 181 employees at December 31, 1998. The increase in furniture and equipment expenses in 1999 and in occupancy expenses in 2000 and 1999 was primarily attributable to an increase in the number of employees and new banking locations. The increase in professional fees was primarily due to consultants the Company has used for a variety of ongoing projects. Client services expense include outside data processing service costs, courier and armored car costs, imprinted check costs, and other client services costs, all of which are related to the level of and growth in loans and deposits at the Company. PROVISION FOR INCOME TAXES The Company files consolidated federal and combined state income tax returns. Amounts provided for income tax expense are based on income reported for financial statement purposes and do not necessarily represent amounts currently payable under tax laws. The provision for income taxes was $3,049,000, $2,606,000, $2,267,000 for the years ended December 31, 2000, 1999, and 1998, respectively. The Company's effective tax rates were 36.0%, 35.8%, and 39.3% for the years ended December 31, 2000, 1999, and 1998, respectively. The effective tax rates are lower than the statutory rate of 42% due to the Company purchasing additional corporate owned life insurance policies on executive officers of the Company and changes in the level of investments in municipal securities, offset by certain nondeductible merger-related expenses in 2000. 27
28 FINANCIAL CONDITION At December 31, 2000, the Company's total assets were $846,224,000, an increase of 25% from $677,233,000 at December 31, 1999. Total portfolio loans were $610,781,000, an increase of 52% from December 31, 1999, and total deposits were $738,186,000, an increase of 23% from December 31, 1999. The above reflects the continued strong internal growth of the Company. SECURITIES PORTFOLIO The following table sets forth the carrying value of investment securities at the dates indicated: <TABLE> <CAPTION> Years Ended December 31, (Dollars in thousands) 2000 1999 1998 ----------------------------------------------------------------------------------- <S> <C> <C> <C> Securities available-for-sale (at fair value) U.S. treasury $ 8,524 $11,501 $41,123 U.S. agencies 48,202 21,466 31,588 Mortgage-backed securities 18,870 10,001 6,779 Municipals 14,297 7,877 2,708 Preferred stock --- --- 2,072 Commercial paper 1,001 977 2,295 ------- ------- ------- Total securities available-for-sale $90,894 $51,822 $86,565 ======= ======= ======= Securities held-to-maturity (at amortized cost) U.S. treasury $ --- $ --- $ 3,538 U.S. agencies --- --- 1,509 Mortgage-backed securities 5,783 6,760 7,616 CMOs 2,215 2,403 2,887 Municipals 11,910 13,834 23,001 ------- ------- ------- Total securities held-to-maturity $19,908 $22,997 $38,551 ======= ======= ======= </TABLE> The following table summarizes the amounts and distribution of the Company's investment securities and the weighted average yields as of December 31, 2000: <TABLE> <CAPTION> December 31, 2000 ---------------------------------------------------------------------------------------------------------- Maturity ---------------------------------------------------------------------------------------------------------- After Five Years After One Year and and Within Ten (Dollars in thousands) Within One Year Within 5 Years Years After Ten Years Total - ----------------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> Securities available-for-sale: Amount Yield Amount Yield Amount Yield Amount Yield Amount Yield U.S. treasury $ 8,016 5.28% $ 508 6.34% $ --- ---% $ --- ---% $ 8,524 5.34% U.S. agencies 3,002 6.67% 43,715 6.43% 1,485 6.31% --- ---% 48,202 6.44% Mortgage-backed securities --- ---% 3,762 6.22% 11,097 6.93% 4,011 7.40% 18,870 6.89% Municipals - taxable 320 6.51% --- ---% --- ---% --- ---% 320 6.51% Municipals - tax exempt 1,782 6.62% 3,774 6.54% 7,283 5.23% 1,138 5.53% 13,977 5.79% Commercial paper --- ---% 1,001 6.71% --- ---% --- ---% 1,001 6.71% -------- -------- -------- -------- -------- Total available- for-sale $ 13,120 5.81% $ 52,760 6.43% $ 19,865 6.27% $ 5,149 7.00% $ 90,894 6.34% -------- -------- -------- -------- -------- Securities held-to-maturity: Mortgage-backed securities $ --- ---% $ 5,783 6.33% $ --- ---% $ --- ---% $ 5,783 6.33% CMOs --- ---% 1,002 6.38% 505 6.55% 708 6.56% 2,215 6.48% Municipals - taxable 1,885 6.49% 2,614 6.55% --- ---% --- ---% 4,499 6.52% Municipals - tax exempt --- ---% 1,331 4.67% 6,080 4.51% --- ---% 7,411 4.54% -------- -------- -------- -------- -------- Total held-to-maturity $ 1,885 6.49% $ 10,730 6.18% $ 6,585 4.67% $ 708 6.56% $ 19,908 5.72% -------- -------- -------- -------- -------- Total securities $ 15,005 5.89% $ 63,490 6.39% $ 26,450 5.87% $ 5,857 6.95% $110,802 6.23% ======== ======== ======== ======== ======== </TABLE> Note: Yields on tax exempt municipal securities are not presented on a fully tax equivalent basis. During 1999, the Company transferred approximately $11.67 million of certain securities from the held-to-maturity to available-for-sale classification upon adoption of and as allowed by SFAS No. 133 "Accounting for Derivative Instrument and Hedging Activities." The gross realized and gross unrealized gains or losses on the securities transferred were not significant to the Company. 28
29 As of December 31, 2000, the only securities held by the Company where the aggregate book value of the Company's investment in securities of a single issuer exceeded 10% of the Company's shareholders' equity were direct obligations of the U.S. government or U.S. government agencies. Securities are pledged to meet requirements imposed as a condition of deposit by some depositors, such as political subdivisions (public funds) or of other funds such as bankruptcy trustee deposits. Securities with amortized cost of $12,357,000 and $13,544,000 as of December 31, 2000 and 1999 were pledged to secure public and certain other deposits as required by law or contract. LOANS Total portfolio loans grew to $610,781,000, up 52% from $401,240,000 at December 31, 1999, building on the increase of 19% from $337,931,000 at December 31, 1998. The Company's allowance for loan losses was $9,651,000, or 1.58% of total loans, as of December 31, 2000, as compared to $6,511,000, or 1.62% of total loans, at December 31, 1999, and $5,069,000, or 1.50% of total loans, at December 31, 1998. The Company had no non-performing assets as of December 31, 2000, as compared to $1,402,000 and $1,354,000 as of December 31, 1999 and 1998, respectively. The loan portfolio is primarily composed of commercial loans to companies principally engaged in manufacturing, wholesale and service businesses and real estate lending, with the balance in consumer loans. While no specific industry concentration is considered significant, the Company's lending operations are located in the Company's market areas that are dependent on the technology and real estate industries and their supporting companies. Real estate values in portions of Santa Clara County and neighboring San Mateo County are among the highest in the country at present. The Company's borrowers could be adversely impacted by a downturn in these sectors of the economy which could reduce the demand for loans and adversely impact the borrowers' abilities to repay their loans. The following table presents the Company's loans outstanding at year-end by loan type: <TABLE> <CAPTION> December 31, -------------------------------------------------------------------------------------------- % of % of % of (Dollars in thousands) 2000 Total 1999 Total 1998 Total 1997 - ------------------------------------------------------------------------------------------------------------------------------ <S> <C> <C> <C> <C> <C> <C> <C> Commercial $ 200,846 33% $ 141,101 35% $ 95,587 28% $ 69,060 Real estate - mortgage 230,468 38% 153,518 38% 100,870 30% 66,363 Real estate - land and 171,325 28% 96,868 24% 86,102 25% 57,019 construction Consumer 8,172 1% 10,048 3% 55,656 17% 5,307 - ------------------------------------------------------------------------------------------------------------------------------ Total loans 610,811 100% 401,535 100% 338,215 100% 197,749 Deferred loan fees (30) (295) (284) (403) Allowance for loan losses (9,651) (6,511) (5,069) (3,270) - ------------------------------------------------------------------------------------------------------------------------------ Loans, net $ 601,130 $ 394,729 $ 332,862 $ 194,076 ============================================================================================================================== % of % of (Dollars in thousands Total 1996 Total ------------------------------------ <S> <C> <C> <C> Commercial 35% $ 44,829 35% Real estate - mortgage 34% 45,979 37% Real estate - land and 29% 29,482 23% construction Consumer 2% 6,471 5% - ------------------------------------------------------------------ Total loans 100% 126,761 100% Deferred loan fees (327) Allowance for loan losses (2,180) - ------------------------------------------------------------------ Loans, net $ 124,254 ================================================================== </TABLE> The change in the Company's loan portfolio is primarily due to the increase in the commercial and real estate loan portfolio offset by a decline in consumer loans resulting from the sale of the Internet credit card portfolio in 1999. The increase in the commercial and real estate loan portfolios is due to the Company's continued expansion and focus on originating these types of loans. The Company's commercial loans are made for working capital, financing the purchase of equipment or for other business purposes. Such loans include loans with maturities ranging from thirty days to one year and "term loans," with maturities normally ranging from one to five years. Short-term business loans are generally intended to finance current transactions and typically provide for periodic principal payments, with interest payable monthly. Term loans normally provide for floating interest rates, with monthly payments of both principal and interest. The Company is an active participant in the Small Business Administration (SBA) and California guaranteed lending programs, and has been approved by the SBA as a lender under the Preferred Loan Program. The Company regularly makes SBA-guaranteed loans and considers such loans to be investment loans; however, the guaranteed portion of these loans may be sold in the secondary market. In the event of the sale of a guaranteed portion SBA loan, the Company retains the servicing rights for the sold portion. As of December 31, 2000, 1999 and 1998, $12.3 million, $14.5 million and $11.0 million, respectively, in SBA loans were serviced by the Company for others. 29
30 The Company's real estate term loans consist primarily of loans made based on the borrower's cash flow and are secured by deeds of trust on commercial and residential property to provide a secondary source of repayment. It is the Company's policy to restrict real estate term loans to no more than 80% of the lower of the property's appraised value or the purchase price of the property, depending on the type of property and its utilization. The Company offers both fixed and floating rate loans. Maturities on such loans are generally restricted to between five and ten years (on an amortization ranging from fifteen to twenty-five years with a balloon payment due at maturity); however, SBA and certain other real estate loans easily sold in the secondary market may be granted for longer maturities. The Company's real estate land and construction loans are primarily interim loans made by the Company to finance the construction of commercial and single family residential properties. These loans are typically short term. The Company utilizes underwriting guidelines to assess the likelihood of repayment from sources such as sale of the property or permanent mortgage financing prior to making the construction loan. The Company makes consumer loans for the purpose of financing automobiles, various types of consumer goods, and other personal purposes. Additionally, the Company makes equity lines of credit and equity loans available to its clientele. Consumer loans generally provide for the monthly payment of principal and interest. Most of the Company's consumer loans are secured by the personal property being purchased, or, in the instances of equity loans or lines, real property. With certain exceptions, the Banks are permitted to make extensions of its credit to any one borrowing entity up to 15% of the Banks' capital and reserves for unsecured loans and up to 25% of the Banks' capital and reserves for secured loans. For HBC these lending limits were $6.8 million and $11.3 million at December 31, 2000. For HBEB these lending limits were $1.4 million and $2.3 million at December 31, 2000. For HBSV these lending limits were $1.1 million and $1.9 million at December 31, 2000. For BLA these lending limits were $3.2 million and $5.4 million at December 31, 2000. The Company does not have any concentrations in its loan portfolio by industry or group of industries, however, 66% and 62% of its net loans were secured by real property as of December 31, 2000 and 1999, respectively. This increase is attributed to a strong local real estate market and the Company's continued focus on these types of lending. The following table presents the maturity distribution of the Company's loans as of December 31, 2000. The table shows the distribution of such loans between those loans with predetermined (fixed) interest rates and those with variable (floating) interest rates. Floating rates generally fluctuate with changes in the prime rate as reflected in the western edition of The Wall Street Journal. As of December 31, 2000, approximately 87% of the Company's loan portfolio consisted of floating interest rate loans. <TABLE> <CAPTION> Over One Year Due in But Less Than Dollars in thousands) One Year or Less Five Years Over Five Years Total - ---------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Commercial $183,538 $ 17,197 $ 225 $200,960 Real estate - mortgage 95,628 117,694 17,146 230,468 Real estate - land and construction 168,232 3,093 --- 171,325 Consumer 6,207 1,945 20 8,172 - ---------------------------------------------------------------------------------------------------- Total loans $453,605 $139,929 $ 17,391 $610,925 ==================================================================================================== Loans with variable interest rates $440,970 $ 92,813 $ 673 $534,456 Loans with fixed interest rates 12,635 47,116 16,718 76,469 - ---------------------------------------------------------------------------------------------------- Total loans $453,605 $139,929 $ 17,391 $610,925 ==================================================================================================== </TABLE> 30
31 NONPERFORMING ASSETS Nonperforming assets consist of nonaccrual loans, loans past due 90 days and still accruing, troubled debt restructurings and other real estate owned. Management generally places loans on nonaccrual status when they become 90 days past due, unless they are well secured and in the process of collection. When a loan is placed on nonaccrual status, any interest previously accrued but not collected is generally reversed from income. Loans are charged off when management determines that collection has become unlikely. Restructured loans are those where the Banks have granted a concession on the interest paid or original repayment terms due to financial difficulties of the borrower. Other real estate owned ("OREO") consists of real property acquired through foreclosure on the related underlying defaulted loans. The following table shows nonperforming assets at the dates indicated: <TABLE> <CAPTION> December 31, ------------ (Dollars in thousands) 2000 1999 1998 1997 1996 - ----------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> Nonaccrual loans $ --- $1,402 $1,354 $ 61 $ 67 Loans 90 days past due and still accruing --- --- --- --- --- Restructured loans --- --- --- --- --- Total nonperforming loans --- 1,402 1,354 61 67 Foreclosed assets --- --- --- --- --- Total nonperforming assets $ --- $1,402 $1,354 $ 61 $ 67 Nonperforming assets as a percentage of period end loans plus foreclosed assets ---% 0.35% 0.40% 0.03% 0.05% </TABLE> As of December 31, 2000, the Company had no loans on nonaccrual status, no loans past due 90 days or more and still accruing interest, and no impaired loans. As of December 31, 1999, the Company had $1,402,000 in loans on nonaccrual status, no loans past due 90 days or more and still accruing interest, and no impaired loans. As of December 31, 1998, the Company had $1,354,000 in loans on nonaccrual status, no significant loans past due 90 days or more and still accruing interest, and no impaired loans. Although nonperforming assets increased $48,000 in 1999 from 1998, nonperforming assets as a percentage of total portfolio loans decreased from 0.40% to 0.35% from December 31, 1998 to December 31,1999. For the year ended December 31, 2000, the Company did not have any foregone interest income on nonaccrual loans. For the year ended December 31, 1999 and 1998, the Company had foregone $63,000 and $35,000 of interest income on non-accrual loans. The Company did not recognize any interest income for cash payments received on nonaccrual loans in 2000, 1999, or 1998. The Company assigns a risk grade consistent with the system recommended by regulatory agencies to all of its loans. Grades range from "Pass" to "Loss" depending on credit quality, with "Pass" representing loans that involve an acceptable degree of risk. Management conducts a critical evaluation of the loan portfolio monthly. This evaluation includes periodic loan by loan review for certain loans to evaluate the level of impairment as well as detailed reviews of other loans (either individually or in pools) based on an assessment of the following factors: past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower's ability to repay, collateral value, loan volumes and concentrations, size and complexity of the loans, recent loss experience in particular segments of the portfolio, bank regulatory examination results, and current economic conditions in the Company's marketplace, in particular the state of the technology industry and the real estate market. This process attempts to assess the risk of loss inherent in the portfolio by segregating loans into four components for purposes of determining an appropriate level of the allowance: "watch," "special mention," "substandard" and "doubtful." Additionally, the Company maintains a program for regularly scheduled reviews of certain new and renewed loans by an outside loan review consultant. Any loans identified during an external review process that expose the Company to increased risk are appropriately downgraded and an increase in the allowance for loan losses is established for such loans. Further, the Company is examined periodically by the FDIC, FRB, and the Department, at which time a further review of loan quality is conducted. 31
32 Loans that demonstrate a weakness, for which there is a possibility of loss if the weakness is not corrected, are categorized as "classified." Classified loans include all loans considered as special mention, substandard, and doubtful and may result from problems specific to a borrower's business or from economic downturns that affect the borrower's ability to repay or that cause a decline in the value of the underlying collateral (particularly real estate). At December 31, 2000, the principal balance of classified loans was $5,632,000. These loans constituted 1% of total loans and 7% of capital and reserves at that date. As of December 31, 1999, the principal balance of classified loans was $5,728,000. These loans constituted 1% of total loans and 9% of capital and reserves as of that date. As of December 31, 1998, classified loans were $8,629,000. These loans constituted 3% of total loans and 18% of capital and reserves as of that date. Other than those loans already classified at December 31, 2000, the Company has not identified any other potential problem loans, which would result in these loans being included as non-performing or classified loans at a future date. ALLOWANCE FOR PROBABLE LOAN LOSSES It is the policy of management to maintain the allowance for probable loan losses at a level adequate for risks inherent in the loan portfolio. Based on information currently available to analyze loan loss delinquency and a history of actual charge-offs, management believes that the loan loss provision and allowance are adequate. However, the loan portfolio can be adversely affected if California economic conditions and the real estate market in the Company's market area were to weaken. Also continued problems in the distribution of energy may effect the local market. Finally any weakness of a prolonged nature in the technology industry would have a negative impact on the local market. The effect of such events although uncertain at this time, could result in an increase in the level of nonperforming loans and increased loan losses, which could adversely affect the Company's future growth and profitability. No assurance of the ultimate level of credit losses can be given with any certainty. Loans are charged against the allowance when management believes that the collectibility of the principal is unlikely. See "Provision for probable loan losses" on page 26. The following table summarizes the Company's loan loss experience as well as provisions and charges to the allowance for loan losses and certain pertinent ratios for the periods indicated: <TABLE> <CAPTION> (Dollars in thousands) 2000 1999 1998 1997 1996 - ------------------------------------------------------------------------------------------------------------ <S> <C> <C> <C> <C> <C> Balance, beginning of period $ 6,511 $ 5,069 $ 3,270 $ 2,180 $ 1,394 Charge-offs: Commercial (52) (203) (108) (223) --- Real estate - mortgage --- --- --- --- --- Real estate - land and construction --- --- --- --- --- Consumer --- (629) (71) (115) (170) ------- ------- ------- ------- ------- Total charge-offs (52) (832) (179) (338) (170) Recoveries: Commercial 33 67 137 98 --- Real estate - mortgage --- --- --- --- --- Real estate - land and construction --- --- --- --- --- Consumer --- 9 35 --- 126 ------- ------- ------- ------- ------- Total recoveries 33 76 172 98 126 Net charge-offs (19) (756) (7) (240) (44) Provision for loan losses 3,159 2,198 1,806 1,330 830 - ------------------------------------------------------------------------------------------------------------ Balance, end of period $ 9,651 $ 6,511 $ 5,069 $ 3,270 $ 2,180 ============================================================================================================ RATIOS: Net charge-offs to average loans outstanding ---% 0.20% ---% 0.14% 0.04% Allowance for loan losses to average loans 1.80% 1.71% 1.87% 1.97% 2.23% Allowance for loan losses to total loans at end of period 1.58% 1.62% 1.50% 1.66% 1.75% Allowance for loan losses to non-performing loans ---% 464% 374% 5,360% 3,254% </TABLE> Charge-offs reflect the realization of losses in the portfolio that were recognized previously though provisions for loan losses. The net charge-offs in 2000 were $19,000, compared to $756,000 in 1999, $7,000 in 1998, $240,000 in 1997, and $44,000 in 1996. The decrease in net charge-offs in 2000 was primarily due to the decrease in charge-offs related to the Internet credit card portfolio, which was sold in 1999. However, historical net charge-offs are not necessarily indicative of the amount of net charge-offs that the Company will realize in the future. 32
33 The following table summarizes the allocation of the allowance for loan losses (ALL) by loan type and the allocation as a percent of loans outstanding in each loan category at the dates indicated: <TABLE> <CAPTION> December 31, 2000 1999 1998 1997 1996 ----------------------------------------------------------------------------------------------------- Percent Percent Percent Percent Percent of ALL of ALL of ALL of ALL of ALL in each in each in each in each in each category category category category category to total to total to total to total to total (Dollars in thousands) Allowance loans Allowance loans Allowance loans Allowance loans Allowance loans - ------------------------------------------------------------------------------------------------------------------------------------ <S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> Commercial $4,244 2.11% $3,069 2.18% $1,961 2.05% $1,171 1.70% $ 674 1.50% Real estate - mortgage 1,509 0.65% 1,025 0.67% 617 0.61% 444 0.67% 317 0.69% Real estate - land and construction 2,084 1.22% 1,343 1.39% 1,173 1.36% 676 1.19% 482 1.63% Consumer 158 1.93% 170 1.69% 1,245 2.24% 106 2.00% 167 2.58% Unallocated 1,656 --% 904 --% 73 --% 873 --% 540 --% -------- ------ ------ ------ ------ Total $9,651 1.58% $6,511 1.62% $5,069 1.50% $3,270 1.66% $2,180 1.75% ======== ====== ====== ====== ====== </TABLE> The increase in the allowance for probable loan losses reflects the growth in the Company's overall level of loans, primarily commercial and real estate loan portfolio, offset by the decrease in required reserves resulting from the sale of Internet credit card portfolio in 1999. Loans are charged against the allowance when management believes that the collect ability of the principal is doubtful. The Company's methodology for assessing the appropriateness of the allowance consists of several key elements, which include specific allowances, the formula allowance and the unallocated allowance. Specific allowances are established in cases where management has identified significant conditions or circumstances related to a credit that management believes indicate the probability that a loss may be incurred in excess of the amount determined by the application of the formula allowance. The formula allowance is calculated by applying loss factors to outstanding loans and certain unused commitments. Loss factors are based on management's experience and may be adjusted for significant factors that, in management's judgment, affect the collectibility of the portfolio as of the evaluation date. Due to the Company's limited historical loss experience, management utilizes their prior industry experience to determine the loss factor for each category of loan. The unallocated allowance is based upon management's evaluation of various conditions that are not directly measured in the determination of the formula and specific allowances. The evaluation of the inherent loss with respect to these conditions is subject to a higher degree of uncertainty because they are not identified with specific problem credits or portfolio segments. The current business, economic, and real estate markets along with the seasoning of the portfolio and the nature and duration of the current business cycle will effect the amount of unallocated reserve. In an effort to improve its analysis of risk factors associated with its loan portfolio, the Company continues to monitor and to make appropriate changes to its internal loan policies. These efforts better enable the Company to assess risk factors prior to granting new loans and to assess the sufficiency of the allowance for loan losses. Management believes that it has adequately provided an allowance for estimated probable losses in the credit portfolio. Significant deterioration in Northern California real property values or economic downturns could impact future operating results, liquidity or capital resources and require additional provisions to the allowance or cause losses in excess of the allowance. 33
34 DEPOSITS Total deposits were $738,186,000 at December 31, 2000, an increase of 23%, compared to $601,420,000 at December 31, 1999. All deposit types increased; however, the largest increase was in time deposits $100,000 and over. Noninterest bearing deposits increased to $207,885,000 at December 31, 2000, compared to $151,279,000 at December 31, 1999. Interest bearing deposits increased to $68,587,000 at December 31, 2000, as compared to $46,876,000 at December 31, 1999. Time deposits increased $242,415,000 at December 31, 2000, as compared to $186,230,000 at December 31, 1999. The following table summarizes the distribution of average deposits and the average rates paid for the periods indicated: <TABLE> <CAPTION> Years ended December 31, 2000 1999 1998 --------------------------------------------------------------------------- Average Average Average Average Average Average (Dollars in thousands) Balance Rate Paid Balance Rate Paid Balance Rate Paid - ------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> Demand, noninterest bearing $183,422 ---% $141,250 ---% $129,445 ---% Demand, interest bearing 55,616 1.82% 39,996 1.79% 27,628 2.21% Savings and money market 228,336 4.16% 186,112 3.28% 165,437 3.41% Time deposits, under $100,000 73,058 5.85% 58,423 5.08% 33,154 5.32% Time deposits, $100,000 and over 151,275 5.75% 86,963 4.83% 67,646 5.09% Time deposits - Brokered 10,544 6.55% 8,812 5.76% 3,826 5.88% Deposits -------- -------- -------- Total average deposits $702,251 3.44% $521,556 2.78% $427,136 2.74% ======== ======== ======== </TABLE> As of December 31, 2000, the Company had a deposit mix of 30% in savings and money market accounts, 33% in time deposits, 9% in interest-bearing demand accounts, and 28% in noninterest-bearing demand deposits. On the same date, approximately $6,931,000, or less than 1%, of deposits were from public sources, and approximately $44,507,000, or 6%, of deposits were from title companies. As of December 31, 1999, the Company had a deposit mix of 36% in savings and money market accounts, 31% in time deposits, 8% in interest-bearing demand accounts, and 25% in noninterest-bearing demand deposits. On the same date, approximately $3,854,000, or less than 1%, of deposits were from public sources, and approximately $22,334,000, or 4%, of deposits were from title companies. The Company's net interest income is enhanced by increasing its percentage of noninterest bearing deposits. The Company obtains deposits from a cross-section of the communities it serves. The Company's business is not seasonal in nature. The Company had brokered deposits totaling approximately $9,238,000 at December 31, 2000, and $10,651,000 at December 31, 1999. These brokered deposits generally mature within one year period. The Company is not dependent upon funds from sources outside the United States. The following table indicates the maturity schedule of the Company's time deposits of $100,000 or more as of December 31, 2000: <TABLE> <CAPTION> (Dollars in thousands) Balance % of total --------------------------------------------------------------------- <S> <C> <C> Three months or less $ 78,068 45% Over three months through six months 54,229 32% Over six months through twelve months 33,282 19% Over twelve months 6,284 4% --------------------------------------------------------------------- Total $171,863 100% ==================================================================== </TABLE> The Company focuses primarily on servicing business deposit accounts that are frequently over $100,000 in average size. Certain types of accounts that the Company makes available are typically in excess of $100,000 in average balance per account, and certain types of business clients whom the Company serves typically carry deposits in excess of $100,000 on average. The account activity for some account types and client types necessitates appropriate liquidity management practices by the Company to ensure its ability to fund deposit withdrawals. 34
35 LIQUIDITY AND ASSET/LIABILITY MANAGEMENT To meet liquidity needs, the Company maintains a portion of its funds in cash deposits in other banks, in Federal funds sold, and in investment securities. As of December 31, 2000, the Company's primary liquidity ratio was 15.04%, comprised of $61.2 million in investment securities available-for-sale of maturities (or probable calls) of up to five years, less $12.0 million of securities that were pledged to secure public and certain other deposits as required by law and contract; Federal funds sold of $19.3 million, and $40.8 million in cash and due from banks, as a percentage of total unsecured deposits of $726.2 million. As of December 31, 1999, the Company's primary liquidity ratio was 27.98%, comprised of $25.5 million in investment securities available-for-sale of maturities (or probable calls) of up to five years, less $17.3 million securities that were pledged to secure public and certain other deposits as required by law and contract; Federal funds sold of $135.9 million, and $19.3 million in cash and due from banks, as a percentage of total unsecured deposits of $584.1 million. As of December 31, 1998, the Company's primary liquidity ratio was 16.71%, comprised of $61.2 million in investment securities available-for-sale of maturities (or probable calls) of up to five years, less $46.4 million of securities that were pledged to secure public and certain other deposits as required by law and contract; Federal funds sold of $34.6 million, and $28.1 million in cash and due from banks, as a percentage of total unsecured deposits of $463.5 million. The following table summarizes the Company's borrowings under its federal funds purchased, security repurchase arrangements and lines of credit for the periods indicated: <TABLE> <CAPTION> 2000 1999 1998 ---- ---- ---- <S> <C> <C> <C> Average balance during the year $ 2,020,000 $16,887,000 $ 6,862,000 Average interest rate during the year 5.17% 5.30% 5.30% Maximum month-end balance during the $ 18,000,000 $14,000,000 $22,000,000 Average rate at December 31 5.13% 7.44% 5.04% </TABLE> The Company has Federal funds purchase lines and lines of credit of totaling $44,500,000. As of December 31, 2000, the Company borrowed $18,000,000 from FHLB. CAPITAL RESOURCES The following table summarizes risk-based capital, risk-weighted assets, and risk-based capital ratios of the Company: <TABLE> <CAPTION> December 31, (Dollars in thousands) 2000 1999 1998 ---- ---- ---- <S> <C> <C> <C> Capital components: Tier 1 Capital $ 78,982 $ 57,610 $ 41,144 Tier 2 Capital 9,427 6,154 5,069 -------------------------------- Total risk-based capital $ 88,409 $ 63,764 $ 46,213 ================================= Risk-weighted assets $753,947 $509,748 $437,401 Average assets $850,072 $674,088 $565,424 MINIMUM Capital ratios: REGULATORY REQUIREMENTS ------------ Total risk-based capital 11.7% 12.5% 10.5% 8.0% Tier 1 risk-based capital 10.5% 11.3% 9.4% 4.0% Leverage ratio(1) 9.3% 8.5% 7.3% 4.0% </TABLE> (1) Tier 1 capital divided by average assets (excluding goodwill). 35
36 The table above presents the capital ratios of the Company computed in accordance with applicable regulatory guidelines and compared to the standards for minimum capital adequacy requirements under the FDIC's prompt corrective action authority as of December 31, 2000. The risk-based and leverage capital ratios are defined in Item 1 - "Business - Supervision and Regulation - Capital Adequacy Guidelines" on page 7. At December 31, 2000, the Company's capital met all minimum regulatory requirements. As of December 31, 2000, management believes that HBC, HBEB, HBSV, and BLA were considered "well capitalized." At December 31, 1999 and 1998, the Company's capital met all minimum regulatory requirements. As of December 31, 1999, HBC, HBEB and BLA were considered "well capitalized". HBSV commenced operations on January 18, 2000. In August 1999, the Company completed a best efforts public stock offering selling 758,138 shares at $15.00 per share. Total proceeds from this offering were $11,200,000 after deducting expenses of $172,000. The Company used $7,000,000 of the proceeds of the offering to capitalize HBSV, which commenced operations on January 18, 2000. In 2000, to enhance regulatory capital and to provide liquidity the Company issued the following: In the first quarter of 2000, the Company issued $7,000,000 aggregate principal amount of 10.875% subordinated debentures due 2030 to a subsidiary trust, which in turn issued a similar amount of trust preferred securities. In the third quarter of 2000, the Company issued $7,000,000 aggregate principal amount of 10.60.% subordinated debentures due 2030 to a subsidiary trust, which in turn issued a similar amount of trust preferred securities. See "Mandatorily Redeemable Cumulative Trust Preferred Securities of Subsidiary Grantor Trust" on page 19. Under applicable regulatory guidelines the trust preferred securities currently qualify as Tier I capital. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities" was issued in September 2000. SFAS No. 140 is a replacement of SFAS No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities". Most of the provisions of SFAS No. 125 were carried forward to SFAS No. 140 without reconsideration by the FASB, and some were changed in only minor ways. In issuing SFAS No. 140, the FASB included issues and decisions that had been addressed and determined since the original publication of SFAS No. 125. SFAS No. 140 is effective for transfers and servicing of financial assets and extinguishments of liabilities occurring after March 31, 2001. Management believes that adopting these components of SFAS No. 140 will not have a material impact on the financial position or results of operations of the Company. SFAS No. 140 must be applied prospectively. For recognition and reclassification of collateral and for disclosures about securitizations and collateral, this statement was adopted as of December 31, 2000 and did not have a material impact on the financial position or results of operations of the Company. MARKET RISK Market risk is the risk of loss to future earnings, to fair values, or to future cash flows that may result from changes in the price of a financial instrument. The value of a financial instrument may change as a result of changes in interest rates, foreign currency exchange rates, commodity prices, equity prices and other market changes that affect market risk sensitive instruments. Market risk is attributed to all market risk sensitive financial instruments, including securities, loans, deposits, borrowings, its trading activities for its own account, and its role as a financial intermediary in customer-related transactions. The objective of market risk management is to avoid excessive exposure of the Company's earnings and equity to loss and to reduce the volatility inherent in certain financial instruments. INTEREST RATE SENSITIVITY The planning of asset and liability maturities is an integral part of the management of an institution's net yield. To the extent maturities of assets and liabilities do not match in a changing interest rate environment, net yields may change over time. Even with perfectly matched repricing of assets and liabilities, risks remain in the form of prepayment of loans or investments or in the form of delays in the adjustment of rates of interest applying to either 36
37 earning assets with floating rates or to interest bearing liabilities. The Company has generally been able to control its exposure to changing interest rates by maintaining primarily floating interest rate loans and a majority of its time certificates with relatively short maturities. The table below sets forth the interest rate sensitivity of the Company's interest earning assets and interest bearing liabilities as of December 31, 2000, using the rate sensitivity GAP ratio. For purposes of the following table, an asset or liability is considered rate-sensitive within a specified period when it can be repriced or when it is scheduled to mature within the specified time frame: <TABLE> <CAPTION> Within Due in Three Due After Three to Twelve One to Five Due After Not Rate- (Dollars in thousands) Months Months Years Five Years Sensitive Total - ------------------------------------------------------------------------------------------------------------------------ INTEREST EARNING ASSETS: <S> <C> <C> <C> <C> <C> <C> Federal funds sold $ 19,300 $ --- $ --- $ --- $ --- $ 19,300 Securities 3,320 11,685 63,490 32,307 --- 110,802 Total loans, including loans held-for-sale 447,563 41,829 139,929 17,391 --- 646,712 - ------------------------------------------------------------------------------------------------------------------------ Total interest earning assets 470,183 53,514 203,419 49,698 --- 776,814 - ------------------------------------------------------------------------------------------------------------------------ Cash and due from banks --- --- --- --- 40,769 40,769 Other assets --- --- --- --- 28,641 28,641 - ------------------------------------------------------------------------------------------------------------------------ Total assets $ 470,183 $ 53,514 $ 203,419 $ 49,698 $ 69,410 $ 846,224 ======================================================================================================================== INTEREST BEARING LIABILITIES: Demand, interest bearing $ 68,587 $--- $--- $--- $--- $ 68,587 Savings and money market 219,299 --- --- --- --- 219,299 Time deposits 99,340 130,790 12,275 10 --- 242,415 - ------------------------------------------------------------------------------------------------------------------------ Total interest bearing liabilities 387,226 130,790 12,275 10 --- 530,301 - ------------------------------------------------------------------------------------------------------------------------ Demand non-interest bearing 60,358 --- --- --- 147,527 207,885 Accrual interest payable, borrowing, and other liabilities --- --- --- --- 42,305 42,305 Shareholders' equity --- --- --- --- 65,733 65,733 - ------------------------------------------------------------------------------------------------------------------------ Total liabilities and shareholders' equity $ 447,584 $ 130,790 $ 12,275 $ 10 $ 255,565 $ 846,224 ======================================================================================================================== Interest rate sensitivity GAP $ 22,599 $ (77,276) $ 191,144 $ 49,688 $(186,155) $ --- ======================================================================================================================== Cumulative interest rate sensitivity GAP $ 22,599 $ (54,677) $ 136,467 $ 186,155 $ --- $ --- Cumulative interest rate sensitivity GAP ratio 2.67% (6.46%) 16.13% 22.00% ---% ---% </TABLE> The careful planning of asset and liability maturities and the matching of interest rates to correspond with this maturity matching is an integral part of the active management of an institution's net yield. To the extent maturities of assets and liabilities do not match in a changing interest rate environment, net yields may change over time. Even with perfectly matched repricing of assets and liabilities, risks remain in the form of prepayment of loans or investments or in the form of delays in the adjustment of rates of interest applying to either earning assets with floating rates or to interest bearing liabilities. The Company has generally been able to control its exposure to changing interest rates by maintaining primarily floating interest rate loans and a majority of its time certificates in relatively short maturities. Interest rate changes do not affect all categories of assets and liabilities equally or at the same time. Varying interest rate environments can create unexpected changes in prepayment levels of assets and liabilities, which may have a significant effect on the net interest margin and are not reflected in the interest sensitivity analysis table. Because of these factors, an interest sensitivity gap report may not provide a complete assessment of the exposure to changes in interest rates. To supplement traditional GAP analysis, the Company performs simulation modeling to estimate the potential effects of changing interest rate environments. The process allows the Company to explore the complex relationships within the GAP over time and various interest rate environments. For additional information on the Company's simulation model and the methodology used to estimate the potential effects of changing interest rates, see Item 7A - "Quantitative and qualitative disclosures about market risk" below. Liquidity risk represents the potential for loss as a result of limitations on the Company's ability to adjust for future cash flows, to meet the needs of depositors and borrowers, and to fund operations on a timely and cost-effective basis. The liquidity policy approved by the board requires annual review of the Company's liquidity by the asset/liability committee, which is composed of senior executives, and the finance and investment committee of the board of directors. 37
38 The Company's internal asset/liability committee and the finance and investment committee of the board each meet monthly to monitor the Company's investments, liquidity needs and to oversee its asset/liability management. The Company evaluates the rates offered on its deposit products on a weekly basis. 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 ultimately impact both the level of income and expense recorded on most of the Company's assets and liabilities, and the market value of all interest-earning assets, other than those which have a short term to maturity. Since all of the Company's interest-bearing assets and liabilities are located at the Banks, all of the Company's interest rate risk exposure lies at that level, as well. As a result, all interest rate risk management procedures are performed at the Banks' level. Based upon the nature of the Company's operations, the Company is not subject to foreign exchange or commodity price risk. The Company does not own any trading assets. As of December 31, 2000, the Company does not use interest rate derivatives to hedge its interest rate risk. The Company's exposure to market risk is reviewed on a regular basis by the Asset/Liability Committee (ALCO). Interest rate risk is the potential of economic losses due to future interest rate changes. These economic losses can be reflected as a loss of future net interest income and/or a loss of current fair market values. The objective is to measure the effect on net interest income and to adjust the balance sheet to minimize the inherent risk while at the same time maximize income. Management realizes certain risks are inherent, and that the goal is to identify and accept the risks. Management uses two methodologies to manage interest rate risk: 1) a standard GAP analysis; and 2) an interest rate shock simulation model. The Company has no market risk sensitive instruments held for trading purposes. The detail from the Company's GAP analysis is shown in Item 7, above, and is not discussed here. The Company applies a market value (MV) methodology to gauge its interest rate risk exposure as derived from its simulation model. Generally, MV is the discounted present value of the difference between incoming cash flows on interest earning assets and other investments and outgoing cash flows on interest bearing liabilities and other liabilities. The application of the methodology attempts to quantify interest rate risk as the change in the MV which would result from a theoretical 200 basis point (1 basis point equals 0.01%) change in market interest rates. Both a 200 basis point increase and a 200 basis point decrease in market rates are considered. At December 31, 2000, it was estimated that the Company's MV would increase 8.04% in the event of a 200 basis point increase in market interest rates. The Company's MV at the same date would decrease 8.89% in the event of a 200 basis point decrease in market interest rates. Presented below, as of December 31, 2000 and 1999, is an analysis of the Company's interest rate risk as measured by changes in MV for instantaneous and sustained parallel shifts of 200 basis points in market interest rates: <TABLE> <CAPTION> 2000 1999 ---- ---- Market Value as a % of Market Value as a % of (Dollars in thousands) Present Value of Assets (Dollars in thousands) Present Value of Assets ----------------------- ----------------------- $ Change in % Change in $ Change in % Change in in Market Market Market Market Change in rates Value Value MV Ratio Change (bp) Value Value MV Ratio Change(bp) - --------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> <C> <C> + 200 bp $ 8,617 8.04% 13.7% 102 $ 9,448 13.3% 15.6% 184 0 bp --- --- 12.7% --- --- --- 13.8% --- - 200 bp $(9,532) (8.89)% 11.5% (113) $(10,450) (14.7)% 11.7% (203) - --------------------------------------------------------------------------------------------------------------- </TABLE> Management believes that the MV methodology overcomes three shortcomings of the typical maturity gap methodology. First, it does not use arbitrary repricing intervals and accounts for all expected future cash flows. Second, because the MV method projects cash flows of each financial instrument under different interest rate environments, it can incorporate the effect of embedded options on an institutions' interest rate risk exposure. Third, it allows interest rates on different instruments to change by varying amounts in response to a change in market interest rates, resulting in more accurate estimates of cash flows. However, as with any method of gauging interest rate risk, there are certain shortcomings inherent to the MV 38
39 methodology. The model assumes interest rate changes are instantaneous parallel shifts in the yield curve. In reality, rate changes are rarely instantaneous. The use of the simplifying assumption that short-term and long-term rates change by the same degree may also misstate historic rate patterns, which rarely show parallel yield curve shifts. Further, the model assumes that certain assets and liabilities of similar maturity or period to repricing will react the same to changes in rates. In reality, certain types of financial instruments may react in advance of changes in market rates, while the reaction of other types of financial instruments may lag behind the change in general market rates. Additionally, the MV methodology does not reflect the full impact of annual and lifetime restrictions on changes in rates for certain assets, such as adjustable rate loans. When interest rates change, actual loan prepayments and actual early withdrawals from certificates may deviate significantly from the assumptions used in the model. Finally, this methodology does not measure or reflect the impact that higher rates may have on adjustable-rate loan clients' ability to service their debt. All of these factors are considered in monitoring the Company's exposure to interest rate risk. Liquidity risk represents the potential for loss as a result of limitations on our ability to adjust our future cash flows to meet the needs of depositors and borrowers and to fund operations on a timely and cost-effective basis. The Liquidity Policy approved by the Board requires annual review of the Company's liquidity by the Asset/Liability Committee, which is composed of senior executives, and the Finance and Investment Committee of the Board of Directors. ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements and independent auditors' report are set forth on pages F-1 through F-24, which follows Item 14 - "exhibits, financial statement schedules, and reports on form 8-K." The following table discloses the Company's selected quarterly financial data as required by Item 302 of Regulation S-K All amounts have been restated on a historical basis to reflect the merger with Western Holdings Bancorp, which closed in October 2000, as a pooling of interests as if the Companies had been combined for all periods presented. <TABLE> <CAPTION> For the Quarter Ended December 31, September 30, June 30, March 31, December 31, September 30, June 30, March 31, 2000 2000 2000 2000 1999 1999 1999 1999 ---------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> <C> <C> Interest income $19,089 $18,553 $16,301 $13,978 $12,977 $11,682 $ 10,393 $ 10,366 Interest expense 7,108 7,213 5,921 4,859 4,732 3,937 3,392 3,337 ------- ------- ------ ------- ------- ------- -------- ------- Net interest income 11,981 11,340 10,380 9,119 8,245 7,745 7,001 7,029 Provision for loan losses 1,290 655 534 680 428 431 616 723 ------- ------- ------ ------- ------- ------- -------- ------- Net interest income after Provision 10,691 10,685 9,846 8,439 7,817 7,314 6,385 6,306 Noninterest income 743 785 614 735 1,579 2,023 934 1,515 Noninterest expense 11,002 8,043 8,225 6,790 7,016 7,384 5,852 6,346 ------- ------- ------ ------- ------- ------- -------- ------- Net income before taxes 432 3,427 2,235 2,384 2,380 1,953 1,467 1,475 Provision for income taxes 183 1,253 746 867 849 725 481 551 ------- ------- ------ ------- ------- ------- -------- ------- Net income $ 249 $ 2,174 $ 1,489 $ 1,517 $ 1,531 $ 1,228 $ 986 $ 924 ======= ======= ======= ======= ======= ======= ======== ======= Net income per share basic $ 0.02 $ 0.20 $ 0.14 $ 0.15 $ 0.15 $ 0.12 $ 0.10 $ 0.10 Net income per share diluted $ 0.02 $ 0.20 $ 0.13 $ 0.14 $ 0.14 $ 0.11 $ 0.09 $ 0.09 </TABLE> ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. 39
40 PART III ITEM 10 - DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Reference is made to the Company's Proxy Statement for the May 24, 2001 Annual Meeting of Shareholders for incorporation of information concerning directors and persons nominated to become directors of the Company. Information concerning executive officers of the Company as of March 29, 2001 is also included in the Company's Proxy Statement. On June 15, 2000 John E. Rossell resigned as president and chief executive officer of Heritage. As a result, Brad L. Smith, chairman of Heritage, assumed the role of chief executive officer of Heritage and acting president of Heritage Bank of Commerce, and Richard Conniff, a director of Heritage and president of Heritage Bank East Bay, assumed the role of president and chief operating officer of Heritage. ITEM 11 - EXECUTIVE COMPENSATION Information concerning executive compensation is incorporated by reference from the text under the caption "Executive Compensation" in the Proxy Statement for the May 24, 2001 Annual Meeting of Shareholders. ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT - BENEFICIAL OWNERSHIP OF COMMON STOCK Information concerning ownership of the equity stock of the Company by certain beneficial owners and management is incorporated by reference from the text under the caption "Proposal One - Election of Directors" in the Proxy Statement for the May 24, 2001 Annual Meeting of Shareholders ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information concerning certain relationships and related transactions with officers, directors, and the Company is incorporated by reference from the text under the caption "Transactions with Management and Others" in the Proxy Statement for the May 24, 2001 Annual Meeting of Shareholders. 40
41 PART IV ITEM 14 - EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)(1) FINANCIAL STATEMENTS The Financial Statements of the Company, Management's Discussion and Analysis of Financial Condition and Results of Operations, and the independent auditors' report are set forth on pages F-1 through F-24. (a)(2) FINANCIAL STATEMENT SCHEDULES All schedules to the Financial Statements are omitted because of the absence of the conditions under which they are required or because the required information is included in the Financial Statements or accompanying notes. (a)(3) EXHIBITS <TABLE> <CAPTION> Incorporated by Reference to Form ------------------------------------------ Filed Herewith 8-A Dated 10-K Dated Exhibit No. ----------------------------------------------------------- <S> <C> <C> <C> <C> 2.1 Agreement and Plan of Merger and Reorganization dated as of May 9, 2000 between Heritage Commerce Corp and Western Holdings Bancorp (incorporated by reference from Annex A of the registration statement on Form S-4, Registration No. 333- 40384, filed with the Commission on June 29, 2000) 3.1 Heritage Commerce Corp Articles of 3-5-98 4.1 Incorporation: [Incorporated herein by reference from Exhibit 4 to Heritage Commerce Corp's Form 8-A: Registration of Securities Pursuant to Section 12(g) of the Securities Exchange Act of 1934 dated March 5, 1998 (File No. 000-23877)] 3.2 Heritage Commerce Corp Bylaws 3-5-98 4.2 10.1 Real Property Leases for properties located 3-5-98 10.1 at 150 Almaden Blvd., San Jose and 100 Park Center Plaza, San Jose. 10.2 Employment agreement with Mr. Rossell dated 3-5-98 10.2 June 8, 1994* 10.3 Employment agreement with Mr. Gionfriddo 3-5-98 10.3 dated June 8, 1994 * 10.4 Amendment No. 2 to Employment Agreement with 3-31-98 10.4 Mr. Gionfriddo * 10.5 Employment agreement with Mr. Conniff dated 3-31-99 10.5 April 30, 1998 * 10.6 Employment agreement with Mr. Nethercott 3-31-99 10.6 dated April 16, 1998 * 10.7 Employment agreement with Mr. McGovern dated 3-31-99 10.7 July 16, 1998 * 21.1 Subsidiaries of the registrant X 23.1 Consent of Deloitte & Touche LLP X 23.2 Consent of Arthur Andersen LLP X 23.3 Consent of PricewaterhouseCoopers LLP X </TABLE> * Management contract or compensatory plan or arrangement. 41
42 (b) Reports on Form 8-K The Registrant filed a Current Report on Form 8-K under Item 5, containing condensed summarized statements of financial position and results of operations, dated October 24, 2000, to report third quarter 2000 financial results. The Registrant filed a Current Report on Form 8-K dated October 16, 2000 under Item 2 and 7, to report the consummation of its merger with Western Holdings Bancorp. The Report incorporated by reference or included as an exhibit certain audited financial statements of Western Holdings Bancorp and certain pro forma financial statements of the Registrant and Western Holdings Bancorp. The Registrant filed a Current report on Form 8-K under Item 5, containing condensed summarized statement of financial position and results of operations, dated January 26, 2001, to report the year end 2000 financial results. The Registrant filed a Current report on Form 8-K under Item 5, dated March 26, 2001, to report Heritage Bank South Valley to open new branch office in Gilroy. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report on Form 10-K to be signed on its behalf by the undersigned thereunto duly authorized. Heritage Commerce Corp DATE: March 29, 2001 BY: /s/ Brad Smith Brad Smith Chairman of the Board and CEO Pursuant to the requirements of the Securities Exchange Act of 1934, this report on Form 10-K has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated: <TABLE> <CAPTION> Signature Title Date - ------------------------------------------------------------------------------ <S> <C> <C> /s/ FRANK BISCEGLIA Director 3/29/01 - ----------------------------------- Frank Bisceglia /s/ JAMES BLAIR Director 3/29/01 - ----------------------------------- James Blair /s/ RICHARD CONNIFF Director and President of 3/29/01 - ----------------------------------- the Company and Chief Richard Conniff Operating Officer /s/ WILLIAM DEL BIAGGIO, JR. Director 3/29/01 - ----------------------------------- William Del Biaggio, Jr. /s/ ANNEKE DURY Director 3/29/01 - ----------------------------------- Anneke Dury </TABLE> 42
43 <TABLE> <CAPTION> <S> <C> <C> /s/ HUGH BARTON Director 3/29/01 - ----------------------------------- Hugh Barton /s/ ROY LAVE Director 3/29/01 - --------------------------------- Roy Lave /s/ HOWARD J. WEILAND Director 3/29/01 - --------------------------------- Howard J. Weiland /s/ JOHN W. LARSEN Director 3/29/01 - --------------------------------- John W. Larsen /s/ LAWRENCE D. MCGOVERN Executive Vice President and 3/29/01 - --------------------------------- Chief Financial Officer, Lawrence D. McGovern Principal Financial and Accounting Officer /s/ LON NORMANDIN Director 3/29/01 - --------------------------------- Lon Normandin /s/ JACK PECKHAM Director 3/29/01 - --------------------------------- Jack Peckham /s/ ROBERT PETERS Director 3/29/01 - --------------------------------- Robert Peters /s/ HUMPHREY POLANEN Director 3/29/01 - --------------------------------- Humphrey Polanen Director and Chairman of the 3/29/01 /s/ BRAD L. SMITH Company and Chief Executive - --------------------------------- Officer, Principal Executive Brad L. Smith Officer </TABLE> 43
44 HERITAGE COMMERCE CORP INDEX TO FINANCIAL STATEMENTS DECEMBER 31, 2000 <TABLE> <CAPTION> Page <S> <C> Independent Auditors' Report F-2 Consolidated Balance Sheets as of December 31, 2000 and 1999 F-5 Consolidated Income Statements for the years ended December 31, 2000, 1999 and 1998 F-6 Consolidated Statements of Changes in Shareholders' Equity as of December 31, 2000, 1999 F-7 and 1998 Consolidated Statements of Cash Flows as of December 31, 2000, 1999 and 1998 F-8 Notes to Consolidated Financial Statements F-9 </TABLE> F-1
45 EXHIBIT (a)(1) INDEPENDENT AUDITORS' REPORT To the Board of Directors and Shareholders of Heritage Commerce Corp: We have audited the consolidated balance sheets of Heritage Commerce Corp and subsidiaries (the "Company") as of December 31, 2000 and 1999, and the related consolidated statements of income, changes in shareholders' equity, and cash flows for each of the three years in the period ended December 31, 2000. The financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements based on our audits. The consolidated financial statements give retroactive effect to the merger of Heritage Commerce Corp and Western Holdings Bancorp ("Western Holdings"), which has been accounted for as a pooling of interests as described in Note 2 to the consolidated financial statements. We did not audit the balance sheet of Western Holdings as of December 31, 1999; or the related statements of income, changes in shareholders' equity, and cash flows of Western Holdings for the years ended December 31, 1999 and 1998, which statements reflect: total assets of $200,455,000 as of December 31, 1999, total net interest income of $9,277,000 and $7,418,000 for the years ended December 31, 1999 and 1998, respectively; and, net income of $1,643,000 and $1,356,000 for the years ended December 31, 1999 and 1998, respectively. Those statements were audited by other auditors whose reports have been furnished to us, and our opinion insofar as it relates to the amounts included for Western Holdings for 1999 and 1998, is based solely on the reports of such other auditors. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. 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 and the report of the other auditors provide a reasonable basis for our opinion. In our opinion, based on our audits and the reports of the other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Heritage Commerce Corp and subsidiaries as of December 31, 2000 and 1999, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2000 in conformity with accounting principles generally accepted in the United States of America. /s/ Deloitte & Touche LLP San Jose, California January 25, 2001 F-2
46 EXHIBIT (a)(2) INDEPENDENT AUDITORS' REPORT To the Board of Directors and Shareholders of Western Holdings Bankcorp: We have audited the consolidated balance sheet of Western Holdings Bancorp (a California corporation) and Subsidiary (the Company) as of December 31, 1999, and the related consolidated statements of income, shareholders' equity, and cash flows for the year then ended prior to the restatement (and, therefore, are not presented herein) for the merger with Heritage Commerce Corp on October 1, 2000, which was accounted for as a pooling of interests (see Note 2 to the restated financial statements). These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with auditing standards generally accepted in the 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 audit provides 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 Western Holdings Bancorp and Subsidiary as of December 31, 1999, and the results of their operations and their cash flows for the year then ended in conformity with accounting principles generally accepted in the United States. /s/ Arthur Andersen LLP San Francisco, California, January 21, 2000 F-3
47 EXHIBIT (a)(3) INDEPENDENT AUDITORS' REPORT To the Board of Directors and Shareholders of Western Holdings Bancorp and Subsidiary: In our opinion, the consolidated statements of income, of shareholders' equity and of cash flows of Western Holdings Bancorp and Subsidiary (not presented separately herein) present fairly, in all material respects, the results of their operations and their cash flows for the year ended December 31, 1998, in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit of these statements in accordance with auditing standards generally accepted in the United States of America, which 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, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. We have not audited the consolidated financial statements of Western Holdings Bancorp for any period subsequent to December 31, 1998. As discussed in Note 10 to the financial statements, Western Holdings Bancorp is subject to a litigation claim for which neither the amount of the loss nor the outcome can be reasonably assured. /s/ PricewaterhouseCoopers LLP San Francisco, CA January 22, 1999 F-4
48 HERITAGE COMMERCE CORP CONSOLIDATED BALANCE SHEETS <TABLE> <CAPTION> December 31, 2000 1999 ------------- ------------- <S> <C> <C> ASSETS Cash and due from banks $ 40,769,000 $ 19,324,000 Federal funds sold 19,300,000 135,900,000 ------------- ------------- Total cash and cash equivalents 60,069,000 155,224,000 Securities available-for-sale, at fair value 90,894,000 51,822,000 Securities held-to-maturity, at amortized cost 19,908,000 22,997,000 (fair value of $20,075,000 for 2000 and $22,263,000 for 1999) Loans held for sale, at lower of cost or market 35,931,000 22,243,000 Loans, net of deferred fees of $30,000 for 2000 and $295,000 for 1999 610,781,000 401,240,000 Allowance for probable loan losses (9,651,000) (6,511,000) ------------- ------------- Loans, net 601,130,000 394,729,000 Premises and equipment, net 6,415,000 6,892,000 Accrued interest receivable and other assets 12,920,000 8,654,000 Other investments 18,957,000 14,672,000 ------------- ------------- TOTAL $ 846,224,000 $ 677,233,000 ============= ============= LIABILITIES AND SHAREHOLDERS' EQUITY Liabilities: Deposits Demand, noninterest bearing $ 207,885,000 $ 151,279,000 Demand, interest bearing 68,587,000 46,876,000 Savings and money market 219,299,000 217,035,000 Time deposits, under $100,000 70,552,000 68,683,000 Time deposits, $100,000 and over 171,863,000 117,547,000 ------------- ------------- Total deposits 738,186,000 601,420,000 Federal Home Loan Bank borrowings 18,000,000 12,000,000 Accrued interest payable and other liabilities 10,305,000 7,269,000 Mandatorily redeemable cumulative trust preferred securities of subsidiary grantor trust 14,000,000 -- ------------- ------------- Total liabilities 780,491,000 620,689,000 ------------- ------------- Commitments and contingencies Shareholders' equity: Preferred stock, no par value; 10,000,000 shares authorized: none outstanding -- -- Common stock, no par value; 30,000,000 shares authorized; shares issued and outstanding: 10,939,124 in 2000 and 9,737,739 in 1999 62,469,000 51,206,000 Accumulated other comprehensive income (loss), net of taxes 515,000 (1,254,000) Retained earnings 2,749,000 6,592,000 ------------- ------------- Total shareholders' equity 65,733,000 56,544,000 ------------- ------------- TOTAL $ 846,224,000 $ 677,233,000 ============= ============= </TABLE> See notes to consolidated financial statements. F-5
49 HERITAGE COMMERCE CORP CONSOLIDATED INCOME STATEMENTS <TABLE> <CAPTION> Years ended December 31, 2000 1999 1998 ----------- ----------- ----------- <S> <C> <C> <C> Interest income: Loans, including fees $56,709,000 $36,742,000 $28,625,000 Securities, taxable 5,637,000 4,699,000 7,275,000 Securities, non-taxable 617,000 606,000 679,000 Federal funds sold 4,958,000 3,371,000 1,614,000 ----------- ----------- ----------- Total interest income 67,921,000 45,418,000 38,193,000 ----------- ----------- ----------- Interest expense: Deposits 24,174,000 14,502,000 11,685,000 Mandatorily redeemable trust preferred securities 823,000 -- -- Other 104,000 896,000 363,000 ----------- ----------- ----------- Total interest expense 25,101,000 15,398,000 12,048,000 ----------- ----------- ----------- Net interest income before provision for probable loan losses 42,820,000 30,020,000 26,145,000 Provision for probable loan losses 3,159,000 2,198,000 1,806,000 ----------- ----------- ----------- Net interest income after provision for probable loan losses 39,661,000 27,822,000 24,339,000 ----------- ----------- ----------- Noninterest income: Other investments 778,000 429,000 226,000 Service charges and other fees on deposit accounts 716,000 560,000 407,000 Servicing income 236,000 1,903,000 316,000 Gain on sale of Internet credit card portfolio 60,000 289,000 --- Gain on sale of shares of demutualized life insurance company 47,000 530,000 --- Gain on sales of securities available-for-sale 44,000 969,000 792,000 Gain on sale of deposits 16,000 240,000 --- Gain on sale of loans --- 262,000 435,000 Other income 980,000 869,000 1,002,000 ----------- ----------- ----------- Total noninterest income 2,877,000 6,051,000 3,178,000 ----------- ----------- ----------- Noninterest expenses: Salaries and employee benefits 17,477,000 14,493,000 10,941,000 Merger-related costs 3,164,000 --- --- Occupancy 2,399,000 2,034,000 1,424,000 Professional fees 1,861,000 1,659,000 1,041,000 Client services 1,839,000 1,527,000 2,426,000 Furniture and equipment 1,528,000 1,676,000 1,184,000 Advertising and promotion 1,029,000 1,113,000 1,001,000 Loan origination costs 1,011,000 539,000 449,000 Stationery & supplies 388,000 300,000 247,000 Telephone 359,000 208,000 172,000 Other 3,005,000 3,049,000 2,859,000 ----------- ----------- ----------- Total noninterest expenses 34,060,000 26,598,000 21,744,000 ----------- ----------- ----------- Income before income taxes 8,478,000 7,275,000 5,773,000 Provision for income taxes 3,049,000 2,606,000 2,267,000 ----------- ----------- ----------- Net income $ 5,429,000 $ 4,669,000 $ 3,506,000 =========== =========== =========== Earnings per share: Basic $ 0.51 $ 0.47 $ 0.39 Diluted $ 0.49 $ 0.43 $ 0.35 </TABLE> See notes to consolidated financial statements. F-6
50 HERITAGE COMMERCE CORP CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY YEARS ENDED DECEMBER 31, 2000, 1999, AND 1998 <TABLE> <CAPTION> Common Stock Accumulated Other Total Other ------------ Comprehensive Income Retained Shareholders' Comprehensive Shares Amount (Net of Taxes) Earning Equity Income ---------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> BALANCE, JANUARY 1, 1998 7,396,648 $28,528,000 $ 432,000 $ 2,513,000 $31,473,000 $ --- Net income --- --- --- 3,506,000 3,506,000 3,506,000 Net change in unrealized gain (loss) on securities available-for-sale, net of reclassification adjustment and taxes --- --- 110,000 --- 110,000 110,000 ------------ Total comprehensive income $ 3,616,000 ============ Common stock issued pursuant to July 1998 offering (net of issuance costs of $154,000) 580,644 5,846,000 --- --- 5,846,000 Repurchase of common stock (24,528) (130,000) --- --- (130,000) Stock dividend 242,847 1,386,000 --- (1,386,000) --- Stock options exercised 380,536 1,185,000 --- --- 1,185,000 ---------------------------------------------------------------------------- BALANCES, DECEMBER 31, 1998 8,576,147 36,815,000 542,000 4,633,000 41,990,000 Net income --- --- --- 4,669,000 4,669,000 $ 4,669,000 Net change in unrealized gain (loss) on securities available-for-sale, net of reclassification adjustment and taxes --- --- (1,796,000) --- (1,796,000) (1,796,000 ------------ Total comprehensive income $ 2,873,000 ============ Common stock issued pursuant to June 1999 offering (net of issuance costs of $172,000) 758,138 11,200,000 --- --- 11,200,000 Stock dividend 302,171 2,710,000 --- (2,710,000) --- Cash paid for factional shares (199) (4,000) --- --- (4,000) Stock options exercised 101,482 485,000 --- --- 485,000 ---------------------------------------------------------------------------- BALANCES, DECEMBER 31, 1999 9,737,739 51,206,000 (1,254,000) 6,592,000 56,544,000 Net income --- --- --- 5,429,000 5,429,000 $ 5,429,000 Net change in unrealized gain (loss) on securities available-for-sale, net of reclassification adjustment and taxes --- --- 1,769,000 --- 1,769,000 1,769,000 ------------ Total comprehensive income $ 7,198,000 ============ Stock dividend 639,444 9,272,000 --- (9,272,000) Cash paid for fractional shares (325) (3,000) --- --- (3,000) Stock options exercised 562,266 1,994,000 --- --- 1,994,000 ---------------------------------------------------------------------------- BALANCES, DECEMBER 31, 2000 10,939,124 $ 62,469,000 $ 515,000 $ 2,749,000 $ 65,733,000 ============================================================================ </TABLE> See notes to consolidated financial statements F-7
51 HERITAGE COMMERCE CORP CONSOLIDATED STATEMENTS OF CASH FLOWS <TABLE> <CAPTION> Years ended December 31, 2000 1999 1998 ------------- ------------- ------------- <S> <C> <C> <C> CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 5,429,000 $ 4,669,000 $ 3,506,000 Adjustments to reconcile net income to net cash provided by operating activities: (Loss) on disposals of property and equipment --- (283,000) (50,000) Depreciation and amortization 1,547,000 1,419,000 1,053,000 Provision for probable loan losses 3,159,000 2,198,000 1,806,000 Gain on sales of securities available-for-sale (44,000) (969,000) (792,000) Deferred income taxes (391,000) (709,000) (1,076,000) Amortization / accretion of discounts and premiums on 92,000 (239,000) 242,000 securities Proceeds from sales of loans held for sale --- 4,317,000 3,932,000 Originations of loans held for sale (13,845,000) (17,941,000) (5,674,000) Maturities of loans held for sale 157,000 7,839,000 694,000 Effect of changes in: Accrued interest receivable and other assets (3,869,000) (1,923,000) (3,493,000) Accrued interest payable and other liabilities 2,606,000 10,133,000 3,932,000 ------------ ------------- ------------- Net cash provided by operating activities (5,159,000) 8,511,000 4,080,000 ------------ ------------- ------------- CASH FLOWS FROM INVESTING ACTIVITIES: Net increase in loans (209,563,000) (47,203,000) (163,191,000) Purchases of securities available-for-sale (52,042,000) (39,550,000) (65,401,000) Maturities/Paydowns/Calls of securities available-for-sale 5,230,000 30,652,000 41,439,000 Proceeds from sales of securities available-for-sale 9,937,000 53,475,000 19,546,000 Purchase of securities held-to-maturity -- --- (20,203,000) Maturities/Paydowns/Calls of securities held-to-maturity 3,040,000 3,949,000 19,314,000 Purchase of corporate-owned life insurance (3,763,000) (4,214,000) (3,457,000) Purchase of property and equipment (1,071,000) (1,140,000) (3,669,000) Redemption (purchase) of other investment (521,000) 1,858,000 (1,733,000) Proceeds from sale of leased equipment --- --- 101,000 ------------ ------------- ------------- Net cash used in investing activities (248,753,000) (2,173,000) (177,254,000) ------------- ------------- CASH FLOWS FROM FINANCING ACTIVITIES: Net increase in deposits 136,766,000 91,504,000 154,188,000 Proceeds from issuance of mandatorily redeemable cumulative trust preferred securities of Subsidiary Grantor Trust 14,000,000 --- --- Repurchase of common stock --- --- (130,000) Net proceeds from issuance of common stock 1,991,000 11,681,000 7,031,000 Net change in FHLB borrowings 6,000,000 (17,000,000) 18,500,000 ------------ ------------- ------------- Net cash provided by financing activities 158,757,000 86,185,000 179,589,000 ------------ ------------- ------------- Net increase in cash and cash equivalents (95,155,000) 92,523,000 6,415,000 Cash and cash equivalents, beginning of year 155,224,000 62,701,000 56,286,000 ------------ ------------- ------------- Cash and cash equivalents, end of year $ 60,069,000 $ 155,224,000 $ 62,701,000 ============ ============= ============= - ------------------------------------------------------------------------------------------------------------------------------ Supplemental disclosures of cash flow information: Cash paid during the year for: Interest $ 17,324,000 $ 14,383,000 $ 11,228,000 Income taxes $ 5,974,000 $ 3,443,000 $ 1,795,000 Supplemental schedule of non-cash investing and financing activity: Transfer from retained earnings to common stock for stock dividend $ 9,272,000 $ 2,710,000 $ 1,386,000 Transfer of investment securities from HTM to AFS $ --- $ 11,669,000 $ --- </TABLE> See notes to consolidated financial statements. F-8
52 HERITAGE COMMERCE CORP NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) SIGNIFICANT ACCOUNTING POLICIES Description of Business and Basis of Presentation Heritage Commerce Corp (the "Company") operates as the bank holding company for four subsidiary banks: Heritage Bank of Commerce ("HBC"), Heritage Bank East Bay ("HBEB"), Heritage Bank South Valley ("HBSV"), and Bank of Los Altos ("BLA") (collectively the "Banks"). All are California state chartered banks which offer a full range of commercial and personal banking services to residents and the business/professional community in Santa Clara and Alameda Counties, California. HBC was incorporated on November 23, 1993 and commenced operations on June 8, 1994. HBEB was incorporated on October 21, 1998 and commenced operations on December 7, 1998. HBSV was incorporated on December 1, 1999 and commenced operations on January 18, 2000. The merger between Heritage Commerce Corp and Western Holdings Bancorp and its subsidiary, Bank of Los Altos, was effective on October 1, 2000, resulting in BLA operating as a wholly owned subsidiary of the Company. The merger was accounted for as a pooling-of-interests and all amounts have been restated on a historical basis as if the companies had been combined for all periods presented. During the year 2000, the Company formed two subsidiaries, Heritage Capital Trust I and Heritage Statutory Trust I, which are Delaware statutory business trusts formed for the exclusive purpose of issuing and selling trust preferred securities. The accounting and reporting policies of the Company and its subsidiary banks conform to accounting principles generally accepted in the United States of America ("GAAP") and prevailing practices within the banking industry. Use of Estimates The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Consolidation The consolidated financial statements include the accounts of the Company and its subsidiary banks. All material intercompany accounts and transactions have been eliminated. Cash and Cash Equivalents The Company considers all highly liquid debt instruments purchased with remaining terms to maturity of three months or less from the date of acquisition to be cash equivalents. Cash and cash equivalents include cash on hand, amounts due from banks, and federal funds sold. Generally, federal funds are sold and purchased for one-day periods. Securities The Company classifies its securities into two categories, available-for-sale and held-to-maturity, at the time of purchase. Securities available-for-sale are recorded at fair value with a corresponding recognition of the net unrealized holding gain or loss, net of income taxes, as a net amount within accumulated other comprehensive income, which is a separate component of shareholders' equity, until realized. Securities held-to-maturity are recorded at amortized cost, based on the Company's positive intent and ability to hold the securities to maturity. A decline in the market value of any available-for-sale or held-to-maturity security below cost that is deemed other than temporary results in a charge to earnings and the corresponding establishment of a new cost basis for the security. F-9
53 Premiums and discounts are amortized, or accreted, over the life of the related investment security as an adjustment to income using a method that approximates the interest method. Interest income is recognized when earned. Realized gains and losses for securities classified as available-for-sale are included in earnings and are derived using the specific identification method for determining the cost of securities sold. Loans Held for Sale The Company holds for sale the guaranteed portion of certain Small Business Administration (SBA) loans. These loans are carried at the lower of cost or market, determined in the aggregate. Gains or losses on SBA loans held for sale are recognized upon completion of the sale, and are based on the difference between the net sales proceeds and the relative fair value of the guaranteed portion of the loan sold compared to the relative fair value of the unguaranteed portion. The servicing assets that result from the sale of SBA loans, sold with servicing rights retained, are amortized over the lives of the loans using a method approximating the interest method. The Company accounts for the transfer and servicing of financial assets based on the financial and servicing assets it controls and liabilities it has incurred, derecognizes financial assets when control has been surrendered, and derecognizes liabilities when extinguished. Servicing assets are measured at their fair value and are amortized in proportion to and over the period of net servicing income and are assessed for impairment on an ongoing basis. Impairment is determined by stratifying the servicing rights based on interest rates and terms. Fair value is determined using prices for similar assets with similar characteristics, when available, or based upon discounted cash flows using market-based assumptions. Impairment is recognized through a valuation allowance. Any servicing assets in excess of the contractually specified servicing fees have been reclassified at fair value as an interest-only (I/O) strip receivable and treated like an available for sale security. The servicing asset, net of any required valuation allowance, and I/O strip receivable are included in other assets. Loans Loans are stated at the principal amount outstanding. The majority of the Company's loans are at variable interest rates. Interest on loans is credited to income when earned. Generally, if a loan is classified as non-accrual, the accrual of interest is discontinued, any accrued and unpaid interest is reversed, and the amortization of deferred loan fees and costs is discontinued. Loans are classified as non-accrual when the payment of principal or interest is 90 days past due, unless the amount is well secured and in the process of collection. Any interest or principal payments received on non-accrual loans are applied toward reduction of principal. Non-accrual loans generally are not returned to performing status until the obligation is brought current, has performed in accordance with the contract terms for a reasonable period of time, and the ultimate collectibility of the total contractual principal and interest is no longer in doubt. Renegotiated loans are those in which the Company has formally restructured a significant portion of the loan. The remaining portion is charged off, with a concession either in the form of below market rate financing, or debt forgiveness on the charged off portion. Loans that have been renegotiated and have not met specific performance standards for payment are classified as renegotiated loans within the classification of nonperforming assets. Upon payment performance, such loans may be transferred from nonperforming status to accrual status. At December 31, 2000 and 1999 the Company did not have any renegotiated loans outstanding. Non-refundable loan fees and direct origination costs are deferred and recognized over the expected lives of the related loans using the effective yield interest method. F-10
54 HERITAGE COMMERCE CORP NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Allowance for Probable Loan Losses The Company maintains an allowance for probable loan losses to absorb probable losses inherent in the loan portfolio. The allowance is based on ongoing, monthly assessments of the probable estimated losses. Loans are charged against the allowance when management believes that the collectibility of the principal is doubtful. The allowance is increased by the provision for loan losses, which is charged against current period operating results and decreased by the amount of charge-offs, net of recoveries. The Company's methodology for assessing the appropriateness of the allowance consists of several key elements, which include the formula allowance, specific allowances and the unallocated allowance. The formula allowance is calculated by applying loss factors to outstanding loans and certain unused commitments. Loss factors are based on the Company's historical loss experience and may be adjusted for significant factors that, in management's judgment, affect the collectibility of the portfolio as of the evaluation date. Specific allowances are established in cases where management has identified significant conditions or circumstances related to a credit that management believes indicate the probability that a loss has been incurred in excess of the amount determined by the application of the formula allowance. The allowance also incorporates the results of measuring impaired loans. Management considers a loan to be impaired when it is probable that the Company will be unable to collect all amounts due according to the original contractual terms of the note agreement. When a loan is considered to be impaired, the amount of impairment is measured based on the present value of expected future cash flows discounted at the note's effective interest rate, or the fair value of the collateral if the loan is collateral dependent. The unallocated allowance is based upon management's evaluation of various conditions that are not directly measured in the determination of the formula and specific allowances. The conditions evaluated in connection with the unallocated allowance may include existing general economic and business conditions affecting the key lending areas of the Company, in particular the technology industry and the real estate market, credit quality trends, collateral values, loan volumes and concentrations, seasoning of the loan portfolio, specific industry conditions within portfolio segments, recent loss experience in particular segments of the portfolio, duration of the current business cycle, and bank regulatory examination results. Premises and Equipment Premises and equipment are stated at cost. Depreciation and amortization are computed on a straight-line basis over the lesser of the lease terms or estimated useful lives of five to fifteen years, if appropriate. The Company evaluates the recoverability of long-lived assets on an on-going basis. Other Investments Other investments consist of cash surrender value of life insurance policies for certain officers and directors of the Company and its subsidiary banks. Income Taxes The Company files consolidated federal and combined state income tax returns. Amounts provided for income tax expense are based on income reported for financial statement purposes and do not necessarily represent amounts currently payable under tax laws. Deferred taxes, which arise principally from temporary differences between the period in which certain income and expenses are recognized for financial accounting purposes and the period in which they affect taxable income, are included in the amounts provided for income taxes. Under this method, the computation of the net deferred tax liability or asset gives current recognition to changes in the tax laws. F-11
55 HERITAGE COMMERCE CORP NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Stock-Based Compensation The Company accounts for stock-based awards to employees using the intrinsic value method in accordance with Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees. The Company presents the required proforma disclosures of the effect of stock-based compensation on net income and earnings per share using the fair value method in accordance with SFAS No. 123, Accounting for Stock-Based Compensation. Comprehensive Income Comprehensive income includes net income and other comprehensive income, which represents the changes in its net assets during the period from non-owner sources. The Company's only source of other comprehensive income is derived from unrealized gain and loss on securities available-for-sale and is presented net of tax. The following is a summary of the components of other comprehensive income. <TABLE> <CAPTION> For The Year Ended December 31, 2000 1999 1998 ----------- ----------- ----------- <S> <C> <C> <C> Net Income $ 5,429,000 $ 4,669,000 $ 3,506,000 ----------- ----------- ----------- Other comprehensive income, net of tax: Net unrealized holding gain (loss) on available-for-sale securities during the year 1,797,000 (1,174,000) 591,000 Less: reclassification adjustment for realized gains on available for sale securities included in net income during the year 28,000 622,000 481,000 ----------- ----------- ----------- Other comprehensive income 1,769,000 (1,796,000) 110,000 ----------- ----------- ----------- Comprehensive income $ 7,198,000 $ 2,873,000 $ 3,616,000 =========== =========== =========== </TABLE> Segment Reporting HBC, HBEB, HBSV, and BLA are commercial banks, which offer similar products to customers located in Santa Clara, Alameda, and Contra Costa counties of California. No customer accounts for more than 10 percent of revenue for HBC, HBEB, HBSV, BLA or the Company. Management evaluates the Company's performance as a whole and does not allocate resources based on the performance of different lending or transaction activities. Accordingly, the Company and its subsidiary banks all operate as one business segment. Earnings Per Share Basic earnings per share is computed by dividing net income by the weighted average common shares outstanding. Diluted earnings per share reflects potential dilution from outstanding stock options, using the treasury stock method. For each of the years presented, net income is the same for basic and diluted earnings per share. Reconciliation of weighted average shares used in computing basic and diluted earnings per share is as follows: <TABLE> <CAPTION> Years ended December 31, 2000 1999 1998 -------------------------------------- <S> <C> <C> <C> Weighted average common shares outstanding - used in computing basic earnings per share 10,607,584 9,885,036 8,990,769 Dilutive effect of stock options outstanding, Using the treasury stock method 500,745 1,037,941 926,138 -------------------------------------- Shares used in computing diluted earnings per share 11,108,329 10,922,977 9,916,907 ====================================== </TABLE> F-12
56 HERITAGE COMMERCE CORP NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Derivative Instruments and Hedging Activities The Company elected early adoption of Statement of Accounting Standards (SFAS) No. 133, "Accounting for Derivative Instruments and Hedging Activities" in 1999. The Company, in conjunction with relationships with five of its borrowers, has received warrants to purchase preferred and common stock of these companies, subject to certain restrictions. The Company has determined that such warrants represent embedded derivatives and as such has estimated the value of the warrants and included this amount in other assets. The Company does not have any freestanding derivatives and is not involved in any hedging activities. Reclassifications Certain amounts in the 1999 and 1998 financial statements have been reclassified to conform to the 2000 presentation. These reclassifications had no impact on shareholders' equity or net income. Recently issued Accounting Pronouncements SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities" was issued in September 2000. SFAS No. 140 is a replacement of SFAS No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities". Most of the provisions of SFAS No. 125 were carried forward to SFAS No. 140 without reconsideration by the FASB, and some were changed in only minor ways. In issuing SFAS No. 140, the FASB included issues and decisions that had been addressed and determined since the original publication of SFAS No. 125. SFAS No. 140 is effective for transfers and servicing of financial assets and extinguishments of liabilities occurring after March 31, 2001. Management believes that adopting these components of SFAS No. 140 will not have a material impact on the financial position or results of operations of the Company. SFAS No. 140 must be applied prospectively. For recognition and reclassification of collateral and for disclosures about securitizations and collateral, this statement was adopted as of December 31, 2000 and did not have a material impact on the financial position or results of operations of the Company. (2) BUSINESS COMBINATIONS In October 2000, the Company merged with Western Holdings Bancorp and its wholly owned subsidiary, Bank of Los Altos, which became a wholly owned subsidiary of Heritage Commerce Corp. Upon consummation of the merger, the outstanding common shares of Western Holdings Bancorp were converted into an aggregate of approximately 3,392,000 shares of Heritage Commerce Corp's common stock based on an exchange ratio of 1.2264 shares of Heritage Commerce Corp common stock for each share of Western Holdings Bancorp common stock. The transaction was accounted for as a pooling-of-interests. The following table presents the net interest income and net income for the nine months ended September 30, 2000 (Unaudited). These nine month results are included in the consolidated results of operations for the year ended December 31, 2000 presented in the accompanying consolidated income statement. <TABLE> <CAPTION> Nine Months Ended September 30, 2000 Heritage Western Holdings Combined (Dollars in thousands) Commerce Corp Bancorp Total ------------------------------------------------------------------------- <S> <C> <C> <C> Net interest income $21,735 $ 9,147 $30,882 Net income $ 3,258 $ 1,922 $ 5,180 </TABLE> F-13
57 HERITAGE COMMERCE CORP NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (3) SECURITIES The amortized cost and estimated fair value of securities as of December 31, 2000 were as follows: <TABLE> <CAPTION> Gross Gross Estimated Amortized Unrealized Unrealized Fair (Dollars in thousands) Cost Gains Losses Value ------- ------- ------- ------- <S> <C> <C> <C> <C> Securities available-for-sale: U.S. Treasury $ 8,527 $ --- $ 3 $ 8,524 U.S. Government Agencies 47,694 508 --- 48,202 Municipals 14,055 242 --- 14,297 FHLMC mortgage-backed securities 10,551 179 --- 10,730 GNMA mortgage-backed securities 8,212 --- 72 8,140 Other Debt Securities 1,000 1 --- 1,001 ------- ------- ------- ------- Total securities available-for-sale $90,039 $ 930 $ 75 $90,894 ======= ======= ======= ======= Securities held-to-maturity: Municipals $11,910 $ 211 $ --- $12,121 FHLMC mortgage-backed securities 3,573 --- 12 3,561 GNMA mortgage-backed securities 2,210 --- 7 2,203 CMOs 2,215 --- 25 2,190 ------- ------- ------- ------- Total securities held-to-maturity $19,908 $ 211 $ 44 $20,075 ======= ======= ======= ======= </TABLE> The amortized cost and estimated fair value of securities as of December 31, 1999 were as follows: <TABLE> <CAPTION> Gross Gross Estimated Amortized Unrealized Unrealized Fair (Dollars in thousand) Cost Gains Losses Value ------- -------- ------- ------- <S> <C> <C> <C> <C> Securities available-for-sale: U.S. Treasury $11,613 $ --- $ 112 $11,501 U.S. Government Agencies 22,491 --- 1,025 21,466 Municipals 8,161 --- 284 7,877 FHLMC mortgage-backed securities 1,623 --- 89 1,534 GNMA mortgage-backed securities 8,971 --- 504 8,467 Other Debt Securities 999 --- 22 977 ------- -------- ------- ------- Total securities available-for-sale $53,858 $ --- $ 2,036 $51,822 ======= ======== ======= ======= Securities held-to-maturity: Municipals $13,834 $ --- $ 220 $13,614 FHLMC mortgage-backed securities 4,365 --- 221 4,144 GNMA mortgage-backed securities 2,395 --- 130 2,265 CMOs 2,403 --- 163 2,240 ------- -------- ------- ------- Total securities held-to-maturity $22,997 $ --- $ 734 $22,263 ======= ======== ======= ======= </TABLE> During 1999, the Company transferred $11,669,000 of certain securities from the held-to-maturity to available-for-sale classification upon adoption and as allowed by SFAS No. 133 "Accounting for Derivative Instruments and Hedging Activities". The gross realized and gross unrealized gains or losses on the securities transferred were not significant to the Company. F-14
58 HERITAGE COMMERCE CORP NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The amortized cost and estimated fair values of securities as of December 31, 2000 by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or pre-pay obligations with or without call or pre-payment penalties. <TABLE> <CAPTION> Held-to-maturity Available-for-sale Amortized Estimated Fair Amortized Estimated Fair (Dollars in thousands) Cost Value Cost Value ------- ------- ------- ------- <S> <C> <C> <C> <C> Due within one year $ 1,885 $ 1,895 $13,108 $13,120 Due after one through five years 10,730 10,780 52,253 52,760 Due after five through ten years 6,585 6,721 19,663 19,865 Due after ten years 708 679 5,015 5,149 ------- ------- ------- ------- Total $19,908 $20,075 $90,039 $90,894 ======= ======= ======= ======= </TABLE> Sales of securities available-for-sale resulted in gross realized gains of $44,000, $969,000, and $797,000 during the years ended December 31, 2000, 1999, and 1998, respectively. Sales of securities available-for-sale did not result in any gross realized losses for the years ended December 31, 2000 and 1999. Sales of securities available-for-sale resulted in gross realized losses of $5,000 for the year ended December 31, 1998. Securities with amortized cost of $22,884,000 and $44,116,000 as of December 31, 2000 and 1999 were pledged to secure public and certain other deposits as required by law or contract. (4) LOANS Loans as of December 31 were as follows: <TABLE> <CAPTION> 2000 1999 ------------- ------------- Loans held for sale $ 35,931,000 $ 22,243,000 ============= ============= <S> <C> <C> Loans held for investment Commercial 200,846,000 144,288,000 Real estate - mortgage 230,468,000 153,518,000 Real estate - land and construction 171,325,000 96,868,000 Consumer 8,172,000 6,861,000 ------------- ------------- Total loans 610,811,000 401,535,000 Deferred loan fees (30,000) (295,000) Allowance for loan losses (9,651,000) (6,511,000) ------------- ------------- Loans, net $ 601,130,000 $ 394,729,000 ============= ============= </TABLE> Changes in the allowance for probable loan losses were as follows: <TABLE> <CAPTION> Years Ended December 31, 2000 1999 1998 ----------- ----------- ----------- <S> <C> <C> <C> Balance, beginning of year $ 6,511,000 $ 5,069,000 $ 3,270,000 Loans charged-off (52,000) (832,000) (179,000) Recoveries 33,000 76,000 172,000 ----------- ----------- ----------- Net loans charged-off (19,000) (756,000) (7,000) Provision for loan losses 3,159,000 2,198,000 1,806,000 Balance, end of year $ 9,651,000 $ 6,511,000 $ 5,069,000 =========== =========== =========== </TABLE> F-15
59 HERITAGE COMMERCE CORP NOTES TO CONSOLIDATED FINANCIAL STATEMENTS As of December 31, 2000, the Company had no loans on nonaccrual status, no loans past due 90 days or more and still accruing interest, and no impaired loans. As of December 31, 1999, the Company had $1,402,000 in loans on nonaccrual status, no loans past due 90 days or more and still accruing interest, and no impaired loans. As of December 31, 1998, the Company had $1,354,000 in loans on nonaccrual status, no significant loans past due 90 days or more and still accruing interest, and no impaired loans. For the year ended December 31, 2000, the Company did not have any foregone interest income on non-accrual loans. For the years ended December 31, 1999 and 1998, the Company had foregone $63,000 and $35,000 of interest income on non-accrual loans. The Company did not recognize any interest income for cash payments received on nonaccrual loans in 2000, 1999, or 1998. At December 31, 2000 and 1999, the Company serviced loans guaranteed by the Small Business Administration which it had sold to the secondary market of approximately $12,264,000 and $14,524,000, respectively. Concentrations of credit risk arise when a number of clients are engaged in similar business activities, or activities in the same geographic region, or have similar features that would cause their ability to meet contractual obligations to be similarly affected by changes in economic conditions. The Company's loan portfolio is concentrated in commercial (primarily manufacturing, wholesale, and service) and real estate lending, with the balance in consumer loans. While no specific industry concentration is considered significant, the Company's lending operations are located in the Company's market areas that are dependent on the technology and real estate industries and their supporting companies. Thus, the Company's borrowers could be adversely impacted by a downturn in these sectors of the economy which could reduce the demand for loans and adversely impact the borrowers' abilities to repay their loans. HBC, HBEB, HBSV, and BLA make loans to executive officers, directors, and their affiliates in the ordinary course of business. These transactions were on substantially the same terms as those prevailing at the time for comparable transactions with unrelated parties and do not involve more than normal risk or unfavorable terms for the Bank. The following table presents the loans outstanding to related parties for the years ended December 31, 2000 and 1999. <TABLE> <CAPTION> 2000 1999 ---- ---- <S> <C> <C> Beginning balance $ 1,456,000 $ 1,368,000 Advances on loans during the year 1,517,000 666,000 Repayment on loans during the year (898,000) (578,000) -------------------------- Ending balance $ 2,075,000 $ 1,456,000 ========================== </TABLE> (5) PREMISES AND EQUIPMENT Premises and equipment as of December 31 were as follows: <TABLE> <CAPTION> 2000 1999 ------------ ------------ <S> <C> <C> Land $ --- $ 265,000 Building --- 580,000 Furniture and equipment 6,063,000 5,517,000 Leasehold improvements 3,859,000 3,225,000 Software 930,000 834,000 ------------ ------------ 10,852,000 10,421,000 Accumulated depreciation and amortization (4,437,000) (3,529,000) ------------ ------------ Premises and equipment, net $ 6,415,000 $ 6,892,000 ============ ============ </TABLE> F-16
60 HERITAGE COMMERCE CORP NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Depreciation expense was $1,547,000 and $1,419,000, and $1,053,000 for the years ended December 31, 2000, 1999, and 1998, respectively. (6) DEPOSITS At December 31, 2000, the scheduled maturities of time deposits were as follows: <TABLE> <CAPTION> Year - ---- <S> <C> 2001 $230,846,000 2002 10,133,000 2003 and after 1,436,000 ------------ Total time deposits $242,415,000 ============ </TABLE> (7) BORROWING ARRANGEMENTS FHLB Borrowings & Available Lines of Credit The Company maintains a collateralized line of credit with the Federal Home Loan Bank (the FHLB) of San Francisco. Under this line, the Company can borrow from the FHLB on a short-term (typically overnight) or long-term (over one year) basis. Based on FHLB stock requirements at December 31, 2000, this line provided for maximum borrowings of $50,000,000. During the year of 2000, $5,000,000 long-term FHLB loans were repaid. As of December 31, 2000, the Company borrowed $18,000,000 from FHLB. At December 31, 2000, the Company has federal funds purchase lines and lines of credit of totaling $44,500,000. <TABLE> <CAPTION> December 31, 2000 1999 1998 ----------- ----------- ----------- <S> <C> <C> <C> Long-term borrowings: FHLB loan, fixed rate of 5.84% $ -- $ 2,000,000 $ -- FHLB loan, fixed rate of 6.29% -- 3,000,000 -- ----------- ----------- ----------- Total long-term borrowings -- 5,000,000 -- Short-term borrowings 18,000,000 7,000,000 22,000,000 ----------- ----------- ----------- Total FHLB borrowings $18,000,000 $12,000,000 $22,000,000 =========== =========== =========== </TABLE> Information concerning borrowings under the above arrangements is as follows: <TABLE> <CAPTION> 2000 1999 1998 -------------- -------------- -------------- <S> <C> <C> <C> Average balance during the year $ 2,020,000 $ 16,887,000 $ 6,862,000 Average interest rate during the year 5.17% 5.30% 5.30% Maximum month-end balance during the year $ 18,000,000 $ 14,000,000 $ 22,000,000 Average rate at December 31 5.13% 7.44% 5.04% </TABLE> F-17
61 HERITAGE COMMERCE CORP NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (8) Mandatorily Redeemable Cumulative Trust Preferred Securities of Subsidiary Grantor Trust Heritage Capital Trust I Heritage Capital Trust I is a Delaware business trust formed by Heritage Commerce Corp for the purpose of issuing Company obligated mandatorily redeemable cumulative trust preferred securities. During the first quarter of 2000, Heritage Capital Trust I issued 7,000 Trust Preferred Securities with a liquidation value of $1,000 per security to the Company for gross proceeds of $7,000,000. The entire proceeds of the issuance were invested by Heritage Capital Trust I in $7,000,000 aggregate principal amount of 10 7/8% subordinated debentures due 2030 (the Subordinated Debentures) issued by the Company. The Subordinated Debentures represent the sole assets of Heritage Capital Trust I. The Subordinated Debentures mature on March 8, 2030, bear interest at the rate of 10 7/8%, payable semi-annually, and are redeemable by the Company at a premium beginning on or after March 8, 2010 based on a percentage of the principal amount of the Subordinated Debentures as stipulated in the Indenture Agreement, plus any accrued and unpaid interest to the redemption date. The Subordinated Debentures are redeemable at 100 percent of the principal amount plus any accrued and unpaid interest to the redemption date at any time on or after March 8, 2020. The Trust Preferred Securities are subject to mandatory redemption to the extent of any early redemption of the Subordinated Debentures and upon maturity of the Subordinated Debentures on March 8, 2030. The Subordinated Debentures bear the same terms and interest rates as the Trust Preferred Securities. Holders of the trust preferred securities are entitled to cumulative cash distributions at an annual rate of 10 7/8 % of the liquidation amount of $1,000 per security. The distributions on the trust preferred securities are treated as interest expense in the consolidated income statements. The Company has the option to defer payment of the distributions for a period of up to five years, as long as the Company is not in default in the payment of interest on the Subordinated Debentures. The Company has guaranteed, on a subordinated basis, distributions and other payments due on the trust preferred securities (the Guarantee). The Guarantee, when taken together with the Company's obligations under the Subordinated Debentures, the Indenture Agreement pursuant to which the Subordinated Debentures were issued and the Company's obligations under the Trust Agreement governing the subsidiary trust, provide a full and unconditional guarantee of amounts due on the Trust Preferred Securities. Heritage Statutory Trust I Heritage Capital Statutory Trust I is a Delaware business trust formed by Heritage Commerce Corp for the purpose of issuing Company obligated mandatorily redeemable cumulative trust preferred securities. During the third quarter of 2000, Heritage Capital Statutory Trust I issued 7,000 Trust Preferred Securities with a liquidation value of $1,000 per security to the Company for gross proceeds of $7,000,000. The entire proceeds of the issuance were invested by Heritage Capital Statutory Trust I in $7,000,000 aggregate principal amount of 10.60% subordinated debentures due 2030 (the Subordinated Debentures) issued by the Company. The Subordinated Debentures represent the sole assets of Heritage Capital Statutory Trust I. The Subordinated Debentures mature on September 7, 2030, bear interest at the rate of 10.60%, payable semi-annually, and are redeemable by the Company at a premium beginning on or after September 7, 2010 based on a percentage of the principal amount of the Subordinated Debentures as stipulated in the Indenture Agreement, plus any accrued and unpaid interest to the redemption date. The Subordinated Debentures are redeemable at 100 percent of the principal amount plus any accrued and unpaid interest to the redemption date at any time on or after September 7, 2020. The Trust Preferred Securities are subject to mandatory redemption to the extent of any early redemption of the Subordinated Debentures and upon maturity of the Subordinated Debentures on September 7, 2030. The Subordinated Debentures bear the same terms and interest rates as the Trust Preferred Securities. F-18
62 HERITAGE COMMERCE CORP NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Holders of the trust preferred securities are entitled to cumulative cash distributions at an annual rate of 10.60% of the liquidation amount of $1,000 per security. The distributions on the trust preferred securities are treated as interest expense in the consolidated income statements. The Company has the option to defer payment of the distributions for a period of up to five years, as long as the Company is not in default in the payment of interest on the Subordinated Debentures. The Company has guaranteed, on a subordinated basis, distributions and other payments due on the trust preferred securities (the Guarantee). The Guarantee, when taken together with the Company's obligations under the Subordinated Debentures, the Indenture Agreement pursuant to which the Subordinated Debentures were issued and the Company's obligations under the Trust Agreement governing the subsidiary trust, provide a full and unconditional guarantee of amounts due on the Trust Preferred Securities. The Subordinated Debentures and related trust investments in the Subordinated Debentures have been eliminated in consolidation and the Trust Preferred Securities reflected as outstanding in the accompanying consolidated financial statements. Under applicable regulatory guidelines all of the Trust Preferred Securities currently qualify as Tier I capital. (9) INCOME TAXES The provision for income taxes for the years ended December 31, consisted of the following: <TABLE> <CAPTION> 2000 1999 1998 ----------- ----------- ----------- <S> <C> <C> <C> Current: Federal $2,052,000 $ 2,512,000 $ 2,595,000 State 606,000 803,000 748,000 ---------- ----------- ----------- Total current 2,658,000 3,315,000 3,343,000 ---------- ----------- ----------- Deferred: Federal 184,000 (640,000) (885,000) State 207,000 (69,000) (191,000) ---------- ----------- ----------- Total deferred 391,000 (709,000) (1,076,000) Provision for income taxes $3,049,000 $ 2,606,000 $ 2,267,000 =========== =========== =========== </TABLE> The effective tax rate differs from the federal statutory rate for the years ended December 31, as follows: <TABLE> <CAPTION> 2000 1999 1998 ---- ---- ---- <S> <C> <C> <C> Statutory federal income tax rate 35.0% 35.0% 35.0% State income taxes, net of federal tax benefit 3.1 6.6 6.3 Merger cost 6.9 -- -- Non-taxable interest income (3.2) (3.2) (3.5) Officers' life insurance (3.1) (1.9) (1.2) Other (2.7) (0.7) 2.7 ----- ----- ----- Effective tax rate 36.0% 35.8% 39.3% ===== ===== ===== </TABLE> F-19
63 HERITAGE COMMERCE CORP NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Net deferred tax asset as of December 31 consists of the following: <TABLE> <CAPTION> 2000 1999 ---- ---- <S> <C> <C> Deferred tax assets: Allowance for loan losses $3,491,000 $ 2,208,000 Accrued expenses 8,000 408,000 State income taxes 91,000 -- Securities available-for-sale -- 132,000 Net operating loss carryforward 519,000 788,000 Other 106,000 448,000 ---------- ----------- Total deferred tax assets 4,215,000 3,984,000 ---------- ----------- Deferred tax liabilities: Securities available-for-sale (332,000) -- Loan fees (172,000) -- State income taxes 0 (208,000) Other (154,000) (146,000) ---------- ----------- Total deferred tax liabilities (658,000) (354,000) ---------- ----------- Net deferred tax assets $3,557,000 $ 3,630,000 ========== =========== </TABLE> The Company believes that it is more likely than not that it will realize the above deferred tax assets in future periods; therefore, no valuation allowance has been provided against its deferred tax assets. The Company has net operating loss carryforwards of $1,451,375 for federal income tax purposes and $290,275 for California. The net operating losses expire in 2005 and 2001, respectively. These losses related to the entity that was the predecessor of the Bank of Los Altos, and are subject to restrictions as a result of the change of control that limits the maximum annual recovery of the net operating loss to $290,275. F-20
64 HERITAGE COMMERCE CORP NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (10) STOCK BASED COMPENSATION The Company has a stock option plan (the Plan) for directors, officers, and key employees. The Plan provides for the grant of incentive and non-qualified stock options. The Plan provides that the option price for both incentive and non-qualified stock options will be determined by the Board of Directors at no less than the fair value at the date of grant. Options granted vest on a schedule determined by the Board of Directors at the time of grant. Generally, options vest over four years. All options expire no later than ten years from the date of grant. As of December 31, 2000, 89,242 shares are available for future grants under the Plan. Option activity under the Plan is as follows: <TABLE> <CAPTION> Number Weighted Average of Shares Exercise Price - ---------------------------------------------------------------------------------------------------------------- <S> <C> <C> Options Outstanding at January 1, 1998 (1,200,869 exercisable at a weighted average exercise price of $3.00) 1,774,374 $ 2.97 - ---------------------------------------------------------------------------------------------------------------- Granted (weighted average fair value of $4.09) 494,921 10.33 Exercised (418,589) 1.61 Cancelled (16,178) 5.10 - ---------------------------------------------------------------------------------------------------------------- Options Outstanding at December 31, 1998 (1,195,274 exercisable at a weighted average exercise price of $4.58) 1,834,528 5.23 - ---------------------------------------------------------------------------------------------------------------- Granted (weighted average fair value of $6.46) 255,634 12.68 Exercised (109,467) 4.07 Cancelled (24,461) 7.96 - ---------------------------------------------------------------------------------------------------------------- Options Outstanding at December 31, 1999 (1,475,340 exercisable at a weighted average exercise price of $5.22) 1,956,234 6.26 - ---------------------------------------------------------------------------------------------------------------- Granted (weighted average fair value of $4.77) 246,144 8.17 Exercised (562,475) 3.27 Cancelled (66,070) 9.14 - ---------------------------------------------------------------------------------------------------------------- Options Outstanding at December 31, 2000 (1,086,985 exercisable at weighted average exercise price of $6.54) 1,573,833 $ 7.79 - ---------------------------------------------------------------------------------------------------------------- </TABLE> Additional information regarding options outstanding under the Plan as of December 31, 2000 is as follows: <TABLE> <CAPTION> Options Outstanding Options Exercisable - ---------------------------------------------------------------- ----------------------------- Weighted Average Remaining Weighted Weighted Range of Number Contractual Average Number Average Exercise Prices Outstanding Life (Yrs.) Exercise Price Exercisable Exercise Price - --------------------------------------------------------------- ---------------------------- <S> <C> <C> <C> <C> <C> $ 1.42 - 4.41 553,272 4.10 $ 3.00 551,421 $ 2.99 4.42 - 5.32 92,013 6.27 5.10 90,489 5.09 5.33 - 9.70 361,278 8.12 9.14 153,022 9.19 9.71 - 16.37 567,270 8.54 12.05 292,053 12.31 - --------------------------------------------------------------- ---------------------------- $ 1.42 - 16.37 1,573,833 6.75 $ 7.79 1,086,985 $ 6.54 =============================================================== ============================ </TABLE> As discussed in Note 1, the Company continues to account for its stock-based awards using the intrinsic value method in accordance with APB Opinion No. 25, Accounting for Stock Issued to Employees, and its related interpretations. Accordingly, no compensation expense has been recognized in the financial statements for employee stock option arrangements. F-21
65 HERITAGE COMMERCE CORP NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SFAS No. 123, Accounting for Stock-Based Compensation, requires the disclosure of pro forma net income and earnings per share had the Company adopted the fair value method at the grant date of all stock options. Under SFAS No. 123, the fair value of stock-based awards to employees is calculated through the use of option pricing models, even though such models were developed to estimate the fair value of freely tradable, fully transferable options without vesting restrictions, which differ significantly from the Company's stock option awards. Those models also require subjective assumptions, which greatly affect the calculated values. The Company's calculations were made using the Black-Scholes option pricing model with the following weighted average assumptions: expected life, 84 months; risk-free interest rate, 5.7% for 2000, 5.5% for 1999, and 4.7% for 1998; stock volatility of 35% in 2000, and 39% in 1999 and 30% in 1998; and no dividends during the expected term. The Company's calculations are based on a multiple option valuation approach, and forfeitures are recognized as they occur. Had compensation expense for the Company's stock option plan been determined under the requirements of SFAS No. 123 the Company's pro forma net income and earnings per common share would have been as follows: <TABLE> <CAPTION> Years ended December 31, 2000 1999 1998 ----------------------------------------- <S> <C> <C> <C> Net income As reported $5,429,000 $4,669,000 $3,506,000 Pro forma 4,501,000 3,893,000 2,955,000 Net income per common share - basic As reported 0.51 0.47 0.39 Pro forma 0.42 0.39 0.33 Net income per common share - diluted As reported 0.49 0.43 0.35 Pro forma 0.41 0.36 0.30 </TABLE> (11) LEASES The Company leases its premises under non-cancelable operating leases with terms, including renewal options, ranging from five to fifteen years. Future minimum payments under the agreements are as follows: <TABLE> <S> <C> Year ending December 31, 2001 $ 1,899,000 2002 1,942,000 2003 1,901,000 2004 1,879,000 2005 1,777,000 Thereafter 7,328,000 ----------- Total $16,726,000 =========== </TABLE> Rent expense under operating leases was $1,630,000, $1,359,000, and $994,000, during the years ended December 31, 2000, 1999, and 1998. Rent expense was reduced by deferred rent concessions on one of the Company's locations of $46,000 for the years ended December 31, 2000 and 1999, and $47,000 during the year ended December 31, 1998. F-22
66 HERITAGE COMMERCE CORP NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (12) BENEFIT PLANS The Company offers a 401(k) savings plan. All salaried employees are eligible to contribute up to 20% of their pre-tax compensation (to a maximum of $10,500 in 2000) to the plan through salary deductions under Section 401(k) of the Internal Revenue Code. The Company does not match employee contributions. The Company also sponsors an employee stock ownership plan. The plan allows the Company to purchase shares on the open market and award those shares to certain employees in lieu of paying cash bonuses. To be eligible to receive an award of shares under this plan, an employee must have worked at least 1,000 hours during the year and must be employed by the Company, or its subsidiaries, on December 31. Awards under this plan generally vest over four years. During 2000, 1999 and 1998, the Company made contributions of $250,000, $250,000, and $200,000 into the plan. The amount contributed into this plan was recognized as salaries and benefits expense in the Company's financial statements. At December 31, 2000, the ESOP owned approximately 43,000 shares of the Company's stock. The Company also has a nonqualified deferred compensation plan for the directors ("Deferral Plan"). Under the Deferral Plan, a participating director may defer up to 100% of his monthly board fees into the Deferral Plan for up to ten years. Amounts deferred earn interest at the rate of 8% per annum. The director may elect a distribution schedule of up to ten years with interest accruing (at the same 8%) on the declining balance. The Company's deferred compensation obligation of $200,000 and $170,000 as of December 31, 2000 and 1999 is included in "Accrued interest payable and other liabilities". The Company has purchased life insurance policies on the lives of directors who have agreed to participate in the Deferral Plan. It is expected that the earnings on these policies will offset the cost of the program. In addition, the Company will receive death benefit payments upon the death of the director. The proceeds will permit the Company to "complete" the deferral program as the director originally intended if he dies prior to the completion of the deferral program. The disbursement of deferred fees is accelerated at death and commences one month after the director dies. In the event of the director's disability prior to attainment of his benefit eligibility date, the director may request that the Board permit him to receive an immediate disability benefit equal to the annualized value of the director's deferral account. The Company has a supplemental retirement plan covering key executives and directors (Plan). The Plan is a nonqualified defined benefit plan and is unsecured and unfunded and there are no Plan assets. The Company has purchased insurance on the lives of the directors and executive officers in the plan and intends to use the cash values of these policies ($15,983,000 and $12,219,000 at December 31, 2000 and 1999, respectively) to pay the retirement obligations. The accrued pension obligation was $2,125,000 and $510,000 as of December 31, 2000 and 1999, respectively, and is included in "Accrued interest payable and other liabilities". The following table sets forth the unqualified supplemental retirement defined benefit pension plan's status at December 31, 2000: <TABLE> <S> <C> Change in projected benefit obligation Projected benefit obligation at beginning of year $ 253,000 Service cost 1,879,000 Interest cost 18,000 ------------ Projected benefit obligation at end of year $ 2,150,000 </TABLE> F-23
67 HERITAGE COMMERCE CORP NOTES TO CONSOLIDATED FINANCIAL STATEMENTS <TABLE> <S> <C> Change in Plan assets Fair value of Plan assets at beginning of year $ --- Fair value of Plan assets at end of year $ --- Funding Unfunded Status $(2,150,000) Unrecognized net actuarial gain 25,000 ----------- Accrued pension cost $(2,125,000) Weighted-average assumptions as of December 31 Discount rate 7.00% Rate of compensation increase N/A Expected return on Plan assets N/A </TABLE> The elements of pension costs for the unqualified supplemental retirement defined benefit pension plan at December 31, 2000 was as following: <TABLE> <S> <C> Components of net periodic benefits cost Service cost $ 1,879,000 Interest cost 18,000 ----------- Net periodic benefit cost $ 1,897,000 </TABLE> The net periodic pension cost was determined using the following assumptions: <TABLE> <S> <C> Discount rate 7.00% Rate of compensation increase N/A Expected return on Plan assets N/A </TABLE> (13) DISCLOSURES OF FAIR VALUE OF FINANCIAL INSTRUMENTS The estimated fair value amounts have been determined by using available market information and appropriate valuation methodologies. However, considerable judgment is required to interpret market data to develop the estimates of fair value. Accordingly, the estimates presented are not necessarily indicative of the amounts that could be realized in a current market exchange. The use of different market assumptions and/or estimation techniques may have a material effect on the estimated fair value amounts. The carrying amounts and estimated fair values of the Company's financial instruments as of December 31, 2000 and 1999 were as follows: <TABLE> <CAPTION> 2000 1999 --------------------------------------------------------- Carrying Estimated Carrying Estimated Amounts Fair Value Amounts Fair Value - ---------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Assets Cash and cash equivalents $ 60,069,000 $ 60,069,000 $155,224,000 $155,224,000 Securities 110,802,000 110,969,000 74,819,000 74,085,000 Loans, net 637,061,000 639,365,000 416,972,000 419,172,000 Cash surrender value of life insurance 15,983,000 15,983,000 12,219,000 12,219,000 - ---------------------------------------------------------------------------------------------------- Liabilities Time deposits 242,415,000 -- 186,230,000 185,952,000 Other deposits 495,771,000 495,771,000 415,190,000 415,190,000 Federal Home Loan Bank borrowings 18,000,000 18,000,000 12,000,000 12,000,000 Mandatorily redeemable cumulative trusts preferred securities 14,000,000 14,000,000 --- --- - ---------------------------------------------------------------------------------------------------- </TABLE> F-24
68 HERITAGE COMMERCE CORP NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The following methods and assumptions were used to estimate the fair value in the table, above: Cash and Cash Equivalents The carrying amount approximates fair value because of the short maturities of these instruments. Securities The fair value of securities is estimated based on bid market prices. The fair value of certain municipal securities is not readily available through market sources other than dealer quotations, so fair value estimates are based on such dealer quotations. Loans, net Loans with similar financial characteristics are grouped together for purposes of estimating their fair value. Loans are segregated by type such as commercial, term real estate, residential construction, and consumer. Each loan category is further segmented into fixed and adjustable rate interest terms. The fair value of performing, fixed rate loans is calculated by discounting scheduled future cash flows using estimated market discount rates that reflect the credit and interest rate risk inherent in the loan. The fair value of variable rate loans is the carrying amount as these loans generally reprice within 90 days. The fair value calculations are adjusted by the allowance for possible loan losses. Cash Surrender Value of Life Insurance The carrying amount represents a reasonable estimate of fair value. Deposits The fair value of deposits with no stated maturity, such as non-interest bearing demand deposits, savings, and money market accounts, approximates the amount payable on demand. The fair value of the demand deposit intangible has not been included in the fair value estimate. The carrying amount approximates the fair value of time deposits with a remaining maturity of less than 90 days. The fair value of all other time deposits is calculated based on discounting the future cash flows using rates currently offered by the Bank for time deposits with similar remaining maturities. Commitments to Fund Loans/Standby Letters of Credit The fair values of commitments are estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. The amounts of and differences between the carrying value of commitments to fund loans or stand by letters of credit and their fair value is not significant and therefore is not included in the table above. FHLB Borrowing The carrying amount approximates fair value because of the short maturities of these instruments. F-25
69 HERITAGE COMMERCE CORP NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Mandatorily Redeemable Cumulative Trust Preferred Securities of Subsidiary Grantor Trust The fair value of Mandatorily Redeemable Cumulative Trust Preferred Securities of Subsidiary Grantor Trust was determined based on the current market value for like kind instruments of a similar maturity and structure. Limitations Fair value estimates are made at a specific point in time, based on relevant market information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Bank's entire holdings of a particular financial instrument. Fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates. (14) COMMITMENTS AND CONTINGENCIES Financial Instruments with Off-Balance Sheet Risk HBC, HBEB, HBSV, and BLA are party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its clients. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk, in excess of the amounts recognized in the balance sheets. The Banks' exposure to credit loss in the event of non-performance of the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments. The Banks use the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. Credit risk is the possibility that a loss may occur because a party to a transaction failed to perform according to the terms of the contract. The Banks' control the credit risk of these transactions through credit approvals, limits, and monitoring procedures. Management does not anticipate any significant losses as a result of these transactions. Commitments to extend credit as of December 31, were as follows: <TABLE> <CAPTION> 2000 1999 ---- ---- <S> <C> <C> Commitments to extend credit $351,401,000 $545,936,000 Standby letters of credit 6,792,000 4,463,000 ------------ ------------ $358,193,000 $550,399,000 ============ ============ </TABLE> Commitments to extend credit are agreements to lend to a client as long as there is no violation of conditions established in the contract. Commitments generally have fixed expiration dates or other termination clauses. Since some of the commitments are expected to expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements. The Banks evaluate each client's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Banks upon extension of credit, is based on management's credit evaluation of the borrower. Collateral held varies but may include cash, marketable securities, accounts receivable, inventory, property, plant and equipment, income-producing commercial properties, and/or residential properties. Fair value of these instruments is not material. F-26
70 HERITAGE COMMERCE CORP NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Standby letters of credit are written conditional commitments issued by the Banks to guaranty the performance of a client to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to clients. Fair value of these instruments is not material. Claims In 1992 and for a period prior thereto, a former officer and director of Bank of Los Altos served as a director of Pacific National Financial Company (PNFC), a Canadian corporation, when a PNFC subsidiary was Bank of Los Altos's parent company. In December 1998, Bank of Los Altos received a request for indemnity from the former officer under an indemnity agreement entered into by Bank of Los Altos in December 1992. The request for indemnity relates to three complaints filed in July 1998 naming the former officer and seven other former directors of PNFC and seeks damages of $166 million ($Canadian 240 million) arising from their role as PNFC directors. The largest of the three actions alleges that the defendants breached their fiduciary duties to PNFC, resulting in its 1992 bankruptcy. The former officer has requested that Bank of Los Altos pay for his defense and indemnify him in connection with such actions. Although Bank of Los Altos has reserved its rights under the indemnity agreement, it has conditionally agreed to be responsible for payment of the former officer's defense costs. Following service of the complaints in December, 1998, Bank of Los Altos has been informed by counsel that there has been no effort to prosecute the cases by the plaintiffs or any communications from plaintiffs stating an intent to proceed with the litigation. Based on the representations of the former officer and discussions with legal counsel, management and the Board of Directors of the Company and Bank of Los Altos have no reason to believe that the indemnification will result in any material effect on the financial statements of the Company. (15) REGULATORY MATTERS The Company and its subsidiary Banks are subject to various regulatory capital requirements administered by the 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 financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Banks must meet specific capital guidelines that involve quantitative measures of the Company's and the Banks' assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Company's and the Banks' capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Company and the Banks 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 that, as of December 31, 2000, the Company and the Banks meets all capital adequacy guidelines to which it is subject. The most recent notification from the FDIC for the Banks as of December 31, 2000 categorized HBC, HBEB, HBSV, and BLA as "well capitalized" under the regulatory framework for prompt corrective action. As of December 31, 1999, FDIC categorized HBC, HBEB, and BLA as "well capitalized" under the regulatory framework for prompt corrective action. HBSV commenced operations in January 2000. To be categorized as "well capitalized" the Banks must maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the Bank's category. F-27
71 HERITAGE COMMERCE CORP NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The Company's actual capital amounts and ratios are presented in the table. <TABLE> <CAPTION> For Capital Actual Adequacy Purposes: ------------------------------------------------------------------- Amount Ratio Amount Ratio ------------------------------------------------------------------- <S> <C> <C> <C> <C> As of December 31, 2000 Total Capital $88,409,000 11.7% $60,451,000 (greater than or equal to) 8.0% (to risk-weighted assets) Tier 1 Capital $78,982,000 10.5% $30,088,000 (greater than or equal to) 4.0% (to risk-weighted assets) Tier 1 Capital $78,982,000 9.3% $33,971,000 (greater than or equal to) 4.0% (to average assets) As of December 31, 1999 Total Capital $63,764,000 12.5% $40,673,000 (greater than or equal to) 8.0% (to risk-weighted assets) Tier 1 Capital $57,610,000 11.3% $20,365,000 (greater than or equal to) 4.0% (to risk-weighted assets) Tier 1 Capital $57,610,000 8.5% $26,779,000 (greater than or equal to) 4.0% (to average assets) </TABLE> HBC's actual capital amounts and ratios are also presented in the table. <TABLE> <CAPTION> For Capital Actual Adequacy Purposes: --------------------------------------------------------------- Amount Ratio Amount Ratio --------------------------------------------------------------- As of December 31, 2000 <S> <C> <C> <C> <C> Total Capital $44,148,000 10.3% $34,290,000 (greater than or equal to) 8.0% (to risk-weighted assets) Tier 1 Capital $38,800,000 9.1% $17,055,000 (greater than or equal to) 4.0% (to risk-weighted assets) Tier 1 Capital $38,800,000 8.3% $18,699,000 (greater than or equal to) 4.0% (to average assets) </TABLE> <TABLE> <CAPTION> To Be Well-Capitalized Under Prompt Corrective Action Provisions: ----------------------------------------------- Amount Ratio ----------------------------------------------- As of December 31, 2000 <S> <C> <C> Total Capital $42,862,000 (greater than or equal to) 10.0% (to risk-weighted assets) Tier 1 Capital $25.582.000 (greater than or equal to) 6.0% (to risk-weighted assets) Tier 1 Capital $23,374,000 (greater than or equal to) 5.0% (to average assets) </TABLE> <TABLE> <CAPTION> For Capital Actual Adequacy Purposes: ----------------------------------------------------------------------- Amount Ratio Amount Ratio ----------------------------------------------------------------------- As of December 31, 1999 <S> <C> <C> <C> <C> Total Capital $34,010,000 10.5% $25,558,000 (greater than or equal to) 8.0% (to risk-weighted assets) Tier 1 Capital $29,611,000 9.3% $12,779,000 (greater than or equal to) 4.0% (to risk-weighted assets) Tier 1 Capital $29,611,000 7.3% $16,187,000 (greater than or equal to) 4.0% (to average assets) </TABLE> <TABLE> <CAPTION> To Be Well-Capitalized Under Prompt Corrective Action Provisions: ----------------------------------------------- Amount Ratio ----------------------------------------------- As of December 31, 1999 <S> <C> <C> Total Capital $31,948,000 (greater than or equal to) 10.0% (to risk-weighted assets) Tier 1 Capital $19,169,000 (greater than or equal to) 6.0% (to risk-weighted assets) Tier 1 Capital $20,234,000 (greater than or equal to) 5.0% (to average assets) </TABLE> F-28
72 HERITAGE COMMERCE CORP NOTES TO CONSOLIDATED FINANCIAL STATEMENTS HBEB's actual capital amounts and ratios are also presented in the table. <TABLE> <CAPTION> For Capital Actual Adequacy Purposes: ------------------------------------------------------------------------- Amount Ratio Amount Ratio ------------------------------------------------------------------------- As of December 31, 2000 <S> <C> <C> <C> <C> Total Capital $8,704,000 10.9% $6,388,000 (greater than or equal to) 8.0% (to risk-weighted assets) Tier 1 Capital $7,734,000 9.7% $3,189,000 (greater than or equal to) 4.0% (to risk-weighted assets) Tier 1 Capital $7,734,000 8.6% $3,597,000 (greater than or equal to) 4.0% (to average assets) As of December 31, 1999 Total Capital $6,212,000 11.8% $4,212,000 (greater than or equal to) 8.0% (to risk-weighted assets) Tier 1 Capital $5,608,000 10.7% $2,106,000 (greater than or equal to) 4.0% (to risk-weighted assets) Tier 1 Capital $5,608,000 8.1% $2,770,000 (greater than or equal to) 4.0% (to average assets) </TABLE> <TABLE> <CAPTION> To Be Well-Capitalized Under Prompt Corrective Action Provisions: ------------------------------------------------- Amount Ratio ------------------------------------------------- As of December 31, 2000 <S> <C> <C> Total Capital $7,985,000 (greater than or equal to) 10.0% (to risk-weighted assets) Tier 1 Capital $4,784,000 (greater than or equal to) 6.0% (to risk-weighted assets) Tier 1 Capital $4,497,000 (greater than or equal to) 5.0% (to average assets) As of December 31, 1999 Total Capital $5,265,000 (greater than or equal to) 10.0% (to risk-weighted assets) Tier 1 Capital $3,159,000 (greater than or equal to) 6.0% (to risk-weighted assets) Tier 1 Capital $3,472,000 (greater than or equal to) 5.0% (to average assets) </TABLE> HBSV's actual capital amounts and ratios are also presented in the table. <TABLE> <CAPTION> For Capital Actual Adequacy Purposes: ----------------------------------------------------------------------- Amount Ratio Amount Ratio ----------------------------------------------------------------------- As of December 31, 2000 <S> <C> <C> <C> <C> Total Capital $7,335,000 15.5% $3,786,000 (greater than or equal to) 8.0% (to risk-weighted assets) Tier 1 Capital $6,777,000 14.4% $1,883,000 (greater than or equal to) 4.0% (to risk-weighted assets) Tier 1 Capital $6,777,000 13.7% $1,979,000 (greater than or equal to) 4.0% (to average assets) </TABLE> <TABLE> <CAPTION> To Be Well-Capitalized Under Prompt Corrective Action Provisions: --------------------------------------------- Amount Ratio --------------------------------------------- As of December 31, 2000 <S> <C> <C> Total Capital $4,732,000 (greater than or equal to) 10.0% (to risk-weighted assets) Tier 1 Capital $2,824,000 (greater than or equal to) 6.0% (to risk-weighted assets) Tier 1 Capital $2,473,000 (greater than or equal to) 5.0% (to average assets) </TABLE> F-29
73 BLA's actual capital amounts and ratios are also presented in the table. <TABLE> <CAPTION> For Capital Actual Adequacy Purposes: -------------------------------------------------------------------------- Amount Ratio Amount Ratio -------------------------------------------------------------------------- <S> <C> <C> <C> <C> As of December 31, 2000 Total Capital (to risk-weighted assets) $21,476,000 10.9% $15,762,000 (greater than or equal to) 8.0% Tier 1 Capital (to risk-weighted assets) $19,218,000 9.8% $ 7,844,000 (greater than or equal to) 4.0% Tier 1 Capital (to average assets) $19,218,000 7.6% $10,115,000 (greater than or equal to) 4.0% </TABLE> <TABLE> <CAPTION> To Be Well-Capitalized Under Prompt Corrective Action Provisions: ----------------------------------------------- Amount Ratio ----------------------------------------------- <S> <C> <C> As of December 31, 2000 Total Capital (to risk-weighted assets) $19,703,000 (greater than or equal to) 10.0% Tier 1 Capital (to risk-weighted assets) $11,766,000 (greater than or equal to) 6.0% Tier 1 Capital (to average assets) $12,643,000 (greater than or equal to) 5.0% </TABLE> <TABLE> <CAPTION> For Capital Actual Adequacy Purposes: --------------------------------------------------------------------------- Amount Ratio Amount Ratio --------------------------------------------------------------------------- <S> <C> <C> <C> <C> As of December 31, 1999 Total Capital $13,852,000 10.0% $10,960,000 (greater than or equal to) 8.0% (to risk-weighted assets) Tier 1 Capital $12,344,000 8.9% $ 5,513,000 (greater than or equal to) 4.0% (to risk-weighted assets) Tier 1 Capital (to average assets) $12,344,000 6.1% $ 7,988,000 (greater than or equal to) 4.0% </TABLE> <TABLE> <CAPTION> To Be Well-Capitalized Under Prompt Corrective Action Provisions: ------------------------------------------------ Amount Ratio ------------------------------------------------ <S> <C> <C> As of December 31, 1999 Total Capital $13,700,000 (greater than or equal to) 10.0% (to risk-weighted assets) Tier 1 Capital $ 8,274,000 (greater than or equal to) 6.0% (to risk-weighted assets) Tier 1 Capital (to average assets) $10,089,000 (greater than or equal to) 5.0% </TABLE> The Company is required to maintain reserves with the Federal Reserve Bank of San Francisco. Reserve requirements are based on a percentage of certain deposits. As of December 31, 2000, the Company maintained reserves of $7,224,000 in the form of vault cash and balances at the Federal Reserve Bank of San Francisco, which satisfied the regulatory requirements. Under California law, the holders of common stock are entitled to receive dividends when and as declared by the Board of Directors, out of funds legally available therefor. The California Banking Law provides that a state-licensed bank may not make a cash distribution to its shareholders in excess of the lesser of the following: (i) the bank's retained earnings, or (ii) the bank's net income for its last three fiscal years, less the amount of any distributions made by the bank to its shareholders during such period. However, a bank, with the prior approval of the Commissioner, may make a distribution to its shareholders of an amount not to exceed the greater of (i) a bank's retained earnings, (ii) its net income for its last fiscal year, or (iii) its net income for the current fiscal year. In the event that the Commissioner determines that the shareholders' equity of a bank is inadequate or that the making of a distribution by a bank would be unsafe or unsound, the Commissioner may order a bank to refrain from making such a proposed distribution. At December 31, 2000, the amount available for such dividend without prior written approval was approximately $12,203,000 for HBC and $86,000 for HBEB, $81,000 for HBSV, and $4,544,000 for BLA. Similar restrictions apply to the amounts and sum of loans advances and other transfers of funds from the banks to the Company. (16) PARENT COMPANY ONLY CONDENSED FINANCIAL INFORMATION The condensed financial statements of Heritage Commerce Corp (parent company only) follow: <TABLE> <CAPTION> For the Years Ended, December 31, December 31, CONDENSED BALANCE SHEETS 2000 1999 ---------------------------- <S> <C> <C> Cash and cash equivalents $ 5,746,000 $11,323,000 Investment in and advancements to subsidiaries 73,476,000 46,559,000 Other assets 2,540,000 86,000 ----------- ----------- Total $81,762,000 $57,968,000 =========== =========== Liabilities 1,606,000 $ 1,424,000 Amounts due to nonbank subsidiaries 14,423,000 -- Shareholders' Equity 65,733,000 56,544,000 ----------- ----------- Total $81,762,000 $57,968,000 =========== =========== </TABLE> F-30
74 <TABLE> <CAPTION> For the Years Ended, December 31, December 31, December 31, CONDENSED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME 2000 1999 1998 ------------------------------------------------ <S> <C> <C> <C> Dividends from Bank subsidiaries $ 250,000 $ -- $ 475,000 Interest income 243,000 204,000 27,000 Management and service fees 6,995,000 -- -- Other income 100,000 -- -- Interest expense (2,0000) (16,000) -- Other expenses (10,552,000) (61,000) (655,000) ------------------------------------------------ Income (loss) before equity in net income of subsidiary banks (2,966,000) 127,000 (153,000) Equity in undistributed net income of subsidiaries 7,218,000 4,582,000 3,532,000 Income tax benefit (expense) 1,177,000 (40,000) 127,000 ------------------------------------------------ Net Income 5,429,000 4,669,000 3,506,000 ------------------------------------------------ Other comprehensive income 1,769,000 (1,796,000) 110,000 ------------------------------------------------ Comprehensive income $ 7,198,000 $ 2,873,000 $ 3,616,000 ================================================ </TABLE> <TABLE> <CAPTION> For the Years Ended, CONDENSED STATEMENTS OF CASH FLOWS December 31, December 31, December 31, 2000 1999 1998 ------------------------------------------------ <S> <C> <C> <C> Cash flows from operating activities: Net Income $ 5,429,000 $ 4,669,000 $ 3,506,000 Adjustments to reconcile net income to net cash provided by (used in) operations: Provision for deferred income taxes (1,042,000) 40,000 (11,000) Equity in undistributed income (losses) of subsidiaries (7,218,000) (4,582,000) (3,532,000) Net change in other assets (1,177,000) 19,000 (7,000) Net change in other liabilities 1,518,000 (31,000) (618,000) ------------------------------------------------ Net cash provided by (used in) by operating activities (2,490,000) 115,000 (662,000) Cash flows from investing activities: Other (dividends received from Bank subsidiaries) (17,079,000) (250,000) 300,000 Cash distributed to Bank subsidiaries -- (2,985,000) (250,000) ------------------------------------------------ Net cash (used in) investing activities (17,079,000) (3,235,000) 50,000 Cash flows from financing activities: Proceeds from issuance of common stock 1,991,000 11,641,000 7,031,000 Cash distributed to Bank subsidiaries -- -- (5,500,000) Payment to repurchase common stock -- -- (130,000) Proceeds from issuance of long-term debt 14,000,000 -- -- Proceeds from other short-term borrowings -- 4,000,000 -- Repayments of other short-term borrowings (2,000,000) (2,000,000) -- ------------------------------------------------ Net cash provided by financing activities 13,991,000 13,641,000 1,401,000 Net increase (decrease) in cash and cash equivalents (5,578,000) 10,521,000 789,000 Cash and cash equivalents, beginning of year 11,324,000 803,000 14,000 ------------------------------------------------ Cash and cash equivalents, end of year $ 5,746,000 $ 11,324,000 $ 803,000 ================================================ </TABLE> F-31
75 EXHIBIT INDEX <TABLE> <CAPTION> Incorporated by Reference to Form --------------------------------- Filed 8-A Exhibit Herewith Dated 10-K Dated No. ---------- --------- ----------- ----------- <S> <C> <C> <C> <C> <C> 2.1 Agreement and Plan of Merger and Reorganization dated as of May 9, 2000 between Heritage Commerce Corp and Western Holdings Bancorp (incorporated by reference from Annex A of the registration statement on Form S-4, Registration No. 333-40384, filed with the Commission on June 29, 2000) 3.1 Heritage Commerce Corp Articles of 3-5-98 4.1 Incorporation: [Incorporated herein by reference from Exhibit 4 to Heritage Commerce Corp's Form 8-A: Registration of Securities Pursuant to Section 12(g) of the Securities Exchange Act of 1934 dated March 5, 1998 (File No. 000-23877)] 3.2 Heritage Commerce Corp Bylaws 3-5-98 4.2 10.1 Real Property Leases for properties located 3-5-98 10.1 at 150 Almaden Blvd., San Jose and 100 Park Center Plaza, San Jose. 10.2 Employment agreement with Mr. Rossell dated 3-5-98 10.2 June 8, 1994* 10.3 Employment agreement with Mr. Gionfriddo 3-5-98 10.3 dated June 8, 1994 * 10.4 Amendment No. 2 to Employment Agreement with 3-31-98 10.4 Mr. Gionfriddo * 10.5 Employment agreement with Mr. Conniff dated 3-31-99 10.5 April 30, 1998 * 10.6 Employment agreement with Mr. Nethercott 3-31-99 10.6 dated April 16, 1998 * 10.7 Employment agreement with Mr. McGovern dated 3-31-99 10.7 July 16, 1998 * 21.1 Subsidiaries of the registrant X 23.1 Consent of Deloitte & Touche LLP X 23.2 Consent of Arthur Andersen LLP X 23.3 Consent of PricewaterhouseCoopers LLP X </TABLE> * Management contract or compensatory plan or arrangement.