Heritage Commerce 10Q 2021 Q2 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 June 30, 2021
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.)
224 Airport Parkway, San Jose, California (Address of Principal Executive Offices)	95110 (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 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 60,206,566 shares of Common Stock outstanding on July 30, 2021

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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)	6

	Consolidated Balance Sheets	6

	Consolidated Statements of Income	7

	Consolidated Statements of Comprehensive Income	8

	Consolidated Statements of Changes in Shareholders’ Equity	9

	Consolidated Statements of Cash Flows	10

	Notes to Unaudited Consolidated Financial Statements	11

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	45

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	78

Item 4.	Controls and Procedures	79

PART II. OTHER INFORMATION

Item 1.	Legal Proceedings	79

Item 1A.	Risk Factors	79

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	79

Item 3.	Defaults Upon Senior Securities	79

Item 4.	Mine Safety Disclosures	79

Item 5.	Other Information	79

Item 6.	Exhibits	80

SIGNATURES		81

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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. Risks and uncertainties that could cause our financial performance to differ materially from our goals, plans, expectations and projections expressed in forward-looking statements include those set forth in our filings with the Securities and Exchange Commission (“SEC”), Item 1A of the Heritage Commerce Corp’s (“the Company”) Annual Report on Form 10-K for the year ended December 31, 2020, and including, but not limited to the following:

●

the effect of the COVID-19 pandemic, and other infectious illness outbreaks that may arise in the future, on our customers, employees, businesses, liquidity, financial results and overall condition and which has created significant uncertainties in U.S. and global markets, including our customers' ability to make timely payments on obligations, and operating expense due to alternative approaches to doing business;

●

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, including related asset and market prices;

●

credit related 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 our allowance for credit losses and our provision for credit losses;

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●

increased capital requirements for our continual 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 or at all;

●

regulatory limits on Heritage Bank of Commerce’s ability to pay dividends to the Company;

●

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

●

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, results of operations and growth prospects;

●

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 (“SBA”) 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 regulatory or other governmental inquiries, and the results of regulatory examinations or reviews;

●

the expense and uncertain resolution of litigation matters whether occurring in the ordinary course of business or otherwise;

●

availability of and competition for acquisition opportunities;

●

risks resulting from domestic terrorism;

●

risks resulting from social unrest and protests;

●

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

●

our participation as a lender in the SBA Paycheck Protection Program (“PPP”) and similar programs and its effect on our liquidity, financial results, businesses and customers, including the availability of program funds and the ability of customers to comply with requirements and otherwise perform with respect to loans obtained under such programs;

●

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

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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

HERITAGE COMMERCE CORP

CONSOLIDATED BALANCE SHEETS

(Unaudited)


	June 30,		December 31,
	2021		2020

	(Dollars in thousands)
Assets
Cash and due from banks	$	41,904	$	30,598
Other investments and interest-bearing deposits in other financial institutions		1,286,418		1,100,475
Total cash and cash equivalents		1,328,322		1,131,073
Securities available-for-sale, at fair value		145,955		235,774
Securities held-to-maturity, at amortized cost, net of allowance for credit losses of $51 at June 30, 2021
and $54 at December 31, 2020 (fair value of $426,755 at June 30, 2021 and $304,927 at December 31, 2020)		421,286		297,389
Loans held-for-sale - SBA, at lower of cost or fair value, including deferred costs		4,344		1,699
Loans, net of deferred fees		2,824,796		2,619,261
Allowance for credit losses on loans		(43,956)		(44,400)
Loans, net		2,780,840		2,574,861
Federal Home Loan Bank, Federal Reserve Bank stock and other investments, at cost		32,495		33,522
Company-owned life insurance		77,393		77,523
Premises and equipment, net		10,040		10,459
Goodwill		167,631		167,631
Other intangible assets		15,177		16,664
Accrued interest receivable and other assets		89,392		87,519
Total assets	$	5,072,875	$	4,634,114

Liabilities and Shareholders' Equity
Liabilities:
Deposits:
Demand, noninterest-bearing	$	1,840,516	$	1,661,655
Demand, interest-bearing		1,140,867		960,179
Savings and money market		1,174,587		1,119,968
Time deposits - under $250		42,118		45,027
Time deposits - $250 and over		110,111		103,746
CDARS - interest-bearing demand, money market and time deposits		36,273		23,911
Total deposits		4,344,472		3,914,486
Subordinated debt, net of issuance costs		39,832		39,740
Accrued interest payable and other liabilities		105,127		101,999
Total liabilities		4,489,431		4,056,225

Shareholders' equity:
Preferred stock, 0 par value; 10,000,000 shares authorized; NaN issued and outstanding
at June 30, 2021 and December 31, 2020		—		—
Common stock, 0 par value; 100,000,000 shares authorized;
60,202,766 shares issued and outstanding at June 30, 2021 and
59,917,457 shares issued and outstanding at December 31, 2020		495,665		493,707
Retained earnings		99,311		94,899
Accumulated other comprehensive loss		(11,532)		(10,717)
Total shareholders' equity		583,444		577,889
Total liabilities and shareholders' equity	$	5,072,875	$	4,634,114

See notes to consolidated financial statements (unaudited).

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HERITAGE COMMERCE CORP

CONSOLIDATED STATEMENTS OF INCOME

(Unaudited)


	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2021		2020		2021		2020

	(Dollars in thousands, except per share amounts)
Interest income:
Loans, including fees	$	33,439	$	32,845	$	67,275	$	67,627
Securities, taxable		1,944		3,155		3,672		7,103
Securities, exempt from Federal tax		404		484		833		995
Other investments, interest-bearing deposits
in other financial institutions and Federal funds sold		845		648		1,613		2,349
Total interest income		36,632		37,132		73,393		78,074

Interest expense:
Deposits		1,179		1,615		2,411		3,400
Subordinated debt		577		577		1,148		1,154
Total interest expense		1,756		2,192		3,559		4,554

Net interest income before provision for credit losses on loans		34,876		34,940		69,834		73,520
Provision for (recapture of) credit losses on loans		(493)		1,114		(2,005)		14,384
Net interest income after provision for credit losses on loans		35,369		33,826		71,839		59,136

Noninterest income:
Service charges and fees on deposit accounts		659		650		1,260		1,619
Increase in cash surrender value of life insurance		458		458		914		916
Gain on proceeds from company owned life insurance		396		—		462		—
Servicing income		104		205		286		388
Gain on sales of SBA loans		83		—		633		67
Gain on sales of securities		—		170		—		270
Gain on the disposition of foreclosed assets		—		—		—		791
Other		469		595		915		1,220
Total noninterest income		2,169		2,078		4,470		5,271

Noninterest expense:
Salaries and employee benefits		12,572		12,300		26,530		26,503
Occupancy and equipment		2,247		1,766		4,521		3,538
Professional fees		1,771		1,155		3,490		2,590
Other		9,185		5,791		14,478		14,155
Total noninterest expense		25,775		21,012		49,019		46,786
Income before income taxes		11,763		14,892		27,290		17,621
Income tax expense		2,950		4,274		7,273		5,142
Net income	$	8,813	$	10,618	$	20,017	$	12,479

Earnings per common share:
Basic	$	0.15	$	0.18	$	0.33	$	0.21
Diluted	$	0.15	$	0.18	$	0.33	$	0.21

See notes to consolidated financial statements (unaudited).

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HERITAGE COMMERCE CORP

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited)


	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2021		2020		2021		2020

		(Dollars in thousands)
Net income	$	8,813	$	10,618	$	20,017	$	12,479
Other comprehensive income (loss):
Change in net unrealized holding (losses) gains on available-for-sale
securities and I/O strips		(640)		(556)		(1,489)		6,621
Deferred income taxes		186		161		433		(1,920)
Change in net unamortized unrealized gain on securities available-for-
sale that were reclassified to securities held-to-maturity		(13)		(13)		(26)		(26)
Deferred income taxes		4		4		8		8
Reclassification adjustment for gains realized in income		—		(170)		—		(270)
Deferred income taxes		—		50		—		79
Change in unrealized (losses) gains on securities and I/O strips, net of
deferred income taxes		(463)		(524)		(1,074)		4,492

Change in net pension and other benefit plan liability adjustment		283		75		372		150
Deferred income taxes		(84)		(22)		(113)		(44)
Change in pension and other benefit plan liability, net of
deferred income taxes		199		53		259		106
Other comprehensive (loss) income		(264)		(471)		(815)		4,598

Total comprehensive income	$	8,549	$	10,147	$	19,202	$	17,077

See notes to consolidated financial statements (unaudited).

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HERITAGE COMMERCE CORP

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

(Unaudited)


						Accumulated
						Other		Total
	Common Stock			Retained		Comprehensive		Shareholders’
	Shares	Amount		Earnings		Loss		Equity

	(Dollars in thousands, except per share amounts)
Balance, December 31, 2019	59,368,156	$	489,745	$	96,741	$	(9,778)	$	576,708
Cumulative effect of change in accounting principles	—		—		(6,062)		—		(6,062)
Balance, January 1, 2020	59,368,156		489,745		90,679		(9,778)		570,646
Net income	—		—		1,861		—		1,861
Other comprehensive income	—		—		—		5,069		5,069
Amortization of restricted stock awards,
net of forfeitures and taxes	—		348		—		—		348
Cash dividend declared $0.13 per share	—		—		(7,737)		—		(7,737)
Stock option expense, net of forfeitures and taxes	—		148		—		—		148
Stock options exercised	200,063		1,106		—		—		1,106
Balance, March 31, 2020	59,568,219		491,347		84,803		(4,709)		571,441

Net income	—		—		10,618		—		10,618
Other comprehensive income	—		—		—		(471)		(471)
Issuance of restricted stock awards, net	168,117		—		—		—		—
Amortization of restricted stock awards,
net of forfeitures and taxes	—		463		—		—		463
Cash dividend declared $0.13 per share	—		—		(7,767)		—		(7,767)
Stock option expense, net of forfeitures and taxes	—		139		—		—		139
Stock options exercised	120,431		384		—		—		384
Balance, June 30, 2020	59,856,767	$	492,333	$	87,654	$	(5,180)	$	574,807

Balance, January 1, 2021	59,917,457	$	493,707	$	94,899	$	(10,717)	$	577,889
Net income	—		—		11,204		—		11,204
Other comprehensive loss	—		—		—		(551)		(551)
Issuance (forfeitures) of restricted stock awards, net	(34,358)		—		—		—		—
Amortization of restricted stock awards,
net of forfeitures and taxes	—		458		—		—		458
Cash dividend declared $0.13 per share	—		—		(7,789)		—		(7,789)
Stock option expense, net of forfeitures and taxes	—		132		—		—		132
Stock options exercised	49,235		320		—		—		320
Balance, March 31, 2021	59,932,334		494,617		98,314		(11,268)		581,663

Net income	—		—		8,813		—		8,813
Other comprehensive loss	—		—		—		(264)		(264)
Issuance of restricted stock awards, net	187,325		—		—		—		—
Amortization of restricted stock awards,
net of forfeitures and taxes	—		438		—		—		438
Cash dividend declared $0.13 per share	—		—		(7,816)		—		(7,816)
Stock option expense, net of forfeitures and taxes	—		146		—		—		146
Stock options exercised	83,107		464		—		—		464
Balance, June 30, 2021	60,202,766	$	495,665	$	99,311	$	(11,532)	$	583,444

See notes to consolidated financial statements (unaudited).

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HERITAGE COMMERCE CORP

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)


	Six Months Ended
	June 30,
	2021		2020

	(Dollars in thousands)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	20,017	$	12,479
Adjustments to reconcile net income to net cash provided by operating activities:
Amortization of discounts and premiums on securities		1,969		1,453
Gain on sale of securities available-for-sale		—		(270)
Gain on sale of SBA loans		(633)		(67)
Proceeds from sale of SBA loans originated for sale		6,676		916
SBA loans originated for sale		(8,688)		(4,121)
Provision for (recapture of) credit losses on loans		(2,005)		14,384
Increase in cash surrender value of life insurance		(914)		(916)
Depreciation and amortization		508		475
Amortization of other intangible assets		1,487		1,822
Stock option expense, net		278		287
Amortization of restricted stock awards, net		896		811
Amortization of subordinated debt issuance costs		92		92
Gain on proceeds from company-owned life insurance		(462)		—
Effect of changes in:
Accrued interest receivable and other assets		(1,574)		(23,437)
Accrued interest payable and other liabilities		3,472		21,963
Net cash provided by operating activities		21,119		25,871

CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of securities held-to-maturity		(181,805)		—
Maturities/paydowns/calls of securities available-for-sale		87,503		30,810
Maturities/paydowns/calls of securities held-to-maturity		56,797		42,408
Proceeds from sales of securities available-for-sale		—		56,598
Purchase of mortgage loans		(140,030)		—
Net change in loans		(63,944)		(152,881)
Changes in Federal Home Loan Bank stock and other investments		1,027		(3,667)
Proceeds from redemption of company-owned life insurance		1,506		—
Purchase of premises and equipment		(89)		(1,725)
Net cash (used in) investing activities		(239,035)		(28,457)

CASH FLOWS FROM FINANCING ACTIVITIES:
Net change in deposits		429,986		485,458
Net change in short-term borrowings		—		(328)
Exercise of stock options		784		1,490
Payment of cash dividends		(15,605)		(15,504)
Net cash provided by financing activities		415,165		471,116
Net increase in cash and cash equivalents		197,249		468,530
Cash and cash equivalents, beginning of period		1,131,073		457,370
Cash and cash equivalents, end of period	$	1,328,322	$	925,900

Supplemental disclosures of cash flow information:
Interest paid	$	3,464	$	4,584
Income taxes paid (refunds), net		9,192		(524)

See notes to consolidated financial statements (unaudited).

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HERITAGE COMMERCE CORP

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2021

(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 (the “Bank” or “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, 2020.

HBC is a commercial bank serving customers primarily located in Alameda, Contra Costa, Marin, San Benito, San Francisco, San Mateo, and Santa Clara 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. NaN customer accounts for more than 10% of revenue for HBC or the Company. The Company reports its results for 2 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. Material estimates that are particularly susceptible to significant change include the determination of the allowance for credit losses and any impairment of goodwill or intangible assets. It is reasonably possible the Company’s estimate of the allowance for credit losses and evaluation of impairment of goodwill or intangible assets could change as a result of the continued impact of the COVID-19 pandemic on the economy. The resulting change in these estimates could be material to the Company’s consolidated financial statements.

The results for the three and six months ended June 30, 2021 are not necessarily indicative of the results expected for any subsequent period or for the entire year ending December 31, 2021.

COVID-19

Capital and Liquidity

While the Company believes that it has sufficient capital to withstand an extended economic recession brought about by COVID-19, its reported and regulatory capital ratios could be adversely impacted by credit losses. The Company relies on cash on hand as well as dividends from its subsidiary bank to service its debt. If the Company’s capital deteriorates such that its subsidiary bank is unable to pay dividends to it for an extended period of time, the Company may not be able to service its debt.

The Company maintains access to multiple sources of liquidity. Wholesale funding markets have remained open to us. If funding costs are elevated for an extended period of time, it could have an adverse effect on the Company’s net interest margin. If an extended recession caused large numbers of the Company’s deposit customers to withdraw their funds, the Company might become more reliant on volatile or more expensive sources of funding.

Asset Valuation

The extent to which the COVID-19 pandemic will impact our business, results of operations and financial condition will depend on future developments, which are highly uncertain and difficult to predict. Those developments and factors include the duration and spread of the pandemic, its severity, the actions to contain the pandemic or address its

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impact, and how quickly and to what extent normal economic and operating conditions can resume. We do not yet know the full extent of the impact. However, the effects could have a material adverse impact on our business, asset valuations, financial condition and results of operations. Material adverse impacts may include all or a combination of valuation impairments on our intangible assets, investments, loans, or deferred tax assets.

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 December 2019, the FASB issued Accounting Standards Update No. 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes to simplify various aspects of the current guidance to promote consistent application of the standard among reporting entities by moving certain exceptions to the general principles. The amendments are effective as of January 1, 2021 and had no material impact on the consolidated financial statements.

Accounting Guidance Issued But Not Yet Adopted

In March 2020, the FASB issued ASU 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting, which provides temporary, optional guidance to ease the potential burden in accounting for, or recognizing the effects of, the transition away from the LIBOR or other interbank offered rate on financial reporting. To help with the transition to new reference rates, the ASU provides optional expedients and exceptions for applying GAAP to affected contract modifications and hedge accounting relationships. The main provisions include:

●

A change in a contract’s reference interest rate would be accounted for as a continuation of that contract rather than as the creation of a new one for contracts, including loans, debt, leases, and other arrangements, that meet specific criteria.

●

When updating its hedging strategies in response to reference rate reform, an entity would be allowed to preserve its hedge accounting.

The guidance is applicable only to contracts or hedge accounting relationships that reference LIBOR or another reference rate expected to be discontinued. Because the guidance is meant to help entities through the transition period, it will be in effect for a limited time and will not apply to contract modifications made and hedging relationships entered into or evaluated after December 31, 2022, except for hedging relationships existing as of December 31, 2022, for which an entity has elected certain optional expedients that are retained through the end of the hedging relationship. The amendments in this ASU are effective March 12, 2020 through December 31, 2022.

ASU 2020-04 permits relief solely for reference rate reform actions and permits different elections over the effective date for legacy and new activity. Accordingly, the Company is evaluating and reassessing the elections on a quarterly basis. For current elections in effect regarding the assertion of the probability of forecasted transactions, the Company elects the expedient to assert the probability of the hedged interest payments and receipts regardless of any expected modification in terms related to reference rate reform.

The Company believes the adoption of this guidance on activities subsequent to December 31, 2020 through December 31, 2022 will not have a material impact on the consolidated financial statements.

London Inter-Bank Offered Rate (“LIBOR”) Transition and Phase-Out

We have loans and borrowings that are tied to LIBOR benchmark interest rates. It is anticipated that the LIBOR index will be phased-out by the end of 2021 and the Federal Reserve Bank of New York has established the Secured Overnight Financing Rate (“SOFR”) as its recommended alternative to LIBOR. We have created a sub-committee of our Asset Liability Management Committee to address LIBOR transition and phase-out issues. We are currently reviewing

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loan documentation, technology systems and procedures we will need to implement for the transition. We do not expect the transition to have a material impact to the financial statements.

2) 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 1,057,945 and 1,722,342 weighted average stock options outstanding for the three months ended June 30, 2021 and 2020, and 1,072,945 and 1,490,688 for the six months ended June 30, 2021 and 2020, 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				Six Months Ended
	June 30,				June 30,
	2021		2020		2021		2020

	(Dollars in thousands, except per share amounts)
Net income	$	8,813	$	10,618	$	20,017	$	12,479

Weighted average common shares outstanding for basic
earnings per common share		60,089,327		59,420,592		60,008,071		59,353,759
Dilutive potential common shares		640,814		691,831		564,386		798,728
Shares used in computing diluted earnings per common share		60,730,141		60,112,423		60,572,457		60,152,487

Basic earnings per share	$	0.15	$	0.18	$	0.33	$	0.21
Diluted earnings per share	$	0.15	$	0.18	$	0.33	$	0.21

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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 June 30, 2021 and 2020
			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		Maturity		Items(1)		Total

	(Dollars in thousands)
Beginning balance April 1, 2021, net of taxes	$	3,327	$	252	$	(14,847)	$	(11,268)
Other comprehensive income (loss) before reclassification,
net of taxes		(454)		—		51		(403)
Amounts reclassified from other comprehensive income (loss),
net of taxes		—		(9)		148		139
Net current period other comprehensive income (loss),
net of taxes		(454)		(9)		199		(264)

Ending balance June 30, 2021, net of taxes	$	2,873	$	243	$	(14,648)	$	(11,532)

Beginning balance April 1, 2020, net of taxes	$	6,627	$	289	$	(11,625)	$	(4,709)
Other comprehensive loss before reclassification,
net of taxes		(395)		—		(10)		(405)
Amounts reclassified from other comprehensive income (loss),
net of taxes		(120)		(9)		63		(66)
Net current period other comprehensive income (loss),
net of taxes		(515)		(9)		53		(471)

Ending balance June 30, 2020, net of taxes	$	6,112	$	280	$	(11,572)	$	(5,180)

(1)	This AOCI component is included in the computation of net periodic benefit cost (see Note 8—Benefit Plans) and includes split-dollar life insurance benefit plan.

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	Six Months Ended June 30, 2021 and 2020
			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		Maturity		Items(1)		Total

	(Dollars in thousands)
Beginning balance January 1, 2021, net of taxes	$	3,929	$	261	$	(14,907)	$	(10,717)
Other comprehensive loss before reclassification,
net of taxes		(1,056)		—		(2)		(1,058)
Amounts reclassified from other comprehensive income (loss),
net of taxes		—		(18)		261		243
Net current period other comprehensive income (loss),
net of taxes		(1,056)		(18)		259		(815)

Ending balance June 30, 2021, net of taxes	$	2,873	$	243	$	(14,648)	$	(11,532)

Beginning balance January 1, 2020, net of taxes	$	1,602	$	298	$	(11,678)	$	(9,778)
Other comprehensive income (loss) before reclassification,
net of taxes		4,701		—		(6)		4,695
Amounts reclassified from other comprehensive income (loss),
net of taxes		(191)		(18)		112		(97)
Net current period other comprehensive income (loss),
net of taxes		4,510		(18)		106		4,598

Ending balance June 30, 2020, net of taxes	$	6,112	$	280	$	(11,572)	$	(5,180)

(1)	This AOCI component is included in the computation of net periodic benefit cost (see Note 8—Benefit Plans) and includes split-dollar life insurance benefit plan.

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	Amounts Reclassified from
	AOCI
	Three Months Ended
	June 30,				Affected Line Item Where
Details About AOCI Components	2021		2020		Net Income is Presented

	(Dollars in thousands)
Unrealized gains on available-for-sale securities
and I/O strips	$	—	$	170	Gain on sales of securities
		—		(50)	Income tax expense
		—		120	Net of tax
Amortization of unrealized gain on securities available-
for-sale that were reclassified to securities
held-to-maturity		13		13	Interest income on taxable securities
		(4)		(4)	Income tax expense
		9		9	Net of tax

Amortization of defined benefit pension plan items ⁽¹⁾
Prior transition obligation and acturial losses ⁽²⁾		1		15
Prior service cost and actuarial losses ⁽³⁾		(211)		(105)
		(210)		(90)	Other noninterest expense
		62		27	Income tax benefit
		(148)		(63)	Net of tax
Total reclassification for the period	$	(139)	$	66


	Amounts Reclassified from
	AOCI
	Six Months Ended
	June 30,				Affected Line Item Where
Details About AOCI Components	2021		2020		Net Income is Presented

	(Dollars in thousands)
Unrealized gains on available-for-sale securities
and I/O strips	$	—	$	270	Gain on sales of securities
		—		(79)	Income tax expense
		—		191	Net of tax
Amortization of unrealized gain on securities
available-for-sale that were reclassified to securities
held-to-maturity		26		26	Interest income on taxable securities
		(8)		(8)	Income tax expense
		18		18	Net of tax
Amortization of defined benefit pension plan items ⁽¹⁾
Prior transition obligation and actuarial losses ⁽²⁾		2		30
Actuarial losses⁽³⁾		(372)		(190)
		(370)		(160)	Other noninterest expense
		109		48	Income tax benefit
		(261)		(112)	Net of tax
Total reclassification from AOCI for the period	$	(243)	$	97

(1)	This AOCI component is included in the computation of net periodic benefit cost (see Note 8—Benefit Plans).

(2)	This is related to the split dollar life insurance benefit plan.

(3)	This is related to the supplemental executive retirement plan.

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4) Securities

The amortized cost and estimated fair value of securities were as follows for the periods indicated:


			Gross		Gross		Allowance		Estimated
	Amortized		Unrealized		Unrealized		for Credit		Fair
June 30, 2021	Cost		Gains		(Losses)		Losses		Value

	(Dollars in thousands)
Securities available-for-sale:
Agency mortgage-backed securities	$	126,682	$	4,210	$	—	$	—	$	130,892
U.S. Treasury		14,969		94		—		—		15,063
Total	$	141,651	$	4,304	$	—	$	—	$	145,955

			Gross		Gross		Estimated		Allowance
	Amortized		Unrecognized		Unrecognized		Fair		for Credit
June 30, 2021	Cost		Gains		(Losses)		Value		Losses

	(Dollars in thousands)
Securities held-to-maturity:
Agency mortgage-backed securities	$	361,184	$	5,330	$	(1,121)	$	365,393	$	—
Municipals - exempt from Federal tax		60,153		1,209		—		61,362		(51)
Total	$	421,337	$	6,539	$	(1,121)	$	426,755	$	(51)


			Gross		Gross		Allowance		Estimated
	Amortized		Unrealized		Unrealized		for Credit		Fair
December 31, 2020	Cost		Gains		(Losses)		Losses		Value

	(Dollars in thousands)
Securities available-for-sale:
Agency mortgage-backed securities	$	170,215	$	5,111	$	—	$	—	$	175,326
U.S. Treasury		59,797		651		—		—		60,448
Total	$	230,012	$	5,762	$	—	$	—	$	235,774

			Gross		Gross		Estimated		Allowance
	Amortized		Unrecognized		Unrecognized		Fair		for Credit
December 31, 2020	Cost		Gains		(Losses)		Value		Losses

	(Dollars in thousands)
Securities held-to-maturity:
Agency mortgage-backed securities	$	228,652	$	6,075	$	(230)	$	234,497	$	—
Municipals - exempt from Federal tax		68,791		1,639		—		70,430		(54)
Total	$	297,443	$	7,714	$	(230)	$	304,927	$	(54)

Securities with unrealized losses at June 30, 2021 and December 31, 2020, 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
June 30, 2021	Value		(Losses)		Value		(Losses)		Value		(Losses)

	(Dollars in thousands)
Securities held-to-maturity:
Agency mortgage-backed securities	$	67,111	$	(1,121)	$	—	$	—	$	67,111	$	(1,121)
Total	$	67,111	$	(1,121)	$	—	$	—	$	67,111	$	(1,121)


	Less Than 12 Months				12 Months or More				Total
	Fair		Unrealized		Fair		Unrealized		Fair		Unrealized
December 31, 2020	Value		(Losses)		Value		(Losses)		Value		(Losses)

	(Dollars in thousands)
Securities held-to-maturity:
Agency mortgage-backed securities	$	30,930	$	(230)	$	—	$	—	$	30,930	$	(230)
Total	$	30,930	$	(230)	$	—	$	—	$	30,930	$	(230)

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There were 0 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 June 30, 2021, the Company held 398 securities (107 available-for-sale and 291 held-to-maturity), of which 12 had fair value below amortized cost. At June 30, 2021, there were $67,111,000 of agency mortgage-backed securities held-to-maturity, carried with an unrealized loss for less than 12 months. The total unrealized loss for securities less than 12 months was ($1,121,000) at June 30, 2021. The unrealized loss was due to higher interest rates in comparison to when the security was purchased. The issuer is 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. Therefore, the Company does not consider these debt securities to have credit-related losses as of June 30, 2021.

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


	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2021		2020		2021		2020

	(Dollars in thousands)
Proceeds	$	—	$	30,085	$	—	$	56,598
Gross gains		—		170		—		270
Gross losses		—		—		—		—

The amortized cost and estimated fair values of securities as of June 30, 2021 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 3 months or less	$	9,997	$	10,044
Due after 3 months through one year		4,972		5,019
Agency mortgage-backed securities		126,682		130,892
Total	$	141,651	$	145,955


	Held-to-maturity
	Amortized		Estimated
	Cost		Fair Value

	(Dollars in thousands)
Due after 3 months through one year	$	499	$	500
Due after one through five years		10,605		10,865
Due after five through ten years		31,284		31,824
Due after ten years		17,765		18,173
Agency mortgage-backed securities		361,184		365,393
Total	$	421,337	$	426,755

Securities with amortized cost of $39,825,000 and $40,238,000 as of June 30, 2021 and December 31, 2020 were pledged to secure public deposits and for other purposes as required or permitted by law or contract.

The table below presents a rollforward by major security type for the six months ended June 30, 2021 of the allowance for credit losses on debt securities held-to-maturity held at period end:


		Municipals
		(Dollars in thousands)
Beginning balance January 1, 2021	$	54
Provision for (recapture of) credit losses		(3)
Ending balance June 30, 2021	$	51

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For the six months ended June 30, 2021, there was a reduction of $3,000 to the allowance for credit losses on the Company’s held-to-maturity municipal investment securities portfolio. This reduction was the result of a reduction in municipal securities amortized balances resulting from regular payments. The bond ratings for the Company’s municipal investment securities at June 30, 2021 were consistent with the ratings at December 31, 2020.

5) Loans and Allowance for Credit Losses on Loans

The allowance for credit losses on loans was calculated by pooling loans of similar credit risk characteristics and credit monitoring procedures. The loan portfolio is classified into eight segments of loans - commercial, commercial real estate – owner occupied, commercial real estate – non-owner occupied, land and construction, home equity, multifamily, residential mortgages and consumer and other.

The risk characteristics of each loan portfolio segment are as follows:

Commercial

Commercial loans primarily rely on the identified cash flows of the borrower for repayment and secondarily on the underlying collateral provided by the borrower. However, the cash flows of the borrowers may not be as expected and the collateral securing these loans may vary in value. Most commercial loans are secured by the assets being financed or other business assets such as accounts receivable, inventory or equipment and may incorporate a personal guarantee; however, some loans may be unsecured. Included in commercial loans are $286,461,000 of PPP loans at June 30, 2021 and $290,679,000 at December 31, 2020. NaN allowance for credit losses has been recorded for PPP loans as they are fully guaranteed by the SBA.

Commercial Real Estate (“CRE”)

CRE loans rely primarily on the cash flows of the properties securing the loan and secondarily on the value of the property that is securing the loan. CRE loans comprise two segments differentiated by owner occupied CRE and non-owner CRE. Owner occupied CRE loans are secured by commercial properties that are at least 50% occupied by the borrower or borrower affiliate. Non-owner occupied CRE loans are secured by commercial properties that are less than 50% occupied by the borrower or borrower affiliate. CRE loans may be adversely affected by conditions in the real estate markets or in the general economy.

Land and Construction

Land and construction loans are generally based on estimates of costs and value associated with the complete project. Construction loans usually involve the disbursement of funds with repayment substantially dependent on the success of the completion of the project. Sources of repayment for these loans may be permanent loans from HBC or other lenders, or proceeds from the sales of the completed project. These loans are monitored by on-site inspections and are considered to have higher risk than other real estate loans due to the final repayment dependent on numerous factors including general economic conditions.

Home Equity

Home equity loans are secured by 1-4 family residences that are generally owner occupied. Repayment of these loans depends primarily on the personal income of the borrower and secondarily by the value of the property securing the loan which can be impacted by changes in economic conditions such as the unemployment rate and property values.

Multifamily

Multifamily loans are loans on residential properties with five or more units. These loans rely primarily on the cash flows of the properties securing the loan for repayment and secondarily on the value of the properties securing the loan. The cash flows of these borrowers can fluctuate along with the values of the underlying property depending on general economic conditions.

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Residential Mortgages

Residential mortgage loans are secured by 1-4 family residences which are generally owner-occupied. Repayment of these loans depends primarily on the personal income of the borrower and secondarily by the value of the property securing the loan which can be impacted by changes in economic conditions such as the unemployment rate and property values. During the second quarter of 2021, the Company purchased 2 single family residential mortgage loan portfolios totaling $140,030,000, all of which are domiciled in California, with an average principal balance of $585,000, and a weighted average yield of approximately 3.39% (excluding servicing costs, which are netted against interest income contributing to a lower overall average yield).

Consumer and Other

Consumer and other loans are secured by personal property or are unsecured and rely primarily on the income of the borrower for repayment and secondarily on the collateral value for secured loans. Borrower income and collateral value can vary dependent on economic conditions.

Loans by portfolio segment and the allowance for credit losses on loans were as follows for the periods indicated:


	June 30,		December 31,
	2021		2020

	(Dollars in thousands)
Loans held-for-investment:
Commercial	$	844,147	$	846,386
Real estate:
CRE - owner occupied		583,091		560,362
CRE - non-owner occupied		742,135		693,103
Land and construction		129,426		144,594
Home equity		107,873		111,885
Multifamily		198,771		166,425
Residential mortgages		205,904		85,116
Consumer and other		21,519		18,116
Loans		2,832,866		2,625,987
Deferred loan fees, net		(8,070)		(6,726)
Loans, net of deferred fees		2,824,796		2,619,261
Allowance for credit losses on loans		(43,956)		(44,400)
Loans, net	$	2,780,840	$	2,574,861

Changes in the allowance for credit losses on loans were as follows for the periods indicated:


	Three Months Ended June 30, 2021
			CRE		CRE
			Owner		Non-owner		Land &		Home		Multi-		Residential		Consumer
	Commercial		Occupied		Occupied		Construction		Equity		Family		Mortgage		and Other		Total

	(Dollars in thousands)
Beginning of period balance	$	11,600	$	8,368	$	16,431	$	2,754	$	1,171	$	2,751	$	918	$	303	$	44,296
Charge-offs		(105)		—		—		—		—		—		—		—		(105)
Recoveries		115		4		—		68		16		—		—		55		258
Net recoveries		10		4		—		68		16		—		—		55		153
Provision for (recapture of) credit losses on loans		(753)		(166)		54		(686)		(118)		199		1,050		(73)		(493)
End of period balance	$	10,857	$	8,206	$	16,485	$	2,136	$	1,069	$	2,950	$	1,968	$	285	$	43,956

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	Three Months Ended June 30, 2020
			CRE		CRE
			Owner		Non-owner		Land &		Home		Multi-		Residential		Consumer
	Commercial		Occupied		Occupied		Construction		Equity		Family		Mortgage		and Other		Total

	(Dollars in thousands)
Beginning of period balance	$	12,801	$	7,737	$	15,645	$	2,603	$	1,746	$	1,622	$	708	$	1,841	$	44,703
Charge-offs		(465)		-		-		-		-		-		-		-		(465)
Recoveries		46		1		-		13		31		-		-		1		92
Net (charge-offs) recoveries		(419)		1		-		13		31		-		-		1		(373)
Provision for (recapture of) credit losses on loans		797		809		(196)		(64)		74		206		117		(629)		1,114
End of period balance	$	13,179	$	8,547	$	15,449	$	2,552	$	1,851	$	1,828	$	825	$	1,213	$	45,444


	Six Months Ended June 30, 2021
			CRE		CRE
			Owner		Non-owner		Land &		Home		Multi-		Residential		Consumer
	Commercial		Occupied		Occupied		Construction		Equity		Family		Mortgage		and Other		Total

	(Dollars in thousands)
Beginning of period balance	$	11,587	$	8,560	$	16,416	$	2,509	$	1,297	$	2,804	$	943	$	284	$	44,400
Charge-offs		(368)		—		—		—		—		—		—		—		(368)
Recoveries		928		8		—		884		39		—		—		70		1,929
Net recoveries		560		8		—		884		39		—		—		70		1,561
Provision for (recapture of) credit losses on loans		(1,290)		(362)		69		(1,257)		(267)		146		1,025		(69)		(2,005)
End of period balance	$	10,857	$	8,206	$	16,485	$	2,136	$	1,069	$	2,950	$	1,968	$	285	$	43,956


	Six Months Ended June 30, 2020
			Owner		Non-owner		Land &		Home		Multi-		Residential		Consumer
	Commercial		Occupied		Occupied		Construction		Equity		Family		Mortgage		and Other		Total

	(Dollars in thousands)
Beginning of period balance	$	10,453	$	3,825	$	3,760	$	2,621	$	2,244	$	57	$	243	$	82	$	23,285
Adoption of Topic 326		(3,663)		3,169		7,912		(1,163)		(923)		1,196		435		1,607		8,570
Balance at adoption on January 1, 2020		6,790		6,994		11,672		1,458		1,321		1,253		678		1,689		31,855
Charge-offs		(1,135)		—		—		—		—		—		—		(3)		(1,138)
Recoveries		255		1		—		32		54		—		—		1		343
Net (charge-offs) recoveries		(880)		1		—		32		54		—		—		(2)		(795)
Provision for (recapture of) credit losses on loans		7,269		1,552		3,777		1,062		476		575		147		(474)		14,384
End of period balance	$	13,179	$	8,547	$	15,449	$	2,552	$	1,851	$	1,828	$	825	$	1,213	$	45,444

Management’s methodology for estimating the allowance balance consists of several key elements, which include pooling loans with similar characteristics into segments and using a discounted cash flow calculation to estimate losses. The discounted cash flow model inputs include loan level cash flow estimates for each loan segment based on peer and bank historic loss correlations with certain economic factors. Management uses a four quarter forecast of each economic factor that is used for each loan segment and the economic factors are assumed to revert to the historic mean over an eight quarter period after the forecast period. The economic factors management has selected include the California unemployment rate, California gross domestic product, California home price index, and a national CRE value index. These factors are evaluated and updated occasionally and as economic conditions change. Additionally, management uses qualitative adjustments to the discounted cash flow quantitative loss estimates in certain cases when management has assessed an adjustment is necessary. These qualitative adjustments are applied by pooled loan segment and have been made for increased risk due to loan quality trends, collateral risk, or other risks management determines are not adequately captured in the discounted cash flow loss estimation. Specific allowances on individually evaluated loans are combined to the allowance on pools of loans with similar risk characteristics to derive to total allowance for credit losses on loans.

The decrease in the allowance for credit losses on loans and related recapture of provision for the six months ended June 30, 2021, was primarily attributed to a net decrease of ($56,000) in the reserve for pooled loans, driven by improvements in forecasted macroeconomic conditions offset by changes in the portfolio, and a ($388,000) decrease in specific reserves for individually evaluated loans compared to December 31, 2020. The decrease in the allowance for credit losses for pooled loans from December 31, 2020 is largely the result of improvements in the economic factors used in our methodology and reductions in qualitative adjustments for risks such as collateral values, concentrations of credit risk (geographic, large borrower, and industry), economic conditions, changes in underwriting standards, experience and depth of lending staff, trends in delinquencies, and the level of criticized loans to address asset-specific risks and current conditions that were not fully considered by the macroeconomic variables driving the quantitative estimate.

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The following tables presents the amortized cost basis of nonperforming loans and loans past due over 90 days and still accruing for the periods indicated:


	June 30, 2021
						Restructured
	Nonaccrual		Nonaccrual			and Loans
	with no Specific		with Specific			over 90 Days
	Allowance for		Allowance for			Past Due
	Credit		Credit			and Still
	Losses		Losses			Accruing	Total

	(Dollars in thousands)
Commercial	$	415	$	1,378	$	164	$	1,957
Real estate:
CRE - Owner Occupied		1,774		—		—		1,774
CRE - Non-Owner Occupied		—		—		725		725
Home equity		168		—		—		168
Multifamily		1,149		—		—		1,149
Consumer and other		407		—		—		407
Total	$	3,913	$	1,378	$	889	$	6,180


	December 31, 2020
					Restructured
	Nonaccrual		Nonaccrual		and Loans
	with no Specific		with no Specific		over 90 Days
	Allowance for		Allowance for		Past Due
	Credit		Credit		and Still
	Losses		Losses		Accruing		Total

	(Dollars in thousands)
Commercial	$	752	$	1,974	$	81	$	2,807
Real estate:
CRE - Owner Occupied		3,706		—		—		3,706
Home equity		949		—		—		949
Consumer and other		407		—		—		407
Total	$	5,814	$	1,974	$	81	$	7,869

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


	June 30, 2021
	30 - 59		60 - 89		90 Days or
	Days		Days		Greater		Total
	Past Due		Past Due		Past Due		Past Due		Current		Total

	(Dollars in thousands)
Commercial	$	4,467	$	1,187	$	261	$	5,915	$	838,232	$	844,147

Real estate:
CRE - Owner Occupied		1,172		9		1,143		2,324		580,767		583,091
CRE - Non-Owner Occupied		145		—		725		870		741,265		742,135
Land and construction		—		—		—		—		129,426		129,426
Home equity		—		—		—		—		107,873		107,873
Multifamily		—		—		—		—		198,771		198,771
Residential mortgages		—		—		—		—		205,904		205,904
Consumer and other		—		—		407		407		21,112		21,519
Total	$	5,784	$	1,196	$	2,536	$	9,516	$	2,823,350	$	2,832,866

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	December 31, 2020
	30 - 59		60 - 89		90 Days or
	Days		Days		Greater		Total
	Past Due		Past Due		Past Due		Past Due		Current		Total

	(Dollars in thousands)
Commercial	$	3,524	$	259	$	392	$	4,175	$	842,211	$	846,386

Real estate:
CRE - Owner Occupied		1,133		—		29		1,162		559,200		560,362
CRE - Non-Owner Occupied		—		485		—		485		692,618		693,103
Land and construction		—		—		—		—		144,594		144,594
Home equity		—		—				—		111,885		111,885
Multifamily		—		—		—		—		166,425		166,425
Residential mortgages		—		—		—		—		85,116		85,116
Consumer and other		—		—		407		407		17,709		18,116
Total	$	4,657	$	744	$	828	$	6,229	$	2,619,758	$	2,625,987

Past due loans 30 days or greater totaled $9,516,000 and $6,229,000 at June 30, 2021 and December 31, 2020, respectively, of which $1,658,000 and $1,918,000 were on nonaccrual, at June 30, 2021 and December 31, 2020, respectively. At June 30, 2021, there were also $3,633,000 of loans less than 30 days past due included in nonaccrual loans held-for-investment. At December 31, 2020, there were also $5,870,000 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.

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, and 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 their contractual loan terms. Loans categorized as special mention have potential weaknesses that may, if not checked or corrected, weaken the credit or inadequately protect the Company’s position at some future date. These loans pose elevated risk, but their weaknesses do not yet justify a substandard classification. Classified loans are those loans that are assigned a substandard, substandard-nonaccrual, or doubtful risk rating using the following definitions:

Special Mention. A Special Mention asset has potential weaknesses that deserve management's close attention. If left uncorrected, these potential weaknesses may result in a deterioration of the repayment prospects for the asset or in the credit position at some future date. Special Mention assets are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification.

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 will 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.

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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 credit losses on loans. Therefore, there is 0 balance to report as of June 30, 2021 and December 31, 2020.

Loans may be reviewed at any time throughout a loan’s duration. If new information is provided, a new risk assessment may be performed if warranted.

The following tables present term loans amortized cost by vintage and loan grade classification, and revolving loans amortized cost by loan grade classification at June 30, 2021 and December 31, 2020. The loan grade classifications are based on the Bank’s internal loan grading methodology. Loan grade categories for doubtful and loss rated loans are not included on the tables below as there are no loans with those grades at June 30, 2021 and December 31, 2020. The vintage year represents the period the loan was originated or in the case of renewed loans, the period last renewed. The amortized balance is the loan balance less any purchase discounts, and plus any loan purchase premiums. The loan categories are based on the loan segmentation in the Company's CECL reserve methodology based on loan purpose and type.

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														Revolving
														Loans
		Term Loans Amortized Cost Basis by Originated Period												Amortized
											2016 and			Cost
	6/30/2021		12/31/2020		12/31/2019		12/31/2018		12/31/2017		Prior			Basis		Total

	(Dollars in thousands)
Commercial:
Pass	$	302,753	$	163,815	$	19,144	$	15,904	$	9,543	$	8,699	$	307,122	$	826,980
Special Mention		323		733		-		1,082		447		270		978		3,833
Substandard		1,349		3,337		-		16		452		30		6,357		11,541
Substandard-Nonaccrual		30		1,143		-		-		-		106		514		1,793
Total		304,455		169,028		19,144		17,002		10,442		9,105		314,971		844,147

CRE - Owner Occupied:
Pass		78,046		154,477		74,843		66,269		37,006		135,709		24,038		570,388
Special Mention		531		2,648		680		1,495		770		1,089		-		7,213
Substandard				2,547		-		394		735		40		-		3,716
Substandard-Nonaccrual		-		1,774		-		-		-		-		-		1,774
Total		78,577		161,446		75,523		68,158		38,511		136,838		24,038		583,091

CRE - Non-Owner Occupied:
Pass		131,832		148,179		121,987		55,878		75,126		165,195		22,377		720,574
Special Mention		-		2,808		-		2,527		606		6,338		2,165		14,444
Substandard		-		5,240		-		1,392		-		485		-		7,117
Substandard-Nonaccrual		-		-		-		-		-		-		-		-
Total		131,832		156,227		121,987		59,797		75,732		172,018		24,542		742,135

Land and construction:
Pass		58,297		56,553		4,443		-		-		1,321		7,453		128,067
Special Mention		-		-		-		-		-		-		-		-
Substandard		1,359		-		-		-		-		-		-		1,359
Substandard-Nonaccrual		-		-		-		-		-		-		-		-
Total		59,656		56,553		4,443		-		-		1,321		7,453		129,426

Home equity:
Pass		-		-		-		61		-		-		104,746		104,807
Special Mention		-		-		-		-		-		-		1,932		1,932
Substandard		-		-		-		-		-		143		823		966
Substandard-Nonaccrual		-		107		-		-		-		-		61		168
Total		-		107		-		61		-		143		107,562		107,873

Multifamily:
Pass		42,576		32,568		37,612		16,321		21,215		35,092		915		186,299
Special Mention		-		-		-		-		-		10,444		-		10,444
Substandard		-		879		-		-		-		-		-		879
Substandard-Nonaccrual		1,149		-		-		-		-		-		-		1,149
Total		43,725		33,447		37,612		16,321		21,215		45,536		915		198,771

Residential mortgage:
Pass		137,195		18,204		9,379		3,157		5,129		30,567		960		204,591
Special Mention		-		-		-		-		-		-		-		-
Substandard		-		-		-		-		-		1,313		-		1,313
Substandard-Nonaccrual		-		-		-		-		-		-		-		-
Total		137,195		18,204		9,379		3,157		5,129		31,880		960		205,904

Consumer and other:
Pass		-		6		409		1,456		17		1,051		17,953		20,892
Special Mention		-		-		-		-		-		-		-		-
Substandard		20		-		-		-		-		-		200		220
Substandard-Nonaccrual		-		-				407		-		-		-		407
Total		20		6		409		1,863		17		1,051		18,153		21,519

Total loans	$	755,460	$	595,018	$	268,497	$	166,359	$	151,046	$	397,892	$	498,594	$	2,832,866

Risk Grades:
Pass	$	750,699	$	573,802	$	267,817	$	159,046	$	148,036	$	377,634	$	485,564	$	2,762,598
Special Mention		854		6,189		680		5,104		1,823		18,141		5,075		37,866
Substandard		2,728		12,003		-		1,802		1,187		2,011		7,380		27,111
Substandard-Nonaccrual		1,179		3,024		-		407		-		106		575		5,291
Grand Total	$	755,460	$	595,018	$	268,497	$	166,359	$	151,046	$	397,892	$	498,594	$	2,832,866

Table of Contents


														Revolving
														Loans
		Term Loans Amortized Cost Basis by Originated Period												Amortized
												2015 and		Cost
		2020		2019		2018		2017		2016		Prior		Basis		Total

	(Dollars in thousands)
Commercial:
Pass	$	431,369	$	33,350	$	21,154	$	13,840	$	7,341	$	8,292	$	296,286	$	811,632
Special Mention		15,720		716		1,301		953		713		170		1,937		21,510
Substandard		4,036		-		19		758		2,396		73		3,236		10,518
Substandard-Nonaccrual		2,106		56		36		-		115		26		387		2,726
Total		453,231		34,122		22,510		15,551		10,565		8,561		301,846		846,386

CRE - Owner Occupied:
Pass		168,224		73,064		68,068		51,705		50,716		109,350		15,964		537,091
Special Mention		3,151		2,568		4,128		783		-		2,569		-		13,199
Substandard		2,561		-		400		2,954		-		451		-		6,366
Substandard-Nonaccrual		3,678		-		-		-		-		28		-		3,706
Total		177,614		75,632		72,596		55,442		50,716		112,398		15,964		560,362

CRE - Non-Owner Occupied:
Pass		166,550		128,361		68,796		99,816		57,422		150,683		1,926		673,554
Special Mention		11,930		-		2,557		-		-		-		-		14,487
Substandard		3,166		-		1,411		-		485		-		-		5,062
Substandard-Nonaccrual		-		-		-		-		-		-		-		-
Total		181,646		128,361		72,764		99,816		57,907		150,683		1,926		693,103

Land and construction:
Pass		114,932		22,054		-		-		-		1,343		4,906		143,235
Special Mention		-		-		-		-		-		-		-		-
Substandard		1,359		-		-		-		-		-		-		1,359
Substandard-Nonaccrual		-		-		-		-		-		-		-		-
Total		116,291		22,054		-		-		-		1,343		4,906		144,594

Home equity:
Pass		266		-		74		-		-		-		109,848		110,188
Special Mention		-		-		-		-		-		-		-		-
Substandard		-		-		-		-		-		143		605		748
Substandard-Nonaccrual		117		-		-		-		-		-		832		949
Total		383		-		74		-		-		143		111,285		111,885

Multifamily:
Pass		31,481		39,183		17,248		24,572		16,235		30,751		880		160,350
Special Mention		-		-		-		-		-		5,186		-		5,186
Substandard		889		-		-		-		-		-		-		889
Substandard-Nonaccrual		-		-		-		-		-		-		-		-
Total		32,370		39,183		17,248		24,572		16,235		35,937		880		166,425

Residential mortgage:
Pass		12,798		10,048		3,246		7,324		28,115		15,568		-		77,099
Special Mention		5,089		-		1,630		-				-		-		6,719
Substandard		-		-		-		-		-		1,298		-		1,298
Substandard-Nonaccrual		-		-		-		-		-		-		-		-
Total		17,887		10,048		4,876		7,324		28,115		16,866		-		85,116

Consumer and other:
Pass		10		522		1,486		20		116		987		14,568		17,709
Special Mention		-		-		-		-		-		-		-		-
Substandard		-		-		-		-		-		-		-		-
Substandard-Nonaccrual		-		-		407		-		-		-		-		407
Total		10		522		1,893		20		116		987		14,568		18,116

Total loans	$	979,432	$	309,922	$	191,961	$	202,725	$	163,654	$	326,918	$	451,375	$	2,625,987

Risk Grades:.
Pass	$	925,630	$	306,582	$	180,072	$	197,277	$	159,945	$	316,974	$	444,378	$	2,530,858
Special Mention		35,890		3,284		9,616		1,736		713		7,925		1,937		61,101
Substandard		12,011		-		1,830		3,712		2,881		1,965		3,841		26,240
Substandard-Nonaccrual		5,901		56		443		-		115		54		1,219		7,788
Grand Total	$	979,432	$	309,922	$	191,961	$	202,725	$	163,654	$	326,918	$	451,375	$	2,625,987

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The following table presents the amortized cost basis of collateral-dependent loans by loan classification at June 30, 2021:


	Collateral Type
	Real
	Estate		Business
	Property		Assets		Unsecured			Total

	(Dollars in thousands)
Commercial	$	25	$	1,324	$	29	$	1,378
Total	$	25	$	1,324	$	29	$	1,378

The following table presents the amortized cost basis of collateral-dependent loans by loan classification at December 31, 2020:


	Collateral Type
	Real
	Estate		Business
	Property		Assets		Unsecured		Total

	(Dollars in thousands)
Commercial	$	29	$	1,815	$	130	$	1,974
Total	$	29	$	1,815	$	130	$	1,974

When management determines that foreclosures are probable, expected credit losses for collateral-dependent loans are based on the fair value of the collateral at the reporting date, adjusted for selling costs as appropriate. For loans for which foreclosure is not probable, but for which repayment is expected to be provided substantially through the operation or sale of the collateral and the borrower is experiencing financial difficulty, management has elected the practical expedient under ASC 326 to estimate expected credit losses based on the fair value of collateral, adjusted for selling costs as appropriate. The class of loan represents the primary collateral type associated with the loan. Significant quarter over quarter changes are reflective of changes in nonaccrual status and not necessarily associated with credit quality indicators like appraisal value.

The book balance of troubled debt restructurings at June 30, 2021 was $552,000, which included $448,000 of nonaccrual loans and $104,000 of accruing loans. The book balance of troubled debt restructurings at December 31, 2020 was $674,000, which included $468,000 of nonaccrual loans and $206,000 of accruing loans. Approximately $331,000 and $352,000 in specific reserves were established with respect to these loans as of June 30, 2021 and December 31, 2020, respectively.

The following table presents loans by class modified as troubled debt restructurings for the periods indicated:


	During the Six Months Ended
		June 30, 2021
				Pre-modification		Post-modification
		Number		Outstanding		Outstanding
		of		Recorded		Recorded
Troubled Debt Restructurings:		Contracts		Investment		Investment

	(Dollars in thousands)
Commercial		1	$	3	$	3
Total		1	$	3	$	3


	During the Six Months Ended
		June 30, 2020
				Pre-modification		Post-modification
		Number		Outstanding		Outstanding
		of		Recorded		Recorded
Troubled Debt Restructurings:		Contracts		Investment		Investment

	(Dollars in thousands)
Commercial		3	$	13	$	13
Total		3	$	13	$	13

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There were 0 loans modified as trobled debt restructings during the three months ended June 30, 2021 and 2020.

There was 1 new loan with total recorded investment of $3,000 that was modified as a troubled debt restructuring during the six months ended June 30, 2021.

During the three and six months ended June 30, 2021, there were 0 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 in the allowance for credit losses on loans.

A loan is considered to be in payment default when it is 30 days contractually past due under the modified terms. There were 0 defaults on troubled debt restructurings, within twelve months following the modification, during the three months ended June 30, 2021 and 2020.

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.

On April 7, 2020, U.S. banking agencies issued the Interagency Statement on Loan Modifications and Reporting for Financial Institutions Working with Customers Affected by the Coronavirus. The statement describes accounting for COVID-19-related loan modifications and clarifies the interaction between current accounting rules and the temporary relief provided by the CARES Act. Initially, the Bank made accommodations for payment deferrals for a number of customers with a window of up to 90 days, with the potential of an additional 90 days of payment deferral (180 days maximum) upon application. The Bank also waived all customary applicable fees. Of the loans for which deferrals were originally granted, nearly all have returned to regular payment status. At June 30, 2021, there were 3 remaining second deferments totaling $1,800,000, of which 2 loans were secured by real estate, and 1 loan was secured by business assets.

6) Goodwill and Other Intangible Assets

Goodwill

At June 30, 2021, the carrying value of goodwill was $167,631,000, which included $13,044,000 of goodwill related to its acquisition of Bay View Funding, $32,619,000 from its acquisition of Focus Business Bank, $13,819,000 from its acquisition of Tri-Valley Bank, $24,271,000 from its acquisition of United American Bank and $83,878,000 from Presidio Bank.

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 reporting units, including the existing goodwill and intangible assets, and estimating the fair value of each reporting unit.

The Company completed its annual goodwill impairment analysis as of November 30, 2020 with the assistance of an independent valuation firm. The goodwill related to the acquisition of Bay View Funding was tested separately for impairment under this analysis. No events or circumstances since the November 30, 2020 annual impairment test were noted that would indicate it was more likely than not a goodwill impairment exists, for either the Company’s banking or factoring reporting units.

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The following table summarizes the carrying amount of goodwill by segment for the periods indicated:


	June 30,		December 31,
	2021		2020

	(Dollars in thousands)
Banking	$	154,587	$	154,587
Factoring		13,044		13,044
Total Goodwill	$	167,631	$	167,631

Other Intangible Assets

The Company’s intangible assets are summarized as follows for the periods indicated:


	June 30, 2021
	Gross
	Carrying		Accumulated
	Amount		Amortization		Total

	(Dollars in thousands)
Core deposit intangibles	$	25,023	$	(10,567)	$	14,456
Customer relationship and brokered relationship intangibles		1,900		(1,266)		634
Below market leases		770		(683)		87
Total	$	27,693	$	(12,516)	$	15,177


	December 31, 2020
	Gross
	Carrying		Accumulated
	Amount		Amortization		Total

	(Dollars in thousands)
Core deposit intangibles	$	25,023	$	(9,153)	$	15,870
Customer relationship and brokered relationship intangibles		1,900		(1,171)		729
Below market leases		770		(705)		65
Total	$	27,693	$	(11,029)	$	16,664

Estimated amortization expense for future years is as follows:



				Customer &	Below/
	Core			Brokered	(Above)		Total
	Deposit			Relationship	Market		Amortization
Year	Intangible			Intangible	Lease		Expense

		(Dollars in thousands)
2021 remaining	$	1,415	$	95	$	(1)	$	1,509
2022		2,447		190		(2)		2,635
2023		2,217		190		(2)		2,405
2024		2,023		159		5		2,187
2025		1,795		—		18		1,813
Thereafter		4,559		—		69		4,628
	$	14,456	$	634	$	87	$	15,177

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 0 impairment of intangible assets at June 30, 2021 and December 31, 2020.

7) Income Taxes

Some items of income and expense are recognized in one year for tax purposes, and another when applying generally accepted accounting principles, which leads 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 $26,917,000, and $28,221,000, at June 30, 2021 and December 31, 2020, respectively. After consideration of the matters in the preceding paragraph, the Company determined that it is more likely than 0t that the net deferred tax assets at June 30, 2021 and December 31, 2020 will be fully realized in future years.

The following table reflects the carrying 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:


	June 30,		December 31,
	2021		2020

	(Dollars in thousands)
Low income housing investments	$	4,827	$	5,246
Future commitments	$	596	$	596

The Company expects $46,000 of the future commitments to be paid in 2021, and $550,000 in 2022 through 2025.

For tax purposes, the Company had low income housing tax credits of $210,000 for the three months ended June 30, 2021 and June 30, 2020, and low income housing investment expense of $209,000 and $211,000, respectively. For tax purposes, the Company had low income housing tax credits of $420,000 for the six months ended June 30, 2021 and June 30, 2020, and low income housing investment expense of $418,000 and $420,000, respectively. The Company recognized low income housing investment expense as a component of income tax expense.

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8) 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 0 Plan assets. The following table presents the amount of periodic cost recognized for the periods indicated:


	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2021		2020		2021		2020

	(Dollars in thousands)
Components of net periodic benefit cost:
Service cost	$	120	$	123	$	240	$	246
Interest cost		190		236		380		467
Amortization of prior service cost		75		—		100		—
Amortization of net actuarial loss		136		105		272		190
Net periodic benefit cost	$	521	$	464	$	992	$	903

The components of net periodic benefit cost other than the service cost component are included in the line item “other noninterest expense” in the Consolidated Statements of Income.

Split-Dollar Life Insurance Benefit Plan

The Company maintains life insurance policies for some current and 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:


	June 30,		December 31,
	2021		2020

	(Dollars in thousands)
Change in projected benefit obligation:
Projected benefit obligation at beginning of year	$	9,689	$	8,198
Interest cost		110		246
Actuarial loss		—		1,245
Projected benefit obligation at end of period	$	9,799	$	9,689


	June 30,		December 31,
	2021		2020

	(Dollars in thousands)
Net actuarial loss	$	5,217	$	5,170
Prior transition obligation		925		970
Accumulated other comprehensive loss	$	6,142	$	6,140


	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2021		2020		2021		2020

	(Dollars in thousands)
Amortization of prior transition obligation and actuarial losses	$	(1)	$	(15)	$	(2)	$	(30)
Interest cost		55		62		110		124
Net periodic benefit cost	$	54	$	47	$	108	$	94

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9) 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.

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 June 30, 2021
Available-for-sale securities:
Agency mortgage-backed securities	$	130,892	$	—	$	130,892	$	—
U.S. Treasury		15,063		15,063		—		—
I/O strip receivables		274		—		274		—

Assets at December 31, 2020
Available-for-sale securities:
Agency mortgage-backed securities	$	175,326	$	—	$	175,326	$	—
U.S. Treasury		60,448		60,448		—		—
I/O strip receivables		305		—		305		—

There were 0 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 collateral dependent loans individually evaluated with specific allocations of the allowance for credit losses on loans 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. There were no material collateral dependent loans carried at fair value on a non-recurring basis at June 30, 2021 or December 31, 2020.

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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. At June 30, 2021 and December 31, 2020, there were 0 foreclosed assets on the balance sheet.

The carrying amounts and estimated fair values of financial instruments at June 30, 2021 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	$	1,328,322	$	1,328,322	$	—	$	—	$	1,328,322
Securities available-for-sale		145,955		15,063		130,892		—		145,955
Securities held-to-maturity		421,286		—		426,755		—		426,755
Loans (including loans held-for-sale), net		2,785,184		—		4,344		2,796,339		2,800,683
FHLB stock, FRB stock, and other
investments		32,495		—		—		—		N/A
Accrued interest receivable		10,397		103		1,510		8,784		10,397
I/O strips receivables		274		—		274		—		274
Liabilities:
Time deposits	$	158,644	$	—	$	158,843	$	—	$	158,843
Other deposits		4,185,828		—		4,185,828		—		4,185,828
Subordinated debt		39,832		—		40,432		—		40,432
Accrued interest payable		548		—		548		—		548

The carrying amounts and estimated fair values of the Company’s financial instruments at December 31, 2020:


			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	$	1,131,073	$	1,131,073	$	—	$	—	$	1,131,073
Securities available-for-sale		235,774		60,448		175,326		—		235,774
Securities held-to-maturity		297,389		—		304,927		—		304,927
Loans (including loans held-for-sale), net		2,576,560		—		1,699		2,572,993		2,574,692
FHLB stock, FRB stock, and other
investments		33,522		—		—		—		N/A
Accrued interest receivable		10,546		309		1,512		8,725		10,546
I/O strips receivables		305		—		305		—		305
Liabilities:
Time deposits	$	153,407	$	—	$	153,740	$	—	$	153,740
Other deposits		3,761,079		—		3,761,079		—		3,761,079
Subordinated debt		39,740		—		40,340		—		40,340
Accrued interest payable		545		—		545		—		545

10) 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 21, 2020, the shareholders approved an amendment

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to the Heritage Commerce Corp 2013 Equity Incentive Plan to increase the number of shares available from 3,000,000 to 5,000,000 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. For the six months ended June 30, 2021, the Company granted 350,750 shares of nonqualified stock options and 187,325 shares of restricted stock. The fair value of restricted stock awards that vested was $1,749,000 as of June 30, 2021. There were 1,940,811 shares available for the issuance of equity awards under the 2013 Plan as of June 30, 2021.

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, 2021	2,546,821	$	9.30
Granted	350,750	$	12.08
Exercised	(132,342)	$	5.93
Forfeited or expired	(36,766)	$	12.89
Outstanding at June 30, 2021	2,728,463	$	9.77	5.71	$	6,286,272
Vested or expected to vest	2,564,755			5.71	$	5,909,096
Exercisable at June 30, 2021	1,996,727			4.51	$	5,826,621

Information related to the equity plans for the periods indicated:


	Six Months Ended
	June 30,
	2021		2020
Intrinsic value of options exercised	$	679,403	$	2,057,914
Cash received from option exercise	$	784,264	$	1,489,991
Tax benefit (expense) realized from option exercises	$	57,215	$	33,783
Weighted average fair value of options granted	$	2.33	$	1.15

As of June 30, 2021, there was $1,410,000 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 2.96 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:


	Six Months Ended
	June 30,
	2021		2020
Expected life in months(1)	72		72
Volatility(1)	33	%	29	%
Weighted average risk-free interest rate(2)	1.10	%	0.53	%
Expected dividends(3)	4.30	%	5.71	%

(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.

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Restricted stock activity under the equity plans is as follows:


		Weighted
		Average Grant
	Number	Date Fair
Total Restricted Stock Award	of Shares	Value
Nonvested shares at January 1, 2021	298,700	$	10.83
Granted	187,325	$	12.01
Vested	(153,101)	$	11.42
Forfeited or expired	(34,358)	$	10.23
Nonvested shares at June 30, 2021	298,566	$	11.03

As of June 30, 2021, there was $3,201,000 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 2.03 years.

11) 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 Subordinated Debt, net of unamortized issuance costs of $168,000, totaled $39,832,000 at June 30, 2021. 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. See “LIBOR Transition and Phase–Out” above.

12) 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 June 30, 2021, that management believes have changed the categorization of the Company or HBC as “well-capitalized.”

The Company’s consolidated capital ratios and the HBC’s capital ratios exceeded the regulatory guidelines for a well-capitalized financial institution under the Basel III regulatory requirements at June 30, 2021.

As permitted by the interim final rule issued on March 27, 2020 by our federal regulatory agency, we elected the option to delay the estimated impact of the adoption of the CECL Standard in our regulatory capital for two years. This two-year delay is in addition to the three-year transition period the agency had already made available. The adoption will delay the effects of CECL on our regulatory capital for the next two years, after which the effects will be phased-in over a three-year period from January 1, 2022 through December 31, 2024, with 75% recognized in 2022, 50% recognized in 2023, and 25% recognized in 2024. Under the interim final rule, the amount of adjustments to regulatory capital deferred until the phase-in period includes both the initial impact of adoption of the CECL Standard at January 1, 2020 and 25% of subsequent changes in our allowance for credit losses during each quarter of the two-year period ending December 31, 2021.

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 June 30, 2021 and December 31, 2020, the Company and HBC met all capital adequacy guidelines to which they were subject.

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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 June 30, 2021 and December 31, 2020.


					Required For
					Capital
					Adequacy
					Purposes
	Actual				Under Basel III
	Amount		Ratio		Amount		Ratio⁽¹⁾

	(Dollars in thousands)
As of June 30, 2021
Total Capital	$	491,475	15.6	%	$	329,965	10.5	%
(to risk-weighted assets)
Tier 1 Capital	$	418,134	13.3	%	$	267,115	8.5	%
(to risk-weighted assets)
Common Equity Tier 1 Capital	$	418,134	13.3	%	$	219,977	7.0	%
(to risk-weighted assets)
Tier 1 Capital	$	418,134	8.6	%	$	194,156	4.0	%
(to average assets)

(1)	Includes 2.5% capital conservation buffer, 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, 2020
Total Capital	$	483,870	16.5	%	$	307,067	10.5	%
(to risk-weighted assets)
Tier 1 Capital	$	410,307	14.0	%	$	248,578	8.5	%
(to risk-weighted assets)
Common Equity Tier 1 Capital	$	410,307	14.0	%	$	204,711	7.0	%
(to risk-weighted assets)
Tier 1 Capital	$	410,307	9.1	%	$	180,281	4.0	%
(to average assets)

(2)	Includes 2.5% capital conservation buffer, 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 June 30, 2021, and December 31, 2020.


									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 June 30, 2021
Total Capital	$	469,701	15.0	%	$	314,070	10.0	%	$	329,773	10.5	%
(to risk-weighted assets)
Tier 1 Capital	$	436,192	13.9	%	$	251,256	8.0	%	$	266,959	8.5	%
(to risk-weighted assets)
Common Equity Tier 1 Capital	$	436,192	13.9	%	$	204,145	6.5	%	$	219,849	7.0	%
(to risk-weighted assets)
Tier 1 Capital	$	436,192	9.0	%	$	242,600	5.0	%	$	194,080	4.0	%
(to average assets)

(1)	Includes 2.5% capital conservation buffer, 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, 2020
Total Capital	$	461,933	15.8	%	$	292,258	10.0	%	$	306,871	10.5	%
(to risk-weighted assets)
Tier 1 Capital	$	428,109	14.6	%	$	233,806	8.0	%	$	248,419	8.5	%
(to risk-weighted assets)
Common Equity Tier 1 Capital	$	428,109	14.6	%	$	189,968	6.5	%	$	204,580	7.0	%
(to risk-weighted assets)
Tier 1 Capital	$	428,109	9.5	%	$	225,263	5.0	%	$	180,211	4.0	%
(to average assets)

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

The Subordinated Debt, net of unamortized issuance costs, totaled $39,832,000 at June 30, 2021, 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 Financial Protection and Innovation (“DFPI”) 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 June 30, 2021, HBC would not be required to obtain regulatory approval, and the amount available for cash dividends is $35,173,000. Similar restrictions applied to the amount and sum of loan advances and other transfers of

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funds from HBC to the parent company. HBC distributed to HCC dividends of $8,000,000, during the second and first quarters of 2021, for a total of $16,000,000.

13) Commitments and Loss Contingencies

Loss Contingencies

Within the ordinary course of our business, we are subject to private lawsuits, government audits, administrative proceedings and other claims. A number of these claims may exist at any given time, and some of the claims may be pled as class actions. We could be affected by adverse publicity and litigation costs resulting from such allegations, regardless of whether they are valid or whether we are legally determined to be liable. A summary of proceedings outstanding at June 30, 2021 follows:

●

In January and February 2019, Double Jump, Inc. and a number of its affiliates (collectively, the “DC Solar Debtors”) each commenced bankruptcy cases in the United States Bankruptcy Court of Nevada. The chapter 7 trustee of the DC Solar Debtors had indicated that it may bring an adversary action against Heritage related to our former deposit relationships with the DC Solar Debtors and their sponsored investment funds. The Bank entered into a settlement agreement, dated July 7, 2021 with the trustee. The Bank settled all claims of the trustee against the Bank, its affiliates, past and current employees, including all direct and derivative claims arising out of the Bank’s allegedly negligent handling, supervision and management of depository accounts that were maintained for the DC Solar Debtors and related investment funds. The Bank has denied all liability. The Bank received a full and complete release of the trustee’s claims. The settlement is subject to Bankruptcy Court approval. The hearing for approval is scheduled for September 17, 2021, but is subject to change. The Bank considers the settlement to be an insured event subject to reimbursement by liability insurance. The Bank reserved $4,000,000 toward the settlement amount in the second quarter of 2021, and the Bank will pursue reimbursement from its insurance carriers. All legal fees incurred in connection with the trustee action and the settlement agreement have been expensed to date.

●

In December 2020, Solar Eclipse Investment Fund III, et al v. Heritage Bank of Commerce, et al., was filed against Heritage, and others, in the Solano County Superior Court for the State of California (“Solar Eclipse”). Also in December 2020, Solarmore Management Services, Inc. v. Jeff Carpoff et al., (“Solarmore”) filed an amended complaint in the United States District Court for the Eastern District of California against Heritage and others. Both of these cases relate to our former deposit relationships with D.C. Solar and their affiliates (collectively “D.C. Solar”) and its sponsored investment funds. D.C. Solar is a former customer that allegedly perpetrated a Ponzi scheme and declared bankruptcy. These actions seek unspecified damages and are in an early phase. We intend to vigorously defend these actions.

●

In November 2020, a former and a then-current bank employee purporting to represent a class of Bank employees, alleged in a lawsuit that the Bank violated the California Labor Code and California Business and Professions Code, by failing to permit required meal and rest breaks, and by failing to provide accurate wage statements, among other claims. The lawsuit seeks unspecified penalties under the California Private Attorneys General Act (“PAGA”) in addition to other monetary payments. In late December 2020 the same former and then-current bank employees filed a lawsuit asserting, as individual employees, causes of action against the Bank for gender discrimination, retaliation, constructive discharge of the former employee, and sexual harassment, among other claims. Plaintiffs allege denial of promotional opportunities, and harassment and discrimination by Bank employees and customers of the Bank. This case is in an early phase. Counsel for the plaintiffs have agreed to pause the litigation of the individual claims while the parties explore mediation.

In February 2021, the Bank was notified of another set of PAGA and potential class claims alleged by letter to the California Labor and Workforce Development Agency transmitted on behalf of another former Bank employee. The notice to the California Labor and Workforce Development Agency, which is a prerequisite to a PAGA filing, alleged the same claims, class, and relief requests that are the subject of the lawsuit filed in November 2020, and disclosed no new claims. The former employee has also threatened individual claims similar to the other two former employees. Counsel for the plaintiffs have agreed to explore mediation of the threatened individual claims.

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We intend to vigorously defend the filed class and PAGA complaint, the action filed by the employees as individuals, any subsequent related class action and PAGA filing, and any action filed by the former employee on whose behalf the draft complaint was provided.

The Company makes a provision for a liability relating to legal matters when it is both probable that a liability has been incurred and the amount of the loss can be reasonably estimated. These provisions are reviewed at least quarterly and adjusted to reflect the impacts of negotiations, estimated settlements, legal rulings, advice of legal counsel and other information and events pertaining to a particular matter. The outcomes of legal proceedings and other contingencies are, however, inherently unpredictable and subject to significant uncertainties. As a result, the Company is not able to reasonably estimate the amount or range of possible losses, including losses that could arise as a result of application of non-monetary remedies, with respect to the contingencies it faces, and the Company’s estimates may not prove to be accurate.

At this time, we believe that the amount of reasonably possible losses resulting from final disposition of any pending lawsuits, audits, proceedings and claims will not have a material adverse effect individually or in the aggregate on our financial position, results of operations or liquidity. It is possible, however, that our future results of operations for a particular quarter or fiscal year could be impacted by changes in circumstances relating to lawsuits, audits, proceedings or claims. Legal costs related to such claims are expensed as incurred.

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 $1,168,495,000 at June 30, 2021, and $1,114,193,000 at December 31, 2020. Unused commitments represented 41% outstanding gross loans at June 30, 2021, 43% at June 30, 2020, and 42% at December 31, 2020.

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:


	June 30, 2021						December 31, 2020
	Fixed		Variable				Fixed		Variable
	Rate		Rate		Total		Rate		Rate		Total

	(Dollars in thousands)
Unused lines of credit and commitments
to make loans	$	131,878	$	1,018,383	$	1,150,261	$	121,560	$	970,614	$	1,092,174
Standby letters of credit		2,877		15,357		18,234		3,049		18,970		22,019
	$	134,755	$	1,033,740	$	1,168,495	$	124,609	$	989,584	$	1,114,193

For the six months ended June 30, 2021, there was an increase of $23,000 to the allowance for credit losses on the Company’s off-balance sheet credit exposures. The increase in the allowance for credit losses for off-balance sheet credit exposures in the first six months of 2021 was driven by an increase in unused loan commitments. The allowance for credit losses on the Company’s off-balance sheet credit exposures was $1,101,000 at June 30, 2021 and $1,078,000 at December 31, 2020.

14) 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

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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 Company currently accounts for sales of foreclosed assets in accordance with Topic 360-20. In most cases the Company will seek to engage a real estate agent for the sale of foreclosed assets immediately upon foreclosure. However, in some cases, where there is clear demand for the property in question, the Company may elect to allow for a marketing period on no more than six months to attempt a direct sale of the property. We generally recognize the sale, and any associated gain or loss, of a real estate property when control of the property transfers. Any gains or losses from the sale are recorded to noninterest income/expense.

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
	June 30,
	2021		2020

	(Dollars in thousands)
Noninterest Income In-scope of Topic 606:
Service charges and fees on deposit accounts	$	659	$	650
Gain on the disposition of foreclosed assets		—		—
Total noninterest income in-scope of Topic 606		659		650
Noninterest Income Out-of-scope of Topic 606		1,510		1,428
Total noninterest income	$	2,169	$	2,078


	Six Months Ended
	June 30,
	2021		2020

	(Dollars in thousands)
Noninterest Income In-scope of Topic 606:
Service charges and fees on deposit accounts	$	1,260	$	1,619
Gain on the disposition of foreclosed assets		—		791
Total noninterest income in-scope of Topic 606		1,260		2,410
Noninterest Income Out-of-scope of Topic 606		3,210		2,861
Total noninterest income	$	4,470	$	5,271

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15) Noninterest Expense

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


	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2021		2020		2021		2020

	(Dollars in thousands)
Salaries and employee benefits	$	12,572	$	12,300	$	26,530	$	26,503
Reserve for legal settlement		4,000		—		4,000		—
Occupancy and equipment		2,247		1,766		4,521		3,538
Professional fees		1,771		1,155		3,490		2,590
Amortization of intangible assets		754		964		1,487		1,822
Insurance expense		661		516		1,324		1,034
Data processing		583		779		1,117		1,755
Software subscriptions		501		746		977		1,635
Other		2,686		2,786		5,573		7,909
Total noninterest expense	$	25,775	$	21,012	$	49,019	$	46,786

The following table presents the merger-related costs included in other and salaries and employee benefits by category for the periods indicated:


	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2021		2020		2021		2020

	(Dollars in thousands)
Salaries and employee benefits	$	—	$	—	$	—	$	356
Other		(24)		59		34		2,127
Total merger-related costs	$	(24)	$	59	$	34	$	2,483

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16) Leases

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. 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 option. No lease extensions are reasonably certain to be exercised, therefore it was not considered in the calculation of the ROU asset and lease liability. As of June 30, 2021, operating lease ROU assets, included in other assets, and lease liabilities, included in other liabilities, totaled $36,601,000.

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


		Three Months Ended				Six Months Ended
		June 30,				June 30,

		2021		2020		2021		2020

	(Dollars in thousands)
Operating Lease Cost (Cost resulting from lease payments)	$	1,621	$	1,733	$	3,292	$	3,502
Operating Lease - Operating Cash Flows (Fixed Payments)	$	1,220	$	1,379	$	2,406	$	2,570
Operating Lease - ROU assets	$	36,601	$	37,137	$	36,601	$	37,137
Operating Lease - Liabilities	$	36,601	$	37,137	$	36,601	$	37,137
Weighted Average Lease Term - Operating Leases		7.79 yrs		8.50 years		7.79 yrs		8.50 years
Weighted Average Discount Rate - Operating Leases		4.48%		4.53%		4.48%		4.53%

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


		(Dollars in thousands)
2021 remaining		$	2,998
2022			6,353
2023	��		5,724
2024			5,341
2025			4,929
Thereafter			19,011
Total undiscounted cash flows			44,356
Discount on cash flows			(7,755)
Total lease liability		$	36,601

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17) Business Segment Information

The following presents the Company’s operating segments. The Company operates through 2 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 credit losses on loans 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 June 30, 2021
	Banking⁽¹⁾		Factoring		Consolidated

	(Dollars in thousands)

Interest income	$	33,860	$	2,772	$	36,632
Intersegment interest allocations		202		(202)		—
Total interest expense		1,756		—		1,756
Net interest income		32,306		2,570		34,876
Provision for (recapture of) credit losses on loans		(486)		(7)		(493)
Net interest income after provision		32,792		2,577		35,369
Noninterest income		2,049		120		2,169
Noninterest expense		24,331		1,444		25,775
Intersegment expense allocations		127		(127)		—
Income before income taxes		10,637		1,126		11,763
Income tax expense		2,617		333		2,950
Net income	$	8,020	$	793	$	8,813

Total assets	$	5,003,894	$	68,981	$	5,072,875
Loans, net of deferred fees	$	2,777,685	$	47,111	$	2,824,796
Goodwill	$	154,587	$	13,044	$	167,631


	Three Months Ended June 30, 2020
	Banking⁽¹⁾		Factoring		Consolidated

	(Dollars in thousands)
Interest income	$	34,570		2,562	$	37,132
Intersegment interest allocations		218		(218)		—
Total interest expense		2,192		—		2,192
Net interest income		32,596		2,344		34,940
Provision for credit losses on loans		1,107		7		1,114
Net interest income after provision		31,489		2,337		33,826
Noninterest income		1,883		195		2,078
Noninterest expense		19,336		1,676		21,012
Intersegment expense allocations		106		(106)		—
Income before income taxes		14,142		750		14,892
Income tax expense		4,052		222		4,274
Net income	$	10,090	$	528	$	10,618

Total assets	$	4,546,199	$	68,202	$	4,614,401
Loans, net of deferred fees	$	2,644,480	$	41,909	$	2,686,389
Goodwill	$	154,587	$	13,044	$	167,631

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

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	Six Months Ended June 30, 2021
	Banking ⁽¹⁾		Factoring		Consolidated

	(Dollars in thousands)
Interest income	$	67,971	$	5,422	$	73,393
Intersegment interest allocations		413		(413)		—
Total interest expense		3,559		—		3,559
Net interest income		64,825		5,009		69,834
Provision for (recapture of) credit losses on loans		(1,949)		(56)		(2,005)
Net interest income after provision		66,774		5,065		71,839
Noninterest income		4,209		261		4,470
Noninterest expense		46,228		2,791		49,019
Intersegment expense allocations		233		(233)		—
Income before income taxes		24,988		2,302		27,290
Income tax expense		6,593		680		7,273
Net income	$	18,395	$	1,622	$	20,017

Total assets	$	5,003,894	$	68,981	$	5,072,875
Loans, net of deferred fees	$	2,777,685	$	47,111	$	2,824,796
Goodwill	$	154,587	$	13,044	$	167,631


	Six Months Ended June 30, 2020
	Banking⁽¹⁾		Factoring		Consolidated

	(Dollars in thousands)
Interest income	$	72,635	$	5,439	$	78,074
Intersegment interest allocations		502		(502)		—
Total interest expense		4,554		—		4,554
Net interest income		68,583		4,937		73,520
Provision for credit losses on loans		13,981		403		14,384
Net interest income after provision		54,602		4,534		59,136
Noninterest income		4,906		365		5,271
Noninterest expense		43,519		3,267		46,786
Intersegment expense allocations		235		(235)		—
Income before income taxes		16,224		1,397		17,621
Income tax expense		4,729		413		5,142
Net income	$	11,495	$	984	$	12,479

Total assets	$	4,546,199	$	68,202	$	4,614,401
Loans, net of deferred fees	$	2,644,480	$	41,909	$	2,686,389
Goodwill	$	154,587	$	13,044	$	167,631

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

18) Subsequent Events

On July 22, 2021, the Company announced that its Board of Directors declared a $0.13 per share quarterly cash dividend to holders of common stock. The dividend will be payable on August 26, 2021, to shareholders of record at close of business day on August 12, 2021.

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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” or the “Bank”), 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, 2020. There have been no changes in the Company's application of critical accounting policies since December 31, 2020.

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 Alameda, Contra Costa, Marin, San Benito, San Francisco, San Mateo, and Santa Clara. The Company’s market includes the cities of Oakland, San Francisco and San Jose and 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 June 30, 2021, net income was $8.8 million, or $0.15 per average diluted common share, compared to $10.6 million, or $0.18 per average diluted common share, for the three months ended June 30, 2020. The Company’s annualized return on average tangible assets was 0.73% and annualized return on average tangible equity was 8.84% for the three months ended June 30, 2021, compared to 1.01% and 11.06%, respectively, for the three months ended June 30, 2020.

For the six months ended June 30, 2021, net income was $20.0 million, or $0.33 per average diluted common share, compared to $12.5 million, or $0.21 per average diluted common share, for the six months ended June 30, 2020. The Company’s annualized return on average tangible assets was 0.85% and annualized return on average tangible equity was 10.16% for the six months ended June 30, 2021, compared to 0.62% and 6.45%, respectively, for the six months ended June 30, 2020.

Small Business Administration (“SBA”) Paycheck Protection Program (“PPP”)

In response to economic stimulus laws passed by Congress in 2020 and 2021, the Bank has now funded two rounds of SBA PPP loans. At June 30, 2021, after accounting for loan payoffs and SBA loan forgiveness, Round 1 PPP loans were $91.9 million and Round 2 PPP loans were $194.6 million. In total the Bank had $286.5 million in outstanding PPP loan balances at June 30, 2021. The following table shows interest income, fee income and deferred origination costs generated by the PPP loans, and the PPP loan outstanding balances and related deferred fees and costs for the periods indicated:

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	At or For the Quarter Ended:						At or For the Six Months Ended:
PPP LOANS	June 30,		March 31,		June 30,		June 30,		June 30,
(in $000’s, unaudited)	2021		2021		2020		2021		2020
Interest income	$	831	$	784	$	582	$	1,615	$	582
Fee income, net		1,876		3,401		637		5,276		637
Total	$	2,707	$	4,185	$	1,219	$	6,891	$	1,219

Deferred origination costs (contra expense)	$	41	$	766	$	1,240	$	807	$	1,240

PPP loans outstanding at period end:
Round 1	$	91,849	$	170,391	$	324,550	$	91,849	$	324,550
Round 2		194,612		179,353		—		194,612		—
Total	$	286,461	$	349,744	$	324,550	$	286,461	$	324,550

Deferred fees outstanding at period end	$	(7,747)	$	(8,757)	$	(10,430)	$	(7,747)	$	(10,430)
Deferred costs outstanding at period end		869		1,099		1,155		869		1,155
Total	$	(6,878)	$	(7,658)	$	(9,275)	$	(6,878)	$	(9,275)

On December 27, 2020, the President signed into law the Economic Aid to Hard-Hit Small Businesses, Nonprofits, and Venues Act (the “Act”) which revised rules regarding PPP loans, provided supplemental PPP loan funding for new and existing borrowers and expanded the types of business expenses that are forgivable under the PPP program. On January 6, 2021, Treasury issued new Interim Final Rules (“IFRs”) to address the Act’s creation of PPP Second Draw Loans as well as other changes to the PPP program requirements. The IFRs codified aspects of the PPP program not specifically addressed in the Act:

●

Extending the application deadline to submit a PPP loan application to May 31, 2021, and the SBA approval deadline to June 30, 2021.

●

Allowing new PPP borrowers to use either 2019 or 2020 for business records in determining maximum loan amount.

●

Maintaining a $2 million loan amount necessity certification safe harbor.

●

Allowing borrowers who returned or did not originally accept PPP loan proceeds to reapply for receipt of those funds.

Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”)

On April 7, 2020, U.S. banking agencies issued the Interagency Statement on Loan Modifications and Reporting for Financial Institutions Working with Customers Affected by the Coronavirus. The statement describes accounting for COVID-19-related loan modifications and clarifies the interaction between current accounting rules and the temporary relief provided by the CARES Act. Initially, the Bank made accommodations for payment deferrals for a number of customers with a window of up to 90 days, with the potential of an additional 90 days of payment deferral (180 days maximum) upon application. The Bank also waived all customary applicable fees. Of the loans for which deferrals were originally granted, nearly all have returned to regular payment status. At June 30, 2021, there were three remaining second deferments totaling $1.8 million.

In addition to its portfolio of SBA PPP loans, the Bank also has a portfolio of SBA 7(a) loans totaling $46.5 million as of June 30, 2021. The following table reflects the status of these SBA 7(a) loans as of June 30, 2021:


			Number
		Dollars	of Loans

		(Dollars in thousands)
SBA 7(a) loans (monthly payments are made
through the CARES Act)	$	28,075	158
CARES extended SBA payment		17,857	81
Payments Not Made / NSF / Returned		410	2
New loans / No payment due		120	5
Total Portfolio	$	46,462	246

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The CARES Act was amended in December 2020 to include $3.5 billion of extended debt relief payments for SBA borrowers. The program will initially provide for three payments of principal and interest to a maximum of $9,000 per month under various criteria and then an additional five payments for borrowers considered “underserved” as defined in the amended legislation.

Credit Quality and Performance

At June 30, 2021, nonperforming assets (“NPAs”) declined by ($2.9) million, or (32%), to $6.2 million, compared to $9.1 million at June 30, 2020, and decreased by ($1.7) million, or (21%) from $7.9 million at December 31, 2020. The change in NPAs at June 30, 2021, compared to June 30, 2020 and December 31, 2020, was primarily from the sale of properties which resulted in the payoff of loans, and from the paydown of other loans, partially offset by new credits that went on NPA status during the six months of 2021. Classified assets increased to $32.4 million, or 0.64% of total assets, at June 30, 2021, compared to $31.5 million, or 0.68% of total assets, at June 30, 2020, and decreased from $34.0 million, or 0.73% of total assets, at December 31, 2020.

The Company continues to monitor portfolio loans made to commercial customers with businesses in higher risk sectors due to the COVID-19 pandemic. The following table provides a breakdown of such loans as a percentage of total loans at the periods indicated:


	% of��Total		% of Total		% of Total
	Loans at		Loans at		Loans at
HIGHER RISK SECTORS	June 30, 2021		June 30, 2020		December 31, 2020
Health care and social assistance:
Offices of dentists	1.88	%	1.79	%	2.01	%
Offices of physicians (except mental health specialists)	0.76	%	0.76	%	0.81	%
Other community housing services	0.23	%	0.27	%	0.28	%
All others	2.12	%	2.21	%	2.15	%
Total health care and social assistance	4.99	%	5.03	%	5.25	%
Retail trade:
Gasoline stations with convenience stores	2.42	%	1.90	%	2.16	%
All others	1.91	%	2.44	%	2.34	%
Total retail trade	4.33	%	4.34	%	4.50	%
Accommodation and food services:
Full-service restaurants	1.41	%	1.38	%	1.30	%
Limited-service restaurants	0.56	%	0.79	%	0.57	%
Hotels (except casino hotels) and motels	0.81	%	0.89	%	0.95	%
All others	0.68	%	0.70	%	0.68	%
Total accommodation and food services	3.46	%	3.76	%	3.50	%
Educational services:
Elementary and secondary schools	0.58	%	0.65	%	0.58	%
Education support services	0.44	%	0.40	%	0.45	%
All others	0.20	%	0.24	%	0.19	%
Total educational services	1.22	%	1.29	%	1.22	%
Arts, entertainment, and recreation	1.31	%	1.26	%	1.34	%
Purchased participations in micro loan portfolio	0.39	%	0.80	%	0.60	%
Total higher risk sectors	15.70	%	16.48	%	16.41	%

The decrease in higher risk sector loans at June 30, 2021 and December 31, 2020, compared to June 30 2020, was primarily due to the forgiveness of PPP loans.

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Factoring Activities - Bay View Funding

Based in San Jose, 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:


	June 30,		June 30,
	2021		2020

	(Dollars in thousands)
Total factored receivables at period-end	$	47,111	$	41,909
Average factored receivables:
For the three months ended	$	48,993	$	44,574
For the six months ended	$	48,546	$	46,022
Total full time equivalent employees at period-end		31		36

Second Quarter 2021 Highlights

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

●

Net interest income, before provision for credit losses on loans, remained flat at $34.9 million for the second quarter of 2021, compared to $34.9 million for the second quarter of 2020. Net interest income, before provision for credit losses on loans, decreased (5%) to $69.8 million for the first six months of 2021, compared to $73.5 million for the first six months of 2020, primarily due to decreases in the prime rate and decreases in yields on investment securities and overnight funds, which were partially offset by interest income and fees on PPP loans.

●

The fully tax equivalent (“FTE”) net interest margin contracted 46 basis points to 3.00% for the second quarter of 2021, from 3.46% for the second quarter of 2020, primarily due declines in the average yields on loans, investment securities, and overnight funds, partially offset by a decline in the cost of interest-bearing liabilities and higher interest income and fees on PPP loans.

●

For the first six months of 2020, the FTE net interest margin contracted 73 basis points to 3.10%, compared to 3.83% for the first six months of 2020, primarily due to the impact of decreases in the yields on loans, investment securities, and overnight funds, partially offset by additional interest and fee income from PPP loans.

●

The average yield on the loan portfolio decreased to 4.80% for the second quarter of 2021, compared to 4.92% for the second quarter of 2020, primarily due to a decline in the average yield on loans, and an increase in the average balances of lower yielding residential mortgages and PPP loans relative to the average yield on core bank and asset-based lending loans, partially offset by an increase in interest and fees on PPP loans.

●

The average yield on the loan portfolio decreased to 5.01% for the six months ended June 30, 2021, compared to 5.23% for the six months ended June 30, 2020, primarily due to decreases in the prime rate on loans, and an increase in the average balance of lower yielding PPP loans, partially offset by an increase in fees on PPP loans.

●

In aggregate, the original total net purchase discount on loans from the Focus Business Bank, Tri-Valley Bank, United American Bank, and Presidio Bank loan portfolios was $25.2 million. In aggregate, the remaining net purchase discount on total loans acquired was $10.1 million at June 30, 2021.

●

The average cost of total deposits was 0.11% for the second quarter of 2021, compared to 0.17% for the second quarter of 2020. The average cost of total deposits was 0.12% for the first six months of 2021, compared to 0.19% for the first six months of 2020.

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●

There was a recapture of ($493,000) in credit losses on loans in the second quarter of 2021, primarily due to improvements in forecasted macroeconomic conditions offset by changes in the portfolio, compared to a $1.1 million provision for credit losses on loans for the second quarter of 2020.

●

For the six months ended June 30, 2021, there was a recapture of ($2.0) million in credit losses on loans for the six months ended June 30, 2021, compared to a $14.4 million provision for credit losses on loans for the six months ended June 30, 2020. The higher provision for credit losses on loans for the first six months of 2020 was driven primarily by a significantly deteriorated economic outlook resulting from the Coronavirus pandemic. Ongoing impacts of the CECL methodology will be dependent upon changes in economic conditions and forecasts, originated and acquired loan portfolio composition, portfolio duration, and other factors.

●

Total noninterest income was $2.2 million for the second quarter of 2021, compared to $2.1 million for the second quarter of 2020. For the six months ended June 30, 2021, noninterest income decreased to $4.5 million, compared to $5.3 million for the six months ended June 30, 2020, primarily as a result of lower service charges and fees on deposits during the first six months of 2021, and a $791,000 gain on disposition of foreclosed assets during the first six months of 2020.

●

Total noninterest expense for the second quarter of 2021 increased to $25.8 million, compared to $21.0 million for the second quarter of 2020, primarily due to a $4.0 million reserve for a legal settlement. Noninterest expense for the six months ended June 30, 2021 increased to $49.0 million, compared to $46.8 million for the six months ended June 30, 2020, primarily due to the $4.0 million reserve for a legal settlement, partially offset by higher merger-related costs during the first six months of 2020.

●

The efficiency ratio for the second quarter of 2021 was 69.58%, compared to 56.76% for the second quarter of 2020. The efficiency ratio for the six months ended June 30, 2021 was 65.97%, compared to 59.38% for the six months ended June 30, 2020. Excluding the $4.0 million reserve for a legal settlement, the efficiency ratio was 58.78% for the second quarter of 2021. Excluding the $4.0 million reserve for a legal settlement and $1.5 million in severance expense, the efficiency ratio was 58.60% for the first six months of 2021.

●

Income tax expense for the second quarter of 2021 was $3.0 million, compared to $4.3 million for the second quarter of 2020. The effective tax rate for the second quarter of 2021 was 25.1%, compared to 28.7% for the second quarter of 2020. Income tax expense for the six months ended June 30, 2021 was $7.3 million, compared to $5.1 million for the six months ended June 30, 2020. The effective tax rate for the six months ended June 30, 2021 was 26.7%, compared to 29.2% for the six months ended June 30, 2020.

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 18% to $1.47 billion at June 30, 2021, from $1.25 billion at June 30, 2020, and increased 8% from $1.37 billion at December 31, 2020.

●

At June 30, 2021, securities held-to-maturity, at amortized cost, totaled $421.3 million, compared to $322.7 million at June 30, 2020, and $297.4 million, at December 31, 2020.

●

Loans, excluding loans held-for-sale, increased $138.4 million, or 5%, to $2.82 billion at June 30, 2021, compared to $2.69 billion at June 30, 2020, and increased $205.5 million, or 8%, compared to $2.62 billion at December 31, 2020. Total loans at June 30, 2021 included $286.5 million of PPP loans, compared to $324.6 million at June 30, 2020, and $290.7 million at December 31, 2020. Total loans at June 30, 2021, excluding PPP loans, increased $176.5 million from June 30, 2020, and increased $209.8 million from December 31, 2020.

●

NPAs were $6.2 million, or 0.12% of total assets, at June 30, 2021, compared to $9.1 million, or 0.20% of total assets, at June 30, 2020, and $7.9 million, or 0.17% of total assets, at December 31, 2020.

●

Classified assets were $32.4 million, or 0.64% of total assets, at June 30, 2021, compared to $31.5 million, or 0.68% of total assets, at June 30, 2020, and $34.0 million, or 0.73% of total assets, at December 31, 2020.

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●

Net recoveries totaled $153,000 for the second quarter of 2021, compared to net charge-offs of $373,000 for the second quarter of 2020, and net recoveries of $326,000 for the fourth quarter of 2020.

●

The allowance for credit losses on loans (“ACLL”) at June 30, 2021 was $44.0 million, or 1.56% of total loans, representing 711.26% of total nonperforming loans. The ACLL at June 30, 2020 was $45.4 million, or 1.69% of total loans, representing 498.02% of total nonperforming loans. The ACLL at December 31, 2020 was $44.4 million, or 1.70% of total loans, representing 564.24% of total nonperforming loans. The ACLL to total loans, excluding PPP loans, was 1.73% at June 30, 2021, 1.92% at June 30, 2020 and 1.91% at December 31, 2020.

●

Deposits, excluding all time deposits and CDARS deposits, increased $415.4 million, or 11%, to $4.16 billion at June 30, 2021, compared to $3.74 billion at June 30, 2020. Deposits, excluding all time deposits and CDARS deposits, at June 30, 2021 increased $414.2 million, or 11%, compared to $3.74 billion at December 31, 2020.

●

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 3.67% at June 30, 2021, compared to 3.25% at June 30, 2020, and 3.61% at December 31, 2020.

●

The loan to deposit ratio was 65.02% at June 30, 2021, compared to 68.88% at June 30, 2020, and 66.91% at December 31, 2020.

●

The Company’s consolidated capital ratios exceeded regulatory guidelines and the HBC’s capital ratios exceeded the regulatory guidelines for a well-capitalized financial institution under the Basel III regulatory requirements at June 30, 2021.




							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 Capital		15.6	%		15.0	%		10.0	%		10.5	%
Tier 1 Capital		13.3	%		13.9	%		8.0	%		8.5	%
Common Equity Tier 1 Capital		13.3	%		13.9	%		6.5	%		7.0	%
Tier 1 Leverage		8.6	%		9.0	% ��		5.0	%		4.0	%

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

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 the 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

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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.

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 and anounts 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.

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Distribution, Rate and Yield


	Three Months Ended						Three Months Ended
	June 30, 2021						June 30, 2020
			Interest		Average				Interest		Average
	Average		Income /		Yield /		Average		Income /		Yield /
	Balance		Expense		Rate		Balance		Expense		Rate

	(Dollars in thousands)
Assets:
Loans, gross ⁽¹⁾⁽²⁾	$	2,794,421	$	33,439	4.80	%	$	2,687,093	$	32,845	4.92	%
Securities — taxable		479,419		1,944	1.63	%		611,709		3,155	2.07	%
Securities — exempt from Federal tax⁽³⁾		62,257		511	3.29	%		76,160		612	3.23	%
Other investments, interest-bearing deposits
in other financial institutions and Federal funds sold		1,341,987		845	0.25	%		700,711		648	0.37	%
Total interest earning assets		4,678,084		36,739	3.15	%		4,075,673		37,260	3.68	%
Cash and due from banks		42,449						37,716
Premises and equipment, net		10,147						9,096
Goodwill and other intangible assets		183,283						186,716
Other assets		133,134						125,037
Total assets	$	5,047,097					$	4,434,238
Liabilities and shareholders’ equity:
Deposits:
Demand, noninterest-bearing	$	1,808,638					$	1,660,547

Demand, interest-bearing		1,139,090		477	0.17	%		890,158		525	0.24	%
Savings and money market		1,179,321		528	0.18	%		1,009,078		794	0.32	%
Time deposits — under $100		15,335		8	0.21	%		17,825		18	0.41	%
Time deposits — $100 and over		133,935		164	0.49	%		127,877		277	0.87	%
CDARS — interest-bearing demand, money
market and time deposits		31,236		2	0.03	%		15,365		1	0.03	%
Total interest-bearing deposits		2,498,917		1,179	0.19	%		2,060,303		1,615	0.32	%
Total deposits		4,307,555		1,179	0.11	%		3,720,850		1,615	0.17	%

Subordinated debt, net of issuance costs		39,802		577	5.81	%		39,617		577	5.86	%
Short-term borrowings		28		—	0.00	%		62		—	0.00	%
Total interest-bearing liabilities		2,538,747		1,756	0.28	%		2,099,982		2,192	0.42	%
Total interest-bearing liabilities and demand,
noninterest-bearing / cost of funds		4,347,385		1,756	0.16	%		3,760,529		2,192	0.23	%
Other liabilities		116,703						100,770
Total liabilities		4,464,088						3,861,299
Shareholders’ equity		583,009						572,939
Total liabilities and shareholders’ equity	$	5,047,097					$	4,434,238

Net interest income / margin				34,983	3.00	%				35,068	3.46	%
Less tax equivalent adjustment				(107)						(128)
Net interest income			$	34,876					$	34,940

(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 of net deferred loan fees into loan interest income was $2,192,000 for the second quarter of 2021 (of which $1,876,000 was from PPP loans), compared to $773,000 for the second quarter of 2020 (of which $637,000 was from PPP loans).

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

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	Six Months Ended						Six Months Ended
	June 30, 2021						June 30, 2020
			Interest		Average				Interest		Average
	Average		Income /		Yield /		Average		Income /		Yield /
	Balance		Expense		Rate		Balance		Expense		Rate

Assets:
Loans, gross ⁽¹⁾⁽²⁾	$	2,707,858	$	67,275	5.01	%	$	2,600,409	$	67,627	5.23	%
Securities — taxable		458,256		3,672	1.62	%		641,004		7,103	2.23	%
Securities — exempt from Federal tax⁽³⁾		64,373		1,053	3.30	%		78,265		1,259	3.23	%
Other investments, interest-bearing deposits
in other financial institutions and Federal funds sold		1,319,249		1,613	0.25	%		550,734		2,349	0.86	%
Total interest earning assets⁽³⁾		4,549,736		73,613	3.26	%		3,870,412		78,338	4.07	%
Cash and due from banks		41,640						41,128
Premises and equipment, net		10,257						8,851
Goodwill and other intangible assets		183,648						187,110
Other assets		125,961						126,192
Total assets	$	4,911,242					$	4,233,693
Liabilities and shareholders’ equity:
Deposits:
Demand, noninterest-bearing	$	1,761,035					$	1,549,745

Demand, interest-bearing		1,082,962		956	0.18	%		845,479		1,067	0.25	%
Savings and money market		1,158,693		1,100	0.19	%		964,750		1,708	0.36	%
Time deposits — under $100		15,616		17	0.22	%		18,301		40	0.44	%
Time deposits — $100 and over		132,397		335	0.51	%		130,096		582	0.90	%
CDARS — interest-bearing demand, money
market and time deposits		28,265		3	0.02	%		15,960		3	0.04	%
Total interest-bearing deposits		2,417,933		2,411	0.20	%		1,974,586		3,400	0.35	%
Total deposits		4,178,968		2,411	0.12	%		3,524,331		3,400	0.19	%

Subordinated debt, net of issuance costs		39,780		1,148	5.82	%		39,594		1,154	5.86	%
Short-term borrowings		36		—	0.00	%		196		—	0.00	%
Total interest-bearing liabilities		2,457,749		3,559	0.29	%		2,014,376		4,554	0.45	%
Total interest-bearing liabilities and demand,
noninterest-bearing / cost of funds		4,218,784		3,559	0.17	%		3,564,121		4,554	0.26	%
Other liabilities		111,364						93,577
Total liabilities		4,330,148						3,657,698
Shareholders’ equity		581,094						575,995
Total liabilities and shareholders’ equity	$	4,911,242					$	4,233,693

Net interest income ⁽³⁾ / margin				70,054	3.10	%				73,784	3.83	%
Less tax equivalent adjustment ⁽³⁾				(220)						(264)
Net interest income			$	69,834					$	73,520

(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 of net deferred loan fees into loan interest income was $5,881,000 for the first six months of 2021 (of which $5,276,000 was from PPP loans), compared to $912,000 for the first six months of 2020 (of which $637,000 was from PPP loans).

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

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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 June 30,
	2021 vs. 2020
	Increase (Decrease)
	Due to Change in:
	Average		Average		Net
	Volume		Rate		Change

	(Dollars in thousands)
Income from the interest earning assets:
Loans, gross	$	1,282	$	(688)	$	594
Securities — taxable		(542)		(669)		(1,211)
Securities — exempt from Federal tax⁽¹⁾		(114)		13		(101)
Other investments, interest-bearing deposits
in other financial institutions and Federal funds sold		408		(211)		197
Total interest income on interest-earning assets		1,034		(1,555)		(521)

Expense from the interest-bearing liabilities:
Demand, interest-bearing		100		(148)		(48)
Savings and money market		75		(341)		(266)
Time deposits — under $100		(1)		(9)		(10)
Time deposits — $100 and over		8		(121)		(113)
CDARS — interest-bearing demand, money market
and time deposits		1		—		1
Subordinated debt, net of issuance costs		3		(3)		—
Short-term borrowings		—		—		—
Total interest expense on interest-bearing liabilities		186		(622)		(436)
Net interest income	$	848	$	(933)		(85)
Less tax equivalent adjustment						21
Net interest income					$	(64)

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

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	Six Months Ended June 30,
	2021 vs. 2020
	Increase (Decrease)
	Due to Change in:
	Average		Average		Net
	Volume		Rate		Change

	(Dollars in thousands)
Income from the interest earning assets:
Loans, gross	$	2,670	$	(3,022)	$	(352)
Securities — taxable		(1,477)		(1,954)		(3,431)
Securities — exempt from Federal tax⁽¹⁾		(228)		22		(206)
Other investments, interest-bearing deposits
in other financial institutions and Federal funds sold		930		(1,666)		(736)
Total interest income on interest-earning assets		1,895		(6,620)		(4,725)

Expense from the interest-bearing liabilities:
Demand, interest-bearing		201		(312)		(111)
Savings and money market		191		(799)		(608)
Time deposits — under $100		(3)		(20)		(23)
Time deposits — $100 and over		6		(253)		(247)
CDARS — interest-bearing demand, money market
and time deposits		1		(1)		—
Subordinated debt, net of issuance costs		5		(11)		(6)
Short-term borrowings		—		—		—
Total interest expense on interest-bearing liabilities		401		(1,396)		(995)
Net interest income	$	1,494	$	(5,224)		(3,730)
Less tax equivalent adjustment						44
Net interest income					$	(3,686)

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

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The Company’s fully tax equivalent (“FTE”) net interest margin, expressed as a percentage of average earning assets, contracted 46 basis points to 3.00% for the second quarter of 2021, from 3.46% for the second quarter of 2020, primarily due to declines in the average yields on loans, investment securities, and overnight funds, partially offset by a decline in the cost of interest-bearing liabilities and higher interest income and fees on PPP loans.

For the first six months of 2021, the net interest margin contracted 73 basis points to 3.10%, compared to 3.83% for the first six months of 2020, primarily due to the impact of decreases in the yields on loans, investment securities, and overnight funds, partially offset by additional interest and fee income from PPP loans.

During the second quarter of 2021, the Company began a three prong approach to investing excess liquidity. The first was the acquisition of two residential mortgage loan portfolios totaling $140.0 million during the second quarter of 2021 (see “Loans” for further discussion of the loan purchases). The Company also purchased $141.6 million of agency mortgage-backed securities held-to-maturity during the second quarter of 2021 (see “Securities Portfolio” for a further discussion of the securities purchases). In addition, the Company’s core loans, excluding PPP loans and residential mortgage loans, increased by $59.6 million, or 3%, during the second quarter of 2021 from the first quarter of 2021.

The following tables present the average balance of loans outstanding, interest income, and the average yield for the periods indicated:


	For the Quarter Ended						For the Quarter Ended
	June 30, 2021						June 30, 2020
	Average		Interest		Average		Average		Interest		Average
	Balance		Income		Yield		Balance		Income		Yield

	(Dollars in thousands)
Loans, core bank and asset-based lending	$	2,293,398	$	26,004	4.55	%	$	2,369,004	$	27,694	4.70	%
PPP loans		334,604		831	1.00	%		231,251		582	1.01	%
PPP fees, net		—		1,876	2.25	%		—		637	1.11	%
Bay View Funding factored receivables		48,993		2,772	22.69	%		44,574		2,562	23.12	%
Residential mortgages		113,467		981	3.47	%		31,219		197	2.54	%
Purchased CRE loans		14,602		110	3.02	%		25,542		210	3.31	%
Loan fair value mark / accretion		(10,643)		865	0.15	%		(14,497)		963	0.16	%
Total loans (includes loans held-for-sale)	$	2,794,421	$	33,439	4.80	%	$	2,687,093	$	32,845	4.92	%

The average yield on the loan portfolio decreased to 4.80% for the second quarter of 2021, compared to 4.92% for the second quarter of 2020, primarily due to a decline in the average yield on loans, and an increase in the average balances of lower yielding residential mortgages and PPP loans, relative to the average yield on core bank and asset-based lending loans, partially offset by an increase in interest and fees on PPP loans.


	For the Quarter Ended						For the Quarter Ended
	June 30, 2021						December 31, 2020
	Average		Interest		Average		Average		Interest		Average
	Balance		Income		Yield		Balance		Income		Yield

	(Dollars in thousands)
Loans, core bank and asset-based lending	$	2,293,398	$	26,004	4.55	%	$	2,256,944	$	26,348	4.64	%
PPP loans		334,604		831	1.00	%		313,335		787	1.00	%
PPP fees, net		—		1,876	2.25	%		—		1,935	2.46	%
Bay View Funding factored receivables		48,993		2,772	22.69	%		50,720		2,856	22.40	%
Residential mortgages		113,467		981	3.47	%		24,955		118	1.88	%
Purchased CRE loans		14,602		110	3.02	%		20,854		176	3.36	%
Loan fair value mark / accretion		(10,643)		865	0.15	%		(12,017)		687	0.12	%
Total loans (includes loans held-for-sale)	$	2,794,421	$	33,439	4.80	%	$	2,654,791	$	32,907	4.93	%

The average yield on the total loan portfolio decreased to 4.80% for the second quarter of 2021, compared to 4.93% for the fourth quarter of 2020, primarily due to a decline in the average yield on loans, and an increase in the average balance of lower yielding residential mortgages, and a decrease in fees on PPP loans.

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	Six Months Ended						Six Months Ended
	June 30, 2021						June 30, 2020
	Average		Interest		Average		Average		Interest		Average
	Balance		Income		Yield		Balance		Income		Yield

	(Dollars in thousands)
Loans, core bank and asset-based lending	$	2,259,558	$	51,588	4.60	%	$	2,395,469	$	57,798	4.85	%
PPP loans		326,928		1,615	1.00	%		115,669		582	1.01	%
PPP fees, net		—		5,276	3.25	%		—		637	1.11	%
Bay View Funding factored receivables		48,546		5,422	22.52	%		46,022		5,439	23.77	%
Residential mortgages		68,083		1,099	3.26	%		32,147		427	2.67	%
Purchased CRE loans		15,875		281	3.57	%		26,441		459	3.49	%
Loan fair value mark / accretion		(11,132)		1,994	0.18	%		(15,339)		2,285	0.19	%
Total loans (includes loans held-for-sale)	$	2,707,858	$	67,275	5.01	%	$	2,600,409	$	67,627	5.23	%

The average yield on the loan portfolio decreased to 5.01% for the first six months of 2021, compared to 5.23% for the first six months of 2020, primarily due to decreases in the prime rate on loans, and an increase in the average balance of lower yielding PPP loans, partially offset by an increase in fees on PPP loans.

The average cost of total deposits was 0.11% for the second quarter of 2021, compared to 0.17% for the second quarter of 2020. The cost of total deposits was 0.12% for the six months of 2021, compared to 0.19% for the first six months of 2020.

Net interest income, before provision for credit losses on loans, remained relatively flat at $34.9 million for the second quarter of 2021, compared to $34.9 million for the second quarter of 2020. Net interest income, before provision for credit losses on loans decreased (5%) to $69.8 million for the first six months of 2021, compared to $73.5 million for the first six months of 2020, primarily due to decreases in the prime rate and decreases in yields on investment securities and overnight funds, which were partially offset by interest income and fees on PPP loans.

Provision for Credit Losses on Loans

Credit risk is inherent in the business of making loans. The Company establishes an allowance for credit losses on loans through charges to earnings, which are presented in the statements of income as the provision for credit losses on loans. Specifically identifiable and quantifiable known losses are promptly charged off against the allowance. The provision for credit losses on loans is determined by conducting a quarterly evaluation of the adequacy of the Company’s allowance for credit losses on loans 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 credit losses on loans 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. The provision for credit losses on loans and level of allowance for each period are also dependent on forecast data for the state of California including GDP and unemployment projections provided by the California Economic Forecast (“CEF”, www.CaliforniaForecast.com).

During the second quarter of 2021, there was a recapture of ($493,000) in credit losses on loans, primarily due to improvements in forecasted macroeconomic conditions offset by changes in the portfolio, compared to a $1.1 million provision for credit losses on loans taken in the second quarter of 2020. There was a recapture of ($2.0) million in credit losses on loans for the six months ended June 30, 2021, compared to a $14.4 million provision for credit losses on loans for the six months ended June 30, 2020. The higher provision for credit losses on loans for the first six months of 2020 was driven primarily by a significantly deteriorated economic outlook resulting from the Coronavirus pandemic. Ongoing impacts of the CECL methodology will be dependent upon changes in economic conditions and forecasts, originated and acquired loan portfolio composition, portfolio duration, and other factors. Provisions for credit losses on loans are charged to operations to bring the allowance for credit losses on loans to a level deemed appropriate by the Company based on the factors discussed under “Credit Quality and Performance” and “Credit Quality and Allowance for Credit Losses on Loans.”

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Noninterest Income



					Increase
	Three Months Ended				(decrease)
	June 30,				2021 versus 2020
	2021		2020		Amount		Percent

	(Dollars in thousands)
Service charges and fees on deposit accounts	$	659	$	650	$	9	1	%
Increase in cash surrender value of life insurance		458		458		—	0	%
Gain on proceeds from company owned life insurance		396		—		396	N/A
Servicing income		104		205		(101)	(49)	%
Gain on sales of SBA loans		83		—		83	N/A
Gain on sales of securities		—		170		(170)	(100)	%
Other		469		595		(126)	(21)	%
Total	$	2,169	$	2,078	$	91	4	%



					Increase
	Six Months Ended				(decrease)
	June 30,				2021 versus 2020
	2021		2020		Amount		Percent

	(Dollars in thousands)
Service charges and fees on deposit accounts	$	1,260	$	1,619	$	(359)	(22)	%
Increase in cash surrender value of life insurance		914		916		(2)	—	%
Gain on proceeds from company owned life insurance		462		—		462	N/A
Servicing income		286		388		(102)	(26)	%
Gain on sales of SBA loans		633		67		566	845	%
Gain on sales of securities		—		270		(270)	(100)	%
Gain on the disposition of foreclosed assets		—		791		(791)	(100)	%
Other		915		1,220		(305)	(25)	%
Total	$	4,470	$	5,271	$	(801)	(15)	%

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 second quarter of 2021, SBA loan sales resulted in a $83,000 gain, compared to no gain on sales of SBA loans for the second quarter of 2020. For the six months ended June 30, 2021, SBA loan sales resulted in a $633,000 gain, compared to a $67,000 gain on sale of SBA loans for the six months ended June 30, 2020.

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

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



					Increase
	Three Months Ended				(Decrease)
	June 30,				2021 versus 2020
	2021		2020		Amount		Percent

	(Dollars in thousands)
Salaries and employee benefits	$	12,572	$	12,300	$	272	2	%
Reserve for legal settlement		4,000		—		4,000	N/A
Occupancy and equipment		2,247		1,766		481	27	%
Professional fees		1,771		1,155		616	53	%
Amortization of intangible assets		754		964		(210)	(22)	%
Insurance expense		661		516		145	28	%
Data processing		583		779		(196)	(25)	%
Software subscriptions		501		746		(245)	(33)	%
Other, excluding merger-related costs		2,710		2,727		(17)	(1)	%
Total noninterest expense, excluding merger-related costs		25,799		20,953		4,846	23	%
Other merger-related costs (1)		(24)		59		(83)	(141)	%
Total noninterest expense, including merger-related costs	$	25,775	$	21,012	$	4,763	23	%


					Increase
	Six Months Ended				(Decrease)
	June 30,				2021 versus 2020
	2021		2020		Amount		Percent

	(Dollars in thousands)
Salaries and employee benefits	$	26,530	$	26,147	$	383	1	%
Reserve for legal settlement		4,000		—		4,000	N/A
Occupancy and equipment		4,521		3,538		983	28	%
Professional fees		3,490		2,590		900	35	%
Amortization of intangible assets		1,487		1,822		(335)	(18)	%
Insurance expense		1,324		1,034		290	28	%
Data processing		1,117		1,755		(638)	(36)	%
Software subscriptions		977		1,635		(658)	(40)	%
Other, excluding merger-related costs		5,539		5,782		(243)	(4)	%
Total noninterest expense, excluding merger-related costs		48,985		44,303		4,682	11	%
Salaries and employee benefits merger-related costs (2)		—		356		(356)	(100)	%
Other merger-related costs (1)		34		2,127		(2,093)	(98)	%
Total noninterest expense, including merger-related costs	$	49,019	$	46,786	$	2,233	5	%

(1)	Included in the “Other noninterest expense” category in the Consolidated Statements of Income.

(2)	Included in “Salaries and employee benefits” category in the Consolidated Statements of Income.

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


	Three Months Ended June 30,
			Percent of				Percent of
	2021		Total		2020		Total

	(Dollars in thousands)
Salaries and employee benefits	$	12,572	49	%	$	12,300	59	%
Reserve for legal settlement		4,000	15	%		—	—	%
Occupancy and equipment		2,247	9	%		1,766	8	%
Professional fees		1,771	7	%		1,155	5	%
Amortization of intangible assets		754	3	%		964	5	%
Insurance expense		661	3	%		516	2	%
Data processing		583	2	%		779	4	%
Software subscriptions		501	2	%		746	4	%
Other, excluding merger-related costs		2,710	10	%		2,727	13	%
Total noninterest expense, excluding merger-related costs		25,799	100	%		20,953	100	%
Other merger-related costs (1)		(24)	0	%		59	0	%
Total noninterest expense, including merger-related costs	$	25,775	100	%	$	21,012	100	%


	Six Months Ended June 30,
			Percent				Percent
	2021		of Total		2020		of Total

	(Dollars in thousands)
Salaries and employee benefits	$	26,530	54	%	$	26,147	56	%
Reserve for legal settlement		4,000	8	%		—	—	%
Occupancy and equipment		4,521	9	%		3,538	8	%
Professional fees		3,490	7	%		2,590	6	%
Amortization of intangible assets		1,487	3	%		1,822	4	%
Insurance expense		1,324	3	%		1,034	2	%
Data processing		1,117	2	%		1,755	4	%
Software subscriptions		977	2	%		1,635	3	%
Other, excluding merger-related costs		5,539	12	%		5,782	12	%
Total noninterest expense, excluding merger-related costs		48,985	100	%		44,303	95	%
Salaries and employee benefits merger-related costs (2)		—	0	%		356	1	%
Other merger-related costs (1)		34	0	%		2,127	4	%
Total noninterest expense, including merger-related costs	$	49,019	100	%	$	46,786	100	%

(1)Included in the “Other noninterest expense” category in the Consolidated Statements of Income.

(2)Included in “Salaries and employee benefits” category in the Consolidated Statements of Income.

Total noninterest expense for the second quarter of 2021 increased to $25.8 million, compared to $21.0 million for the second quarter of 2020, primarily due to a $4.0 million reserve for a previously disclosed legal settlement (see our Current Report of Form 8-K filed with the Securities Exchange Commission on July 7, 2021). Noninterest expense for the six months ended June 30, 2021 increased to $49.0 million, compared to $46.8 million for the six months ended June 30, 2020, primarily due to the above referenced reserve for a legal settlement, partially offset by higher data processing, software subscriptions, and merger-related costs during the first six months of 2020.

Full time equivalent employees were 330, and 340, and 331, at June 30, 2021, June 30, 2020, and December 31, 2020, respectively.

Income Tax Expense

The Company computes its provision for income taxes on a monthly 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:


	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2021		2020		2021		2020
Effective income tax rate	25.1	%	28.7	%	26.7	%	29.2	%

The difference in the effective tax rate for the periods reported compared to the combined Federal and state statutory tax rate of 29.6% is primarily the result of the Company’s investment in life insurance policies whose earnings are not subject to taxes, tax credits related to investments in low income housing limited partnerships (net of low income housing investment losses), and tax-exempt interest income earned on municipal bonds.

The Company’s Federal and state income tax expense for the second quarter of 2021 was $3.0 million, compared to $4.3 million for the second quarter of 2020. The Company’s Federal and state income tax expense for the six months ended June 30, 2021 was $7.3 million, compared to $5.1 million for the six months ended June 30, 2020.

Some items of income and expense are recognized in one year for tax purposes, and another when applying generally accepted accounting principles, which leads 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 $26.9 million at June 30, 2021, $27.2 million at June 30, 2020, and $28.2 million at December 31, 2020. 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 June 30, 2021, June 30, 2020, and December 31, 2020 will be fully realized in future years.

FINANCIAL CONDITION

At June 30, 2021, total assets increased 10% to $5.07 billion, compared to $4.61 billion at June 30, 2020, and increased 9% from $4.63 billion at December 31, 2020.

Securities available-for-sale, at fair value, were $146.0 million at June 30, 2021, a decrease of (55%) from $323.6 million at June 30, 2020, and a decrease of (38%) from $235.8 million at December 31, 2020. Securities held-to-maturity, at amortized cost, were $421.3 million at June 30, 2021, an increase of 31% from $322.7 million at June 30, 2020, and an increase of 42% from $297.4 million at December 31, 2020.

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compared to $3.74 billion at June 30, 2020. Deposits, excluding all time deposits and CDARS deposits increased $414.2 million, or 11%, compared to $3.74 billion at December 31, 2020.

Securities Portfolio

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


	June 30,				December 31,
	2021		2020		2020

	(Dollars in thousands)
Securities available-for-sale (at fair value):
Agency mortgage-backed securities	$	130,892	$	232,335	$	175,326
U.S. Treasury		15,063		91,230		60,448
Total	$	145,955	$	323,565	$	235,774
Securities held-to-maturity (at amortized cost):
Agency mortgage-backed securities	$	361,184	$	249,070	$	228,652
Municipals — exempt from Federal tax		60,153		73,662		68,791
Total	$	421,337	$	322,732	$	297,443

The following table summarizes the weighted average life and weighted average yields of securities at June 30, 2021:


	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	$	693	2.07	%	$	130,199	1.69	%	$	—	N/A		$	—	N/A		$	130,892	1.69	%
U.S. Treasury		15,063	2.93	%		—	N/A			—	N/A			—	N/A			15,063	2.93	%
Total	$	15,756	2.89	%	$	130,199	1.69	%	$	—	N/A		$	—	N/A		$	145,955	1.82	%

Securities held-to-maturity (at amortized cost):
Agency mortgage-backed securities	$	4,480	0.48	%	$	142,313	1.73	%	$	129,421	1.54	%	$	84,970	1.90	%	$	361,184	1.69	%
Municipals — exempt from Federal tax (1)		32,336	3.23	%		27,817	3.35	%		—	N/A			—	N/A			60,153	3.29	%
Total	$	36,816	2.90	%	$	170,130	2.00	%	$	129,421	1.54	%	$	84,970	1.90	%	$	421,337	1.91	%

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

The securities 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

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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.

During the second quarter of 2021, the Company purchased $141.6 million of agency mortgage-backed securities (securities held-to-maturity), with a book yield of 1.53% and an average life of 5.84 years. During the first six months of 2021, 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 56% of total assets at June 30, 2021, represented 58% at June 30, 2020, and represented 57% at December 31, 2020. The ratio of loans to deposits was 65.02% at June 30, 2021, compared to 68.88% at June 30, 2020, and 66.91% at December 31, 2020.

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:


	June 30, 2021				June 30, 2020				December 31, 2020
	Balance		% to Total		Balance		% to Total		Balance		% to Total

	(Dollars in thousands)
Commercial	$	557,686	20	%	$	553,843	21	%	$	555,707	21	%
SBA PPP loans		286,461	10	%		324,550	12	%		290,679	11	%
Real estate:
CRE - owner occupied		583,091	21	%		553,463	21	%		560,362	21	%
CRE - non-owner occupied		742,135	26	%		725,776	26	%		693,103	27	%
Land and construction		129,426	4	%		138,284	6	%		144,594	6	%
Home equity		107,873	4	%		112,679	4	%		111,885	4	%
Multifamily		198,771	7	%		169,637	6	%		166,425	6	%
Residential mortgages		205,904	7	%		95,033	3	%		85,116	3	%
Consumer and other		21,519	1	%		22,759	1	%		18,116	1	%
Total Loans		2,832,866	100	%		2,696,024	100	%		2,625,987	100	%
Deferred loan fees, net		(8,070)	—			(9,635)	—			(6,726)	—
Loans, net of deferred fees		2,824,796	100	%		2,686,389	100	%		2,619,261	100	%
Allowance for credit losses on loans		(43,956)				(45,444)				(44,400)
Loans, net	$	2,780,840			$	2,640,945			$	2,574,861

The Company’s loan portfolio is concentrated in commercial loans, (primarily manufacturing, wholesale, and services oriented entities), and commercial real estate (“CRE”), 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 June 30, 2021, compared to 66% at June 30, 2020, and 67% at December 31, 2020. 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 CRE loans, commercial loans, construction loans and unsecured lending, among others. The Company uses underwriting guidelines to assess the borrower’s historical cash flow to determine debt service, and 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

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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 six months ended June 30, 2021 and 2020, loans were sold resulting in a gain on sales of SBA loans of $633,000 and $67,000, respectively

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 36 days for the first six months of 2021, compared to 38 days for the first six months of 2020. The balance of the purchased receivables was $47.1 million at June 30, 2021, compared to $41.9 million at June 30, 2020 and $47.2 million at December 31, 2020.

The commercial loan portfolio, excluding PPP loans, increased $3.8 million, or 1%, to $557.7 million at June 30, 2021, from $553.8 million at June 30, 2020 and increased $2.0 million, or 0.36%, from $555.7 million at December 31, 2020. Commercial and industrial (“C&I”) line usage was 27% at June 30, 2021, and June 30, 2020 and 28% at December 31, 2020.

In addition, the Company had $286.5 million in PPP loans at June 30, 2021, compared to $324.6 million at June 30, 2020 and $290.7 million at December 31, 2020.

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 owner-occupied loan portfolio increased $29.6 million, or 5%, to $583.1 million at June 30, 2021, from $553.5 million at June 30, 2020, and increased $22.7 million, or 4%, from $560.4 million at December 31, 2020. CRE non-owner occupied loans increased $16.3 million, or 2%, to $742.1 million, compared to $725.8 million at June 30, 2020, and increased $49.0 million, or 7% from $693.1 million at December 31, 2020. At June 30, 2021, 44% of the CRE loan portfolio was 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 ($8.9) million, or (6%), to $129.4 million at June 30, 2021, compared to $138.3 million at June 30, 2020, and decreased ($15.2) million, or (10%), from $144.6 million at December 31, 2020.

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 decreased ($4.8) million, or (4%), to $107.9 million at June 30, 2021, compared to $112.7 million at June 30, 2020, and decreased ($4.0) million, or (4%), from $111.9 million at December 31, 2020.

Multifamily loans increased $29.2 million, or 17%, to $198.8 million, at June 30, 2021, compared to $169.6 million at June 30, 2020, and increased $32.4 million, or 19%, from $166.4 million at December 31, 2020.

From time to time the Company has purchased single family residential mortgage loans. Residential mortgage loans increased $110.9 million, or 117%, to $205.9 million at June 30, 2021, compared to $95.0 million at June 30, 2020, and increased $120.8 million, or 142% from $85.1 million at December 31, 2020. The increase in residential mortgage loans at June 30, 2021, compared to June 30, 2020 and December 31, 2020, was the result of the purchase of two single

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family residential mortgage loan portfolios during the second quarter of 2021 totaling $140.0 million, all of which are domiciled in California, with an average principal balance of $585,000, and a weighted average yield of approximately 3.39% (excluding servicing costs, which are netted against interest income contributing to a lower overall average yield).

Consumer and other loans decreased ($1.3) million, or (5%), to $21.5 million at June 30, 2021, compared to $22.8 million at June 30, 2020, and increased $3.4 million, or 19% from $18.1 million at December 31, 2020.

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 totaling 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 $96.8 million and $161.4 million at June 30, 2021, respectively.

Loan Maturities

The following table presents the maturity distribution of the Company’s loans (excluding loans held-for-sale) as of June 30, 2021. 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 June 30, 2021, approximately 44% of the Company’s loan portfolio consisted of floating interest rate loans. Excluding fixed-rate PPP loans, approximately 48% of the Company’s loan portfolio consisted of floating interest rate loans as of June 30, 2021.


			Over One
	Due in		Year But
	One Year		Less than		Over
	or Less		Five Years		Five Years		Total

	(Dollars in thousands)
Commercial	$	272,125	$	215,372	$	70,189	$	557,686
SBA PPP loans		99,318		187,143		—		286,461
Real estate:
CRE - owner occupied		114,955		146,683		321,453		583,091
CRE - non-owner occupied		236,325		237,281		268,529		742,135
Land and construction		108,247		10,819		10,360		129,426
Home equity		107,766		—		107		107,873
Multifamily		3,690		76,685		118,396		198,771
Residential mortgages		4,979		17,748		183,177		205,904
Consumer and other		12,723		7,113		1,683		21,519
Loans	$	960,128	$	898,844	$	973,894	$	2,832,866

Loans with variable interest rates	$	826,056	$	253,785	$	152,983	$	1,232,824
SBA PPP loans with fixed interest rates		99,318		187,143		—		286,461
Other loans with fixed interest rates		34,754		457,916		820,911		1,313,581
Loans	$	960,128	$	898,844	$	973,894	$	2,832,866

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Loan Servicing

As of June 30, 2021 and 2020, $73.6 million and $81.3 million, respectively, in SBA loans were serviced by the Company for others. Activity for loan servicing rights was as follows:


	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2021		2020		2021		2020

	(Dollars in thousands)
Beginning of period balance	$	606	$	539	$	531	$	583
Additions		18		—		141		17
Amortization		(96)		(60)		(144)		(121)
End of period balance	$	528	$	479	$	528	$	479

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 June 30, 2021 and 2020, 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				Six Months Ended
	June 30,				June 30,
	2021		2020		2021		2020

	(Dollars in thousands)
Beginning of period balance	$	296	$	458	$	305	$	503
Unrealized holding (loss) gain		(22)		24		(31)		(21)
End of period balance	$	274	$	482	$	274	$	482

Credit Quality and Allowance for Credit Losses on Loans

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 collateral values. 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 $9.5 million and $6.2 million June 30, 2021 and December 31, 2020, respectively, of which $1.7 million were on nonaccrual at June 30, 2021 and $1.9 million at December 31, 2020. At June 30, 2021, there were also $3.6 million loans less than 30 days

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past due included in nonaccrual loans held-for-investment. At December 31, 2020, there were also $5.9 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 on all nonaccrual loans. 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:


	June 30,						December 31,
	2021			2020			2020

	(Dollars in thousands)
Nonaccrual loans — held-for-investment	$	5,291		$	8,457		$	7,788
Restructured and loans 90 days past due and
still accruing		889			668			81
Total nonperforming loans		6,180			9,125			7,869
Foreclosed assets		—			—			—
Total nonperforming assets	$	6,180		$	9,125		$	7,869

Nonperforming assets as a percentage of loans
plus foreclosed assets		0.22	%		0.34	%		0.30	%
Nonperforming assets as a percentage of total assets		0.12	%		0.20	%		0.17	%

Nonperforming assets were $6.2 million, or 0.12% of total assets, at June 30, 2021, compared to $9.1 million, or 0.20% of total assets, at June 30, 2020, and $7.9 million, or 0.17% of total assets, at December 31, 2020.

The following table presents the amortized cost basis of nonperforming loans and loans past due over 90 days and still accruing at June 30, 2021:



					Restructured
	Nonaccrual		Nonaccrual		and Loans
	with no Special		with Special		over 90 Days
	Allowance for		Allowance for		Past Due
	Credit		Credit		and Still
	Losses		Losses		Accruing		Total

	(Dollars in thousands)
Commercial	$	415	$	1,378	$	164	$	1,957
Real estate:
CRE - Owner Occupied		1,774		—		—		1,774
CRE - Non-Owner Occupied		—		—		725		725
Home equity		168		—		—		168
Multifamily		1,149		—		—		1,149
Consumer and other		407		—		—		407
Total	$	3,913	$	1,378	$	889	$	6,180

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The following table presents the amortized cost basis of nonperforming loans and loans past due over 90 days and still accruing at December 31, 2020:



					Restructured
	Nonaccrual		Nonaccrual		and Loans
	with no Special		with Special		over 90 Days
	Allowance for		Allowance for		Past Due
	Credit		Credit		and Still
	Losses		Losses		Accruing		Total

	(Dollars in thousands)
Commercial	$	752	$	1,974	$	81	$	2,807
Real estate:
CRE - Owner Occupied		3,706		—		—		3,706
Home equity		949		—		—		949
Consumer and other		407		—		—		407
Total	$	5,814	$	1,974	$	81	$	7,869

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 presents the amortized cost basis of collateral-dependent loans by loan classification at June 30, 2021:


		Collateral Type
		Real
		Estate		Business
		Property		Assets		Unsecured		Total

	(Dollars in thousands)
Commercial	$	25	$	1,324	$	29	$	1,378
Total	$	25	$	1,324	$	29	$	1,378

The following table presents the amortized cost basis of collateral-dependent loans by loan classification at December 31, 2020:


		Collateral Type
		Real
		Estate		Business
		Property		Assets		Unsecured		Total

	(Dollars in thousands)
Commercial	$	29	$	1,815	$	130	$	1,974
Total	$	29	$	1,815	$	130	$	1,974

Classified loans increased to $32.4 million, or 0.64% of total assets, at June 30, 2021, compared to $31.5 million, or 0.68% of total assets, at June 30, 2020 and decreased from $34.0 million, or 0.73% of total assets at December 31, 2020. Deferrals included in classified assets total $1.1 million at June 30, 2021.

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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.

Beginning January 1, 2020, we calculated allowance for credit losses on loans using CECL methodology. The allowance for credit losses on loans estimation process involves procedures to appropriately consider the unique characteristics of loan portfolio segments. These segments are further disaggregated into loan classes, the level at which credit risk is monitored. When computing the level of expected credit losses, credit loss assumptions are estimated using a model that categorizes loan pools based on loss history, delinquency status, and other credit trends and risk characteristics, including current conditions and reasonable and supportable forecasts about the future. Determining the appropriateness of the allowance is complex and requires judgment by management about the effect of matters that are inherently uncertain. In future periods, evaluations of the overall loan portfolio in light of the factors and forecasts then prevailing, may result in significant changes in the allowance and credit loss expense in those future periods.

The allowance level is influenced by loan volumes, loan risk rating migration or delinquency status, changes in historical loss experience, and other conditions influencing loss expectations, such as reasonable and supportable forecasts of economic conditions. The methodology for estimating the amount of expected credit losses reported in the allowance for credit losses has two basic components: first, an asset-specific component involving individual loans that do not share risk characteristics with other loans and the measurement of expected credit losses for such individual loans; and second, a pooled component for estimated expected credit losses for pools of loans that share similar risk characteristics.

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 credit losses on loans.

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

Commercial loans primarily rely on the identified cash flows of the borrower for repayment and secondarily on the value of underlying collateral provided by the borrower. However, the cash flows of the borrowers may not be as expected and the collateral securing these loans may vary in value. Most commercial loans are secured by the assets being financed or on other business assets such as accounts receivable, inventory or equipment and may incorporate a personal guarantee; however, some loans may be unsecured. Included in commercial loans are $286.5 million of PPP loans at June 30, 2021, $324.6 million at June 30, 2020 and $290.7 million at December 31, 2020. No allowance for credit losses has been recorded for PPP loans as they are fully guaranteed by the SBA. No allowance for credit losses has been recorded for PPP loans as they are fully guaranteed by the SBA.

CRE

Land and Construction

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Home Equity

Home equity loans are secured by 1-4 family residences that are generally owner occupied. Repayment of these loans depends primarily on the personal income of the borrower and secondarily on the value of the property securing the loan which can be impacted by changes in economic conditions such as the unemployment rate and property values.

Multifamily

Residential Mortgages

Consumer and Other

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 credit losses on loans and the associated provision for credit losses on loans.

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 Financial Protection and Innovation (“DFPI”) also review the allowance for credit losses on loans as an integral part of the examination process. Based on information currently available, management believes that the allowance for credit losses on loans 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 further. 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.

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Changes in the allowance for credit losses on loans were as follows for the periods indicated:


	Three Months Ended June 30, 2021
			CRE		CRE
			Owner		Non-owner		Land &		Home		Multi-		Residential		Consumer
	Commercial		Occupied		Occupied		Construction		Equity		Family		Mortgages		and Other		Total

	(Dollars in thousands)
Beginning of period balance	$	11,600	$	8,368	$	16,431	$	2,754	$	1,171	$	2,751	$	918	$	303	$	44,296
Charge-offs		(105)		-		-		-		-		-		-		-		(105)
Recoveries		115		4		-		68		16		-		-		55		258
Net recoveries		10		4		-		68		16		-		-		55		153
Provision for (recapture of) credit losses on loans		(753)		(166)		54		(686)		(118)		199		1,050		(73)		(493)
End of period balance	$	10,857	$	8,206	$	16,485	$	2,136	$	1,069	$	2,950	$	1,968	$	285	$	43,956


	Three Months Ended June 30, 2020
			CRE		CRE
			Owner		Non-owner		Land &		Home		Multi-		Residential		Consumer
	Commercial		Occupied		Occupied		Construction		Equity		Family		Mortgages		and Other		Total

	(Dollars in thousands)
Beginning of period balance	$	12,801	$	7,737	$	15,645	$	2,603	$	1,746	$	1,622	$	708	$	1,841	$	44,703
Charge-offs		(465)		-		-		-		-		-		-		-		(465)
Recoveries		46		1		-		13		31		-		-		1		92
Net (charge-offs) recoveries		(419)		1		-		13		31		-		-		1		(373)
Provision for (recapture of) credit losses on loans		797		809		(196)		(64)		74		206		117		(629)		1,114
End of period balance	$	13,179	$	8,547	$	15,449	$	2,552	$	1,851	$	1,828	$	825	$	1,213	$	45,444


	Six Months Ended June 30, 2021
			CRE		CRE
			Owner		Non-owner		Land &		Home		Multi-		Residential		Consumer
	Commercial		Occupied		Occupied		Construction		Equity		Family		Mortgages		and Other		Total

	(Dollars in thousands)
Beginning of period balance	$	11,587	$	8,560	$	16,416	$	2,509	$	1,297	$	2,804	$	943	$	284	$	44,400
Charge-offs		(368)		-		-		-		-		-		-		-		(368)
Recoveries		928		8		-		884		39		-		-		70		1,929
Net recoveries		560		8		-		884		39		-		-		70		1,561
Provision for (recapture of) credit losses on loans		(1,290)		(362)		69		(1,257)		(267)		146		1,025		(69)		(2,005)
End of period balance	$	10,857	$	8,206	$	16,485	$	2,136	$	1,069	$	2,950	$	1,968	$	285	$	43,956


	Six Months Ended June 30, 2020
			CRE		CRE
			Owner		Non-owner		Land &		Home		Multi-		Residential		Consumer
	Commercial		Occupied		Occupied		Construction		Equity		Family		Mortgages		and Other		Total

	(Dollars in thousands)
Beginning of period balance	$	10,453	$	3,825	$	3,760	$	2,621	$	2,244	$	57	$	243	$	82	$	23,285
Adoption of Topic 326		(3,663)		3,169		7,912		(1,163)		(923)		1,196		435		1,607		8,570
Balance at adoption on January 1, 2020		6,790		6,994		11,672		1,458		1,321		1,253		678		1,689		31,855
Charge-offs		(1,135)		-		-		-		-		-		-		(3)		(1,138)
Recoveries		255		1		-		32		54		-		-		1		343
Net (charge-offs) recoveries		(880)		1		-		32		54		-		-		(2)		(795)
Provision for (recapture of) credit losses on loans		7,269		1,552		3,777		1,062		476		575		147		(474)		14,384
End of period balance	$	13,179	$	8,547	$	15,449	$	2,552	$	1,851	$	1,828	$	825	$	1,213	$	45,444

The following table provides a summary of the allocation of the allowance for credit losses on loans by class at the dates indicated. The allocation presented should not be interpreted as an indication that charges to the allowance for credit losses on loans 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.

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Allocation of Allowance for Credit Losses on Loans


	June 30,
	2021				2020				December 31, 2020
			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	$	10,857	30	%	$	13,179	33	%	$	11,587	32	%
Real estate:
CRE - owner occupied		8,206	21	%		8,547	21	%		8,560	21	%
CRE - non-owner occupied		16,485	26	%		15,449	26	%		16,416	27	%
Land and construction		2,136	4	%		2,552	6	%		2,509	6	%
Home equity		1,069	4	%		1,851	4	%		1,297	4	%
Multifamily		2,950	7	%		1,828	6	%		2,804	6	%
Residential mortgages		1,968	7	%		825	3	%		943	3	%
Consumer and other		285	1	%		1,213	1	%		284	1	%
Total	$	43,956	100	%	$	45,444	100	%	$	44,400	100	%

The allowance for credit losses on loans totaled $44.0 million, or 1.56% of total loans at June 30, 2021. The allowance for credit losses on loans was $45.4 million, or 1.69% of total loans at June 30, 2020, and $44.4 million, or 1.70% of total loans at December 31, 2020. The allowance for credit losses on loans was 711.26% of nonperforming loans at June 30, 2021, compared to 498.02% of nonperforming loans at June 30, 2020, and 564.24% of nonperforming loans at December 31, 2020. The allowance for credit losses on loans to total loans, excluding PPP loans, was 1.73% at June 30, 2021, 1.92% at June 30, 2020 and 1.91% at December 31, 2020. The Company had net recoveries of $153,000, or (0.02%) of average loans, for the second quarter of 2021, compared to net charge-offs of $373,000, or 0.06% of average loans, for the second quarter of 2020 and net recoveries of $326,000, or (0.05%) of average loans for the fourth quarter of 2020.

The following table shows the drivers of change in ACLL under CECL for each of the first two quarters of 2021:


DRIVERS OF CHANGE IN ACLL UNDER CECL
(in $000’s, unaudited)
ACLL at December 31, 2020	$	44,400
Net recoveries during the first quarter of 2021		1,408
Portfolio changes during the first quarter of 2021		313
Economic factors during the first quarter of 2021		(1,825)
ACLL at March 31, 2021		44,296
Net recoveries during the second quarter of 2021		153
Portfolio changes during the second quarter of 2021		2,153
Economic factors during the second quarter of 2021		(2,646)
ACLL at June 30, 2021	$	43,956

Leases

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 were $36.6 million on its consolidated statement of financial condition at June 30, 2021, 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.

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

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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:


	June 30, 2021				June 30, 2020				December 31, 2020
	Balance		% to Total		Balance		% to Total		Balance		% to Total

	(Dollars in thousands)
Demand, noninterest-bearing	$	1,840,516	42	%	$	1,714,058	42	%	$	1,661,655	42	%
Demand, interest-bearing		1,140,867	26	%		934,780	24	%		960,179	24	%
Savings and money market		1,174,587	27	%		1,091,740	28	%		1,119,968	29	%
Time deposits — under $250		42,118	1	%		49,493	2	%		45,027	1	%
Time deposits — $250 and over		110,111	3	%		93,822	3	%		103,746	3	%
CDARS — interest-bearing demand,
money market and time deposits		36,273	1	%		16,333	1	%		23,911	1	%
Total deposits	$	4,344,472	100	%	$	3,900,226	100	%	$	3,914,486	100	%

The Company obtains deposits from a cross-section of the communities it serves. The Company’s business is not generally seasonal in nature. Public funds were less than 1% of deposits at June 30, 2021, June 30, 2020, and December 31, 2020.

Total deposits increased $444.2 million, or 11%, to $4.34 billion at June 30, 2021, compared to $3.90 billion at June 30, 2020. Total deposits increased $430.0 million, or 11%, from $3.91 billion at December 31, 2020. Deposits, excluding all time deposits and CDARS deposits, increased $415.4 million, or 11%, to $4.16 billion at June 30, 2021, compared to $3.74 billion at June 30, 2020. Deposits, excluding all time deposits and CDARS deposits, increased $414.2 million, or 11%, compared to $3.74 billion at December 31, 2020.

At June 30, 2021, the $36.3 million CDARS deposits comprised $29.4 million of interest-bearing demand deposits, $441,000 of money market accounts and $6.4 million of time deposits. At June 30, 2020, the $16.3 million CDARS deposits comprised $8.7 million of interest-bearing demand deposits, $763,000 of money market accounts and $6.9 million of time deposits. At December 31, 2020, the $23.9 million CDARS deposits comprised $18.6 million of interest-bearing demand deposits, $663,000 of money market accounts and $4.6 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 June 30, 2021:


	Balance		% of Total

	(Dollars in thousands)
Three months or less	$	47,482	41	%
Over three months through six months		32,944	28	%
Over six months through twelve months		28,818	25	%
Over twelve months		7,282	6	%
Total	$	116,526	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.

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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				Six Months Ended
	June 30,				June 30,
	2021		2020		2021		2020
Return on average assets	0.70	%	0.96	%	0.82	%	0.59	%
Return on average tangible assets	0.73	%	1.01	%	0.85	%	0.62	%
Return on average equity	6.06	%	7.45	%	6.95	%	4.36	%
Return on average tangible equity	8.84	%	11.06	%	10.16	%	6.45	%
Average equity to average assets ratio	11.55	%	12.92	%	11.83	%	13.61	%

Liquidity and Asset/Liability Management

The Company’s liquidity position supports its ability to maintain cash flows sufficient to fund operations, meet all of its financial obligations and commitments, and accommodate unexpected sudden changes in balances of loans and deposits in a timely manner. 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 repayment of liabilities. An integral part of the Company’s ability to manage its liquidity position appropriately is derived from its 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.

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 net 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 the loan to deposit ratio. The loan to deposit ratio was 65.02% at June 30, 2021, compared to 68.88% at June 30, 2020, and 66.91% at December 31, 2020.

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 June 30, 2021, June 30, 2020, and December 31, 2020. HBC had $220.6 million of loans pledged to the FHLB as collateral on an available line of credit of $159.4 million at June 30, 2021, none of which was outstanding. HBC also had $2.1 million of securities pledged to the FHLB as collateral on an available line of credit of $2.0 million at June 30, 2021, none of which was outstanding.

HBC can also borrow from the FRB’s discount window. HBC had $965.5 million of loans pledged to the FRB as collateral on an available line of credit of $555.0 million at June 30, 2021, none of which was outstanding.

At June 30, 2021, HBC had Federal funds purchased arrangements available of $90.0 million. There were no Federal funds purchased outstanding at June 30, 2021, June 30, 2020, and December 31, 2020.

The Company has a $10.0 million line of credit with a correspondent bank, of which none was outstanding at June 30, 2021.

HBC may also utilize securities sold under repurchase agreements to manage its liquidity position. There were no securities sold under agreements to repurchase at June 30, 2021, June 30, 2020, and December 31, 2020.

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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.

On May 26, 2017, the Company completed an underwritten public offering of $40.0 million aggregate principal amount of 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.

It is anticipated that the LIBOR index will be phased-out by the end of 2021 and the Federal Reserve Bank of New York has established the Secured Overnight Financing Rate (“SOFR”) as its recommended alternative to LIBOR. We have created a sub-committee of our Asset Liability Management Committee to address LIBOR transition and phase-out issues. We are currently reviewing loan documentation, technology systems and procedures we will need to implement for the transition.

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:


	June 30,			June 30,			December 31,
	2021			2020			2020

	(Dollars in thousands)
Capital components:
Common Equity Tier 1 capital	$	418,134		$	399,669		$	410,307
Additional Tier 1 capital		—			—			—
Tier 1 Capital		418,134			399,669			410,307
Tier 2 Capital		73,341			74,344			73,563
Total Capital	$	491,475		$	474,013		$	483,870

Risk-weighted assets	$	3,142,524		$	2,983,550		$	2,924,448
Average assets for capital purposes	$	4,853,907		$	4,232,259		$	4,507,032

Capital ratios:
Total Capital		15.6	%		15.9	%		16.5	%
Tier 1 Capital		13.3	%		13.4	%		14.0	%
Common equity Tier 1 Capital		13.3	%		13.4	%		14.0	%
Tier 1 Leverage(1)		8.6	%		9.4	%		9.1	%

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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:


	��	June 30,			June 30,			December 31,
		2021			2020			2020

		(Dollars in thousands)
Capital components:
Common Equity Tier 1 capital		$	436,192		$	417,084		$	428,109
Additional Tier 1 capital			—			—			—
Tier 1 Capital			436,192			417,084			428,109
Tier 2 Capital			33,509			34,697			33,824
Total Capital		$	469,701		$	451,781		$	461,933

Risk-weighted assets		$	3,140,695		$	2,982,526		$	2,922,577
Average assets for capital purposes		$	4,852,000		$	4,230,356		$	4,505,265

Capital ratios:
Total Capital			15.0	%		15.1	%		15.8	%
Tier 1 Capital			13.9	%		14.0	%		14.6	%
Common Equity Tier 1 Capital			13.9	%		14.0	%		14.6	%
Tier 1 Leverage(1)			9.0	%		9.9	%		9.5	%

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

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 Capital	10.5	%	10.0	%
Tier 1 Capital	8.5	%	8.0	%
Common equity Tier 1 Capital	7.0	%	6.5	%
Tier 1 Leverage	4.0	%	5.0	%

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

The Basel III capital rules introduced 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 June 30, 2021, 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 June 30, 2021, June 30, 2020, and December 31, 2020, the Company and HBC met all capital adequacy guidelines to which they were subject. There are no conditions or events since June 30, 2021, that management believes have changed the categorization of the Company or HBC as well-capitalized.

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At June 30, 2021, the Company had total shareholders’ equity of $583.4 million, compared to $574.8 million at June 30, 2020, and $577.9 million at December 31, 2020. At June 30, 2021, total shareholders’ equity included $495.7 million in common stock, $99.3 million in retained earnings, and ($11.5) million of accumulated other comprehensive loss. The book value per share was $9.69 at June 30, 2021, compared to $9.60 at June 30, 2020, and $9.64 at December 31, 2020. The tangible book value per share was $6.65 at June 30, 2021, compared to $6.49 at June 30, 2020, and $6.57 at December 31, 2020.

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


ACCUMULATED OTHER COMPREHENSIVE LOSS	June 30,		December 31,		June 30,
(in $000's, unaudited)	2021		2020		2020
Unrealized gain on securities available-for-sale	$	2,674	$	3,709	$	5,767
Remaining unamortized unrealized gain on securities
available-for-sale transferred to held-to-maturity		243		261		280
Split dollar insurance contracts liability		(6,142)		(6,140)		(4,865)
Supplemental executive retirement plan liability		(8,506)		(8,767)		(6,707)
Unrealized gain on interest-only strip from SBA loans		199		220		345
Total accumulated other comprehensive loss	$	(11,532)	$	(10,717)	$	(5,180)

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 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 Management’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.

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

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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).

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 June 30, 2021. 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	$	62,496	49.4	%
+300	$	47,041	37.2	%
+200	$	31,549	25.0	%
+100	$	15,940	12.6	%
0		—	—
−100	$	(12,357)	(9.8)	%
−200	$	(23,548)	(18.6)	%

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.

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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 June 30, 2021. 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 June 30, 2021, the period covered by this report on Form 10-Q.

During the three and six months ended June 30, 2021, 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.

Part II—OTHER INFORMATION

ITEM 1—LEGAL PROCEEDINGS

We evaluate all claims and lawsuits with respect to their potential merits, our potential defenses and counterclaims, settlement or litigation potential and the expected effect on us. The outcome of any claims or litigation, regardless of the merits, is inherently uncertain. Any claims and other lawsuits, and the disposition of such claims and lawsuits, whether through settlement or litigation, could be time-consuming and expensive to resolve, divert our attention from executing our business plan, result in efforts to enjoin our activities, and lead to attempts by third parties to seek similar claims.

For more information regarding legal proceedings, see Note 13 “Commitments and Loss Contingencies” to the consolidated financial statements.

ITEM 1A—RISK FACTORS

A discussion of risk factors affecting us as is set forth in Part I, Item 1A. Risk Factors, on pages 27-57 of our 2020 Annual Report on Form 10-K. The discussion of risk factors provides a description of some of the important risk factors that could affect our actual results and could cause our results to vary materially from those expressed in public statements or documents. However, other factors besides those included in the discussion of risk factors, or discussed elsewhere in any of our reports filed with or furnished to the SEC could affect our business or results. The readers should not consider any description of such factors to be a complete set of all potential risks that we may face.

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

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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		Certificate of Amendment of Articles of Incorporation of Heritage Commerce Corp as filed with the Secretary of State on August 29, 2019 (incorporated by reference to Exhibit 3.3 to the Registrant’s Quarterly Report on Form 10-Q filed on November 11, 2019)
3.4		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 Instance Document - the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document
101.SCH		XBRL Taxonomy Extension Schema
101.CAL		XBRL Taxonomy Extension Calculation Linkbase
101.DEF		XBRL Taxonomy Extension Definition Linkbase
101.LAB		XBRL Taxonomy Extension Label Linkbase
101.PRE		XBRL Taxonomy Extension Presentation Linkbase
104.		The cover page from Heritage Commerce Corp's Quarterly Report on Form 10-Q for the quarter ended June 30, 2021, formatted in Inline XBRL

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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: August 6, 2021	/s/ wALTER T. KACZMAREK
	Walter T. Kaczmarek
	Chief Executive Officer

Date: August 6, 2021	/s/ Lawrence D. mcgovern
	Lawrence D. McGovern
	Chief Financial Officer

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Heritage Commerce (HTBK) 10-Q2021 Q2 Quarterly report

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