Item 1. Business
General
Heritage Oaks Bancorp (the "Company", “we” or “our”) is a California corporation organized in 1994 to act as the holding company of Heritage Oaks Bank (the “Bank"). In 1994, the Company acquired all of the outstanding common stock of the Bank in a holding company formation transaction.
In October 2006, the Company formed Heritage Oaks Capital Trust II (the “Trust II”). Trust II 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.
On April 23, 2007, the Company redeemed all of the Floating Rate Junior Subordinated Debt Securities it held associated with Heritage Oaks Capital Trust I, a wholly owned subsidiary of Heritage Oaks Bancorp. The redemption price was 100% of the principal amount redeemed plus accrued and unpaid interest as of the redemption date. As a result of the redemption of the securities associated with Heritage Oaks Capital Trust I, the Trust was dissolved on June 1, 2007. See also Note 8 to the Consolidated Financial Statements filed on this Form 10-K for a more detailed discussion related to the redemption of these securities.
In June of 2007, the Company sold four of its properties to First States Group, L.P. (“First States”), an unaffiliated party, in a sale-leaseback transaction for $12.8 million. In connection with the sale, the Bank entered into four separate lease agreements with First States Investors, LLC to lease back three branches and one administrative facility under which the bank will continue to utilize for the normal course of business. The three branches are located in Paso Robles, Arroyo Grande and Santa Maria, California. The administrative facility is located in Paso Robles, California. See also Item 2 Description of Properties, on this Form 10-K for a more detailed discussion related to this sale-leaseback transaction.
In September 2007, the Company formed Heritage Oaks Capital Trust III (the “Trust III”). Trust III 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.
On October 12, 2007 the Company acquired Business First National Bank (“Business First”). Business First was merged into Heritage Oaks Bank, a wholly owned subsidiary of the Company. The acquisition added two branches to the Heritage Oaks Bank network and marked the Company’s entry into southern Santa Barbara County. The Company is operating these two branches as Business First, a division of Heritage Oaks Bank. The consideration paid for Business First was $19.5 million, consisting of approximately 75% common stock and 25% cash. Business First shareholders received 0.5758 shares of Heritage Oaks Bancorp common stock for each share of Business First they owned and $3.44 per share in cash. Upon the acquisition of Business First, Dr. Michael J. Behrman and Mr. Michael E. Pfau, previous members of Business First’s Board of Directors, were added to the Board of Directors of the Company. See also Note 23 to the Consolidated Financial Statements filed on this Form 10-K for additional information regarding this acquisition.
Other than holding the shares of the Bank, the Company conducts no significant activities, although it is authorized, with the prior approval of the Board of Governors of the Federal Reserve System (the "Federal Reserve Board"), the Company's principal regulator, to engage in a variety of activities which are deemed closely related to the business of banking. The Company has also incorporated a subsidiary, CCMS Systems, Inc. which is currently inactive and has not been capitalized. The Company has no present plans to activate the proposed subsidiary, nor engage in such other permitted activities.
Banking Services
The Bank was licensed by the California Department of Financial Institutions (“DFI”) and commenced operation in January 1983. As a California state bank, the Bank is subject to primary supervision, examination and regulation by the DFI and the Federal Deposit Insurance Corporation (“FDIC”). The Bank 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 thereof.
At December 31, 2008, the Company had approximately $805.6 million in consolidated assets, $668.0 million in net consolidated loans, $603.5 million in consolidated deposits, and $70.0 million in stockholders' equity.
The Bank is headquartered in Paso Robles, California with one branch office in Paso Robles, Arroyo Grande, Atascadero, Cambria, Morro Bay, Templeton and San Miguel, two branch offices in San Luis Obispo and Santa Barbara and three branch offices in Santa Maria. The Bank conducts a commercial banking business in the counties of San Luis Obispo and Santa Barbara, including accepting demand, savings and time deposits, and making commercial, real estate, SBA, agricultural, credit card, and consumer loans. The Bank also offers installment note collection, issues cashier’s checks and money orders, sells travelers checks, and provides bank-by-mail, night depository, safe deposit boxes, online banking, and other customary banking services. The Bank does not offer trust services or international banking services and does not plan to do so in the near future.
The Bank’s operating policies since inception have emphasized small business, commercial and retail banking. Most of the Bank’s customers are retail customers, farmers and small to medium-sized businesses. The Bank takes real estate, listed and unlisted securities, savings and time deposits, automobiles, machinery and equipment as collateral for loans. The areas in which the Bank has directed virtually all of its lending activities are: commercial and industrial loans, installment loans, construction loans, and other real estate loans or commercial loans secured by real estate. As of December 31, 2008, the Bank had approximately $680.1 million in gross loan balances, of which approximately $499.7 million or 73.5% consisted of interim construction and other real estate secured loans, primarily for single family residences or for commercial development. A more detailed discussion of the loan portfolio can be found under Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 3 of the Consolidated Financial Statements filed on this Form 10-K.
Most of the Bank’s deposits are obtained through local promotional activities and advertising in the local media. A material portion of the Bank’s deposits have not been obtained from a single person or a few persons, the loss of any one or more of these accounts would have a materially adverse effect on the business of the Bank. However, there are several deposit relationships that the Bank considers to be volatile. These accounts are closely monitored by Bank Management and had combined balances of $61.6 million or 10.2% of total deposits at December 31, 2008. A more detailed discussion of the Bank’s deposits and accounts Management considers to be volatile can be found under Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations of this Form 10-K.
The principal sources of the Company’s consolidated revenues are (i) interest and fees on loans, (ii) interest on investments, (iii) service charges on deposit accounts and other charges and fees, (iv) mortgage origination fees and (v) miscellaneous income.
The following provides a breakdown of the components that make up the Company’s consolidated revenues for the years ended December 31, 2008, 2007 and 2006:
The Company has not engaged in any material research activities relating to the development of new services or the improvement of existing bank services, except as otherwise discussed herein. There has been no significant change in the types of services offered by the Bank since its inception. The Company has no present plans regarding "a new line of business" requiring the investment of a material amount of total assets. Most of the Company’s business originates from San Luis Obispo and Santa Barbara Counties and there is no emphasis on foreign sources and application of funds. The Company’s business, based upon performance to date, does not appear to be seasonal. Additionally, Management is unaware of any material effect upon the Company’s capital expenditures, earnings or competitive position as a result of federal, state or local environmental regulations.
The Bank holds service marks issued by the U.S. Patent and Trademark Office for the “Acorn” design, the “Oakley” design and “Deeply Rooted in Your Hometown.”
Employees
As of December 31, 2008, The Bank had 223 full-time equivalent employees. The Bank believes that its employee relations are positive.
Local Economic Climate
The economy in the Company’s service area is based primarily on agriculture, tourism, light industry, oil and retail trade. Services supporting these industries have also developed in the areas of medical, financial and educational services. The population of San Luis Obispo County, the City of Santa Maria (in Northern Santa Barbara County), and the City of Santa Barbara totaled approximately 262,000, 86,000, and 86,000 respectively, according to the most recent economic data provided by the U.S. Census Bureau. The moderate climate allows a year round growing season for numerous vegetables and fruits. Vineyards and cattle ranches also contribute largely to the local economy. The Central Coast’s leading agricultural industry is the production of high quality wine grapes and production of premium quality wines. Vineyards in production have grown significantly over the past several years throughout the Company’s service area. Access to numerous recreational activities including lakes, mountains and beaches, provide a relatively stable tourist industry from many areas including the Los Angeles/Orange County basin, the San Francisco Bay area and the San Joaquin Valley. While the economy in our primary markets of San Luis Obispo and Santa Barbara counties have not been immune to the negative impacts of both the national and state economies, the abundant tourism that has developed over the past decade in our market area, especially in the wine industry and coastal communities, has helped sustain our local economy in previous economic downturns.
proved to be a challenging year not only on the national level, but within the state of California and more specifically our primary market area. As the U.S. housing market continued to wane throughout 2008 and economic growth began to significantly slow, the ability of borrowers to satisfy their obligations to the financial sector began to languish. These among other factors placed severe stress on the U.S. financial system, leading to a crisis of confidence, further downturn in economic growth and unprecedented volatility in the U.S. equity and credit markets. As mentioned, our primary market area has historically enjoyed a more stable level of economic activity; however we believe these more macro level concerns have started to become more evident within our market area. Recent indications show the unemployment rate within California to be approximately 9.3%. This is up approximately 3.4% from the 5.9% reported at December 2007. Within our primary market area, recent indications show the unemployment rate within San Luis Obispo and Santa Barbara counties to be approximately 6.6% and 6.3%, respectively. This represents increases of approximately 2.3% and 1.9% from the 4.3% and 4.4% reported for San Luis Obispo and Santa Barbara counties at December 2007. Additionally, housing prices have fallen significantly year over year within California, showing an approximate 42% year over year decline as of December 2008. Within the Company’s primary market, we have seen housing prices fall in San Luis Obispo and Santa Barbara counties from year ago levels by approximately 29% and 34%, respectively. However, sales have been relatively strong within the Company’s primary market area, climbing approximately 32% during 2008, the majority of which can be attributed to sales of foreclosed properties. That said, the lack of oversupply in our market, desirable climate, close proximity to beaches, water sport lakes and the wine industry, for both San Luis Obispo and Santa Barbara Counties have to some degree provided support for the real-estate market in our area.
Competition
Banking and the financial services business in California generally, and in the Company’s service area specifically, is highly competitive. The increasingly competitive environment is a result primarily of changes in regulation, changes in technology and product delivery systems, and the accelerating pace of consolidation among financial services providers and the appearance of new banking organizations.
In order to compete with other financial institutions in its service area, the Bank relies principally upon local advertising programs; direct personal contact by officers, directors, employees, and shareholders; and specialized services such as courier pick-up and delivery of non-cash banking items. The Bank emphasizes to customers the advantages of dealing with a locally owned and community oriented institution. The Bank also seeks to provide special services and programs for individuals in its primary service area who are employed in the agricultural, professional and business fields, such as loans for equipment, furniture, tools of the trade or expansion of practices or businesses. Larger banks may have a competitive advantage because of higher lending limits and major advertising and marketing campaigns. They also perform services, such as trust services, international banking, discount brokerage and insurance services that the Bank is not authorized or prepared to offer currently. The Bank has made arrangements with correspondent banks and with others to provide such services for its customers. For borrowers requiring loans in excess of the Bank’s legal lending limits, the Bank has offered, and intends to offer in the future, such loans on a participating basis with correspondent banks and with other independent banks, retaining the portion of such loans which is within its lending limit.
Commercial banks compete with savings and loan associations, credit unions, other financial institutions, securities brokerage firms, and other entities for funds. For instance, yields on corporate and government debt securities and other commercial paper affect the ability of commercial banks to attract and hold deposits. The recent stresses placed on the U.S. financial system have had a direct impact on the levels of liquidity at many financial institutions, which in turn has made the competition for deposits more challenging in the current economic environment. Commercial banks also compete for loans with savings and loan associations, credit unions, consumer finance companies, mortgage companies, and other lending institutions.
The financial services industry is undergoing rapid technological changes involving frequent introductions of new technology-driven products and services that have further increased competition. There can also be no assurance that these technological improvements, if made, will increase the Company’s operational efficiency or that the Company will be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to our customers.
Effect of Government Policies and Recent Legislation
Banking is a business that depends on rate differentials. In general, the difference between the interest rate paid by the Company on deposits and other borrowings and the interest rate received by the Company on loans extended to its customers and securities held in its investment portfolio comprise the major portion of the Company’s earnings. These rates are highly sensitive to many factors that are beyond the control of the Company. Accordingly, the earnings and growth of the Company are subject to the influence of domestic and foreign economic conditions, including inflation, recession and unemployment.
The commercial banking business is not only affected by general economic conditions but is also influenced by the monetary and fiscal policies of the federal government and the policies of regulatory agencies, particularly the Federal Reserve Board. The Federal Reserve Board implements national monetary policies (with objectives such as curbing inflation, combating recession and providing liquidity) by its open-market operations in U.S. Government securities, by adjusting the required level of reserves for financial institutions subject to its reserve requirements and by varying the discount rates applicable to borrowings by depository institutions. The actions of the Federal Reserve Board in these areas influence the growth of bank loans, investments and deposits and also affect interest rates charged on loans and paid on deposits. The nature and impact on the Company of any future changes in monetary policies cannot be predicted.
From time to time, legislation is enacted which has the effect of increasing the cost of doing business, limiting or expanding permissible activities or affecting the competitive balance between banks and other financial institutions. Proposals to change the laws and regulations governing the operations and taxation of banks, bank holding companies and other financial institutions are frequently made in Congress, in the California legislature and before various bank regulatory and other professional agencies. See also “Supervision and Regulation - Sarbanes-Oxley Act of 2002 and Financial Services Modernization Legislation.”
Supervision and Regulation
General
The Company and the Bank are extensively regulated under both federal and state law. Set forth below is a summary description of certain laws that relate to the regulation of the Company and the Bank. The description does not purport to be complete and is qualified in its entirety by reference to the applicable laws and regulations.
The Company
The Company is a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended (the "Bank Holding Company Act"), and is registered as such with, and subject to the supervision of, the Federal Reserve Board. The Company is required to file with the Federal Reserve Board quarterly and annual reports and such additional information as the Federal Reserve Board may require pursuant to the Bank Holding Company Act. The Federal Reserve Board may conduct examinations of bank holding companies and their subsidiaries.
The Company is required to obtain the approval of the Federal Reserve Board before it may acquire all or substantially all of the assets of any bank, or ownership or control of the voting shares of any bank if, after giving effect to such acquisition of shares, the Company would own or control more than 5% of the voting shares of such bank. Prior approval of the Federal Reserve Board is also required for the merger or consolidation of the Company and another bank holding company.
The Company is prohibited by the Bank Holding Company Act, except in certain statutorily prescribed instances, from acquiring direct or indirect ownership or control of more than 5% of the outstanding voting shares of any company that is not a bank or bank holding company and from engaging, directly or indirectly, in activities other than those of banking, managing or controlling banks or furnishing services to its subsidiaries. However, the Company may, subject to the prior approval of the Federal Reserve Board, engage in any, or acquire shares of companies engaged in, activities that are deemed by the Federal Reserve Board to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. See discussion under "Financial Modernization Act" below for additional information.
The Federal Reserve Board may require that the Company terminate an activity or terminate control of or liquidate or divest subsidiaries or affiliates when the Federal Reserve Board determines that the activity or the control or the subsidiary or affiliates constitutes a significant risk to the financial safety, soundness or stability of any of its banking subsidiaries. The Federal Reserve Board also has the authority to regulate provisions of certain bank holding company debt, including authority to impose interest ceilings and reserve requirements on such debt. Under certain circumstances, the Company must file written notice and obtain approval from the Federal Reserve Board prior to purchasing or redeeming its equity securities.
Under the Federal Reserve Board's regulations, a bank holding company is required to serve as a source of financial and managerial strength to its subsidiary banks and may not conduct its operations in an unsafe and unsound manner. In addition, it is the Federal Reserve Board's policy that in serving as a source of strength to its subsidiary banks, a bank holding company should stand ready to use available resources to provide adequate capital funds to its subsidiary banks during periods of financial stress or adversity and should maintain the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks. A bank holding company's failure to meet its obligations to serve as a source of strength to its subsidiary banks will generally be considered by the Federal Reserve Board to be an unsafe and unsound banking practice or a violation of the Federal Reserve Board's regulations or both.
The Company and the Bank are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit, sale or lease of property or furnishing of services. For example, with certain exceptions, neither the Company nor the Bank may condition an extension of credit to a customer on either (1) a requirement that the customer obtain additional services provided by us or (2) an agreement by the customer to refrain from obtaining other services from a competitor.
The Company is subject to the periodic reporting requirements of the Securities Exchange Act of 1934, as amended, and files reports and proxy statements pursuant to such Act with the Securities and Exchange Commission (the “SEC”).
The Bank
The Bank is chartered under the laws of the State of California and its deposits are insured by the FDIC to the extent provided by law. The Bank is subject to the supervision of, and is regularly examined by, the DFI and the FDIC. For the Bank, such supervision and regulation includes comprehensive reviews of all major aspects of the Bank’s business and condition. Various requirements and restrictions under the laws of the United States and the State of California affect the operations of the Bank. Federal and California statutes relate to many aspects of the Bank’s operations, including reserves against deposits, interest rates payable on deposits, loans, investments, mergers and acquisitions, borrowings, dividends and locations of branch offices. Further, the Bank is required to maintain certain levels of capital.
If, as a result of an examination of a bank, the FDIC or the DFI should determine that the financial condition, capital resources, asset quality, earnings prospects, management, liquidity, or other aspects of a bank’s operations are unsatisfactory or that a bank or its respective management is violating or has violated any law or regulation, various remedies are available to these regulatory agencies. Such remedies include the power to enjoin "unsafe or unsound" practices, to require affirmative action to correct any conditions resulting from any violation or practice, to issue an administrative order that can be judicially enforced, to direct an increase in capital, to restrict growth, to assess civil monetary penalties, to remove officers and directors, and ultimately to terminate deposit insurance, which for a California chartered bank would result in a revocation of the bank’s charter.
Capital Standards
The Federal Reserve Board and the FDIC have adopted risk-based minimum capital guidelines intended to provide a measure of capital that reflects the degree of risk associated with a banking organization's operations for both transactions reported on the balance sheet as assets and transactions, such as letters of credit and recourse arrangements, which are recorded as off balance sheet items. Under these guidelines, nominal dollar amounts of assets and credit equivalent amounts of off balance sheet items are multiplied by one of several risk adjustment percentages, which range from 0% for assets with low credit risk, such as certain U.S. Treasury securities, to 100% for assets with relatively high credit risk, such as business loans.
A banking organization's risk-based capital ratios are obtained by dividing its qualifying capital by its total risk adjusted assets. The regulators measure risk-adjusted assets, which include off balance sheet items, against both total qualifying capital (the sum of Tier I capital and limited amounts of Tier II capital) and Tier I capital. Tier I capital consists primarily of common stock, retained earnings, non-cumulative perpetual preferred stock (cumulative perpetual preferred stock for bank holding companies) and minority interests in certain subsidiaries, less most intangible assets. Tier II capital may consist of a limited amount of the allowance for possible loan losses, cumulative preferred stock, long term preferred stock, eligible term subordinated debt and certain other instruments with some characteristics of equity. The inclusion of elements of Tier II capital is subject to certain other requirements and limitations of the federal banking agencies. The federal banking agencies require a minimum ratio of qualifying total capital to risk-adjusted assets of 8% and a minimum ratio of Tier I capital to risk-adjusted assets of 4%.
In addition to the risk-based guidelines, federal banking regulators require banking organizations to maintain a minimum amount of Tier I capital to total assets, referred to as the leverage ratio. For a banking organization rated in the highest of the five categories used by regulators to rate banking organizations, the minimum leverage ratio of Tier I capital to total assets is 3%. For all banking organizations not rated in the highest category, the minimum leverage ratio must be at least 4%. In addition to these uniform risk-based capital guidelines and leverage ratios that apply across the industry, the regulators have the discretion to set individual minimum capital requirements for specific institutions at rates significantly above the minimum guidelines and ratios. Future changes in regulations or practices could further reduce the amount of capital recognized for purposes of capital adequacy. Such a change could affect the ability of the Company to grow and could restrict the amount of profits, if any, available for the payment of dividends.
The regulatory capital requirements, as well as the actual capital ratios for the Bank and the Company as of December 31, 2008, are presented in detail in Note 11, Regulatory Matters of the Consolidated Financial Statements. See also “Capital” within Management’s Discussion and Analysis of Financial Condition and Results of Operations of this Form 10-K. As of December 31, 2008, both the Bank and the Company exceeded the minimum capital requirements to be well capitalized.
Under applicable regulatory guidelines, the Company’s trust preferred securities issued by our subsidiary capital trusts qualify as Tier I capital up to a maximum limit of 25% of total Tier I capital. Any additional portion of the trust preferred securities would qualify as Tier II capital. As of December 31, 2008, the subsidiary trusts had $13.4 million in trust preferred securities outstanding, of which $13.0 million qualify as Tier I capital.
In addition, the DFI has authority to take possession of the business and properties of a bank in the event that the tangible shareholders' equity of a Bank is less than the greater of (i) 4% of the banks total assets or (ii) $1,000,000.
Prompt Corrective Action and Other Enforcement Mechanisms
Federal banking agencies possess broad powers to take corrective and other supervisory action to resolve the problems of insured depository institutions, including but not limited to those institutions that fall below one or more prescribed minimum capital ratios described above. An institution that, based upon its capital levels, 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. At each successive lower capital category, an insured depository institution is subject to more restrictions. The federal banking agencies, however, may not treat a significantly undercapitalized institution as critically undercapitalized unless its capital ratio actually warrants such treatment.
In addition to measures taken under the prompt corrective action provisions, commercial banking organizations may be subject to potential enforcement actions by the federal regulators for unsafe or unsound practices in conducting their businesses or for violations of any law, rule, regulation, or any condition imposed in writing by the agency or any written agreement with the agency. Enforcement actions may include:
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the imposition of a conservator or receiver or the issuance of a cease-and-desist order that can be judicially enforced;
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the termination of insurance of deposits (in the case of a depository institution);
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the imposition of civil money penalties;
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the issuance of directives to increase capital;
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the issuance of formal and informal agreements;
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the issuance of removal and prohibition orders against institution-affiliated parties; and
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the enforcement of such actions through injunctions or restraining orders based upon a judicial determination that the agency would be harmed if such equitable relief was not granted.
Additionally, a holding company's inability to serve as a source of strength to its subsidiary banking organizations could serve as an additional basis for a regulatory action against the holding company.
Banks are also subject to certain Federal Reserve Board restrictions on extensions of credit to executive officers, directors, principal shareholders or any related interests of such persons (i.e., insiders). Extensions of credit (1) must be made on substantially the same terms and pursuant to the same credit underwriting procedures as those for comparable transactions with persons who are neither insiders nor employees, and (2) must not involve more than the normal risk of repayment or present other unfavorable features. Banks are also subject to certain lending limits and restrictions on overdrafts to insiders. A violation of these restrictions may result in regulatory sanctions on the bank or its insiders.
Safety and Soundness Standards
The Federal Deposit Insurance Corporation Improvement Act (“FDICIA”) imposes certain specific restrictions on transactions and requires federal banking regulators to adopt overall safety and soundness standards for depository institutions related to internal control, loan underwriting and documentation and asset growth. Among other things, FDICIA limits the interest rates paid on deposits by undercapitalized institutions, restricts the use of brokered deposits, limits the aggregate extensions of credit by a depository institution to an executive officer, director, principal shareholder or related interest, and reduces deposit insurance coverage for deposits offered by undercapitalized institutions for deposits by certain employee benefits accounts. The federal banking agencies may require an institution to submit to an acceptable compliance plan as well as have the flexibility to pursue other more appropriate or effective courses of action given the specific circumstances and severity of an institution's noncompliance with one or more standards.
Premiums for Deposit Insurance
The deposits of the Bank have historically been insured by the FDIC up to $100,000 per insured depositor, except certain types of retirement accounts, which are insured up to $250,000 per insured depositor. On October 3, 2008, the maximum amount insured under FDIC deposit insurance was temporarily increased from $100,000 to $250,000 per insured depositor through December 31, 2009. This increase was part of the Emergency Economic Stabilization Act of 2008. Additionally, the Bank has elected to participate in the FDIC’s Temporary Liquidity Guarantee Program. Under this program, all non-interest bearing deposit transaction accounts at the Bank with balances over $250,000 will also be fully insured through December 31, 2009 at an additional cost to the Bank of 10 basis points per dollar over $250,000 on a per account basis.
The FDIC has set a designated reserve ratio of 1.25% ($1.25 against $100 of insured deposits) for the Deposit Insurance Fund (“DIF”). The Federal Deposit Insurance Reform Act of 2005 (“FDIC Act”) provides the FDIC Board of Directors the authority to set the designated reserve ratio between 1.15% and 1.50%. The FDIC must adopt a restoration plan when the reserve ratio falls below 1.15% and begin paying dividends when the reserve ratio exceeds 1.35%. There is no requirement to achieve a specific ratio within a given time frame. The FDIC Board of Directors has not declared any dividends as of December 31, 2008. The DIF reserve ratio calculated by the FDIC that was in effect at December 31, 2008 was 0.76%.
In 2007, FDIC regulations established a new risk-based assessment system under which deposit insurance assessments are based upon supervisory ratings for all insured institutions, financial ratios for most institutions, and long-term debt issuer ratings for large institutions that have them.
In 2007 and 2008, the annual insurance premiums on bank deposits insured by the DIF varied between $0.05 per $100 of deposits for banks classified in the highest capital and supervisory evaluation categories to $0.43 per $100 of deposits for banks classified in the lowest capital and supervisory evaluation categories. In 2007 and 2008 the Bank was classified in the highest capital and supervisory evaluation category. Under the FDIC Act, the Bank received a one time assessment credit of approximately $126 thousand, discussed more fully below. In 2007, the Bank exhausted this credit.
In 2006, the annual insurance premiums on bank deposits insured by the DIF varied between $0 per $100 of deposits for banks classified in the highest capital and supervisory evaluation categories to $0.27 per $100 of deposits for banks classified in the lowest capital and supervisory evaluation categories. In 2006, the Bank paid no annual insurance premiums because of the one time assessment credit discussed above.
The FDIC Act required the FDIC to establish a one-time historical assessment credit that provides banks a credit that could be used to offset insurance assessments. This one-time historical assessment credit was established to benefit banks that had funded deposit insurance funds prior to December 31, 1996. This one-time historical assessment credit was based upon the Bank’s insured deposits as of December 31, 1996. As stated above, the Bank’s one-time historical assessment credit was $126 thousand when it was established in 2006. During 2007, the Bank fully utilized this credit and only partially offset 2007 assessments. As a result, the Bank’s Federal deposit insurance expense increased in 2008 and will increase further in 2009.
As required by law, in October 2008, the FDIC Board adopted a restoration plan that would increase the reserve ratio to the 1.15% threshold within five years. As part of that plan, in December, 2008, the FDIC Board of Directors voted to increase risk-based assessment rates uniformly by seven cents, on an annual basis, for the first quarter of 2009 due to deteriorating financial conditions in the banking industry.
In addition to risk-based deposit insurance assessments, additional assessments may be imposed by the Financing Corporation, a separate U.S. government agency affiliated with the FDIC, on insured deposits to pay for the interest cost of Financing Corporation bonds. Financing Corporation assessment rates for 2008 ranged from $.0110 to $.0114 per $100 of deposits. Financing Corporation assessments of $68 thousand, $55 thousand and $51 thousand were paid by the Bank for the years ended December 31, 2008, 2007 and 2006, respectively, and are included in other expense.
The FDIC is authorized to terminate a depository institution’s deposit insurance if it finds that the institution is being operated in an unsafe and unsound manner or has violated any rule, regulation, order or condition administered by the institution’s regulatory authorities. Any such termination of deposit insurance would likely have a material adverse effect on the Bank, the severity of which would depend on the amount of deposits affected by such a termination.
Under federal law, deposits and certain claims for administrative expenses and employee compensation against an insured depository institution are afforded a priority over other general unsecured claims against such an institution, including federal funds and letters of credit, in the liquidation or other resolution of such an institution by any receiver appointed by regulatory authorities. Such priority creditors would include the FDIC.
Sarbanes-Oxley Act of 2002
On July 30, 2002, the Sarbanes-Oxley Act of 2002 (“SOX”), was signed into law to address corporate and accounting fraud. SOX establishes a new accounting oversight board that will enforce auditing standards and restricts the scope of services that accounting firms may provide to their public company audit clients. Among other things, SOX also (i) requires chief executive officers and chief financial officers to certify to the accuracy of periodic reports filed with the SEC; (ii) imposes new disclosure requirements regarding internal controls, off-balance-sheet transactions, and pro forma (non-GAAP) disclosures; (iii) accelerates the time frame for reporting of insider transactions and periodic disclosures by public companies; and (iv) requires companies to disclose whether or not they have adopted a code of ethics for senior financial officers and whether the audit committee includes at least one “audit committee financial expert.”
Under SOX, the SEC is required to regularly and systematically review corporate filings, based on certain enumerated factors. To deter wrongdoing, SOX: (i) subjects bonuses issued to top executives to disgorgement if a restatement of a company’s financial statements was due to corporate misconduct; (ii) prohibits an officer or director from misleading or coercing an auditor; (iii) prohibits insider trades during pension fund “blackout periods;” (iv) imposes new criminal penalties for fraud and other wrongful acts; and (v) extends the period during which certain securities fraud lawsuits can be brought against a company or its officers.
As a public reporting company, the Company is subject to the requirements of SOX and related rules and regulations issued by the SEC and NASDAQ. The Company has incurred additional expense as a result of the Act, although not material, and does not expect that such compliance will have a material impact on our business in future periods.
Financial Services Modernization Legislation
On November 12, 1999, the Gramm-Leach-Bliley Act of 1999 (the "Financial Services Modernization Act") was signed into law. The Financial Services Modernization Act is intended to modernize the banking industry by removing barriers to affiliation among banks, insurance companies, the securities industry and other financial service providers. It provides financial organizations with the flexibility of structuring such affiliations through a holding company structure or through a financial subsidiary of a bank, subject to certain limitations. The Financial Services Modernization Act establishes a new type of bank holding company, known as a financial holding company, which may engage in an expanded list of activities that are "financial in nature," which include securities and insurance brokerage, securities underwriting, insurance underwriting and merchant banking. The Company has not sought “financial holding company” status and has no present plans to do so.
The Financial Services Modernization Act also sets forth a system of functional regulation that makes the Federal Reserve Board the "umbrella supervisor" for holding companies, while providing for the supervision of the holding company's subsidiaries by other federal and state agencies.
In addition, the Bank is subject to other provisions of the Financial Services Modernization Act, including those relating to CRA, privacy and safe-guarding confidential customer information, regardless of whether the Company elects to become a financial holding company or to conduct activities through a financial subsidiary of the Bank. The Company does not, however, currently intend to file notice with the Federal Reserve Board to become a financial holding company or to engage in expanded financial activities through a financial subsidiary of the Bank.
The Company and the Bank do not believe that the Financial Services Modernization Act will have a material adverse effect on its operations in the near-term. However, to the extent that it permits banks, securities firms, and insurance companies to affiliate, the financial services industry may experience further consolidation. The Financial Services Modernization Act is intended to grant to community banks certain powers as a matter of right that larger institutions have accumulated on an ad hoc basis. Nevertheless, this act may have the result of increasing the amount of competition that the Company faces from larger institutions and other types of companies offering financial products, many of which may have substantially more financial resources than the Company.
USA Patriot Act of 2001
On October 26, 2001, The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism, or the Patriot Act, of 2001 was signed into law. Among other things, the Patriot Act (i) prohibits banks from providing correspondent accounts directly to foreign shell banks; (ii) imposes due diligence requirements on banks opening or holding accounts for foreign financial institutions or wealthy foreign individuals; (iii) requires financial institutions to establish an anti-money-laundering compliance program; and (iv) eliminates civil liability for persons who file suspicious activity reports. The Patriot Act also increases governmental powers to investigate terrorism, including expanded government access to account records and to make rules to implement the Patriot Act. On March 9, 2006, the USA Patriot Improvement and Reauthorization Act was signed into law, which extended and modified the original act. While we believe the Patriot Act, as amended and reauthorized, may, to some degree, affect our operations, we do not believe that it will have a material adverse effect on our business and operations.
Transactions between Affiliates
Transactions between a bank and its "affiliates" are quantitatively and qualitatively restricted under the Federal Reserve Act. The Federal Reserve Board issued Regulation W on October 31, 2002, which comprehensively implements Sections 23A and 23B of the Federal Reserve Act. Sections 23A and 23B and Regulation W restrict loans by a depository institution to its affiliates, asset purchases by a depository institution from its affiliates, and other transactions between a depository institution and its affiliates. Regulation W unifies in one public document the Federal Reserve Board’s interpretations of Section 23A and 23B. Regulation W had an effective date of April 1, 2003.
Community Reinvestment Act
The Bank is subject to certain fair lending requirements and reporting obligations involving home mortgage lending operations and Community Reinvestment Act ("CRA") activities. The CRA generally requires the federal banking agencies to evaluate the record of a financial institution in meeting the credit needs of their local communities, including low and moderate income neighborhoods. In addition to substantial penalties and corrective measures that may be required for a violation of certain fair lending laws, the federal banking agencies may take compliance with such laws and CRA into account when regulating and supervising other activities. When a bank holding company applies for approval to acquire a bank or another bank holding company, the Federal Reserve Board will review the assessment of each subsidiary bank of the applicant bank holding company, and such records may be the basis for denying the application. A bank's compliance with its CRA obligations is based on a performance-based evaluation system which bases CRA ratings on an institution's lending service and investment performance, resulting in a rating by the appropriate bank regulatory agency of "outstanding,” "satisfactory,” "needs to improve" or "substantial noncompliance.” In its last examination by the FDIC, the Bank received a CRA rating of "Satisfactory."
Privacy
Federal banking rules limit the ability of banks and other financial institutions to disclose non-public information about consumers to nonaffiliated third parties. Pursuant to these rules, financial institutions must provide:
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initial notices to customers about their privacy policies, describing the conditions under which they may disclose non-public information to nonaffiliated third parties and affiliates;
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annual notices of their privacy policies to current customers; and
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a reasonable method for customers to “opt out” of disclosures to nonaffiliated third parties.
These privacy provisions affect how consumer information is transmitted through diversified financial companies and conveyed to outside vendors. We have implemented our privacy policies in accordance with the law. In recent years, a number of states have implemented their own versions of privacy laws. For example, in 2003, California adopted standards that are more restrictive than federal law, allowing bank customers the opportunity to bar financial companies from sharing information with their affiliates.
Predatory Lending
The term "predatory lending," much like the terms "safety and soundness" and "unfair and deceptive practices," is far-reaching and covers a potentially broad range of behavior. As such, it does not lend itself to a concise or a comprehensive definition. But typically predatory lending involves at least one, and perhaps all three, of the following elements:
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making unaffordable loans based on the assets of the borrower rather than on the borrower's ability to repay an obligation, or asset-based lending;
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inducing a borrower to refinance a loan repeatedly in order to charge high points and fees each time the loan is refinanced, or loan flipping; and
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engaging in fraud or deception to conceal the true nature of the loan obligation from an unsuspecting or unsophisticated borrower.
Federal Reserve Board regulations aimed at curbing such lending significantly widened the pool of high-cost home-secured loans covered by the Home Ownership and Equity Protection Act of 1994, a federal law that requires extra disclosures and consumer protections to borrowers. The following triggers coverage under the Home Ownership and Equity Protection Act of 1994:
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interest rates for first lien mortgage loans in excess of 8 percentage points above comparable Treasury securities;
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subordinate-lien loans of 10 percentage points above Treasury securities; and
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fees such as optional insurance and similar debt protection costs paid in connection with the credit transaction, when combined with points and fees if deemed excessive.
In addition, the regulation bars loan flipping by the same lender or loan servicer within a year. Lenders also will be presumed to have violated the law-which says loans shouldn't be made to people unable to repay them-unless they document that the borrower has the ability to repay. Lenders that violate the rules face cancellation of loans and penalties equal to the finance charges paid. The Company does not expect these rules and potential state action in this area to have a material impact on our financial condition or results of operations.
Bank Secrecy Act and Money Laundering Control Act
In 1970, Congress passed the Currency and Foreign Transactions Reporting Act, otherwise known as the Bank Secrecy Act (the “BSA”), which established requirements for recordkeeping and reporting by banks and other financial institutions. The BSA was designed to help identify the source, volume and movement of currency and other monetary instruments into and out of the United States in order to help detect and prevent money laundering connected with drug trafficking, terrorism and other criminal activities. The primary tool used to implement BSA requirements is the filing of Suspicious Activity Reports. Today, the BSA requires that all banking institutions develop and provide for the continued administration of a program reasonably designed to assure and monitor compliance with certain recordkeeping and reporting requirements regarding both domestic and international currency transactions. These programs must, at a minimum, provide for a system of internal controls to assure ongoing compliance, provide for independent testing of such systems and compliance, designate individuals responsible for such compliance and provide appropriate personnel training.
Where You Can Find More Information
Under the Securities Exchange Act of 1934 Sections 13 and 15(d), periodic and current reports must be filed with the SEC. The Company electronically files the following reports with the SEC: Form 10-K (Annual Report), Form 10-Q (Quarterly Report), Form 8-K (Current Report), insider ownership reports and Form DEF 14A (Proxy Statement). The Company may file additional forms. The SEC maintains an Internet site, www.sec.gov, in which all forms filed electronically may be accessed. Additionally, all forms filed with 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. None of the information on or hyperlinked from the Company’s website is incorporated into this Annual Report on Form 10-K.
The Company also posts its Committee Charters, Code of Ethics, Code of Conduct and Corporate Governance Guidelines on the Company website.
Item 1A.
Item 1A. Risk Factors
An investment in our common stock is subject to risks inherent to our business. The material risks and uncertainties that Management believes may affect our business are described below. Before making an investment decision, you should carefully consider the risks and uncertainties described below together with all of the other information included or incorporated by reference in this Annual Report. The risks and uncertainties described below are not the only ones facing our business. Additional risks and uncertainties that Management is not aware of or focused on or that Management currently deems immaterial may also impair our business operations. This Annual Report is qualified in its entirety by these risk factors.
If any of the following risks actually occur, our financial condition and results of operations could be materially and adversely affected. If this were to happen, the value of our common stock could decline significantly, and you could lose all or part of your investment.
Risks Associated With Our Business
We Are Highly Dependent On Real Estate and a Downturn in the Real Estate Market May Hurt Our Business
A significant portion of our loan portfolio is dependent on real estate. At December 31, 2008, real estate served as the principal source of collateral with respect to approximately 73.5% of our loan portfolio. A decline in current economic conditions, a decline in the local housing market, both of which we are experiencing currently, 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 and the value of real estate owned by us, as well as our financial condition and results of operations in general and the market value of our common stock. Acts of nature, including earthquakes, floods and fires, which may cause uninsured damage and other loss of value to real estate that secures these loans, may also negatively impact our financial condition.
We Also Have a Concentration in Higher Risk Commercial Real Estate Loans
We also have a high concentration in commercial real estate (“CRE”) loans. CRE loans as defined by final guidance issued by Bank regulators are defined as construction, land development, other land loans, loans secured by multifamily (5 or more) residential properties, and loans secured by non-farm nonresidential properties. Following this definition, approximately 64.5% of our lending portfolio can be classified as CRE lending. CRE loans generally involve a higher degree of credit risk than residential mortgage lending due, among other things, to the large amounts loaned to individual borrowers. Losses incurred on loans to a small number of borrowers could have a material adverse impact on our income and financial condition. In addition, unlike residential mortgage loans, commercial real estate loans generally depend on the cash flow from the property to service the debt. Cash flow may be significantly affected by general economic conditions.
Additionally, federal banking regulators recently issued final guidance regarding commercial real estate lending. This guidance suggests that institutions that are potentially exposed to significant commercial real estate concentration risk will be subject to increased regulatory scrutiny. Institutions that have experienced rapid growth in commercial real estate lending, have notable exposure to a specific type of commercial real estate lending, or are approaching or exceed certain supervisory criteria that measure an institution’s commercial real estate portfolio against its capital levels, may be subject to such increased regulatory scrutiny. Our commercial real estate portfolio may be viewed as falling within one or more of the foregoing categories, and accordingly we may become subject to increased regulatory scrutiny because of our commercial real estate portfolio. If it is determined by our regulator that we have an undue concentration in commercial real estate lending, we may be required to maintain increased levels of capital and/or be required to reduce our concentration in commercial real estate loans. At the most recent regulatory examination in October 2008, there was no recommendation in regard to these issues.
Recession and Changes in Domestic and Foreign Financial Markets May Have a Material Negative Impact on Our Results of Operations and Financial Condition
Economic indices have shown that since the fourth quarter of 2007, the United States economy has been in a recession. This has been reflected in significant business failures and job losses, including the potential bankruptcies of three U.S. automobile manufacturing companies and by job losses in excess of 500,000 in each of November and December 2008. Job losses at this level are expected to continue during the first calendar quarter of 2009.
In addition, in the past year, the domestic and foreign financial markets, securities trading markets and economies generally have experienced significant turmoil including, without limitation, government takeovers of troubled institutions, government brokered mergers of such firms to avoid bankruptcy or failures, bankruptcies of securities trading firms and insurance companies, failures of financial institutions and securities brokerage firms, declines in real property values, and wide fluctuations in energy prices, all of which have contributed to reduced availability of credit for businesses and consumers, elevated foreclosures on residential and commercial properties, falling home prices, reduced liquidity and a lack of stability across the entire financial sector. These recent events and the corresponding uncertainty and decline in financial markets are likely to continue for the foreseeable future. The full extent of the repercussions to our nation’s economy in general and our business in particular therefrom are not fully known at this time. Such events may have a negative effect on (i) our ability to service our existing customers and attract new customers, (ii) the ability of our borrowers to operate their business as successfully as in the past, (iii) the financial security and net worth of our customers, and (iv) the ability of our customers to repay their loans with us in accordance with the terms thereof.
We do not believe these difficult conditions are likely to improve in the near future. A worsening of these conditions would likely exacerbate the adverse effects of these difficult market and economic conditions on us, our customers and the other financial institutions in our market.
Recently Enacted Legislation and Other Measures Undertaken by the U.S. Treasury, the FRB and Other Governmental Agencies May Not Help Stabilize the U.S. Financial System or Improve the Housing Market
On October 3, 2008, President Bush signed into law the Emergency Economic Stabilization Act of 2008 (the “EESA”), which, among other measures, authorized the Treasury Secretary to establish the Troubled Asset Relief Program (“TARP”). EESA gives broad authority to Treasury to purchase, manage, modify, sell and insure the troubled mortgage related assets that triggered the current economic crisis as well as other “troubled assets.” EESA includes additional provisions directed at bolstering the economy, including:
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Authority for the FRB to pay interest on depository institution balances;
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Mortgage loss mitigation and homeowner protection;
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Temporary increase in FDIC insurance coverage from $100,000 to $250,000 through December 31, 2009; and
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Authority to the SEC to suspend mark-to-market accounting requirements for any issuer or class of category of transactions.
Pursuant to the TARP, the Treasury has the authority to, among other things, purchase up to $700 billion of mortgages, mortgage-backed securities and certain other financial instruments from financial institutions for the purpose of stabilizing and providing liquidity to the U.S. financial markets. Under the TARP, the Treasury has created a capital purchase program, pursuant to which it is providing access to capital to financial institutions through a standardized program to acquire preferred stock (accompanied by warrants) from eligible financial institutions that will serve as Tier 1 capital.
EESA also contains a number of significant employee benefit and executive compensation provisions, some of which apply to employee benefit plans generally, and others which impose on financial institutions that participate in the TARP program restrictions on executive compensation.
EESA followed, and has been followed by, numerous actions by the FRB, Congress, Treasury, the SEC and others to address the liquidity and credit crisis that has followed the sub-prime meltdown that commenced in 2007. These measures include homeowner relief that encourage loan restructuring and modification; the establishment of significant liquidity and credit facilities for financial institutions and investment banks; the lowering of the federal funds rate; emergency action against short selling practices; a temporary guaranty program for money market funds; the establishment of a commercial paper funding facility to provide back-stop liquidity to commercial paper issuers; coordinated international efforts to address illiquidity and other weaknesses in the banking sector.
On October 14, 2008, the FDIC announced the establishment of a temporary liquidity guarantee program to provide insurance for all non-interest bearing transaction accounts and guarantees of certain newly issued senior unsecured debt issued by financial institutions (such as the Bank) and bank holding companies (such as the Company). Under the program, newly issued senior unsecured debt issued on or before June 30, 2009 will be insured in the event the issuing institution subsequently fails, or its holding company files for bankruptcy. The debt includes all newly issued unsecured senior debt (e.g., promissory notes, commercial paper and inter-bank funding). The aggregate coverage for an institution may not exceed 125% of its debt outstanding on December 31, 2008 that was scheduled to mature before June 30, 2009. The guarantee will extend to June 30, 2012 even if the maturity of the debt is after that date.
On February 17, 2009, President Obama signed into law The American Recovery and Reinvestment Act of 2009 (the “Stimulus Bill”), more commonly known as the economic stimulus or economic recovery package. The Stimulus Bill includes a wide variety of programs intended to stimulate the economy and provide for extensive infrastructure, energy, health and education needs. In addition, the Stimulus Bill imposes certain new executive compensation and corporate expenditure limits on all current and future TARP recipients that are in addition to those previously announced by the U.S. Treasury.
The actual impact that EESA, the Stimulus Bill and such related measures undertaken to alleviate the credit crisis will have generally on the financial markets, including the extreme levels of volatility and limited credit availability currently being experienced, is unknown. The failure of such measures to help stabilize the financial markets and a continuation or worsening of current financial market conditions could materially and adversely affect our business, financial condition, results of operations, access to credit or the trading price of our common stock.
Current Levels of Market Volatility are Unprecedented
The capital and credit markets have been experiencing volatility and disruption for more than a year. In recent months, the volatility and disruption has reached unprecedented levels. In some cases, the markets have produced significant downward pressure on stock prices and credit availability for certain issuers without regard to those issuers’ underlying financial strength. If current levels of market disruption and volatility continue or worsen, there can be no assurance that we will not experience an adverse effect, which may be material, on our ability to access capital and on our business, financial condition and results of operations.
FDIC Deposit Insurance Assessments Will Increase Substantially, Which Will Adversely Affect Our Net Earnings
FDIC deposit insurance expense for the year ended December 31, 2008 was approximately $388 thousand. Deposit insurance assessments will increase in 2009 due to recent strains on the FDIC deposit insurance fund resulting from the cost of recent bank failures and an increase in the number of banks likely to fail over the next few years. On December 16, 2008, the FDIC issued a final rule increasing that assessment range for the first quarter of 2009. The FDIC has announced that it intends to issue a final rule in early 2009, to be effective on April 1, 2009, to set new assessment rates beginning with the second quarter of 2009 and to make other changes to its assessment rule. It has also stated that it may need to set a higher base rate schedule at the time of the issuance of its final assessment rate rule, depending upon the information available at that time including, without limitation, on its updated bank failure and loss projections.
Our Real Estate Lending Also Exposes Us to the Risk of Environmental Liabilities
In the course of our business, we may foreclose and take title to real estate, and could be subject to environmental liabilities with respect to these properties. We may be held liable to a governmental entity or to third persons for property damage, personal injury, investigation and clean-up costs incurred by these parties in connection with environmental contamination, or may be required to investigate or clean up hazardous or toxic substances, or chemical releases at a property. The costs associated with investigation or remediation activities could be substantial. In addition, as the owner or former owner of a contaminated site, we may be subject to common law claims by third parties based on damages and costs resulting from environmental contamination emanating from the property. If we ever become subject to significant environmental liabilities, our business, financial condition, liquidity and results of operations could be materially and adversely affected.
Our Business Is Subject To Interest Rate Risk and Changes in Interest Rates May Adversely Affect Our Performance and Financial Condition
Our earnings are impacted by changing interest rates. Changes in interest rates impact the demand for new loans, the credit profile of our borrowers, the rates received on loans and securities and rates paid on deposits and borrowings. The difference between the rates received on loans and securities and the rates paid on deposits and borrowings is known as interest rate spread. Given our current volume and mix of interest-bearing liabilities and interest-earning assets, we would expect our interest rate spread to increase if interest rates rise and, conversely, to decline if interest rates fall. Increasing levels of competition in the banking and financial services business may decrease our net interest margin by forcing us to offer lower lending interest rates and pay higher deposit interest rates. Although we believe our current level of interest rate sensitivity is reasonable, significant fluctuations in interest rates and increasing competition may have an adverse effect on our business, financial condition and results of operations.
A sustained decrease in market interest rates could adversely affect our earnings. When interest rates decline, borrowers tend to refinance higher-rate, fixed-rate loans at lower rates, prepaying their existing loans. Under those circumstances, we would not be able to reinvest those prepayments in assets earning interest rates as high as the rates on the prepaid loans. In addition, our commercial real estate and commercial loans, which carry interest rates that, in general, adjust in accordance with changes in the prime rate, will adjust to lower rates. We are also significantly affected by the level of loan demand available in our market. The inability to make sufficient loans directly affects the interest income we earn. Lower loan demand will generally result in lower interest income realized as we place funds in lower yielding investments.
Failure to Successfully Execute Our Strategy May Adversely Affect Our Performance
Our financial performance and profitability depends on our ability to execute our corporate growth strategy. Continued growth, however, may present operating and other problems that could adversely affect our business, financial condition and results of operations. Accordingly, there can be no assurance that we will be able to execute our growth strategy or maintain the level of profitability that we have recently experienced. Factors that may adversely affect our ability to attain our long-term financial performance goals include those stated elsewhere in this section, as well as:
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Inability to control non-interest expense, including, but not limited to, rising employee, regulatory compliance, and healthcare costs;
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Inability to increase non-interest income; and
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Continuing ability to expand, through de novo branching or finding acquisition targets at valuation levels we find attractive.
Economic Conditions in the Central Coast of California Area May Adversely Affect Our Operations and / or Cause Us to Sustain Losses
Our retail and commercial banking operations are concentrated primarily in San Luis Obispo and Santa Barbara Counties. As a result of this geographic concentration, our results of operations depend largely upon economic conditions in this area. A significant source of risk arises from the possibility that losses will be sustained if a significant number of our borrowers, guarantors and related parties fail to perform in accordance with the terms of their loans. This risk increases when the economy is weak. We have adopted underwriting and credit monitoring procedures and credit policies, including the establishment and review of the allowance for loan losses, that Management believes is appropriate to minimize this risk by assessing the likelihood of nonperformance, tracking loan performance and diversifying our loan portfolio. These policies and procedures, however, may not prevent unexpected losses that may have material adverse affects on our results of operations in general and the market value of our stock.
Our primary market area is an increasingly competitive and overcrowded banking market. Our ability to achieve the growth outlined in our corporate strategic goals may be dependent in part on an ability to grow through the successful addition of new branches or the identification and acquisition of potential targets at acceptable pricing levels either inside or outside of our primary market. If we are unable to attract significant new business through strategic branching, or acquire new business through the acquisition of other banks, our growth in loans and deposits and, therefore, our earnings, may be adversely affected.
We Face Strong Competition from Financial Service Companies and Other Companies That Offer Banking Services, Which May Hurt Our Business
As previously mentioned, the financial services business in our market areas 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 both in attracting quality assets and deposits and in making loans. We compete for loans principally through the interest rates and loan fees we charge and the efficiency and quality of services we provide. 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, or decrease our net interest margin by forcing us to offer lower lending interest rates and pay higher rates on our deposits. Therefore, our results may differ in future periods depending upon the nature or level of competition.
Technology and other changes are allowing parties to complete financial transactions that historically have involved banks through alternative methods. For example, consumers can now maintain funds that 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.
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 in most of our activities can be intense and we may not be able to hire people or to retain them. The unexpected loss of services of one or more of our key personnel could have a material adverse impact on our business because of their skills, knowledge of our market, years of industry experience and the difficulty of promptly finding qualified replacement personnel.
Our Internal Operations Are Subject to a Number of Risks
We are subject to certain operations 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, uninsured or in excess of applicable insurance limits, it could have a significant adverse impact on our business, financial condition or results of operations.
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Information Systems
We rely heavily on communications and information systems to conduct our business. Any failure, interruption or breach in security of these systems could result in failures or disruptions in our customer relationship management, general ledger, deposit, loan and other systems. While we have policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of our information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions or security breaches of our information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations.
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Technological Advances
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 adverse impact on our business and, in turn, our financial condition and results of operations.
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Severe Weather, Natural Disasters, Acts of War or Terrorism and Other External Events
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. For example, the Central Coast of California is subject to earthquakes and fires. 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. While we have not experienced such an occurrence to date, other severe weather or natural disasters, acts of war or terrorism or other adverse external events may occur in the future. Although management has established disaster recovery policies and procedures, the occurrence of any such event could have a material adverse effect on our business, which, in turn, could have a material adverse effect on our financial condition and results of operations.
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We Depend On Cash Dividends From Our Subsidiary 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 other obligations, including any cash dividends. See “Item 5. Market for Common Equity and Related Stockholder Matters.” Various statutory provisions restrict the amount of dividends our subsidiary bank can pay to us without regulatory approval.
Risks Associated With Our Industry
We Are Subject to Government Regulation That May Limit or Restrict Our Activities, Which in Turn May Adversely Impact Our Operations
The financial services industry is regulated extensively. Federal and State regulation is designed primarily to protect the deposit insurance funds and consumers, and not to benefit our shareholders. These regulations can sometimes impose significant limitations on our operations. New laws and regulations or changes in existing laws and regulations or repeal of existing laws and regulations may adversely impact our business. We anticipate that continued compliance with various regulatory provisions will impact future operating expenses. Further, federal monetary policy, particularly as implemented through the Federal Reserve System, significantly affects economic conditions for us.
New Legislative and Regulatory Proposals May Affect Our Operations and Growth
Proposals to change the laws and regulations governing the operations and taxation of, and federal insurance premiums paid by, banks and other financial institutions and companies that control such institutions are frequently raised in the U.S. Congress, state legislatures and before bank regulatory authorities. The likelihood of any major changes in the future and the impact such changes might have on us or our subsidiaries are impossible to determine. Similarly, proposals to change the accounting treatment applicable to banks and other depository institutions are frequently raised by the SEC, the federal banking agencies, the IRS and other appropriate authorities. The likelihood and impact of any additional future changes in law or regulation and the impact such changes might have on us or our subsidiaries are impossible to determine at this time.
Risks Associated With Our Stock
Our Participation in the U.S. Treasury’s Capital Purchase Program (“CPP”) May Pose Certain Risks to Holders of Our Common Stock
As previously disclosed, the Company recently received preliminary approval to participate in the CPP by selling to the U.S. Treasury up to $21.0 million in preferred stock and warrants to purchase approximately $3.2 million of the Company’s common stock. The Company currently anticipates participating in the CPP. Although the Company believes that its anticipated participation in the CPP is in the best interests of our shareholders in that it will enhance Company and Bank capital and provide additional funds for future growth, it may pose certain risks to the holders of our common stock such as the following:
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Under the terms outlined by the U.S. Treasury for participants in the CPP, the Company is required to issue warrants to the U.S Treasury to purchase shares of its common stock. The issuance of these warrants may be significantly dilutive to current common stockholders.
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Warrants issued to the U.S. Treasury are immediately exercisable, thus the U.S. Treasury may at any time become a significant holder of the Company’s common stock and possess significant voting power.
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Although the preferred equity issued to the U.S. Treasury is non-voting, the terms of the CPP stipulate that the U.S. Treasury may vote their senior equity in matters deemed by the U.S. Treasury to have an impact on their holdings.
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Under the terms of the CPP the Company must seek the approval of the U.S. Treasury for any increases in dividends paid to holders of our common stock as well as any repurchases of our common stock.
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Although the Company does not foresee any material changes to the terms associated with its participation in the CPP, the U.S. Government, as a sovereign body, may at any time change the terms of our participation in the CPP and or significantly influence Company policy.
For more information about the Company’s participation in the CPP, see Note. 24 Subsequent Events, of the Consolidated Financial Statements filed on this Form 10-K.
Our Stock Trades Less Frequently Than Others
Although our common stock is listed for trading on the NASDAQ Global Market, the trading volume in our common stock is less than that of other larger financial services companies. A public trading market having the desired characteristics of depth, liquidity and orderliness depends on the presence in the marketplace of willing buyers and sellers of our common stock at any given time. This presence depends on the individual decisions of investors and general economic and market conditions over which we have no control. Given the lower trading volume of our common stock, significant sales of our common stock, or the expectation of these sales, could cause our stock price to fall.
Our Stock Price is affected by a Variety of Factors
Stock price volatility may make it more difficult for you to resell your common stock when you want and at prices you find attractive. Our stock price can fluctuate significantly in response to a variety of factors discussed in this section, including, among other things:
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Actual or anticipated variations in quarterly results of operations;
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Recommendations by securities analysts;
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Operating and stock price performance of other companies that investors deem comparable to our company;
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News reports relating to trends, concerns and other issues in the financial services industry; and
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Perceptions in the marketplace regarding our company and/or its competitors and the industry in which we operate.
Our Common Stock is Not an Insured Deposit
Our common stock is not a bank deposit and, therefore, is not insured against loss by the FDIC, any other deposit insurance fund or by any other public or private entity. Investment in our common stock is inherently risky for the reasons described in this “Risk Factors” section and elsewhere in this report and is subject to the same market forces that affect the price of common stock in any company. As a result, if you acquire our common stock, you may lose some or all of your investment.
Our Articles of Incorporation and By-Laws, As Well As Certain Banking Laws, May Have an Anti-Takeover Effect
Provisions of our articles of incorporation, bylaws and federal banking laws, including regulatory approval requirements, could make it more difficult for a third party to acquire us, even if doing so would be perceived to be beneficial to our shareholders. The combination of these provisions may hinder a non-negotiated merger or other business combination, which, in turn, could adversely affect the market price of our common stock.
Item 1B.
Item 1B. Unresolved Staff Commitments
None.
Item 2.
Item 2. Properties
The Company’s headquarters are located at 545 12th Street in Paso Robles, California. It is an office occupied solely by the Bank. Additionally, the Company occupies a three story administrative facility from where all administrative functions are based. This facility is located at 1222 Vine Street in Paso Robles, California. The Company also occupies fourteen branches within the counties of San Luis Obispo and Santa Barbara. The bank currently owns one of the fourteen branches that it occupies and leases the remaining branches from various parties for an approximate aggregate amount of $184 thousand per month. Additionally, the Company subleases part of three branches to unaffiliated parties. The income associated with these subleases is approximately $13 thousand per month.
In June of 2007, the Company sold four of its properties to First States Group, L.P. (“First States”), an unaffiliated party, in a sale-leaseback transaction for approximately $12.8 million. In connection with the sale, the Bank entered into four separate lease agreements with First States Investors, LLC to lease back three branches and one administrative facility. The three branches are located in Paso Robles, Arroyo Grande and Santa Maria, California. The administrative facility is located in Paso Robles, California. The annual base rents for the Paso Robles, Arroyo Grande, and Santa Maria branches are $204 thousand, $95 thousand, and $155 thousand, respectively. The initial annual base rent for the administrative facility is $466 thousand. Each of the four leases contain an annual rent escalation clause equal to the lower of CPI-U (Consumer Price Index for all Urban Consumers) or 2.5 percent, commencing in the second year of the lease term. Each of the four leases provide for an initial term of 15 years with the option to renew for two 10 year terms. The Company entered into this transaction in order to convert non-earning assets to earning assets.
The Company believes its facilities are adequate for its present needs. The Company believes that the insurance coverage on all properties is adequate. Most of the 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
The Bank is, from time to time, subject to various pending and threatened legal actions which arise out of the normal course of its business. Neither the Company nor the Bank is a party to any pending material legal or administrative proceedings (other than ordinary routine litigation incidental to the Company's or the Bank’s business).
Item 4.
Item 4. Submission of Matters to a Vote of Securities Holders
There were no matters submitted to a vote of the shareholders in the fourth quarter of 2008.
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 Global Market under the symbol “HEOP.” The following table summarizes those trades of the Company’s Common Stock on NASDAQ, setting forth the approximate high and low closing sales prices for each quarterly period ended since January 1, 2007:
Prices listed above have been adjusted to reflect all stock dividend and split activity.
Holders
As of February 2, 2009, there were 2,437 holders of the Company's Common Stock. There are no other classes of equity securities outstanding. However, the Company recently received shareholder approval to authorize a class of preferred stock to, among other things, allow for the Company’s participation in the U.S. Treasury’s CPP.
Dividends
The Company is a legal entity separate and distinct from the Bank. The Company's shareholders are entitled to receive dividends when and as declared by its Board of Directors, out of funds legally available therefore, 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 1-1/4 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 1-1/4 times its current liabilities. Refer to Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations on junior subordinated debenture limitations on dividends.
The ability of the Company to pay a cash dividend and to service the debt on its junior subordinated debentures depends largely on the Bank’s ability to pay a cash dividend to the Company. 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 DFI, make a distribution to its shareholders in an amount not exceeding the greatest of (x) its retained earnings; (y) its net income for its last fiscal year; or (z) its net income for its current fiscal year. In the event that the DFI 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 DFI 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. (See, "Item 1 - Description of Business - Prompt Corrective Action and Other Enforcement Mechanisms"). Additionally, 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. Under these provisions, the amount available for distribution from the Bank to the Company was approximately $15.0 million at December 31, 2008.
On January 9, 2009, the Company received preliminary approval to participate in the U.S. Treasury’s CPP. Under the terms of the program, the Company must obtain approval by the U.S. Treasury for a period of three years following the initial date of the U.S. Treasury’s investment for any proposed increases in the payment of cash dividends on its common stock. For additional information related to the Company’s participation in the CPP, see Note 24. Subsequent Events, of the Consolidated Financial Statements filed on this Form 10-K.
The following table provides a summary of dividends the Company has declared and paid on its common stock during the last two years ending December 31, 2008:
Whether or not dividends will be paid in the future will be determined by the Board of Directors after consideration of various factors. The Company’s profitability and regulatory capital ratios in addition to other financial conditions will be key factors considered by the Board of Directors in making such determinations regarding the payment of dividends by the Company. As part of a capital preservation initiative, during the second quarter of 2008, the Company suspended quarterly cash dividends.
Securities Authorized for Issuance under Equity Compensation Plans
In May 2005, stockholders approved the Company’s 2005 Equity Based Compensation Plan (the “2005 Plan”). The principal purpose of the 2005 Plan is to promote the success of the Company by providing an additional means to attract, motivate, retain and reward key employees and directors of the Company and its subsidiaries with stock options and other equity based incentives for high levels of individual performance and improved financial performance of the Company. The 2005 Plan provides no further grants may be made from the 1997 Stock Option Plan.
The 2005 Plan authorizes the granting of: Incentive Stock Options; Non-Qualified Stock Options; Stock Appreciation Rights; Restricted Stock Awards; Restricted Stock Units; and Performance Share Cash Only Awards. Vesting restrictions on awards may be time based and/or performance based, participation in the 2005 Plan is limited to officers at the level of Vice President or above and other officers who provide substantial services to the Company as well as the Company’s directors.
The following table summarizes information as of December 31, 2008 relating to equity compensation plans of the Company pursuant to which grants of options, restricted stock or other rights to acquire shares may be granted from time to time:
(1) Under the 2005 Equity Based Compensation Plan, the Company is authorized to issue restricted stock awards. Restricted stock awards are not included in the table above. At December 31, 2008 there were 63,761 shares of restricted stock issued and outstanding. See also Note 14. Share Based Compensation Plans, of the Consolidated Financial Statements on this Form 10-K for more information on the Company's equity compensation plans.
(2) Includes securities available for issuance of stock options and restricted stock.
Purchases of Equity Securities
On July 21, 2006, the Board of Directors adopted a resolution authorizing the repurchase of up to 42,000 shares of the Company’s common stock. Purchases were to be made, as conditions warrant, from time to time in the open market or through privately negotiated transactions. The duration of the program was for one year and the timing of purchases was to depend on market conditions. Subsequently, on October 20, 2006, the Board of Directors adopted a resolution to increase the number of shares available for repurchase under the 2006 plan to 105,000. In July 2007, the Board of Directors authorized a one year extension of this plan, which expired in August 2008.
As of December 31, 2008, the Company repurchased and retired 56,175 shares of its common stock under the 2006 stock repurchase plan at a weighted average price of $16.61. The Company made no repurchases of its common stock during 2008. As mentioned above, the Repurchase Plan expired in August 2008.
Item 6.
Item 6. Selected Financial Data
The table below provides selected financial data that highlights the Company’s performance results for the five years ended December 31, 2008, 2007, 2006, 2005 and 2004 and for the three months ended December 31, 2008 and 2007:
(1) For 2008 cash dividends totaling $0.08 per share were paid. For the years 2007 and 2006, cash dividends totaling $0.32 and $0.49 per share were paid. In the first quarter of 2006, the Company paid a special cash dividend of $0.25 per share. No cash dividends were paid in 2005 and 2004.
(2) Actual shares have been adjusted to fully reflect stock dividends and stock splits.
(3) Net interest margin represents net interest income as a percentage of average interest-earning assets.
(4) Efficiency ratio represents non-interest expenses, excluding loan loss provision, as a percentage of the aggregate of net interest income and non-interest income.
(5) Non-performing loans are defined as loans that are past due 90 days or more as well as loans placed in non-accrual status.
(6) Non-performing assets are defined as assets that are past due 90 days or more and assets placed in non-accrual status plus other real estate owned.
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following is an analysis of the financial condition and results of operations of the Company for years ended December 31, 2008, 2007 and 2006. The analysis should be read in connection with the consolidated financial statements and notes thereto appearing elsewhere in this report.
When viewing financial information found on this Form 10-K as of and for the periods ended December 31, 2008, 2007 and 2006, it is important to consider that the Company acquired Business First on October 12, 2007. Therefore, the Company’s financial position and results of operations will not reflect the acquisition for periods prior to that date. 2008 represents the first full calendar year for which balances and operating results for Business First are fully reflected in the Company’s financial statements.
Financial Overview
For the years ended December 31, 2008, 2007 and 2006 the Company earned $1.7 million, $6.9 million and $6.7 million or $0.21, $0.96 and $0.96 per share on a fully diluted basis, respectively. On a year over year basis, net income declined approximately $5.3 million or 76.2%. The primary factor behind the decline can be attributed to substantial provisions the Bank made to the allowance for loan losses during 2008.
The following provides financial highlights as of and for the year ended December 31, 2008:
·
Interest income for the year ended December 31, 2008 was approximately $50.2 million, which represents an increase of approximately $5.0 million or 11.0%. The rise in interest income is mainly attributable to the acquisition of Business First. The Business First acquisition occurred during the fourth quarter of 2007, thus 2008 represents the first year that balances for Business First and corresponding interest income and expense are reflected for a full calendar year. For the year ended December 31, 2008, the Business First acquisition accounted for approximately $12.1 million in interest income.
·
Interest expense for the year ended December 31, 2008 was approximately $12.6 million, which represents a decline of approximately $2.2 million or 14.8%. The primary reason behind the year over year decline in interest expense can be attributed to the dramatic declines in the overnight Fed Funds rate made by the FOMC during 2008. For the year ended December 31, 2008, Business First accounted for approximately $1.8 million of interest expense.
·
Net interest income for the year ended December 31, 2008 was approximately $37.6 million. When compared to the same period ended a year earlier, this represents an increase of approximately $7.2 million or 23.5%. The year over year rise in net interest income can be attributed to the acquisition of Business First, the abundant availability of inexpensive alternative funding sources and the re-pricing of our deposits in conjunction with the moves made by the FOMC to lower the overnight Fed Funds rate. Given that a relatively large portion of the Bank’s deposits possess a floating interest rate, Management was able to re-price the Bank’s interest bearing liabilities more rapidly, mitigating substantial declines in the net interest margin during 2008. For the year ended December 31, 2008, the net interest margin was 5.21%, representing a decline of 26 basis points when compared to the 5.47% reported for the year ended December 31, 2007.
·
For the year ended December 31, 2008, non-interest income totaled approximately $6.2 million or $0.9 million higher than the $5.3 million reported for the same period ended a year earlier. The majority of the year over year increase can be attributed to higher service charges on deposit accounts obtained in the acquisition of Business First. Additionally, during the second quarter of 2008, the Bank recognized income in the approximate amount of $0.3 million related to the initial public offering of Visa, Inc.
·
Non-interest expenses for the year ended December 31, 2008 were approximately $29.4 million or $5.5 million higher than the $23.9 million reported for the same period ended a year earlier.
The following provides a summary of significant changes contributing to the year over year increase in non-interest expenses:
·
Increases in salaries and employee benefits accounted for approximately 37.3% or $2.1 million of the year over year increase. Additional staff from the Business First acquisition as well as branch expansion within 2008 contributed significantly to higher salaries and employee benefits.
·
Also contributing to the year over year increase in non-interest expenses was an approximate $0.4 million increase in data processing costs related to increased transaction volume stemming from the Business First acquisition.
·
Higher regulatory fees also contributed to the year over year increase. During 2008, the Company incurred regulatory fees that were approximately $0.3 million higher that that reported for the same period ended a year earlier, resulting from the absence of a one-time credit the Company recognized during 2007 for past contributions it made to the FDIC insurance fund.
·
Expenses related to the amortization of the Bank’s core deposit intangible (“CDI”) were approximately $0.5 million higher in 2008 when compared to 2007.
·
Occupancy expenses for 2008 were approximately $0.8 million higher than that reported for the same period ended a year earlier. Additional rental costs stemming from the Business First acquisition, branch expansion, and the impact of the sale leaseback transaction the Bank entered into during the second quarter of 2007 all contributed to the year over year increase within this category.
As the Company moves into 2009, Management has implemented various cost containment measures and continues to explore other areas where additional efficiencies may be gained. See also, “Non-Interest Expenses” under Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations on this Form 10-K for a more detailed analysis of the Company’s non-interest expenses.
·
As a result of the items mentioned in the preceding discussion the Company’s operating efficiency ratio for the year ended December 31, 2008 was 67.27%. For the years ended December 31, 2007 and 2006 the operating efficiency ratio was 66.83% and 65.47%, respectively.
·
Return on equity (“ROE”) for the year ended December 31, 2008 was 2.29%. ROE declined substantially from that reported for 2007 as a result of the substantial provisions the Bank made to the allowance for loan losses during 2008. For the years ended December 2007 and 2006 the Company reported returns on equity of 12.37% and 14.10%, respectively.
·
Return on average assets (“ROAA”) for the year ended December 31, 2008 was 0.21%. A lower ROAA from that reported for 2007 is attributable in large part to the substantial increases in loan loss provisions previously mentioned. For the years ended December 31, 2007 and 2006 the Company reported returns on average assets of 1.14% and 1.32%, respectively.
·
At December 31, 2008 net loan balances were $668.0 million or approximately $62.7 million higher than that reported at December 31, 2007. See also, “Loans” under Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations on this Form 10-K for a more detailed discussion on the Company’s loan portfolio.
·
Total deposit balances at December 31, 2008 were approximately $41.3 million lower than the $644.8 million reported at December 31, 2007. The dramatic decline in the over night Federal Funds rate during 2008 and Management’s response in lowering offering rates in an effort to mitigate declines in the net interest margin, contributed greatly to the year over year decline. Declines in deposit balances were most evident within promotional deposit products and money market balances. See also, “Deposits and Borrowed Funds” under Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations on this Form 10-K for a more detailed discussion regarding deposit balances.
·
Federal Home Loan Bank (“FHLB”) borrowings were $109.0 million at December 31, 2008. This represents an increase of approximately $101.0 million when compared to the $8.0 million reported at December 31, 2007. The substantial increase in FHLB borrowing can be attributed to the large decline in deposit balances during 2008 as a result of Management’s effort to maintain an appropriate cost of funds in a declining rates environment.
·
At December 31, 2008, the allowance for loan losses was $10.4 million. As a percentage of total gross and non-performing loan balances, the allowance for loan losses was 1.53% and 55.75%, respectively. For the year ended December 31, 2008, provision for loan losses was approximately $12.2 million. When compared to the same period ended a year earlier, this represents increases of approximately $11.5 million. The increased provision for loan losses can be attributed in part to weakened economic conditions, increases in the trend of delinquent loans, as well as loans the Bank charged-off during 2008.
At December 31, 2008, the balance of loans placed on non-accrual status was approximately $18.3 million. This represents an increase of approximately $18.0 million from the $0.3 million reported at December 31, 2007. During 2008, the Bank charged-off approximately $8.1 million in loans and recovered approximately $0.1 million in loan balances previously charged-off. At December 31, 2008 the balance of Other Real Estate Owned (“OREO”) was $1.3 million. During the fourth quarter of 2008, the Bank moved approximately $1.1 million in non-performing loan balances to Other Real Estate Owned status. See also “Non Performing Assets” under Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations on this Form 10-K for additional information related to non-performing assets.
Recent Developments
During the third and fourth quarters of 2008, the credit and equity markets came under significant duress as confidence by many in the U.S. financial system began to wane. During the later part of 2007 and throughout 2008, U.S. financial institutions were forced to significantly write-down the values of certain classes of assets in response to the weakened real estate market. This lead to great strains on the capital levels of many financial institutions, which in turn lead to a lack of confidence by many and others providing funding to the nation’s banks, leading to a crisis of liquidity. With liquidity levels of many financial institutions significantly weakened, borrowing costs began to rise considerably and the flow of credit to consumers and between banks all but came to a halt. In response to this, the weakened economy and other factors, the U.S. Congress passes the Emergency Economic Stabilization Act of 2008 (the “EESA”). Under the EESA, the Department of the U.S. Treasury formed the Troubled Asset Relief Program (the “TARP”). The TARP gives the U.S. Treasury the power to make purchases of certain troubled assets as well as the direct purchase of equity from U.S. financial institutions under the CPP. Although the Company’s liquidity levels remain adequate and the Bank and Company remain well capitalized, the Company applied to participate in the CPP to keep all capital raising options available. Recently, the Company received preliminary approval on January 9, 2009 to sell $21.0 million in preferred equity to the U.S. Treasury. On February 27, 2009, the Company received shareholder approval to add an authorized class of preferred stock to the Company’s Articles of Incorporation that will allow the Company to participate in the CPP and also allow for more flexibility in capital raising efforts in general. For a more detailed discussion regarding the Company’s participation in the CPP, see Note. 24. Subsequent Events, of the Consolidated Financial Statements filed on this Form 10-K.
On October 12, 2007 the Company acquired Business First National Bank (“Business First”). Business First was merged with and into Heritage Oaks Bank, a wholly owned subsidiary of the Company. The consideration paid for Business First was approximately $19.5 million, consisting of approximately 75% common stock and 25% cash. Business First shareholders received 0.5758 shares of Heritage Oaks Bancorp common stock for each share of Business First they owned and $3.44 per share in cash. For more information related to the acquisition of Business First, see Note 23. Business Combinations, of the Consolidated Financial Statements filed on this Form 10-K.
In April 2007, the Company redeemed all the Floating Rate Junior Subordinated Debt Securities it held associated with Heritage Oaks Capital Trust I. The redemption price was 100% of the principal amount redeemed, or $8.2 million, plus $0.4 million for the standard interest payment due on April 22, 2007. As a result of the redemption of these securities, the trust was dissolved on June 1, 2007. Subsequently, the Company, in September 2007, issued $5.2 million in Junior Subordinated Debt Securities to Heritage Oaks Capital Trust III. Interest on these securities is payable quarterly at a fixed rate of 6.89%. The Company used the proceeds from the sale of the securities to assist in the acquisition of Business First, for general corporate purposes, and for capital contributions to the Bank for future growth. For a more detailed discussion regarding these securities, see Note 8. Borrowings, of the Consolidated Financial Statements filed on this Form 10-K.
In June 2007, the Company completed the sale of four of the Bank’s properties to First States Group, L.P. (“First States”), an unaffiliated party, for $12.8 million. In connection with the sale, the Bank entered into four separate lease agreements with First States Investors, LLC to lease back three branches and one administrative facility under which the Bank will continue to utilize for the normal course of business. Each of the four leases provide for an initial term of 15 years with the option to renew for two 10 year terms. In connection with the sale of the properties mentioned, the Bank will recognize a gain of approximately $3.4 million. This gain will be recognized over a fifteen year period in accordance with SFAS No. 13 “Accounting for Leases.” In addition to deferring the gain on sale, the Bank has recorded an income tax liability and a deferred tax asset in the approximate amounts of $1.4 million, directly related to the deferred gain on sale. For the year ended December 31, 2007, the Company recognized a gain of approximately $0.1 million related to the sale-leaseback transaction, which was recorded as an offset to rental expense. The Company entered into this transaction in order to convert non-earning assets to earning assets. See also Item 2. Properties, of this Form 10-K for additional information related to this transaction.
Results of Operations
The Company reported net income of $1.7 million for the year ended December 31, 2008 compared to $6.9 million and $6.7 million for the years 2007 and 2006, respectively. Basic earnings per share were $0.22, $0.99 and $1.00 at December 31, 2008, 2007 and 2006, respectively. Diluted earnings per share were $0.21, $0.96 and $0.96 at December 31, 2008, 2007 and 2006, respectively. Earnings were negatively impacted on a year over year basis due in large part to the substantial increase in provisions the Bank made to the allowance for loan losses. Additionally, the dramatic decline in interest rates during 2008 contributed to a lower net interest margin, placing additional pressure on earnings. For the year ended December 31, 2008, the Company’s net interest margin was 5.21%, compared to the 5.47% and 5.94% reported for the years ended December 31, 2007 and 2006, respectively.
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 paid on deposits and borrowings, and the interest earned on loans and investments. The net interest margin 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 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 sets forth average balance sheet information, interest income and expense, average yields and rates and net interest income and margin for the years ended December 31, 2008, 2007 and 2006. The average balance of non-accruing loans has been included in loan totals:
(1)
Non-accruing loans have been included in total loans.
(2)
Loan fees of $1,297; $1,227; and $1,275 for the years ending December 31, 2008; 2007; and 2006 respectively have been included in interest income computation.
(3)
Net interest margin has been calculated by dividing the net interest income by total average earning assets.
The table below sets forth changes from 2007 to 2008 for average interest-earning assets and their respective average yields:
(1)
Non-accruing loans have been included in loan totals.
(2)
Loan fees of $1,297 and $1,227 have been included in the interest income computation for the years ended December 31, 2008 and 2007, respectively.
Net interest income for the year ended December 31, 2008 was approximately $37.6 million or $7.2 million and 23.5% higher than the $30.4 million reported for the year ended December 31, 2007. Average earning assets at December 31, 2008 were approximately $722.1 million or $166.2 million and 29.9% higher than that reported a year earlier. Of the year over year increase in average earning assets approximately $136.5 million can be attributed to the acquisition of Business First. The Business First acquisition occurred during the fourth quarter of 2007, thus 2008 represents the first year that average balances for Business First are reflected for a full calendar year.
The increase in average earning assets can be attributed in large part to an approximate $158.7 million increase in average gross loan balances during 2008. Of this increase, approximately $137.2 million can be attributed to the acquisition of Business First. For the year ended December 31, 2008, the yield earned on the loan portfolio was 7.17%, which represents a decline of approximately 136 basis points from the 8.53% reported for 2007. The decline in the yield of the loan portfolio is primarily attributable to the dramatic decline in the overnight Fed Funds rate during 2008. It is the decline in the yield on the loan portfolio that contributed greatly to the decline in the yield on average earning assets. For the year ended December 31, 2008, the yield on average earning assets was 6.95%. This when compared to the 8.13% the Company reported for the year ended December 31, 2007, represents a decline of approximately 118 basis points. The yield on average earning assets for the year ended December 31, 2006 was 7.99%.
The table below sets forth changes from 2007 to 2008 for average interest-bearing liabilities and the respective average rates paid:
(1)
Consists of Federal Home Loan Bank borrowings of $76,881 and $33,136 and repurchase agreements of $2,283 and $1,855 for the years ended December 31, 2008 and 2007, respectively.
(2)
Average rate paid on Federal Home Loan Bank borrowings and repurchase agreements of 2.51% and 5.44% and 2.01% and 4.91% for the years ended December 31, 2008 and 2007, respectively.
Average interest bearing liabilities increased approximately $146.9 million from the $401.6 million reported at December 31, 2007. The year over year increase can be attributed to higher average balances of savings, NOW and money market accounts of which approximately $41.1 million of the change can be attributed to the acquisition of Business First. Additionally, the year over year increase in FHLB borrowing also contributed significantly to the increase in interest bearing liabilities. For the year ended December 31, 2008, the rate the Company paid on interest bearing liabilities was 2.29% or 138 basis points lower than the 3.67% reported for 2007. A significantly lower overnight Fed Funds rate during the majority of 2008, contributed significantly to the year over year decline in the rate paid on average interest bearing liabilities. As the Federal Reserve moved aggressively to lower rates during 2008 in response to, among other things, weakness in the credit markets and general economic conditions, the Bank moved to lower the rates paid on its deposits. This in conjunction with declines in the cost of relatively short term borrowing from the FHLB, were primary factors in the decline of the rate paid on interest bearing liabilities.
For the year ended December 31, 2008, the average balance of floating rate interest bearing deposits was approximately $293.1 million or 53.4% of total interest bearing liabilities. The ability to rapidly re-price the majority of its interest bearing liabilities in conjunction with the moves made by the FOMC during 2008 to lower the overnight Fed Funds rate was instrumental to the Bank in mitigating a substantial decline in its net interest margin.
The hypothetical impacts of sudden interest rate movements applied to the Company’s asset and liability balances are modeled monthly. 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. The results for the Company’s December 31, 2008 balances indicate that the net interest income at risk over a one year time horizon from a 1.0% and 2.0% upward and downward rate movement are within the Company’s policy guidelines for such changes. See Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
As a financial institution, the Company’s primary component of market risk is interest rate volatility. Fluctuations in interest rates will ultimately impact both the level of 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 banking subsidiary level. Thus, virtually all of the Company’s interest rate risk exposure lies at the banking subsidiary level other than $13.4 million in subordinated debentures issued by the Company’s subsidiary grantor trusts. As a result, all significant interest rate risk procedures are performed at the banking subsidiary level. The subsidiary bank’s real estate loan portfolio, concentrated primarily within Santa Barbara and San Luis Obispo Counties, of California, are subject to risks associated with the local economy.
The fundamental objective behind the management of the Company’s 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. Management believes that it can continue to manage the short-term effect of interest rate changes under various interest rate scenarios.
Management employs the use of an Asset and Liability Management software that is used to measure the Bank’s exposure to future changes in interest rates. This model measures the expected cash flows and re-pricing of each financial asset/liability separately in measuring the Bank’s interest sensitivity. Based on the results of this model, Management believes the Bank’s balance sheet is “asset sensitive.” The Company generally expects expansion in its net interest income if rates rise and expects, conversely, contraction if rates fall. The level of potential or expected contraction indicated by the tables below is considered acceptable by Management and is compliant with the Bank’s ALCO policies. Management will continue to perform this analysis each quarter to further validate the expected results against actual data.
The hypothetical impacts of sudden interest rate movements applied to the Company’s asset and liability balances are modeled monthly. The results of this movement 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. The results for the Company’s December 31, 2008 balances indicate that the net interest income at risk over a one year time horizon for a 1% and 2% rate increase and decrease are within the Company’s policy guidelines for such changes.
It is important to note that the above table is a summary of several forecasts and actual results may vary. The forecasts are based on estimates and assumptions of Management 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. Changes that vary significantly from the assumptions and estimates may have significant 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 provides a summary of the loans the Bank can expect to see come off their floors if the prime rate were to increase by the amounts presented as of December 31, 2008:
As evidenced in the table above, the Bank can expect to see approximately $154.0 million in loans come off their floors if the prime rate were to increase by 350 basis points as of December 31, 2008.
The following table provides a summary for loans that currently possess a fixed rate or are at their floors as of December 31, 2008:
As evidenced in the table above, approximately $405.1 million or 59.2% of loans in the portfolio are either fixed or at their floor.
The Company also attempts to quantify the impact of interest rate changes on borrowers’ ability to pay on loans and the impact of similar rate changes on the value of collateral held against loans. To this end, the Company, from time to time, will sample loans and analyze them under a rate shock scenario to specifically assess the impact of the rate shock on financial ratios such as interest rate coverage and loan-to-value. The results of the analysis have generally revealed that in the case of such a rate shock, a high percentage of loans tested would continue to express ratios within current underwriting guidelines. The results of these analyses are considered acceptable by Management.
Item 8.
Item 8. Financial Statements and Supplementary Data
Heritage Oaks Bancorp and Subsidiaries
Management’s Assessment of Internal Control over Financial Reporting
The management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting. The Company’s internal control over financial reporting is a process designed under the supervision of the Company’s Chief Executive Officer and Chief Financial Officer to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the Company’s financial statements for external purposes in accordance with U.S. generally accepted accounting principles.
As of December 31, 2008, management assessed the effectiveness of the Company’s internal control over financial reporting based on the criteria for effective internal control over financial reporting established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and guidance issued by the Securities and Exchange Commission. Based on the assessment, management determined that the Company maintained effective internal control over financial reporting as of December 31, 2008, based on those criteria.
Vavrinek, Trine, Day & Co., LLP, the independent registered public accounting firm that audited the consolidated financial statements of the Company included in this Annual Report on Form 10-K, has issued an attestation report on management’s assessment of the Company’s internal control over financial reporting as of December 31, 2008. The report, which expresses unqualified opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting as of December 31, 2008, is included below under the heading “Report of Independent Registered Public Accounting Firm.”
The Company’s management, including its Chief Executive Officer and Chief Financial Officer, does not expect that its disclosure controls and procedures, or its internal controls will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefit of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected.
/s/ Lawrence P. Ward
/s/ Margaret A. Torres
Lawrence P. Ward
Chief Executive Officer
Margaret A. Torres
Executive Vice President,
Chief Financial Officer
Report of Independent Registered Public Accounting Firm
Board of Directors and Stockholders
Heritage Oaks Bancorp and Subsidiary
Paso Robles, California
We have audited Heritage Oaks Bancorp and Subsidiaries (the Company) internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. 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 audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
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 financial statements for external purposes in conformity with U.S. 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 financial statements in accordance with U.S. generally accepted accounting principles, and the 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 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 Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board, the consolidated balance sheets of the Company as of December 31, 2008 and 2007, and the related consolidated statements of operations, shareholders’ equity and comprehensive income and cash flows for the three years in the period ended December 31, 2008, and our report dated March 6, 2009 expressed an unqualified opinion on those financial statements.
/s/Vavrinek, Trine, Day & Co., LLP
Rancho Cucamonga, California
March 6, 2009
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, 2008 and 2007, and the related consolidated statements of income, changes in stockholders' equity and cash flows for each of the three years in the period ended December 31, 2008. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements 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 audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Heritage Oaks Bancorp and Subsidiaries as of December 31, 2008 and 2007, and the results of its operations, changes in its stockholders' equity, and its cash flows for each of the three years in the period ended December 31, 2008, in conformity with U.S. generally accepted accounting principles.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 6, 2009 expressed an unqualified opinion thereon.
/s/Vavrinek, Trine, Day & Co., LLP
Rancho Cucamonga, California
March 6, 2009
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 Stockholders' Equity
The accompanying notes are an integral part of these consolidated financial statements.
Heritage Oaks Bancorp
and Subsidiaries
Consolidated Statements of Cash Flows
The accompanying notes are an integral part of these consolidated financial statements.
Heritage Oaks Bancorp and Subsidiaries
Notes to Consolidated Financial Statements
Note 1. Summary of Significant Accounting Policies
The accounting and reporting policies of Heritage Oaks Bancorp (“the Company”) and subsidiaries conform to accounting principles generally accepted in the United States of America and to general practices within the banking industry. A summary of the Company's significant accounting and reporting policies consistently applied in the preparation of the accompanying financial statements follows:
Principles of Consolidation
The Consolidated Financial Statements include the Company and its wholly owned subsidiaries, Heritage Oaks Bank, (the “Bank”) and CCMS Systems, Inc. Inter-company balances and transactions have been eliminated.
Nature of Operations
The Company has been organized as a single operating segment. The Bank operates fifteen branches within San Luis Obispo and Santa Barbara counties. The Bank offers traditional banking products such as checking, savings and certificates of deposit, as well as mortgage loans and commercial and consumer loans to customers who are predominately small to medium-sized businesses and individuals.
Investment in Non-Consolidated Subsidiary
The Company accounts for its investments in its wholly owned special purpose entities, Heritage Oaks Capital Trust II (the “Trust II”) and Heritage Oaks Capital Trust III (the “Trust III”), using the equity method under which the subsidiary’s net earnings are recognized in the Company’s statements of income.
Use of Estimates in the Preparation of Financial Statements
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires Management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Estimates that are particularly susceptible to significant change relate to the determination of the allowance for losses on loans and the valuation of real estate acquired in connection with foreclosures or in satisfaction of loans. In connection with the determination of the allowance for losses on loans and foreclosed real estate, Management obtains independent appraisals for significant properties.
While Management uses available information to recognize losses on loans and foreclosed real estate and collateral, future additions to the allowance 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 losses on loans and foreclosed real estate. Such agencies may require the Company to recognize additions to the allowance 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 losses on loans and foreclosed real estate may change.
Cash and Due from Banks
Banking regulations require that all banks maintain a percentage of their deposits as reserves in cash or on deposit with the Federal Reserve Bank. The Bank is in compliance with the reserve requirements as of December 31, 2008. The Company maintains amounts due from banks that exceed federally insured limits. The Company has not experienced any losses in such accounts.
Cash and Cash Equivalents
For purposes of reporting cash flows, cash and cash equivalents include cash, due from banks, federal funds sold and money market funds. Generally, federal funds are sold for one-day periods.
Investment Securities
In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which addresses the accounting for investments in equity securities that have readily determinable fair values and for investments in all debt securities, securities are classified in three categories and accounted for as follows: debt and mortgage-backed securities that the Company has the positive intent and ability to hold to maturity are classified as held-to-maturity and are measured at amortized cost; debt and equity securities bought and held principally for the purpose of selling in the near term are classified as trading securities and are measured at fair value, with unrealized gains and losses included in earnings; debt and equity securities not classified as either held-to-maturity or trading securities are deemed as available-for-sale and are measured at fair value, with unrealized gains and losses, net of applicable taxes, reported in a separate component of stockholders' 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. Premiums and discounts are amortized or accreted using the interest method over the expected lives of the related securities.
Declines in the fair values of individual held-to-maturity and available-for-sale securities below their cost that are other than temporary result in write-downs of individual securities to their fair value. The related write-downs are included in earnings as realized losses. In estimating other-than-temporary impairment losses, Management considers: (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 Bank 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, current cash flows, credit enhancements, loan-to-values, credit scores, delinquency and default rates.
Loans and Interest on Loans
Loans receivable that 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 of specific valuation accounts and net of any deferred fees or costs on originated loans, or unamortized premiums or discounts on purchased loans.
Loan origination fees and certain direct origination costs are capitalized and recognized as an adjustment in yield of the related loan.
Loans on which the accrual of interest has been discontinued are designated as non-accrual loans. The accrual of interest on loans is discontinued when principal or interest is past due 90 days based on contractual terms of the loan or when, in the opinion of Management, there is reasonable doubt as to collectibility. When loans are placed on non-accrual status, all interest previously accrued but not collected is reversed against current period interest income. Interest income generally is not recognized on specific impaired loans unless the likelihood of further loss is remote. Interest payments received on such loans are applied as a reduction to the loan principal balance. Interest accruals are resumed on such loans only when they are brought current with respect to interest and principal and when, in the judgment of Management, the loans are estimated to be fully collectible as to all principal and interest.
The Company considers a loan to be impaired when it is probable that the Company will be unable to collect all amounts due (principal and interest) according to the contractual terms of the loan agreement. Measurement of impairment is based on the expected future cash flows of an impaired loan which are to be discounted at the loan’s 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 at the fair value of the collateral. The Bank recognizes interest income on impaired loans based on its existing methods of recognizing interest income on non-accrual loans. All loans are generally charged off at such time the loan is classified as a loss.
Other Real Estate Owned
Real estate and other property acquired in full or partial settlement of loan obligations is referred to as other real estate owned (“OREO”). OREO is originally recorded in the Company’s financial statements at fair value less any estimated costs to sell. When property is acquired through foreclosure or surrendered in lieu of foreclosure, the Company measures the fair value of the property acquired against its recorded investment in the loan. If the fair value of the property at the time of acquisition is less than the recorded investment in the loan, the difference is charged to the allowance for loan losses. Any subsequent fluctuations in the fair value of OREO are recorded against a valuation allowance for foreclosed assets, established 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 are recorded in other income or expense as incurred.
Loans Held for Sale
Loans held for sale are carried at the lower of aggregate cost or market value, which is determined by the specified value in the commitments. Net unrealized losses, if any, are recognized through a valuation allowance by charges to expense.
Allowance for Loan Losses
The allowance for loan losses is maintained at a level which, in Management's judgment, is adequate to absorb credit losses inherent in the loan portfolio. The amount of the allowance is based on Management's evaluation of the collectibility 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 allowance is increased by a provision for loan losses, which is charged to earnings and reduced by charge-offs, net of recoveries. Changes in the allowance relating to impaired loans are charged or credited to the provision for loan losses. Because of uncertainties inherent in the estimation process, Management’s estimate of credit losses inherent in the loan portfolio and the related allowance may change.
Loans are considered impaired if, based on current information and events, it is probable that we will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. The measurement of impaired loans is generally based on the present value of expected future cash flows discounted at the historical effective interest rate stipulated in the loan agreement, except that all collateral-dependent loans are measured for impairment based on the fair value of the collateral. In measuring the fair value of the collateral, Management uses assumptions and methodologies consistent with those that would be utilized by unrelated third parties. Allowances for impaired loans are generally determined based on collateral values or the present value of estimated cash flows.
As mentioned, changes in the financial condition of individual borrowers, economic conditions, historical loss experience and the condition of the various markets in which collateral may be sold may all affect the required level of the allowance for loan losses and the associated provision for loan losses.
Property, 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 ranges from three to ten years for furniture and fixtures and forty 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 operations as incurred.
Goodwill and Intangible Assets
The Company has engaged in the acquisition of financial institutions and the assumption of deposits and purchase of assets from other financial institutions. The Company has paid premiums on these acquisitions, and such premiums are recorded as intangible assets, in the form of goodwill or core deposit intangible assets.
Goodwill represents the excess of the purchase price over the estimated fair value of the net assets acquired. In accordance with the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets,” goodwill is not amortized whereas identifiable intangible assets with finite lives are amortized over their useful lives. On an annual basis, the Company is required to test goodwill for impairment. The Company’s assessment at December 31, 2008, pursuant to its Goodwill Impairment Testing Policy, was performed with the assistance of an independent third party and resulted in no impairment.
Core deposit intangibles represent the intangible value of depositor relationships resulting from deposit liabilities assumed in acquisitions. Core deposit intangibles are amortized over a period of six to ten years.
Intangibles are evaluated periodically for impairment. This evaluation involves estimating cash flows for future periods. If the future cash flows were found to be materially less than the recorded balances of goodwill and other intangible assets, the net book value of the intangible would be written down, through a charge to earnings, to the net estimated recoverable value.
Income Taxes
Provisions for income taxes are based on amounts reported in the statements of income (after exclusion of non-taxable income such as interest on state and municipal securities) and include deferred taxes on temporary differences in the recognition of income and expense for tax and financial statement purposes. Deferred taxes are computed on the liability method as prescribed in Statement of Financial Accounting Standards (“SFAS”) No. 109, "Accounting for Income Taxes."
Deferred Tax Assets
We use an estimate of future earnings to support our position that the benefit of our deferred tax assets will be realized. If future income should prove nonexistent or less than the amount of the deferred tax assets within the tax years to which they may be applied, the asset may not be realized and our net income will be reduced. See also Note 9 Income Taxes, of these Consolidated Financial Statements for additional information related to deferred income taxes.
Supplemental Employee Compensation Benefits Agreements
The Company has entered into supplemental employee compensation benefits agreements with certain executive and senior officers. The measurement of the liability under these agreements includes estimates involving life expectancy, length of time before retirement, and expected benefit levels. Should these estimates prove materially wrong, we could incur additional or reduced expense to provide these benefits.
Disclosure about Fair Value of Financial Instruments
The Company’s estimated fair value amounts 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 the estimated fair value amounts, such amounts have not been comprehensively revalued for purposes of these 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.
Financial Instruments
In the ordinary course of business, the Company has entered into off-balance sheet financial instruments consisting of commitments to extend credit, commercial letters of credit, and standby letters of credit as more fully described in Note 10 of these Consolidated Financial Statements. Such financial instruments are recorded in the financial statements when they are funded or related fees are incurred or received.
Comprehensive Income
In accordance with SFAS No. 130, “Reporting Comprehensive Income,” the Company classifies items of other comprehensive income by their nature in the financial statements and displays the accumulated other comprehensive income separately from retained earnings in the equity section of the Balance Sheet. Changes in unrealized gain (loss) on available-for-sale securities net of income taxes is the only component of accumulated other comprehensive income for the Company.
Reclassifications
Certain amounts in the 2006 and 2007 financial statements have been reclassified to conform to the 2008 presentation.
Earnings Per Share (“EPS”)
Basic EPS excludes dilution and is computed by dividing income available to common stockholders by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity.
Share-Based Compensation
Effective January 1, 2006, the Company adopted the provisions of SFAS No. 123(R), “Share-Based Payments,” a revision to the previously issued guidance on accounting for stock options and other forms of equity-based compensation. SFAS No. 123(R) requires companies to recognize in the income statement the grant-date fair value of stock options and other equity-based forms of compensation issued to employees over the employees’ requisite service period (generally the vesting period). Prior to January 1, 2006, we accounted for share-based compensation to employees under the intrinsic value method prescribed in Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees.” Under the intrinsic value method, compensation expense was recognized only to the extent an option’s exercise price is less than the market value of the underlying stock on the date of grant. No share-based compensation expense was reflected in net income as all options are required by the plan to be granted with an exercise price equal to the estimated fair value of the underlying common stock on the date of grant. We also followed the disclosure requirements of SFAS No. 123, “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure - An Amendment of FASB Statement 123.” We adopted SFAS No. 123(R) under the modified prospective method which means that the unvested portion of previously granted awards and any awards that are granted or modified after the date of adoption will be measured and accounted for under the provisions of SFAS No. 123(R). Accordingly, financial statement amounts for prior periods presented have not been restated to reflect the fair value method of recognizing compensation cost relating to stock options. The Company will continue to use straight-line recognition of expenses for awards with graded vesting.
In March 2005, the Securities and Exchange Commission (“the SEC”) issued Staff Accounting Bulletin No. 107 (“SAB No. 107”) regarding the SEC's interpretation of SFAS No.123(R) and the valuation of share-based payments for public companies. The Company has applied the provisions of SAB No. 107 in its adoption of SFAS No. 123(R). See also Note 14 of the Consolidated Financial Statements for additional information related to share-based compensation.
Recent Accounting Pronouncements
In June 2008, the Financial Accounting Standards Board (“FASB”) issued Staff Position No. EITF 03-6-1, Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities ("FSP EITF 03-6-1"). The FSP addresses whether instruments granted in share-based payment transactions are participating securities prior to vesting and, therefore, need to be included in the earnings allocation in computing EPS under the two-class method. The FSP affects entities that accrue cash dividends on share-based payment awards during the awards' service period when the dividends do not need to be returned if the employees forfeit the awards. FSP EITF 03-6-1 is effective for fiscal years beginning after December 15, 2008. The Company does not expect the adoption of FSP EITF 03-6-1 to have a material impact on its financial position, results of operations and cash flows.
In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109 (“FIN 48”) which clarifies the accounting and disclosure for uncertainty in tax positions, as defined. FIN 48 seeks to reduce the diversity in practice associated with certain aspects of the recognition and measurement related to accounting for income taxes and provides that the tax effects from an uncertain tax position be recognized in the financial statements only if, based on its merits, the position is more likely than not to be sustained in audit by the taxing authorities. This interpretation is effective for fiscal years beginning after December 15, 2006. Effective January 1, 2007, the Company adopted FIN 48. Management believes that all tax positions taken as of December 31, 2008 are highly certain and, accordingly, no accounting adjustments have been made to the financial statements.
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” SFAS No. 157 enhances existing guidance for measuring assets and liabilities using fair value. Prior to the issuance of SFAS No. 157, guidance for applying fair value was incorporated in several accounting pronouncements. SFAS No. 157 provides a single definition of fair value, together with a framework for measuring it, and requires additional disclosure about the use of fair value to measure assets and liabilities. SFAS No. 157 also emphasizes that fair value is a market-based measurement, not an entity-specific measurement, and sets forth a fair value hierarchy with the highest priority being quoted prices in active markets. Under SFAS No. 157, fair value measurements are disclosed by level within that hierarchy. While SFAS No. 157 does not add any new fair value measurements, it does change current practice. Changes to practice include: (1) a requirement for an entity to include its own credit standing in the measurement of its liabilities; (2) a modification of the transaction price presumption; (3) a prohibition on the use of block discounts when valuing large blocks of securities for broker-dealers and investment companies; and (4) a requirement to adjust the value of restricted stock for the effect of the restriction even if the restriction lapses within one year. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Effective January 1, 2008, the Company adopted SFAS No. 157. The adoption of this standard has not had a material impact on the Company’s financial position, results of operations or cash flows.
In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans (an amendment of FASB Statements No. 87, 88, 106, and 132R).” SFAS No. 158, requires an employer to: (1) Recognize in its statement of financial position an asset for a plan’s over funded status or a liability for a plan’s under funded status; (2) measure a plan’s assets and its obligations that determine its funded status as of the end of the employer’s fiscal year (with limited exceptions); and (3) recognize changes in the funded status of a defined benefit postretirement plan in the year in which the changes occur. Those changes will be reported in comprehensive income of a business entity and in changes in net assets of a not-for-profit organization. The requirement by SFAS No. 158 to recognize the funded status of a benefit plan and the disclosure requirements of SFAS No. 158 are effective as of the end of the fiscal year ending after December 15, 2006 for entities with publicly traded equity securities. The Company adopted this portion of the pronouncement effective January 1, 2007. The adoption of this portion has not had a material impact on the financial position, results of operation or cash flows of the Company. The requirement to measure plan assets and benefit obligations as of the date of the employer’s fiscal year-end statement of financial position is effective for fiscal years ending after December 15, 2008. The adoption of SFAS No. 158 did not have a material effect on the financial position of the company.
In February 2007, the FASB issued SFAS No. 159,“Establishing the Fair Value Option for Financial Assets and Liabilities.” The FASB has issued SFAS No. 159 to permit all entities to choose to elect, at specified election dates, to measure eligible financial instruments at fair value. An entity shall report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date, and recognize upfront costs and fees related to those items in earnings as incurred and not deferred. SFAS No. 159 applies to fiscal years beginning after November 15, 2007, with early adoption permitted for an entity that has also elected to apply the provisions of SFAS No. 157, Fair Value Measurements. An entity is prohibited from retrospectively applying SFAS No. 159, unless it chooses early adoption. SFAS No. 159 also applies to eligible items existing at November 15, 2007 (or early adoption date). The Company adopted SFAS No. 159 on January 1, 2008 and elected not to measure certain eligible financial instruments at their fair values and as a result the adoption of SFAS No. 159 did not have a material impact on its financial position, results of operations or cash flows.
In December 2007, the FASB issued SFAS No. 141 (revised), “Business Combinations.” SFAS No. 141(R) changes the accounting for business combinations including the measurement of acquirer shares issued in consideration for a business combination, the recognition of contingent consideration, the accounting for pre-acquisition gain and loss contingencies, the recognition of capitalized in-process research and development, the accounting for acquisition-related restructuring cost accruals, the treatment of acquisition related transaction costs and the recognition of changes in the acquirer’s income tax valuation allowance. The Company is required to adopt SFAS No. 141(R) no later than January 1, 2009. The Company does not believe the adoption of this standard will have a material impact on its financial position, results of operations or cash flows.
In December 2007, the FASB issued SFAS No. 160, “Non-controlling Interests in Consolidated Financial Statements, an amendment of ARB No. 51.” SFAS No. 160 changes the accounting for non-controlling (minority) interests in consolidated financial statements including the requirements to classify non-controlling interests as a component of consolidated stockholders’ equity, and the elimination of “minority interest” accounting in results of operations with earnings attributable to non-controlling interests reported as part of consolidated earnings. Additionally, SFAS No. 160 revises the accounting for both increases and decreases in a parent’s controlling ownership interest. The Company must adopt SFAS No. 160 no later than January 1, 2009. The Company does not believe the adoption of this standard will have a material impact on its financial position, results of operations or cash flows.
In February 2008, the FASB issued FASB Staff Position (“FSP”) FAS 157-1, “Application of FASB Statement No. 157 and Other Accounting Pronouncements That Address Fair Value Measurements for Purposes of Lease Classification or Measurement Under Statement 13,” and FSP FAS 157-2, “Effective Date of FASB Statement No. 157.” FSP FAS 157-1 removes leasing from the scope of SFAS No. 157, “Fair Value Measurements.” FSP FAS 157-2 delays the effective date of SFAS No. 157 from 2008 to 2009 for all non-financial assets and non-financial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). The Company does not expect the implementation of FSP 157-1 to have a material impact on its financial position, results of operations, or cash flows. Additionally, in accordance with FSP 157-2 the Company will delay the application of SFAS No. 157 for non-financial assets and non-financial liabilities until January 1, 2009 and does not expect the application to have a material impact on the Company’s financial position, results of operations, or cash flows.
In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities - an amendment of FASB Statement No. 133,” which amends and expands the disclosure requirements of SFAS No. 133 with the intent to provide users of financial statements with an enhanced understanding of: how and why an entity uses derivative instruments; how derivative instruments and related hedged items are accounted for under SFAS No. 133 and its related interpretations; and how derivative instruments and related hedged items affect an entity’s financial position, results of operations, and cash flows. To meet those objectives, this Statement requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of and gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative agreements. This Statement is effective for fiscal and interim periods after November 15, 2008 with earlier adoption encouraged. Disclosures will not be required retrospectively to prior reporting periods. The Company has elected to adopt SFAS No. 161 effective January 1, 2009. The Company does not believe the adoption of this standard will have a material impact on its financial position, results of operations or cash flows.
In May 2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles.” SFAS No. 162 identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of the financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles (“GAAP”) in the Unites States. The FASB issued SFAS No. 162, because the current GAAP hierarchy, as set forth in the American Institute of Certified Public Accountants (“AICPA”) Statement on Auditing Standards No. 69, “The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles,” is directed to the auditor and not the entity, it is complex, and it ranks FASB Statements of Financial Accounting Concepts below industry practices that are widely recognized as generally accepted but that are not subject to due process. This statement is effective 60 days following the SEC’s approval of the Public Company Accounting Oversight Board (“PCAOB”) amendments to AU Section 411, “The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles.” The Company does not anticipate the adoption of SFAS No. 162 to have a material impact of its financial position, results of operations or cash flows.
In May 2008, the FASB issued SFAS No. 163, “Accounting for Financial Guarantee Insurance Contracts, an interpretation of FASB Statement No. 60.” SFAS No. 163 seeks to bring consistency in the recognition and measurement of claim liabilities. This statement also clarifies how SFAS No. 60 applies to financial guarantee contracts, including the recognition and measurement to be used to account for premium revenue and claim liabilities, increasing the comparability in financial reporting of financial guarantee contracts by insurance enterprises. The Company must adopt SFAS No. 163 no later than January 1, 2009. The Company does not anticipate the adoption of SFAS No. 163 to have a material impact on its financial position, results of operations or cash flows.
On October 10, 2008, the FASB issued Financial Accounting Standards Board Staff Position (“FSP”) FSP FAS 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active.” The FSP clarifies the application of SFAS No. 157, “Fair Value Measurements”, in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is not active. The FSP is effective immediately, and includes prior periods for which financial statements have not been issued, and therefore the Company is subject to the provisions under the FSP effective September 30, 2008. The implementation of FSP FAS 157-3 did not affect the Company's fair value measurements as of December 31, 2008.
Note 2. Investment Securities
At December 31, 2008 and 2007, the investment securities portfolio was comprised solely of securities classified as available-for-sale, in accordance with SFAS No. 115, resulting in investment securities available-for-sale being carried at fair value adjusted for amortization of premiums and accretions of discounts.
The tables below set forth the fair values of investment securities available-for-sale at December 31, 2008 and 2007:
The amortized cost and fair values of investment securities available-for-sale at December 31, 2008 and 2007, by contractual maturity are shown below. 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.
During 2008, the Company sold $1.5 million of available for sale investments and recognized gross gains in the approximate amount of $37 thousand. For the years ended December 31, 2007 and 2006, the Company reported gross gains from the sale and maturity of available for sale investments in the approximate amounts of $6 thousand and $9 thousand, respectively.
Securities having a carrying value and a fair value of approximately $43.5 million and $33.5 million at December 31, 2008 and 2007, respectively, were pledged to secure public deposits and for other purposes as required by law.
Those investment securities available for sale which have an unrealized loss position at December 31, 2008 and 2007 are detailed below:
There are ten securities that have been in a loss position for twelve months or longer as of December 31, 2008, compared to sixteen as of December 31, 2007. These unrealized losses can be attributed in part to the unrest we have seen in the credit markets during 2008.
Management periodically evaluates investments in the portfolio for other than temporary impairment and more specifically when conditions warrant such an evaluation. When evaluating whether impairment is other then temporary, Management 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 Bank 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, current cash flows, credit enhancements, loan-to-values, credit scores, delinquency and default rates.
As the Company has the ability to hold these securities until maturity, or for the foreseeable future, no declines are deemed to be other than temporary at December 31, 2008.
Note 3. Loans
The following table sets forth the balance for each major loan category as of December 31, 2008 and 2007:
Concentration of Credit Risk
At December 31, 2008 and 2007, approximately $499.7 million and $458.6 million of the Bank’s loan portfolio was collateralized by various forms of real estate. Such loans are generally made to borrowers located in the counties San Luis Obispo and Santa Barbara. The Bank attempts to reduce its concentration of credit risk by making loans which are diversified by project type. While Management believes that the collateral presently securing this portfolio is adequate, there can be no assurances that further significant deterioration in the California real estate market would not expose the Bank to significantly greater credit risk.
Loans serviced for others are not included in the accompanying balance sheets. The unpaid principal balance of loans serviced for others was $20.5 million, $18.2 million and $7.5 million at December 31, 2008, 2007 and 2006, respectively.
The Bank also originates Small Business Administration (“SBA”) loans for sale to governmental agencies and institutional investors. At December 31, 2008 and 2007, the unpaid principal balance of SBA loans serviced for others totaled $1.5 million and $2.0 million, respectively. The Company did not recognize gains from the sale of SBA loans in 2008, however gains on sales were recorded in the amounts of $36 thousand and $19 thousand for the years ended December 31, 2007 and 2006, respectively.
Impaired Loans
The following provides a summary of the Bank’s investment in impaired loans, the corresponding valuation allowance for such loans, and income recognized thereon as of December 31, 2008, 2007 and 2006:
The provisions of SFAS No. 114 and SFAS No. 118 permit the valuation allowances reported above to be determined on a loan-by-loan basis or by aggregating loans with similar risk characteristics. Because the loans currently identified as impaired have unique risk characteristics, valuation allowances the Bank has recorded were determined on a loan-by-loan basis.
Non-accruing loans totaled approximately $18.3 million and $0.3 million at December 31, 2008 and 2007, respectively. As of December 31, 2008 and 2007, all loans on non-accrual were classified as impaired. If interest on non-accruing loans had been recognized at the original interest rates, interest income would have increased $0.9 million, $0.1 million, and $0.1 million, in 2008, 2007, and 2006, respectively.
At December 31, 2008 there were two loans in the aggregate amount of $0.3 million that were 90 days or more past due and still accruing. There were no loans 90 days or more past due and still accruing interest at December 31, 2007. Additionally, there were and no loans classified as troubled debt restructurings as of December 31, 2008 and 2007.
Note 4. Allowance for Loan Losses
The following table provides a summary of the activity within the allowance for loan losses for the years ended December 31, 2008, 2007 and 2006:
Note 5. Property, Premises and Equipment
At December 31, 2008 and 2007, property, premises and equipment consisted of the following:
During 2003, the Bank purchased land for future development of a Paso Robles, California administrative facility for approximately $1.1 million. Construction was completed and the Bank moved into the facility in June 2006. In the second quarter of 2007, the Bank sold this facility and three other branches to First States Group, L.P. in a sale lease-back transaction for approximately $12.8 million. The Bank subsequently entered into four separate lease agreements with First States Investors, LLC to lease back the three branches and administrative facility for a period of 15 years with the option to renew for two 10 year terms. Each of the four leases are subject to an annual rent escalation clause equal to the lower of CPI-U (Consumer Price Index for all Urban Consumers) or 2.5 percent, commencing in the second year of the lease term. The sale of these properties resulted in a gain of approximately $3.4 million that the Bank will recognize over a period of 15 years in accordance with SFAS No. 13 “Accounting for Leases.” For the years ended December 31, 2008 and 2007 the Bank made payments in the aggregate amount of $922 thousand and $448 thousand, respectively to lease these facilities. Additionally, the Bank recognized approximately $227 thousand and $114 thousand of the deferred gain on sale during the years ended December 31, 2008 and 2007, respectively. The recognition of these gains is reflected in the Company’s operating results for the periods mentioned as credits to occupancy expense.
In addition to the lease agreements mentioned in the preceding paragraph, the Company leases land, buildings, and equipment under non-cancelable operating leases expiring at various dates through 2022. See Note 10, Commitments and Contingencies of these Consolidated Financial Statements for a more detailed discussion regarding the Company’s operating lease obligations.
Note 6. Intangible Assets
Goodwill
The balance of goodwill at December 31, 2008 was approximately $11.0 million. This when compared to the $10.9 million reported at December 31, 2008, represents an increase of approximately $0.1 million.
Core Deposit Intangible (“CDI”)
Intangible assets consisted of core deposit intangibles subject to amortization. Amortizations for 2008, 2007 and 2006 were $0.9 million, $0.4 million and $0.3 million, respectively. In October 2007, the Company recorded approximately $3.8 million in CDI related to core deposits it obtained in the acquisition of Business First.
The following table summarizes the gross carrying amount, accumulated amortization and net carrying amount of core deposit intangibles and provides an estimate for future amortization as of December 31, 2008:
Note 7. Time Deposit Liabilities
The following table provides a summary for the maturity of the Bank’s time certificates of deposit as of December 31, 2008:
As of December 31, 2008 brokered time deposits in the approximate amount of $20.1 million were reflected in the table above. Of these balances, approximately $10.0 million will mature in 2009, approximately $7.5 million will mature in 2010 and approximately $2.5 million will mature in 2011.
Note 8. Borrowings
The Bank has several sources from which it may obtain borrowed funds, including two sources that it considers primary in obtaining secondary funding, Federal Funds purchased through arrangements it has established with correspondent banks and advances from the Federal Home Loan Bank. Borrowing is obtained for a variety of reasons including daily liquidity needs and balance sheet growth. The following provides a summary of the borrowing available to the Bank and Company as well borrowings that were outstanding as of December 31, 2008:
Federal Funds Purchased
The Bank has borrowing lines with correspondent banks totaling $20.0 million as of December 31, 2008. As of December 31, 2008 there were no balances outstanding on these borrowing lines.
Federal Home Loan Bank Advances
As previously mentioned, the Bank has established borrowing lines with the Federal Home Loan Bank (“FHLB”). At December 31, 2008, the Bank had the following borrowings with the FHLB, the majority of which are collateralized by loans.
(dollar amounts in thousands)
At December 31, 2008 approximately $455.6 million in loans and securities were pledged as collateral to the FHLB for the borrowings presented in the table above. Additionally, the Bank has an $11.4 million letter of credit with the FHLB secured by loans. At December 31, 2008, the Bank had a remaining borrowing capacity with existing collateral of approximately $68.5 million secured by loans and securities.
Securities Sold Under Agreements to Repurchase
Securities sold under agreements to repurchase, which are classified as secured borrowings, generally mature within one to four days from the transaction date. Securities sold under agreements to repurchase are reflected at the amount of cash received in connection with the transaction. At December 31, 2008 and 2007, the Bank had $2.8 million and $1.9 million in securities sold under agreements to repurchase. Interest expense recorded related to these borrowings was $46 thousand, $91 thousand, and $88 thousand for the years ended December 31, 2008, 2007, and 2006, respectively. The carrying value of underlying securities provided as collateral for these transactions was $4.4 million at December 31, 2008 and 2007, respectively.
Notes Payable
On October 10, 2007, the Company renewed a revolving line of credit in the amount of $3.5 million through Pacific Coast Bankers Bank (“PCBB”). The line is secured by 51% of the outstanding shares of the Bank’s stock. The line bears interest at the Wall Street Journal prime rate with interest payments due quarterly. The line is scheduled to mature on October 10, 2009 at which time the line converts to an eight-year term loan maturing on October 10, 2017 with principal and interest payments due quarterly. Under the terms of the agreement, the Company will not incur any additional debt over $2.0 million exclusive of the inter-company debt and existing debt without prior written consent of PCBB. In addition, the Bank must be “well” capitalized on an on-going basis as defined by our Regulators. At December 31, 2008 and 2007, there were no outstanding balances on this line.
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 the issuance of these securities for general corporate purposes, which include among other things, capital contributions to the Bank, investments, payment of dividends, and repurchases of our common stock.
On April 23, 2007, the Company redeemed all of the Floating Rate Junior Subordinated Debt Securities it held associated with Heritage Oaks Capital Trust I, a wholly owned subsidiary of Heritage Oaks Bancorp. The redemption price was 100% of the principal amount redeemed plus accrued and unpaid interest as of the redemption date. The Company paid $0.4 million for the standard interest payment due in April 2007, plus a payment of $8.2 million for the principal amount to be redeemed on that date. These amounts were funded from the Company’s general corporate reserves. As a result of the redemption of the securities associated with Heritage Oaks Capital Trust I, the Trust was dissolved on June 1, 2007.
On September 20, 2007, the Company issued $5.2 million of Junior Subordinated Deferrable Interest Debentures to Heritage Oaks Capital Trust III (“Trust III”), a statutory trust created under the laws of the State of Delaware. These debentures issued to Trust III are subordinated to effectively all borrowings of the Company. The Company used the proceeds from the sale of the securities to assist in the acquisition of Business First, for general corporate purposes, and for capital contributions to the Bank for future growth.
At December 31, 2008, the Company had a total of $13.4 million in Junior Subordinated Deferrable Interest Debentures issued and outstanding, issued to Heritage Oaks Capital Trusts II and III. The debt securities are subordinated to effectively all borrowings of the Company and can be redeemed at par if certain events occur that impact the tax treatment, regulatory treatment or the capital treatment of the issuance. Upon the issuance of the debt securities, the Company purchased a 3.1% minority interest in both Heritage Oaks Capital Trusts II and III, totaling $248 thousand and $155 thousand, respectively. The balance of the equity of Heritage Oaks Capital Trusts II and III is comprised of mandatory redeemable preferred securities and is included in other assets. Interest associated with the securities issued to Heritage Oaks Capital Trusts II and III is payable quarterly at a variable rate of 3-month LIBOR plus 1.71% and 6.888% fixed, respectively.
The following table provides a summary of the securities the Company has issued to Heritage Oaks Capital Trusts II and III as of December 31, 2008:
The Company has the right under the indentures to defer interest payments for a period not to exceed twenty consecutive quarterly periods (each an “Extension Period”) provided that no extension period may extend beyond the maturity of the debt securities. If the Company elects to defer interest payments pursuant to terms of the agreements, then the Company may not (i) declare or pay any dividends or distributions on, or redeem, purchase, acquire or make a liquidation payment with respect to any of the Company’s capital stock, or (ii) make any payment of principal or premium, if any, or interest on or repay, repurchase or redeem any debt securities of the Company that rank pari passu with or junior in interest to the Debt Securities, other than, among other items, a dividend in the form of stock, warrants, options or other rights in the same stock as that on which the dividend is being paid or ranks pari passu with or junior to such stock. The prohibition on payment of dividends and payments on pari passu or junior debt also applies in the case of an event of default under the agreements.
Under FASB Interpretation No. 46, “Consolidation of Variable Interest Entities, an interpretation of ARB No. 51” (“FIN 46”) the Company is not allowed to consolidate Heritage Oaks Capital Trusts II and III into the Company’s financial statements. Prior to the issuance of FIN 46, Bank holding companies typically consolidated these entities. On February 28, 2005, the Federal Reserve Board issued a rule which provides that, notwithstanding the deconsolidation of such trusts, junior subordinated debentures, such as those issued by the Company, may continue to constitute up to 25% of a bank holding company's Tier I capital, subject to certain new limitations which will not become effective until March 31, 2009 and which, in any event, are not expected to affect the treatment of the Company's Junior Subordinated Debentures as Tier I capital for regulatory purposes. As of December 31, 2008, the Company has included $13.0 million of the net junior subordinated debt in its Tier I Capital for regulatory capital purposes.
At December 31, 2008, the Company had sufficient cash to service interest payments on the $13.4 million in junior subordinated debentures for approximately seven quarters without dividends from subsidiaries. The Bank’s capacity to provide cash to the Company, while remaining “well-capitalized”, was approximately $2.2 million at December 31, 2008.
Note 9. Income Taxes
The Company is subject to income taxation by both federal and state taxing authorities. Our federal income tax returns for the years ended December 31, 2007, 2006 and 2005 are open to audit by the federal authorities and our California state tax returns for the years ended December 31, 2007, 2006, 2005 and 2004 are open to audit by state authorities.
The Company’s income tax provision differed from the amounts computed using the federal statutory tax rate of 34 percent. The following table provides a summary for the computation of the Company’s income tax provision for the years ended December 31, 2008, 2007 and 2006:
The following table provides a summary for the current and deferred amounts of the Company’s income tax provision (benefit) for the years ended December 31, 2008, 2007, and 2006:
The following table provides a summary for the significant components of the Company’s net deferred tax asset as of December 31, 2008 and 2007:
As part of the bank acquisitions in 2003 and 2007, the Company has approximately $1.9 million and $1.3 million of net operating losses (“NOL”) available for carry-forward for federal and state tax purposes, respectively, at December 31, 2008. The realization of the NOL is limited for federal tax purposes and for state tax purposes under current tax law. Any amount not utilized for federal tax purposes and state tax purposes will expire in various years through 2025 and 2015, respectively.
As part of the Company’s analysis for the potential impact FIN 48 might have on its financial condition, results of operations and cash flows, it was concluded that a previous position taken on the Company’s 2004 and 2005 tax returns in regard to deferred loan fees could not be supported and as a result amended returns were filed for those periods. For income tax purposes, both Federal and Franchise, this was a “timing” issue and did not flow through the income statement. The balance sheet was impacted to the extent that current taxes payable was increased and offset by a deferred tax asset in the same amount. The 2004 and 2005 amended tax returns were filed in June 2007. Although no penalties were paid, the Company did pay approximately $96 thousand in interest directly related to the 2004 and 2005 amended returns during the year ended December 31, 2007.
Note 10. Commitments and Contingencies
The Company is involved in various litigations from time to time. In the opinion of Management and the Company’s legal counsel, the disposition of all such litigation pending will not have a material effect on the Company’s financial statements.
Commitments to Extend Credit
In the normal course of business, the Bank enters into financial commitments to meet the financing needs of our 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 statement of financial position.
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. The Bank evaluates each customer's credit worthiness on a case-by-case basis and the amount of collateral obtained, if deemed necessary by the Bank, is based on Management's credit evaluation of the customer.
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 is done for loans reflected in the consolidated financial statements.
As of December 31, 2008 and 2007, the Bank had the following outstanding financial commitments whose contractual amount represents credit risk:
Other Commitments
The following table provides a summary of the future minimum lease payments the Bank is expected to make based upon obligations at December 31, 2008:
The Company has leases that contain options to extend for periods from five to twenty 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, 2008, 2007, and 2006, were approximately $2.3 million, $1.4 million, and $0.6 million, respectively. Increases associated with lease expenditures can be attributed to the sale lease-back transaction the Bank entered into during the second quarter of 2007, as more fully discussed in Note 5 of these Consolidated Financial Statements, branch expansion, and the acquisition of Business First National Bank.
At December 31, 2008, the Company had four subleases in place, two of which are for additional space within existing branch offices and two are for an entire facility that was vacated as the result of consolidation from the 2003 Hacienda Bank acquisition. These subleases are for various terms and accounted for an approximate $230 thousand credit to rental expense during 2008. The Company expects to receive sublease revenue for 2009 and 2010 of approximately $119 thousand and $65 thousand, respectively.
Note 11. Regulatory Matters
The Company (on a consolidated basis) and the Bank are subject to various regulatory capital requirements administered by federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company’s and the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of the Company’s and the Bank’s assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The Company’s and the Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Prompt corrective action provisions are not applicable to bank holding companies.
Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined) and of Tier I capital (as defined) to average assets (as defined). Management believes, as of December 31, 2008, the Company and the Bank meet all capital adequacy requirements to which it is subject.
As of the most recent notification, the Federal Deposit Insurance Corporation (“FDIC”) 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 would otherwise change the Bank's categorization. To be categorized as well-capitalized, the Bank must maintain minimum capital ratios as set forth in the table below.
The following table also sets forth the Company’s and the Bank’s actual regulatory capital amounts and ratios as of December 31, 2008 and 2007:
As disclosed in Note 8. Borrowings, the proceeds from the issuance of Junior Subordinated Debentures, subject to percentage limitations, are considered Tier I capital by the Company for regulatory reporting purposes. At December 31, 2008 and 2007, the Company included $13.0 million of proceeds from the issuance of the debt securities in its Tier I capital.
Note 12. Salary Continuation Plan
The Company established salary continuation agreements with the President and Chief Executive Officer, Chief Financial Officer, Chief Lending Officer, Chief Administrative Officer and certain Executive and Senior Vice Presidents, as authorized by the Board of Directors. These agreements 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 would be made to the beneficiaries for a determined number of years. At December 31, 2008 and 2007, the present value of the Company’s liability under these Agreements was approximately $2.4 million and $2.0 million, respectively, and is included in other liabilities in the Company’s Consolidated Financial Statements. For the years ended December 31, 2008, 2007 and 2006, expenses associated with the Company’s salary continuation plans were approximately $425 thousand, $373 thousand and $367 thousand, respectively. The Company maintains life insurance policies, which are intended to fund all costs associated with the agreements. The cash surrender values of these life insurance policies totaled approximately $10.7 million and $9.9 million, at December 31, 2008 and 2007, respectively.
Note 13. Employee Benefit Plans
401(k) Pension Plan
During 1994, the Company established a savings plan for employees that allow participants to make contributions by salary deduction equal to 15 percent or less of their salary pursuant to section 401(k) of the Internal Revenue Code. Employee contributions are matched up to 25 percent of the employee’s contribution. Employees vest immediately in their own contributions and they vest in the Company’s contribution based on years of service. Expenses the Company incurred associated with the plan were approximately $209 thousand, $168 thousand, and $148 thousand, for the years ended December 31, 2008, 2007, and 2006, respectively.
Employee Stock Ownership Plan
The Company sponsors an employee stock ownership plan (“ESOP”) that covers all employees who have completed 12 consecutive months of service, are over 21 years of age and work a minimum of 1,000 hours per year. The amount of the Company’s annual contribution to the ESOP is at the discretion of the Board of Directors. The contributions made to this plan for the years ended December 31, 2007 and 2006 were approximately $200 thousand, and $364 thousand, respectively. The Company made no contributions to the plan during 2008.
Note 14. Share-Based Compensation Plans
At December 31, 2008, the Company had two stock option plans, which are described below:
The “2005 Equity Based Compensation Plan”
The 2005 Equity Based Compensation Plan (the “2005 Plan”) authorizes the granting of Incentive Stock Options, Non-Qualified Stock Options, Stock Appreciation Rights, Restricted Stock Awards, Restricted Stock Units and Performance Share Cash Only Awards. The 2005 Plan provides for a maximum of ten percent (10%) of the Company’s issued and outstanding shares of common stock as of March 25, 2005 and adjusted on each anniversary thereafter to be ten percent (10%) of the then issued and outstanding number of shares. As of December 31, 2008, the maximum number of shares that were available for issuance from the 2005 Plan was 516,294.
For all awards except stock options, the grant date fair value is either the fair market value per share or book value per share (corresponding to the type of stock awarded) as of the grant date. For stock option awards, the grant date fair value is determined using the Black-Scholes option pricing model. For all awards, the Company recognizes related compensation costs only for those shares expected to vest on a straight-line basis over the requisite service period of the award, for which we use the related vesting term. The Company estimates forfeiture rates based on historical employee option exercise and employee termination experience.
The majority of options granted under the 2005 Plan represent fully vested substitute options granted by the Company to Business First option holders upon the acquisition. All other option grants under the 2005 Plan were made to various members of the Company’s Board of Directors and employees of the Bank and vest at a rate of 33 1/3% per year for three years. Options granted under the 2005 Plan typically possess a term of ten years.
In the event of a change in control in which the Company is not the surviving entity, all awards granted under the 2005 Plan shall immediately vest and or become immediately exercisable, except as otherwise determined at the time of grant of the award and specified in the award agreement or unless the survivor corporation, or the purchaser of assets of the Company agrees to assume the obligations of the Company with respect to all outstanding awards or to substitute such awards with equivalent awards with respect to the common stock of the successor.
The “1997 Stock Option Plan”
The 1997 Stock Option Plan is a tandem stock option plan permitting options to be granted either as “Incentive Stock Options” or as “Non-Qualified Stock Options” under the Internal Revenue Code. All outstanding options were granted at prices equal to the fair market value of the Company’s stock on the day of the grant. Options granted vest at a rate of 20 percent per year for five years, and expire no later than ten years from the grant date. However, on May 26, 2005, the stockholders of the Company approved the 2005 Plan, discussed in the preceding paragraph, which stipulates no further grants will be made from the 1997 Stock Option Plan.
Restricted Stock Awards
The Company grants restricted stock periodically as a part of the 2005 Plan for the benefit of employees. Restricted shares issued are typically new shares and currently “cliff” vest in five years.
The following tables summarize activity with respect to restricted share-based compensation for the years ended December 31, 2008 and 2007:
The compensation cost related to restricted stock that has been charged against income (included in salaries and employee benefits) was $180 thousand, $247 thousand and $223 thousand for the years ended December 31, 2008, 2007 and 2006, respectively. The total income tax benefit recognized related to restricted stock compensation was $74 thousand, $101 thousand, and $91 thousand for the years ended December 31, 2008, 2007 and 2006. No restricted shares vested during 2008, 2007 and 2006. At December 31, 2008, there was $493 thousand of total unrecognized compensation cost related to non-vested restricted stock which is expected to be recognized over a weighted average period of 2.19 years.
Stock Options
The following table provides a summary of information related to the Company’s stock option awards for the years ended December 31, 2008, 2007 and 2006:
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 three years ended 2008, 2007 and 2006 was $0.3 million, $1.1 million and $0.9 million, respectively. The intrinsic value of options outstanding in all plans at December 31, 2007 and 2006 was approximately $1.8 million and $5.4 million. There was no intrinsic value for options outstanding as of December 31, 2008. The total intrinsic value of options exercisable in all plans at December 31, 2007 and 2006 was approximately $1.8 million and $5.0 million, respectively. Given that the weighted average exercise price of exercisable options was higher than the Company’s stock price at December 31, 2008, there was substantially no intrinsic value for options exercisable. The Company received income tax benefits of $115, $446 and $365 for the years ended December 31, 2008, 2007 and 2006, respectively, related to the exercise of non-qualified employee stock options, and disqualifying dispositions in the exercise of incentive stock options. Prior to the adoption of SFAS No. 123(R), the Company presented all tax benefits of deductions resulting from the exercise of stock options as operating cash flows in the Statement of Cash Flows. SFAS No. 123(R) requires the cash flows from the tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options (excess tax benefits) to be classified as financing cash flows. The amount of excess tax benefit classified as a financing cash flow at December 31, 2008 was $115.
Share-Based Compensation Expense
The following table provides a summary of the expense the Company has recognized related to share-based compensation awards as a result of the Company’s January 1, 2006 adoption of SFAS No. 123(R). The table below also shows the impact those expenses have had on diluted earnings per share and the remaining expense associated with those awards as of and for the years ended December 31, 2008, 2007 and 2006:
As of December 31, 2008, there was a total of approximately $277 thousand of unrecognized compensation cost related to non-vested stock options which is expected to be recognized over a weighted average period of 1.90 years.
The following table presents the assumptions used in the calculation of the weighted average fair value of options granted at various dates during 2008 and 2007 using the Black-Scholes option pricing model:
The table above presents the assumptions used to estimate the fair value of stock options granted on the date of grant using the Black-Scholes pricing model. The Black-Scholes model incorporates a range of assumptions for inputs that are disclosed in the table above. Expected volatilities are based on the daily historical stock price over the expected life of the option. The expected term of options granted is derived from the output of the model and represents the period of time that options granted are expected to be outstanding. Dividend yields are estimated based the dividend yield on the Company’s common stock at the time of grant. The risk-free rate for periods within the contractual life of the stock option is based on the U.S. Treasury yield curve in effect at the time of grant.
Estimates of fair value derived from the Company’s use of the Black-Scholes pricing model are theoretical values for stock options and changes in the assumptions used in the models could result in different fair value estimates. The actual value of the stock options granted will depend on the market value of the Company’s common stock when the options are exercised.
Note 15. 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 the Bank’s business and, in Management’s opinion, were made at prevailing rates and terms.
The following table sets forth loans made to directors and executive officers of the Company as of December 31, 2008 and 2007:
Deposits from related parties held by the Bank at December 31, 2008 and 2007 amounted to approximately $3.7 million and $8.7 million, respectively.
Note 16. Restriction on Transfers of Funds to Parent
There are legal limitations on the ability of the Bank to provide funds to the Company. Dividends declared by the Bank may not exceed, in any calendar year, without approval of the California Department of Financial Institutions (“DFI”), its respective net income for the year and the retained net income for the preceding two years. Section 23A of the Federal Reserve Act restricts the Bank from extending credit to the Company and other affiliates amounting to more than 20 percent of its contributed capital and retained earnings.
Note 17. Fair Value of Financial Instruments
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. 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. Because no market value exists for a significant portion of the financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature, involve uncertainties and matters of judgment and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates.
Fair value estimates are based on financial instruments both on and off the balance sheet without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. Additionally, tax consequences related to the realization of the unrealized gains and losses can have a potential effect on fair value estimates and have not been considered in many of the estimates.
The estimated fair value of financial instruments at December 31, 2008 and 2007 is summarized as follows:
The following methods and assumptions were used by the Company in estimating fair value disclosures:
·
Cash and Cash Equivalents
The carrying amounts reported in the balance sheet for cash and cash equivalents approximate those assets' fair values due to the short-term nature of the assets.
·
Interest Bearing Deposits
Fair values for time deposits 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.
·
Investments Including FHLB Stock, FRB Stock and Mortgage-Backed Securities
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 supporting a valuation model.
·
Loans and Loans Held for Sale
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 commercial real estate and rental property mortgage loans and commercial and industrial loans) 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 carrying amount of accrued interest receivable approximates its fair value.
·
Bank Owned Life Insurance
Fair values are based on current cash surrender values at each reporting date provided by the underlying insurers.
·
Deposits
The fair values disclosed for demand deposits (for example, interest-bearing checking accounts and passbook 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 calculation 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 fair value.
·
FHLB Advances
The fair value disclosed for FHLB advances is determined by discounting contractual cash flows at current market interest rates for similar instruments.
·
Securities Sold Under Agreement to Repurchase
The carrying amounts reported in the balance sheets for securities sold under agreement to repurchase approximate those liabilities’ fair values due to the short-term nature of the liabilities.
·
Junior Subordinated Debentures
The fair value disclosed for junior subordinated debentures is based on contractual cash flows at current market interest rates for similar instruments.
·
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.
Note 18. Fair Value Disclosures
Effective January 1, 2008, the Company determines the fair market values of certain financial instruments based on the fair value hierarchy established in SFAS No. 157, “Fair Value Measurements,” which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value.
The following provides a summary of the hierarchical levels, as defined by SFAS No. 157, used to measure fair value:
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 2 assets and liabilities may include debt securities with quoted prices that are traded less frequently than exchange-traded instruments and other instruments whose value is determined using a pricing model with inputs that are observable in the market or can be derived principally from or corroborated by observable market data. This category generally includes U.S. Government and agency mortgage-backed debt securities, corporate debt securities, derivative contracts, residential mortgage and loans held-for-sale.
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 whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation. This category generally includes certain private equity investments, retained residual interests in securitizations, residential MSRs, asset-backed securities (ABS), highly structured or long-term derivative contracts and certain collateralized debt obligations (CDO) where independent pricing information was not able to be obtained for a significant portion of the underlying assets.
Fair Value Measurements
The Company used the following methods and significant assumptions to estimate fair value:
·
Securities
The fair value of securities available-for-sale are determined by obtaining quoted prices on nationally recognized exchanges or matrix pricing which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather relying on the security’s relationship to other benchmark quoted securities.
·
Loans Held For Sale
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.
·
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 contractual terms of the loan agreement. Impairment is measured based on the fair value of the underlying collateral or the discounted expected future cash flows. The Company measures impairment on all non-accrual loans for which it has established specific reserves as part of the specific allocated allowance component of the allowance for loan losses. As such, the Company records impaired loans 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, the Company records impaired loans as non-recurring Level 3. At December 31, 2008, substantially all of the Company’s impaired loans were evaluated based on the fair value of their underlying collateral based upon the most recent appraisal available to Management.
·
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. 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, the Company records other real estate owned or foreclosed collateral as non-recurring Level 3.
The following table provides a summary of the financial instruments the Company measures at fair value on a recurring basis as of December 31, 2008:
The following table provides a summary of the changes in balance sheet carrying values associated with Level 3 financial instruments during the twelve months ended December 31, 2008:
(1) Realized or unrealized gains from the changes in values of Level 3 financial instruments represent gains from changes in values of financial instruments only for the period(s) in which the instruments were classified as Level 3.
The assets presented under level 3 of the fair value hierarchy described in SFAS No. 157 represent available for sale investment securities in the form of certificates of participation where an active market for such securities is not currently available.
The following table provides a summary of the financial instruments the Company measures at fair value on a non-recurring basis as of December 31, 2008:
In addition to the assets presented in the table above, the Company uses fair value measurements on a non-recurring basis in its assessment of assets classified as Goodwill. These assets are recorded at fair value initially and assessed for impairment periodically thereafter. During the fiscal year ended December 31, 2008, the carrying amount of goodwill assets were compared to their fair value. No change in carrying amount resulted in accordance with the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets.” Additionally, the Company has certain other loans that are measured at fair value on a non-recurring basis such as loans that were acquired in the acquisition of Business First National Bank.
Note 19. Earnings Per Share
The following is a reconciliation of net income and shares outstanding to the income and number of shares used to compute earnings per share. Share information has been retroactively adjusted for stock dividends as discussed in Note 20 of these Consolidated Financial Statements:
Note 20. Other Income and Expense
The following tables provide a breakdown of fees and other income and expenses for the years ended December 31, 2008, 2007, and 2006:
Note 21. Cash Dividends, Stock Dividends and Stock Splits
Stock Dividends and Stock Splits
On April 24, 2008, the Board of Directors declared a five percent stock dividend payable on May 16, 2008 to stockholders of record on May 2, 2008. All references in financial statements and notes to financial statements to number of shares, per share amounts, and market prices of the Company’s common stock have been restated to reflect the increased number of shares outstanding.
Cash Dividends
The following table provides a summary of dividends the Company has declared and paid on its common stock during the last two years ending December 31, 2008:
Note 22. Stock Repurchase Program
On July 21, 2006, the Board of Directors adopted a resolution authorizing the repurchase of up to 42,000 shares of the Company’s common stock. Purchases were to be made, as conditions warrant, from time to time in the open market or through privately negotiated transactions. The duration of the program was for one year and the timing of purchases was to depend on market conditions. Subsequently, on October 20, 2006, the Board of Directors adopted a resolution to increase the number of shares available for repurchase under the 2006 plan to 105,000. In July 2007, the Board of Directors authorized a one year extension of this plan, which expired in August 2008.
As of December 31, 2008, the Company repurchased and retired 56,175 shares of its common stock under the 2006 stock repurchase plan at a weighted average price of $16.61. The Company made no repurchases of its common stock during 2008. As mentioned above, the Repurchase Plan expired in August 2008.
Note 23. Business Combinations
On October 12, 2007 the Company acquired Business First National Bank (“Business First”). Business First was merged with and into the Bank, a wholly owned subsidiary of the Company. The consideration paid for Business First was approximately $19.5 million, consisting of approximately 75% common stock and 25% cash. Business First shareholders received 0.5758 shares of the Company’s common stock for each share of Business First they owned and $3.44 per share in cash. Upon the acquisition of Business First, the Company issued 892,724 shares of its common stock and approximately $5.1 million in cash to the former shareholders of Business First. The value of the shares issued in connection with this acquisition was approximately $13.8 million and was determined by multiplying the number of new shares issued by the closing market price of the Company’s common stock on the closing date of October 12, 2007. The remaining component of the consideration related to the value of stock options previously issued by Business First that were rolled into substitute stock option agreements granted by the Company.
The following table provides a summary of the assets acquired and liabilities assumed as of the date of the acquisition:
In conjunction with the acquisition of Business First, the Company recorded approximately $6.0 million in goodwill. It should be noted that goodwill associated with the Business First acquisition is not deductible for tax purposes, since the acquisition is not considered a purchase of assets. During 2008, Goodwill related to the acquisition of Business First increased approximately $0.1 million, due to costs capitalized related to the acquisition.
The following table presents the assumptions used in the calculation of the weighted average fair value of the substitute stock options agreements granted by the Company on the date of grant using the Black-Scholes option pricing model:
The following un-audited pro-forma financial information assumes the acquisition of Business First occurred on January 1, 2006.
The pro-forma financial information presented in the table above is based on certain assumptions and estimates which the Company believes are reasonable. The pro-forma consolidated results of operations do not purport to be indicative of the results which would actually have been obtained had the acquisition occurred on the dates indicated or which may be obtained in the future.
As a result of the acquisition, the combined organization is not only expected to be able to compete more effectively and take advantage of banking opportunities in Santa Barbara and San Luis Obispo counties, but generate certain efficiencies and long-term cost savings as a result of economies of scale.
The Company’s Consolidated Statements of Income include the results of operations of Business First from October 12, 2007 through December 31, 2008.
Note 24. Subsequent Events
On January 7, 2009, the Company received preliminary approval (the “Preliminary Approval”) to participate in the U.S. Treasury’s Capital Purchase Program (“CPP”). The Preliminary Approval provides for the purchase approximately $21.0 million of the Company’s Senior Preferred Stock by the U.S. Treasury. The preferred stock will carry a coupon of 5% for five years and 9% thereafter. Senior preferred issued to the U.S. Treasury will be non-voting, cumulative, and perpetual and may be redeemed at 100% of the issue price following three years from the date of issue. The Company would be subject to certain limitations upon its participation in the CPP including:
·
The requirement to obtain consent from the U.S. Treasury for any proposed increases in common stock dividends prior to the third anniversary date of the preferred equity issuance.
·
The Senior Preferred Stock cannot be redeemed for three years unless the Company obtains proceeds to replace the Senior Preferred Stock through a qualified equity offering.
·
The U.S. Treasury must consent to any buy back of our common stock.
·
The Company must adhere to restrictions placed on the amount of and type of compensation paid to its executives while participating in the CPP, pursuant to section 111 of the Emergency Economic Stabilization Act of 2008 (“EESA”).
In addition, the Company would issue warrants to the U.S. treasury to purchase shares of the Company’s common stock in an amount equal to 15% of the of the preferred equity issuance or approximately $3.2 million (617,173 shares). The warrants would be exercisable immediately at a price of equal to the average closing price of the Company’s common stock over the 20-day period ending the day prior to the Company’s preliminary approval ($5.15 per share). These warrants will expire after a period of 10 years from issuance and are transferable by the U.S. Treasury. It is expected that the issuance of this warrant will increase the level of diluted shares outstanding following its issuance.
On February 27, 2009, the Company received shareholder approval for an amendment of our Articles of Incorporation to add a class of preferred stock, which is needed if the Company ultimately participates in the CPP. It is the Company’s present intention to complete a transaction with the U.S. Treasury, however recent changes to executive compensation limits made by comments are causing the Company’s Board of Directors and Management to reanalyze the CPP.
Note 25. Parent Company Financial Information
Heritage Oaks Bancorp
Condensed Balance Sheets
Heritage Oaks Bancorp
Condensed Statements of Income
Heritage Oaks Bancorp
Condensed Statements of Cash Flows
Quarterly Financial Information (un-audited)
The following table provides a summary of results for the periods indicated:
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A. Controls and Procedures
As required by SEC Rule 13a-15(b), the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer along with the Company’s Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of the end of the period covered by this report. The evaluation of disclosure controls and procedures includes an evaluation of some components of the Company’s internal control over financial reporting, and internal control over financial reporting is also separately evaluated on an annual basis for purposes of providing the management report which can be found under Item 8. Financial Statements and Supplementary Data, beginning on page 59 of this report. Based upon that evaluation, the Company’s Chief Executive Officer along with the Company’s Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective in timely alerting them to material information relating to the Company (including its consolidated subsidiary) required to be included in the Company’s periodic SEC filings. There have been no significant changes in the Company’s internal control over financial reporting during the Company’s most recent fiscal quarter that have materially affected, or are likely to materially affect, the Company’s internal control over financial reporting.
Disclosure controls and procedures are the Company’s controls and other procedures that are designed to ensure that information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. These controls and subsequent results are communicated to executive management providing the ability to make timely decisions regarding required disclosure.
Item 9B.
Item 9B. Other Information
None.
Part III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance
Code of Ethics
We have adopted a Code of Conduct, which applies to all employees, officers and directors of the Company and Bank. Our Code of Conduct meets the requirements of a “code of ethics” as defined by Item 406 of Regulation S-K and applies to our Chief Executive Officer, Chief Financial Officer and Principal Accounting Officer, as well as all other employees, as indicated above. Our Code of Conduct is 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 (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.
There have been no material changes to the procedures by which security holders may recommend nominees to the Company’s Board during 2008.
The balance of the information required by Item 10 of Form 10-K is incorporated by reference from the information contained in the Company’s Proxy Statement for the 2009 Annual Meeting of Shareholders which will be filed pursuant to Regulation 14-A.
Item 11.
Item 11. Executive Compensation
The information required by Item 11 of Form 10-K is incorporated by reference from the information contained in the Company’s Proxy Statement for the 2009 Annual Meeting of Shareholders which will be filed pursuant to Regulation 14-A.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The information required by Item 12 of Form 10-K is incorporated by reference from the information contained in the Company’s Proxy Statement for the 2009 Annual Meeting of Shareholders which will be filed pursuant to Regulation 14-A. See (Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities).
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence
The information required by Item 13 of Form 10-K is incorporated by reference from the information contained in the Company’s Proxy Statement for the 2009 Annual Meeting of Shareholders which will be filed pursuant to Regulation 14-A.
Item 14.
Item 14. Principal Accounting Fees and Services
The information required by Item 14 of Form 10-K is incorporated by reference from the information contained in the Company’s Proxy Statement for the 2009 Annual Meeting of Shareholders which will be filed pursuant to Regulation 14-A.
Part IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules
(a) 1. 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 to 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 107 for exhibits filed as part of this report.
(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.
The Company
/s/ Lawrence P. Ward
/s/ Margaret A. Torres
Lawrence P. Ward
Margaret A. Torres
President and Chief Executive Officer
Executive Vice President, Chief Financial Officer
Dated: March 6, 2009
and Principal Accounting Officer
Dated:March 6, 2009
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 Morris
Chairman of the Board of Directors
March 6, 2009
Michael Morris
/s/ Donald H. Campbell
Vice Chairman of the Board of Directors
March 6, 2009
Donald H. Campbell
/s/ Michael Behrman
Director
March 6, 2009
Michael Behrman
/s/ Kenneth Dewar
Director
March 6, 2009
Kenneth Dewar
/s/ Mark C. Fugate
Director
March 6, 2009
Mark C. Fugate
/s/ Dolores T. Lacey
Director
March 6, 2009
Dolores T. Lacey
/s/ Merle F. Miller
Director
March 6, 2009
Merle F. Miller
/s/ Daniel J. O’Hare
Director
March 6, 2009
Daniel J. O’Hare
/s/ Michael E. Pfau
Director
March 6, 2009
Michael E. Pfau
/s/ Alex Simas
Director
March 6, 2009
Alex Simas
/s/ Lawrence P. Ward
Director
March 6, 2009
Lawrence P. Ward
Exhibit Index
(3.1a)
Articles of Incorporation incorporated by reference from Exhibit 3.1a to Registration Statement on Form S-4 No. 33-77504 filed with the SEC on April, 1994.
(3.1b)
Amendment to the Articles of Incorporation filed with the Secretary of State on October 16, 1997 filed with the SEC in the Company’s 10-KSB for the year ending December 31, 1997.
(3.2)
The Company Bylaws as amended November 16, 2000 filed with the SEC in the Company’s 10-KSB for the year ended December 31, 2000.
(4.1)
Specimen form of The Company stock certificate incorporated by reference from Exhibit 4.1 to Registration Statement on Form S-4 No. 33-77504 filed with the SEC on April 8, 1994.
(10.1)
Stock Option Plan incorporated by reference from Exhibit 10.2 to Registration Statement on Form S-4 No. 33-77504, filed with the SEC on April 8, 1994.
(10.2)
Form of Stock Option Agreement incorporated by reference from Exhibit 4.2 to Registration Statement on Form S-4 No. 33-77504, filed with the SEC on April 8, 1994.
(10.5)
The Company 1995 Bonus Plan, filed with the SEC in the Company’s 10K Report for the year ended December 31, 1994.
(10.6)
Salary Continuation Agreement with Lawrence P. Ward, filed with the SEC in the Company’s 10-QSB Report for the quarter ended March 31, 2001.
(10.7)
Salary Continuation Agreement with Gwen R. Pelfrey, filed with the SEC in the Company’s 10K Report for the year ended December 31, 1994.
(10.11)
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, File No. 333-83235 filed with the SEC on July 20, 1999.
(10.12)
Form of Stock Option Agreement incorporated by reference from Exhibit 4b to Registration Statement on Form S-8 No. 333-31105 filed with the SEC on July 11, 1997.
(10.15)
Master data processing agreement with Mid West Payment Systems, Inc. commencing October 1, 1998 filed with the SEC in the Company’s 10-KSB for the year ended December 31, 1998.
(10.16)
Salary Continuation Agreement with Margaret A. Torres, filed with the SEC in the Company’s 10KSB Report for the year ended December 31, 1999.
(10.17)
Salary Continuation Agreement with Paul Tognazzini, filed with the SEC in the Company’s 10-KSB Report for the year ended December 31, 2001.
(10.19)
Service Bureau Processing Agreement entered into between Alltel Information Services, Inc. and Heritage Oaks Bank, dated August 1, 1999. Filed with the SEC in the Company’s 10-KSB reported for the year ended December 31, 1999.
(10.22)
Executive Salary Continuation Agreement dated February 1, 2002 between Heritage Oaks Bank and Margaret A. Torres, filed with the SEC in the Company’s 10-QSB reported for March 31, 2002.
(10.23)
Executive Salary Continuation Agreement dated February 1, 2002 between Heritage Oaks Bank and Paul Tognazzini, filed with the SEC in the Company’s 10-QSB reported for March 31, 2002.
(10.24)
Executive Salary Continuation Agreement dated February 1, 2002 between Heritage Oaks Bank and Gwen R. Pelfrey, filed with the SEC in the Company’s 10-QSB reported for March 31, 2002.
(10.25)
Executive Salary Continuation Agreement dated February 1, 2002 between Heritage Oaks Bank and Gloria Brady, filed with the SEC in the Company’s 10-QSB reported for March 31, 2002.
(10.26)
Executive Salary Continuation Agreement dated February 1, 2002 between Heritage Oaks Bank and Joe Carnevali, filed with the SEC in the Company’s 10-QSB reported for March 31, 2002.
(10.27)
Executive Salary Continuation Agreement dated February 1, 2002 between Heritage Oaks Bank and Donna Breuer, filed with the SEC in the Company’s 10-QSB reported for March 31, 2002.
(10.28)
Executive Salary Continuation Agreement dated February 1, 2002 between Heritage Oaks Bank and Chris Sands, filed with the SEC in the Company’s 10-QSB reported for March 31, 2002.
(10.29)
Money Access Services Processing Agreement for ATM processing, signed on October 3, 2002, filed with the SEC in the Company’s 10-QSB reported for September 30, 2002.
(10.30)
The Company Employee Stock Ownership Plan, Summary Plan Description, filed with the SEC in the Company’s 10-KSB reported for December 31, 2002.
(10.31)
The Company Employee Stock Ownership Plan, Summary of Material Modifications to the Summary Plan Description dated July 2002, filed with the SEC in the Company’s 10-KSB reported for December 31, 2002.
(10.32)
A Construction Agreement dated February 12, 2003 between Heritage Oaks Bank and HBE Financial Facilities, a Division of HBE Corporation, filed with the SEC in the Company’s 10-QSB for March 31, 2003.
(10.33)
Executive Salary Continuation Agreement dated July 1, 2003 between Heritage Oaks Bank and Mark Stasinis, filed with the SEC in the Company’s 10-QSB reported for June 30, 2003.
(10.34)
Executive Salary Continuation Agreement dated July 1, 2003 between Heritage Oaks Bank and Kelley Stolz, filed with the SEC in the Company’s 10-QSB reported for June 30, 2003.
(10.35)
Executive Salary Continuation Agreement dated July 1, 2003 between Heritage Oaks Bank and Paul Deline, filed with the SEC in the Company’s 10-QSB reported for June 30, 2003.
(10.36)
Executive Salary Continuation Agreement dated July 1, 2003 between Heritage Oaks Bank and Mitch Massey, filed with the SEC in the Company’s 10-QSB reported for June 30, 2003.
(10.38)
Promissory Note executed on October 3, 2003 for $3.5 million with Pacific Coast Bankers Bank, filed with the SEC in the Company’s 10-QSB reported for September 30, 2003.
(10.39)
Employment Agreement with Lawrence P. Ward, President and Chief Executive Officer of Heritage Oaks Bank, dated February 1, 2004 and filed with the SEC in the Company’s 10-KSB reported for December 31, 2003.
(10.41)
Fifth Amendment to Service Bureau Processing Agreement dated June 19, 2004 between Fidelity Information Services, Inc. and Heritage Oaks Bank, filed with the SEC in the Company’s 10QSB for June 30, 2004.
(10.43)
Form of Change in Control Agreements.
(14)
Code of Ethics, filed with the SEC in the Company’s 10-KSB for the year ended December 31, 2003.
(21)
Subsidiaries of the Company. Heritage Oaks Bank is the only financial subsidiaries of the Company.
(23)
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**
**Filed herewith.