ITEM 1. BUSINESS
GENERAL
Heritage Bank of Commerce (the "Bank") commenced operations as a California state-chartered bank on June 8, 1994. The Bank was organized to address the needs of small, closely-held businesses and their owners in the community of San Jose, California and the surrounding cities. Consolidation in the local banking market, particularly among independent, community banks, left a competitive void that the founders of the Bank sought to fill with an institution devoted to a highly customized service approach. The Bank offers financial solutions tailored to the particular needs of its clients, rather than the formulaic and impersonal approach used by many of the Bank's larger competitors. With an initial capitalization in excess of $14 million, the Bank invested heavily in technology to maximize employee efficiency.
As a result, the Bank has, in the intervening three and one-half years, developed a wide array of products and services for small businesses and their owners, such as factoring, SBA-guarantied loans, light aircraft financing, and personal computer-based on-line cash management, together with more common products such as accounts receivable lines of credit and traditional passbook savings accounts. In addition, the Bank has developed an expertise in unusual areas such as deposit services for U.S. Bankruptcy Trustees. Indeed, the Bank's ability to develop such specialized expertise has been instrumental in its rapid deposit growth. A second equity offering to the public in 1996 that raised an additional $6 million provided a base for continued asset growth and higher lending limits. Recently, the Bank has expanded its geographic reach with the opening of a branch office in Fremont, California.
The Bank's deposit accounts are insured under the Federal Deposit Insurance Act, up to the maximum applicable limits thereof. The Bank is not a member of the Federal Reserve System. The Bank's main office is located in the city of San Jose, California.
Formation of Bank Holding Company
On December 18, 1997, the shareholders of the Bank met at a special meeting to approve the formation of a bank holding company by the adoption of a merger agreement. The merger agreement provides for the Bank to merge and become a wholly-owned subsidiary of the newly formed Heritage Commerce Corp bank holding company (the "Company"). The merger agreement became effective February 17, 1998, when the shareholders of the Bank received one share of the Heritage Commerce Corp common stock for each share of Bank common stock held. The Company is registered with the Board of Governors of the Federal Reserve System (FRB) as a bank holding Company under the Bank Holding Company Act (BHCA). For the purposes of the Securities Exchange Act of 1934, the Company is the successor to the Bank.
In the opinion of the Bank's Board of Directors, a bank holding company structure provides the Bank with certain advantages, including additional flexibility in expansion of the Bank's business through the formation of new subsidiary banks and other Company subsidiaries in new markets, the acquisition of other financial institutions, the raising of additional funds through borrowing (if needed), the ability to repurchase its securities, and flexibility in acquiring or establishing other businesses related to banking, all of which actions are subject to applicable regulatory requirements.
The terms the Bank and the Company are interchangeable throughout this report.
New Branches and Subsidiaries
On February 9, 1998, the Bank opened a full-service branch in the city of Fremont, California. The Bank's Board of Directors view this geographic expansion as a natural extension of the Bank's primary market area to include southern Alameda county, which has a high concentration of potential clients with banking service requirements similar to those of the Bank's current client mix.
Once the branch is established in the community, the Company intends to apply to the California Department of Financial Institutions for authority to organize a de novo bank. Once authorized, the de novo bank will become a subsidiary of the Company and take control of the existing branch in Fremont.
General Banking Services
The Bank's customer base consists primarily of small to medium-sized businesses and their owners, managers, and employees residing in the Santa Clara Valley. Businesses served include manufacturers, distributors, contractors, professional corporations/partnerships, and service businesses. The Bank had approximately 2,700 and 2,300 deposit accounts at December 31, 1997 and 1996, respectively.
The Bank offers a range of loans, primarily commercial, including real estate, construction, Small Business Administration (SBA), inventory and accounts receivable, and equipment loans. The Bank also accepts checking, savings, and time deposits; NOW and money market deposit accounts; and provides travelers' checks, safe deposit, and other customary non-deposit banking services. The Bank issues VISA and MasterCard credit cards through a correspondent bank. The Bank has no subsidiaries and does not have a trust department. In March, 1996, the Bank entered into an agreement to refer trust business to Enterprise Trust & Investment Company (Enterprise), an unaffiliated trust and investment company regulated by the California Department of Financial Institutions. The Bank shares in the fees generated by the business that it refers to Enterprise.
The Bank's main and executive offices are located at 150 Almaden Boulevard, San Jose, California 95113. In addition, the Bank established a branch office at 3077 Stevenson Blvd., Fremont, California 94538. See Item 2
ITEM 2. PROPERTIES
The Bank's main office is located at 150 Almaden Boulevard, San Jose, California. The main office is leased under non-cancelable operating leases with a non-affiliated third party with terms, including renewal options, ranging from five to fourteen years. The primary operating area consists of approximately 13,500 square feet of space comprising the entire usable ground floor and a portion of the second floor of a fifteen-story class-A office building in downtown San Jose, California. The lease arrangement for the primary operating area is a "partial gross lease" for fifteen years commencing June 8, 1996 and expiring February 28, 2010. The monthly rent under the lease for the first five year term is $21,465. During the second five year term the monthly rent increases to $25,515 and will increase to 95 percent of fair rental value starting from year eleven until the term expires. Provisions of the lease include the right to early termination after 120 months.
In addition, approximately 1,255 square feet of space is leased contiguous to the primary operating area for meetings, staff training, and marketing events. The lease for this additional space commenced January 1, 1997 and expires December 31, 2001. The monthly rent for this additional space is $2,259.
In August 1997, the Bank leased an area on the second floor of the Bank's main office containing approximately 2,175 square feet of space. The monthly rent is $4,024 until May 31, 2001, when the monthly rent increase to $4,785 for the following five year period. The rent for the period from May 31, 2006 until the end of the lease will be 95 percent of fair rental value at that time. The lease for this additional space is coterminous with the original lease.
Since April 21, 1997, the Bank has also leased space at 100 Park Center Plaza, Suite 430, San Jose, consisting of approximately 3,277 square feet of space. The lease commenced on April 21, 1997 and will terminate on April 30, 2000. The rent for the entire term of the lease is $5,243 per month.
In February, 1998, the Bank leased space at 3077 Stevenson Blvd., Fremont, California, consisting of 6,590 square feet of space in a stand-alone office building. The lease, which commenced February 1, 1998, is for a ten year period expiring January, 2008. The rent for the first twelve month period is $13,180 per month, and the rent increases annually thereafter by 4% per year.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
To the best of the Bank's knowledge, there are no pending legal proceedings to which the Bank is a party which may have a materially adverse effect on the Bank's financial condition, results of operations, or cashflows.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
On December 18, 1997, the shareholders of the Bank met at a special meeting to approve the formation of a bank holding company by the adoption of a merger agreement. The merger agreement provides for the Bank to merge and become a wholly-owned subsidiary of the newly formed Heritage Commerce Corp bank holding company. At the special meeting, the merger agreement passed with a vote of 2,199,348 for the merger and 315 votes against with total outstanding shares of 3,294,898. The merger agreement became effective February 17, 1998, when the shareholders of the Bank received one share of the Heritage Commerce Corp common stock for each share of Bank common stock held.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's Common Stock is listed on the Over-the-Counter Electronic Bulletin Board under the symbol "HTBC." There is only a limited over-the-counter market for the Company's Common Stock. Everen Securities, Smith Barney Shearson, Incorporated, Sutro & Co., Incorporated and Van Kasper & Company have acted as market makers for the Common Stock. These market makers have no obligation to make a market for the Company's Common Stock, and they may discontinue making a market at any time. No assurance can be given that an active trading market will develop or be sustained for the Common Stock at any time in the future.
The information in the following table indicates the high and low "bid" quotations for the Common Stock for each quarterly period since January 1, 1996, and is based upon information provided by the market makers. These quotations reflect inter-dealer prices, without retail mark-up, mark-down, or commission, do not reflect actual transactions, and do not include nominal amounts traded directly by shareholders or through other dealers who are not market makers.
- --------------- (1) During the period indicated, the Bank was in the process of completing an Offering for 825,495 shares at $7.93.
Listed amounts are adjusted to reflect (i) a 10 percent stock dividend which was paid on February 26, 1996 to shareholders of record as of February 5, 1996, (ii) a 5 percent stock dividend which was paid on February 26, 1997 to shareholders of record as of February 5, 1997, and (iii) a 3 for 2 stock split on August 15, 1997 to shareholders of record as of August 1, 1997.
According to information known to management, the most recent trade in the Company's Common Stock prior to the date of this Annual Report occurred on March 12, 1998 for 5,000 shares, at a sales price of $15.00 per share. Effective February 17, 1998, the Bank's stock was exchanged on a share for share basis with the stock of the Company.
DIVIDENDS
Under California law the holders of common stock of the Company are entitled to receive dividends when and as declared by the Board of Directors, out of funds legally available therefor, subject to certain restrictions. A California corporation such as the Company may make a distribution to its shareholders if its retained earnings will equal at least the amount of the proposed distribution. California law further provides that in the event sufficient retained earnings are not available for the proposed distribution a corporation may nevertheless make a distribution to its shareholders, if, after giving effect to the distribution, it meets two conditions, which generally stated are as follows: (i) the corporation's assets must equal at least 125% of its liabilities; and (ii) the corporation's current assets must equal at least its current liabilities or, if the average of the corporation's earnings before taxes on income and before interest expense for the two preceding fiscal years
was less than the average of the corporation's interest expense for such fiscal years, then the corporation's current assets must equal at least 125% of its current liabilities. Most bank holding companies are unable to meet this test.
The payment of cash dividends by the Company depends on various factors, including the earnings and capital requirements of itself and its subsidiaries, and other financial conditions. The primary source of funds for payment of dividends by the Company to its shareholders will be the receipt of dividends and management fees from the Bank. The Company has no present intention of paying dividends in the foreseeable future. The legal ability of the Bank to pay dividends will be subject to restrictions set forth in the California banking law and regulations of the FDIC. No assurance can be given that the Bank will pay dividends at any time.
For regulatory restrictions on payment of dividends, see Item 1 -- "BUSINESS -- Regulation and Supervision -- Limitations on Dividends."
To date, neither the Bank nor the Company has paid cash dividends. It is the current policy of the Company to retain earnings to increase its capital to support growth. Payment of cash dividends in the future will depend upon the Bank's earnings and financial condition and other factors deemed relevant by management. Accordingly, it is likely that no cash dividends will be declared in the foreseeable future.
In December 1995, the Bank's Board of Directors declared a 10% stock dividend payable to shareholders of record as of February 5, 1996. The payable date of the dividend was February 26, 1996. In accordance with generally accepted accounting principles, the Bank accounted for the 1996 transaction by increasing the recorded accumulated deficit and transferring to permanent capital an amount equal to the fair value of the additional shares issued. The fair value of the additional shares issued is $1,384,000, based on a market value of $6.51 per share in January 1996.
In January, 1997, the Bank's Board of Directors declared a 5% stock dividend payable to shareholders of record as of February 5, 1997. The payable date of the dividend was February 26, 1997. In accordance with generally accepted accounting principles, the Bank accounted for the 1997 transaction by increasing the recorded accumulated deficit and transferring to permanent capital an amount equal to the fair value of the additional shares issued. The fair value of the additional shares issued is $1,304,000, based on a market value of $8.34 per share in January 1997.
In August, 1997, the Bank's Board of Directors declared a 3 for 2 stock split payable to shareholders of record as of August 1, 1997. In accordance with generally accepted accounting principles, the Bank accounted for the transaction by restating all share information to reflect the effects of the split. The payable date of the split was August 15, 1997.
For regulatory restrictions on the payment of dividends, see Item 1 -- "BUSINESS -- Regulation and Supervision -- Limitations on Dividends."
Number Of Equity Security Holders
As of February 28, 1998, there were 860 holders of Common Stock, the only outstanding class of equity security of the Company.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following table presents a summary of selected financial information that should be read in conjunction with the Bank's financial statements and notes thereto included under Item 8 -- "FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA." All financial information represents the financial operations and condition of the Bank prior to the formation of the Company.
SELECTED FINANCIAL DATA
- --------------- (1) Figures for 1994 are for the 207 day period from June 8 (inception) to December 31, 1994.
(2) All share figures are adjusted to reflect (i) a 10% stock dividend paid to shareholders of record as of February 5, 1996; (ii) a 5% stock dividend payable to shareholders of record as of February 5, 1997; and (iii) a 3-for-2 stock split payable to shareholders of record as of August 1, 1997, except number of shares outstanding at year-end, which are only adjusted retrospectively to reflect the 3-for-2 stock split. All prior period per share amounts have been restated for the implementation of SFAS No. 128, as described in Note 1 to the financial statements.
(3) Represents net income (loss) divided by the average number of shares of common stock outstanding for the respective period.
(4) Represents net income (loss) divided by the average number of shares of common stock and common stock-equivalents outstanding for the respective period.
(5) Represents shareholders' equity divided by the number of shares of common stock outstanding at the end of the period indicated.
(6) Average balances used in this chart and throughout this Annual Report are based on daily averages.
(7) Non-performing assets consist of non-accrual loans, loans past due 90 days or more, restructured loans, and other real estate owned. As of the dates indicated, the Bank had no non-performing assets.
(8) The Risk-Based and Leverage Capital ratios are defined in Item 1 -- "BUSINESS -- Supervision And Regulation -- Capital Adequacy Guidelines."
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Certain matters discussed or incorporated by reference in this Annual Report on Form 10-K including, but not limited to matters described in this section are forward looking statements that are subject to risks and uncertainties that could cause actual results to differ materially from those projected. Changes to such risks and uncertainties which could impact future financial performance, include, among others, (1) competitive pressures in the banking industry; (2) changes in interest rate environment, (3) general economic conditions, nationally, regionally and in operating market areas; (4) changes in the regulatory environment; (5) changes in business conditions and inflation; and (6) changes in securities markets. Therefore, the information set forth herein should be carefully considered when evaluating the business prospects of the Bank.
RESULTS OF OPERATIONS
OVERVIEW
Net income for the year ended December 31, 1997 was $1,565,000, or $0.48 per share (basic), compared to $1,401,000 or $0.48 per share (basic) and $201,000, or $0.08 per share (basic) for the years ended December 31, 1996 and 1995, respectively. This increase was primarily attributable to growth in the level of earning assets, funded by new deposits at favorable weighted average rates of interest, as well as to improvements in the Bank's mix of earning assets in favor of higher yielding assets, such as loans.
Average interest-earning assets for 1997 were up 47% over 1996. The increase was primarily attributable to growth in loans and, as a result, the average rate on interest-earning assets increased to 8.40% in 1997, up from 8.00% in 1996. Average interest-bearing deposits for 1997 were up 49% over 1996, with the increase primarily attributable to growth in savings and money market accounts. The impact on the Bank's average rate paid on interest-bearing liabilities, however, was modest, an increase to 3.49% in 1997, up from 3.28% in 1996. As a result, net interest margin improved to 6.23% in 1997 from 5.99% in 1996.
The Bank's loan quality remained high in 1997. As of December 31, 1997, loans classified by the Bank constituted 2% and 11%, respectively, of total loans and capital (shareholders' equity) and reserves (allowance for loan losses), down from 5% and 18%, respectively, as of December 31, 1996. Net loan charge-offs during 1997 were 0.18% of average loans outstanding; the Bank had no loan charge-offs in any prior year.
Fee income rose a modest 16% from 1996 to 1997. Many of the Bank's deposit accounts maintain balances higher than that which is required to offset activity charges and, as such, are not assessed fees. Other components of non-interest income such as gain on sale of securities available-for-sale and on sale of SBA loans rose more dramatically, up 681% and 103%, respectively, from 1996 to 1997.
Return on average equity in 1997 was 7.38%, compared to 8.56% in 1996 and 1.67% in 1995. Return on average equity fell in 1997, in spite of the fact that net income increased on an absolute basis over 1996, due to an increase in average equity that resulted from the Bank's second offering which occurred in the latter half of 1996.
Return on average assets in 1997 dropped to 0.74% from 0.96% in 1996. In 1997, average assets grew at a faster rate than net earnings, which were adversely impacted by higher taxes as the Bank exhausted the remainder of its operating loss carry forwards in 1996. Return on average assets was 0.22% in 1995.
NET INTEREST INCOME AND NET INTEREST MARGIN
The following table presents the average amounts outstanding for the major categories of the Bank's interest-earning assets and interest-bearing liabilities, the average interest rates earned or paid thereon, and the net yield on average interest-earning assets for the periods indicated:
- --------------- (1) Yields and amounts earned on loans include loan fees of $709,000, $388,000, and $115,000 for the years ended December 31, 1997, 1996, and 1995, respectively.
(2) Interest income is reflected on an actual basis, not a fully taxable equivalent basis.
(3) The yield on investment securities does not include a fair value adjustment.
Net interest income for the year ended December 31, 1997 was $12,047,000, an increase of $4,168,000 (or 53%) over the $7,879,000 reported for 1996. The increase occurred primarily as a result of growth that occurred in the Bank's earning assets, the yield on which was enhanced by an improvement in the net yield on interest-earning assets during 1997 as compared with 1996. The increase in net yield on interest earning assets in turn resulted from an improved mix of assets (in favor of higher yielding assets such as loans). The Bank's average interest-earning assets were $193,359,000 in 1997, up $61,848,000 (or 47%) from the average of $131,511,000 for 1996. The net yield on interest-earning assets improved during 1997 to 6.23% from 5.99% for 1996.
The following table sets forth an analysis of the changes in interest income and interest expense:
Note: Yields and amounts earned on loans include loan fees of $709,000, $388,000, and $115,000 for the years ended December 31, 1997, 1996, and 1995, respectively.
The total change is shown in the column designated "Net Change" and is allocated in the columns to the left, to the portions respectively attributable to volume changes and rate changes that occurred during the period. Changes due to both volume and rate have been allocated between the volume and rate categories in proportion to the relationship of the changes due solely to the changes in volume and rate, respectively.
PROVISIONS FOR LOAN LOSSES
During 1997, the provision for loan losses was $1,060,000, up $230,000 (or 28%) from $830,000 during 1996. The increase in the provision during 1997 reflected the overall growth in the loan portfolio and the Bank's policy of making provisions to the allowance for loan losses. The provision for 1996 was up $334,000 (or 67%) from $496,000 during 1995.
The allowance for loan losses was 1.77%, 1.69%, and 1.34% of total loans at December 31, 1997, 1996, and 1995, respectively.
NON-INTEREST INCOME
The following table sets forth the various components of the Bank's non-interest income:
Non-interest income for the year ended December 31, 1997 was $590,000, up $294,000 (or 99%) from $296,000 for 1996. This increase was primarily the result of gains recognized on the sale of securities available-for-sale (up $143,000), sales of SBA loans (up $104,000), and an increase in deposit service charges (up $24,000).
NON-INTEREST EXPENSES
The following table sets forth the various components of the Bank's non-interest expenses:
Non-interest expenses for the year ended December 31, 1997 were $9,168,000, up $3,444,000 (or 60%) from $5,724,000 for the year ended December 31, 1996. The increase in non-interest expenses reflects the growth in infrastructure to support the Bank's loan and deposit growth.
Non-interest expenses consist primarily of salaries and employee benefits (54%, 51%, and 50% of total non-interest expenses for 1997, 1996, and 1995, respectively) and client services (13%, 16%, and 12% of total non-interest expenses for 1997, 1996, and 1995, respectively). The increase in salaries and benefits expenses was primarily attributable to an increase in the number of employees. The Bank employed 88 people at December 31, 1997, up 33 from 55 employees at December 31, 1996. Client services expenses include outside data processing service costs, courier and armored car costs, imprinted check costs, and other client services, all of which are directly related to the amount of funds on deposit at the Bank. The increase in furniture and equipment expenses and in occupancy expenses was primarily attributable to an increase in the number of employees. Advertising expenses increased in 1997 due to the Bank's co-sponsorship of a professional auto racing team.
YEAR 2000
The inability of computers, software, and other equipment utilizing microprocessors to recognize and properly process data fields containing a two-digit year is commonly referred to as the Year 2000 Compliance issue. As the year 2000 approaches, such systems may be unable to process accurately certain date-based information.
The Company has identified all significant applications that will require modification to ensure Year 2000 Compliance. Internal and external resources are being used to make the required modifications and test Year 2000 Compliance. The modification process of all significant applications is underway and should be substantially complete by June 30, 1998. The Company plans to complete the testing process of all significant applications by December 31, 1998.
In addition, the Company has communicated with a vendor with whom it does significant business to determine their Year 2000 Compliance readiness and the extent to which the Company is vulnerable to any third-party Year 2000 risks. However, there can be no guarantee that the systems of other companies on which the Company's systems rely will be timely converted, or that a failure to convert by another company, or a conversion that is incompatible with the Company's systems, would not have a material adverse effect on the Company. The Company's bank subsidiary has begun the process of assessing the credit risk related to its borrowers' Year 2000 Compliance progress, and will integrate a Year 2000 Compliance element into its credit approval process by December 31, 1998.
The total cost to the Company of Year 2000 Compliance activities has not been and is not anticipated to be material to its financial position or results of operations in any given year. These costs and the date on which the Company plans to complete the Year 2000 modification and testing process are based on management's best estimates, which were derived utilizing numerous assumptions of future events including the continued availability of certain resources, third-party modification plans, and other factors. However, there can be no guarantee that these estimates will be achieved and actual results could differ from those plans.
PROVISION FOR INCOME TAXES
Provision for income taxes was $844,000, $220,000, and $1,000, for the years ended December 31, 1997, 1996, and 1995, respectively. The Bank's effective tax rates were 35.0%, 13.6%, and 0.5%, for the years ended December 31, 1997, 1996, and 1995, respectively. The decrease in the effective tax rate from the statutory tax rate in 1996 and 1995 was due to state income taxes, change in the valuation allowance, and non-taxable interest income. The 1995 provision reflected state minimum income taxes due to utilization of net operating losses.
FINANCIAL CONDITION
SECURITIES PORTFOLIO
The following table summarizes the amounts and distribution of the Bank's investment securities and the weighted average yields as of December 31, 1997:
Note: Yields on tax exempt municipal securities are not on a fully tax equivalent basis.
As of December 31, 1997, the only securities held by the Bank where the aggregate book value of the Bank's investment in securities of a single issuer exceeded 10% of the Bank's shareholders' equity were direct obligations of the U.S. government or U.S. government agencies.
Securities are pledged to meet requirements imposed as a condition of deposit by some depositors, such as political subdivisions (public funds) or of other funds such as bankruptcy trustee deposits. Securities with amortized cost of $27,470,000 as of December 31, 1997 were pledged to secure public and certain other deposits as required by law or contract.
LOANS
General. The following table presents the Bank's loans outstanding at year end by loan type:
The Bank's commercial loans are made for the purpose of providing working capital, financing the purchase of equipment or for other business purposes. Such loans include loans with maturities ranging from thirty days to one year and "term loans," with maturities normally ranging from one to twenty-five years. Short-term business loans are generally intended to finance current transactions and typically provide for periodic principal payments, with interest payable monthly. Term loans normally provide for floating interest rates, with monthly payments of both principal and interest.
The Bank is an active participant in the Small Business Administration (SBA) and California guarantied lending programs, and has been approved by the SBA as a lender under the Preferred Loan Program (PLP). The Bank regularly makes SBA-guarantied loans, the guarantied portion of which is held for possible resale in the secondary market. In the event of the sale of a guarantied portion SBA loan, the Bank retains the servicing rights for the sold portion. At December 31, 1997, 1996, and 1995, $6.0 million, $2.1 million and $77 thousand, respectively, in SBA loans were serviced by the Bank for others. The Bank generally considers its SBA loans to be investment loans, but has from time to time sold the guarantied portion of certain loans.
The Bank's real estate term loans consist primarily of loans made based on the borrower's cash flow and are secured by deeds of trust on commercial and residential property to provide a secondary source of repayment. It is the Bank's policy to restrict real estate term loans to no more than 80% of the lower of the Bank's appraised value or the purchase price of the property, depending on the type of property and its utilization. The Bank offers both fixed and floating rate loans. Maturities on such loans are generally restricted to between five and seven years (on an amortization ranging from fifteen to twenty-five years with a balloon payment due at maturity); however, SBA and certain other real estate loans easily sold in the secondary market may be granted for longer maturities.
The Bank's real estate land and construction loans are primarily interim loans made by the Bank to finance the construction of commercial and single family residential properties. These loans are typically short term. The Bank utilizes underwriting guidelines to assess the likelihood of repayment from sources such as sale of the property or permanent mortgage financing prior to making the construction loan.
Consumer loans are made for the purpose of financing automobiles, various types of consumer goods, and other personal purposes. Additionally, the Bank makes equity lines of credit and equity loans available to its clientele. Consumer loans generally provide for the monthly payment of principal and interest. Most of the Bank's consumer loans are secured by the personal property being purchased, or, in the instances of equity loans or lines, real property.
With certain exceptions, the Bank is permitted to make extensions of its credit to any one borrowing entity up to 15% of the Bank's capital and reserves for unsecured loans and up to 25% of the Bank's capital and reserves for secured loans. These lending limits for the Bank were $3.7 million and $6.2 million, respectively, at December 31, 1997. The Bank sells participations in its loans when necessary to stay within lending limits. The Bank generally maintains an "in-house limit" of $3.0 million for unsecured loans, and $5.0 million for secured loans.
Loan Concentrations. The Bank does not have any concentrations in its loan portfolio by industry or group of industries, however, 59% and 54% of its net loans were secured by real property as of December 31, 1997 and 1996, respectively.
Loan Portfolio Maturities and Interest Rate Sensitivity. The following table sets forth the maturity distribution of the Bank's loans at December 31, 1997:
Note: Total shown is net of deferred loan fees of $113,000 at December 31, 1997.
The table shows the distribution of such loans between those loans with predetermined (fixed) interest rates and those with variable (floating) interest rates. Floating rates generally fluctuate with changes in the prime rate as reflected in the western edition of The Wall Street Journal. As of December 31, 1997, approximately 83% of the Bank's loan portfolio consisted of floating interest rate loans.
Credit Risk Management. The risk of non-payment of loans is an inherent feature of the banking business. That risk varies with the type and purpose of the loan, the collateral that is utilized to secure payment, and ultimately, the creditworthiness of the borrower. In order to minimize this credit risk, the Bank requires that all loans be approved by at least the Chief Credit Officer, the Senior Loan Officer, or the Chief Executive Officer, who individually have approval authority of $150,000 each, and in combination may approve loans of up to $600,000. Loans in excess of $600,000 must be approved by the Officers' Loan Committee. Loans over $1,000,000 must be approved by the Directors' Loan Committee. The Bank has established an in-house lending limit of $3,000,000 for unsecured transactions, and $5,000,000, for secured transactions, which is subject to review or exception from time to time.
The Bank assigns a risk grade consistent with the system recommended by regulatory agencies to all of its loans. Grades range from "Pass" to "Loss," depending on credit quality, with "Pass" representing loans that involve an acceptable degree of risk. Additionally, the Bank maintains a program for regularly scheduled reviews of certain new and renewed loans by an outside loan review consultant. Any loans identified during an external review process that expose the Bank to increased risk are appropriately downgraded and an increase in the allowance for loan losses is established for such loans. Further, the Bank is examined periodically by the FDIC, FRB, and the California Department of Financial Institutions, at which time a further review of loans is conducted.
Loans that demonstrate a weakness, for which there is a possibility of loss if the weakness is not corrected, are categorized as "classified." Classified loans may result from problems specific to a borrower's business or from economic downturns which affect the borrower's ability to repay or which cause a decline in the value of the underlying collateral (particularly real estate). Management believes that it has adequately provided an allowance to provide for estimated probable losses in the credit portfolio. Significant deterioration in Northern California real property values or economic downturns could impact future operating results, liquidity, or capital resources and require additional provisions to the allowance or cause losses in excess of the allowance.
Non-Performing Assets. At December 31, 1997, 1996 and 1995, the Bank had no non-accrual loans. During the year ended December 31, 1997 the average balance of non-accrual loans was $100,000. At December 31, 1997, 1996 and 1995, the Bank had no assets classified as other real estate owned. The Bank has no troubled debt restructuring and no loans 90 days past-due and still accruing.
For the year ended December 31, 1997, the Bank had forgone interest income in the amount of $17,000 as a result of non- accrual loans. Through December 31, 1996, the Bank had not foregone any interest income as a result of non-accrual loans or restructured debt.
As of December 31, 1997, loans classified by the Bank were $2,695,000. These loans constituted 2% of total loans and 11% of the Bank's capital and reserves as of that date. As of December 31, 1996, loans classified by the Bank were $4,005,000. These loans constituted 5% of total loans and 18% of the Bank's capital and reserves as of that date. As of December 31, 1995, loans classified by the Bank were $296,804. These loans constituted 1% of total loans and 2% of the Bank's capital and reserves as of that date. Through December 31, 1997, the Bank has not made loans to any foreign entities.
ALLOWANCE FOR LOAN LOSSES
The following table summarizes the Bank's loan loss experience as well as transactions in the allowance for loan losses and certain pertinent ratios for the periods indicated:
The following table summarizes the allocation of the allowance for loan losses by loan type and the allocation as a percent of loans outstanding in each loan category for the periods indicated:
The Bank maintains an allowance for loan losses to provide for probable losses in the loan portfolio. Additions to the allowance are made by charges to operating expenses in the form of a provision for loan losses. All loans that are judged to be uncollectable are charged against the allowance and any recoveries are credited to the allowance. Management conducts a critical evaluation of the loan portfolio monthly. This evaluation includes an assessment of the following factors: past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower's ability to repay, the estimated value of any underlying collateral, and current economic conditions. At December 31, 1997, 1996, and 1995 the allowance for loan losses was 1.77%, 1.69%, and 1.34%, respectively, of gross loans then outstanding.
During 1997, the Bank charged off three loans with principal balance totaling $224,000, and recovered two of those loans for $48,000, with accrued interest and costs. Through December 31, 1996, the Bank had no loan charge-offs and no charge-off recoveries.
In an effort to improve its analysis of risk factors associated with its loan portfolio, the Bank continues to monitor and to make appropriate changes to its internal loan policies. These efforts better enable the Bank to assess risk factors prior to granting new loans and to assess the sufficiency of the allowance for loan losses. The allowance for loan losses is deemed adequate by the management for known and currently anticipated future risks inherent in the loan portfolio. However, the Bank's loan portfolio can be adversely affected if California economic conditions and the real estate market in the Bank's market area were to weaken. The effect of such events although uncertain at this time, could result in an increase in the level of non-performing loans and increased loan losses which could adversely affect the Bank's future growth and profitability.
DEPOSITS
The following table summarizes the distribution of average deposits and the average rates paid for the periods indicated:
At December 31, 1997, the Bank had a deposit mix of 26% in money market accounts, 17% in time deposits, 14% in savings deposits, 3% in NOW accounts, and 40% in non-interest-bearing demand deposits. On the same date, $158,000 of the Bank's deposits were from public sources. At December 31, 1996, the Bank had a deposit mix of 24% in money market accounts, 20% in time deposits, 15% in savings deposits, 3% in NOW accounts, and 38% in non-interest-bearing demand deposits. On the same date, $200,000 of the Bank's deposits were from public sources. The Bank's net interest income is enhanced by its percentage of non-interest bearing deposits.
The Bank's deposits are obtained from a cross-section of the communities it serves. The Bank's business is not seasonal in nature. The Bank had brokered deposits totaling approximately $12 million at December 31, 1997. The Bank is not dependent upon funds from sources outside the United States.
DEPOSIT CONCENTRATION AND DEPOSIT VOLATILITY
The following table indicates the maturity schedule of the Bank's time deposits of $100,000 or more as of December 31, 1997:
The Bank focuses primarily on servicing business accounts that are frequently over $100,000 in average size. Certain types of accounts that the Bank makes available are typically in excess of $100,000 in average balance per account, and certain types of business clients whom the Bank serves typically carry deposits in excess of $100,000 on average. The account activity for some account types and client types necessitates appropriate liquidity management practices by the Bank to ensure its ability to fund deposit withdrawals.
LIQUIDITY AND LIABILITY MANAGEMENT
To meet liquidity needs, the Bank maintains a portion of its funds in cash deposits in other banks, in federal funds sold, and in investment securities. As of December 31, 1997, the Bank's primary liquidity ratio was 37.6%, comprised of $48.2 million in investment securities available-for-sale of maturities (or probable calls) of up to five years, federal funds sold of $27.1 million, and $16.1 million in cash and due from banks, as a percentage of total deposits of $243.0 million. As of December 31, 1996, the Bank's primary liquidity ratio was 37.9%, comprised of $42.9 million in investment securities available-for-sale of maturities (or probable calls) of up to five years, and $12.6 million in cash and due from banks, as a percentage of total deposits of $146.4 million.
Liquidity was essentially unchanged from 1996 to 1997 as deposit growth was matched by commensurate growth in liquid assets.
The following table summarizes the Bank's borrowings under its federal funds purchased and security repurchase arrangements for the periods indicated:
The Bank has federal funds purchase lines of $15,000,000 and $2,000,000, respectively, from its two correspondent banks, and a repurchase arrangement of $10,000,000 with a commercial brokerage firm. There were no borrowings under these arrangements as of December 31, 1997.
INTEREST RATE SENSITIVITY
The table below sets forth the interest rate sensitivity of the Bank's interest earning assets and interest bearing liabilities as of December 31, 1997, using the rate sensitivity gap ratio. For purposes of the following table, an asset or liability is considered rate-sensitive within a specified period when it can be repriced or when it is scheduled to mature within the specified time frame:
The careful planning of asset and liability maturities and the matching of interest rates to correspond with this maturity matching is an integral part of the active management of an institution's net yield. To the extent maturities of assets and liabilities do not match in a changing interest rate environment, net yields may change over time. Even with perfectly matched repricing of assets and liabilities, risks remain in the form of prepayment of loans or investments or in the form of delays in the adjustment of rates of interest applying to either earning assets with floating rates or to interest bearing liabilities. The Bank has generally been able to control its exposure to changing interest rates by maintaining primarily floating interest rate loans and a majority of its time certificates in relatively short maturities.
Since interest rate changes do not affect all categories of assets and liabilities equally or simultaneously, a cumulative gap analysis alone cannot be used to evaluate the Bank's interest rate sensitivity position. To supplement traditional gap analysis, the Bank performs simulation modeling to estimate the potential effects of changing interest rates. The process allows the Bank to explore the complex relationships within the gap over time and various interest rate environments. For additional information on the Bank's simulation model and the methodology used to estimate the potential effects of changing interest rates, see Item 7A
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
As a financial institution, the Company's primary component of market risk is interest rate volatility. Fluctuations in interest rates will ultimately impact both the level of income and expense recorded on most of the Bank's assets and liabilities, and the market value of all interest-earning assets, other than those which have a short term to maturity. Since all of the Company's interest-bearing assets and liabilities are located at the Bank, all of the Company's interest rate risk exposure lies at the Bank level, as well. As a result, all interest rate risk management procedures are performed at the Bank level. Based upon the nature of the Bank's operations, the Bank is not subject to foreign exchange or commodity price risk. The Company does not own any trading assets. As of December 31, 1997, the Company does not use interest rate derivatives to hedge its interest rate risk.
The Bank's exposure to market risk is reviewed on a regular basis by the Asset/Liability Committee (ALCO). Interest rate risk is the potential of economic losses due to future interest rate changes. These economic losses can be reflected as a loss of future net interest income and/or a loss of current fair market values. The objective is to measure the effect on net interest income and to adjust the balance sheet to minimize the inherent risk while at the same time maximize income. Management realizes certain risks are inherent, and that the goal is to identify and accept the risks. Management uses two methodologies to manage interest rate risk: 1) a standard GAP analysis; and 2) an interest rate shock simulation model. The Bank has no market risk sensitive instruments held for trading purposes.
The detail from the Bank's GAP analysis is shown in Item 7, above, and is not discussed here. The Bank applies a market value (MV) methodology to gauge its interest rate risk exposure as derived from its simulation model. Generally, MV is the discounted present value of the difference between incoming cash flows on interest earning assets and other investments and outgoing cash flows on interest bearing liabilities and other liabilities. The application of the methodology attempts to quantify interest rate risk as the change in the MV which would result from a theoretical 200 basis point (1 basis point equals 0.01%) change in market interest rates. Both a 200 basis point increase and a 200 basis point decrease in market rates are considered.
At December 31, 1997, it was estimated that the Company's MV would increase 5.2% in the event of a 200 basis point increase in market interest rates. The Company's MV at the same date would decrease 6.8% in the event of a 200 basis point decrease in market interest rates.
Presented below, as of December 31, 1997, is an analysis of the Company's interest rate risk as measured by changes in MV for instantaneous and sustained parallel shifts of 200 basis points in market interest rates:
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.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements and independent auditors' report are set forth in Appendix F, which follows Item 14 -- "EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K."
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
On December 1, 1997, Heritage Bank of Commerce (the Bank) notified KPMG Peat Marwick LLP (KPMG) that the Bank was terminating KPMG as independent certified public accountants for the Bank. The termination was effective on that date. On December 1, 1997, the Bank engaged Deloitte & Touche LLP as independent auditors for the Bank.
At no time during the engagement of KPMG by the Bank was there any disagreement on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedure, which disagreements if not resolved to the satisfaction of KPMG would have caused it to make reference in connection with its report to the subject matter of the disagreement. The preceding sentence includes disagreements, whether resolved or not resolved to the satisfaction of KPMG, at the decision-making levels of the Bank and KPMG. No report of KPMG on the financial statements of the Bank for any of the past three years contained an adverse opinion or a disclaimer of opinion or was qualified as to uncertainty, audit scope, or accounting principles.
The Bank's decision to change accountants was recommended by the Bank's Audit Committee and approved by the Bank's Board of Directors.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Reference is made to the Company's Proxy Statement for the May 21, 1998 Annual Meeting of Shareholders for incorporation of information concerning directors and persons nominated to become directors of the Company. Information concerning executive officers of the Company as of February 28, 1998 is included in Part I above in accordance with Instruction 3 to Item 401(b) of Regulation S-K.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Information concerning executive compensation is incorporated by reference from the text under the caption "Executive Compensation" in the Proxy Statement for the May 21, 1998 Annual Meeting of Shareholders.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT -- BENEFICIAL OWNERSHIP OF COMMON STOCK
Information concerning ownership of the equity stock of the Company by certain beneficial owners and management is incorporated by reference from page 4 and the text under the caption "Proposal One -- Election of Directors" in the Proxy Statement for the May 21, 1998 Annual Meeting of Shareholders
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information concerning certain relationships and related transactions with officers, directors, and the Company is incorporated by reference from the text under the caption "Transactions with Management and Others" in the Proxy Statement for the May 21, 1998 Annual Meeting of Shareholders.
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a)(1) FINANCIAL STATEMENTS
The Financial Statements of the Company, the Management Statement, and the independent auditors' report are set forth on pages 38 through 56.
(a)(2) FINANCIAL STATEMENT SCHEDULES
All schedules to the Financial Statements are omitted because of the absence of the conditions under which they are required or because the required information is included in the Financial Statements or accompanying notes.
(a)(3) EXHIBITS
(b) Reports on Form 8-K
On December 1, 1997, the Registrant, pursuant to the 1934 Act, filed Form with the FDIC to report a change in certifying accountants. [This exhibit is incorporated by reference to the paper filing of Heritage Commerce Corp's Form 8-A filed March 5, 1998 (File No. 000-23877).]
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
HERITAGE COMMERCE CORP
Date: March 31, 1998 By: /s/ JOHN E. ROSSELL ------------------------------------ John E. Rossell President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated:
HERITAGE COMMERCE CORP
DECEMBER 31, 1997
EXHIBIT (a)(1)
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Shareholders of Heritage Bank of Commerce San Jose, California
We have audited the accompanying balance sheet of Heritage Bank of Commerce as of December 31, 1997, and the related statements of income, shareholders' equity, and cash flows for the year then ended. These financial statements are the responsibility of the Bank's management. Our responsibility is to express an opinion on these financial statements based on our audit. The balance sheet of the Bank for the year ended December 31, 1996 and the related statements of income, shareholders' equity, and cash flows for each of the two years in the period ended December 31, 1996 were audited by other auditors whose report, dated January 10, 1997, expressed an unqualified opinion on those statements.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provide a reasonable basis for our opinion.
In our opinion, such 1997 financial statements present fairly, in all material respects, the financial position of the Bank as of December 31, 1997, and the results of its operations and its cash flows for the year then ended in conformity with generally accepted accounting principles.
Deloitte & Touche LLP San Jose, California January 23, 1998
INDEPENDENT AUDITOR'S REPORT
The Board of Directors Heritage Bank of Commerce:
We have audited the accompanying balance sheet of Heritage Bank of Commerce (the Bank) as of December 31, 1996, and the related statements of income, shareholders' equity, and cash flows for each of the years in the two-year period then ended. These financial statements are the responsibility of the Bank's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion the financial statements referred to above present fairly, in all material respects, the financial position of Heritage Bank of Commerce as of December 31, 1996, and the results of its operations and its cash flows for each of the years in the two-year period then ended in conformity with generally accepted accounting principles.
KPMG PEAT MARWICK, LLP January 10, 1997
HERITAGE BANK OF COMMERCE
BALANCE SHEETS
ASSETS
See notes to financial statements.
HERITAGE BANK OF COMMERCE
INCOME STATEMENTS
See notes to financial statements.
HERITAGE BANK OF COMMERCE
STATEMENTS OF SHAREHOLDERS' EQUITY YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
See notes to financial statements
HERITAGE BANK OF COMMERCE
STATEMENTS OF CASH FLOWS
See notes to financial statements.
HERITAGE BANK OF COMMERCE
NOTES TO FINANCIAL STATEMENTS
(L) SIGNIFICANT ACCOUNTING POLICIES
Description of Business and Basis of Presentation
Heritage Bank of Commerce (the Bank) is a California state chartered bank which offers a full range of commercial and personal banking services to residents and the business/professional community in Santa Clara County, California, through a facility located in downtown San Jose, California. The Bank was incorporated on November 23, 1993 as Heritage Bank of Commerce and commenced operations on June 8, 1994. The accounting and reporting policies of the Bank conform to generally accepted accounting principles and prevailing practices within the banking industry.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The allowance for possible loan losses is a material estimate. Actual results could differ from those estimates.
Cash and Cash Equivalents
The Bank considers all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents. Cash and cash equivalents include cash on hand, amounts due from banks, and federal funds sold. Generally, federal funds are sold and purchased for one-day periods.
Securities
The Bank classifies its securities into two categories, available-for-sale and held-to-maturity, at the time of purchase. Securities available-for-sale are measured at fair value with a corresponding recognition of the net unrealized holding gain or loss as a separate component of shareholders' equity, net of taxes, until realized. Securities held-to-maturity are measured at amortized cost, based on the Bank's positive intent and ability to hold the securities to maturity.
A decline in the market value of any available-for-sale or held-to-maturity security below cost that is deemed other than temporary results in a charge to earnings and the corresponding establishment of a new cost basis for the security. No such declines have occurred.
Premiums and discounts are amortized, or accreted, over the life of the related investment security as an adjustment to income using the straight-line method. Interest income is recognized when earned. Realized gains and losses for securities classified as available-for-sale are included in earnings and are derived using the specific identification method for determining the cost of securities sold.
Loans Held for Sale
The Bank holds for sale the guarantied portion of certain Small Business Administration (SBA) loans. These loans are carried at the lower of cost or market, determined in the aggregate.
Gains or losses on loans held for sale are recognized upon completion of the sale, and are based on the difference between the net sales proceeds and the relative fair value of the guarantied portion of the loan sold compared to the relative fair value of the unguarantied portion. A portion of the gain is deferred and amortized over the life of the loan based on the difference between the principal retained and the relative value of the unguarantied portion of the loan.
The servicing assets that result from the sale of SBA loans sold with servicing rights retained are amortized over the lives of the loans using a method approximating the interest method.
HERITAGE BANK OF COMMERCE
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
Loans
Loans are stated at the principal amount outstanding. The majority of the Bank's loans are at variable interest rates. Interest on loans is credited to income when earned.
Generally, a loan is classified as non-accrual, the accrual of interest is discontinued, any accrued and unpaid interest is reversed, and the amortization of deferred loan fees and costs is discontinued, when the payment of principal or interest is 90 days past due, unless the amount is well secured and in the process of collection. Any interest or principal payments received on non-accrual loans are normally applied toward reduction of principal. Non-accrual loans generally are not returned to performing status until the obligation is brought current, has performed in accordance with the contract terms for a reasonable period of time, and the ultimate collectability of the total contractual principal and interest is no longer in doubt.
Management, considering current information and events, considers a loan to be impaired when it is probable that the Bank will be unable to collect all amounts due according to the contractual terms of the note agreement. When a loan is considered to be impaired, the amount of impairment is measured based on the present value of expected future cash flows discounted at the note's effective interest rate, or the fair value of the collateral if the loan is secured by real estate.
Non-refundable loan fees and direct origination costs are deferred and recognized over the expected lives of the related loans using the effective yield interest method.
Allowance for Loan Losses
The allowance for loan losses is established through a provision charged to expense. Loans are charged against the allowance when management believes that the collectability of the principal is doubtful. Recoveries are credited to the allowance. The allowance for loan losses is a valuation allowance that management believes will be adequate to absorb losses inherent in existing loans, based on evaluations of collectability. These evaluations take into consideration such factors as the composition of the portfolio, overall portfolio quality, loan concentrations, specific problem loans, and current and anticipated local economic conditions that may affect a borrower's ability to repay.
Premises and Equipment
Premises and equipment are stated at cost. Depreciation and amortization are computed on a straight-line basis over the lesser of the lease terms or estimated useful lives of five to fifteen years.
Other Investments
Other investments consist of cash surrender value of life insurance policies for certain officers and directors of the Bank.
Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities
The Bank adopted Statement of Financial Accounting Standards (SFAS) No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, effective January 1, 1997. SFAS No. 125 provides accounting and reporting standards for transfers and servicing of financial assets and extinguishments of liabilities based on consistent application of a financial-components approach that focuses on control. It distinguishes transfers of financial assets that are sales from transfers that are secured borrowings. Under this approach, after a transfer of financial assets, an entity recognizes all financial and servicing assets it controls and liabilities it has incurred and derecognizes financial assets it no longer controls and liabilities that have been extinguished. The adoption of this Statement did not have a significant impact on the Bank's financial position or results of operations.
Long-Lived Assets
The Bank evaluates the recoverability of long-lived assets on an on-going basis.
HERITAGE BANK OF COMMERCE
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
Income Taxes
Income taxes are provided at current rates. Deferred income taxes reflect the net tax effects of temporary differences between carrying amounts of assets and liabilities for financial reporting purposes and amounts used for income tax purposes. A valuation allowance is established to reduce the deferred tax asset if it is "more likely than not" that the related tax benefits will not be realized in the future.
Stock-Based Compensation
As allowed for by SFAS No. 123, Accounting for Stock-Based Compensation, the Bank accounts for stock-based awards to employees using the intrinsic value method in accordance with Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees.
Earnings Per Share
Earnings per share are computed in compliance with SFAS No. 128, Earnings Per Share. Basic earnings per share are computed by dividing net income by the weighted average common shares outstanding. Diluted earnings per share reflect potential dilution from outstanding stock options, using the treasury stock method. For each of the years presented, net income is the same to basic and diluted earnings per share. Reconciliation of weighted average shares used in computing earnings per share are as follows:
All share numbers have been retroactively restated for stock dividends and stock splits.
Reclassifications
Certain amounts in the 1996 and 1995 financial statements have been reclassified to conform to the 1997 presentation. These reclassifications had no impact on shareholders' equity and net income.
New Accounting Pronouncements
In June 1997, the Financial Accounting Standards Board issued SFAS No. 130 Reporting Comprehensive Income, which requires that an enterprise report, by major components and as a single total, the change in its net assets during the period from non-owner sources; and SFAS No. 131 Disclosures about Segments of an Enterprise and Related Information, which establishes annual and interim reporting standards for an enterprise's business segments and related disclosures about its products, services, geographic areas, and major customers. The Bank is required to adopt these statements in 1998 and their adoption will not impact the Bank's financial position, results of operations or cash flows.
HERITAGE BANK OF COMMERCE
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
(2) SECURITIES
The amortized cost and estimated fair value of securities as of December 31, 1997 were as follows:
The amortized cost and estimated fair value of securities as of December 31, 1996 were as follows:
The amortized cost and estimated fair values of securities as of December 31, 1997 by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or pre-pay obligations with or without call or pre-payment penalties.
Sales of securities available-for-sale resulted in gross realized gains of $170,000, $21,000, and $6,000 during the years ended December 31, 1997, 1996, and 1995, respectively.
HERITAGE BANK OF COMMERCE
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
Sales of securities available-for-sale resulted in gross realized losses of $6,000, nil, and $3,000 during the years ended December 31, 1997, 1996, and 1995, respectively.
Securities with amortized cost of $27,470,000 as of December 31, 1997 were pledged to secure public and certain other deposits as required by law or contract.
(3) LOANS
Loans as of December 31 were as follows:
Changes in the allowance for loan losses were as follows:
As of December 31, 1997, 1996, and 1995, the Bank had no loans for which interest is no longer being accrued, no loans past due 90 days or more, and no loans considered to be impaired. For the year ended December 31, 1997, the Bank had foregone $17,000 of interest income as a result of non-accrual loans or restructured debt. For the years ended December 31, 1996 and 1995, the Bank had no forgone interest income as a result of non-accrual loans or restructured debt.
The Bank had no non-accrual loans as of December 31, 1997 or 1996. SBA loans serviced for others are not included in the accompanying balance sheets. The unpaid principal balances of these loans as of December 31, 1997 and 1996 were approximately $5,961,000 and $2,105,000, respectively. Concentrations of credit risk arise when a number of clients are engaged in similar business activities, or activities in the same geographic region, or have similar features that would cause their ability to meet contractual obligations to be similarly affected by changes in economic conditions. Although the Bank has a diversified loan portfolio, a substantial portion of its clients' ability to honor contracts is reliant upon the economic stability of Santa Clara County, California, including the real estate markets of the county. Loans are made on the basis of a secure repayment source, which generally is based on a detailed cash flow analysis; collateral is generally a secondary source for loan qualification.
The Bank makes loans to executive officers, directors, and their affiliates in the ordinary course of business. These transactions were on substantially the same terms as those prevailing at the time for comparable transactions with unrelated parties and do not involve more than normal risk or unfavorable terms
HERITAGE BANK OF COMMERCE
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
for the Bank. At December 31, 1997 and 1996 the Bank had $2,145,000 and $2,565,000 in loans outstanding to related parties.
(4) PREMISES AND EQUIPMENT
Premises and equipment as of December 31 were as follows:
(5) DEPOSITS
Deposits as of December 31, were as follows:
At December 31, 1997, the scheduled maturities of time deposits was as follows:
(6) BORROWING ARRANGEMENTS
Available Lines of Credit
The Bank has federal funds purchase lines of $15,000,000 and $2,000,000, respectively, from two correspondent banks, and a repurchase arrangement of $10,000,000 with a commercial brokerage firm. There were no borrowings under these arrangements as of December 31, 1997. The repurchase agreement is an overnight loan, with terms negotiated based on the nature of the securities offered for repurchase.
Information concerning borrowings under the above arrangements is as follows:
HERITAGE BANK OF COMMERCE
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
(7) INCOME TAXES
The provision for income taxes for the years ended December 31, consisted of the following:
The effective tax rate differs from the federal statutory rate for the years ended December 31, as follows:
Net deferred tax asset as of December 31 consists of the following:
As it is more likely than not that the deferred tax assets would be realized, the valuation allowance decreased by $209,000, $478,000, and $77,000 during the years ended December 31, 1997, 1996, and 1995, respectively.
HERITAGE BANK OF COMMERCE
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
(8) SHAREHOLDERS' EQUITY
Common Stock
In December, 1995, the Bank declared a 10% stock dividend payable to shareholders of record as of February 5, 1996. In January, 1997, the Bank declared a 5% stock dividend payable to shareholders of record as of February 5, 1997. In July, 1997, the Bank declared a three-for-two stock split for shareholders of record as of August 1, 1997. All share numbers have been retroactively restated for stock splits and stock dividends.
Stock Option Plan
The Bank has a stock option plan (the Plan) for directors, officers, and key employees. The Plan provides for the grant of incentive and non-qualified stock options. The Plan provides that the option price will be determined by the Board of Directors at no less than the fair value at the date of grant. Options granted vest on a schedule determined by the Board of Directors at the time of grant. Generally, options vest over four years. All options expire no later than ten years from the date of grant. The Plan had 623,700 shares (adjusted for stock dividends and splits) originally authorized for issuance. During 1997, an additional 362,469 shares were added to the Plan for future grants. At December 31, 1997, 316,289 shares are available for future grants under the Plan.
Option activity under the Plan is as follows:
Additional information regarding options outstanding under the Plan as of December 31, 1997 is as follows:
HERITAGE BANK OF COMMERCE
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
As discussed in Note 1, the Bank continues to account for its stock-based awards using the intrinsic value method in accordance with APB Opinion No. 25, Accounting for Stock Issued to Employees, and its related interpretations. Accordingly, no compensation expense has been recognized in the financial statements for employee stock option arrangements.
SFAS No. 123, Accounting for Stock-Based Compensation, requires the disclosure of pro forma net income and earnings per share had the Bank adopted the fair value method as of the beginning of fiscal 1995. Under SFAS No. 123, the fair value of stock-based awards to employees is calculated through the use of option pricing models, even though such models were developed to estimate the fair value of freely tradable, fully transferable options without vesting restrictions, which differ significantly from the Bank's stock option awards. Those models also require subjective assumptions, which greatly affect the calculated values. The Bank's calculations were made using the Black-Scholes option pricing model with the following weighted average assumptions: expected life, 84 months; risk-free interest rate, 5.75% for 1997 and 6.60% for 1996 and 1995; stock volatility of 30% in 1997 and 20% in 1996 and 1995; and no dividends during the expected term. The Bank's calculations are based on a multiple option valuation approach, and forfeitures are recognized as they occur.
If the computed fair values of the 1997, 1996, and 1995 awards had been amortized to expense over the vesting periods of the awards, pro forma net income and earnings per share would have been as follows:
(9) LEASES
The Bank leases its premises under non-cancelable operating leases with terms, including renewal options, ranging from five to fifteen years. Future minimum payments under the agreements are as follows:
Rent expense under operating leases was $314,000, $225,000, and $250,000 during the years ended December 31, 1997, 1996, and 1995, respectively.
(10) EMPLOYEE BENEFIT PLANS
The Bank offers a 401(k) savings plan. All salaried employees are eligible to contribute up to 20% of their pre-tax compensation to the plan through salary deductions under Section 401(k) of the Internal Revenue Code. The Bank does not match employee contributions.
During 1997, the Bank initiated an employee stock ownership plan. The plan allows the Bank to purchase shares on the open market and award those shares to certain employees in lieu of paying cash bonuses. To be eligible to receive an award of shares under this plan, an employee must have worked at least 1,000 hours during the year and must be employed by the Bank on December 31. Awards under this plan generally vest over four years. During 1997, the Bank funded $98,000 into the plan. The amount funded into this plan was recognized as salaries and benefits expense in the Bank's financial statements.
HERITAGE BANK OF COMMERCE
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
(11) DISCLOSURES OF FAIR VALUE OF FINANCIAL INSTRUMENTS
The estimated fair value amounts have been determined by using available market information and appropriate valuation methodologies. However, considerable judgement is required to interpret market data to develop the estimates of fair value. Accordingly, the estimates presented are not necessarily indicative of the amounts that could be realized in a current market exchange. The use of different market assumptions and/or estimation techniques may have a material effect on the estimated fair value amounts.
The carrying amounts and estimated fair values of the Bank's financial instruments as of December 31, 1997 and 1996 were as follows:
The following methods and assumptions were used to estimate the fair value in the table, above:
Cash and Cash Equivalents
The carrying amount approximates fair value because of the short maturities of these instruments. Securities
The fair value of securities is estimated based on bid market prices. The fair value of certain municipal securities is not readily available through market sources other than dealer quotations, so fair value estimates are based on such dealer quotations.
Loans, net
Loans with similar financial characteristics are grouped together for purposes of estimating their fair value. Loans are segregated by type such as commercial, term real estate, residential construction, and consumer. Each loan category is further segmented into fixed and adjustable rate interest terms.
The fair value of performing, fixed rate loans is calculated by discounting scheduled future cash flows using estimated market discount rates that reflect the credit and interest rate risk inherent in the loan. The fair value of variable rate loans is the carrying amount as these loans generally reprice within 90 days. The fair value calculations are adjusted by the allowance for possible loan losses.
Deposits
The fair value of deposits with no stated maturity, such as non-interest bearing demand deposits, savings, and money market accounts, approximates the amount payable on demand. The carrying amount approximates the fair value of time deposits with a remaining maturity of less than 90 days. The fair value of all other time deposits is calculated based on discounting the future cash flows using rates currently offered by the Bank for time deposits with similar remaining maturities.
HERITAGE BANK OF COMMERCE
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
Securities Sold Under Agreements to Repurchase
The fair value of securities sold under agreements to repurchase approximates the carrying amount due to the short maturity.
Limitations
Fair value estimates are made at a specific point in time, based on relevant market information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Bank's entire holdings of a particular financial instrument. Fair value estimates are based on judgements regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgement and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates.
Fair value estimates are based on existing financial instruments, as of the reporting dates, without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. In addition, tax ramifications related to the realization of unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in the estimates.
(12) COMMITMENTS AND CONTINGENT LIABILITIES
Financial Instruments with Off-Balance Sheet Risk
The Bank is party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its clients. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk, in excess of the amounts recognized in the balance sheets.
The Bank's exposure to credit loss in the event of non-performance of the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. Credit risk is the possibility that a loss may occur because a party to a transaction failed to perform according to the terms of the contract. The Bank controls the credit risk of these transactions through credit approvals, limits, and monitoring procedures. Management does not anticipate any significant losses as a result of these transactions.
Commitments to extend credit as of December 31, were as follows:
Commitments to extend credit are agreements to lend to a client as long as there is no violation of conditions established in the contract. Commitments generally have fixed expiration dates or other termination clauses. Since some of the commitments are expected to expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements. The Bank evaluates each client's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on management's credit evaluation of the borrower. Collateral held varies but may include cash, marketable securities, accounts receivable, inventory, property, plant and equipment, income-producing commercial properties, and/or residential properties. Fair value of these instruments are not considered material.
HERITAGE BANK OF COMMERCE
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
Standby letters of credit are written conditional commitments issued by the Bank to guaranty the performance of a client to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to clients. Fair value of these instruments are not considered material.
(13) REGULATORY MATTERS
The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory -- and possibly additional discretionary -- actions by regulators that, if undertaken, could have a direct material effect on the Bank's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank's assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank's capital amounts and classifications are also subject to qualitative judgements by the regulators about components, risk weightings, and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined). Management believes that, as of December 31, 1997, the Bank meets all capital adequacy guidelines to which it is subject.
The most recent notification from the FDIC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized the Bank must maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the institution's category.
The Bank's actual capital amounts and ratios are also presented in the table.
The Bank is required to maintain reserves with the Federal Reserve Bank of San Francisco. Reserve requirements are based on a percentage of certain deposits. At December 31, 1997, the Bank maintained reserves of $3,449,000 in the form of vault cash and balances at the Federal Reserve Bank of San Francisco, which satisfied the regulatory requirements.
Under California law, the holders of common stock are entitled to receive dividends when and as declared by the Board of Directors, out of funds legally available therefor. The California Banking Law provides that a
HERITAGE BANK OF COMMERCE
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
state licensed bank may not make a cash distribution to its shareholders in excess of the lesser of the following: (i) the bank's retained earnings, or (ii) the bank's net income for its last three fiscal years, less the amount of any distributions made by the bank to its shareholders during such period. However, a bank, with the prior approval of the Commissioner, may make a distribution to its shareholders of an amount not to exceed the greater of (i) a bank's retained earnings, (ii) its net income for its last fiscal year, or (iii) its net income for the current fiscal year. In the event that the Commissioner determines that the shareholders' equity of a bank is inadequate or that the making of a distribution by a bank would be unsafe or unsound, the Commissioner may order a bank to refrain from making such a proposed distribution.
(14) OTHER MATTERS (UNAUDITED)
Formation of Bank Holding Company
On December 18, 1997, the shareholders of the Bank met at a special meeting to approve the formation of a bank holding company by the adoption of a merger agreement which provided for the merger of a merger subsidiary, a subsidiary of the newly formed Heritage Commerce Corp, with and into the Bank under the name and charter of the Bank. By this action, the Bank will become a wholly-owned subsidiary of Heritage Commerce Corp. Shareholders of the Bank received one share of Heritage Commerce Corp Common Stock for each share of Bank Common Stock held. The merger was effective February 17, 1998.
New Branches
On February 9, 1998, the Bank opened a full-service branch in the city of Fremont, California.
EXHIBIT INDEX
(b) Reports on Form 8-K
On December 1, 1997, the Registrant, pursuant to the 1934 Act, filed Form with the FDIC to report a change in certifying accountants. [This exhibit is incorporated by reference to the paper filing of Heritage Commerce Corp's Form 8-A filed March 5, 1998 (File No. 000-23877).]