Heritage Commerce (HTBK) 10-Q 2005 Q2 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2005

OR

[  ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from ________to _________

Commission file number 000-23877

Heritage Commerce Corp

(Exact name of Registrant as Specified in its Charter)

California	77-0469558
(State or Other Jurisdiction of Incorporation or Organization)	(I.R.S. Employer Identification Number)

150 Almaden Boulevard

San Jose, California    95113

(Address of Principal Executive Offices including Zip Code)

(408) 947-6900

(Registrant's Telephone Number, Including Area Code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file reports), and (2) has been subject to such filing requirements for the past 90 days. YES [X] NO [   ]

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). YES [X] NO [   ]

APPLICABLE ONLY TO CORPORATE ISSUERS:

The Registrant had 11,769,158 shares of Common Stock outstanding on August 2, 2005.

Heritage Commerce Corp and Subsidiaries

Quarterly Report on Form 10-Q

Table of Contents

PART I. FINANCIAL INFORMATION	Page No.
Item 1. Condensed Consolidated Financial Statements (unaudited):	2
Condensed Consolidated Balance Sheets	2
Condensed Consolidated Income Statements	3
Condensed Consolidated Statements of Changes in Shareholders' Equity	4
Condensed Consolidated Statements of Cash Flows	5
Notes to Condensed Consolidated Financial Statements	6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations	11
Item 3. Quantitative and Qualitative Disclosures About Market Risk	32
Item 4. Controls and Procedures	32
PART II. OTHER INFORMATION
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	33
Item 4. Submissions of Matters to a Vote of Security Holders	34
Item 6. Exhibits	35
Signatures	35

Part I -- FINANCIAL INFORMATION

ITEM 1.FINANCIAL STATEMENTS

Heritage Commerce Corp and Subsidiaries
Condensed Consolidated Balance Sheets (Unaudited)
	June 30,			December 31,
(Dollars in thousands)	2005			2004
Assets
Cash and due from banks	$	34,685		$	33,646
Federal funds sold		26,300			24,100
Total cash and cash equivalents		60,985			57,746
Securities available-for-sale, at fair value		226,630			232,809
Loans held for sale, at lower of cost or market		35,702			37,178
Loans, net of deferred costs		713,691			725,530
Allowance for loan losses		(11,436	)		(12,497	)
Loans, net		702,255			713,033
Federal Home Loan Bank and Federal Reserve Bank stock		5,746			4,695
Company owned life insurance		30,660			26,303
Premises and equipment, net		2,846			3,183
Accrued interest receivable and other assets		32,872			33,226
Total assets	$	1,097,696		$	1,108,173
Liabilities and Shareholders' Equity
Liabilities:
Deposits
Demand, noninterest bearing	$	256,859		$	277,451
Demand, interest bearing		129,655			120,890
Savings and money market		322,229			357,318
Time deposits, under $100		37,841			38,295
Time deposits, $100 and over		124,760			104,719
Brokered deposits, $100 and over		38,090			19,862
Total deposits		909,434			918,535
Notes payable to subsidiary grantor trusts		23,702			23,702
Securities sold under agreement to repurchase		40,700			47,800
Accrued interest payable and other liabilities		19,675			19,557
Total liabilities		993,511			1,009,594
Shareholders' equity:
Preferred stock, no par value; 10,000,000
shares authorized; none outstanding		-			-
Common Stock, no par value; 30,000,000 shares authorized
shares outstanding: 11,741,309 at June 30, 2005 and
11,669,837 at December 31, 2004		67,524			67,409
Unearned restricted stock award		(881	)		-
Unallocated ESOP shares		-			(193	)
Accumulated other comprehensive loss		(1,545	)		(1,730	)
Retained earnings		39,087			33,093
Total shareholders' equity		104,185			98,579
Total liabilities and shareholders' equity	$	1,097,696		$	1,108,173
See notes to condensed consolidated financial statements

Heritage Commerce Corp and Subsidiaries
Condensed Consolidated Income Statement (Unaudited)
	Three Months Ended				Six Months Ended
	June 30,				June 30,
			2004				2004
			(As Restated				(As Restated
(Dollars in thousands, except per share data)	2005		see Note 2)		2005		see Note 2)
Interest income:
Loans, including fees	$	13,169	$	10,430	$	25,567	$	20,504
Securities, taxable		1,784		1,615		3,594		2,898
Securities, non-taxable		51		70		105		185
Interest bearing deposits in other financial institutions		18		1		31		4
Federal funds sold		325		92		502		161
Total interest income		15,347		12,208		29,799		23,752
Interest expense:
Deposits		2,883		1,579		5,293		3,160
Subsidiary grantor trusts		525		481		1,037		963
Other		260		238		534		364
Total interest expense		3,668		2,298		6,864		4,487
Net interest income before provision for loan losses		11,679		9,910		22,935		19,265
Provision for loan losses		394		575		807		1,138
Net interest income after provision for loan losses		11,285		9,335		22,128		18,127
Noninterest income:
Gain on sale of loans		698		639		1,458		1,366
Loan servicing income		466		375		858		679
Service charges and other fees on deposit accounts		395		497		788		970
Gain on sale of leased equipment		299		-		299		-
Increase in cash surrender value of life insurance		290		234		556		562
Equipment leasing		52		245		131		490
Gain on sale of securities available-for-sale		-		264		-		476
Mortgage brokerage fees		-		30		-		149
Other		390		323		805		679
Total noninterest income		2,590		2,607		4,895		5,371
Noninterest expense:
Salaries and employee benefits		4,760		5,456		9,665		10,176
Occupancy		841		872		1,692		1,914
Retirement plan expense		370		981		738		1,218
Client services		345		231		751		416
Advertising and promotion		323		252		512		499
Amortization of low income housing projects		293		203		546		362
Professional fees		225		961		721		1,316
Furniture and equipment		204		255		403		492
Data processing expense		169		183		341		322
Amortization of leased equipment		83		250		334		516
Other		1,265		1,163		2,484		2,228
Total noninterest expense		8,878		10,807		18,187		19,459
Income before income taxes		4,997		1,135		8,836		4,039
Income tax expense		1,657		366		2,842		1,299
Net income	$	3,340	$	769	$	5,994	$	2,740
Earnings per share:
Basic	$	0.28	$	0.07	$	0.51	$	0.24
Diluted	$	0.27	$	0.06	$	0.49	$	0.23
See notes to condensed consolidated financial statements

HERITAGE COMMERCE CORP AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY (UNAUDITED)
Six Months Ended June 30, 2005
	Common Stock						Unearned Award Restricted			Unallocated ESOP			Accumlated Other Comprehensive			Retained		Total Shareholders'			Comprehensive
	Shares			Amount			Stock			Shares			Loss			Earnings		Equity			Income
Balance, January 1, 2005		11,669,837		$	67,409		$	-		$	(193	)	$	(1,730	)	$	33,093	$	98,579
Net Income		-			-			-									5,994		5,994		$	5,994
Net change in unrealized gain/loss on securities available-for-sale and Interest-Only strips, net of reclassification adjustment and taxes					-			-			-			185			-		185			185
Total comprehensive income		-			-			-						-							$	6,179
ESOP shares released		-			284			-			193			-					477
Restricted stock award		51,000			926			(926	)		-			-					-
Amortization of restricted stock award		-			-			45			-			-					45
Redemption payment on commom stock		-			(12	)		-			-			-					(12	)
Common stock repurchased		(207,400	)		(3,874	)													(3,874	)
Stock options exercised		227,872			2,791			-			-			-					2,791
Balance, June 30, 2005		11,741,309		$	67,524		$	(881	)	$	-		$	(1,545	)	$	39,087	$	104,185
See notes to condensed consolidated financial statements

HERITAGE COMMERCE CORP AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
	Six Months Ended
	June 30,
				2004
				(As Restated
(Dollars in thousands)	2005			see Note 2)
CASH FLOWS FROM OPERATING ACTIVITIES
Net Income	$	5,994		$	2,740
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		548			783
Provision for loan losses		807			1,138
Gain on sale of leased equipment		(299	)		-
Gain on sale of securities available for sale		-			(476	)
Non-cash compensation expense related to ESOP		477			228
Amortization of restricted stock award		45			-
Amortization/accreation of discounts and premiums on securities		616			455
Gain on sale of loans		(1,458	)		(1,366	)
Proceeds from sales of loans held for sale		24,147			27,392
Originations of loans held for sale		(35,153	)		(33,747	)
Maturities/paydowns/payoffs of loans held for sale		13,940			6,443
Increase in cash surrender value of life insurance		(556	)		(562	)
Change in:
Accrued interest receivable and other assets		89			(6,418	)
Accrued interest payable and other liabilities		789			6,098
Net cash provided by operating activities		9,986			2,708
CASH FLOWS FROM INVESTING ACTIVITIES
Net change in loans		9,971			(43,084	)
Purchases of securities available for sale		(6,000	)		(117,736	)
Maturities/paydowns/calls of securities available for sale		11,251			13,371
Proceeds from sales of securities available for sale		-			22,641
Sale of leased equipment		389			-
Purchase of company owned life insurance		(3,800	)		-
Purchases of Federal Home Loan Bank stock		(1,051	)		(2,118	)
Purchases of premises and equipment		(211	)		(391	)
Net cash provided by (used in) investing activities		10,549			(127,317	)
CASH FLOWS FROM FINANCING ACTIVITIES
Net increase in deposits		(9,101	)		83,759
Net proceeds from issuance of common stock		2,791			2,571
Redemption of common stock		(3,886	)		(1,934	)
Net changes in securities sold under agreement to repurchase		(7,100	)		(3,800	)
Net cash provided by (used in) financing activities		(17,296	)		80,596
Net increase in cash and cash equivalents		3,239			(44,013	)
Cash and cash equivalents, beginning of period		57,746			114,217
Cash and cash equivalents, end of period	$	60,985		$	70,204
Supplemental disclosures of cash paid during the period for:
Interest	$	6,296		$	4,555
Income taxes	$	1,670		$	-
See notes to condensed consolidated financial statements

HERITAGE COMMERCE CORP AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

June 30, 2005

(Unaudited)

1)Basis of Presentation

The unaudited condensed consolidated financial statements of Heritage Commerce Corp (the “Company”) and its wholly owned subsidiary, Heritage Bank of Commerce (“HBC”), have been prepared pursuant to the rules and regulations for reporting on Form 10-Q. Accordingly, certain information and notes required by accounting principles generally accepted in the United States of America ("GAAP") for annual financial statements are not included herein. The interim statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Form 10-K for the year ended December 31, 2004. The Company has also established the following unconsolidated subsidiary grantor trusts: Heritage Capital Trust I; Heritage Statutory Trust I; Heritage Statutory Trust II; and Heritage Commerce Corp Statutory Trust III which are Delaware Statutory business trusts formed for the exclusive purpose of issuing and selling trust preferred securities.

HBC is a commercial bank serving customers located in Santa Clara, Alameda, and Contra Costa counties of California. No customer accounts for more than 10 percent of revenue for HBC or the Company. Management evaluates the Company’s performance as a whole and does not allocate resources based on the performance of different lending or transaction activities. Accordingly, the Company and its subsidiary operate as one business segment.

In the Company’s opinion, all adjustments necessary for a fair presentation of these condensed consolidated financial statements have been included and are of a normal and recurring nature.

The results for the three months and six months ended June 30, 2005 are not necessarily indicative of the results expected for any subsequent period or for the entire year ending December 31, 2005.

Certain amounts in the June 30, 2004 three month and six month ended condensed consolidated financial statements have been reclassified to conform to 2005 presentation. Loan origination cost amortization of $351,000 and $669,000 in the condensed consolidated income statement for the three months and six months ended June 30, 2004, respectively, was reclassified from noninterest expense to interest income on loans to conform to the 2005 presentation. The reclassification had no effect on income before income taxes or net income in the 2004 periods. This reclassification is also reflected in the condensed consolidated income statements for the three months ended March 31, 2005.

Service fees of $244,000 and $490,000 in the condensed consolidated income statement for the three months and six months ended June 30, 2004, respectively, were reclassified from interest income on loans to noninterest income to conform to the 2005 presentation. The reclassification had no effect on income before income taxes or net income in the 2004 periods. This reclassification is also reflected in the condensed consolidated income statements for the three months ended March 31, 2005.

Servicing rights amortization of $186,000 and $387,000 in the condensed consolidated income statements for the three and six months ended June 30, 2004, respectively, was reclassified from interest income to noninterest income to conform to the 2005 presentation. The reclassification had no effect on income before income taxes or net income in the 2004 periods. This reclassification is also reflected in the condensed consolidated income statements for the three months ended March 31, 2005.

2)   Restatement

Subsequent to the issuance of the Company's condensed consolidated financial statements for the six months ended June 30, 2004, management determined that the six months ended June 30, 2004 condensed consolidated financial statements should be restated as a result of the following accounting errors:

·   An asset which the Company had accounted for as a direct financing lease and classified as a part of the loan portfolio during the first six months of 2004 should have been accounted for as equipment subject to an operating lease. The after-tax income statement effect of correcting this error on the three and six months ended June 30, 2004 was to reduce income by $36,000 and $77,000, respectively.

·   The Company determined that its previous method of accounting for rent holidays and step-up rents in its facilities lease agreements was not appropriate and that it should have accounted for rent holidays and step-up rents on a straight-line basis. The after-tax income statement effect of correcting this error on the six months ended June 30, 2004 was to increase income by $5,000 and $10,000, respectively.

The following is a summary of the significant effects of the restatement adjustments and reclssifications on the condensed consolidated income statements for the three and six months ended June 30, 2004:

	Three Months Ended										Six Months Ended
			Restatement										Restatement
			Adjustments										Adjustments
	As Previously		and								As Previously		and
(Dollars in thousands, except per share data)	Reported		Reclassifications (1)						As Restated		Reported		Reclassifications (1)					As Restated
Interest income on loans, including fees	$	10,912	$	(482	)			$	10,430	$	21,427	$	(923	)			$	20,504
Total interest income		12,690		(482	)				12,208		24,675		(923	)				23,752
Net interest income before provision for loan losses		10,392		(482	)				9,910		20,188		(923	)				19,265
Provision for loan losses		600		(25	)				575		1,200		(62	)				1,138
Net interest income after provision for loan losses		9,792		(457	)				9,335		18,988		(861	)				18,127
Equipment leasing		-		245					245		-		490					490
Loan servicing income		561		(186	)				375		1,066		(387	)				679
Other noninterest income		79		244					323		189		490					679
Total noninterest income		2,304		303					2,607		4,778		593					5,371
Occupancy		880		(8	)				872		1,930		(16	)				1,914
Amortization of leased equipment		-		250					250		-		516					516
Loan origination costs		411		(411	)	(2	)		-		768		(768	)	(2	)		-
Total noninterest expense		10,916		(109	)				10,807		19,628		(169	)				19,459
Income before income taxes		1,180		(45	)				1,135		4,137		(98	)				4,039
Income tax expense		380		(14	)				366		1,330		(31	)				1,299
Net income		800		(31	)				769		2,807		(67	)				2,740
Earnings per share:
Basic	$	0.07	$	-				$	0.07	$	0.24	$	-				$	0.24
Diluted	$	0.07	$	(0.01	)			$	0.06	$	0.24	$	(0.01	)			$	0.23

(1) Includes reclassifications described in Note 1.

(2) $351,000 and $669,000 of loan origination costs for the three and six months ended June 30, 2004, respectively, were reclassified to interest income on loans. $60,000 and $99,000 of loan origination costs for the three and six months ended June 30, 2004, respectively, were reclassified to noninterest expense.

3)Securities Available-for-Sale

The following table shows the gross unrealized losses and fair value of the Company’s securities with unrealized losses aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at June 30, 2005:

	Less Than 12 Months				12 Months or More				Total
	Fair		Unrealized		Fair		Unrealized		Fair		Unrealized
(Dollars in thousands)	Value		Losses		Value		Losses		Value		Losses
U.S. Treasury	$	-	$	-	$	5,962	$	37	$	5,962	$	37
U.S. Government Agencies		26,845		192		63,118		795		89,963		987
Municipals		3,720		43		4,495		88		8,215		131
FHLMC and FNMA mortgage-backed securities		23,255		46		65,648		1,611		88,903		1,657
CMOs		7,486		14		11,853		246		19,339		260
Total	$	61,306	$	295	$	151,076	$	2,777	$	212,382	$	3,072

As of June 30, 2005, the Company held 101 securities, of which 80 had fair values below amortized cost. Forty-seven securities have been carried with an unrealized loss for over 12 months. Higher interest rates at June 30, 2005 resulted in lower market values for the period and was the primary reason that certain securities had unrealized losses. There was no security that sustained a downgrade in credit ratings. All principal amounts are expected to be paid when securities mature. The Company does not consider these securities to be other-than-temporarily impaired at June 30, 2005.

4)Stock-Based Compensation

The Company accounts for stock-based awards to employees using the intrinsic value method in accordance with Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees. No compensation expense has been recognized in the financial statements for employee stock option arrangements, as the Company’s stock option plan provides for the issuance of options at a price of no less than the fair market value at the date of the grant.

Statement of Financial Accounting Standards ("SFAS") No. 123, Accounting for Stock-Based Compensation, requires the disclosure of pro forma net income and earnings per share had the Company adopted the fair value method at the grant date of all stock options. Under SFAS No. 123, the fair value of stock-based awards to employees is calculated through the use of option pricing models, even though such models were developed to estimate the fair value of freely tradable, fully transferable options without vesting restrictions, which differ significantly from the Company's stock option awards. Those models also require subjective assumptions, which affect the calculated values. The Company's calculations were made using the Black-Scholes option pricing model with the following weighted average assumptions: expected life, 84 months; risk-free interest rate, 4.12% and 4.14% for June 30, 2005 and 2004; stock volatility of 17% and 30% in June 30, 2005 and 2004; and no dividends during the expected term. The Company's calculations are based on a multiple option valuation approach, and forfeitures are recognized as they occur.

In December 2004, the FASB issued SFAS No. 123 (revised 2004), "Share-Based Payment." This Statement requires that compensation costs related to share-based payment transactions be recognized in the financial statements. Measurement of the cost of employee service will be based on the grant-date fair value of the equity or liability instruments issued. That cost will recognized over the period during which an employee is required to provide service in exchange for the award. Additionally, liability awards will be remeasured each reporting period. Statement 123R replaces SFAS No. 123, "Accounting for Stock-Based Compensation" and supersedes APB Opinion No. 25 "Accounting for Stock Issued to Employees". On April 14, 2005, the SEC issued rule 2005-57, which allows companies to delay implementation of the Statement to the beginning of the next fiscal year. The Company has not yet concluded on the method of adoption allowed by the Statement and is currently evaluating the impact of this accounting guidance on its financial condition and results of operations.

Subsequent to the issuance of the condensed consolidated financial statements for the three and six months ended June 30, 2004, management determined that compensation expense for amortization of fair value of stock awards, net of tax for the three and six months ended June 30, 2004 had been calculated incorrectly. Accordingly, such pro forma amounts presented in the table below have been restated. The effect was to decrease compensation expense for amortization of fair value of stock awards, net of taxes, $91,000 and $195,000, respectively, for the three and six months ended June 30, 2004. Pro forma net income per common share increased $0.01 per basic and diluted share for the three and six months ended June 30, 2004. The correction did not impact the Company's consolidated financial position, results of operations, or cash flows for any period presented.

The Company awarded 51,000 restricted shares of common stock to Walter T. Kaczmarek, President and Chief Executive Officer of the Company, pursuant to the terms of a Restricted Stock Agreement dated March 17, 2005. The grant price was $18.15. Under the terms of the Restricted Stock Agreement, the restricted shares will vest 25% per year at the end of years three, four, five and six, provided Mr. Kaczmarek is still with the Company. Compensation cost associated with the restricted stock issued is measured based on the market price of the stock at the grant date and is expensed on a straight-line basis over the service period. Restricted stock compensation expense for the three and six months ended June 30, 2005 was $39,000 and $45,000, respectively.

Had compensation expense for the Company's stock options been determined under the requirements of SFAS No. 123 the Company's pro forma net income and earnings per common share would have been as follows:

	Three Months Ended						Six Months Ended
	June 30,						June 30,
(Dollars in thousands, except per share data)	2005			2004			2005			2004
Net income as reported	$	3,340		$	769		$	5,994		$	2,740
Less: Compensation expense for stock options determined
under fair value method		(111	)		(111	)		(204	)		(208	)
Pro forma net income	$	3,229		$	658		$	5,790		$	2,532
Net income per common share - basic
As reported	$	0.28		$	0.07		$	0.51		$	0.24
Pro forma	$	0.27		$	0.06		$	0.49		$	0.22
Net income per common share - diluted
As reported	$	0.27		$	0.06		$	0.49		$	0.23
Pro forma	$	0.27		$	0.06		$	0.48		$	0.21

5) Earnings Per Share

Basic earnings per share is computed by dividing net income by the weighted average common shares outstanding. Diluted earnings per share reflects potential dilution from outstanding stock options, using the treasury stock method. There were 27,582 and 16,830 stock options for three months ended June 30, 2005 and 2004 and 18,122 and 118,816 for six months ended June 30, 2005 and 2004, respectively, considered to be antidilutive and excluded from the computation of diluted earnings per share. For each of the periods presented, net income is the same for basic and diluted earnings per share. Reconciliation of weighted average shares used in computing basic and diluted earnings per share is as follows:

	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2005		2004		2005		2004
Weighted average common shares outstanding - used
in computing basic earnings per share		11,826,778		11,543,552		11,798,730		11,463,679
Dilutive effect of stock options outstanding,
using the treasury stock method		358,807		411,020		359,132		445,384
Shares used in computing diluted earnings per share		12,185,585		11,954,572		12,157,862		11,909,063

6) Comprehensive Income

Comprehensive income includes net income and other comprehensive income, which represents the change in the Company’s net assets during the period from non-owner sources. The Company's sources of other comprehensive income are unrealized gains and losses on securities available-for-sale and I/O strips, which are treated like available-for-sale securities, and are presented net of tax. Reclassification adjustments resulting from gains or losses on securities that were realized and included in net income of the current period that also had been included in other comprehensive income as unrealized holding gains or losses in the period in which they are excluded from comprehensive income of the current period. The Company's total comprehensive income was as follows:

	Three Months Ended					Six Months Ended
	June 30,					June 30,
(Dollars in thousands)	2005		2004			2005		2004
Net income	$	3,340	$	769		$	5,994	$	2,740
Other comprehensive income (loss), net of tax:
Net unrealized holding gains (losses) on available-for-sale
securities and Interest-Only strips, during the period, net of tax		1,299		(3,441	)		185		(2,376	)
Less: reclassification adjustment for net realized
gains, net of tax on available-for-sale securities
included in net income during the period		-		(179	)		-		(323	)
Other comprehensive income (loss)		1,299		(3,620	)		185		(2,699	)
Comprehensive income (loss)	$	4,639	$	(2,851	)	$	6,179	$	41

7) Supplemental Retirement Plan

The Company has a supplemental retirement plan covering current and former key executives and directors (Plan). The Plan is a nonqualified defined benefit plan. Benefits are unsecured as there are no Plan assets. The following table presents the amount of periodic cost recognized for the second quarter and six months ended June 30, 2005 and 2004:

	Three Months Ended				Six Months Ended
	June 30,				June 30,
(Dollars in thousands)	2005		2004		2005		2004
Components of net periodic benefits cost
Service cost	$	216	$	118	$	413	$	236
Interest cost		110		97		220		194
Prior service cost		3		-		6		-
Amortization of loss		50		29		101		58
Net periodic cost	$	379	$	244	$	740	$	488

8)  Commitments and Contingencies

Financial Instruments with Off-Balance Sheet Risk

HBC is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its clients. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk, in excess of the amounts recognized in the balance sheets.

HBC's exposure to credit loss in the event of non-performance of the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments. HBC uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. Credit risk is the possibility that a loss may occur because a party to a transaction failed to perform according to the terms of the contract. HBC controls the credit risk of these transactions through credit approvals, limits, and monitoring procedures. Management does not anticipate any significant losses as a result of these transactions.

Commitments to extend credit as of June 30, 2005 and December 31, 2004 were as follows:

	June 30,		December 31,
(Dollars in thousands)	2005		2004
Commitments to extend credit	$	331,149	$	313,036
Standby letters of credit		9,464		5,256
	$	340,613	$	318,292

Commitments to extend credit are agreements to lend to a client as long as there is no violation of conditions established in the contract. Commitments generally have fixed expiration dates or other termination clauses. Since some of the commitments are expected to expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements. HBC evaluates each client's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by HBC upon the extension of credit, is based on management's evaluation of the borrower. Collateral held varies but may include cash, marketable securities, accounts receivable, inventory, property, plant and equipment, income-producing commercial properties, and/or residential properties.

Standby letters of credit are written with conditional commitments issued by HBC to guaranty the performance of a client to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to clients.

Claims

The Company is involved in certain legal actions arising from normal business activities. Management, based upon the advice of legal counsel, believes the ultimate resolution of all pending legal actions will not have a material effect on the financial statements of the Company.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following management discussion and analysis give effects to the restatement and reclassifications in Notes 1 and 2 to the condensed consolidated financial statements.

Discussions of certain matters in this Report on Form 10-Q may constitute forward looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), and as such, may involve risks and uncertainties. Forward-looking statements, which are based on certain assumptions and describe future plans, strategies, and expectations, are generally identifiable by the use of words such as "believe", "expect", "intend", "anticipate", "estimate", "project", “assume��, “plan”, “predict”, “forecast” or similar expressions. These forward-looking statements relate to, among other things, expectations of the business environment in which the Company operates, projections of future performance, potential future performance, potential future credit experience, perceived opportunities in the market, and statements regarding the Company's mission and vision. The Company's actual results, performance, and achievements may differ materially from the results, performance, and achievements expressed or implied in such forward-looking statements due to a wide range of factors. These factors include, but are not limited to changes in interest rates, reducing interest margins or increasing interest rate risk, general economic conditions nationally or in the State of California, legislative and regulatory changes adversely affecting the business in which the Company operates, monetary and fiscal policies of the US Government, real estate valuations, the availability of sources of liquidity at a reasonable cost, competition in the financial services industry, the occurrence of events such as the terrorist acts of September 11, 2001, and other risks. All of the Company's operations and most of its customers are located in California. In addition, acts and threats of terrorism or the impact of military conflicts have increased the uncertainty related to the national and California economic outlook and could have an effect on the future operations of the Company or its customers, including borrowers. The Company does not undertake, and specifically disclaims any obligation, to update any forward-looking statements to reflect occurrences or unanticipated events or circumstances after the date of such statements.

EXECUTIVE SUMMARY

When evaluating financial condition and performance, management looks at certain key metrics and measures. The Company’s evaluation includes an analysis including comparisons with peer group financial institutions and with its own performance objectives established in the internal planning process.

The primary activity of the Company is commercial banking. The Company’s operations are located primarily in the southern and eastern regions of the general San Francisco Bay area of California. The largest city in this area is San Jose and the Company’s market includes the headquarters of a number of technology based companies in the region known commonly as Silicon Valley. The Company’s customers are primarily closely held businesses and professionals.

Through its asset and liability management process, the Company monitors a number of ratios to analyze the Company’s performance over time and also to compare the Company against similarly sized and situated companies in the banking industry. Management considers the following ratios to be important benchmarks for the Company’s performance and financial conditions:

·   Return on average assets: Net income as a percentage of average assets. Measures the earning power of the balance sheet. For the three months and six months ended June 30, 2005, the return on average assets was 1.19% and 1.08%, respectively, compared to 0.80% for the year ended December 31, 2004.

·   Return on average equity: Net income as a percentage of average shareholders’ equity. Measures the return on invested capital. For the three months and six months ended June 30, 2005, the return on average equity was 12.91% and 11.81%, respectively, compared to 9.04% for the year ended December 31, 2004.

·   Net interest margin: Net interest income as a percentage of average interest earning assets. Measures the earning power of interest earning assets funded by interest bearing liabilities. For the three months and six months ended June 30, 2005, the net interest margin was 4.53% and 4.47%, respectively, compared to 4.24% for the year ended December 31, 2004.

·   Efficiency ratio: Non-interest expense divided by net interest income before provision for loan losses plus noninterest income. Measures the cost of producing revenue as a percentage of total revenue. For the three months and six months ended June 30, 2005, the efficiency ratio was 62.22% and 65.35%, respectively, compared to 76.07% for the year ended December 31, 2004.

There is no single ratio or metric that summarizes the performance of the Company. The ratios above each take an element of the Company’s performance and quantify it so that it can be compared over time and benchmarked against other peer companies. Management uses these and other ratios and metrics in assessing and planning the Company’s performance.

The Company believes that the initiatives it undertook in 2004, coupled with increases in short term interest rates including the target Federal funds rate and the prime rate, will cause its performance to improve and to more closely match the performance of peer banks in the future.

CRITICAL ACCOUNTING POLICIES

General

Heritage Commerce Corp’s financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The financial information contained within our consolidated financial statements is, to a significant extent, based on approximate measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. In certain instances, we use a discount factor and prepayment assumptions to determine the present value of assets and liabilities. A change in the discount factor or prepayment spreads could increase or decrease the values of those assets and liabilities which would result in either a beneficial or adverse impact to our financial results. We use historical loss factors as one factor in determining the inherent loss that may be present in our loan portfolio. Actual losses could differ significantly from the historical factors that we use. We apply Accounting Principles Board (APB) No. 25, “Accounting for Stock Issued to Employees” and related interpretations to account for our stock option plan awards. Other estimates that we use are related to the expected useful lives of our depreciable assets. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of our transactions would be the same, the timing of when the transactions would be recorded could change.

Allowance for Loan Losses

The allowance for loan losses is an estimate of the losses that may be sustained in the Company’s loan portfolio. The allowance is based on two basic principles of accounting: (1) Statement of Financial Accounting Standards (SFAS) No. 5 “Accounting for Contingencies”, which requires that losses be accrued when they are probable of occurring and estimable and (2) SFAS No. 114, “Accounting by Creditors for Impairment of a Loan”, which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the impaired loan balance.

The Company’s allowance for loan losses has three basic components: the formula allowance for various pools of loans, the specific allowance for individual impaired loans, and the unallocated allowance. Each of these components is determined based upon estimates that can and do change when the actual events occur. The formula allowance uses an historical loss view as an indicator of future losses and as a result formula losses could differ from the losses incurred in the future. The specific allowance uses various techniques to arrive at an estimate of loss. Historical loss information and fair market value of collateral are used to estimate those losses. The use of these values is inherently subjective and our actual losses could differ from the estimates. The unallocated allowance captures losses that are attributable to various economic events, industry or geographic sectors whose impact on the portfolio have occurred but have yet to be recognized in either the formula or specific allowances. For further information regarding our allowance for credit losses, see Allowance for Loan Losses on page 25.

Loan Sales and Servicing

The amounts of gains recorded on sales of loans and the initial recording of servicing assets and interest only strips are based on the estimated fair values of the respective components. In recording the initial value of the servicing assets and the fair value of the interest-only (I/O) strips receivable, the Company uses estimates which are based on management’s expectations of future prepayment and discount rates. In evaluating the servicing assets, management used a discounted cash flow modeling technique, which requires estimates regarding the amount and timing of future cash flows, including assumptions about loan repayment rates and cost to service, as well as interest rate assumptions that contemplate the risks involved. For the quarter ended June 30, 2005, management’s estimate of constant prepayment rate (“CPR”) was 14% and the weighted average discount rate assumption was 9%. These prepayment and discount rates were based on current market conditions and historical market performance of pools of serviced loans. If actual prepayments with respect to sold loans occur more quickly than projected, the carrying value of the servicing assets may have to be adjusted through a charge to earnings. A corresponding decrease in the value of the I/O strip receivable would also be expected.

Stock Based Awards

Under APB No. 25, compensation cost for stock options is measured as the excess, if any, of the fair market value of the Company’s stock at the date of the grant over the amount required to be paid to the Company by the optionee upon exercising the option. Because the Company’s stock option plans provide for the issuance of options at a price of no less than the fair market value at the date of the grant, no compensation expense is required to be recognized for stock options on the date of grant.

In December 2004, the FASB issued SFAS No. 123 (revised 2004), "Share-Based Payment.” This Statement requires that compensation costs related to share-based payment transactions be recognized in the financial statements. Measurement of the cost of employee service will be based on the grant-date fair value of the equity or liability instruments issued. That cost will be recognized over the period during which an employee is required to provide service in exchange for the award. Additionally, liability awards will be remeasured each reporting period. Statement 123R replaces SFAS No. 123, "Accounting for Stock-Based Compensation" and supercedes APB Opinion No. 25 "Accounting for Stock Issued to Employees." On April 14, 2005, the SEC issued rule 2005-57, which allows companies to delay implementation of Statement 123R to the beginning of the next fiscal year. The Company has not yet concluded on the method of adoption allowed by Statement 123R and is currently evaluating the impact of this accounting guidance on its financial condition and results of operations.

RESULTS OF OPERATIONS

Overview

For the three and six months ended June 30, 2005, consolidated net income was $3,340,000 and $5,994,000, respectively, compared to $769,000 and $2,740,000, respectively, for the three and six months ended June 30, 2004, an increase of 334% and 119%, respectively. Earnings per diluted share were $0.27 and $0.49, respectively, for the three and six months ended June 30, 2005, compared to $0.06 and $0.23, respectively, for the three and six months ended June 30, 2004, an increase of 350% and 113%, respectively. The increase for the three months and six months ended June 30, 2005 from the same periods in 2004 was attributed not only to increases in the volume of average earning assets and increases in key market interest rates in 2005. The net income and earnings per share in the second quarter ended 2004 was negatively impacted by severance costs for the elimination of 11 full time positions to reduce operating costs and the resignation of the former CEO. Annualized return on average assets and return on average equity for the three months ended June 30, 2005 were 1.19% and 12.91%, compared to 0.29% and 3.35%, for the same period in 2004. Annualized return on average assets and return on average equity for the six months ended June 30, 2005 were 1.08% and 11.81%, compared to 0.54% and 6.01%, for the same period in 2004.

Net interest income increased $1,769,000, or 18%, and $3,670,000, or 19%, for the three and six months ended June 30, 2005 compared to the same period in 2004. The Company's net interest margin was 4.53% and 4.47%, respectively, for the three and six months ended June 30, 2005, an increase of 44 and 33 basis points from 4.09% and 4.14%, respectively, for the three and six months ended June 30, 2004. The increase in net interest margin for the three and six months ended June 30, 2005 reflects an increase in the yield on earning assets of 92 and 70 basis points offset by a corresponding increase in the cost of interest bearing liabilities of 62 and 51 basis points. The increase in net interest income for the three and six months ended June 30, 2005 compared to the same period in 2004 is the result of the increase in net interest margin and an increase in the volume of earning assets. The increase in net interest margin and volume of earning assets was primarily attributable to an increase in the average level of loans and increase in the average level of securities in 2005 compared to the comparable periods in 2004. These increases were funded by an increase in interest bearing liabilities.

Total assets at June 30, 2005 were $1,097,696,000, an increase of $6,663,000, or 1%, from $1,091,033,000 as of June 30, 2004, and a decrease of $10,477,000, or 1%, from total assets of $1,108,173,000 as of December 31, 2004. Total deposits at June 30, 2005 were $909,434,000, a decrease of $9,735,000, or 1%, from $919,169,000 as of June 30, 2004, and a decrease of $9,101,000, or 1%, from total deposits of $918,535,000 as of December 31, 2004.

Total loans at June 30, 2005 were $713,691,000, an increase of $10,412,000, or 1%, compared to $703,279,000 as of June 30, 2004, and a decrease of $11,839,000, or 2%, from $725,530,000 as of December 31, 2004. The Company's allowance for loan losses was $11,436,000, or 1.60% of total loans at June 30, 2005, compared to $12,626,000, or 1.80% of total loans, and $12,497,000, or 1.72% of total loans, at June 30, 2004 and December 31, 2004, respectively. The decrease in the overall level of the allowance of loan losses since December 31, 2004 is primarily attributable to the charge-off of one commercial loan in 2005, which was partially offset by the provisions made during the first and second quarter of 2005. Nonperforming assets including nonaccrual loans, loans past due 90 days or more and still accruing, restructured loans, foreclosed assets, and other real estate owned at June 30, 2005 were $5,561,000, compared to $2,632,000 at June 30, 2004 and $1,330,000 at December 31, 2004.

The Company's shareholders' equity at June 30, 2005 was $104,185,000, compared to $90,391,000 at June 30, 2004 and $98,579,000 as of December 31, 2004. The increase in shareholders’ equity from these prior periods was primarily attributable to net income and proceeds from the exercise of common stock options, partially offset by the repurchase of common stock. Book value per share increased to $8.87 at June 30, 2005, from $7.79 at June 30, 2004 and $8.45 at December 31, 2004. The Company's leverage capital ratio was 11.3% at June 30, 2005 compared to 10.6% at June 30, 2004 and 10.9% at December 31, 2004.

Net Interest Income and Net Interest Margin

Net interest income is the largest component of the Company's total revenue. Net interest income is the difference between the interest and fees earned on loans and investments and the interest paid on deposits and other liabilities. Net interest income depends on two factors: (1) the volume or balance of earning assets compared to the volume or balance of interest bearing deposits and liabilities, and (2) the interest rate earned on those interest earning assets compared with the interest rate paid on those interest bearing assets and liabilities. Net interest margin is net interest income expressed as a percentage of average earning assets. To maintain its net interest margin, the Company must manage the relationship between interest earned and paid.

The following table presents the Company’s average balance sheet, net interest income and the resultant yields and rates paid for the period presented:

	For the Three Months Ended							For the Three Months Ended
	June 30, 2005							June 30, 2004
			Interest		Average					Interest		Average
	Average		Income/		Yield/			Average		Income/		Yield/
(Dollars in thousands)	Balance		Expense		Rate			Balance		Expense		Rate
Assets:
Loans, gross	$	756,362	$	13,169		6.98	%	$	715,038	$	10,430		5.87	%
Securities		230,781		1,835		3.19	%		220,990		1,685		3.07	%
Interest bearing deposits in other financial institutions		2,724		18		2.65	%		607		1		0.66	%
Federal funds sold		45,216		325		2.88	%		38,742		92		0.96	%
Total interest earnings assets		1,035,083		15,347		5.95	%		975,377		12,208		5.03	%
Cash and due from banks		36,326							50,239
Premises and equipment, net		2,934							3,812
Other assets		49,232							41,307
Total assets	$	1,123,575						$	1,070,735
Liabilities and shareholders' equity:
Deposits:
Demand, interest bearing	$	133,184	$	393		1.18	%	$	110,531	$	115		0.42	%
Savings and money market		341,168		1,196		1.41	%		350,445		866		0.99	%
Time deposits, under $100		37,897		224		2.37	%		39,211		137		1.41	%
Time deposits, $100 and over		121,146		717		2.37	%		98,457		348		1.42	%
Brokered time deposits, $100 and over		38,510		353		3.68	%		10,102		113		4.50	%
Securities sold under agreement to repurchase and
notes payable to subsidiary grantor trusts		70,880		785		4.44	%		71,520		719		4.04	%
Total interest bearing liabilities		742,785	$	3,668		1.98	%		680,266	$	2,298		1.36	%
Demand, noninterest bearing		257,054							283,460
Other liabilities		19,991							14,723
Total liabilities		1,019,830							978,449
Shareholders' equity:		103,745							92,286
Total liabilities and shareholders' equity	$	1,123,575						$	1,070,735
Net interest income / margin			$	11,679		4.53	%			$	9,910		4.09	%

Note: Yields and amounts earned on loans include loan fees of $381,000 and $454,000 for the three month periods ended June 30, 2005 and 2004, respectively. Interest income is reflected on an actual basis, not a fully taxable equivalent basis. Nonaccrual loans of $5,016,000 and $2,102,000 for the period ended June 30, 2005 and 2004, respectively, are included in the average balance calculation above.

	For the Six Months Ended							For the Six Months Ended
	June 30, 2005							June 30, 2004
			Interest		Average					Interest		Average
	Average		Income/		Yield/			Average		Income/		Yield/
(Dollars in thousands)	Balance		Expense		Rate			Balance		Expense		Rate
Assets:
Loans, gross	$	762,012	$	25,567		6.77	%	$	701,408	$	20,504		5.88	%
Securities		232,611		3,699		3.21	%		198,587		3,083		3.12	%
Interest bearing deposits in other financial institutions		2,639		31		2.37	%		1,322		4		0.61	%
Federal funds sold		36,869		502		2.75	%		33,943		161		0.95	%
Total interest earnings assets		1,034,131		29,799		5.81	%		935,260		23,752		5.11	%
Cash and due from banks		37,407							47,638
Premises and equipment, net		3,031							3,898
Other assets		47,752							38,735
Total assets	$	1,122,321						$	1,025,531
Liabilities and shareholders' equity:
Deposits:
Demand, interest bearing	$	130,113	$	686		1.06	%	$	108,337	$	234		0.43	%
Savings and money market		350,659		2,319		1.33	%		343,404		1,707		1.00	%
Time deposits, under $100		37,879		408		2.17	%		39,411		279		1.42	%
Time deposits, $100 and over		115,429		1,266		2.21	%		97,354		697		1.44	%
Brokered time deposits, $100 and over		34,154		614		3.63	%		10,877		243		4.49	%
Securities sold under agreement to repurchase and
notes payable to subsidiary grantor trusts		72,366		1,571		4.38	%		62,207		1,327		4.29	%
Total interest bearing liabilities		740,600	$	6,864		1.87	%		661,590	$	4,487		1.36	%
Demand, noninterest bearing		259,251							259,076
Other liabilities		20,128							13,210
Total liabilities		1,019,979							933,876
Shareholders' equity:		102,342							91,655
Total liabilities and shareholders' equity	$	1,122,321						$	1,025,531
Net interest income / margin			$	22,935		4.47	%			$	19,265		4.14	%

Note: Yields and amounts earned on loans include loan fees of $763,000 and $882,000 for the six month periods ended June 30, 2005 and 2004, respectively. Interest income is reflected on an actual basis, not a fully taxable equivalent basis. Nonaccrual loans of $5,016,000 and $2,102,000 for the period ended June 30, 2005 and 2004, respectively, are included in the average balance calculation above.

Net interest income for the three and six months ended June 30, 2005 increased 18% and 19%, respectively, over the same period in 2004. For the three and six months ended June 30, 2005, average interest earning assets increased by $59,706,000, or 6%, and $98,871,000, or 11%, over the prior period in 2004. For the three and six months ended June 30, 2005, the average yield on interest earning assets was 5.95% and 5.81%, respectively, an increase of 92 and 70 basis points from 5.03% and 5.11% for the same period in 2004. The rates paid on interest bearing liabilities increased 62 and 51 basis points to 1.98% and 1.87% for the three and six months ended June 30, 2005 compared to 1.36% and 1.36% for the same period in 2004. As a result, the net interest margin increased 44 and 33 basis points to 4.53% and 4.47% for the three and six months ended June 30, 2005, from 4.09% and 4.14% for the same period in 2004. The increase in net interest income was attributable to increases in the volume of average earning assets and increases in key market interest rates in 2005. The changes in volume contributed $482,000 for the three months ended June 30, 2005 and $1,560,000 for the six months ended June 30, 2005, respectively, to net interest income. The effect of the changes in rates contributed $1,287,000 and $2,110,000, respectively, for the three and six months ended June 30, 2005. These changes resulted in an overall increase of $1,769,000 and $3,670,000, respectively, for the three and six months ended June 30, 2005 from 2004.

The following table sets forth an analysis of the changes in interest income resulting from changes in the average volume of interest earning assets and liabilities and changes in the average rates earned and paid. The total change is shown in the column designated “Net Change” and is allocated in the columns to the left, for the portions attributable to volume changes and rate changes that occurred during the period indicated. Changes due to both volume and rate have been allocated to the change in volume.

	Three Months Ended June 30,
	2005 vs. 2004
	Increase (Decrease) Due to Change In:
	Average			Average			Net
(Dollars in thousands)	Volume			Rate			Change
Interest earning assets
Loans, gross	$	760		$	1,979		$	2,739
Securities		82			68			150
Interest bearing deposits in other financial institutions		14			3			17
Federal funds sold		48			185			233
Total interest earnings assets	$	904		$	2,235		$	3,139
Interest bearing liabilities
Demand, interest bearing	$	68		$	210		$	278
Savings and money market		(33	)		363			330
Brokered time deposits, $100 and over		261			(21	)		240
Time deposits, under $100		(7	)		94			87
Time deposits, $100 and over		137			232			369
Securities sold under agreement to repurchase		(4	)		70			66
Total interest bearing liabilities		422			948			1,370
Net interest income	$	482		$	1,287		$	1,769

	Six Months Ended June 30,
	2005 vs. 2004
	Increase (Decrease) Due to Change In:
	Average			Average			Net
(Dollars in thousands)	Volume			Rate			Change
Interest earning assets
Loans, gross	$	1,954		$	3,109		$	5,063
Investment securities		529			87			616
Interest bearing deposits in other financial institutions		15			12			27
Federal funds sold		38			303			341
Total interest earnings assets	$	2,536		$	3,511		$	6,047
Interest bearing liabilities
Demand, interest bearing	$	115		$	337		$	452
Savings and money market		48			564			612
Brokered time deposits, $100 and over		418			(47	)		371
Time deposits, under $100		(17	)		146			129
Time deposits, $100 and over		196			373			569
Securities sold under agreement to repurchase		216			28			244
Total interest bearing liabilities		976			1,401			2,377
Net interest income	$	1,560		$	2,110		$	3,670

Provision for Loan Losses

The provision for loan losses represents the current period expense associated with maintaining an appropriate allowance for credit losses. The loan loss provision and level of allowance for each period is dependent upon many factors, including loan growth, net charge-offs, changes in the composition of the loan portfolio, delinquencies, management’s assessment of the quality of the loan portfolio, the valuation of problem loans and the general economic conditions in the Company’s market area. Periodic fluctuations in the provision for loan losses result from management’s assessment of the adequacy of the allowance for loan losses; however, actual loan losses may vary from current estimates. For the three and six months ended June 30, 2005, the provision for loan losses was $394,000 and $807,000, respectively, compared to $575,000 and $1,138,000, respectively, for the same period in 2004. See additional discussion under the caption "Allowance for Loan Losses.”

Noninterest Income

The following table sets forth the various components of the Company’s noninterest income for the periods indicated:

	Three Months Ended				Increase (decrease)
	June 30,				2005 versus 2004
(Dollars in thousands)	2005		2004		Amount			Percent
Gain on sale of loans	$	698	$	639	$	59			9	%
Loan servicing income		466		375		91			24	%
Service charges and other fees on deposit accounts		395		497		(102	)		-21	%
Gain on sale of leased equipment		299		-		299			N/A
Increase in cash surrender value of life insurance		290		234		56			24	%
Equipment leasing		52		245		(193	)		-79	%
Gain on sales securities available-for-sale		-		264		(264	)		-100	%
Mortgage brokerage fees		-		30		(30	)		-100	%
Other		390		323		67			21	%
Total	$	2,590	$	2,607	$	(17	)		-1	%

	Six Months Ended				Increase (decrease)
	June 30,				2005 versus 2004
(Dollars in thousands)	2005		2004		Amount			Percent
Gain on sale of loans	$	1,458	$	1,366	$	92			7	%
Loan servicing income		858		679		179			26	%
Service charges and other fees on deposits accounts		788		970		(182	)		-19	%
Gain on sale of leased equipment		299		-		299			N/A
Increase in cash surrender value of life insurance		556		562		(6	)		-1	%
Equipment leasing		131		490		(359	)		-73	%
Gain on sales securities available-for-sale		-		476		(476	)		-100	%
Mortgage brokerage fees		-		149		(149	)		-100	%
Other		805		679		126			19	%
Total	$	4,895	$	5,371	$	(476	)		-9	%

Noninterest income for the three and six months ended June 30, 2005 was $2,590,000 and $4,895,000, respectively, a decrease of 1% and 9%, respectively, from $2,607,000 and $5,371,000 for the same period in 2004.

In the three and six months ended June 30, 2005, gain on sale of Small Business Administration (SBA) loans and other guaranteed business loans increased 9% and 7% to $698,000 and $1,458,000, respectively, and loan servicing income increased 24% and 26% to $466,000 and $858,000, respectively, compared to the same period in 2004. The Company has an ongoing program of originating SBA and other guaranteed business loans and selling the government guaranteed portion in the secondary market, while retaining the servicing of the whole loans. The increased noninterest income from SBA and other guaranteed business lending in the three and six months ended June 30, 2005 compared to the same periods in 2004 was offset by a decrease in lease income of $193,000 and $359,000, respectively, for the three months and six months ended June 30, 2005 due to the sale of all leased equipment during the second quarter and the absence of securities gains recognized in the three and six months ended June 30, 2005, compared to $264,000 and $476,000 in securities gains in the three and six months ended June 30, 2004.

Deposit related activity charges were down $102,000 and $182,000 from the three and six months ended June 30, 2004 compared to the three and six months ended June 30, 2005 primarily because higher interest rates applied to collected balances create a waiver of (or credit against) service charges for many business customers.

Noninterest Expense

The following table sets forth the various components of the Company’s noninterest expense for the periods indicated:

	Three Months				Increase (decrease)
	June 30,				2005 versus 2004
(Dollars in thousands)	2005		2004		Amount			Percent
Salaries and employee benefits	$	4,760	$	5,456	$	(696	)		-13	%
Occupancy		841		872		(31	)		-4	%
Retirement plan expense		370		981		(611	)		-62	%
Client services		345		231		114			49	%
Advertising and promotion		323		252		71			28	%
Amortization of low income housing projects		293		203		90			44	%
Professional fees		225		961		(736	)		-77	%
Furniture and equipment		204		255		(51	)		-20	%
Data processing expense		169		183		(14	)		-8	%
Amortization of leased equpiment		83		250		(167	)		-67	%
Other		1,265		1,163		102			9	%
Total	$	8,878	$	10,807	$	(1,929	)		-18	%

	Six Months Ended				Increase (decrease)
	June 30,				2005 versus 2004
(Dollars in thousands)	2005		2004		Amount			Percent
Salaries and employee benefits	$	9,665	$	10,176	$	(511	)		-5	%
Occupancy		1,692		1,914		(222	)		-12	%
Retirement plan expense		738		1,218		(480	)		-39	%
Client services		751		416		335			81	%
Advertising and promotion		512		499		13			3	%
Amortization of low income housing projects		546		362		184			51	%
Professional fees		721		1,316		(595	)		-45	%
Furniture and equipment		403		492		(89	)		-18	%
Data processing expense		341		322		19			6	%
Amortization of leased equpiment		334		516		(182	)		-35	%
Other		2,484		2,228		256			11	%
Total	$	18,187	$	19,459	$	(1,272	)		-7	%

The following table indicates the percentage of noninterest expense in each category:

	For The Three Months Ended June 30,
			Percent					Percent
(Dollars in thousands)	2005		of Total			2004		of Total
Salaries and employee benefits	$	4,760		54	%	$	5,456		50	%
Occupancy		841		9	%		872		8	%
Retirement plan expense		370		4	%		981		9	%
Client services		345		4	%		231		2	%
Advertising and promotion		323		4	%		252		2	%
Amortization of low income housing projects		293		3	%		203		2	%
Professional fees		225		3	%		961		9	%
Furniture and equipment		204		2	%		255		3	%
Data processing expense		169		2	%		183		2	%
Amortization of leased equpiment		83		1	%		250		2	%
Other		1,265		14	%		1,163		11	%
Total	$	8,878		100	%	$	10,807		100	%

	For The Six Months Ended June 30,
			Percent					Percent
(Dollars in thousands)	2005		of Total			2004		of Total
Salaries and employee benefits	$	9,665		53	%	$	10,176		52	%
Occupancy		1,692		9	%		1,914		10	%
Retirement plan expense		738		4	%		1,218		6	%
Client services		751		4	%		416		2	%
Advertising and promotion		512		3	%		499		3	%
Amortization of low income housing projects		546		3	%		362		2	%
Professional fees		721		4	%		1,316		7	%
Furniture and equipment		403		2	%		492		3	%
Data processing expense		341		2	%		322		2	%
Amortization of leased equpiment		334		2	%		516		2	%
Other		2,484		14	%		2,228		11	%
Total	$	18,187		100	%	$	19,459		100	%

Noninterest expense for the three and six months ended June 30, 2005 was $8,878,000 and $18,187,000, respectively, down $1,929,000 and $1,272,000, or 18% and 7%, from $10,807,000 and $19,459,000 for the same period in the prior year.

For the three and six month period ended June 30, 2005 compared to the three and six month period ended June 30, 2004:

·   Salaries and employee benefits decreased $696,000 and $511,000, respectively, or 13% and 5%, compared to the same period in 2004. The decrease was primarily due to expenses related to the severance expense in the second quarter of 2004. Salaries and employee benefits as a percentage of total noninterest expense increased to 54% and 53%, respectively, from 50% and 52%, respectively, over the comparative three and six month period.

·   Occupancy decreased by $31,000 and $222,000, respectively, or 4% and 12%, compared to the same period in 2004. The decrease was primarily as a result of lower depreciation on leasehold improvements in 2005. Occupancy costs as a percentage of total noninterest expense increased to 9% from 8% over the comparative three month period but decreased to 9% from 10% over the comparative six month period.

·   Retirement plan expense decreased $611,000 and $480,000, respectively, or 62% and 39%, compared to the same period in 2004. The decrease was primarily related to the resignation of the former CEO in the second quarter of 2004 resulting in an accelerated retirement plan payment. Retirement plan expense as a percentage of total noninterest expense decreased to 4% from 9% and 6%, respectively, over the comparative three and six month period.

·   Client services increased $114,000 and $335,000, respectively, or 49% and 81%, compared to the same period in 2004. The increase from 2004 was primarily due to the increase in services fees charged to the Company from the third party vendors. Client services as a percentage of total noninterest expense increased to 4% from 2% over the comparative three and six month period.

·   Professional fees decreased $736,000 and $595,000, respectively, or 77% and 45%, compared to the same period in 2004. The comparable periods in 2004 included significant legal fees associated with a proxy contest and other corporate governance matters. Professional fees as a percentage of total noninterest expense decreased to 3% and 4%, respectively, from 9% and 7% over the comparative three and six month period.

·   Advertising and promotion increased $71,000 and $13,000, respectively, or 28% and 3%, compared to the same period in 2004. The increase from 2004 was primarily due to certain advertising and product promotion in the second quarter of 2005. Advertising and promotion as a percentage of total noninterest expense increased to 4% from 2% over the comparative three month period but remains the same at 3% over the comparative six month period.

·   Amortization of low income housing projects increased $90,000 and $184,000, respectively, or 44% and 51%, compared to the same period in 2004. The increase was primarily due to an additional investment in a low income housing project in June 2004. Amortization of low income housing projects as a percentage of total noninterest expense increased to 3% from 2% over the comparative three and six months period.

·   Furniture and equipment expense decreased by $51,000 and $89,000, respectively, or 20% and 18%, compared to the same period in 2004. The decrease was primarily due to fewer equipment repairs, and lower depreciation on furniture and equipment in 2005. Furniture and equipment, as a percentage of total noninterest expense decreased to 2% from 3% over the comparative three and six month period.

·   Data processing expense decreased $14,000, or 8%, for the quarter ended June 30, 2005, but increased $19,000, or 6%, for the six months ended June 30, 2005, compared to the same period in 2004; however, data processing expense as a percentage of total noninterest expense remains at 2% over the comparative three and six month period.

·   Amortization of leased equipment decreased $167,000 and $182,000, respectively, or 67% and 35%, compared to the same period in 2004. All of the leased equipments was sold in the second quarter of 2005. Amortization of leased equipment as a percentage of total noninterest expense decreased to 1% from 2% but remains at 2% over the comparative three and six month period.

·   Other noninterest expense increased $102,000 and $256,000, or 9% and 11%, compared to the same period in 2004. Other noninterest expense as a percentage of total noninterest expense increased to 14% from 11% over the comparative three and six month period.

Income Taxes

Income tax expense for the three and six months ended June 30, 2005 was $1,657,000 and $2,842,000, respectively, as compared to $366,000 and $1,299,000 for the same periods in the prior year. The following table shows the effective income tax rate for each period indicated.

	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2005			2004			2005			2004
Effective income tax rate		33.16	%		32.25	%		32.16	%		32.16	%

The difference in the effective tax rate compared to the statutory tax rate of 42% is primarily the result of the Company’s investment in life insurance policies whose earnings are not subject to taxes, tax credits related to investments in low income housing and investments in tax-free municipal securities.

FINANCIAL CONDITION

As of June 30, 2005, total assets were $1,097,696,000, a decrease of $10,477,000, or 1%, from $1,108,173,000 at December 31, 2004, and an increase of $6,663,000, or 1%, from the same period in 2004. Securities available-for-sale decreased $6,179,000, or 3%, and $3,805,000, or 2%, at June 30, 2005 from December 31, 2004, from June 30, 2004. Total loans decreased $11,839,000, or 2%, at June 30, 2005 from December 31, 2004, and increased $10,412,000, or 1%, from June 30, 2004. Total deposits decreased $9,101,000, or 1%, to $909,434,000 at June 30, 2005 from $918,535,000 at December 31, 2004, and decreased $9,735,000, or 1%, from $919,169,000 at June 30, 2004.

Securities Portfolio

A major component of the Company's earning assets is its securities portfolio. The following table sets forth the estimated fair value of securities at the dates indicated:

	June 30,				December 31,
(Dollars in thousands)	2005		2004		2004
Securities available-for-sale (at fair value)
U.S. Treasury	$	11,962	$	5,934	$	5,942
U.S. Government Agencies		89,963		90,439		90,308
Mortgage-Backed Securities		96,748		105,531		107,735
Municipals - Tax Exempt		8,619		9,084		9,206
CMOs		19,338		19,447		19,618
Total	$	226,630	$	230,435	$	232,809

The following table summarizes the composition of the Company’s securities available-for-sale and the weighted average yields at June 30, 2005:

	June 30, 2005
	Maturity
						After One and					After Five and
	Within One Year					Within Five Years					Within TenYears					After Ten Years					Total
(Dollars in thousands)	Amount		Yield			Amount		Yield			Amount		Yield			Amount		Yield			Amount		Yield
Securities available for sale:
U.S. Treasury	$	5,962		1.67	%	$	6,000		3.50	%	$	-		-		$	-		-		$	11,962		2.59	%
Agencies		61,196		2.15	%		28,767		2.74	%		-		-			-		-			89,963		2.34	%
Mortgage Backed		-		-			173		5.02	%		10,149		3.83	%		86,426		3.98	%		96,748		3.96	%
CMOs		-		-			-		-			-		-			19,338		2.88	%		19,338		2.88	%
Municipals - non-taxable		404		4.71	%		8,215		2.18	%		-		-			-		-			8,619		2.30	%
Total	$	67,562		2.12	%	$	43,155		2.75	%	$	10,149		3.83	%	$	105,764		3.78	%	$	226,630		3.09	%

Securities that are classified as available for sale are carried at their fair value. This means that the carrying amount will increase or decrease based on changes in interest rates or, very rarely, changes in credit rating.

As of June 30, 2005, the only securities held by the Company where the aggregate carrying value of the Company's investment in securities of a single issuer exceeded 10% of the Company's shareholders' equity were direct obligations of the U.S. government or U.S. government agencies.

The securities portfolio of the Company is also used as collateral to meet requirements imposed as a condition of deposit by some depositors such as political subdivisions (public funds) or bankruptcy trustees and other contractual obligations such as repurchase agreements. Securities with amortized cost of $79,572,000 and $73,730,000 as of June 30, 2005 and 2004 were pledged to secure public and certain other deposits as required by law or contract and other contractual obligations. A portion of these deposits can only be secured by U.S. Treasury securities. The Company has not used interest rate swaps or other derivative instruments to hedge fixed rate loans or to otherwise mitigate interest rate risk.

Loans

Loans decreased $11,839,000, or 2%, to $713,691,000 at June 30, 2005 from $725,530,000 at December 31, 2004, and increased $10,412,000, or 1%, from $703,279,000 at June 30, 2004.

For the three and six months ended June 30, 2005, $19,121,000 and $35,153,000, respectively, in guaranteed loans were generated and held for sale, and $10,277,000 and $22,689,000, respectively, of guaranteed loans held for sale were sold into the secondary market.

At June 30, 2005 and December 31, 2004, the Company serviced SBA and other business loans, which it had sold into the secondary market, of approximately $173,472,000 and $166,813,000, respectively. At June 30, 2005 and December 31, 2004, the carrying amount of the servicing assets was $2,170,000 and $2,213,000, respectively. There was no valuation allowance as of June 30, 2005 or December 31, 2004. The balance of Interest-Only (I/O) strip receivables at June 30, 2005 and December 31, 2004 was $4,672,000, net of unrealized gain of $2,019,000, and $3,954,000, net of unrealized gain of $1,536,000, respectively. These assets represent the servicing spread generated from the sold guaranteed portions of SBA and other business loans.

Servicing income from these loans was $466,000 and $858,000, respectively, for the three and six months ended June 30, 2005, compared to $375,000 and $679,000 for the same period in 2004. Amortization of the related assets was $492,000 and $1,166,000, respectively, for the three and six months ended June 30, 2005, compared to $366,000 and $745,000 for the same period in 2004. Heritage Bank of Commerce is a preferred lender with the U.S. Small Business Administration, which allows the Company to grant certain U.S. Small Business Administration loans without the prior approval of the SBA.

The following table summarizes the composition of the Company’s loan portfolio at the dates indicated:

	June 30, 2005						June 30, 2004						December 31, 2004
(Dollars in thousands)	2005			% to Total			2004			% to Total			2004			% to Total
Commercial	$	291,774			41	%	$	298,828			43	%	$	300,452			41	%
Real estate - mortgage		289,471			41	%		290,956			41	%		303,154			42	%
Real estate - land and construction		129,708			18	%		111,161			16	%		118,290			16	%
Consumer		1,945			0	%		1,625			0	%		2,908			1	%
Total loans		712,898			100	%		702,570			100	%		724,804			100	%
Deferred loan costs		793						709						726
Allowance for loan losses		(11,436	)					(12,626	)					(12,497	)
Loans, net	$	702,255					$	690,653					$	713,033

The following table sets forth the maturity distribution of the Company’s loan portfolio at June 30, 2005:

			Over One
	Due in		Year But
	One Year		Less than		Over
(Dollars in thousands)	or Less		Five Years		Five Years		Total
Commercial	$	276,270	$	12,291	$	3,213	$	291,774
Real estate - mortgage		183,995		57,772		47,704		289,471
Real estate - land and construction		129,708		-		-		129,708
Consumer		1,824		121		-		1,945
Total loans	$	591,797	$	70,184	$	50,917	$	712,898
Loans with variable interest rates	$	571,764	$	24,596	$	1,691	$	598,051
Loans with fixed interest rates		20,033		45,588		49,226		114,847
Total loans	$	591,797	$	70,184	$	50,917	$	712,898

The table above also shows the distribution of loans between those with predetermined (fixed) interest rates and those with variable (floating) interest rates. Floating rates generally fluctuate with changes in the prime rate as reflected in the western edition of The Wall Street Journal. At June 30, 2005, approximately 84% of the Company’s loan portfolio consisted of floating interest rate loans.

Nonperforming assets

Nonperforming assets consist of nonaccrual loans, loans past due 90 days and still accruing, troubled debt restructurings and other real estate owned. Management generally places loans on nonaccrual status when they become 90 days past due, unless they are well secured and in the process of collection. When a loan is placed on nonaccrual status, any interest previously accrued but not collected is generally reversed from income. Loans are charged off when management determines that collection has become unlikely. Restructured loans are those where the Company has granted a concession on the interest paid or original repayment terms due to financial difficulties of the borrower. Other real estate owned (“OREO”) consists of real property acquired through foreclosure on the related underlying defaulted loans. The following table shows nonperforming assets at the dates indicated:

	June 30,						December 31,
(Dollars in thousands)	2005			2004			2004
Nonaccrual loans	$	5,016		$	2,102		$	1,028
Loans 90 days past due and still accruing		545			530			302
Restructured loans		-			-			-
Total nonperforming loans		5,561			2,632			1,330
Other real estate owned		-			-			-
Total nonperforming assets	$	5,561		$	2,632		$	1,330
Nonperforming assets as a percentage of
loans plus other real estate owned		0.78	%		0.37	%		0.18	%

As of June 30, 2005, the Company had $5,016,000 loans on nonaccrual status, which were considered impaired loans, compared to $1,028,000 as of December 31, 2004 and $2,102,000 as of June 30, 2004. The increase in nonaccrual loans from 2004 was primarily due to a single loan with a carrying value of $1,984,000 as of June 30, 2005 classified as nonperforming loans in the first quarter of 2005; however, the carrying value of the loan is secured by real and personal property of the borrower and guarantors which the Company believes is sufficient to cover any loss exposure.

Allowance for Loan Losses

The Company assigns a risk grade consistent with the system recommended by regulatory agencies to all of its loans. Grades range from "Pass" to "Loss" depending on credit quality, with "Pass" representing loans that involve an acceptable degree of risk. Management conducts an evaluation of the "Pass" loan portfolio at least annually. Among other things, this evaluation takes into consideration loan payment history, covenant compliance and economic conditions then in existence. For loans where a higher degree of risk has been identified, the evaluation includes periodic loan by loan review for certain loans to evaluate the level of impairment as well as detailed reviews of other loans (either individually or in pools) based on an assessment of the following factors: past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower's ability to repay, collateral value, loan volumes and concentrations, size and complexity of the loans, recent loss experience in particular segments of the portfolio, bank regulatory examination results, and current economic conditions in the Company's marketplace, in particular the state of the technology industry and the real estate market.

This process attempts to assess the risk of loss inherent in the portfolio by segregating loans into four components for purposes of determining an appropriate level of the allowance: "watch," "special mention," "substandard" and "doubtful.” Additionally, the Company maintains a program for regularly scheduled reviews of certain new and renewed loans by an outside loan review consultant. Any loans identified during an external review process that expose the Company to increased risk are appropriately downgraded and an increase in the allowance for loan losses is established for such loans. Further, the Company is examined periodically by the FDIC, FRB, and the California Department of Financial Institutions at which time a further review of loan quality is conducted.

Loans that demonstrate a weakness, for which there is a possibility of loss if the weakness is not corrected, are categorized as "classified." Classified loans include all loans graded substandard, doubtful and loss and may result from problems specific to a borrower's business or from economic downturns that affect the borrower's ability to repay or that cause a decline in the value of the underlying collateral (particularly real estate).

It is the policy of management to maintain the allowance for loan losses at a level adequate for risks inherent in the loan portfolio. Based on information currently available to analyze loan loss risk and a history of actual charge-offs, management believes that the loan loss allowance is adequate. However, the loan portfolio could be adversely affected if the California economy or real estate values in the Company’s market area were to weaken. Also, any weakness of a prolonged nature in the technology industry would have a negative impact on the local market. The effect of such events, although uncertain at this time, could result in an increase in the level of nonperforming loans and increased loan losses, which could adversely affect the Company's future growth and profitability. No assurance of the ultimate level of credit losses can be given with any certainty. Loans are charged against the allowance when management believes that the collectibility of the principal is unlikely.

The following table summarizes the Company’s loan loss experience as well as provisions, charge-offs and recoveries to the allowance for loan losses and certain pertinent ratios for the periods indicated:

	Six Months Ended						For the Year Ended
	June 30,						December 31,
(Dollars in thousands)	2005			2004			2004
Balance, beginning of period / year	$	12,497		$	13,451		$	13,451
Net charge-offs		(1,868	)		(1,963	)		(1,339	)
Provision for loan losses		807			1,138			666
Reclassification to other liabilities		-			-			(281	)	(1	)
Balance, end of period/ year	$	11,436		$	12,626		$	12,497
Ratios
Net charge-offs to average loans outstanding		0.52	%		0.58	%		0.19	%
Allowance for loan losses to average loans		1.59	%		1.88	%		1.80	%
Allowance for loan losses to total loans		1.60	%		1.80	%		1.72	%
Allowance for loan losses to nonperforming assets		206	%		480	%		940	%

(1) The Company reclassified the allowance for loan losses on unused commitments of $281,000 to other liabilities as of December 31, 2004. As of June 30, 2005, this allowance was $223,000.

Charge-offs reflects the realization of losses in the portfolio that were recognized previously though provisions for loan losses. The net charge-offs as of June 30, 2005 were $1,868,000, compared to $1,963,000 as of June 30, 2004. Historical net charge-offs are not necessarily indicative of the amount of net charge-offs that the Company will realize in the future.

The following table summarizes the allocation of the allowance for loan losses (ALL) by loan type and the allocated allowance as a percent of loans outstanding in each loan category at the dates indicated:

	June 30, 2005					June 30, 2004					December 31, 2004
			Percent					Percent					Percent
			of ALL by					of ALL by					of ALL by
			category to					category to					category to
			total loans					total loans					total loans
(Dollars in thousands)	Amount		by category			Amount		by category			Amount		by category
Commercial	$	7,657		2.62	%	$	9,690		3.24	%	$	8,691		2.89	%
Real estate - mortgage		1,388		0.48	%		1,625		0.56	%		1,671		0.55	%
Real estate - land and construction		2,176		1.68	%		1,253		1.13	%		1,711		1.45	%
Consumer		68		3.47	%		44		2.71	%		38		1.31	%
Unallocated		147		-			14		--			386		--
Total	$	11,436		1.60	%	$	12,626		1.80	%	$	12,497		1.72	%

The decrease in the overall level of the allowance and in the allowance as a percentage of total loans since December 31, 2004 is primarily the result of net charge-offs in 2005. Other than the loans already classified, the Company has not identified any additional potential problem loans at June 30, 2005.

Loans are charged against the allowance when management believes that the collectibility of the principal is doubtful. The Company's methodology for assessing the appropriateness of the allowance consists of several key elements, which include specific allowances, the formula allowance and the unallocated allowance.

Specific allowances are established in cases where management has identified significant conditions or circumstances related to a credit that management believes indicate the probability that a loss may be incurred in excess of the amount determined by the application of the formula allowance. As of June 30, 2005, nonperforming loans had a related specific valuation allowance of $226,000 compared to a specific valuation allowance of $270,000 at December 31, 2004.

The formula allowance is calculated by applying loss factors to outstanding loans. Loss factors are based on management's experience and may be adjusted for significant factors that, in management's judgment, may affect the collectibility of the portfolio as of the evaluation date. The formula allowance at June 30, 2005 was $11,063,000 compared to $11,841,000 on December 31, 2004. The decrease was primarily attributable to the charge-off related to one loan and the specific allowance established for that loan.

The unallocated allowance is based upon management's evaluation of various conditions that are not directly measured in the determination of the formula and specific allowances. The evaluation of the inherent loss with respect to these conditions is subject to a higher degree of uncertainty because they are not identified with specific problem credits or portfolio segments. As of June 30, 2005, the Company’s unallocated allowance was $147,000, compared to $386,000 on December 31, 2004. In evaluating the appropriateness of the unallocated allowance, management considered the following factors:

·   Bank’s Lending Policies and Procedures - Changes in lending policies and procedures, including underwriting standards and collection, charge-off, and recovery practices.

·   Economic Conditions - Changes in national and local economic and business conditions, trends, and developments, including the condition of various market segments.

·   Changes in the Bank’s Lending Management and Staff - Changes in the experience, ability and depth of lending management and other relevant staff.

·   Changes in Trend and Volume of Past Due and Classified Loans - Changes in the trend of the volume and severity of past due and classified loans; and trends in the volume of nonaccrual loans, troubled debt restructurings and other loan modifications.

·   Quality of the Bank’s Loan Review System - Changes in the quality of the Bank’s loan review system and the degree of oversight by the Bank’s Board of Directors.

·   Credit Concentrations - The existence and effect of any concentrations of credit and changes in the level of such concentrations.

There can be no assurance that the adverse impact of any of these above conditions on the Bank will not be in excess of the current level of estimated losses. The current business, economic, and real estate markets along with the seasoning of the portfolio and the nature and duration of the current business cycle will affect the amount of estimated losses.

In an effort to improve its analysis of risk factors associated with its loan portfolio, the Company continues to monitor and to make appropriate changes to its internal loan policies. These efforts better enable the Company to assess risk factors prior to granting new loans and to assess the sufficiency of the allowance for loan losses.

Management believes that it has adequately provided an allowance for estimated probable losses in the credit portfolio. Significant deterioration in Northern California real property values or economic downturns could impact future operating results, liquidity or capital resources and require additional provisions to the allowance or cause losses in excess of the allowance.

Deposits

Total deposits were $909,434,000 at June 30, 2005, a decrease of 1%, compared to deposits at December 31, 2004, and at June 30, 2004. At June 30, 2005, compared to December 31, 2004, noninterest bearing demand deposits decreased $20,592,000, or 7%; interest bearing demand deposits increased $8,765,000, or 7%; savings and money market deposits decreased $35,089,000, or 10%; time deposits increased $19,587,000, or 14%; and brokered deposits increased $18,228,000, or 92%.

The following table summarizes the distribution of average deposits and the average rates paid for the periods indicated:

	Six Months Ended					Six Months Ended					Year Ended
	June 30, 2005					June 30, 2004					December 31, 2004
			Average					Average					Average
	Average		Rate			Average		Rate			Average		Rate
(Dollars in thousands)	Balance		Paid			Balance		Paid			Balance		Paid
Demand, noninterest bearing	$	259,251		--	%	$	259,076		--	%	$	275,192		--	%
Demand, interest bearing		130,113		1.06	%		108,337		0.43	%		112,439		0.48	%
Savings and money market		350,659		1.33	%		343,404		1.00	%		350,922		1.04	%
Time deposits, under $100		37,879		2.17	%		39,411		1.42	%		38,717		1.49	%
Time deposits, $100 and over		115,429		2.21	%		97,354		1.44	%		100,309		1.55	%
Brokered deposits, $100 and over		34,154		3.63	%		10,877		4.49	%		11,460		4.13	%
Total average deposits	$	927,485		1.15	%	$	858,459		0.74	%	$	889,039		0.76	%

As of June 30, 2005, the Company had a deposit mix of 36% in savings and money market accounts, 22% in time deposits, 14% in interest bearing demand accounts, and 28% in noninterest bearing demand deposits. As of June 30, 2005, approximately $6,529,000, or less than 1%, of deposits were from public sources, and approximately $59,740,000, or 7%, of deposits were from title and escrow companies. As of June 30, 2004, the Company had a deposit mix of 40% in savings and money market accounts, 15% in time deposits, 12% in interest bearing demand accounts, and 33% in noninterest bearing demand deposits. As of June 30, 2004, approximately $6,510,000, or less than 1%, of deposits were from public sources, and approximately $86,977,000, or 9%, of deposits were from title and escrow companies.  The Company obtains deposits from a cross-section of the communities it serves. The Company's business is not seasonal in nature. The Company had brokered deposits totaling approximately $38,090,000 and $3,925,000 at June 30, 2005 and 2004, respectively. These brokered deposits generally mature within one to three years. The Company is not dependent upon funds from sources outside the United States.

The following table indicates the maturity schedule of the Company’s time deposits of $100,000 or more as of June 30, 2005.

Time Deposits of $100,000 and Over
(Dollars in thousands)	Balance		% of Total
Three months or less	$	68,726		42	%
Over three months through twelve months		50,319		31	%
Over twelve months		43,805		27	%
Total	$	162,850		100	%

The Company focuses primarily on providing and servicing business deposit accounts that are frequently over $100,000 in average balance per account. As a result certain types of business clients whom the Company serves typically carry average deposits in excess of $100,000. The account activity for some account types and client types necessitates appropriate liquidity management practices by the Company to ensure its ability to fund deposit withdrawals.

Return on Equity and Assets

The following table indicates the ratios on the annualized return on average assets and average equity and average equity to average assets for each indicated period.

	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2005			2004			2005			2004
Return on average assets		1.19	%		0.29	%		1.08	%		0.54	%
Return on average equity		12.91	%		3.35	%		11.81	%		6.01	%
Average equity to average assets ratio		9.23	%		8.62	%		9.12	%		8.94	%

Interest Rate Sensitivity

The planning of asset and liability maturities is an integral part of the management of an institution’s net yield. To the extent maturities of assets and liabilities do not match in a changing interest rate environment, net yields may change over time. Even with perfectly matched repricing of assets and liabilities, risks remain in the form of prepayment of loans or investments or in the form of delays in the adjustment of rates of interest applying to either earning assets with floating rates or to interest bearing liabilities. The Company has generally been able to control its exposure to changing interest rates by maintaining primarily floating interest rate loans and a majority of its time certificates with relatively short maturities.

The following table sets forth the interest rate sensitivity of the Company’s interest-earning assets and interest-bearing liabilities at June 30, 2005, using the rate sensitivity gap ratio. For purposes of the following table, an asset or liability is considered rate-sensitive within a specified period when it can be repriced or when it is scheduled to mature within the specified time frame:

				Due in			Due After
	Within			Three to			One to			Due After			Not Rate
(Dollars in thousands)	Three Months			Twelve Months			Five Years			Five Years			Sensitive			Total
Interest earning assets:
Federal funds sold	$	26,300		$	-		$	-		$	-		$	-		$	26,300
Interest bearing deposits in other financial institutions		3,015			-			-			-			-			3,015
Securities		5,496			62,065			43,155			115,914			-			226,630
Total loans, including loans held for sale		550,375			77,917			70,184			50,917			-			749,393
Total interest earning assets		585,186			139,982			113,339			166,831						1,005,338
Cash and dues from banks														31,670			31,670
Other assets					30,660									30,028			60,688
Total assets	$	585,186		$	170,642		$	113,339		$	166,831		$	61,698		$	1,097,696
Interest bearing liabilities:
Demand, interest bearing	$	129,655		$	-		$	-		$	-		$	-		$	129,655
Savings and money market		322,229			-			-			-			-			322,229
Time deposits		83,214			69,192			48,285			-			-			200,691
Securities sold under agreement to repurchase		8,000			10,900			21,800			-			-			40,700
Notes payable to subsidiary grantor trusts		9,279			-			-			14,423			-			23,702
Total interest bearing liabilities		552,377			80,092			70,085			14,423			-			716,977
Noninterest demand deposits		46,700			-			-			-			210,159			256,859
Accrual interest payable and other liabilities		-			-			-			-			19,675			19,675
Shareholders' equity		-			-			-			-			104,185			104,185
Total liabilities and shareholder's equity	$	599,077		$	80,092		$	70,085		$	14,423		$	334,019		$	1,097,696
Interest rate sensitivity GAP	$	(13,891	)	$	90,550		$	43,254		$	152,408		$	(272,321	)	$	-
Cumulative interest rate sensitivity GAP	$	(13,891	)	$	76,659		$	119,913		$	272,321		$	-		$	-
Cumulative interest rate sensitivity GAP ratio		-1	%		7	%		11	%		25	%		0	%		0	%

Interest rate changes do not affect all categories of assets and liabilities equally or at the same time. Varying interest rate environments can create unexpected changes in prepayment levels of assets and liabilities, which may have a significant effect on the net interest margin and are not reflected in the interest sensitivity analysis table. Because of these factors, an interest sensitivity gap report may not provide a complete assessment of the exposure to changes in interest rates. To supplement traditional GAP analysis, the Company performs simulation modeling to estimate the potential effects of changing interest rate environments but there is no significant impact as of June 30, 2005, compared to December 31, 2004. The process allows the Company to explore the complex relationships within the GAP over time and various interest rate environments.

Liquidity risk represents the potential for loss as a result of limitations on the Company's ability to adjust for future cash flows, to meet the needs of depositors and borrowers, and to fund operations on a timely and cost-effective basis. The liquidity policy approved by the board of directors requires annual review of the Company's liquidity by the asset/liability committee, which is composed of senior executives, and the finance and investment committee of the board of directors.

The Company's internal Asset/Liability Committee and the Finance and Investment Committee of the Board of Directors each meet monthly to monitor the Company's investments, liquidity needs and to oversee its asset/liability management. The Company evaluates the rates offered on its deposit products on a weekly basis.

Liquidity and Asset/Liability Management

To meet liquidity needs, the Company maintains a portion of its funds in cash deposits in other banks, in Federal funds sold, and in securities. At June 30, 2005, the Company’s primary liquidity ratio was 17.44%, comprised of $110,717,000 in securities available-for-sale with maturities (or probable calls) of up to five years, less $15,837,000 of securities that were pledged to secure public and certain other deposits as required by law and contract; Federal funds sold of $26,300,000, and $34,685,000 in cash and due from banks, as a percentage of total unsecured deposits of $893,597,000. At December 31, 2004 and June 30, 2004, the Company's primary liquidity ratio was 16.35% and 17.59%, respectively.

The following table summarizes the Company's borrowings under its Federal funds purchased, security repurchase arrangements and lines of credit for the periods indicated:

	June 30, 2005
(Dollars in thousands)	2005			2004
YTD average balance	$	47,178		$	38,505
YTD average interest rate		2.28	%		1.91	%
Maximum month-end balance	$	57,800		$	48,600
Average rate at June 30		3.44	%		1.91	%

The Company has Federal funds purchase and lines of credit arrangements totaling $57,000,000 from correspondent banks. As of June 30, 2005, the Company had borrowing capacity of approximately $101,000,000 under a borrowing line with the Federal Home Loan Bank secured by certain loans and securities.

Capital Resources

The following table summarizes risk-based capital, risk-weighted assets, and risk-based capital ratios of the Company:

	June 30,						December 31,
(Dollars in thousands)	2005			2004			2004
Capital components:
Tier 1 Capital	$	126,560		$	114,835		$	121,096
Tier 2 Capital		11,373			10,904			11,623
Total risk-based capital	$	137,933		$	125,739		$	132,719
Risk-weighted assets	$	929,924		$	879,146		$	929,241
Average assets	$	1,125,216		$	1,071,685		$	1,112,526
										Minimum
										Regulatory
Capital ratios										Requirements
Total risk-based capital		14.83	%		14.30	%		14.30	%	8.00	%
Tier 1 risk-based capital		13.61	%		13.00	%		13.00	%	4.00	%
Leverage (1)		11.25	%		10.70	%		10.90	%	4.00	%

  (1)     Tier 1 capital divided by average assets (excluding goodwill).  

At June 30, 2005 and 2004, and December 31, 2004, the Company’s capital met all minimum regulatory requirements. As of March 31, 2005, management believes that HBC was considered “Well Capitalized” under the Prompt Corrective Action Provisions.

To enhance regulatory capital and to provide liquidity the Company, through unconsolidated subsidiary grantor trusts, issued the following mandatorily redeemable cumulative trust preferred securities of subsidiary grantor trusts: In the first quarter of 2000, the Company issued $7,000,000 aggregate principal amount of 10.875% subordinated debentures due on March 8, 2030 to a subsidiary trust, which in turn issued a similar amount of trust preferred securities. In the third quarter of 2000, the Company issued $7,000,000 aggregate principal amount of 10.60% subordinated debentures due on September 7, 2030 to a subsidiary trust, which in turn issued a similar amount of trust preferred securities. In the third quarter of 2001, the Company issued $5,000,000 aggregate principal amount of Floating Rate Junior Subordinated Deferrable Interest Debentures due on July 31, 2031 to a subsidiary trust, which in turn issued a similar amount of trust preferred securities. In the third quarter of 2002, the Company issued $4,000,000 aggregate principal amount of Floating Rate Junior Subordinated Deferrable Interest Debentures due on September 26, 2032 to a subsidiary trust, which in turn issued a similar amount of trust preferred securities. Under applicable regulatory guidelines, the Trust Preferred securities currently qualify as Tier I capital. The subsidiary trusts are not consolidated in the Company’s consolidated financial statements and the subordinated debt payable to the subsidiary grantor trusts is recorded as debt of the Company to the related trusts.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

No material changes have occurred during the quarter to the Company’s market risk profile or information. For further information refer to the Company’s Form 10-K.

ITEM 4. CONTROLS AND PROCEDURES

Disclosure Control and Procedures

The Company carried out an evaluation, under the supervision and with the participation of the Company's management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures as of June 30, 2005. As defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), disclosure controls and procedures are controls and procedures designed to ensure that information required to be disclosed in reports filed or submitted under the Exchange Act are recorded, processed, summarized and reported on a timely basis. Based upon that evaluation and as result of the material weakness described below, the Chief Executive Officer and Chief Financial Officer have concluded that the Company's disclosure controls and procedures were effective as of June 30, 2005.

Changes in Internal Control over Financial Reporting

As mentioned in the March 31, 2005 Form 10Q, the Company had a material weakness according to which the Company did not design and implement controls over the selection and application of accounting policies for complex, non-routine transactions which was identified during the December 31, 2004 audit. During the second quarter of 2005, the Company created a formal process related to the design and implementation of control over the selection and application of complex, non-routine transactions. This process includes the early identification of complex, non-routine transactions. These transactions are initially documented by the Company’s internal accounting staff. There are regular meetings with accounting staff and executive level officers who are involved and familiar with these types of accounting issues, and who review the initial documentation of complex, non-routine transactions. Outside legal and accounting advice has been obtained when needed to review the complex, non-routine accounting transactions. In addition, the Company has hired additional employees with more banking and accounting experience to assist in reviewing the non-routine and complex accounting transactions.

Based on the Company’s new procedures, new additions to the staff and continuing expert consultation, the Company has had sufficient remediation for the material weakness found. The new procedures and in house expertise will properly address the review of the related policies and procedures for complex, non-routine accounting transactions. The internal controls over financial reporting were operating effectively as of June 30, 2005. Therefore, management has determined that there is no material weakness in the Company’s internal control over financial reporting as of June 30, 2005. However, the effectiveness of any system of internal controls is subject to inherent limitations and there can be no assurance that the Company’s internal control over financial reporting will prevent or detect all errors. The Company intends to continue to evaluate and strengthen its system of internal control over financial reporting.

During the six months ended June 30, 2005, except as noted above there were no changes in our internal controls over financial reporting that materially affected, or are reasonably likely to affect, our internal controls over financial reporting.

Part II — OTHER INFORMATION

ITEM 2 - Unregistered Sales of Equity Securities and Use of Proceeds

In June 2004, the Company’s Board of Director authorized the purchase of up to $10 million of its common stock, which represents approximately 700,000 shares, or 6%, of its outstanding shares at current market price. The share repurchase authorization is valid through December 31, 2005.

The Company has financed the stock repurchases by using its available cash. Shares may be repurchased by the Company in open market purchases or in privately negotiated transactions as permitted under applicable rules and regulations. The repurchase program may be modified, suspended or terminated by the Board of Directors at any time without notice. The extent to which the Company repurchases its shares and the timing of such repurchases will depend upon market conditions and other corporate considerations.

As of June 30, 2005, repurchases of equity securities are presented in the table below.

							Approximate
					Total Number of		Dollar of Shares That
					Shares Purchased		May Yet Be
	Total Number of		Price Paid		as Part of Publicly		Purchased
Settlement Date	Shares Purchased		Per Share		Announced Plans		Under the Plan
May 20, 2005		11,800	$	17.92		11,800	$	5,574,569.20
May 23, 2005		8,000	$	18.44		8,000	$	5,427,057.20
May 24, 2005		8,300	$	18.33		8,300	$	5,274,934.80
May 25, 2005		8,100	$	18.43		8,100	$	5,125,676.10
May 26, 2005		28,500	$	18.69		28,500	$	4,593,011.10
May 27, 2005		7,900	$	18.65		7,900	$	4,445,649.24
May 31, 2005		7,300	$	18.71		7,300	$	4,309,088.14
June 1, 2005		7,200	$	18.55		7,200	$	4,175,554.78
June 2, 2005		6,900	$	18.26		6,900	$	4,049,556.30
June 3, 2005		12,000	$	18.50		12,000	$	3,827,537.10
June 6, 2005		7,600	$	18.56		7,600	$	3,686,450.70
June 7, 2005		7,900	$	18.69		7,900	$	3,538,776.00
June 8, 2005		8,200	$	18.71		8,200	$	3,385,395.00
June 9, 2005		8,400	$	18.73		8,400	$	3,228,079.80
June 10, 2005		8,600	$	18.73		8,600	$	3,067,036.20
June 13, 2005		8,200	$	18.71		8,200	$	2,913,574.02
June 14, 2005		8,100	$	18.84		8,100	$	2,761,010.52
June 15, 2005		8,400	$	19.00		8,400	$	2,601,410.52
June 16, 2005		8,800	$	19.00		8,800	$	2,434,254.52
June 17, 2005		8,700	$	19.02		8,700	$	2,268,740.50
June 20, 2005		9,000	$	19.31		9,000	$	2,094,968.50
June 21, 2005		9,500	$	19.25		9,500	$	1,912,093.50
		207,400				207,400

ITEM 4. SUBMISSIONS OF MATTERS TO A VOTE OF SECURITY HOLDERS

The Company held its 2005 Annual Meeting of Shareholders on May 26, 2005. There were 11,788,426 issued and outstanding shares of Company Common Stock on March 30, 2005, the Record Date for the 2005 Annual Meeting. Each of the shares voting at the meeting was entitled to one vote.

At the 2005 Annual Meeting, the following actions were taken:

Election of Directors

The Company’s board is divided into three classes. At the 2005 Annual Meeting, four directors of the Company were elected. The following chart indicates the number of shares cast for each elected director:

Name of DirectorVotes ForVotes Withheld

Jack W. Conner10,126,138281,038

Walter T. Kaczmarek10,106,098301,078

Charles J. Toeniskoetter 10,117,574289,602

Ranson W. Webster10,076,989330,187

In addition to the above four individuals, the following previously elected directors’ terms continued after the meeting:

Name of DirectorTitle

Frank G. BiscegliaDirector

James BlairDirector

William Del Biaggio, Jr.     Director

Humphrey P. PolanenDirector

Louis “Lon” O. NormandinDirector

Jack PeckhamDirector

Robert T. MolesDirector

To approve an amendment to the Commerce Corp Bylaws to declassify the Board of Directors so that each director would stand for re-election on an annual basis.

FOR10,354,520

AGAINST30,676

ABSTAIN21,980

To approve an amendment to the Commerce Corp Articles of Incorporation to reinstate cumulative voting for shareholders of Commerce Corp..

FOR7,225,836

AGAINST395,721

ABSTAIN63,775

BROKERED NON-VOTES2,721,844

ITEM 6. EXHIBITS

ExhibitDescription

31.1Certification of Registrant’s Chief Executive Officer Pursuant To Section 302 of the Sarbanes-Oxley Act of 2003

31.2Certification of Registrant’s Chief Executive Officer Pursuant To Section 302 of the Sarbanes-Oxley Act of 2003

32.1Certification of Registrant’s Chief Executive Officer Pursuant To 18 U.S.C. Section 1350

32.2Certification of Registrant’s Chief Financial Officer Pursuant To 18 U.S.C. Section 1350

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	Heritage Commerce Corp (Registrant)
August 9, 2005 Date	/s/ Walter T. Kaczmarek Walter T. Kaczmarek Chief Executive Officer
August 9, 2005 Date	/s/ Lawrence D. McGovern Lawrence D. McGovern Chief Financial Officer