Item 1. Business
Organizational Structure and History
Heritage Oaks Bancorp (the "Company") is a California corporation organized in 1994 and is registered as a bank holding company for Heritage Oaks Bank (the "Bank"). The Company acquired all of the outstanding common stock of the Bank and its subsidiaries in 1994. The Bank is licensed by the California Department of Business Oversight, Division of Financial Institutions ("DBO") and commenced operation in January 1983. As a California state bank, the Bank is subject to primary supervision, examination and regulation by the DBO and the Federal Deposit Insurance Corporation ("FDIC"), and is also subject to certain other federal laws and regulations. The deposits of the Bank are insured by the FDIC up to the applicable limits. As used in this Annual Report on Form 10-K, any reference to the term "Management" refers to the executive management team of the Company and its subsidiaries.
The Company formed Heritage Oaks Capital Trust II in October 2006. This trust is a statutory business trust formed under the laws of the State of Delaware and is a wholly-owned, non-financial, non-consolidated subsidiary of the Company. The Company also acquired Mission Community Capital Trust I and Santa Lucia Bancorp (CA) Capital Trust as part of the acquisition of Mission Community Bancorp in 2014. These trusts are statutory business trusts, and are wholly-owned, non-financial, non-consolidated subsidiaries of the Company. Additionally, the Company has incorporated a subsidiary, CCMS Systems, Inc., which is currently inactive and has not been capitalized.
The Company is authorized to engage in a variety of banking activities with the prior approval of the Board of Governors of the Federal Reserve System (the "Federal Reserve Board"), the Company's principal regulator. However, banking activities primarily occur at the Bank. As a legal entity separate and distinct from its subsidiaries, the Company's principal source of funds are dividends received from the Bank, as well as equity or debt it issues. Legal limitations are imposed on the amount of dividends that may be paid by the Bank to the Company. See Item 1. Business - Supervision and Regulation and Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities - Dividends.
Recent Developments
Merger Agreement
On December 12, 2016, the Company and Pacific Premier Bancorp, Inc., a Delaware corporation ("PPBI"), entered into an Agreement and Plan of Reorganization (the "Merger Agreement") pursuant to which the Company will be merged with and into PPBI, with PPBI surviving (the "Corporate Merger"), immediately followed by the merger of Heritage Oaks Bank with and into Pacific Premier Bank, the wholly-owned bank subsidiary of PPBI ("Pacific Premier"), with Pacific Premier surviving (the "Bank Merger"). The Corporate Merger and Bank Merger are collectively referred to in this Annual Report on Form 10-K as the "Announced Transaction." The consideration paid to shareholders of the Company will consist of whole shares of PPBI common stock, and cash in lieu of fractional shares of PPBI common stock. Upon consummation of the Corporate Merger, each share of the Company's common stock issued and outstanding immediately prior to the effective time of the merger will be cancelled and converted into the right to receive 0.3471 shares of PPBI common stock.
The consummation of the Announced Transaction is subject to a number of conditions, which include: (i) the approval of the Merger Agreement by the Company's shareholders and the approval of the issuance of shares of PPBI common stock by PPBI's shareholders; (ii) as of the month-end prior to the closing of the Announced Transaction, Heritage Oaks Bank must have an aggregate outstanding balance of non-maturity deposits equal to at least $1.25 billion; (iii) as of the closing of the Announced Transaction, the Company shall have tangible common equity of not less than $183.0 million, subject to certain assumptions and adjustments that are set forth in the Merger Agreement; (iv) the receipt of all necessary regulatory approvals for the Announced Transaction, without the imposition of conditions or requirements, other than conditions or requirements related to remedial actions, that the PPBI board of directors reasonably determines in good faith would not, individually or in the aggregate, materially reduce the economic benefits of the Announced Transaction; (v) the absence of any regulation, judgment, decree, injunction or other order of a governmental authority which prohibits the consummation of the Announced Transaction or which makes illegal the consummation of the Announced Transaction; (vi) the effective registration of the shares of PPBI common stock to be issued to the Company's shareholders with the Securities and Exchange Commission ("SEC") and the approval of such shares for listing on the Nasdaq Global Market; (vii) all representations and warranties made by PPBI and the Company in the Merger Agreement must remain true and correct, except for certain inaccuracies that would not have, or would not reasonably be expected to have, a material adverse effect; and (viii) PPBI and the Company must have performed their respective obligations under the Merger Agreement in all material respects. The foregoing description of the Merger Agreement does not purport to be complete and is qualified in its entirety by reference to the full text of the Merger Agreement, which has been previously filed with the SEC on Form 8-K dated December 13, 2016.
The representations, warranties and covenants of each party set forth in the Merger Agreement have been made only for purposes of, and were and are solely for the benefit of the parties to, the Merger Agreement, may be subject to limitations agreed upon by the contracting parties, including being qualified by confidential disclosures made for the purposes of allocating contractual risk between the parties to the Merger Agreement instead of establishing these matters as facts, and may be subject to standards of materiality applicable to the contracting parties that differ from those applicable to investors.
Termination of Mortgage Banking Business
In January 2017, the Company's Management and Board of Directors decided to discontinue activities related to the consumer mortgage banking business, effective February 1, 2017. This decision is primarily attributable to current market conditions, such as rising interest rates, and increasing housing prices. The discontinuation of the consumer mortgage banking business did not involve the sale of existing mortgage assets, rather it entailed the termination of certain business activities such as originating and selling consumer mortgage loans. The Company, however, continues to offer home equity lines of credit and home equity loans. The Company ceased accepting new applications on February 1, 2017, and will terminate all consumer mortgage origination related operations on or about April 30, 2017, other than servicing existing consumer mortgage loans within the Company's loan portfolio. In order to ensure that Heritage Oaks Bank customers continue to have access to consumer mortgage products, the Company entered into a referral arrangement with another bank that has a strategic focus on the consumer mortgage business, and which is not a competitor in terms of deposit gathering and their branch geographic footprint. Effective February 1, 2017, many of the Company's consumer mortgage banking team members joined this other bank. The Company will continue to serve the needs of mortgage customers with loans that were in process of origination prior to February 1, 2017, and will continue to service all loans remaining in the Company's portfolio indefinitely. The Company will honor all contractual commitments to both customers and investors that were in process prior to February 1, 2017. Management expects that the majority of existing loan applications that were in process prior to February 1, 2017 will close within 90 days.
Banking Activities
Headquartered in Paso Robles, California, the Bank is a community-oriented financial services firm that provides banking products and services to small and medium sized businesses and consumers. Products and services are offered primarily through 12 retail branches located on the Central Coast of California, in San Luis Obispo and Santa Barbara Counties and through other direct channels, including a loan production office in Ventura County.
Business Strategy
The Company's business objective is to be the leading community bank on the Central Coast of California to targeted businesses and consumers. We seek to achieve this objective by employing our business strategies as follows:
Deliver Superior Customer Service
We believe that it is imperative for us to deliver superior customer service to be successful. The pursuit of superior customer service is not a slogan for us but rather a fundamental aspect of our culture. A key element to superior customer service is providing authority to local decision makers so that customers are given a quick response to their financial needs, while at the same time providing the proper tools to the local decision makers to ensure that the products and services offered are profitable for us and safe and sound.
Enhance Product Delivery to Our Customers
We believe that our customers should have a positive experience at every point of contact with us. The primary point of contact with our customers continues to be our retail offices. We continue to implement user-friendly technologies for our customers who want to interact with us through electronic channels such as the internet, phone, or other mobile devices. We currently offer online banking, bill pay, and cash management; remote deposit capture; Automated Clearing House ("ACH") and positive payments; automatic payroll deposits; eDelivery; prepaid gift and payroll cards; some advanced function ATMs; and mobile banking. We expect to continue to expand our electronic delivery channels as customer preferences change and newer devices and technologies are developed. We believe the combination of high touch service in retail locations and user-friendly electronic banking services enhances our customer experience. It also provides us additional delivery channels to attract more customers.
Maintain Strong Brand Awareness
We expend a considerable amount of resources maintaining and enhancing our retail brand. We believe that our brand should reflect the superior customer service we offer as a community bank and our commitment to the communities where we operate. Maintaining strong brand awareness requires a consistent brand design; effective use of marketing and merchandising; participation and sponsorship in community based events; and usage of multiple media sources. We hold service marks issued by the U.S. Patent and Trademark Office for the "Oakley" design; and the tag line "Heritage Oaks Bank - We're central to the Coast." We continually evaluate the effectiveness of our brand and from time to time will take steps to improve our overall brand awareness in the markets we serve.
Increase Market Share in Existing Markets and Expand into New Markets
During the economic downturn, there were a number of community banks, which operated in the Central Coast of California, that were acquired by larger commercial banks. We believe these acquisitions provide us with the opportunity to increase market share in San Luis Obispo and Santa Barbara Counties and potentially expand into new markets contiguous to these counties, such as our 2012 expansion in Ventura County with the opening of a loan production office. In the past we have regularly evaluated opportunities to either open de novo retail offices; purchase branches from other financial institutions; or to acquire financial institutions in proximity to our geographic footprint, as evidenced by our December 2012 purchase of the Morro Bay branch of Coast National Bank and our merger with Mission Community Bancorp ("MISN") and Mission Community Bank, which closed in February 2014.
The Company believes the combination with MISN created a more valuable retail and business community banking franchise, with a low cost core deposit base, strong capital ratios, attractive net interest margins, lower operating costs, and better overall returns for the shareholders of the combined institution. It also created a banking platform that is well positioned for future growth.
Community Service
We strongly believe in enhancing the economic vitality and welfare of the communities where we work and live. In 2016, Bank employees provided approximately 2,500 hours in direct volunteer support of local community activities, projects, and events. The Bank also provided in-kind support throughout the year including providing meeting rooms at retail branch and administrative locations, and giving surplus furniture and used computers to local partners. Bank employees also serve on boards of local non-profit and charitable organizations. Finally, we donated over $0.4 million during 2016 to local organizations and charities to support community related activities.
Products and Services
We offer a full array of financial products and services to targeted businesses and consumers. We regularly monitor our customers' financial needs to determine whether we should design or offer new products and services. We also regularly monitor the pricing and profitability of these financial products and services to ensure that we are able to achieve a reasonable rate of return for the risks we assume in offering such products and services. The Bank offers to its commercial clients commercial loans secured by real estate, other commercial loans and lines of credit, agricultural loans, construction financing, other real estate loans and small business administration loans. The Bank also offers interest rate swap products to commercial clients who meet certain suitability requirements. For consumers, the Bank offers home equity lines of credit and other consumer loans. The Bank employs relationship managers focused on the development and origination of new loan and banking relationships across the markets it serves. Deposits are obtained primarily through retail deposit gathering efforts as well as through commercial, state and municipal account relationships. Deposit products offered include personal and business checking and savings accounts, time deposit accounts, individual retirement accounts ("IRAs"), health savings accounts ("HSAs"), money market accounts. The Bank also offers online banking, mobile banking, wire transfers, safe deposit boxes, cashier's checks, traveler's checks, bank-by-mail, remote deposit capture, night depository services and other customary banking services.
Competition, Market and Economic Conditions
The banking and financial services industry in California generally, and in the Company's service area specifically, is highly competitive. Although the Company holds a significant presence within its primary market areas, money center banks and large regional banks, by virtue of their larger capital bases, have significantly larger lending limits than we do and generally have more expansive branch networks.
Competition also includes other community-focused commercial banks. In addition, credit unions also present a significant competitive challenge for us. Credit unions currently have an exemption from income taxes and as a result can offer higher deposit rates and lower loan rates than we can on a comparable basis.
As the industry becomes increasingly dependent upon and oriented toward technology-driven delivery systems, permitting transactions to be conducted by telephone, computer, the internet and smartphone and tablet devices, non-bank institutions are able to attract funds and provide lending and other financial services without offices located in our primary service area. 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.
In order to compete with other financial institutions in our service area, we principally rely upon direct personal contact with our customers and potential customers by executive officers, directors and employees, local advertising programs, and specialized services. We emphasize to our customers the advantages of dealing with a community oriented bank. We also seek to provide special services and programs for businesses and individuals in our primary service area who are employed in the agricultural, professional, municipal and business fields, such as loans for equipment, tools of trade or expansion of practices or businesses.
The economy in the Company's primary market area (San Luis Obispo, Santa Barbara and Ventura Counties) is based primarily on agriculture, hospitality, light industry, oil and retail trade. Additionally, the local economy in San Luis Obispo County and to a lesser degree Santa Barbara County is dependent on the level of employment generated by state and local government agencies. Services supporting these industries have also developed in the areas of medical, financial and educational services. The populations of San Luis Obispo County, the City of Santa Maria (in Northern Santa Barbara County), and the City of Santa Barbara totaled approximately 281,000, 106,000, and 92,000 respectively, according to the most recent data provided by the U.S. Census Bureau.
The moderate climate allows a year round growing season in the local economy's agricultural sector. Vineyards in production have grown significantly over the past several years throughout the Company's service area. Additionally, fruit, nut, and vegetable farming, as well as cattle ranching, represent major parts of the agriculture industry in the Company's market area. Furthermore, access to numerous recreational activities and destinations including beaches, mountains, lakes, and wineries provide a relatively stable tourism industry from many areas including the Los Angeles/Orange County basin, the San Francisco Bay area and the San Joaquin Valley.
Beginning in 2012 and continuing through 2016, the business climate has shown steady signs of improvement including improved real estate prices and a decline in the unemployment rates. The most recent labor market information published by the California Employment Development Department shows the unemployment rate within California to be approximately 5.0%, compared to over 12% at the peak of the economic crisis in 2010.
The Company's profitability, like most financial institutions, is primarily dependent on interest rate differentials. Interest rates are highly sensitive to many factors that are beyond the Company's control and cannot be predicted, such as inflation, recession and unemployment, and the impact that future changes in domestic and foreign economic conditions might have on the Company. A more detailed discussion of the Company's interest rate risks and the mitigation of those risks is included in Item 7A. Quantitative and Qualitative Disclosures About Market Risk, in this Annual Report on Form 10-K.
The Company's business is also influenced by the monetary and fiscal policies of the Federal government and the policies of regulatory agencies. The Federal Reserve Board implements national monetary policies (with objectives such as maintaining price stability, stimulating growth and reducing unemployment) through its open market operations in U.S. Government securities, by adjusting the required level of reserves for depository institutions subject to its reserve requirements, and by varying the target Federal funds and discount rates applicable to borrowings by depository institutions. The actions of the Federal Reserve Board in these areas influence the growth of bank loans and deposits, and also affect interest earned on interest earning assets and interest paid on interest bearing liabilities. The nature of any future changes in monetary and fiscal policies on the Company cannot be predicted and the impact could be material and adverse.
Management remains cautiously optimistic that there will be continued slow but steady improvement in economic conditions in 2017 in our primary markets. However, there have been continued concerns regarding both the global economy and the national economy due primarily to excessive government debt, public perceptions of unsound fiscal policies, and a significant decline in the price of oil, and equity markets. There are also growing concerns that the prolonged drought, which has affected most of California, could have adverse impacts on the Central Coast of California's critical agriculture market, and therefore our loan portfolio, in the future should drought conditions continue to persist. If either of these uncertainties materialize they could eventually affect our local economy, and ultimately negatively impact the financial condition of borrowers to whom the Company has extended credit. In turn, the Company may suffer higher credit losses as a result.
Employees
At December 31, 2016, the Company employed 302 full-time equivalent employees. The Company's employees are not represented by a union or covered by a collective bargaining agreement. Management believes that its employee relations are positive.
Supervision and Regulation
General
The Company is a legal entity separate and distinct from the Bank. The Company is registered with and subject to regulation, supervision and examination by the Federal Reserve Board as a bank holding company. The Company is also subject to certain provisions of the California Financial Code applicable to bank holding companies. As a California state-chartered bank whose accounts are insured by the FDIC, the Bank is subject to regulation, supervision and regular examination by the California Department of Business Oversight (the "DBO") and the FDIC. Such supervision and regulation covers substantially all of the Bank's business activities, including, among others, capital standards, general investment authority, deposit taking and borrowing authority, mergers, establishment of branch offices and permitted subsidiary investments and activities. In addition, while the Bank is not a member of the Federal Reserve System, the Bank is subject to certain regulations of the Federal Reserve Board. The federal and state regulatory systems are intended primarily for the protection of bank depositors, the FDIC deposit insurance fund (the "DIF") and the banking system as a whole and not for the benefit of shareholders.
Legislation and Regulatory Developments
Bank holding companies and their subsidiaries are subject to significant regulation and restrictions by federal and state laws and regulatory agencies. The following paragraph summarizes certain of the laws and regulations that apply to the Company and the Bank. These descriptions of statutes and regulations and their possible effects do not purport to be complete descriptions of all of the provisions of those statutes and regulations and their possible effects on the Company or the Bank, nor do they purport to identify every statute and regulation that may apply to the Company and the Bank.
From time to time, federal and state legislation is enacted that may have the effect of materially increasing the cost of doing business, limiting or expanding permissible activities, or affecting the competitive balance between banks and other financial services providers. For example, the implementation and impact of legislation and regulations enacted since 2008 in response to the U.S. economic downturn and financial industry instability continued in 2016 as federal banking agencies implemented additional requirements under the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank Act"). State and federal bank regulatory agencies continue to adopt other regulations and guidelines intended to assure the financial strength and safety and soundness of banks and the stability of the U.S. banking system.
Regulatory Enforcement Authority
If the FDIC determines that a bank's financial condition, capital resources, asset quality, earnings prospects, management, liquidity or other aspects of its operations are unsatisfactory, or that it or its management is violating or has violated any law or regulation, various remedies are available to the FDIC. Such remedies include the power to: enjoin "unsafe or unsound" practices; require affirmative action to correct any conditions resulting from any violation or practice; issue an administrative order that can be judicially enforced; direct an increase in capital; restrict growth; assess civil monetary penalties; remove officers and directors; institute a receivership; and, ultimately terminate the bank's deposit insurance, which would result in a revocation of its charter. The DBO separately holds many of the same remedial powers.
In the exercise of their supervisory and examination authority, the federal and state bank regulatory agencies have recently emphasized corporate governance, capital planning and stress testing, liquidity management, enterprise risk management and other board responsibilities, anti-money laundering compliance, information technology adequacy, cyber security preparedness, vendor management and fair lending and other consumer compliance obligations.
Until November 29, 2016, the Bank was subject to a Consent Order (the "BSA Consent Order") dated November 5, 2014 issued by the FDIC and the DBO relating to identified deficiencies in the Bank's centralized Bank Secrecy Act and anti-money laundering compliance program. The FDIC and the DBO terminated the BSA Consent Order on November 29, 2016.
Capital Adequacy Requirements
Bank holding companies and banks are subject to regulatory capital requirements administered by their state and federal banking agencies. Federal banking agencies adopted new capital rules (the "New Capital Rules") that generally became effective in 2015, but many elements are being phased in over multiple years. The New Capital Rules replace previous risk-based and leverage capital requirements for banking organizations and were adopted to meet requirements of the Dodd-Frank Act and to implement the international Basel Committee on Banking Supervision Basel III agreements. The risk-based capital guidelines for bank holding companies and banks and, additionally for banks, prompt corrective action regulations (see "Item 1. Business - Prompt Corrective Action Provisions"), require capital ratios that vary based on the perceived degree of risk associated with a banking organization's operations for both transactions reported on the balance sheet as assets, such as loans, and those recorded as off-balance sheet items, such as commitments, letters of credit and recourse arrangements. The risk-based capital ratio is determined by classifying assets and certain off-balance sheet financial instruments into weighted categories, with higher levels of capital being required for those categories perceived as representing greater risks and dividing its qualifying capital by its total risk-adjusted assets and off-balance sheet items. Capital amounts and classifications are also subject to qualitative judgments by regulators about components, risk weighting, and other factors.
Many of the requirements in the New Capital Rules and other regulations and rules apply only to larger or internationally active institutions and not to institutions with less than $10 billion of assets, which currently includes the Company and the Bank. These requirements include required annual stress tests for institutions with $10 billion or more of assets with reporting requirements and Enhanced Prudential Standards, Comprehensive Capital Analysis and Review requirements; capital plan and Resolution Plan or living will submissions, an additional countercyclical capital buffer, a supplementary leverage ratio and the Liquidity Coverage Ratio rule requiring sufficient high-quality liquid assets which may apply to institutions with $50 billion or more or $250 billion or more assets or which may be identified as Global Systemically Important Banking Institutions.
The New Capital Rules narrow the definition of regulatory capital and establish higher minimum risk-based capital ratios that require banking organizations to maintain a new minimum "common equity Tier 1" ratio of 4.5%, a Tier 1 capital ratio of 6.0% (increased from 4.0%), a total risk-based capital ratio of 8.0%, and a minimum leverage ratio of 4.0% (calculated as Tier 1 capital to average consolidated assets). The effective date of these requirements for the Company and the Bank was January 1, 2015.
In addition, a capital conservation buffer of 2.5% above each of these levels (that is being phased in over three years, which began at 0.625% on January 1, 2016, increased to 1.25% on January 1, 2017, and which will be increased by 0.625% on each of January 1, 2018 and January 1, 2019) will be required for banking institutions to avoid restrictions on their ability to pay dividends, repurchase stock or pay discretionary bonuses. Including the capital conservation buffer of 2.5%, the New Capital Rules would result in the following minimum ratios to be considered well capitalized: (i) a Tier 1 capital ratio of 8.5%, (ii) a common equity Tier 1 capital ratio of 7.0%, and (iii) a total capital ratio of 10.5%. At December 31, 2016, the respective capital ratios of the Company and the Bank exceeded the minimum percentage requirements to be deemed "well capitalized" for regulatory purposes.
In addition, the New Capital Rules include changes in the permitted composition of Tier 1 capital to exclude trust preferred securities subject to certain grandfathering exceptions for organizations like the Company which had less than $15 billion in assets as of December 31, 2009, limitations on the amount of mortgage servicing rights and deferred tax assets permitted to be included in Tier 1 capital, and the required inclusion of unrealized gains and losses on available for sale debt and equity securities unless the organization opts out of including such unrealized gains and losses. The Company and the Bank made this opt out election.
While the New Capital Rules set higher regulatory capital standards for the Company and the Bank, bank regulators may also continue their past policies of expecting banks to maintain additional capital beyond the new minimum requirements. The implementation of the New Capital Rules or more stringent requirements to maintain higher levels of capital or to maintain higher levels of liquid assets could adversely impact the Company's net income and return on equity, restrict the ability to pay dividends and require the raising of additional capital. Please also see "Capital" under Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations for disclosure concerning the Company's and Bank's regulatory capital ratios.
Prompt Corrective Action Provisions
The Federal Deposit Insurance Act requires the federal bank regulatory agencies to take "prompt corrective action" with respect to a depository institution if that institution does not meet certain capital adequacy standards, including requiring the prompt submission of an acceptable capital restoration plan. Depending on the Bank's capital ratios, the agencies' regulations define five categories in which an insured depository institution will be placed: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized. The prompt corrective action standards were also changed as the New Capital Rules ratios became effective. Under the new standards, in order to be considered well-capitalized, the Bank will be required to meet the new common equity Tier 1 ratio of 6.5%, an increased Tier 1 ratio of 8% (increased from 6%), an unchanged total capital ratio of 10% and an unchanged leverage ratio of 5%.
At each successive lower capital category, an insured bank is subject to more restrictions, including restrictions on a bank's activities, operational practices or the ability to pay dividends. Based upon its capital levels, a bank that is classified as well capitalized, adequately capitalized, or undercapitalized may be treated as though it were in the next lower capital category if the appropriate federal banking agency, after notice and opportunity for hearing, determines that an unsafe or unsound condition, or an unsafe or unsound practice, warrants such treatment. The federal banking agencies also may require banks and bank holding companies subject to enforcement actions to maintain capital ratios in excess of the minimum ratios otherwise required to be deemed well capitalized. Failure to meet statutorily mandated capital guidelines or more restrictive ratios separately established for a financial institution could subject a bank or bank holding company to a variety of enforcement remedies, including issuance of a capital directive, the termination of deposit insurance by the FDIC, a prohibition on accepting or renewing brokered deposits, limitations on the rates of interest that the institution may pay on its deposits and other restrictions on its business.
Dividends
Under California law, a California corporation such as the Company may make a distribution to its shareholders to the extent that either the corporation's retained earnings meet or exceed the amount of the proposed distribution or the value of the corporation's assets exceed the amount of its liabilities plus the amount of shareholders preferences, if any, and certain other conditions are met. It is the Federal Reserve Board's policy, however, that bank holding companies should generally pay dividends on common stock only out of income available over the past year, and only if prospective earnings retention is consistent with the organization's expected future needs and financial condition. It is also the Federal Reserve Board's policy that bank holding companies should not maintain dividend levels that undermine their ability to be a source of strength to their banking subsidiaries. The Federal Reserve Board also discourages dividend payment ratios that are at maximum allowable levels unless both asset quality and capital are very strong.
The Bank is a legal entity that is separate and distinct from its holding company. The Company depends on the performance of the Bank for funds which may be received as dividends from the Bank for use in the operation of the Company and the ability of the Company to pay dividends to shareholders. Future cash dividends by the Bank will also depend upon management's assessment of future capital requirements, contractual restrictions, and other factors. The New Capital Rules restrict dividend payments by the Bank to the Company if the capital conservation buffer is not achieved.
California law limits the ability of the Bank to pay cash dividends to the Company to the lesser of the Bank's retained earnings or net income for its last three fiscal years (less any distributions to shareholders made during such period). If the Bank is unable to pay cash dividends under this test, the Bank may pay cash dividends with the prior approval of the DBO, in an amount not exceeding the greatest of (1) retained earnings of the bank; (2) the net income of the bank for its last fiscal year; or (3) the net income of the bank for its current fiscal year.
Deposit Insurance
Substantially all of the deposits of the Bank are insured up to applicable limits by the DIF of the FDIC and are subject to deposit insurance assessments to maintain the DIF. All FDIC-insured institutions are also required to pay assessments to the FDIC to fund interest payments on bonds issued by the Financing Corporation ("FICO"), an agency of the Federal government established to recapitalize the predecessor to the DIF. These assessments will continue until the FICO bonds mature in 2017.
The amount of FDIC assessments paid by each DIF member institution is based on its asset size and its relative risk of default as measured by regulatory capital ratios and other supervisory factors. The Bank is generally unable to control the amount of premiums that we are required to pay for FDIC insurance, which can be affected by the cost of bank failures to the FDIC among other factors. Any future increases in FDIC insurance premiums may have a material and adverse effect on the Bank's earnings and could have a material adverse effect on the value of, or market for, the Company's common stock.
The Dodd-Frank Act revised the FDIC's DIF management authority by setting requirements for the DIF's reserve ratio and redefining the assessment base used to calculate banks' quarterly assessments. In 2016, the FDIC adopted a rule increasing the DIF's minimum reserve ratio to 1.35% by September 30, 2020, as required by the Dodd-Frank Act. As required by the Dodd-Frank Act, the cost of increasing the DIF's reserve ratio from 1.15% to 1.35% will be borne by depository institutions with total consolidated assets of $10 billion or more.
Operations and Consumer Compliance Laws
The Bank must comply with numerous federal and state anti-money laundering and consumer protection statutes and implementing regulations, including, but not limited to, the USA PATRIOT Act of 2001, the Bank Secrecy Act, the Foreign Account Tax Compliance Act, the Community Reinvestment Act, the Fair Debt Collection Practices Act, the Fair Credit Reporting Act, the Equal Credit Opportunity Act, the Truth in Lending Act, the Fair Housing Act, the Home Mortgage Disclosure Act, the Real Estate Settlement Procedures Act, the National Flood Insurance Act, the California Homeowner Bill of Rights and various federal and state privacy protection laws, including the Telephone Consumer Protection Act, CAN-SPAM Act. Noncompliance with any of these laws could subject the Bank to compliance enforcement actions as well as lawsuits and could also result in administrative penalties, including, fines and reimbursements. The Company and the Bank are also subject to federal and state laws prohibiting unfair or fraudulent business practices, untrue or misleading advertising and unfair competition.
These laws and regulations mandate certain disclosure and reporting requirements and regulate the manner in which financial institutions must deal with customers when taking deposits, making loans, servicing, collecting and foreclosure of loans, and providing other services. Failure to comply with these laws and regulations can subject the Bank to various penalties, including but not limited to enforcement actions, injunctions, fines or criminal penalties, punitive damages to consumers, and the loss of certain contractual rights.
CFPB
The Dodd Frank Act created the Consumer Finance Protection Bureau ("CFPB") as an independent entity within the Federal Reserve Board with broad rulemaking, supervisory and enforcement authority over consumer financial products and services, including deposit products, residential mortgages, home equity loans and credit cards. The CFPB's functions include investigating consumer complaints, conducting market research, rulemaking, supervising and examining bank consumer transactions, and enforcing rules related to consumer financial products and services. CFPB regulations and guidance apply to all financial institutions and banks. Those with $10 billion or more in assets are subject to examination by the CFPB. Banks with less than $10 billion in assets will continue to be examined for compliance by their primary federal banking agency.
Bank Holding Company and Bank Regulation
The Company and the Bank are subject to a wide range of other requirements and restrictions contained in both federal and state banking laws, including the following:
• Requirements that bank holding companies serve as a source of strength for their banking subsidiaries. In addition, the regulatory agencies have "prompt corrective action" authority to limit activities and order an assessment of a bank holding company if the capital of a bank subsidiary falls below capital levels required by the regulators.
• Safety and soundness requirements. Banks must be operated in a safe and sound manner and meet standards applicable to internal controls, information systems, internal audit, loan documentation, credit underwriting, interest rate exposure, asset growth, liquidity management and compensation, as well as other operational and management standards. These safety and soundness requirements give bank regulatory agencies significant latitude in exercising their supervisory authority and their authority to initiate informal or formal enforcement actions.
• Requirements for approval of acquisitions and activities. Prior approval or non-objection of the applicable federal regulatory agencies is required for most acquisitions and mergers and in order to engage in certain non-banking activities and activities that have been determined by the Federal Reserve Board to be financial in nature, incidental to financial activities, or complementary to a financial activity. Laws and regulations governing state-chartered banks contain similar provisions concerning acquisitions and activities.
• The Community Reinvestment Act (the "CRA"). The CRA requires that banks help meet the credit needs in their communities, including the availability of credit to low and moderate income neighborhoods and individuals. If the Company or the Bank fails to adequately serve their communities, penalties may be imposed, including denials of applications for branches, to add subsidiaries and affiliates, or to merge with or purchase other financial institutions. In its last reported examination by the FDIC in 2015, the Bank received a CRA rating of "Satisfactory."
• The Bank Secrecy Act, the USA Patriot Act, and other anti-money laundering laws. These laws and regulations require financial institutions to assist U.S. Government agencies in detecting and preventing money laundering and other illegal acts by maintaining policies, procedures and controls designed to detect and report money laundering, terrorist financing, and other suspicious activity.
• The Volcker Rule. The "Volcker Rule," which was adopted as part of the Dodd-Frank Act, prohibits bank holding companies, banks and their affiliated companies from engaging in short-term proprietary trading of certain securities and commodity futures for their own account. The Volcker Rule also limits banking entities' investments in, and other relationships with, hedge funds and private equity funds, although the Federal Reserve Board has extended the conformance period for certain existing investments to July 2017. The Company and the Bank held no investment positions or fund relationships at December 31, 2016 which were subject to the final rule and have controls in place to ensure compliance with the Volcker Rule going forward.
•Limitations on the amount of loans to one borrower and to executive officers and directors.
•Limitations on transactions with affiliates.
•Restrictions on the nature and amount of any investments in, and ability to underwrite certain securities.
•Requirements for opening of branches intra- and interstate.
•Fair lending and truth in lending laws to ensure equal access to credit and to protect consumers in credit transactions.
•Provisions of the federal and state laws dealing with privacy for nonpublic personal information of customers.
Securities Laws and Corporate Governance
The Company is subject to the disclosure and regulatory requirements of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended, both as administered by the SEC. As a company listed on the NASDAQ Capital Market, the Company is also subject to NASDAQ's continuing listing standards for listed companies.
The Company is also subject to the Sarbanes-Oxley Act of 2002, provisions of the Dodd-Frank Act, and other federal and state laws and regulations which address, among other issues, required executive certification of financial presentations, corporate governance requirements for board audit committees and their members, disclosure of controls and procedures and internal control over financial reporting, auditing and accounting, executive compensation, and enhanced and timely disclosure of corporate information. NASDAQ has also adopted corporate governance rules, which are intended to allow shareholders and investors to more easily and efficiently monitor the performance of companies and their directors.
Where You Can Find More Information
Under Section 13 of the Securities Exchange Act of 1934, as amended, periodic and current reports must be filed with or furnished to the SEC. The Company electronically files or furnishes such reports with the SEC and any amendments thereto, including the following: Form 10-K, Form 10-Q, Form 8-K and Form DEF 14A. The SEC maintains an Internet site, www.sec.gov, through which all forms filed and furnished electronically may be accessed. Additionally, all forms filed with or furnished to the SEC and additional shareholder information is available free of charge on the Company's website: www.heritageoaksbancorp.com. The Company posts these reports to its website as soon as reasonably practicable after filing them with the SEC. The Company also posts its Committee Charters, Code of Ethics, Code of Conduct and Corporate Governance Guidelines on the Company's website. None of the information on or hyperlinked from the Company's website is incorporated into this Annual Report on Form 10-K.
Item 1A.
Item 1A. Risk Factors
In the course of conducting its business operations, the Company is exposed to a variety of risks, some of which are inherent in the financial services industry and others of which are more specific to its own business. The following discussion addresses the most significant risks that could affect the Company's business, financial condition, liquidity, results of operations, and capital position and stock price. The risks identified below are not intended to be a comprehensive list of all risks faced by the Company. Additional risks and uncertainties that the Company is not aware of or that the Company currently deems immaterial may also impair our business.
Renewed weakness in economic conditions could have a material and adverse effect on our business.
Our performance could be materially and adversely affected to the extent there is deterioration in business and economic conditions that have a direct or indirect adverse effect on us, our customers and our counterparties. These conditions could result in one of the following: (i) a decrease in the demand for loans and other products and services offered by us, (ii) a decrease in customer savings generally and a corresponding decrease in the demand for savings and investment products offered by us, and (iii) an increase in the number of customers and counterparties that become delinquent, file for protection under the bankruptcy laws and/or default on their loans and other obligations to us. An increase in the number of delinquencies, bankruptcies or defaults could result in a higher level of non-performing assets, provisioning for credit losses, and valuation adjustments on loans held-for-sale.
We are highly dependent on the real estate market on the Central Coast of California and a renewed downturn in the real estate market may have a material and adverse effect on our business.
A significant portion of our loan portfolio is collateralized by real estate. Although we have seen what we believe are the signs of stabilization in the local economies in which we operate, a renewed decline in economic conditions, the local housing market or rising interest rates could have an adverse effect on the demand for new loans, the ability of borrowers to repay outstanding loans, the value of real estate and other collateral securing loans or the value of real estate owned by us, any combination of which could materially and adversely impact our financial condition and results of operations.
In addition, a large portion of the loan portfolio is collateralized by real estate that is subject to risks related to acts of nature, including drought, earthquakes, floods, landslides and fires. To the extent that these events occur, they may cause uninsured damage and other loss of value to real estate that secures these loans, which may also materially and adversely impact our financial condition and results of operations.
Our results of operations and financial condition can be impacted by the effect of the drought in California on our agricultural and related business.
The Company provides financing to agricultural businesses and other industries dependent on agriculture in the Central Coast of California. We recognize the cyclical nature of the industry, often caused by fluctuating commodity prices and changing climatic conditions. The Company remains committed to providing credit to agricultural customers and will always have a material exposure to this industry. In addition, the State of California has been experiencing drought conditions since 2013. The lack of rain will have an adverse impact on our agricultural customers' operating costs, crop yields and crop quality, which could impact such customers' ability to repay their loans to us consistent with the terms of such loans. The longer the drought continues, the more significant this impact will become. As a result, the Company's results of operations, financial condition, cash-flows and stock price can be negatively influenced by the impact of the drought on the banking needs of our agricultural customers.
We have a concentration in commercial real estate loans.
We have a high concentration in commercial real estate ("CRE") loans. CRE loans are defined as construction, land development, other land loans such as farmland, loans secured by multi-family (5 or more units) residential properties and loans secured by non-farm, non-residential properties. Following this definition, approximately 64.9% of our gross loans can be classified as CRE lending as of December 31, 2016. CRE loans generally involve a higher degree of credit risk than certain other types of lending due to, among other things, the generally large amounts loaned to individual borrowers. Losses incurred on loans to a small number of these borrowers could have a material and adverse impact on our operating results and financial condition. In addition, commercial real estate loans generally depend on the cash flow from the property to service the debt. Cash flow may be adversely affected by general economic conditions, which may result in non-performance by certain borrowers.
The cost and other effects of the full implementation of the Dodd-Frank Act remain unknown and may have a material and adverse effect on our business.
The federal banking agencies continue to implement the remaining requirements in the Dodd-Frank Act as well as promulgating other regulations and guidelines intended to assure the financial strength and safety and soundness of banks and the stability of the U.S. banking system. The full compliance burden and impact of the Dodd Frank Act on the Company's and the Bank's business, financial condition, and results of operations and profitability remain uncertain.
Further significant changes in banking laws or regulations, the interpretation of those rules and regulations, and changes in federal monetary policy could materially affect our business.
In addition to the Dodd-Frank Act discussed above, the banking industry is subject to extensive federal and state regulation. The implementation of new laws or changes in existing laws, including changes in the interpretations of such laws and related rules and regulations by regulators, courts or others, could have a negative impact on our business. Federal and state regulatory agencies also frequently adopt changes to their regulations or change the manner in which existing regulations are applied. Significant changes in these laws and regulations and/or the interpretation and enforcement thereof could materially and adversely affect our business. We cannot predict the substance or impact of any change in regulation, whether by regulators or as a result of legislation, or in the way such statutory or regulatory requirements are interpreted or enforced. Compliance with such current and potential regulation may significantly increase our costs, impede the efficiency of our business practices, require us to increase our regulatory capital and limit our ability to pursue business opportunities in an efficient manner.
Our business is also impacted by federal monetary policy, particularly as implemented through the Federal Reserve Board. Federal monetary policy significantly affects our credit conditions, primarily through open market operations in United States government securities, the discount rate for member bank borrowing, and bank reserve requirements. Changes in trade and monetary and fiscal policies and laws, including the interest rate policies of the Federal Reserve Board could have a material and adverse impact on our business, financial condition and results of operations.
Implementation of new Basel III capital rules adopted by the federal bank regulatory agencies require increased capital levels that we may not be able to satisfy and could impede our growth and profitability.
The new Basel III Capital Rules became effective January 1, 2015. The new rules increase minimum capital ratios, add a new minimum common equity ratio, add a new capital conservation buffer, and change the risk-weightings of certain assets. These changes will be phased in through 2019. As the rules are phased in they could have a material and adverse effect on our liquidity, capital resources and financial condition. See also Item 1. Business - Capital Adequacy Requirements, for a further discussion of Basel III Capital Rules.
Our business is subject to credit exposure and our allowance for loan and lease losses may not be sufficient to cover actual loan losses.
We make various assumptions and judgments about the collectability of our loan portfolio, including the creditworthiness of our borrowers and the probability of such borrowers making payments, as well as the value of real estate and other assets serving as collateral for the repayment of many of our loans when considering the adequacy of the Company's allowance. If our assumptions are incorrect, our allowance for loan and lease losses may be insufficient to cover losses inherent in our loan portfolio, which may adversely impact our operating results. Our regulators, as an integral part of their regular examination process, periodically review our allowance for loan losses and may require us to increase it by recognizing additional provisions for loan losses or to decrease our allowance for loan losses by recognizing loan charge-offs. Any additional provisions for loan losses or charge-offs, as required by these regulatory agencies, could have a material and adverse effect on our financial condition and results of operations.
The Company's business is subject to interest rate risk and variations in interest rates may negatively affect its financial performance.
A substantial portion of the Company's income is derived from the differential or "spread" between the interest earned on loans, securities and other interest earning assets, and the interest paid on deposits, borrowings and other interest bearing liabilities. Interest rates are highly sensitive to many factors that are beyond the Company's control, including general economic conditions and the policies of various governmental and regulatory authorities. As interest rates change, net interest income is affected. With fixed rate assets (such as fixed rate loans and investment securities) and liabilities (such as certificates of deposit), the effect on net interest income depends on the cash flows associated with the maturity of the asset or liability. Asset/liability management policy may not be successfully implemented and from time to time the Company's risk position may not be balanced. An unanticipated rapid decrease or increase in interest rates could have a material and adverse effect on the spreads between the interest rates earned on assets and the rates of interest paid on liabilities, and therefore on the level of net interest income. For instance, any rapid increase in interest rates in the future could result in interest expense increasing faster than interest income because of fixed rate loans and longer term investments. Further, substantially higher interest rates could reduce loan demand and may result in slower loan growth than previously experienced. Any one of these occurrences would have a material and adverse effect on the Company's results of operation and financial condition. Conversely, lower interest rates could lead to lower net interest margin due to maturing loans being financed at a lower rate as well as increased refinancing activity to lock in lower rates.
Competition from within and outside the financial services industry may materially and adversely affect our business.
The financial services business in our market area is highly competitive. It is becoming increasingly competitive due to changes in regulation, technological advances and the accelerating pace of consolidation among financial services providers. We face competition in attracting and retaining core business relationships. Increasing levels of competition in the banking and financial services business may reduce our market share, decrease loan demand, cause the prices we charge for our services to fall, resulting in a decline in the rates we charge on loans and/or cause higher rates to be paid on deposits. Therefore, our results may differ in future periods depending upon the nature and level of competition.
Additionally, technology and other changes are allowing parties to complete financial transactions, which historically have involved banks, through alternative methods. For example, consumers can now maintain funds, which would have historically been held as bank deposits in brokerage accounts or mutual funds. Consumers can also complete transactions such as paying bills and/or transferring funds directly without the assistance of banks. The process of eliminating banks as intermediaries, known as "disintermediation," could result in the loss of fee income, as well as the loss of customer deposits and the related income generated from those deposits. The loss of these revenue streams and the lower cost deposits as a source of funds could have a material adverse effect on our financial condition and results of operations.
Liquidity risk could impair our ability to fund operations and negatively impact our financial condition.
Liquidity is essential to our business. An inability to raise funds through deposits, borrowings, the sale of loans and other sources could have a material and adverse effect on our liquidity. Our access to funding sources in amounts adequate to finance our activities could be impaired by factors that affect us specifically or the financial services industry in general. Factors that could detrimentally impact our access to liquidity sources include a decrease in the level of our business activity due to a market downturn or adverse regulatory action against us.
Declines in the market value of our investment portfolio may adversely affect our financial performance, liquidity and capital.
We maintain an investment portfolio that includes, but is not limited to, mortgage-backed securities, municipal securities and asset backed securities. The market value of investments in our portfolio has become increasingly volatile over the last few years, largely due to disruptions in the capital markets and fluctuations in long term interest rates. The market value of investments may be affected by factors other than the underlying performance of the servicer of the securities, or the mortgages underlying the securities, such as changes in interest rates, credit ratings downgrades, adverse changes in the business climate, and a lack of liquidity in the secondary market for certain investment securities. Furthermore, problems at the federal and state government levels may trickle down to municipalities and adversely impact our investment in municipal bonds.
On a quarterly basis, we evaluate investments and other assets for impairment. We may be required to record impairment charges if our investments suffer a decline in value that is considered other-than-temporary. If we determine that a significant impairment has occurred, we would be required to charge the credit-related portion of the other-than-temporary impairment against earnings, which may have a material adverse effect on our results of operations in the periods in which the charges occur.
Loss of customer deposits could increase the Company's funding costs.
The Company relies on bank deposits to be a low cost and stable source of funding. The Company competes with banks and other financial services companies for deposits. If the Company's competitors raise the rates they pay on deposits, the Company's funding costs may increase, either because the Company raises its rates to avoid losing deposits or because the Company loses deposits and must rely on more expensive sources of funding. Higher funding costs reduce the Company's net interest margin and net interest income. Checking and savings account balances and other forms of customer deposits may decrease when customers perceive alternative investments, such as the stock market, as providing a better risk/return tradeoff. When customers move money out of bank deposits and into other investments, the Company may lose a relatively low cost source of funds, increasing the Company's funding costs and reducing the Company's net interest income.
Failure to successfully execute our strategic plan may adversely affect our performance.
Our financial performance and profitability depend on our ability to execute our corporate strategies. Each year, our board of directors approves our long-term strategic plan and annual operating budget. Our near-term business strategy includes pursuing organic growth within our geographic footprint within the markets we currently serve. Our failure to achieve organic loan and deposit growth in our current market area may adversely impact our near-term financial performance goals. Other factors that may adversely affect our ability to attain our long-term financial performance goals include an inability to control non-interest expense, including, but not limited to, rising employee compensation, regulatory compliance and healthcare costs, limitations imposed on us through regulatory actions, and our inability to increase net interest income due to a continued low interest rate environment as well as competitive pressures within our primary market area.
We may not be able to attract and retain skilled people.
Our success depends, in large part, on our ability to attract and retain key people. Competition for the best people can be intense and we may not be able to hire people or to retain them without offering very high compensation. The unexpected loss of the services of one or more of our key personnel could have a material and adverse impact on our business because of the loss of their skills, knowledge of our market and years of industry experience and the difficulty of promptly finding qualified replacement personnel.
The bank regulatory agencies have published guidance and regulations which limit the manner and amount of compensation that banking organizations provide to employees. These regulations and guidance may materially and adversely affect our ability to retain key personnel. Due to these restrictions, we may not be able to successfully compete with other larger financial institutions to attract, retain and appropriately incentivize high performing employees. If we were to suffer such adverse effects with respect to our employees, our business, financial condition and results of operations could be materially and adversely affected.
The Company faces operational risks that may result in unexpected losses.
We are subject to certain operational risks, including, but not limited to, data processing system failures and errors, customer or employee fraud and catastrophic failures resulting from terrorist acts or natural disasters. We maintain a system of internal controls to mitigate against such occurrences and maintain insurance coverage for such risks that are insurable, but should such an event occur that is not prevented or detected by our internal controls, or is uninsured or in excess of applicable insurance limits, it could have a material and adverse impact on our business, financial condition and results of operations.
Our controls and procedures could fail or be circumvented.
Management regularly reviews and updates our internal controls, disclosure controls and procedures and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, but not absolute, assurances of the effectiveness of these systems and controls, and that the objectives of these controls have been met. Any failure or circumvention of our controls and procedures, and any failure to comply with regulations related to controls and procedures could adversely affect our business, results of operations and financial condition.
The occurrence of fraudulent activity, breaches of our information security or cybersecurity-related incidents could have a material adverse effect on our business, financial condition and results of operations.
Information technology systems are critical to our business. We use various technology systems to manage our customer relationships, general ledger, securities, deposits, and loans. As a financial institution, we are susceptible to fraudulent activity, information security breaches and cybersecurity-related incidents that may be committed against us or our clients, which may result in financial losses or increased costs to us or our clients, disclosure or misuse of our information or our clients' information, misappropriation of assets, privacy breaches against our clients, litigation, or damage to our reputation. These risks may increase in the future as we continue to increase our mobile-payment and other internet-based product offerings and expand our internal usage of web-based products and applications.
Such fraudulent activity may take many forms, including check fraud, electronic fraud, wire fraud, phishing, computer viruses, social engineering and other dishonest acts. Information security breaches and cybersecurity-related incidents may include fraudulent or unauthorized access to systems used by us or our clients, denial or degradation of service attacks, and malware or other cyberattacks. In recent periods, there continues to be a rise in electronic fraudulent activity, security breaches and cyber-attacks within the financial services industry, especially in the commercial banking sector due to cyber criminals targeting commercial bank accounts. Consistent with industry trends, we have also experienced an increase in attempted electronic fraudulent activity, security breaches and cybersecurity-related incidents in recent periods. Moreover, in the past year, several large corporations, including retail companies, have suffered major data breaches, where in some cases, exposing sensitive financial and other personal information of their clients and subjecting them to potential fraudulent activity. Some of our clients may have been affected by these breaches, which increase their risks of identity theft, credit card fraud and other fraudulent activity that could involve their accounts with the Bank.
Information pertaining to us and our clients is maintained, and transactions are executed, on our networks and systems, those of our clients and certain of our third party partners, such as our online banking or reporting systems. The secure maintenance and transmission of confidential information, as well as execution of transactions over these systems, are essential to protect us and our clients against fraud and security breaches and to maintain our clients' confidence. Increases in criminal activity levels and sophistication, advances in computer capabilities, new discoveries, vulnerabilities in third-party technologies (including browsers and operating systems) or other developments could result in a compromise or breach of the technology, processes and controls that we use to prevent fraudulent transactions and to protect data about us, our clients and underlying transactions, as well as the technology used by our clients to access our systems. Although we have developed, and continue to invest in, systems and processes that are designed to detect and prevent security breaches and cyber-attacks and periodically test our security, the inability to anticipate, or failure to adequately mitigate, breaches of security could result in: losses to us or our clients; our loss of business and/or clients; damage to our reputation; the incurrence of additional expenses; disruption to our business, and/or our ability to grow our online services or other businesses; additional regulatory scrutiny or penalties; or exposure to civil litigation or possible financial liability, any of which could have a material adverse effect on our business, financial condition and results of operations.
To date, we have not experienced any material losses relating to cyber-attacks or other information security breaches, but there can be no assurance that we will not suffer such attacks or attempted breaches, or incur such losses in the future. Our risk and exposure to these matters remains heightened because of, among other things, the evolving nature and growth of these threats, our plans to continue to implement and increase Internet and mobile banking to meet customer demand, and the current economic and political environment. As cyber and other data security threats continue to evolve, we may be required to expend significant additional resources to continue to modify and enhance our protective measures or to investigate and remediate any security vulnerabilities.
The potential for fraud when regularly dealing with credit cards, debit cards, prepaid cards, and ACH transactions is significant.
Issuers of credit, debit and prepaid cards and other industry participants, as well as depository institutions participating in the ACH network have suffered significant losses in recent years with respect to the theft of personal, financial and confidential data that has been illegally exploited for personal gain. In addition, we operate a number of electronic, check and other payment connections that are vulnerable to individuals engaging in fraudulent activities that seek to compromise payments and related financial systems illegally. The theft of such information is regularly reported and affects not only individuals but businesses as well. In recent years, losses from such fraud have been substantial. Although fraud has not had a material impact on the profitability of the Bank, it is possible that such activity could adversely impact it in the future.
Further, the Company may be affected by data breaches at retailers and other third parties who participate in data interchanges with us and our customers that involve the theft of customer credit and debit card data, which may include the theft of the Company's debit card PIN numbers and commercial card information used to make purchases at such retailers and other third parties. Such data breaches could result in us incurring significant expenses to reissue debit cards and cover losses, which could result in a material adverse effect on the Company's results of operations or financial condition.
The Company is subject to significant financial and reputational risks from potential legal liability and regulatory action.
We face significant legal risks in our business, and the volume of claims and amount of damages and penalties claimed in litigation and regulatory proceedings against other financial institutions remain high. Increased litigation costs, substantial legal liability or significant regulatory action against us could negatively impact our financial condition and results of operations or cause significant reputational harm to the Company, which in turn could adversely impact its business prospects.
Impairment of goodwill or intangible assets would result in a charge to earnings.
Goodwill and intangible assets are evaluated for impairment annually or when events or circumstances indicate that the carrying value of those assets may not be recoverable. We may be required to record a charge to earnings during the period in which any impairment of goodwill or intangibles is determined.
Necessary changes in technology could be costly.
The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. Our future success depends, in part, upon our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in our operations. Many of our competitors have substantially greater resources to invest in technological improvements.
We may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to our customers. Failure to successfully keep pace with technological change affecting the financial services industry could have a material and adverse impact on our business, financial condition and results of operations.
The Company relies on third party service providers for key systems, placing us and our customers at risk if the vendor has service outages, work stoppages or is subjected to attacks on their IT systems that expose information relating to us and our customers.
The Company uses a third party software service provider to perform all of its transaction data processing. The Company also outsources other customer service applications, such as on-line banking, ACH and wire transfers, to third party vendors. If these service providers were to experience technical difficulties or incur any extended outages in services, it could have a material and adverse impact on the Company and its customers. Because such service providers service us and other banks, their systems could be affected by denial of service attacks directed at their other bank customers. In addition, third parties may seek to penetrate our vendors' IT systems, obtain information about us or our customers or access our customers' accounts, and exploit that information to wrongfully withdraw or transfer our customers' funds, which could have material and adverse impacts on our customers and the Company. Further, if the Company was required to switch service providers due to deterioration in service quality or other factors, there is no guarantee that it could obtain comparable services at a comparable price.
Our operations face severe weather, natural disasters, acts of war or terrorism and other external risks.
Severe weather, natural disasters, acts of war or terrorism and other adverse external events could have a significant impact on our ability to conduct business. Such events could affect the stability of our deposit base; impair the ability of borrowers to repay outstanding loans, impair the value of collateral securing loans, cause significant property damage, result in loss of revenue and/or cause us to incur additional expenses. The Central Coast of California is subject to earthquakes, droughts, fires, floods and landslides. Operations in our market could be disrupted by both the evacuation of large portions of the population as well as damage and or lack of access to our banking and operation facilities. The local market that the Company serves is also currently facing drought conditions which could not only impact the largest industry in our market footprint, agriculture, but could have rippling effects on other industries, including hospitality. The occurrence of any such event could have a material and adverse effect on our business, financial condition and results of operations.
Maintaining our reputation as a community bank is critical to our success and the failure to do so may materially and adversely affect our performance.
We are a community bank and our reputation is one of the most valuable components of our business. As such, we strive to conduct our business in a manner that enhances our reputation. If our reputation is negatively affected by the actions of our employees, or otherwise, our business, operating results and financial condition may be materially and adversely affected.
We may enter into new lines of business or offer new products and services which expose us to additional risk or which are not successful.
We may enter into new lines of business or offer new products or services as new opportunities arise or as our business strategy changes. New lines of business or new products or services may involve significant business, reputational or regulatory risk, including increased regulatory scrutiny. The success of these efforts depends on many factors, including the competitive landscape, market adoption and successful implementation. We may experience significant losses to the extent that we invest significant time and resources to a new line of business, product or service and it is not successful. There can be no assurance that we can successfully manage these risks and failure to do so could have a material adverse effect on our financial condition or results of operations.
Changes in accounting standards or tax legislation could have a negative impact on our business.
Our accounting policies and methods are fundamental to how we record and report our financial condition and results of operations. From time to time the Financial Accounting Standards Board and the SEC change the financial accounting and reporting standards that govern the preparation of our financial statements or elected representatives approve changes to tax laws that could affect our corporate taxes. These changes can be hard to predict and can materially impact how we record and report our financial condition and results of operations.
We depend on cash dividends from the Bank to meet our cash obligations.
As a holding company, dividends from our subsidiary bank provide a substantial portion of our cash flow used to service the interest payments on our trust preferred securities and any cash dividends to our shareholders. Various statutory provisions restrict the amount of dividends the Bank can pay to us without regulatory approval. If the Bank is unable to generate the profits necessary to service the interest payments, or we are unable to obtain regulatory approval to make dividends from the Bank to the Company, our business, operating results and financial condition may be materially and adversely affected.
The soundness of other financial institutions could adversely affect us.
Financial services institutions are interrelated as a result of trading, clearing, counterparty and other relationships. We have exposure to many different industries and counterparties, and we routinely execute transactions with counterparties in the financial industry, including brokers and dealers, commercial banks, investment banks, mutual and hedge funds, and other institutional clients. Many of these transactions expose us to credit risk in the event of default of our counterparty or client. In addition, our credit risk may be exacerbated when the collateral held by us cannot be realized at prices not sufficient to recover the full amount of the financial instrument exposure due us. Any such losses could have a material adverse effect on our financial condition and results of operations.
Because the market price of PPBI common stock will fluctuate, the Company's shareholders cannot be sure of the exact value of the consideration they will receive in the Corporate Merger.
Upon the effective time of the Corporate Merger, each share of Company common stock will be cancelled and converted into the right to receive the merger consideration, consisting of shares of PPBI common stock pursuant to the terms of the Merger Agreement. The value of the merger consideration to be received by Company shareholders will be based on an exchange ratio, which is fixed at 0.3471 shares of PPBI common stock for each share of Company common stock. Because the price of PPBI common stock could fluctuate during the period of time between the Company special meeting and the time the Company's shareholders actually receive their shares of PPBI common stock as merger consideration, the Company's shareholders will be subject to the risk of a decline in the price of PPBI common stock during this period. The Company does not have the right to terminate the Merger Agreement or to re-solicit the vote of its shareholders solely because of changes in the market prices of PPBI common stock. Stock price changes may result from a variety of factors, including general market and economic conditions, changes in the values and perceptions of financial services stocks generally and PPBI in particular, changes in PPBI's business, operations and prospects and regulatory considerations. Many of these factors are beyond PPBI's control. Accordingly, at the time of the Company special meeting, the Company's shareholders will not know or be able to calculate the exact value of the shares of PPBI common stock they will receive upon completion of the Corporate Merger.
Directors and officers of the Company have some interests in the Announced Transaction that are in addition to or different than the interests of the Company's shareholders.
The Company's directors and officers have interests in the Announced Transaction as individuals that are in addition to, or different from, their interests as shareholders of the Company, which are:
• The Company's directors and officers will receive, upon consummation of the Announced Transaction, options to acquire PPBI common stock in substitution of their Company options; in addition, directors and officers of the Company or its subsidiaries who will be retained by PPBI or its subsidiaries following the consummation of the Announced Transaction, will receive, upon consummation of the Announced Transaction, restricted shares of PPBI common stock in substitution of their Company restricted stock, and restricted stock units of PPBI in substitution of their Company restricted stock units; directors and officers of the Company and its subsidiaries who will not be retained by PPBI or its subsidiaries following the consummation of the Announced Transaction will have the vesting of their Company stock options, Company restricted stock and Company restricted stock units accelerated and (i) the Company restricted stock shall be converted into the right to receive the merger consideration and (ii) the cash-settled Company restricted stock units shall be converted into the right to receive cash; officers of the Company, whether or not retained, holding performance-based Company restricted stock units will receive cash for such awards;
• The agreement of PPBI to honor indemnification obligations of the Company for a period of six (6) years, as well as to purchase liability insurance for the Company's directors and officers for six (6) years following the merger, subject to the terms of the Merger Agreement;
• Cash payments to certain officers of the Company in the aggregate amount of approximately $4.75 million, on a pre-tax basis, pursuant to the terms of their respective employment-related agreements with the Company;
• The appointment of Simone Lagomarsino, the President and Chief Executive Officer of the Company and Heritage Oaks Bank, Michael Morris, the Chairman of the Board of the Company and Heritage Oaks Bank, and Michael Pfau, the Vice Chairman of the Board of the Company and Heritage Oaks Bank, to serve on the boards of directors of PPBI and Pacific Premier Bank effective upon completion of the merger;
• Robert Osterbauer, Executive Vice President and commercial banking division Manager, North and Agribusiness Lending, with Heritage Oaks Bank, and Brooks Wise, Executive Vice President and commercial banking division Manager, South, with Heritage Oaks Bank, have entered into employment agreements with Pacific Premier Bank, which will each be effective upon the closing of the Corporate Merger, which provide compensation to those individuals for continued provision of services to, or employment with, Pacific Premier Bank following the Bank Merger; and
• Effective as of the closing of the Corporate Merger, PPBI will establish a Community Advisory Board for the Central Coast Region, which shall be comprised of all members of the Company's board of directors as of the closing of the Corporate Merger who are willing to so serve and no additional compensation will paid for service on the Community Advisory Board.
The Company and PPBI boards of directors were aware of these interests and considered them, among other things, in their approval of the Merger Agreement and the transactions contemplated by the Merger Agreement.
The termination fee and the restrictions on solicitation contained in the Merger Agreement may discourage other companies from trying to acquire the Company.
Until the completion of the Corporate Merger, with some limited exceptions, the Company is prohibited from soliciting, initiating, encouraging or participating in any discussion of or otherwise considering any inquiries or proposals that may lead to an acquisition proposal, such as a merger or other business combination transaction, with any person other than PPBI. In addition, the Company has agreed to pay a termination fee to PPBI in specified circumstances. These provisions could discourage other companies from trying to acquire the Company even though those other companies might be willing to offer greater value to the Company's shareholders than PPBI has offered in the Announced Transaction. The payment of the termination fee could also have a material adverse effect on the Company's financial condition.
PPBI may fail to realize the anticipated benefits of the Announced Transaction.
The success of the Announced Transaction will depend on, among other things, PPBI's ability to realize the anticipated revenue enhancements and efficiencies and to combine the businesses of PPBI and the Company in a manner that does not materially disrupt the existing customer relationships of the Company or result in decreased revenues resulting from any loss of customers and that permits growth opportunities to occur. If PPBI is not able to successfully achieve these objectives, the anticipated benefits of the merger may not be realized fully or at all or may take longer to realize than expected.
PPBI and the Company have operated and, until the completion of the Announced Transaction, will continue to operate, independently. It is possible that the integration process could result in the loss of key employees, the disruption of each company's ongoing businesses or inconsistencies in standards, controls, procedures and policies that adversely affect PPBI's ability to maintain relationships with clients, customers, depositors and employees or to achieve the anticipated benefits of the Announced Transaction. Integration efforts between the two companies could also divert management attention and resources. These integration matters could have an adverse effect on each of PPBI and the Company during the transition period and on the combined company following completion of the merger.
The market price of PPBI common stock after the Announced Transaction may be affected by factors different from those affecting the shares of the Company or PPBI currently.
Upon completion of the Corporate Merger, holders of Company common stock will become holders of PPBI common stock. PPBI's business differs from that of the Company, and, accordingly, the financial condition and results of operations of the combined company and the market price of PPBI common stock after the completion of the Announced Transaction may be affected by factors different from those currently affecting the financial condition and results of operations of the Company or PPBI on a standalone basis.
The fairness opinion received by PPBI's board of directors from its financial advisor, D.A. Davidson, and the fairness opinion received by the Company's board of directors from the Company's financial advisor, Sandler O'Neill, will not be updated to reflect any changes since the date of such opinions.
Changes in the operations and prospects of PPBI or the Company, general market and economic conditions and other factors that may be beyond the control of PPBI and/or the Company may alter the value of PPBI or the Company or the market price for shares of PPBI common stock or Company common stock by the time the Announced Transaction is completed. Neither the fairness opinion delivered by D.A. Davidson to the PPBI board of directors nor the fairness opinion delivered by Sandler O'Neill to the Company board of directors speaks as of any date other than the date of such opinion, which was December 12, 2016 in the case of D.A. Davidson's opinion, and December 11, 2016 in the case of Sandler O'Neill's opinion. The Merger Agreement does not require that either D.A. Davidson's or Sandler O'Neill's fairness opinion be updated as a condition to the completion of the Announced Transaction, and neither PPBI nor the Company intends to request that the respective fairness opinions be updated.
The Announced Transaction is subject to the receipt of approvals or waivers from regulatory authorities that may impose conditions that could have an adverse effect on PPBI.
Before the Announced Transaction can be completed, various approvals or waivers must be obtained from bank regulatory authorities. Regulatory approval or waivers are not guaranteed and even if granted, the bank regulatory authorities may impose conditions on the completion of the Announced Transaction or require changes to the terms of the Merger Agreement. Although PPBI and the Company do not currently expect that any such conditions or changes will be imposed, there can be no assurance that they will not be, and such conditions or changes could have the effect of delaying completion of the merger, imposing additional costs on, or limiting the revenues of PPBI following the merger or causing the Announced Transaction between PPBI and HEOP to terminate.
The Announced Transaction cannot be completed unless the PPBI shareholders approve the issuance of PPBI common stock in the merger and the Company's shareholders approve the Merger Agreement.
In order for the Announced Transaction to be completed, the PPBI shareholders must approve the issuance of PPBI common stock in the Announced Transaction and the Company shareholders must approve the Merger Agreement and the other transactions contemplated by the Merger Agreement. While a vote of PPBI's shareholders is not required to approve the Announced Transaction, the approval of PPBI's shareholders is required under applicable NASDAQ rules in order for PPBI to be authorized to issue the shares of PPBI common stock to the Company's shareholders as the merger consideration. Approval of the issuance of PPBI common stock to the Company stockholders under NASDAQ rules requires approval of at least a majority of the total votes cast at the PPBI special meeting. The approval of the Merger Agreement by the Company's shareholders requires the affirmative vote of the holders of a majority of the outstanding shares of Company common stock. If either or both of these required votes is not obtained from the shareholders of each of the respective companies, the merger may not be consummated.
The Announced Transaction is subject to certain closing conditions that, if not satisfied or waived, will result in the Announced Transaction not being completed, which may cause the prices of PPBI common stock and the Company's common stock to decline.
Consummation of the Announced Transaction is subject to customary conditions to closing in addition to the receipt of the required regulatory approvals and approval of the Company's shareholders of the Merger Agreement and the approval of PPBI's shareholders of the issuance of PPBI common stock in connection with the Announced Transaction. If any condition to the Announced Transaction is not satisfied or waived, to the extent permitted by law, the Announced Transaction will not be completed. In addition, PPBI and the Company may terminate the Merger Agreement under certain circumstances even if the Merger Agreement is approved by the Company's shareholders and the issuance of PPBI common stock in connection with the Announced Transaction is approved by PPBI's shareholders, including if the merger has not been completed on or before August 30, 2017. If the merger is not completed, the respective trading prices of PPBI common stock and Company common stock on the NASDAQ Global Stock Market may decline to the extent that the current prices reflect a market assumption that the Announced Transaction will be completed. In addition, neither company would realize any of the expected benefits of having completed the Announced Transaction.
The unaudited condensed pro forma combined financial data included in the joint proxy statement/prospectus are presented for illustrative purposes only and may not be an indication of the combined company's financial condition or results of operations following the Announced Transaction.
The unaudited condensed pro forma combined financial data contained in the joint proxy statement/prospectus are presented for illustrative purposes only, are based on various adjustments, assumptions and preliminary estimates and may not be an indication of the combined company's financial condition or results of operations following the Announced Transaction for several reasons. The actual financial condition and results of operations of the combined company following the Merger may not be consistent with, or evident from, these unaudited pro forma condensed combined financial data. In addition, the assumptions used in preparing the unaudited pro forma condensed combined financial data may not prove to be accurate, and other factors may affect the combined company's financial condition or results of operations following the merger. Any potential decline in the combined company's financial condition or results of operations may cause significant variations in the stock price of the combined company.
The shares of PPBI common stock to be received by Company shareholders as a result of the Announced Transaction will have different rights than shares of the Company's common stock.
Upon completion of the Announced Transaction, the Company's shareholders will become PPBI shareholders and their rights as shareholders will be governed by the PPBI amended and restated certificate of incorporation, the PPBI amended and restated bylaws and Delaware General Corporation Law. The rights associated with Company common stock are different from the rights associated with PPBI common stock.
We will be subject to contractual restrictions and business uncertainties while the merger with PPBI is pending.
Although there is no assurance as to the exact timing, the merger currently is expected to close at the end of the first quarter of 2017 or early in the second quarter of 2017. The Merger Agreement requires us to operate in the ordinary course of business pending the Merger's completion, but restricts us from certain activities, including making acquisitions or opening of new branches, divestitures, issuance of securities and other customary restrictions without PPBI's consent. These restrictions may limit or prevent us from pursuing attractive business opportunities that may arise prior to the completion of the merger, and which we might pursue absent the Merger Agreement.
Uncertainty about the effects of the merger, including branch consolidation and any divestitures that may be required, on our employees and customers may have an adverse effect on us. Certain employees may experience uncertainty about their future roles. These uncertainties may make it more difficult for us to attract, retain and motivate key personnel until the merger is completed, and could cause our customers and others that deal with us to consider changing existing business relationships with us. It is not unusual for competitors to use mergers as an opportunity to seek the merging parties' customers and to hire certain of their staffs. If key employees depart the Corporation or the Bank in light of uncertainty over the merger or our integration efforts with PPBI, our business could be adversely affected.
Termination of the Merger Agreement could negatively affect us.
If, for any reason, the Merger Agreement is terminated, our business may be adversely affected as a result of not pursuing other beneficial opportunities prior to such termination and our management focus on completing the merger. If the Merger Agreement is terminated and our board of directors seeks another merger or business combination, we may not be able to find a party willing to offer equivalent or more attractive consideration than the consideration PPBI has agreed to provide in the merger, especially if the termination fee of $15.0 million becomes payable as a result. See also "Failure to successfully execute our strategic plan may adversely affect our performance."
Item 1B.
Item 1B. Unresolved Staff Comments
None.
Item 2.
Item 2. Properties
The Company's headquarters are located at 1222 Vine Street in Paso Robles, California. As of December 31, 2016, the Bank operates 12 branches within the Counties of San Luis Obispo and Santa Barbara. The Bank currently owns its headquarters and eight of its branches and leases the remaining branches and administrative facilities from various parties. The Bank also leases one location in Ventura County where it operates a loan production office. The Company believes its facilities are adequate for its present needs. The Company believes that the insurance coverage on all properties is adequate for its present needs. Most of the Company's leases contain multiple renewal options and provisions for rental increases, principally for changes in the cost of living index, property taxes and maintenance.
Item 3.
Item 3. Legal Proceedings
Merger litigation
On February 16, 2017, Robert Garfield, a purported shareholder of the Company, filed a complaint seeking class action status in the Superior Court of the State of California, County of San Luis Obispo, against the Company, each of its directors and PPBI, entitled Robert Garfield vs. Heritage Oaks Bancorp, et. al. (Case No. 17cv0097). The complaint alleges, among other things, that the Company's directors breached their fiduciary duties with regard to the proposed merger. Among other things, the complaint seeks class action status, a court order enjoining the Company and its directors from proceeding with or consummating the merger, disclosure of all material information to the Company's shareholders, compensatory or recessionary damages and the payment of attorneys' and experts' fees. The Company believes that it has defenses to all of the claims and requested relief. The Company is unable to state whether the likelihood of an unfavorable outcome of the dispute is probable or remote. The Company is also unable to provide an estimate of the range or amount of potential loss (if the outcome should be unfavorable). The Company intends to defend this lawsuit vigorously.
The outcome of the litigation summarized above and other legal and regulatory matters is inherently uncertain. While the Company does not believe that any such claims, lawsuits or regulations will have a material adverse effect on its financial condition or results of operations, unfavorable rulings could occur. Were an unfavorable ruling to occur, there exists the possibility of a material adverse impact on our liquidity, reputation, consolidated financial position, results of operations, and/or stock price. Except as indicated above, neither the Company nor the Bank is involved in any legal proceedings other than routine litigation incidental to the business of the Company or the Bank.
Item 4.
Item 4. Mine Safety Disclosures
Not applicable.
Part II
Item 5.
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Market Information
The Company's common stock trades on the NASDAQ Capital Market under the symbol "HEOP." As of February 23, 2017, there were approximately 2,860 holders of record of the Company's common stock. The following table summarizes those trades of the Company's Common Stock on NASDAQ, setting forth the high and low sales prices for each quarterly period ended since January 1, 2015, as well as per share amount of dividends declared on the Company's common stock:
Dividends
The Company's Board of Directors has responsibility for the oversight and approval of the declaration of dividends. The timing and amount of any future dividends will depend on the Company's near and long term earnings capacity, current and future capital position, investment opportunities, statutory and regulatory limitations, general economic conditions and other factors deemed relevant by the Company's Board of Directors. No assurances can be given that any dividends will be paid in the future or, if payment is made, no assurances can be given about the size of any such dividends or whether dividends will continue to be paid.
Dividends the Company declares are subject to the restrictions set forth in the California General Corporation Law (the "Corporation Law"). The Corporation Law provides that a corporation may make a distribution to its shareholders if the corporation's retained earnings equal at least the amount of the proposed distribution. The Corporation Law also provides that, in the event that sufficient retained earnings are not available for the proposed distribution, a corporation may nevertheless make a distribution to its shareholders if it meets two conditions, which generally stated are as follows: (i) the corporation's assets equal at least 1 and 1/4 times its liabilities, and (ii) the corporation's current assets equal at least its current liabilities or, if the average of the corporation's earnings before taxes on income and before interest expenses for the two preceding fiscal years was less than the average of the corporation's interest expenses for such fiscal years, then the corporation's current assets must equal at least 1 and 1/4 times its current liabilities. Additionally, the Federal Reserve Board has authority to limit the payment of dividends by bank holding companies, such as the Company, in certain circumstances, requiring, among other things, a holding company to consult with the Federal Reserve Board prior to payment of a dividend if the Company does not have sufficient recent earnings in excess of the proposed dividend.
The principal source of funds from which the Company may pay dividends is the receipt of dividends from the Bank. The availability of dividends from the Bank is limited by various statutes and regulations. The Bank is subject first to corporate restrictions on its ability to pay dividends. Further, the Bank may not pay a dividend if it would be undercapitalized for Bank regulatory purposes after the dividend payment is made. The payment of cash dividends by the Bank is subject to restrictions set forth in the California Financial Code (the "Financial Code"). The Financial Code provides that a bank may not make a cash distribution to its shareholders in excess of the lesser of (a) bank's retained earnings; or (b) bank's net income for its last three fiscal years, less the amount of any distributions made by the bank or by any majority-owned subsidiary of the bank to the shareholders of the bank during such period. However, a bank may, with the approval of the DBO, make a distribution to its shareholders in an amount not exceeding the greatest of (a) its retained earnings; (b) its net income for its last fiscal year; or (c) its net income for its current fiscal year. In the event that the DBO determines that the shareholders' equity of a bank is inadequate or that the making of a distribution by the bank would be unsafe or unsound, the DBO may order the bank to refrain from making a proposed distribution. The FDIC may also restrict the payment of dividends if such payment would be deemed unsafe or unsound or if after the payment of such dividends, the bank would be included in one of the "undercapitalized" categories for capital adequacy purposes pursuant to federal law.
While the Federal Reserve Board has no general restriction with respect to the payment of cash dividends by an adequately capitalized bank to its parent holding company, the Federal Reserve Board might, under certain circumstances, place restrictions on the ability of a particular bank to pay dividends based upon peer group averages and the performance and maturity of the particular bank, or object to management fees to be paid by a subsidiary bank to its holding company on the basis that such fees cannot be supported by the value of the services rendered or are not the result of an arm's length transaction.
Repurchase of Common Stock
On July 22, 2016, the Company announced it had amended its previously announced program for the repurchase of up to $5.0 million of its outstanding common stock pursuant to a written plan compliant with Rule 10b5-1 and Rule 10b-18. Under the amended program, repurchase activity was set to commence on August 6, 2016 and continue until February 8, 2017, the program's new expiration date, or expire earlier upon the completion of the repurchase of $5.0 million of the Company's common stock in addition to what has already been purchased under the program, as well as under certain other circumstances as set forth in the amended program. The Company has no obligation to repurchase any shares under this program, and may suspend or discontinue it at any time. All shares repurchased as part of the repurchase program will be cancelled, and therefore no longer available for reissuance.
For the year ended December 31, 2016, the Company repurchased and cancelled 226,170 shares of its common stock at an aggregate cost of $1.6 million, or $7.23 per share. The Company made no repurchases of its common stock during the three months ended December 31, 2016.
In connection with the announcement of the Announced Transaction between the Company and PPBI, as discussed in "Recent Developments" of Item 1. Business included in this Annual Report on Form 10-K, the Company's stock repurchase plan as discussed above, automatically terminated pursuant to its terms.
Securities Authorized for Issuance Under Equity Compensation Plans
The following table provides information at December 31, 2016, with respect to shares of Company common stock that may be issued under the Company's existing equity compensation plans:
(1)Under the 2015 Equity Incentive Plan, the Company is authorized to issue restricted stock awards and restricted stock units. Outstanding restricted stock awards and restricted stock units are not included in the table above. At December 31, 2016, there were 188,519 shares of restricted stock awards issued and outstanding with a weighted average grant date fair value of $7.59 per share and 115,207 restricted stock units outstanding. Restricted stock units consist of 36,716 performance based restricted stock units with a weighted average grant date fair value of $7.56 per share that settle in shares of the Company's common stock, and 78,491 restricted stock units that settle in cash and are classified and accounted for as a liability. See also Note 13. Share-based Compensation Plans, of the consolidated financial statements filed on this Form 10-K for more information on the Company's equity compensation plans. (2)Includes securities available for issuance: including stock options, restricted stock awards, and restricted stock units.
Stock Performance
Please see "Stock Performance" of "Compensation Discussion and Analysis" under Part III, Item 11. Executive Compensation, of this Form 10-K for a comparison of the Company's common stock performance over the last five years.
Item 6.
Item 6. Selected Financial Data
The following table provides selected financial data for the past five years. The following should be read in conjunction with the consolidated financial statements and the notes thereto, which are included in this report.
(1)Net interest margin represents net interest income as a percentage of average interest-earning assets. (2)The efficiency ratio is defined as total non-interest expense as a percentage of the combined: net interest income, non-interest income, excluding gains and losses on the sale of securities, gains and losses on the sale of other real estate owned ("OREO"), OREO related costs, gains and losses on the sale of fixed assets, and amortization of intangible assets. (3) Non-performing loans are defined as loans that are past due 90 days or more, as well as loans placed on non-accrual status. (4)Non-performing assets are defined as all non-performing loans, and OREO assets.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis should be read in conjunction with the Heritage Oaks Bancorp's consolidated financial statements and notes filed on this Form 10-K, herein referred to as "the Consolidated Financial Statements" included and incorporated by reference herein. "Bancorp" will be used in this discussion when referring only to the holding company as distinct from the consolidated company. "Bank" will be used when referring to Heritage Oaks Bank. The Bank together with the Bancorp are hereinafter collectively referred to as the "Company," "we" or "our."
Executive Overview
This overview of management's discussion and analysis, highlights select information in the financial results of the Company, and may not contain all of the information that is important to you. For a more complete understanding of the Company's financial condition, results of operations, trends, commitments, uncertainties, liquidity, capital resources, critical accounting policies and estimates, as well as risk factors you should carefully read this entire document. Each of these items could have an impact on the Company's consolidated financial results.
Heritage Oaks Bancorp ("Bancorp") is a California corporation organized in 1994, and is registered as a bank holding company for Heritage Oaks Bank (the "Bank"), which opened for business in 1983. The Bank, which is the Company's sole operating subsidiary, operates within San Luis Obispo, Santa Barbara and Ventura Counties. As of December 31, 2016, the Bank operated two branch offices each in Paso Robles, and San Luis Obispo; single branch offices in Atascadero, Templeton, Cambria, Morro Bay, Arroyo Grande, Santa Maria, Goleta and Santa Barbara; as well as a single loan production office in Ventura/Oxnard.
The principal business of the Bank consists of attracting deposits and investing those funds primarily in commercial real estate and commercial business loans, operating and real estate procurement loans for agricultural businesses, multi-family residential property loans and a variety of consumer loans. The Bank offers a variety of deposit accounts for both individuals and businesses with varying rates and terms, which generally include checking accounts, savings accounts, money market deposits, and certificates of deposit. The Bank solicits deposits primarily in its market area, and periodically accepts brokered deposits.
Other than holding all of the issued and outstanding shares of the Bank, the Bancorp conducts no significant activities. As a bank holding company, the Bancorp generally is prohibited from acquiring direct or indirect ownership or control of more than 5 percent of the voting shares of any company which is not a bank or bank holding company, or from engaging directly or indirectly in activities other than those of banking, managing or controlling banks, or providing services for its subsidiaries. The principal exceptions to these prohibitions involve certain non-bank activities which, by statute or regulation or order of the Federal Reserve Board, have been identified as activities closely related to the business of banking or managing or controlling banks. In October 2006, the Company formed Heritage Oaks Capital Trust II. This trust is a statutory business trust formed under the laws of the State of Delaware and is a wholly-owned, non-financial, non-consolidated subsidiary of the Company, the sole purpose of which is to issue trust preferred securities. In conjunction with the acquisition of Mission Community Bancorp in February 2014, the Company assumed two additional trusts: Mission Community Capital Trust I, and Santa Lucia Bancorp (CA) Capital Trust, both of which are statutory business trusts formed under the laws of the State of Delaware, the sole purpose of which is to issue trust preferred securities.
On February 28, 2014, the Company completed the acquisition of Mission Community Bancorp and its subsidiary Mission Community Bank (collectively "MISN," or the "MISN Transaction"). The total value of the transaction was $69.0 million, which was comprised of cash of $8.7 million and 7,541,326 shares of the Company's common stock valued at $60.3 million. The operating results of MISN are included in the Company's operating results beginning on March 1, 2014. Please also refer to Note 3. Business Combination, of the consolidated financial statements filed on this Form 10-K.
Merger Agreement
On December 12, 2016, the Company and Pacific Premier Bancorp, Inc., a Delaware corporation ("PPBI"), entered into an Agreement and Plan of Reorganization (the "Merger Agreement") pursuant to which the Company will be merged with and into PPBI, with PPBI surviving (the "Corporate Merger"), immediately followed by the merger of Heritage Oaks Bank with and into Pacific Premier Bank, the wholly-owned bank subsidiary of PPBI ("Pacific Premier"), with Pacific Premier surviving (the "Bank Merger"). The Corporate Merger and Bank Merger are collectively referred to in this Annual Report on Form 10-K as the "Announced Transaction." The consideration paid to shareholders of the Company will consist of whole shares of PPBI common stock, and cash in lieu of fractional shares of PPBI common stock. Upon consummation of the Corporate Merger, each share of the Company's common stock issued and outstanding immediately prior to the effective time of the merger will be cancelled and converted into the right to receive 0.3471 shares of PPBI common stock.
The Merger agreement contains customary representations and warranties from the Company to PPBI, which are qualified by the confidential disclosures provided by the Company to PPBI, and customary representations and warranties from PPBI to the Company.
The foregoing description of the Merger Agreement does not purport to be complete and is qualified in its entirety by reference to the full text of the Merger Agreement, which has been previously filed with the SEC on Form 8-K dated December 13, 2016.
Termination of BSA/AML Consent Order
On November 29, 2016, the Bank announced the termination by the Federal Deposit Insurance Corporation ("FDIC") and California Department of Business Oversight ("DBO") of the BSA/AML Consent Order issued by the FDIC and DBO on November 5, 2014 relating to the Bank's Bank Secrecy Act compliance program.
Financial Highlights
The Company generated net income available to common shareholders of $16.9 million, or $0.49 per diluted common share, for the year ended December 31, 2016, as compared to net income available to common shareholders of $15.3 million, or $0.44 per diluted common share, for the year ended December 31, 2015 and $8.8 million, or $0.27 per diluted common share, for the year ended December 31, 2014.
Significant factors impacting the Company's net income for the year ending December 31, 2016 are discussed below. Please also refer to "Results of Operations" for a more detailed discussion concerning our operating results for the years ended December 31, 2016, 2015, and 2014.
• Net Interest Income: For the year ended December 31, 2016, net interest income was $65.6 million, or $3.3 million and 5.4% higher than the $62.3 million reported for the year ended December 31, 2015. The net interest margin was 3.60% for the year ended December 31, 2016, compared to 3.70% for the previous year. The increase in net interest income was due primarily to a $141.5 million increase in average interest earning assets, driven by a $111.3 million increase in average loan balances. The decline in the net interest margin can be attributed in large part to a decrease in the overall yield on the loan portfolio to 4.66% for the year ended December 31, 2016 from 4.95% for the year ended December 31, 2015, stemming from the prevailing low interest rate environment. For the year ended December 31, 2016 interest income and the yield on earning assets was $71.3 million and 3.92%, respectively, compared to $68.1 million and 4.05%, respectively for 2015. For the year ended December 31, 2016 interest expense was $5.7 million and the cost of funds was 0.33%, respectively, compared to interest expense of $5.8 million and the cost of funds of 0.36%, respectively for 2015.
• Non-Interest Expense: Non-interest expense increased by $3.1 million to $51.3 million for the year ended December 31, 2016, from $48.2 million for the year ended December 31, 2015. The increase in non-interest expense is primarily attributed to a $2.8 million increase in salaries and benefits costs, as well as a $0.9 million increase in merger related expenses associated with the Announced Acquisition of the Company by PPBI. Increased salaries and benefits costs can be attributed to higher base compensation, incentive plan expense, and mortgage commissions. Increases in non-interest expense were partially offset by a $0.9 million decrease in professional services expenses associated with the absence of higher legal costs recognized in 2015. The efficiency ratio for the year ended December 31, 2016 was 65.09% compared to 66.15% for the year ended December 31, 2015.
• Provision for Loan and Lease Losses: During the year ended December 31, 2016 the Company recorded a reversal of provision for loan and lease losses of $1.5 million. The reversal of provision for loan and lease losses during the year ended 2016 was attributable to continued improvement in loan credit quality metrics, including an overall decline in the level of non-performing loans, as well as net recoveries totaling $1.3 million during the year ended December 31, 2016. As of December 31, 2016, the allowance for loan and lease losses was $17.2 million, or 1.24% of total gross loans, compared to $17.5 million, or 1.40% of total gross loans at December 31, 2015. The allowance for loan and lease losses for acquired non-PCI and PCI loans was $0.1 million, or 0.10%, of total acquired loans, as of December 31, 2016.
• Non-Interest Income: Non-interest income increased $2.1 million to $12.2 million for the year ended December 31, 2016 from $10.1 million for the year ended December 31, 2015. The increase in non-interest income can be primarily attributed to $1.2 million in gains on derivative instruments associated with the "back-to-back" interest rate swap program implemented in 2016, as well as a $0.9 million increase in mortgage banking revenues. These and other increases in non-interest income were partially offset by the absence of gains on the extinguishment of debt totaling $0.6 million, primarily attributable to the partial redemption of $3.0 million in junior subordinated debentures which occurred in the third quarter of 2015.
Critical Accounting Policies and Estimates
Our accounting policies are integral to understanding the Company's financial condition and results of operations. Accounting policies management considers to be significant, including newly issued standards to be adopted in future periods, are disclosed in Note 1. Summary of Significant Accounting Policies, of the consolidated financial statements filed on this Form 10-K. The following discussions should be read in conjunction with the consolidated financial statements of this Form 10-K.
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America ("U.S. GAAP") requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ materially and adversely from those estimates. Estimates that are particularly susceptible to significant change relate to the determination of purchase accounting adjustments related to the fair value of assets purchased and liabilities assumed through strategic acquisitions, the allowance for loan and lease losses, the valuation of real estate acquired through foreclosure, the carrying value of the Company's net deferred tax assets, and estimates used in the determination of the fair value of certain financial instruments.
Allowance for Loan and Lease Losses ("ALLL")
In connection with the determination of the specific credit component of the ALLL for impaired loans in the loan portfolio, generally management obtains independent appraisals at least once a year for significant properties. Although management uses all available information to recognize losses on impaired loans, future additions to the ALLL may be necessary based on changes in local economic conditions or other factors outside the Company's control.
As also discussed in Note 1. Summary of Significant Accounting Policies, of the consolidated financial statements filed on this Form 10-K, during the third quarter of 2015, the Company made a specific enhancement to its methodology for determining the general reserve component of ALLL. This enhancement related specifically to the methodology used to calculate the loss rates for loan risk grades within each loan type in the determination of the general reserve component of the ALLL. The enhanced methodology uses more granular loan level data to calculate loss rates for specific loan grades within each loan type, allowing for more detailed loan migration analysis, and the ability to determine average loss rates for each loan risk grade. Although the total general reserve allocation of the ALLL for each loan type and portfolio segment is still based on total average historical losses for their respective loan types, management believes the allocation of the ALLL to each loan risk grade, within each loan type and the evaluation of the loss emergence period has become more granular under this methodology enhancement. The implementation of the ALLL model enhancements did not result in a required increase or decrease in the balance of the ALLL, or a material impact to the overall allocation of the ALLL. The ALLL model enhancement has allowed the Company to apply more precision in determining loss rates for specific loan grades within each loan type.
The general portfolio allocation of the ALLL is determined by pooling loans by collateral type and purpose. These loans are then further segmented by an internal loan grading system that classifies the credit quality of loans as: pass, special mention, substandard and doubtful. Estimated loss rates are then applied to each segment according to loan grade to determine the amount of the general portfolio allocation. Estimated loss rates are determined through a migration analysis of historical loss rates for each segment of the loan portfolio based on the Company's prior experience with such loans. In addition, adjustments are made to historical loss factors based on a qualitative analysis of certain internal and external factors that may have either a positive or negative impact on the overall credit quality of the loan portfolio.
Loans and leases acquired through purchase or through a business combination, such as those acquired in the MISN Transaction in 2014, are recorded at their fair value at the acquisition date. Credit discounts are included in the determination of fair value and therefore an ALLL is not recorded at the acquisition date. Acquired loans are evaluated upon acquisition for evidence of deterioration in credit quality since origination such that it is probable at acquisition that the Company will be unable to collect all contractually required payments. Such loans are classified as purchased credit impaired ("PCI") loans while all other acquired loans are classified as non-PCI loans. PCI loans are accounted for under ASC 310-30, while all other acquired loans without evidence of deteriorated credit quality since their origination are not within the scope of ASC 310-30 ("non-PCI loans"). Should the Company's ALLL methodology indicate that the credit discount associated with acquired, non-PCI loans, is no longer sufficient to cover probable losses inherent in those loans, the Company establishes an ALLL for those loans through a charge to current period earnings through a provision for loan and lease losses.
The Company has elected to account for PCI loans at an individual loan level. The Company estimates the amount and timing of expected cash flows for each loan. The expected cash flows in excess of the loan's carrying value, which is fair value on the date of acquisition, is referred to as the accretable yield, and is recorded as interest income over the remaining expected life of the loan. The excess of the loan's contractual cash flows, including principal and interest, over the expected cash flows is referred to as the non-accretable difference, and is not recorded in the Company's consolidated financial statements. Quarterly, management performs an evaluation of expected future cash flows for PCI loans. If current expectations of future cash flows are less than management's previous expectations, other than due to decreases in interest rates and prepayment assumptions, an ALLL is established with a charge to current period earnings through a provision for loan and lease losses. If there has been a probable and significant increase in expected future cash flows over that which was previously expected, the Company will first reduce any previously established ALLL, and then record an adjustment to interest income through a prospective increase in the accretable yield.
Due to the many judgments and variables that are part of the determination of both the specific and general allocation components of the ALLL, it is reasonably possible that the ALLL may change in future periods and those changes could be material and have an adverse effect on our financial condition and results of operations. See also Note 6. Loans and Allowance for Loan and Lease Losses, of the consolidated financial statements filed on this Form 10-K.
Realizability of Deferred Tax Assets
The Company uses an estimate of its future earnings in determining if it is more likely than not that the carrying value of its deferred tax assets will be realized over the period they are expected to reverse. If based on all available evidence, the Company believes that a portion or all of its deferred tax assets will not be realized, a valuation allowance is established. See also Note 8. Income Taxes, of the consolidated financial statements filed on this Form 10-K.
Fair Value of Financial Instruments
The degree of judgment utilized in measuring the fair value of financial instruments generally correlates to the level of observable pricing. Financial instruments with readily available, active quoted prices, or for which fair value can be measured from actively quoted prices, generally will have a higher degree of observable pricing and a lesser degree of judgment utilized in measuring fair value. Conversely, financial instruments rarely traded or not quoted will generally have little or no observable pricing and a higher degree of judgment is utilized in measuring the fair value of such instruments. Observable pricing is impacted by a number of factors, including the type of financial instrument, whether the financial instrument is new to the market and the characteristics specific to the financial instrument, including but not limited to credit and duration profiles. See also Note 4. Fair Value of Assets and Liabilities, of the consolidated financial statements filed on this Form 10-K.
Non-GAAP Financial Measures
The tables below provide reconciliations of shareholders' equity (U.S. GAAP) to tangible common equity (non-U.S. GAAP). The Company uses tangible common equity in the determination of the performance measures: tangible common book value per share and return on tangible common equity. The Company believes that the presentation of tangible common book value per share and return on tangible common equity in this report provides useful measures for investors because they are widely used in the financial services industry to compare the relative market value and financial performance of one financial institution against another. Additionally, the Company believes the measure of return on tangible common equity is more representative of the return to the Company's shareholders relative to their investment in the Company.
The calculations of tangible common equity and average tangible common equity are intended to complement other measures defined by U.S. GAAP. Since U.S. GAAP does not include these measures, the Company believes there are no comparable U.S. GAAP financial measures to these calculations. Despite the importance of these measures to the Company, there are no standardized definitions for these measures and, as a result, the Company's calculations may not be comparable with other organizations. Additionally, there may be limits in the usefulness of these measures to investors. As a result, the Company encourages readers to consider all of the information in its consolidated financial statements and the notes thereto in their entirety and not to rely on a single financial measure.
(1)Determined by dividing tangible common equity by outstanding shares as of the end of the period.
(1)Determined by dividing net income available to common shareholders by average tangible common equity.
Results of Operations
Net Interest Income and Margin
Net interest income, the primary component of the net earnings of a financial institution, refers to the difference between the interest earned on loans, investments and other interest earning assets, and the interest paid on deposits and borrowings. The net interest margin ("NIM") is the amount of net interest income expressed as a percentage of average earning assets. Factors considered in the analysis of net interest income are the composition and volume of interest earning assets and interest bearing liabilities, the amount of non-interest bearing liabilities, non-accruing loans, and changes in market interest rates.
The table below presents average balance sheet information, interest income and expense, average yields / rates and net interest income and margin for the years ended December 31, 2016, 2015 and 2014:
(1)Non-accruing loans have been included in total loans. (2)Loan fees have been included in interest income. (3)Net interest margin represents net interest income as a percentage of average interest earning assets.
The volume and rate variances table below sets forth the dollar difference in interest earned and paid for each major category of interest earning assets and interest bearing liabilities for each of the years ended December 31, 2016 and 2015 and the amount of such change attributable to changes in average balances (volume) or changes in average yields and rates:
Discussion of 2016 Compared to 2015
For the years ended December 31, 2016 and 2015, net interest income was $65.6 million and $62.3 million, respectively, and the NIM was 3.60% and 3.70%, respectively. The historically low interest rate environment continued to have an adverse impact on earning assets yields, and in particular, the overall yield on the loan portfolio during 2016, which was the primary driver behind the decline in the NIM during 2016. The 10-Year U.S. Treasury yield remained low throughout 2016, eventually falling below 1.40% during July 2016, and only began to rise back above 2.00% during November 2016. The impact of the low prevailing interest rate environment on our loan portfolio is that the loans that prepay or payoff have been at higher average yields than the yields generated from new loan originations, and renewals, resulting in a lower overall yield on the loan portfolio and contributing to the decline in the yield on earning assets and the NIM. During 2016, the yield of newly originated loans held for investment averaged 3.88% as compared to an average yield of 4.06% for the same period in 2015, while the yield on loan payoffs averaged 4.62% in 2016, as compared to 4.76% in 2015. During 2016, the Company originated approximately $42.5 million in new loans under its back-to-back interest rate swap program. While these loans are variable rate loans, which reprice with changes in short-term LIBOR rates, they were originated at a weighted average yield of approximately 2.85%, contributing to the lower overall yield on originated loans during 2016. As interest rates rise, it is anticipated yields on these loans will reset higher than their originated yields.
Average loan yields declined by 29 basis points to 4.66% for 2016, when compared to 4.95% for 2015. As previously mentioned, the historically low interest rate environment continued to have an adverse impact on loan yields during 2016 as yields on new loan originations and renewals have been lower than the yields on loans that prepaid during that same period.
Loan yields and the NIM have benefitted from discount accretion on loans acquired through the MISN Transaction in 2014, and this discount accretion has somewhat muted the impact of the historically low interest rate environment on our loan yields during 2016 and 2015. Total discount accretion from acquired loans was $2.2 million and $2.7 million during the years ended December 31, 2016 and 2015, respectively. Purchase discount accretion from acquired loans increased our loan yields by 17 basis points and 23 basis points during the years ended December 31, 2016 and 2015, respectively. The level of purchase discount accretion decreased during 2016 when compared to 2015 due to a slight decline in accelerated accretion resulting from payoffs of certain acquired loans, as well as lower scheduled accretion due to normal portfolio attrition in conjunction with payoffs experienced in prior periods. The impact of discount accretion on earning asset yields and the NIM was 12 basis points and 16 basis points for the years ended December 31, 2016 and 2015, respectively. The Company anticipates the amount of purchase discount accretion from acquired loans will continue to decline, absent any unscheduled loan payoffs, due to the decline in the amount of scheduled discount accretion attributable to the maturity of acquired loans.
The average yield on investment securities increased in 2016 to 1.97% from 1.85% for 2015. The increase in the average yield on investment securities during 2016 was driven in large part by the Federal Open Market Committee's decision to increase the federal funds rate by 0.25% in December 2015. This increase in the federal funds rate had a positive impact on floating rate investments in the securities portfolio, such as floating rate SBA securities, floating rate commercial mortgage backed securities, and floating rate agency mortgage backed securities; all of which realized higher coupon rates in 2016 given their ties to benchmark rates such as prime, LIBOR and short term treasury yields.
Our earnings are directly influenced by changes in interest rates. The Company is currently in a net asset sensitive position, and a large percentage of our interest sensitive assets and liabilities re-price with changes in interest rates. A significant portion of the variable rate loans in our loan portfolio have had their interest rates set to their respective contractual interest rate floors. To the extent that interest rates rise, the Company will not experience the benefit of rising interest rates until those rates rise above contractual interest rate floors. See Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
The assets and liabilities of a financial institution are primarily monetary in nature. As such they represent obligations to pay or receive fixed and determinable amounts of money that are not affected by future changes in prices. Generally, the impact of inflation on a financial institution is reflected by fluctuations in interest rates, the ability of customers to repay their obligations and upward pressure on operating expenses. Although inflationary pressures are not considered to be of any particular hindrance in the current economic environment, they may have an impact on the Company's future earnings in the event those pressures become more prevalent.
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 interest income and interest expense recorded on a large portion of the Company's assets and liabilities, and the market value of all interest earning assets and interest bearing liabilities, other than those which possess a short term to maturity. Virtually all of the Company's interest earning assets and interest bearing liabilities are located at the Bank level. Thus, virtually all of the Company's interest rate risk exposure lies at the Bank level other than $13.5 million in subordinated debentures issued by the Company's subsidiary grantor trusts. Therefore, the Company's management performs all significant interest rate risk procedures at the Bank level. In addition to risk related to interest rate changes, the Bank's real estate loan portfolio, concentrated primarily within San Luis Obispo and Santa Barbara Counties of California, is subject to risks of changes in the underlying value of collateral as a result of changes in the local economy.
The fundamental objective of the Company's management of its assets and liabilities is to maximize the Company's economic value while maintaining adequate liquidity and an exposure to interest rate risk deemed by management to be acceptable. Management believes an acceptable degree of exposure to interest rate risk results from the management of assets and liabilities through maturities, pricing and mix to attempt to neutralize the potential impact of changes in market interest rates. The Company's profitability is dependent to a large extent upon its net interest income, which is the difference between its interest income on interest earning assets, such as loans and investments, and its interest expense on interest bearing liabilities, such as deposits and borrowings. The Company is subject to interest rate risk to the degree that its interest earning assets re-price differently than its interest bearing liabilities. The Company manages its mix of assets and liabilities with the goals of limiting its exposure to interest rate risk, ensuring adequate liquidity, and coordinating its sources and uses of funds.
The Company seeks to control interest rate risk exposure in a manner that will allow for adequate levels of earnings and capital over a range of possible interest rate environments. The Company has adopted formal policies and practices to monitor and manage interest rate risk exposure. Management believes historically it has effectively managed the effect of changes in interest rates on its operating results and believes that it can continue to manage the short-term effects of interest rate changes under various interest rate scenarios.
Management employs asset and liability management software to measure the Company's exposure to future changes in interest rates. The software measures the expected cash flows and re-pricing of each financial asset/liability separately in measuring the Company's interest rate sensitivity. Based on the results of the software's output, management believes the Company's balance sheet is evenly matched over the short term and slightly asset sensitive over the longer term as of December 31, 2016. This means that the Company would expect (all other things being equal) to experience a limited change in its net interest income if rates rise or fall. The level of potential or expected change indicated by the tables below is considered acceptable by management and is compliant with the Company's Management ALCO policies. Management will continue to perform this analysis each quarter.
The hypothetical impacts of sudden interest rate movements applied to the Company's asset and liability balances are modeled quarterly. The results of these models indicate how much of the Company's net interest income is "at risk" from various rate changes over a one year horizon. This exercise is valuable in identifying risk exposures. Management believes the results for the Company's December 31, 2016 balances indicate that the net interest income at risk over a one year time horizon for a 100 basis points ("bp") and 200 bp rate increase and a 100 bp decrease is acceptable to management and within policy guidelines at this time. Given the low interest rate environment, a 200 bp decrease is not considered a realistic possibility and is therefore not presented.
The results in the table below indicate the change in net interest income the Company would expect to see as of December 31, 2016, if interest rates were to change immediately in the amounts set forth:
It is important to note that the above table is a summary of several forecasts and actual results may vary from any of the forecasted amounts and such difference may be material and adverse to the Company. The forecasts are based on estimates and assumptions made by management, and that may turn out to be different, and may change over time. Factors affecting these estimates and assumptions include, but are not limited to: 1) competitor behavior, 2) economic conditions both locally and nationally, 3) actions taken by the Federal Reserve Board, 4) customer behavior and 5) management's responses to each of the foregoing. Factors that vary significantly from the assumptions and estimates may have material and adverse effects on the Company's net interest income. Therefore, the results of this analysis should not be relied upon as indicative of actual future results.
The following table shows management's estimates of how the loan portfolio is segregated between variable-daily, variable other than daily and fixed rate loans, and estimates of re-pricing opportunities for the entire loan portfolio at December 31, 2016 and December 31, 2015:
As of December 31, 2016, the table above identifies approximately 12.7% of the loan portfolio that will re-price immediately in a changing rate environment. At December 31, 2016, approximately $935.7 million, or 67.5%, of the Company's loan portfolio is considered variable.
The following table provides a summary of the loans the Company can expect to see adjust above floor rates based on given movements in market rates as of December 31, 2016:
As interest rates began to fall at the end of the last decade, the Company moved to protect the net interest margin by implementing floors on new loan originations. Management believes this strategy proved successful in insulating the net interest margin in the declining interest rate environment experienced over the last several years. However, looking forward into a possible rising rate environment, management believes that these loan floors could result in compression of the net interest margin and potentially a decline in net interest income. As such, the Company began lowering the floor rates on new and renewed loans over the last couple of years to reduce the level of market interest rate movement required to adjust above floor rates and return those loans to a fully variable interest rate profile.
Item 8.
Item 8. Consolidated Financial Statements and Supplementary Data
Heritage Oaks Bancorp
and Subsidiaries
Audited Consolidated Financial Statements and related documents required by this item are included in this Annual Report on Form 10-K on the pages indicated:
Management's Report of Internal Controls Over Financial Reporting
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets as of December 31, 2016 and 2015
Consolidated Statements of Income for the Years Ended December 31, 2016, 2015 and 2014
Consolidated Statements of Comprehensive Income for the Years Ended December 31, 2016, 2015 and
Consolidated Statements of Changes in Shareholders' Equity for the Years Ended December 31, 2016, 2015 and 2014
Consolidated Statements of Cash Flows for the Years Ended December 31, 2016, 2015 and
Notes to Consolidated Financial Statements
The following un-audited supplementary financial data is included in this Annual Report on Form 10-K on the page indicated:
Quarterly Financial Information
Management's Report on Internal Control Over Financial Reporting
The Board of Directors and Shareholders
Heritage Oaks Bancorp
The management of Heritage Oaks Bancorp is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is defined in Rule 13a-15(f) promulgated under the Securities Exchange Act of 1934 as a process designed by, or under the supervision of our Chief Executive Officer and Chief Financial Officer and effected by the board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of Consolidated Financial Statements for external purposes in accordance with U.S. generally accepted accounting principles and includes those policies and procedures that:
• Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of our assets;
• Provide reasonable assurance that transactions are recorded as necessary to permit preparation of Consolidated Financial Statements in accordance with U.S. generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of our management and directors; and
• Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on the Consolidated Financial Statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Management assessed the effectiveness of our internal control over financial reporting as of December 31, 2016. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission ("COSO") in Internal Control - Integrated Framework (2013). Based on that assessment, the Company's management believes that, as of December 31, 2016, our internal control over financial reporting is effective based on those criteria.
Crowe Horwath LLP, the independent registered public accounting firm that audited the Company's Consolidated Financial Statements included in this Annual Report on Form 10-K for the year ended December 31, 2016, has issued an audit report on the effectiveness of the Company's internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board that appears on page 75.
Report of Independent Registered Public Accounting Firm
Board of Directors
Heritage Oaks Bancorp
Paso Robles, California
We have audited the accompanying consolidated balance sheets of Heritage Oaks Bancorp and Subsidiaries (the "Company") as of December 31, 2016 and 2015, and the related consolidated statements of income, comprehensive income, changes in shareholders' equity and cash flows for the years ended December 31, 2016, 2015 and 2014. We also have audited the Company's internal control over financial reporting as of December 31, 2016, based on criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission ("COSO") in Internal Control - Integrated Framework (2013). The Company's management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management's Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on these consolidated financial statements and an opinion on the company's internal control over financial reporting based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the consolidated financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of consolidated financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of consolidated financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the consolidated financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2016 and 2015, and the results of their operations and their cash flows for the years ended December 31, 2016, 2015 and 2014, in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2016, based on criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission ("COSO") in Internal Control - Integrated Framework (2013).
/s/Crowe Horwath LLP
Sacramento, California
March 3, 2017
Heritage Oaks Bancorp
and Subsidiaries
Consolidated Balance Sheets
The accompanying notes are an integral part of these consolidated financial statements.
Heritage Oaks Bancorp
and Subsidiaries
Consolidated Statements of Income
The accompanying notes are an integral part of these consolidated financial statements.
Heritage Oaks Bancorp
and Subsidiaries
Consolidated Statements of Comprehensive Income
The accompanying notes are an integral part of these consolidated financial statements.
Heritage Oaks Bancorp
and Subsidiaries
Consolidated Statements of Changes in Shareholders' Equity
The accompanying notes are an integral part of these consolidated financial statements.
Heritage Oaks Bancorp
and Subsidiaries
Consolidated Statements of Cash Flows
Heritage Oaks Bancorp
and Subsidiaries
Consolidated Statements of Cash Flows (Continued)
The accompanying notes are an integral part of these consolidated financial statements.
Note 1. Summary of Significant Accounting Policies
Nature of Operations
Heritage Oaks Bancorp ("Bancorp") is a California corporation organized in 1994, and is the holding company for Heritage Oaks Bank (the "Bank"), which opened for business in 1983. The Bank, which is the Company's sole operating subsidiary, operates branches within San Luis Obispo and Santa Barbara Counties and has a loan production office in Ventura County. The Bank offers traditional banking products such as checking, savings, money market accounts and certificates of deposit, as well as mortgage, commercial, and consumer loans to customers who are predominately small to medium-sized businesses and to individuals. As such, the Company is subject to a concentration risk associated with its banking operations in San Luis Obispo and Santa Barbara Counties, and to a lesser degree Ventura County. No one customer accounts for more than 10% of revenue or assets in any period presented and the Company has no assets nor does it generate any revenue from outside of the United States. While the chief decision-makers of the Company monitor the revenue streams of the various products and services, operations are managed and financial performance is evaluated on a Company-wide basis. Operating segments are aggregated into one as operating results for all segments are similar. Accordingly, all of the financial service operations are considered by management to be aggregated in one reportable operating segment.
Principles of Consolidation
The consolidated financial statements of the Company include the accounts of the holding company ("Bancorp") and its wholly owned subsidiaries, the Bank and CCMS Systems, Inc. (an inactive entity). All material intercompany balances and transactions have been eliminated.
Reclassifications
Certain amounts in the 2014 and 2015 consolidated financial statements have been reclassified to conform to the 2016 presentation. These reclassifications did not have any effect on the prior years' reported net income or shareholders' equity.
Investment in Non-Consolidated Subsidiaries
The Company accounts for its investment in Heritage Oaks Capital Trust II, Mission Community Capital Trust I, and Santa Lucia Bancorp (CA) Capital Trust, as unconsolidated subsidiaries using the equity method of accounting, as the Company is not the primary beneficiary of the trust. Mission Community Capital Trust I and Santa Lucia Bancorp (CA) Capital Trust were acquired as part of the acquisition of Mission Community Bancorp on February 28, 2014. The sole purpose of each of these trusts is for the issuance of trust preferred securities.
Use of Estimates in the Preparation of Consolidated Financial Statements
The accounting and reporting policies of the Company conform to accounting principles generally accepted in the United States of America ("U.S. GAAP") and to general practices within the banking industry. In order to prepare the consolidated financial statements in conformity with U.S. GAAP, management is required to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan and lease losses, the valuation of real estate acquired through foreclosure, the carrying value of the Company's deferred tax assets and estimates used in the determination of the fair value of certain financial instruments.
Note 1. Summary of Significant Accounting Policies - continued
In connection with the determination of the allowance for loan and lease losses and the value of foreclosed real estate, management obtains independent appraisals for significant properties. While management uses available information to recognize losses on loans and leases, and foreclosed real estate and collateral, future additions to the allowance for loan and lease losses may be necessary based on changes in local economic conditions. In addition, regulatory agencies, as an integral part of their examination process, periodically review the Company's allowance for loan and lease losses and foreclosed real estate.
These agencies may require the Company to recognize additions to the allowance for loan and lease losses based on their judgments about information available to them at the time of their examination. Because of these factors, it is reasonably possible that the allowance for loan and lease losses and foreclosed real estate may change in future periods. See also Note 6. Loans and Allowance for Loan and Lease Losses, of these consolidated financial statements.
The Company uses an estimate of its future earnings in determining if it is more likely than not that the carrying value of its deferred tax assets will be realized over the period they are expected to reverse. If based on all available evidence, the Company believes that a portion or all of its deferred tax assets will not be realized; a valuation allowance may be established. See also Note 8. Income Taxes, of these consolidated financial statements.
The degree of judgment utilized in measuring the fair value of financial instruments, and assets and liabilities acquired in business combinations generally correlates to the level of pricing observability. Financial instruments, and acquired assets and liabilities with readily available active quoted prices or for which fair value can be measured from actively quoted prices generally will have a higher degree of observable pricing and a lesser degree of judgment utilized in measuring fair value. Conversely, financial instruments, and acquired assets and liabilities rarely traded or not quoted will generally have little or no observable pricing and a higher degree of judgment is utilized in measuring the fair value. Observable pricing is impacted by a number of factors, including the type of asset or liability, whether the asset or liability is new to the market and not yet established, and the characteristics specific to the transaction. See also Note 3. Business Combination, and Note 4. Fair Value of Assets and Liabilities, of these consolidated financial statements.
Business Combinations and Related Matters
Business combinations are accounted for under the acquisition method of accounting in accordance with ASC 805, Business Combinations. Under the acquisition method the acquiring entity in a business combination recognizes 100 percent of the acquired assets and assumed liabilities, regardless of the percentage owned, at their estimated fair values as of the date of acquisition. Any excess of the purchase price over the fair value of net assets and other identifiable intangible assets acquired is recorded as goodwill. Assets acquired and liabilities assumed from contingencies must also be recognized at fair value, if the fair value can be determined during the measurement period. Results of operations of an acquired business are included in the statement of operations from the date of acquisition. Acquisition-related costs, including conversion charges, are expensed as incurred. The Company applied this guidance to the acquisition of Mission Community Bancorp that was consummated on February 28, 2014.
Note 1. Summary of Significant Accounting Policies - continued
Recent Accounting Pronouncements
Recent Accounting Guidance Adopted
In September, 2015, the Financial Accounting Standards Board ("FASB") issued ASU No. 2015-16, Simplifying the Accounting for Measurement Period Adjustments (Topic 805). This ASU eliminates the requirement to restate prior period financial statements for measurement period adjustments to assets acquired and liabilities assumed in a business combination. The new guidance under this update requires the cumulative impact of measurement period adjustments be recognized in the period the adjustment is determined. This update does not change what constitutes a measurement period adjustment, nor does it change the length of the measurement period. The new standard became effective for interim annual periods beginning after December 15, 2015 and should be applied prospectively to measurement period adjustments that occur after the effective date. This update did not have an impact on the Company's consolidated financial statements.
Recent Accounting Guidance Not Yet Effective
In August 2016, the FASB issued ASU No. 2016-15, Statement of Cash Flows - Classification of Certain Cash Receipts and Cash Payments (Topic 230). This update clarifies how entities should classify certain cash receipts and cash payments on the statement of cash flows with the objective of reducing the existing diversity in practice related to eight specific cash flow issues. The amendments in this update are effective for annual periods beginning after December 15, 2017, and interim periods within those fiscal years. Early adoption is permitted. The Company is currently evaluating this update, but does not expect the adoption of the amendments within this update will have a material impact on the Company's consolidated financial statements.
In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326). This update changes the methodology used by financial institutions under current U.S. GAAP to recognize credit losses in the financial statements. Currently, U.S. GAAP requires the use of the incurred loss model, whereby financial institutions recognize in current period earnings, incurred credit losses and those inherent in the financial statements, as of the date of the balance sheet. This guidance results in a new model for estimating the allowance for loan and lease losses, commonly referred to as the Current Expected Credit Loss ("CECL") model. Under the CECL model, financial institutions are required to estimate future credit losses and recognize those losses in current period earnings. The amendments within the update are effective for fiscal years and all interim periods beginning after December 15, 2019, with early adoption permitted. Upon adoption of the amendments within this update, the Company will be required to make a cumulative-effect adjustment to the opening balance of retained earnings in the year of adoption. The Company is currently in the process of evaluating the impact the adoption of this update will have on its consolidated financial statements. The Company believes the CECL model will generally result in earlier recognition of credit losses for loans and other financing receivables in the consolidated financial statements. The Company is evaluating historical loan level data requirements necessary for the implementation of the CECL model, as well as various methodologies for determining expected credit losses.
Note 1. Summary of Significant Accounting Policies - continued
In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842). This update improves the understanding and comparability of lessees' financial commitments by requiring lease assets and lease liabilities to be recognized on the balance sheet for those leases classified as operating leases under current U.S. GAAP. This update requires a lessee to recognize on the balance sheet a lease liability to make lease payments and a right of use asset, representing the right to use the underlying asset, during the term of the lease. This update is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years, using a modified retrospective approach, with early adoption permitted. The Company is currently in the process of evaluating the impact that the adoption of this update will have on its financial statements. While the impact of the adoption of this update is dependent upon leases outstanding at the time of adoption, the Company preliminarily believes the adoption of this update will not have a material impact on the Company's consolidated financial statements, as the current gross amount of estimated future lease payments is less than 0.4% of total assets as of December 31, 2016.
In March 2016, the FASB issued ASU No. 2016-09, Compensation - Stock Compensation: Improvements to Employee Share-Based Payment Accounting (Topic 718). This update simplifies several aspects of accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. The new guidance under the update requires all excess tax benefits and tax deficiencies be recognized as income tax expense or benefit on the income statement. The amendments within the update are effective for fiscal years and all interim periods beginning after December 31, 2016, with early adoption permitted. The Company is currently in the process of evaluating the impact the adoption of this update will have on the consolidated financial statements. The Company preliminarily believes the adoption of this update will result in a marginal amount of volatility within income tax expense, depending on the amount and timing of share-based compensation award activity such as: the vesting of restricted stock awards and restricted stock units, as well as the exercise of stock options.
In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606). This update requires an entity to recognize revenue as performance obligations are met, in order to reflect the transfer of promised goods or services to customers in an amount that reflects the consideration the entity is entitled to receive for those goods or services. The following steps are applied in the updated guidance: (1) identify the contract(s) with a customer; (2) identify the performance obligations in the contract; (3) determine the transaction price; (4) allocate the transaction price to the performance obligations in the contract; and (5) recognize revenue when, or as, the entity satisfies a performance obligation. The amendments within this update are effective for the quarter ending March 31, 2018. The Company is currently in the process of evaluating the impact of the adoption of this update will have on the consolidated financial statements. The Company preliminarily believes the adoption of this update will not have a material impact on the consolidated financial statements, as a majority of the Company's revenue generating transactions are not included in the scope of this update.
In January 2016, the FASB issued ASU No. 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities (Topic 825). The amendments in this update require that public entities measure equity investments with readily determinable fair values, at fair value, with changes in their fair value recorded through net income. This ASU also clarifies that an entity should evaluate the need for a valuation allowance on a deferred tax asset related to available for sale securities in combination with the entity's other deferred tax assets. The amendments within the update are effective for fiscal years and all interim periods beginning after December 15, 2017. The Company is currently in the process of evaluating the impact of the adoption of this update, but preliminarily does not expect a material impact on the Company's consolidated financial statements as the majority of the Company's investment securities are classified as available for sale debt securities.
Note 1. Summary of Significant Accounting Policies - continued
Disclosure about Fair Value of Financial Instruments
Estimates of fair value have been determined by the Company using available market information and appropriate valuation methodologies. However, considerable judgment is required to develop the estimates of fair value. Accordingly, the estimates are not necessarily indicative of the amounts the Company could have realized in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts.
Although management is not aware of any factors that would significantly affect estimated fair value amounts, such amounts have not been comprehensively revalued for purposes of these consolidated financial statements since the balance sheet date and, therefore, current estimates of fair value may differ significantly from the amounts presented in the accompanying notes.
The Company determines the fair market values of financial instruments based on the fair value hierarchy established in U.S. GAAP. The fair value of a financial instrument is the amount at which the asset or obligation could be exchanged in a current transaction between willing parties, other than a forced or liquidation sale, and is based on an exit price in the principal market or most advantageous market in which the reporting entity could transact. Fair value estimates are made at a specific point in time based on relevant market information and 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 entire holdings or a particular financial instrument. Pursuant to U.S. GAAP, the Company is required to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. Specifically, U.S. GAAP describes three levels of inputs that may be used to measure fair value, as outlined below:
Level 1 - Quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date. Level 1 assets and liabilities may include debt and equity securities that are traded in an active exchange market and that are highly liquid and are actively traded in over the counter markets.
Level 2 - Observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.
Level 3 - Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments where fair value is determined using pricing models, discounted cash flow methodologies using market interest rates, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation.
The following methods and assumptions were used by the Company in estimating fair values of financial instruments. Many of these estimates are subjective in nature, involve uncertainties and matters of judgment and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect these estimates.
Cash and Cash Equivalents
The carrying amounts reported in the balance sheet for cash and cash equivalents approximate the fair values of those assets due to the short-term nature of the assets.
Note 1. Summary of Significant Accounting Policies - continued
Investments in Securities Available for Sale
Fair values are based upon quoted market prices, where available. If quoted market prices are not available, fair values are extrapolated from the quoted prices of similar instruments or through the use of other observable data supported by a valuation model. The fair value of newly issued securities, for which there is not a sufficient history of market transactions on which to base a fair value determination under Level 1 or 2 of the hierarchy, are initially valued under Level 3 of the hierarchy. At such time that sufficient history of market transactions is established, the securities' fair value is determined under Level 1 or 2 of the hierarchy and accordingly the security is transferred out of Level 3 and into the applicable level.
Federal Home Loan Bank Stock
The fair value of Federal Home Loan Bank ("FHLB") stock is not readily determinable due to the lack of its transferability, as ownership of these securities is restricted to member banks.
Loans, Loans Held for Sale, and Accrued Interest Receivable
For variable rate loans that re-price frequently and with no significant change in credit risk, fair values are based on carrying amounts. The fair values for other loans (for example, fixed rate loans and loans that possess a rate variable other than daily or that are at their floor rate) are estimated using discounted cash flow analysis, based on interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. Loan fair value estimates include judgments regarding future expected loss experience and risk characteristics.
The fair value of loans held for sale is determined, when possible, using quoted secondary market prices. If no such quoted price exists, the fair value of the loan is determined using quoted prices for a similar asset or assets, adjusted for the specific attributes of that loan. The carrying amount of accrued interest receivable approximates its fair value.
Impaired Loans
A loan is considered impaired when it is probable that payment of interest and principal will not be made in accordance with the original contractual terms of the loan agreement. Impairment is measured based on a discounted cash flow analysis or in the case of loans that are deemed collateral dependent, impairment is measured based on the fair value of the underlying collateral, which is supported by the appraised value of the collateral less any estimated costs to sell. Collateral dependent impaired loans are classified as non-recurring Level 2 when the fair value of the underlying collateral is based on an observable market price or current appraised value. When current market prices are not available or the Company determines that the fair value of the underlying collateral is further impaired below appraised values based on Company specific experience with similar collateral, the Company records impaired loans as non-recurring Level 3.
Note 1. Summary of Significant Accounting Policies - continued
Other Real Estate Owned and Foreclosed Collateral
Other real estate owned and foreclosed collateral are adjusted to fair value, less any estimated costs to sell, at the time the loans are transferred into this category. The fair value of these assets is based on independent appraisals, observable market prices for similar assets, or management's estimation of value. When the fair value is based on independent appraisals or observable market prices for similar assets, the Company records other real estate owned or foreclosed collateral as non-recurring Level 2 assets. When appraised values are not available, there is no observable market price for similar assets, or management determines the fair value of the asset is further impaired below appraised values or observable market prices based on Company specific experience with similar assets, the Company records other real estate owned or foreclosed collateral as non-recurring Level 3 assets. The most common adjustment to reported appraised values of collateral is a monthly discount linked to the passage of time since the last appraisal. This discount factor may range between 1% and 3% per month and is consistent with that used in the appraisals to discount for the passage of time between the transaction date for comparable properties used in the appraisal and the appraisal date.
Federal Home Loan Bank Advances
The fair value disclosed for FHLB advances is determined by discounting contractual cash flows at current market interest rates for similar instruments.
Non-Interest Bearing Deposits
The fair values disclosed for non-interest bearing deposits are, by definition, equal to the amount payable on demand at the reporting date (that is, their carrying amounts).
Interest Bearing Deposits and Accrued Interest Payable
The fair values disclosed for interest bearing deposits (for example, interest bearing checking accounts and savings accounts) are, by definition, equal to the amount payable on demand at the reporting date (that is, their carrying amounts). The fair values for certificates of deposit are estimated using a discounted cash flow analysis that applies interest rates currently being offered on certificates to a schedule of aggregated contractual maturities on such time deposits. The carrying amount of accrued interest payable approximates its fair value.
Junior Subordinated Debentures
The fair value disclosed for junior subordinated debentures is based on market prices of similar instruments issued with similar contractual terms and by issuers with a similar credit profile as the Company.
Note 1. Summary of Significant Accounting Policies - continued
Derivative Financial Instruments
Derivative financial instruments consist of back-to-back interest rate swap contracts between the Company and certain of its borrowers, as well as between the Company and a counterparty bank. These interest rate swaps involve the exchange of fixed and variable rate interest payments between the Company and its counterparties, and are accounted for as free standing derivative contracts, carried at fair value in the Company's consolidated financial statements. The fair value of these contracts is determined through a third party valuation model used by the Company's counterparty bank, which uses observable market data inputs such as cash LIBOR rates, prices of Eurodollar futures contracts, and market swap rates. The Company records interest rate swap contacts as recurring Level 2 assets and liabilities.
Off-Balance Sheet Instruments
Fair values of commitments to extend credit and standby letters of credit are based upon fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreement and the counterparties' credit standing.
Cash and Cash Equivalents
Banking regulations require that all banks maintain a percentage of their deposits as reserves in cash or on deposit with the Federal Reserve Bank. In management's opinion, the Bank is in compliance with the reserve requirements as of December 31, 2016. The Company maintains amounts due from banks that exceed federally insured limits. Historically the Company has not experienced any losses in such accounts. For purposes of reporting cash flows, cash and cash equivalents include cash and due from banks. Generally, interest bearing balances due from banks represent excess liquidity that the Company and/or Bank invests through other institutions overnight.
Investment Securities Available for Sale
The Company's investment securities are classified as available for sale and are measured at fair value, with changes in unrealized gains and losses, net of applicable taxes, reported as a separate component of shareholders' equity. The fair values of most securities that are designated available for sale are based on quoted market prices. If quoted market prices are not available, fair values are extrapolated from the quoted prices of similar instruments or through the use of other observable data supporting a valuation model. Gains or losses on sales of investment securities are determined on the specific identification method and recorded as a component of non-interest income. Premiums and discounts are amortized or accreted using the interest method over the expected lives of the related securities and recognized in interest income.
Other than Temporary Impairment ("OTTI")
The Company periodically evaluates investments in the portfolio for OTTI and more specifically when conditions warrant such an evaluation. When evaluating whether impairment is other than temporary, the Company considers, among other things, the following: (1) the length of time the security has been in an unrealized loss position, (2) the extent to which the security's fair value is less than its cost, (3) the financial condition of the issuer, (4) any adverse changes in ratings issued by various rating agencies, (5) the intent and ability of the Company to hold such securities for a period of time sufficient to allow for any anticipated recovery in fair value and (6) in the case of mortgage related securities, credit enhancements, loan-to-values, credit scores, delinquency and default rates, cash flows and the extent to which those cash flows are within management's initial expectations based on pre-purchase analyses.
Note 1. Summary of Significant Accounting Policies - continued
When an investment is deemed to be other than temporarily impaired, the Company assesses whether it has the intent to sell the investment, or if it is more likely than not that it will be required to sell the investment before its anticipated recovery of its full basis in the security. If the Company does not intend, nor anticipates it will be required to sell the investment, it must still perform an evaluation of future cash flows it expects to receive from the investment to determine if a credit loss has occurred. The evaluation includes future cash flows from the investment the Company expects to collect, based on an assessment of all available information about the applicable investment. The Company considers such factors as: the structure of the security and the Company's position within that structure, the remaining payment terms for the security, prepayment speeds, default rates, loss severity on the collateral supporting the security, expected changes in real estate prices, and assumptions regarding interest rates, to determine whether the Company will recover the remaining amortized cost basis of the security.
In the event that a credit loss is deemed to have occurred, only the amount of impairment related to the credit loss is recognized in current period earnings. OTTI amounts related to all other factors, such as market conditions, are recorded as a component of accumulated other comprehensive income.
Federal Home Loan Bank Stock
The Bank is a member of the FHLB and as a condition of membership, the Bank is required to purchase stock in the FHLB. The required ownership of FHLB stock is based on the level of borrowing the Bank has obtained from the FHLB. FHLB stock is carried at cost, classified as a restricted security, and periodically evaluated for impairment based on ultimate recovery of par value. There have been no events that would suggest that an impairment in the carrying value of the stock has occurred as of December 31, 2016. Dividends received on the FHLB stock are reported as a component of interest income.
Loans Held for Sale
Loans held for sale are carried at the lower of cost or fair value, which is determined by the specified value in the sales contract with the third party buyer. Net unrealized losses, if any, are recognized through a valuation allowance through charges to other non-interest expense.
Loans Held for Investment
Loans management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at their outstanding unpaid principal balances reduced by any charge-offs or specific valuation allowances and net of any deferred fees or costs on originated loans, or unamortized premiums or discounts on purchased loans. Nonrefundable fees and certain costs associated with originating or acquiring loans are deferred and accreted/amortized as an adjustment to interest income over the contractual lives of the loan. Upon prepayment, unamortized loan fees, net of costs, are immediately recognized in interest income. Other fees, including those collected upon principal prepayments, are included in interest income when received.
Loans for which the accrual of interest has been discontinued are designated as non-accruing loans. The accrual of interest on loans is discontinued when principal and/or interest has become delinquent 90 days or more based on the contractual terms of the loan and/or when, in the opinion of management, there is reasonable doubt as to collectability, unless the loan is well secured and in the process of collection. When loans are placed on non-accrual status, all interest previously accrued, but not collected, is reversed against current period interest income. This policy is consistently applied to all portfolio segments.
Note 1. Summary of Significant Accounting Policies - continued
Interest income generally is not recognized on non-accruing loans unless the likelihood of further loss is remote. Interest payments received on non-accrual loans is generally applied as a reduction to the loan principal balance. Interest accruals are resumed only when the loan is brought current with respect to interest and principal and when, in the judgment of management, all remaining principal and interest is deemed to be fully collectable, there has been at least six months of sustained repayment performance since the loan was placed on non-accrual status and/or management believes, based on current information, that the loan is no longer impaired. Interest payments received from the borrower and applied as a reduction to the principal balance of the loan while the loan was on non-accrual status is not recognized in interest income until such time that the loan is repaid in full.
The Company considers a loan to be impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the original contractual terms of the loan agreement. Measurement of impairment is based on expectations of future cash flows which are discounted at the loan's original effective interest rate, or measured by reference to an observable market value, if one exists, or the fair value of the collateral for a collateral-dependent loan. The Company selects the measurement method on a loan-by-loan basis except that collateral dependent loans for which foreclosure is probable are measured for impairment based on the fair value of the collateral. The Company recognizes interest income on impaired loans based on its existing methods of recognizing interest income on non-accrual loans. All impaired loans are generally charged-off, either partially or fully, at such time that it is highly certain a loss has been realized.
Acquired Loans and Leases
Loans and leases acquired through purchase or through a business combination are recorded at their fair value at the acquisition date. Credit discounts are included in the determination of fair value; therefore, an allowance for loan and lease losses is not recorded at the acquisition date. Subsequent to acquisition, if the Company's allowance for loan and lease losses methodology indicates that the credit discount associated with acquired, non-purchased credit impaired loans, is no longer sufficient to cover probable losses inherent in those loans, the Company establishes an allowance for those loans through a charge to provision for loan and lease losses.
Purchased Credit Impaired Loans ("PCI loans")
Acquired loans are evaluated upon acquisition for evidence of deterioration in credit quality since their origination to determine if it is probable the Company will be unable to collect all contractually required payments. These loans are classified as PCI loans, while all other acquired loans are classified as non-PCI loans. The Company has elected to account for PCI loans at the individual loan level. The Company estimates the amount and timing of expected cash flows for each loan. The expected cash flow in excess of the loan's carrying value, which is fair value on the date of acquisition, is referred to as the accretable yield, and is recorded as interest income over the remaining expected life of the loan. The excess of the loan's contractual principal and interest over expected cash flows is referred to as the non-accretable difference, and is representative of contractual amounts the Company does not expect to collect. The non-accretable difference is not recorded in the Company's consolidated financial statements.
Note 1. Summary of Significant Accounting Policies - continued
Allowance for Loan and Lease Losses ("ALLL")
The Company manages credit risk not only through extensive risk analyses performed prior to a loan's approval, but also through the ongoing monitoring of loans within the portfolio, and more specifically certain types of loans that generally involve a greater degree of risk, such as commercial real estate, commercial lines of credit, agriculture, and construction/land loans. The Company monitors loans in the portfolio through an exhaustive internal process, at least quarterly, as well as with the assistance of independent loan reviews. These reviews generally not only focus on problem loans, but also internally rated "pass" credits within certain pools of loans that may be expected to experience stress due to economic conditions. This process allows the Company to validate credit risk grade ratings, underwriting structure, and the Company's estimated exposure in the current economic environment as well as enhance communications with borrowers where necessary in an effort to mitigate potential future losses. All significant problem loans are analyzed in detail at least quarterly, in order to properly estimate potential exposure to loss associated with these loans in a timely manner.
Each segment of loans in the portfolio possesses varying degrees of risk, based on, among other things, the type of loan, the purpose of the loan, the type of collateral securing the loan, and the sensitivity the borrower has to changes in certain external factors such as economic conditions. The following provides a summary of the risks associated with various segments of the Company's loan portfolio, which are factors management regularly considers when evaluating the adequacy of the ALLL:
•Real estate secured loans - consist primarily of loans secured by commercial real estate, multi-family, farmland, and 1 to 4 family residential properties. As the majority of this segment is comprised of commercial real estate loans, risks associated with this segment lie primarily within that loan type. Adverse economic conditions may result in a decline in business activity and increased vacancy rates for commercial properties. These factors, in conjunction with a decline in real estate prices, may expose the Company to the potential for losses if a borrower cannot continue to service the loan with operating revenues, and the value of the property has declined to a level such that it no longer fully covers the Company's recorded investment in the loan.
•Construction and land - although construction and land loans generally possess a higher inherent risk of loss than other loans, improvements in the mix, collateral and nature of loans help to mitigate risks within this segment of the portfolio. Risk arises from the necessity to complete projects within specified cost and time limits. Trends in the construction industry may also impact the credit quality of these loans, as demand drives construction activity. In addition, trends in real estate values significantly impact the credit quality of these loans, as property values determine the economic viability of future construction projects.
•Commercial - consist primarily of commercial and industrial loans (business lines of credit), agriculture loans, and other commercial purpose loans. Repayment of commercial and industrial loans is generally provided from the cash flows of the related business to which the loan was made. Adverse changes in economic conditions may result in a decline in business activity, which can impact a borrower's ability to continue to make scheduled payments. The risk of repayment of agriculture loans arises largely from factors beyond the control of the Company or the related borrower, such as commodity prices, general weather conditions, and drought.
Note 1. Summary of Significant Accounting Policies - continued
•Consumer - the consumer loan portfolio is comprised primarily of a large number of small loans with scheduled amortization over a specific period. The majority of consumer loans include installment loans, revolving credit plans, and credit card balances. Weakened economic conditions may result in an increased level of delinquencies within this segment, as economic pressures may impact the capacity of such borrowers to repay their obligations.
ALLL Model Methodology
During the third quarter of 2015, the Company made a specific enhancement to its methodology for determining the general reserve component of the ALLL. This enhancement related specifically to the methodology used to calculate the loss rates for loan risk grades within each loan type in the determination of the general reserve component of the ALLL. The enhanced methodology uses more granular loan level data to calculate loss rates for specific loan grades within each loan type, allowing for more detailed loan migration analysis, and the ability to determine average loss rates for each loan risk grade. Although the total general reserve component of the ALLL for each loan type and portfolio segment is still based on total average historical losses for their respective loan types, management believes the allocation of the ALLL to each loan risk grade, within each loan type and the evaluation of the loss emergence period has become more granular under this methodology enhancement. The implementation of the ALLL model enhancement did not result in a required increase or decrease in the balance of the ALLL, or a material impact to the overall allocation of the ALLL.
The ALLL is maintained at a level which, in management's judgment, is appropriate to absorb probable credit losses inherent in the loans within the loan portfolio as of the balance sheet date. The amount of the ALLL is based on management's evaluation of the collectability of the loan portfolio, including the nature and volume of the portfolio, credit concentrations, trends in historical loss experience, the level of certain classified balances and specific impaired loans, and economic conditions and the related impact on specific borrowers and industry groups. The ALLL is increased by provisions for loan and lease losses and decreased by reversals of provisions for loan and lease losses, charged or credited to current period earnings. The ALLL is also decreased by loan charge-offs and increased by recoveries on previously charged-off loans. Changes in the ALLL relating to impaired loans, including troubled debt restructurings ("TDRs"), are charged or credited to the provision for loan and lease losses. Due to uncertainties inherent in the estimation process, management's estimate of probable credit losses inherent in the loan portfolio and the related allowance may change.
The process in which management determines the appropriate level of the ALLL involves the exercise of considerable judgment and the use of estimates. While management utilizes its best judgment and all available information in determining the adequacy of the ALLL, the ultimate adequacy of the ALLL is dependent upon a variety of factors beyond the Company's control, including but not limited to, the performance of the loan portfolio, changes in current and future economic conditions and the view of regulatory agencies regarding the level of classified assets. Weakness in economic conditions and any other factor that may adversely affect credit quality and/or that may result in higher levels of: past due and non-accruing loans, loan defaults, and/or increased loan charge-offs, may require additional provisions for loan and lease losses in future periods and a higher balance in the Company's ALLL. The ALLL, as more fully described below, is comprised of three components: general reserves, specific loan reserves, and a reserve for PCI loans. Please also see "Acquired Loans and Leases" of this Summary of Significant Accounting Policies for discussion concerning PCI loans.
Note 1. Summary of Significant Accounting Policies - continued
General Reserves - The general reserve component of the ALLL, which is not attributable to loans specifically identified as impaired, is determined through a two-step process. First a quantitative allocation is determined by pooling performing loans by collateral type and purpose. These pools of loans are then further segmented by an internal risk grading system that classifies loans as: pass, special mention, substandard and doubtful. The Company's risk grade system allows management, among other things, to identify the risk associated with each loan, and to provide a basis for estimating credit losses inherent in the portfolio. Risk grades are generally assigned based on information concerning the borrower and the strength of the collateral. Risk grades are reviewed regularly by the Company's credit committee and are scrutinized by independent loan reviews performed semi-annually, as well as by regulatory agencies during scheduled examinations. Once credit risk grades have been assigned, estimated loss rates are then applied to each segment according to risk grade to determine the amount of the general portfolio allocation. Estimated loss rates are determined through a migration analysis of historical losses for each segment of the loan portfolio, based on the Company's prior experience with such loans, and the use of detailed loan level data, encompassing historical losses and average balance information for each loan type and risk grade. The following provides brief definitions for credit risk grade ratings assigned to loans in the portfolio:
•Pass - credits that have strong credit quality with adequate collateral or secondary source of repayment and little existing or known weaknesses. However, pass may include credits with exposure to certain potential factors that may adversely impact the credit, if they materialize, resulting in these credits being put on a watch list to monitor more closely than other pass rated credits. Such factors may be credit / relationship specific or general to an entire industry.
•Special Mention - credits that have potential weaknesses that deserve management's close attention. If not corrected, these potential weaknesses may result in deterioration of the repayment prospects for the credit at some future date.
•Substandard - credits that have a defined weakness or weaknesses which may jeopardize the orderly liquidation of the loan through cash flows, making it likely that repayment may have to come from some other source, such as the liquidation of collateral. The Company is more likely to incur losses on substandard credits if the weakness or weaknesses identified in the credit are not corrected.
•Doubtful - credits that possess the characteristics of a substandard credit, but because of certain existing deficiencies related to the credit, full collection is highly questionable. The probability of incurring some loss on such credits is high, but because of certain important and reasonably specific pending factors which may work to the advantage of strengthening the credit, charge-off is deferred until such time as the Company becomes reasonably certain that certain pending factors related to the credit will no longer provide some form of benefit.
Note 1. Summary of Significant Accounting Policies - continued
The second component of the general reserve allocation of the ALLL is the qualitative allocation, and is determined by estimates the Company makes in regard to certain internal and external factors that may have either a positive or negative impact on the overall losses inherent in the loan portfolio. Internal factors include trends in credit quality of the loan portfolio, the existence and the effects of concentrations, the composition and volume of the loan portfolio and the scope and frequency of the loan review process as well as any other factor determined by management to have an impact on the credit quality of the loan portfolio. External factors include local, state and national economic and business conditions, as well as the estimated impact that environmental factors may have on certain segments of the loan portfolio, such as drought. While management regularly reviews the estimated impact these internal and external factors are expected to have on the loan portfolio, there can be no assurance that an adverse change in any one or combination of these factors will not be in excess of management's expectations.
Specific Loan Reserves - The specific reserve component of the ALLL is determined through the measurement of impairment on loans that have been identified as impaired during each reporting period. A comprehensive analysis is performed at the time a loan is deemed impaired, which includes obtaining updated financial information regarding the borrower, obtaining updated appraisals on any collateral securing the loan and ultimately determining the extent to which the loan is impaired. In measuring the fair value of the collateral, management uses assumptions and methodologies consistent with those that would be utilized by third party valuation experts. For collateral dependent loans, impairment is measured based on an evaluation of the fair value of the collateral relative to the recorded investment in the loan. If the primary source of repayment of the loan is deemed to be cash flows from the borrower, impairment is measured through a discounted cash flow analysis using the loan's effective interest rate. Once the amount of impairment has been determined, the Company establishes a corresponding valuation allowance which then becomes a component of the Company's specific loan reserve in the ALLL.
Reserve for PCI Loans - Quarterly, management performs an evaluation of future cash flows for PCI loans. These evaluations are performed on the individual loan level for each PCI loan. If current expectations of future cash flows are less than management's previous expectations, other than due to decreases in interest rates and prepayment assumptions, an allowance for loan and leases losses is recorded with a charge to provision for loan and lease losses. In the event there has been a probable and significant increase in expected future cash flows over that which was previously expected, the Company first reduces any previously established allowance for loan and lease losses, and then records an adjustment to interest income through a prospective increase in the accretable yield.
Impaired Loans
A loan is identified as impaired when, based on current information, it is probable that the Company will be unable to collect all amounts due according to the original contractual terms of the loan agreement. The Company periodically performs a review of all significant problem loans. If based on this review it is determined that the loan is impaired, the Company obtains updated appraisal information on the underlying collateral for collateral dependent loans and updated cash-flow information if the loan is unsecured or primarily dependent on future operating or other cash flows from the borrower. Once the updated financial information is obtained and analyzed by management, a valuation allowance, if necessary, is established against the loan or a loss is recognized by a charge to the ALLL. Therefore, at the time a loan is considered impaired a valuation allowance typically has already been established or balances deemed uncollectable have been charged-off.
Note 1. Summary of Significant Accounting Policies - continued
When a borrower discontinues making payments according to the original contractual terms of the loan agreement, the Company must determine if it is appropriate to continue the accrual of interest on the loan. Generally, the Company places loans on non-accrual status and ceases the recognition of interest income when a loan has become delinquent 90 days or more, and/or when management believes the collection of all contractually required amounts is unlikely. Therefore, the Company generally places impaired loans on non-accrual status due to doubt surrounding the ultimate collection of contractual amounts due. Loans typically move to non-accrual status from the Company's substandard risk grade. When a loan is first classified as substandard, the Company performs a review of the loan in order to determine if the loan is impaired. If upon a loan's migration to non-accruing status, the financial information on the borrower previously obtained while the loan was classified as substandard is deemed to be outdated, the Company typically orders new appraisals on underlying collateral or obtains the most recent cash-flow information in order to have the most current indication of fair value. For collateral dependent loans, if a complete appraisal is expected to take a significant amount of time to complete, the Company may also rely on a broker's price opinion or other meaningful market data, such as comparable sales, in order to derive its best estimate of a property's fair value, while waiting for an appraisal at the time of the decision to classify the loan as substandard and/or non-accruing.
An analysis of the underlying collateral is performed for loans on non-accrual status at least quarterly and new appraisals are typically received at least annually. Corresponding changes in any related valuation allowance are made or balances deemed to be fully uncollectable are charged-off. Cash-flow information for impaired loans dependent primarily on future operating or other cash-flows are updated quarterly as well, with subsequent shortfalls resulting in valuation allowance adjustments.
In certain instances the Company may work with the borrower to modify the terms of the loan agreement or otherwise restructure the loan in a way that would allow the borrower to continue to perform under the modified terms of the loan agreement. In those instances where modifications are made to loans, for which the borrower is experiencing financial difficulty and the Company has granted the borrower a concession that it would not have otherwise considered, the modifications constitute a TDR. Concessions may include a reduction in the contractual rate of interest, extension payments or maturity, and/or a combination of other actions designed to maximize collection efforts. The Company's policy for monitoring loan modifications for potential TDRs is focused on loans risk graded as special mention, substandard or doubtful. TDRs are considered impaired loans and require the Company to measure the amount of impairment, if any, and establish a specific reserve for the loan at the time the loan is restructured.
The Company considers a loan to be impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the original contractual terms of the loan agreement. Measurement of impairment is based on expectations of future cash flows which are discounted at the loan's original effective interest rate, or measured by reference to an observable market value, if one exists, or the fair value of the collateral for a collateral-dependent loan. The Company selects the measurement method on a loan-by-loan basis except that collateral dependent loans for which foreclosure is probable are measured for impairment based on the fair value of the collateral. The Company recognizes interest income on impaired loans based on its existing methods of recognizing interest income on non-accrual loans. All impaired loans are generally charged-off, either partially or fully, at such time that it is highly certain a loss has been realized.
Note 1. Summary of Significant Accounting Policies - continued
Loan Charge-offs
The Company typically moves to charge-off loan balances when the loan becomes 90 days past due, unless it is well secured and in the process of collection. The Company may also move to charge-off a loan when based on various evidence, it believes those balances are no longer collectable. Evidence may include updated information related to a borrower's financial condition or updated information related to collateral securing the loan. If a loan's credit quality deteriorates to the point that collection of principal through traditional means is believed by management to be doubtful, and management determines there is value in the collateral securing the loan through obtaining periodic appraisals, the Company generally takes steps to protect and liquidate the collateral.
Any loss resulting from the difference between the Company's recorded investment in the loan and the fair market value of the collateral obtained through repossession is recognized by a charge to the ALLL. For most real estate and commercial loans, the Company generally recognizes a charge-off to bring the carrying balance of the loan down to the estimated fair value of the underlying collateral or some other estimate of fair value when: (i) management determines that the asset is no longer collectable, (ii) repayment prospects for the credit have become unclear and/or are likely to occur over a time-frame the Company deems to be no longer reasonable, (iii) the loan or portion of the loan has been deemed a loss by the Company's internal review and/or independent review functions, or has been deemed a loss by regulatory examiners, (iv) the borrower has or is in the process of filing for bankruptcy. The Company's charge-off policy is consistently applied to all portfolio segments.
The Company may defer charge-off on a loan, due to certain factors the Company has identified that may work to its benefit in minimizing potential losses. Those factors may include: working with the borrower to restructure the loan in an effort to bring about a more favorable outcome, the identification of an additional source of repayment, sufficient collateral to cover the Company's recorded investment in the loan, or any other identified factor that may work to strengthen the credit and reduce the potential for loss.
Appraisals for Loans Secured by Real Estate Collateral
For loan commitments greater than $750 thousand and a remaining term greater than one year at the loan's anniversary date, the Bank has a policy to perform an annual review of the borrower's financial condition and of any real estate securing the loan. This review includes, among other things, a physical inspection of the real estate securing the loan, an analysis of any related rent rolls, an analysis of all borrower and guarantor tax returns and financial statements. This information is used internally by the Bank to validate all covenants and the risk grade assigned to the loan. If during the review process the Bank learns of additional information that would suggest that the borrower's ability to repay has deteriorated since the original underwriting of the loan, and repayment may now be dependent on liquidation of the collateral, an additional independent appraisal of the collateral is requested. If based on the updated appraisal information it is determined the value of the collateral is impaired and the Bank no longer expects to collect all previously determined amounts related to the loan as stipulated in the loan's original agreement, the Bank typically moves to establish a valuation allowance for the loan or charge-off such differences.
Note 1. Summary of Significant Accounting Policies - continued
In general, once a loan is deemed to be impaired and/or the loan was downgraded to substandard status, the loan becomes the responsibility of the Bank's Special Assets department, which provides more diligent oversight of problem credits. This oversight includes, among other things, a review of all previous appraisals of collateral securing such loans and determining in the Bank's best judgment if those appraisals still represent the current fair value of the loan. Additional appraisals may be ordered at this time and annually thereafter, if deemed necessary.
Reserve for Off-Balance Sheet Loan Commitments
The Company has exposure to losses from unfunded loan commitments and letters of credit. Since the funds have not been disbursed on these commitments, they are not reported as loans outstanding. Estimated losses related to these commitments are not included in the ALLL, instead they are accounted for as a separate loss contingency reserve and included within other liabilities on the Company's consolidated balance sheets. Adjustments to this reserve are recorded as a charge to earnings, which is included in other non-interest expense on the consolidated statements of income. Losses are experienced when the Company is contractually obligated to make a payment under these instruments and must seek repayment from a party that may not be as financially sound in the current period as it was when the commitment was originally made.
Premises and Equipment
Land is carried at cost. Premises and equipment are carried at cost less accumulated depreciation and amortization. Depreciation is computed using the straight-line method over the estimated useful lives, which range from three to ten years for furniture and fixtures and thirty years for buildings. Leasehold improvements are amortized using the straight-line method over the estimated useful lives of the improvements or the remaining lease term, whichever is shorter. Expenditures for improvements or major repairs are capitalized and those for ordinary repairs and maintenance are charged to expense as incurred.
Income Taxes
Income taxes reported in the consolidated financial statements are computed based on an asset and liability approach. The Company recognizes the amount of taxes payable or refundable for the current year, and deferred tax assets and liabilities for the future tax consequences that have been recognized in the financial statement or tax returns. The measurement of tax assets and liabilities is based on the provisions of enacted tax laws. The Company files consolidated federal and combined state income tax returns. A tax position is recognized as a benefit only if it is "more likely than not" that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the "more likely than not" test, no tax benefit is recorded. Interest expense and penalties associated with unrecognized tax benefits, if any, are classified as income tax expense in the consolidated statements of operations. Deferred income taxes reflect the tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax reporting purposes.
Note 1. Summary of Significant Accounting Policies - continued
Deferred tax assets are recognized subject to management's judgment that realization is more likely than not. In making the determination whether a deferred tax asset is more likely than not to be realized, management performs a quarterly evaluation of all available positive and negative evidence including the possibility of future reversals of existing taxable temporary differences, projected future taxable income, tax planning strategies and recent financial results. A deferred tax asset valuation allowance is established to reduce the net carrying amount of deferred tax assets if it is determined to be more likely than not that all or some portion of the deferred tax asset will not be realized. See also Note 8. Income Taxes, of these consolidated financial statements for additional information related to deferred income taxes.
Bank Owned Life Insurance ("BOLI")
The Company has purchased life insurance policies on certain employees, which are referred to as BOLI. These policies are recorded in the consolidated balance sheets at their cash surrender value. Income and expense from these policies and changes in the cash surrender value are recorded in non-interest income and non-interest expense in the consolidated statements of income.
Goodwill and Other Intangible Assets
Intangible assets are comprised of goodwill, core deposit intangibles and other identifiable intangibles acquired in business combinations. Intangible assets with definite useful lives are amortized over their respective estimated useful lives. If an event occurs that indicates the carrying amount of an intangible asset may not be recoverable, management reviews the asset for impairment. Any goodwill and any intangible asset acquired in a purchase business combination determined to have an indefinite useful life is not amortized, but is evaluated for impairment, at a minimum, on an annual basis.
The Company applies a qualitative analysis of conditions in order to determine if it is more likely than not that the carrying value is impaired. In the event that the qualitative analysis suggests that the carrying value of goodwill may be impaired, the Company, with the assistance of an independent third party valuation firm, uses several quantitative valuation methodologies in evaluating goodwill for impairment including a discounted cash flow approach that includes assumptions made concerning the future earnings potential of the organization, and a market-based approach that looks at values for organizations of comparable size, structure and business model. The current year's review of qualitative factors did not indicate that impairment has occurred, as such no quantitative analysis was performed at December 31, 2016.
Other Real Estate Owned ("OREO")
Real estate and other property acquired in full or partial settlement of loan obligations is referred to as OREO. These assets are originally recorded in the Company's consolidated financial statements at their estimated fair value less any costs to sell the property. When OREO assets are acquired, typically through foreclosure or surrendered in lieu of foreclosure, the Company compares the estimated fair value of the property against its recorded investment in the related loan. If the estimated fair value of the property, including estimates for the cost to sell, is less than the recorded investment in the related loan, the difference in the carrying value of the loan is charged to the allowance for loan and lease losses prior to the loan's transfer to OREO. Should the fair value of OREO decline in subsequent periods, the Company establishes a valuation allowance for OREO through a charge to non-interest expense. All related operating or maintenance costs are charged to non-interest expense as incurred. Any subsequent gains or losses on the sale of OREO assets are recorded as a component of non-interest income.
Note 1. Summary of Significant Accounting Policies - continued
Federal Home Loan Bank Borrowings
The Company may borrow from the FHLB at competitive rates, which typically approximate the London Inter-Bank Offered Rate ("LIBOR") for the equivalent term because they are secured with investments in high quality loans. Interest is accrued on a monthly basis based on the outstanding borrowing's interest rate and is included in interest expense on other borrowings.
Salary Continuation Plan Agreements
The Company has entered into salary continuation plan agreements with certain executive and senior officers. The measurement of the liability under these agreements is estimated using a discounted cash flow model, which includes estimates involving the length of time before retirement, estimated long-term discount rates based on the Bank's long-term borrowing rates at the time the agreement is executed, and expected benefit levels. Should these estimates vary substantially from actual events, the level of expense recognized in the future to provide these benefits could materially vary.
Accumulated Other Comprehensive Income
The Company records changes in the unrealized gain (loss) on available for sale securities, net of income taxes, as an adjustment to accumulated other comprehensive income. Unrealized gains (losses) on available for sale securities are reclassified to current period earnings as the gains (losses) are realized upon the sale of securities. Unrealized losses related to OTTI are reclassified to current period earnings at the time OTTI is deemed to have occurred. Unrealized gains (losses) related to available for sale securities was the only component of accumulated other comprehensive income for the Company for the years ended December 31, 2016, 2015 and 2014.
Share-Based Compensation
The Company grants incentive and non-qualified stock options, as well as restricted stock to directors and employees as a form of compensation. U.S. GAAP requires the Company to recognize compensation expense for the grant-date fair value of stock options and other equity-based forms of compensation over the period the awards are expected to vest. For liability classified awards, the Company re-measures the amount of the liability attributable to those each period, which is based on changes in the Company's stock price. The Company uses a straight-line method for the recognition of all share-based compensation expense. See also Note 13. Share-Based Compensation Plans, of these consolidated financial statements for additional information related to share-based compensation.
Earnings Per Share
Basic earnings per common share are computed by dividing net income allocable to common shareholders by the weighted average number of common shares outstanding for the reporting period. Diluted earnings per common share are computed by dividing net income allocable to common shareholders by the weighted average number of common shares outstanding over the reporting period, adjusted to include the effect of potentially dilutive common shares. Potentially dilutive common shares are determined using the treasury stock method and include incremental shares issuable upon the exercise of stock options and other share-based compensation awards, such as restricted stock and restricted stock units that settle in shares of the Company's common stock. Unvested restricted stock awards contain non-forfeitable rights to receive dividends. As such, these awards are considered participating securities and the Company has applied the two-class method in the computation of basic and diluted earnings per share in periods where these awards are outstanding.
Note 1. Summary of Significant Accounting Policies - continued
Under the two-class method, distributed and undistributed earnings allocable to participating securities are deducted from net income to determine net income allocable to common shareholders, which is then used in the numerator of both basic and diluted earnings per share calculations. The computation of diluted earnings per common share excludes the impact of the assumed exercise or issuance of securities that would have an anti-dilutive effect, which can occur when the Company reports a net loss or when the market price for the Company's stock falls below the exercise price of equity awards issued by the Company.
Loss Contingencies
Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. Legal costs incurred to defend such matters are expensed as incurred. Management does not believe there are any such matters that will have a material effect on the consolidated financial statements.
Derivative Financial Instruments
Derivative financial instruments consist of back-to-back interest rate swap contracts which are accounted for as free standing derivative contracts, carried at fair value, and are included in other assets and other liabilities in the Company's consolidated financial statements. These interest rate swaps allow the Company to provide variable rate financing to qualified borrowers, while allowing these borrowers to effectively convert their variable rate obligations to a fixed stream of cash flows. Changes in the fair value of these derivative instruments are recorded in other non-interest income. Since the interest rate swap contacts the Company enters into with certain of its borrowers have identical terms to the interest rate swap contracts entered into with the counterparty bank, changes in the fair value of interest rate swap assets and liabilities offset each other in the consolidated statements of income. Favorable variances in the pricing of interest rate swaps between the Company and its borrowers compared to that of the pricing of corresponding swaps between the Company and its counterparty bank are recognized as gains on derivative instruments at the inception of the transaction and are included in non-interest income.
Note 2. Merger Agreement
Merger Agreement
On December 12, 2016, the Company and Pacific Premier Bancorp, Inc., a Delaware corporation ("PPBI"), entered into an Agreement and Plan of Reorganization (the "Merger Agreement") pursuant to which the Company will be merged with and into PPBI, with PPBI surviving (the "Corporate Merger"), immediately followed by the merger of Heritage Oaks Bank with and into Pacific Premier Bank, the wholly-owned bank subsidiary of PPBI ("Pacific Premier"), with Pacific Premier surviving (the "Bank Merger"). The Corporate Merger and Bank Merger are collectively referred to in this Annual Report on Form 10-K as the "Announced Transaction." The consideration paid to shareholders of the Company will consist of whole shares of PPBI common stock, and cash in lieu of fractional shares of PPBI common stock. Upon consummation of the Corporate Merger, each share of the Company's common stock issued and outstanding immediately prior to the effective time of the merger will be cancelled and converted into the right to receive 0.3471 shares of PPBI common stock.
Note 2. Merger Agreement - continued
The Merger agreement contains customary representations and warranties from the Company to PPBI, which are qualified by the confidential disclosures provided by the Company to PPBI, and customary representations and warranties from PPBI to the Company.
Note 3. Business Combination
Acquisition of Mission Community Bancorp
On February 28, 2014, the Company acquired 100% of the outstanding common shares of Mission Community Bancorp ("MISN") and all unexercised warrants and options to purchase MISN common stock were cancelled, in exchange for 7,541,326 shares of the Company's common stock and $8.7 million in cash (the "MISN Transaction"). Through the MISN Transaction, the Company acquired $453.7 million in assets, including $280.6 million in loans, and assumed $384.7 million in liabilities, including $371.5 million in deposits. The MISN Transaction was valued at $69.0 million. In conjunction with the MISN Transaction, MISN's wholly-owned bank subsidiary, Mission Community Bank, was merged with and into Heritage Oaks Bank.
The following table presents unaudited pro forma information as if the MISN Transaction had occurred on January 1, 2013, which includes the pre-acquisition period for MISN. The unaudited pro forma information includes adjustments for interest income on loans and securities acquired, amortization of intangibles arising from the transaction, depreciation expense on property acquired, interest expense on deposits and borrowings acquired, and the related income tax effects. The unaudited pro forma financial information is not necessarily indicative of the results of operations that would have occurred had the transaction been effected on the assumed date.
Note 4. Fair Value of Assets and Liabilities
Recurring Basis
The following table provides a summary of the financial instruments the Company measures at fair value on a recurring basis as of December 31, 2016 and 2015:
Note 4. Fair Value of Assets and Liabilities - continued
There were no transfers between levels of fair value measures during 2016 and 2015 for assets measured at fair value on a recurring basis. There were no liabilities measured on a recurring basis during 2015. As of December 31, 2016 and 2015, there were no assets or liabilities classified as Level 3.
Non-recurring Basis
The Company may be required, from time to time, to measure certain assets and liabilities at fair value on a non-recurring basis. These include assets and liabilities that are measured at the lower of cost or fair value, and that were recognized at fair value which was below cost. Certain impaired loans are recorded in the Company's consolidated financial statements using the discounted cash flow method versus the collateral method. The discounted cash flow method as prescribed by ASC 310 Receivables, is not a fair value measurement since the discount rate utilized is the loan's effective interest rate, which is not considered a market rate for those loans. The discounted cash flow approach is used to measure impairment for certain impaired loans, because of the significant payment history and the global cash flow analysis performed on each borrower.
Note 4. Fair Value of Assets and Liabilities - continued
The following tables provide a summary of assets the Company measures at fair value on a non-recurring basis as of December 31, 2016 and 2015. There were no assets or liabilities measured at fair value on a non-recurring basis as of December 31, 2015.
There were no transfers between levels of fair value measures during 2016 and 2015 for assets measured at fair value on a non-recurring basis.
Note 4. Fair Value of Assets and Liabilities - continued
Fair Value of Financial Instruments
The following tables provide a summary of the estimated fair value of financial instruments at December 31, 2016 and 2015:
Note 4. Fair Value of Assets and Liabilities - continued
Information on off-balance sheet instruments as of December 31, 2016 and 2015 follows:
Note 5. Investment Securities
The following tables set forth the amortized cost and fair values of the Company's investment securities, all of which are reported as available for sale at December 31, 2016 and 2015:
Note 5. Investment Securities - continued
Those investment securities available for sale which have an unrealized loss position at December 31, 2016 and 2015 are detailed below:
A total of 138 and 104 securities were in an unrealized loss position as of December 31, 2016 and 2015, respectively. As of December 31, 2016, the Company believes that unrealized losses on its investment securities are not attributable to credit quality, but rather fluctuations in market prices. In the case of the agency mortgage related securities, contractual cash flows are guaranteed by agencies of the U.S. Government. While the Company's investment security holdings have contractual maturity dates that range from 1 to 40 years, they have a much shorter effective duration dependent on the instrument's priority in the overall cash flow structure and the characteristics of the loans underlying the investment security.
Management does not intend to sell and it is unlikely that management will be required to sell the securities prior to their anticipated recovery. As of December 31, 2016, the Company does not believe unrealized losses related to any of its securities are other than temporary.
Note 5. Investment Securities - continued
The proceeds from the sales and calls of securities and the associated gains and losses are listed below for the years ended December 31, 2016, 2015 and 2014:
The income tax expense related to these net realized gains was $0.4 million, $0.3 million, and $0.3 million, during the years ended December 31, 2016, 2015 and 2014 respectively.
The table below provides a maturity distribution of available for sale investment securities at December 31, 2016 and 2015. The table reflects the expected lives of mortgage-backed securities, based on the Company's historical prepayment experience, because borrowers have the right to prepay obligations without prepayment penalties. Contractual maturities are reflected for all other security types. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Securities having an amortized cost and a fair value of $184.8 million and $183.8 million, respectively at December 31, 2016, and $153.9 million and $155.2 million, respectively at December 31, 2015 were pledged to secure public deposits. At December 31, 2016 and 2015, there were no holdings of securities of any one issuer, other than the U.S. Government and its agencies, in an amount greater than 10% of total securities.
Note 5. Investment Securities - continued
The following table summarizes earnings on investment securities, both taxable, and those that are exempt from federal taxation:
Note 6. Loans and Allowance for Loan and Lease Losses
The following table provides a summary of outstanding loan balances:
Note 6. Loans and Allowance for Loan and Lease Losses - continued
Non-PCI loans acquired in the MISN Transaction totaled $132.4 million and $163.8 million as of December 31, 2016 and 2015, respectively, and are included in total non-PCI loans in the table above. The decline in MISN loan balances is attributable to loan prepayments, payoffs, and scheduled principal reduction. Loans held for sale consist of single-family residential mortgage loans under contract to be sold in the secondary market. In most cases these loans are sold within thirty to sixty days.
Concentration of Credit Risk
The Company held loans that were collateralized by various forms of real estate, including residential 1 to 4 family loans originated and held for sale, totaling $1.1 billion and $1.0 billion at December 31, 2016 and 2015, respectively. These loans are generally made to borrowers located in the counties of San Luis Obispo, Santa Barbara, and Ventura. The Company attempts to reduce its concentration of credit risk by making loans which are diversified by product type. While Management believes that the collateral presently securing this portfolio is adequate, there can be no assurance that deterioration in the California real estate market, or the impact of the current California drought on our real estate collateralized loans, would not expose the Company to significantly greater credit risk.
Loans Serviced for Others
Loans serviced for others are not included in the Company's consolidated financial statements. The unpaid principal balance of loans serviced for others, exclusive of Small Business Administration ("SBA") loans, was $33.3 million and $38.0 million at December 31, 2016 and 2015, respectively. Periodically, the Company originates SBA loans for sale for which it retains the servicing of the guaranteed portion of the loan sold. At December 31, 2016 and 2015, the unpaid principal balance of SBA loans serviced for others totaled $6.3 million and $8.5 million, respectively. The Company did not sell any SBA loans during the years ended December 31, 2016 and 2015. Gains related to the sale of SBA loans totaled $43 thousand for the year ended December 31, 2014 and are included as a component of other income in non-interest income.
Pledged Loans
At December 31, 2016, the Bank pledged $748.8 million of loans to the FHLB of San Francisco to secure a credit facility totaling $517.8 million under a blanket lien. Of this credit facility, $10.2 million is available as a line of credit, while the remainder is available for potential future borrowings.
Purchased Credit Impaired Loans
As part of the MISN Transaction, described in Note 3. Business Combination, of these consolidated financial statements, the Company acquired certain loans classified as PCI loans. These loans have exhibited evidence of deterioration in credit quality since their origination, and at their acquisition it was deemed probable all contractually required payments would not be collected.
Note 6. Loans and Allowance for Loan and Lease Losses - continued
The table below summarizes the unpaid principal balance and carrying amount of PCI loans as of December 31, 2016 and 2015:
The following table summarizes the accretable yield, or income expected to be collected on PCI loans:
(1)Attributable to loans acquired in the MISN Transaction. (2)Changes in expected cash flows during the year ended December 31, 2016 were driven by prepayments on PCI loans. Changes in expected cash flows during the years ended December 31, 2015 and 2014 were attributed to positive changes in expectations of future cash flows on PCI loans.
Note 6. Loans and Allowance for Loan and Lease Losses - continued
Impaired Loans
The following tables provide a summary of the Company's recorded investment in non-PCI and PCI impaired loans as of and for the periods presented.
Note 6. Loans and Allowance for Loan and Lease Losses - continued
(1)At December 31, 2016 there was no ALLL for PCI loans.
Note 6. Loans and Allowance for Loan and Lease Losses - continued
Note 6. Loans and Allowance for Loan and Lease Losses - continued
(1)At December 31, 2014 there was no ALLL for PCI loans.
Note 6. Loans and Allowance for Loan and Lease Losses - continued
The Company did not record income from the receipt of cash payments related to non-accruing loans during the years ended December 31, 2016, 2015 and 2014. If interest on non-accruing loans had been recognized at the original interest rates stipulated in the respective loan agreements, interest income would have increased $0.6 million for each of the years ended December 31, 2016, 2015 and 2014, respectively. Interest income recognized on impaired loans in the tables above represents interest the Company recognized on accruing TDRs, as well as accretion on accruing PCI loans.
At December 31, 2016, there were no residential 1 to 4 family loans in process of foreclosure, or residential 1 to 4 family properties included in foreclosed assets.
Troubled Debt Restructurings
The majority of the Bank's TDRs were granted concessions with respect to interest rates, payment structure and/or maturity. Modifications to loans as TDRs during the years ended December 31, 2016 and 2015 were primarily comprised of extensions of a loan's maturity at the loan's original interest rate, which was lower than the market rate of interest for new credit with similar risk. Extensions of maturity were for periods ranging from 6 months to 10 years. At December 31, 2016, the Company was not committed to lend any additional funds to borrowers with loans modified as TDRs. As of December 31, 2016 the Company had established valuation allowances for loans modified as TDRs totaling $0.4 million.
The following table provides a summary of loans classified as TDRs as of December 31, 2016 and 2015:
Note 6. Loans and Allowance for Loan and Lease Losses - continued
The following tables summarize loan modifications which resulted in TDRs during the periods presented below:
Note 6. Loans and Allowance for Loan and Lease Losses - continued
The following table summarizes loans that were modified as troubled debt restructurings within the twelve months prior to the balance sheet date, and for which there was a payment default during the years ended December 31, 2016, 2015 and 2014:
Note 6. Loans and Allowance for Loan and Lease Losses - continued
Allowance for Loan and Lease Losses
The following tables summarize the activity in the allowance for loan and lease losses by portfolio segment for the years ended December 31, 2016, 2015 and 2014:
Note 6. Loans and Allowance for Loan and Lease Losses - continued
The following tables disaggregate the allowance for loan and lease losses and the recorded investment in loans by impairment methodology as of December 31, 2016 and 2015:
At December 31, 2016, total gross loans of $1.4 billion in the table above include $140.3 million of non-PCI and PCI loans acquired in the MISN Transaction. Loans acquired in the MISN Transaction were initially recorded at fair value, and had no related ALLL on the acquisition date. At December 31, 2016 and 2015 the ALLL for non-PCI loans acquired in the MISN Transaction, was $0.1 million and $0.3 million, respectively, and is included in the ALLL for loans collectively evaluated for impairment. The incremental ALLL allocation for acquired non-PCI loans was not due to deterioration in credit quality, but rather due to accelerated accretion of purchase discounts attributable to loan pay-downs and payoffs. There was no ALLL for PCI loans as of December 31, 2016, compared to $0.1 million at December 31, 2015. The change in the ALLL for PCI loans is attributable to favorable changes in expected future cash flows on certain PCI loans.
Note 6. Loans and Allowance for Loan and Lease Losses - continued
Reserve for Off-Balance Sheet Loan Commitments
The Company has exposure to losses from unfunded loan commitments and letters of credit. Estimated losses inherent in the outstanding balance of these commitments is not included in the ALLL, but is recorded separately, and included as a component of other liabilities in the consolidated balance sheets. The balance of the reserve for off-balance sheet commitments was $0.5 million at December 31, 2016 and 2015.
Credit Quality
The following tables stratify loans held for investment by the Company's internal risk grading system as of December 31, 2016 and 2015:
Note 6. Loans and Allowance for Loan and Lease Losses - continued
Note 6. Loans and Allowance for Loan and Lease Losses - continued
Aging of Loans Held for Investment
The following tables summarize the aging of loans held for investment as December 31, 2016 and 2015:
(1)At December 31, 2016, $6.2 million of non-accruing loans were current, $21 thousand were 30-59 days past due, $32 thousand were 60-89 days past due, and $0.6 million were 90+ days past due.
Note 6. Loans and Allowance for Loan and Lease Losses - continued
(1)At December 31, 2015, $6.4 million of non-accruing loans were current, $28 thousand were 30-59 days past due, $26 thousand were 60-89 days past due, and $1.4 million were 90+ days past due.
Note 7. Property, Premises and Equipment
At December 31, 2016 and 2015, property, premises and equipment consisted of the following:
Depreciation expense totaled $2.2 million, $2.1 million, and $1.8 million for the years ended December 31, 2016, 2015 and 2014, respectively. The Company leases land, buildings, and equipment under non-cancelable operating leases expiring at various dates through 2022. See Note 19. Commitments and Contingencies, of these consolidated financial statements for additional information regarding the Company's operating lease obligations.
Note 8. Income Taxes
The table below details the components of the Company's net deferred tax assets as of December 31, 2016 and 2015:
Deferred tax assets relate to amounts that are expected to be realized through subsequent reversals of existing taxable temporary differences over the projection period. The ultimate realization of the Company's deferred tax assets is dependent on the generation of future taxable income during the periods in which those temporary differences reverse. U.S. GAAP requires the Company to assess whether a valuation allowance should be established against deferred tax assets based on the consideration of all available evidence using a "more likely than not" standard. In making such judgments, significant weight is given to evidence, both positive and negative, that can be objectively verified. At December 31, 2016 and 2015, there was no valuation allowance for the Company's deferred tax assets. The accounting for deferred taxes is based on an estimate of future results. Differences between anticipated and actual outcomes of these future tax consequences could have an impact on the Company's consolidated results of operations or financial position.
In 2014, Management assessed the impact of the MISN Transaction for limitations under I.R.C. Section 382 and determined that, given the assumption that the Company generates sufficient future taxable income to utilize net operating losses ("NOLs"), no loss of NOL carry-forward utilization would result from the estimated annual I.R.C. Section 382 base limitation resulting from the transaction. Furthermore, due to the fact that MISN was in a net unrealized built-in gain position ("NUBIG") the Company's annual I.R.C. Section 382 limitation will likely increase over the next three years for realized built-in gains ("RBIG").
Note 8. Income Taxes - continued
As of December 31, 2016, the Company has deferred tax assets attributable to NOLs available for carry-forward for federal and state tax purposes totaling $9.5 million and $14.0 million, respectively. Deferred tax assets attributable to these NOLs total $4.3 million as of December 31, 2016. This amount is comprised of $2.8 million for federal and $1.5 million for state. Of the $4.3 million in NOLs, $0.3 million of state NOLs are attributable to operating losses the Company incurred in prior years, and $3.0 million and $1.0 million of federal and state NOLs are attributable to the MISN Transaction. The realization of NOL carry-forwards attributable to operating losses the Company incurred in prior years will expire in 2029. NOLs attributable to the MISN Transaction will expire in 2034. The realization of these NOL carry-forwards for federal and state tax purposes is limited under current tax law with limitations placed on the amount of NOL that can be utilized annually. The Company does not, however, believe that these annual limitations will impact the ultimate deductibility of these NOL carry-forwards. Additionally, at December 31, 2016, the Company has $0.5 million in alternative minimum tax credit ("AMT") for federal income tax purposes, and $0.3 million AMT for state income tax purposes, that have no expiration.
The Company is subject to income taxation by both federal and state taxing authorities. Income tax returns for the years ended December 31, 2016, 2015, 2014 and 2013 are open to audit by federal taxing authorities, while income tax returns are open to audit by state taxing authorities for the years ended December 31, 2016, 2015, 2014, 2013 and 2012. As of December 31, 2016 the Company's 2013 federal income tax return was under examination by the IRS. The Company does not anticipate any material impact to the financial statements as a result of this examination. The Company does not have any uncertain income tax positions and accrued interest charges and penalties as of December 31, 2016 and 2015 were immaterial to the financial statements.
The following table provides a summary for the current and deferred components of the Company's income tax provision for the years ended December 31, 2016, 2015 and 2014:
Note 8. Income Taxes - continued
The following table reconciles the statutory federal income tax expense and rate to the Company's effective income tax expense and rate for the years ended December 31, 2016, 2015 and 2014:
Note 9. Goodwill and Other Intangible Assets
Intangible assets consist of goodwill and core deposit intangible assets ("CDI") associated with the acquisition of core deposit balances, including those acquired in the MISN Transaction in 2014. At December 31, 2016 and 2015, the carrying value of goodwill was $24.9 million, of which $13.6 million can be attributed to the MISN Transaction.
CDI assets are subject to amortization. Amortization for the years ended December 31, 2016, 2015 and 2014 was $0.9 million, $1.0 million and $1.1 million, respectively.
The following tables summarize the gross carrying amount, accumulated amortization and net carrying amount of CDI and provides an estimate for future amortization as of December 31, 2016:
Note 10. Deposits
The following table provides a summary for the maturity of the Bank's time certificates of deposit as of December 31, 2016:
Note 11. Borrowings
The Bank has several sources from which it may obtain borrowed funds. While deposits are the Bank's primary funding source, borrowings are a secondary source of funds. Borrowings can take the form of Federal Funds purchased through arrangements it has established with correspondent banks or advances from the FHLB. Borrowing may occur for a variety of reasons including daily liquidity needs and balance sheet growth. The following provides a summary of the borrowing facilities available to the Bank and Company as well as the amount of borrowings that were outstanding as of December 31, 2016 and 2015.
Federal Funds Purchased
The Bank has borrowing lines with correspondent banks totaling $77.0 million as of December 31, 2016. As of December 31, 2016 and 2015, there were no balances outstanding on these borrowing lines.
Federal Home Loan Bank Borrowings
At December 31, 2016 and 2015, the Bank had $107.5 million and $103.5 million of borrowings with the FHLB. The following table provides a summary of those borrowings as of December 31, 2016:
Borrowings from the FHLB are collateralized by a blanket lien on certain qualifying loans in the Company's loan portfolio. FHLB borrowings require monthly interest only payments, with the full amount borrowed due at maturity. Of the $107.5 million outstanding, $77.5 million are comprised of fixed rate borrowings with rates ranging from 0.87% to 2.73%. The remaining $30.0 million are comprised of short-term, variable rate borrowings, with an interest rate of 0.55% as of December 31, 2016, which is tied to the Federal Funds Rate.
At December 31, 2016, $748.8 million in loans were pledged as collateral to secure a credit facility of $517.8 million under a blanket lien, of which $107.5 million was outstanding at December 31, 2016, as represented in the table above. Additionally, of the total amount of the credit facility with the FHLB, $10.2 million is available as a line of credit.
Note 11. Borrowings - continued
During 2015, the Bank prepaid certain FHLB borrowings in an effort to lower the future overall cost of borrowings from the FHLB. Certain of these borrowings had prepayment incentive fees associated with them, while others contained prepayment penalties. The result of the prepayment of these borrowings was a $0.1 million gain on the extinguishment of debt, and $0.1 million in additional interest expense recorded during the year ended December 31, 2015.
Holding Company Line of Credit
In addition to the Bank's sources of liquidity, the Company has an unsecured revolving line of credit with a correspondent bank totaling $10.0 million, which provides an additional source of liquidity to the holding company. This line of credit is subject to annual renewal. The Company pays a 0.20% annual fee to maintain this credit facility, as well as a 0.25% annual rate on the unused portion of the line. Interest on borrowings is at prime, or at the Company's option, a fixed rate based on LIBOR.
Junior Subordinated Debentures
On October 27, 2006, the Company issued $8.2 million of floating rate junior subordinated debt securities to Heritage Oaks Capital Trust II, a statutory trust created under the laws of the State of Delaware. These debentures are subordinated to effectively all borrowings of the Company. The Company used the proceeds from these borrowings for general corporate purposes, which include among other things, capital contributions to the Bank, investments, payment of dividends, and repurchases of the Company's common stock. During 2015, the Company redeemed $3.0 million of the original $8.2 million issuance of junior subordinated debentures to Heritage Oaks Capital Trust II. In connection with this redemption, the Company realized a pre-tax gain on the extinguishment of debt in the amount of $0.5 million. The remaining outstanding debentures associated with Heritage Oaks Capital Trust II are callable by the Company at par. At December 31, 2016, the carrying value of these debentures was $5.2 million.
As part of the MISN Transaction in 2014, the Company assumed floating rate junior subordinated debt in the amount of $8.2 million. The trust preferred securities associated with these debentures were issued by Mission Community Capital Trust I and Santa Lucia Bancorp (CA) Capital Trust prior to the MISN Transaction. These debentures are effectively subordinated to all borrowings of the Company. At December 31, 2016, the carrying value of these borrowings was $5.3 million, which reflects purchase accounting fair value adjustments of $2.9 million, related to the MISN Transaction. These borrowings are callable by the Company at par.
Purchase accounting adjustments were based on current market rates for similar instruments at the time of the MISN Transaction, and are accreted into interest expense over the lives of the debentures. Accretion of the discount on the junior subordinated debt assumed in the MISN Transaction totaled $0.2 million for each of the years ended December 31, 2016, 2015 and 2014.
Note 11. Borrowings - continued
The following table provides detail concerning junior subordinated debentures outstanding at December 31, 2016:
Pursuant to rules issued by the Federal Reserve Board, the Company is permitted to include junior subordinated debt in its determination of Tier I capital. Junior subordinated debt may not, however, constitute more than 25% of the Company's Tier I capital, subject to certain limitations. The Company was able to include $10.2 million and $10.0 million of junior subordinated debt in its Tier I capital for regulatory capital purposes as of December 31, 2016 and 2015, respectively. Please also see Note 14. Shareholders' Equity, of these consolidated financial statements for additional information concerning regulatory capital for the Company and the Bank.
Note 12. Employee Benefit Plans
Salary Continuation Agreements and Bank Owned Life Insurance
The Company established salary continuation agreements with certain senior and executive officers, as authorized by the Board of Directors. As of the end of 2011, the Company elected to no longer enter into these type of agreements with new officers, but continues to honor the terms of the agreements in place as of that date. These agreements generally provide for annual cash payments for a period not to exceed 15 years, payable at age 60-65, depending on the agreement. In the event of death prior to retirement age, annual cash payments are made to the beneficiaries for a determined number of years. At December 31, 2016 and 2015, the Company's liability under these agreements was $2.4 million and $2.5 million, respectively, and is included in other liabilities in the Company's consolidated financial statements. For each of the years ended December 31, 2016, 2015 and 2014, expenses associated with the Company's salary continuation plans were $0.2 million.
The Company maintains bank owned life insurance policies, referred to as BOLI, which assist the Company in the offset of costs associated with salary continuation agreements. The carrying value of BOLI totaled $33.7 million and $32.9 million at December 31, 2016 and 2015, respectively. Earnings on BOLI for the years ended December 31, 2016, 2015 and 2014 were $1.2 million, $0.9 million, and $0.8 million, respectively. The increase in earnings on BOLI in 2016 can be attributed to a purchase of $7.5 million in additional BOLI policies during the fourth quarter of 2015. These additional purchases were made to help offset the cost of existing employee benefit plans, as well as to help protect the Company in the event of a loss of key management.
Note 12. Employee Benefit Plans - continued
401(k) Savings Plan
The Company offers a savings plan for employees, which allows participants to make contributions by salary deferral in amounts up to the maximum amount specified pursuant to section 401(k) of the Internal Revenue Code. The Company matches employee contributions based on a prescribed formula and employees vest in the Company's contribution based on years of service. The Company incurred expenses associated with the plan of $0.4 million, $0.4 million, and $0.3 million for each of the years ended December 31, 2016, 2015 and 2014.
Note 13. Share-based Compensation Plans
As of December 31, 2016, the Company had one active share-based employee compensation plan, which was approved by the Company's shareholders in May 2015. This plan, referred to as the "2015 Equity Incentive Plan," authorizes the Company to grant various types of share-based compensation awards to the Company's employees and Board of Directors such as stock options, restricted stock awards, and restricted stock units. Under the 2015 Equity Incentive Plan a maximum of 2,500,000 shares of the Company's common stock may be issued. Shares issued under this plan, other than stock options and stock appreciation rights, are counted against the plan on a two shares for every one share actually issued basis. Awards that are cancelled, expired, forfeited, fail to vest, or otherwise result in issued shares not being delivered to the grantee, are again made available for the issuance of future share-based compensation awards. Additionally, under this plan, no one individual may be granted shares in aggregate that exceed more than 250,000 shares during any calendar year. The Company's Board of Directors may terminate the 2015 Equity Incentive Plan at any time, and for any reason before the plan expires on December 3, 2024.
The Company also has one non-active share-based compensation plan. This plan is referred to as the "2005 Equity Based Compensation Plan." As of December 31, 2016, no further grants can be made from this plan.
Restricted Stock Awards
The Company grants restricted stock periodically for the benefit of employees and to the members of the Board of Directors. Restricted stock awards typically vest ratably over a period of three to five years depending on the specific terms of the award. Restricted stock awards may be subject to the achievement of certain performance goals. Compensation costs related to restricted stock awards are recognized over the period the awards are expected to vest and are included in salaries and employee benefits. Compensation cost related to awards that are subject to performance conditions is recognized over the vesting period if the Company believes it is more likely than not that the performance conditions will be achieved. If the Company believes it is more likely than not that performance conditions will not be achieved, the Company ceases the accrual of compensation cost for the related award, and previously recognized compensation cost for the unvested portion of the award is reversed from earnings. The Company includes a forfeiture rate assumption in its accrual for compensation cost associated with restricted stock awards, which is based on the Company's historical experience with such awards.
Note 13. Share-based Compensation Plans - continued
The following table provides a summary of activity related to restricted stock awards granted for the year ended December 31, 2016:
Included in the table above are performance-based grants of restricted stock totaling 13,245 shares as of December 31, 2016.
Restricted Stock Units
Restricted stock units are granted periodically for the benefit of employees. Upon vesting, certain of these awards settle in shares of the Company's common stock, while others settle in cash. Awards that settle in shares of the Company's common stock are made to executive officers, while those that settle in cash are made to other officers of the Bank. The Company recognizes compensation cost associated with restricted stock units that settle in shares of the Company's common stock through charges to current period earnings, included in salaries and employee benefits, and a corresponding increase in additional paid in capital. Compensation cost for these awards is recognized ratably over the period in which the awards are expected to vest. For restricted stock units that settle in cash, the Company accrues a liability for the ultimate settlement of the award through charges to current period earnings, included in salaries and employee benefits. Compensation cost for these awards is recognized ratably over the period in which the awards are expected to vest. However, the ultimate settlement value of these awards and the related compensation cost may fluctuate, based on increases and decreases in the value of the Company's common stock over the vesting period.
Restricted stock units that settle in shares of the Company's common stock have vesting conditions which are based on pre-determined performance targets. Based on the achievement of these performance targets, the number of awards that vest can be adjusted upward to a maximum of 150% of the granted amount or downward to zero. Certain of the Company's performance based restricted stock units have performance targets based on the Company's return on average assets and total shareholder return over a specified period of time, relative to the Company's pre-determined peer group.
The grant date fair value of performance based restricted stock units that do not contain a market condition, such as those where vesting is based on return on average assets, is equivalent to the price of the Company's common stock on the date of grant. The Company incorporates a forfeiture rate assumption in its accrual for compensation cost for these awards, which is based on the Company's historical experience with similar awards. For awards that contain a market condition, the Company employs the use of a Monte Carlo simulation through an independent party to determine the grant date fair value of those awards. The Monte Carlo simulation estimates the grant date fair value of these awards using input assumptions similar to those in the Black-Scholes model, however it also incorporates into the grant date fair value calculation the probability that the performance targets will or will not be achieved.
Note 13. Share-based Compensation Plans - continued
The grant date fair value for restricted stock units that settle in cash is equivalent to the price of the Company's common stock on the date of grant.
The following table provides a summary of activity related to restricted stock units that settle in shares of the Company's common stock for the year ended December 31, 2016:
The following table provides a summary of activity related to restricted stock units that settle in cash for the year ended December 31, 2016:
Stock Options
Stock options are granted periodically for the benefit of employees. The fair value of each stock option award is determined on the date of grant using the Black-Scholes option valuation model, which uses assumptions such as expected volatility of the Company's common stock, expected term of the option, expected dividend yield on the Company's common stock, and the expected risk free rate of interest. Expectations for volatility are based on the historical volatility of the Company's common stock. The Company estimates forfeiture rates based on historical option exercise and termination experience for its employees. The Company recognizes share-based compensation costs ratably over the vesting period of the award, which is typically a period of three to five years.
Note 13. Share-based Compensation Plans - continued
The following table provides a summary of activity related to stock options as well as information related to stock options that have vested or are expected to vest and exercisable as of and for the year ended December 31, 2016:
The total intrinsic value, the amount by which the stock price exceeded the exercise price on the date of exercise, of options exercised in all plans during the years ended December 31, 2016, 2015, and 2014 was $0.5 million, $0.2 million and $0.2 million, respectively. The tax benefit related to the exercise of stock options and disqualifying dispositions on the exercise of incentive stock options was $0.1 million and $0.1 million for the years ended December 31, 2016 and 2015. Tax benefits recognized on the exercise of options and disqualifying dispositions were not material for the year ended December 31, 2014.
The following table presents the assumptions used in the calculation of the weighted average fair value of options granted at various dates during the years ended December 31, 2016, 2015 and 2014:
Note 13. Share-based Compensation Plans - continued
Share-Based Compensation Expense
The following table provides a summary of the expense the Company recognized related to share-based compensation awards, as well as the remaining expense associated with those awards as of and for the years ended December 31, 2016, 2015 and 2014:
At December 31, 2016, compensation expense related to unvested stock options, restricted stock awards and restricted stock units is expected to be recognized over 2.0 years, 1.7 years and 2.3 years respectively.
Note 14. Shareholders' Equity
Preferred Stock
Under its Amended Articles of Incorporation, the Company is authorized to issue up to 5,000,000 shares of preferred stock, in one or more series, having such voting powers, designations, preferences, rights, qualifications, limitations and restrictions as determined by the Board of Directors.
On June 4, 2015, the holder of the Company's Series C Convertible Perpetual Preferred Stock ("Series C Preferred Stock") completed the exchange of its remaining 348,697 shares of Series C Preferred Stock outstanding for shares of the Company's common stock on a one-for-one exchange ratio basis. The exchange was pursuant to terms of an Exchange Agreement between the Company and the holder of the Series C Preferred Stock entered into on October 29, 2014, which was subsequently amended on December 22, 2014 allowing for an initial exchange of 840,841 Series C Preferred Stock that took place on December 24, 2014. As of December 31, 2015, there were no remaining shares of the Company's Series C Preferred Stock issued and outstanding.
Note 14. Shareholders' Equity - continued
On the date the Company made a firm commitment to issue the Series C Preferred Stock, the fair market value of the Company's common stock was higher than the conversion price of $3.25 per share of the Series C Preferred Stock. As a result, the Series C Preferred Stock was issued with a beneficial conversion feature associated with it. In connection with each exchange of Series C Preferred Stock, the Company recorded charges to retained earnings of $70 thousand and $168 thousand during the years ended December 31, 2015 and 2014, respectively.
Cash Dividends
During the years ended December 31, 2016 and 2015, the Company paid dividends on its common stock totaling $0.24 per share and $0.23 per share, respectively. The holder of the Company's Series C Preferred Stock, which was outstanding through June 2015, participated in these dividends during the period of time the Series C Preferred Stock was outstanding.
As discussed in Note 25. Subsequent Events, of these consolidated financial statements, On January 25, 2017, the Company's Board of Directors declared a cash dividend of $0.06 per share, payable on February 28, 2017, to shareholders of the Company's common stock as of February 15, 2017.
See also Note 15. Restrictions on Transfers of Funds to Parent, of these consolidated financial statements for additional information on limitations on dividends on common stock.
Stock Repurchase Program
On July 22, 2016, the Company announced it had amended its previously announced program for the repurchase of up to $5.0 million of its outstanding common stock pursuant to a written plan compliant with Rule 10b5-1 and Rule 10b-18. Under the amended program, repurchase activity was able to commence on August 6, 2016 and could continue until February 8, 2017, the program's new expiration date, or expire earlier upon the completion of the repurchase of $5.0 million of the Company's common stock in addition to what had already been purchased under the program, as well as under certain other circumstances as set forth in the amended program. The Company had no obligation to repurchase any shares under this program, and was able to suspend or discontinue it at any time. All shares repurchased as part of the repurchase program were cancelled, and therefore no longer available for reissuance.
During the year ended December 31, 2016, the Company repurchased and cancelled 226,170 shares of its common stock at an aggregate cost of $1.6 million, or $7.23 per share. As of December 31, 2016, the Company had repurchased and cancelled a total of 281,598 shares of its common stock under this plan at an aggregate total cost of $2.1 million or $7.28 per share. Repurchases of the Company's common stock were made pursuant to a written plan compliant with Rule 10b5-1 and Rule 10b-18.
On December 13, 2016, the Company's previously announced stock repurchase plan for the repurchase of up to $5.0 million of its outstanding common stock pursuant to a written plan compliant with Rule 10b5-1 and Rule 10b-18, automatically terminated pursuant to its terms as a result of the public announcement of the Merger Agreement, whereby the Company has agreed to be merged with and into Pacific Premier Bancorp, Inc. Please also see Note 2. Merger Agreement, of these consolidated financial statements, for additional information concerning the Merger Agreement.
Note 14. Shareholders' Equity - continued
Regulatory Capital
Capital ratios for commercial banks in the United States are generally calculated using four different formulas. These calculations are referred to as the "Leverage Ratio," and three "risk-based" calculations known as: "Common Equity Tier I Capital Ratio," "Tier One Risk Based Capital Ratio" and "Total Risk Based Capital Ratio." These metrics were developed through joint efforts of banking authorities from different countries around the world. The standards are based on the premise that different types of assets have different levels of risk associated with them and take into consideration the off-balance sheet exposures of banks when assessing capital adequacy.
The Bank seeks to maintain strong levels of capital in order to generally be considered "well-capitalized" under the Prompt Corrective Action framework as determined by regulatory agencies. The Company's potential sources of capital include retained earnings and the issuance of equity, while the Bank's primary sources of capital include retained earnings and capital contributions from Bancorp.
At December 31, 2016 and 2015, the most recent regulatory notifications categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed that categorization. Management believes as of December 31, 2016, the Company and the Bank meet all capital adequacy requirement to which they are subject.
In 2013, the Board of Governors of the Federal Reserve System ("FRB"), the FDIC, and the Office of the Comptroller of the Currency ("OCC") issued final rules under Basel III (the "Basel III Capital Rules"), establishing a new comprehensive framework for regulatory capital for U.S. banking organizations. These rules implement the Basel Committee's December 2010 proposed framework, certain provisions of the Dodd-Frank Act, and revise the risk-based capital requirements applicable to bank-holding companies, and depository institutions, including the Company. These rules became effective for the Company on January 1, 2015, and are subject to phase-in periods for certain of their components through 2019.
The significant changes outlined under the Basel III Capital Rules that are applicable to the Company and the Bank include:
• A Common Equity Tier I ("CET I") capital measure, with a minimum ratio requirement of 4.5% CET I to risk-weighted assets, and for Prompt Corrective Action purposes 6.5% or greater to generally be considered "well-capitalized."
• The capital conservation buffer is determined in addition to CET I of: 0.625% for 2016; 1.25% for 2017; 1.875% for 2018; and 2.5% for 2019. The capital conservation buffer began phasing-in on January 1, 2016.
• The exclusion from CET I of certain items on a phased-in basis, such as deferred tax assets and intangible assets. For 2016, certain deferred tax assets and intangible assets are phased-out of CET I at a rate of 60%, compared to 40% for 2015.
When Basel III Capital Rules are fully phased-in on January 1, 2019, the Company and the Bank will also be required to maintain a 2.5% "capital conservation buffer," which is designed to absorb losses during periods of economic stress. This capital conservation buffer will be comprised entirely of CET I, and will be in addition to minimum risk-weighted asset ratios outlined under the Basel III Capital Rules. If a banking organization fails to hold capital above minimum capital ratios, including the capital conservation buffer, it will be subject to certain restrictions on capital distributions and discretionary bonus payments.
Note 14. Shareholders' Equity - continued
The following table sets forth the Company's and the Bank's regulatory capital ratios, including those applicable following the implementation of Basel III Capital Rules on January 1, 2015:
(1)On a fully phased-in basis, effective January 1, 2019, under Basel III Capital rules, minimum capital ratios will be as follows: Common Equity Tier I capital: 7.0%; Leverage ratio: 6.5%; Tier I capital: 8.5%; Total risk-based capital: 10.5%. (2)Reflects minimum threshold to be considered "well capitalized" under the Prompt Corrective Action framework, specific to depository institutions. As of December 31, 2016 and 2015, the Company was able to include $10.2 million and $10.0 million of junior subordinated debt in its Tier I capital for regulatory capital purposes.
Note 15. Restriction on Transfers of Funds to Parent
There are legal limitations on the ability of the Bank to provide funds to the Bancorp, which may be used for, among other things, holding Company operating costs, and the payment of dividends to the holders of the Company's common stock. Under certain circumstances, the Bank may need to seek approval from the DBO prior to paying any dividends to the Bancorp. Additionally, Section 23A of the Federal Reserve Act restricts the Bank from extending credit to the Bancorp and other affiliates amounting to more than 20 percent of its contributed capital and retained earnings.
Note 16. Earnings Per Share
The following tables set forth the number of shares used in the calculation of both basic and diluted earnings per common share:
(1)For the year ended December 31, 2015, diluted EPS as presented under the two-class method is $0.44 per share ($0.443 per share when extended), compared to $0.45 per share ($0.445 per share when extended) as presented last year. This change in rounding is due to the application of the two-class method for presenting EPS, where an allocation of $83 thousand in earnings for the year ended December 31, 2015 is made to participating securities, which represent restricted stock awards.
For the years ended December 31, 2016, 2015 and 2014, common stock equivalents associated primarily with stock options, totaling approximately 62,000 shares, 120,000 shares and 99,000 shares, respectively, were excluded from the calculation of diluted earnings per share, as their impact would be anti-dilutive.
Note 17. Derivative Instruments
From time to time, the Company enters into interest rate swap agreements with certain borrowers to assist them in mitigating their interest rate risk exposure associated with the loans they have with the Company. At the same time, the Company enters into identical interest rate swap agreements with another financial institution to mitigate the Company's interest rate risk exposure associated with the swap agreements it enters into with its borrowers. At December 31, 2016, the Company had swaps with matched terms with an aggregate notional amount of $92.7 million the fair value of swap assets and swap liabilities were
Note 17. Derivative Instruments - continued
$1.4 million, respectively. The fair values of these swaps are recorded as components of other assets and other liabilities in the Company's consolidated balance sheet. Changes in the fair value of these swaps, which occur due to changes in interest rates, are recorded in the Company's income statement as a component of non-interest income. Since the terms of the swap agreements between the Company and its borrowers have been matched with the terms of swap agreements with another financial institution, the adjustments for the change in their fair value offset each other in non-interest income.
Although changes in the fair value of swap agreements between the Company and borrowers and the Company and other financial institutions offset each other, changes in the credit risk of these counterparties may result in a difference in the fair value of these swap agreements. Offsetting swap agreements the Company has with other financial institutions are collateralized with cash, and swap agreements with borrowers are secured by the collateral arrangements for the underlying loans these borrowers have with the Company. During the year ended December 31, 2016, there were no losses recorded on swap agreements, attributable to the change in credit risk associated with a counterparty. All interest rate swap agreements entered into by the Company as of December 31, 2016 are not designated as hedging instruments.
The following table summarizes the Company's derivative instruments, included in "other assets" and "other liabilities" in the consolidated balance sheet, as of December 31, 2016:
The Company was not party to any swap agreements as of December 31, 2015.
Note 18. Balance Sheet Offsetting
Derivative financial instruments may be eligible for offset in the consolidated balance sheets, such as those subject to enforceable master netting arrangements or a similar agreement. Under these agreements, the Company has the right to net settle multiple contracts with the same counterparty. The Company offers an interest rate swap product to qualified customers which are then paired with derivative contracts the Company enters into with a counterparty bank. While derivative contracts entered into with counterparty banks may be subject to enforceable master netting agreements, derivative contracts with customers may
Note 18. Balance Sheet Offsetting - continued
not be subject to enforceable master netting arrangements. As such, these instruments have been excluded from the table below.
Financial instruments that are eligible for offset in the consolidated balance sheet as of December 31, 2016 are presented in the table below:
(1)Represents cash collateral held with counterparty bank. There were no financial assets or liabilities eligible for offset as of December 31, 2015.
Note 19. Commitments and Contingencies
In the normal course of business, various claims and lawsuits are brought by and against the Company. In the opinion of management and the Company's legal counsel, the disposition of all pending or threatened proceedings will not have a material effect on the Company's consolidated financial statements.
Commitments to Extend Credit
In the normal course of business, the Bank enters into financial commitments to meet the financing needs of its customers. These financial commitments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk not recognized in the Company's consolidated financial statements. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Standby letters of credit are conditional commitments to guarantee the performance of a Bank customer to a third party. Since many of the commitments and standby letters of credit are expected to expire without being drawn upon, the total amounts do not necessarily represent future cash requirements. Management evaluates each customer's credit worthiness on a case-by-case basis, and determines the amount of collateral deemed adequate to secure the loan, if collateral security is determined to be necessary for the particular loan. The Bank's exposure to loan loss in the event of nonperformance on commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments as it does for loans reflected in the Company's consolidated financial statements.
Note 19. Commitments and Contingencies - continued
The Company had the following outstanding financial commitments as of December 31, 2016 and 2015:
(1)Includes a standby letter of credit to one customer in the amount of $10.2 million and $10.4 million at December 31, 2016 and 2015.
Commitments to extend credit and standby letters of credit are made at both fixed and variable rates of interest. At December 31, 2016, the Company had $31.2 million in fixed rate commitments and $245.0 million in variable rate commitments.
Other Commitments
The following table provides a summary of the future minimum required contractual payments the Bank is expected to make based upon obligations at December 31, 2016:
(1)Deposits with no stated maturity of $1.4 billion are included in amounts due less than one year.
The Company has leases that contain options to extend for periods from five to seven years. Options to extend which have been exercised and the related lease commitments are included in the table above. Total rent expense charged for leases during the reporting periods ended December 31, 2016, 2015 and 2014, were approximately $1.5 million, $1.6 million and $1.8 million, respectively.
In connection with the $13.5 million outstanding contractual balance of debt securities issued to Heritage Oaks Capital Trust II, Mission Community Capital Trust I, and Santa Lucia Bancorp (CA) Capital Trust, the Company is the full and unconditional guarantor of distributions of the issuing trusts. There are no Special Purpose Entity ("SPE") trusts, corporations, or other legal entities established by the Company which reside off-balance sheet. There are no other off-balance sheet items other than the aforementioned items related to letter of credit accommodations and undisbursed loan commitments. Management is not aware of any other off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on the Company's financial condition, results of operations, liquidity, capital expenditures or capital resources that would be material to investors.
Note 20. Related Party Transactions
The Bank has entered into loan and deposit transactions with certain directors and executive officers of the Bank and the Company. These loans were made and deposits were taken in the ordinary course of business. The following table sets forth loans made to directors and executive officers of the Company as of December 31, 2016:
Deposits from related parties held by the Bank at December 31, 2016 and 2015 amounted to $7.2 million and $21.7 million, respectively.
In addition to the loan and deposit relationships noted above, the Company paid firms affiliated with certain of its directors for facility rent and legal consultation fees. These payments totaled $1 thousand, $151 thousand, and $255 thousand for the years ended December 31, 2016, 2015 and 2014, respectively.
Note 21. Restructuring Activities
In conjunction with the MISN Transaction described in Note 3. Business Combination, of these consolidated financial statements, the Company initiated a restructuring and integration plan which resulted in additional non-interest expenses during 2014. These additional costs were attributable to the integration of MISN systems into the Company's systems, the elimination of owned and leased facilities and related fixed assets, contract cancellation costs of duplicative systems and services, and termination benefits paid to employees displaced as a result of the MISN Transaction and for retention of key employees through integration-related milestone dates.
Note 21. Restructuring Activities - continued
The following table provides a summary of the costs associated with the restructuring and integration plan for the years ended December 31, 2016, 2015 and 2014:
The following table summarizes the change in the accrued liability related to the Company's restructuring and integration plan associated with the MISN Transaction for the years ended December 31, 2016, 2015 and 2014:
(1)Represents initial charges the Company incurred related to the restructuring and integration plan associated with the MISN Transaction. (2)Adjustments related to previously accrued amounts associated with planned staff reduction, contract terminations, and other adjustments.
Note 22. Regulatory Matters
Termination of BSA/AML Consent Order
On November 29, 2016, the Bank announced the termination by the Federal Deposit Insurance Corporation ("FDIC") and California Department of Business Oversight ("DBO") of the BSA/AML Consent Order issued by the FDIC and DBO on November 5, 2014 relating to the Bank's Bank Secrecy Act compliance program.
Note 23. Parent Company Financial Information
Heritage Oaks Bancorp
Condensed Balance Sheets
Note 23. Parent Company Financial Information - continued
Heritage Oaks Bancorp
Condensed Statements of Income
Note 23. Parent Company Financial Information - continued
Heritage Oaks Bancorp
Condensed Statements of Comprehensive Income
Note 23. Parent Company Financial Information - continued
Heritage Oaks Bancorp
Condensed Statements of Cash Flows
Note 24. Quarterly Financial Information (unaudited)
The following table provides a summary of results for the periods indicated:
Note 25. Subsequent Events
Termination of Mortgage Banking Business
In January 2017, the Company's Management and Board of Directors decided to discontinue activities related to the consumer mortgage banking business, effective February 1, 2017. The discontinuation of the consumer mortgage banking business will not involve a sale of assets, but rather the discontinuation of originating and selling consumer mortgage loans. The Company will however continue to offer home equity lines of credit and home equity loans. For the year ended December 31, 2016 revenues from mortgage banking activities totaled approximately $3.4 million and non-interest expenses attributable to mortgage banking activities totaled approximately $3.2 million.
Dividend Declaration
On January 25, 2017, the Company's Board of Directors declared a cash dividend of $0.06 per share, payable on February 28, 2017, to shareholders of the Company's common stock as of February 15, 2017.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A. Controls and Procedures
Disclosure Controls and Procedures
The Company maintains disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act), designed to ensure that information required to be disclosed by the Company in the reports that the Company files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms and that such information is accumulated and communicated to management, including the Principal Executive Officer and the Principal Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure.
In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
Management, with the participation of the Principal Executive Officer and the Principal Financial Officer have evaluated the effectiveness of the Company's disclosure controls and procedures as of the end of the period covered by this Annual Report on Form 10-K. Based on such evaluation, the Principal Executive Officer and the Principal Financial Officer have concluded that, as of the end of such period, the Company's disclosure controls and procedures are effective in ensuring that information required to be disclosed by the Company in the reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms, and is accumulated and communicated to management, including the Principal Executive Officer and the Principal Financial Officer as appropriate, to allow for timely decisions regarding required disclosure.
Management's Report on Internal Control Over Financial Reporting
Management's report on the Company's internal control over financial reporting is set forth on page 58 and is incorporated herein by reference.
Attestation Report of Independent Public Accounting Firm
The attestation report of Crowe Horwath LLP on the Company's internal control over financial reporting is set forth on page 75 and is incorporated herein by reference.
Change in Internal Control over Financial Reporting
There has been no change in internal control over financial reporting in the quarter ended December 31, 2016 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Item 9B.
Item 9B. Other Information
None.
Part III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance
Board of Directors
The Bylaws of the Company currently provide for not fewer than seven (7) or more than thirteen (13) directors with the exact number within such range to be set by a resolution of the Board of Directors. Currently the size of the Board of Directors is set at eleven (11).
The following table sets forth the names of the members of the Board of Directors of the Company and certain additional information as of December 31, 2016, including their age, biographical information, qualifications, business experience and directorships with other public companies covering at least the last five years.
Name and Relationship
With Company
Position, Principal Occupation, Business Experience and Directorships
Age
Michael J. Behrman
Director
Dr. Behrman joined the Company and Bank as a director, following the Company's acquisition of Business First National Bank in October 2007. Dr. Behrman is an orthopedic surgeon specializing in hand and upper extremity disorders. He founded Associated Hand Surgeons and has offices in Santa Barbara and Solvang. For over 20 years he has served various positions such as Vice Chairman, Department of Orthopedics, at Santa Barbara's Cottage Hospital and Chairman, Department of Orthopedics, at St. Francis Medical Center in Santa Barbara. He has an extensive knowledge of and a connection to the medical community along the Central Coast, and the medical community is one of the target markets identified by the Company, enhancing his contribution as a director.
Mark C. Fugate
Director
Joined the Company and the Bank as a director in November of 2003 following the Company's acquisition of Hacienda Bank. Since 1989 he has been in business as a commercial real estate broker, developer and investor, asset manager and farmer, with real property holdings in coastal California, the San Joaquin Valley, and the greater Phoenix area. Mr. Fugate currently serves as real estate broker and co-owner of Charter Brokerage Company. Among his many attributes is his knowledge in running a small business and investing in and managing commercial real estate. In addition, he has served and continues to serve on the boards of several nonprofits and community organizations including the Santa Maria Valley Chamber of Commerce and the Econ Alliance of Northern Santa Barbara County. His leadership abilities and long connection to the local community enhance his ability to serve on the Board.
Howard N. Gould
Director
Joined the Board of the Company and the Bank in March of 2014 following the Company's acquisition of Mission Community Bancorp. Mr. Gould is a Board nominee of Carpenter Fund Manager GP, LLC, a principal shareholder of the Company. Mr. Gould is Vice Chair of Carpenter and Company (2005-present) and Managing Member of Carpenter Fund Manager GP, LLC (2007-present). He has held key executive management positions in multi-billion dollar banks over several decades, including Vice Chairman and COO of Sanwa Bank/United California Bank, and Vice Chairman of Bank of the West. He is a director of Western Alliance Bancorporation, Phoenix, AZ (2015-present) and is former director of Bridge Capital Holdings, Inc. and Bridge Bank, N.A., San Jose, California (2008-2015), Pacific Mercantile Bancorp (2014-2015) and Pacific Mercantile Bank (2013-2015), Costa Mesa, California; and Mission Community Bancorp and Mission Community Bank, San Luis Obispo, California (2008-2014). In addition to his bank executive management experiences he was also partner in one of the most active financial services consulting practices in the United States. Mr. Gould served as a Commissioner of Financial Institutions for the State of California under two Governors and he provides the Company significant insight into banking "best" practices and the regulation of financial institutions.
Name and Relationship
With Company
Position, Principal Occupation, Business Experience and Directorships
Age
Dee Lacey
Director
Has served as a director of the Company and of the Bank since January 23, 1997. Ms. Lacey is a co-owner of Lacey Livestock. Appointed by the Secretary of Agriculture, Ms. Lacey has represented the California Beef Producers on a national level. She served on a community college board of trustees for several years and was a local school board trustee for over 20 years. Ms. Lacey is well known in the community and has received numerous awards honoring her service to education, agriculture, libraries and museums, all of which enable her to provide a valuable perspective as a director.
Simone F. Lagomarsino
President, CEO and Director
Has been a director, President and Chief Executive Officer of the Company, and Chief Executive Officer of the Bank since September 10, 2011. She was appointed President of the Bank in January 2012 and served in that position until January 2015. In March 2016, she reassumed the positon of President of the Bank. Additionally, she currently serves on the boards of directors of the Federal Home Loan Bank of San Francisco, the Alzheimer's Association's California Central Coast Chapter, Sierra Vista Regional Medical Center, and the Foundation for the Performing Arts Center of San Luis Obispo. Ms. Lagomarsino, a financial services professional, has over 30 years of experience in executive leadership positions. Ms. Lagomarsino's extensive background in banking enables her to provide valuable perspective to the Board.
James J. Lynch
Director
Joined the Company and Bank in June of 2010. Mr. Lynch is a Managing Partner of the Patriot Financial Partners group of funds. Mr. Lynch serves as the Board nominee of those funds, which are a principal shareholder of the Company. He served as Vice Chairman of Sovereign Bancorp from 2005-2007 and Chairman and Chief Executive Officer of Sovereign's Mid Atlantic Division from 2002-2007. Mr. Lynch also served as President and Chief Executive Officer of Fleet Bank in Pennsylvania and Southern New Jersey from 2001-2002. He has been Chairman and CEO at Summit Bank and Prime Bank in Pennsylvania. Mr. Lynch is former director of Palmetto Bancshares, Inc. (2010-2015); Cape Bank / Cape Bancorp (2009-2015); and Florida Business Bancorp, Inc. (2010-2015). Mr. Lynch currently serves on several non-profit boards. His extensive background in banking enables him to provide valuable perspective to the Board.
Michael J. Morris
Chairman of the Board
Joined the Company and the Bank as a director in January of 2001 and has served as the Chairman of the Company and the Bank since May 24, 2007. He is an attorney and serves as Chairman of the Board of the law firm of Andre, Morris & Buttery. He has been a member of the Board of Directors of NioCorp, Centennial, CO, a publicly held company traded on the Toronto Stock Exchange since 2014. He has served as a member and chairman of various non-profit boards of directors. He has practiced law in California for over 40 years, during which he has represented a broad array of corporate and individual clients. The inclusion of Mr. Morris as a director provides the Board with a unique understanding of a broad range of legal and regulatory matters in its oversight of the Company. Furthermore, his extensive knowledge of local markets and the communities served by the Company gives him unique insights into the Company's lending challenges and opportunities.
Daniel J. O'Hare
Director
Joined the Company and the Bank as a director in November of 2004. Since 1999, he has served as President and Managing Director of Glenn Burdette, Inc. He has worked as a public accountant for over 30 years. His professional background during the last three decades includes significant experience in management and leadership, manufacturing, construction, real estate development, banking, health care, hospitality and agriculture. He also has extensive training and knowledge of GAAP. His extensive financial expertise enhances his contribution to the Company as a director.
Michael E. Pfau
Vice Chairman of the Board
Joined the Board of the Company and the Bank in October 2007 following the acquisition of Business First Bank by the Company. Mr. Pfau is the founding partner of the law firm Reicker, Pfau, Pyle & McRoy LLP, in Santa Barbara. His law practice focuses upon the representation of emerging-growth technology companies, institutional real estate investors, and high net worth individuals. His transactional experience includes the representation of parties involved with public and private securities offerings, initial public offerings, and asset-purchase, merger, and stock-for-stock merger and acquisition transactions, as well as sophisticated real estate purchase and lease transactions. He has served as a member and chairman of various non-profit boards. Mr. Pfau's expertise in complex business transactions and knowledge of the Santa Barbara market, as well as his extensive legal experience, enhance his ability to contribute to the Company as a director.
Name and Relationship
With Company
Position, Principal Occupation, Business Experience and Directorships
Age
Alexander F. Simas
Director
Joined the Company and Bank Boards of Directors in November of 2003 following the Company's acquisition of Hacienda Bank. Mr. Simas practices law and is chief executive officer of the law firm of Kirk & Simas, PLC. He has worked as an attorney for more than 35 years on small and large business transactions. Many of his cases focus on compensation issues, which positions Mr. Simas to add specialized knowledge and expertise as a member of the Board.
Stephen P. Yost
Director
Joined the Company and Bank as a director in March of 2014. Mr. Yost is a Board nominee of Carpenter Fund Manager GP, LLC, a principal shareholder of the Company. Mr. Yost has over forty years of experience in banking, including twenty-six at First Interstate Bank, primarily focused on risk management. He is also a principal of Kestrel Advisors, a credit risk management consulting company (2006-present), and his experience includes work at Comerica Bank (Imperial Bank), Executive Vice President/Manager Special Assets Group; Executive Vice President/Regional Chief Credit Officer and Executive Vice President/Chief Credit Officer (1998-2006). He currently serves as a Director of Pacific Mercantile Bank, Irvine, California (2013-present); and is a former Director of Manhattan Bancorp, El Segundo, California (2006-2015) and Mission Community Bancorp, San Luis Obispo, CA (2010-2014).
Executive Officers
During 2016, the Board designated the following officers as executive officers of the Company and/or Heritage Oaks Bank: Chief Executive Officer, President, Chief Financial Officer, Chief Credit Officer, Chief Risk Officer, Chief Information Officer, Corporate Secretary, Chief Bank Counsel, Commercial Banking Division Manager, North & Ag Lending, and Commercial Banking Division Manager, South. Set forth below, except for Ms. Lagomarsino, who is a director and whose information has been presented earlier, is a brief description of these executive officers who held these positions at December 31, 2016. The age indicated below is as of December 31, 2016.
Jason Castle, 39, Executive Vice President/Chief Financial Officer. On August 17, 2015, Mr. Castle was appointed Executive Vice President and Chief Financial Officer of the Company and the Bank. Mr. Castle has over 16 years of experience in the financial services industry, including over 11 years in senior management roles at a diverse set of financial institutions, ranging from a multi-billion dollar regional financial institution to a newly formed de novo financial institution. Prior to his appointment to Chief Financial Officer of the Company, Mr. Castle served as Senior Vice President and Chief Accounting Officer of the Company and the Bank beginning in January of 2014. Prior to that Mr. Castle was a Consulting Manager with Glenn, Burdette, certified public accountants from November 2012 through January 2014; the Controller for Toyota Financial Savings Bank from July through October 2012; and the Controller of Heritage Oaks Bank from July 2010 through July 2012. Mr. Castle is a Certified Public Accountant, and spent five years in the public accounting industry prior to transitioning into the banking industry.
William Schack, 54, Executive Vice President/Chief Credit Officer, joined the Company in June 2013. Mr. Schack has extensive financial services industry experience. Prior to joining Heritage Oaks Bank, he was the Chief Credit Officer at First California Bank since 2009 and was promoted to executive vice president there in 2011. Mr. Schack has held various credit management positions at financial institutions in Southern California during his over thirty year career.
T. Joseph Stronks, 48, Executive Vice President/Chief Information Officer, joined the Bank in October 2007 as SVP / Central Services and eBanking. In March 2010, Mr. Stronks was promoted to Senior Operations Officer and was again promoted in December 2012 earning the title Executive Vice President. In September 2016, he was promoted to his current positon. As Chief Information Officer, Mr. Stronks oversees the back-office Operations, Electronic Banking, Facilities, Information Technology, Loss & Fraud Prevention, and Security departments. He has over 25 years of community banking experience.
Joshua Tucker, 43, Executive Vice President and Chief Risk Officer, joined the Company in January 2016. He oversees all of the Bank's compliance, Bank Secrecy Act/Anti-Money Laundering and risk management functions. Mr. Tucker has over 18 years of legal, compliance and risk management experience. Before joining Heritage Oaks Bank, he served as Deputy Chief Compliance Officer, Director of Enterprise Risk Management, and Chief of Administration for Compliance and Operational Risk at U.S. Bancorp/U.S. Bank. He is also licensed to practice law in California.
Greg Gehlmann, 55, Senior Vice President/Chief Bank Counsel & Corporate Secretary, joined the Company in November 2014. Prior to joining the Company, he was an expert witness regarding fiduciary duties of corporate directors and officers and the duties / responsibilities law firms in advising troubled companies. From 2005 to 2013, he served as General Counsel & Corporate Secretary at First Financial Bancorp, Cincinnati, Ohio. Mr. Gehlmann also served as Chief Risk Officer of First Financial from 2006 to 2008. Prior to that, he practiced law for 16 years in Washington, D.C. representing public and private companies, as well as investors, underwriters, directors, officers, and principals regarding corporate governance, corporate securities, banking, and general business and transactional matters.
Robert Osterbauer, 46, Executive Vice President, Commercial Banking Division Manager, North & Ag Lending, joined the Bank in May 2012. Prior to joining the Bank, he spent seven years at Rabobank NA, where he most recently managed the bank's Central Coast agribusiness division. He is a Certified Public Accountant.
Brooks Wise, 57, Executive Vice President, Commercial Banking Division Manager, South, joined the Bank in March 2014 when it merged with Mission Community Bank. He spent seven years at Mission Community Bank and served as President and a member of the board of directors from 2007 to 2014. Brooks has over 30 years of California banking experience in bank management, business development and commercial lending.
Section 16(a) Beneficial Ownership Reporting Compliance
Section 16(a) of the Securities Exchange Act of 1934, as amended ("Exchange Act"), requires our directors and executive officers, as well as persons who own more than ten percent (10%) of our common stock, to file with the SEC initial reports of beneficial ownership and reports of changes in beneficial ownership of our common stock. Directors, executive officers and greater-than-ten percent (10%) stockholders are required by SEC regulations to furnish us with copies of all forms they file pursuant to Section 16(a) of the Securities and Exchange Act of 1934, as amended. During 2016, the following officers of the Company failed to timely file his/her Form 4: Simone Lagomarsino (regarding the forfeiture of certain performance-based restricted stock on February 28, 2016 / filing was made on April 5, 2016 due to a delay in the compensation committee determining whether such shares vested or were forfeited); Messrs. Schack, Stronks and Osterbauer (regarding grants of restricted stock on April 1, 2016 / filings were made on April 19, 2016).
Code of Conduct
We have adopted a Code of Conduct, which applies to all employees, officers and directors of the Company and Bank. We also have adopted a Code of Ethics that applies to the Chief Executive Officer, Chief Financial Officer and all other executive officers of the Bank, and all individuals serving in the finance, accounting, tax and investor relations roles. Our Code of Conduct and our Code of Ethics meet the requirements of a "code of ethics" as defined by Item 406 of Regulation S-K and applies to our Chief Executive Officer and Chief Financial Officer, as well as all other employees, as indicated above. Our Code of Conduct and Code of Ethics are posted on our website at www.heritageoaksbancorp.com under the heading "Investor Relations - Governance Documents." Any change to or waiver of the code of conduct or code of ethics (other than technical, administrative and other non-substantive changes) will be posted
on the Company's website or reported on a Form 8-K filed with the Securities and Exchange Commission. While the Board may consider a waiver for an executive officer or director, the Board does not expect to grant such waivers.
Procedures for Recommending Director Nominees
There have been no material changes to the procedures by which security holders may recommend nominees to the Company's Board during 2016.
Audit Committee
The Audit Committee, consisting of six (6) directors, all of whom are independent as defined in the NASDAQ Marketplace Rules and Section 10A of the Securities Exchange Act of 1934, selects and recommends the appointment of independent auditors, reviews and approves professional services performed by them and reviews the reports of their work. The Audit Committee also reviews and approves the programs, work plan and reports of the Company's internal audit program. The Board of Directors has determined that Director O'Hare has the attributes listed in the definition of "audit committee financial expert" as set forth in the Instructions to Item 407(d)(5)(i) of Regulation S-K and the NASDAQ listing requirements. Mr. O'Hare acquired these attributes through education and experience as a certified public accountant.
Item 11.
Item 11. Executive Compensation
Compensation Committee Report
The Compensation Committee has reviewed and discussed the Compensation Discussion and Analysis contained in this Form 10-K. Based on the Compensation Committee's review of and discussions with management with respect to the Compensation Discussion and Analysis, the Committee recommended to the Board of Directors that the Compensation Discussion and Analysis be included in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2016.
Submitted by the Compensation Committee of the Board:
Alexander F. Simas, Committee Chairman
Michael J. Behrman
Howard N. Gould
Dee Lacey
James J. Lynch
Daniel J. O'Hare
Michael E. Pfau
Compensation Committee Interlocks and Insider Participation
During the last completed fiscal year, none of the members of the Compensation Committee was an officer or employee, or formerly an officer, of the Company or any of its subsidiaries. None of such directors had any business or financial relationship with the Company requiring disclosure under this heading in this report.
COMPENSATION DISCUSSION AND ANALYSIS
This section addresses the compensation programs, philosophy and objectives, of the Company and its banking subsidiary, Heritage Oaks Bank (collectively, the "Company"), including the process for making compensation decisions, the role of the CEO in the design of such programs, and the Company's 2016 executive compensation components. This section also addresses the factors most relevant to understanding the Company's compensation programs and what they are designed to reward, including the essential elements of compensation, the reasons for determining payment of each element of compensation, and how each compensation element fits into the Company's overall compensation objectives and affects decisions regarding other compensation elements.
Executive Summary
The Compensation Committee of the Board of Directors (the "Compensation Committee") establishes and administers the compensation and benefit programs for the "Named Executive Officers", i.e., the persons identified in the Summary Compensation Table below ("NEOs") and other senior executives. The Compensation Committee consists entirely of independent directors. The Compensation Committee carefully establishes the components of the executive compensation programs in light of the goals of attracting and retaining high quality executives and incenting behavior that creates long-term shareholder value. The Compensation Committee considers the compensation programs of comparable financial institutions reflected in survey data and periodically engages a compensation consultant to review the compensation programs to ensure that the Company's compensation programs are competitive with market practices.
The Compensation Committee philosophy, practices and policies have been developed over a number of years and have not historically been subject to sweeping, material changes.
Named Executive Officers. For 2016, the Company's named executive officers ("NEOs") include Simone Lagomarsino, President and Chief Executive Officer, Jason Castle, Chief Financial Officer, William Schack, Chief Credit Officer, Robert Osterbauer, Commercial Banking Division Manager/North and Agribusiness Lending, and Joshua Tucker, Chief Risk Officer.
Financial Highlights. The Company believes 2016 was a year of strong earnings and growth for the Company. Some financial highlights for 2016 include:
• Net income was $16.9 million, the highest level reported in the Company's history, resulting in earnings per share of $0.49.
• The Company continued its quarterly dividend of $0.06 per share. The annual dividend yield for 2016 was 1.95% based on the closing price of the Company's common stock at December 30, 2016.
• Total deposit balances grew by 7.6% compared with balances at December 31, 2015.
• Non-interest bearing deposit balances increased by 11.5% during 2016 and accounted for 34.1% of total deposits at year end.
• Gross loans grew by 11.1% during 2016.
• Loan credit quality continued to improve with non-performing assets to total assets declining to 0.49% compared with 0.63% a year earlier.
• Regulatory capital ratios for the Company at the end of the year were above the levels required to be considered a "well capitalized" financial institution for regulatory purposes with the Tier 1 Leverage Capital ratio at 9.88% and the Total Risk Based Capital ratio at 13.87%.
Executive Compensation Highlights.
• A portion of long-term equity incentive awards to executive officers (75% for the CEO and 35% for all other NEOs and certain other executives) has a performance-based feature. In order to achieve target payout, performance of at least the 60th percentile of the peer group specified by the Compensation Committee must be achieved.
• Consistent with Company-wide merit practices, base salaries were increased in a range of 2.4% to 5% for all NEOs. In addition, three NEOs had additional adjustments during the year due to a mid-year peer analysis.
• The Compensation Committee approved the Company's 2016 Incentive Plan payout at approximately 107% of target.
• Meridian Compensation Partners LLC ("Meridian") was retained by the committee to provide general executive compensation consulting services.
Regulatory and Corporate Governance Highlights.
• In November 2016, the Federal Deposit Insurance Corporation and the California Department of Business Organizations terminated the Bank Secrecy Act Consent Order ("Consent Order").
• The Company received 89.75% shareholder support for 2016 Advisory Vote on Executive Compensation ("Say on Pay").
• Each year the Company inventories its incentive compensation plans and the Company's Chief Risk Officer evaluates these plans for excessive risk. Such inventory did not identify any risks arising from the Company's incentive compensation policies and practices that are likely to expose the Company to excessive risk.
Pending Acquisition:
As previously announced, the Company entered into a definitive agreement to be acquired by Pacific Premier Bancorp, Inc. (NASDAQ: PPBI) for an aggregate purchase price of $405.6 million, or $11.68 per share based on the closing price for Pacific Premier Bancorp, Inc.'s common stock of $33.65 as of December 12, 2016. Under the terms of the definitive agreement, upon consummation of the transaction, holders of Company common stock will have the right to receive 0.3471 shares of Pacific Premier common stock for each share of Company common stock they own. The acquisition remains subject to regulatory and shareholder approvals. This acquisition will provide the Company's customers with an expanded product set and services and Bank customers will continue to receive the same excellent customer service. The acquisition also increases the combined entity's geographic footprint to cover the coast of California from San Diego to Paso Robles.
Stock Performance:
The following chart compares the cumulative total shareholder return on the Company's common stock over the last five years with the cumulative total return of the Nasdaq Composite Index, and two Company-selected groups of peer institutions (assuming the investment of $100 in each index on December 31, 2011 and reinvestment of all dividends). The Heritage Oaks Peer Group 1 consists of all publicly traded banks & thrifts in the United States with assets of between $750 million and $4 billion as of December 31, 2016. The Heritage Oaks Peer Group 2 consists of 14 publicly traded banks located in the Western United States used by the Compensation Committee in evaluating executive compensation. For a list of the companies in Peer Group 2, see "Compensation Consultants / Peer Group Review / Market Study Comparisons."
Philosophy
The Company's executive compensation programs are designed to attract and retain high quality executive officers critical to the Company's long-term success. The Company's Board of Directors and management believe that the most effective executive compensation program is one that is designed to reward the achievement of specific annual, long-term and strategic goals. This approach aligns executives' interests with those of the shareholders by rewarding performance above established goals, with the goal of improving shareholder value without rewarding excessive risk-taking. This is achieved with a combination of base salaries, annual performance-based cash incentives and long-term equity incentives (which vest over three (3) to five (5) year periods, based in part on performance over such periods). Each component of total compensation generally was evaluated against standard compensation surveys of institutions similar to the Company in asset size and geography. The Compensation Committee's compensation philosophy is to target base salaries at the median and target total compensation (including annual bonuses, long-term equity incentives, and benefits) between the 50th and 75th percentiles of comparable financial institution survey data. The Company believes paying total compensation between the 50th and 75th percentile for above-average performance is critical for attracting and retaining the qualified executives it needs to achieve its business objectives. Overall, compensation paid to Company executives is believed to be competitive with market practices.
Base salary levels for each NEO and other senior executives are established based on the officer's roles and responsibilities, benchmarked against surveys of comparable financial institutions. Any performance-based incentive bonuses and long-term equity incentives are based on both corporate and/or individual performance objectives. The Compensation Committee may use any type of performance criteria, market comparison, and extraordinary events when making the decision regarding compensation.
Say-on-Pay.
Since 2009, the Company has included an advisory vote to approve NEOs compensation, providing shareholders with an opportunity to communicate their views on the Company's compensation program for the NEOs. In 2016, the Company's compensation paid to its NEOs was approved by 89.75% of the voting shareholders. The Compensation Committee considered the results of this vote in setting compensation for the NEOs for 2016 and concluded that the strong support of the Company's compensation program clearly indicates that shareholders concur with the Company's alignment of compensation and performance.
Process for Making Compensation Decisions
Role of the Chief Executive Officer
During the established annual review cycle, the Company's Chief Executive Officer (the "CEO") conducts an annual performance evaluation process for all executives directly reporting to her (including those NEOs that report directly to her). As part of each annual performance evaluation, the CEO considers, among other key factors: i) the executive's performance of job responsibilities and achievement of individual and/or departmental objectives; and ii) the executive's management and leadership skills. In addition, the executive's contributions to the Company's overall financial goals are considered.
Based on this evaluation and the review of proxy data and industry compensation survey reports, the CEO determines, for each of the NEOs (other than herself), recommendations for base salary adjustments, including merit increases, and any bonus amounts and presents these to the Compensation Committee for its review. Any NEO's performance-based bonus is determined by reference to the incentive compensation plan, if any, adopted by the Board for the applicable period as well as by the Company's financial performance and individual performance goals. The Compensation Committee reviews the CEO's recommendations and can modify a recommended amount in its discretion. Recommendations for the grant of equity awards to NEOs under the Company's equity compensation plan are submitted to the Compensation Committee for approval as appropriate.
Role of the Compensation Committee
The Compensation Committee is responsible for evaluating and overseeing the Company's compensation programs. The Compensation Committee evaluates the Company's financial performance and relative shareholder returns when developing the executive compensation philosophy and incentive plans and ensures compensation plans do not reward excessive risk-taking. Generally, the types of compensation and benefits provided to the NEOs are similar to the compensation and benefits provided to other executive officers. The Compensation Committee is also responsible for reviewing and approving corporate goals and objectives relevant to compensation of the Company's CEO, evaluating the performance of the CEO in light of those goals and objectives and determining and recommending to the Board of Directors the CEO's compensation levels based on this evaluation. Additionally, the Compensation Committee reviews compensation levels for members of the Company's executive management team including the CEO's recommendations on any annual bonus and salary increases for the other NEOs.
The Compensation Committee also periodically reviews the compensation levels of the Board of Directors. In its review, the Compensation Committee looks to ensure that the compensation is fair, reasonably competitive and commensurate with the amount of work required both from the individual directors as well as from the Board in the aggregate.
The Compensation Committee has followed certain fundamental objectives to ensure the effectiveness of the Company's executive compensation strategy. These objectives include the following:
1.Internal and external fairness. The Compensation Committee recognizes the importance of perceived fairness of compensation practices both internally and externally. The Compensation Committee evaluates the Company's financial performance when reviewing executive compensation plans, taking into consideration such factors as the economic environment and general market conditions as well as the economic impact of the Company's compensation practices.
2.Performance-based cash incentives. The Company established a cash incentive plan based on the achievement of specific Compensation Committee approved financial, strategic, and/or operational goals. In addition, individual NEO performance is evaluated to determine whether to increase or decrease each individual payout. Additional bonuses are available for individual performance above and beyond the cash incentive plan.
3.Shareholder value and long-term incentives. The Compensation Committee believes that the long-term success of the Company and its ability to consistently increase shareholder value is dependent on its ability to attract and retain skilled executives. The Company's compensation strategy encourages equity-based compensation to align the interests of management with the shareholders.
4.Full disclosure. The Compensation Committee provides full disclosure to members of the Board of Directors of the Company of the compensation practices and issues to ensure that all directors understand the implications of the Compensation Committee's decisions. The Compensation Committee reviews compensation survey data of comparable financial institutions and considers management's individual efforts for the benefit of the Company, as well as various subjective measures in determining the adequacy and appropriateness of the compensation of executives. The Compensation Committee considers the performance of the executives as well as their longevity with the Company and recognizes that the competition among financial institutions for attracting and retaining executives has become more intense in the past few years. The Compensation Committee takes such considerations into account and ensures that the Company is providing appropriate long-term equity incentives to enable it to continue to attract new executives and to retain the ones it already employs. General economic conditions and the past practices of the Company are also factors that are considered by the Compensation Committee. The Compensation Committee has established various processes to assist in ensuring that the Company's compensation program is achieving its objectives. Among these are:
Assessment of Company Performance
In establishing total compensation the Compensation Committee continuously monitors the Company's performance with other comparable financial institutions, notably those in the Western United States. This information is used in two ways: first, to gauge generally overall Company performance relative to peer companies and, second, to gauge overall Company performance against the Company's own strategic objectives. The two metrics used for performance-based restricted stock units granted in 2016 compares the Company's performance to a selected peer group. In addition, the Compensation committee also compares the Company's performance against the Company's strategic objectives.
Assessment of Individual Performance
Individual performance has a strong impact on the compensation of all employees, including the CEO and the other NEOs. For the executive officers, the Compensation Committee receives a performance assessment and compensation recommendation from the CEO, other than for herself, and also exercises its judgment based on the Board's interactions with its executive officers. As with the CEO, the performance evaluation of these executives is based on his or her contribution to the Company's performance, and other leadership accomplishments. Incentive payouts are adjusted up or down based on the executive's overall performance evaluation.
Total Compensation Review
The Compensation Committee reviews each executive's base pay, any incentive bonus compensation, and any equity incentive awards annually. It can make adjustments to base salaries throughout the year as warranted.
Compensation Consultants / Peer Group Review / Market Study Comparisons
In 2015 the Compensation Committee engaged Meridian to develop a peer group of public banks similar in size and location to the Company. Based on the recommendations of Meridian, the Committee established the following peer group:
The Compensation Committee utilized the peer group as a guide in designing 2016 compensation.
During 2016, the Compensation Committee utilized the services of Meridian to evaluate board and executive compensation and to assist in the design of the Company's equity grants to employees for 2016. Fees billed by Meridian in 2016 for advice and services provided to the Compensation Committee were $89,969. Meridian did not provide any other services to the Company in 2016.
2016 Executive Compensation Components
For the fiscal year ended December 31, 2016, the principal components of compensation for the NEOs were: i) base salary, ii) performance-based cash incentive bonuses, iii) equity awards, and iv) perquisites and other retirement benefits. The Company's policies and practices for each of the principal compensation components are explained in the following paragraphs.
Base Salary
Base salary is established based on market data and is adjusted based on individual performance, updated market data, and experience. The NEO base salaries were reviewed by the Compensation Committee in February 2016. CEO Lagomarsino received a 3.33% merit increase and NEOs Castle, Schack, and Osterbauer received 5.0%, 2.4% and 2.5% increases, respectively. Mr. Tucker was hired in the beginning of 2016 and therefore was not eligible for a base salary review in 2016. The Compensation Committee determined the base salaries were commensurate with the NEOs responsibilities and were competitive in the marketplace.
In July 2016, the Compensation Committee reviewed executive officer compensation data prepared by Meridian to review 2016 and evaluate 2017 executive compensation levels. In reviewing the data, it was determined that adjustments would be made to the base salaries in July 2016 for two NEOs: Messrs. Castle (increase of 9.5% to $230,000) and Schack (increase of 7.1% to 260,000). Furthermore, in September 2016, the Compensation Committee increased CEO Lagomarsino's base salary by 7.5% to $500,000.
Performance-Based Cash Bonus
Performance-based cash incentive bonuses for NEOs under the 2016 Incentive Plan are based on the overall performance of the Company for 2016, modified by individual performance. For 2016, the Committee set five (5) criteria to determine payout under the plan: net income after taxes, gross loan growth, deposit growth, non-accrual loans as a percent of gross loans, and classified loans as a percent of gross loans (measured against the Company's budget). Each of the criteria was weighted as follows:
• Net Income After Taxes - 50% • Gross Loan Growth - 20% • Deposit Growth - 10% • Non-Accrual Loans as a % of Gross Loans - 10% • Classified Loans as a % of Gross Loans - 10%
The plan provided for pool payout levels at a threshold of 60%, a target of 100% and a maximum of 130% of the target payout for each of the above criteria. However, to be eligible for any payout under the plan, a minimum net income threshold level was required. Based on the Company's performance, the minimum threshold for net income was met.
Based on the Company's 2016 performance, the metrics as measured against the budget were as follows:
• Net Income After Taxes - Between target and maximum • Gross Loan Growth - Between target and maximum • Deposit Growth - Maximum • Non-Accrual Loans as a % of Gross Loans - Maximum • Classified Loans as a % of Gross Loans - Between target and maximum
Prior to considering individual performance, payout under the plan equated to approximately 109% of payout with respect to the NEOs. In December 2016, the Compensation Committee determined that CEO Lagomarsino would receive $150,000 under the plan, which was 111% of target. The committee has also determined that NEOs Castle, Schack, Osterbauer and Tucker will receive $60,000, $45,000, $35,000, and $20,000, respectively under the plan. These amounts represent 136% of target for Mr. Castle, 90% of target for Mr. Schack, 167% of target for Mr. Osterbauer, and 57% of target for Mr. Tucker. For information on threshold, target and maximum amounts, please see the "Grants of Plan-Based Awards for Period Ending December 31, 2016" table.
Discretionary Bonuses
The Company may award discretionary bonuses to employees, including executive officers, for extraordinary performance by an individual. In October 2016, the Board awarded CEO Lagomarsino a bonus of $100,000 for her efforts in getting the Consent Order terminated. In December 2016, the Board awarded her a bonus of $100,000 for her efforts to prepare the Company for the pending acquisition by Pacific Premier Bank. In addition, Chief Risk Officer Tucker received a sign-on bonus of $30,000 in the beginning of 2016 and a $20,000 bonus in October 2016 for his efforts in building the Company's risk management program as well as for his efforts in getting the Consent Order terminated.
Equity Awards
The 2015 Equity Incentive Plan allows the Company to offer multiple equity vehicles as incentives, including stock options, restricted stock, restricted stock units and stock appreciation rights. Executives may be awarded a blend of equity incentives.
Equity awards are granted to allow executives to share in the growth and prosperity of the Company, to retain executives over the long term, to align the executives' interests with those of our shareholders, and to maintain competitive levels of total compensation. Awards to newly-hired executives (except for the CEO, which are approved by the Board of Directors) are made within prescribed Compensation Committee guidelines. A list of any awards made at the time of hire are provided to the Compensation Committee at its next regularly scheduled meeting. All equity awards for executives are reviewed by the Compensation Committee to ensure they have been made within pre-authorized limits and the parameters of the Company's equity compensation plans.
Executives may receive stock grants annually after being hired. With respect to annual grants, awards are granted upon recommendation by the CEO and approval by the Compensation Committee, considering the executive's level of responsibility and influence on the performance of the Company. Any grants to the CEO are determined by the Compensation Committee.
Annual grants are based on a target percentage of base salary for NEOs, but are subject to adjustment up or down due to individual performance. For 2016, the following guidelines were utilized for equity grants to executives during the annual review process:
These guidelines were developed based on a 2014 report prepared for the Company by McLagan, an independent compensation consultant.
The option strike price or restricted stock grant date value is based on the fair market value on the effective date of the grant.
In 2016, the Compensation Committee, with the assistance of Meridian, evaluated its methodology for granting equity awards. In prior years, equity awards to executives were granted in the form of options and/or restricted stock and grants could be made twice a year. The Compensation Committee determined in 2016 that equity grants will be made only once a year at the regularly scheduled Compensation Committee meeting in March of each year. In addition, stock options would no longer be used, instead senior executives would receive a combination of performance-based restricted stock units ("PRSUs") and time vesting restricted stock. 35% of NEO long-term incentive grants (75% with respect to the CEO) were in the form of PRSUs, with vesting based upon meeting performance goals at the end of a three-year period. The restricted stock grants vest over a three-year period in equal annual amounts. Awards made at the March 2016 meeting were granted on the first trading day in April 2016 based on the fair market value of the Company's common stock on such date. The equity awards granted in 2016 contain double trigger vesting in the event of a change in control and termination of employment without cause or for good reason within 12 months following the change in control.
The performance metrics for the 2016 PRSUs are:
•Total Shareholder Return (TSR) - relative to Comparator Group (defined below), average percentile for the three calendar years within the Performance Period. TSR calculated as (Final Value - Initial Value + Dividends during Performance Period Reinvested) / Initial Value.
• Final Value is average stock closing price during 20 trading days immediately preceding and including the last day of Performance Period.
• Initial Value is average stock closing price during 20 trading days immediately preceding first day of Performance Period.
•Return on Assets (ROA) - relative to Comparator Group, average percentile for the three calendar years within the Performance Period. ROA (percentage) calculated as (Annual Net Income / Average Annual Assets) × 100.
Company Percentile Ranking: 50% of TSR average percentile ranking relative to Comparator Group during Performance Period, plus 50% of ROA average percentile ranking relative to Comparator Group during Performance Period.
The Comparator Group is comprised of all United States exchange-traded (NASDAQ, NYSE and NYSE Mkt) banks and thrift institutions with assets at the beginning of the Performance Period greater than $750 million and less than $4 billion. Any entity that is acquired or subject to bankruptcy filing is to be removed from the Comparator Group. Any entity that is the surviving entity in an acquisition or merger shall remain in the Comparator Group.
The vesting, and number of shares to be issued upon vesting, of the PRSUs is determined within 120 days following the end of the Performance Period as follows:
The Performance Period for the 2016 PRSU grants is three years (2016, 2017, and 2018). PRSUs cliff vest after three years, at the level earned from reaching the specific targets discussed above.
For actual awards to the NEOs for 2016, see "Grants of Plan-Based Awards for Period Ending December 31, 2016."
Perquisites and Other Benefits
Consistent with the Company's compensation objectives, NEOs are provided perquisites and other benefits that management believes are reasonable and consistent with the Company's overall
compensation program and which keep the Company competitive in the marketplace. The Company periodically reviews the level of perquisites and other benefits provided to the NEOs for suitability with the program objectives.
The Company believes it is competitive with market practices by providing medical, dental, vision and life insurance, and a 401(k) employer matching contribution of $0.50 per dollar of employee contributions up to the first five percent (5%) of compensation, within applicable statutory limitations. Employer 401(k) contributions vest 25% for each year of service and are fully vested after the employee has four years of service.
Salary Continuation Agreement
The Company is party to a Salary Continuation Agreement, or SCA, with Chief Executive Officer Lagomarsino. The agreement is a non-qualified executive benefit plan that provides a post-employment monthly retirement benefit, or payments in the event of death or disability. Benefits vest over ten (10) years after the SCA issuance date and the benefit is $100,000 per year to be paid monthly for fifteen (15) years upon termination of employment with the Bank after attaining age 65. The agreement provides for a reduced lump sum payment in the event of early termination (without cause), and for monthly benefit payments in the event of disability, or death of the participant, or termination following a change in control. The SCA contains a change in control provision which entitles Ms. Lagomarsino to full benefits under the plan if employment is terminated within twelve (12) months of a defined change in control event. Upon such a termination, benefits are fully vested at 100% and payments commence immediately following termination. Currently, Ms. Lagomarsino is 50% vested in her benefit under the SCA.
Employment Contracts and Change in Control Arrangements
Employment Agreement. On October 29, 2014, the Company and the Bank entered into an employment agreement with its President and Chief Executive Officer, Simone F. Lagomarsino. The agreement provides that Ms. Lagomarsino shall serve on the Board of Directors of the Company and the Bank.
Pursuant to the agreement, Ms. Lagomarsino receives a base salary and is eligible to earn an annual cash bonus award of a specified percentage of her base salary, based upon the achievement of annual performance goals established by the Compensation Committee. In addition, Ms. Lagomarsino is entitled to receive certain other benefits that the Bank extends to all of its executive employees, such as life insurance, disability insurance, health, dental, vision and other insurance benefits and 401(k) plan participation. Under the employment agreement, the Company may grant from time to time to Ms. Lagomarsino equity awards under and subject to the terms and conditions of the Company's equity compensation plans. Ms. Lagomarsino is entitled to fringe benefits and perquisites consistent with the practices of the Bank and the use of an automobile, and a gym or personal trainer in an amount not to exceed $500.00 per month.
In the event the employment of Ms. Lagomarsino is terminated by the Company or the Bank for "Cause", Ms. Lagomarsino is entitled to base salary earned, accrued vacation, unpaid annual bonus with respect to any completed calendar year immediately preceding the termination date, such employee benefits including equity compensation and deferred compensation, if any, as to which she may be entitled under the Bank's employee benefit plans as of the termination date, and unreimbursed business expenses, each through the date of termination (the "Accrued Amounts").
In addition to what Ms. Lagomarsino is entitled to in the event of termination for "Cause", if she is terminated without "Cause" or she terminates her employment for "Good Reason", Ms. Lagomarsino will receive: (i) equal installment payments over a one-year period, which are in the aggregate equal to her annual base salary for the year in which the termination date occurs, (ii) a lump sum payment equal to the
product of (a) the annual bonus, if any, that she earned for the calendar year prior to the one in which the termination date occurs and (b) a fraction, the numerator of which is the number of days she was employed by the Company and the Bank during the year of termination and the denominator of which is the number of days in such year (the "Pro Rata Bonus"), (iii) any payments she is entitled to under her salary continuation agreement; and (iv) reimbursement for the difference between the monthly COBRA premiums paid by her for herself and her dependents and the monthly premiums paid by similarly situated active executives, if applicable, for up to twelve months following the occurrence of termination. (the "COBRA Benefits"). The treatment of any outstanding equity awards shall be determined in accordance with the terms of the Company's stock compensation plans pursuant to which the Company granted equity awards to Ms. Lagomarsino, and the applicable award agreements.
If Ms. Lagomarsino's employment is terminated on account of "Disability" or death, she (or her estate in the case of death) will receive the Accrued Amounts, and the Pro Rata Bonus in a lump sum.
If Ms. Lagomarsino terminates her employment for "Good Reason" or her employment is terminated without "Cause" within twelve (12) months following a "Change in Control", in addition to the Accrued Amounts, she is entitled to receive: (i) a lump sum payment equal to one (1) times the sum of her annual base salary and annual bonus for the year previous to the year in which the termination date occurs (or if greater, the year immediately preceding the year in which the change in control occurs); (ii) equal installment payments over a two-year period, which are in the aggregate equal to two (2) times the sum of her annual base salary and annual bonus for the year previous to the year in which the termination date occurs (or if greater, the year immediately preceding the year in which the change in control occurs); (iii) a lump Pro Rata Bonus; and (iv) COBRA Benefits, until the earliest of (A) the twenty-four month anniversary of her termination; (B) the date she is no longer eligible to receive COBRA coverage; and (C) the date on which she becomes eligible to receive substantially similar coverage from another employer. The treatment of any outstanding equity awards is to be determined in accordance with the terms of the Company's stock compensation plans pursuant to which the Company granted equity awards to Ms. Lagomarsino, and the applicable award agreements. See also "Salary Continuation Agreement." If any of the payments or benefits received or to be received by Ms. Lagomarsino constitute "parachute payments" within the meaning of Section 280G of the Internal Revenue Code, the payments are to be reduced to avoid any excise tax.
As a condition to the receipt of any of the foregoing post-termination payments and benefits (except in the case of termination of employment due to death), Ms. Lagomarsino is required to provide the Company and the Bank with a general release from any and all claims, known and unknown, that Ms. Lagomarsino may have against the Company and/or the Bank.
The employment agreement contains standard confidentiality and other business protection covenants, including covenants not to solicit or disparage. Generally speaking, Ms. Lagomarsino agrees not to induce any employees to leave or otherwise interfere with or disrupt the relationships between the Bank and its employees, or divert or attempt to divert from the Bank any of its customers, during the term of her employment and for a period of one year following her separation from the Bank. The employment agreement also contains a standard indemnification provision.
Executive Salary Protection Agreements. The Bank is a party to executive salary protection agreements with each of Jason Castle, Robert Osterbauer, and William Schack. Each of these agreements provide for severance benefits in the event of certain qualifying terminations of employment, occurring in connection with a change in control.
Pursuant to each of the executive salary protection agreements, in the event of a "change in control", the executives are entitled to severance benefits if the executive's employment is terminated (other than for cause), or the executive terminates his employment as a result of (a) a reduction by more than fifteen
percent in base salary or annual bonus opportunity, other than a general reduction in base or bonus that affects all similarly situated employees in substantially the same proportions; (b) a relocation of the executive's principal place of employment by more than thirty-five miles; (c) removal from his appointed position (with respect to Mr. Schack only); (d) a material adverse change in the executive's assigned duties; or (e) the failure of a successor to assume and agree to perform the agreement, and such termination occurs within three months prior to, or within twelve months following, a "change in control."
Upon such a termination, each of Messrs. Castle, Osterbauer and Schack would be entitled to a lump sum equal to one and one-half times: (i) his annual salary at the rate in effect immediately prior to the triggering event; plus (ii) his cash bonus, if any, earned for the calendar year ended immediately prior to the occurrence of the triggering event. Messrs. Castle, Osterbauer and Schack also are entitled to reimbursement for the difference between the monthly COBRA premiums paid by them for themselves and their dependents and the monthly premiums paid by similarly situated active executives, if applicable, until the earliest of (i) the twelve-month anniversary of their termination; (ii) the date they are no longer eligible to receive COBRA coverage; and (iii) the date on which they become eligible to receive substantially similar coverage from another employer.
The agreements contain standard confidentiality and other business protection covenants, including covenants not to solicit or disparage.
As a condition to the receipt of any of the foregoing payments and benefits, the executive is required to provide the Bank with a general release from any and all claims, known and unknown, that the executive may have against the Bank.
Salary Protection Agreements. In addition, the Company is a party to salary protection agreements with each of Joseph Stronks, Brooks Wise, Greg Gehlmann, Josh Tucker, and two other officers. Each of these agreements provide for severance benefits in the event of certain qualifying terminations of employment, occurring in connection with a change in control.
Pursuant to each of the salary protection agreements, in the event of a "change in control" the executives are entitled to severance benefits if the executive's employment is terminated (other than for cause), or the executive terminates his or her employment as a result of (a) a reduction by more than fifteen percent of his or her annual total cash compensation package (defined as the sum of (i) base salary, (ii) incentive bonus opportunity, and (iii) auto allowance , if applicable, other than a general reduction in annual total cash compensation that affects similarly situated employees in substantially the same proportions; (b) a relocation of the executive's principal place of employment by more than thirty-five miles; or (c) the failure of a successor to assume and agree to perform the agreement, and such termination occurs within three months prior to, or within twelve months following, a "change in control" event as defined in the agreement.
Upon such a termination, Mr. Stronks would be entitled to a lump sum equal to 100% of his base salary at the rate in effect immediately prior to the triggering event. Upon such a termination, Messrs. Wise, Gehlmann, Tucker and the two other executives would be entitled to a lump sum equal to 50% of their base salary at the rate in effect immediately prior to the triggering event.
The agreements contain standard confidentiality and other business protection covenants, including covenants not to solicit or disparage.
As a condition to the receipt of any of the foregoing payments and benefits, the executive is required to provide the Bank with a general release from any and all claims, known and unknown, that the executive may have against the Bank.
Evaluation for Excessive Risk
The following outlines the method by which the Company reviews and evaluates compensation policies and procedures to prevent unnecessary and excessive risks that could threaten the value of the Company:
• Internal human resources, legal, and risk management personnel conduct a review of the components of the Company's incentive plans including any proposed design changes and report annually to the Compensation Committee.
• The Company maintains an Executive Incentive Compensation Recovery Policy whereby the Company will require reimbursement of any incentive payment or long-term equity award to an executive officer where:
• The payment was predicated upon achieving certain financial results that were subsequently the subject of a substantial restatement of Company financial statements filed with the SEC;
• The Audit Committee determines the executive engaged in intentional misconduct that caused or substantially caused the need for the substantial restatement; and
• A lower payment would have been made to the executive based upon the restated financial results.
• To further mitigate risk, the Compensation Committee has responsibility for the evaluation and ratification of the Company's incentive compensation plans.
In making the above reviews, the Company and the Compensation Committee have not identified any risks arising from the Company's incentive compensation policies and practices for the Company's NEOs and its employees that are likely to have a material adverse effect on the Company. It is both the Compensation Committee's and management's intent to continue to evolve the Company's processes going forward by monitoring regulations and best practices for sound incentive compensation.
Summary Compensation Table
The following table sets forth summary compensation information for the president and chief executive officer, the chief financial officer and each of the other three (3) most highly compensated executive officers as of the end of the last fiscal year (collectively, the "NEOs").
(1)Amounts shown include cash compensation received as well as amounts earned but deferred at the election of those officers under the 401(k) Plan. (2)Bonus amounts are shown in the year paid. In 2016, CEO Lagomarsino and Mr. Tucker received cash bonuses for their extraordinary contributions in 2016. See "Executive Compensation Components - Discretionary Bonus." (3)For the awards of stock, the dollar amount represents the grant date fair value computed in accordance with FASB ASC Topic 718. Includes PRSUs and restricted stock. See "Grants of Plan-Based Awards for Period Ending December 31, 2016." These amounts do not reflect the actual value that may be realized by the NEOs. Depending on our stock performance, the actual value may be more or less than the amount shown or zero. For actual value received in 2016 for awards granted in previous years, see the table "Option Exercises and Stock Awards Vested". See also "Outstanding Equity Awards at Fiscal Year End December 31, 2016." (4)Amounts shown reflect the fair value of stock options granted for the 2016, 2015 and 2014 fiscal years pursuant to FASB ASC Topic 718. (5)Non-equity incentive plan compensation is shown in the year earned. Typically, payouts under the plan are made in the year following the achievement of the performance metrics. An employee must be employed on the date of payout to be entitled to payout under the plan. (6)Amounts shown are the annual accrual dollar amounts under Ms. Lagomarsino's salary continuation agreement. This amount is determined annually based on the discount rate policy and pursuant to Financial Institutions Letter 16-2004. (7)All other compensation for the year that could not properly be reported in any other column. The specific elements are discussed below.
For Ms. Lagomarsino, amounts in 2016 include $8,359 in restricted stock dividends, automobile usage valued at $10,193, $4,766 in 401(k) Company matching contributions (as well as an additional 401(k) Company match of $4,375), and $1,164 in gym membership fees.
For Mr. Castle, amounts in 2016 include $2,988 in restricted stock dividends, an automobile allowance of $6,000, $5,820 in 401(k) Company matching contributions (as well as an additional 401(k) Company match of $595), $240 in gym membership fees, and a $500 new employee referral fee.
For Mr. Schack, amounts in 2016 includes $4,462 in restricted stock dividends, an automobile allowance of $6,000, $5,372 in 401(k) Company matching contributions (as well as an additional 401(k) Company match of $493), $160 in gym membership fees and a $50 gift card.
For Mr. Osterbauer, amounts in 2016 include $4,627 in restricted stock dividends, an automobile allowance of $12,000, $3,987 in 401(k) Company matching contributions (as well as an additional 401(k) Company match of $2,131), $750 Health Savings Account contribution, and a $50 gift card.
For Mr. Tucker, amounts in 2016 include $867 in restricted stock dividends, an automobile allowance of $5,864, $2,381 in 401(k) Company matching contributions, a $30,000 sign-on bonus, $19,500 in moving expenses, and a $50 gift card.
Grants of Plan-Based Awards for Period Ending December 31, 2016
(1)Each of the NEOs participated in the 2016 Incentive Plan ("STIP"). The award opportunities presented in the table are based on percentages of salary and threshold, target and maximum levels of corporate performance. Awards are subject to adjustment for individual performance, and, as a result, actual individual awards may be less than the stated threshold amount and may exceed the stated maximum amount. Actual awards earned for 2016 are reported in the Summary Compensation Table under the column headed "Non-Equity Incentive Compensation."
(2)STIP payment amounts assume minimum thresholds are met and executive is not otherwise disqualified due to individual performance evaluation scores. The minimum threshold level of corporate performance was met for 2016.
(3)The option exercise price represents the fair market value of the Company's common stock at the close of the market on the date of grant.
(4)Represents the grant date fair value of $7.80 per share as of April 1, 2016. Shares vest 33.33% a year over a three-year period beginning April 1, 2017.
(5)Represents the grant date fair value of $7.27 per share as of March 1, 2016. Shares vest equally 20.00% a year over a five-year period beginning March 1, 2017.
(6)Represents the grant date fair market value $7.80 per share. PRSUs are subject to forfeiture if the TSR performance metric is not met. PRSUs vest, if at all, three years from the date of grant. For a discussion of the awards, including information on the vesting percentages associated with threshold, target and maximum payout amounts, please see "Equity Awards" under "2016 Equity Compensation Components."
(7)Represents the grant date fair market value. PRSUs are subject to forfeiture if the ROA performance measure is not met. The value of PRSUs with a ROA performance measure are calculated based on a Monte Carlo simulation value at the date of grant: $7.34 per share vs. a grant date value of $7.80 per share. PRSUs vest, if at all, three years from the date of grant. For a discussion of the awards, including information on the vesting percentages associated with threshold, target and maximum payout amounts, please see "Equity Awards" under "2016 Equity Compensation Components."
(8)Options vest equally 33.33% a year over a three-year period beginning March 1, 2017.
(9)The Black Scholes pricing model was used to derive the fair value of the option awards. The assumptions used in valuing the grants in 2016 are presented in the above table.
Outstanding Equity Awards at Fiscal Year End December 31, 2016
(1)Equity incentive plan awards are subject to the Company meeting certain performance criteria. If performance measures are not met, no shares will vest. (2)The value indicated is based on the per share price of $12.30 as of the close of business on December 30, 2016. (3)Represents unvested performance-based restricted stock awards. (4)Represents PRSUs at a target number of shares. See "Grants of Planned Based Awards for Period Ending December 31, 2016."
(5)The following tables provide the scheduled vesting of stock options, restricted stock awards, performance-based restricted stock awards ("PRSA"), and performance-based restricted stock units ("PRSU"). Stock options in the table are Incentive Stock Options ("ISO"), except where noted as Non-qualified Stock Options ("NQ"). Restricted stock awards are time-based restricted stock awards, except where noted as PRSA or PRSU.
Stock Options:
Restricted Stock Awards, Performance-based Restricted Stock Awards and Performance-based Restricted Stock Units:
Option Exercises and Stock Awards Vested / Forfeited in 2016
(1)The value realized on exercise is the difference between the closing price of the Company's Common Stock on the date of exercise and the exercise price of the options multiplied by the number of shares acquired on exercise. (2)The value realized/forfeited on vesting is the closing price of the Company's Common Stock on the date of vesting/forfeiture multiplied by the number of shares vested/forfeited. Specific to Ms. Lagomarsino, 7,080 shares and 3,083 shares of time-based vesting restricted stock awards vested on February 1, 2016 and March 2, 2016, respectively. Also specific to Ms. Lagomarsino, the Compensation Committee determined that certain performance-based goals were not met and therefore a total of 10,163 shares of performance-based restricted stock awards were forfeited on February 24, 2016.
Pension Benefits Table - 2016
(1)The benefit begins accruing at the effective date of the agreement and vests ten percent (10%) per year for up to ten (10) years. This is a non-qualified supplemental executive retirement plan and the benefit is paid out in equal monthly installments for 15 years, commencing at employment termination or at the age of 65. The benefit accelerates upon a change in control.
Potential Payments upon Termination or Change in Control
The table below summarizes the potential change-in-control benefits that would become payable to each of our NEOs as of December 31, 2016, based on the assumption that termination and/or a change in control occurred on such date, as provided under the NEOs' Employment Agreement and Salary Continuation Agreement (Ms. Lagomarsino) or Salary Protection Agreements (with respect to the other NEOs) as described in more detail in the CD&A. See "Salary Continuation Agreements" and "Employment Contracts and Change in Control Arrangements."
(1)See "Employment Contracts and Change in Control Arrangements - Employment Agreement." With respect to Termination/Change-in-Control, certain amounts are subject to cutback because of a provision of the named executive officer's employment agreement limiting such payments to the maximum amount permitted under Section 280G of the Code without creating adverse tax consequences. Any such reduction will be taken from cash severance. (2)See "Employment Contracts and Change in Control Arrangements - Executive Salary Protection Agreements." (3)See "Employment Contracts and Change in Control Arrangements - Salary Protection Agreements." (4)Unvested 401(k) Company match as of December 31, 2016. (5)Assumes events take place on December 31, 2016. Amounts in the table above do not take into consideration the terms of the Announced Merger with Pacific Premier Bancorp, Inc. (6)Assumes the acceleration of all unvested options, restricted stock, or PRSUs upon a change in control. Share value is as of December 31, 2016.
Payments for Voluntary Termination by NEO, Termination for Cause
In the event of an NEO's voluntary termination of employment (other than as specifically set forth in the agreement - for "Good Reason") or the Company's termination of the NEO's employment for "Cause," the NEO is not entitled to any special benefits under their respective employment or other agreements or any stock awards.
2016 Director Compensation
The following table sets forth certain information regarding the compensation earned by or awarded to each non-employee director who served on the Board of Directors in 2016.
(1)For the Company, the Chairman of the Board received an annual retainer of $15,700 for all meetings, including committee and Board meetings. All other directors received an annual retainer of $9,000. The director who served as chair of the Audit Committee received an annual retainer of $7,500, and directors who served as the chairs of the Compensation, and Enterprise Risk & Compliance Committees received an annual retainer of $5,000. The director who served as chair of the Nominating & Governance Committee received an annual retainer of $3,500. Executive Committee members (other than the Chairman and the CEO) received an annual retainer of $5,000. Any changes in annual retainers were pro-rated for the actual number of months in which they were in effect, and are paid monthly at one-twelfth (1/12) the annual rate, one (1) month in arrears.
In 2016, the Bank paid the law firm of Andre, Morris and Buttery $1,178 for legal services. Chairman Morris is the Chairman of the Board of the law firm of Andre, Morris and Buttery. The fees are not reflected in the table above.
(1a)For the Bank, the Chairman of the Board received an annual retainer of $62,800 for all meetings, including committee and Board meetings. All other directors received an annual retainer of $36,000. Directors who served as chair of either the Loan or Asset/Liability and Investment ("ALCO") Committees received an annual retainer of $5,000. Any changes in annual retainers were pro-rated for the actual number of months in which they were in effect, and are paid monthly at one-twelfth (1/12) the annual rate, one (1) month in arrears. (2)Market value of shares of restricted stock awards granted to non-employee directors on September 1, 2016 pursuant to the 2015 Equity Incentive Plan. All non-employee directors received a grant of 3,101 shares of restricted stock. Mr. Morris received an additional 621 restricted shares for his efforts as Chairman of the Board. Shares vest one year after the grant date. (3)Dividends on unvested restricted stock. (4)Don Campbell was a board member until May 25, 2016. Includes Director Emeritus fees of $1,000 per month paid from July 2016 through December 2016, and a one-time stock grant.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Securities Authorized for Issuance under Equity Compensation Plans
On May 27, 2015, the Company's shareholders approved the 2015 Equity Incentive Plan pursuant to which directors, officers and other Company or Bank employees may be granted equity based awards. Equity-based awards allowed by this plan include Incentive Stock Options, Non-Qualified Stock Options, Stock Appreciation Rights, Restricted Stock Awards, Restricted Stock Units, Performance Share Awards, or any combination thereof. Some equity-based awards were made in 2016 in connection with the hiring or promotion of certain executive officers. All other awards in 2016 were made pursuant to periodic reviews of the senior executives and are reflected for the NEOs in the tables herein.
Prior to its expiration on March 25, 2015, the Company maintained the 2005 Equity Based Compensation Plan. Since its expiration, no further awards can be made under this plan.
Equity based awards are provided to align employees' performance with shareholder interests. The Compensation Committee may review any type of performance criteria, market comparison, and extraordinary events when making the decision to offer an equity-based award.
See also "Item II - Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities."
Security Ownership of Certain Beneficial Owners and Management
As of February 23, 2017, no individual known to the Company owned more than five percent (5%) of the outstanding shares of its common stock, except as described below. The following table reflects the common stock outstanding at February 23, 2017.
(1)Carpenter Fund Manager GP, LLC ("Fund Manager") is the general partner of each of Carpenter Community BancFund, LP; Carpenter Community BancFund-A, LP; and Carpenter Community BancFund-CA, L.P (the "Carpenter Funds"). (2)Patriot Financial Partners, GP, LP ("Patriot GP") is a general partner of each of Patriot Financial Partners, LP and Patriot Financial Partners Parallel, LP (together, the "Funds") and Patriot Financial Partners, GP, LLC ("Patriot LLC") is a general partner of Patriot GP. In addition, each of W. Kirk Wycoff, Ira M. Lubert and James J. Lynch are general partners of the Funds and Patriot GP and members of Patriot LLC. Accordingly, securities owned by the Funds may be regarded as being beneficially owned by Patriot GP, Patriot LLC and each of W. Kirk Wycoff, Ira M. Lubert and James J. Lynch. (3)This information is based on a Schedule 13G filed with the SEC February 14, 2017. The Banc Funds Company, LLC, ("TBFC") is the general partner of MidBanc VI LP, MidBanc VII LP, and MidBanc VIII LP. The general partners of Banc Fund VI L.P., Banc Fund VII L.P., and Banc Fund VIII L.P., are MidBanc VI LP, MidBanc VII LP, and MidBanc VIII LP,
respectively. Charles J. Moore is the principal owner of TBFC and the manager of each of Banc Fund VI L.P., Banc Fund VII L.P., and Banc Fund VIII L.P. and therefore has voting and dispositive power over these securities.
The following table sets forth as of February 23, 2017, the number of shares of the Company's common stock which may be deemed to be beneficially owned by (i) each of the directors, (ii) each Named Executive Officer, and (iii) all directors and executive officers as a group, and the percentage of the outstanding common stock beneficially owned by such persons. Please see Footnotes referenced below.
*Indicates less than 1% of outstanding shares.
(1)Except as otherwise indicated in these notes, and subject to applicable community property laws and shared voting and investment power, the table includes shares held by each person's spouse and minor children; shares held by a family trust as to which such person is a trustee with sole voting and investment power (or shares power with a spouse); and/or shares held in an Individual Retirement Account as to which such person has pass-through voting rights and investment power. Includes restricted stock not fully vested. (2)Includes shares of Common Stock subject to stock options exercisable within 60 days of February 23, 2017. (3)Carpenter Fund Manager GP, LLC ("Fund Manager") is the general partner of each of Carpenter Community BancFund, LP, Carpenter Community BancFund-A, LP, and Carpenter Community BancFund-CA, LP, (together, the "Carpenter Funds"). Mr. Gould serves as one of five Managing Members of Fund Manager and as such holds shared voting and investment power with respect to 5,873,016 shares. Mr. Gould disclaims beneficial ownership of these shares. (4)Patriot Financial Partners, GP, LP ("Patriot GP") is the sole general partner of each of Patriot Financial Partners, L.P. and Patriot Financial Partners Parallel, LP (together, the "Funds"). Accordingly, securities owned by the Funds may be regarded as being beneficially owned by Patriot GP. Patriot Financial Partners GP, LLC ("Patriot LLC") is the general partner of Patriot GP. Accordingly, securities owned or deemed to be owned by Patriot GP may be regarded as being beneficially owned by Patriot LLC. Mr. Lynch is a general partner of the Funds and Patriot GP and a member of Patriot LLC. (5)Includes 20,354 shares held as a trustee of Glenn, Burdette, Phillips and Bryson Tax and Business Services, Inc. 401(k) and 33,732 shares held in his own 401(k).
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence
Director Independence
Each of the Company's directors is "independent" within the meaning of NASDAQ's Marketplace Rules, except for Simone F. Lagomarsino, the CEO and President of the Company.
Indebtedness and Other Transactions with Directors and Executive Officers
In accordance with the Code of Conduct, the Board of Directors is responsible for reviewing and acting upon all related party transactions required to be disclosed by Item 404(a) of Regulation S-K (i.e., a transaction between the Company and a related party where the amount involved exceeds $120,000 and the related party has a direct or indirect material interest) for potential conflicts of interest. All transactions with related persons require prior approval of the Board of Directors. Related parties include any of our directors, director nominees and executive officers, any person known to own more than 5% of our common stock, the immediate family members of any of the foregoing persons, and any corporation or other entity in which the foregoing persons are employed or are a general partner, principal or owner of greater than 5% of the entity's stock.
Prior to engaging in any such transactions, a description of the nature and structure of the transaction, along with any necessary supporting documentation, is submitted to the Board of Directors. In determining whether to approve a reportable related party transaction, the Board of Directors will consider, among other things, the following:
Whether the terms of the transaction are fair to the Company;
Whether the transaction is material to the Company;
The importance of the related person to the transaction;
The role the related person has played in arranging the transaction;
The structure of the transaction; and
The interests of all related persons in the transaction.
The Company will only enter into a related party transaction if the Board of Directors determines that the transaction is beneficial to the Company, and the terms of the transaction are fair to the Company. The Company did not enter into any reportable related party transactions during 2016; however, the Company did enter into certain non-material transactions with related parties. See Note 20. Related Party Transactions, of the consolidated financial statements filed on this Form 10-K.
Additionally, the Company's subsidiary, Heritage Oaks Bank, has had and expects to have banking transactions in the ordinary course of business with related persons on substantially the same terms (including interest rates, collateral and repayment terms) as those prevailing at the time for comparable loans with persons not related to the Company. During 2016 no loan to any related person involved more than normal risk of collectability nor do any of the loans include any features that would be considered unfavorable to the Bank. All loans to directors or executive officers would be subject to the limitations prescribed by California Financial Code Section 3370, et seq. and by the Financial Institutions Regulatory and Interest Rate Control Act of 1978.
Item 14.
Item 14. Principal Accounting Fees and Services
INDEPENDENT PUBLIC ACCOUNTANTS
The firm of Crowe Horwath LLP ("Crowe"), independent registered public accounting firm, has been selected by the Audit Committee of the Board of Directors to perform audit services for the Company and its subsidiary, Heritage Oaks Bank, for the fiscal year ending December 31, 2016, and such selection has been approved by resolution of the Board of Directors.
Crowe Horwath LLP served the Company as independent registered public accountants for the 2016 and 2015 fiscal years. Crowe has no interest, financial or otherwise, in the Company.
Fees
The following table sets forth the aggregate fees (including expenses) billed for audit services, as well as fees billed with respect to audit-related, tax and all other services, provided by Crowe to the Company and its related entities for the last two fiscal years.
Description of Services
Audit Fees consist of fees billed for professional services rendered in connection with the audit of our annual consolidated financial statements and internal control over financial reporting, review of consolidated financial statements included in Form 10-Qs, review of certain periodic reports and other documents filed with the SEC, and services that are normally provided in connection with statutory or regulatory filings or engagements.
Audit-Related Fees consist of fees billed for assurance and related services that are reasonably related to the performance of the audit or review of financial statements, including employee benefit plan audits and HUD reporting.
All Other Fees include fees related to an Anti-Money Laundering ("AML") system validation review for Heritage Oaks Bank in 2016 and 2015.
Preapproval of Services by Principal Accountant
The Audit Committee will consider annually and, if appropriate, approve audit services by its principal accountant. In addition, the Audit Committee will consider and, if appropriate, pre-approve certain defined audit and non-audit services. The Audit Committee will also consider on a case-by-case basis and, if appropriate, approve specific engagements. For the fiscal year 2016, the Audit Committee considered the services provided by Crowe compatible with maintaining the principal accountant's independence. 100% of the audit-related, tax and other fees were pre-approved. The Charter for the Audit Committee contains policies and procedures for pre-approval of audit and non-audit services from the Company's independent public accountant.
AUDIT COMMITTEE REPORT
The material in this report is not "soliciting material," is not deemed filed with the SEC and is not to be incorporated by reference in any of the Company's filings under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, whether made before or after the date of this filing and irrespective of any general incorporation language therein.
The Audit Committee currently consists of six (6) members of the Board of Directors, each of whom is independent under the NASDAQ Marketplace Rules and SEC rules and regulations applicable to audit committees. The Board of Directors has adopted, and annually reviews, an Audit Committee charter, available on the Company's investor relations website at www.heritageoaksbancorp.com. The charter specifies the scope of the Audit Committee's responsibilities and how it carries out those responsibilities.
In performing its functions, the Audit Committee met fourteen (14) times during the year and regularly met in executive session without Bank management. The Audit Committee acts only in an oversight capacity and necessarily relies on the work and assurances of the Company's management, which has the primary responsibility for financial statements and reports, and of the independent accountants. The independent accountants, in their report, express an opinion on the conformity of the Company's annual financial statements with accounting principles generally accepted in the United States of America and on the Company's internal control over financial reporting and compliance. In addition, the Audit Committee engages outside consultants who advise it on internal control and credit quality matters. It also maintains a process for handling employee complaints regarding accounting procedures and internal controls.
The Audit Committee has reviewed and discussed the Company's December 31, 2016, audited financial statements with management and with Crowe, the Company's independent registered public accounting firm. The Audit Committee has also discussed with Crowe the matters required to be discussed by the statement on Auditing Standards No. 61, as amended (AICPA, Professional Standards, Vol. 1. AU section 380).
The Audit Committee has also received from Crowe the written disclosures and the letter required by applicable requirements of the Public Company Accounting Oversight Board regarding the independent accountant's communications with the Audit Committee concerning independence and has discussed with Crowe their independence from the Company.
Based on the review and discussions referred to above, the Audit Committee recommended to the Board of Directors that the December 31, 2016 audited financial statements be included in the Company's Annual Report on Form 10-K for the year ended December 31, 2016.
Submitted by the Audit Committee of the Board
Daniel J. O'Hare (Chairman)
Mark C. Fugate
Dee Lacey
Michael Pfau
Alexander F. Simas
Stephen Yost
Part IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules
(a)1. Consolidated Financial Statements
The Company's consolidated financial statements, include the notes thereto, and the report of the independent registered public accounting firm thereon, are set forth in the index for Item 8 of this form.
(a)2. Financial Statement Schedules
All financial statement schedules for the Company have been included in the Consolidated Financial Statements or the related footnotes. Additionally, a listing of the supplementary financial information required by this item is set forth in the index for Item 8 of this Form 10-K.
(a)3. Exhibits
A list of exhibits of this Form 10-K is set forth in the "Exhibit Index" immediately preceding such exhibits and is incorporated herein by reference.
(b) Exhibits Required By Item 601 of Regulation S-K
Reference is made to the Exhibit Index on page 187 for exhibits filed as part of this report.
(b)(c) Additional Financial Statements
Not Applicable.
Signatures
Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Heritage Oaks Bancorp
Date: March 3, 2017
/s/ Simone F. Lagomarsino
Simone F. Lagomarsino
President and Chief Executive Officer
(Principal Executive Officer)
/s/ Jason C. Castle
Jason C. Castle
Executive Vice President and
Chief Financial Officer
(Principal Financial 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 dates indicated.
/s/ Michael J. Morris
Michael J. Morris
Chairman of the Board of Directors
March 3, 2017
/s/ Michael E. Pfau
Michael E. Pfau
Vice Chairman of the Board of Directors
March 3, 2017
/s/ Michael J. Behrman
Michael J. Behrman
Director
March 3, 2017
/s/ Mark C. Fugate
Mark C. Fugate
Director
March 3, 2017
/s/ Howard N. Gould
Howard N. Gould
Director
March 3, 2017
/s/ Dolores T. Lacey
Dolores T. Lacey
Director
March 3, 2017
/s/ Simone F. Lagomarsino
Simone F. Lagomarsino
Director
March 3, 2017
/s/ James J. Lynch
James J. Lynch
Director
March 3, 2017
/s/ Daniel J. O'Hare
Daniel J. O'Hare
Director
March 3, 2017
/s/ Alexander F. Simas
Alexander F. Simas
Director
March 3, 2017
/s/ Stephen P. Yost
Stephen P. Yost
Director
March 3, 2017
Exhibit Index
(2.1)
Agreement and Plan of Merger, dated October 21, 2013, by and between Heritage Oaks Bancorp and Mission Community Bancorp incorporated by reference from Exhibit 2.1 to the Form 8-K filed with the SEC on October 22, 2013, Commission File No. 000-225020.
(2.2)
Agreement and Plan of Reorganization, dated December 12, 2016, by and between Pacific Premier Bancorp, Inc. and Heritage Oaks Bancorp incorporated by reference from Exhibit 2.1 to the Form 8-K filed with the SEC on December 13, 2016, Commission File No. 000-225020.
(3.1)
Articles of Incorporation incorporated by reference from Exhibit 3.1a to Registration Statement on Form S-4 Commission File No. 33-77504 filed with the SEC on April 8, 1994.
(3.2)
Amendment to the Articles of Incorporation incorporated by reference from the Company's 10-KSB for the year ending December 31, 1997 filed with the SEC on March 27, 1998, Commission File No. 000-25020.
(3.3)
Certificate of Amendment of Articles of Incorporation incorporated by reference from the Form 8-K filed with the SEC on March 5, 2009, Commission File No. 000-25020.
(3.4)
Bylaws, as amended, incorporated by reference from the Registration Statement on Form S-3, filed with the SEC on April 23, 2009, Commission File No. 333-158732.
(3.5)
Amendment to Article 3.3 of the Bylaws, incorporated by reference from the Form 8-K filed with the SEC on May 24, 2013, Commission File No. 000-25020.
(4.1)
Specimen form of the Company's Common stock certificate incorporated by reference from Exhibit 4.1 to Registration Statement on Form S-4 Commission File No. 33-77504 filed with the SEC on April 8, 1994.
(4.2)
Certificate of Determination of Series C Convertible Perpetual Preferred Stock incorporated by reference from the Form 8-K filed with the SEC on March 15, 2010, Commission File No. 000-25020.
(10.1)
2015 Equity Incentive Plan, incorporated by reference from Appendix C to the Definitive Proxy Statement filed on Form DEF-14A with the SEC on April 30, 2015, Commission File No. 000-25020.*
(10.2)
1997 Stock Option Plan incorporated by reference from Exhibit 4a to Registration Statement on Form S-8 No.333-31105 filed with the SEC on July 11, 1997 as amended, incorporated by reference, from Registration Statement on Form S-8, Commission File No. 333-83235 filed with the SEC on July 20, 1999.*
(10.3)
Form of Stock Option Agreement incorporated by reference from Exhibit 4b to Registration Statement on Form S-8 Commission File No. 333-31105 filed with the SEC on July 11, 1997.*
(10.4)
2005 Equity Based Compensation Plan incorporated by reference from Appendix C to the Definitive Proxy Statement filed on Form DEF-14A with the SEC on May 6, 2005, Commission File No. 000-25020.*
(10.5)
Form of Salary Continuation Agreement incorporated by reference from the Company's Form 10-K for the year ended December 31, 2011, filed with the SEC on February 28, 2012, Commission File No. 000-25020.*
(10.6)
Sixth Amendment to Service Bureau Processing Agreement dated July 6, 2010 between Fidelity Information Services, Inc. and Heritage Oaks Bank, incorporated by reference from the Form 8-K filed with the SEC on July 9, 2010, Commission File No. 000-25020.
(10.7)
Registration Rights Agreement, incorporated by reference from the Form 8-K filed with the SEC on March 10, 2010, Commission File No. 000-25020.
(10.8)
Stipulation to the Issuance of a BSA Consent Order and BSA Consent Order between Heritage Oaks Bank and the Federal Deposit Insurance Corporation and the California Department of Business Oversight, dated November 5, 2014, incorporated by reference from the Form 8-K filed with the SEC on October 30, 2014, Commission File No. 000-25020.
(10.9)
Exchange Agreement by and between Heritage Oaks Bancorp and Castle Creek Partners IV, LP, dated October 29, 2014, incorporated by reference from the Form 8-K/A filed with the SEC on October 31, 2014, Commission File No. 000-25020.
(10.10)
First Amendment to Exchange Agreement by and between Heritage Oaks Bancorp and Castle Creek Partners IV, LP, dated December 22, 2014, incorporated by reference from the Form 8-K filed with the SEC on December 24, 2014, Commission File No. 000-25020.
(10.11)
Employment Agreement by and among Simone F. Lagomarsino and Heritage Oaks Bancorp and Heritage Oaks Bank, dated October 29, 2014, incorporated by reference from the Form 8-K filed with the SEC on October 30, 2014, Commission File No. 000-25020.*
(10.12)
Salary Protection Agreement by and among Jason Castle and Heritage Oaks Bancorp and Heritage Oaks Bank, dated August 17, 2015, incorporated by reference from the Form 10-Q filed with the SEC on October 30, 2015, Commission File No. 000-25020.*
(10.13)
Executive Salary Protection Agreement dated July 24, 2015 by and between Heritage Oaks Bank and Robert Osterbauer, incorporated by reference from the Form 10-Q filed with the SEC on July 30, 2015, Commission File No. 000-25020.*
(10.14)
Form of Performance Based Restricted Stock Units Agreement (2016 Grants - 2015 Equity Incentive Plan), incorporated by reference from the Form 10-Q filed with the SEC on August 5, 2016, Commission File No. 000-25020.*
(10.15)
Form of Restricted Stock Award Agreement (2015 Equity Incentive Plan), incorporated by reference from the Form 10-Q filed with the SEC on August 5, 2016, Commission File No. 000-25020.*
(10.16)
Heritage Oaks Bancorp Severance Policy dated December 11, 2016*/**
(21)
Subsidiaries of the Company. Heritage Oaks Bank is the only financial subsidiary of the Company.
(23.1)
Consent of Independent Registered Accounting Firm**
(31.1)
Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002**
(31.2)
Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002**
(32.1)
Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002**
(32.2)
Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002**
The following materials from the Company's annual report on Form 10-K for the year ended December 31, 2016, formatted in XBRL (eXtensible Business Reporting Language): (i) Consolidated Balance Sheets as of December 31, 2016 and December 31, 2015, (ii) Consolidated Statements of Income for the years ended December 31, 2016, 2015 and 2014, (iii) Consolidated Statements of Comprehensive Income, (iv) Consolidated Statements of Shareholders' Equity for the years ended December 31, 2016, 2015 and 2014 (v) Consolidated Statements of Cash Flows, for the years ended December 31, 2016, 2015 and 2014, and (vi) Notes to Consolidated Financial Statements.
*Management contract or compensatory plan agreement. **Filed herewith.