Heritage Commerce (HTBK) 10-Q 2019 Q1 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10‑Q

(MARK ONE)
☒	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2019
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 (State or Other Jurisdiction of Incorporation or Organization)	77‑0469558 (I.R.S. Employer Identification No.)
150 Almaden Boulevard, San Jose, California (Address of Principal Executive Offices)	95113 (Zip Code)

(408) 947‑6900

(Registrant’s Telephone Number, Including Area Code)

N/A

(Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report)

Securities registered pursuant to Section 12(b) of the Act:

Title of each class:	Trading Symbol:	Name of each exchange on which registered:
Common Stock, No Par Value	HTBK	The NASDAQ Stock Market LLC

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

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S‑T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  YES ☒  NO ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer ☐	Accelerated filer ☒	Non‑accelerated filer ☐	Smaller reporting company ☐
			Emerging growth company ☐

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b‑2 of the Exchange Act).  YES ☐  NO ☒

The Registrant had 43,338,253 shares of Common Stock outstanding on April 30, 2019.

HERITAGE COMMERCE CORP

QUARTERLY REPORT ON FORM 10‑Q

TABLE OF CONTENTS

		Page No.
Cautionary Note on Forward‑Looking Statements		3
Part I. FINANCIAL INFORMATION
Item 1.	Consolidated Financial Statements (unaudited)	5
	Consolidated Balance Sheets	5
	Consolidated Statements of Income	6
	Consolidated Statements of Comprehensive Income	7
	Consolidated Statements of Changes in Shareholders’ Equity	8
	Consolidated Statements of Cash Flows	9
	Notes to Unaudited Consolidated Financial Statements	10
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	40
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	69
Item 4.	Controls and Procedures	69
PART II. OTHER INFORMATION
Item 1.	Legal Proceedings	70
Item 1A.	Risk Factors	70
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	70
Item 3.	Defaults Upon Senior Securities	70
Item 4.	Mine Safety Disclosures	70
Item 5.	Other Information	70
Item 6.	Exhibits	70
SIGNATURES		71

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Cautionary Note Regarding Forward‑Looking Statements

This Report on Form 10‑Q contains various statements that may constitute forward‑looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, Rule 175 promulgated thereunder, and Section 21E of the Securities Exchange Act of 1934, as amended, Rule 3b‑6 promulgated thereunder and are intended to be covered by the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Any statements about our expectations, beliefs, plans, objectives, assumptions or future events or performance are not historical facts and may be forward‑looking. These forward‑looking statements often can be, but are not always, identified by the use of words such as “assume,” “expect,” “intend,” “plan,” “project,” “believe,” “estimate,” “predict,” “anticipate,” “may,” “might,” “should,” “could,” “goal,” “potential” and similar expressions. We base these forward‑looking statements on our current expectations and projections about future events, our assumptions regarding these events and our knowledge of facts at the time the statements are made. These statements include statements relating to our projected growth, anticipated future financial performance, and management’s long‑term performance goals, as well as statements relating to the anticipated effects on results of operations and financial condition.

These forward‑looking statements are subject to various risks and uncertainties that may be outside our control and our actual results could differ materially from our projected results. In addition, our past results of operations do not necessarily indicate our future results. The forward‑looking statements could be affected by many factors, including but not limited to:

· current and future economic and market conditions in the United States generally or in the communities we serve, including the effects of declines in property values and overall slowdowns in economic growth should these events occur;

· effects of and changes in trade, monetary and fiscal policies and laws, including the interest rate policies of the Federal Open Market Committee of the Federal Reserve Board;

· our ability to anticipate interest rate changes and manage interest rate risk;

· changes in inflation, interest rates, and market liquidity which may impact interest margins and impact funding sources;

· volatility in credit and equity markets and its effect on the global economy;

· our ability to effectively compete with other banks and financial services companies and the effects of competition in the financial services industry on our business;

· our ability to achieve loan growth and attract deposits;

· risks associated with concentrations in real estate related loans;

· the relative strength or weakness of the commercial and real estate markets where our borrowers are located;

· other than temporary impairment charges to our securities portfolio;

· changes in the level of nonperforming assets and charge offs and other credit quality measures, and their impact on the adequacy of the Company’s allowance for loan losses and the Company’s provision for loan losses;

· increased capital requirements for our continued growth or as imposed by banking regulators, which may require us to raise capital at a time when capital is not available on favorable terms if at all;

· regulatory limits on Heritage Bank of Commerce’s ability to pay dividends to the holding company;

· changes in our capital management policies, including those regarding business combinations, dividends, and share repurchases;

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· operational issues stemming from, and/or capital spending necessitated by, the potential need to adapt to industry changes in information technology systems, on which we are highly dependent;

· our inability to attract, recruit,  and retain qualified officers and other personnel could harm our ability to implement our strategic plan, impair our relationships with customers and adversely affect our business, and results of operations;

· the potential increase in reserves and allowance for loan loss as a result of the transition to the current expected credit loss standard (“CECL”) established by the Financial Accounting Standards Board to account for future expected credit losses;

· possible impairment of our goodwill and other intangible assets;

· possible  adjustment of the valuation of our deferred tax assets;

· our ability to keep pace with technological changes, including our ability to identify and address cyber-security risks such as data security breaches, “denial of service” attacks, “hacking” and identity theft;

· inability of our framework to manage risks associated with our business, including operational risk and credit risk;

· risks of loss of funding of Small Business Administration or SBA loan programs, or changes in those programs;

· compliance with governmental and regulatory requirements, including the Dodd-Frank Act and others relating to banking, consumer protection, securities , accounting and tax matters;

· significant changes in applicable laws and regulations, including those concerning taxes, banking and securities;

· effect of changes in accounting policies and practices, as may be adopted by the regulatory agencies, as well as the Public Company Accounting Oversight Board, the Financial Accounting Standards Board and other accounting standard setters;

· costs and effects of legal and regulatory developments, including resolution of legal proceedings or regulatory or other governmental inquiries, and the results of regulatory examinations or reviews;

· availability and competition for acquisition opportunities;

· risks resulting from domestic terrorism;

· risks of natural disasters (including earthquakes) and other events beyond our control; and

· our success in managing the risks involved in the foregoing factors.

Forward-looking statements speak only as of the date they are made. The Company does not undertake to update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made or to reflect the occurrence of unanticipated events. You should consider any forward looking statements in light of this explanation, and we caution you about relying on forward-looking statements.

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Part I—FINANCIAL INFORMATION

ITEM 1—CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

HERITAGE COMMERCE CORP

CONSOLIDATED BALANCE SHEETS (Unaudited)

	March 31,		December 31,
	2019		2018
	(Dollars in thousands)
Assets
Cash and due from banks	$	38,699	$	30,273
Other investments and interest-bearing deposits in other financial institutions		196,278		134,295
Total cash and cash equivalents		234,977		164,568
Securities available-for-sale, at fair value		452,521		459,043
Securities held-to-maturity, at amortized cost (fair value of $362,581 at
March 31, 2019 and $366,175 at December 31, 2018)		367,023		377,198
Loans held-for-sale - SBA, at lower of cost or fair value, including deferred costs		3,216		2,649
Loans, net of deferred fees		1,848,318		1,886,405
Allowance for loan losses		(27,318)		(27,848)
Loans, net		1,821,000		1,858,557
Federal Home Loan Bank and Federal Reserve Bank stock and other investments, at cost		25,221		25,216
Company-owned life insurance		62,189		61,859
Premises and equipment, net		6,998		7,137
Goodwill		83,753		83,753
Other intangible assets		11,454		12,007
Accrued interest receivable and other assets		47,525		44,575
Total assets	$	3,115,877	$	3,096,562
Liabilities and Shareholders' Equity
Liabilities:
Deposits:
Demand, noninterest-bearing	$	1,016,770	$	1,021,582
Demand, interest-bearing		704,996		702,000
Savings and money market		759,306		754,277
Time deposits - under $250		56,385		58,661
Time deposits - $250 and over		90,042		86,114
CDARS - interest-bearing demand, money market and time deposits		12,745		14,898
Total deposits		2,640,244		2,637,532
Subordinated debt, net of issuance costs		39,414		39,369
Accrued interest payable and other liabilities		57,703		52,195
Total liabilities		2,737,361		2,729,096
Shareholders' equity:
Preferred stock, no par value; 10,000,000 shares authorized; none issued and outstanding
at March 31, 2019 and December 31, 2018		—		—
Common stock, no par value; 60,000,000 shares authorized; 43,323,753 shares issued
and outstanding at March 31, 2019 and 43,288,750 shares issued and
outstanding at December 31, 2018		301,550		300,844
Retained earnings		85,953		79,003
Accumulated other comprehensive loss		(8,987)		(12,381)
Total shareholders' equity		378,516		367,466
Total liabilities and shareholders' equity	$	3,115,877	$	3,096,562

See notes to unaudited consolidated financial statements

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HERITAGE COMMERCE CORP

CONSOLIDATED STATEMENTS OF INCOME (Unaudited)

	Three Months Ended
	March 31,
	2019		2018
Interest income:
Loans, including fees	$	26,807	$	22,284
Securities, taxable		4,509		3,862
Securities, exempt from Federal tax		548		560
Other investments, interest-bearing deposits
in other financial institutions and Federal funds sold		1,585		1,171
Total interest income		33,449		27,877
Interest expense:
Deposits		1,836		958
Subordinated debt		571		571
Total interest expense		2,407		1,529
Net interest income before provision for loan losses		31,042		26,348
Provision (credit) for loan losses		(1,061)		506
Net interest income after provision for loan losses		32,103		25,842
Noninterest income:
Service charges and fees on deposit accounts		1,161		902
Increase in cash surrender value of life insurance		330		363
Servicing income		191		181
Gain on sales of SBA loans		139		235
Gain on sales of securities		—		87
Other		647		427
Total noninterest income		2,468		2,195
Noninterest expense:
Salaries and employee benefits		10,770		9,777
Occupancy and equipment		1,506		1,106
Professional fees		818		684
Other		4,824		4,423
Total noninterest expense		17,918		15,990
Income before income taxes		16,653		12,047
Income tax expense		4,507		3,238
Net income	$	12,146	$	8,809
Earnings per common share:
Basic	$	0.28	$	0.23
Diluted	$	0.28	$	0.23

See notes to unaudited consolidated financial statements

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HERITAGE COMMERCE CORP

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)

	Three Months Ended
	March 31,
	2019		2018
Net income	$	12,146	$	8,809
Other comprehensive income:
Change in net unrealized holding (losses) gains on available-for-sale
securities and I/O strips		4,871		(7,985)
Deferred income taxes		(1,467)		2,315
Change in net unamortized unrealized gain on securities available-for-
sale that were reclassified to securities held-to-maturity		(26)		(11)
Deferred income taxes		8		3
Reclassification adjustment for losses (gains) realized in income		—		(87)
Deferred income taxes		—		26
Change in unrealized (losses) gains on securities and I/O strips, net of
deferred income taxes		3,386		(5,739)
Change in net pension and other benefit plan liability adjustment		12		50
Deferred income taxes		(4)		(15)
Change in pension and other benefit plan liability, net of
deferred income taxes		8		35
Other comprehensive income (loss)		3,394		(5,704)
Total comprehensive income	$	15,540	$	3,105

See notes to unaudited consolidated financial statements

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HERITAGE COMMERCE CORP

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (Unaudited)

	Three Months Ended March 31, 2019 and 2018
						Accumulated
						Other		Total
	Common Stock			Retained		Comprehensive		Shareholders’
	Shares	Amount		Earnings		Loss		Equity
	(Dollars in thousands)
Balance, January 1, 2018	38,200,883	$	218,355	$	62,136	$	(9,252)	$	271,239
Net income	—		—		8,809		—		8,809
Other comprehensive loss	—		—		—		(5,704)		(5,704)
Amortization of restricted stock awards,
net of forfeitures	—		228		—		—		228
Cash dividend declared $0.11 per share	—		—		(4,206)		—		(4,206)
Stock option expense, net of fortfeitures	—		176		—		—		176
Stock options exercised	68,906		449		—		—		449
Balance, March 31, 2018	38,269,789	$	219,208	$	66,739	$	(14,956)	$	270,991
Balance, January 1, 2019	43,288,750	$	300,844	$	79,003	$	(12,381)	$	367,466
Net income	—		—		12,146		—		12,146
Other comprehensive income	—		—		—		3,394		3,394
Amortization of restricted stock awards,
net of forfeitures	—		271		—		—		271
Cash dividend declared $0.12 per share	—		—		(5,196)		—		(5,196)
Stock option expense, net of forfeitures	—		166						166
Stock options exercised	35,003		269		—		—		269
Balance, March 31, 2019	43,323,753	$	301,550	$	85,953	$	(8,987)	$	378,516

See notes to unaudited consolidated financial statements

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HERITAGE COMMERCE CORP

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

	Three Months Ended
	March 31,
	2019		2018
	(Dollars in thousands)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	12,146	$	8,809
Adjustments to reconcile net income to net cash provided by operating activities:
Amortization of discounts and premiums on securities		516		1,131
(Gain) on sale of securities available-for-sale		—		(87)
Gain on sale of SBA loans		(139)		(235)
Proceeds from sale of SBA loans originated for sale		1,935		3,041
SBA loans originated for sale		(2,363)		(2,246)
Provision (credit) for loan losses		(1,061)		506
Increase in cash surrender value of life insurance		(330)		(363)
Depreciation and amortization		188		196
Amortization of other intangible assets		553		241
Stock option expense, net		166		176
Amortization of restricted stock awards, net		271		228
Amortization of subordinated debt issuance costs		45		46
Effect of changes in:
Accrued interest receivable and other assets		5,145		3,288
Accrued interest payable and other liabilities		(4,062)		(2,297)
Net cash provided by operating activities		13,010		12,434
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of securities available-for-sale		—		(15,193)
Purchase of securities held-to-maturity		—		(5,022)
Maturities/paydowns/calls of securities available-for-sale		11,242		14,957
Maturities/paydowns/calls of securities held-to-maturity		9,808		13,002
Proceeds from sales of securities available-for-sale		—		38,754
Net change in loans		38,618		(8,559)
Changes in Federal Home Loan Bank stock and other investments		(5)		(6)
Purchase of premises and equipment		(49)		(46)
Net cash provided by investing activities		59,614		37,887
CASH FLOWS FROM FINANCING ACTIVITIES:
Net change in deposits		2,712		(60,797)
Exercise of stock options		269		449
Payment of cash dividends		(5,196)		(4,206)
Net cash used in financing activities		(2,215)		(64,554)
Net increase (decrease) in cash and cash equivalents		70,409		(14,233)
Cash and cash equivalents, beginning of period		164,568		316,222
Cash and cash equivalents, end of period	$	234,977	$	301,989
Supplemental disclosures of cash flow information:
Interest paid	$	1,724	$	977
Income taxes paid		8		4
Supplemental schedule of non-cash activity:
Due to broker for securities purchased	$	—	$	5,439
Recording of right to use assets in exchange for lease obligations		9,566		—

See notes to unaudited consolidated financial statements

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HERITAGE COMMERCE CORP

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2019

(Unaudited)

1) Basis of Presentation

The unaudited consolidated financial statements of Heritage Commerce Corp (the “Company” or “HCC”) 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 that were included in the Company’s Form 10-K for the year ended December 31, 2018.

HBC is a commercial bank serving customers primarily located in Santa Clara, Alameda, Contra Costa, San Benito, and San Mateo counties of California. CSNK Working Capital Finance Corp. a California corporation, dba Bay View Funding (“Bay View Funding”) is a wholly owned subsidiary of HBC, and provides business-essential working capital factoring financing to various industries throughout the United States. No customer accounts for more than 10% of revenue for HBC or the Company. The Company reports its results for two segments: banking and factoring. The Company’s management uses segment results in its operating and strategic planning.

In management’s opinion, all adjustments necessary for a fair presentation of these consolidated financial statements have been included and are of a normal and recurring nature. All intercompany transactions and balances have been eliminated.

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ significantly from these estimates.

The results for the three months ended March 31, 2019 are not necessarily indicative of the results expected for any subsequent period or for the entire year ending December 31, 2019.

Business Combinations

The Company accounts for acquisitions of businesses using the acquisition method of accounting. Under the acquisition method, assets acquired and liabilities assumed are recorded at their estimated fair values at the date of acquisition. Management utilizes various valuation techniques including discounted cash flow analyses to determine these fair values. Any excess of the purchase price over amounts allocated to the acquired assets, including identifiable intangible assets, and liabilities assumed is recorded as goodwill.

Goodwill and Other Intangible Assets

Goodwill resulted from the acquisition of Tri-Valley Bank (“Tri-Valley”) on April 6, 2018 and United American Bank (“United American”) on May 4, 2018, and from acquisitions in prior years. Goodwill represents the excess of the purchase price over the fair value of acquired tangible assets and liabilities and identifiable intangible assets. Goodwill is assessed at least annually for impairment and any such impairment is recognized in the period identified.

Other intangible assets consist of core deposit intangible assets and a below market value lease intangible asset, arising from the United American and Tri-Valley acquisitions. They are initially measured at fair value and then are amortized over their estimated useful lives. The core deposit intangible assets from the acquisitions of United American and Tri-Valley are being amortized on an accelerated method over ten years. The below market value lease intangible assets are being amortized on the straight line method over three years for United American and eleven years for Tri-Valley. 

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Reclassifications

              Certain reclassifications of prior year balances have been made to conform to the current year presentation. These reclassifications had no impact on the Company’s consolidated financial position, results of operations or net change in cash and cash equivalents.

Adoption of New Accounting Standards

In February 2016, the FASB issued ASU No. 2016-02, “Leases (Topic 842).” This update revises the model to assess how a lease should be classified and provides guidance for lessees and lessors, when presenting right-of-use assets and lease liabilities on the balance sheet. Under the new guidance, lessees will be required to recognize the following for all leases, with the exception of short-term leases, at the commencement date: (1) a lease liability, which is a lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis; and (2) a right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. Under the new guidance, lessor accounting is largely unchanged. This update became effective for the Company on January 1, 2019.

In July 2018, the FASB issued supplementary ASU No. 2018-11, Leases (Topic 842): Targeted Improvements, which provides for an additional transition method allowing for a modified retrospective adoption approach where the guidance would only be applied to existing leases in effect at the adoption date and new leases going forward, with a cumulative effect adjustment to retained earnings as of the adoption date and additional required disclosures regarding leasing arrangements only for those periods after adoption. This update also allows lessors to not separate non-lease components from the associated lease component if certain conditions are met. The Company has elected the practical expedients permitted by ASU 2018-11. The Company adopted the new guidance on January 1, 2019.

At the adoption date, the Company reported increase assets and liabilities of approximately $9.6 million on its consolidated balance sheet as a result of recognizing right-of-use assets and lease liabilities related to non-cancellable operating lease agreements for office space. The adoption of this guidance did not have a material impact to its Consolidated Statetements of Income or Cash Flows. See Note 17 – Leases for more information.

In March 2017, the FASB issued ASU 2017-08, Premium Amortization on Purchased Callable Debt Securities. This update shortens the amortization period of certain callable debt securities held at a premium to the earliest call date.  The amendments in this update were effective for the Company on January 1, 2019.  The amendments are applied on a modified retrospective basis through a cumulative-effect adjustment to retained earnings as of the beginning of the period of adoption and the Company is required to provide change in accounting principle disclosures. The Company adopted the new guidance on January 1, 2019, and there was no material impact to the financial statements and no cumulative adjustments were made.

Newly Issued, but not yet Effective Accounting Standards

In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments – Credit Losses: Measurement of Credit Losses on Financial Instruments. The standard is the final guidance on the new current expected credit loss (“CECL”) model. The amendments in this update replace the incurred loss impairment methodology in current GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to estimate future credit loss estimates. As CECL encompasses all financial assets carried at amortized cost, the requirement that reserves be established based on an organization’s reasonable and supportable estimate of expected credit losses extends to held-to-maturity debt securities.  The guidance allows for a modified retrospective approach with a cumulative effect adjustment to the balance sheet upon adoption (charge to retained earnings instead of the income statement). The new guidance is effective for public business entities for fiscal years, and interim periods within those years, beginning after December 15, 2019. While early application is permitted for fiscal years beginning after December 15, 2018, the Company plans to adopt this standard on January 1, 2020. The Company has established a company-wide, cross-functional governance structure, which oversees overall strategy for implementation of CECL. We are currently evaluating various loss methodologies to determine their correlation to our various loan categories historical performance. The project plan is targeting the data and model validation completion during the second quarter of 2019, with parallel processing of our existing allowance for loan loss model with CECL prior to implementation. The Company is focused on completing data and model validation, refining assumptions and continued review of the models. The Company also continues to focus on researching and resolving interpretive

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accounting issues in the ASU, contemplating various related accounting policies, developing processes and related controls and considering various reporting disclosures. The Company also continues to believe that the adoption of the standard will result in an overall increase in the allowance for loan losses to cover credit losses over the estimated life of the financial assets. However, the magnitude of the increase in its allowance for loan losses at the adoption date will depend upon the nature and characteristics of the portfolio at the adoption date, as well as macroeconomic conditions and forecasts at that time.

In January 2017, the FASB issued accounting standards ASU No. 2017-04, Simplifying the Test for Goodwill Impairment. The provisions of the update eliminate the existing second step of the goodwill impairment test which provides for the allocation of reporting unit fair value among existing assets and liabilities, with the net remaining amount representing the implied fair value of goodwill. In replacement of the existing goodwill impairment rule, the update will provide that impairment should be recognized as the excess of any of the reporting unit’s goodwill over the fair value of the reporting unit. Under the provisions of this update, the amount of the impairment is limited to the carrying value of the reporting unit’s goodwill. For public business entities that are SEC filers, the amendments of the update will become effective in fiscal years beginning after December 15, 2019. Management does not expect the requirements of this update to have a material impact on the Company’s financial position, results of operations or cash flows.

2) Shareholders’ Equity and Earnings Per Share

Basic earnings per common share is computed by dividing net income by the weighted average common shares outstanding. Diluted earnings per share reflect potential dilution from outstanding stock options using the treasury stock method. There were 539,000 and 275,000 stock options for the three months ended March 31, 2019 and 2018, respectively, considered to be antidilutive and excluded from the computation of diluted earnings per share. A reconciliation of these factors used in computing basic and diluted earnings per common share is as follows:

	Three Months Ended
	March 31,
	2019		2018
	(Dollars in thousands, except per share amounts)
Net income	$	12,146	$	8,809
Weighted average common shares outstanding for basic
earnings per common share		43,108,208		38,240,495
Dilutive potential common shares		562,133		574,227
Shares used in computing diluted earnings per common share		43,670,341		38,814,722
Basic earnings per share	$	0.28	$	0.23
Diluted earnings per share	$	0.28	$	0.23

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3) Accumulated Other Comprehensive Income (Loss) (“AOCI”)

The following table reflects the changes in AOCI by component for the periods indicated:

	Three Months Ended March 31, 2019 and 2018
			Unamortized
			Unrealized
	Unrealized		Gain on
	Gains (Losses) on		Available-
	Available-		for-Sale		Defined
	for-Sale		Securities		Benefit
	Securities		Reclassified		Pension
	and I/O		to Held-to-		Plan
	Strips(1)		Maturity		Items		Total
	(Dollars in thousands)
Beginning balance January 1, 2019, net of taxes	$	(5,007)	$	344	$	(7,718)	$	(12,381)
Other comprehensive income (loss) before reclassification, net of taxes		3,404		—		(7)		3,397
Amounts reclassified from other comprehensive income (loss), net of taxes		—		(18)		15		(3)
Net current period other comprehensive income (loss), net of taxes		3,404		(18)		8		3,394
Ending balance March 31, 2019, net of taxes	$	(1,603)	$	326	$	(7,710)	$	(8,987)
Beginning balance January 1, 2018, net of taxes	$	(362)	$	375	$	(9,265)	$	(9,252)
Other comprehensive income (loss) before reclassification, net of taxes		(5,670)		—		(5)		(5,675)
Amounts reclassified from other comprehensive income (loss), net of taxes		(61)		(8)		40		(29)
Net current period other comprehensive income (loss), net of taxes		(5,731)		(8)		35		(5,704)
Ending balance March 31, 2018, net of taxes	$	(6,093)	$	367	$	(9,230)	$	(14,956)

	Amounts Reclassified from
	AOCI(1)
	Three Months Ended
	March 31,				Affected Line Item Where
Details About AOCI Components	2019		2018		Net Income is Presented
	(Dollars in thousands)
Unrealized gains on available-for-sale securities
and I/O strips	$	—	$	87	Gain on sales of securities
		—		(26)	Income tax expense
		—		61	Net of tax
Amortization of unrealized gain on securities available-
for-sale that were reclassified to securities
held-to-maturity		26		11	Interest income on taxable securities
		(8)		(3)	Income tax expense
		18		8	Net of tax
Amortization of defined benefit pension plan items (1)
Prior transition obligation		25		16
Actuarial losses		(46)		(73)
		(21)		(57)	Salaries and employee benefits
		6		17	Income tax benefit
		(15)		(40)	Net of tax
Total reclassification for the year	$	3	$	29

13

(1) This AOCI component is included in the computation of net periodic benefit cost (see Note 9—Benefit Plans) and includes split-dollar life insurance benefit plan.

4) Securities

The amortized cost and estimated fair value of securities at March 31, 2019 and December 31, 2018 were as follows:

			Gross		Gross		Estimated
	Amortized		Unrealized		Unrealized		Fair
March 31, 2019	Cost		Gains		(Losses)		Value
	(Dollars in thousands)
Securities available-for-sale:
Agency mortgage-backed securities	$	299,847	$	343	$	(4,612)	$	295,578
U.S. Treasury		148,095		1,387		—		149,482
U.S. Government sponsored entities		7,447		14		—		7,461
Total	$	455,389	$	1,744	$	(4,612)	$	452,521
Securities held-to-maturity:
Agency mortgage-backed securities	$	281,102	$	281	$	(4,758)	$	276,625
Municipals - exempt from Federal tax		85,921		683		(648)		85,956
Total	$	367,023	$	964	$	(5,406)	$	362,581

			Gross		Gross		Estimated
	Amortized		Unrealized		Unrealized		Fair
December 31, 2018	Cost		Gains		(Losses)		Value
	(Dollars in thousands)
Securities available-for-sale:
Agency mortgage-backed securities	$	311,523	$	98	$	(8,767)	$	302,854
U.S. Treasury		147,823		930		—		148,753
U.S. Government sponsored entities		7,433		4		(1)		7,436
Total	$	466,779	$	1,032	$	(8,768)	$	459,043
Securities held-to-maturity:
Agency mortgage-backed securities	$	291,241	$	59	$	(9,153)	$	282,147
Municipals - exempt from Federal tax		85,957		312		(2,241)		84,028
Total	$	377,198	$	371	$	(11,394)	$	366,175

Securities with unrealized losses at March 31, 2019 and December 31, 2018, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position are as follows:

	Less Than 12 Months				12 Months or More				Total
	Fair		Unrealized		Fair		Unrealized		Fair		Unrealized
March 31, 2019	Value		(Losses)		Value		(Losses)		Value		(Losses)
	(Dollars in thousands)
Securities available-for-sale:
Agency mortgage-backed securities	$	—	$	—	$	269,629	$	(4,612)	$	269,629	$	(4,612)
Total	$	—	$	—	$	269,629	$	(4,612)	$	269,629	$	(4,612)
Securities held-to-maturity:
Agency mortgage-backed securities	$	—	$	—	$	250,516	$	(4,758)	$	250,516	$	(4,758)
Municipals - exempt from Federal tax		—		—		32,440		(648)		32,440		(648)
Total	$	—	$	—	$	282,956	$	(5,406)	$	282,956	$	(5,406)

14

	Less Than 12 Months				12 Months or More				Total
	Fair		Unrealized		Fair		Unrealized		Fair		Unrealized
December 31, 2018	Value		(Losses)		Value		(Losses)		Value		(Losses)
	(Dollars in thousands)
Securities available-for-sale:
Agency mortgage-backed securities	$	3,868	$	(21)	$	281,082	$	(8,746)	$	284,950	$	(8,767)
U.S. Government sponsored entities		3,974		(1)		—		—		3,974		(1)
Total	$	7,842	$	(22)	$	281,082	$	(8,746)	$	288,924	$	(8,768)
Securities held-to-maturity:
Agency mortgage-backed securities	$	16,088	$	(103)	$	255,917	$	(9,050)	$	272,005	$	(9,153)
Municipals - exempt from Federal tax		5,019		(27)		57,301		(2,214)		62,320		(2,241)
Total	$	21,107	$	(130)	$	313,218	$	(11,264)	$	334,325	$	(11,394)

There were no holdings of securities of any one issuer, other than the U.S. Government and its sponsored entities, in an amount greater than 10% of shareholders’ equity. At March 31, 2019, the Company held 525 securities (202 available-for-sale and 323 held‑to‑maturity), of which 288 had fair values below amortized cost. At March 31, 2019, there were $269,629,000 of agency mortgage-back securities available-for-sale, $250,516,000 of agency mortgage-backed securities held-to-maturity, and $32,440,000 of municipal bonds held-to-maturity, carried with an unrealized loss for 12 months or more. The total unrealized loss for securities 12 months or more was $10,018,000 at March 31, 2019. The unrealized losses were due to higher interest rates. The issuers are of high credit quality and all principal amounts are expected to be paid when securities mature. The fair value is expected to recover as the securities approach their maturity date and/or market rates decline. The Company does not believe that it is more likely than not that the Company will be required to sell a security in an unrealized loss position prior to recovery in value. The Company does not consider these securities to be other than temporarily impaired at March 31, 2019.

The proceeds from sales of securities and the resulting gains and losses were as follows for the periods indicated:

	Three Months Ended
	March 31,
	2019		2018
	(Dollars in thousands)
Proceeds	$	—	$	38,754
Gross gains		—		1,050
Gross losses		—		(963)

The amortized cost and estimated fair values of securities as of March 31, 2019  are shown by contractual maturity below. The expected maturities will differ from contractual maturities if borrowers have the right to call or pre‑pay obligations with or without call or pre‑payment penalties. Securities not due at a single maturity date are shown separately.

	Available-for-sale
	Amortized		Estimated
	Cost		Fair Value
	(Dollars in thousands)
Due after 3 months through one year	$	5,468	$	5,475
Due after one through five years		150,074		151,468
Agency mortgage-backed securities		299,847		295,578
Total	$	455,389	$	452,521

15

	Held-to-maturity
	Amortized		Estimated
	Cost		Fair Value
	(Dollars in thousands)
Due after 3 months through one year	$	770	$	771
Due after one through five years		4,941		5,038
Due after five through ten years		27,670		27,988
Due after ten years		52,540		52,159
Agency mortgage-backed securities		281,102		276,625
Total	$	367,023	$	362,581

Securities with amortized cost of $34,806,000 and $36,229,000 as of  March 31, 2019 and December 31, 2018 were pledged to secure public deposits and for other purposes as required or permitted by law or contract.

5) Loans

Loans were as follows for the periods indicated:

	March 31,		December 31,
	2019		2018
	(Dollars in thousands)
Loans held-for-investment:
Commercial	$	559,718	$	597,763
Real estate:
CRE		1,012,641		994,067
Land and construction		98,222		122,358
Home equity		118,448		109,112
Residential mortgages		49,786		50,979
Consumer		9,690		12,453
Loans		1,848,505		1,886,732
Deferred loan fees, net		(187)		(327)
Loans, net of deferred fees		1,848,318		1,886,405
Allowance for loan losses		(27,318)		(27,848)
Loans, net	$	1,821,000	$	1,858,557

At March 31, 2019, total net loans included in the table above include $34,433,000, $103,540,000 and $174,328,000, of the loans acquired in the Focus Business Bank (“Focus”), Tri-Valley, and United American acquisitions that were not purchased credit impaired loans, respectively. At December 31, 2018, total net loans included in the table above include $36,958,000, $111,952,000 and $181,453,000, of the loans acquired in the Focus, Tri-Valley, and United American acquisitions, respectively, that were not purchased credit impaired loans.

There was a ($1,061,000) credit to the provision for loan losses for the first quarter of 2019, compared to a provision for loan losses of $506,000 for the first quarter of 2018. Net recoveries totaled $531,000 for the first quarter of 2019, compared to net charge-offs of ($25,000) for the first quarter of 2018.

Changes in the allowance for loan losses were as follows for the periods indicated:

	Three Months Ended March 31, 2019
	Commercial		Real Estate		Consumer		Total
	(Dollars in thousands)
Beginning of period balance	$	17,061	$	10,671	$	116	$	27,848
Charge-offs		(226)		—		—		(226)
Recoveries		715		42		—		757
Net recoveries		489		42		—		531
Provision (credit) for loan losses		(1,993)		958		(26)		(1,061)
End of year balance	$	15,557	$	11,671	$	90	$	27,318

16

	Three Months Ended March 31, 2018
	Commercial		Real Estate		Consumer		Total
	(Dollars in thousands)
Beginning of period balance	$	10,608	$	8,950	$	100	$	19,658
Charge-offs		(245)		—		—		(245)
Recoveries		157		63		—		220
Net (charge-offs) recoveries		(88)		63		—		(25)
Provision (credit) for loan losses		645		(155)		16		506
End of period balance	$	11,165	$	8,858	$	116	$	20,139

The following table presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment, based on the impairment method at the following period‑ends:

	March 31, 2019
	Commercial		Real Estate		Consumer		Total
	(Dollars in thousands)
Allowance for loan losses:
Ending allowance balance attributable to loans:
Individually evaluated for impairment	$	6,467	$	897	$	—	$	7,364
Collectively evaluated for impairment		9,090		10,774		90		19,954
Total allowance balance	$	15,557	$	11,671	$	90	$	27,318
Loans:
Individually evaluated for impairment	$	8,536	$	8,980	$	—	$	17,516
Collectively evaluated for impairment		551,182		1,270,117		9,690		1,830,989
Total loan balance	$	559,718	$	1,279,097	$	9,690	$	1,848,505

	December 31, 2018
	Commercial		Real Estate		Consumer		Total
	(Dollars in thousands)
Allowance for loan losses:
Ending allowance balance attributable to loans:
Individually evaluated for impairment	$	6,944	$	—	$	—	$	6,944
Collectively evaluated for impairment		10,117		10,671		116		20,904
Total allowance balance	$	17,061	$	10,671	$	116	$	27,848
Loans:
Individually evaluated for impairment	$	9,495	$	5,645	$	—	$	15,140
Collectively evaluated for impairment		588,268		1,270,871		12,453		1,871,592
Total loan balance	$	597,763	$	1,276,516	$	12,453	$	1,886,732

17

The following table presents loans held-for-investment individually evaluated for impairment by class of loans as of March 31, 2019 and December 31, 2018. The recorded investment included in the following table represents loan principal net of any partial charge-offs recognized on the loans. The unpaid principal balance represents the recorded balance prior to any partial charge-offs. The recorded investment in consumer loans collateralized by residential real estate property that are in process of foreclosure according to local requirements of the applicable jurisdiction are not material as of the periods indicated:

	March 31, 2019						December 31, 2018
					Allowance						Allowance
	Unpaid				for Loan		Unpaid				for Loan
	Principal		Recorded		Losses		Principal		Recorded		Losses
	Balance		Investment		Allocated		Balance		Investment		Allocated
	(Dollars in thousands)
With no related allowance recorded:
Commercial	$	1,615	$	1,615	$	—	$	1,849	$	1,849	$	—
Real estate:
CRE		—		—		—		5,094		5,094		—
Land and construction		—		—		—		—		—		—
Home Equity		538		538		—		551		551		—
Total with no related allowance recorded		2,153		2,153		—		7,494		7,494		—
With an allowance recorded:
Commercial		6,921		6,921		6,467		7,646		7,646		6,944
Real estate:
Commercial		8,442		8,442		897		—		—		—
Total with an allowance recorded		15,363		15,363		7,364		7,646		7,646		6,944
Total	$	17,516	$	17,516	$	7,364	$	15,140	$	15,140	$	6,944

The following tables present interest recognized and cash‑basis interest earned on impaired loans for the periods indicated:

	Three Months Ended March 31, 2019
			Real Estate
					Land and		Home
	Commercial		CRE		Construction		Equity		Consumer		Total
	(Dollars in thousands)
Average of impaired loans during the period	$	9,016	$	6,768	$	—	$	544	$	—	$	16,328
Interest income during impairment	$	—	$	—	$	—	$	—	$	—	$	—
Cash-basis interest recognized	$	—	$	—	$	—	$	—	$	—	$	—

	Three Months Ended March 31, 2018
			Real Estate
					Land and		Home
	Commercial		CRE		Construction		Equity		Consumer		Total
	(Dollars in thousands)
Average of impaired loans during the period	$	2,474	$	501	$	59	$	371	$	1	$	3,406
Interest income during impairment	$	—	$	—	$	—	$	—	$	—	$	—
Cash-basis interest recognized	$	—	$	—	$	—	$	—	$	—	$	—

18

Nonperforming loans include both smaller dollar balance homogenous loans that are collectively evaluated for impairment and individually classified loans. Nonperforming loans were as follows at period‑end:

	March 31,				December 31,
	2019		2018		2018
	(Dollars in thousands)
Nonaccrual loans - held-for-investment	$	15,958	$	3,637	$	13,699
Restructured and loans over 90 days past due and still accruing		1,357		158		1,188
Total nonperforming loans		17,315		3,795		14,887
Other restructured loans		201		241		253
Total impaired loans	$	17,516	$	4,036	$	15,140

The following table presents the nonperforming loans by class for the periods indicated:

	March 31, 2019						December 31, 2018
				Restructured						Restructured
				and Loans						and Loans
				over 90 Days						over 90 Days
				Past Due						Past Due
				and Still						and Still
	Nonaccrual			Accruing	Total		Nonaccrual			Accruing	Total
	(Dollars in thousands)
Commercial	$	7,203	$	1,132	$	8,335	$	8,279	$	963	$	9,242
Real estate:
CRE		8,442		—		8,442		5,094		—		5,094
Home equity		313		225		538		326		225		551
Total	$	15,958	$	1,357	$	17,315	$	13,699	$	1,188	$	14,887

The following tables present the aging of past due loans by class for the periods indicated:

	March 31, 2019
	30 - 59		60 - 89		90 Days or
	Days		Days		Greater		Total		Loans Not
	Past Due		Past Due		Past Due		Past Due		Past Due		Total
	(Dollars in thousands)
Commercial	$	4,207	$	6,948	$	2,014	$	13,169	$	546,549	$	559,718
Real estate:
CRE		—		6,192		2,251		8,443		1,004,198		1,012,641
Land and construction		—		—		—		—		98,222		98,222
Home equity		168		—		—		168		118,280		118,448
Residential mortgages		—		—		—		—		49,786		49,786
Consumer		—		—		—		—		9,690		9,690
Total	$	4,375	$	13,140	$	4,265	$	21,780	$	1,826,725	$	1,848,505

	December 31, 2018
	30 - 59		60 - 89		90 Days or
	Days		Days		Greater		Total		Loans Not
	Past Due		Past Due		Past Due		Past Due		Past Due		Total
	(Dollars in thousands)
Commercial	$	5,698	$	1,916	$	1,258	$	8,872	$	588,891	$	597,763
Real estate:
CRE		—		—		—		—		994,067		994,067
Land and construction		—		—		—		—		122,358		122,358
Home equity				—		—		—		109,112		109,112
Residential mortgages		—		—		—		—		50,979		50,979
Consumer		1		—		—		1		12,452		12,453
Total	$	5,699	$	1,916	$	1,258	$	8,873	$	1,877,859	$	1,886,732

19

Past due loans 30 days or greater totaled $21,780,000 and $8,873,000 at March 31, 2019 and December 31, 2018, respectively, of which $15,089,000 and $430,000 were on nonaccrual, respectively. At March 31, 2019, there were also $869,000 of loans less than 30 days past due included in nonaccrual loans held-for-investment. At December 31, 2018, there were also $13,269,000 loans less than 30 days past due included in nonaccrual loans held-for-investment. Management’s classification of a loan as “nonaccrual” is an indication that there is reasonable doubt as to the full recovery of principal or interest on the loan. At that point, the Company stops accruing interest income, and reverses any uncollected interest that had been accrued as income. The Company begins recognizing interest income only as cash interest payments are received and it has been determined the collection of all outstanding principal is not in doubt. The loans may or may not be collateralized, and collection efforts are pursued.

Credit Quality Indicators

Concentrations of credit risk arise when a number of customers are engaged in similar business activities, or activities in the same geographic region, or have similar features that would cause their ability to meet contractual obligations to be similarly affected by changes in economic conditions. The Company’s loan portfolio is concentrated in commercial (primarily manufacturing, wholesale, and service) and real estate lending, with the remaining balance in consumer loans. While no specific industry concentration is considered significant, the Company’s lending operations are located in the Company’s market areas that are dependent on the technology and real estate industries and their supporting companies. Thus, the Company’s borrowers could be adversely impacted by a downturn in these sectors of the economy which could reduce the demand for loans and adversely impact the borrowers’ ability to repay their loans.

The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. The Company analyzes loans individually by classifying the loans as to credit risk. This analysis is performed on a quarterly basis. Nonclassified loans generally include those loans that are expected to be repaid in accordance with contractual loans terms. Classified loans are those loans that are assigned a substandard, substandard-nonaccrual, or doubtful risk rating using the following definitions:

Substandard.  Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well‑defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.

Substandard‑Nonaccrual.  Loans classified as substandard‑nonaccrual are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any, and it is probable that the Company will not receive payment of the full contractual principal and interest. Loans so classified have a well‑defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected. In addition, the Company no longer accrues interest on the loan because of the underlying weaknesses.

Doubtful.  Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.

Loss.  Loans classified as loss are considered uncollectable or of so little value that their continuance as assets is not warranted. This classification does not necessarily mean that a loan has no recovery or salvage value; but rather, there is much doubt about whether, how much, or when the recovery would occur. Loans classified as loss are immediately charged off against the allowance for loan losses. Therefore, there is no balance to report as of March 31, 2019 and December 31, 2018.

20

The following table provides a summary of the loan portfolio by loan type and credit quality classification at period end:

	March 31, 2019						December 31, 2018
	Nonclassified		Classified		Total		Nonclassified		Classified		Total
	(Dollars in thousands)
Commercial	$	545,151		14,567	$	559,718	$	584,845	$	12,918	$	597,763
Real estate:
CRE		1,003,770		8,871		1,012,641		985,193		8,874		994,067
Land and construction		98,222		—		98,222		122,358		—		122,358
Home equity		116,710		1,738		118,448		107,495		1,617		109,112
Residential mortgages		49,786		—		49,786		50,979		—		50,979
Consumer		9,690		—		9,690		12,453		—		12,453
Total	$	1,823,329	$	25,176	$	1,848,505	$	1,863,323	$	23,409	$	1,886,732

Classified loans were $25.2 million, or 0.81% of total assets, at March 31, 2019, compared to $30.8 million, or 1.07% of total assets, at March 31, 2018 and $23.4 million, or 0.76% of total assets, at December 31, 2018. In order to determine whether a borrower is experiencing financial difficulty, an evaluation is performed of the probability that the borrower will be in payment default on any of its debt in the foreseeable future without the modification. This evaluation is performed in accordance with the Company’s underwriting policy.

The book balance of troubled debt restructurings at March 31, 2019 was $580,000, accruing loans. The book balance of troubled debt restructurings at December 31, 2018 was $649,000, which included $36,000 of nonaccrual loans and $613,000 of accruing loans. Approximately $1,000 and $38,000 of specific reserves were established with respect to these loans as of March 31, 2019 and December 31, 2018, respectively.

There were no new loans modified as troubled debt restructurings during the three months ended March 31, 2019 and 2018.

During the three months ended March 31, 2019, there were no new loans modified as troubled debt restructurings in which the amount of principal or accrued interest owed from the borrower was forgiven or which resulted in a charge-off or change to the allowance for loan losses.

A loan is considered to be in payment default when it is 30 days contractually past due under the modified terms. There were no defaults on troubled debt restructurings, within twelve months following the modification, during the three and ended March 31, 2019 and 2018.

A loan that is a troubled debt restructuring on nonaccrual status may return to accruing status after a period of at least six months of consecutive payments in accordance with the modified terms.

6) Business Combinations

On April 6, 2018, the Company completed its acquisition of Tri-Valley for a transaction value of $32,320,000. At closing the Company issued 1,889,613 shares of the Company’s common stock with an aggregate market value of $30,725,000 on the date of closing.  The number of shares issued was based on a fixed exchange ratio of 0.0489 of a share of the Company’s common stock for each outstanding share of Tri-Valley common stock. In addition, at closing the

21

Company paid cash to the holder of a stock warrant and holders of outstanding stock options and related fees and fractional shares totaling $1,595,000.  The following table summarizes the consideration paid for Tri-Valley:

	(Dollars in thousands)
Cash paid for:
Warrant	$	889
Options		615
Other		91
Total cash paid		1,595
Issuance of 1,889,613 shares of common stock to Tri-
Valley shareholders at $16.26 per share at Closing		30,725
Total consideration	$	32,320

The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the date of acquisition.

		As					As
		Recorded		Fair			Recorded
		by		Value			at
		Tri-Valley		Adjustments			Acquisition
		(Dollars in thousands)
Assets acquired:
Cash and cash equivalents	$	21,757	$	1,153	(a)	$	22,910
Loans		123,532		(2,563)	(b)		120,969
Allowance for loan losses		(1,969)		1,969	(c)		—
Other intangible assets		—		1,978	(d)		1,978
Other assets, net		9,939		(2,894)	(e)		7,045
Total assets acquired	$	153,259	$	(357)			152,902
Liabilities assumed:
Deposits	$	135,351	$	37	(f)		135,388
Other liabilities		608		—			608
Total liabilities assumed	$	135,959	$	37			135,996
Net assets acquired							16,906
Purchase price							30,725
Goodwill recorded in the merger						$	13,819

Explanation of certain fair value related adjustments for the Tri-Valley acquisition:

(a)  Represents the cash acquired in the merger, the disposition of other real estate owned of $1,132,000, a gain on the sale of securities of $53,000, partially offset by invoices paid after closing for services prior to closing of $29,000, and cash paid for fractional shares in the transaction of $3,000. The remaining $1,592,000 of cash paid for the transaction is an adjustment to prepaid assets included in other assets, net.

(b)Represents the fair value adjustment to the net book value of loans, which includes an interest rate mark and credit mark adjustment.

(c)Represents the elimination of Tri-Valley’s allowance for loan losses.

(d)Represents intangible assets recorded to reflect the fair value of core deposits and a below market lease. The core deposit intangible asset was recorded as an identifiable intangible asset and is amortized on an accelerated basis over the estimated average life of the deposit base.  The below market lease intangible assets are amortized on the straight line method over eleven years.

(e)Represents an adjustment to net deferred tax assets resulting from the fair value adjustments related to the acquired assets, liabilities assumed and identifiable intangible assets recorded,and the disposition of other real estate owned.

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(f)  Represents the fair value adjustment on time deposits, which was be accreted as a reduction of 

     interest expense.

Tri-Valley’s results of operations have been included in the Company’s results of operations beginning April 7, 2018.

On May 4, 2018, the Company completed its acquisition of United American for a transaction value of $56,417,000.  At closing the Company issued 2,826,032 shares of the Company’s common stock with an aggregate market value of $47,280,000 on the date of closing.  The number of shares issued was based on a fixed exchange ratio of 2.1644 of a share of the Company’s common stock for each outstanding share of United American common stock and each common stock equivalent underlying the United American Series D Preferred Stock and Series E Preferred Stock. The shareholders of the United American Series A Preferred Stock and Series B Preferred Stock received $1,000 cash for each share totaling $8,700,000 and $435,000, respectively.  In addition, the Company paid $2,000 in cash for fractional shares, for total cash consideration of $9,137,000.  The following table summarizes the consideration paid for United American:

	(Dollars in thousands)
Consideration paid:
Cash paid for:
Series A Preferred Stock	$	8,700
Series B Preferred Stock		435
Other		2
Total cash paid		9,137
Issuance of 2,826,032 shares of common stock to United
American shareholders at $16.73 per share at Closing		47,280
Total consideration	$	56,417

The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the date of acquisition.

		As					As
		Recorded		Fair			Recorded
		by		Value			at
		United American		Adjustments			Acquisition
		(Dollars in thousands)
Assets acquired:
Cash and cash equivalents	$	45,638	$	(32,520)	(a)	$	13,118
Securities available-for-sale		64,144		(421)	(b)		63,723
Loans		196,694		18,783	(c)		215,477
Allowance for loan losses		(2,952)		2,952	(d)		—
Other intangible assets		—		6,383	(e)		6,383
Other assets, net		9,119		(1,078)	(f)		8,041
Total assets acquired	$	312,643	$	(5,901)			306,742
Liabilities assumed:
Deposits	$	281,189	$	51	(g)		281,240
Other borrowings		62		—			62
Other liabilities		2,617		(187)	(h)		2,430
Total liabilities	$	283,868	$	(136)			283,732
Net assets acquired							23,010
Purchase price							47,280
Goodwill recorded in the merger						$	24,270

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Explanation of certain fair value related adjustments for the United American acquisition:

(a) Represents the cash acquired in the merger, net of cash paid for the transaction of $9,137,000, the repurchase of $23,732,000 loan participations from ATBancorp, and $51,000 for invoices paid after closing for services prior to closing, partially offset by a tax refund of $400,000.

(b) Represents the fair value adjustment on investment securities available-for-sale.

(c) Represents the repurchase of $23,732,000 loan participations from ATBancorp, partially offset by the fair value adjustment to the net book value of loans of $4,680,000, which includes an interest rate mark and credit mark adjustment, and net charge-offs of $269,000 subsequent to closing.

(d) Represents the elimination of United American’s allowance for loan losses.

(e) Represents intangible assets recorded to reflect the fair value of core deposits and a below market lease. The core deposit intangible asset was recorded as an identifiable intangible asset and is amortized on an accelerated basis over the estimated average life of the deposit base.  The below market lease intangible assets are amortized on the straight line method over three years.

(f) Represents an adjustment to net deferred tax assets resulting from the fair value adjustments related to the acquired assets, liabilities assumed and identifiable intangible assets recorded.

(g) Represents the fair value adjustment on time deposits, which was be accreted as a reduction of interest expense.

(h) Represents the reversal of accrued accounts payable.

United American’s results of operations have been included in the Company’s results of operations beginning May 5, 2018.

The Company believed the mergers provide the opportunity to combine three independent business banking franchises with similar philosophies and cultures into a combined $3.1 billion business bank based in San Jose, California. The pooling of the three banks’ resources and knowledge enhanced the Company’s capabilities, operational efficiencies, and community outreach. The Company also believed the combined bank will be much better positioned to meet the needs of the Company’s customers, shareholders and the community.  Pre-tax acquisition and integration costs of $615,000 for the first quarter of 2018 was included in other noninterest expense.

The fair value of net assets acquired includes fair value adjustments to certain receivables of which some were considered impaired and some were not considered impaired as of the acquisition date. The fair value adjustments were determined using discounted contractual cash flows, adjusted for expected losses and prepayments, where appropriate. The receivables that were not considered impaired at the acquisition date were not subject to the guidance relating to purchased credit impaired loans, which have shown evidence of credit deterioration since origination. There were no PCI loans at March 31, 2019 and December 31, 2018.

Goodwill of $13,819,000 arising from the Tri-Valley acquisition and $24,270,000 from the United American acquisition is largely attributable to synergies and cost savings resulting from combining the operations of the companies. As these transactions were structured as a tax-free exchange, the goodwill will not be deductible for tax purposes. As of April 6, 2019 and May 4, 2019 the Company finalized its valuation of all assets acquired and liabilities assumed in its acquisition of Tri-Valley and United American, respectively, resulting in no material changes to acquisition accounting adjustments.

7) Goodwill and Other Intangible Assets

Goodwill

At March 31, 2019, the carrying value of goodwill was $83,753,000, which included $13,044,000 of goodwill related to its acquisition of Bay View Funding, $32,620,000 from its acquisition of Focus, $13,819,000 from its acquisition of Tri-Valley and $24,270,000 from its acquisition of United American.

Goodwill impairment exists when a reporting unit’s carrying value exceeds its fair value, which is determined through a qualitative assessment whether it is more likely than not that the fair value of equity of the reporting unit exceeds the carrying value (“Step Zero”). If the qualitative assessment indicates it is more likely than not that the fair value of equity of a reporting unit is less than book value, then a quantitative two-step impairment test is required. Step 1 includes the determination of the carrying value of the Company’s single reporting unit, including the existing goodwill

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and intangible assets, and estimating the fair value of the reporting unit. If the carrying amount of a reporting unit exceeds its fair value, the Company is required to perform a second step to the impairment test. Step 2 requires that the implied fair value of the reporting unit goodwill be compared to the carrying amount of that goodwill. If the carrying amount of the reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss shall be recognized in an amount equal to that excess.

The Company completed its annual goodwill impairment analysis as of November 30, 2018 with the assistance of an independent valuation firm.  No events or circumstances since the November 30, 2018 annual impairment test were noted that would indicate it was more likely than not a goodwill impairment exists.

Other Intangible Assets

Other intangible assets acquired in the acquisition of United American in May 2018 included a core deposit intangible asset of $5,723,000, amortized on an accelerated method over its estimated useful life of 10 years, and a below market value lease intangible asset of $660,000,  amortized over its estimated useful life of 3 years. Accumulated amortization of the core deposit intangible and below market lease was $1,014,000 and $756,000 at March 31, 2019 and December 31, 2018, respectively.

Other intangible assets acquired in the acquisition of Tri-Valley in April 2018 include a core deposit intangible asset of $1,768,000, amortized on an accelerated method over its estimated useful life of 10 years, and a below market value lease intangible asset of $210,000,  amortized over its estimated useful life of 11 years. Accumulated amortization of the core deposit intangible and below market lease was $287,000 and $222,000 at March 31, 2019 and December 31, 2018, respectively.

The core deposit intangible asset acquired in the acquisition of Focus in August 2015 was $6,285,000. This asset is amortized on an accelerated method over its estimated useful life of 10 years. Accumulated amortization of this intangible asset was $2,953,000 and $2,770,000 at March 31, 2019 and December 31, 2018, respectively.

Other intangible assets acquired in the acquisition of Bay View Funding in November 2014 included a below market value lease intangible assets of $109,000, a non-compete agreement intangible asset of $250,000, and a customer relationship and brokered relationship intangible assets of $1,900,000, amortized over the 10 year estimated useful lives. Accumulated amortization of the customer relationship and brokered relationship intangible assets was $838,000 and $791,000 at March 31, 2019 and December 31, 2018, respectively. The below market lease and non-compete agreement intangible assets were fully amortized at December 31, 2017.

Estimated amortization expense for 2019, the next five years and thereafter is as follows:

	United		United								Bay View Funding
	American		American		Tri-Valley		Tri-Valley		Focus		Customer&
	Core		Below		Core		Below		Core		Brokered		Total
	Deposit		Market		Deposit		Market		Deposit		Relationship		Amortization
Year	Intangible		Lease		Intangible		Lease		Intangible		Intangible		Expense
		(Dollars in thousands)
2019	$	777	$	255	$	240	$	18	$	734	$	190	$	2,214
2020		665		235		208		18		716		190		2,032
2021		602		—		184		18		596		190		1,590
2022		553		—		167		18		502		190		1,430
2023		521		—		158		18		420		190		1,307
2024		499		—		152		18		346		159		1,174
Thereafter		1,520		—		451		88		201		—		2,260
	$	5,137	$	490	$	1,560	$	196	$	3,515	$	1,109	$	12,007

Impairment testing of the intangible assets is performed at the individual asset level. Impairment exists if the carrying amount of the asset is not recoverable and exceeds its fair value at the date of the impairment test. For intangible assets, estimates of expected future cash flows (cash inflows less cash outflows) that are directly associated with an intangible asset are used to determine the fair value of that asset. Management makes certain estimates and assumptions in determining the expected future cash flows from core deposit and customer relationship intangibles including account

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attrition, expected lives, discount rates, interest rates, servicing costs and other factors. Significant changes in these estimates and assumptions could adversely impact the valuation of these intangible assets. If an impairment loss exists, the carrying amount of the intangible asset is adjusted to a new cost basis. The new cost basis is then amortized over the remaining useful life of the asset. Based on its assessment, management concluded that there was no impairment of intangible assets at March 31, 2019 and December 31, 2018.

8) Income Taxes

Some items of income and expense are recognized in different years for tax purposes than when applying generally accepted accounting principles, leading to timing differences between the Company’s actual current tax liability and the amount accrued for this liability based on book income. These temporary differences comprise the “deferred” portion of the Company’s tax expense or benefit, which is accumulated on the Company’s books as a deferred tax asset or deferred tax liability until such time as they reverse.

Under generally accepted accounting principles, a valuation allowance is required if it is “more likely than not” that a deferred tax asset will not be realized. The determination of the realizability of the deferred tax assets is highly subjective and dependent upon judgment concerning management’s evaluation of both positive and negative evidence, including forecasts of future income, cumulative losses, applicable tax planning strategies, and assessments of current and future economic and business conditions.

The Company had net deferred tax assets of $24,263,000, and $27,089,000, at March 31, 2019 and December 31, 2018, respectively. After consideration of the matters in the preceding paragraph, the Company determined that it is more likely than not that the net deferred tax assets at March 31, 2019 and December 31, 2018 will be fully realized in future years.

The following table reflects the carry amounts of the low income housing investments included in accrued interest receivable and other assets, and the future commitments included in accrued interest payable and other liabilities for the periods indicated:

	March 31,		December 31,
	2019		2018
	(Dollars in thousands)
Low income housing investments	$	3,253	$	3,172
Future commitments	$	273	$	273

The Company expects $14,000 of the future commitments to be paid in 2019, $14,000 in 2020, and $245,000 in 2021 through 2023.

For tax purposes, the Company had low income housing tax credits of $106,000 for the three months ended March 31, 2019 and March 31, 2018, and low income housing investment expense of $109,000 and $119,000, respectively.  The Company recognized low income housing investment expense as a component of income tax expense.

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9) Benefit Plans

Supplemental Retirement Plan

The Company has a supplemental retirement plan (the “Plan”) covering some current and some former key employees and directors. 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 periods indicated:

	Three Months Ended
	March 31,
	2019		2018
Components of net periodic benefit cost:
Service cost	$	55	$	62
Interest cost		264		237
Amortization of net actuarial loss		46		73
Net periodic benefit cost	$	365	$	372

Split‑Dollar Life Insurance Benefit Plan

The Company maintains life insurance policies for some current and some former directors and officers that are subject to split‑dollar life insurance agreements. The following table sets forth the funded status of the split‑dollar life insurance benefits for the periods indicated:

	March 31,		December 31,
	2019		2018
	(Dollars in thousands)
Change in projected benefit obligation:
Projected benefit obligation at beginning of year	$	6,903	$	6,711
Interest cost		70		227
Actuarial loss (gain)		—		(35)
Projected benefit obligation at end of period	$	6,973	$	6,903

	March 31,		December 31,
	2019		2018
	(Dollars in thousands)
Net actuarial loss	$	2,620	$	2,573
Prior transition obligation		1,126		1,149
Accumulated other comprehensive loss	$	3,746	$	3,722

	Three Months Ended
	March 31,
	2019		2018
Amortization of prior transition obligation	$	(25)	$	(16)
Interest cost		70		57
Net periodic benefit cost	$	45	$	41

10) Fair Value

Accounting guidance establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:

Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

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Level 2: Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities in active markets; quoted prices for identical assets or liabilities in markets that are not active; or other inputs that are observable or can be corroborated by observable market data (for example, interest rates and yield curves observable at commonly quoted intervals, prepayment speeds, credit risks, and default rates).

Level 3: Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

Financial Assets and Liabilities Measured on a Recurring Basis

The fair values of securities available-for sale-are determined by obtaining quoted prices on nationally recognized securities exchanges (Level 1 inputs) or matrix pricing, which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities, but rather by relying on the securities’ relationship to other benchmark quoted securities (Level 2 inputs).

The fair value of interest‑only (“I/O”) strip receivable assets is based on a valuation model used by a third party. The Company is able to compare the valuation model inputs and results to widely available published industry data for reasonableness (Level 2 inputs).

			Fair Value Measurements Using
					Significant
			Quoted Prices in		Other		Significant
			Active Markets for		Observable		Unobservable
			Identical Assets		Inputs		Inputs
	Balance		(Level 1)		(Level 2)		(Level 3)
	(Dollars in thousands)
Assets at March 31, 2019
Available-for-sale securities:
Agency mortgage-backed securities	$	295,578		—	$	295,578		—
U.S. Treasury		149,482		149,482		—		—
U.S. Government sponsored entities		7,461		—		7,461		—
I/O strip receivables		571		—		571		—
Assets at December 31, 2018
Available-for-sale securities:
Agency mortgage-backed securities	$	302,854		—	$	302,854		—
U.S. Treasury		148,753		148,753		—		—
U.S. Government sponsored entities		7,436		—		7,436		—
I/O strip receivables		568		—		568		—

There were no transfers between Level 1 and Level 2 during the period for assets measured at fair value on a recurring basis.

Assets and Liabilities Measured on a Non‑Recurring Basis

The fair value of impaired loans with specific allocations of the allowance for loan losses is generally based on recent real estate appraisals. The appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.

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Foreclosed assets are valued at the time the loan is foreclosed upon and the asset is transferred to foreclosed assets. The fair value is based primarily on third party appraisals, less costs to sell. The appraisals may utilize a single valuation approach or a combination of approaches including the comparable sales and income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are typically significant and result in a Level 3 classification of the inputs for determining fair value.

			Fair Value Measurements Using
				Significant
			Quoted Prices in	Other	Significant
			Active Markets for	Observable	Unobservable
			Identical Assets	Inputs	Inputs
	Balance		(Level 1)	(Level 2)	(Level 3)
	(Dollars in thousands)
Assets at March 31, 2019
Impaired loans - held-for-investment:
Commercial	$	454	—	—	$	454
Real estate:
CRE		7,546	—	—		7,546
	$	8,000	—	—	$	8,000
Assets at December 31, 2018
Impaired loans - held-for-investment:
Commercial	$	702	—	—	$	702
	$	702	—	—	$	702

The following table shows the detail of the impaired loans held-for-investment and the impaired loans held‑for‑investment carried at fair value for the periods indicated:

	March 31, 2019		December 31, 2018
	(Dollars in thousands)
Impaired loans held-for-investment:
Book value of impaired loans held-for-investment carried at fair value	$	15,364	$	7,646
Book value of impaired loans held-for-investment carried at cost		2,152		7,494
Total impaired loans held-for-investment	$	17,516	$	15,140
Impaired loans held-for-investment carried at fair value:
Book value of impaired loans held-for-investment carried at fair value	$	15,364	$	7,646
Specific valuation allowance		(7,364)		(6,944)
Impaired loans held-for-investment carried at fair value, net	$	8,000	$	702

Impaired loans held‑for‑investment which are measured primarily for impairment using the fair value of the collateral were $17,516,000 at March 31, 2019.  In addition, these loans had a specific valuation allowance of $7,364,000 at March 31, 2019. Impaired loans held‑for‑investment totaling $15,364,000 at March 31, 2019, were carried at fair value as a result of partial charge‑offs and specific valuation allowances at period‑end. The remaining $2,152,000 of impaired loans were carried at cost at March 31, 2019, as the fair value of the collateral exceeded the cost basis of each respective loan. Partial charge‑offs and changes in specific valuation allowances during the first three months of 2019 on impaired loans held‑for‑investment carried at fair value at March 31, 2019 resulted in an additional provision for loan losses of $288,000.

At March 31, 2019, there were no foreclosed assets.

Impaired loans held‑for‑investment were $15,140,000 at December 31, 2018. In addition, these loans had a specific valuation allowance of $6,944,000 at December 31, 2018. Impaired loans held‑for‑investment totaling $7,646,000 at December 31, 2018 were carried at fair value as a result of partial charge‑offs and specific valuation allowances at year‑end. The remaining $7,494,000 of impaired loans were carried at cost at December 31, 2018, as the fair value of the collateral exceeded the cost basis of each respective loan. Partial charge‑offs and changes in specific valuation allowances during 2018 on impaired loans held‑for‑investment carried at fair value at December 31, 2018 resulted in an additional provision for loan losses of $7,042,000.

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At December 31, 2018, there were no foreclosed assets.

The following table presents quantitative information about Level 3 fair value measurements for financial instruments measured at fair value on a non‑recurring basis at the periods indicated:

	March 31, 2019
			Valuation	Unobservable	Range
	Fair Value		Techniques	Inputs	(Weighted Average)
	(Dollars in thousands)
Impaired loans - held-for-investment:
Commercial	$	454	Market Approach	Discount adjustment for differences between comparable sales	0% to 1% (1%)
Real estate:
CRE		7,546	Market Approach	Discount adjustment for differences between comparable sales	0% to 13% (5%)

	December 31, 2018
			Valuation	Unobservable	Range
	Fair Value		Techniques	Inputs	(Weighted Average)
	(Dollars in thousands)
Impaired loans - held-for-investment:
Commercial	$	702	Market Approach	Discount adjustment for differences between comparable sales	0% to 1%

The Company obtains third party appraisals on its impaired loans held-for-investment and foreclosed assets to determine fair value. Generally, the third party appraisals apply the “market approach,” which is a valuation technique that uses prices and other relevant information generated by market transactions involving identical or comparable (that is, similar) assets, liabilities, or a group of assets and liabilities, such as a business. Adjustments are then made based on the type of property, age of appraisal, current status of property and other related factors to estimate the current value of collateral.

The carrying amounts and estimated fair values of financial instruments at March 31, 2019 are as follows:

			Estimated Fair Value
					Significant
			Quoted Prices in		Other		Significant
			Active Markets for		Observable		Unobservable
	Carrying		Identical Assets		Inputs		Inputs
	Amounts		(Level 1)		(Level 2)		(Level 3)		Total
	(Dollars in thousands)
Assets:
Cash and cash equivalents	$	234,977	$	234,977	$	—	$	—	$	234,977
Securities available-for-sale		452,521		149,482		303,039		—		452,521
Securities held-to-maturity		367,023		—		362,581		—		362,581
Loans (including loans held-for-sale), net		1,824,216		—		3,216		1,799,945		1,803,161
FHLB stock, FRB stock, and other
investments		25,221		—		—		—		N/A
Accrued interest receivable		9,014		876		2,229		6,785		9,890
I/O strips receivables		571		—		571		—		571
Liabilities:
Time deposits	$	148,969	$	—	$	149,347	$	—	$	149,347
Other deposits		2,491,275		—		2,491,275		—		2,491,275
Subordinated debt		39,414		—		39,064		—		39,064
Accrued interest payable		1,135		—		1,135		—		1,135

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The carrying amounts and estimated fair values of the Company’s financial instruments at December 31, 2018:

			Estimated Fair Value
					Significant
			Quoted Prices in		Other		Significant
			Active Markets for		Observable		Unobservable
	Carrying		Identical Assets		Inputs		Inputs
	Amounts		(Level 1)		(Level 2)		(Level 3)		Total
	(Dollars in thousands)
Assets:
Cash and cash equivalents	$	164,568	$	164,568	$	—	$	—	$	164,568
Securities available-for-sale		459,043		148,753		310,290		—		459,043
Securities held-to-maturity		377,198		—		366,175		—		366,175
Loans (including loans held-for-sale), net		1,861,206		—		2,649		1,826,654		1,829,303
FHLB stock, FRB stock, and other
investments		25,216		—		—		—		N/A
Accrued interest receivable		9,577		597		2,274		6,706		9,577
I/O strips receivables		568		—		568		—		568
Liabilities:
Time deposits	$	147,560	$	—	$	147,916	$	—	$	147,916
Other deposits		2,489,972		—		2,489,972		—		2,489,972
Subordinated debt		39,369		—		38,969		—		38,969
Accrued interest payable		497		—		497		—		497

In accordance with our adoption of ASU 2016-01 in 2018, the methods utilized to measure the fair value of financial instruments at March 31, 2019 and December 31, 2018 represent an approximation of exit price, however, an actual exit price may differ.

11) Equity Plan

The Company maintained an Amended and Restated 2004 Equity Plan (the “2004 Plan”) for directors, officers, and key employees. The 2004 Plan was terminated on May 23, 2013. On May 23, 2013, the Company’s shareholders approved the 2013 Equity Incentive Plan (the “2013 Plan”). On May 25, 2017, the shareholders approved an amendment to the Heritage Commerce Corp 2013 Equity Incentive Plan to increase the number of shares available from 1,750,000 to 3,000,000 shares. The equity plans provide for the grant of incentive and nonqualified stock options and restricted stock. The equity plans provide that the option price for both incentive and nonqualified stock options will be determined by the Board of Directors at no less than the fair value at the date of grant. Options granted vest on a schedule determined by the Board of Directors at the time of grant. Generally options vest over four years. All options expire no later than ten years from the date of grant. Restricted stock is subject to time vesting. There were 1,172,592 shares available for the issuance of equity awards under the 2013 Plan as of March 31, 2019.

Stock option activity under the equity plans is as follows:

				Weighted
		Weighted		Average
		Average		Remaining	Aggregate
	Number	Exercise		Contractual	Intrinsic
Total Stock Options	of Shares	Price		Life (Years)	Value
Outstanding at January 1, 2019	1,570,603	$	10.76
Exercised	(35,003)	$	7.66
Forfeited or expired	(9,086)	$	15.02
Outstanding at March 31, 2019	1,526,514	$	10.81	6.29	$	3,932,974
Vested or expected to vest	1,434,923			6.29	$	3,696,996
Exercisable at March 31, 2019	1,083,415			5.37	$	3,806,137

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Information related to the equity plans for the periods indicated:

	Three Months Ended
	March 31,
	2019			2018
Intrinsic value of options exercised	$	197,994	$	560,332
Cash received from option exercise	$	268,691	$	449,294
Tax benefit realized from option exercises	$	26,578	$	164,978
Weighted average fair value of options granted	$	3.24	$	3.00

As of March 31, 2019, there was $1,199,000 of total unrecognized compensation cost related to nonvested stock options granted under the equity plans. That cost is expected to be recognized over a weighted‑average period of approximately 2.53 years.

The fair value of each option grant is estimated on the date of grant using the Black Scholes option pricing model that uses the assumptions noted in the following table, including the weighted average assumptions for the option grants for the periods indicated:

	Three Months Ended
	March 31,
	2019	2018
Expected life in months(1)	N/A	72
Volatility(1)	N/A	22	%
Weighted average risk-free interest rate(2)	N/A	2.58	%
Expected dividends(3)	N/A	2.51	%

(1) The expected life of employee stock options represents the weighted average period the stock options are expected to remain outstanding based on historical experience. Volatility is based on the historical volatility of the stock price over the same period of the expected life of the option.

(2) Based on the U.S. Treasury constant maturity interest rate with a term consistent with the expected life of the option granted.

(3) Each grant’s dividend yield is calculated by annualizing the most recent quarterly cash dividend and dividing that amount by the market price of the Company’s common stock as of the grant date

Restricted stock activity under the equity plans is as follows:

		Weighted
		AverageGrant
	Number	DateFair
Total Restricted Stock Award	of Shares	Value
Nonvested shares at January 1, 2019	193,298	$	11.04
Vested	(1,250)	$	14.01
Nonvested shares at March 31, 2019	192,048	$	11.04

As of March 31, 2019, there was $1,817,000 of total unrecognized compensation cost related to nonvested restricted stock awards granted under the equity plans. The cost is expected to be recognized over a weighted‑average period of approximately 2.46 years.

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12) Subordinated Debt

On May 26, 2017, the Company completed an underwritten public offering of $40,000,000 aggregate principal amount of its fixed-to-floating rate subordinated notes (“Subordinated Debt”) due June 1, 2027. The Subordinated Debt initially bears a fixed interest rate of 5.25% per year. Commencing on June 1, 2022, the interest rate on the Subordinated Debt resets quarterly to the three-month LIBOR rate plus a spread of 336.5 basis points, payable quarterly in arrears.  Interest on the Subordinated Debt is payable semi-annually on June 1st and December 1st of each year through June 1, 2022 and quarterly thereafter on March 1st, June 1st, September 1st and December 1st of each year through the maturity date or early redemption date.  The Company at its option may redeem the Subordinated Debt, in whole or in part, on any interest payment date on or after June 1, 2022 without a premium.

13) Capital Requirements

The Company and its subsidiary bank are subject to various regulatory capital requirements administered by the banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory—and possibly additional discretionary—actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements and operations. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and HBC must meet specific capital guidelines that involve quantitative measures of assets, liabilities, and certain off balance sheet items as calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. There are no conditions or events since March 31, 2019, that management believes have changed the categorization of the Company or HBC as “well-capitalized.” 

As of January 1, 2015, HCC and HBC along with other community banking organizations became subject to new capital requirements and certain provisions of the new rules will be phased in from 2015 through 2019. The Federal Banking regulators approved the new rules to implement the revised capital adequacy standards of the Basel Committee on Banking Supervision, commonly called Basel III, and address relevant provisions of The Dodd Frank Wall Street Reform and Consumer Protection Act of 2010, as amended. The new capital rules establish a “capital conservation buffer,” which must consist entirely of common equity Tier 1 capital. The capital conservation buffer is to be phased-in over four years beginning on January 1, 2016. The buffer was 0.625% of risk-weighted assets for 2016, 1.25% for 2017, 1.875% for 2018, and is 2.5% for 2019 and thereafter. The Company and HBC must maintain a capital conservation buffer above the minimum risk-based capital requirements in order to avoid certain limitations on capital distributions, stock repurchases and discretionary bonus payments to executive officers. The Company’s consolidated capital ratios and the Bank’s capital ratios exceeded the regulatory guidelines for a well-capitalized financial institution under the Basel III regulatory requirements at March 31, 2019.

Quantitative measures established by regulation to help ensure capital adequacy require the Company and HBC to maintain minimum amounts and ratios (set forth in the tables below) of total, Tier 1 capital, and common equity Tier 1 capital (as defined in the regulations) to risk weighted assets (as defined), and of Tier 1 capital to average assets (as defined). Management believes that, as of March 31, 2019 and December 31, 2018, the Company and HBC met all capital adequacy guidelines to which they were subject.

The Company’s consolidated capital amounts and ratios are presented in the following table, together with capital adequacy requirements, under the Basel III regulatory requirements as of March 31, 2019 and December 31, 2018.

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					Required For
					Capital
					Adequacy
					Purposes
	Actual				Under Basel III
	Amount		Ratio		Amount		Ratio (1)
	(Dollars in thousands)
As of March 31, 2019
Total Capital	$	352,830	15.6	%	$	237,991	10.5	%
(to risk-weighted assets)
Tier 1 Capital	$	285,417	12.6	%	$	192,660	8.5	%
(to risk-weighted assets)
Common Equity Tier 1 Capital	$	285,417	12.6	%	$	158,661	7.0	%
(to risk-weighted assets)
Tier 1 Capital	$	285,417	9.5	%	$	120,576	4.0	%
(to average assets)

(1) Includes 2.5% capital conservation buffer, effective January 1, 2019, except the Tier 1 Capital to average assets ratio.

					Required For
					Capital
					Adequacy
					Purposes
	Actual				Under Basel III
	Amount		Ratio		Amount		Ratio (1)
		(Dollars in thousands)
As of December 31, 2018
Total Capital	$	344,597	15.0	%	$	227,514	9.875	%
(to risk-weighted assets)
Tier 1 Capital	$	276,675	12.0	%	$	181,435	7.875	%
(to risk-weighted assets)
Common Equity Tier 1 Capital	$	276,675	12.0	%	$	146,876	6.375	%
(to risk-weighted assets)
Tier 1 Capital	$	276,675	8.9	%	$	124,726	4.000	%
(to average assets)

(1) Includes 1.875% capital conservation buffer, effective January 1, 2018 except the Tier 1 Capital to average assets ratio.

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HBC’s actual capital amounts and ratios are presented in the following table, together with capital adequacy requirements, under the Basel III regulatory requirements as of March 31, 2019, and December 31, 2018.

									Required For
									Capital
					To Be Well-Capitalized				Adequacy
					Under Basel III PCA Regulatory				Purposes
	Actual				Requirements				Under Basel III
	Amount		Ratio		Amount		Ratio		Amount		Ratio (1)
	(Dollars in thousands)
As of March 31, 2019
Total Capital	$	330,915	14.6	%	$	226,530	10.0	%	$	237,856	10.5	%
(to risk-weighted assets)
Tier 1 Capital	$	302,917	13.4	%	$	181,224	8.0	%	$	192,550	8.5	%
(to risk-weighted assets)
Common Equity Tier 1 Capital	$	302,917	13.4	%	$	147,244	6.5	%	$	158,571	7.0	%
(to risk-weighted assets)
Tier 1 Capital	$	302,917	10.1	%	$	150,656	5.0	%	$	120,525	4.0	%
(to average assets)

(1) Includes 2.5% capital conservation buffer, effective January 1, 2018, except the Tier 1 Capital to average assets ratio.

									Required For
									Capital
					To Be Well-Capitalized				Adequacy
					Under Basel III PCA Regulatory				Purposes
	Actual				Requirements				Under Basel III
	Amount		Ratio		Amount		Ratio		Amount		Ratio (1)
		(Dollars in thousands)
As of December 31, 2018
Total Capital	$	322,283	14.0	%	$	230,275	10.0	%	$	227,397	9.875	%
(to risk-weighted assets)
Tier 1 Capital	$	293,730	12.8	%	$	184,220	8.0	%	$	181,342	7.875	%
(to risk-weighted assets)
Common Equity Tier 1 Capital	$	293,730	12.8	%	$	149,679	6.5	%	$	146,800	6.375	%
(to risk-weighted assets)
Tier 1 Capital	$	293,730	9.4	%	$	155,832	5.0	%	$	124,666	4.000	%
(to average assets)

(1) Includes 1.875% capital conservation buffer, effective January 1, 2018, except the Tier 1 Capital to average assets ratio.

The Subordinated Debt, net of unamortized issuance costs, totaled $39,414,000 at March 31, 2019, and qualifies as Tier 2 capital for the Company under the guidelines established by the Federal Reserve Bank. 

Under California General Corporation Law, the holders of common stock are entitled to receive dividends when and as declared by the Board of Directors, out of funds legally available. The California Financial Code provides that a state licensed bank may not make a cash distribution to its shareholders in excess of the lesser of the following: (i) the bank’s retained earnings; or (ii) the bank’s net income for its last three fiscal years, less the amount of any distributions made by the bank to its shareholders during such period. However, a bank, with the prior approval of the Commissioner of the California Department of Business Oversight—Division of Financial Institutions (“DBO”) may make a distribution to its shareholders of an amount not to exceed the greater of (i) a bank’s retained earnings; (ii) its net income for its last fiscal year; or (iii) its net income for the current fiscal year. Also with the prior approval of the Commissioner of the DBO and the shareholders of the bank, the bank may make a distribution to its shareholders, as a reduction in capital of the bank. In the event that the Commissioner determines that the shareholders’ equity of a bank is inadequate or that the making of a distribution by a bank would be unsafe or unsound, the Commissioner may order a bank to refrain from making such a proposed distribution. As of March 31, 2019, HBC would not be required to obtain regulatory approval, and the amount available for cash dividends is $38,136,000. Similar restrictions applied to the amount and sum of loan

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advances and other transfers of funds from HBC to the parent company. During the first quarter of 2019, HBC distributed to HCC dividends of $5,000,000.

14) Loss Contingencies

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.

15) Revenue Recognition

On January 1, 2018, the Company adopted ASU No. 2014-09 (Topic 606) and all subsequent ASUs that modified Topic 606. Topic 606 does not apply to revenue associated with financial instruments, including revenue from loans and securities. In addition, certain noninterest income streams such as fees associated with mortgage servicing rights, financial guarantees, gain on sale of securities, bank-owned life insurance, gain on sales of SBA loans, and certain credit card fees are also not in scope of the new guidance. Topic 606 is applicable to noninterest revenue streams such as deposit related fees, interchange fees, and merchant income. However, the recognition of these revenue streams did not change significantly upon adoption of Topic 606. Substantially all of the Company’s revenue is generated from contracts with customers. The following noninterest income revenue streams are in-scope of Topic 606:

Service charges and fees on deposit accounts consist of account analysis fees (i.e., net fees earned on analyzed business and public checking accounts), monthly service fees, check orders, and other deposit account related fees. We sometimes charge customers fees that are not specifically related to the customer accessing its funds, such as account maintenance or dormancy fees. The amount of deposit fees assessed varies based on a number of factors, such as the type of customer and account, the quantity of transactions, and the size of the deposit balance. We charge, and in some circumstances do not charge, fees to earn additional revenue and influence certain customer behavior. An example would be where we do not charge a monthly service fee, or do not charge for certain transactions, for customers that have a high deposit balance. Deposit fees are considered either transactional in nature (such as wire transfers, nonsufficient fund fees, and stop payment orders) or non-transactional (such as account maintenance and dormancy fees). These fees are recognized as earned or as transactions occur and services are provided. Check orders and other deposit account related fees are largely transactional based and, therefore, the Company’s performance obligation is satisfied, and related revenue recognized, at a point in time. Payment for service charges on deposit accounts is primarily received immediately or in the following month through a direct charge to customers’ accounts.

The following presents noninterest income, segregated by revenue streams in-scope and out-of-scope of Topic 606, for the periods indicated:

	Three Months Ended
	March 31,
	2019		2018
	(Dollars in thousands)
Noninterest Income In-scope of Topic 606:
Service charges and fees on deposit accounts	$	1,161	$	902
Noninterest Income Out-of-scope of Topic 606		1,307		1,293
Total noninterest income	$	2,468	$	2,195

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16) Noninterest Expense

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

	Three Months Ended
	March 31,
	2019		2018
Salaries and employee benefits	$	10,770	$	9,777
Occupancy and equipment		1,506		1,106
Professional fees		818		684
Data processing		679		353
Software subscriptions		589		593
Amortization of intangible assets		553		241
Insurance expense		436		407
Other acquisition and integration related costs		—		615
Other		2,567		2,214
Total	$	17,918	$	15,990

17) Leases

On January 1, 2019, the Company adopted ASU No. 2016-02, Leases (Topic 842).  Under the new guidance, the Company recognizes the following for all leases, at the commencement date: (1) a lease liability, which is a lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis; and (2) a right-of-use (“ROU”) asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. While the new standard impacts lessors and lessees, the Company is impacted as a lessee of the offices and real estate used for operations.  The Company's lease agreements include options to renew at the Company's discretion. The extensions are not reasonably certain to be exercised, therefore it was not considered in the calculation of the ROU asset and lease liability. Total assets and total liabilities increased $8.6 million on its consolidated statement of financial condition at March 31, 2019, as a result of recognizing right-of-use assets, included in other assets, and lease liabilities, included in other liabilities, related to non-cancelable operating lease agreements for office space. 

The following table presents the quantitative information for the Company’s leases:

		March 31,
		2019
	(Dollars in thousands)
Operating Lease Cost (Cost resulting from lease payments)	$	1,050
Operating Lease - Operating Cash Flows (Fixed Payments)	$	1,013
Operating Lease - ROU assets	$	8,630
Operating Lease - Liabilities	$	8,630
Weighted Average Lease Term - Operating Leases		3.50 years
Weighted Average Discount Rate - Operating Leases		5.25%

The following maturity analysis shows the undiscounted cash flows due on the Company’s operating lease liabilities:

	(Dollars in thousands)
2019	$	3,040
2020		2,666
2021		1,351
2022		1,144
2023		605
Thereafter		691
Total undiscounted cash flows		9,497
Discount on cash flows		(867)
Total lease liability	$	8,630

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18) Business Segment Information

The following presents the Company’s operating segments. The Company operates through two business segments: Banking segment and Factoring segment. Transactions between segments consist primarily of borrowed funds. Intersegment interest expense is allocated to the Factoring segment based on the Company’s prime rate and funding costs. The provision for loan loss is allocated based on the segment’s allowance for loan loss determination which considers the effects of charge-offs. Noninterest income and expense directly attributable to a segment are assigned to it. Taxes are paid on a consolidated basis and allocated for segment purposes. The Factoring segment includes only factoring originated by Bay View Funding.

	Three Months Ended March 31, 2019
	Banking(1)		Factoring		Consolidated
	(Dollars in thousands)
Interest income	$	30,496		2,953	$	33,449
Intersegment interest allocations		314		(314)		—
Total interest expense		2,407		—		2,407
Net interest income		28,403		2,639		31,042
Provision (credit) for loan losses		(892)		(169)		(1,061)
Net interest income after provision		29,295		2,808		32,103
Noninterest income		2,232		236		2,468
Noninterest expense		16,201		1,717		17,918
Intersegment expense allocations		121		(121)		—
Income before income taxes		15,447		1,206		16,653
Income tax (benefit) expense		4,151		356		4,507
Net income	$	11,296	$	850	$	12,146
Total assets	$	3,053,116	$	62,761	$	3,115,877
Loans, net of deferred fees	$	1,800,064	$	48,254	$	1,848,318
Goodwill	$	70,709	$	13,044	$	83,753

(1) Includes the holding company’s results of operations

	Three Months Ended March 31, 2018
	Banking(1)		Factoring		Consolidated
	(Dollars in thousands)
Interest income	$	24,731	$	3,146	$	27,877
Intersegment interest allocations		327		(327)		—
Total interest expense		1,529		—		1,529
Net interest income		23,529		2,819		26,348
Provision for loan losses		488		18		506
Net interest income after provision		23,041		2,801		25,842
Noninterest income		2,086		109		2,195
Noninterest expense		14,467		1,523		15,990
Intersegment expense allocations		175		(175)		—
Income before income taxes		10,835		1,212		12,047
Income tax expense		2,880		358		3,238
Net income	$	7,955	$	854	$	8,809
Total assets	$	2,722,472	$	63,076	$	2,785,548
Loans, net of deferred fees	$	1,541,466	$	49,735	$	1,591,201
Goodwill	$	32,620	$	13,044	$	45,664

(1) Includes the holding company’s results of operations

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19) Subsequent Events

On April 25, 2019, the Company announced that its Board of Directors declared a $0.12 per share quarterly cash dividend to holders of common stock. The dividend will be paid on May 23, 2019 to shareholders of record on May 9, 2019.

39

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

The following discussion provides information about the results of operations, financial condition, liquidity, and capital resources of Heritage Commerce Corp (the “Company” or “HCC”), its wholly‑owned subsidiary, Heritage Bank of Commerce (“HBC”), and HBC’s wholly‑owned subsidiary, CSNK Working Capital Finance Corp., a California Corporation, dba Bay View Funding (“Bay View Funding”). This information is intended to facilitate the understanding and assessment of significant changes and trends related to our financial condition and the results of operations. This discussion and analysis should be read in conjunction with our consolidated financial statements and the accompanying notes presented elsewhere in this report. Unless we state otherwise or the context indicates otherwise, references to the “Company,” “Heritage,” “we,” “us,” and “our,” in this Report on Form 10‑Q refer to Heritage Commerce Corp and its subsidiaries.

CRITICAL ACCOUNTING POLICIES

Critical accounting policies are discussed in our Form 10‑K for the year ended December 31, 2018. There are no changes to these policies as of March 31, 2019.  

EXECUTIVE SUMMARY

This summary is intended to identify the most important matters on which management focuses when it evaluates the financial condition and performance of the Company. When evaluating financial condition and performance, management looks at certain key metrics and measures. The Company’s evaluation includes comparisons with peer group financial institutions and 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 entirely in  the general San Francisco Bay Area of California in the counties of Santa Clara, Alameda, Contra Costa, San Mateo, and San Benito. 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.

Performance Overview

For the three months ended March 31, 2019, net income was $12.1 million, or $0.28 per average diluted common share, compared to $8.8 million, or $0.23 per average diluted common share, for the three months ended March 31, 2018. The Company’s annualized return on average tangible assets was 1.63% and annualized return on average tangible equity was 17.90% for the three months ended March 31, 2019, compared to 1.31% and 16.30%, respectively, for the three months ended March 31, 2018.

Tri-Valley Bank and United American Bank Mergers

The Company completed the merger of its wholly-owned bank subsidiary Heritage Bank of Commerce with Tri-Valley Bank (“Tri-Valley”) effective as of the close on April 6, 2018. Tri-Valley’s results of operations have been included in the Company’s results of operations beginning April 7, 2018.

Tri-Valley was a full-service California state-chartered commercial bank with branches in San Ramon and Livermore, California and served businesses and individuals primarily in Contra Costa and Alameda counties in Northern California.  The Company closed the San Ramon office on July 13, 2018.

The Company completed the merger of its wholly-owned bank subsidiary Heritage Bank of Commerce with United American Bank (“United American”) effective as of the close on May 4, 2018. United American’s results of operations have been included in the Company’s results of operations beginning May 5, 2018.

United American was a full-service commercial bank located in San Mateo County with full-service branches located in San Mateo, Redwood City and Half Moon Bay, California and serviced businesses, professionals and individuals.  The Company closed the Half Moon Bay office on August 10, 2018. 

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Tri-Valley added $103.5 million in loans and $74.5 million in deposits, at March 31, 2019.  United American added $174.3 million in loans and $219.1 million in deposits, at March 31, 2019. 

Factoring Activities - Bay View Funding

Based in Santa Clara, California, Bay View Funding provides business-essential working capital factoring financing to various industries throughout the United States. The following table reflects selected financial information for Bay View Funding for the periods indicated:

	March 31,		March 31,
	2019		2018
	(Dollars in thousands)
Total factored receivables	$	48,254	$	49,735
Average factored receivables
for the three months ended	$	48,502	$	49,071
Total full time equivalent employees		39		35

First Quarter 2019 Highlights

The following are important factors that impacted the Company’s results of operations:

· Net interest income, before provision for loan losses, increased 18% to $31.0 million for the first quarter of 2019, compared to $26.3 million for the first quarter of 2018, primarily due to the impact of the increase in loans and deposits from the Tri-Valley and United American acquisitions, and the positive impact of rising interest rates.

· For the first quarter of 2019, the fully tax equivalent (“FTE”) net interest margin increased 25 basis points to 4.38% from 4.13% for the first quarter of 2018, primarily due to a higher average balance of loans, the accretion of the loan purchase discount into loan interest income from the Tri-Valley and the United American acquisitions, and the impact of increases in the prime rate and the rate on overnight funds.

· The average yield on the loan portfolio increased to 5.92% for the first quarter of 2019, compared to 5.76% for the first quarter of 2018, primarily due to increases in the prime rate, and an increase in the accretion of the loan purchase discount into loan interest income from the acquisitions.  The average yield on the Company’s legacy loan portfolio (excluding the purchased residential loans, purchased commercial real estate (“CRE”) loans, factored receivables portfolio, and accretion of the loan purchase discount from the acquisitions) increased 17 basis points for the first quarter of 2019, compared to the first quarter of 2018. The average yield on the purchased residential loans was 2.77% for the first quarter of 2019, compared to 2.73% for the first quarter of 2018. The average yield on the purchased CRE loans was 3.58% for the first quarter of 2019, compared to 3.52% the first quarter of 2018.

· The accretion of the loan purchase discount into loan interest income from the acquisitions was $455,000 for the first quarter of 2019 compared to $57,000 for the first quarter of 2018.  The total purchase discount on loans from Focus Business Bank (“Focus”) loan portfolio was $5.4 million on the acquisition date of August 20, 2015, of which $623,000 remains outstanding as of March 31, 2019.  The total purchase discount on loans from Tri-Valley loan portfolio was $2.6 million on the acquisition date of April 6, 2018, of which $2.1 million remains outstanding as of March 31, 2019.  The total purchase discount on loans from United American loan portfolio was $4.7 million on the acquisition date of May 4, 2018, of which $3.3 million remains outstanding as of March 31, 2019.

· There was a $1.1 million credit to the provision for loan losses for the first quarter of 2019, compared to a $506,000 provision for loan losses of for the first quarter of 2018. 

· Total noninterest income increased 12% to $ 2.5 million for the first quarter of 2019, compared to $2.2 million for the first quarter of 2018, primarily due to higher service charges and fees on deposit accounts and higher termination fees at Bay View Funding included in other noninterest income,  partially offset by lower gain on sales of Small Business Administration (“SBA”) loans.   

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· Total noninterest expense for the first quarter of 2019 was $17.9 million, compared to $16.0 million for the first quarter of 2018, primarily due to higher salaries and employee benefits as a result of annual salary increases, and additional employees and operating costs of the Tri-Valley and United American acquisitions, partially offset by costs related to the merger transactions of $615,000 incurred in the first quarter of 2018.    

· The efficiency ratio for the first quarter of 2019 was 53.47%, compared to 56.02% for the first quarter of 2018.

· The income tax expense for the first quarter of 2019 was $4.5 million, compared to income tax expense of $3.2 million for the first quarter of 2018.  The effective tax rate for the first quarter of 2019 was 27.1%, compared to 26.9% for the first quarter of 2018.

The following are important factors in understanding our current financial condition and liquidity position:

· Cash, other investments and interest‑bearing deposits in other financial institutions and securities available‑for‑sale, at fair value, increased 6% to $687.5 million at March 31, 2019, from $646.8 million at March 31, 2018, and increased 10% from $623.6 million at December 31, 2018.

· At March 31, 2019, securities held‑to‑maturity, at amortized cost, totaled $367.0 million, compared to $395.3 million at March 31, 2018, and $377.2 million at December 31, 2018.

· Loans, excluding loans held-for-sale, increased $257.1 million, or 16%, to $1.85 billion at March 31, 2019, compared to $1.59 billion at March 31, 2018, which included $174.3 million in loans from United American, $103.5 million in loans from Tri-Valley, partially offset by a decrease of $6.4 million in purchased residential mortgage loans, a decrease of $4.7 million of purchased CRE loans, and a decrease of $9.6 million in the Company’s legacy portfolio. Loans, excluding loans held-for-sale, decreased (2%) to $1.85 billion at March 31, 2019, compared to $1.89 billion December 31, 2018, primarily due to payoffs in the commercial land and construction loan portfolios.

· Nonperforming assets (“NPAs”) were $17.3 million, or 0.56% of total assets, at March 31, 2019, compared to $3.8 million, or 0.14% of total assets, at March 31, 2018, and $14.9 million, or 0.48% of total assets, at December 31, 2018.  The increase in NPAs at March 31, 2019, compared to March 31, 2018, was primarily due to two lending relationships, which is discussed in more detail below under Credit Quality. 

· Classified assets were $25.2 million, or 0.81% of total assets, at March 31, 2019, compared to $30.8 million, or 1.10% of total assets, at March 31, 2018, and $23.4 million, 0.76% of total assets, at December 31, 2018.  There were no foreclosed assets at March 31, 2019, March 31, 2018, and December 31, 2018.

· Net recoveries totaled $531,000 for the first quarter of 2019, compared to net charge-offs of $25,000 for the first quarter of 2018, and net recoveries of $280,000 for the fourth quarter of 2018.

· The allowance for loan losses (“ALLL”) at March 31, 2019 was $27.3 million, or 1.48% of total loans, representing 157.77% of total nonperforming loans. The allowance for loan losses at March 31, 2018 was $20.1 million, or 1.27% of total loans, representing 530.67% of total nonperforming loans. The allowance for loan losses at December 31, 2018 was $27.8 million, or 1.48% of total loans, representing 187.06% of total nonperforming loans.

· Total deposits increased $218.1 million, or 9%, to $2.64 billion at March 31, 2019, compared to $2.42 billion at March 31, 2018, which included $219.1 million in deposits from United American, $74.5 million in deposits from Tri-Valley, partially offset by a decrease of $75.5 million, or (3%) in the Company’s legacy deposits.  Total deposits remained relatively flat from $2.64 billion at December 31, 2018. 

· Deposits, excluding all time deposits and CDARS deposits, increased $195.6 million, or 9%, to $2.48 billion at March 31, 2019, compared to $2.29 billion at March 31, 2018, which included $199.5 million of deposits added from United American, $68.1 million of deposits added from Tri-Valley, partially offset by a decrease of $72.0 million, or (3%), in the Company’s legacy deposits.  Deposits, excluding all time deposits and CDARS deposits, at March 31, 2019 remained relatively flat compared to $2.48 billion at December 31, 2018.

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· The ratio of noncore funding (which consists of time deposits of $250,000 and over, CDARS deposits, brokered deposits, securities under an agreement to repurchase, subordinated debt, and short‑term borrowings) to total assets was 4.56% at March 31, 2019, compared to 4.53% at both March 31, 2018 and December 31, 2018.

· The loan to deposit ratio was 70.01% at March 31, 2019, compared to 65.69% at March 31, 2018, and 71.52% at December 31, 2018.

· The Company’s consolidated capital ratios exceeded regulatory guidelines and the Bank’s capital ratios exceeded the regulatory guidelines for a well‑capitalized financial institution under the Basel III regulatory requirements at March 31, 2019.

							Well-capitalized
	Heritage			Heritage			Financial Institution			Basel III Minimum
	Commerce			Bank of			Basel III PCA Regulatory			Regulatory
Capital Ratios	Corp			Commerce			Guidelines			Requirement(1)
Total Risk-Based		15.6	%		14.6	%		10.0	%		10.5	%
Tier 1 Risk-Based		12.6	%		13.4	%		8.0	%		8.5	%
Common Equity Tier 1 Risk-based		12.6	%		13.4	%		6.5	%		7.0	%
Leverage		9.5	%		10.1	%		5.0	%		4.0	%

(1) Fully phased in Basel III requirements for both HCC and HBC include a 2.5% capital conservation buffer, except the leverage ratio.

Deposits

The composition and cost of the Company’s deposit base are important in analyzing the Company’s net interest margin and balance sheet liquidity characteristics. The Company’s depositors are generally located in its primary market area. Depending on loan demand and other funding requirements, the Company also obtains deposits from wholesale sources including deposit brokers. HBC is a member of the Certificate of Deposit Account Registry Service (“CDARS”) program. The CDARS program allows customers with deposits in excess of FDIC insured limits to obtain coverage on time deposits through a network of banks within the CDARS program. The Company has a policy to monitor all deposits that may be sensitive to interest rate changes to help assure that liquidity risk does not become excessive due to concentrations.

Total deposits increased $218.1 million, or 9%, to $2.64 billion at March 31, 2019, compared to $2.42 billion at March 31, 2018, which included $219.1 million in deposits from United American, $74.5 million in deposits from Tri-Valley, partially offset by a decrease of $75.5 million, or (3%) in the Company’s legacy deposits.  Total deposits remained relatively flat from $2.64 billion at December 31, 2018. 

Deposits, excluding all time deposits and CDARS deposits, increased $195.6 million, or 9%, to $2.48 billion at March 31, 2019, compared to $2.29 billion at March 31, 2018, which included $199.5 million of deposits added from United American, $68.1 million of deposits added from Tri-Valley, partially offset by a decrease of $72.0 million, or (3%), in the Company’s legacy deposits.  Deposits, excluding all time deposits and CDARS deposits, at March 31, 2019 remained relatively flat compared to $2.48 billion at December 31, 2018.

Liquidity

Our liquidity position refers to our ability to maintain cash flows sufficient to fund operations and to meet obligations and other commitments in a timely fashion. The Company manages liquidity to be able to meet unexpected sudden changes in levels of its assets or deposit liabilities without maintaining excessive amounts of balance sheet liquidity. Excess balance sheet liquidity can negatively impact the Company’s interest margin. At March 31, 2019, we had $235.0 million in cash and cash equivalents and approximately $664.0 million in available borrowing capacity from various sources including the Federal Home Loan Bank (“FHLB”), the Federal Reserve Bank of San Francisco (“FRB”), Federal funds facilities with several financial institutions, and line of credit with a correspondent bank. The Company also

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had $779.9 million at fair value in unpledged securities available at March 31, 2019. Our loan to deposit ratio was 70.01% at March 31, 2019, compared to 65.69% at March 31, 2018, and 71.52% at December 31, 2018.

Lending

Our lending business originates principally through our branch offices located in our primary markets. In addition, Bay View Funding provides factoring financing throughout the United States. Total loans, excluding loans held-for-sale, increased $257.1 million, or 16%, to $1.85 billion at March 31, 2019, compared to $1.59 billion at March 31, 2018, which included $174.3 million in loans from United American, $103.5 million in loans from Tri-Valley, partially offset by a decrease of $6.4 million in purchased residential mortgage loans, a decrease of $4.7 million of purchased CRE loans, and a decrease of $9.6 million in the Company’s legacy portfolio. Loans, excluding loans held-for-sale, decreased (2%) to $1.85 billion at March 31, 2019, compared to $1.89 billion December 31, 2018, primarily due to payoffs in the commercial land and construction loan portfolios. The loan portfolio remains well-diversified with commercial and industrial (“C&I”) loans accounting for 30% of the loan portfolio at March 31, 2019, which included $48.3 million of factored receivables. CRE loans accounted for 55% of the total loan portfolio, of which 39% were occupied by businesses that own them.  Land and construction loans accounted for 5% of total loans, consumer and home equity loans accounted for 7% of total loans, and residential mortgage loans accounted for the remaining 3% of total loans at March 31, 2019.  

Net Interest Income

The management of interest income and expense is fundamental to the performance of the Company. Net interest income, the difference between interest income and interest expense, is the largest component of the Company’s total revenue. Management closely monitors both total net interest income and the net interest margin (net interest income divided by average earning assets). Net interest income before provision for loan losses increased 18% to $31.0 million for the first quarter of 2019, compared to $26.3 million for the first quarter of 2018, primarily due to the impact of the increase in loans and deposits from the Tri-Valley and United American acquisitions and the positive impact of rising interest rates.

The Company through its asset and liability policies and practices seeks to maximize net interest income without exposing the Company to an excessive level of interest rate risk. Interest rate risk is managed by monitoring the pricing, maturity and repricing options of all classes of interest‑bearing assets and liabilities. This is discussed in more detail under “Liquidity and Asset/Liability Management.” In addition, we believe there are measures and initiatives we can take to improve the net interest margin, including increasing loan rates, adding floors on floating rate loans, reducing nonperforming assets, managing deposit interest rates, and reducing higher cost deposits.

The net interest margin is also adversely impacted by the reversal of interest on nonaccrual loans and the reinvestment of loan payoffs into lower yielding investment securities and other short‑term investments.

Management of Credit Risk

We continue to identify, quantify, and manage our problem loans. Early identification of problem loans and potential future losses helps enable us to resolve credit issues with potentially less risk and ultimate losses. We maintain an allowance for loan losses in an amount that we believe is adequate to absorb probable incurred losses in the portfolio. While we strive to carefully manage and monitor credit quality and to identify loans that may be deteriorating, circumstances can change at any time for loans included in the portfolio that may result in future losses, that as of the date of the financial statements have not yet been identified as potential problem loans. Through established credit practices, we adjust the allowance for loan losses accordingly. However, because future events are uncertain, there may be loans that will deteriorate, some of which could occur in an accelerated time‑frame. As a result, future additions to the allowance for loan losses may be necessary. Because the loan portfolio contains a number of commercial loans, commercial real estate, construction and land development loans with relatively large balances, deterioration in the credit quality of one or more of these loans may require a significant increase to the allowance for loan losses. Future additions to the allowance may also be required based on changes in the financial condition of borrowers. Additionally, Federal and state banking regulators, as an integral part of their supervisory function, periodically review our allowance for loan losses. These regulatory agencies may require us to recognize further loan loss provisions or charge‑offs based upon their judgments, which may be different from ours. Any increase in the allowance for loan losses would have an adverse effect, which may be material, on our financial condition and results of operation. Further discussion of the management of credit risk appears under “Provision for Loan Losses” and “Allowance for Loan Losses.”

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In June 2016, the FASB issued new guidance on measurement of credit losses on financial instruments, which is the final guidance on the new current expected credit loss (“CECL”) model.  The new guidance will replace the incurred loss impairment methodology in current GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to estimate future credit loss estimates.  While early application is permitted for fiscal years beginning after December 15, 2018, the Company plans to adopt this standard on January 1, 2020. The Company has established a company-wide, cross-functional governance structure, which oversees overall strategy for implementation of CECL. We are currently evaluating various loss methodologies to determine their correlation to our various loan categories historical performance. The project plan is targeting the data and model validation completion during the second quarter of 2019, with parallel processing of our existing allowance for loan loss model with CECL prior to implementation. The Company is focused on completing data and model validation, refining assumptions and continued review of the models. The Company also continues to focus on researching and resolving interpretive accounting issues in the ASU, contemplating various related accounting policies, developing processes and related controls and considering various reporting disclosures.  The Company also continues to believe that the adoption of the standard will result in an overall increase in the allowance for loan losses to cover credit losses over the estimated life of the financial assets. However, the magnitude of the increase in its allowance for loan losses at the adoption date will depend upon the nature and characteristics of the portfolio at the adoption date, as well as macroeconomic conditions and forecasts at that time. Further discussion of the adoption of CECL appears in Note 1 – Basis of Presentation – Newly Issued, but not yet Effective Accounting Standards in the financial statements in this Form 10-Q.

Noninterest Income

While net interest income remains the largest single component of total revenues, noninterest income is an important component. A portion of the Company’s noninterest income is associated with its SBA lending activity, consisting of gains on the sale of loans sold in the secondary market and servicing income from loans sold with servicing retained. Other sources of noninterest income include loan servicing fees, service charges and fees, cash surrender value from company owned life insurance policies, and gains on the sale of securities.

Noninterest Expense

Management considers the control of operating expenses to be a critical element of the Company’s performance. Total noninterest expense for the first quarter of 2019 was $17.9 million, compared to $16.0 million for the first quarter of 2018, primarily due to higher salaries and employee benefits as a result of annual salary increases, and additional employees and operating costs of the Tri-Valley and United American acquisitions, partially offset by costs related to the merger transactions of $615,000 incurred in the first quarter of 2018.  

Capital Management

As part of its asset and liability management process, the Company continually assesses its capital position to take into consideration growth, expected earnings, risk profile and potential corporate activities that it may choose to pursue.

RESULTS OF OPERATIONS

The Company earns income from two primary sources. The first is net interest income, which is interest income generated by earning assets less interest expense on interest‑bearing liabilities. The second is noninterest income, which primarily consists of gains on the sale of loans, loan servicing fees, customer service charges and fees, the increase in cash surrender value of life insurance, and gains on the sale of securities. The majority of the Company’s noninterest expenses are operating costs that relate to providing a full range of banking and lending services to our customers.

Net Interest Income and Net Interest Margin

The level of net interest income depends on several factors in combination, including yields on earning assets, the cost of interest‑bearing liabilities, the relative volumes of earning assets and interest‑bearing liabilities, and the mix of products which comprise the Company’s earning assets, deposits, and other interest‑bearing liabilities. To maintain its net interest margin the Company must manage the relationship between interest earned and paid.

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The following Distribution, Rate and Yield table presents the average amounts outstanding for the major categories of the Company’s balance sheet, the average interest rates earned or paid thereon, and the resulting net interest margin on average interest earning assets for the periods indicated. Average balances are based on daily averages.

Distribution, Rate and Yield

	Three Months Ended						Three Months Ended
	March 31, 2019						March 31, 2018
			Interest		Average				Interest		Average
	Average		Income /		Yield /		Average		Income /		Yield /
	Balance		Expense		Rate		Balance		Expense		Rate
	(Dollars in thousands)
Assets:
Loans, gross (1)(2)	$	1,837,090	$	26,807	5.92	%	$	1,568,589	$	22,284	5.76	%
Securities — taxable		741,288		4,509	2.47	%		695,003		3,862	2.25	%
Securities — exempt from Federal tax (3)		85,943		694	3.27	%		88,470		709	3.25	%
Other investments, interest-bearing deposits
in other financial institutions and Federal funds sold		221,270		1,585	2.91	%		246,892		1,171	1.92	%
Total interest earning assets		2,885,591		33,595	4.72	%		2,598,954		28,026	4.37	%
Cash and due from banks		37,207						33,943
Premises and equipment, net		7,090						7,303
Goodwill and other intangible assets		95,554						51,166
Other assets		84,141						76,952
Total assets	$	3,109,583					$	2,768,318
Liabilities and shareholders’ equity:
Deposits:
Demand, noninterest-bearing	$	1,024,142					$	945,848
Demand, interest-bearing		701,702		618	0.36	%		608,523		302	0.20	%
Savings and money market		751,191		907	0.49	%		689,257		444	0.26	%
Time deposits — under $100		20,380		21	0.42	%		17,288		12	0.28	%
Time deposits — $100 and over		126,571		288	0.92	%		126,951		198	0.63	%
CDARS — interest-bearing demand, money
market and time deposits		13,322		2	0.06	%		16,460		2	0.05	%
Total interest-bearing deposits		1,613,166		1,836	0.46	%		1,458,479		958	0.27	%
Total deposits		2,637,308		1,836	0.28	%		2,404,327		958	0.16	%
Subordinated debt, net of issuance costs		39,386		571	5.88	%		39,199		571	5.91	%
Short-term borrowings		106		—	0.00	%		39		—	0.00	%
Total interest-bearing liabilities		1,652,658		2,407	0.59	%		1,497,717		1,529	0.41	%
Total interest-bearing liabilities and demand,
noninterest-bearing / cost of funds		2,676,800		2,407	0.36	%		2,443,565		1,529	0.25	%
Other liabilities		61,991						54,414
Total liabilities		2,738,791						2,497,979
Shareholders’ equity		370,792						270,339
Total liabilities and shareholders’ equity	$	3,109,583					$	2,768,318
Net interest income / margin				31,188	4.38	%				26,497	4.13	%
Less tax equivalent adjustment				(146)						(149)
Net interest income			$	31,042					$	26,348

(1) Includes loans held‑for‑sale. Nonaccrual loans are included in average balance.

(2) Yield amounts earned on loans include fees and costs. The accretion (amortization) of deferred loan fees (costs) into loan interest income was $91,000 for the first quarter of 2019, compared to $217,000 for the first quarter of 2018.

(3) Reflects the fully tax equivalent adjustment for Federal tax-exempt income based on a 21%.

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Volume and Rate Variances

The Volume and Rate Variances table below sets forth the dollar difference in interest earned and paid for each major category of interest‑earning assets and interest‑bearing liabilities for the noted periods, and the amount of such change attributable to changes in average balances (volume) or changes in average interest rates. Volume variances are equal to the increase or decrease in the average balance times the prior period rate, and rate variances are equal to the increase or decrease in the average rate times the prior period average balance. Variances attributable to both rate and volume changes are equal to the change in rate times the change in average balance and are included below in the average volume column.

	Three Months Ended March 31,
	2019 vs. 2018
	Increase (Decrease)
	Due to Change in:
	Average		Average		Net
	Volume		Rate		Change
	(Dollars in thousands)
Income from the interest earning assets:
Loans, gross	$	3,910	$	613	$	4,523
Securities — taxable		276		371		647
Securities — exempt from Federal tax (1)		(19)		4		(15)
Other investments, interest-bearing deposits
in other financial institutions and Federal funds sold		(187)		601		414
Total interest income on interest earning assets		3,980		1,589		5,569
Expense from the interest-bearing liabilities:
Demand, interest-bearing		78		238		316
Savings and money market		74		389		463
Time deposits — under $100		3		6		9
Time deposits — $100 and over		—		90		90
Subordinated debt, net of issuance costs		3		(3)		—
Total interest expense on interest-bearing liabilities		158		720		878
Net interest income	$	3,822	$	869		4,691
Less tax equivalent adjustment						3
Net interest income					$	4,694

(1) Reflects the fully tax equivalent adjustment for Federal tax-exempt income based on a 21%.

The Company’s net interest margin (FTE), expressed as a percentage of average earning assets, increased 25 basis points to 4.38% for the first quarter of 2019, from 4.13% for the first quarter of 2018, primarily due to a higher average balance of loans, the accretion of the loan purchase discount into loan interest income from the Tri-Valley  and United American acquisitions, and the impact of increases in the prime rate and the rate on overnight funds.

The average yield on the loan portfolio increased to 5.92% for the first quarter of 2019, compared to 5.76% for the first quarter of 2018, primarily due to to increases in the prime rate, and an increase in the accretion of the loan purchase discount into loan interest income from the acquisitions. The average yield on the Company’s legacy loan portfolio (excluding the purchased residential loans, purchased CRE loans, factored receivables portfolio, and accretion of the loan purchase discount from the acquisitions) increased 17 basis points for the first quarter of 2019, compared to the first quarter of 2018. The average yield on the purchased residential loans was 2.77% for the first quarter of 2019, compared to 2.73% for the first quarter of 2018. The average yield on the purchased CRE loans was 3.58% for the first quarter of 2019, compared to 3.52% the first quarter of 2018.

The cost of total deposits was 0.28% for the first quarter of 2019, compared to 0.16% for the first quarter of 2018.

Net interest income, before the provision for loan losses, increased 18% to $31.0 million for the first quarter of 2019, compared to $26.3 million for the first quarter of 2018. Net interest income increased for the first quarter of 2019,

47

compared to the first quarter of 2018, primarily due to the impact of the increase in loans and deposits from the Tri-Valley and United American acquisitions and the positive impact of rising interest rates.

Provision for Loan Losses

Credit risk is inherent in the business of making loans. The Company establishes an allowance for loan losses through charges to earnings, which are presented in the statements of income as the provision for loan losses. Specifically identifiable and quantifiable known losses are promptly charged off against the allowance. The provision for loan losses is determined by conducting a quarterly evaluation of the adequacy of the Company’s allowance for loan losses and charging the shortfall or excess, if any, to the current quarter’s expense. This has the effect of creating variability in the amount and frequency of charges to the Company’s earnings. The provision for loan losses and level of allowance for each period are 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.

There was a $1.1 million credit to the provision for loan losses for the first quarter of 2019, compared to a $506,000 provision for loan losses for the first quarter of 2018. Provisions for loan losses are charged to operations to bring the allowance for loan losses to a level deemed appropriate by the Company based on the factors discussed under “Allowance for Loan Losses.”

The allowance for loan losses totaled $27.3 million, or 1.48% of total loans at March 31, 2019, compared to $20.1 million, or 1.27% of total loans at March 31, 2018, and $27.8 million, or 1.48% of total loans at December 31, 2018.  The allowance for loan losses to total nonperforming loans decreased to 157.77% at March 31, 2019, compared to 530.67% at March 31, 2018, primarily due to the single lending relationship that was placed on nonaccrual during the second quarter of 2018.  Net recoveries totaled $531,000 for the first quarter of 2019, compared to net charge-offs of $25,000 for the first quarter of 2018, and net recoveries of $280,000 for the fourth quarter of 2018.

Noninterest Income

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

					Increase
	Three Months Ended				(decrease)
	March 31,				2019 versus 2018
	2019		2018		Amount		Percent
	(Dollars in thousands)
Service charges and fees on deposit accounts	$	1,161	$	902	$	259	29	%
Increase in cash surrender value of life insurance		330		363		(33)	(9)	%
Servicing income		191		181		10	6	%
Gain on sales of SBA loans		139		235		(96)	(41)	%
Gain on sales of securities		—		87		(87)	(100)	%
Other		647		427		220	52	%
Total	$	2,468	$	2,195	$	273	12	%

Total noninterest income increased to $2.5 million for the first quarter of 2019, compared to $2.2 million for the first quarter of 2018, primarily due to higher service charges and fees on deposit accounts and higher termination fees at Bay View Funding included in other noninterest income,  partially offset by lower gain on sales of SBA loans and no gains on sales of securities in the first quarter of 2018. 

Historically, a portion of the Company’s noninterest income has been associated with its SBA lending activity, as gains on the sale of loans sold in the secondary market and servicing income from loans sold with servicing rights retained. For the first quarter ended March 31, 2019, SBA loan sales resulted in a $139,000 gain, compared to a $235,000 gain on sales of SBA loans for the first quater ended March 31, 2018.

The servicing assets that result from the sales of SBA loans with servicing retained are amortized over the expected term of the loans using a method approximating the interest method. Servicing income generally declines as the respective loans are repaid.

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Noninterest Expense

					Increase
	Three Months Ended				(Decrease)
	March 31,				2019 versus 2018
	2019		2018		Amount		Percent
	(Dollars in thousands)
Salaries and employee benefits	$	10,770	$	9,777	$	993	10	%
Occupancy and equipment		1,506		1,106		400	36	%
Professional fees		818		684		134	20	%
Data processing		679		353		326	92	%
Software subscriptions		589		593		(4)	(1)	%
Amortization of intangible assets		553		241		312	129	%
Insurance expense		436		407		29	7	%
Other acquisition and integration related costs		—		615		(615)	(100)	%
Other		2,567		2,214		353	16	%
Total	$	17,918	$	15,990	$	1,928	12	%

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

Noninterest Expense by Category

	Three Months Ended March 31,
			Percent of				Percent of
	2019		Total		2018		Total
	(Dollars in thousands)
Salaries and employee benefits	$	10,770	60	%	$	9,777	61	%
Occupancy and equipment		1,506	9	%		1,106	7	%
Professional fees		818	5	%		684	4	%
Data processing		679	4	%		353	2	%
Software subscriptions		589	3	%		593	4	%
Amortization of intangible assets		553	3	%		241	1	%
Insurance expense		436	2	%		407	3	%
Other acquisition and integration related costs		—	0	%		615	4	%
Other		2,567	14	%		2,214	14	%
Total	$	17,918	100	%	$	15,990	100	%

Total noninterest expense for the first quarter of 2019 was $17.9 million, compared to $16.0 million for the first quarter of 2018.  The increase in noninterest expense in the first quarter of 2019, compared to first quarter of 2018, was primarily due to higher salaries and employee benefits as a result of annual salary increases, and additional employees and operating costs of the Tri-Valley and United American acquisitions, partially offset by costs related to the merger transactions of $615,000 incurred in the first quarter of 2018.  Full time equivalent employees were 309, 271, and 302 at March 31, 2019, March 31, 2018, and December 31, 2018, respectively .

Income Tax Expense

The Company computes its provision for income taxes on a quarterly basis. The effective tax rate is determined by applying the Company’s statutory income tax rates to pre‑tax book income as adjusted for permanent differences between pre‑tax book income and actual taxable income. These permanent differences include, but are not limited to, increases in the cash surrender value of life insurance policies, interest on tax‑exempt securities, certain expenses that are not allowed as tax deductions, and tax credits.

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The following table shows the Company’s effective income tax rates for the periods indicated:

	March 31,
	2019		2018
Effective income tax rate	27.1	%	26.9	%

The Company’s income tax expense for the first quarter of 2019 was $4.5 million, compared to income tax expense of $3.2 million for the first quarter of 2018. 

Some items of income and expense are recognized in different years for tax purposes than when applying generally accepted accounting principles leading to timing differences between the Company’s actual tax liability, and the amount accrued for this liability based on book income. These temporary differences comprise the “deferred” portion of the Company’s tax expense or benefit, which is accumulated on the Company’s books as a deferred tax asset or deferred tax liability until such time as they reverse.

Realization of the Company’s deferred tax assets is primarily dependent upon the Company generating sufficient future taxable income to obtain benefit from the reversal of net deductible temporary differences and the utilization of tax credit carryforwards and the net operating loss carryforwards for Federal and state income tax purposes. The amount of deferred tax assets considered realizable is subject to adjustment in future periods based on estimates of future taxable income. Under generally accepted accounting principles a valuation allowance is required to be recognized if it is “more likely than not” that the deferred tax assets will not be realized. The determination of the realizability of the deferred tax assets is highly subjective and dependent upon judgment concerning management’s evaluation of both positive and negative evidence, including forecasts of future income, cumulative losses, applicable tax planning strategies, and assessments of current and future economic and business conditions.

The Company had net deferred tax assets of $24.3 million at March 31, 2019, $18.6 million at March 31, 2018,  and $27.1 million at December 31, 2018. After consideration of the matters in the preceding paragraph, the Company determined that it is more likely than not that the net deferred tax assets March 31, 2019, March 31, 2018, and December 31, 2018 will be fully realized in future years.  

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Business Segment Information

The following presents the Company’s operating segments. Transactions between segments consist primarily of borrowed funds. Intersegment interest expense is allocated to the Factoring segment based on the Company’s prime rate and funding costs. The provision for loan loss is allocated based on the segment’s allowance for loan loss determination which considers the effects of charge‑offs. Noninterest income and expense directly attributable to a segment are assigned to it. Taxes are paid on a consolidated basis and allocated for segment purposes. The Factoring segment includes only factoring originated by Bay View Funding.

	Three Months Ended March 31, 2019
	Banking(1)		Factoring		Consolidated
	(Dollars in thousands)
Interest income	$	30,496	$	2,953	$	33,449
Intersegment interest allocations		314		(314)		—
Total interest expense		2,407		—		2,407
Net interest income		28,403		2,639		31,042
Provision (credit) for loan losses		(892)		(169)		(1,061)
Net interest income after provision		29,295		2,808		32,103
Noninterest income		2,232		236		2,468
Noninterest expense		16,201		1,717		17,918
Intersegment expense allocations		121		(121)		—
Income before income taxes		15,447		1,206		16,653
Income tax expense		4,151		356		4,507
Net income	$	11,296	$	850	$	12,146
Total assets	$	3,053,116	$	62,761	$	3,115,877
Loans, net of deferred fees	$	1,800,064	$	48,254	$	1,848,318
Goodwill	$	70,709	$	13,044	$	83,753

(1) Includes the holding company’s results of operations

	Three Months Ended March 31, 2018
	Banking(1)		Factoring		Consolidated
	(Dollars in thousands)
Interest income	$	24,731	$	3,146	$	27,877
Intersegment interest allocations		327		(327)		—
Total interest expense		1,529		—		1,529
Net interest income		23,529		2,819		26,348
Provision for loan losses		488		18		506
Net interest income after provision		23,041		2,801		25,842
Noninterest income		2,086		109		2,195
Noninterest expense		14,467		1,523		15,990
Intersegment expense allocations		175		(175)		—
Income before income taxes		10,835		1,212		12,047
Income tax expense		2,880		358		3,238
Net income	$	7,955	$	854	$	8,809
Total assets	$	2,722,472	$	63,076	$	2,785,548
Loans, net of deferred fees	$	1,541,466	$	49,735	$	1,591,201
Goodwill	$	32,620	$	13,044	$	45,664

(1) Includes the holding company’s results of operations

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Banking.  Our banking segment’s net income was $11.3 million for the three months ended March 31, 2019, compared to net income of $8.0 million for the three months ended March 31, 2018. Net interest income increased to $28.4 million for the three months ended March 31, 2019, compared to $23.5 million for the three months March 31, 2018, primarily due to the impact of the increase in loans and deposits from the Tri-Valley and United American acquisitions and the positive impact of rising interest rates. The credit to the provision for loan losses was ($892,000) for the three months ended March 31, 2019, compared to a provision for loan losses of $488,000 for the three months ended March 31, 2018. Noninterest income was $2.2 million for the three months ended March 31, 2019, compared to $2.1 million for the three months ended March 31, 2018. Noninterest income increased for the three months ended March 31, 2019, compared to three months ended ended March 31, 2018, primarily due to higher service charges and fees on deposit accounts and higher terminaton fees at Bay View Funding included in other noninterest income. Noninterest expense increased to $16.2 million for the three months ended March 31, 2019, compared to $14.5 million for the three months ended March 31, 2018. The increase in noninterest expense in the first three months of 2019, compared to first three months of 2018, was primarily due to higher salaries and employee benefits as a result of annual salary increases, and additional employees and operating costs of Tri-Valley and United American acquisitions, partially offset by costs related to the merger transactions of $615,000 incurred in the first quarter of 2018.    

Factoring.  Bay View Funding’s primary business operation is purchasing and collecting factored receivables. Factored receivables are receivables that have been transferred by the originating organization and typically have not been subject to previous collection efforts. In a factoring transaction Bay View Funding directly purchases the receivables generated by its clients at a discount to their face value. The transactions are structured to provide the clients with immediate working capital when there is a mismatch between payments to the client for a good and service and the payment of operating costs incurred to provide such good or service. The average life of the factored receivables was 40 days for the three months ended March 31, 2019, compared to 35 days for the three months ended March 31, 2018. The increase in the average life of factored receivables was primarily due to more customers with selling terms greater than 30 days during the first quarter of 2019, compared to the first quarter of 2018. Net interest income for the three months ended March 31, 2019, decreased to $2.6 million, compared to $2.8 million for the three months ended March 31, 2018, primarily due to a decrease in the average balance of factored receivables outstanding.

FINANCIAL CONDITION

At March 31, 2019, total assets increased to $3.12 billion, compared to $2.79 billion at March 31, 2018, primarily due to the Tri-Valley and United American acquisitions.  As of  March 31, 2019, Tri-Valley added $103.5 million in loans and $74.5 million in deposits. As of  March 31, 2019, United American added $174.3 million in loans and $219.1 million in deposits. Total assets increased 1% from $3.10 billion at December 31, 2018.

Securities available‑for‑sale, at fair value, were $452.5 million at March 31, 2019, an increase of 31% from $344.8 million at March 31, 2018, and a decrease of (1%) from $459.0 million at December 31, 2018. Securities held‑to‑maturity, at amortized cost, were $367.0 million at March 31, 2019, a decrease of (7%) from $395.3 million at March 31, 2018, and a decrease of (3%) from $377.2 million at December 31, 2018. Total loans, excluding loans held‑for‑sale, increased $257.1 million, or 16%, to $1.85 billion at March 31, 2019, compared to $1.59 billion at March 31, 2018, which included $174.3 million in loans from United American, $103.5 million in loans from Tri-Valley, partially offset by a decrease of $6.4 million in purchased residential mortgage loans, a decrease of $4.7 million of purchased CRE loans, and a decrease of $9.6 million in the Company’s legacy portfolio. Loans, excluding loans held-for-sale, decreased (2%) to $1.85 billion at March 31, 2019, compared to $1.89 billion December 31, 2018, primarily due to payoffs in the commercial land and construction loan portfolios.

Total deposits increased $218.1 million, or 9%, to $2.64 billion at March 31, 2019, compared to $2.42 billion at March 31, 2018, which included $219.1 million in deposits from United American, $74.5 million in deposits from Tri-Valley, partially offset by a decrease of $75.5 million, or (3%) in the Company’s legacy deposits.  Total deposits remained flat compared to $2.64 billion at December 31, 2018. 

Deposits, excluding all time deposits and CDARS deposits, increased $195.6 million, or 9%, to $2.48 billion at March 31, 2019, compared to $2.29 billion at March 31, 2018, which included $199.5 million of deposits added from United American, $68.1 million of deposits added from Tri-Valley, partially offset by a decrease of $72.0 million, or (3%), in the Company’s legacy deposits.  Deposits, excluding all time deposits and CDARS deposits, at March 31, 2019 remained relatively flat compared to $2.48 billion at December 31, 2018.

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Securities Portfolio

The following table reflects the balances for each category of securities at the dates indicated:

	March 31,				December 31,
	2019		2018		2018
	(Dollars in thousands)
Securities available-for-sale (at fair value):
Agency mortgage-backed securities	$	295,578	$	344,766	$	302,854
U.S. Treasury		149,482		—		148,753
U.S. Government sponsored entities		7,461		—		7,436
Total	$	452,521	$	344,766	$	459,043
Securities held-to-maturity (at amortized cost):
Agency mortgage-backed securities	$	281,102	$	307,083	$	291,241
Municipals — exempt from Federal tax		85,921		88,191		85,957
	$	367,023	$	395,274	$	377,198

The following table summarizes the weighted average life and weighted average yields of securities at March 31, 2019:

	Weighted Average Life
					After One and				After Five and
	Within One				Within Five				Within Ten				After Ten
	Year or Less				Years				Years				Years				Total
	Amount		Yield		Amount		Yield		Amount		Yield		Amount		Yield		Amount		Yield
	(Dollars in thousands)
Securities available-for-sale (at fair value):
Agency mortgage-backed securities	$	—	N/A		$	176,237	2.30	%	$	119,341	2.49	%	$	—	N/A		$	295,578	2.37	%
U.S. Treasury		—	N/A			149,482	2.80	%		—	N/A			—	N/A			149,482	2.80	%
U.S. Government sponsored entities		5,475	2.63	%		1,986	2.67	%		—	N/A			—	N/A			7,461	2.64	%
Total	$	5,475	2.63	%	$	327,705	2.53	%	$	119,341	2.49	%	$	—	N/A		$	452,521	2.52	%
Securities held-to-maturity (at amortized cost):
Agency mortgage-backed securities	$	—	N/A		$	127,529	2.08	%	$	112,735	2.35	%	$	40,838	3.39	%	$	281,102	2.38	%
Municipals — exempt from Federal tax (1)		12,800	3.36	%		44,897	3.27	%		7,231	3.11	%		20,993	3.14	%		85,921	3.24	%
Total	$	12,800	3.36	%	$	172,426	2.39	%	$	119,966	2.40	%	$	61,831	3.30	%	$	367,023	2.58	%

(1) Reflects tax equivalent adjustment for Federal tax exempt income based on a 21% tax rate.

The securities portfolio is the second largest component of the Company’s interest‑earning assets, and the structure and composition of this portfolio is important to an analysis of the financial condition of the Company. The portfolio serves the following purposes: (i) it provides a source of pledged assets for securing certain deposits and borrowed funds, as may be required by law or by specific agreement with a depositor or lender; (ii) it provides liquidity to even out cash flows from the loan and deposit activities of customers; (iii) it can be used as an interest rate risk management tool, since it provides a large base of assets, the maturity and interest rate characteristics of which can be changed more readily than the loan portfolio to better match changes in the deposit base and other funding sources of the Company; and (iv) it is an alternative interest‑earning use of funds when loan demand is weak or when deposits grow more rapidly than loans.

The Company’s portfolio may include: (i) U.S. Treasury securities and U.S. Government sponsored entities’ debt securities for liquidity and pledging; (ii) mortgage‑backed securities, which in many instances can also be used for pledging, and which generally enhance the yield of the portfolio; (iii) municipal obligations, which provide tax free income and limited pledging potential; (iv) single entity issue trust preferred securities, which generally enhance the yield on the portfolio; (v) corporate bonds, which also enhance the yield on the portfolio; (vi) money market mutual funds; (vii) certificates of deposit; (viii) commercial paper; (ix) bankers acceptances; (x) repurchase agreements; (xi) collateralized mortgage obligations; and (xii) asset-backed securities.

The Company classifies its securities as either available‑for‑sale or held‑to‑maturity at the time of purchase. Accounting guidance requires available‑for‑sale securities to be marked to fair value with an offset to accumulated other comprehensive income (loss), a component of shareholders’ equity. Monthly adjustments are made to reflect changes in the fair value of the Company’s available‑for‑sale securities.

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The investment securities available‑for‑sale portfolio, at fair value, totaled $452.5 million at March 31, 2019, a increase of 31% from $344.8 million at March 31, 2018, and a decrease of (1%) from $459.0 million at December 31, 2018. At March 31, 2019, the Company’s securities available-for-sale portfolio comprised $295.6 million of agency mortgage-backed securities (all issued by U.S. Government sponsored entities), $149.5 of million U.S. Treasury, and $7.4 million of U.S. Government sponsored entities debt securities. The pre-tax unrealized loss on securities available-for-sale at March 31, 2019 was ($2.9) million, compared to a pre-tax unrealized loss on securities available-for-sale of ($9.5) million at March 31, 2018, and a pre-tax unrealized loss on securities available-for-sale of ($7.7) million at December 31, 2018.  All other factors remaining the same, when market interest rates are rising, the Company will experience a lower unrealized gain (or a higher unrealized loss) on the securities portfolio.

At March 31, 2019, investment securities held‑to‑maturity, at amortized cost, totaled $367.0 million, a decrease of (7%) from $395.3 million at March 31, 2018, and a decrease of (3%) from $377.2 million at December 31, 2018. At March 31, 2019, the Company’s securities held-to-maturity portfolio comprised $281.1 million of agency mortgage-backed securities, and $85.9 million of tax-exempt municipal bonds.  

The Company has not used interest rate swaps or other derivative instruments to hedge fixed rate loans or securities.

Loans

The Company’s loans represent the largest portion of invested assets, substantially greater than the securities portfolio or any other asset category, and the quality and diversification of the loan portfolio is an important consideration when reviewing the Company’s financial condition. Gross loans, excluding loans held‑for‑sale, represented 59% of total assets at March 31, 2019, represented 57% at March 31, 2018, and represented 61% at December 31, 2018. The ratio of loans to deposits was 70.01% at March 31, 2019, compared to 65.69% at March 31, 2018, and 71.52% at December 31, 2018.

Loan Distribution

The Loan Distribution table that follows sets forth the Company’s gross loans, excluding loans held‑for‑sale, outstanding and the percentage distribution in each category at the dates indicated:

	March 31, 2019				March 31, 2018				December 31, 2018
	Balance		% to Total		Balance		% to Total		Balance		% to Total
	(Dollars in thousands)
Commercial	$	559,718	30	%	$	572,790	36	%	$	597,763	32	%
Real estate:
CRE		1,012,641	55	%		775,547	49	%		994,067	52	%
Land and construction		98,222	5	%		113,470	7	%		122,358	6	%
Home equity		118,448	6	%		76,087	4	%		109,112	6	%
Residential mortgages		49,786	3	%		42,868	3	%		50,979	3	%
Consumer		9,690	1	%		10,958	1	%		12,453	1	%
Total Loans		1,848,505	100	%		1,591,720	100	%		1,886,732	100	%
Deferred loan fees, net		(187)	—			(519)	—			(327)	—
Loans, net of deferred fees		1,848,318	100	%		1,591,201	100	%		1,886,405	100	%
Allowance for loan losses		(27,318)				(20,139)				(27,848)
Loans, net	$	1,821,000			$	1,571,062			$	1,858,557

The Company’s loan portfolio is concentrated in commercial loans, (primarily manufacturing, wholesale, and services oriented entities), and commercial real estate, with the remaining balance in land development and construction, home equity, purchased residential mortgages, and consumer loans. The Company does not have any concentrations by industry or group of industries in its loan portfolio, however, 69% of its gross loans were secured by real property at March 31, 2019, compared to 63% at March 31, 2018 and 67% at December 31, 2018. While no specific industry concentration is considered significant, the Company’s bank lending operations are substantially located in areas that are dependent on the technology and real estate industries and their supporting companies.

The Company has established concentration limits in its loan portfolio for commercial real estate loans, commercial loans, construction loans and unsecured lending, among others. All loan types are within established limits. The Company uses underwriting guidelines to assess the borrowers’ historical cash flow to determine debt service, and

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we further stress test the debt service under higher interest rate scenarios. Financial and performance covenants are used in commercial lending to allow the Company to react to a borrower’s deteriorating financial condition should that occur.

The Company’s commercial loans are made for working capital, financing the purchase of equipment or for other business purposes. Commercial loans include loans with maturities ranging from thirty days to one year and “term loans” with maturities normally ranging from one to five years. Short‑term business loans are generally intended to finance current transactions and typically provide for periodic principal payments, with interest payable monthly. Term loans normally provide for floating interest rates, with monthly payments of both principal and interest.

The Company is an active participant in the SBA and U.S. Department of Agriculture guaranteed lending programs, and has been approved by the SBA as a lender under the Preferred Lender Program. The Company regularly makes such guaranteed loans (collectively referred to as “SBA loans”). The guaranteed portion of these loans is typically sold in the secondary market depending on market conditions. When the guaranteed portion of an SBA loan is sold the Company retains the servicing rights for the sold portion. During the first quarter ended March 31, 2019, loans were sold resulting in a gain on sales of SBA loans of $139,000, compared to $235,000 for the first quarter ended March 31, 2018.

The Company’s factoring receivables are from the operations of Bay View Funding whose primary business is purchasing and collecting factored receivables. Factored receivables are receivables that have been transferred by the originating organization and typically have not been subject to previous collection efforts. These receivables are acquired from a variety of companies, including but not limited to service providers, transportation companies, manufacturers, distributors, wholesalers, apparel companies, advertisers, and temporary staffing companies. The portfolio of factored receivables is included in the Company’s commercial loan portfolio. The average life of the factored receivables was 40 days for the first quarter of 2019, compared to 35 days for the first quarter of 2018. The balance of the purchased receivables was $48.3 million at March 31, 2019, compared to $49.7 million at March 31, 2018 and $53.6 million at December 31, 2018.

The commercial loan portfolio decreased $13.1 million to $559.7 million at March 31, 2019 from $572.8 million at March 31, 2018, primarily due to a decrease of $23.4 million, or (4%), in the Company’s legacy portfolio, partially offset by $7.9 million of loans added from United American, and $2.4 million of loans added from Tri-Valley. The commercial loan portfolio decreased $38.1 million, or (6%), from $597.8 million at December 31, 2018.  C&I line usage was 37% at March 31, 2019, compared to 36% at both March 31, 2018 and December 31, 2018.

The Company’s CRE loans consist primarily of loans based on the borrower’s cash flow and are secured by deeds of trust on commercial property to provide a secondary source of repayment. The Company generally restricts real estate term loans to no more than 75% of the property’s appraised value or the purchase price of the property depending on the type of property and its utilization. The Company offers both fixed and floating rate loans. Maturities for CRE loans are generally between five and ten years (with amortization ranging from fifteen to twenty five years and a balloon payment due at maturity), however, SBA and certain other real estate loans that can be sold in the secondary market may be granted for longer maturities.

The CRE loan portfolio increased $237.1 million, or 31%, to $1.01 billion at March 31, 2019, compared to $775.5 million at March 31, 2018, which included $123.6 million of loans added from United American, $89.7 million of loans added from Tri-Valley, and an increase of $28.5 million, or 4%, in the Company’s legacy portfolio, partially offset by a decrease of $4.7 million in purchased CRE loans.  The CRE loan portfolio increased $18.6 million from $994.1 million at December 31, 2018.  At March 31, 2019, there was 39% of the CRE loan portfolio secured by owner-occupied real estate.

The Company’s land and construction loans are primarily to finance the development/construction of commercial and single family residential properties. The Company utilizes underwriting guidelines to assess the likelihood of repayment from sources such as sale of the property or availability of permanent mortgage financing prior to making the construction loan. Construction loans are provided only in our market area, and the Company has extensive controls for the disbursement process. Land and construction loans decreased $15.3 million, or (13%), to $98.2 million at March 31, 2019, compared to $113.5 million at March 31, 2018, and decreased $24.1 million, or (20%), from $122.3 million at December 31, 2018.

The Company makes home equity lines of credit available to its existing customers. Home equity lines of credit are underwritten initially with a maximum 75% loan to value ratio. Home equity lines of credit increased $42.3 million, or

55

56%, to $118.4 million at March 31, 2019, compared to $76.1 million at March 31, 2018, which included $27.5 million of loans added from United American, and $11.4 million of loans added from Tri-Valley, an increase of $3.4 million, or 5%, in the Company’s legacy portfolio.  Home equity lines of credit increased $9.3 million, or 9%, from $109.1 million at December 31, 2018.

Residential mortgage loans increased $6.9 million, or 16%, to $49.8 million at March 31, 2019, compared to $42.9 million at March 31, 2018, primarily due to $13.3 million of loans added from United American, partially offset by a $6.4 million decrease in purchased residential mortgage loans.  Residential mortgage loans decreased to $49.8 million from $51.0 million at December 31, 2018.

Additionally, the Company makes consumer loans for the purpose of financing automobiles, various types of consumer goods, and other personal purposes. Consumer loans generally provide for the monthly payment of principal and interest. Most of the Company’s consumer loans are secured by the personal property being purchased or, in the instances of home equity loans or lines, real property.

With certain exceptions, state chartered banks are permitted to make extensions of credit to any one borrowing entity up to 15% of the bank’s capital and reserves for unsecured loans and up to 25% of the bank’s capital and reserves for secured loans. For HBC, these lending limits were $63.5 million and $105.8 million at March 31, 2019, respectively.

Loan Maturities

The following table presents the maturity distribution of the Company’s loans (excluding loans held‑for‑sale) as of March 31, 2019. The table shows the distribution of such loans between those loans with predetermined (fixed) interest rates and those with variable (floating) interest rates. Floating rates generally fluctuate with changes in the prime rate as reflected in the Western Edition of The Wall Street Journal. As of March 31, 2019, approximately 50% of the Company’s loan portfolio consisted of floating interest rate loans.

			Over One
	Due in		Year But
	One Year		Less than		Over
	or Less		Five Years		Five Years		Total
	(Dollars in thousands)
Commercial	$	445,297		95,838		18,583	$	559,718
Real estate:
CRE		140,716		450,079		421,846		1,012,641
Land and construction		96,327		1,895		—		98,222
Home equity		112,259		3,008		3,181		118,448
Residential mortgages		1,527		8,035		40,224		49,786
Consumer		9,541		148		1		9,690
Loans	$	805,667	$	559,003	$	483,835	$	1,848,505
Loans with variable interest rates	$	715,769		146,460		69,300	$	931,529
Loans with fixed interest rates		89,898		412,543		414,535		916,976
Loans	$	805,667	$	559,003	$	483,835	$	1,848,505

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Loan Servicing

As of March 31, 2019 and 2018, $102.4 million and $132.8 million, respectively, in SBA loans were serviced by the Company for others. Activity for loan servicing rights was as follows:

	Three Months Ended
	March 31,
	2019		2018
	(Dollars in thousands)
Beginning of period balance	$	871	$	1,373
Additions		31		56
Amortization		(95)		(205)
End of period balance	$	807	$	1,224

Loan servicing rights are included in accrued interest receivable and other assets on the unaudited consolidated balance sheets and reported net of amortization. There was no valuation allowance as of March 31, 2019 and 2018, as the fair value of the assets was greater than the carrying value.

Activity for the I/O strip receivable was as follows:

	Three Months Ended
	March 31,
	2019		2018
	(Dollars in thousands)
Beginning of period balance	$	568	$	968
Unrealized holding gain (loss)		3		(23)
End of period balance	$	571	$	945

Credit Quality

Financial institutions generally have a certain level of exposure to credit quality risk, and could potentially receive less than a full return of principal and interest if a debtor becomes unable or unwilling to repay. Since loans are the most significant assets of the Company and generate the largest portion of its revenues, the Company’s management of credit quality risk is focused primarily on loan quality. Banks have generally suffered their most severe earnings declines as a result of customers’ inability to generate sufficient cash flow to service their debts and/or downturns in national and regional economies and declines in overall asset values including real estate. In addition, certain debt securities that the Company may purchase have the potential of declining in value if the obligor’s financial capacity to repay deteriorates.

The Company’s policies and procedures identify market segments, set goals for portfolio growth or contraction, and establish limits on industry and geographic credit concentrations. In addition, these policies establish the Company’s underwriting standards and the methods of monitoring ongoing credit quality. The Company’s internal credit risk controls are centered in underwriting practices, credit granting procedures, training, risk management techniques, and familiarity with loan customers as well as the relative diversity and geographic concentration of our loan portfolio.

The Company’s credit risk may also be affected by external factors such as the level of interest rates, employment, general economic conditions, real estate values, and trends in particular industries or geographic markets. As an independent community bank serving a specific geographic area, the Company must contend with the unpredictable changes in the general California market and, particularly, primary local markets. The Company’s asset quality has suffered in the past from the impact of national and regional economic recessions, consumer bankruptcies, and depressed real estate values.

Nonperforming assets are comprised of the following: loans for which the Company is no longer accruing interest; restructured loans which have been current under six months; loans 90 days or more past due and still accruing interest (although they are generally placed on nonaccrual when they become 90 days past due, unless they are both well‑secured and in the process of collection); and foreclosed assets. Past due loans 30 days or greater totaled

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$21.8 million and $8.9 million at March 31, 2019 and December 31, 2018, respectively, of which $15.1 million and $430,000 were on nonaccrual, respectively. At March 31, 2019, there were also $869,000 loans less than 30 days past due included in nonaccrual loans held‑for‑investment. At December 31, 2018, there were also $13.3 million loans less than 30 days past due included in nonaccrual loans held‑for‑investment.

Management’s classification of a loan as “nonaccrual” is an indication that there is reasonable doubt as to the full recovery of principal or interest on the loan. At that point, the Company stops accruing interest income, and reverses any uncollected interest that had been accrued as income. The Company begins recognizing interest income only as cash interest payments are received and it has been determined the collection of all outstanding principal is not in doubt. The loans may or may not be collateralized, and collection efforts are pursued. Loans may be restructured by management when a borrower has experienced some change in financial status causing an inability to meet the original repayment terms and where the Company believes the borrower will eventually overcome those circumstances and make full restitution. Foreclosed assets consist of properties acquired by foreclosure or similar means that management is offering or will offer for sale.

The following table summarizes the Company’s nonperforming assets at the dates indicated:

	March 31,						December 31,
	2019			2018			2018
	(Dollars in thousands)
Nonaccrual loans — held-for-investment	$	15,958		$	3,637		$	13,699
Restructured and loans 90 days past due and
still accruing		1,357			158			1,188
Total nonperforming loans		17,315			3,795			14,887
Foreclosed assets		—			—			—
Total nonperforming assets	$	17,315		$	3,795		$	14,887
Nonperforming assets as a percentage of loans
plus foreclosed assets		0.94	%		0.24	%		0.79	%
Nonperforming assets as a percentage of total assets		0.56	%		0.14	%		0.48	%

Nonperforming assets were $17.3 million, or 0.56% of total assets, at March 31, 2019, compared to $3.8 million, or 0.14% of total assets, at March 31, 2018, and $14.9 million, or 0.48% of total assets, at December 31, 2018. The increase in nonperforming assets at March 31, 2019, compared to March 31, 2018 and December 31, 2018, was primarily due to two lending relationships.

A large lending relationship was placed on nonaccrual during the second quarter of 2018.  At March 31, 2019, the recorded investment of this lending relationship was $10.8 million, and the Company had a $5.9 million specific loan loss allocated for this lending relationship, compared to a recorded investment of $12.0 million, and a $6.7 million specific loan loss reserve allocated for this lending relationship at December 31, 2018. 

In addition, the Company has two secured CRE loans outstanding to entities affiliated with DC Solar Solutions, Inc. (“DC Solar”), which were placed on nonaccrual during the first quarter of 2019.  In February 2019, DC Solar and a number of its affiliates, including each of the borrowers of the loans, filed a Chapter 11 petition under the Bankruptcy Code, which was subsequently converted to a Chapter 7 proceeding on March 22, 2019. At March 31, 2019, the recorded investment of these two CRE loans totaled $3.3 million.

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The following table presents nonperforming loans by class at the dates indicated:

	March 31, 2019						December 31, 2018
				Restructured						Restructured
				and Loans						and Loans
				over 90 Days						over 90 Days
				Past Due						Past Due
				and Still						and Still
	Nonaccrual			Accruing	Total		Nonaccrual			Accruing	Total
	(Dollars in thousands)
Commercial	$	7,203	$	1,132	$	8,335	$	8,279	$	963	$	9,242
Real estate:
CRE		8,442		—		8,442		5,094		—		5,094
Home equity		313		225		538		326		225		551
Total	$	15,958	$	1,357	$	17,315	$	13,699	$	1,188	$	14,887

Loans with a well‑defined weakness, which are characterized by the distinct possibility that the Company will sustain a loss if the deficiencies are not corrected, are categorized as “classified.” Classified loans include all loans considered as substandard, substandard‑nonaccrual, and doubtful 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). Loans held‑for‑sale are carried at the lower of cost or estimated fair value, and are not allocated an allowance for loan losses.

The following table provides a summary of the loan portfolio by loan type and credit quality classification at the dates indicated:

	March 31, 2019						March 31, 2018						December 31, 2018
	Nonclassified		Classified		Total		Nonclassified		Classified		Total		Nonclassified		Classified		Total
	(Dollars in thousands)
Commercial	$	545,151	$	14,567	$	559,718	$	548,538	$	24,252	$	572,790	$	584,845	$	12,918	$	597,763
Real estate:
CRE		1,003,770		8,871		1,012,641		769,707		5,840		775,547		985,193		8,874		994,067
Land and construction		98,222		—		98,222		113,470		—		113,470		122,358		—		122,358
Home equity		116,710		1,738		118,448		75,416		671		76,087		107,495		1,617		109,112
Residential mortgages		49,786		—		49,786		42,868		—		42,868		50,979		—		50,979
Consumer		9,690		—		9,690		10,958		—		10,958		12,453		—		12,453
Total	$	1,823,329	$	25,176	$	1,848,505	$	1,560,957	$	30,763	$	1,591,720	$	1,863,323	$	23,409	$	1,886,732

Classified loans were $25.2 million, or 0.81% of total assets, at March 31, 2019, compared to $30.8 million, or 1.10%of total assets, at March 31, 2018 and $23.4 million, or 0.76% of total assests at December 31, 2018. In order to determine whether a borrower is experiencing financial difficulty, an evaluation is performed of the probability that the borrower will be in payment default on any of its debt in the foreseeable future without the modification. This evaluation is performed in accordance with the Company’s underwriting policy.

The following provides a rollforward of troubled debt restructurings (“TDRs”):

	Three Months Ended March 31, 2019
	Performing		Nonperforming
	TDRs		TDRs		Total
	(Dollars in thousands)
Balance at January 1, 2019	$	613	$	36	$	649
Principal repayments		(33)		(36)		(69)
Balance at March 31, 2019	$	580	$	—	$	580

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	Three Months Ended March 31, 2018
	Performing		Nonperforming
	TDRs		TDRs		Total
	(Dollars in thousands)
Balance at January 1, 2018	$	309	$	16	$	325
Additions		46		—		46
Principal repayments		(48)		—		(48)
Balance at March 31, 2018	$	307	$	16	$	323

Allowance for Loan Losses

The allowance for loan losses is an estimate of probable incurred losses in the loan portfolio. Loans are charged‑off against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance for loan losses. Management’s methodology for estimating the allowance balance consists of several key elements, which include specific allowances on individual impaired loans and the formula driven allowances on pools of loans with similar risk characteristics. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged‑off.

Specific allowances are established for impaired loans. Management considers a loan to be impaired when it is probable that the Company will be unable to collect all amounts due according to the original contractual terms of the loan agreement, including scheduled interest payments. Loans for which the terms have been modified with a concession granted, and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings and classified as impaired. When a loan is considered to be impaired, the amount of impairment is measured based on the fair value of the collateral less costs to sell if the loan is collateral dependent, or on the present value of expected future cash flows or values that are observable in the secondary market. If the measure of the impaired loans is less than the investment in the loan, the deficiency will be charged‑off against the allowance for loan losses if the amount is a confirmed loss, or, alternatively, a specific allocation within the allowance will be established. Loans that are considered impaired are specifically excluded from the formula portion of the allowance for loan losses analysis.

The estimated loss factors for pools of loans that are not impaired are based on determining the probability of default and loss given default for loans within each segment of the portfolio, adjusted for significant factors that, in management’s judgment, affect collectability as of the evaluation date. The Company’s historical delinquency experience and loss experience are utilized to determine the probability of default and loss given default for segments of the portfolio where the Company has experienced losses in the past. For segments of the portfolio where the Company has no significant prior loss experience, the Company uses quantifiable observable industry data to determine the probability of default and loss given default.

The following provides a summary of the risks associated with various segments of the Company’s loan portfolio, which are factors management regularly considers when evaluating the adequacy of the allowance:

· Commercial loans consist primarily of commercial and industrial loans (business lines of credit), and other commercial purpose loans. Repayment of commercial and industrial loans is generally provided from the cash flows of the related business to which the loan was made. Adverse changes in economic conditions may result in a decline in business activity, which may impact a borrower’s ability to continue to make scheduled payments. The factored receivables at Bay View Funding are included in the Company’s commercial loan portfolio; however, they are evaluated for risk primarily based on the agings of the receivables. Faster turning receivables imply less risk and therefore warrant a lower associated allowance. Should the overall aging for the portfolio increase, this structure will by formula increase the allowance to reflect the increasing risk. Should the portfolio turn more quickly, it would reduce the associated allowance to reflect the reducing risk.

· Real estate loans consist primarily of loans secured by commercial and residential real estate. Also included in this segment are land and construction loans and home equity lines of credit secured by real estate. As the majority of this segment is comprised of commercial real estate loans, risks associated with this segment lay primarily within these loan types. Adverse economic conditions may result in a decline in business activity and increased vacancy rates for commercial properties. These factors, in conjunction with a decline in real estate prices, may expose the Company to the potential for losses if a borrower cannot continue to service

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the loan with operating revenues, and the value of the property has declined to a level such that it no longer fully covers the Company’s recorded investment in the loan.

· Consumer loans consist primarily of a large number of small loans and lines of credit. The majority of installment loans are made for consumer and business purchases. Weakened economic conditions may result in an increased level of delinquencies within this segment, as economic pressures may impact the capacity of such borrowers to repay their obligations.

As a result of the matters mentioned above, changes in the financial condition of individual borrowers, economic conditions, historical loss experience and the condition of the various markets in which collateral may be sold may all affect the required level of the allowance for loan losses and the associated provision for loan losses.

It is the policy of management to maintain the allowance for loan losses at a level adequate for risks inherent in the loan portfolio. On an ongoing basis, we have engaged an outside firm to perform independent credit reviews of our loan portfolio. The Federal Reserve Board and the California Department of Business Oversight—Division of Financial Institutions also review the allowance for loan losses as an integral part of the examination process. Based on information currently available, management believes that the allowance for loan losses is adequate. However, the loan portfolio can be adversely affected if California economic conditions and the real estate market 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.

The following tables summarize the Company’s loan loss experience, as well as provisions and charges to the allowance for loan losses and certain pertinent ratios for the periods indicated:

	Three Months Ended March 31, 2019
	Commercial			Real Estate			Consumer			Total
	(Dollars in thousands)
Beginning of period balance	$	17,061		$	10,671		$	116		$	27,848
Charge-offs		(226)			—			—			(226)
Recoveries		715			42			—			757
Net (charge-offs) recoveries		489			42			—			531
Provision (credit) for loan losses		(1,993)			958			(26)			(1,061)
End of period balance	$	15,557		$	11,671		$	90		$	27,318
RATIOS:
Annualized net charge-offs (recoveries) to average loans (1)		(0.11)	%		(0.01)	%		0.00	%		(0.12)	%
Allowance for loan losses to total loans (1)		0.85	%		0.63	%		0.00	%		1.48	%
Allowance for loan losses to nonperforming loans		89.85	%		67.40	%		0.52	%		157.77	%

	Three Months Ended March 31, 2018
	Commercial			Real Estate			Consumer			Total
	(Dollars in thousands)
Beginning of period balance	$	10,608		$	8,950		$	100		$	19,658
Charge-offs		(245)			—			—			(245)
Recoveries		157			63			—			220
Net recoveries		(88)			63			—			(25)
Provision (credit) for loan losses		645			(155)			16			506
End of period balance	$	11,165		$	8,858		$	116		$	20,139
RATIOS:
Annualized net charge-offs (recoveries) to average loans (1)		0.02	%		(0.01)	%		0.00	%		0.01	%
Allowance for loan losses to total loans (1)		0.70	%		0.56	%		0.01	%		1.27	%
Allowance for loan losses to nonperforming loans		294.20	%		233.41	%		3.06	%		530.67	%

(1)   Average loans and total loans exclude loans held‑for‑sale.

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The following table provides a summary of the allocation of the allowance for loan losses by class at the dates indicated. The allocation presented should not be interpreted as an indication that charges to the allowance for loan losses will be incurred in these amounts or proportions, or that the portion of the allowance allocated to each category represents the total amount available for charge‑offs that may occur within these classes.

Allocation of Allowance for Loan Losses

	March 31,
	2019				2018				December 31, 2018
			Percent				Percent				Percent
			of Loans				of Loans				of Loans
			in each				in each				in each
			category				category				category
			to total				to total				to total
	Allowance		loans		Allowance		loans		Allowance		loans
	(Dollars in thousands)
Commercial	$	15,557	30	%	$	11,165	36	%	$	17,061	32	%
Real estate:
CRE		7,735	55	%		5,778	49	%		6,737	52	%
Land and construction		1,896	5	%		1,573	7	%		2,008	6	%
Home equity		1,723	6	%		1,311	4	%		1,609	6	%
Residential mortgages		317	3	%		196	3	%		317	3	%
Consumer		90	1	%		116	1	%		116	1	%
Total	$	27,318	100	%	$	20,139	100	%	$	27,848	100	%

The allowance for loan losses totaled $27.3 million, or 1.48% of total loans at March 31, 2019, compared to $20.1 million, or 1.27% of total loans at at March 31, 2018, and $27.8 million, or 1.48% of total loans at December 31, 2018. The Company had net recoveries of $531,000, or (0.12%) of average loans, for the first quarter of 2019, compared to net charge-offs of $25,000, or 0.01% of average loans, for the first quarter of 2018, and net recoveries of $280,000, or (0.06%) of average loans, for the fourth quarter of 2018.

The allowance for loan losses related to the commercial portfolio decreased $1.5 million, at March 31, 2019 from December 31, 2018, primarily due to the reduction of a specific loan loss reserve allocated for a single large lending relationship that was placed on nonaccrual during the second quarter of 2018. The allowance for loan losses related to the real estate portfolio increased $1.0 million at March 31, 2019 from December 31, 2018, primarily due to an increase in CRE loans.

Goodwill and Other Intangible Assets

Goodwill represents the excess of the purchase price over the fair value of acquired tangible assets and liabilities and identifiable intangible assets. The fair values of assets acquired and liabilities assumed are subject to adjustment during the first twelve months after the acquisition date if additional information becomes available to indicate a more accurate or appropriate value for an asset or liability. Total goodwill was $83.7 million at both March 31, 2019 and December 31, 2018, which consisted of $13.0 million related to the Bay View Funding acquisition, $32.6 million related to the Focus acquisition, $13.8 million related to the Tri-Valley acquisition, and $24.3 million related to the United American acquisition. 

On April 6, 2018, the Company completed its acquisition of Tri-Valley for a transaction value of $32.3 million. At closing the Company issued 1,889,613 shares of the Company’s common stock with an aggregate market value of $30.7 million on the date of closing.  The number of shares issued was based on a fixed exchange ratio of 0.0489 of a share of the Company’s common stock for each outstanding share of Tri-Valley common stock. In addition, at closing the Company paid cash to the holder of a stock warrant and holders of outstanding stock options and related fees and fractional shares totaling $1.6 million. The Company recorded goodwill of $13.8 million for the Tri-Valley acquisition.

On May 4, 2018, the Company completed its acquisition of United American for a transaction value of $56.4 million.  At closing the Company issued 2,826,032 shares of the Company’s common stock with an aggregate market value of $47.3 million on the date of closing.  The number of shares issued was based on a fixed exchange ratio of 2.1644 of a share of the Company’s common stock for each outstanding share of United American common stock and each common stock equivalent underlying the United American Series D Preferred Stock and Series E Preferred Stock. The

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shareholders of the United American Series A Preferred Stock and the Series B Preferred Stock received $1,000 cash for each share totaling $8.7 million and $435,000, respectively.  In addition, the Company paid $2,000 in cash for fractional shares, for total cash consideration of $9.1 million.  The Company recorded goodwill of $24.3 million for the United American acquisition.

The Company completed its annual goodwill impairment analysis as of November 30, 2018 with the assistance of an independent valuation firm.  No events or circumstances since the November 30, 2018 annual impairment test were noted that would indicate it was more likely than not a goodwill impairment exists.

Other intangible assets were $11.5 million at March 31, 2019, compared to $12.0 million at December 31, 2018.  A customer relationship and brokered relationship, and intangible assets arising from the acquisition of Bay View Funding were $1.1 million at both March 31, 2019 and December 31, 2018, net of accumulated amortization.  The core deposit intangible assets arising from the acquisition of Focus was $3.3 million at March 31, 2019 and $3.5 million at December 31, 2018, net of accumulated amortization.  The core deposit intangible and below market lease intangible assets arising from the Tri-Valley acquisition were $1.7 million at March 31, 2019 and $1.8 million at December 31, 2018, net of accumulated amortization.  The core deposit intangible and below market lease intangible assets arising from the United American acquisition were $5.4 million at March 31, 2019 and $5.6 million at December 31, 2018, net of accumulated amortization.

Deposits

The composition and cost of the Company’s deposit base are important components in analyzing the Company’s net interest margin and balance sheet liquidity characteristics, both of which are discussed in greater detail in other sections herein. The Company’s liquidity is impacted by the volatility of deposits from the propensity of that money to leave the institution for rate‑related or other reasons. Deposits can be adversely affected if economic conditions weaken in California, and the Company’s market area in particular. Potentially, the most volatile deposits in a financial institution are jumbo certificates of deposit, meaning time deposits with balances that equal or exceed $250,000, as customers with balances of that magnitude are typically more rate‑sensitive than customers with smaller balances.

The following table summarizes the distribution of deposits and the percentage of distribution in each category of deposits for the periods indicated:

	March 31, 2019				March 31, 2018				December 31, 2018
	Balance		% to Total		Balance		% to Total		Balance		% to Total
	(Dollars in thousands)
Demand, noninterest-bearing	$	1,016,770	38	%	$	975,846	40	%	$	1,021,582	39	%
Demand, interest-bearing		704,996	27	%		621,402	26	%		702,000	27	%
Savings and money market		759,306	29	%		688,217	28	%		754,277	28	%
Time deposits — under $250		56,385	2	%		49,861	2	%		58,661	2	%
Time deposits — $250 and over		90,042	3	%		71,446	3	%		86,114	3	%
CDARS — interest-bearing demand,
money market and time deposits		12,745	1	%		15,420	1	%		14,898	1	%
Total deposits	$	2,640,244	100	%	$	2,422,192	100	%	$	2,637,532	100	%

The Company obtains deposits from a cross‑section of the communities it serves. The Company’s business is not generally seasonal in nature. There were no public funds at March 31, 2019. Public funds were less than 1% of deposits and March 31, 2018, and December 31, 2018.

Total deposits increased $218.1 million, or 9%, to $2.64 billion at March 31, 2019, compared to $2.42 billion at March 31, 2018, which included $219.1 million of deposits from United American, $74.5 million in deposits from Tri-Valley, partially offset by decrease of $75.5 million, or (3%), in the Company’s legacy deposits.  Total deposits remained relatively flat from $2.64 billion at December 31, 2018. 

Deposits, excluding all time deposits and CDARS deposits, increased $195.6 million, or 9%, to $2.48 billion at March 31, 2019, compared to $2.29 billion at March 31, 2018, which included $199.5 million of deposits added from United American, $68.1 million of deposits added from Tri-Valley, partially offset by a decrease of $72.0 million, or (3%), in the Company’s legacy deposits.  Deposits, excluding all time deposits and CDARS deposits, at March 31, 2019 remained relatively flat compared to $2.48 billion at December 31, 2018.

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Time deposits of $250,000 and over increased $18.6 million, or 26%, to $90.0 million at March 31, 2019, compared to $71.4 million at March 31, 2018, which included $9.1 million of deposits added from United American, and $2.5 million of deposits added from Tri-Valley, and an increase of $7.0 million, or 10%, in the Company’s legacy deposits.  Time deposits of $250,000 and over at March 31, 2019 increased $3.9 million, or 5%, compared to $86.1 million at December 31, 2018.

At March 31, 2019, the $12.7 million CDARS deposits comprised $7.7 million of interest-bearing demand deposits, $2.5 million of money market accounts and $2.5 million of time deposits. At March 31, 2018, the $15.4 million CDARS deposits comprised $9.1 of million of interest-bearing demand deposits, $2.1 million of money market accounts and $4.2 million of time deposits. At December 31, 2018, the $14.9 million CDARS deposits comprised $8.7 million of interest-bearing demand deposits, $3.4 million of money market accounts and $2.8 million of time deposits.

The following table indicates the contractual maturity schedule of the Company’s time deposits of $250,000 and over, and all CDARS time deposits as of March 31, 2019:

	Balance		% of Total
	(Dollars in thousands)
Three months or less	$	38,526	42	%
Over three months through six months		19,760	21	%
Over six months through twelve months		27,101	29	%
Over twelve months		7,197	8	%
Total	$	92,584	100	%

The Company focuses primarily on providing and servicing business deposit accounts that are frequently over $250,000 in average balance per account. As a result, certain types of business clients that the Company serves typically carry average deposits in excess of $250,000. The account activity for some account types and client types necessitates appropriate liquidity management practices by the Company to help ensure its ability to fund deposit withdrawals.

Return on Equity and Assets

The following table indicates the ratios for return on average assets and average equity, and average equity to average assets for the periods indicated:

	Three Months Ended
	March 31,
	2019		2018
Return on average assets	1.58	%	1.29	%
Return on average tangible assets	1.63	%	1.31	%
Return on average equity	13.28	%	13.22	%
Return on average tangible equity	17.90	%	16.30	%
Average equity to average assets ratio	11.92	%	9.77	%

Off‑Balance Sheet Arrangements

In the normal course of business the Company makes commitments to extend credit to its customers as long as there are no violations of any conditions established in the contractual arrangements. These commitments are obligations that represent a potential credit risk to the Company, but are not reflected on the Company’s consolidated balance sheets. Total unused commitments to extend credit were $729.1 million at March 31, 2019, compared to $697.9 million at March 31, 2018, and $740.4 million at December 31, 2018. Unused commitments represented 39% outstanding gross loans at March 31, 2019, 44% at March 31, 2018, and 39% at December 31, 2018.

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The effect on the Company’s revenues, expenses, cash flows and liquidity from the unused portion of the commitments to provide credit cannot be reasonably predicted because there is no certainty that lines of credit and letters of credit will ever be fully utilized. The following table presents the Company’s commitments to extend credit for the periods indicated:

		March 31,
	2019				2018				December 31, 2018
	Fixed Rate		Variable Rate		Fixed Rate		Variable Rate		Fixed Rate		Variable Rate
	(Dollars in thousands)
Unused lines of credit and commitments
to make loans	$	154,548	$	557,581	$	108,101	$	576,005	$	130,871	$	593,839
Standby letters of credit		2,882		14,066		3,972		9,823		2,770		12,899
	$	157,430	$	571,647	$	112,073	$	585,828	$	133,641	$	606,738

Liquidity and Asset/Liability Management

Liquidity refers to the Company’s ability to maintain cash flows sufficient to fund operations and to meet obligations and other commitments in a timely and cost effective fashion. At various times the Company requires funds to meet short‑term cash requirements brought about by loan growth or deposit outflows, the purchase of assets, or liability repayments. An integral part of the Company’s ability to manage its liquidity position appropriately is the Company’s large base of core deposits, which are generated by offering traditional banking services in its service area and which have historically been a stable source of funds. To manage liquidity needs cash inflows must be properly timed to coincide with anticipated outflows or sufficient liquidity resources must be available to meet varying demands. The Company manages liquidity to be able to meet unexpected sudden changes in levels of its assets or deposit liabilities without maintaining excessive amounts of balance sheet liquidity. Excess balance sheet liquidity can negatively impact the Company’s interest margin. In order to meet short‑term liquidity needs the Company utilizes overnight Federal funds purchase arrangements and other borrowing arrangements with correspondent banks, solicits brokered deposits if cost effective deposits are not available from local sources, and maintains collateralized lines of credit with the FHLB and FRB. In addition, the Company can raise cash for temporary needs by selling securities under agreements to repurchase and selling securities available‑for‑sale.

One of the measures of liquidity is our loan to deposit ratio. Our loan to deposit ratio was 70.01% at March 31, 2019, compared to 65.69% at March 31, 2018, and 71.52% at December 31, 2018.

FHLB and FRB Borrowings and Available Lines of Credit

HBC has off‑balance sheet liquidity in the form of Federal funds purchase arrangements with correspondent banks, including the FHLB and FRB. HBC can borrow from the FHLB on a short‑term (typically overnight) or long‑term (over one year) basis. HBC had no overnight borrowings from the FHLB at March 31, 2019, March 31, 2018, and December 31, 2018. HBC had $220.4 million of loans pledged to the FHLB as collateral on an available line of credit of $174.7 million at March 31, 2019, none of which was outstanding.

HBC can also borrow from the FRB’s discount window. HBC had $740.6 million of loans pledged to the FRB as collateral on an available line of credit of $429.3 million at March 31, 2019, none of which was outstanding.

At March 31, 2019, HBC had Federal funds purchase arrangements available of $55.0 million. There were no Federal funds purchased outstanding at March 31, 2019, March 31, 2018, and December 31, 2018.

The Company has a $5.0 million line of credit with a correspondent bank, of which none was outstanding at March 31, 2019.

HBC may also utilize securities sold under repurchase agreements to manage our liquidity position. There were no securities sold under agreements to repurchase at March 31, 2019, March 31, 2018, and December 31, 2018.

Subordinated Debt

On May 26, 2017, the Company completed an underwritten public offering of $40,000,000 aggregate principal amount of its fixed-to-floating rate subordinated notes (“Subordinated Debt”) due June 1, 2027. The Subordinated Debt initially bears a fixed interest rate of 5.25% per year. Commencing on June 1, 2022, the interest rate on the Subordinated

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Debt resets quarterly to the three-month LIBOR rate plus a spread of 336.5 basis points, payable quarterly in arrears.  Interest on the Subordinated Debt is payable semi-annually on June 1st and December 1st of each year through June 1, 2022 and quarterly thereafter on March 1st, June 1st, September 1st and December 1st of each year through the maturity date or early redemption date.  The Company at its option may redeem the Subordinated Debt, in whole or in part, on any interest payment date on or after June 1, 2022 without a premium. 

Capital Resources

The Company uses a variety of measures to evaluate capital adequacy. Management reviews various capital measurements on a regular basis and takes appropriate action to ensure that such measurements are within established internal and external guidelines. The external guidelines, which are issued by the Federal Reserve and the FDIC, establish a risk‑adjusted ratio relating capital to different categories of assets and off‑balance sheet exposures.

The following table summarizes risk‑based capital, risk‑weighted assets, and risk‑based capital ratios of the consolidated Company under the Basel III requirements for the periods indicated:

	March 31,				March 31,			December 31,
	2019				2018			2018
	(Dollars in thousands)
Capital components:
Common equity Tier 1 capital	$	285,417		$	232,905		$	276,675
Additional Tier 1 capital		—			—			—
Tier 1 Capital		285,417			232,905			276,675
Tier 2 Capital		67,413			60,001			67,922
Total risk-based capital	$	352,830		$	292,906		$	344,597
Risk-weighted assets	$	2,266,583		$	1,999,026		$	2,303,941
Average assets for capital purposes	$	3,014,407		$	2,721,601		$	3,118,150
Capital ratios:
Total risk-based capital		15.6	%		14.7	%		15.0	%
Tier 1 risk-based capital		12.6	%		11.7	%		12.0	%
Common equity Tier 1 risk-based capital		12.6	%		11.7	%		12.0	%
Leverage(1)		9.5	%		8.6	%		8.9	%

The following table summarizes risk based capital, risk-weighted assets, and risk-based capital ratios of HBC under the Basel III requirements for the periods indicated:

	March 31,			March 31,			December 31,
	2019			2018			2018
	(Dollars in thousands)
Capital components:
Common equity Tier 1 capital	$	302,917		$	248,872		$	293,730
Additional Tier 1 capital		—			—			—
Tier 1 Capital		302,917			248,872			293,730
Tier 2 Capital		27,998			20,772			28,553
Total risk-based capital	$	330,915		$	269,644		$	322,283
Risk-weighted assets	$	2,265,298		$	1,997,776		$	2,302,751
Average assets for capital purposes	$	3,013,118		$	2,720,382		$	3,116,645
Capital ratios:
Total risk-based capital		14.6	%		13.5	%		14.0	%
Tier 1 risk-based capital		13.4	%		12.5	%		12.8	%
Common equity Tier 1 risk-based capital		13.4	%		12.5	%		12.8	%
Leverage(1)		10.1	%		9.1	%		9.4	%

(1) Tier 1 capital divided by quarterly average assets (excluding intangible assets and disallowed deferred tax assets).

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The following table presents the applicable well‑capitalized regulatory guidelines and the standards for minimum capital adequacy requirements under Basel III and the regulatory guidelines for a “well–capitalized” financial institution under Prompt Corrective Action (“PCA”):

			Well-capitalized
			Financial
	Minimum		Institution PCA
	Regulatory		Regulatory
	Requirement(1)		Guidelines
Capital ratios:
Total risk-based capital	10.5	%	10.0	%
Tier 1 risk-based capital	8.5	%	8.0	%
Common equity Tier 1 risk-based capital	7.0	%	6.5	%
Leverage	4.0	%	5.0	%

(1) Includes 2.5% capital conservation buffer, except the leverage capital ratio.

The Basel III capital rules introduce a new “capital conservation buffer,” for banking organizations to maintain a common equity Tier 1 ratio more than 2.5% above these minimum risk‑weighted asset ratios. The capital conservation buffer is designed to absorb losses during periods of economic stress. Banking institutions with a ratio of common equity Tier 1 to risk‑weighted assets above the minimum but below the capital conservation buffer will face constraints on dividends, equity repurchases and compensation based on the amount of the shortfall.

At March 31, 2019, the Company’s consolidated capital ratio exceeded regulatory guidelines and HBC’s capital ratios exceed the highest regulatory capital requirement of “well‑capitalized” under Basel III prompt corrective action provisions. Quantitative measures established by regulation to help ensure capital adequacy require the Company and HBC to maintain minimum amounts and ratios of total risk‑based capital, Tier 1 capital, and common equity Tier 1 (as defined in the regulations) to risk‑weighted assets (as defined), and of Tier 1 capital to average assets (as defined). Management believes that, as of March 31, 2019, March 31, 2018, and December 31, 2018, the Company and HBC met all capital adequacy guidelines to which they were subject. There are no conditions or events since March 31, 2019, that management believes have changed the categorization of the Company or HBC as well‑capitalized.

At March 31, 2019, the Company had total shareholders’ equity of $378.5 million, compared to $271.0 million at March 31, 2019, and $367.5 million at December 31, 2018. At March 31, 2019, total shareholders’ equity included $301.5 million in common stock, $86.0 million in retained earnings, and ($9.0) million of accumulated other comprehensive loss. The book value per share was $8.74 at March 31, 2019, compared to $7.08 at March 31, 2018, and $8.49 at December 31, 2018. The tangible book value per share was $6.54 at March 31, 2019, compared to $5.75 at March 31, 2018, and $6.28 at December 31, 2018.

The following table reflects the components of accumulated other comprehensive loss, net of taxes, for the periods indicated:

ACCUMULATED OTHER COMPREHENSIVE LOSS	March 31,		December 31,		March 31,
(in $000's, unaudited)	2019		2018		2018
Unrealized loss on securities available-for-sale	$	(2,010)	$	(5,412)	$	(6,764)
Remaining unamortized unrealized gain on securities
available-for-sale transferred to held-to-maturity		325		343		365
Split dollar insurance contracts liability		(3,746)		(3,722)		(3,707)
Supplemental executive retirement plan liability		(3,963)		(3,995)		(5,521)
Unrealized gain on interest-only strip from SBA loans		407		405		671
Total accumulated other comprehensive loss	$	(8,987)	$	(12,381)	$	(14,956)

Market Risk

Market risk is the risk of loss of future earnings, fair values, or future cash flows that may result from changes in the price of a financial instrument. The value of a financial instrument may change as a result of changes in interest rates, foreign currency exchange rates, commodity prices, equity prices and other market changes that affect market risk

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sensitive instruments. Market risk is attributed to all market risk sensitive financial instruments, including securities, loans, deposits and borrowings, as well as the Company’s role as a financial intermediary in customer‑related transactions. The objective of market risk management is to avoid excessive exposure of the Company’s earnings and equity to loss and to reduce the volatility inherent in certain financial instruments.

Interest Rate Management

Market risk arises from changes in interest rates, exchange rates, commodity prices and equity prices. The Company’s market risk exposure is primarily that of interest rate risk, and it has established policies and procedures to monitor and limit earnings and balance sheet exposure to changes in interest rates. The Company does not engage in the trading of financial instruments, nor does the Company have exposure to currency exchange rates.

The principal objective of interest rate risk management (often referred to as “asset/liability management”) is to manage the financial components of the Company in a manner that will optimize the risk/reward equation for earnings and capital in relation to changing interest rates. The Company’s exposure to market risk is reviewed on a regular basis by the Managemnent’s Asset/Liability Committee and the Director’s Finance and Investment Committee. Interest rate risk is the potential of economic losses due to future interest rate changes. These economic losses can be reflected as a loss of future net interest income and/or a loss of current fair market values. The objective is to measure the effect on net interest income and to adjust the balance sheet to minimize the inherent risk while at the same time maximizing income. Management realizes certain risks are inherent, and that the goal is to identify and manage the risks. Management uses two methodologies to manage interest rate risk: (i) a standard GAP analysis; and (ii) an interest rate shock simulation model.

The planning of asset and liability maturities is an integral part of the management of an institution’s net interest margin. To the extent maturities of assets and liabilities do not match in a changing interest rate environment, the net interest margin may change over time. Even with perfectly matched repricing of assets and liabilities, risks remain in the form of prepayment of loans or securities 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.

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.

The Company uses modeling software for asset/liability management in order to simulate the effects of potential interest rate changes on the Company’s net interest margin, and to calculate the estimated fair values of the Company’s financial instruments under different interest rate scenarios. The program imports current balances, interest rates, maturity dates and repricing information for individual financial instruments, and incorporates assumptions on the characteristics of embedded options along with pricing and duration for new volumes to project the effects of a given interest rate change on the Company’s interest income and interest expense. Rate scenarios consisting of key rate and yield curve projections are run against the Company’s investment, loan, deposit and borrowed funds’ portfolios. These rate projections can be shocked (an immediate and parallel change in all base rates, up or down) and ramped (an incremental increase or decrease in rates over a specified time period), based on current trends and econometric models or stable economic conditions (unchanged from current actual levels).

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The following table sets forth the estimated changes in the Company’s annual net interest income that would result from the designated instantaneous parallel shift in interest rates noted, as of March 31, 2019. Computations of prospective effects of hypothetical interest rate changes are based on numerous assumptions including relative levels of market interest rates, loan prepayments and deposit decay, and should not be relied upon as indicative of actual results.

	Increase/(Decrease) in
	Estimated Net
	Interest Income
	Amount		Percent
	(Dollars in thousands)
Change in Interest Rates (basis points)
+400	$	23,201	18.5	%
+300	$	17,500	13.9	%
+200	$	11,859	9.4	%
+100	$	6,139	4.9	%
0	$	—	—	%
−100	$	(9,313)	(7.4)	%
−200	$	(20,946)	(16.7)	%

This data does not reflect any actions that we may undertake in response to changes in interest rates such as changes in rates paid on certain deposit accounts based on local competitive factors, which could reduce the actual impact on net interest income.

As with any method of gauging interest rate risk, there are certain shortcomings inherent to the methodology noted above. The model assumes interest rate changes are instantaneous parallel shifts in the yield curve. In reality, rate changes are rarely instantaneous. The use of the simplifying assumption that short‑term and long‑term rates change by the same degree may also misstate historic rate patterns, which rarely show parallel yield curve shifts. Further, the model assumes that certain assets and liabilities of similar maturity or period to repricing will react in the same way to changes in rates. In reality, certain types of financial instruments may react in advance of changes in market rates, while the reaction of other types of financial instruments may lag behind the change in general market rates. Additionally, the methodology noted above does not reflect the full impact of annual and lifetime restrictions on changes in rates for certain assets, such as adjustable rate loans. When interest rates change, actual loan prepayments and actual early withdrawals from certificates may deviate significantly from the assumptions used in the model. Finally, this methodology does not measure or reflect the impact that higher rates may have on adjustable‑rate loan clients’ ability to service their debt. All of these factors are considered in monitoring the Company’s exposure to interest rate risk.

ITEM 3—QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The information concerning quantitative and qualitative disclosure or market risk called for by Item 305 of Regulation S‑K is included as part of Item 2 above.

ITEM 4—CONTROLS AND PROCEDURES

Disclosure Control and Procedures

The Company has 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 March 31, 2019. 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 reasonably assure that information required to be disclosed in our reports filed or submitted under the Exchange Act are recorded, processed, summarized and reported on a timely basis. Disclosure controls are also designed to reasonably assure that such information is accumulated and communicated to our management, including the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. Based upon their evaluation, our Chief Executive Officer and Chief Financial Officer concluded the Company’s disclosure controls were effective at March 31, 2019, the period covered by this report on Form 10‑Q.

During the three months ended March 31, 2019, there were no changes in our internal controls over financial reporting that materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.

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Part II—OTHER INFORMATION

ITEM 1—LEGAL PROCEEDINGS

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 1A—RISK FACTORS

In addition to the other information set forth in this Report, you should carefully consider the other factors discussed in Part I, “Item 1A. Risk Factors” in our Annual Report on Form 10‑K for the year ended December 31, 2018, which could materially affect our business, financial condition and/or operating results. There were no material changes from risk factors previously disclosed in our 2018 Annual Report on Form 10‑K. The risk factors identified are in addition to those contained in any other cautionary statements, written or oral, which may be or otherwise addressed in connection with a forward‑looking statement or contained in any of our subsequent filings with the Securities and Exchange Commission.

ITEM 2—UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

None

ITEM 3—DEFAULTS UPON SENIOR SECURITIES

None

ITEM 4—MINE SAFETY DISCLOSURES

None

ITEM 5—OTHER INFORMATION

None

ITEM 6—EXHIBITS

Exhibit	Description
3.1	Heritage Commerce Corp Restated Articles of Incorporation, (incorporated by reference to Exhibit 3.1 to the Registrant’s Annual Report on Form 10‑K filed on March 16, 2009)
3.2	Certificate of Amendment of Articles of Incorporation of Heritage Commerce Corp as filed with the California Secretary of State on June 1, 2010 (incorporated by reference to Exhibit 3.2 to the Registrant’s Registration Statement on Form S‑1 filed July 23, 2010).
3.3	Heritage Commerce Corp Bylaws, as amended (incorporated by reference to the Registrant’s Current Report on Form 8‑K filed on June 28, 2013)
31.1	Certification of Registrant’s Chief Executive Officer Pursuant To Section 302 of the Sarbanes‑Oxley Act of 2002
31.2	Certification of Registrant’s Chief Financial Officer Pursuant To Section 302 of the Sarbanes‑Oxley Act of 2002
32.1	Certification of Registrant’s Chief Executive Officer Pursuant To 18 U.S.C. Section 1350
32.2	Certification of Registrant’s Chief Financial Officer Pursuant To 18 U.S.C. Section 1350
101.INS	XBRL Instance Document, filed herewith
101.SCH	XBRL Taxonomy Extension Schema Document, filed herewith
101.CAL	XBRL Taxonomy Extension Calculation Linkbase Document, filed herewith
101.DEF	XBRL Taxonomy Extension Definition Linkbase Document, filed herewith
101.LAB	XBRL Taxonomy Extension Label Linkbase Document, filed herewith
101.PRE	XBRL Taxonomy Extension Presentation Linkbase Document, filed herewith

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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)
Date: May 9, 2019	/s/ WALTER T. KACZMAREK
	Waletr T. Kaczmarek
	Chief Executive Officer
Date: May 9, 2019	/s/ Lawrence D. McGovern
	Lawrence D. McGovern
	Chief Financial Officer

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