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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
------------------------
FORM 10-K
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(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, 1998
[ ] 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 (IRS EMPLOYER IDENTIFICATION NO.)
INCORPORATION OR ORGANIZATION)
150 ALMADEN BOULEVARD
SAN JOSE, CALIFORNIA 95113
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
</TABLE>
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (408) 947-6900
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
NONE
<TABLE>
<S> <C>
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
COMMON STOCK (NO PAR VALUE) NASDAQ
(TITLE OF EACH CLASS) (NAME OF EACH EXCHANGE ON WHICH REGISTERED)
</TABLE>
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the 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 March 23,
1999, on the Nasdaq National Market was $110,489,775.
As of March 1, 1999, 5,559,234 shares of the registrant's common stock (no
par value) were outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
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<CAPTION>
DOCUMENTS INCORPORATED PARTS OF FORM 10-K INTO WHICH INCORPORATED
---------------------- ------------------------------------------
<S> <C>
Definitive proxy statement for the Company's Part III
1999 Annual Meeting of Shareholders to be
filed within 120 days of the end of the
fiscal year ended December 31, 1998.
</TABLE>
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HERITAGE COMMERCE CORP
INDEX TO
ANNUAL REPORT ON FORM 10-K
FOR YEAR ENDED DECEMBER 31, 1998
<TABLE>
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PAGE
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<S> <C> <C>
PART I
Item 1 Business.................................................... 1
Item 2 Properties.................................................. 12
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........................................................ 31
Item 8 Financial Statements and Supplementary Data................. 33
Item 9 Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure.................................... 33
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......................................................... 34
</TABLE>
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PART I
ITEM 1 -- BUSINESS
GENERAL
Heritage Commerce Corp (the "Company") is registered with the Board of
Governors of the Federal Reserve System (FRB) as a bank holding company under
the Bank Holding Company Act (BHCA). The Company was organized in 1997 to be the
holding company for Heritage Bank of Commerce ("HBC"). HBC merged with and
became a wholly owned subsidiary of the Company effective February 17, 1998,
when the shareholders of HBC received one share of the Heritage Commerce Corp
common stock for each share of HBC common stock held.
On January 27, 1999, the Company's Board of Directors announced the
declaration of a 3-for-2 stock split effective for shareholders of record on
February 5, 1999. Accordingly, all historical financial information has been
restated as if the stock split had been in effect for all periods presented.
NEW BRANCHES AND SUBSIDIARIES
The Company's primary strategy is to establish new de novo banks, branches,
or representative offices in contiguous geographic areas. By virtue of each
subsidiary's local ownership, management, and decision making, the Company hopes
to benefit from the continuing trend in the banking industry towards merger and
consolidation. The Company's, as well as the Banks', business strategy and
promotional activities emphasize service and responsiveness to local needs.
On February 9, 1998, HBC opened a full-service branch in the city of
Fremont, California. On December 7, 1998, the Company received approval to open
Heritage Bank East Bay ("HBEB" and together with HBC, the "Banks"), a de novo
bank, in the city of Fremont, California. On that date, HBEB became a subsidiary
of the Company and took control of HBC's existing branch in Fremont and Loan
Production Office in San Ramon, California.
On December 22, 1998, HBC received authorization from the California
Department of Financial Institutions to open a full service branch in the city
of Morgan Hill, California. HBC's Board of Directors view this geographic
expansion as a continuation into HBC's primary market area, Santa Clara County,
since Morgan Hill has a high concentration of potential clients with banking
service requirements similar to those of HBC's current client mix. HBC opened
the branch on March 1, 1999.
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 Morgan
Hill.
GENERAL BANKING SERVICES
The Company's customer base consists primarily of small to medium-sized
businesses and their owners, managers, and employees residing in Santa Clara and
Alameda counties. Businesses served include manufacturers, distributors,
contractors, professional corporations/partnerships, and service businesses. The
Company had approximately 3,500 deposit accounts at December 31, 1998.
The Company offers a range of loans, primarily commercial, including real
estate, construction, Small Business Administration (SBA), inventory and
accounts receivable, and equipment loans. The Company also accepts checking,
savings, and time deposits; NOW and money market deposit accounts; and provides
travelers' checks, safe deposit, and other customary non-deposit banking
services. The Company issues VISA and MasterCard credit cards through the
Independent Bankers Association. The Company does not have a trust department.
HBC's main and executive offices and the Company's offices are located at
150 Almaden Boulevard, San Jose, California 95113. In addition, HBEB is located
at 3077 Stevenson Blvd., Fremont, California 94538. See
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Item 2 -- "PROPERTIES." The Company's primary market area is Santa Clara and
Alameda counties. The Company 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 Company's market areas specifically, is highly competitive. The increasingly
competitive environment is a result primarily of changes in regulation, changes
in technology and product delivery systems, and the accelerating pace of
consolidation among financial services providers. The Company competes for
loans, deposits and customers for financial services with other commercial
banks, savings and loan associations, securities and brokerage companies,
mortgage companies, insurance companies, finance companies, money market funds,
credit unions, and other non-bank financial service providers. Many of these
competitors are much larger in total assets and capitalization, have greater
access to capital markets and offer a broader array of financial services than
the Company. In order to compete with the other financial services providers,
the Company principally relies upon local promotional activities, personal
relationships established by officers, directors, and employees with its
customers, and specialized services tailored to meet its customers' needs. In
those instances where the Company is unable to accommodate a customer's needs,
the Company seeks to have those services provided in whole or in part by its
correspondent banks. See Item 1 -- "BUSINESS -- Supervision And Regulation."
SUPERVISION AND REGULATION
GENERAL
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, the FRB is required to consider whether the
performance of such activities by a bank holding company or its subsidiaries can
reasonably be expected to produce benefits to the public such as greater
convenience, increased competition, or gains in efficiency that outweigh the
possible adverse effects, such as undue concentration of resources, decreased or
unfair competition, conflicts of interest, or unsound banking practices.
Generally, bank holding companies are required to give notice to or obtain prior
approval of the FRB to engage in any new activity or to acquire more than 5% of
any class of voting stock of any bank.
Both HBC and HBEB are members 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, HBC and HBEB pay a semi-annual
assessment and are subject to the rules and regulations of the FDIC pertaining
to deposit insurance and other matters.
HBC and HBEB are California state-chartered banks, but are not members of
the Federal Reserve System. State banks chartered in California are subject to
regulation, supervision and regular examination by the California Department of
Financial Institutions and by the Federal Deposit Insurance Corporation. The
regulations of the FDIC and the Department govern most aspects of HBC's and
HBEB'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
The Company's ability to pay cash dividends is dependent on dividends paid
to it by HBC and HBEB. 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
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event sufficient retained earnings are not available for the proposed
distribution a corporation may nevertheless make a distribution to its
shareholders if, after giving effect to the distribution, it meets two
conditions, which generally stated are as follows: (i) the corporation's assets
must equal at least 125% of its liabilities; and (ii) the corporation's current
assets must equal at least its current liabilities or, if the average of the
corporation's earnings before taxes on income and before interest expense for
the two preceding fiscal years was less than the average of the corporation's
interest expense for such fiscal years, then the corporation's current assets
must equal at least 125% of its current liabilities. Most bank holding companies
are unable to meet this test.
The payment of cash dividends by the Company depends on various factors,
including the earnings and capital requirements of itself and its subsidiaries,
and other financial conditions. The primary source of funds for payment of
dividends by the Company to its shareholders will be the receipt of dividends
and management fees from the Banks. The Company has no present intention of
paying dividends in the foreseeable future. The legal ability of the Banks to
pay dividends is subject to restrictions set forth in the California banking law
and regulations of the FDIC. No assurance can be given that the Banks will pay
dividends at any time. For restrictions applicable to the Banks, see Item
5 -- "MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS -- Dividends."
SAFETY AND SOUNDNESS STANDARDS
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.
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.
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The following table presents the capital ratios of the Company computed in
accordance with applicable regulatory guidelines and compared to the standards
for minimum capital adequacy requirements and for well-capitalized institutions
under the FDIC's prompt corrective action authority as of December 31, 1998:
<TABLE>
<CAPTION>
DECEMBER 31, 1998
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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... $33,675,000 10.4% $25,895,000 >=8.0% N/A >=N/A
Tier 1 capital/risk-weighted
assets......................... $29,850,000 9.2% $12,948,000 >=4.0% N/A >=N/A
Tier 1 capital/average assets.... $29,850,000 9.0% $13,282,000 >=4.0% N/A >=N/A
</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>
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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
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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 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.
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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
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<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).
At December 31, 1998, HBEB's assessment rate was equivalent to a well
capitalized, group A institution while HBC was equivalent to an adequately
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.
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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 is now 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 increases HBC's and HBEB's premiums, as they are required
to share in the cost of carrying the FICO bonds. The increase is 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
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
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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 unless certain specified
procedures are followed. In addition, a bank that is "adequately capitalized"
may not pay an interest rate on any deposits in excess of 75 basis points over
certain prevailing market rates. There are no such restrictions on a bank that
is "well capitalized."
FEDERAL RESERVE BORROWINGS
The FRB may not make advances to an undercapitalized institution for more
than 60 days in any 120-day period without a viability certification by a
federal banking agency or by the Chairman of the FRB after an examination by the
FRB. If an institution is deemed critically undercapitalized, an extension of
FRB credit cannot continue for more than five days without demand for payment
unless the FRB is willing to accept responsibility for any resulting loss to the
FDIC. As a practical matter, this provision is likely to mean that FRB credit
will not be extended beyond the limitations in this provision.
POTENTIAL ENFORCEMENT ACTIONS; SUPERVISORY AGREEMENTS
Banks and their institution-affiliated parties may be subject to potential
enforcement actions by the FRB, the FDIC or the Office of the Comptroller of the
Currency (OCC) for unsafe or unsound practices in conducting their businesses,
or for violations of any law, rule or regulation or provision, any consent order
with any agency, any condition imposed in writing by the agency or any written
agreement with the agency.
7
<PAGE> 10
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 acquisitions of branches are permitted to a bank only if the
law of the state where the branch is located expressly permits
interstate acquisition of a branch without acquiring the entire bank.
- Interstate de novo branching is permitted to a bank only if a state has
adopted legislation to "opt in" to interstate de novo branching
authority.
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.
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
8
<PAGE> 11
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 Company, and the
companies with which they are associated, may conduct banking transactions with
the Company in the ordinary course of business. Any loans and commitments to
loans included in such transactions must be made in accordance with applicable
law, on substantially the same terms, including interest rates and collateral,
as those prevailing at the time for comparable transactions with other persons
of similar creditworthiness, and on terms not involving more than the normal
risk of 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 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 Company cannot be predicted.
9
<PAGE> 12
ENVIRONMENTAL REGULATION
Federal, state, and local regulations regarding the discharge of materials
into the environment may have an impact on the Company. Under federal law,
liability for environmental damage and the cost of cleanup may be imposed on any
person or entity who is an owner or operator of contaminated property. State law
provisions impose substantially similar requirements. Both federal and state
laws 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 Company cannot predict whether it will be adequately
protected for the types of loans made by it. In addition, the Company is still
subject to the risks that a borrower's financial position will be impaired by
liability under the environmental laws and that property securing a loan made by
the Company may be environmentally impaired and not provide adequate security
for the Company. The Company attempts to protect its position against
environmental risks by performing prudent due diligence. Environmental
questionnaires and information on the use of toxic substances are requested as
part of its underwriting procedures. The Company lends based on its evaluation
of the collateral, net worth of the borrower, and the borrower's capacity for
unforeseen business interruptions or risks.
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 authorize, among other matters, previously
impermissible share repurchases by state banks, subject to the prior approval of
the Commissioner.
In November 1996, the OCC issued final regulations permitting national
banks to engage in a wider range of activities through subsidiaries. "Eligible
institutions" (those national banks that are well-capitalized, have a high
overall rating and a satisfactory CRA rating, and are not subject to an
enforcement order) may engage in activities related to banking through operating
subsidiaries after going through a new expedited application process. In
addition, the new regulations include a provision whereby a national bank may
apply to the OCC to engage in an activity through a subsidiary in which the bank
itself may not engage. In determining whether to permit the subsidiary to engage
in the activity, the OCC will evaluate why the bank itself is not permitted to
10
<PAGE> 13
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.
IMPACT OF ECONOMIC CONDITIONS AND MONETARY POLICIES
The earnings and growth of the Company will be affected by general economic
conditions, both domestic and international, and by the monetary and fiscal
policies of the United States Government and its agencies, particularly the FRB.
One function of the FRB is to regulate the national supply of bank credit in
order to mitigate recessionary and inflationary pressures. Among the instruments
of monetary policy used to implement those objectives are open market
transactions in United States Government securities, changes in the discount
rate on member bank borrowings and changes in reserve requirements held by
depository institutions. The monetary policies of the FRB have had a significant
effect on the operating results of commercial banks in the past and are expected
to continue to do so in the future. However, the effect, if any, of such
policies on the future business and earnings of the Company cannot be accurately
predicted.
LEGISLATION AND PROPOSED CHANGES
From time to time, legislation is enacted which has the effect of
increasing the cost of doing business, limiting or expanding permissible
activities, or affecting the competitive balance between banks and other
financial institutions. Proposals to change the laws and regulations governing
the operations and taxation of banks, bank holding companies and other financial
institutions are frequently made in Congress, in the California legislature and
before various bank regulatory agencies.
11
<PAGE> 14
Typically, the intent of such legislation is to strengthen the banking
industry, even if it may on occasion prove a burden on management's plans. No
prediction can be made as to the likelihood of any major changes or the impact
such changes might have on the Company.
EMPLOYEES
At December 31, 1998, the Company employed 123 persons, primarily on a
full-time basis. The Company's employees are not represented by any union or
collective bargaining agreement and the Company believes its employee relations
are satisfactory.
ITEM 2 -- PROPERTIES
The Company'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 Company leased an area on the second floor of the
Company'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.
The Company has also leased space at 100 Park Center Plaza, Suite 300 and
430, San Jose, consisting of approximately 5,623 and 3,277 square feet of space.
The lease for Suite 300 commenced on June 1, 1998 and will terminate on May 31,
2003. The rent starts at $11,527 in the first year and ends at $12,651 in the
last year of the lease. The lease for Suite 430 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 Company leased space for HBEB's primary office at
3077 Stevenson Blvd., Fremont, California, consisting of 6,590 square feet of
space in a stand-alone office building. The lease, which commenced February 1,
1998, is for a ten-year period expiring January 2008. The rent for the first
twelve-month period is $13,180 per month, and the rent increases annually
thereafter by 4%. In addition to the space in Fremont, the Company has leased
space at 12657 Alcosta Boulevard, San Ramon, California, for HBEB for use as a
loan production office. The monthly rent for this lease is $3,231 and it expires
on August 31, 2001.
Refer to Note 9 of the Company's Consolidated Financial Statements,
beginning on page F-1 of this Report on Form 10-K, for additional information on
rent expense.
ITEM 3 -- LEGAL PROCEEDINGS
To the best of the Company's knowledge, there are no pending or threatened
legal proceedings to which the Company is a party, which may have a materially
adverse effect on the Company's financial condition, results of operations, or
cash flows.
ITEM 4 -- SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None
12
<PAGE> 15
PART II
ITEM 5 -- MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
On July 30, 1998 the Company's Common Stock was approved for listing on the
Nasdaq National Market under the symbol "HTBK." Prior to July 30, 1998, the
Company's Common Stock (before February 17, 1998, HBC's common stock) was listed
on the Over-the-Counter Electronic Bulletin Board under the symbol "HTBC."
Everen Securities, Hoefer & Arnett, Incorporated, Sutro & Co., Incorporated and
Van Kasper & Company have acted as market makers for the Common Stock. These
market makers have 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 be sustained for the Common Stock at
any time in the future.
The information in the following table for the third and fourth quarters in
1998 indicates the high and low closing prices for the Common Stock, based upon
information provided by the Nasdaq National Market. The information for quarters
prior to the third quarter of 1998 is based upon information provided by the
market makers. These quotations reflect inter-dealer prices, without retail
mark-up, markdown, 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>
1998
Fourth Quarter............................... $14.67 $11.33
Third Quarter................................ 14.00 9.67
Second Quarter............................... 11.33 9.67
First Quarter................................ 11.33 10.00
1997
Fourth Quarter............................... $13.33 $10.67
Third Quarter................................ 9.67 5.78
Second Quarter............................... 5.67 5.55
First Quarter................................ 5.78 5.39
</TABLE>
Listed amounts are adjusted to reflect (i) a 5 percent stock dividend which
was paid on February 26, 1997 to shareholders of record as of February 5, 1997,
(ii) a 3-for-2 stock split on August 15, 1997 to shareholders of record as of
August 1, 1997, and (iii) a 3-for-2 stock split on February 19, 1999 to
shareholders of record as of February 5, 1999.
Effective February 17, 1998, HBC'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 a bank are entitled to
receive dividends when and as declared by the Board of Directors, out of funds
legally available therefor. The California Banking Law provides that a
state-licensed bank may not make a cash distribution to its shareholders in
excess of the lesser of the following: (i) the bank's retained earnings, or (ii)
the bank's net income for its last three fiscal years, less the amount of any
distributions made by the bank to its shareholders during such period. However,
a bank, with the prior approval of the Commissioner of the Department of
Financial Institutions ("Commissioner"), may make a distribution to its
shareholders of an amount not to exceed the greater of (i) a bank's retained
earnings, (ii) its net income for its last fiscal year, or (iii) its net income
for the current fiscal year. In the event that the Commissioner determines that
the shareholders' equity of a bank is inadequate or that the making of a
distribution by a bank would be unsafe or unsound, the Commissioner may order a
bank to refrain from making such a proposed distribution.
13
<PAGE> 16
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.
For regulatory restrictions on payment of dividends by the Company, see
Item 1 -- "BUSINESS -- Regulation and Supervision -- Limitations on Dividends."
To date, neither the Banks 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
Company'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 January 1997, the Company'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 Company 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 $5.56 per share in January 1997.
In August 1997, the Company'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 Company accounted for the
transaction by restating all share information to reflect the effect of the
split. The payable date of the split was August 15, 1997.
In January 1999, the Company's Board of Directors declared a 3 for 2 stock
split payable to shareholders of record as of February 5, 1999. In accordance
with generally accepted accounting principles, the Company accounted for the
transaction by restating all share information to reflect the effect of the
split. The payable date of the split was February 19, 1999.
NUMBER OF EQUITY SECURITY HOLDERS
As of March 1, 1999, there were 835 holders of Common Stock, the only
outstanding class of equity security of the Company.
14
<PAGE> 17
ITEM 6 -- SELECTED FINANCIAL DATA
The following table presents a summary of selected financial information
that should be read in conjunction with the Company's consolidated financial
statements and notes thereto included under Item 8 -- "FINANCIAL STATEMENTS AND
SUPPLEMENTARY DATA." Financial information for 1998 represents the consolidated
financial operation and condition of Heritage Commerce Corp. Financial
information for years prior to 1998 represents the financial operations and
condition of Heritage Bank of Commerce prior to formation of the Company.
SELECTED FINANCIAL DATA
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
------------------------
1998 1997 1996 1995 1994(1)
---------- ---------- ---------- ---------- ----------
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S> <C> <C> <C> <C> <C>
INCOME STATEMENT DATA:
Interest income.............................. $ 26,904 $ 16,251 $ 10,525 $ 6,421 $ 1,244
Interest expense............................. 7,951 4,204 2,646 1,696 214
---------- ---------- ---------- ---------- ----------
Net interest income before provision for loan
losses..................................... 18,953 12,047 7,879 4,725 1,030
Provision for loan losses.................... 1,576 1,060 830 496 76
---------- ---------- ---------- ---------- ----------
Net interest income after provision for loan
losses..................................... 17,377 10,987 7,049 4,229 954
Non-interest income.......................... 1,703 590 296 71 18
Non-interest expenses........................ 15,605 9,168 5,724 4,098 2,976
---------- ---------- ---------- ---------- ----------
Income (loss) before income taxes............ 3,475 2,409 1,621 202 (2,004)
Income taxes................................. 1,325 844 220 1 1
---------- ---------- ---------- ---------- ----------
Net income (loss)............................ $ 2,150 $ 1,565 $ 1,401 $ 201 $ (2,005)
========== ========== ========== ========== ==========
PER SHARE DATA(2):
Basic net income (loss)(3)................... $ 0.41 $ 0.32 $ 0.32 $ 0.05 $ (0.55)
Diluted net income (loss)(4)................. 0.37 0.30 0.31 0.05 (0.55)
Book value(5)................................ 5.53 4.52 4.41 4.02 3.21
Weighted average number of shares
outstanding -- basic....................... 5,242,516 4,937,533 4,368,394 3,667,368 3,660,220
Weighted average number of shares
outstanding -- diluted..................... 5,844,038 5,221,857 4,550,929 3,715,393 3,660,147
BALANCE SHEET DATA:
Investment securities........................ $ 76,793 $ 87,697 $ 75,268 $ 51,449 $ 30,336
Net loans.................................... 232,482 126,485 81,513 41,950 10,455
Allowance for loan losses.................... 3,825 2,285 1,402 572 76
Total assets................................. 404,931 267,575 173,303 132,160 59,037
Total deposits............................... 368,958 242,978 146,379 118,746 47,082
Total shareholders' equity................... 30,697 22,336 20,524 12,829 11,741
SELECTED PERFORMANCE RATIOS:
Return on average assets(6).................. 0.65% 0.74% 0.96% 0.22% n/m
Return on average equity..................... 8.23% 7.38% 8.56% 1.67% n/m
Net interest margin.......................... 6.33% 6.23% 5.99% 5.81% 5.13%
Average net loans as a percentage of average
deposits................................... 58.81% 52.98% 48.23% 37.68% 17.21%
Average total shareholders' equity as a
percentage of average total assets......... 7.89% 9.98% 11.23% 13.25% 31.97%
SELECTED ASSET QUALITY RATIOS(7):
Net loan charge-offs to average loans........ 0.02% 0.18% -- -- --
Allowance for loan losses to total loans..... 1.62% 2.02% 2.07% 1.53% 0.80%
CAPITAL RATIOS(8):
Tier 1 risk-based............................ 9.2% 14.6% 21.4% 22.5% 75.9%
Total risk-based............................. 10.4% 15.8% 22.6% 23.6% 76.4%
Leverage..................................... 9.0% 10.3% 13.9% 13.5% 29.6%
</TABLE>
15
<PAGE> 18
NOTES:
(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; (iii) a 3-for-2
stock split payable to shareholders of record as of August 1, 1997; and (iv)
a 3-for-2 stock split payable to shareholders of record as of February 5,
1999.
(3) Represents net income divided by the average number of shares of common
stock outstanding for the respective period.
(4) Represents net income divided by the average number of shares of common
stock and common stock-equivalents outstanding for the respective period.
(5) Represents shareholders' equity divided by the number of shares of common
stock outstanding at the end of the period indicated.
(6) Average balances used in this 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 December 31,
1998, the Company had $1,288,000 in non-performing assets. As of the
December 31, 1997, 1996 and 1995, the Company 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."
16
<PAGE> 19
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.
Heritage Commerce Corp (the "Company") operates as the bank holding company
for two subsidiary banks: Heritage Bank of Commerce ("HBC") and Heritage Bank
East Bay ("HBEB")(collectively the "Banks"). Both are California state chartered
banks which offer a full range of commercial and personal banking services to
residents and the business/professional community in Santa Clara and Alameda
Counties, California. HBC was incorporated on November 23, 1993 and commenced
operations on June 8, 1994. Accordingly, all figures for 1994 are for the 207
day period from June 8 (inception) to December 31, 1994. HBEB was incorporated
on October 21, 1998 and commenced operations on December 7, 1998. The accounting
and reporting policies of the Company and its subsidiary banks conform to
generally accepted accounting principles and prevailing practices within the
banking industry. No customer accounts for more than 10 percent of revenue for
either HBC, HBEB or the Company. Accordingly, the Company and its subsidiary
banks all operate as one business segment.
RESULTS OF OPERATIONS
OVERVIEW
Net income for the year ended December 31, 1998 was $2,150,000, or $0.37
per share (diluted) compared to $1,565,000, or $0.30 per share (diluted) and
$1,401,000 or $0.31 per share (diluted) for the years ended December 31, 1997
and 1996, respectively. This increase was primarily attributable to growth in
the level of earning assets, funded by new deposits at favorable weighted
average interest rates, as well as to improvements in the Company's mix of
earning assets in favor of higher yielding assets, such as loans.
On January 27, 1999, the Company's Board of Directors announced the
declaration of a 3-for-2 stock split effective for shareholders of record on
February 5, 1999. Accordingly, all historical financial information has been
restated as if the stock split had been in effect for all periods presented.
Average interest-earning assets for 1998 were up 53% over 1997. The
increase was primarily attributable to growth in loans and, as a result, the
average rate on interest-earning assets increased to 8.99% in 1998, up from
8.40% in 1997. Average interest-bearing deposits for 1998 were up 65% over 1997,
with the increase primarily attributable to growth in savings and money market
accounts. The Company's average rate paid on interest-bearing liabilities
increased to 3.99% in 1998, up from 3.49% in 1997. As a result, net interest
margin improved to 6.32% in 1998 from 6.23% in 1997.
The Company's loan quality remained high in 1998. As of December 31, 1998,
nonperforming assets, comprised of loans past due 90 days or more, increased to
$1,288,000 from zero as of December 31, 1997. As a result of this increase,
nonperforming assets as a percent of total assets rose to 0.32% as of December
31, 1998 from zero the previous year. However, net loan charge-offs during 1998
were 0.02% of average loans outstanding down from 0.18% in 1997. The Company had
no loan charge-offs in 1996 or any prior year.
Fee income rose 32% in 1998 from 1997 due to the increase in total
deposits. However, many of the Company'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 382% and 62%, respectively, in 1998 from 1997.
Return on average equity in 1998 was 8.23%, compared to 7.38% in 1997 and
8.56% in 1996. Return on average equity increased by 11.8% in 1998 from 1997 due
to substantial growth in net income, offset by the Company's stock offering of
$5,846,000.
Return on average assets in 1998 dropped to 0.65% from 0.74% in 1997. In
1998, average assets grew at a faster rate than net earnings. Return on average
assets was 0.96% in 1996.
17
<PAGE> 20
NET INTEREST INCOME AND NET INTEREST MARGIN
The following table presents the average amounts outstanding for the major
categories of the Company'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>
1998 1997 1996
----------------------------- ----------------------------- -----------------------------
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)................... $177,428 $19,777 11.15% $ 98,930 $10,376 10.49% $ 61,130 $ 6,138 10.04%
Investment securities(2)(3)..... 93,944 5,594 5.95 84,196 5,323 6.32 57,769 3,724 6.45
Federal funds sold.............. 25,309 1,307 5.16 10,233 552 5.39 12,612 663 5.26
-------- ------- ----- -------- ------- ----- -------- ------- -----
Total interest-earning
assets................ $296,681 $26,678 8.99% $193,359 $16,251 8.40% $131,511 $10,525 8.00%
-------- ------- ----- -------- ------- ----- -------- ------- -----
Cash and due from banks......... 21,741 13,961 11,270
Premises and equipment, net..... 2,841 1,756 1,152
Other assets.................... 10,213 3,586 1,802
Total assets............ $331,476 $212,662 $145,735
======== ======== ========
LIABILITIES AND SHAREHOLDERS'
EQUITY:
Deposits:
Demand, interest-bearing...... $ 7,368 $ 137 1.86% $ 4,988 $ 95 1.91% $ 3,654 $ 68 1.86%
Savings and money-market...... 122,157 4,230 3.46 80,168 2,401 3.00 60,686 1,772 2.92
Time deposits, $100,000 and
over........................ 48,861 2,463 5.04 27,314 1,330 4.87 11,220 557 4.96
Time deposits, less than
$100,000.................... 16,638 878 5.28 7,530 361 4.79 4,962 244 4.92
Brokered Deposits............. 3,826 225 5.88 -- -- -- -- -- --
Other borrowings................ 41 3 7.32 297 17 5.72 85 5 5.88
-------- ------- ----- -------- ------- ----- -------- ------- -----
Total interest-bearing
liabilities........... $198,891 $ 7,936 3.99% 120,297 $ 4,204 3.49% 80,607 $ 2,646 3.28%
Demand deposits................. 102,834 69,376 47,696
Other liabilities............... 3,598 1,782 1,062
Total liabilities....... 305,323 191,455 129,365
Shareholders' equity............ 26,153 21,207 16,371
Total liabilities and
shareholders'
equity................ 331,476 $212,662 $145,736
======== ======== ========
Net interest income/margin...... $18,742 6.32% $12,047 6.23% $ 7,879 5.99%
======= ===== ======= ===== ======= =====
</TABLE>
- ---------------
(1) Yields and amounts earned on loans include loan fees of $1,500,000, $709,000
and $388,000 for the years ended December 31, 1998, 1997, and 1996,
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, 1998 was $18,742,000,
an increase of $6,695,000 (or 56%) over the $12,047,000 reported for 1997. Net
interest income for the year ended December 31, 1998 does not include income of
$211,000 from corporate owned life insurance. The increase occurred primarily as
a result of growth that occurred in the Company's earning assets, the yield on
which was enhanced by an improvement in the net yield on interest-earning assets
during 1998 as compared with 1997. 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 Company's average interest-earning assets
were $296,681,000 in 1998, up $103,322,000 (or 53%) from the average of
$193,359,000 for 1997. The net yield on interest-earning assets improved during
1998 to 6.32% from 6.23% for 1997.
18
<PAGE> 21
The following table sets forth an analysis of the changes in interest
income and interest expense:
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31
1998 VERSUS 1997 1997 VERSUS 1996
--------------------------- --------------------------
INCREASE (DECREASE) INCREASE (DECREASE)
DUE TO CHANGE IN: DUE TO CHANGE IN:
AVERAGE AVERAGE NET AVERAGE AVERAGE NET
VOLUME RATE CHANGE VOLUME RATE CHANGE
------- ------- ------- ------- ------- ------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
Interest-earning assets:
Loans, net............................ $ 8,712 $ 689 $ 9,401 $3,953 $285 $4,238
Investment securities................. 592 (322) 270 1,672 (72) 1,599
Federal funds sold.................... 780 (24) 756 (128) 16 (111)
------- ----- ------- ------ ---- ------
Total interest-earning
assets...................... $10,084 $ 343 $10,427 $5,497 $229 $5,726
======= ===== ======= ====== ==== ======
Interest-bearing liabilities:
Demand, interest-bearing.............. $ 44 $ (2) $ 42 $ 25 $ 2 $ 27
Savings and money-market.............. 1,409 420 1,829 583 46 629
Time deposits, $100,000 and over...... 1,085 49 1,134 784 (11) 773
Time deposits, less than $100,000..... 477 40 517 123 (7) 117
Brokered deposits..................... 225 -- 225 -- -- --
Other borrowings...................... (16) 1 (15) 12 -- 12
------- ----- ------- ------ ---- ------
Total interest-bearing
liabilities................. $ 3,224 $ 508 $ 3,732 $1,527 $ 30 $1,558
------- ----- ------- ------ ---- ------
Net interest income..................... $ 6,860 $(165) $ 6,695 $3,970 $199 $4,168
======= ===== ======= ====== ==== ======
</TABLE>
Note: Yields and amounts earned on loans include loan fees of $1,500,000,
$709,000 and $388,000 for the years ended December 31, 1998, 1997, and
1996, 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 1998, the provision for loan losses was $1,576,000, up $516,000 (or
49%) from $1,060,000 during 1997. The increase in the provision during 1998
reflected the overall growth in the loan portfolio and the Company's policy of
making provisions to the allowance for loan losses. The provision for 1997 was
up $230,000 (or 28%) from $830,000 during 1996.
The allowance for loan losses was 1.62%, 2.02%, and 2.07% of total loans at
December 31, 1998, 1997, and 1996, respectively. See Item 7 -- "Management's
Discussion and Analysis of Financial Condition and Results of
Operations -- Allowance for Loan Losses" for additional information.
NON-INTEREST INCOME
The following table sets forth the various components of the Company's
non-interest income:
<TABLE>
<CAPTION>
INCREASE (DECREASE)
-----------------------------------
YEARS ENDED DECEMBER 31, 1998 VERSUS 1997 1997 VERSUS 1996
-------------------------- ---------------- ----------------
1998 1997 1996 AMOUNT PERCENT AMOUNT PERCENT
-------- ------ ------ ------ ------- ------ -------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C>
Gain on securities
available-for-sale................. $ 790 $164 $ 21 $ 626 382% $143 681%
Other income......................... 352 48 25 304 633 23 92
Gain on sale of loans held-for
sale............................... 332 205 101 127 62 104 103
Service charges and other fees....... 229 173 149 56 32 24 16
------ ---- ---- ------ ----- ---- ---
Total...................... $1,703 $590 $296 $1,113 189% $294 99%
====== ==== ==== ====== ===== ==== ===
</TABLE>
19
<PAGE> 22
Non-interest income for the year ended December 31, 1998 was $1,703,000, up
$1,113,000 (or 189%) from $590,000 for 1997. This increase was primarily the
result of gains recognized on the sale of securities available-for-sale (up
$626,000), an increase in other income (up $304,000), and sales of SBA loans (up
$127,000).
NON-INTEREST EXPENSES
The following table sets forth the various components of the Company's
non-interest expenses:
<TABLE>
<CAPTION>
INCREASE (DECREASE)
-----------------------------------
YEARS ENDED DECEMBER 31, 1998 VERSUS 1997 1997 VERSUS 1996
------------------------- ---------------- ----------------
1998 1997 1996 AMOUNT PERCENT AMOUNT PERCENT
------- ------ ------ ------ ------- ------ -------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C>
Salaries and benefits........... $ 7,722 $4,933 $2,942 $2,789 57% $1,991 68%
Client services................. 2,426 1,169 910 1,257 108 259 28
Furniture and equipment......... 828 542 330 286 53 212 64
Occupancy....................... 792 440 293 352 80 147 50
Advertising and promotion....... 786 450 260 336 75 190 73
Professional fees............... 718 372 224 346 93 148 66
Loan origination costs.......... 449 326 146 123 38 180 124
Other........................... 1,884 936 619 948 101 317 51
------- ------ ------ ------ -- ------ ---
Total................. $15,605 $9,168 $5,724 $6,437 70% $3,444 60%
======= ====== ====== ====== == ====== ===
</TABLE>
Non-interest expenses for the year ended December 31, 1998 were
$15,605,000, up $6,437,000 (or 70%) from $9,168,000 for the year ended December
31, 1997. The increase in non-interest expenses reflects the growth in
infrastructure to support the Company's loan and deposit growth.
Non-interest expenses consist primarily of salaries and employee benefits
(49%, 54%, and 51% of total non-interest expenses for 1998, 1997, and 1996,
respectively) and client services (16%, 13%, and 16% of total non-interest
expenses for 1998, 1997, and 1996, respectively). The increase in salaries and
benefits expenses was primarily attributable to an increase in the number of
employees. The Company employed 123 people at December 31, 1998, up 35 from 88
employees at December 31, 1997. Client services expenses include outside data
processing service costs, courier and armored car costs, imprinted check costs,
and other client services costs, all of which are directly related to the amount
of funds on deposit at the Company. 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 1998 due to the
Company's co-sponsorship of a professional auto racing team.
YEAR 2000
The possible 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 problem. On
January 1, 2000, such systems may be unable to accurately process certain
date-based information.
This discussion of the implications of the year 2000 problem for the
Company contains numerous forward-looking statements based on inherently
uncertain information. The cost of the project and the date on which the Company
plans to complete the internal year 2000 modifications are based on management's
best estimates of future events. The Company cannot guarantee these estimates
and actual results could differ. Although management believes it will be able to
make the necessary modifications in advance, failure to modify the systems may
have a material adverse effect on the Company.
20
<PAGE> 23
The Company has developed a plan to assess its year 2000 preparedness,
consisting of the following phases:
- Awareness of the year 2000 problems
- Risk assessment of internal and external systems
- Renovation of problems found in the risk assessment phase
- Validation of renovated systems
- Implementation of validated systems
Resolution of the year 2000 problem is among the Company's highest
priorities, and the Company is preparing for the century change with a
comprehensive enterprise-wide year 2000 program. The Company has identified all
of the major systems and has sought external and internal resources to renovate
and test the systems. The Company is testing purchased software and systems
supported by external parties as part of the program. The Company is evaluating
customers and vendors that have significant relationships with the Company to
determine whether they are adequately preparing for the year 2000. In addition,
the Company is developing contingency plans to reduce the impact of some
potential of some potential events that may occur. The Company cannot guarantee,
however, that the systems of vendors or customers with whom it does business
will be completed on a timely basis, or that contingency plans will shield
operations from failures that may occur.
The Company has identified over 90 individual projects. The projects vary
in size, importance and materiality from large undertakings, such as remediating
complicated data systems, to smaller, but still important, projects such as
installing compliant computer utility systems. All of the projects currently
identified have begun, and approximately 90% have been completed.
The Company assigns projects a priority, indicating the importance of the
function to our continuing operation. This prioritization facilitates reporting
on projects based on their relative importance. The Company has prioritized
projects as "High Priority -- In House", "High Priority -- Not In House" and
"Medium Priority". Both High Priority categories have projects classified as
"Mission Critical".
Mission Critical projects are defined as:
- systems vital to the continuance of a broad core business activity;
- functions, the interruption of which for longer than 3 days would
threaten our viability; or
- functions that provide the environment and infrastructure necessary to
continue the broad core business activities.
Testing of all mission critical systems was complete as of March 12,1999
and the Company has completed a follow-up assessment of many of our clients'
year 2000 preparedness. Currently, our focus is on vendor follow-up and
contingency plans. The Company has communicated with all vendors 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. Of all the vendors that present year 2000 risks, approximately 75% have
passed testing. The Company does not significantly rely on "embedded technology"
in its critical processes. All building systems in the Company's main offices
use mechanical systems rather than embedded technology and therefore do not pose
any year 2000 risks.
Risks
The principal risks associated with the year 2000 problem can be grouped
into three categories:
- the Company does not successfully ready its operations for the next
century,
- disruption of our operations due to operational failures of third
parties, and
21
<PAGE> 24
- business interruption among fund providers and obligors such that
expected funding and repayment does not take place
The only risk largely under the Company's control is preparing our internal
operations for the year 2000. The Company, like other financial institutions, is
heavily dependent on its computer systems. The complexity of these systems and
their interdependence make it impractical to convert to alternative systems
without interruptions if necessary modifications are not completed on schedule.
Management believes the Company will be able to make the necessary modifications
on schedule.
Failure of third parties may jeopardize the Company's operations, but the
seriousness of this risk depends on the nature and duration of the failures. The
most serious impact on the Company's operations from vendors would result if
basic services such as telecommunications, electric power, and services provided
by other financial institutions and governmental agencies were disrupted. Some
public disclosure about readiness preparation among basic infrastructure and
other suppliers is now available. The Company is unable, however, to estimate
the likelihood of significant disruptions among its basic infrastructure
suppliers. In view of the unknown probability of occurrence and impact on its
operations, the Company considers the loss of basic infrastructure services to
be the most reasonably likely worst case year 2000 scenario.
Operational failures among our customers could affect their ability to
continue to provide funding or meet obligations when due. The information the
Company develops in the customer assessments described earlier allows us to
identify those customers that exhibit a risk of not making adequate preparations
for the century change. The Company is taking appropriate actions to manage
these risks.
Contingency Plans
The Company is developing year 2000 remediation contingency plans and
business resumption contingency plans specific to the year 2000. Remediation
contingency plans address the actions the Company would take if the current
approach to remediating a system is falling behind schedule or otherwise appears
to be in jeopardy of failing to deliver a year 2000-ready systems when needed.
Business resumption contingency plans address the actions that the Company would
take if critical business functions cannot be carried out in the normal manner
upon entering the next century due to system or supplier failure.
Cost
The total cost to the Company of year 2000 compliance issues, which
includes testing, system replacement and any anticipated lost revenue, has been
approximately $20,000, and is not anticipated to increase substantially through
the completion of all projects. These costs and the date on which the Company
plans to complete the Year 2000 modifications 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
Provisions for income taxes were $1,325,000, $844,000, and $220,000, for
the years ended December 31, 1998, 1997, and 1996, respectively. The Company's
effective tax rates were 38.1%, 35.0%, and 13.6%, for the years ended December
31, 1998, 1997, and 1996, respectively.
22
<PAGE> 25
FINANCIAL CONDITION
SECURITIES PORTFOLIO
The following table summarizes the amounts and distribution of the
Company's investment securities and the weighted average yields as of December
31, 1998:
<TABLE>
<CAPTION>
DECEMBER 31, 1998
----------------------------------------------------------------------------------------------
MATURITY
---------------------------------------------------------------------------
AFTER FIVE YEARS
AFTER ONE YEAR AND
AND WITHIN TEN TOTAL AMORTIZED
WITHIN ONE YEAR WITHIN 5 YEARS YEARS AFTER 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............... $12,046 6.14% $27,207 5.98% $ -- --% $ -- --% $39,253 6.03%
U.S. government agencies.... -- -- 3,007 6.31 -- -- -- -- 3,007 6.31
Municipals -- tax exempt.... -- -- -- -- 1,601 4.77 995 4.93 2,596 4.83
Preferred stock............. -- -- 2,015 5.90 -- -- -- -- 2,015 5.90
Commercial paper............ -- -- 1,511 6.43 748 6.30 -- -- 2,259 6.39
------- ---- ------- ---- ------- ---- ------ ---- ------- ----
Total
Available-for-sale... $12,046 6.14% $33,740 6.02% $ 2,349 5.26% $ 995 4.93% $49,130 5.99%
Securities held-to-maturity:
Municipals -- taxable....... $ -- --% $ 7,865 6.40% $ 517 6.45% $ -- --% $ 8,382 6.40%
Municipals -- tax exempt.... 152 4.83 2,011 4.93 9,924 4.64 2,533 4.70 14,620 4.69
U.S. Government agencies.... 1,509 6.72 -- -- -- -- -- -- 1,509 6.72
U.S. Treasury............... 1,000 6.28 1,033 6.44 -- -- -- -- 2,033 6.36
------- ---- ------- ---- ------- ---- ------ ---- ------- ----
Total
held-to-maturity.... $ 2,661 6.45% $10,909 6.13% 10,441 4.73% 2,533 4.70% $26,544 5.48%
------- ---- ------- ---- ------- ---- ------ ---- ------- ----
Total securities...... $14,707 6.19% $44,649 6.05% $12,790 4.83% $3,528 4.76% $75,674 5.81%
======= ==== ======= ==== ======= ==== ====== ==== ======= ====
</TABLE>
Note: Yields on tax exempt municipal securities are not on a fully tax
equivalent basis.
As of December 31, 1998, the only securities held by the Company where the
aggregate book value of the Company's investment in securities of a single
issuer exceeded 10% of the Company's shareholders' equity were direct
obligations of the U.S. government or U.S. government agencies.
Securities are pledged to meet requirements imposed as a condition of
deposit by some depositors, such as political subdivisions (public funds) or of
other funds such as bankruptcy trustee deposits. Securities with amortized cost
of $43,296,000 as of December 31, 1998 were pledged to secure public and certain
other deposits as required by law or contract.
LOANS
General. The following table presents the Company's loans outstanding at
year-end by loan type:
<TABLE>
<CAPTION>
DECEMBER 31,
------------------------------------------------------------------------------
1998 % OF TOTAL 1997 % OF TOTAL 1996 % OF TOTAL 1995
-------- ---------- -------- ---------- ------- ---------- -------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C>
Commercial........... $ 79,567 34% $ 48,422 43% $29,420 44% $18,291
Real
estate -- mortgage.. 57,216 24 38,446 34 26,070 38 13,345
Real estate -- land
and construction... 49,270 21 25,780 22 11,918 17 5,105
Consumer............. 50,349 21 824 1 558 1 735
-------- --- -------- --- ------- --- -------
Total
loans...... $236,402 100% $113,472 100% $67,966 100% $37,476
Deferred loan fees... (95) (113) (79) (119)
Allowance for loan
losses............. (3,825) (2,285) (1,402) (572)
-------- -------- ------- -------
Net loans............ $232,482 $111,074 $66,485 $36,785
======== ======== ======= =======
<CAPTION>
DECEMBER 31,
--------------------------------
% OF TOTAL 1994 % OF TOTAL
---------- ------ ----------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
Commercial........... 48% $5,591 58%
Real
estate -- mortgage.. 36 1,370 14
Real estate -- land
and construction... 14 2,550 27
Consumer............. 2 111 1
--- ------ ---
Total
loans...... 100% $9,622 100%
Deferred loan fees... (36)
Allowance for loan
losses............. (76)
Net loans............ $9,510
======
</TABLE>
For years prior to 1998, these loans consist solely of certain SBA loans,
which the Company intends to sell to various third parties. In addition to
certain SBA loans held for sale, in 1998 the Company had $16,620,000 in held for
sale loans associated with its internet credit card. The Company intends to sell
these loans to a third party in 1999.
23
<PAGE> 26
The Company'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 Company is an active participant in the Small Business Administration
(SBA) and California guaranteed lending programs, and has been approved by the
SBA as a lender under the Preferred Loan Program. The Company regularly makes
SBA-guaranteed loans, the guaranteed portion of which is held for possible
resale in the secondary market. In the event of the sale of a guaranteed portion
SBA loan, the Company retains the servicing rights for the sold portion. As of
December 31, 1998, 1997, and 1996, $9.1 million, $6.0 million, and $2.1 million,
respectively, in SBA loans were serviced by the Company for others. The Company
generally considers its SBA loans to be investment loans, but has from time to
time sold the guaranteed portion of certain loans.
The Company's real estate term loans consist primarily of loans made based
on the borrower's cash flow and are secured by deeds of trust on commercial and
residential property to provide a secondary source of repayment. It is the
Company's policy to restrict real estate term loans to no more than 80% of the
lower of the property's appraised value or the purchase price of the property,
depending on the type of property and its utilization. The Company offers both
fixed and floating rate loans. Maturities on such loans are generally restricted
to between five and 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 Company's real estate land and construction loans are primarily interim
loans made by the Company to finance the construction of commercial and single
family residential properties. These loans are typically short term. The Company
utilizes underwriting guidelines to assess the likelihood of repayment from
sources such as sale of the property or permanent mortgage financing prior to
making the construction loan.
Consumer loans are made for the purpose of financing automobiles, various
types of consumer goods, and other personal purposes. Additionally, the Company
makes equity lines of credit and equity loans available to its clientele.
Consumer loans generally provide for the monthly payment of principal and
interest. Most of the Company's consumer loans are secured by the personal
property being purchased, or, in the instances of equity loans or lines, real
property.
In February 1998, HBC entered into a contract with Internet Access
Financial Corporations to provide a credit card over the internet. These
customers are not limited to Northern California, the Company's primary market
area, as the product is available to anyone across the country. The growth in
the consumer loan portfolio is attributed to the introduction of this internet
credit card.
With certain exceptions, the Banks are permitted to make extensions of its
credit to any one borrowing entity up to 15% of the Banks' capital and reserves
for unsecured loans and up to 25% of the Banks' capital and reserves for secured
loans. For HBC these lending limits were $4.3 million and $7.1 million at
December 31, 1998. For HBEB these lending limits were $900 thousand and $1.5
million at December 31, 1998.
Loan Concentrations. The Company does not have any concentrations in its
loan portfolio by industry or group of industries, however, 43% and 59% of its
net loans were secured by real property as of December 31, 1998 and 1997,
respectively. This decrease is attributed to the large increase in the total
loan portfolio, specifically the introduction of the internet credit card.
24
<PAGE> 27
Loan Portfolio Maturities and Interest Rate Sensitivity. The following
table sets forth the maturity distribution of the Company's loans at December
31, 1998:
<TABLE>
<CAPTION>
OVER ONE YEAR
BUT LESS
DUE IN THAN
ONE YEAR OR LESS FIVE YEARS OVER FIVE YEARS TOTAL
---------------- ------------- --------------- --------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C>
Commercial................. $ 72,060 $ 6,542 $ 869 $ 79,471
Real estate -- mortgage.... 27,903 17,275 12,038 57,216
Real estate -- land and
construction............. 49,270 -- -- 49,270
Consumer................... 49,477 862 11 50,350
-------- ------- ------- --------
Total loans...... $198,710 $24,679 $12,918 $236,307
======== ======= ======= ========
Loans with variable
interest rates........... $188,876 $ 5,189 $ -- $194,065
Loans with fixed interest
rates.................... 9,834 19,490 12,918 42,242
-------- ------- ------- --------
Total............ $198,710 $24,679 $12,918 $236,307
======== ======= ======= ========
</TABLE>
Note: Total shown is net of deferred loan fees of $95,000 at December 31, 1998.
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,
1998, approximately 84% of the Company's loan portfolio consisted of floating
interest rate loans.
Credit Risk Management.
The Company assigns a risk grade consistent with the system recommended by
regulatory agencies to all of its loans. Grades range from "Pass" to "Loss,"
depending on credit quality, with "Pass" representing loans that involve an
acceptable degree of risk. Additionally, the Company maintains a program for
regularly scheduled reviews of certain new and renewed loans by an outside loan
review consultant. Any loans identified during an external review process that
expose the Company to increased risk are appropriately downgraded and an
increase in the allowance for loan losses is established for such loans.
Further, the Company is examined periodically by the FDIC, FRB, and the
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 that 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. As of December 31, 1998, the Company had $1,288,000
in non-accrual loans. At December 31, 1997 and 1996, the Company had no
non-accrual loans. At December 31, 1998, 1997 and 1996, the Company had no
assets classified as "Other Real Estate Owned." As of December 31, 1998, 1997
and 1996, the Company had no troubled debt restructuring and no loans 90 days
past due and still accruing. The increase in the total loan portfolio is
primarily responsible for the increase in nonperforming assets.
For the year ended December 31, 1998, the Company had forgone interest
income in the amount of $35,000 as a result of non-accrual loans. For the year
ended December 31, 1997, the Company had forgone interest income in the amount
of $17,000 as a result of non-accrual loans. Through December 31, 1996, the
Company had not foregone any interest income as a result of non-accrual loans or
restructured debt.
As of December 31, 1998, loans classified by the Company were $7,819,000.
These loans constituted 3% of total loans and 23% of the Company's capital and
reserves as of that date. As of December 31, 1997, loans
25
<PAGE> 28
classified by the Company were $2,695,000. These loans constituted 2% of total
loans and 11% of the Company's capital and reserves as of that date. As of
December 31, 1996, loans classified by the Company were $4,005,000. These loans
constituted 5% of total loans and 18% of the Company's capital and reserves as
of that date. As the Company has made no changes to its methodology for
classifying loans, the increase in classified loans is due to the increase in
the total loan portfolio. Through December 31, 1998, the Company has not made
loans to any foreign entities. Currently, the Company does not have any loans it
expects to classify as nonperforming assets.
ALLOWANCE FOR LOAN LOSSES
The following table summarizes the Company'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,
------------------------------------------
1998 1997 1996 1995 1994
------ ------ ------ ---- ----
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
Balance, beginning of period...................... $2,285 $1,402 $ 572 $ 76 $ --
Charge-offs....................................... (173) (224) -- -- --
Recoveries........................................ 137 47 -- -- --
------ ------ ------ ---- ----
Net charged-offs.................................. (36) (177) -- -- --
------ ------ ------ ---- ----
Provision for loan losses......................... 1,576 1,060 830 496 76
------ ------ ------ ---- ----
Balance, end of period............................ $3,825 $2,285 $1,402 $572 $ 76
====== ====== ====== ==== ====
RATIOS:
Net charge-offs to average loans outstanding.... 0.02% 0.18% --% --% --%
Allowance for loan losses to average loans...... 2.11% 2.31% 2.29% 1.94% 1.60%
Allowance for loan losses to total loans at end
of period.................................... 1.62% 2.02% 2.07% 1.53% 0.80%
</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 at the dates indicated:
<TABLE>
<CAPTION>
DECEMBER 31,
------------------------------------------------------------------------------------------------------
1998 1997 1996 1995
----------------------- ------------------------ ----------------------- -----------------------
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........... $1,567 1.98% $ 821 1.70% $ 512 1.74% $267 1.46%
Real estate --
mortgage............ 224 0.39 205 0.53 117 0.45 102 0.76
Real estate -- land
and construction.... 815 1.65 379 1.47 227 1.90 54 1.06
Consumer............. 1,146 2.26 7 0.85 6 1.08 6 0.82
Unallocated.......... 73 873 540 143
------ ---- ------ ---- ------ ---- ---- ----
Total......... $3,825 1.62 $2,285 2.02% $1,402 2.07% $572 1.53%
====== ==== ====== ==== ====== ==== ==== ====
<CAPTION>
DECEMBER 31,
-----------------------
1994
-----------------------
ALLOCATION
AS A % OF
LOANS
OUTSTANDING
ALLOWANCE IN CATEGORY
--------- -----------
(DOLLARS IN THOUSANDS)
<S> <C> <C>
Commercial........... $ -- --%
Real estate --
mortgage............ -- --
Real estate -- land
and construction.... -- --
Consumer............. -- --
Unallocated.......... 76
---- ----
Total......... $ 76 0.80%
==== ====
</TABLE>
The Company maintains an allowance for loan losses to absorb potential
credit losses inherent in the loan portfolio. The allowance is based on ongoing,
monthly assessments of the probable estimated losses, and to a lesser extent,
unused commitments to provide financing. Loans are charged against the allowance
when management believes that the collectability of the principal is doubtful.
The allowance is increased by a provision for loan losses, which is charged
against current period operating results and decreased by the amount of
charge-offs, net of recoveries. The Company's methodology for assessing the
appropriateness of the allowance consists of several key elements, which include
the formula allowance, specific allowances and the unallocated allowance.
The formula allowance is calculated by applying loss factors to outstanding
loans and certain unused commitments. Loss factors are based on management's
experience and may be adjusted for significant factors
26
<PAGE> 29
that, in management's judgment, affect the collectibility of the portfolio as of
the evaluation date. Due to the Company's lack of historical loss experience,
management utilizes their prior industry experience to determine the loss factor
for each category of loan.
Specific allowances are established in cases where management has
identified significant conditions or circumstances related to a credit that
management believes indicate the probablility that a loss may be incurred in
excess of the amount determined by the application of the formula allowance.
The unallocated allowance is based upon management's evaluation of various
conditions that are not directly measured in the determination of the formula
and specific allowances. The conditions evaluated in connection with the
unallocated allowance may include existing general economic and business
conditions affecting the key lending areas of the Company, credit quality
trends, collateral values, loan volumes and concentrations, seasoning of the
loan portfolio, specific industry conditions within portfolio segments, recent
loss experience in particular segments of the portfolio, duration of the current
business cycle, and bank regulatory examination results.
During 1998, the Company charged off eight loans with principal balances
totaling $173,000, and recovered four of those loans for $137,000, with accrued
interest and costs. During 1997, the Company charged off three loans with
principal balance totaling $224,000, and recovered two of those loans for
$47,000, with accrued interest and costs. Through December 31, 1996, the Company
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 Company continues to monitor and to make appropriate changes
to its internal loan policies. These efforts better enable the Company to assess
risk factors prior to granting new loans and to assess the sufficiency of the
allowance for loan losses. 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 Company's loan portfolio can be adversely affected
if California economic conditions and the real estate market in the Company'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 Company'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,
-------------------------------------------
1998 1997
-------------------- --------------------
AVERAGE AVERAGE AVERAGE AVERAGE
BALANCE RATE PAID BALANCE RATE PAID
-------- --------- -------- ---------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C>
Demand, non-interest bearing........... $102,834 --% $ 69,376 --%
Demand, interest bearing............... 7,368 1.85 4,988 1.91
Savings and money market............... 122,157 3.46 80,168 3.00
Time deposits, $100,000 and over....... 48,861 5.04 27,314 4.87
Time deposits less than $100,000....... 16,638 5.28 7,530 4.79
Brokered Deposits...................... 3,826 5.87 -- --
-------- ---- -------- ----
Total average deposits....... $301,684 2.63% $189,376 2.22%
======== ==== ======== ====
</TABLE>
At December 31, 1998, the Company had a deposit mix of 33% in money market
accounts, 25% in time deposits, 6% in savings deposits, 2% in NOW accounts and
34% in non-interest-bearing demand deposits. On the same date, $2,228,000, or
less than 1%, of the Company's deposits were from public sources and
$63,893,000, or 17% of the Company's deposits were from title companies. At
December 31, 1997, the Company 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, or less
27
<PAGE> 30
than 1%, of the Company's deposits were from public sources and $32,402,000, or
13%, were from title companies. The Company's net interest income is enhanced by
its percentage of non-interest bearing deposits.
The Company's deposits are obtained from a cross-section of the communities
it serves. The Company's business is not seasonal in nature. The Company had
brokered deposits totaling approximately $11,000,000 at December 31, 1998. These
brokered deposits generally mature within one year and are used to offset a
portion of the internet credit card loan portfolio. The Company 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 Company's time
deposits of $100,000 or more as of December 31, 1998:
<TABLE>
<CAPTION>
BALANCE % OF TOTAL
-------- -----------
(DOLLARS IN THOUSANDS)
<S> <C> <C>
Three months or less.................................... $29,929 51%
Over three months through twelve months................. 27,318 46
Over twelve months...................................... 1,600 3
------- ---
Total......................................... $58,847 100%
======= ===
</TABLE>
The Company focuses primarily on servicing business accounts that are
frequently over $100,000 in average size. Certain types of accounts that the
Company makes available are typically in excess of $100,000 in average balance
per account, and certain types of business clients whom the Company serves
typically carry deposits in excess of $100,000 on average. The account activity
for some account types and client types necessitates appropriate liquidity
management practices by the Company to ensure its ability to fund deposit
withdrawals.
LIQUIDITY AND LIABILITY MANAGEMENT
To meet liquidity needs, the Company maintains a portion of its funds in
cash deposits in other banks, in federal funds sold, and in investment
securities. As of December 31, 1998, the Company's primary liquidity ratio was
25.3%, comprised of $46.8 million in investment securities available-for-sale of
maturities (or probable calls) of up to five years, federal funds sold of $28.6
million, and $18.0 million in cash and due from banks, as a percentage of total
deposits of $369.0 million. As of December 31, 1997, the Company'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. Deposit growth
exceeded liquid asset growth in 1998 from 1997.
The following table summarizes the Company's borrowings under its federal
funds purchased and security repurchase arrangements for the periods indicated:
<TABLE>
<CAPTION>
1998 1997
------- --------
<S> <C> <C>
Average balance during the year......................... $40,000 $297,000
Average interest rate during the year................... 6.17% 5.72%
Maximum month-end balance during the year............... $ -- $300,000
Average rate at December 31............................. -- --
</TABLE>
The Company has federal funds purchase lines of $15,000,000 and $6,000,000,
respectively, from its two correspondent banks, and a repurchase arrangement of
$20,000,000 with a commercial brokerage firm. There were no borrowings under
these arrangements as of December 31, 1998.
28
<PAGE> 31
MARKET RISK
Market risk is the risk of loss to future earnings, to fair values, or to
future cash flows that may result from changes in the price of a financial
instrument. The value of a financial instrument may change as a result of
changes in interest rates, foreign currency exchange rates, commodity prices,
equity prices and other market changes that affect market risk sensitive
instruments. Market risk is attributed to all market risk sensitive financial
instruments, including securities, loans, deposits, borrowings, its trading
activities for its own account, and its role as a financial intermediary in
customer-related transactions. The objective of market risk management is to
avoid excessive exposure of the Company's earnings and equity to loss and to
reduce the volatility inherent in certain financial instruments.
INTEREST RATE SENSITIVITY
The table below sets forth the interest rate sensitivity of the Company's
interest earning assets and interest bearing liabilities as of December 31,
1998, 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............ $ 28,600 $ -- $ -- $ -- $ 28,600
Securities.................... 4,006 10,796 45,559 16,431 76,792
Total loans................... 213,382 18,407 24,678 12,918 269,385
Other assets.................. 5,461 -- -- -- 5,461
-------- -------- -------- -------- --------
Total interest earning
assets.............. 251,449 29,203 70,237 29,349 380,238
-------- -------- -------- -------- --------
Cash and due from banks......... $ 18,039 18,039
Other assets.................... 6,654 6,654
-------- -------- -------- -------- --------- --------
Total assets.......... $251,449 $ 29,203 $ 70,237 $ 29,349 $ 24,693 $404,931
======== ======== ======== ======== ========= ========
INTEREST BEARING LIABILITIES:
Demand, interest-bearing...... $ 9,061 $ -- $ -- $ -- $ 9,061
Savings and money market...... 143,518 -- -- -- 143,518
Time deposits................. 37,891 50,910 2,584 -- 91,385
-------- -------- -------- -------- --------
Total interest bearing
liabilities......... 190,470 50,910 2,584 -- 243,964
-------- -------- -------- -------- --------
Non-interest demand deposits.... $ 124,993 124,993
Other liabilities............... 5,277 5,277
Shareholders' equity............ 30,697 30,697
-------- -------- -------- -------- --------- --------
Total liabilities and
shareholders'
equity.............. $190,470 $ 50,910 $ 2,584 $ 160,967 $404,931
======== ======== ======== ======== ========= ========
Interest rate sensitivity gap... $ 60,979 $(21,707) $ 67,653 $ 29,349 $(136,274) --
======== ======== ======== ======== ========= ========
Cumulative interest rate
sensitivity gap............... $ 60,979 $ 39,272 $106,925 $136,274 -- --
Cumulative interest rate
sensitivity gap ratio......... 15.06% 9.70% 26.41% 33.65%
</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
29
<PAGE> 32
either earning assets with floating rates or to interest bearing liabilities.
The Company has generally been able to control its exposure to changing interest
rates by maintaining primarily floating interest rate loans and a majority of
its time certificates in relatively short maturities.
Liquidity risk represents the potential for loss as a result of limitations
on our ability to adjust our future cash flows to meet the needs of depositors
and borrowers and to fund operations on a timely and cost-effective basis. The
Liquidity Policy approved by the Board requires annual review of our liquidity
by the Asset/Liability Committee, which is comprised of senior executives, and
the Finance and Investment Committee of the Board of Directors.
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 Company's interest rate sensitivity position. To supplement
traditional gap analysis, the Company performs simulation modeling to estimate
the potential effects of changing interest rates. The process allows the Company
to explore the complex relationships within the gap over time and various
interest rate environments. For additional information on the Company's
simulation model and the methodology used to estimate the potential effects of
changing interest rates, see Item 7A -- "QUANTITATIVE AND QUALITATIVE
DISCLOSURES ABOUT MARKET RISK."
The Company's internal Asset/Liability Committee and the Finance and
Investment Committee of the Board each meet monthly to monitor the Company's
investments, liquidity needs and to oversee its asset/liability management. The
Company evaluates the rates offered on its deposit products on a weekly basis.
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
1998 1997 1996 1995 1994 REQUIREMENTS
-------- -------- -------- -------- ------- ------------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
Capital components:
Tier 1 Capital.................... $ 29,850 $ 21,899 $ 20,273 $ 12,324 $12,027
Tier 2 Capital.................... 3,825 1,885 1,188 572 76
-------- -------- -------- -------- -------
Total risk-based
capital............... $ 33,675 $ 23,784 $ 21,461 $ 12,896 $12,103
======== ======== ======== ======== =======
Risk-weighted assets.............. 323,688 150,418 94,776 54,730 18,851
Average assets.................... 332,062 251,767 175,001 122,464 53,731
Capital ratios:
Total risk-based capital..... 10.4% 15.8% 22.6% 23.6% 76.4% 8.0%
Tier 1 risk-based capital.... 9.2 14.6 21.4 22.5 75.9% 4.0
Leverage ratio(1)............ 9.0 10.3 13.9 10.1 29.6% 4.0
</TABLE>
- ---------------
(1) Tier 1 capital divided by average assets (excluding goodwill).
At December 31, 1998 and 1997, the Company's capital exceeded all minimum
regulatory requirements and the Company was considered to be "well capitalized,"
as defined in the applicable regulations, however, as of the same date HBC was
considered "adequately capitalized." The table above presents the capital ratios
of the Company computed in accordance with applicable regulatory guidelines and
compared to the standards for minimum capital adequacy requirements under the
FDIC's prompt corrective action authority as of December 31, 1998. The
risk-based and leverage capital ratios are defined in Item 1 -- "BUSINESS --
Supervision and Regulation -- Capital Adequacy Guidelines."
On June 8, 1998, the Company filed a Registration Statement (Commission
File Number 333-50277) to register 387, 097 shares of Common Stock at $15.50 per
share for an aggregate offering price of $6,000,000. On July 30, 1998, the
Company closed this best efforts public stock offering after selling all
registered shares.
30
<PAGE> 33
Total proceeds from this offering were $5,846,000 after deducting expenses of
$154,000, comprised of $33,000 in legal expenses, $68,000 in printing expenses
and $53,000 in consulting expenses. Of the total net proceeds, $5,500,000 was
distributed to HBEB with the remaining amount to be kept by the Company for
general working capital.
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.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities". The Statement will require the Company to
recognize all derivatives on the balance sheet at fair value. SFAS No. 133
requires that derivative instruments used to hedge be identified specifically to
assets, liabilities, firm commitments or anticipated transactions and measured
as effective and ineffective when hedging changes in fair value or cash flows.
Derivative instruments that do not qualify as either a fair value or cash flow
hedge will be valued at fair value with the resultant gain or loss recognized in
current earnings. Changes in the effective portion of fair value hedges will be
recognized in current earnings along with the change in fair value of the hedged
item. Changes in the effective portion of the fair value of cash flow hedges
will be recognized in other comprehensive income until realization of the cash
flows of the hedged through current earnings. Any ineffective portion of hedges
will be recognized in current earnings. Management believes that adoption of
SFAS No. 133 will have no impact on the Company's financial position or results
of operations. The statement is effective for fiscal years beginning after June
15, 1999, with earlier application encouraged. The Company expects to adopt SFAS
No. 133 as of January 1, 2000.
In October 1998, the FASB issued SFAS No. 134, "Accounting for
Mortgage-Backed Securities Retained after the Securitization of Mortgage Loans
Held for Sale by a Mortgage Banking Enterprise". This Statement amends SFAS No.
65, "Accounting for Certain Mortgage Banking Activities", which established
accounting and reporting standards for certain activities of mortgage banking
and other similar enterprises. After securitization of mortgage loans held for
sale, SFAS No. 134 requires an entity to classify the resulting mortgage-backed
securities or other retained interests, based on its ability or intent to sell
or hold those investments. Management believes that the adoption of SFAS No. 134
will have no impact on the Company's financial position or results of
operations. This Statement is effective for fiscal years beginning after
December 15, 1998.
In June 1998, the AICPA issued SOP 98-5, "Reporting on the Costs of
Start-Up Activities". SOP 98-5 requires that entities expense start-up costs and
organization costs as they are incurred. Management believes that the adoption
of SOP 98-5 will not have a material effect on the Company's financial position
or results of operations. The Statement is effective for fiscal years beginning
after December 15, 1998.
ITEM 7A -- QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
As a financial institution, the Company's primary component of market risk
is interest rate volatility. Fluctuations in interest rates will ultimately
impact both the level of income and expense recorded on most of the Company's
assets and liabilities, and the market value of all interest-earning assets,
other than those which have a short term to maturity. Since all of the Company's
interest-bearing assets and liabilities are located at the Banks, all of the
Company's interest rate risk exposure lies at that level, as well. As a result,
all interest rate risk management procedures are performed at the Banks level.
Based upon the nature of the Company's operations, the Company is not subject to
foreign exchange or commodity price risk. The Company does not own any trading
assets. As of December 31, 1998, the Company does not use interest rate
derivatives to hedge its interest rate risk.
The Company's exposure to market risk is reviewed on a regular basis by the
Asset/Liability Committee (ALCO). Interest rate risk is the potential of
economic losses due to future interest rate changes. These economic losses can
be reflected as a loss of future net interest income and/or a loss of current
fair market
31
<PAGE> 34
values. The objective is to measure the effect on net interest income and to
adjust the balance sheet to minimize the inherent risk while at the same time
maximize income. Management realizes certain risks are inherent, and that the
goal is to identify and accept the risks. Management uses two methodologies to
manage interest rate risk: 1) a standard GAP analysis; and 2) an interest rate
shock simulation model. The Company has no market risk sensitive instruments
held for trading purposes.
The detail from the Company's GAP analysis is shown in Item 7, above, and
is not discussed here. The Company applies a market value (MV) methodology to
gauge its interest rate risk exposure as derived from its simulation model.
Generally, MV is the discounted present value of the difference between incoming
cash flows on interest earning assets and other investments and outgoing cash
flows on interest bearing liabilities and other liabilities. The application of
the methodology attempts to quantify interest rate risk as the change in the MV
which would result from a theoretical 200 basis point (1 basis point equals
0.01%) change in market interest rates. Both a 200 basis point increase and a
200 basis point decrease in market rates are considered.
At December 31, 1998, it was estimated that the Company's MV would increase
17.6% in the event of a 200 basis point increase in market interest rates. The
Company's MV at the same date would decrease 20.2% in the event of a 200 basis
point decrease in market interest rates.
Presented below, as of December 31, 1998, 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 ------------------------
CHANGE IN RATES MARKET VALUE MARKET VALUE MV RATIO CHANGE (BP)
- --------------- ------------ ------------ --------- ------------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C>
+200 bp $ 10,460 17.6% 17.2% 257
0 bp -- -- 14.6 --
-200 bp (12,021) (20.2) 11.7 (295)
</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 advance of changes in market rates,
while the reaction of other types of financial instruments may lag behind the
change in general market rates. Additionally, the MV methodology does not
reflect the full impact of annual and lifetime restrictions on changes in rates
for certain assets, such as adjustable rate loans. When interest rates change,
actual loan prepayments and actual early withdrawals from certificates may
deviate significantly from the assumptions used in the model. Finally, this
methodology does not measure or reflect the impact that higher rates may have on
adjustable-rate loan clients' ability to service their debt. All of these
factors are considered in monitoring the Company's exposure to interest rate
risk.
Liquidity risk represents the potential for loss as a result of limitations
on our ability to adjust our future cash flows to meet the needs of depositors
and borrowers and to fund operations on a timely and cost effective basis. The
Liquidity Policy approved by the Board requires annual review of our liquidity
by the Asset/ Liability Committee, which is composed of senior executives, and
the Finance and Investment Committee of the Board of Directors.
32
<PAGE> 35
ITEM 8 -- FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements and independent auditors' report are set forth on
pages F-1 through F-14, which follows Item 14 -- "EXHIBITS, FINANCIAL STATEMENT
SCHEDULES, AND REPORTS ON FORM 8-K."
The following table discloses the Company's selected quarterly financial
data as required by Item 302 of Regulation S-K. All 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; (iii) a 3-for-2 stock split payable to shareholders of
record as of August 1, 1997; and (iv) a 3-for-2 stock split payable to
shareholders of record as of February 5, 1999.
<TABLE>
<CAPTION>
FOR THE QUARTER ENDED
-------------------------------------------------------------------------------------
DECEMBER 31, SEPTEMBER 31, JUNE 30, MARCH 31, DECEMBER 31, SEPTEMBER 31,
1998 1998 1998 1998 1997 1997
------------ ------------- ---------- ---------- ------------ -------------
<S> <C> <C> <C> <C> <C> <C>
Interest income...... $8,062,000 $7,564,000 $6,106,000 $5,172,000 $4,831,000 $4,279,000
Interest expense..... 2,592,000 2,350,000 1,667,000 1,342,000 1,200,000 1,130,000
---------- ---------- ---------- ---------- ---------- ----------
Net interest
income............. 5,470,000 5,214,000 4,439,000 3,830,000 3,631,000 3,149,000
Provision for loan
losses............. 516,000 550,000 350,000 160,000 455,000 240,000
---------- ---------- ---------- ---------- ---------- ----------
Net interest income
after Provision.... 4,954,000 4,664,000 4,089,000 3,670,000 3,176,000 2,909,000
Non-interest
income............. 937,000 501,000 186,000 79,000 176,000 225,000
Non-interest
expense............ 4,977,000 4,198,000 3,412,000 3,018,000 2,701,000 2,472,000
---------- ---------- ---------- ---------- ---------- ----------
Net income before
taxes.............. 914,000 967,000 863,000 731,000 651,000 662,000
Provision for income
taxes.............. 321,000 393,000 333,000 278,000 227,000 233,000
---------- ---------- ---------- ---------- ---------- ----------
Net income........... $ 593,000 $ 574,000 $ 530,000 $ 453,000 $ 424,000 $ 429,000
========== ========== ========== ========== ========== ==========
Net income per share
basic.............. $ 0.10 $ 0.11 $ 0.11 $ 0.09 $ 0.09 $ 0.09
Net income per share
diluted............ $ 0.10 $ 0.09 $ 0.09 $ 0.08 $ 0.08 $ 0.08
<CAPTION>
FOR THE QUARTER ENDED
-----------------------
JUNE 30, MARCH 31,
1997 1997
---------- ----------
<S> <C> <C>
Interest income...... $3,747,000 $3,394,000
Interest expense..... 972,000 902,000
---------- ----------
Net interest
income............. 2,775,000 2,492,000
Provision for loan
losses............. 145,000 220,000
---------- ----------
Net interest income
after Provision.... 2,630,000 2,272,000
Non-interest
income............. 115,000 74,000
Non-interest
expense............ 2,183,000 1,812,000
---------- ----------
Net income before
taxes.............. 562,000 534,000
Provision for income
taxes.............. 197,000 187,000
---------- ----------
Net income........... $ 365,000 $ 347,000
========== ==========
Net income per share
basic.............. $ 0.07 $ 0.07
Net income per share
diluted............ $ 0.07 $ 0.07
</TABLE>
ITEM 9 -- CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
33
<PAGE> 36
PART III
ITEM 10 -- DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Reference is made to the Company's Proxy Statement for the May 27, 1999
Annual Meeting of Shareholders for incorporation of information concerning
directors and persons nominated to become directors of the Company. Information
concerning executive officers of the Company as of March 1, 1999 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 27, 1999 Annual Meeting of Shareholders.
ITEM 12 -- SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT -- BENEFICIAL OWNERSHIP OF COMMON STOCK
Information concerning ownership of the equity stock of the Company by
certain beneficial owners and management is incorporated by reference from the
text under the caption "Proposal One -- Election of Directors" in the Proxy
Statement for the May 27, 1999 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 27, 1999 Annual Meeting of Shareholders.
PART IV
ITEM 14 -- EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a)(1) FINANCIAL STATEMENTS
The Financial Statements of the Company, Management's Discussion and
Analysis of Financial Condition and Results of Operation, and the independent
auditors' report are set forth on pages F-1 through F-24.
(a)(2) FINANCIAL STATEMENT SCHEDULES
All schedules to the Financial Statements are omitted because of the
absence of the conditions under which they are required or because the required
information is included in the Financial Statements or accompanying notes.
34
<PAGE> 37
(a)(3) EXHIBITS
<TABLE>
<CAPTION>
INCORPORATED BY REFERENCE
TO REPORT ON FORM
EXHIBIT FILED ------------------------------------
NUMBER DESCRIPTION HEREWITH 8-A DATED 10-K DATED EXHIBIT NO.
- ------- ----------- -------- --------- ---------- -----------
<C> <S> <C> <C> <C> <C>
3.1 Heritage Commerce Corp Articles of 3-5-98 4.1
Incorporation:
[Incorporated herein by reference from Exhibit
4 to Heritage Commerce Corp's Form 8-A:
Registration of Securities Pursuant to Section
12(g) of the Securities Exchange Act of 1933
dated March 5, 1998 (File No. 000-23877)]
3.2 Heritage Commerce Corp Bylaws: 3-5-98 4.2
[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)]
10.1 Real Property Leases for properties located at 3-5-98 1
150 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 3-5-98 1
June 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)]
10.3 Employment agreement with Mr. Gionfriddo dated 3-5-98 1
June 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 3-31-98 10.4
Mr. Gionfriddo
10.5 Employment agreement with Mr. Conniff dated X
April 30, 1998.
10.6 Employment agreement with Mr. Nethercott dated X
April 16, 1998.
10.7 Employment agreement with Mr. McGovern dated X
July 16, 1998.
21.1 Subsidiaries of the registrant X
23.1 Consent of Deloitte & Touche LLP dated March X
26, 1999
23.2 Consent of KPMG Peat Marwick LLP dated March X
25, 1999
27.1 Financial data schedule X
</TABLE>
(b) REPORTS ON FORM 8-K
On October 19, 1998, the Registrant filed Form 8-K with the Securities and
Exchange Commission to report third quarter 1998 financial results and the
opening of a loan production office in the city of San Ramon, California.
On December 7, 1998, the Registrant filed Form 8-K with the Securities and
Exchange Commission to announce that receipt of approval to open a de novo bank
in the city of Fremont, California.
35
<PAGE> 38
SIGNATURE PAGE
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 29, 1999 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
--------- ----- ----
<C> <S> <C>
/s/ FRANK BISCEGLIA Director March 29, 1999
- --------------------------------------------------------
Frank Bisceglia
/s/ JAMES BLAIR Director March 29, 1999
- --------------------------------------------------------
James Blair
/s/ ARTHUR CARMICHAEL, JR. Director March 29, 1999
- --------------------------------------------------------
Arthur Carmichael, Jr.
/s/ RICHARD CONNIFF Director and Chief Executive March 29, 1999
- -------------------------------------------------------- Officer of Heritage Bank
Richard Conniff East Bay
/s/ WILLIAM DEL BIAGGIO, JR. Director March 29, 1999
- --------------------------------------------------------
William Del Biaggio, Jr.
/s/ ANNEKE DURY Director March 29, 1999
- --------------------------------------------------------
Anneke Dury
/s/ TRACEY ENFANTINO Director March 29, 1999
- --------------------------------------------------------
Tracey Enfantino
/s/ GLENN GEORGE Director March 29, 1999
- --------------------------------------------------------
Glenn George
/s/ ROBERT GIONFRIDDO Director March 29, 1999
- --------------------------------------------------------
Robert Gionfriddo
/s/ P. MICHAEL HUNT Director March 29, 1999
- --------------------------------------------------------
P. Michael Hunt
/s/ JOHN W. LARSEN Director March 29, 1999
- --------------------------------------------------------
John W. Larsen
/s/ LAWRENCE D. MCGOVERN Executive Vice President and March 29, 1999
- -------------------------------------------------------- Chief Financial Officer
Lawrence D. McGovern
</TABLE>
36
<PAGE> 39
<TABLE>
<CAPTION>
SIGNATURE TITLE DATE
--------- ----- ----
<C> <S> <C>
/s/ LON NORMANDIN Director March 29, 1999
- --------------------------------------------------------
Louis O. (Lon) Normandin
/s/ JACK PECKHAM Director March 29, 1999
- --------------------------------------------------------
Jack Peckham
/s/ ROBERT PETERS Director March 29, 1999
- --------------------------------------------------------
Robert Peters
/s/ HUMPHREY POLANEN Director March 29, 1999
- --------------------------------------------------------
Humphrey Polanen
/s/ JOHN E. ROSSELL III Director and Principal March 29, 1999
- -------------------------------------------------------- Executive Officer
John E. Rossell III
/s/ KIRK ROSSMAN Director March 29, 1999
- --------------------------------------------------------
Kirk Rossman
/s/ BRAD SMITH Director March 29, 1999
- --------------------------------------------------------
Brad Smith
</TABLE>
37
<PAGE> 40
HERITAGE COMMERCE CORP
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Independent Auditors' Report................................ F-2
Consolidated Balance Sheets as of December 31, 1998 and
1997...................................................... F-4
Consolidated Income Statements as of December 31, 1998, 1997
and 1996.................................................. F-5
Consolidated Statements of Shareholders' Equity as of
December 31, 1998, 1997 and 1996.......................... F-6
Consolidated Statements of Cash Flows as of December 31,
1998, 1997 and 1996....................................... F-7
Notes to Consolidated Financial Statements.................. F-8
</TABLE>
F-1
<PAGE> 41
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Shareholders of
Heritage Commerce Corp
San Jose, California
We have audited the accompanying consolidated balance sheet of Heritage
Commerce Corp and subsidiaries (the "Company") as of December 31, 1998 and 1997,
and the related consolidated statements of income, shareholders' equity, and
cash flows for the years then ended. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits. The Company's
consolidated statements of income, shareholders' equity, and cash flows for the
year 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 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 consolidated 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, such consolidated 1998 and 1997 consolidated financial
statements present fairly, in all material respects, the financial position of
Heritage Commerce Corp and subsidiaries as of December 31, 1998 and 1997, and
the results of their operations and their cash flows for the years then ended in
conformity with generally accepted accounting principles.
Deloitte & Touche LLP
San Jose, California
January 20, 1999 (February 5, 1999
as to the stock split information in
Note 1, paragraph 2)
F-2
<PAGE> 42
INDEPENDENT AUDITORS' REPORT
To the Board of Directors
Heritage Bank of Commerce:
We have audited the accompanying statement of income, shareholders' equity,
and cash flows of Heritage Bank of Commerce (the Bank) for the year ended
December 31, 1996. 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.
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 audits provide a reasonable basis for our opinion.
In our opinion, such financial statements referred to above present fairly,
in all material respects, the results of operations and cash flows of Heritage
Bank of Commerce for the year ended December 31, 1996, in conformity with
generally accepted accounting principles.
KPMG LLP
Mountain View, California
January 10, 1997
F-3
<PAGE> 43
HERITAGE COMMERCE CORP
CONSOLIDATED BALANCE SHEETS
ASSETS
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
----------------------------
1998 1997
------------ ------------
<S> <C> <C>
Cash and due from banks..................................... $ 18,039,000 $ 16,060,000
Federal funds sold.......................................... 28,600,000 27,125,000
------------ ------------
Total cash and cash equivalents................... 46,639,000 43,185,000
Securities available-for-sale, at fair value................ 50,249,000 61,166,000
Securities held-to-maturity, at cost (fair value of
$27,240,000 and $26,938,000).............................. 26,544,000 26,531,000
Loans held for sale at fair value........................... 33,079,000 15,411,000
Loans....................................................... 236,307,000 113,359,000
Allowance for loan losses................................... (3,825,000) (2,285,000)
------------ ------------
Loans, net........................................ 232,482,000 111,074,000
Premises and equipment, net................................. 3,238,000 1,971,000
Accrued interest receivable and other assets................ 7,240,000 3,764,000
Other investments........................................... 5,460,000 4,473,000
------------ ------------
TOTAL............................................. $404,931,000 $267,575,000
============ ============
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities:
Deposits.................................................. $350,047,000 $242,978,000
Deposits held for sale.................................... 18,911,000 --
Accrued interest payable and other liabilities............ 5,276,000 2,261,000
------------ ------------
Total liabilities................................. 374,234,000 245,239,000
------------ ------------
Commitments and contingencies
Shareholders' equity:
Common Stock, no par value; 30,000,000 shares authorized;
shares issued and outstanding: 5,554,552 in 1998 and
4,943,848 in 1997...................................... 29,418,000 23,447,000
Accumulated other comprehensive income.................... 658,000 418,000
Retained earnings/(deficit)............................... 621,000 (1,529,000)
------------ ------------
Total shareholders' equity........................ 30,697,000 22,336,000
------------ ------------
TOTAL............................................. $404,931,000 $267,575,000
============ ============
</TABLE>
See notes to consolidated financial statements.
F-4
<PAGE> 44
HERITAGE COMMERCE CORP
CONSOLIDATED INCOME STATEMENTS
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
---------------------------------------
1998 1997 1996
----------- ----------- -----------
<S> <C> <C> <C>
Interest income:
Loans, including fees................................. $19,777,000 $10,376,000 $ 6,138,000
Securities, taxable................................... 4,915,000 5,188,000 3,723,000
Securities, tax exempt................................ 679,000 87,000 1,000
Federal funds sold.................................... 1,307,000 552,000 663,000
Other investments..................................... 226,000 48,000 --
----------- ----------- -----------
Total interest income................................... 26,904,000 16,251,000 10,525,000
----------- ----------- -----------
Interest expense:
Deposits.............................................. 7,948,000 4,187,000 2,641,000
Other................................................. 3,000 17,000 5,000
----------- ----------- -----------
Total interest expense.................................. 7,951,000 4,204,000 2,646,000
----------- ----------- -----------
Net interest income before provision for loan losses.... 18,953,000 12,047,000 7,879,000
Provision for loan losses............................... 1,576,000 1,060,000 830,000
----------- ----------- -----------
Net interest income after provision for loan losses..... 17,377,000 10,987,000 7,049,000
----------- ----------- -----------
Other income:
Gain on sale of loans held for sale................... 332,000 205,000 101,000
Service charges and other fees........................ 229,000 173,000 149,000
Gain on sale of securities available for sale......... 790,000 164,000 21,000
Other income.......................................... 352,000 48,000 25,000
----------- ----------- -----------
Total other income...................................... 1,703,000 590,000 296,000
----------- ----------- -----------
Other expenses:
Salaries and employee benefits........................ 7,722,000 4,933,000 2,942,000
Client services....................................... 2,426,000 1,169,000 910,000
Furniture and equipment............................... 828,000 542,000 330,000
Advertising and promotion............................. 786,000 450,000 260,000
Occupancy............................................. 792,000 440,000 293,000
Professional fees..................................... 718,000 372,000 224,000
Loan origination costs................................ 449,000 326,000 146,000
Other................................................. 1,884,000 936,000 619,000
----------- ----------- -----------
Total other expenses.................................... 15,605,000 9,168,000 5,724,000
----------- ----------- -----------
Net income before income taxes.......................... 3,475,000 2,409,000 1,621,000
Income taxes............................................ 1,325,000 844,000 220,000
----------- ----------- -----------
Net income.............................................. $ 2,150,000 $ 1,565,000 $ 1,401,000
=========== =========== ===========
Earnings per share:
Basic................................................. $0.41 $0.32 $0.32
Diluted............................................... $0.37 $0.30 $0.31
</TABLE>
See notes to consolidated financial statements.
F-5
<PAGE> 45
HERITAGE COMMERCE CORP
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
<TABLE>
<CAPTION>
ACCUMULATED OTHER
COMMON STOCK COMPREHENSIVE RETAINED TOTAL OTHER
----------------------- INCOME EARNINGS/ SHAREHOLDERS' COMPREHENSIVE
SHARES AMOUNT NET OF TAXES (DEFICIT) EQUITY INCOME
--------- ----------- ----------------- ----------- ------------- -------------
<S> <C> <C> <C> <C> <C> <C>
BALANCE JANUARY 1, 1996.... 3,188,301 $14,170,000 $ 466,000 $(1,807,000) $12,829,000
Net income................. -- -- -- 1,401,000 1,401,000 $1,401,000
Net change in unrealized
gain on securities
available-for-sale, net
of taxes................. -- -- (245,000) -- (245,000) (245,000)
----------
Total comprehensive
income................. $1,156,000
==========
Stock dividend............. 318,802 1,384,000 -- (1,384,000) --
Stock options exercised.... 10,144 39,000 -- -- 39,000
Common Stock issued
pursuant to August 1996
offering (net of issuance
costs of $51,000)........ 1,178,802 6,500,000 -- -- 6,500,000
--------- ----------- --------- ----------- -----------
BALANCES DECEMBER 31,
1996..................... 4,696,049 $22,093,000 $ 221,000 $(1,790,000) $20,524,000
Net income................. -- -- -- 1,565,000 1,565,000 $1,565,000
Net change in unrealized
gain on securities
available-for-sale, net
of taxes................. -- -- 197,000 -- 197,000 197,000
----------
Total comprehensive
income................. $1,762,000
==========
Stock dividend............. 234,523 1,304,000 -- (1,304,000) --
Fractional shares canceled
due to stock split....... (291) (2,000) -- (2,000)
Stock options exercised.... 13,567 52,000 -- -- 52,000
--------- ----------- --------- ----------- -----------
BALANCES DECEMBER 31,
1997..................... 4,943,848 $23,447,000 $ 418,000 $(1,529,000) $22,336,000
Net income................. -- -- -- 2,150,000 2,150,000 $2,150,000
Net change in unrealized
gain on securities
available-for-sale, net
of taxes................. -- -- 240,000 -- 240,000 240,000
----------
Total comprehensive
income................. $2,390,000
==========
Common Stock issued
pursuant to July 1998
offering (net of issuance
costs of $154,000)....... 580,644 5,846,000 -- -- 5,846,000
Stock options exercised.... 30,060 125,000 -- -- 125,000
--------- ----------- --------- ----------- -----------
BALANCES DECEMBER 31,
1998..................... 5,554,552 $29,418,000 $ 658,000 $ 621,000 $30,697,000
</TABLE>
See notes to consolidated financial statements
F-6
<PAGE> 46
HERITAGE COMMERCE CORP
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
-------------------------------------------
1998 1997 1996
------------- ------------ ------------
<S> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income.......................................... $ 2,150,000 $ 1,565,000 $ 1,401,000
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization..................... 639,000 388,000 260,000
Provision for loan losses......................... 1,576,000 1,060,000 830,000
Gain on sales of securities available-for-sale.... (790,000) (164,000) (21,000)
Deferred income tax expense....................... (1,016,000) (448,000) (133,000)
Amortization/accretion of discounts and premiums
on securities.................................. 242,000 56,000 52,000
Proceeds from sales of loans held for sale........ 3,932,000 4,198,000 1,724,000
Originations of loans held for sale............... (5,674,000) (4,626,000) (11,587,000)
Maturities of loans held for sale................. 694,000 45,000 --
Increase in accrued interest receivable and other
assets......................................... (2,461,000) (952,000) (806,000)
Increase (decrease) in accrued interest payable
and other liabilities.......................... 2,869,000 605,000 (295,000)
Proceeds from relocation.......................... -- -- 1,100,000
------------- ------------ ------------
Net cash provided by (used in) operating
activities........................................ 2,161,000 1,727,000 (7,475,000)
------------- ------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Net increase in loans, net of charge-offs........... (139,604,000) (45,650,000) (30,450,000)
Purchases of securities available-for-sale.......... (25,481,000) (49,116,000) (27,611,000)
Maturities of securities available-for-sale......... 18,407,000 16,588,000 13,683,000
Proceeds from sales of securities
available-for-sale................................ 19,046,000 21,955,000 5,081,000
Purchases of securities held-to-maturity............ (8,855,000) (7,659,000) (16,248,000)
Proceeds from maturities of securities
held-to-maturity.................................. 8,722,000 6,388,000 1,000,000
Purchase of corporate-owned life insurance.......... (987,000) (4,473,000) --
Purchases of property and equipment................. (1,906,000) (829,000) (887,000)
------------- ------------ ------------
Net cash used by investing activities............... (130,658,000) (62,796,000) (55,432,000)
------------- ------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net increase in deposits............................ 125,981,000 96,599,000 27,633,000
(Repayments) proceeds from sale of securities under
agreements to repurchase.......................... -- (5,010,000) 5,010,000
Net proceeds from issuance of common stock.......... 5,970,000 50,000 6,539,000
------------- ------------ ------------
Net cash provided by financing activities........... 131,951,000 91,639,000 39,182,000
------------- ------------ ------------
Net increase (decrease) in cash and cash
equivalents....................................... 3,454,000 30,570,000 (23,725,000)
Cash and cash equivalents, beginning of year........ 43,185,000 12,615,000 36,340,000
------------- ------------ ------------
Cash and cash equivalents, end of year.............. $ 46,639,000 $ 43,185,000 $ 12,615,000
============= ============ ============
Supplemental disclosures of cash flow information:
Cash paid during the year for:
Interest....................................... $ 7,198,000 $ 4,477,000 $ 2,610,000
Income taxes................................... $ 1,684,000 $ 1,536,000 $ 218,000
Supplemental schedule of non-cash investing and
financing activity:
Transfer from retained earnings (deficit) to
common stock due to stock dividend............. $ -- $ 1,304,000 $ 1,384,000
</TABLE>
See notes to consolidated financial statements.
F-7
<PAGE> 47
HERITAGE COMMERCE CORP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) SIGNIFICANT ACCOUNTING POLICIES
Description of Business and Basis of Presentation
Heritage Commerce Corp (the "Company") operates as the bank holding company
for two subsidiary banks: Heritage Bank of Commerce ("HBC") and Heritage Bank
East Bay ("HBEB")(collectively the "Banks"). Both are California state chartered
banks which offer a full range of commercial and personal banking services to
residents and the business/professional community in Santa Clara and Alameda
Counties, California. HBC was incorporated on November 23, 1993 and commenced
operations on June 8, 1994. HBEB was incorporated on October 21, 1998 and
commenced operations on December 7, 1998. The accounting and reporting policies
of the Company and its subsidiary banks conform to generally accepted accounting
principles and prevailing practices within the banking industry.
On January 27, 1999, the Company's Board of Directors announced the
declaration of a 3-for-2 stock split effective for shareholders of record on
February 5, 1999. Accordingly, all historical financial information has been
restated as if the stock split had been in effect for all periods presented.
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. Actual results could differ from those estimates.
Consolidation
The consolidated financial statements include the accounts of the Company
and its subsidiary banks. All material intercompany accounts and transactions
have been eliminated.
Cash and Cash Equivalents
The Company considers all highly liquid debt instruments purchased with 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 Company 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 Company's positive intent and
ability to hold the securities to maturity.
A decline in the market value of any available-for-sale or held-to-maturity
security below cost that is deemed other than temporary results in a charge to
earnings and the corresponding establishment of a new cost basis for the
security. 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 Company holds for sale the guaranteed portion of certain Small Business
Administration (SBA) loans and certain credit card loans. These loans are
carried at the lower of cost or market, determined in the aggregate.
F-8
<PAGE> 48
HERITAGE COMMERCE CORP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
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 guaranteed portion of the loan sold compared to the
relative fair value of the unguaranteed 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 unguaranteed 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.
Loans
Loans are stated at the principal amount outstanding. The majority of the
Company's loans are at variable interest rates. Interest on loans is credited to
income when earned.
Generally, if a loan is classified as non-accrual, the accrual of interest
is discontinued, any accrued and unpaid interest is reversed, and the
amortization of deferred loan fees and costs is discontinued, 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.
Renegotiated loans are those in which the Company has formally restructured
a significant portion of the loan. The remaining portion is normally charged
off, with a concession either in the form of below market rate financing, or
debt forgiveness on the charged off portion. Loans that have been renegotiated
and have not met specific performance standards for payment are classified as
renegotiated loans within the classification of nonperforming assets. Upon
payment performance, such loans may be transferred from nonperforming status to
accrual state.
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 Company maintains an allowance for loan losses to absorb potential
credit losses inherent in the loan portfolio. The allowance is based on ongoing,
monthly assessments of the probable estimated losses, and to a lesser extent,
unused commitments to provide financing. Loans are charged against the allowance
when management believes that the collectability of the principal is doubtful.
The allowance is increased by a provision for loan losses, which is charged
against current period operating results and decreased by the amount of
charge-offs, net of recoveries. The Company's methodology for assessing the
appropriateness of the allowance consists of several key elements, which include
the formula allowance, specific allowances and the unallocated allowance.
The formula allowance is calculated by applying loss factors to outstanding
loans and certain unused commitments. Loss factors are based on management's
experience and may be adjusted for significant factors that, in management's
judgment, affect the collectibility of the portfolio as of the evaluation date.
Due to the Company's lack of historical loss experience, management has derived
a matrix, based on past experience including that of similar banks, to determine
the loss factor for each category of loan.
Specific allowances are established in cases where management has
identified significant conditions or circumstances related to a credit that
management believes indicate the probablility that a loss may be incurred in
excess of the amount determined by the application of the formula allowance. The
allowance also incorporates the results of measuring impaired loans as provided
in Statement of Financial Accounting Standards ("SFAS") No. 114, "Accounting by
Creditors for Impairment of a Loan" and SFAS No. 118, "Accounting by Creditors
for Impairment of a Loan -- Income Recognition and Disclosures." These
F-9
<PAGE> 49
HERITAGE COMMERCE CORP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
accounting standards prescribe the measurement methods, income recognition and
disclosures related to impairment loans. Management considers a loan to be
impaired when it is probable that the Company will be unable to collect all
amounts due according to the 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.
The unallocated allowance is based upon management's evaluation of various
conditions that are not directly measured in the determination of the formula
and specific allowances. The conditions evaluated in connection with the
unallocated allowance may include existing general economic and business
conditions affecting the key lending areas of the Company, credit quality
trends, collateral values, loan volumes and concentrations, seasoning of the
loan portfolio, specific industry conditions within portfolio segments, recent
loss experience in particular segments of the portfolio, duration of the current
business cycle, and bank regulatory examination results.
Premises and Equipment
Premises and equipment are stated at cost. Depreciation and amortization
are computed on a straight-line basis over the lesser of the lease terms or
estimated useful lives of five to fifteen years.
Other Investments
Other investments consist of cash surrender value of life insurance
policies for certain officers and directors of the Company and its subsidiary
banks.
Long-Lived Assets
The Company evaluates the recoverability of long-lived assets on an
on-going basis. The Company adopted SFAS No. 121, Accounting for the Impairment
of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, effective
January 1, 1998. The adoption of this Statement did not have a significant
impact on the Company's financial position or results of operations.
Income Taxes
The Company files consolidated federal and combined state income tax
returns. Amounts provided for income tax expense are based on income reported
for financial statement purposes and do not necessarily represent amounts
currently payable under tax laws. Deferred taxes, which arise principally from
temporary differences between the period in which certain income and expenses
are recognized for financial accounting purposes and the period in which they
affect taxable income, are included in the amounts provided for income taxes.
Under this method, the computation of the net deferred tax liability or asset
gives current recognition to changes in the tax laws.
Stock-Based Compensation
As allowed for by SFAS No. 123, Accounting for Stock-Based Compensation,
the Company accounts for stock-based awards to employees using the intrinsic
value method in accordance with Accounting Principles Board (APB) Opinion No.
25, Accounting for Stock Issued to Employees.
Comprehensive Income
The Company has adopted SFAS No. 130 Reporting Comprehensive Income, which
requires that an enterprise report and display, by major components and as a
single total, the change in its net assets during the period from non-owner
sources. The adoption of this statement resulted in a change in financial
statement presentation, but did not have an impact on the Company's consolidated
financial position, results of operations or cash flows.
F-10
<PAGE> 50
HERITAGE COMMERCE CORP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Segment Reporting
The Company has adopted 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 this statement did not impact our consolidated financial position,
results of operations, or cash flows, and any effect was limited to the form and
content of our disclosures. Also see Note 13.
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 for basic and
diluted earnings per share. All share numbers have been retroactively restated
for stock dividends and stock splits dated August 1997 and February 1999.
Reconciliation of weighted average shares used in computing earnings per share
are as follows:
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
---------------------------------
1998 1997 1996
--------- --------- ---------
<S> <C> <C> <C>
Weighted average common shares outstanding.... 5,242,516 4,937,533 4,368,394
Dilutive effect of stock options outstanding,
using the treasury stock method............. 601,522 284,324 182,535
--------- --------- ---------
Shares used in computing diluted earnings per
share....................................... 5,844,038 5,221,857 4,550,929
</TABLE>
Reclassifications
Certain amounts in the 1997 and 1996 financial statements have been
reclassified to conform to the 1998 presentation. These reclassifications had no
impact on shareholders' equity and net income.
Recently Issued Accounting Pronouncements
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities". The Statement will require the Company to
recognize all derivatives on the balance sheet at fair value. SFAS No. 133
requires that derivative instruments used to hedge be identified specifically to
assets, liabilities, firm commitments or anticipated transactions and measured
as effective and ineffective when hedging changes in fair value or cash flows.
Derivative instruments that do not qualify as either a fair value or cash flow
hedge will be valued at fair value with the resultant gain or loss recognized in
current earnings. Changes in the effective portion of fair value hedges will be
recognized in current earnings along with the change in fair value of the hedged
item. Changes in the effective portion of the fair value of cash flow hedges
will be recognized in other comprehensive income until realization of the cash
flows of the hedged through current earnings. Any ineffective portion of hedges
will be recognized in current earnings. Management believes that adoption of
SFAS No. 133 will have no impact on the Company's financial position or results
of operations. The statement is effective for fiscal years beginning after June
15, 1999, with earlier application encouraged. The Company expects to adopt SFAS
No. 133 as of January 1, 2000.
In October 1998, the FASB issued SFAS No. 134, "Accounting for
Mortgage-Backed Securities Retained after the Securitization of Mortgage Loans
Held for Sale by a Mortgage Banking Enterprise". This Statement amends SFAS No.
65, "Accounting for Certain Mortgage Banking Activities", which established
accounting and reporting standards for certain activities of mortgage banking
and other similar enterprises. After securitization of mortgage loans held for
sale, SFAS No. 134 requires an entity to classify the resulting mortgage-backed
securities or other retained interests, based on its ability or intent to sell
or hold those investments. Management believes that the adoption of SFAS No. 134
will have no impact on the Company's financial position or results of
operations. This Statement is effective for fiscal years beginning after
December 15, 1998.
F-11
<PAGE> 51
HERITAGE COMMERCE CORP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
In June 1998, the AICPA issued SOP 98-5, "Reporting on the Costs of
Start-Up Activities". SOP 98-5 requires that entities expense start-up costs and
organization costs as they are incurred. Management believes that the adoption
of SOP 98-5 will not have a material effect on the Company's financial position
or results of operations. The Statement is effective for fiscal years beginning
after December 15, 1998.
(2) SECURITIES
The amortized cost and estimated fair value of securities as of December
31, 1998 were as follows:
<TABLE>
<CAPTION>
GROSS GROSS ESTIMATED
AMORTIZED UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
----------- ---------- ---------- -----------
<S> <C> <C> <C> <C>
Securities available-for-sale:
U.S. Treasury........................ $39,254,000 $ 869,000 $ -- $40,123,000
U.S. Government Agencies............. 3,007,000 44,000 -- 3,051,000
Municipals........................... 2,595,000 113,000 -- 2,708,000
Preferred Stock...................... 2,015,000 57,000 -- 2,072,000
Commercial Paper..................... 2,259,000 36,000 -- 2,295,000
----------- ---------- ---- -----------
Total securities available-for-sale.... $49,130,000 $1,119,000 $ -- $50,249,000
=========== ========== ==== ===========
Securities held-to-maturity:
Municipals........................... $23,001,000 $ 650,000 $ -- $23,651,000
U.S. Government Agencies............. 1,509,000 7,000 -- 1,516,000
U.S. Treasury........................ 2,034,000 39,000 -- 2,073,000
----------- ---------- ---- -----------
Total securities held-to-maturity...... $26,544,000 $ 696,000 $ -- $27,240,000
=========== ========== ==== ===========
</TABLE>
The amortized cost and estimated fair value of securities as of December
31, 1997 were as follows:
<TABLE>
<CAPTION>
GROSS GROSS ESTIMATED
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>
F-12
<PAGE> 52
HERITAGE COMMERCE CORP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The amortized cost and estimated fair values of securities as of December
31, 1998 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 HELD-TO-MATURITY SECURITIES AVAILABLE-FOR-SALE
---------------------------- ------------------------------
AMORTIZED ESTIMATED FAIR AMORTIZED ESTIMATED FAIR
COST VALUE COST VALUE
----------- -------------- ------------ ---------------
<S> <C> <C> <C> <C>
Due within one year................ $ 2,661,000 $ 2,675,000 $12,046,000 $12,141,000
Due after one through five years... 10,909,000 11,236,000 33,741,000 34,650,000
Due after five through ten years... 10,441,000 10,719,000 2,349,000 2,414,000
Due after ten years................ 2,533,000 2,610,000 994,000 1,044,000
----------- ----------- ----------- -----------
Total.................... $26,544,000 $27,240,000 $49,130,000 $50,249,000
=========== =========== =========== ===========
</TABLE>
Sales of securities available-for-sale resulted in gross realized gains of
$670,000, $170,000, and $21,000 during the years ended December 31, 1998, 1997,
and 1996, respectively.
Sales of securities available-for-sale resulted in gross realized losses of
$5,000, $6,000, and nil during the years ended December 31, 1998, 1997, and
1996, respectively.
Securities with amortized cost of $43,296,000 as of December 31, 1998 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>
1998 1997
------------ ------------
<S> <C> <C>
Loans held for sale............................... $ 33,079,000 $ 15,411,000
============ ============
Loans held for investment Commercial.............. 79,566,000 48,422,000
Real estate -- term............................... 57,216,000 38,446,000
Real estate -- land and construction.............. 49,270,000 25,780,000
Consumer.......................................... 50,350,000 824,000
------------ ------------
Total loans....................................... 236,402,000 113,472,000
Allowance for loan losses......................... (3,825,000) (2,285,000)
Deferred loan fees................................ (95,000) (113,000)
------------ ------------
Loans, net........................................ $232,482,000 $111,074,000
============ ============
</TABLE>
Changes in the allowance for loan losses were as follows:
<TABLE>
<CAPTION>
AT OR FOR THE YEARS ENDED DECEMBER 31,
--------------------------------------
1998 1997 1996
---------- ---------- ----------
<S> <C> <C> <C>
Balance, beginning of year............. $2,285,000 $1,402,000 $ 572,000
Actual charge-offs..................... 173,000 224,000 --
Less recoveries........................ 137,000 47,000 --
Net loans charged-off.................. 36,000 177,000 --
Provision for loan losses.............. 1,576,000 1,060,000 830,000
---------- ---------- ----------
Balance, end of year................... $3,825,000 $2,285,000 $1,402,000
========== ========== ==========
</TABLE>
As of December 31, 1998, the Company had $1,288,000 in loans for which
interest is no longer being accrued, $12,000 in loans past due 90 days or more,
and no impaired loans. As of December 31, 1997, and 1996, the Company had no
loans for which interest is no longer being accrued, no loans past due 90 days
or more, and no impaired loans. For the year ended December 31, 1998, the
Company had foregone $35,000 of interest income as a result of non-accrual loans
or restructured debt. For the years ended December 31, 1997
F-13
<PAGE> 53
HERITAGE COMMERCE CORP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
and 1996, the Company had $17,000 and no forgone interest income as a result of
non-accrual loans or restructured debt.
HBC's SBA loans serviced for others are not included in the accompanying
balance sheets. The unpaid principal balances of these loans as of December 31,
1998 and 1997 were approximately $9,130,000 and $5,961,000, respectively.
Concentrations of credit risk arise when a number of clients are engaged in
similar business activities, or activities in the same geographic region, or
have similar features that would cause their ability to meet contractual
obligations to be similarly affected by changes in economic conditions.
The Company's loan portfolio is concentrated in commercial (primarily
manufacturing, wholesale, and service) and real estate lending, with the balance
in consumer loans. Due to increased customer dispersion outside of the Company's
primary market area attributed to the introduction of the internet credit card,
the Company has decreased the geographic risks inherent in its loan portfolio.
However, while no specific industry concentration is considered significant, the
Company's lending operations are located in the Company's market areas that are
dependent on the technology and real estate industries and their supporting
companies. Thus, the Company's borrowers could be adversely impacted by a
downturn in these sectors of the economy which could reduce the demand for loans
and adversely impact the borrowers' abilities to repay their loans.
In February 1998, HBC entered into a contract with Internet Access
Financial Corporation to provide a credit card over the internet. These
customers are not limited to Northern California, the Company's primary market
area, as the product is available to anyone across the country.
HBC and HBEB make loans to executive officers, directors, and their
affiliates in the ordinary course of business. These transactions were on
substantially the same terms as those prevailing at the time for comparable
transactions with unrelated parties and do not involve more than normal risk or
unfavorable terms for the Banks. During 1998, new loans in the amount of
$188,000 were made to related parties, while $1,340,000 was repaid to the Banks.
As of December 31, 1998 and 1997 the Banks had $993,000 and $2,145,000 in loans
outstanding to related parties.
(4) PREMISES AND EQUIPMENT
Premises and equipment as of December 31 were as follows:
<TABLE>
<CAPTION>
1998 1997
---------- ----------
<S> <C> <C>
Furniture and equipment............................. $2,677,000 $1,812,000
Leasehold improvements.............................. 1,368,000 644,000
Software............................................ 678,000 361,000
---------- ----------
4,723,000 2,817,000
Accumulated depreciation and amortization........... (1,485,000) (846,000)
---------- ----------
Premises and equipment, net......................... $3,238,000 $1,971,000
========== ==========
</TABLE>
(5) DEPOSITS
Deposits as of December 31, were as follows:
<TABLE>
<CAPTION>
1998 1997
------------ ------------
<S> <C> <C>
Demand, non-interest bearing.................... $120,854,000 $ 97,737,000
Demand, interest bearing........................ 9,035,000 6,319,000
Savings and money market........................ 131,518,000 96,712,000
Time deposits, $100,000 and over................ 58,847,000 34,948,000
Time deposits, less than $100,000............... 29,793,000 7,262,000
------------ ------------
Total deposits........................ $350,047,000 $242,978,000
============ ============
</TABLE>
F-14
<PAGE> 54
HERITAGE COMMERCE CORP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
In addition to the deposits listed above are deposits held for sale
totaling $18,911,000. This amount consists of a portion of HBC's bankruptcy
deposit portfolio.
As of December 31, 1998, the scheduled maturities of time deposits were as
follows:
<TABLE>
<CAPTION>
YEAR
----
<S> <C>
1999.................................................... $86,053,000
2000.................................................... 1,737,000
2001.................................................... 850,000
-----------
Total time deposits........................... $88,640,000
===========
</TABLE>
(6) BORROWING ARRANGEMENTS
Available Lines of Credit
The Company has federal funds purchase lines of $15,000,000 and $6,000,000,
respectively, from two correspondent banks, and a repurchase arrangement of
$20,000,000 with a commercial brokerage firm. There were no borrowings under
these arrangements as of December 31, 1998. 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>
1998 1997
------- --------
<S> <C> <C>
Average balance during the year......................... $40,000 $297,000
Average interest rate during the year................... 6.17% 5.72%
Maximum month-end balance during the year............... $ -- $300,000
Average rate at December 31............................. -- --
</TABLE>
(7) INCOME TAXES
The provision for income taxes for the years ended December 31, consisted
of the following:
<TABLE>
<CAPTION>
1998 1997 1996
----------- ---------- ---------
<S> <C> <C> <C>
Current:
Federal............................. $ 1,734,000 $ 939,000 $ 135,000
State............................... 607,000 353,000 218,000
----------- ---------- ---------
Total current............... 2,341,000 1,292,000 353,000
----------- ---------- ---------
Deferred:
Federal............................. (814,000) (372,000) (104,000)
State............................... (202,000) (76,000) (29,000)
----------- ---------- ---------
Total deferred.............. (1,016,000) (448,000) (133,000)
----------- ---------- ---------
Provision for income taxes............ $ 1,325,000 $ 844,000 $ 220,000
=========== ========== =========
</TABLE>
The effective tax rate differs from the federal statutory rate for the
years ended December 31, as follows:
<TABLE>
<CAPTION>
1998 1997 1996
---- ---- -----
<S> <C> <C> <C>
Statutory federal income tax rate................. 35.0% 35.0% 35.0%
State income taxes, net of federal tax benefit.... 7.7 7.5 7.7
Change in valuation allowance..................... -- (8.7) (29.5)
Non-taxable interest income....................... (5.8) (2.3) --
Officer's life insurance.......................... (2.2) -- --
Other............................................. 3.4 3.5 0.4
---- ---- -----
Effective tax rate................................ 38.1% 35.0% 13.6%
==== ==== =====
</TABLE>
F-15
<PAGE> 55
HERITAGE COMMERCE CORP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Net deferred tax asset as of December 31 consists of the following:
<TABLE>
<CAPTION>
1998 1997
---------- ----------
<S> <C> <C>
Deferred tax assets:
Allowance for loan losses........................... $1,541,000 $ 886,000
Excess servicing rights............................. 114,000 99,000
Deferred rent....................................... 77,000 89,000
Accrued expenses.................................... 237,000 20,000
Other............................................... 31,000 31,000
---------- ----------
Deferred tax asset.................................... 2,000,000 1,125,000
---------- ----------
Deferred tax liabilities:
Securities available-for-sale....................... (448,000) (314,000)
Accrual to cash adjustment.......................... (164,000) (278,000)
Depreciation........................................ (76,000) (169,000)
State income taxes.................................. (163,000) (97,000)
---------- ----------
Deferred tax liability................................ (851,000) (858,000)
---------- ----------
Net deferred tax asset................................ $1,149,000 $ 267,000
========== ==========
</TABLE>
(8) SHAREHOLDERS' EQUITY
Common Stock
In December, 1995, HBC declared a 10% stock dividend payable to
shareholders of record as of February 5, 1996. In January, 1997, the HBC
declared a 5% stock dividend payable to shareholders of record as of February 5,
1997. In July, 1997, HBC declared a three-for-two stock split for shareholders
of record as of August 1, 1997. In January, 1999 the Company declared a
three-for-two stock split for shareholders of record as of February 5, 1999.
Stock Option Plan
The Company has a stock option plan (the Plan) for directors, officers, and
key employees. The Plan provides for the grant of incentive and non-qualified
stock options. The Plan provides that the option price for both incentive and
non-qualified stock options will be determined by the Board of Directors at no
less than the fair value at the date of grant. Options granted vest on a
schedule determined by the Board of Directors at the time of grant. Generally,
options vest over four years. All options expire no later than ten years from
the date of grant. The Plan had 935,550 shares (adjusted for stock dividends and
splits) originally authorized for issuance, with an addition to the plan of
543,703 shares made during 1997. During 1998, an additional 178,093 shares were
added to the Plan for future grants. As of December 31, 1998, 315,232 shares are
available for future grants under the Plan.
F-16
<PAGE> 56
HERITAGE COMMERCE CORP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Option activity under the Plan is as follows:
<TABLE>
<CAPTION>
NUMBER WEIGHTED AVERAGE
OF SHARES EXERCISE PRICE
--------- ----------------
<S> <C> <C>
Balances, January 1, 1996
(223,734 exercisable at a weighted average exercise $ 3.87
price of $3.85).................................. 789,333
--------- ------
Granted (weighted average fair value of $2.11)..... 98,016 5.09
Exercised.......................................... (10,144) 3.85
Cancelled.......................................... (15,485) 3.91
--------- ------
Balances, December 31, 1996
(413,223 exercisable at a weighted average exercise 4.01
price of $3.89).................................. 861,720
--------- ------
Granted (weighted average fair value of $2.95)..... 120,928 6.48
Exercised.......................................... (13,567) 3.87
Cancelled.......................................... (10,298) 4.37
--------- ------
Balances, December 31, 1997
(652,924 exercisable at a weighted average exercise 4.32
price of $4.09).................................. 958,783
--------- ------
Granted (weighted average fair value of $4.92)..... 425,400 11.54
Exercised.......................................... (30,060) 4.15
Cancelled.......................................... (12,009) 5.79
--------- ------
Balances, December 31, 1998
(902,867 exercisable at a weighted average exercise $ 6.60
price of $5.25).................................. 1,342,114
========= ======
</TABLE>
Additional information regarding options outstanding under the Plan as of
December 31, 1998 is as follows:
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
------------------------------------------ ----------------------------
WEIGHTED
AVERAGE
REMAINING WEIGHTED WEIGHTED
RANGE OF NUMBER CONTRACTUAL AVERAGE NUMBER AVERAGE
EXERCISE PRICES OUTSTANDING LIFE (YRS.) EXERCISE PRICE EXERCISABLE EXERCISE PRICE
--------------- ----------- ----------- -------------- ----------- --------------
<S> <C> <C> <C> <C> <C>
$ 3.85 - 4.85... 744,831 5.62 $ 3.89 675,607 $ 3.88
4.86 - 5.85... 150,883 8.14 5.56 90,001 5.57
5.86 - 10.67... 202,500 9.36 10.29 38,112 10.23
10.68 - 18.01... 243,900 9.81 12.43 99,147 12.33
--------- -------
$ 3.85 - 18.01... 1,342,114 7.23 $ 6.60 902,867 $ 5.25
========= =======
</TABLE>
As discussed in Note 1, the Company continues to account for its
stock-based awards using the intrinsic value method in accordance with APB
Opinion No. 25, Accounting for Stock Issued to Employees, and its related
interpretations. Accordingly, no compensation expense has been recognized in the
financial statements for employee stock option arrangements.
SFAS No. 123, Accounting for Stock-Based Compensation, requires the
disclosure of pro forma net income and earnings per share had the Company
adopted the fair value method at the grant date of all stock options. Under SFAS
No. 123, the fair value of stock-based awards to employees is calculated through
the use of option pricing models, even though such models were developed to
estimate the fair value of freely tradable, fully transferable options without
vesting restrictions, which differ significantly from the Company's stock option
awards. Those models also require subjective assumptions, which greatly affect
the calculated values. The Company's calculations were made using the
Black-Scholes option pricing model with the following
F-17
<PAGE> 57
HERITAGE COMMERCE CORP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
weighted average assumptions: expected life, 84 months; risk-free interest rate,
4.70% for 1998, 5.75% for 1997 and 6.60% for 1996; stock volatility of 30% in
1998 and 1997 and 20% in 1996; and no dividends during the expected term. The
Company's calculations are based on a multiple option valuation approach, and
forfeitures are recognized as they occur.
If the computed fair values of the 1998, 1997, and 1996 awards had been
amortized to expense over the vesting periods of the awards, pro forma net
income and earnings per common share would have been as shown in the following
table. Options that were granted prior to January 1, 1995 with vesting periods
in 1995 and later are excluded from the pro-forma results indicated for 1996 in
the following table:
<TABLE>
<CAPTION>
1998 1997 1996
---------- ---------- ----------
<S> <C> <C> <C>
Net Income
As reported................................ $2,150,000 $1,565,000 $1,401,000
Pro forma.................................. 1,146,000 1,000,000 1,093,000
Net income per common share -- basic
As reported................................ 0.41 0.32 0.32
Pro forma.................................. 0.22 0.20 0.25
Net income per common share -- diluted
As reported................................ 0.37 0.30 0.31
Pro forma.................................. 0.20 0.19 0.24
</TABLE>
(9) LEASES
The Company leases its premises under non-cancelable operating leases with
terms, including renewal options, ranging from five to fifteen years. Future
minimum payments under the agreements are as follows:
<TABLE>
<S> <C>
Year ending December 31,
1999................................................... $ 783,000
2000................................................... 750,000
2001................................................... 760,000
2002................................................... 750,000
2003................................................... 673,000
Thereafter............................................... 3,623,000
----------
Total.................................................... $7,339,000
==========
</TABLE>
Rent expense under operating leases was $613,000, $314,000, and $225,000,
during the years ended December 31, 1998, 1997, and 1996, respectively. Rent
expense was reduced by deferred rent concessions on one of the Company's
locations of $47,000, $50,000, and $32,000, respectively.
(10) BENEFIT PLANS
The Company offers a 401(k) savings plan. All salaried employees are
eligible to contribute up to 20% of their pre-tax compensation (subject to an
IRS limitation of $10,000 in 1998) to the plan through salary deductions under
Section 401(k) of the Internal Revenue Code. The Company does not match employee
contributions.
During 1997, the Company initiated an employee stock ownership plan. The
plan allows the Company to purchase shares on the open market and award those
shares to certain employees in lieu of paying cash bonuses. To be eligible to
receive an award of shares under this plan, an employee must have worked at
least 1,000 hours during the year and must be employed by the Company, or its
subsidiaries, on December 31. Individual awards under this plan generally vest
over four years, with prorated payments made to qualified employees upon
termination of employment. During 1998 and 1997, the Company funded $200,000 and
$98,000 into the plan. The amount funded into this plan was recognized as
salaries and benefits expense in the Company's financial statements.
F-18
<PAGE> 58
HERITAGE COMMERCE CORP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
During 1997 the Company also adopted HBC's director compensation program.
An option of the director compensation program is the deferral of fees
("Deferral Plan"). Under the Deferral Plan, a participating director may defer
up to 100% of his monthly board fees into the Deferral Plan for up to ten years.
Amounts deferred earn interest at the rate of 8% per annum. The director may
elect a distribution schedule of up to ten years with interest accruing (at the
same 8%) on the declining balance.
The Company has purchased life insurance policies on the lives of directors
who have agreed to participate in the Deferral Plan. It is expected that the
earnings on these policies will offset the cost of the program. In addition, the
Company will receive death benefit payments upon the death of the director. The
proceeds will permit the Company to "complete" the deferral program as the
director originally intended if he dies prior to the completion of the deferral
program. The disbursement of deferred fees is accelerated at death and commences
one month after the director dies.
In the event of the director's disability prior to attainment of his
benefit eligibility date, the director may request that the Board permit him to
receive an immediate disability benefit equal to the value of the director's
deferral account.
In June of 1997, the Company provided each of its directors, and certain
officers, with a non qualified, defined contribution retirement and death
benefit plan. The amount of each respective potential annual retirement benefit
is indexed to the financial performance of life insurance policies, owned by the
Company and insuring the life of the respective director. The Company records as
income any earnings on the policies, however, it retains only the amount of
earnings which would have been earned had it purchased a one year Treasury Bill.
The "excess earnings" of each insurance policy is credited to a liability
reserve account for the benefit of the director. Each plan participant earns a
vested interest in the balance of his or her respective liability reserve
account, at the rate of 12% per annum, beginning with that individual's first
year of service and cumulating for as long as the director remains in the
service of the Company, or until the director achieves 100% vesting. In
addition, as required by SFAS No. 87, the Company has estimated the expected
future benefit obligation under these plans and is recording the annual increase
in benefit
(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 Company's financial
instruments as of December 31, 1998 and 1997 were as follows:
<TABLE>
<CAPTION>
1998 1997
--------------------------- ---------------------------
CARRYING ESTIMATED CARRYING ESTIMATED
AMOUNTS FAIR VALUE AMOUNTS FAIR VALUE
------------ ------------ ------------ ------------
<S> <C> <C> <C> <C>
Assets
Cash and cash equivalents..... $ 46,639,000 $ 46,639,000 $ 43,185,000 $ 43,185,000
Securities.................... 76,793,000 77,490,000 87,697,000 88,104,000
Loans, net.................... 265,561,000 265,513,000 126,485,000 126,474,000
Liabilities
Demand deposits, non-interest
bearing.................... $124,995,000 $124,995,000 $ 97,737,000 $ 97,737,000
Demand deposits, interest
bearing.................... 9,061,000 9,061,000 6,319,000 6,319,000
Savings and money market...... 143,518,000 143,518,000 96,712,000 96,712,000
Time deposits................. 91,384,000 91,578,000 42,210,000 42,205,000
</TABLE>
F-19
<PAGE> 59
HERITAGE COMMERCE CORP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
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
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 Company for time deposits with similar
remaining maturities.
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 Company'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.
(12) COMMITMENTS AND CONTINGENT LIABILITIES
Financial Instruments with Off-Balance Sheet Risk
Both HBC and HBEB are party to financial instruments with off-balance sheet
risk in the normal course of business to meet the financing needs of its
clients. These financial instruments include commitments to extend credit and
standby letters of credit. Those instruments involve, to varying degrees,
elements of credit and interest rate risk, in excess of the amounts recognized
in the balance sheets.
The Banks' exposure to credit loss in the event of non-performance of the
other party to the financial instrument for commitments to extend credit and
standby letters of credit is represented by the contractual notional amount of
those instruments. The Banks use the same credit policies in making commitments
and
F-20
<PAGE> 60
HERITAGE COMMERCE CORP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
conditional obligations as it does for on-balance sheet instruments. Credit risk
is the possibility that a loss may occur because a party to a transaction failed
to perform according to the terms of the contract. The Banks' control the credit
risk of these transactions through credit approvals, limits, and monitoring
procedures. Management does not anticipate any significant losses as a result of
these transactions.
Commitments to extend credit as of December 31, were as follows:
<TABLE>
<CAPTION>
1998 1997
------------ -----------
<S> <C> <C>
Commitments to extend credit..................... $114,816,000 $68,611,000
Standby letters of credit........................ 4,619,000 2,370,000
------------ -----------
$119,435,000 $70,981,000
============ ===========
</TABLE>
Commitments to extend credit are agreements to lend to a client as long as
there is no violation of conditions established in the contract. Commitments
generally have fixed expiration dates or other termination clauses. Since some
of the commitments are expected to expire without being drawn upon, the total
commitment amount does not necessarily represent future cash requirements. The
Banks evaluate each client's creditworthiness on a case-by-case basis. The
amount of collateral obtained, if deemed necessary by the Banks upon extension
of credit, is based on management's credit evaluation of the borrower.
Collateral held varies but may include cash, marketable securities, accounts
receivable, inventory, property, plant and equipment, income-producing
commercial properties, and/or residential properties. Fair value of these
instruments is not material.
Standby letters of credit are written conditional commitments issued by the
Banks to guaranty the performance of a client to a third party. The credit risk
involved in issuing letters of credit is essentially the same as that involved
in extending loan facilities to clients. Fair value of these instruments is not
material.
(13) BUSINESS SEGMENTS
Both HBC and HBEB are commercial banks, which primarily offer similar
products to customers located in Santa Clara and Alameda counties of California.
No customer accounts for more than 10 percent of revenue for either HBC, HBEB or
the Company. Accordingly, the Company and its subsidiary banks all operate as
one business segment.
(14) REGULATORY MATTERS
The Company and its subsidiaries are subject to various regulatory capital
requirements administered by the federal banking agencies. Failure to meet
minimum capital requirements can initiate certain mandatory -- and possibly
additional discretionary -- actions by regulators that, if undertaken, could
have a direct material effect on the Company's financial statements. Under
capital adequacy guidelines and the regulatory framework for prompt corrective
action, the Company must meet specific capital guidelines that involve
quantitative measures of the Company's assets, liabilities, and certain
off-balance-sheet items as calculated under regulatory accounting practices. The
Company'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 Company 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, 1998, the
Company meets all capital adequacy guidelines to which it is subject.
The most recent notification from the FDIC categorized HBEB as
well-capitalized and HBC as adequately capitalized under the regulatory
framework for prompt corrective action. Under the framework, HBC's capital
levels do not allow the Bank to accept brokered deposits without prior approval
from the regulators. To be categorized as adequately capitalized the Company
must maintain minimum total risk-
F-21
<PAGE> 61
HERITAGE COMMERCE CORP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
based, Tier I risk-based, and Tier I leverage ratios as set forth in the table.
There are no conditions or events since that notification that management
believes have changed the Bank's category.
The Company's actual capital amounts and ratios are also presented in the
table.
<TABLE>
<CAPTION>
TO BE WELL-
CAPITALIZED UNDER
FOR CAPITAL PROMPT CORRECTIVE
ACTUAL ADEQUACY PURPOSES: ACTION PROVISIONS:
------------------- ------------------- -------------------
AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO
----------- ----- ----------- ----- ----------- -----
<S> <C> <C> <C> <C> <C> <C>
As of December 31, 1998
Total Capital (to risk-
weighted assets)....... $33,675,000 10.4% $25,895,000 >8.0% N/A >N/A
Tier 1 Capital (to risk-
weighted assets)....... $29,850,000 9.2% $12,948,000 >4.0% N/A >N/A
Tier 1 Capital (to
average assets)........ $29,850,000 9.0% $13,282,000 >4.0% N/A >N/A
As of December 31, 1997
Total Capital (to risk-
weighted assets)....... $23,784,000 15.8% $12,033,000 >8.0% N/A >N/A
Tier 1 Capital (to risk-
weighted assets)....... $21,899,000 14.6% $ 6,017,000 >4.0% N/A >N/A
Tier 1 Capital (to
average assets)........ $21,899,000 10.3% $ 8,499,000 >4.0% N/A >N/A
</TABLE>
HBC's actual capital amounts and ratios are also presented in the table.
<TABLE>
<CAPTION>
TO BE WELL-
CAPITALIZED
UNDER PROMPT
FOR CAPITAL CORRECTIVE
ACTUAL ADEQUACY PURPOSES ACTION PROVISIONS
------------------- ------------------- -------------------
AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO
----------- ----- ----------- ----- ----------- -----
<S> <C> <C> <C> <C> <C> <C>
As of December 31, 1998
Total Capital
(to risk-weighted
assets).................... $27,697,000 9.3% $23,837,000 >8.0% $29,797,000 >10%
Tier 1 Capital
(to risk-weighted
assets).................... $24,172,000 8.1% $11,919,000 >4.0% $17,878,000 >6%
Tier 1 Capital
(to average assets)........ $24,172,000 7.3% $13,184,000 >4.0% $16,480,000 >5%
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 1 Capital
(to risk-weighted
assets).................... $21,899,000 14.6% $ 6,017,000 >4.0% $ 9,025,000 >6%
Tier 1 Capital
(to average assets)........ $21,899,000 10.3% $ 8,499,000 >4.0% $10,624,000 >5%
</TABLE>
F-22
<PAGE> 62
HERITAGE COMMERCE CORP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
HBEB's actual capital amounts and ratios are also presented in the table.
<TABLE>
<CAPTION>
TO BE WELL-
CAPITALIZED
UNDER PROMPT
FOR CAPITAL CORRECTIVE
ACTUAL ADEQUACY PURPOSES ACTION PROVISIONS
------------------ ------------------ ------------------
AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO
---------- ----- ---------- ----- ---------- -----
<S> <C> <C> <C> <C> <C> <C>
As of December 31, 1998
Total Capital
(to risk-weighted assets)..... $5,402,000 19.2% $2,254,000 >8.0% $2,818,000 >10%
Tier 1 Capital
(to risk-weighted assets)..... $5,102,000 18.1% $1,127,000 >4.0% $1,691,000 >6%
Tier 1 Capital
(to average assets)........... $5,102,000 13.4% $1,525,000 >4.0% $1,906,000 >5%
</TABLE>
The Company is required to maintain reserves with the Federal Reserve Bank
of San Francisco. Reserve requirements are based on a percentage of certain
deposits. As of December 31, 1998, the Company maintained reserves of $5,217,000
in the form of vault cash and balances at the Federal Reserve Bank of San
Francisco, which satisfied the regulatory requirements.
Under California law, the holders of common stock are entitled to receive
dividends when and as declared by the Board of Directors, out of funds legally
available therefor. The California Banking Law provides that a state-licensed
bank may not make a cash distribution to its shareholders in excess of the
lesser of the following: (i) the bank's retained earnings, or (ii) the bank's
net income for its last three fiscal years, less the amount of any distributions
made by the bank to its shareholders during such period. However, a bank, with
the prior approval of the Commissioner, may make a distribution to its
shareholders of an amount not to exceed the greater of (i) a bank's retained
earnings, (ii) its net income for its last fiscal year, or (iii) its net income
for the current fiscal year. In the event that the Commissioner determines that
the shareholders' equity of a bank is inadequate or that the making of a
distribution by a bank would be unsafe or unsound, the Commissioner may order a
bank to refrain from making such a proposed distribution.
(15) COMPREHENSIVE INCOME
The following is a summary of the components of accumulated other
comprehensive income.
<TABLE>
<CAPTION>
1998 1997 1996
---------- ---------- ----------
<S> <C> <C> <C>
Net Income............................. $2,150,000 $1,565,000 $1,401,000
Other comprehensive income, net of tax:
Add: net unrealized holding gain
(loss) on available-for-sale
securities during the year........ 1,030,000 303,000 (195,000)
Less: reclassification adjustment for
realized gains on available for
sale securities included in net
income during the year............ (790,000) (106,000) (50,000)
---------- ---------- ----------
Other comprehensive income............. 240,000 197,000 (245,000)
---------- ---------- ----------
Accumulated other comprehensive
income............................... $2,390,000 $1,762,000 $1,156,000
========== ========== ==========
</TABLE>
F-23
<PAGE> 63
HERITAGE COMMERCE CORP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(16) PARENT COMPANY ONLY CONDENSED FINANCIAL INFORMATION
As described in Note 1 to the consolidated financial statements, the merger
of Heritage Bank of Commerce with the Company became effective February 17,
1998. The condensed financial statements of Heritage Commerce Corp (parent
company only) follow:
<TABLE>
<CAPTION>
DECEMBER 31,
1998
------------
<S> <C>
CONDENSED BALANCE SHEET
Cash.................................................... $ 466,000
Investment in and advancements to subsidiaries.......... 28,647,000
-----------
Total......................................... $29,113,000
===========
Liabilities............................................. $ (116,000)
Shareholders' Equity.................................... 29,229,000
-----------
Total......................................... $29,113,000
===========
</TABLE>
<TABLE>
<CAPTION>
DECEMBER 31,
1998
------------
<S> <C>
CONDENSED INCOME STATEMENT
Dividends from Bank subsidiaries........................ $ 300,000
Interest income......................................... 15,000
Other expenses.......................................... (617,000)
-----------
Loss before equity in net income of subsidiary banks.... (302,000)
Equity in undistributed net income of subsidiaries...... 2,336,000
Income tax benefit...................................... 116,000
-----------
Net Income.............................................. 2,150,000
-----------
Other comprehensive income.............................. 240,000
-----------
Comprehensive income.................................... $ 2,390,000
===========
</TABLE>
<TABLE>
<CAPTION>
YEAR ENDED
DECEMBER 31,
1998
------------
<S> <C>
STATEMENT OF CASH FLOWS
Cash flows from operating activities:
Net Income............................................ $ 2,150,000
Adjustments to reconcile net income to net cash provided
(used) by operations:
Equity in undistributed income (losses) of
subsidiaries....................................... (2,336,000)
Net change in other liabilities....................... (116,000)
-----------
Net cash used by operating activities................... (302,000)
Cash flows from investing activities:
Other (dividends received from Bank subsidiaries)..... 300,000
-----------
Net cash provided by investing activities............... 300,000
Cash flows from financing activities:
Proceeds from issuance of common stock................ 5,969,000
Proceeds distributed to subsidiaries.................. (5,500,000)
-----------
Net cash provided by financing activities............... 469,000
Net increase in cash and cash equivalents............... 467,000
Cash, beginning of year................................. --
-----------
Cash, end of year....................................... $ 467,000
===========
</TABLE>
F-24
<PAGE> 64
HERITAGE COMMERCE CORP
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(17) OTHER MATTERS (UNAUDITED)
New Branches
On December 22, 1998, HBC received authorization from the California
Department of Financial Institutions to open a full service branch in the city
of Morgan Hill, California. HBC opened the branch on March 1, 1999.
F-25
<PAGE> 65
INDEX TO EXHIBITS
<TABLE>
<CAPTION>
INCORPORATED BY REFERENCE
TO REPORT ON FORM
EXHIBIT FILED ------------------------------------
NUMBER DESCRIPTION HEREWITH 8-A DATED 10-K DATED EXHIBIT NO.
- ------- ----------- -------- --------- ---------- -----------
<C> <S> <C> <C> <C> <C>
3.1 Heritage Commerce Corp Articles of 3-5-98 4.1
Incorporation:
[Incorporated herein by reference from Exhibit
4 to Heritage Commerce Corp's Form 8-A:
Registration of Securities Pursuant to Section
12(g) of the Securities Exchange Act of 1933
dated March 5, 1998 (File No. 000-23877)]
3.2 Heritage Commerce Corp Bylaws: 3-5-98 4.2
[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)]
10.1 Real Property Leases for properties located at 3-5-98 1
150 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 3-5-98 1
June 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).]
10.3 Employment agreement with Mr. Gionfriddo dated 3-5-98 1
June 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 3-31-98 10.4
Mr. Gionfriddo
10.5 Employment agreement with Mr. Conniff dated X
April 30, 1998
10.6 Employment agreement with Mr. Nethercott dated X
April 16, 1998
10.7 Employment agreement with Mr. McGovern dated X
July 16, 1998
21.1 Subsidiaries of the registrant X
23.1 Consent of Deloitte & Touche LLP dated March X
26, 1999
23.2 Consent of KPMG Peat Marwick LLP dated March X
25, 1999
27.1 Financial data schedule X
</TABLE>
<PAGE> 1
EXHIBIT 10.5
EMPLOYMENT AGREEMENT
This employment agreement (the "Agreement") is entered into as of April 30, 1998
(the "Effective Date"), by and between Heritage Commerce Corp (the "Company")
and its wholly owned subsidiary, Heritage Bank of Commerce ("HBC") a California
banking corporation and Richard L. Conniff on the following terms and
conditions.
1. Position. Richard L. Conniff shall be the President and Chief
Executive Officer of Heritage Bank East Bay (in organization, "East Bay"),
Director of East Bay if and when its Board is legally constituted, Director of
the Company and Member of the Management Committee of the Company), Mr. Conniff
shall be subject to the direction of the CEO of the Company and, by extension,
the Board of Directors of HBC. Notwithstanding the foregoing reporting
responsibility, Mr. Conniff will also be responsible to the Board of East Bay
if and when that Board is legally constituted.
The Parties agree that during the term of this Agreement, Conniff may serve as
an executive level officer of the Company, HBC, East Bay or other subsidiaries
of Company yet to be formed. Although Conniff's specific job description may
change from time to time, the terms and conditions of the Agreement as defined
in Sections 2 through 23 will remain in full force and effect. The term "Bank"
is intended to mean Company and/or any of its subsidiaries, as applicable. The
term "Management" is intended to mean the CEO/and or, as applicable, those duly
appointed management committees vested with decision-making authority. The term
"Board" shall, unless more narrowly defined in the context of its immediate
usage, mean any and all boards of directors with purview over the matter at
hand.
The CEO will set a high standard of conduct of courtesy and concern, of
professional and personal discretion and responsibility, forthrightness,
thrift, modesty and hard work. In light of this role with the Bank and the
Bank's position in the industry, the CEO will serve as a model for all
employees of the Bank. Given his role with the Bank and his responsibility
relative to the Bank's presence and stature in the community, the CEO will, at
all times, emulate this high standard of conduct in order to develop and enhance
the Bank's reputation and image.
The CEO shall comply with all pertinent regulatory standards as may affect the
Bank.
The CEO shall devote his entire productive time, attention and energy to the
business of the Bank. In a manner and with such results as are consistent with
his compensation and position, Mr. Conniff will service the Bank's existing
relationships and cultivate and foster new relationships for the Bank. Such new
relationships shall be consistent with the Bank's mission and shall generally
improve the Bank's share of market, volume of business, profitability and return
of assets.
The CEO will at all times keep the Board and appropriate members of the Bank's
management informed of all of his activities undertaken in context of his role,
including his activities in the community. He will introduce his customers and
potential customers and other business and civic contacts to appropriate
members of the Bank's management and to appropriate Board members and to other
employees of the Bank in order to enhance and solidify the Bank's prospects and
position.
<PAGE> 2
The CEO will exercise diligence with respect to the control of the direct and
indirect costs of his activities on behalf of the Bank.
In Addition to the above, Mr. Conniff shall:
(a) be a member of all committees of the East Bay Board and of the Company
Board to which he is duly appointed, except any audit committee;
(b) be responsible for the operation of the Bank, its properties and
related interests in accordance with the directives of management and in
accordance with the objectives and/or policies of the Board;
(d) exercise diligence with respect to the control of the costs of
operation and other expenses directly or indirectly involving interests of the
Bank;
(e) be responsible for achieving the broad objectives of the Bank for
profitability and business development;
(f) be responsible for the quality of the loan portfolio; and
(g) be responsible for budgeting, finance, accounting,planning and for
forming and developing the staff in a manner consistent with the Bank's
immediate needs and strategic goals.
2. Term. The Term of this Agreement will be three years from the
Effective Date hereof. At maturity, and annually thereafter, unless otherwise
amended or terminated, this Agreement shall automatically renew for a term of
one year. Upon the termination of Mr. Conniff's employment, neither he nor the
Bank shall have any further obligation to the other, except as set forth in
Paragraphs 5, 13.1, 13.2, 16 and 18 herein.
3. Base Salary. For the Term of this Agreement while he is an employee,
the Bank shall pay $125,000 per year ("Base Salary"), in accordance with the
Bank's normal payroll procedures, less appropriate withholdings, taxes and
similar deductions. The Base Salary will be reviewed annually by the Personnel
and Planning Committee of the Heritage Commerce Corp Board and is subject to
alteration only at the direction of that Committee.
4. Performance Bonuses. From time to time, but not less than annually,
subject to the discretion of the Board, the Bank shall undertake, in good
faith, to pay performance bonuses during the Term of this Agreement. The Bank
shall not be obligated to pay any specific amount pursuant to this section. Mr.
Conniff will be eligible for Performance Bonuses and the Bank will, in good
faith, pay Performance Bonuses in amounts that it deems reasonable on the basis
of the criteria outlined herein. If Performance Bonuses are paid, the amounts
of such generally will be comparable to those for similarly placed executives
at similarly situated financial institutions, and shall be based on Mr.
Conniff's overall performance and that of the Bank, including such factors as
profitability, deposit base, loan portfolio size and quality, adequacy of the
loan loss reserve, the capital position of the Bank and the satisfactory nature
of regulatory examinations.
<PAGE> 3
5. Incentive Stock Options. The Board of the Company will grant to Mr.
Conniff, incentive stock options to acquire 30,000 shares of the Company's
common stock pursuant to the Heritage Commerce Corp 1994 Tandem Stock Option
Plan. The Board, in its discretion, may grant such additional options, as it
deems appropriate in order to recognize performance for the preceding year and
in order to provide him with the incentive to sustain and enhance the
operational performance of the Bank for the future.
6. Automobile Allowance. During the Term of this Agreement, the Bank
shall pay Mr. Conniff a $500.00 monthly auto allowance.
7. Medical Insurance. The Bank shall provide medical insurance to M.
Conniff and his family with options and coverage consistent with those of the
Bank's group medical plan as in effect from time to time.
8. Life Insurance. The Bank shall provide Mr. Conniff life insurance to
the same extent the Bank provides life insurance to its executive officers. He
shall be entitled to designate the beneficiary of the life insurance provided
by this section.
9. Disability Insurance. The Bank shall provide Mr. Conniff long-term
disability insurance to the same extent the Bank provides such disability
insurance to its executive officers.
10. Indemnification by the Bank. The Bank and Company will indemnify and
hold Mr. Conniff harmless to the extent provided in the Bank's and Company's
by-laws for officers and directors.
11. Monthly Expenses Account. Subject to the Bank's Expense
Reimbursement Policy, Mr. Conniff shall be reimbursed by the Bank for his
reasonable and necessary business expenses incurred in furthering the Bank's
interests, including automobile fuel used in the performance of this agreement
and monthly dues for the Silicon Valley Capital Club. He will prepare and
submit expense reports promptly.
12. Vacation. During the period of this Agreement, Mr. Conniff shall
accrue vacation consistent with the personnel policy of the Bank, but in no
event at less than four weeks per year. In the event that while he is an
employee, he receives any compensation in lieu of accrued vacation, such
payment shall be considered cash compensation in addition to Base Salary and
will not be included in severance calculations called for in Section 13.1,
Termination without Cause, or in Section 13.2, Change of Control, hereunder.
13. Termination and Severance. Each party has the right to terminate Mr.
Conniff's employment with the Bank prior to the end of the Term specified in
paragraph 2 with or without cause at any time. For purposes of this Agreement,
cause shall arise if (i) he willfully breaches or habitually neglect the duties
which he is required to perform under this Agreement, (ii) commits an
intentional act that has a material detrimental effect on the reputation or
business of the Bank, or (iii) he is convicted of a felony or commits any such
act of dishonesty, fraud, intentional misrepresentation or moral turpitude as
would prevent effective performance of his duties under this Agreement. If the
Bank decides to terminate Mr. Conniff's employment for cause, the Bank shall
provide him with notice specifying the
<PAGE> 4
grounds for termination, accompanied by a written statement stating the
relevant facts supporting such grounds. Upon termination of his employment for
cause, he shall not be entitled to any further amounts except for the Base
Salary earned through his last day of employment.
13.1 Termination Without Cause. If the Bank terminates Mr. Conniff's
employment without cause, the Bank will provide him as his full and final
severance the following: (i) a lump sum payment within 10 days after
termination date, equal to his annual Base Salary, annual auto allowance and
average annual Performance Bonus paid, if any, less deductions, (ii) if he is
covered under the Bank's standard group medical and dental plan at the time of
his termination, the Bank will continue to provide equivalent coverage through
C.O.B.R.A. for 12 months after the date of termination at no cost to Mr.
Conniff; (iii) the Bank will continue to provide life insurance (in amounts and
with coverage equivalent to coverage provided immediately prior to his last day
of employment) for one year at no cost to Mr. Conniff (thereafter, Mr. Conniff
shall be responsible for such payments if he so chooses); and (iv) the Bank
will continue to provide disability insurance (in amounts and with coverage
equivalent to coverage provided immediately prior to his last day of
employment) for 12 months at no cost to Mr. Conniff (thereafter, Mr. Conniff
shall be responsible for such payments if he so chooses).
13.2 Change of Control. In the event of a Change of Control, as hereafter
defined, which results in Mr. Conniff's termination or in a material change in
Mr. Conniff's compensation, benefits, title, responsibility or location, Mr.
Conniff will be considered terminated without cause and will be entitled to the
benefits and compensation described in Section 13.1; Termination Without Cause,
except that the amount payable under Section 13.1 (i) will be as follows: a lump
sum payment within 10 days after termination date, equal to twice the aggregate
of his annual Base Salary, annual auto allowance and Average Annual Performance
Bonus paid, if any, less deductions.
The term "Change in Control" shall mean the occurrence of any of the
following events with respect to the Employer (with the term "Employer" 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
Employer to own 100% of the Employer'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 authorities
having jurisdiction over the Employer or any stock exchange on which the
Employer's shares are listed which requires the reporting of a change in
control; (ii) any merger, consolidation or reorganization of the Employer in
which the Employer 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 Employer having an aggregate fair market
value of fifty percent (50%) of the total value of the assets of the Employer,
reflected in the most recent balance sheet of the Employer; (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
<PAGE> 5
owner, directly or indirectly, of securities of the Employer representing
twenty-five (25%) or more of the combined voting power of the Employer'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 Employer cease for any reason to constitute at least a majority
thereof, unless the election, or the nomination for election by the Employer's
shareholders, of each new director is approved by a vote of at least
three-quarters (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 of Control" for
purposes of the Agreement if the event which would otherwise come within the
meaning of the term: "Change of Control" involves (i) a reorganization at the
direction of the Employer solely to form a parent bank holding company which
owns 100% of the Employer's common stock following the reorganization, or (ii)
an Employees Stock Ownership Plan sponsored by the Employer or its parent
holding company which is the party that acquires "control", as described above.
The term "Average Annual Performance Bonus", as used herein, shall mean the
higher of (i) Mr. Conniff's annual performance bonuses averaged from the date of
this Agreement or (ii) the average of his previous three annual performance
bonuses.
13.3 Voluntary Termination. If Mr. Conniff decides of his own volition to
terminate his employment under this Agreement prior to the end of the Term, the
Bank shall be entitled to, and he shall provide the Bank with, one month's prior
written notice; provided however, upon receiving such notice, the Bank may
terminate his employment immediately and pay him for the one-month period that
the notice otherwise would have run, in addition to all other amounts then due
and payable under this Agreement.
14. Confidential and Proprietary Information. Mr. Conniff agrees that all
information, including but not limited to that which is directly or indirectly
related to the Bank's financial status, profitability, deposit base,portfolio
size and quality as well as its customers and prospective customers is
confidential and proprietary to the Bank and that he will maintain such
information as confidential. Mr. Conniff agrees that as a condition of
employment, he will execute such form of confidentiality agreement as the Board
may adopt from time to time for senior officers of the Bank.
15. No Conflicting Agreements. Mr. Conniff represents that his
performance of all of the terms of this Agreement and any service to be rendered
as an employee of the Bank does not and shall not breach any fiduciary or other
duty or any covenant, agreement or understanding, including without limitation,
any agreement relating to any proprietary information, knowledge or data
acquired by him in confidence, trust or otherwise,prior to his employment by the
Bank to which he is a party or by the terms of which he may be bound. Mr.
Conniff covenants and agrees that he shall not disclose to the Bank, or induce
the Bank to use, any proprietary information, knowledge or data, belonging to
any previous employer or others and that he will disclose to the Bank the term
and subject of any prior confidentiality agreement or agreements he has entered
into Mr. Conniff further covenants and agrees not to enter into any agreement or
understanding, either written or oral, in conflict with the provisions of this
Agreement. Further, Richard L. Conniff agrees that for a period of one year
after payment of full and final severance, pursuant either to Section 13.1
(Termination Without Cause) or Section 13.2 (Change of Control), he will
<PAGE> 6
not (i) directly solicit the services of any employee of the Bank or directly
encourage any employee to discontinue his or her employment with the Bank, or
(ii) directly solicit or encourage any customer of the Bank to curtail in any
way the business that customer does with the Bank.
16. Successors and Assigns. This Agreement shall inure to the benefit of
and be binding upon the Bank and any of its successors and assigns. In view of
the personal nature of the services to be performed under this Agreement by Mr.
Conniff, he shall not have the right to assign or transfer any of his rights,
obligations or benefits under this Agreement, except as otherwise noted herein.
17. Governing Law. This Agreement shall at all times and in all respects
be governed by the laws of the State of California applicable to transactions
wholly performed in California between California residents.
18. Mediation. Prior to engaging in any legal or equitable litigation or
other dispute resolution process, regarding any of the terms and conditions of
this agreement between the parties, or concerning the subject matter of the
agreement between the parties, each party specifically agrees to engage, in good
faith, in a mediation process at the expense of the Bank, complying with the
procedures provided for under California Evidence Code, Sections 1115 through
and including 1125 as then currently in effect. The parties further and
specifically agree to use their best efforts to reach a mutually agreeable
resolution of the matter.
19. Advice to Seek Counsel. Mr. Conniff acknowledges that the Bank has
advised him that this Agreement imposes legal obligations upon him and that he
should consult with legal counsel with regard to this Agreement.
20. Notices. Any notice required to be given hereunder shall be
sufficient if in writing and sent by certified or registered mail, return
receipt requested, first class postage paid. The applicable address for the
Bank is at its principal office in San Jose, attention to the CEO. Mr. Conniff's
address shall be as shown on the Bank's records. Notices shall be deemed given
when actually received, or three days after mailing, whichever is earlier.
21. Entire Agreement. This Agreement and any attachments hereto contain
the entire agreement and understanding by and between the Bank and Mr. Conniff
and with respect to the subject matter herein, and no representation, promise,
agreement or understanding, written of oral, not herein contained shall be of
any force or effect. No modification hereof shall be valid or binding unless in
writing and signed by the party intended to be bound. No waiver of any
provision of this Agreement shall be valid unless in writing and signed by the
party against whom such waiver is sought to be enforced. No valid waiver of any
provision of this Agreement at any time shall be deemed a waiver of any other
provision of this Agreement, or shall be deemed a valid waiver of any such
provision at any other time.
If any provision of this Agreement is held by a court of competent jurisdiction
or an arbitration body to be invalid, void or unenforceable, the remaining
provisions of this Agreement shall, nonetheless, continue in full force without
being impaired or invalidated in any way.
<PAGE> 7
22. Headings. The headings and other captions in this Agreement are for
convenience and reference only and shall not be used in interpreting, construing
or enforcing any of the provisions of this Agreement.
23. Regulatory Approval. In the event that any regulatory authority
with jurisdiction over the Bank shall disapprove any provision of this
Agreement, then the parties hereto shall use their best efforts, acting in good
faith, to amend the Agreement in a manner that will be acceptable to the
parties and to the regulatory authorities.
In witness whereof, the Bank and Richard L. Conniff have duly executed this
Agreement and it is effective as of the day and year first set forth above.
HERITAGE BANK OF COMMERCE & HERITAGE COMMERCE CORP.
By: /s/ [SIG] Date: December 8, 1998
------------------------- -------------------------
Title: CEO
----------------------
ACCEPTED BY:
/s/ RICHARD L. CONNIFF Date: December 8, 1998
- ---------------------------- -------------------------
Richard L. Conniff
<PAGE> 1
EMPLOYMENT AGREEMENT
WILLIAM B. NETHERCOTT
This employment agreement (the "Agreement") is entered into as of April 16, 1998
(the "Effective Date"), by and between Heritage Bank of Commerce, a California
banking corporation (the "Bank"), and William B. Nethercott on the following
terms and conditions.
1. Position. Nethercott shall be the Executive Vice President and Chief
Operating Officer ("COO") of Heritage Bank East Bay (in organization) ("HBEB").
In that role, Nethercott shall be subject to the direction of the CEO and the
Board of Directors of HBEB (the "Board"). The parties acknowledge that so long
as Heritage Bank East Bay is in organization, Nethercott shall be an Executive
Vice President of Bank and subject to the direction of the CEO and Board of
Directors of Bank. Nethercott shall also be nominated to serve on the initial
Board of Directors of HBEB. For purposes of this Agreement, the parties
acknowledge that "Bank" and "HBEB" are interchangeable, subject to approval of
the de novo application of Heritage Bank East Bay.
The COO will set a high standard of conduct courtesy and concern, of
professional and personal discretion and responsibility, forthrightness, thrift,
modesty and hard work. In light of this role with the Bank and the Bank's
position in the industry, the COO will serve as model for all employees of the
Bank. Given Nethercott's role with the Bank and Nethercott's responsibility
relative to the Bank's presence and stature in the community, Nethercott will,
at all times, emulate this high standard of conduct in order to develop and
enhance the Bank's reputation and image.
The COO shall comply with all pertinent regulatory standards as may affect the
Bank.
The COO shall devote his entire productive time, attention and energy to the
business of the Bank. In a manner and with such results as are consistent with
his compensation and position, Nethercott will service the Bank's existing
relationships and cultivate and foster new relationships for the Bank. Such new
relationships shall be consistent with the Bank's mission and shall generally
improve the Bank's share of market, volume of business, profitability and return
of assets.
The COO will at all times keep the Board and appropriate members of the Bank's
management informed of his activities in the community. He will introduce his
customers and potential customers and other business and civic contacts to
appropriate members of the Bank's management and to appropriate Board members
and to other employees of the Bank in order to enhance and solidify the Bank's
prospects and position.
The COO will exercise diligence with respect to the control of the direct and
indirect costs of his activities on behalf of the Bank.
<PAGE> 2
In Addition to the above, Nethercott shall:
(b) be responsible for the operation of the Bank, its properties and
related interest in accordance with the direction of the CEO, the management
philosophy of the Board, the basic objectives of the Board and policy as
established by the various Board committees;
(c) be responsible to the CEO and the Board for operating the Bank on a
profitable basis and for the attainment of profit goals established by the
Board;
(d) exercise diligence with respect to the control of the costs of
operation and other expenses directly or indirectly involving interests of the
Bank;
(e) be responsible for achieving the broad objectives of business
development, including growth of both loans and deposits as well as fee or
deposit compensated products of the Bank;
(f) be responsible for the loan portfolio, for budgeting, finance and
accounting, and for strategic planning of the bank; and
(g) be responsible for forming and developing the staff in a manner
consistent with the Bank's immediate needs and strategic goals.
2. Term. The Term of this Agreement shall be three years from the
Effective Date hereof. Upon the termination of his employment, neither
Nethercott nor the Bank shall have any further obligation to the other, except
as set forth in paragraph 5, and 18.
3. Base Salary. For the Term of this Agreement while he is an employee,
the Bank shall pay Nethercott per year ("Base Salary") at a rate of $3,958.33
per bi-monthly pay period, in accordance with the Bank's normal payroll
procedures, less appropriate withholdings, taxes and similar deductions. On the
first day of the seventh month following Nethercott's first day of employment,
Nethercott will be paid a one time amount equal to $5,000.00, as additional
base. Nethercott's Base Salary will be reviewed annually by the CEO and Board of
Directors, consistent with the schedule applied to the annual review of all
executive officers.
4. Performance Bonuses. From time to time, but not less than annually,
subject to the discretion of the Board, the Bank shall undertake, in good faith,
to pay performance bonuses during the Term of this Agreement while Nethercott is
an employee. The Bank shall not be obligated to pay any specific amount pursuant
to this section. Nethercott shall be eligible for Performance Bonuses and the
Bank shall, in good faith, pay Performance Bonuses in amounts that it deems
reasonable on the basis of the following criteria. If Performance Bonuses are
paid, the amounts of such generally will be comparable to similarly placed
executives at similarly performing financial institutions, and shall be based on
Nethercott's overall performance and that of the Bank, including such
<PAGE> 3
factors as profitability, deposit base, loan portfolio size and quality,
adequacy of the loan loss reserve, the capital position of the Bank and the
satisfactory nature of regulatory examinations.
5. Incentive Stock Options. At its first meeting after Nethercott's
first day of employment, the Board of the Holding Company shall grant to
Nethercott incentive stock options to acquire 15,000 shares of the Heritage
Commerce Corp's common stock at the then market price, as determined by the
Board. Nethercott's right to exercise such options shall vest and be
exercisable monthly commencing the last day of the first calendar month
following the Effective Date of this Agreement ("Commencement Date"). The
number of options vesting on the Commencement date and daily thereafter shall
be 1/1460th of the total number of options granted to William Nethercott hereby
except that in the event of a merger or acquisition of the Bank or in the
event of Nethercott's death or disability, the vesting shall immediately
accelerate to a fully vested status.
From time to time, the Board will review the performance of Nethercott and may
grant, in its sole discretion, additional options under a stock option plan.
The Board may grant such additional options as it deems appropriate in order to
recognize performance for the preceding year and in order to provide the
incentive to sustain and enhance the operations performance of the Bank.
6. Termination and Severance. Each party has the right to terminate
Nethercott's employment with the Bank prior to the end of the Term Specified
in paragraph 2 with or without cause at any time. For purposes of this
Agreement, cause shall arise if (i) Nethercott willfully breach or habitually
neglect the duties which Nethercott is required to perform under this
Agreement, (ii) Nethercott commits an intentional act that has a material
detrimental effect on the reputation or business of the Bank, of (iii)
Nethercott is convicted of a felony or Nethercott commits any such act of
dishonesty, fraud, intentional misrepresentation or moral turpitude as would
prevent effective performance of Nethercott's duties under this Agreement. If
the Bank decides to terminate Nethercott's employment for cause, the Bank shall
provide Nethercott with notice specifying the grounds for termination,
accompanied by a written statement stating the relevant facts supporting such
grounds. Upon termination of Nethercott's employment for cause, Nethercott
shall not be entitled to any further amounts except for the Base Salary earned
through Nethercott's last day of employment.
If the Bank terminates Nethercott's employment without cause, the Bank will
provide Nethercott, as Nethercott's full and final severance, the following:
(i) a lump sum payment equal to one half of the sum of Nethercott's average
annual Base Salary plus average annual bonuses, if any, paid for the term of
this agreement, less deductions, (ii) if Nethercott is insured under the Bank's
standard group medical plan at the time of Nethercott's termination, the Bank
will pay the cost of the premiums for Nethercott's health coverage under that
plan for six months, (iii) the cost of life insurance for six months, in
amounts and with coverage as applicable just prior to Nethercott's last day of
employment, and (iv) the cost of disability insurance, in amounts and with
coverage as
3
<PAGE> 4
applicable just prior to his last day of employment for six months. Thereafter,
Nethercott shall be responsible for such payments if Nethercott so choose.
If Nethercott decides to terminate Nethercott's employment under this Agreement
prior to the end of the Term, the Bank shall be entitled to, and Nethercott
shall provide the Bank with, one month's prior written notice; provided
however, upon receiving such notice, the Bank may terminate Nethercott's
employment immediately and pay Nethercott for the one-month period that the
notice otherwise would have run, in addition to all other amounts then due and
payable under this Agreement.
7. Automobile Allowance. During the Term of this Agreement, the Bank
shall pay Nethercott a $450.00 monthly auto allowance plus the cost of fuel for
business auto use.
8. Medical Insurance. The Bank shall provide medical insurance to
Nethercott and Nethercott's family with options and coverages consistent with
those of the Bank's group medical plan as in effect from time to time.
9. Life Insurance. The Bank shall provide Nethercott with life insurance
on Nethercott's life, to the same extent the Bank provides life insurance to
its full time employees. Nethercott shall be entitled to designate the
beneficiary of the life insurance provided by this section.
10. Disability Insurance. The Bank shall provide Nethercott with long
term disability insurance to the same extent the Bank provides such disability
insurance to its full time employees.
11. Indemnification by the Bank. The Bank shall indemnify and hold
Nethercott harmless to the extent provided in the Bank's By-Laws for officers
and directors.
12. Monthly Expenses Account. Subject to the Bank's Expense Reimbursement
Policy, Nethercott shall be reimbursed by the Bank for Nethercott's reasonable
and necessary business expenses incurred in furthering the Bank's interests.
Nethercott will prepare and submit expense reports promptly.
13. Vacation. During the period of this Agreement, Nethercott shall
accrue vacation consistent with the personnel policy of the Bank, but in no
event at less than four weeks per year. In the event that while Nethercott is
an employee, Nethercott receives any compensation in lieu of accrued vacation,
such payment shall be considered cash compensation in addition to Base Salary.
14. Confidential and Proprietary Information. William Nethercott agrees
that all information, including but not limited to that which is directly or
indirectly related to the Bank's financial status, profitability, deposit base,
portfolio size and quality as well as
4
<PAGE> 5
its customers and prospective customers is confidential and proprietary to the
Bank and that he will maintain such information as confidential. William
Nethercott agrees that as a condition of employment he will execute such form of
confidentiality agreement as the Board may adopt from time to time for senior
officers of the Bank.
15. No Conflicting Agreements. William Nethercott represents that his
performance of all of the terms of this Agreement and any service to be
rendered as an employee of the Bank does not and shall not breach any fiduciary
or other duty or any covenant, agreement or understanding, including without
limitation, any agreement relating to any proprietary information, knowledge or
data acquired by William Nethercott in confidence, trust or otherwise, prior to
William Nethercott's employment by the Bank to which William Nethercott is a
party or by the terms of which William Nethercott may be bound. William
Nethercott covenants and agrees that he shall not disclose to the Bank, or
induce the Bank to use, any proprietary information, knowledge or data,
belonging to any previous employer or others and that William Nethercott will
disclose to the Bank the term and subject of any prior confidentiality agreement
or agreements William Nethercott has entered into. William Nethercott further
covenants and agrees not to enter into any agreement or understanding, either
written or oral, in conflict with the provisions of this Agreement.
16. Successors and Assigns. This Agreement shall inure to the benefit of
and be binding upon the Bank and any of its successors and assigns. In view of
the personal nature of the services to be performed under this Agreement by
William Nethercott, he shall not have the right to assign or transfer any of
his rights, obligations or benefits under this Agreement, except as otherwise
noted herein.
17. Governing Law. This Agreement shall at all times and in all respects
be governed by the laws of the State of California applicable to transactions
wholly performed in California between California residents.
18. Arbitration. Any controversy between Nethercott and Bank involving
the construction or application of any of the terms, provisions or conditions
of this Agreement, or of Nethercott's employment by Bank, shall be fully and
finally resolved solely by binding arbitration conducted by American
Arbitration Association. Arbitration shall comply with, and be governed by, the
California Code of Civil Procedure arbitration provisions. Prior to
arbitration, the parties may seek mediation through a mutually agreeable
mediator.
19. Advice to Seek Counsel. Nethercott acknowledges that he has been
advised by the Bank that this Agreement imposes legal obligations upon
Nethercott to consult with legal counsel with regard to this Agreement.
Nethercott acknowledges that Nethercott has been afforded the opportunity to
obtain legal counseling with regard to this Agreement. The cost of such counsel
shall be at Nethercott's expense.
5
<PAGE> 6
20. Notices. Any notice required to be given thereunder shall be
sufficient if in writing and sent by certified or registered mail, return
receipt requested, first class postage paid. The applicable address for the
Bank is at its principal office in Fremont, attention the CEO. Nethercott's
applicable address shall be as shown on the Bank's records. Notices shall be
deemed given when actually received, or three days after mailing, whichever is
earlier.
21. Entire Agreement. This Agreement and any attachments hereto contain
the entire agreement and understanding by and between Nethercott and the Bank
and with respect to the subject matter herein, no representation, promise,
agreement or understanding, written or oral, not herein contained shall be of
any force or effect. No modification hereof shall be valid or binding unless in
writing and signed by the party intended to be bound. No waiver of any
provision of this Agreement shall be valid unless in writing and signed by the
party against whom such waiver is sought to be enforced. No valid waiver of any
provision of this Agreement at any time shall be deemed a waiver of any other
provision of this Agreement, or shall be deemed a valid waiver of any of such
provision at any other time.
If any provision of this Agreement is held by a court of competent jurisdiction
or an arbitration body to be invalid, void or unenforceable, the remaining
provisions of this Agreement shall, nonetheless, continue in full force without
being impaired or invalidated in any way.
22. Headings. The headings and other captions in this Agreement are for
convenience and reference only and shall not be used in interpreting,
construing or enforcing any of the provisions of this Agreement.
23. Regulatory Approval. In the event that any regulatory authority with
jurisdiction over the Bank shall disapprove any provision of this Agreement,
then the parties hereto shall use their best efforts, acting in good faith, to
amend the Agreement in a manner that will be acceptable to the parties and to
the regulatory authorities.
In witness whereof, the Bank and William Nethercott have duly executed this
Agreement and it is effective as of the day and year first set forth above.
HERITAGE BANK OF COMMERCE ACCEPTED BY:
By: [sig] /s/ William B. Nethercott
---------------------------- ----------------------------
William B. Nethercott
Title: President, Fremont Office
<PAGE> 1
EMPLOYMENT AGREEMENT
This employment agreement (the "Agreement") is entered into effect as of July
16, 1998 (the "Effective Date"), by and between Heritage Commerce Corp (the
"Company" or "Bank") and its wholly owned subsidiary, Heritage Bank of Commerce
("HBC") a California banking corporation and Lawrence McGovern (McGovern) on
the following terms and conditions.
1. Position
Mr. McGovern shall be the Executive Vice President and Chief Financial Officer
(CFO) of Heritage Commerce Corp. Mr. McGovern shall be subject to the direction
of the CEO of the Company and, by extension, the Board of Directors of the
Company.
The term "Bank" is intended to mean Company and/or any of its subsidiaries, as
applicable. The term "Management" is intended to mean the CEO and/or, as
applicable, those duly appointed management committees vested with
decision-making authority of the Company. The term "Board" shall, unless more
narrowly defined in the context of its immediate usage, mean any and all boards
of directors with purview over the matter at hand.
The Parties agree that during the term of this Agreement, Mr. McGovern may
serve as an executive level officer of the Company, HBC, or other subsidiaries
of Company yet to be formed. Although Mr. McGovern's specific job description
may change from time to time, the terms and conditions of the Agreement as
defined in Sections 2 through 23 will remain in full force and effect.
The CFO will set a high standard of conduct, courtesy and concern of
professional and personal discretion, responsibility, forthrightness and hard
work. The CFO shall comply with all pertinent financial and accounting
regulatory standards as may affect the Company.
The CFO during normal working hours shall devote his entire productive time,
attention and energy to the business of the Company and shall perform in a
manner and with such results as are consistent with his compensation and
position. The CFO will, at all times, keep Bank Management informed of all
financial and operational data which is relevant to the proper management of
the Company and of his activities undertaken in the context of his role,
including his activities in the community. He will be diligent in developing
and maintaining useful contacts with members of industry, the legal,
accounting, banking and investment banking communities and with vendors to the
Bank of services relating to these areas.
The CFO will be responsible for contributing appropriately to the achievement
of optimal profitability and for the safety and soundness of the Company.
1
<PAGE> 2
In addition to the above, Mr. McGovern's duties and responsibilities require
that he shall:
(a) perform his duties as CFO in accordance with the directives of
management and in accordance with the objectives and/or policies of
the Board;
(b) exercise diligence with respect to the control of the costs of
operation and other expenses directly or indirectly involving
interests of the Company;
(c) be responsible for budgeting, finance, accounting, planning and for
forming and developing the accounting staff under his purview in a
manner consistent with the Company's immediate needs and strategic
goals;
(d) Manage the Company's liquidity position and investment portfolio;
(e) be responsible for the day-to-day financial and accounting position of
the Company; and
(f) be responsible for providing timely and accurate financial reporting
to management and to all appropriate regulatory agencies and outside
auditors.
2. Term.
The Term of this Agreement will be three years from the Effective Date hereof.
At maturity, and annually thereafter, unless otherwise amended or terminated,
this Agreement shall automatically renew for a term of one year. Upon the
termination of Mr. McGovern's employment, neither he nor the Company shall have
any further obligation to the other, except as set forth in Paragraphs 5, 10,
13, 16, 18, and 24 herein.
3. Base Salary.
For the Term of this Agreement while he is an employee, the Company shall pay
$125,000 per year ("Base Salary"), in accordance with the Company's normal
payroll procedures, less appropriate withholdings, taxes and similar deductions.
The Base Salary will be reviewed annually by the CEO and, at the CEO's
discretion, the Personnel and Planning Committee of the Company. The Base
Salary, as adjusted, shall be pro-rated for any partial year.
4. Performance Bonuses.
From time to time, but not less than annually, subject to the discretion of the
Board, the Company shall undertake, in good faith, to pay performance bonuses
during the Term of this Agreement. The Company shall not be obligated to pay any
specific amount pursuant to this paragraph. Mr. McGovern will be eligible for
Performance Bonuses and the Company will, in good faith, pay Performance Bonuses
in amounts that it deems reasonable on the basis of the criteria outlined
herein. If Performance Bonuses are paid,
2
<PAGE> 3
the amounts of such shall be based on Mr. McGovern's overall performance and
that of the Company, including such factors as profitability, deposit base, loan
portfolio size and quality, adequacy of the loan loss reserve, the capital
position of the Company and the satisfactory nature of regulatory examinations.
5. Incentive Stock Options.
The Board of the Company has granted to Mr. McGovern, incentive stock options to
acquire 30,000 shares of the Company's common stock pursuant to the Heritage
Commerce Corp 1994 Tandem Stock Option Plan. The Board, in its discretion, may
grant such additional options, as it deems appropriate in order to recognize
performance and in order to provide Mr. McGovern with the incentive to sustain
and enhance the operational performance of the Company in the future.
6. Automobile Allowance.
During the Term of this Agreement, the Company shall pay Mr. McGovern a $350.00
monthly auto allowance.
7. Medical Insurance.
The Company shall provide medical insurance to Mr. McGovern and his family with
options and coverage consistent with those of the Company's group medical plan
as in effect from time to time.
8. Life Insurance.
The Company shall provide Mr. McGovern life insurance to the same extent the
Company provides life insurance to its executive officers, which shall be not
less than the amount provided upon Mr. McGovern's initial employment. He shall
be entitled to designate the beneficiary of the life insurance provided by this
section.
9. Disability Insurance.
The Company shall provide Mr. McGovern long-term disability insurance to the
same extent the Company provides such disability insurance to its executive
officers.
10. Indemnification by the Company.
The Company and Company will indemnify and hold Mr. McGovern harmless pursuant
to the certain Indemnification Agreement dated October 7 1998, and executed by
Mr. McGovern and the Company and also to the extent provided in the Company's
by-laws for officers and directors.
3
<PAGE> 4
11. Monthly Expenses Account.
Subject to the Company's Expense Reimbursement Policy, Mr. McGovern shall be
reimbursed by the Company for his reasonable and necessary business expenses
incurred in furthering the Company's interests, including automobile fuel used
in the performance of this agreement. He will prepare and submit expense
reports promptly.
12. Vacation.
During the period of this Agreement, Mr. McGovern shall accrue vacation
consistent with the personnel policy of the Company, but in no event at a rate
of less than four weeks per year. In the event that while he is an employee, he
receives any compensation in lieu of accrued vacation, such payment shall be
considered cash compensation in addition to Base Salary and will not be
included in severance calculations call for in Section 13.1, Termination
without Cause, or in Section 13.2, Change of Control, hereunder.
13. Termination and Severance.
Each party has the right to terminate Mr. McGovern's employment with the
Company prior to the end of the Term specified in paragraph 2 with or without
cause at any time. For purposes of this Agreement, cause shall arise if (i) he
willfully breaches or habitually neglect the duties which he is required to
perform under this Agreement, (ii) commits an intentional act that has a
material detrimental effect on the reputation or business of the Company, or
(iii) he is convicted of a felony or commits any such act of dishonesty, fraud,
intentional misrepresentation or moral turpitude as would prevent effective
performance of his duties under this Agreement. If the Company decides to
terminate Mr. McGovern's employment for cause, the Company shall provide him
with notice specifying the grounds for termination, accompanied by a written
statement stating the relevant facts supporting such grounds. Upon termination
of his employment for cause, he shall not be entitled to any further amounts
except for the Base Salary accrued and unpaid vacation pay and any rights under
the stock option plan earned through his last day of employment.
13.1 Termination Without Cause.
If the Company terminates Mr. McGovern's employment without cause, the Company
will provide him as his full and final severance the following: (i) a lump sum
payment within 10 days after termination date, equal to the annual Base Salary,
annual auto allowance and Average Annual Performance Bonus, (as defined below)
paid less normal payroll deductions, (ii) if he is covered under the Company's
standard group medical and dental plan at the time of his termination, the
Company will continue to provide equivalent coverage under C.O.B.R.A. for 12
months after the date of termination at no cost to Mr. McGovern; (iii) the
Company will continue to provide life insurance (in amounts and with coverage
equivalent to coverage provided immediately prior to his last day of
employment) for one year at no cost to Mr. McGovern (thereafter, Mr. McGovern
shall be responsible for such payments if he so chooses; and (iv) the Company
will continue to provide disability insurance (in amounts and with coverage
equivalent to coverage provided immediately prior to his last day of
employment) for 12 months at no cost to Mr.
4
<PAGE> 5
McGovern (thereafter, Mr. McGovern shall be responsible for such payments if he
so chooses); (v) the Company will reimburse Mr. McGovern for bona fide
professional out-placement services, not to exceed $5,000.
13.2 Change of Control
In the event of a Change of Control, as hereafter defined, which results in Mr.
McGovern's termination or in a material change in Mr. McGovern's compensation,
benefits,title, responsibility or principal location, Mr. McGovern will be
considered terminated without cause and will be entitled to the benefits and
compensation described in section 13.1, Termination Without Cause, except that
the amount payable under Section 13.1 (i) will be as follows: a lump sum payment
within 10 days after termination date,equal to one and half times the aggregate
of his annual Base Salary, annual auto allowance and Average Annual Performance
Bonus paid, if any, less normal payroll deductions. A change of location shall
be considered material only if it exceeds a change of more than 10 miles from
150 Almaden Blvd., San Jose, CA.
The term "Change in Control" shall mean the occurrence of any of the following
events with respect to the Employer (with the term "Employer" being defined for
purposes of determining whether a "Change in Control" has occurred to mean the
Company, HBC or any parent bank holding company organized at the direction of
the Company or HBC to own 100% of the outstanding common stock of the Company or
HBC): (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
thee 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
authorities having jurisdiction over the Employer or any stock exchange on which
the Employer's shares are listed which requires the reporting of a change in
control; (ii) any merger, consolidation or reorganization of the Employer in
which the Employer 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 Employer having an aggregate fair market
value of fifty percent (50%) of the total value of the assets of the Employer,
reflected in the most recent balance sheet of the Employer; (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, of securities of the Employer
representing twenty-five (25%) or more of the combined voting power of the
Employer'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 Employer cease for any reason to constitute at least a
majority thereof, unless the election, or the nomination for election by the
Employer's shareholders, of each new director is approved by a vote of at least
three-quarters (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 of Control" for
purposes of the Agreement if the event which would otherwise come within the
meaning of the term: "Change of Control" involves (i) a reorganization at the
direction of the Employer solely to form a parent bank holding company which
owns 100% of the Employer's common stock
5
<PAGE> 6
following the reorganization, or (ii) an Employee Stock Ownership Plan
sponsored by the Employer or its parent holding company which is the party that
acquires "control", as described above.
The term "Average Annual Performance Bonus," as used herein, shall mean the
higher of (i) Mr. McGovern's annual performance bonuses averaged from the date
of this Agreement or (ii) the average of his previous three annual performance
bonuses excluding any year a performance bonus wage was not paid.
13.3 Voluntary Termination.
If Mr. McGovern decides of his own volition to terminate his employment under
this Agreement prior to the end of the Term, the Company shall be entitled to,
and he shall provide the Company with, one month's prior written notice;
provided however, upon receiving such notice, the Company may terminate his
employment immediately and pay him for the one-month period that the notice
otherwise would have run, in addition to all other amounts then due and payable
under this Agreement.
14. Confidential and Proprietary Information.
Mr. McGovern agrees that all information, including but not limited to that
which is directly or indirectly related to the Company's financial status,
profitability, deposit base, portfolio size and quality as well as its
customers and prospective customers is confidential and proprietary to the
Company and that he will maintain such information as confidential. Mr.
McGovern agrees that as a condition of employment, he will execute such form
of confidentiality agreement as the Board may adopt from time to time for
senior officers of the Company to the extent such agreement is consistent with
Paragraph 14.
15. No Conflicting Agreements.
Mr. McGovern represents that his performance of all of the terms of this
Agreement and any service to be rendered as an employee of the Company does not
and shall not breach any fiduciary or other duty or any covenant, agreement or
understanding, including without limitation, any agreement relating to any
proprietary information, knowledge or data acquired by him in confidence, trust
or otherwise, prior to his employment by the Company to which he is a party or
by the terms of which he may be bound. Mr. McGovern covenants and agrees that he
shall not disclose to the Company, or induce the Company to use, any proprietary
information, knowledge or data, belonging to any previous employer or others and
that he will disclose to the Company the term and subject of any prior
confidentiality agreement or agreements he has entered into. Mr. McGovern
further covenants and agrees not to enter into any agreement or understanding,
either written or oral, in conflict with the provisions of this Agreement.
Further, Mr. McGovern agrees that for a period of one year after payment of full
and final severance, pursuant either to Section 13.1 (Termination Without Cause)
or Section 13.2 (Change of Control), he will not directly solicit the services
of any employee of the Company or directly encourage any employee to discontinue
his or her employment with the Company.
6
<PAGE> 7
16. Successors and Assigns.
This Agreement shall inure to the benefit of and be binding upon the Company
and any of its successors and assigns. In view of the personal nature of the
services to be performed under this Agreement by Mr. McGovern, he shall not
have the right to assign or transfer any of his rights, obligations or benefits
under this Agreement, except as otherwise noted herein.
17. Governing Law.
This Agreement shall at all times and in all respects be governed by the laws
of the State of California applicable to transactions wholly performed in
California between California residents.
18. Mediation.
Prior to engaging in any legal or equitable litigation or other dispute
resolution process, regarding any of the terms and conditions of this agreement
between the parties, or concerning the subject matter of the agreement between
the parties, each party specifically agrees to engage, in good faith, in a
mediation process at the expense of the Company, complying with the procedures
provided for under California Evidence Code, Sections 1115 through and including
1125 as then currently in effect. The parties further and specifically agree to
use their best efforts to reach a mutually agreeable resolution of the matter.
The parties understand and specifically agree that should any party(ies) to
this Agreement refuse to participate in mediation for any reason, the other
party(ies) shall be entitled to seek a court order to enforce this provision in
any court of appropriate jurisdiction requiring the dissenting party to attend,
participate, and to make a good faith effort in the mediation process to reach
a mutually agreeable resolution of the matter. Parties to this Agreement agree
to use the American Arbitration Association model for any and all employment
mediation.
19. Advice to Seek Counsel.
Mr. McGovern acknowledges that the Company has advised his that this Agreement
imposes legal obligations upon him and that he should consult with legal
counsel with regard to this Agreement. The Company will bear the cost of legal
review up to a maximum of $1000.
20. Notices. Any notice required to be given hereunder shall be sufficient if
in writing and sent by certified or registered mail, return receipt requested,
first class postage paid. The applicable address for the Company is at its
principal office in San Jose, attention to the CEO. Mr. McGovern's address shall
be shown on the Company's records. Notices shall be deemed given when actually
received, or three days after mailing, whichever is earlier.
7
<PAGE> 8
21. Entire Agreement.
Except as provided in paragraph 8 and paragraph 10, this Agreement and any
attachments hereto contain the entire agreement and understanding by and between
the Company and Mr. McGovern and with respect to the subject matter herein, and
no representation, promise, agreement or understanding, written or oral, not
herein contained shall be of any force or effect. No modification hereof shall
be valid or binding unless in writing and signed by the party intended to be
bound. No waiver of any provision of this Agreement shall be valid unless in
writing and signed by the party against whom such waiver is sought to be
enforced. No valid waiver of any provision of this Agreement at any time shall
be deemed a waiver of any other provision of this Agreement, or shall be deemed
a valid waiver of any of such provision at any other time.
If any provision of this Agreement is held by a court of competent jurisdiction
or an arbitration body to be invalid, void or unenforceable, the remaining
provisions of this Agreement shall, nonetheless, continue in full force without
being impaired or invalidated in any way.
22. Headings.
The headings and other captions in this Agreement are for convenience and
reference only and shall not be used in interpreting, construing or enforcing
any of the provisions of this Agreement.
23. Regulatory Approval.
In the event that any regulatory authority with jurisdiction over the Bank
shall disapprove any provision of this Agreement, then the parties hereto shall
use their best efforts, acting in good faith, to amend the Agreement in a
manner that will be acceptable to the parties and to the regulatory authorities.
24. Attorney's Fees Clause.
If any legal action or any arbitration or other proceeding is brought for the
enforcement of this Agreement or because of any dispute or alleged breach, the
fault or misrepresentation in connection with any of the provisions of this
agreement, the successful or prevailing party shall be entitled to recover
reasonable attorney fees and other costs incurred in that action or proceeding,
in addition to any other relief which they may be entitled to.
8
<PAGE> 9
IN WITNESS HEREOF, THE COMPANY AND MR. MCGOVERN HAVE DULY EXECUTED THIS
AGREEMENT AND IT IS EFFECTIVE AS OF THE DAY AND YEAR FIRST SET FORTH ABOVE.
HERITAGE BANK OF COMMERCE
By: /s/ [SIG] Date: 2-19-99
-------------------------- -------------
Title: CEO
-----------------------
HERITAGE COMMERCE CORPORATION
By: /s/ [SIG] Date: 2-19-99
-------------------------- -------------
Title: CEO
-----------------------
ACCEPTED BY:
/s/ LAWRENCE MCGOVERN Date: 2-19-99
- ------------------------------ -------------
Lawrence McGovern
9
<PAGE> 1
EXHIBIT 21.1
SUBSIDIARIES OF THE REGISTRANT
<TABLE>
<CAPTION>
Name of Subsidiary State of Incorporation
- ------------------ ----------------------
<S> <C>
Heritage Bank of Commerce California
Heritage Bank East Bay California
</TABLE>
<PAGE> 1
EXHIBIT 23.1
INDEPENDENT AUDITORS' CONSENT
We consent to the incorporation by reference in Registration Statement No.
333-59277 of Heritage Commerce Corp on Form S-8 of our report dated January 20,
1999, appearing in this Annual Report on Form 10-K of Heritage Commerce Corp for
the year ended December 31, 1998.
/s/ Deloitte & Touche LLP
San Jose, California
March 26, 1999
<PAGE> 1
EXHIBIT 23.2
CONSENT OF INDEPENDENT AUDITORS
The Board of Directors
Heritage Commerce Corp:
We consent to incorporation by reference in the registration statement (No.
333-59277) on Form S-8 of Heritage Commerce Corp. of our report dated January
10, 1997, relating to the statements of income, retained earnings, and cash
flows for the year ended December 31, 1996, of Heritage Bank of Commerce, which
report appears in the December 31, 1998, annual report on Form 10-K of Heritage
Commerce Corp.
/s/ KPMG LLP
Mountain View, California
March 25, 1999
<TABLE> <S> <C>
<ARTICLE> 9
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE HERITAGE
COMMERCE CORP 1998 REPORT ON FORM 10-K AND IS QUALIFIED IN ITS ENTIRETY BY
REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> DEC-31-1998
<CASH> 18,039,000
<INT-BEARING-DEPOSITS> 229,193,000
<FED-FUNDS-SOLD> 28,600,000
<TRADING-ASSETS> 0
<INVESTMENTS-HELD-FOR-SALE> 49,129,000
<INVESTMENTS-CARRYING> 26,544,000
<INVESTMENTS-MARKET> 27,240,000
<LOANS> 236,307,000
<ALLOWANCE> 3,825,000
<TOTAL-ASSETS> 404,931,000
<DEPOSITS> 350,047,000
<SHORT-TERM> 0
<LIABILITIES-OTHER> 5,276,000
<LONG-TERM> 0
0
0
<COMMON> 29,418,000
<OTHER-SE> 1,279,000
<TOTAL-LIABILITIES-AND-EQUITY> 404,931,000
<INTEREST-LOAN> 19,777,000
<INTEREST-INVEST> 5,594,000
<INTEREST-OTHER> 1,533,000
<INTEREST-TOTAL> 26,904,000
<INTEREST-DEPOSIT> 7,948,000
<INTEREST-EXPENSE> 7,951,000
<INTEREST-INCOME-NET> 18,953,000
<LOAN-LOSSES> 1,576,000
<SECURITIES-GAINS> 790,000
<EXPENSE-OTHER> 15,605,000
<INCOME-PRETAX> 3,475,000
<INCOME-PRE-EXTRAORDINARY> 3,475,000
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 2,150,000
<EPS-PRIMARY> 0.41
<EPS-DILUTED> 0.37
<YIELD-ACTUAL> 6.32
<LOANS-NON> 1,288,000
<LOANS-PAST> 0
<LOANS-TROUBLED> 0
<LOANS-PROBLEM> 0
<ALLOWANCE-OPEN> 2,285,000
<CHARGE-OFFS> 173,000
<RECOVERIES> 137,000
<ALLOWANCE-CLOSE> 3,825,000
<ALLOWANCE-DOMESTIC> 3,753,000
<ALLOWANCE-FOREIGN> 0
<ALLOWANCE-UNALLOCATED> 72,000
</TABLE>
