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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 [FEE REQUIRED]
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED]
FOR THE TRANSITION PERIOD FROM
--------------- TO
--------------- .
COMMISSION FILE NO.
HERITAGE COMMERCE CORP
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
<TABLE>
<S> <C>
CALIFORNIA 77-0469558
(STATE OR OTHER JURISDICTION OF INCORPORATION (I.R.S. EMPLOYER IDENTIFICATION NO.)
OR ORGANIZATION)
150 ALMADEN BOULEVARD 95113
SAN JOSE, CALIFORNIA (ZIP CODE)
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
</TABLE>
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:
<TABLE>
<S> <C>
COMMON STOCK (NO PAR VALUE) NASDAQ ELECTRONIC BULLETIN BOARD
(TITLE OF EACH CLASS) (NAME OF EACH EXCHANGE ON WHICH REGISTERED)
</TABLE>
Indicate by check mark whether the Company (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 Company
was required to file such reports), and (2) has been subject to such filing
requirements for the last 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 voting stock held by non-affiliates of the
registrant, based upon the closing price of its common stock on February 28,
1998, on the NASDAQ Electronic Bulletin Board was $49,438,000
As of February 28, 1998, 3,295,896 shares of the registrant's common stock
(no par value) were outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
<TABLE>
<CAPTION>
DOCUMENTS INCORPORATED PARTS OF FORM 10-K INTO WHICH INCORPORATED
---------------------- ------------------------------------------
<S> <C>
Definitive proxy statement for the Company's 1998 Annual Part III
Meeting of Shareholders to be filed within 120 days of the
end of the fiscal year ended December 31, 1997.
</TABLE>
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HERITAGE COMMERCE CORP
INDEX TO
ANNUAL REPORT ON FORM 10-K
FOR YEAR ENDED DECEMBER 31, 1997
PART I
<TABLE>
<CAPTION>
PAGE
----
<S> <C> <C>
Item 1 Business.................................................... 1
Item 2 Properties.................................................. 13
Item 3 Legal Proceedings........................................... 13
Item 4 Submission of Matters to a Vote of Security Holders......... 13
PART II
Item 5 Market for the Registrant's Common Equity and Related
Shareholder Matters......................................... 14
Item 6 Selected Financial Data..................................... 16
Item 7 Management's Discussion and Analysis of Financial Condition
and Results of Operations................................... 18
Item 7A Quantitative and Qualitative Disclosures About Market
Risk........................................................ 32
Item 8 Financial Statements and Supplementary Data................. 34
Item 9 Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure.................................... 34
PART III
Item 10 Directors and Executive Officers of the Registrant.......... 34
Item 11 Executive Compensation...................................... 34
Item 12 Security Ownership of Certain Beneficial Owners and
Management.................................................. 34
Item 13 Certain Relationships and Related Transactions.............. 34
PART IV
Item 14 Exhibits, Financial Statement Schedules, and Reports on Form
8-K......................................................... 35
</TABLE>
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PART I
ITEM 1. BUSINESS
GENERAL
Heritage Bank of Commerce (the "Bank") commenced operations as a California
state-chartered bank on June 8, 1994. The Bank was organized to address the
needs of small, closely-held businesses and their owners in the community of San
Jose, California and the surrounding cities. Consolidation in the local banking
market, particularly among independent, community banks, left a competitive void
that the founders of the Bank sought to fill with an institution devoted to a
highly customized service approach. The Bank offers financial solutions tailored
to the particular needs of its clients, rather than the formulaic and impersonal
approach used by many of the Bank's larger competitors. With an initial
capitalization in excess of $14 million, the Bank invested heavily in technology
to maximize employee efficiency.
As a result, the Bank has, in the intervening three and one-half years,
developed a wide array of products and services for small businesses and their
owners, such as factoring, SBA-guarantied loans, light aircraft financing, and
personal computer-based on-line cash management, together with more common
products such as accounts receivable lines of credit and traditional passbook
savings accounts. In addition, the Bank has developed an expertise in unusual
areas such as deposit services for U.S. Bankruptcy Trustees. Indeed, the Bank's
ability to develop such specialized expertise has been instrumental in its rapid
deposit growth. A second equity offering to the public in 1996 that raised an
additional $6 million provided a base for continued asset growth and higher
lending limits. Recently, the Bank has expanded its geographic reach with the
opening of a branch office in Fremont, California.
The Bank's deposit accounts are insured under the Federal Deposit Insurance
Act, up to the maximum applicable limits thereof. The Bank is not a member of
the Federal Reserve System. The Bank's main office is located in the city of San
Jose, California.
Formation of Bank Holding Company
On December 18, 1997, the shareholders of the Bank met at a special meeting
to approve the formation of a bank holding company by the adoption of a merger
agreement. The merger agreement provides for the Bank to merge and become a
wholly-owned subsidiary of the newly formed Heritage Commerce Corp bank holding
company (the "Company"). The merger agreement became effective February 17,
1998, when the shareholders of the Bank received one share of the Heritage
Commerce Corp common stock for each share of Bank common stock held. 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). For the
purposes of the Securities Exchange Act of 1934, the Company is the successor to
the Bank.
In the opinion of the Bank's Board of Directors, a bank holding company
structure provides the Bank with certain advantages, including additional
flexibility in expansion of the Bank's business through the formation of new
subsidiary banks and other Company subsidiaries in new markets, the acquisition
of other financial institutions, the raising of additional funds through
borrowing (if needed), the ability to repurchase its securities, and flexibility
in acquiring or establishing other businesses related to banking, all of which
actions are subject to applicable regulatory requirements.
The terms the Bank and the Company are interchangeable throughout this
report.
New Branches and Subsidiaries
On February 9, 1998, the Bank opened a full-service branch in the city of
Fremont, California. The Bank's Board of Directors view this geographic
expansion as a natural extension of the Bank's primary market area to include
southern Alameda county, which has a high concentration of potential clients
with banking service requirements similar to those of the Bank's current client
mix.
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Once the branch is established in the community, the Company intends to
apply to the California Department of Financial Institutions for authority to
organize a de novo bank. Once authorized, the de novo bank will become a
subsidiary of the Company and take control of the existing branch in Fremont.
General Banking Services
The Bank's customer base consists primarily of small to medium-sized
businesses and their owners, managers, and employees residing in the Santa Clara
Valley. Businesses served include manufacturers, distributors, contractors,
professional corporations/partnerships, and service businesses. The Bank had
approximately 2,700 and 2,300 deposit accounts at December 31, 1997 and 1996,
respectively.
The Bank offers a range of loans, primarily commercial, including real
estate, construction, Small Business Administration (SBA), inventory and
accounts receivable, and equipment loans. The Bank 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 Bank issues VISA and MasterCard credit cards through a
correspondent bank. The Bank has no subsidiaries and does not have a trust
department. In March, 1996, the Bank entered into an agreement to refer trust
business to Enterprise Trust & Investment Company (Enterprise), an unaffiliated
trust and investment company regulated by the California Department of Financial
Institutions. The Bank shares in the fees generated by the business that it
refers to Enterprise.
The Bank's main and executive offices are located at 150 Almaden Boulevard,
San Jose, California 95113. In addition, the Bank established a branch office at
3077 Stevenson Blvd., Fremont, California 94538. See Item 2 -- "PROPERTIES." The
Bank's primary market area is Santa Clara and Alameda counties. The Bank serves
a secondary market consisting of the South Bay portion of the San Francisco Bay
area, including portions of all counties contiguous to its primary market area.
COMPETITION
The banking and financial services business in California generally, and in
the Bank'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 Bank competes for loans
and 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 Bank. In order to compete with the other financial services providers, the
Bank 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 Bank is unable to accommodate a customer's needs, the
Bank 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
As a registered bank holding company, (effective February 17, 1998), the
Company is subject to the supervision of, and to regular inspection by, the FRB.
The activities of the Company are 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, 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
2
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required to give notice to or obtain prior approval of the FRB to engage in any
new activity or to acquire more than 5% of any class of voting stock of any.
Bank holding companies are also required to obtain the prior approval of the FRB
before acquiring more than 5% of any class of voting stock of any bank which is
not already majority-owned by the bank holding company.
The Bank is a member of the Federal Deposit Insurance Corporation (FDIC),
which currently insures the deposits of member banks to a maximum of $100,000
per depositor. For this protection, the Bank pays a semi-annual assessment and
is subject to the rules and regulations of the FDIC pertaining to deposit
insurance and other matters.
The Bank is a California state-chartered bank, but is not a member of the
Federal Reserve System. State banks are subject to regulation, supervision and
regular examination by the California Department of Financial Institutions. The
regulations of these agencies govern most aspects of the Bank's business,
including reporting requirements, activities, investments, loans, borrowings,
certain check-clearing activities, branching, mergers and acquisitions, reserves
against deposits, and other areas.
Limitations on Dividends
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. For restrictions
applicable to the Company, see Item 5 -- "MARKET FOR REGISTRANT'S COMMON EQUITY
AND RELATED STOCKHOLDER MATTERS -- DIVIDENDS."
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.
Safety and Soundness Standards
In July 1995, the federal banking agencies adopted final guidelines
establishing standards for safety and soundness, as required by the Federal
Deposit Insurance Corporation Improvement Act of 1991 (FDICIA). 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, asset growth and compensation, and fees
and benefits. Guidelines for asset quality and earnings standards will be
adopted in the future. The guidelines establish the safety and soundness
standards that the agencies will 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. This support may be required at times when a bank
holding company may not be able to provide such support.
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<PAGE> 6
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% (at least 4% in the form of "Tier 1" capital).
Tier 1 capital consists of common equity, non-cumulative perpetual preferred
stock 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
required to maintain capital levels ranging from 1% to 2% above the 3% minimum.
The following table presents the capital ratios of the Bank computed in
accordance with applicable regulatory guidelines and compared to the standards
for minimum capital adequacy requirements and for well-capitalized institutions
under the FDIC's prompt corrective action authority as of December 31, 1997:
<TABLE>
<CAPTION>
DECEMBER 31, 1997
----------------------------------------------------------------
FOR CAPITAL ADEQUACY TO BE
ACTUAL PURPOSES WELL CAPITALIZED
------------------- -------------------- -------------------
AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO
----------- ----- ----------- ------ ----------- -----
<S> <C> <C> <C> <C> <C> <C>
Total risk-based capital/
risk-weighted assets... $23,784,000 15.8% $12,033,000 $ 8.0% $15,042,000 $ 10%
Tier 1
capital/risk-weighted
assets................. $21,899,000 14.6% $ 6,017,000 $ 4.0% $ 9,025,000 $ 6%
Tier 1 capital/average
assets................. $21,899,000 10.3% $ 8,499,000 $ 4.0% $10,624,000 $ 5%
</TABLE>
Federal banking agencies, including the FRB and the FDIC, have adopted
regulations implementing a system of prompt corrective action pursuant to the
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............................... ,8.0% ,4.0% ,4.0%
Significantly undercapitalized................. ,6.0% ,3.0% ,3.0%
Critically undercapitalized (1)................ N/A N/A N/A
</TABLE>
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(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
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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 things, 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.
In June 1996, the federal banking agencies 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
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>
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(1) Subject to a statutory minimum assessment of $2,000 per year (which also
applies to all other assessment risk classifications).
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At December 31, 1997, the Bank's assessment rate was equivalent to a well
capitalized, group A institution.
The crisis in the savings and loan industry during the late 1980's resulted
in the dissolution of the Federal Savings and Loan Insurance Corporation and the
insurance of thrift deposits through a separate fund of the FDIC called the
Savings Association Insurance Fund (SAIF) and the issuance of bonds by the
Financing Corporation (FICO) to cover some of the losses incurred by the failed
savings associations. As the banking industry in general has become more
healthy, deposit insurance premiums for well-managed and strongly-capitalized
BIF-insured institutions have decreased to very low levels. However, because of
the cost of carrying bonds by FICO to cover some of the losses incurred by
failed savings associations, and because SAIF still needed to build reserves,
deposit insurance premiums for SAIF-insured institutions have not decreased.
This disparity between the cost of deposit insurance for healthy banks and
similarly situated thrifts over the last several years caused many healthy
thrifts to seek ways either to convert to BIF insurance or to obtain BIF
insurance for some portion of their deposits in order to remain competitive with
banks. The migration of deposits increased the pressure on the remaining thrifts
to build up reserves at the SAIF and pay the cost of servicing the FICO bonds.
The Economic Growth and Regulatory Paperwork Act of 1996 (Economic Growth
Act) required all remaining SAIF institutions (subject to certain exceptions) to
pay a one-time deposit assessment of $0.657 per $100 of insured deposits in 1996
in order to recapitalize SAIF. The banking agencies are now required by law to
take actions to prevent the migration of deposits from SAIF to BIF until the
year 2000. In addition, the cost of carrying FICO bonds will now be allocated
between BIF-insured institutions and SAIF-insured institutions, with BIF-insured
institutions paying one-fifth the amount paid by SAIF-insured institutions. The
FDIC recently estimated that BIF-insured institutions will pay an assessment of
approximately $0.0128 annually per $100 of insured deposits, and SAIF-insured
institutions will pay an assessment of approximately $0.0644 annually per $100
of insured deposits.
This legislation will increase the Bank's premiums, as it will now be
required to share in the cost of carrying the FICO bonds. The increase will be
slight until the year 2000, at which time it will increase.
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
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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 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. In addition, a bank
that is "adequately capitalized"
7
<PAGE> 10
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
Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994
Interstate Banking and Branching. The Riegle-Neal Interstate Banking and
Branching Efficiency Act of 1994 (Riegle-Neal Act) was enacted in September
1994. Generally, provisions of this Act authorize 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
has opted out.
- Interstate acquisition 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.
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 will 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. A bank will not be 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.
8
<PAGE> 11
Host State Regulation. The Riegle-Neal Amendments Act of 1997 amends
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
will be required for each state in which an interstate bank has a branch.
Interstate banks will be prohibited from using out-of-state branches "primarily
for the purpose of deposit production." Federal banking agencies were required
to adopt regulations by June 1, 1997 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 will be subject to
the CRA to the extent the acquired branch was subject to the CRA before the
acquisition.
California Law: In September, 1995, California 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. This 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 Bank, and the
companies with which they are associated, may conduct banking transactions with
the Bank 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
collectability 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. 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 regulators have recently adopted new rules for compliance with the
provisions of CRA. Under the revised regulations, the 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
9
<PAGE> 12
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 under the revised regulations to compile
and report certain data on their lending activities in order to measure
performance. Some of this data is already required under other laws, such as the
Equal Credit Opportunity Act (ECOA). 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. The federal regulators who are implementing the new regulations have
reported that the time spent at the banks during CRA examinations is reduced
under the new regulations and the banks spend less time on paperwork evidencing
compliance. 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.
The impact of these new rules on the Bank cannot be predicted.
Environmental Regulation
Federal, state, and local regulations regarding the discharge of materials
into the environment may have an impact on the Bank. 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 were amended in 1996 to 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 (CERCLA). 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. This amendment to
California law became effective with respect to judicial proceedings filed and
orders issued after January 1, 1997.
The extent of the protection provided by both the federal and state lender
protection statutes will depend on their interpretation by administrative
agencies and courts. The Bank cannot predict whether it will be adequately
protected for the types of loans made by it. In addition, the Bank 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 Bank may be environmentally impaired and not provide adequate security for
the Bank. The Bank 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 Bank lends based on its evaluation of the
collateral, net worth of the borrower, and the borrower's capacity for
unforeseen business interruptions or risks.
10
<PAGE> 13
Limitation on Activities
The FDICIA prohibits state chartered-banks and their subsidiaries from
engaging, as principal, in activities not permissible by national banks and
their subsidiaries, unless the FDIC 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, effective January 1, 1996, eliminated certain
existing 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, among other matters, authorize 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.
11
<PAGE> 14
Impact of Economic Conditions and Monetary Policies
The earnings and growth of the Bank 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 Bank 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 Bank.
Legislation enacted in 1996 provides for the merger of the BIF and SAIF on
January 1, 1999, if there are no savings associations in existence on that date.
Pursuant to that legislation, the Department of Treasury in May 1997 recommended
in report to Congress that the separate charters for thrifts and banks be
abolished. Various proposals to eliminate the federal thrift charter, create a
uniform financial institutions charter, conform holding company regulation and
abolish the Office of Thrift Supervision ("OTS") have been introduced by
Congress. The House Committee on Banking and Financial Services has considered
and reported H.R. 10, the Financial Services Competition Act of 1997, including
Title III, the "Thrift Charter Transition Act of 1997." This act would (i)
require federal savings associations to convert to national banks or some type
of state charter within two years of enactment; (ii) merger the BIF and SAIF;
and (iii) combine the OTS with the OCC. A converted federal thrift generally
would be permitted to continue to engage in any activity, including the holding
of any asset, lawfully conducted on the date prior to enactment, retain all
branches established or proposed in an pending application as of enactment and
establish new branches in any state in which it has a branch. Otherwise it may
establish new branches only under national bank rules. Beginning two years after
enactment, national banks would be authorized to exercise all powers formerly
authorized for federal savings associations.
Under H.R. 10, holding companies for converted savings associations
generally would become subject to the same regulation as bank holding companies,
with a grandfather provision for former unitary savings and loan holding
companies. Grandfathered companies would be permitted to maintain and establish
affiliations with any type of company and to acquire additional depository
institutions, as long as any acquired depository institution is merged into its
converted savings association and such institution continues to comply with both
the qualified thrift lender test and certain asset and investment limitations to
which it was subject as a federal savings association. Such a converted holding
company would be subject to the same capital requirements (if any) applicable
under OTS regulation if it were a savings and loan holding company on June 19,
1997, and for three years would be subject to substantially similar regulation,
reporting and examination as implemented by the OTS as of January 1, 1997.
H.R. 10, if adopted, would substantially repeal the Glass-Steagall Act
restrictions on bank affiliations with securities firms and thereby allow
commercial banking and investment banking to be combined. It would also repeal
restrictions on bank affiliations with insurance companies.
12
<PAGE> 15
Various revisions and alternatives to H.R. 10 have been proposed. There can
be no assurance as to whether H.R. 10 or any other such legislation will be
enacted, what the provisions of any such final legislation may be, or the extent
to which the legislation would restrict, disrupt or otherwise have a material
effect on operations.
EMPLOYEES
At December 31, 1997, the Bank employed 88 persons, primarily on a
full-time basis. The Bank's employees are not represented by any union or
collective bargaining agreement and the Bank believes its employee relations are
satisfactory.
ITEM 2. PROPERTIES
The Bank's main office is located at 150 Almaden Boulevard, San Jose,
California. The main office is leased under non-cancelable operating leases with
a non-affiliated third party with terms, including renewal options, ranging from
five to fourteen 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 fifteen-story class-A office building in
downtown San Jose, California. The lease arrangement for the primary operating
area is a "partial gross lease" for fifteen 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, approximately 1,255 square feet of space is leased 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 Bank leased an area on the second floor of the Bank'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 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.
Since April 21, 1997, the Bank has also leased space at 100 Park Center
Plaza, Suite 430, San Jose, consisting of approximately 3,277 square feet of
space. The lease commenced on April 21, 1997 and will terminate on April 30,
2000. The rent for the entire term of the lease is $5,243 per month.
In February, 1998, the Bank leased space 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% per year.
ITEM 3. LEGAL PROCEEDINGS
To the best of the Bank's knowledge, there are no pending legal proceedings
to which the Bank is a party which may have a materially adverse effect on the
Bank's financial condition, results of operations, or cashflows.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
On December 18, 1997, the shareholders of the Bank met at a special meeting
to approve the formation of a bank holding company by the adoption of a merger
agreement. The merger agreement provides for the Bank to merge and become a
wholly-owned subsidiary of the newly formed Heritage Commerce Corp bank holding
company. At the special meeting, the merger agreement passed with a vote of
2,199,348 for the merger and 315 votes against with total outstanding shares of
3,294,898. The merger agreement became effective February 17, 1998, when the
shareholders of the Bank received one share of the Heritage Commerce Corp common
stock for each share of Bank common stock held.
13
<PAGE> 16
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's Common Stock is listed on the Over-the-Counter Electronic
Bulletin Board under the symbol "HTBC." There is only a limited over-the-counter
market for the Company's Common Stock. Everen Securities, Smith Barney Shearson,
Incorporated, Sutro & Co., Incorporated and Van Kasper & Company have acted as
market makers for the Common Stock. These market makers have no obligation to
make a market for the Company's Common Stock, and they may discontinue making a
market at any time. No assurance can be given that an active trading market will
develop or be sustained for the Common Stock at any time in the future.
The information in the following table indicates the high and low "bid"
quotations for the Common Stock for each quarterly period since January 1, 1996,
and is based upon information provided by the market makers. These quotations
reflect inter-dealer prices, without retail mark-up, mark-down, or commission,
do not reflect actual transactions, and do not include nominal amounts traded
directly by shareholders or through other dealers who are not market makers.
<TABLE>
<CAPTION>
HIGH LOW
------ ------
<S> <C> <C>
1997
Fourth Quarter................................... $20.00 $16.00
Third Quarter.................................... 14.50 8.67
Second Quarter................................... 8.50 8.33
First Quarter.................................... 8.67 8.09
1996
Fourth Quarter................................... 7.93 7.93
No activity)recorded by
Third Quarter.................................... market makers(1
No activity)recorded by
Second Quarter................................... market makers(1
First Quarter.................................... 7.14 6.83
</TABLE>
- ---------------
(1) During the period indicated, the Bank was in the process of completing an
Offering for 825,495 shares at $7.93.
Listed amounts are adjusted to reflect (i) a 10 percent stock dividend
which was paid on February 26, 1996 to shareholders of record as of February 5,
1996, (ii) a 5 percent stock dividend which was paid on February 26, 1997 to
shareholders of record as of February 5, 1997, and (iii) a 3 for 2 stock split
on August 15, 1997 to shareholders of record as of August 1, 1997.
According to information known to management, the most recent trade in the
Company's Common Stock prior to the date of this Annual Report occurred on March
12, 1998 for 5,000 shares, at a sales price of $15.00 per share. Effective
February 17, 1998, the Bank's stock was exchanged on a share for share basis
with the stock of the Company.
DIVIDENDS
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
14
<PAGE> 17
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 Bank. The Company has no present intention of
paying dividends in the foreseeable future. The legal ability of the Bank to pay
dividends will be subject to restrictions set forth in the California banking
law and regulations of the FDIC. No assurance can be given that the Bank will
pay dividends at any time.
For regulatory restrictions on payment of dividends, see Item
1 -- "BUSINESS -- Regulation and Supervision -- Limitations on Dividends."
To date, neither the Bank nor the Company has 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
Bank's earnings and financial condition and other factors deemed relevant by
management. Accordingly, it is likely that no cash dividends will be declared in
the foreseeable future.
In December 1995, the Bank's Board of Directors declared a 10% stock
dividend payable to shareholders of record as of February 5, 1996. The payable
date of the dividend was February 26, 1996. In accordance with generally
accepted accounting principles, the Bank accounted for the 1996 transaction by
increasing the recorded accumulated deficit and transferring to permanent
capital an amount equal to the fair value of the additional shares issued. The
fair value of the additional shares issued is $1,384,000, based on a market
value of $6.51 per share in January 1996.
In January, 1997, the Bank's Board of Directors declared a 5% stock
dividend payable to shareholders of record as of February 5, 1997. The payable
date of the dividend was February 26, 1997. In accordance with generally
accepted accounting principles, the Bank accounted for the 1997 transaction by
increasing the recorded accumulated deficit and transferring to permanent
capital an amount equal to the fair value of the additional shares issued. The
fair value of the additional shares issued is $1,304,000, based on a market
value of $8.34 per share in January 1997.
In August, 1997, the Bank's Board of Directors declared a 3 for 2 stock
split payable to shareholders of record as of August 1, 1997. In accordance with
generally accepted accounting principles, the Bank accounted for the transaction
by restating all share information to reflect the effects of the split. The
payable date of the split was August 15, 1997.
For regulatory restrictions on the payment of dividends, see Item
1 -- "BUSINESS -- Regulation and Supervision -- Limitations on Dividends."
Number Of Equity Security Holders
As of February 28, 1998, there were 860 holders of Common Stock, the only
outstanding class of equity security of the Company.
15
<PAGE> 18
ITEM 6. SELECTED FINANCIAL DATA
The following table presents a summary of selected financial information
that should be read in conjunction with the Bank's financial statements and
notes thereto included under Item 8 -- "FINANCIAL STATEMENTS AND SUPPLEMENTARY
DATA." All financial information represents the financial operations and
condition of the Bank prior to the formation of the Company.
SELECTED FINANCIAL DATA
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
-------------------------------------------------
1997 1996 1995 1994(1)
---------- ---------- ---------- ----------
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S> <C> <C> <C> <C>
INCOME STATEMENT DATA:
Interest income............................. $ 16,251 $ 10,525 $ 6,421 $ 1,244
Interest expense............................ 4,204 2,646 1,696 214
---------- ---------- ---------- ----------
Net interest income before provision for
loan losses.............................. 12,047 7,879 4,725 1,027
Provision for loan losses................... 1,060 830 496 76
---------- ---------- ---------- ----------
Net interest income after provision for loan
losses................................... 10,987 7,049 4,229 951
Non-interest income......................... 590 296 71 18
Non-interest expenses....................... 9,168 5,724 4,098 2,976
---------- ---------- ---------- ----------
Income (loss) before income taxes........... 2,409 1,621 202 (2,007)
Provision for income taxes.................. 844 220 1 1
---------- ---------- ---------- ----------
Net income (loss)........................... $ 1,565 $ 1,401 $ 201 $ (2,008)
========== ========== ========== ==========
PER SHARE DATA(2):
Basic net income (loss)(3).................. $ 0.48 $ 0.48 $ 0.08 $ (0.82)
Diluted net income (loss)(4)................ 0.45 0.46 0.08 (0.82)
Book value(5)............................... 6.78 6.56 6.03 5.56
Average number of shares outstanding during
the year................................. 3,291,689 2,912,263 2,444,912 2,440,147
Average number of shares and equivalents
outstanding during the year.............. 3,480,237 3,033,953 2,476,929 2,440,147
Number of shares outstanding at year-end.... 3,295,896 3,103,696 2,125,534 2,112,681
BALANCE SHEET DATA:
Investment securities....................... $ 87,697 $ 75,268 $ 51,449 $ 30,336
Net loans................................... 126,485 81,513 41,950 10,455
Allowance for loan losses................... 2,285 1,402 572 76
Total assets................................ 267,575 173,303 132,160 59,037
Total deposits.............................. 242,978 146,379 118,746 47,082
Total shareholders' equity.................. 22,336 20,524 12,829 11,741
SELECTED PERFORMANCE RATIOS:
Return on average assets(6)................. 0.74% 0.96% 0.22% n/m
Return on average equity.................... 7.38% 8.56% 1.67% n/m
Net interest margin......................... 6.23% 5.99% 5.81% 5.13%
Average net loans as a percentage of average
deposits................................. 52% 48% 37% 17%
Average total shareholders' equity as a
percentage of average total assets....... 10% 11% 13% 31%
SELECTED ASSET QUALITY RATIOS(7):
Net loan charge-offs to average loans....... 0.18% -- -- --
Allowance for loan losses to total loans.... 1.77% 1.69% 1.34% 0.73%
CAPITAL RATIOS(8):
Tier 1 risk-based........................... 14.6% 21.4% 22.5% 75.9%
Total risk-based............................ 15.8% 22.6% 23.6% 76.4%
Leverage.................................... 10.3% 13.9% 13.5% 29.6%
</TABLE>
16
<PAGE> 19
- ---------------
(1) Figures for 1994 are for the 207 day period from June 8 (inception) to
December 31, 1994.
(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
payable to shareholders of record as of February 5, 1997; and (iii) a
3-for-2 stock split payable to shareholders of record as of August 1, 1997,
except number of shares outstanding at year-end, which are only adjusted
retrospectively to reflect the 3-for-2 stock split. All prior period per
share amounts have been restated for the implementation of SFAS No. 128, as
described in Note 1 to the financial statements.
(3) Represents net income (loss) divided by the average number of shares of
common stock outstanding for the respective period.
(4) Represents net income (loss) 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 chart and throughout this Annual Report are
based on daily averages.
(7) Non-performing assets consist of non-accrual loans, loans past due 90 days
or more, restructured loans, and other real estate owned. As of the dates
indicated, the Bank had no non-performing assets.
(8) The Risk-Based and Leverage Capital ratios are defined in Item
1 -- "BUSINESS -- Supervision And Regulation -- Capital Adequacy
Guidelines."
17
<PAGE> 20
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. Changes to such risks and uncertainties which could impact future
financial performance, include, among others, (1) competitive pressures in the
banking industry; (2) changes in interest rate environment, (3) general economic
conditions, nationally, regionally and in operating market areas; (4) changes in
the regulatory environment; (5) changes in business conditions and inflation;
and (6) changes in securities markets. Therefore, the information set forth
herein should be carefully considered when evaluating the business prospects of
the Bank.
RESULTS OF OPERATIONS
OVERVIEW
Net income for the year ended December 31, 1997 was $1,565,000, or $0.48
per share (basic), compared to $1,401,000 or $0.48 per share (basic) and
$201,000, or $0.08 per share (basic) for the years ended December 31, 1996 and
1995, respectively. This increase was primarily attributable to growth in the
level of earning assets, funded by new deposits at favorable weighted average
rates of interest, as well as to improvements in the Bank's mix of earning
assets in favor of higher yielding assets, such as loans.
Average interest-earning assets for 1997 were up 47% over 1996. The
increase was primarily attributable to growth in loans and, as a result, the
average rate on interest-earning assets increased to 8.40% in 1997, up from
8.00% in 1996. Average interest-bearing deposits for 1997 were up 49% over 1996,
with the increase primarily attributable to growth in savings and money market
accounts. The impact on the Bank's average rate paid on interest-bearing
liabilities, however, was modest, an increase to 3.49% in 1997, up from 3.28% in
1996. As a result, net interest margin improved to 6.23% in 1997 from 5.99% in
1996.
The Bank's loan quality remained high in 1997. As of December 31, 1997,
loans classified by the Bank constituted 2% and 11%, respectively, of total
loans and capital (shareholders' equity) and reserves (allowance for loan
losses), down from 5% and 18%, respectively, as of December 31, 1996. Net loan
charge-offs during 1997 were 0.18% of average loans outstanding; the Bank had no
loan charge-offs in any prior year.
Fee income rose a modest 16% from 1996 to 1997. Many of the Bank's deposit
accounts maintain balances higher than that which is required to offset activity
charges and, as such, are not assessed fees. Other components of non-interest
income such as gain on sale of securities available-for-sale and on sale of SBA
loans rose more dramatically, up 681% and 103%, respectively, from 1996 to 1997.
Return on average equity in 1997 was 7.38%, compared to 8.56% in 1996 and
1.67% in 1995. Return on average equity fell in 1997, in spite of the fact that
net income increased on an absolute basis over 1996, due to an increase in
average equity that resulted from the Bank's second offering which occurred in
the latter half of 1996.
Return on average assets in 1997 dropped to 0.74% from 0.96% in 1996. In
1997, average assets grew at a faster rate than net earnings, which were
adversely impacted by higher taxes as the Bank exhausted the remainder of its
operating loss carry forwards in 1996. Return on average assets was 0.22% in
1995.
18
<PAGE> 21
NET INTEREST INCOME AND NET INTEREST MARGIN
The following table presents the average amounts outstanding for the major
categories of the Bank's interest-earning assets and interest-bearing
liabilities, the average interest rates earned or paid thereon, and the net
yield on average interest-earning assets for the periods indicated:
<TABLE>
<CAPTION>
1997 1996 1995
----------------------------- ----------------------------- ----------------------------
INTEREST AVERAGE INTEREST AVERAGE INTEREST AVERAGE
AVERAGE INCOME/ YIELD/ AVERAGE INCOME/ YIELD/ AVERAGE INCOME/ YIELD/
BALANCE EXPENSE RATE BALANCE EXPENSE RATE BALANCE EXPENSE RATE
-------- -------- ------- -------- -------- ------- ------- -------- -------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
ASSETS:
Loans, net(1)...................... $ 98,930 $10,376 10.49% $ 61,130 $ 6,138 10.04% $11,509 $ 664 5.77%
Investment securities(2)(3)........ 84,196 5,323 6.32 57,769 3,724 6.45 40,388 2,623 6.49%
Federal funds sold................. 10,233 552 5.39 12,612 663 5.26 29,419 3,134 10.65%
-------- ------- ----- -------- ------- ----- ------- ------ -----
Total interest-earning
assets....................... 193,359 $16,251 8.40% 131,511 $10,525 8.00% 81,316 $6,421 7.90%
-------- ------- ----- -------- ------- ----- ------- ------ -----
Cash and due from banks............ 13,961 11,270 7,723
Premises and equipment, net........ 1,756 1,152 985
Other assets....................... 3,586 1,802 1,204
-------- ------- ----- -------- ------- ----- ------- ------ -----
Total assets................... $212,662 $145,736 $91,228
======== ======= ===== ======== ======= ===== ======= ====== =====
LIABILITIES AND SHAREHOLDERS'
EQUITY:
Deposits:
Demand, interest-bearing......... $ 4,988 $ 95 1.91% $ 3,654 $ 68 1.86% $ 2,059 $ 40 1.93%
Savings and money-market......... 80,168 2,401 3.00 60,686 1,772 2.92 40,871 1,332 3.26%
Time deposits, $100,000 and
over........................... 27,314 1,330 4.87 11,220 557 4.96 1,958 102 5.22%
Time deposits, less than
$100,000....................... 7,530 361 4.79 4,962 244 4.92 4,486 221 4.92%
Other borrowings................... 297 17 5.72 85 5 5.88 11 1 6.04%
-------- ------- ----- -------- ------- ----- ------- ------ -----
Total interest-bearing
liabilities.................. 120,297 $ 4,204 3.49% 80,607 $ 2,646 3.28% 49,385 $1,696 3.43%
Demand deposits.................... 69,376 47,696 29,362
Other liabilities.................. 1,782 1,062 433
Total liabilities.............. 191,455 129,351 79,180
Shareholders' equity............... 21,207 16,371 12,048
Total liabilities and
shareholders' equity......... $212,662 $145,736 $91,228
======== ======= ===== ======== ======= ===== ======= ====== =====
Net interest income/margin......... $12,047 6.23% $ 7,879 5.99% $4,725 5.81%
======== ======= ===== ======== ======= ===== ======= ====== =====
</TABLE>
- ---------------
(1) Yields and amounts earned on loans include loan fees of $709,000, $388,000,
and $115,000 for the years ended December 31, 1997, 1996, and 1995,
respectively.
(2) Interest income is reflected on an actual basis, not a fully taxable
equivalent basis.
(3) The yield on investment securities does not include a fair value adjustment.
Net interest income for the year ended December 31, 1997 was $12,047,000,
an increase of $4,168,000 (or 53%) over the $7,879,000 reported for 1996. The
increase occurred primarily as a result of growth that occurred in the Bank's
earning assets, the yield on which was enhanced by an improvement in the net
yield on interest-earning assets during 1997 as compared with 1996. The increase
in net yield on interest earning assets in turn resulted from an improved mix of
assets (in favor of higher yielding assets such as loans). The Bank's average
interest-earning assets were $193,359,000 in 1997, up $61,848,000 (or 47%) from
the average of $131,511,000 for 1996. The net yield on interest-earning assets
improved during 1997 to 6.23% from 5.99% for 1996.
19
<PAGE> 22
The following table sets forth an analysis of the changes in interest income and
interest expense:
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
-------------------------------------------------------------------------------
1997 VERSUS 1996 1996 VERSUS 1995
------------------------------------- -------------------------------------
INCREASE (DECREASE) DUE TO CHANGE IN: INCREASE (DECREASE) DUE TO CHANGE IN:
AVERAGE AVERAGE AVERAGE AVERAGE
VOLUME RATE NET CHANGE VOLUME RATE NET CHANGE
-------- -------- ----------- -------- -------- -----------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
INTEREST-EARNING ASSETS:
Loans, net................................. $3,953 $285 $4,238 $3,194 $(190) $3,004
Investment securities...................... 1,672 (72) 1,599 1,121 (20) 1,101
Federal funds sold......................... (128) 16 (111) 61 (62) (1)
------ ---- ------ ------ ----- ------
Total interest-earning assets................ $5,497 $229 $5,726 $4,376 $(272) $4,104
====== ==== ====== ====== ===== ======
INTEREST-BEARING LIABILITIES:
Demand, interest-bearing................... $ 25 $ 2 $ 27 $ 30 $ (2) $ 28
Savings and money-market................... 583 46 629 590 (150) 440
Time deposits, $100,000 and over........... 784 (11) 773 334 2 336
Time deposits, less than $100,000.......... 123 (7) 117 148 (6) 142
Other borrowings........................... 12 -- 12 4 -- 4
------ ---- ------ ------ ----- ------
Total interest-bearing liabilities........... $1,527 $ 31 $1,558 $1,106 $(156) $ 950
------ ---- ------ ------ ----- ------
Net interest income.......................... $3,970 $198 $4,168 $3,270 $ 116 $3,154
====== ==== ====== ====== ===== ======
</TABLE>
Note: Yields and amounts earned on loans include loan fees of $709,000,
$388,000, and $115,000 for the years ended December 31, 1997, 1996, and
1995, respectively.
The total change is shown in the column designated "Net Change" and is
allocated in the columns to the left, to the portions respectively attributable
to volume changes and rate changes that occurred during the period. Changes due
to both volume and rate have been allocated between the volume and rate
categories in proportion to the relationship of the changes due solely to the
changes in volume and rate, respectively.
PROVISIONS FOR LOAN LOSSES
During 1997, the provision for loan losses was $1,060,000, up $230,000 (or
28%) from $830,000 during 1996. The increase in the provision during 1997
reflected the overall growth in the loan portfolio and the Bank's policy of
making provisions to the allowance for loan losses. The provision for 1996 was
up $334,000 (or 67%) from $496,000 during 1995.
The allowance for loan losses was 1.77%, 1.69%, and 1.34% of total loans at
December 31, 1997, 1996, and 1995, respectively.
NON-INTEREST INCOME
The following table sets forth the various components of the Bank's
non-interest income:
<TABLE>
<CAPTION>
INCREASE (DECREASE)
YEARS ENDED --------------------------------------
DECEMBER 31, 1997 VERSUS 1996 1996 VERSUS 1995
-------------------- ----------------- -----------------
1997 1996 1995 AMOUNT PERCENT AMOUNT PERCENT
---- ---- ---- ------ ------- ------ -------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C>
Gain on sale of loans held for sale.................. $205 $101 $ -- $104 103% $101 --%
Service charges and other fees....................... 173 149 59 24 16 90 153
Gain on securities available-for-sale................ 164 21 3 143 681 18 600
Other income......................................... 48 25 9 23 92 16 178
---- ---- ---- ---- ---- ---- ----
Total................................................ $590 $296 $ 71 $294 99% $225 317%
==== ==== ==== ==== ==== ==== ====
</TABLE>
Non-interest income for the year ended December 31, 1997 was $590,000, up
$294,000 (or 99%) from $296,000 for 1996. This increase was primarily the result
of gains recognized on the sale of securities available-for-sale (up $143,000),
sales of SBA loans (up $104,000), and an increase in deposit service charges (up
$24,000).
20
<PAGE> 23
NON-INTEREST EXPENSES
The following table sets forth the various components of the Bank's
non-interest expenses:
<TABLE>
<CAPTION>
INCREASE (DECREASE)
-----------------------------------
YEARS ENDED DECEMBER 31, 1997 VERSUS 1996 1996 VERSUS 1995
------------------------ ---------------- ----------------
1997 1996 1995 AMOUNT PERCENT AMOUNT PERCENT
------ ------ ------ ------ ------- ------ -------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C>
Salaries and benefits............. $4,933 $2,942 $2,062 $1,991 68% $880 43%
Client services................... 1,169 910 491 259 28 419 85
Furniture and equipment........... 542 330 220 212 64 110 50
Advertising and promotion......... 450 260 154 190 73 106 69
Occupancy......................... 440 293 296 147 60 (3) (1)
Professional fees................. 372 224 302 148 66 (78) (26)
Loan origination costs............ 326 146 39 180 124 107 274
Other............................. 936 619 534 317 51 85 16
------ ------ ------ ------ --- ---- ---
Total............................. $9,168 $5,724 $4,098 $3,444 60% $225 40%
====== ====== ====== ====== === ==== ===
</TABLE>
Non-interest expenses for the year ended December 31, 1997 were $9,168,000,
up $3,444,000 (or 60%) from $5,724,000 for the year ended December 31, 1996. The
increase in non-interest expenses reflects the growth in infrastructure to
support the Bank's loan and deposit growth.
Non-interest expenses consist primarily of salaries and employee benefits
(54%, 51%, and 50% of total non-interest expenses for 1997, 1996, and 1995,
respectively) and client services (13%, 16%, and 12% of total non-interest
expenses for 1997, 1996, and 1995, respectively). The increase in salaries and
benefits expenses was primarily attributable to an increase in the number of
employees. The Bank employed 88 people at December 31, 1997, up 33 from 55
employees at December 31, 1996. Client services expenses include outside data
processing service costs, courier and armored car costs, imprinted check costs,
and other client services, all of which are directly related to the amount of
funds on deposit at the Bank. The increase in furniture and equipment expenses
and in occupancy expenses was primarily attributable to an increase in the
number of employees. Advertising expenses increased in 1997 due to the Bank's
co-sponsorship of a professional auto racing team.
YEAR 2000
The inability of computers, software, and other equipment utilizing
microprocessors to recognize and properly process data fields containing a
two-digit year is commonly referred to as the Year 2000 Compliance issue. As the
year 2000 approaches, such systems may be unable to process accurately certain
date-based information.
The Company has identified all significant applications that will require
modification to ensure Year 2000 Compliance. Internal and external resources are
being used to make the required modifications and test Year 2000 Compliance. The
modification process of all significant applications is underway and should be
substantially complete by June 30, 1998. The Company plans to complete the
testing process of all significant applications by December 31, 1998.
In addition, the Company has communicated with a vendor with whom it does
significant business to determine their Year 2000 Compliance readiness and the
extent to which the Company is vulnerable to any third-party Year 2000 risks.
However, there can be no guarantee that the systems of other companies on which
the Company's systems rely will be timely converted, or that a failure to
convert by another company, or a conversion that is incompatible with the
Company's systems, would not have a material adverse effect on the Company. The
Company's bank subsidiary has begun the process of assessing the credit risk
related to its borrowers' Year 2000 Compliance progress, and will integrate a
Year 2000 Compliance element into its credit approval process by December 31,
1998.
21
<PAGE> 24
The total cost to the Company of Year 2000 Compliance activities has not
been and is not anticipated to be material to its financial position or results
of operations in any given year. These costs and the date on which the Company
plans to complete the Year 2000 modification and testing process are based on
management's best estimates, which were derived utilizing numerous assumptions
of future events including the continued availability of certain resources,
third-party modification plans, and other factors. However, there can be no
guarantee that these estimates will be achieved and actual results could differ
from those plans.
PROVISION FOR INCOME TAXES
Provision for income taxes was $844,000, $220,000, and $1,000, for the
years ended December 31, 1997, 1996, and 1995, respectively. The Bank's
effective tax rates were 35.0%, 13.6%, and 0.5%, for the years ended December
31, 1997, 1996, and 1995, respectively. The decrease in the effective tax rate
from the statutory tax rate in 1996 and 1995 was due to state income taxes,
change in the valuation allowance, and non-taxable interest income. The 1995
provision reflected state minimum income taxes due to utilization of net
operating losses.
22
<PAGE> 25
FINANCIAL CONDITION
SECURITIES PORTFOLIO
The following table summarizes the amounts and distribution of the Bank's
investment securities and the weighted average yields as of December 31, 1997:
<TABLE>
<CAPTION>
DECEMBER 31, 1997
----------------------------------------------------------------------------------------
MATURITY
----------------------------------------------------------------------
AFTER ONE YEAR AFTER FIVE YEARS TOTAL
WITHIN AND AND WITHIN AFTER AMORTIZED
ONE YEAR WITHIN 5 YEARS TEN YEARS TEN YEARS COST
--------------- --------------- ----------------- -------------- ---------------
AMOUNT YIELD AMOUNT YIELD AMOUNT YIELD AMOUNT YIELD AMOUNT YIELD
------- ----- ------- ----- -------- ------ ------ ----- ------- -----
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Securities available for sale:
U.S. Treasury........................ $ 6,977 6.17% $25,217 6.27% $ 3,026 6.49% $ -- --% $35,220 6.27%
U.S. government agencies............. 2,002 5.60 2,985 6.28 10,383 6.71 1,000 8.00 16,370 6.57
Municipals -- taxable................ -- -- -- -- -- -- 2,000 6.01 2,000 6.01
Municipals -- tax exempt............. -- -- -- -- 735 4.67 1,861 4.89 2,596 4.83
Preferred stock...................... -- -- 1,525 6.18 -- -- 687 5.46 2,212 5.96
Commercial paper..................... -- -- 1,515 6.43 -- -- 522 7.97 2,036 6.82
------- ---- ------- ---- ------- ---- ------ ---- ------- ----
Total Available-for-sale............. $ 8,979 6.04% $31,242 6.27% $14,144 6.56% $6,070 6.10% $60,434 6.29%
Securities held-to-maturity:
Municipals -- taxable................ $ 1,765 5.98% $ 5,816 6.36% $ 1,748 6.50% $ 269 6.30% $ 9,598 6.31%
Municipals -- tax exempt............. 89 4.67 405 5.03 4,957 4.80 1,401 4.98 6,852 4.85
U.S. Government agencies............. -- -- 1,731 6.94 4,302 7.11 -- -- 6,033 7.06
U.S. Treasury........................ 1,993 6.66 2,054 6.36 -- -- -- -- 4,048 6.51
------- ---- ------- ---- ------- ---- ------ ---- ------- ----
Total held-to-maturity............... $ 3,847 6.30% $10,006 6.41% 11,007 5.97% 1,670 5.19% $26,531 6.14%
------- ---- ------- ---- ------- ---- ------ ---- ------- ----
Total securities....................... $12,826 6.12% $41,248 6.31% $25,151 6.30% $7,740 5.90% $86,965 6.24%
======= ==== ======= ==== ======= ==== ====== ==== ======= ====
</TABLE>
Note: Yields on tax exempt municipal securities are not on a fully tax
equivalent basis.
As of December 31, 1997, the only securities held by the Bank where the
aggregate book value of the Bank's investment in securities of a single issuer
exceeded 10% of the Bank'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 $27,470,000 as of December 31, 1997 were pledged to secure public and certain
other deposits as required by law or contract.
LOANS
General. The following table presents the Bank's loans outstanding at year
end by loan type:
<TABLE>
<CAPTION>
DECEMBER 31,
----------------------------------------------------------------------
% OF % OF % OF % OF
1997 TOTAL 1996 TOTAL 1995 TOTAL 1994 TOTAL
-------- ----- ------- ----- ------- ----- ------- -----
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Commercial................................ $ 63,833 50% $44,448 54% $23,456 55% $ 6,538 62%
Real estate -- mortgage................... 38,446 29 26,070 31 13,345 31 2,550 24
Real estate -- land and construction...... 25,780 20 11,918 14 5,105 12 1,370 13
Consumer.................................. 824 1 558 1 735 2 110 1
-------- ---- ------- ---- ------- ---- ------- ----
Total loans............................... $128,883 100% $82,994 100% $42,641 100% $10,568 100%
Deferred loan fees........................ (113) (79) (119) (37)
Allowance for loan losses................. (2,285) (1,402) (572) (76)
-------- ---- ------- ---- ------- ---- ------- ----
Net loans................................. $126,485 $81,513 $41,950 $10,455
======== ==== ======= ==== ======= ==== ======= ====
</TABLE>
23
<PAGE> 26
The Bank's commercial loans are made for the purpose of providing 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 twenty-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 Bank is an active participant in the Small Business Administration
(SBA) and California guarantied lending programs, and has been approved by the
SBA as a lender under the Preferred Loan Program (PLP). The Bank regularly makes
SBA-guarantied loans, the guarantied portion of which is held for possible
resale in the secondary market. In the event of the sale of a guarantied portion
SBA loan, the Bank retains the servicing rights for the sold portion. At
December 31, 1997, 1996, and 1995, $6.0 million, $2.1 million and $77 thousand,
respectively, in SBA loans were serviced by the Bank for others. The Bank
generally considers its SBA loans to be investment loans, but has from time to
time sold the guarantied portion of certain loans.
The Bank'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
Bank's policy to restrict real estate term loans to no more than 80% of the
lower of the Bank's appraised value or the purchase price of the property,
depending on the type of property and its utilization. The Bank offers both
fixed and floating rate loans. Maturities on such loans are generally restricted
to between five and seven 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 Bank's real estate land and construction loans are primarily interim
loans made by the Bank to finance the construction of commercial and single
family residential properties. These loans are typically short term. The Bank
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.
Consumer loans are made for the purpose of financing automobiles, various
types of consumer goods, and other personal purposes. Additionally, the Bank
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 Bank'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 Bank is permitted to make extensions of its
credit to any one borrowing entity up to 15% of the Bank's capital and reserves
for unsecured loans and up to 25% of the Bank's capital and reserves for secured
loans. These lending limits for the Bank were $3.7 million and $6.2 million,
respectively, at December 31, 1997. The Bank sells participations in its loans
when necessary to stay within lending limits. The Bank generally maintains an
"in-house limit" of $3.0 million for unsecured loans, and $5.0 million for
secured loans.
Loan Concentrations. The Bank does not have any concentrations in its loan
portfolio by industry or group of industries, however, 59% and 54% of its net
loans were secured by real property as of December 31, 1997 and 1996,
respectively.
24
<PAGE> 27
Loan Portfolio Maturities and Interest Rate Sensitivity. The following
table sets forth the maturity distribution of the Bank's loans at December 31,
1997:
<TABLE>
<CAPTION>
OVER ONE YEAR
DUE IN BUT LESS
ONE YEAR OR THAN OVER FIVE
LESS FIVE YEARS YEARS TOTAL
---------------- ------------- --------------- --------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C>
Commercial........................... $27,053 $13,313 $23,736 $ 64,102
Real estate -- mortgage.............. 6,276 17,706 14,297 38,279
Real estate -- land and
construction....................... 24,725 837 -- 25,562
Consumer............................. 158 669 -- 827
------- ------- ------- --------
Total loans.......................... $58,212 $32,525 $38,033 $128,770
======= ======= ======= ========
Loans with variable interest rates... $57,321 $22,210 $27,866 $107,397
Loans with fixed interest rates...... 891 10,315 10,167 21,373
------- ------- ------- --------
Total................................ $58,212 $32,525 $38,033 $128,770
======= ======= ======= ========
</TABLE>
Note: Total shown is net of deferred loan fees of $113,000 at December 31, 1997.
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,
1997, approximately 83% of the Bank's loan portfolio consisted of floating
interest rate loans.
Credit Risk Management. The risk of non-payment of loans is an inherent
feature of the banking business. That risk varies with the type and purpose of
the loan, the collateral that is utilized to secure payment, and ultimately, the
creditworthiness of the borrower. In order to minimize this credit risk, the
Bank requires that all loans be approved by at least the Chief Credit Officer,
the Senior Loan Officer, or the Chief Executive Officer, who individually have
approval authority of $150,000 each, and in combination may approve loans of up
to $600,000. Loans in excess of $600,000 must be approved by the Officers' Loan
Committee. Loans over $1,000,000 must be approved by the Directors' Loan
Committee. The Bank has established an in-house lending limit of $3,000,000 for
unsecured transactions, and $5,000,000, for secured transactions, which is
subject to review or exception from time to time.
The Bank 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. Additionally, the Bank 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 Bank to increased risk are appropriately downgraded and an increase
in the allowance for loan losses is established for such loans. Further, the
Bank is examined periodically by the FDIC, FRB, and the California Department of
Financial Institutions, at which time a further review of loans is conducted.
Loans that demonstrate a weakness, for which there is a possibility of loss
if the weakness is not corrected, are categorized as "classified." Classified
loans may result from problems specific to a borrower's business or from
economic downturns which affect the borrower's ability to repay or which cause a
decline in the value of the underlying collateral (particularly real estate).
Management believes that it has adequately provided an allowance to provide 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.
Non-Performing Assets. At December 31, 1997, 1996 and 1995, the Bank had no
non-accrual loans. During the year ended December 31, 1997 the average balance
of non-accrual loans was $100,000. At December 31, 1997, 1996 and 1995, the Bank
had no assets classified as other real estate owned. The Bank has no troubled
debt restructuring and no loans 90 days past-due and still accruing.
25
<PAGE> 28
For the year ended December 31, 1997, the Bank had forgone interest income
in the amount of $17,000 as a result of non- accrual loans. Through December 31,
1996, the Bank had not foregone any interest income as a result of non-accrual
loans or restructured debt.
As of December 31, 1997, loans classified by the Bank were $2,695,000.
These loans constituted 2% of total loans and 11% of the Bank's capital and
reserves as of that date. As of December 31, 1996, loans classified by the Bank
were $4,005,000. These loans constituted 5% of total loans and 18% of the Bank's
capital and reserves as of that date. As of December 31, 1995, loans classified
by the Bank were $296,804. These loans constituted 1% of total loans and 2% of
the Bank's capital and reserves as of that date. Through December 31, 1997, the
Bank has not made loans to any foreign entities.
ALLOWANCE FOR LOAN LOSSES
The following table summarizes the Bank's loan loss experience as well as
transactions in the allowance for loan losses and certain pertinent ratios for
the periods indicated:
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31
-------------------------------
1997 1996 1995 1994
------ ------ ----- -----
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C>
Balance, beginning of period........................... $1,402 $ 572 $ 76 $ --
Charge-offs -- Commercial loans........................ (224) -- -- --
Recoveries -- Commercial loans......................... 47 -- -- --
------ ------ ----- -----
Net charged-offs....................................... (177) -- -- --
------ ------ ----- -----
Provision for loan losses.............................. 1,060 830 496 76
------ ------ ----- -----
Balance, end of period................................. $2,285 $1,402 $ 572 $ 76
====== ====== ===== =====
Ratios:
Net charge-offs to average loans outstanding......... 0.18% --% --% --%
Allowance for loan losses to average loans........... 2.31% 2.29% 1.94% 1.60%
Allowance for loan losses to total loans at end of
period............................................ 1.77% 1.69% 1.34% 0.72%
</TABLE>
The following table summarizes the allocation of the allowance for loan
losses by loan type and the allocation as a percent of loans outstanding in each
loan category for the periods indicated:
<TABLE>
<CAPTION>
DECEMBER 31,
-----------------------------------------------------------------------------------------------------
1997 1996 1995 1994
----------------------- ----------------------- ----------------------- -----------------------
ALLOCATION ALLOCATION ALLOCATION ALLOCATION
AS A % OF AS A % OF AS A % OF AS A % OF
LOANS LOANS LOANS LOANS
OUTSTANDING OUTSTANDING OUTSTANDING OUTSTANDING
ALLOWANCE IN CATEGORY ALLOWANCE IN CATEGORY ALLOWANCE IN CATEGORY ALLOWANCE IN CATEGORY
--------- ----------- --------- ----------- --------- ----------- --------- -----------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Commercial............ $ 821 1.29% $ 512 1.15% $267 1.14% $-- --%
Real
estate -- mortgage.. 205 0.53 117 0.45 102 0.76 -- --
Real estate -- land
and construction.... 379 1.47 227 1.90 54 1.06 -- --
Consumer.............. 7 0.85 6 1.08 6 0.82 -- --
Unallocated........... 873 540 143 76
------ ---- ------ ---- ---- ---- --- ----
Total................. $2,285 1.77% $1,402 1.69% $572 1.34% $76 0.72%
====== ==== ====== ==== ==== ==== === ====
</TABLE>
The Bank maintains an allowance for loan losses to provide for probable
losses in the loan portfolio. Additions to the allowance are made by charges to
operating expenses in the form of a provision for loan losses. All loans that
are judged to be uncollectable are charged against the allowance and any
recoveries are credited to the allowance. Management conducts a critical
evaluation of the loan portfolio monthly. This evaluation includes 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, the estimated value of any underlying collateral, and current economic
conditions. At December 31, 1997, 1996, and 1995 the allowance for loan losses
was 1.77%, 1.69%, and 1.34%, respectively, of gross loans then outstanding.
26
<PAGE> 29
During 1997, the Bank charged off three loans with principal balance
totaling $224,000, and recovered two of those loans for $48,000, with accrued
interest and costs. Through December 31, 1996, the Bank had no loan charge-offs
and no charge-off recoveries.
In an effort to improve its analysis of risk factors associated with its
loan portfolio, the Bank continues to monitor and to make appropriate changes to
its internal loan policies. These efforts better enable the Bank to assess risk
factors prior to granting new loans and to assess the sufficiency of the
allowance for loan losses. The allowance for loan losses is deemed adequate by
the management for known and currently anticipated future risks inherent in the
loan portfolio. However, the Bank's loan portfolio can be adversely affected if
California economic conditions and the real estate market in the Bank's market
area were to weaken. The effect of such events although uncertain at this time,
could result in an increase in the level of non-performing loans and increased
loan losses which could adversely affect the Bank's future growth and
profitability.
DEPOSITS
The following table summarizes the distribution of average deposits and the
average rates paid for the periods indicated:
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
----------------------------------------------
1997 1996
--------------------- ---------------------
AVERAGE AVERAGE AVERAGE AVERAGE
BALANCE RATE PAID BALANCE RATE PAID
-------- --------- -------- ---------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C>
Demand, non-interest bearing..................... $ 69,376 --% $ 47,696 --%
Demand, interest bearing......................... 4,988 1.91 3,654 1.86
Savings and money market......................... 80,168 3.00 60,686 2.92
Time deposits, $100,000 and over................. 27,314 4.87 11,220 4.96
Time deposits less than $100,000................. 7,530 4.79 4,962 4.92
-------- ---- -------- ----
Total average deposits........................... $189,376 2.22% $128,218 2.06%
======== ==== ======== ====
</TABLE>
At December 31, 1997, the Bank had a deposit mix of 26% in money market
accounts, 17% in time deposits, 14% in savings deposits, 3% in NOW accounts, and
40% in non-interest-bearing demand deposits. On the same date, $158,000 of the
Bank's deposits were from public sources. At December 31, 1996, the Bank had a
deposit mix of 24% in money market accounts, 20% in time deposits, 15% in
savings deposits, 3% in NOW accounts, and 38% in non-interest-bearing demand
deposits. On the same date, $200,000 of the Bank's deposits were from public
sources. The Bank's net interest income is enhanced by its percentage of
non-interest bearing deposits.
The Bank's deposits are obtained from a cross-section of the communities it
serves. The Bank's business is not seasonal in nature. The Bank had brokered
deposits totaling approximately $12 million at December 31, 1997. The Bank is
not dependent upon funds from sources outside the United States.
DEPOSIT CONCENTRATION AND DEPOSIT VOLATILITY
The following table indicates the maturity schedule of the Bank's time
deposits of $100,000 or more as of December 31, 1997:
<TABLE>
<CAPTION>
BALANCE % OF TOTAL
-------- -----------
(DOLLARS IN THOUSANDS)
<S> <C> <C>
Three months or less.................................... $20,836 60%
Over three months through six months.................... 8,741 25
Over six months through twelve months................... 5,235 15
Over twelve months...................................... 136 <1
------- ---
Total................................................... $34,948 100%
======= ===
</TABLE>
27
<PAGE> 30
The Bank focuses primarily on servicing business accounts that are
frequently over $100,000 in average size. Certain types of accounts that the
Bank makes available are typically in excess of $100,000 in average balance per
account, and certain types of business clients whom the Bank 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 Bank to ensure its ability to fund deposit withdrawals.
LIQUIDITY AND LIABILITY MANAGEMENT
To meet liquidity needs, the Bank maintains a portion of its funds in cash
deposits in other banks, in federal funds sold, and in investment securities. As
of December 31, 1997, the Bank's primary liquidity ratio was 37.6%, comprised of
$48.2 million in investment securities available-for-sale of maturities (or
probable calls) of up to five years, federal funds sold of $27.1 million, and
$16.1 million in cash and due from banks, as a percentage of total deposits of
$243.0 million. As of December 31, 1996, the Bank's primary liquidity ratio was
37.9%, comprised of $42.9 million in investment securities available-for-sale of
maturities (or probable calls) of up to five years, and $12.6 million in cash
and due from banks, as a percentage of total deposits of $146.4 million.
Liquidity was essentially unchanged from 1996 to 1997 as deposit growth was
matched by commensurate growth in liquid assets.
The following table summarizes the Bank's borrowings under its federal
funds purchased and security repurchase arrangements for the periods indicated:
<TABLE>
<CAPTION>
1997 1996
-------- ---------
(DOLLARS IN THOUSANDS)
<S> <C> <C>
Average balance during the year........................... $ 297 $ 85
Average interest rate during the year..................... 5.72% 5.64%
Maximum month-end balance during the year................. $ 300 $5,010
Average rate at December 31............................... -- 6.75%
</TABLE>
The Bank has federal funds purchase lines of $15,000,000 and $2,000,000,
respectively, from its two correspondent banks, and a repurchase arrangement of
$10,000,000 with a commercial brokerage firm. There were no borrowings under
these arrangements as of December 31, 1997.
28
<PAGE> 31
INTEREST RATE SENSITIVITY
The table below sets forth the interest rate sensitivity of the Bank's
interest earning assets and interest bearing liabilities as of December 31,
1997, 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-
MONTHS MONTHS YEARS FIVE YEARS SENSITIVE TOTAL
-------- ------------ ----------- ---------- --------- --------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
Interest earning assets:
Federal funds sold....... $ 27,125 $ -- $ -- $ -- $ 27,125
Securities............... 3,000 9,844 41,589 33,264 87,697
Total loans.............. 99,936 8,242 12,445 8,147 128,770
Other assets............. 4,473 -- -- -- 4,473
-------- ------- ------- -------- --------- --------
Total interest earning
assets................... 134,534 18,086 54,034 41,411 248,065
-------- ------- ------- -------- --------- --------
Cash and due from banks.... $ 16,060 16,060
Other assets............... 3,450 3,450
-------- ------- ------- -------- --------- --------
Total assets............... $134,534 $18,086 $54,034 $ 41,411 $ 19,510 $267,575
======== ======= ======= ======== ========= ========
Interest bearing
liabilities:
Demand,
interest-bearing...... $ 6,319 $ -- $ -- $ -- $ 6,319
Savings and money
market................ 96,712 -- -- -- 96,712
Time deposits............ 26,050 15,946 214 -- 42,210
-------- ------- ------- -------- --------- --------
Total interest bearing
liabilities.............. 129,081 15,946 214 -- 145,241
-------- ------- ------- -------- --------- --------
Non-interest demand
deposits................. $ 97,737 97,737
Other liabilities.......... 2,261 2,261
Shareholders' equity....... 22,336 22,336
-------- ------- ------- -------- --------- --------
Total liabilities and
shareholders' equity..... $129,081 $15,946 $ 214 $ 122,334 $267,575
======== ======= ======= ======== ========= ========
Interest rate sensitivity
gap...................... $ 5,453 $ 2,140 $53,820 $ 41,411 $(102,824) --
======== ======= ======= ======== ========= ========
Cumulative interest rate
sensitivity gap.......... $ 5,453 $ 7,593 $61,413 $102,824 -- --
Cumulative interest rate
sensitivity gap ratio.... 2.04% 2.84% 22.95% 38.43%
</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 Bank
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.
Since interest rate changes do not affect all categories of assets and
liabilities equally or simultaneously, a cumulative gap analysis alone cannot be
used to evaluate the Bank's interest rate sensitivity position. To supplement
traditional gap analysis, the Bank performs simulation modeling to estimate the
potential effects of changing interest rates. The process allows the Bank to
explore the complex relationships within the gap over time and various interest
rate environments. For additional information on the Bank'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."
29
<PAGE> 32
The Bank's internal Asset/Liability Committee and the Finance and
Investment Committee of the Board each meet monthly to monitor the Bank's
investments, liquidity needs and to oversee its asset/liability management. The
Bank evaluates the rates offered on its deposit products on a weekly basis.
CAPITAL RESOURCES
The following table summarizes risk-based capital, risk-weighted assets,
and risk-based capital ratios of the Company:
<TABLE>
<CAPTION>
DECEMBER 31, MINIMUM
------------------------------------------- REGULATORY
1997 1996 1995 1994 REQUIREMENTS
-------- -------- -------- ------- ------------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
Capital components:
Tier 1 Capital................... $ 21,899 $ 20,273 $ 12,324 $12,027
Tier 2 Capital................... 1,885 1,188 572 76
-------- -------- -------- ------- ---
Total risk-based capital...... $ 23,784 $ 21,461 $ 12,896 $12,103
======== ======== ======== ======= ===
Risk-weighted assets............... 150,418 94,776 54,730 18,851
Average assets..................... 251,767 175,001 122,464 53,731
Capital ratios:
Total risk-based capital......... 15.8% 22.6% 23.6% 76.4% 8.0%
Tier 1 risk-based capital........ 14.6 21.4 22.5 75.9 4.0
Leverage ratio(1)................ 10.3 13.9 10.1 22.4 4.0
</TABLE>
- ---------------
(1) Tier 1 capital divided by average assets (excluding goodwill).
At December 31, 1997 and 1996, the Bank's capital exceeded all minimum
regulatory requirements and the Bank was considered to be "well capitalized," as
defined in the regulations issued by the FDIC. The table above presents the
capital ratios of the Bank 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, 1997. The risk-based and leverage capital ratios are defined in Item
1 -- "BUSINESS -- Supervision and Regulation -- Capital Adequacy Guidelines."
The Company intends to raise additional equity capital to finance future
geographic expansion. In general, the Company plans to form one or more new
subsidiary banks in new markets. No assurance can be given that the Company will
be able to raise the additional capital needed to support the organization of a
new bank. Management believes that the Company has sufficient cash flows to fund
operations for the next year.
COMPARISON OF 1996 VERSUS 1995
Net interest income for the year ended December 31, 1996 was $7,879,000, an
increase of $3,154,000 (or 67%) over the $4,725,000 reported for 1995. The
increase occurred primarily as a result of growth that occurred in the Bank's
earning assets, the yield on which was enhanced by an improvement in the net
yield on interest-earning assets during 1996 as compared with 1995. The increase
in net yield on interest earning assets in turn resulted from an improved mix of
assets (in favor of higher yielding assets such as loans) which offset the
effect of interest rate decreases that occurred during the first quarter of
1996. The Bank's average interest-earning assets were $131,511,000 in 1996, up
$50,195,000 (or 62%) from the average of $81,316,000 for 1995. The net yield on
interest-earning assets improved during 1996 to 5.99% from 5.81% for 1995.
Non-interest income for the year ended December 31, 1996 was $296,000, up
$225,000 (or 317%) from $71,000 for 1995. This increase was primarily the result
of sales of SBA-guarantied loans and certain investment securities
available-for-sale, which resulted in profits on sale, as well as an increase in
deposit levels, which generate monthly service charges.
Non-interest expenses for the year ended December 31, 1996 were $5,724,000,
up $1,626,000 (or 40%) from $4,098,000 for the year ended December 31, 1995.
Growth in the Bank's infrastructure to support loan
30
<PAGE> 33
and deposit growth was responsible for the increase in non-interest expenses.
Salaries and benefits expense rose 43% from 1995 to 1996, with the increase
attributable to growth in the number of employees. The Bank employed 55 people
at December 31, 1996, up 22 from 33 employees at December 31, 1995. Furniture
and equipment expenses and occupancy expenses were similarly affected by the
increase in employees. Client services expenses were up as a result of
additional funds on deposit at the Bank.
ACCOUNTING PRONOUNCEMENTS
The Bank adopted Statement of Financial Accounting Standards (SFAS) No.
125, Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities, effective January 1, 1997. SFAS No. 125 provides
accounting and reporting standards for transfers and servicing of financial
assets and extinguishments of liabilities based on consistent application of a
financial-components approach that focuses on control. It distinguishes
transfers of financial assets that are sales from transfers that are secured
borrowings. Under this approach, after a transfer of financial assets, an entity
recognizes all financial and servicing assets it controls and liabilities it has
incurred and derecognizes financial assets it no longer controls and liabilities
that have been extinguished. The adoption of this Statement did not have any
significant impact on the Bank's financial position or results of operations.
In December 1996, the Financial Accounting Standards Board (FASB) issued
SFAS No. 127, Deferral of the Effective Date of Certain Provisions of FASB
Statement No. 125, which defers the implementation of SFAS No. 125 for
transactions related to repurchase agreements, dollar-roll repurchase
agreements, securities lending and similar transactions until January 1, 1998.
Management believes that the effect of adoption of SFAS No. 125, for those
transactions covered under SFAS No. 127, on the Company's consolidated financial
statements will not be material.
In June 1997, the Financial Accounting Standards Board issued SFAS No. 130
Reporting Comprehensive Income, which requires that an enterprise report, by
major components and as a single total, the change in its net assets during the
period from non-owner sources; and SFAS No. 131 Disclosures about Segments of an
Enterprise and Related Information, which establishes annual and interim
reporting standards for an enterprise's operating segments and related
disclosures about its products, services, geographic areas, and major customers.
Adoption of these Statements will not impact the Company's consolidated
financial position, results of operations, or cash flows, and any effect will be
limited to the form and content of its disclosures. Both statements are
effective with the year-end 1998 financial statements. In addition, disclosure
of comprehensive income is required in the interim financial statements
beginning with the first quarter of 1998.
31
<PAGE> 34
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 Bank'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 Bank, all of the
Company's interest rate risk exposure lies at the Bank level, as well. As a
result, all interest rate risk management procedures are performed at the Bank
level. Based upon the nature of the Bank's operations, the Bank is not subject
to foreign exchange or commodity price risk. The Company does not own any
trading assets. As of December 31, 1997, the Company does not use interest rate
derivatives to hedge its interest rate risk.
The Bank'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 Bank has no market risk sensitive
instruments held for trading purposes.
The detail from the Bank's GAP analysis is shown in Item 7, above, and is
not discussed here. The Bank 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, 1997, it was estimated that the Company's MV would increase
5.2% in the event of a 200 basis point increase in market interest rates. The
Company's MV at the same date would decrease 6.8% in the event of a 200 basis
point decrease in market interest rates.
Presented below, as of December 31, 1997, 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>
MARKET VALUE AS A %
OF PRESENT VALUE OF ASSETS
% CHANGE IN --------------------------
CHANGE IN RATES $ CHANGE IN MARKET VALUE MARKET VALUE MV RATIO CHANGE (BP)
- --------------- ------------------------ ------------ --------- --------------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C>
+ 200 bp $2,296 5.2% 17.3% 86
0 bp -- -- 16.4 --
- 200 bp (3,002) (6.8) 15.3 (112)
</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 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
32
<PAGE> 35
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.
33
<PAGE> 36
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements and independent auditors' report are set forth in
Appendix F, which follows Item 14 -- "EXHIBITS, FINANCIAL STATEMENT SCHEDULES,
AND REPORTS ON FORM 8-K."
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
On December 1, 1997, Heritage Bank of Commerce (the Bank) notified KPMG
Peat Marwick LLP (KPMG) that the Bank was terminating KPMG as independent
certified public accountants for the Bank. The termination was effective on that
date. On December 1, 1997, the Bank engaged Deloitte & Touche LLP as independent
auditors for the Bank.
At no time during the engagement of KPMG by the Bank was there any
disagreement on any matter of accounting principles or practices, financial
statement disclosure, or auditing scope or procedure, which disagreements if not
resolved to the satisfaction of KPMG would have caused it to make reference in
connection with its report to the subject matter of the disagreement. The
preceding sentence includes disagreements, whether resolved or not resolved to
the satisfaction of KPMG, at the decision-making levels of the Bank and KPMG. No
report of KPMG on the financial statements of the Bank for any of the past three
years contained an adverse opinion or a disclaimer of opinion or was qualified
as to uncertainty, audit scope, or accounting principles.
The Bank's decision to change accountants was recommended by the Bank's
Audit Committee and approved by the Bank's Board of Directors.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Reference is made to the Company's Proxy Statement for the May 21, 1998
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 February 28, 1998 is included
in Part I above in accordance with Instruction 3 to Item 401(b) of Regulation
S-K.
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 21, 1998 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 page
4 and the text under the caption "Proposal One -- Election of Directors" in the
Proxy Statement for the May 21, 1998 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 21, 1998 Annual Meeting of Shareholders.
34
<PAGE> 37
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a)(1) FINANCIAL STATEMENTS
The Financial Statements of the Company, the Management Statement, and the
independent auditors' report are set forth on pages 38 through 56.
(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 REPORT ON FORM
EXHIBIT FILED -----------------------
NO. HEREWITH 8-A DATED EXHIBIT NO.
------- -------- --------- -----------
<C> <S> <C> <C> <C>
3.1 Heritage Commerce Corp Articles of Incorporation: 3-5-98 4.1
[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 1933 dated March 5, 1998
(File No. 000-23877)]................................
3.2 Heritage Commerce Corp Bylaws: [Incorporated herein 3-5-98 4.2
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
1933 dated March 5, 1998 (File No. 000-23877)].......
10.1 Real Property Leases for properties located at 150 3-5-98 1
Almaden Blvd., San Jose and 100 Park Center Plaza,
San Jose. [This exhibit is incorporated by reference
to the paper filing of Heritage Commerce Corp's Form
8-A filed March 5, 1998 (File No. 000-23877).].......
10.2 Employment agreement with Mr. Rossell dated June 8, 3-5-98 1
1994 [This exhibit is incorporated by reference to
the paper filing of Heritage Commerce Corp's Form 8-A
filed March 5, 1998 (File No. 000-23877).]...........
10.3 Employment agreement with Mr. Gionfriddo dated June 3-5-98 1
8, 1994 [This exhibit is incorporated by reference to
the paper filing of Heritage Commerce Corp's Form 8-A
filed March 5, 1998 (File No. 000-23877).]...........
10.4 Amendment No. 2 to Employment Agreement with Mr. X
Gionfriddo...........................................
16.1 Letter regarding change in certifying accountant..... X
21.1 Subsidiaries of the registrant....................... X
27.1 Financial data schedule.............................. X
</TABLE>
(b) Reports on Form 8-K
On December 1, 1997, the Registrant, pursuant to the 1934 Act, filed Form
F-3 with the FDIC to report a change in certifying accountants. [This exhibit is
incorporated by reference to the paper filing of Heritage Commerce Corp's Form
8-A filed March 5, 1998 (File No. 000-23877).]
35
<PAGE> 38
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Company has duly caused this report to be signed on
its behalf by the undersigned thereunto duly authorized.
HERITAGE COMMERCE CORP
Date: March 31, 1998 By: /s/ JOHN E. ROSSELL
------------------------------------
John E. Rossell
President
and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the date indicated:
<TABLE>
<CAPTION>
SIGNATURE TITLE DATE
--------- ----- ----
<S> <C> <C>
/s/ FRANK BISCEGLIA Director March 31, 1998
- --------------------------------------------------------
Frank Bisceglia
/s/ JAMES BLAIR Director March 31, 1998
- --------------------------------------------------------
James Blair
/s/ ARTHUR CARMICHAEL, JR. Director March 31, 1998
- --------------------------------------------------------
Arthur Carmichael, Jr.
/s/ WILLIAM DEL BIAGGIO, JR. Director March 31, 1998
- --------------------------------------------------------
William Del Biaggio, Jr.
/s/ ANNEKE DURY Director March 31, 1998
- --------------------------------------------------------
Anneke Dury
/s/ TRACEY ENFANTINO Director March 31, 1998
- --------------------------------------------------------
Tracey Enfantino
/s/ GLENN GEORGE Director March 31, 1998
- --------------------------------------------------------
Glenn George
/s/ ROBERT GIONFRIDDO Director March 31, 1998
- --------------------------------------------------------
Robert Gionfriddo
/s/ P. MICHAEL HUNT Director March 31, 1998
- --------------------------------------------------------
P. Michael Hunt
/s/ LON NORMANDIN Director March 31, 1998
- --------------------------------------------------------
Lon Normandin
/s/ DANIEL A. NORTHWAY Chief Financial Officer March 31, 1998
- -------------------------------------------------------- and Principal Accounting
Daniel A. Northway Officer
</TABLE>
36
<PAGE> 39
<TABLE>
<CAPTION>
SIGNATURE TITLE DATE
--------- ----- ----
<S> <C> <C>
/s/ JACK PECKHAM Director March 31, 1998
- --------------------------------------------------------
Jack Peckham
/s/ ROBERT PETERS Director March 31, 1998
- --------------------------------------------------------
Robert Peters
/s/ HUMPHREY POLANEN Director March 31, 1998
- --------------------------------------------------------
Humphrey Polanen
/s/ JOHN E. ROSSELL, III Director and Principal March 31, 1998
- -------------------------------------------------------- Executive Officer
John E. Rossell, III
/s/ KIRK ROSSMAN Director March 31, 1998
- --------------------------------------------------------
Kirk Rossman
</TABLE>
37
<PAGE> 40
HERITAGE COMMERCE CORP
INDEX TO FINANCIAL STATEMENTS
DECEMBER 31, 1997
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Independent Auditors' Report................................ F-2
Balance Sheets as of December 31, 1997 and 1996............. F-4
Income Statements as of December 31, 1997, 1996 and 1995.... F-5
Statements of Shareholders' Equity as of December 31, 1997,
1996 and 1995............................................. F-6
Statements of Cash Flows as of December 31, 1997, 1996 and
1995...................................................... F-7
Notes to Financial Statements............................... F-8
</TABLE>
F-1
<PAGE> 41
EXHIBIT (a)(1)
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Shareholders of
Heritage Bank of Commerce
San Jose, California
We have audited the accompanying balance sheet of Heritage Bank of Commerce
as of December 31, 1997, and the related statements of income, shareholders'
equity, and cash flows for the year then ended. These financial statements are
the responsibility of the Bank's management. Our responsibility is to express an
opinion on these financial statements based on our audit. The balance sheet of
the Bank for the year ended December 31, 1996 and the related statements of
income, shareholders' equity, and cash flows for each of the two years in the
period ended December 31, 1996 were audited by other auditors whose report,
dated January 10, 1997, expressed an unqualified opinion on those statements.
We conducted our audit in accordance with generally accepted auditing
standards. 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 provide a reasonable basis for our opinion.
In our opinion, such 1997 financial statements present fairly, in all
material respects, the financial position of the Bank as of December 31, 1997,
and the results of its operations and its cash flows for the year then ended in
conformity with generally accepted accounting principles.
Deloitte & Touche LLP
San Jose, California
January 23, 1998
F-2
<PAGE> 42
INDEPENDENT AUDITOR'S REPORT
The Board of Directors
Heritage Bank of Commerce:
We have audited the accompanying balance sheet of Heritage Bank of Commerce
(the Bank) as of December 31, 1996, and the related statements of income,
shareholders' equity, and cash flows for each of the years in the two-year
period then ended. These financial statements are the responsibility of the
Bank's management. Our responsibility is to express an opinion on these
financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion the financial statements referred to above present fairly,
in all material respects, the financial position of Heritage Bank of Commerce as
of December 31, 1996, and the results of its operations and its cash flows for
each of the years in the two-year period then ended in conformity with generally
accepted accounting principles.
KPMG PEAT MARWICK, LLP
January 10, 1997
F-3
<PAGE> 43
HERITAGE BANK OF COMMERCE
BALANCE SHEETS
ASSETS
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
1997 1996
------------ ------------
<S> <C> <C>
Cash and due from banks..................................... $ 16,060,000 $ 12,615,000
Federal funds sold.......................................... 27,125,000 --
------------ ------------
Total cash and cash equivalents................... 43,185,000 12,615,000
Securities available-for-sale, at fair value................ 61,166,000 50,016,000
Securities held-to-maturity, at amortized cost (fair value
of $26,938,000 and $25,454,000, respectively)............. 26,531,000 25,252,000
Loans....................................................... 128,770,000 82,915,000
Allowance for loan losses................................... (2,285,000) (1,402,000)
------------ ------------
Loans, net........................................ 126,485,000 81,513,000
Premises and equipment, net................................. 1,971,000 1,530,000
Accrued interest receivable and other assets................ 3,764,000 2,377,000
Other investments........................................... 4,473,000 --
------------ ------------
Total............................................. $267,575,000 $173,303,000
============ ============
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities:
Deposits.................................................. $242,978,000 $146,379,000
Securities sold under agreements to repurchase............ -- 5,010,000
Accrued interest payable and other liabilities............ 2,261,000 1,390,000
------------ ------------
Total liabilities................................. 245,239,000 152,779,000
------------ ------------
Shareholders' equity:
Common Stock, no par value; 10,000,000 shares authorized;
shares issued and outstanding: 3,295,896 in 1997 and
3,130,696 in 1996...................................... 23,447,000 22,093,000
Net unrealized gain on securities available-for-sale, net
of taxes............................................... 418,000 221,000
Accumulated deficit....................................... (1,529,000) (1,790,000)
------------ ------------
Total shareholders' equity........................ 22,336,000 20,524,000
------------ ------------
Total............................................. $267,575,000 $173,303,000
============ ============
</TABLE>
See notes to financial statements.
F-4
<PAGE> 44
HERITAGE BANK OF COMMERCE
INCOME STATEMENTS
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
----------------------------------------
1997 1996 1995
----------- ----------- ----------
<S> <C> <C> <C>
Interest income:
Loans, including fees.............................. $10,376,000 $ 6,138,000 $3,134,000
Securities, taxable................................ 5,188,000 3,723,000 2,623,000
Securities, tax-exempt............................. 87,000 1,000 --
Federal funds sold................................. 552,000 663,000 664,000
Other investments.................................. 48,000 -- --
----------- ----------- ----------
Total interest income................................ 16,251,000 10,525,000 6,421,000
Interest expense:
Deposits........................................... 4,187,000 2,641,000 1,695,000
Other.............................................. 17,000 5,000 1,000
----------- ----------- ----------
Total interest expense............................... 4,204,000 2,646,000 1,696,000
----------- ----------- ----------
Net interest income before provision for loan
losses............................................. 12,047,000 7,879,000 4,725,000
Provision for loan losses............................ 1,060,000 830,000 496,000
----------- ----------- ----------
Net interest income after provision for loan
losses............................................. 10,987,000 7,049,000 4,229,000
----------- ----------- ----------
Other income:
Gain on sale of loans held for sale................ 205,000 101,000 --
Service charges and other fees..................... 173,000 149,000 59,000
Gain on sales of securities available-for-sale..... 164,000 21,000 3,000
Other income....................................... 48,000 25,000 9,000
----------- ----------- ----------
Total other income................................... 590,000 296,000 71,000
----------- ----------- ----------
Other expenses:
Salaries and employee benefits..................... 4,933,000 2,942,000 2,062,000
Client services.................................... 1,169,000 910,000 491,000
Furniture and equipment............................ 542,000 330,000 220,000
Advertising and promotion.......................... 450,000 260,000 154,000
Occupancy.......................................... 440,000 293,000 296,000
Professional fees.................................. 372,000 224,000 302,000
Loan origination costs............................. 326,000 146,000 39,000
Other.............................................. 936,000 619,000 534,000
----------- ----------- ----------
Total other expenses................................. 9,168,000 5,724,000 4,098,000
----------- ----------- ----------
Net income before income taxes....................... 2,409,000 1,621,000 202,000
Provision for income taxes........................... 844,000 220,000 1,000
----------- ----------- ----------
Net income........................................... $ 1,565,000 $ 1,401,000 $ 201,000
=========== =========== ==========
Earnings per share:
Basic........................................... $ 0.48 $ 0.48 $ 0.08
Diluted......................................... $ 0.45 $ 0.46 $ 0.08
</TABLE>
See notes to financial statements.
F-5
<PAGE> 45
HERITAGE BANK OF COMMERCE
STATEMENTS OF SHAREHOLDERS' EQUITY
YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
<TABLE>
<CAPTION>
NET UNREALIZED
GAIN (LOSS) ON
COMMON STOCK SECURITIES TOTAL
----------------------- AVAILABLE-FOR-SALE, ACCUMULATED SHAREHOLDERS'
SHARES AMOUNT NET OF TAXES DEFICIT EQUITY
--------- ----------- ------------------- ----------- -------------
<S> <C> <C> <C> <C> <C>
BALANCE, JANUARY 1, 1995.... 2,112,681 $14,085,000 $(336,000)
--------- ----------- --------- ----------- -----------
Stock options exercised..... 12,853 85,000 -- -- 85,000
Net income.................. -- -- -- 201,000 201,000
Net change in unrealized
gain on securities
available for-sale, net of
taxes..................... -- -- 802,000 -- 802,000
--------- ----------- --------- ----------- -----------
BALANCES, DECEMBER 31,
1995...................... 2,125,534 14,170,000 466,000 (1,807,000) 12,829,000
--------- ----------- --------- ----------- -----------
Stock dividend.............. 212,535 1,384,000 -- (1,384,000) --
Stock options exercised..... 6,441 39,000 -- -- 39,000
Common Stock issued pursuant
to secondary offering (net
of issuance costs of
$51,000).................. 786,186 6,500,000 -- -- 6,500,000
Net income.................. -- -- -- 1,401,000 1,401,000
Net change in unrealized
gain on securities
available for-sale, net of
taxes..................... -- -- (245,000) -- (245,000)
--------- ----------- --------- ----------- -----------
BALANCES, DECEMBER 31,
1996...................... 3,130,696 22,093,000 221,000 (1,790,000) 20,524,000
--------- ----------- --------- ----------- -----------
Stock dividend.............. 156,349 1,304,000 -- (1,304,000) --
Fractional shares canceled
due to stock split........ (194) (2,000) -- (2,000)
Stock options exercised..... 9,045 52,000 -- -- 52,000
Net income.................. -- -- -- 1,565,000 1,565,000
Net change in unrealized
gain on securities
available-for-sale, net of
taxes..................... -- -- 197,000 -- 197,000
--------- ----------- --------- ----------- -----------
BALANCES, DECEMBER 31,
1997...................... 3,295,896 $23,447,000 $ 418,000 $(1,529,000) $22,336,000
========= =========== ========= =========== ===========
</TABLE>
See notes to financial statements
F-6
<PAGE> 46
HERITAGE BANK OF COMMERCE
STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
--------------------------------------------
1997 1996 1995
------------ ------------ ------------
<S> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income....................................... $ 1,565,000 $ 1,401,000 $ 201,000
Adjustments to reconcile net income to net cash
provided by (used in) operating activities:
Depreciation and amortization.................. 388,000 260,000 193,000
Provision for possible loan losses............. 1,060,000 830,000 496,000
Gain on sales of securities
available-for-sale.......................... (164,000) (21,000) (3,000)
Amortization / accretion of discounts and
premiums on securities...................... 56,000 52,000 170,000
Proceeds from sales of loans held for sale..... 4,198,000 1,724,000 --
Originations of loans held for sale............ (4,626,000) (11,587,000) (4,220,000)
Maturities of loans held for sale.............. 45,000 -- --
Increase in accrued interest receivable and
other assets................................ (1,400,000) (939,000) (681,000)
Increase (decrease) in accrued interest payable
and other liabilities....................... 605,000 (295,000) 371,000
Proceeds from relocation....................... -- 1,100,000 --
------------ ------------ ------------
Net cash provided by (used in) operating
activities..................................... 1,727,000 (7,475,000) (3,473,000)
------------ ------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Net increase in loans............................ (45,650,000) (30,450,000) (27,771,000)
Purchases of securities available-for-sale....... (49,116,000) (27,611,000) (35,167,000)
Maturities of securities available-for-sale...... 16,588,000 13,683,000 14,268,000
Proceeds from sales of securities
available-for-sale............................. 21,955,000 5,081,000 3,016,000
Purchases of securities held-to-maturity......... (7,659,000) (16,248,000) (6,089,000)
Proceeds from maturities of securities
held-to-maturity............................... 6,388,000 1,000,000 3,494,000
Purchase of corporate-owned life insurance....... (4,473,000) -- --
Purchases of property and equipment.............. (829,000) (887,000) (105,000)
------------ ------------ ------------
Net cash used in investing activities............ (62,796,000) (55,432,000) (48,354,000)
------------ ------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net increase in deposits......................... 96,599,000 27,633,000 71,664,000
(Repayments) proceeds from sale of securities
under agreements to repurchase................. (5,010,000) 5,010,000 --
Net proceeds from issuance of common stock....... 50,000 6,539,000 85,000
------------ ------------ ------------
Net cash provided by financing activities........ 91,639,000 39,182,000 71,749,000
------------ ------------ ------------
Net increase (decrease) in cash and cash
equivalents.................................... 30,570,000 (23,725,000) 19,922,000
Cash and cash equivalents, beginning of year..... 12,615,000 36,340,000 16,418,000
------------ ------------ ------------
Cash and cash equivalents, end of year........... $ 43,185,000 $ 12,615,000 $ 36,340,000
============ ============ ============
Supplemental disclosures of cash flow
information:
Cash paid during the year for:
Interest.................................... $ 4,477,000 $ 2,610,000 $ 1,660,000
Income taxes................................ $ 1,536,000 $ 218,000 $ 1,000
Supplemental schedule of non-cash investing and
financing activity:
Transfer from accumulated deficit to common
stock due to stock dividend................. $ 1,304,000 $ 1,384,000 $ --
</TABLE>
See notes to financial statements.
F-7
<PAGE> 47
HERITAGE BANK OF COMMERCE
NOTES TO FINANCIAL STATEMENTS
(L) SIGNIFICANT ACCOUNTING POLICIES
Description of Business and Basis of Presentation
Heritage Bank of Commerce (the Bank) is a California state chartered bank
which offers a full range of commercial and personal banking services to
residents and the business/professional community in Santa Clara County,
California, through a facility located in downtown San Jose, California. The
Bank was incorporated on November 23, 1993 as Heritage Bank of Commerce and
commenced operations on June 8, 1994. The accounting and reporting policies of
the Bank conform to generally accepted accounting principles and prevailing
practices within the banking industry.
Use of Estimates
The preparation of financial statements in conformity with generally
accepted accounting principles 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. The allowance for possible loan losses is a material estimate.
Actual results could differ from those estimates.
Cash and Cash Equivalents
The Bank considers all highly liquid debt instruments purchased with an
original maturity of three months or less 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 Bank classifies its securities into two categories, available-for-sale
and held-to-maturity, at the time of purchase. Securities available-for-sale are
measured at fair value with a corresponding recognition of the net unrealized
holding gain or loss as a separate component of shareholders' equity, net of
taxes, until realized. Securities held-to-maturity are measured at amortized
cost, based on the Bank'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. No such declines have occurred.
Premiums and discounts are amortized, or accreted, over the life of the
related investment security as an adjustment to income using the straight-line
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 Bank holds for sale the guarantied 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 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 guarantied portion of the loan sold compared to the
relative fair value of the unguarantied portion. A portion of the gain is
deferred and amortized over the life of the loan based on the difference between
the principal retained and the relative value of the unguarantied portion of the
loan.
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.
F-8
<PAGE> 48
HERITAGE BANK OF COMMERCE
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
Loans
Loans are stated at the principal amount outstanding. The majority of the
Bank's loans are at variable interest rates. Interest on loans is credited to
income when earned.
Generally, 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, 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 normally 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 collectability of the
total contractual principal and interest is no longer in doubt.
Management, considering current information and events, considers a loan to
be impaired when it is probable that the Bank will be unable to collect all
amounts due according to the 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
secured by real estate.
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.
Allowance for Loan Losses
The allowance for loan losses is established through a provision charged to
expense. Loans are charged against the allowance when management believes that
the collectability of the principal is doubtful. Recoveries are credited to the
allowance. The allowance for loan losses is a valuation allowance that
management believes will be adequate to absorb losses inherent in existing
loans, based on evaluations of collectability. These evaluations take into
consideration such factors as the composition of the portfolio, overall
portfolio quality, loan concentrations, specific problem loans, and current and
anticipated local economic conditions that may affect a borrower's ability to
repay.
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.
Other Investments
Other investments consist of cash surrender value of life insurance
policies for certain officers and directors of the Bank.
Accounting for Transfers and Servicing of Financial Assets and Extinguishments
of Liabilities
The Bank adopted Statement of Financial Accounting Standards (SFAS) No.
125, Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities, effective January 1, 1997. SFAS No. 125 provides
accounting and reporting standards for transfers and servicing of financial
assets and extinguishments of liabilities based on consistent application of a
financial-components approach that focuses on control. It distinguishes
transfers of financial assets that are sales from transfers that are secured
borrowings. Under this approach, after a transfer of financial assets, an entity
recognizes all financial and servicing assets it controls and liabilities it has
incurred and derecognizes financial assets it no longer controls and liabilities
that have been extinguished. The adoption of this Statement did not have a
significant impact on the Bank's financial position or results of operations.
Long-Lived Assets
The Bank evaluates the recoverability of long-lived assets on an on-going
basis.
F-9
<PAGE> 49
HERITAGE BANK OF COMMERCE
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
Income Taxes
Income taxes are provided at current rates. Deferred income taxes reflect
the net tax effects of temporary differences between carrying amounts of assets
and liabilities for financial reporting purposes and amounts used for income tax
purposes. A valuation allowance is established to reduce the deferred tax asset
if it is "more likely than not" that the related tax benefits will not be
realized in the future.
Stock-Based Compensation
As allowed for by SFAS No. 123, Accounting for Stock-Based Compensation,
the Bank 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.
Earnings Per Share
Earnings per share are computed in compliance with SFAS No. 128, Earnings
Per Share. Basic earnings per share are computed by dividing net income by the
weighted average common shares outstanding. Diluted earnings per share reflect
potential dilution from outstanding stock options, using the treasury stock
method. For each of the years presented, net income is the same to basic and
diluted earnings per share. Reconciliation of weighted average shares used in
computing earnings per share are as follows:
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
-----------------------------------
1997 1996 1995
--------- --------- ---------
<S> <C> <C> <C>
Weighted average common shares
outstanding............................. 3,291,689 2,912,263 2,444,912
Dilutive effect of stock options
outstanding, using the treasury stock
method.................................. 188,548 121,690 34,744
--------- --------- ---------
Shares used in computing diluted earnings
per share............................... 3,480,237 3,033,953 2,479,656
</TABLE>
All share numbers have been retroactively restated for stock dividends and
stock splits.
Reclassifications
Certain amounts in the 1996 and 1995 financial statements have been
reclassified to conform to the 1997 presentation. These reclassifications had no
impact on shareholders' equity and net income.
New Accounting Pronouncements
In June 1997, the Financial Accounting Standards Board issued SFAS No. 130
Reporting Comprehensive Income, which requires that an enterprise report, by
major components and as a single total, the change in its net assets during the
period from non-owner sources; and SFAS No. 131 Disclosures about Segments of an
Enterprise and Related Information, which establishes annual and interim
reporting standards for an enterprise's business segments and related
disclosures about its products, services, geographic areas, and major customers.
The Bank is required to adopt these statements in 1998 and their adoption will
not impact the Bank's financial position, results of operations or cash flows.
F-10
<PAGE> 50
HERITAGE BANK OF COMMERCE
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
(2) SECURITIES
The amortized cost and estimated fair value of securities as of December
31, 1997 were as follows:
<TABLE>
<CAPTION>
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
----------- ---------- ---------- -----------
<S> <C> <C> <C> <C>
SECURITIES AVAILABLE-FOR-SALE:
U.S. Treasury.................... $35,220,000 $451,000 $ -- $35,671,000
U.S. Government Agencies......... 16,370,000 202,000 -- 16,572,000
Municipals....................... 4,596,000 67,000 -- 4,663,000
Preferred Stock.................. 2,212,000 48,000 -- 2,260,000
Commercial Paper................. 2,036,000 -- (36,000) 2,000,000
----------- -------- -------- -----------
Total securities
available-for-sale............... $60,434,000 $768,000 $(36,000) $61,166,000
=========== ======== ======== ===========
SECURITIES HELD-TO-MATURITY:
Municipals....................... $16,450,000 $255,000 $ -- $16,705,000
U.S. Government Agencies......... 6,033,000 118,000 -- 6,151,000
U.S. Treasury.................... 4,048,000 34,000 -- 4,082,000
----------- -------- -------- -----------
Total securities
held-to-maturity................. $26,531,000 $407,000 $ -- $26,938,000
=========== ======== ======== ===========
</TABLE>
The amortized cost and estimated fair value of securities as of December
31, 1996 were as follows:
<TABLE>
<CAPTION>
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
----------- ---------- ---------- -----------
<S> <C> <C> <C> <C>
SECURITIES AVAILABLE-FOR-SALE:
U.S. Treasury.................... $28,092,000 $193,000 $(12,000) $28,273,000
U.S. Government Agencies......... 16,624,000 75,000 (31,000) 16,668,000
Municipals....................... 2,517,000 26,000 (2,000) 2,541,000
Commercial Paper................. 2,527,000 10,000 (3,000) 2,534,000
----------- -------- -------- -----------
Total securities
available-for-sale............... $49,760,000 $304,000 $(48,000) $50,016,000
=========== ======== ======== ===========
SECURITIES HELD-TO-MATURITY:
Municipals....................... $ 9,616,000 $ 57,000 $(38,000) $ 9,635,000
U.S. Treasury.................... 8,084,000 62,000 -- 8,146,000
U.S. Government Agencies......... 7,552,000 123,000 (2,000) 7,673,000
----------- -------- -------- -----------
Total securities
held-to-maturity................. $25,252,000 $242,000 $(40,000) $25,454,000
=========== ======== ======== ===========
</TABLE>
The amortized cost and estimated fair values of securities as of December
31, 1997 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>
SECURITIES AVAILABLE-FOR-SALE SECURITIES HELD-TO-MATURITY
------------------------------ ----------------------------
AMORTIZED ESTIMATED FAIR AMORTIZED ESTIMATED FAIR
COST VALUE COST VALUE
------------ --------------- ----------- --------------
<S> <C> <C> <C> <C>
Due within one year......................... $ 8,979,000 $ 8,996,000 $ 3,848,000 $ 3,856,000
Due after one through five years............ 31,241,000 31,583,000 10,006,000 10,138,000
Due after five through ten years............ 14,144,000 14,440,000 11,007,000 11,231,000
Due after ten years......................... 6,070,000 6,147,000 1,670,000 1,713,000
----------- ----------- ----------- -----------
Total............................. $60,434,000 $61,166,000 $26,531,000 $26,938,000
=========== =========== =========== ===========
</TABLE>
Sales of securities available-for-sale resulted in gross realized gains of
$170,000, $21,000, and $6,000 during the years ended December 31, 1997, 1996,
and 1995, respectively.
F-11
<PAGE> 51
HERITAGE BANK OF COMMERCE
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
Sales of securities available-for-sale resulted in gross realized losses of
$6,000, nil, and $3,000 during the years ended December 31, 1997, 1996, and
1995, respectively.
Securities with amortized cost of $27,470,000 as of December 31, 1997 were
pledged to secure public and certain other deposits as required by law or
contract.
(3) LOANS
Loans as of December 31 were as follows:
<TABLE>
<CAPTION>
1997 1996
------------ -----------
<S> <C> <C>
Loans held for sale.............................. $ 15,411,000 $15,028,000
Loans held for investment
Commercial..................................... 48,422,000 29,420,000
Real estate -- mortgage........................ 38,446,000 26,070,000
Real estate -- land and construction........... 25,780,000 11,918,000
Consumer....................................... 824,000 558,000
------------ -----------
Total loans...................................... 128,883,000 82,994,000
Deferred loan fees............................... (113,000) (79,000)
------------ -----------
Loans, net....................................... $128,770,000 $82,915,000
============ ===========
</TABLE>
Changes in the allowance for loan losses were as follows:
<TABLE>
<CAPTION>
AT OR FOR THE YEARS ENDED
DECEMBER 31,
---------------------------
1997 1996 1995
------- ------- -----
<S> <C> <C> <C>
Balance, beginning of year......................... $1,402 $ 572 $ 76
Actual charge-offs................................. 224 -- --
Less recoveries.................................... 47 -- --
------ ------ ----
Net loans charged-off.............................. 177 -- --
Provision for loan losses.......................... 1,060 830 496
------ ------ ----
Balance, end of year............................... $2,285 $1,402 $572
====== ====== ====
</TABLE>
As of December 31, 1997, 1996, and 1995, the Bank had no loans for which
interest is no longer being accrued, no loans past due 90 days or more, and no
loans considered to be impaired. For the year ended December 31, 1997, the Bank
had foregone $17,000 of interest income as a result of non-accrual loans or
restructured debt. For the years ended December 31, 1996 and 1995, the Bank had
no forgone interest income as a result of non-accrual loans or restructured
debt.
The Bank had no non-accrual loans as of December 31, 1997 or 1996. SBA
loans serviced for others are not included in the accompanying balance sheets.
The unpaid principal balances of these loans as of December 31, 1997 and 1996
were approximately $5,961,000 and $2,105,000, 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. Although the Bank has a
diversified loan portfolio, a substantial portion of its clients' ability to
honor contracts is reliant upon the economic stability of Santa Clara County,
California, including the real estate markets of the county. Loans are made on
the basis of a secure repayment source, which generally is based on a detailed
cash flow analysis; collateral is generally a secondary source for loan
qualification.
The Bank makes 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
F-12
<PAGE> 52
HERITAGE BANK OF COMMERCE
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
for the Bank. At December 31, 1997 and 1996 the Bank had $2,145,000 and
$2,565,000 in loans outstanding to related parties.
(4) PREMISES AND EQUIPMENT
Premises and equipment as of December 31 were as follows:
<TABLE>
<CAPTION>
1997 1996
---------- ----------
<S> <C> <C>
Furniture and equipment............................. $1,812,000 $1,245,000
Leasehold improvements.............................. 644,000 471,000
Software............................................ 361,000 276,000
---------- ----------
2,817,000 1,992,000
Accumulated depreciation and amortization........... (846,000) (462,000)
---------- ----------
Premises and equipment, net......................... $1,971,000 $1,530,000
========== ==========
</TABLE>
(5) DEPOSITS
Deposits as of December 31, were as follows:
<TABLE>
<CAPTION>
1997 1996
------------ ------------
<S> <C> <C>
Demand, non-interest bearing.................... $ 97,737,000 $ 55,372,000
Demand, interest bearing........................ 6,319,000 4,153,000
Savings and money market........................ 96,712,000 56,848,000
Time deposits, $100,000 and over................ 34,948,000 22,145,000
Time deposits, less than $100,000............... 7,262,000 7,861,000
------------ ------------
Total deposits.................................. $242,978,000 $146,379,000
============ ============
</TABLE>
At December 31, 1997, the scheduled maturities of time deposits was as
follows:
<TABLE>
<S> <C>
Year 1998....................................... $41,996,000
1999............................................ 167,000
2000............................................ 47,000
-----------
Total time deposits............................. $42,210,000
===========
</TABLE>
(6) BORROWING ARRANGEMENTS
Available Lines of Credit
The Bank has federal funds purchase lines of $15,000,000 and $2,000,000,
respectively, from two correspondent banks, and a repurchase arrangement of
$10,000,000 with a commercial brokerage firm. There were no borrowings under
these arrangements as of December 31, 1997. The repurchase agreement is an
overnight loan, with terms negotiated based on the nature of the securities
offered for repurchase.
Information concerning borrowings under the above arrangements is as
follows:
<TABLE>
<CAPTION>
1997 1996
-------- ----------
<S> <C> <C>
Average balance during the year........................ $297,000 $ 85,000
Average interest rate during the year.................. 5.72% 5.64%
Maximum month-end balance during the year.............. $300,000 $5,010,000
Average rate at December 31............................ -- 6.75%
</TABLE>
F-13
<PAGE> 53
HERITAGE BANK OF COMMERCE
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
(7) INCOME TAXES
The provision for income taxes for the years ended December 31, consisted
of the following:
<TABLE>
<CAPTION>
1997 1996 1995
---------- --------- ------
<S> <C> <C> <C>
CURRENT:
Federal.......................................... $ 939,000 $ 135,000 $ --
State............................................ 353,000 218,000 1,000
---------- --------- ------
Total current...................................... 1,292,000 353,000 1,000
---------- --------- ------
DEFERRED:
Federal.......................................... (372,000) (104,000) --
State............................................ (76,000) (29,000) --
---------- --------- ------
Total deferred..................................... (448,000) (133,000) --
---------- --------- ------
Provision for income taxes......................... $ 844,000 $ 220,000 $1,000
========== ========= ======
</TABLE>
The effective tax rate differs from the federal statutory rate for the
years ended December 31, as follows:
<TABLE>
<CAPTION>
1997 1996 1995
---- ----- -----
<S> <C> <C> <C>
Statutory federal income tax rate........................... 35.0% 35.0% 35.0%
State income taxes, net of federal tax benefit.............. 7.5 7.7 0.3
Change in valuation allowance............................... (8.7) (29.5) (42.0)
Non-taxable interest income................................. (2.3) -- --
Other....................................................... 3.5 0.4 7.2
---- ----- -----
Effective tax rate.......................................... 35.0% 13.6% 0.5%
==== ===== =====
</TABLE>
Net deferred tax asset as of December 31 consists of the following:
<TABLE>
<CAPTION>
1997 1996
---------- ---------
<S> <C> <C>
DEFERRED TAX ASSETS:
Allowance for possible loan losses........................ 886,000 429,000
Servicing rights.......................................... 99,000 --
Deferred rent............................................. 89,000 161,000
Accrued compensation...................................... 20,000 --
State taxes............................................... -- 82,000
Other..................................................... 31,000 100,000
---------- ---------
Gross deferred tax asset.................................... 1,125,000 772,000
Valuation allowance......................................... -- (209,000)
---------- ---------
Deferred tax asset.......................................... 1,125,000 563,000
---------- ---------
DEFERRED TAX LIABILITIES:
Securities available-for-sale............................. (314,000) (35,000)
Accrual to cash adjustment................................ (278,000) (346,000)
Depreciation.............................................. (169,000) (84,000)
State income taxes........................................ (97,000) --
---------- ---------
Deferred tax liability...................................... (858,000) (465,000)
---------- ---------
Net deferred tax asset...................................... $ 267,000 $ 98,000
========== =========
</TABLE>
As it is more likely than not that the deferred tax assets would be
realized, the valuation allowance decreased by $209,000, $478,000, and $77,000
during the years ended December 31, 1997, 1996, and 1995, respectively.
F-14
<PAGE> 54
HERITAGE BANK OF COMMERCE
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
(8) SHAREHOLDERS' EQUITY
Common Stock
In December, 1995, the Bank declared a 10% stock dividend payable to
shareholders of record as of February 5, 1996. In January, 1997, the Bank
declared a 5% stock dividend payable to shareholders of record as of February 5,
1997. In July, 1997, the Bank declared a three-for-two stock split for
shareholders of record as of August 1, 1997. All share numbers have been
retroactively restated for stock splits and stock dividends.
Stock Option Plan
The Bank 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 will be determined by the
Board of Directors at no less than the fair value at the date of grant. Options
granted vest on a schedule determined by the Board of Directors at the time of
grant. Generally, options vest over four years. All options expire no later than
ten years from the date of grant. The Plan had 623,700 shares (adjusted for
stock dividends and splits) originally authorized for issuance. During 1997, an
additional 362,469 shares were added to the Plan for future grants. At December
31, 1997, 316,289 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>
BALANCES, JANUARY 1, 1995................................... -- $ --
------- -----
Granted (weighted average fair value of $2.40).............. 576,056 5.80
Exercised................................................... (14,846) 5.77
Cancelled................................................... (34,963) 5.77
------- -----
BALANCES, DECEMBER 31, 1995................................. 526,247 5.80
(149,156 exercisable at a weighted average exercise price of
$5.77)
------- -----
Granted (weighted average fair value of $3.16).............. 65,363 7.63
Exercised................................................... (6,763) 5.77
Cancelled................................................... (10,326) 5.86
------- -----
BALANCES, DECEMBER 31, 1996................................. 574,521 6.01
(275,482 exercisable at a weighted average exercise price of
$5.83)
------- -----
Granted (weighted average fair value of $4.42).............. 80,620 9.70
Exercised................................................... (9,045) 5.80
Cancelled................................................... (6,870) 6.55
------- -----
BALANCES, DECEMBER 31, 1997................................. 639,226 $6.47
------- -----
</TABLE>
Additional information regarding options outstanding under the Plan as of
December 31, 1997 is as follows:
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
------------------------------------------ ----------------------------
WEIGHTED
AVERAGE
RANGE OF REMAINING WEIGHTED WEIGHTED
EXERCISE NUMBER CONTRACTUAL AVERAGE NUMBER AVERAGE
PRICES OUTSTANDING LIFE (YRS.) EXERCISE PRICE EXERCISABLE EXERCISE PRICE
- ------------- ----------- ----------- -------------- ----------- --------------
<S> <C> <C> <C> <C> <C>
$5.77 - 7.27 514,506 6.62 $ 5.84 388,974 $ 5.81
7.28 - 8.77 110,220 9.15 8.33 62,926 8.48
8.78 - 16.00 14,500 9.91 14.76 361 11.70
------- ---- ------ ------- ------
$5.77 - 16.00 639,226 7.13 $ 6.47 452,261 $ 6.19
------- ---- ------ ------- ------
</TABLE>
F-15
<PAGE> 55
HERITAGE BANK OF COMMERCE
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
As discussed in Note 1, the Bank 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.
SFAS No. 123, Accounting for Stock-Based Compensation, requires the
disclosure of pro forma net income and earnings per share had the Bank adopted
the fair value method as of the beginning of fiscal 1995. 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 Bank's stock option awards.
Those models also require subjective assumptions, which greatly affect the
calculated values. The Bank'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, 5.75% for 1997 and 6.60% for 1996 and
1995; stock volatility of 30% in 1997 and 20% in 1996 and 1995; and no dividends
during the expected term. The Bank's calculations are based on a multiple option
valuation approach, and forfeitures are recognized as they occur.
If the computed fair values of the 1997, 1996, and 1995 awards had been
amortized to expense over the vesting periods of the awards, pro forma net
income and earnings per share would have been as follows:
<TABLE>
<CAPTION>
1997 1996 1995
---------- ---------- ---------
<S> <C> <C> <C>
Pro forma net income (loss)............ $1,000,000 $1,093,000 $(155,000)
Pro forma earnings (loss) per share
Basic................................ $ 0.30 $ 0.38 $ (0.06)
Diluted.............................. $ 0.29 $ 0.36 $ (0.06)
</TABLE>
(9) LEASES
The Bank 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,
1998........................................ $ 537,000
1999........................................ 553,000
2000........................................ 542,000
2001........................................ 556,000
2002........................................ 540,000
Thereafter.................................... 3,905,000
----------
Total............................... $6,633,000
==========
</TABLE>
Rent expense under operating leases was $314,000, $225,000, and $250,000
during the years ended December 31, 1997, 1996, and 1995, respectively.
(10) EMPLOYEE BENEFIT PLANS
The Bank offers a 401(k) savings plan. All salaried employees are eligible
to contribute up to 20% of their pre-tax compensation to the plan through salary
deductions under Section 401(k) of the Internal Revenue Code. The Bank does not
match employee contributions.
During 1997, the Bank initiated an employee stock ownership plan. The plan
allows the Bank 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 Bank on December 31. Awards
under this plan generally vest over four years. During 1997, the Bank funded
$98,000 into the plan. The amount funded into this plan was recognized as
salaries and benefits expense in the Bank's financial statements.
F-16
<PAGE> 56
HERITAGE BANK OF COMMERCE
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
(11) 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 judgement 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 Bank's financial
instruments as of December 31, 1997 and 1996 were as follows:
<TABLE>
<CAPTION>
1997 1996
----------------------------- ----------------------------
CARRYING ESTIMATED FAIR CARRYING ESTIMATED FAIR
AMOUNTS VALUE AMOUNTS VALUE
------------ -------------- ----------- --------------
<S> <C> <C> <C> <C>
ASSETS
Cash and cash equivalents............... $ 43,185,000 $ 43,185,000 $12,615,000 $12,615,000
Securities.............................. 87,697,000 88,104,000 75,268,000 75,470,000
Loans, net.............................. 126,485,000 126,474,000 81,513,000 81,521,000
------------ ------------ ----------- -----------
LIABILITIES
Demand deposits, non-interest bearing... $ 97,737,000 $ 97,737,000 $55,372,000 $55,372,000
Demand deposits, interest bearing....... 6,319,000... 6,319,000 4,153,000 4,153,000
Savings and money market................ 96,712,000 96,712,000 56,848,000 56,848,000
Time deposits........................... 42,210,000 42,205,000 30,006,000 30,005,000
Securities sold under agreements to
repurchase........................... -- -- 5,010,000 5,010,000
</TABLE>
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.
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 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.
F-17
<PAGE> 57
HERITAGE BANK OF COMMERCE
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
Securities Sold Under Agreements to Repurchase
The fair value of securities sold under agreements to repurchase
approximates the carrying amount due to the short maturity.
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 judgements 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 judgement and
therefore cannot be determined with precision. Changes in assumptions could
significantly affect the estimates.
Fair value estimates are based on existing financial instruments, as of the
reporting dates, without attempting to estimate the value of anticipated future
business and the value of assets and liabilities that are not considered
financial instruments. In addition, tax ramifications related to the realization
of unrealized gains and losses can have a significant effect on fair value
estimates and have not been considered in the estimates.
(12) COMMITMENTS AND CONTINGENT LIABILITIES
Financial Instruments with Off-Balance Sheet Risk
The Bank is 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 Bank's exposure to credit loss in the event of non-performance of the
other party to the financial instrument for commitments to extend credit and
standby letters of credit is represented by the contractual notional amount of
those instruments. The Bank uses 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 Bank controls the
credit risk of these transactions through credit approvals, limits, and
monitoring procedures. Management does not anticipate any significant losses as
a result of these transactions.
Commitments to extend credit as of December 31, were as follows:
<TABLE>
<CAPTION>
1997 1996
----------- -----------
<S> <C> <C>
Commitments to extend credit.............. $68,611,000 $36,598,000
Standby letters of credit................. 2,370,000 410,000
----------- -----------
$70,981,000 $37,008,000
=========== ===========
</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
Bank evaluates each client's creditworthiness on a case-by-case basis. The
amount of collateral obtained, if deemed necessary by the Bank 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 are
not considered material.
F-18
<PAGE> 58
HERITAGE BANK OF COMMERCE
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
Standby letters of credit are written conditional commitments issued by the
Bank 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 are not
considered material.
(13) REGULATORY MATTERS
The Bank is 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 Bank's financial statements. Under capital adequacy
guidelines and the regulatory framework for prompt corrective action, the Bank
must meet specific capital guidelines that involve quantitative measures of the
Bank's assets, liabilities, and certain off-balance-sheet items as calculated
under regulatory accounting practices. The Bank's capital amounts and
classifications are also subject to qualitative judgements by the regulators
about components, risk weightings, and other factors.
Quantitative measures established by regulation to ensure capital adequacy
require the Bank to maintain minimum amounts and ratios (set forth in the table
below) of total and Tier I capital (as defined in the regulations) to
risk-weighted assets (as defined), and of Tier I capital (as defined) to average
assets (as defined). Management believes that, as of December 31, 1997, the Bank
meets all capital adequacy guidelines to which it is subject.
The most recent notification from the FDIC categorized the Bank as well
capitalized under the regulatory framework for prompt corrective action. To be
categorized as well capitalized the Bank 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 institution's category.
The Bank's actual capital amounts and ratios are also presented in the
table.
<TABLE>
<CAPTION>
TO BE WELL-CAPITALIZED
FOR CAPITAL UNDER PROMPT CORRECTIVE
ACTUAL ADEQUACY PURPOSES: ACTION PROVISIONS:
------------------- -------------------- ------------------------
AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO
----------- ----- ----------- ------ ------------- -------
<S> <C> <C> <C> <C> <C> <C>
AS OF DECEMBER 31, 1997
Total Capital
(to Risk-Weighted Assets).... $23,784,000 15.8% $12,033,000 $ 8.0% $15,042,000 $ 10%
Tier I Capital
(to Risk-Weighted Assets).... $21,899,000 14.6% $ 6,017,000 $ 4.0% $ 9,025,000 $ 6%
Tier I Capital
(to Average Assets).......... $21,899,000 10.3% $ 8,499,000 $ 4.0% $10,624,000 $ 5%
AS OF DECEMBER 31, 1996
Total Capital
(to Risk-Weighted Assets).... $21,461,000 22.6% $ 7,582,000 $ 8.0% $ 9,478,000 $ 10%
Tier I Capital
(to Risk-Weighted Assets).... $20,273,000 21.4% $ 3,791,000 $ 4.0% $ 5,687,000 $ 6%
Tier I Capital
(to Average Assets).......... $20,273,000 13.9% $ 5,826,000 $ 4.0% $ 7,283,000 $ 5%
</TABLE>
The Bank is required to maintain reserves with the Federal Reserve Bank of
San Francisco. Reserve requirements are based on a percentage of certain
deposits. At December 31, 1997, the Bank maintained reserves of $3,449,000 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
F-19
<PAGE> 59
HERITAGE BANK OF COMMERCE
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
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.
(14) OTHER MATTERS (UNAUDITED)
Formation of Bank Holding Company
On December 18, 1997, the shareholders of the Bank met at a special meeting
to approve the formation of a bank holding company by the adoption of a merger
agreement which provided for the merger of a merger subsidiary, a subsidiary of
the newly formed Heritage Commerce Corp, with and into the Bank under the name
and charter of the Bank. By this action, the Bank will become a wholly-owned
subsidiary of Heritage Commerce Corp. Shareholders of the Bank received one
share of Heritage Commerce Corp Common Stock for each share of Bank Common Stock
held. The merger was effective February 17, 1998.
New Branches
On February 9, 1998, the Bank opened a full-service branch in the city of
Fremont, California.
F-20
<PAGE> 60
EXHIBIT INDEX
<TABLE>
<CAPTION>
INCORPORATED BY
REFERENCE
TO REPORT ON FORM
EXHIBIT FILED -----------------------
NO. HEREWITH 8-A DATED EXHIBIT NO.
------- -------- --------- -----------
<C> <S> <C> <C> <C>
3.1 Heritage Commerce Corp Articles of Incorporation: 3-5-98 4.1
[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 1933 dated March 5, 1998
(File No. 000-23877)]................................
3.2 Heritage Commerce Corp Bylaws: [Incorporated herein 3-5-98 4.2
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
1933 dated March 5, 1998 (File No. 000-23877)].......
10.1 Real Property Leases for properties located at 150 3-5-98 1
Almaden Blvd., San Jose and 100 Park Center Plaza,
San Jose. [This exhibit is incorporated by reference
to the paper filing of Heritage Commerce Corp's Form
8-A filed March 5, 1998 (File No. 000-23877).].......
10.2 Employment agreement with Mr. Rossell dated June 8, 3-5-98 1
1994 [This exhibit is incorporated by reference to
the paper filing of Heritage Commerce Corp's Form 8-A
filed March 5, 1998 (File No. 000-23877).]...........
10.3 Employment agreement with Mr. Gionfriddo dated June 3-5-98 1
8, 1994 [This exhibit is incorporated by reference to
the paper filing of Heritage Commerce Corp's Form 8-A
filed March 5, 1998 (File No. 000-23877).]...........
10.4 Amendment No. 2 to Employment Agreement with Mr. X
Gionfriddo...........................................
16.1 Letter regarding change in certifying accountant..... X
21.1 Subsidiaries of the registrant....................... X
27.1 Financial data schedule.............................. X
</TABLE>
(b) Reports on Form 8-K
On December 1, 1997, the Registrant, pursuant to the 1934 Act, filed Form
F-3 with the FDIC to report a change in certifying accountants. [This exhibit is
incorporated by reference to the paper filing of Heritage Commerce Corp's Form
8-A filed March 5, 1998 (File No. 000-23877).]
<PAGE> 1
EXHIBIT 10.4
Amendment No.2 to Gionfriddo Employment Agreement
This Amendment No. 2 dated June 9, 1997 ("Amendment No. 2), is made to
the terms and conditions set forth hereinafter of that certain Employment
Agreement made between Robert P. Gionfriddo (Mr. Gionfriddo") and Heritage Bank
of Commerce, a California banking corporation ("Bank") dated June 8, 1994 (the
"Agreement") and that certain Amendment to the Agreement made between the Bank
and Mr. Gionfriddo signed October 21, 1996 ("Amendment No. 1"). Except as
amended hereinafter by this Amendment No. 2, each term and condition of the
Agreement and Amendment No. 1 shall remain in full force and effect.
1. The position responsibilities set forth in Paragraph 1 of the Agreement
shall be expanded to add the following:
"In addition to the foregoing, the EVP Business Development shall have
the following responsibilities and perform the following duties:
(a) Personally develop business and promote the Bank, including its
Board of Directors and its management team.
(b) Form and manage a team of business developers. Develop an annual
business development team plan to include staffing, special
programs, personal goals and other activities calculated to
increase profitable business for the Bank, and assist in the
integration of these plans with other Bank plans and the Bank's
overall strategic plan.
Make an annual presentation of your plan to the CEO and to the
Personnel & Planning Committee. Make written quarterly
presentations to the Personnel & Planning Committee detailing
your progress against your plan.
Assist management in the design of compensation programs for
business development personnel. Be proactive in the
administration of the incentive compensation payments to business
development personnel, thereby assuring that the program has
integrity, that itemized sales are legitimate and warrant
compensation, and that the program is reviewed and tailored over
time to insure that it is operating optimally and in the best
interests of the Bank.
(c) Play a leadership role in the development and execution of Bank
sponsored programs (seminars, receptions, etc.) to build the
Bank's reputation and its base of contacts in the community.
(d) Assist management in recruiting banking personnel, directors and
investors.
(e) Participate in Bank planning activities, especially in the
formation of the strategic plan and in the formation of the
annual marketing and bank-wide business development plans.
(f) Participate on the Officers Loan Committee (OLC).
(g) Participate in the appropriate committee and other oversight
functions which deal with issues bearing on customer service,
product development, loan/deposit pipeline development,
marketing,
<PAGE> 2
advertising, and other business development areas as designated
by management.
(h) Assist in the regulatory interface, particularly as relates to
deposit issues.
(i) Manage and administer the Business Development Committee of the
Board.
(j) Assist wherever possible with shareholder, client, and
market-maker relations, to boost and support the Bank.
(k) Promote the development of Bank personnel by including them in
the management of the EVP Business Development's accounts and by
actively distributing accounts to staff for management and
service. Assist wherever possible with employee relations,
including making calls with Bank officers, providing advice, help
and assistance, encouraging employees to come forward with their
problems and concerns, and at all times boosting and supporting
the Bank.
Any inconsistency between the above additional responsibilities
and duties and any other responsibilities and duties specified in
the Agreement shall be resolved in favor of the additional
responsibilities and duties."
2. The Term specified at paragraph 2 of the Agreement shall be extended for
a period of three (3) years from June 8, 1997.
3. The Base Salary specified at paragraph 3 of the Agreement shall be
increased to $135,000 per year at a rate of $5,625.00 per two week pay period,
effective October 1, 1997.
4. The severance payment provisions specified in paragraph 7 shall be
expanded to add severance payments in the event of termination upon a "Change in
Control" as follows:
"If, in the event of a "Change in Control" (as defined below) and in
conjunction with, or by reason of such a "Change in Control", (a) Mr.
Gionfriddo's employment is terminated without cause; or (b) any adverse and
material change occurs in the scope of Mr. Gionfriddo's position,
responsibilities, duties, salary, benefits, or location of employment; or (c)
any event occurs which reasonably constitutes or results in a demotion, a
significant diminution of responsibilities or authority, or a constructive
termination (by resignation or otherwise) of Mr. Gionfriddo's employment, then
upon the occurrence of the events set forth in subparagraph (a), (b) or (c)
above, Mr. Gionfriddo shall be entitled to be paid severance in an amount equal
to (i) twelve (12) months' total compensation pursuant to this Agreement
(including Base Salary, Performance Bonus and all other amounts payable and
includable as taxable income for federal income tax purposes by Mr. Gionfriddo),
if Mr. Gionfriddo is required to sign a non-competition agreement, or (ii)
twelve (12) months' Base Salary only pursuant to this Agreement, if Mr.
Gionfriddo is not required to sign a non-competition agreement.
The term "Change in Control" shall mean the occurrence of any of the
following events with respect to the Bank (with the term "Bank" being defined
for purposes of determining whether a "Change in Control" has occurred to
include any parent bank holding company organized at the direction of the Bank
to won 100% of the Bank's outstanding common stock): (i) a change in control of
a nature that would be required to be reported in response to Item 6(e) of
Schedule 14A of Regulation 14A promulgated under the Securities Exchange Act of
1934, as amended (the "Exchange Act"), or in response to any other form or
report to the regulatory agencies or governmental
<PAGE> 3
authorities having jurisdiction over the Bank or any stock exchange on which the
Bank's shares are listed which requires the reporting of a change in control;
(ii) any merger, consolidation or reorganization of the Bank in which the Bank
does not survive; (iii) any sale, lease, exchange, mortgage, pledge, transfer or
other disposition (in one transaction or a series of transactions) of any assets
of the Bank having an aggregate fair market value of fifty percent (50%) of the
total value of the assets of the Bank, reflected in the most recent balance
sheet of the Bank; (iv) a transaction whereby any "person" (as such term is used
in the Exchange Act) or any individual, corporation, partnership, trust or any
other entity becomes the beneficial owner, directly or indirectly, or securities
of the Bank representing twenty-five percent (25%) or more of the combines
voting power of the Bank's then outstanding securities; or (v) a situation
where, in any one-year period, individuals who at the beginning of such period
constitute the Board of Directors of the Bank cease for any reason to constitute
at least a majority thereof, unless the election, or the nomination for election
by the Bank's shareholders, of each new director is approved by a vote of at
least three-quarter (3/4) of the directors then still in office who were
directors at the beginning of the period. Notwithstanding the foregoing or
anything else contained herein to the contrary, there shall not be a "Change in
Control" for purposes of this Agreement if the event which would otherwise come
within the meaning of the term "Change in Control" involves (i) a reorganization
at the direction of the Bank solely to form a parent bank holding company which
is the party that acquires "control" or is the principal participant in the
transaction constituting a "Change in Control," as described above.
Mr. Gionfriddo acknowledges and agrees that the parties have entered
into this Agreement based upon certain financial and tax accounting assumptions.
Accordingly, with full knowledge of the potential consequences, Mr. Gionfriddo
agrees that, notwithstanding anything contained herein to the contrary: (i) the
amount of any severance payment payable in conjunction with, or by reason of a
"Change in Control" shall be reduced by the amount of the tax credit which the
Bank would have been able to claim had all severance payments been deductible by
the Bank under the Internal Revenue Code of 1986, as amended (the "Code") in the
year in which payment is to be made to Mr. Gionfriddo. Mr. Gionfriddo recognizes
that, in this regard, limitations on deductibility may be imposed under, but not
limited to, Code Section 280G. Consistent with the foregoing, and in the even
that any payment or benefit received or to be received by Mr. Gionfriddo,
whether payable pursuant to the terms of this Agreement or any other plan,
arrangement or agreement with the Bank (together with the severance payment the
"Total Payment"), is deductible (in whole or in part) as a result of Code
Section 280G, the severance payment shall be reduced as described above. For
purposes of this limitation:
(a) No portion of the Total Payment, the receipt or enjoyment of
which Mr. Gionfriddo shall have effectively waived in writing
prior to the date of payment the severance payment, shall be
taken into account;
(b) No portion of the Total Payment shall be taken into account,
which in the opinion of the tax counsel selected by the Bank and
acceptable to Mr. Gionfriddo, does not constitute a "parachute
payment" within the meaning of Section 280G of the Code;
(c) Future payments shall not be reduced beyond the extent necessary
so that the Total Payments (other than those portions referred to
in clauses (a) or (b) above, in their entirety) constitute
reasonable compensation for services actually rendered within the
meaning of Section 280G of the Code, in the opinion of tax
counsel referred to in clause (b) above; and
(d) The value of any non-cash benefit or any deferred payment or
benefit included in the Total Payments shall be determined by the
Bank's independent auditors in accordance with the principles
<PAGE> 4
of Section 280G of the Code.
5. Mr. Gionfriddo and the Bank acknowledge and agree that the increased
auto allowance specified in Amendment No. 1 shall not constitute an agreement to
any future increase in auto allowance and that no further increases shall be
requested by Mr. Gionfriddo.
6. The Bank and Mr. Gionfriddo acknowledge and agree that a Supplemental
Executive Retirement Plan generally of the type discussed with the Board of
Directors of the Bank at its June 1997 meeting will be established for the
benefit of certain Bank executives, including Mr. Gionfriddo, upon such terms
and subject to such conditions as the Board of Directors of the Bank may
determine in its sole discretion.
IN WITNESS WHEREOF, the parties have signed this Amendment No. 2 at San Jose,
California as of the date first above written
Heritage Bank of Commerce
By /s/ John E. Rossell
CEO
Robert P. Gionfriddo
/s/ Robert P. Gionfriddo
10/22/97
<PAGE> 1
EXHIBIT 16.1
KPMG Peat Marwick LLP
50 West San Fernando Street Telephone 408 279 2000 Telefax 408 287 9054
San Jose, CA 95113 Telex 171415 PMMSJC UD
Federal Deposit Insurance Corporation
Division of Supervision
Registration, Disclosure, and Securities Operations Unit
550 17th Street NW
Washington, D.C. 20429
December 4, 1997
Ladies and Gentlemen:
We were previously principal accountants for Heritage Bank of Commerce and,
under the date of January 10, 1997, we reported on the financial statements of
Heritage Bank of Commerce as of and for the years ended December 31, 1996 and
1995. On December 1, 1997, our appointment as principal accountants was
terminated. We have read Heritage Bank of Commerce's statements included under
Item 10 of its Form F-3 dated December 1, 1997, and we agree with such
statements.
Very truly yours,
KPMG Peat Marwick LLP
<PAGE> 1
EXHIBIT 21.1
Subsidiaries to the Registrant
At present, Heritage Bank of Commerce is the only subsidiary of Heritage
Commerce Corp. The address is:
Heritage Bank of Commerce
150 Almaden Boulevard
San Jose, CA 95113
<TABLE> <S> <C>
<ARTICLE> 9
<S> <C> <C> <C>
<PERIOD-TYPE> YEAR YEAR YEAR
<FISCAL-YEAR-END> DEC-31-1997 DEC-31-1996 DEC-31-1995
<PERIOD-START> JAN-01-1997 JAN-01-1996 JAN-01-1995
<PERIOD-END> DEC-31-1997 DEC-31-1996 DEC-31-1995
<CASH> 16,060,000 12,615,000 16,140,000
<INT-BEARING-DEPOSITS> 350,000 0 0
<FED-FUNDS-SOLD> 27,125,000 0 20,200,000
<TRADING-ASSETS> 0 0 0
<INVESTMENTS-HELD-FOR-SALE> 61,166,000<F1> 50,016,000<F1> 41,332,000<F1>
<INVESTMENTS-CARRYING> 26,531,000<F1> 25,252,000<F1> 10,117,000<F1>
<INVESTMENTS-MARKET> 26,938,000<F1> 25,454,000<F1> 10,262,000<F1>
<LOANS> 128,770,000<F2> 82,915,000<F2> 37,357,000<F2>
<ALLOWANCE> 2,285,000 1,402,000 572,000
<TOTAL-ASSETS> 267,575,000<F3> 173,303,000<F3> 132,160,000<F3>
<DEPOSITS> 242,978,000<F4> 146,379,000<F4> 118,746,000<F4>
<SHORT-TERM> 0<F5> 5,010,000<F5> 0<F5>
<LIABILITIES-OTHER> 2,261,000 1,390,000 585,000
<LONG-TERM> 0 0 0
0 0 0
0 0 0
<COMMON> 23,447,000 22,093,000 14,170,000
<OTHER-SE> (1,111,000) (1,569,000) (1,341,000)
<TOTAL-LIABILITIES-AND-EQUITY> 267,575,000 173,303,000 132,160,000
<INTEREST-LOAN> 10,376,000 6,138,000 3,134,000
<INTEREST-INVEST> 5,275,000 3,724,000 2,623,000
<INTEREST-OTHER> 600,000 663,000 664,000
<INTEREST-TOTAL> 16,251,000 10,525,000 6,421,000
<INTEREST-DEPOSIT> 4,187,000 2,641,000 1,695,000
<INTEREST-EXPENSE> 4,204,000 2,646,000 1,696,000
<INTEREST-INCOME-NET> 12,047,000 7,879,000 4,725,000
<LOAN-LOSSES> 1,060,000 830,000 496,000
<SECURITIES-GAINS> 164,000 21,000 3,000
<EXPENSE-OTHER> 9,168,000<F6> 5,724,000<F6> 4,098,000<F6>
<INCOME-PRETAX> 2,409,000 1,621,000 202,000
<INCOME-PRE-EXTRAORDINARY> 2,409,000 1,621,000 202,000
<EXTRAORDINARY> 0 0 0
<CHANGES> 0 0 0
<NET-INCOME> 1,565,000 1,401,000 201,000
<EPS-PRIMARY> 0.48 0.48 0.08
<EPS-DILUTED> 0.45 0.46 0.08
<YIELD-ACTUAL> 6.23 5.99 5.81
<LOANS-NON> 0 0 0
<LOANS-PAST> 0 0 0
<LOANS-TROUBLED> 2,695,000 4,005,000 296,804
<LOANS-PROBLEM> 0 0 0
<ALLOWANCE-OPEN> 1,402,000 572,000 76,000
<CHARGE-OFFS> 224,000 0 0
<RECOVERIES> 47,000 0 0
<ALLOWANCE-CLOSE> 2,285,000 1,402,000 572,000
<ALLOWANCE-DOMESTIC> 1,412,000 862,000 429,000
<ALLOWANCE-FOREIGN> 0 0 0
<ALLOWANCE-UNALLOCATED> 873,000 540,000 143,000
<FN>
<F1>Footnote 1
December 31, 1997
Carrying Value Market Value
----------------------------------------
Securities held-for-sale
U.S. Treasury 35,220,000 35,671,000
U.S. government agency 16,370,000 16,572,000
Municipals 4,596,000 4,663,000
Preferred Stock 2,212,000 2,260,000
Commercial Paper 2,036,000 2,000,000
----------------------------------------
Total 60,434,000 61,166,000
Securities held-to-maturity
U.S. Treasury 4,048,000 4,082,000
U.S. government agency 6,033,000 6,151,000
Municipals 16,450,000 16,705,000
----------------------------------------
Total 26,531,000 26,938,000
- --------------------------------------------------------------------------------
December 31, 1996
Carrying Value Market Value
----------------------------------------
Securities held-for-sale
U.S. Treasury 28,092,000 28,273,000
U.S. government agency 16,624,000 16,668,000
Municipals 2,517,000 2,541,000
Commercial Paper 2,527,000 2,534,000
----------------------------------------
Total 49,760,000 50,016,000
Securities held-to-maturity
U.S. Treasury 8,084,000 8,146,000
U.S. government agency 7,552,000 7,673,000
Municipals 9,616,000 9,635,000
----------------------------------------
Total 25,252,000 25,454,000
- --------------------------------------------------------------------------------
December 31, 1995
Carrying Value Market Value
----------------------------------------
Securities held-for-sale
U.S. Treasury 19,107,000 19,330,000
U.S. government agency 18,167,000 18,384,000
Municipals 2,521,000 2,603,000
Commercial Paper 1,000,000 1,015,000
----------------------------------------
Total 40,795,000 41,332,000
Securities held-to-maturity
U.S. Treasury 5,029,000 5,127,000
U.S. government agency 515,000 521,000
Municipals 4,573,000 4,614,000
-------------------- --------------------
Total 10,117,000 10,262,000
<F2>Footnote 2
Loans as of December 31, 1997 1996 1995
Commercial 48,422,000 29,420,000 18,291,000
Real Estate Term 38,446,000 26,070,000 5,105,000
Real Estate Land and Construction 25,780,000 11,918,000 13,345,000
Consumer 824,000 558,000 735,000
As of December 31, 1997, 1996, 1995, the Bank had outstanding loans in the
amounts of $2,145,000, $2,565,000 and $2,408,000 to directors and executive
officers. 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.
<F3>Footnote 3
Other assets as of December 31, 1997 1996 1995
---------------------------------------------
Premises and Equipment, net 1,971,000 1,530,000 935,000
Accrued interest receivable 3,764,000 2,377,000 1,486,000
Other investments 4,473,000 --- ---
---------------------------------------------
Total 10,208,000 3,907,000 2,421,000
<F4>Footnote 4
As of December 31, 1997 1996 1995
- -----------------------------------------------------------------------------
Non interest bearing
deposits 97,737,000 55,372,000 53,874,000
Interest bearing deposits 145,241,000 141,004,000 64,872,000
<F5>Footnote 5
As of December 31, 1997, the Bank had federal funds purchase lines of
$15,000,000 and $2,000,000, respectively, from two correspondent banks,
and a repurchase arrangement of $10,000,000 with a commercial brokerage
firm. There were no borrowings under these arrangements as of December
31, 1997. The repurchase agreement is an overnight loan, with terms
negotiated based on the nature of the securities offered for repurchase.
As of December 31, 1996, the Bank had borrowing lines totaling
approximately $19,000,000 with two correspondent banks and a commercial
brokerage firm. The Bank has federal funds purchase lines with
availability of $7,000,000 and $2,000,000, respectively, from its two
correspondent banks, and a repurchase arrangement with availability of
$10,000,000 with the same commercial brokerage firm. The repurchase
agreement is an overnight loan, with terms negotiated based on the
nature of the securities offered for repurchase. The securities remain
under the control of the Bank.
As of December 31, 1995, the Bank had borrowing lines totaling
approximately $19,000,000 with two correspondent banks and a commercial
brokerage firm. There were no borrowings outstanding under any of these
lines as of December 31, 1995.
<F6>Footnote 6
Expenses as of December 31, 1997 1996 1995
----------------------------------------
Salaries and employee
benefits 4,933,000 2,942,000 2,062,000
Client Services 1,169,000 910,000 491,000
Furniture and Equipment 542,000 330,000 220,000
Advertising and promotion 450,000 260,000 154,000
Occupancy 440,000 293,000 296,000
Professional fees 372,000 224,000 302,000
Loan origination costs 326,000 146,000 39,000
Other 936,000 619,000 534,000
----------------------------------------
Total 9,168,000 5,724,000 4,098,000
</FN>
</TABLE>
