Valley Commerce Bancorp (VCBP) 10-K 2012 FY Annual report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

(Mark one)
ý	Annual report under Section 13 or 15(d) of the Securities Exchange Act of 1934
For the Fiscal Year December 31, 2012
o	Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

Commission file number:000-51949

Valley Commerce Bancorp
(Exact name of registrant as specified in its charter)

California	46-1981399
(State or other jurisdiction of incorporation or organization)	(I.R.S.  Employer Identification No.)
701 West Main Street, Visalia, California  93291
(Address of principal executive offices and Zip Code)
(559) 622-9000 (Issuer’s telephone number, including area code)

[None]

(Former name, former address and former fiscal year, if changed since last report)

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act: Common Stock, No Par Value; Preferred Stock Purchase Rights

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

Yes  o No  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.

Yes  o No  x

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  x  No  o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Sec. 229.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes  x No  o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  £

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

Large accelerated filero	Accelerated filero	Non-accelerated filero	Smaller reporting companyx
		(Do not check if a
		smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
	Yes  o	No  x

As ofJune 30, 2012 the aggregate market value of the registrant’s common stock held by non-affiliates of the Registrant was $30,630,523 million based on the average bid and asked price reported to the Registrant on that date of $11.00 per share.

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Class	Outstanding at March 28, 2013
Common Stock, no par value	2,815,036 shares

DOCUMENTS INCORPORATED BY REFERENCE

None.

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TABLE OF CONTENTS

Part I

		Page
Item 1.	Business	5
Item 1A.	Risk Factors	17
Item 1B.	Unresolved Staff Comments	19
Item 2.	Properties	19
Item 3.	Legal Proceedings	20
Item 4.	Mine Safety Disclosures	20
Part II
Item 5.	Market For Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity  Securities	21
Item 6.	Selected Financial Data	24
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	26
Item 7A.	Quantitative and Qualitative Disclosure About Market Risk	44
Item 8.	Financial Statements and Supplementary Data	44
Item 9.	Changes in and Disagreements With Accountants on Accounting and Financial Disclosure	104
Item 9A.	Controls and Procedures	104
Item 9B.	Other Information	104
Part III
Item 10.	Directors, Executive Officers, and Corporate Governance.	105
Item 11.	Executive Compensation	111
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	114
Item 13.	Certain Relationships and Related Transactions and Director Independence	116
Item 14.	Principal Accountant Fees and Services	118
Part IV
Item 15.	Exhibits, Financial Statement Schedules	118
	Signatures	119

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PART I

Forward-Looking Information

Certain matters discussed in this Annual Report on Form 10-K including, but not limited to, those described in Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations, are forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ materially from those projected in the forward-looking statements. Such risks and uncertainties include, among others: (1) significant increases in competitive pressure in the banking and financial services industries; (2) changes in the interest rate environment, which could reduce anticipated or actual margins; (3) changes in the regulatory environment; (4) general economic conditions, either nationally or regionally and especially in the Company’s primary service area failing to improve or continuing to deteriorate and resulting in, among other things, a deterioration in credit quality and increases in the provision for loan loss; (5) operational risks, including data processing systems failures or fraud; (6) changes in business conditions and inflation; (7) changes in technology; (8) changes in monetary and tax policies; and (9) changes in the securities markets; (10) civil disturbances or terrorist threats or acts, or apprehension about the possible future occurrences or acts of this type; (11) outbreak or escalation of hostilities in which the United States is involved, any declaration of war by the U.S. Congress or any other national or international calamity, crisis or emergency; (12) changes in laws and regulations; (13) new or recently issued accounting pronouncements; (14) government policies, regulations, and their enforcement (including Bank Secrecy Act-related matters, taxing statutes and regulations; (15) restrictions on dividends that our subsidiaries are allowed to pay to us; (16) the ability to satisfy requirements related to the Sarbanes-Oxley Act and other regulation on internal control; and (17) management’s ability to manage these and other risks. Therefore, the information set forth in such forward-looking statements should be carefully considered when evaluating the business prospects of the Company.

When the Company uses in this Annual Report on Form 10-K the words “anticipate,” “estimate,” “expect,” “project,” “intend,” “commit,” “believe” and similar expressions, the Company intends to identify forward-looking statements.  Such statements are not guarantees of performance and are subject to certain risks, uncertainties and assumptions, including those described in this Annual Report on Form 10-K.  Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those anticipated, estimated, expected, projected, intended, committed or believed.  The future results and shareholder values of the Company may differ materially from those expressed in these forward-looking statements.  Many of the factors that will determine these results and values are beyond the Company’s ability to control or predict. The Company undertakes no obligation to revise or publicly release the results of any revision to these forward-looking statements. For those statements, the Company claims the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995.

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ITEM 1 – BUSINESS

General

Valley Commerce Bancorp (the “Company,” “we” or “us”) was incorporated on February 2, 2002 as a California corporation. The Company is the holding company for Valley Business Bank (the “Bank”), a California state chartered bank based in Visalia California. The Company is registered as a bank holding company under the Bank Holding Company Act of 1956, as amended (the “BHC Act”), and is subject to supervision and regulation by the Board of Governors of the Federal Reserve System (the “FRB”). Our executive offices are located at 701 West Main Street, Visalia, California 93291. The Company’s website is located at www.valleybusinessbank.net.

The BHC Act requires us to obtain the prior approval of the FRB before acquisition of all or substantially all of the assets of any bank or ownership or control of the voting shares of any bank if, after giving effect to the acquisition, we would own or control, directly or indirectly, more than 5% of the voting shares of that bank.

As a bank holding company, we may not engage in any business other than managing or controlling banks or furnishing services to our subsidiary, with the exception of certain activities which, in the opinion of the FRB, are so closely related to banking or to managing or controlling banks as to be incidental to banking. In addition, we are generally prohibited from acquiring direct or indirect ownership or control of more than 5% of the voting shares of any company unless that company is engaged in such authorized activities and the FRB approves the acquisition.

At December 31, 2012, the Company had one banking subsidiary, the Bank. The Company’s principal source of income is dividends from the Bank. The cash outlays of the Company, including operating expenses and debt service costs, as well as any future cash dividends paid to Company shareholders if and when declared by the Board of Directors, costs of repurchasing Company stock, and the cost of servicing debt, will generally be paid from dividends paid to the Company by the Bank. Other sources of cash include settlement of intercompany transactions and funds received from exercise of stock options.

The Company’s principal business is to provide, through its banking subsidiary, financial services in its primary market area in California. The Company serves Tulare and Fresno Counties and the surrounding area through the Bank. The Company does not currently conduct any operations other than through the Bank. Unless the context otherwise requires, references to the Company refer to the Company and the Bank on a consolidated basis.

At December 31, 2012, the Company’s assets totaled $360.9 million. As of December 31, 2012, the Company had a total of 83 employees and 80 full time equivalent employees, including the employees of the Bank.

On November 20, 2012, the Board of Directors of Valley Commerce Bancorp, approved a resolution to deregister the Company’s common stock with the Securities and Exchange Commission (the “SEC”) and terminate the Company’s reporting obligations under the Securities and Exchange Act of 1934, as amended (the “Exchange Act”. The deregistration decision was made pursuant to the Jumpstart Our Business Startups Act or JOBS Act signed into law on April 5, 2012 which allows bank holding companies with 2,000 or fewer shareholders of record to deregister. The deregistration action is expected to become effective in the first quarter of 2013. Once effective, the Company’s obligation to file certain reports with the SEC under the Exchange Act, including annual reports on Form 10-K. Quarterly reports on Form 10-Q, current reports on Form 8-K, and proxy statements, will be immediately suspended.

This Annual Report on Form 10-K and other reports filed under the Securities Exchange Act of 1934 with the SEC will be accessible on the Company’s website, www.valleybusinessbank.net, as soon as practicable after the Company files the document with the SEC. These reports are also available through the SEC’s website at www.sec.gov.

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The Bank.As a California state-chartered bank that is not a member of the Federal Reserve Bank , Valley Business Bank is subject to primary supervision, examination and regulation by the Federal Deposit Insurance Corporation (the “FDIC”), the California Department of Financial Institutions (the “DFI”) and is subject to applicable regulations of the FRB. The Bank’s deposits are insured by the FDIC to applicable limits. As a consequence of the extensive regulation of commercial banking activities in California and the United States, banks are particularly susceptible to changes in California and federal legislation and regulations, which may have the effect of increasing the cost of doing business, limiting permissible activities or increasing competition.

Various other requirements and restrictions under the laws of the United States and the State of California affect the operations of the Bank. Federal and California statutes and regulations relate to many aspects of the Bank’s operations, including reserves against deposits, interest rates payable on deposits, loans, investments, mergers and acquisitions, borrowings, dividends, branching, capital requirements and disclosure obligations to depositors and borrowers. California law presently permits a bank to locate a branch office in any locality in the state. Additionally, California law exempts banks from California usury laws.

The Bank was organized in 1995 and commenced business as a California state chartered bank in 1996.  The Bank’s deposits are insured by the Federal Deposit Insurance Corporation (“FDIC:) up to applicable limits. See “Regulation and Supervision -- Deposit Insurance and Premiums.”

The Bank’s target customers are local businesses, professionals and commercial property owners. The Bank’s income is derived primarily from interest earned on loans, and, to a lesser extent, interest on investment securities, and fees for services provided to deposit customers. The Bank’s major operating expenses are the interest paid on deposits and borrowings, and general operating expenses. In general, the business of the Bank is not seasonal.

The Bank conducts its business through its branch offices located in Visalia, Fresno, Woodlake, Tipton and Tulare, all in California’s South San Joaquin Valley. The Visalia office opened in 1996 and the Visalia/Tulare county area is the current principal market of the Bank. The Woodlake and Tipton branch offices were acquired from Bank of America in 1998, primarily to obtain core deposits. The Fresno Branch was acquired in 2003 to allow the Bank to commence commercial banking operations in the Fresno metropolitan area. The full service Tulare branch office opened in May 2008 in replacement of the Tulare loan production office that had been operating in leased quarters since January 2005.

Bank Lending Activities. The Bank originates primarily commercial mortgage loans, secured and unsecured commercial loans and construction loans. It also originates a small number of consumer and agricultural loans and brokers single-family residential loans to other mortgage lenders. The Bank targets small businesses, professionals and commercial property owners in its market area for loans. It attracts and retains borrowers primarily on the basis of personalized service, responsive handling of their needs, local promotional activity, and personal contacts by officers, directors and staff. The majority of loans bear interest at adjustable rates tied to the Valley Business Bank prime rate, which is administered by management and will not necessarily change at the same time or by the same amount as the prevailing national prime rate. At December 31, 2012, Valley Business Bank’s prime rate was 1% higher than the prevailing national prime rate as published in theWall Street Journal. The remaining loans in the Bank’s portfolio either bear interest at adjustable rates tied to the national prime rate or are priced with fixed rates or under custom pricing programs. For customers whose loan demands exceed the Bank’s lending limits, the Bank seeks to make those loans and concurrently sell participation interests in them to other lenders.

No individual or single group of related accounts is considered material in relation to the Bank’s assets or in relation to the overall business of the Bank. At December 31, 2012 approximately 80% of the Bank’s loan portfolio consisted of real estate-related loans, including construction loans, real estate mortgage loans and commercial loans secured by real estate, while 18% of the loan portfolio was comprised of commercial loans for which repayment is expected to come from the underlying cash flows of the borrower’s business operation.   Currently, the business activities of the Bank are mainly concentrated in Tulare County, California. Consequently, the results of operations and financial condition of the Bank are dependent upon the general trends in this part of the California economy and, in particular, the residential and commercial real estate markets. In addition, the concentration of the Bank’s operations in this area of California exposes it to potentially greater risk than other banking companies with a wider geographic base.

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Bank Deposit Activities. The Bank offers a full range of deposit products including non-interest bearing demand deposit accounts and interest-bearing money market, savings, and time deposit accounts. The Bank also has access to time deposits through deposit brokers. The Bank’s deposits are a combination of business and consumer accounts.  No individual deposit account or group of related deposit accounts is considered material in relation to the Bank’s total deposits. The loss of any one account or group of related accounts is not expected to have a material adverse effect on the Bank.

Other Bank Services. The Bank offers Internet banking services, including electronic payments as well as remote deposit capture and mobile banking. The Bank also offers courier services, safe deposit boxes, and other customary bank services. The Bank provides certain services such as international banking transactions to its customers through correspondent banks. Bank management is continually engaged in the evaluation of products and services to enable the Bank to retain and improve its competitive position. The Bank holds no patents or licenses (other than licenses required by appropriate bank regulatory agencies), franchises, or concessions.

Competition and Growth. The Company’s primary market area is Tulare and Fresno counties. In California generally and in the Company’s market area specifically, major banks and large regional banks dominate the commercial banking industry. Many of the Company’s competitors have substantially greater lending limits than the Bank, as well as more locations, more products and services, greater economies of scale and greater ability to make investments in technology for the delivery of financial services.

The Company’s principal competitors for deposits and loans are major banks, other local banks, savings and loan associations, credit unions, and brokerages. In addition, management anticipates that improved technology and effective marketing strategies will enable nontraditional competitors to effectively compete for loan and deposit business.

Despite a very competitive banking environment and a weakened economy, the Company’s total assets grew from $340.2 million at December 31, 2009, to $360.8 million at December 31, 2012, an increase of 6%. The Company’s success in marketing to its target customers are primarily responsible for this growth.

The Company’s significant balance sheet components for the last four years are detailed further in the following table:

	December 31,
(dollars in 000’s)	2012		2011		2010		2009
Total assets	$	360,879	$	366,521	$	341,421	$	340,172
Loans, net		227,260		224,532		234,304		234,823
Deposits		315,484		315,877		294,278		294,282
Shareholders’ equity		37,903		42,505		38,750		36,869

As of June 30, 2012 (date of latest available statistics from FDIC), there were 16 commercial banks and savings associations with a total of 66 offices in Tulare County. On this same date, the Company’s market share of FDIC-insured deposits in Tulare County was approximately 7.21% of the total $3.4 billion in deposits. The Company believes that it can gain additional market share in its principal market of Tulare County while it works to expand its core customer base in the metropolitan Fresno area.

Supervision and Regulation

General

The Company and the Bank are subject to extensive regulation under both federal and state law. This regulation is intended primarily for the protection of depositors, the deposit insurance fund, and the banking system as a whole, and not the protection of shareholders of the Company. Set forth below is a summary description of some of the significant laws and regulations applicable to the Company and the Bank. The description is qualified in its entirety by reference to the applicable laws and regulations.

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Dodd-Frank Wall Street Reform and Consumer Protection Act

On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) was enacted. The Dodd-Frank Act is intended to effect a fundamental restructuring of federal banking regulation. Among other things, the Dodd-Frank Act creates a new Financial Stability Oversight Council to identify systemic risks in the financial system and gives federal regulators new authority to take control of and liquidate financial firms. The Dodd-Frank Act is expected to have a significant impact on our business operations as its provisions take effect. Among the provisions that are likely to affect us are the following:

•          Holding Company Capital Requirements. The Dodd-Frank Act requires the FRB to apply consolidated capital requirements to depository institution holding companies that are no less stringent than those currently applied to depository institutions. Under these standards, trust preferred securities will be excluded from Tier 1 capital unless such securities were issued prior to May 19, 2010 by a bank holding company with less than $15 billion in assets. The Dodd-Frank Act also requires capital requirements to be countercyclical so that the required amount of capital increases in times of economic expansion and decreases in times of economic contraction, consistent with safety and soundness

•          Source of Strength Requirement. The Dodd-Frank Act codified the FRB’s long-standing “source of strength” policy, requiring that a bank holding company serve as a source of financial strength for any subsidiary bank.

•          Deposit Insurance. The Dodd-Frank Act permanently increases the maximum deposit insurance amount for banks, savings institutions and credit unions to $250,000 per depositor, and extended unlimited deposit insurance to non-interest bearing transaction accounts through December 31, 2012. The Dodd-Frank Act also broadened the base for FDIC insurance assessments. Assessments are now based on the average consolidated total assets less tangible equity capital of a financial institution, rather than on deposits as in the past. Assessment rates would be reduced to a range of 2.5 to 9 basis points on the broader assessment base for banks in the lowest risk category (“well capitalized” and CAMELS I or II) up to 30 to 45 basis points for banks in the highest risk category. The Dodd-Frank Act requires the FDIC to increase the reserve ratio of the Deposit Insurance Fund from 1.15% to 1.35% of insured deposits by 2020 and eliminates the requirement that the FDIC pay dividends to insured depository institutions when the reserve ratio exceeds certain thresholds. The Dodd-Frank Act also eliminated the federal statutory prohibition against the payment of interest on business checking accounts.

•          Corporate Governance. The Dodd-Frank Act requires publicly traded companies to give shareholders a non-binding vote on executive compensation at their first annual meeting taking place six months after the date of enactment and at least every three years thereafter and on so-called “golden parachute” payments in connection with approvals of mergers and acquisitions unless previously voted on by shareholders. Publicly traded companies that qualify as smaller reporting companies, such as the Company, are not required to comply with these voting requirements until 2013. The new legislation also authorizes the SEC to promulgate rules that would allow shareholders to nominate their own candidates using a company’s proxy materials. The Dodd-Frank Act directs the federal banking regulators to promulgate rules prohibiting excessive compensation paid to executives of depository institutions and their holding companies with assets in excess of $1.0 billion, regardless of whether the company is publicly traded. It also gives the SEC authority to prohibit broker discretionary voting on elections of directors and executive compensation matters.

•          Interstate Branching. The Dodd-Frank Act authorizes national and state banks to establish branches in other states to the same extent as a bank chartered by that state would be permitted to branch. Previously, banks could only establish branches in other states if the host state expressly permitted out-of-state banks to establish branches in that state. Accordingly, banks will now be able to enter markets in some states more freely than prior to adoption of the act.

•          Limits on Derivatives. The Dodd-Frank Act prohibits state-chartered banks from engaging in derivatives transactions unless the loans to one borrower limits of the state in which the bank is chartered take into consideration credit exposure to derivatives transactions. For this purpose, derivative transaction includes any contract, agreement, swap, warrant, note or option that is based in whole or in part on the value of, any interest in, or any quantitative measure or the occurrence of any event relating to, one or more commodities securities, currencies, interest or other rates, indices or other assets.

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•          Consumer Financial Protection Bureau. The Dodd-Frank Act created a new, independent federal agency called the Consumer Financial Protection Bureau (“CFPB”), which has broad rulemaking, supervisory and enforcement powers under various federal consumer financial protection laws, including the Equal Credit Opportunity Act, Truth in Lending Act, Real Estate Settlement Procedures Act, Fair Credit Reporting Act, Fair Debt Collection Act, the Consumer Financial Privacy provisions of the Gramm-Leach-Bliley Act and certain other statutes. The CFPB has examination and primary enforcement authority with respect to depository institutions with $10 billion or more in assets. Smaller institutions will be subject to rules promulgated by the CFPB but will continue to be examined and supervised by federal banking regulators for consumer compliance purposes. The CFPB will have authority to prevent unfair, deceptive or abusive practices in connection with the offering of consumer financial products. The Dodd-Frank Act authorizes the CFPB to establish certain minimum standards for the origination of residential mortgages including a determination of the borrower’s ability to repay. In addition, the Dodd-Frank Act will allow borrowers to raise certain defenses to foreclosure if they receive any loan other than a “qualified mortgage” as defined by the CFPB. The Dodd-Frank Act permits states to adopt consumer protection laws and standards that are more stringent than those adopted at the federal level and, in certain circumstances, permits state attorneys general to enforce compliance with both the state and federal laws and regulations.

Emergency Economic Stabilization Act and American Recovery and Reinvestment Act

On October 3, 2008, Congress adopted the Emergency Economic Stabilization Act (“EESA”), including a Troubled Asset Relief Program (“TARP”). TARP gave the United States Treasury Department (“Treasury”) authority to deploy up to $700 billion into the financial system for the purpose of improving liquidity in capital markets. On October 14, 2008, Treasury announced plans to direct $250 billion of this authority into preferred stock investments in banks and bank holding companies through a Capital Purchase Program (“CPP”). The American Recovery and Reinvestment Act of 2009 was signed into law on February 17, 2009 and imposed additional restrictions and requirements on TARP participants. The Company elected to participate in the CPP by issuing (i) 7,700 shares of the Company’s Fixed Rate Cumulative Preferred Stock, Series B (the “Series B Preferred Stock”) and (ii) a warrant to purchase 385 shares of the Company’s Fixed Rate Cumulative Perpetual Preferred Stock Series C stock, (the “Warrant Preferred” or “Series C Preferred Stock”) for a combined purchase price of $7,700,000. The Treasury exercised the Warrant immediately upon issuance, acquiring 385 shares of Series C Preferred Stock. Cumulate dividends accrued on the Series B Preferred Stock at the rate of 5% per annum for the first five years and 9% dividends thereafter. Cumulative dividends accrued on the Series C Preferred Stock at the rate of 9% per annum. On March 21, 2012, the Company repurchased all of the outstanding shares of Series B Preferred Stock and Series C Preferred Stock from Treasury for a total of $8,126,965, which includes the aggregate redemption price of $8,085,000 plus accrued but unpaid dividends of $41,965.

Guidance on Sound Incentive Compensation Policies

In 2010, the federal bank regulators jointly issued final guidance on sound incentive compensation policies ("SICP") intended to ensure that the incentive compensation policies of banking organizations do not undermine safety and soundness by encouraging excessive risk-taking. The SICP guidance, which covers all employees who have the ability to materially affect the risk profile of an organization, is based on the principles that a banking organization's incentive compensation arrangements should (i) provide incentives that do not encourage risk-taking beyond the organization's ability to effectively identify and manage risks, (ii) be compatible with effective internal controls and risk management, and (iii) be supported by strong corporate governance, including active and effective oversight by the organization's board of directors. Any deficiencies in compensation practices that are identified may be incorporated into the organization's supervisory ratings, and result in enforcement actions.

Bank Holding Company Act

The Company is registered as a bank holding company under the Bank Holding Company Act of 1956, as amended (“BHCA”). As a bank holding company, the Company is subject to examination by the FRB and is subject to limitations on the kinds of businesses in which it can engage directly or through subsidiaries. While the Company may manage or control banks, it is generally prohibited from acquiring direct or indirect ownership or control of more than five percent of any class of voting shares of an entity engaged in non-banking activities, unless the FRB finds such activities to be "so closely related to banking" as to be deemed "a proper incident thereto" within the meaning of the BHCA. As a bank holding company, the Company may not acquire more than five percent of the voting shares of any domestic bank without the prior approval of (or, for “well managed” companies, prior written notice to) the FRB. The BHCA includes minimum capital requirements for bank holding companies. See the section titled “–Capital Adequacy Requirements”. Under certain conditions, the FRB may conclude that certain actions of a bank holding company, such as the payment of a cash dividend, would constitute an unsafe and unsound banking practice.

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Sarbanes-Oxley Act

The Sarbanes-Oxley Act of 2002 implemented legislative reforms intended to address corporate and accounting fraud. In addition to the establishment of an accounting oversight board to enforce auditing, quality control and independence standards, the law restricts provision of both auditing and consulting services by accounting firms. To ensure auditor independence, any non-audit services being provided to an audit client require pre-approval by the company's audit committee members. In addition, the audit partners assigned to the company must be rotated every five years. The act requires chief executive officers and chief financial officers, or their equivalent, to certify to the accuracy of periodic reports filed with the SEC, subject to civil and criminal penalties if they knowingly or willfully violate the certification requirement. Under the act legal counsel are required to report evidence of a material violation of the securities laws or a breach of fiduciary duty by a company to its chief executive officer or its chief legal officer, and, if such officer does not appropriately respond, to report such evidence to the audit committee or other similar committee of the board of directors or the board itself.

The act also prohibits any officer or director of a company or any other person acting under their direction from taking any action to fraudulently influence, coerce, manipulate or mislead any independent public or certified accountant engaged in the audit of the company's financial statements for the purpose of rendering the financial statement's materially misleading. The act requires the SEC to prescribe rules requiring inclusion of an internal control report and assessment by both management and the external auditors in the annual report to stockholders. In addition, the act requires that each financial report required to be prepared in accordance with (or reconciled to) accounting principles generally accepted in the United States and filed with the SEC reflect all material correcting adjustments that are identified by a "registered public accounting firm" in accordance with accounting principles generally accepted in the United States and the rules and regulations of the SEC.

The Company’s chief executive officer and chief financial officer are each required to certify that the Company’s quarterly and annual reports do not contain any untrue statement of a material fact. The rules have several requirements, including having these officers certify that: they are responsible for establishing, maintaining and regularly evaluating the effectiveness of the Company’s internal controls; they have made certain disclosures to the Company’s auditors and the audit committee of the Board of Directors about the Company’s internal controls; and they have included information in the Company’s quarterly and annual reports about their evaluation and whether there have been significant changes in the Company’s internal controls or in other factors that could significantly affect internal controls subsequent to the evaluation.

Regulation of the Bank

The Bank is extensively regulated by federal and state authorities. As a California state-chartered commercial bank with deposit accounts insured by the FDIC to the maximum amount permitted by law, the Bank is regulated, supervised and examined by the Commissioner of the California Department of Financial Institutions (“the Commissioner”) and the FDIC. The Bank must also comply with certain regulations issued by the FRB. The regulations of the Commissioner, the FRB and the FDIC govern most aspects of the Bank’s business, including the making of periodic reports by the Bank, as well as the Bank’s activities relating to dividends, investments, loans, borrowings, capital requirements, certain check-clearing activities, branching, mergers and acquisitions, reserves against deposits, the issuance of securities and numerous other areas. The Bank is also subject to the requirements and restrictions of various consumer laws and regulations, as well as applicable provisions of California law, insofar as they do not conflict with and are not preempted by federal banking laws. Supervision, legal action and examination of the Bank by the regulatory agencies are generally intended to protect depositors and are not intended for the protection of shareholders.

The laws of the State of California affect the Bank’s business and operations. The California Financial Code provides that if the Commissioner believes that a bank is violating its articles of incorporation or state law, or is engaging in unsafe or injurious business practices, the Commissioner can order that bank to comply with the law or to cease the unsafe or injurious practices and has authority to impose civil money penalties. The Commissioner has the power to suspend or remove bank officers, directors and employees who violate any law or regulation relating to the business of the bank or breach any fiduciary duty to the bank, engage in any unsafe and unsound practices related to the business of the bank, or are charged with or convicted of a felony involving dishonesty or breach of trust. The Commissioner also has authority to take possession of and to liquidate a bank, to appoint a conservator for a bank and to appoint the FDIC as receiver for a bank.

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The FDIC can pursue an enforcement action against a bank for unsafe and unsound practices in conducting its business, or for violations of any law, rule or regulation or provision, any consent order with any agency, any condition imposed in writing by the agency, or any written agreement with the agency. Enforcement actions may include the imposition of a conservator or receiver, cease-and-desist orders and written agreements, the termination of insurance of deposits, the imposition of civil money penalties and removal and prohibition orders against institution-affiliated parties.

In addition to the regulation and supervision outlined above, banks must be prepared for judicial scrutiny of their lending and collection practices. For example, some banks have been found liable for exercising remedies which their loan documents authorized upon the borrower’s default. This has occurred in cases where the exercise of those remedies was determined to be inconsistent with the previous course of dealing between those banks and the borrowers. As a result, banks have had to exercise increased caution, incur greater expense and face increased exposure to liability when dealing with defaulting loans.

Capital Adequacy Requirements

Federal regulations establish guidelines for calculating “risk-adjusted” capital ratios. These guidelines, which apply to banks and bank holding companies, establish a systematic approach of assigning risk weights to bank assets and commitments, making capital requirements more sensitive to differences in risk profiles among banking organizations. For these purposes, “Tier 1” capital consists of common equity, non-cumulative perpetual preferred stock and minority interests in the equity accounts of consolidated subsidiaries and excludes goodwill. “Tier 2” capital consists of cumulative perpetual preferred stock, limited-life preferred stock, mandatory convertible securities, subordinated debt and (subject to a limit of 1.25% of risk-weighted assets) general loan loss reserves. In calculating the relevant ratio, a bank’s assets and off-balance sheet commitments are risk-weighted; thus, for example, generally loans are included at 100% of their book value while assets considered less risky are included at a percentage of their book value (20%, for example, for inter-bank obligations and Government Agency securities, and 0% for vault cash and U.S. Government securities). Under these regulations, to be considered adequately capitalized, banks and bank holding companies are required to maintain a risk-based capital ratio of 8%, with Tier 1 risk-based capital (primarily shareholders’ equity) constituting at least 50% of total qualifying capital or 4% of risk-weighted assets. The FDIC may impose additional capital requirements on banks based on market risk.

The risk-based capital ratio focuses principally on broad categories of credit risk, and may not take into account many other factors that can affect a bank’s financial condition. These factors include overall interest rate risk exposure; liquidity, funding and market risks; the quality and level of earnings; concentrations of credit risk; certain risks arising from nontraditional activities; the quality of loans and investments; the effectiveness of loan and investment policies; and management’s overall ability to monitor and control financial and operating risks, including the risk presented by concentrations of credit and nontraditional activities. . In addition to evaluating capital ratios, an overall assessment of capital adequacy must take account of each of these other factors including, in particular, the level and severity of problem and adversely classified assets. For this reason, the final supervisory judgment on a bank’s capital adequacy may differ significantly from the conclusions that might be drawn solely from the absolute level of the bank’s risk-based capital ratio. Banks generally are expected to operate above the minimum risk-based capital ratio. Banks contemplating significant expansion plans, as well as those institutions with high or inordinate levels of risk, are required to hold capital consistent with the level and nature of the risks to which they are exposed.

Further, the banking agencies have adopted modifications to the risk-based capital regulations to include standards for interest rate risk exposures. Interest rate risk is the exposure of a bank’s current and future earnings and equity capital arising from movements in interest rates. While interest rate risk is inherent in a bank’s role as a financial intermediary, it introduces volatility to bank earnings and to the economic value of the bank. The banking agencies have addressed this problem by implementing changes to the capital standards to include a bank’s exposure to declines in the economic value of its capital due to changes in interest rates as a factor that the banking agencies consider in evaluating an institution’s capital adequacy. Bank examiners consider a bank’s historical financial performance and its earnings exposure to interest rate movements as well as qualitative factors such as the adequacy of a bank’s internal interest rate risk management.

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Under certain circumstances, the FDIC may determine that the capital ratios for a bank must be maintained at levels which are higher than the minimum levels required by the guidelines. A bank that does not achieve and maintain required capital levels may be subject to supervisory action by the FDIC through the issuance of a capital directive to ensure the maintenance of required capital levels. In addition, the Bank is required to meet certain guide-lines of the FDIC concerning the maintenance of an adequate allowance for loan and lease losses.

The federal banking agencies, including the FDIC, have adopted regulations implementing a system of prompt corrective action under the Federal Deposit Insurance Corporation Improvement Act (“FDICIA”). The regulations establish five capital categories with the following characteristics: (1) ”Well capitalized,” consisting of institutions with a total risk based capital ratio of 10.0% or greater, a Tier 1 risk based capital ratio of 6.0% or greater and a leverage ratio of 5.0% or greater and which are not operating under an order, written agreement, capital directive or prompt corrective action directive; (2) ”Adequately capitalized,” consisting of institutions with a total risk based capital ratio of 8.0% or greater, a Tier 1 risk based capital of 4.0% or greater and a leverage ratio of 4.0% or greater and which do not meet the definition of a “well capitalized” institution; (3) ”Undercapitalized,” consisting of institutions with a total risk based capital ratio of less than 8.0%, a Tier 1 risk based capital ratio of less than 4.0%, or a leverage ratio of less than 4.0%; (4) ”Significantly undercapitalized,” consisting of institutions with a total risk based capital ratio of less than 6.0%, a Tier 1 risk based capital ratio of less than 3.0%, or a leverage ratio of less than 3.0%; and (5) ”Critically undercapitalized,” consisting of institutions with a ratio of tangible equity to total assets that is equal to or less than 2.0%.

The regulations establish procedures for the classification of financial institutions within the capital categories, for filing and reviewing capital restoration plans required under the regulations, and for the issuance of directives by the appropriate regulatory agency, among other matters. See “Supervision and Regulation -- Prompt Corrective Action” for additional discussion regarding regulations.

An institution that is less than well-capitalized cannot accept brokered deposits without the consent of the FDIC. The appropriate federal banking agency, after notice and an opportunity for a hearing, is authorized to treat a well capitalized, adequately capitalized or undercapitalized insured depository institution as if it had a lower capital based classification if it is in an unsafe and unsound condition or engaging in an unsafe and unsound practice. Thus, an adequately capitalized institution can be subjected to the restrictions (described below) that are imposed on undercapitalized institutions (provided that a capital restoration plan cannot be required of the institution), and an undercapitalized institution can be subjected to the restrictions (also described below) applicable to significantly undercapitalized institutions. See “Supervision and Regulation -- Prompt Corrective Action” for additional discussion regarding federal banking agency supervision.

An insured depository institution cannot make a capital distribution (as broadly defined to include, among other things, dividends, redemptions and other repurchases of stock), or pay management fees to any person or persons that control the institution, if it would be undercapitalized following the distribution. However, a federal banking agency may (after consultation with the FDIC) permit an insured depository institution to repurchase, redeem, retire or otherwise acquire its shares if (i) the action is taken in connection with the issuance of additional shares or obligations in at least an equivalent amount and (ii) the action will reduce the institution’s financial obligations or otherwise improve its financial condition. An undercapitalized institution is generally prohibited from increasing its average total assets, and is also generally prohibited from making acquisitions, establishing new branches, or engaging in any new line of business except under an accepted capital restoration plan or with the approval of the FDIC. In addition, a federal banking agency has authority with respect to undercapitalized depository institutions to take any of the actions it is required to or may take with respect to a significantly undercapitalized institution (as described below) if it determines “that those actions are necessary to carry out the purpose” of FDICIA.

The federal banking agencies have adopted a joint agency policy statement to provide guidance on managing interest rate risk. The statement indicates that the adequacy and effectiveness of a bank’s interest rate risk management process and the level of its interest rate exposures are critical factors in the agencies’ evaluation of the bank’s capital adequacy. If a bank has material weaknesses in its risk management process or high levels of exposure relative to its capital, the agencies will direct it to take corrective action. These directives may include recommendations or directions to raise additional capital, strengthen management expertise, improve management information and measurement systems, or reduce levels of exposure, or to undertake some combination of these actions.

At December 31, 2012, the Company and the Bank have capital ratios that place them in the “well capitalized” category. See Note 11 to the Company’s financial statements included in Item 8 of this Annual Report.

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Safety and Soundness Standards

Federal banking regulators have adopted guidelines prescribing standards for safety and soundness. The guidelines create standards for a wide range of operational and managerial matters including (a) internal controls, information systems, and internal audit systems; (b) loan documentation; (c) credit underwriting; (d) interest rate exposure; (e) asset growth; (f) compensation and benefits; and (g) asset quality and earnings. Although meant to be flexible, an institution that falls short of the guidelines’ standards may be requested to submit a compliance plan or be subjected to regulatory enforcement actions.

Deposit Insurance Premiums

The FDIC has developed a risk based assessment system providing that the assessment rate for an insured depository institution varies according to the level of risk incurred in its activities. Institutions are classified into one of four risk categories. The FDIC is able to assess higher rates to institutions with a significant reliance on secured liabilities or a significant reliance on brokered deposits but, for well-managed and well-capitalized institutions, only when accompanied by rapid asset growth.

Assessments are now based on the average consolidated total assets less tangible equity capital of a financial institution, rather than on deposits as in the past. Assessment rates range from 2.5 to 9 basis points on the broader assessment base for banks in the lowest risk category (“well capitalized” and CAMELS I or II) and up to 30 to 45 basis points for banks in the highest risk category.

In February 2009, the FDIC announced a proposed special emergency assessment of 20 basis points, with the possibility of an additional emergency assessment. The FDIC ultimately adopted a special assessment of 5 basis points times an institution’s assets less its Tier 1 capital, not to exceed 10 basis points times its deposit assessment base. In addition, in December 2009, the FDIC assessed an estimate of the insurance premiums for 2009, 2010 and 2011 totaling $1,617,383. This prepaid amount will be amortized to expense over 2009, 2010 and 2011.

The Dodd-Frank Act resulted in additional changes in assessments for deposit insurance, including a revised range of assessment rates against a base determined by reference to assets and capital rather than to deposits. See “Dodd-Frank Wall Street Reform and Consumer Protection Act -- Deposit Insurance” above.

Brokered Deposit Restrictions

Well-capitalized institutions are not subject to limitations on brokered deposits, while an adequately capitalized institution is able to accept, renew or roll over brokered deposits only with a waiver from the FDIC and subject to certain restrictions on the yield paid on such deposits. Undercapitalized institutions are generally not permitted to accept, renew, or roll over brokered deposits.

Prompt Corrective Action

The FDIC has authority: (a) to request that an institution’s primary regulatory agency (in the case of the Bank, the Commissioner) take enforcement action against it based upon an examination by the FDIC or the agency, (b) if no action is taken within 60 days and the FDIC determines that the institution is in an unsafe and unsound condition or that failure to take the action will result in continuance of unsafe and unsound practices, to order that action be taken against the institution, and (c) to exercise this enforcement authority under “exigent circumstances” merely upon notification to the institution’s primary regulatory agency. This authority gives the FDIC the same enforcement powers with respect to any institution and its subsidiaries and affiliates as the primary regulatory agency has with respect to those entities.

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An undercapitalized institution is required to submit an acceptable capital restoration plan to its primary federal bank regulatory agency. The plan must specify (a) the steps the institution will take to become adequately capitalized, (b) the capital levels to be attained each year, (c) how the institution will comply with any regulatory sanctions then in effect against the institution and (d) the types and levels of activities in which the institution will engage. The banking agency may not accept a capital restoration plan unless the agency determines, among other things, that the plan “is based on realistic assumptions, and is likely to succeed in restoring the institution’s capital” and “would not appreciably increase the risk . . . to which the institution is exposed.” A requisite element of an acceptable capital restoration plan for an undercapitalized institution is a guaranty by its parent holding company that the institution will comply with the capital restoration plan. Liability with respect to this guaranty is limited to the lesser of (i) 5% of the institution’s assets at the time when it becomes undercapitalized and (ii) the amount necessary to bring the institution into capital compliance with applicable capital standards as of the time when the institution fails to comply with the plan. The guaranty liability is limited to companies controlling the undercapitalized institution and does not affect other affiliates. In the event of a bank holding company’s bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to priority of payment over the claims of other creditors, including the holders of the company’s long term debt.

FDICIA provides that the appropriate federal regulatory agency must require an insured depository institution that is significantly undercapitalized, or that is undercapitalized and either fails to submit an acceptable capital restoration plan within the time period allowed by regulation or fails in any material respect to implement a capital restoration plan accepted by the appropriate federal banking agency, to take one or more of the following actions: (a) sell enough shares, including voting shares, to become adequately capitalized; (b) merge with (or be sold to) another institution (or holding company), but only if grounds exist for appointing a conservator or receiver; (c) restrict specified transactions with banking affiliates as if the “sister bank” exception to the requirements of Section 23A of the Federal Reserve Act did not exist; (d) otherwise restrict transactions with bank or non-bank affiliates; (e) restrict interest rates that the institution pays on deposits to “prevailing rates” in the institution’s “region”; (f) restrict asset growth or reduce total assets; (g) alter, reduce or terminate activities; (h) hold a new election of directors; (i) dismiss any director or senior executive officer who held office for more than 180 days immediately before the institution became undercapitalized, provided that in requiring dismissal of a director or senior executive officer, the agency must comply with procedural requirements, including the opportunity for an appeal in which the director or officer will have the burden of proving his or her value to the institution; (j) employ “qualified” senior executive officers; (k) cease accepting deposits from correspondent depository institutions; (l) divest non-depository affiliates which pose a danger to the institution; (m) be divested by a parent holding company; and (n) take any other action which the agency determines would better carry out the purposes of the prompt corrective action provisions.

In addition to the foregoing sanctions, without the prior approval of the appropriate federal banking agency, a significantly undercapitalized institution may not pay any bonus to any senior executive officer or increase the rate of compensation for a senior executive officer without regulatory approval. If an undercapitalized institution has failed to submit or implement an acceptable capital restoration plan the appropriate federal banking agency is not permitted to approve the payment of a bonus to a senior executive officer.

Not later than 90 days after an institution becomes critically undercapitalized, the institution’s primary federal bank regulatory agency must appoint a receiver or a conservator, unless the agency, with the concurrence of the FDIC, determines that the purposes of the prompt corrective action provisions would be better served by another course of action. Any alternative determination must be documented by the agency and reassessed on a periodic basis. Notwithstanding the foregoing, a receiver must be appointed after 270 days unless the FDIC determines that the institution has positive net worth, is in compliance with a capital plan, is profitable or has a sustainable upward trend in earnings, and is reducing its ratio of non performing loans to total loans, and unless the head of the appropriate federal banking agency and the chairperson of the FDIC certify that the institution is viable and not expected to fail.

The FDIC is required, by regulation or order, to restrict the activities of critically undercapitalized institutions. The restrictions must include prohibitions on the institution’s doing any of the following without prior FDIC approval: entering into any material transactions not in the usual course of business, extending credit for any highly leveraged transaction; engaging in any “covered transaction” (as defined in Section 23A of the Federal Reserve Act) with an affiliate; paying “excessive compensation or bonuses”; and paying interest on “new or renewed liabilities” that would increase the institution’s average cost of funds to a level significantly exceeding prevailing rates in the market.

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Potential Enforcement Actions and Supervisory Agreements

Under federal law, banks and their institution affiliated parties may be the subject of potential enforcement actions by the FDIC for unsafe and unsound practices in conducting their businesses, or for violations of any law, rule or regulation or provision, any consent order with any agency, any condition imposed in writing by the agency or any written agreement with the agency. During periods of economic stress, regulatory oversight can be expected to increase and regulatory agencies become more aggressive in responding to concerns and trends identified in examinations. One result of this heightened activity is an increase in the issuance of enforcement actions. Enforcement actions may include the imposition of a conservator or receiver, cease and desist orders and written agreements, the termination of insurance of deposits, the imposition of civil money penalties and removal and prohibition orders against institution affiliated parties.

Payment of Dividends

The Company. The ability of the Company to make dividend payments is subject to statutory and regulatory restrictions. A California corporation such as the Company may make a distribution to its shareholders if the corporation’s retained earnings equal at least the amount of the proposed distribution. In the event sufficient retained earnings are not available for the proposed distribution, a California corporation may nevertheless make a distribution to its shareholders if, giving effect to the distribution, the value of the corporation’s assets would equal or exceed the value of its liabilities plus the amount of shareholder preferences, if any.

The primary source of funds for payment of any dividends by the Company to its shareholders will be the receipt of dividends and management fees from the Bank.

The Bank. Under California law the holders of the Bank’s common stock are entitled to receive dividends out of funds legally available for the payment of dividends when and as declared by the Board of Directors, provided the conditions described below are satisfied.

The payment of cash dividends by the Bank depends on various factors, including the earnings and capital requirements of the Bank and other financial conditions. California law provides that, as a state-licensed bank, the Bank may not make a cash distribution to its shareholders in excess of the lesser of the following: (a) the Bank’s retained earnings or (b) 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 that period. However, a bank such as the Bank, with the prior approval of the Commissioner, may make a distribution to its shareholders of an amount not to exceed the greater of (1) the Bank’s retained earnings, (2) the Bank’s net income for its last fiscal year, or (3) the Bank’s net income for the current fiscal year. If the Commissioner determines that the shareholders’ equity of the Bank is inadequate or that the making of a distribution by the Bank would be unsafe or unsound, the Commissioner may order the Bank to refrain from making a proposed distribution.

Accordingly, the future payment of cash dividends by the Company will not only depend upon the Bank's earnings during any fiscal period but will also depend upon the assessment of its Board of Directors of capital requirements and other factors, including dividend guidelines and the maintenance of an adequate allowance for loan and lease losses.

Community Reinvestment Act

Pursuant to the Community Reinvestment Act (“CRA”) of 1977, the federal regulatory agencies that oversee the banking industry are required to use their authority to encourage financial institutions to help meet the credit needs of the local communities in which such institutions are chartered, consistent with safe and sound banking practices. When conducting an examination of a financial institution such as the Bank, the agencies assess the institution’s record of meeting the credit needs of its entire community, including low- and moderate- income neighborhoods. This record is taken into account in an agency’s evaluation of an application for creation or relocation of domestic branches or for merger with another institution. Failure to address the credit needs of a bank’s community may also result in the imposition of certain other regulatory sanctions, including a requirement that corrective action be taken.

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Transactions with Affiliates

Sections 23A and 23B of the Federal Reserve Act and the FRB’s Regulation W limit transactions between a bank and its affiliates and limit a bank’s ability to transfer to its affiliates the benefits arising from the bank's access to insured deposits, the payment system and the discount window and other benefits of the Federal Reserve system. The statute and regulation impose quantitative and qualitative limits on the ability of a bank to extend credit to, or engage in certain other transactions with, an affiliate (and a non-affiliate if an affiliate benefits from the transaction). However, certain transactions that generally do not expose a bank to undue risk or abuse the safety net are exempted from coverage under Regulation W.

Tying Arrangements and Transactions with Affiliated Persons

A bank is prohibited from tie in arrangements in connection with any extension of credit, sale or lease of property or furnishing of services. For example, with some exceptions, a bank may not condition an extension of credit on a promise by its customer to obtain other services provided by it, its holding company or other subsidiaries (if any), or on a promise by its customer not to obtain other services from a competitor.

Directors, officers and principal shareholders of the Bank, and the companies with which they are associated, may have banking transactions with the Bank in the ordinary course of business. Any loans and commitments to loan included in these transactions must be made in compliance with the requirements of applicable law, on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other persons of similar creditworthiness, and on terms not involving more than the normal risk of collectability or presenting other unfavorable features.

Consumer Laws and Regulations

The Bank must also comply with consumer laws and regulations that are designed to protect consumers in transactions with banks. While the list is not exhaustive, these laws and regulations include the Truth in Lending Act, the Truth in Savings Act, the Electronic Funds Transfer Act, the Expedited Funds Availability Act, the Equal Credit Opportunity Act, the Fair Housing Act and the Fair Credit Reporting Act among others. These laws and regulations mandate disclosure requirements and regulate the manner in which financial institutions must deal with customers when taking deposits or making loans. The Bank must comply with the applicable provisions of these consumer protection laws and regulations as part of its ongoing regulatory compliance and customer relations efforts.

Impact of Government Monetary Policy

The earnings of the Bank are and will be affected by the policies of regulatory authorities, including the Federal Reserve. An important function of the Federal Reserve is to regulate the national supply of bank credit. Among the instruments used to implement these objectives are open market operations in U.S. Government securities, changes in reserve requirements against bank deposits, and changes in the discount rate which banks pay on advances from the Federal Reserve System. These instruments are used in varying combinations to influence overall growth and distribution of bank loans, investments and deposits, and their use may also affect interest rates on loans or interest rates paid for deposits. The monetary policies of the FRB have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future. The effect, if any, of such policies upon the future business earnings of the Bank cannot be predicted.

Legislation and Proposed Changes

From time to time, legislation is enacted which has the effect of increasing the cost of doing business, limiting or expanding permissible activities or affecting the competitive balance between banks and other financial institutions. Proposals to change the laws and regulations governing the operations and taxation of banks, bank holding companies and other financial institutions are frequently made in Congress and before various bank regulatory agencies. For example, certain proposals to substantially revise the structure of regulation of financial services are under consideration. No prediction can be made as to the likelihood of any major changes or the impact that new laws or regulations might have on the Company or the Bank.

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Conclusion

It is impossible to predict with any certainty the competitive impact the laws and regulations described above will have on commercial banking in general and on the business of the Company in particular, or to predict whether or when any of the proposed legislation and regulations described above will be adopted. It is anticipated that banking will continue to be a highly regulated industry. Additionally, there has been a continued lessening of the historical distinction between the services offered by financial institutions and other businesses offering financial services, and the trend toward nationwide interstate banking is expected to continue. As a result of these factors, it is anticipated banks will experience increased competition for deposits and loans and, possibly, further increases in their cost of doing business.

Recent Accounting Pronouncements

See Note 2 – “Summary of Significant Accounting Policies – Adoption of New Financial Accounting Standards” of the Company’s Consolidated Financial Statements in Item 8 – Financial Statements and Supplementary Data of this Annual Report on Form 10-K for information related to recent accounting pronouncements.

ITEM 1A - RISK FACTORS

Deterioration of local real estate values could reduce our profitability. At December 31, 2012, approximately 80% of the Company’s loan portfolio was secured by real estate. There was a rapid increase in real estate values in our market area in recent years which peaked in mid-2007. Subsequently, our market area has experienced significant declines in real estate values. A continued downturn in such values would likely reduce the security for many of our loans and adversely affect the ability of many of our borrowers to repay their loan from us.

Deterioration of local economic conditions could reduce our profitability. Our lending operations and customer base are concentrated in Tulare and Fresno Counties which are located in the Central Valley region of California. The continuation of recessionary conditions in our market area could directly affect the Company by causing us to incur losses associated with higher default rates and decreased collateral values in our loan portfolio. In addition, Tulare and Fresno Counties are among the leading counties in the United States for agricultural production and a significant downturn in the local agricultural economy due to commodity prices, real estate prices, public policy decisions, natural disaster, or other factors could result in a decline in the local economy in general, which could in turn negatively impact the Company.

If the Company’s allowance for loan and lease losses is not sufficient to absorb actual loan losses, our profitability could be reduced.The risk of loan losses is inherent in the lending business.The Company maintains an allowance for loan and lease losses (ALLL) based upon the Company’s actual losses over a relevant time period and management’s assessment of all relevant qualitative factors that may cause future loss experience to differ from its historical loss experience. Although the Company maintains a rigorous process for determining the ALLL, it can give no assurance that it will be sufficient to cover future loan losses. If the ALLL is not adequate to absorb future losses, or if bank regulatory agencies require the Company to increase its ALLL, earnings could be significantly and adversely impacted.

Fluctuations in interest rates could reduce profitability.The Company’s earnings depend largely upon net interest income, which is the difference between the total interest income earned on interest earning assets (primarily loans and investment securities) and the total interest expense incurred on interest bearing liabilities (primarily deposits and borrowed funds). The interest earned on assets and paid on liabilities are affected principally by direct competition, and general economic conditions at the state and national level and other factors beyond the Company’s control such as actions of the Federal Reserve Board, the general supply of money in the economy, legislative tax policies, governmental budgetary matters, and other state and federal economic policies. Although the Company maintains a rigorous process for managing the impact of possible interest rate fluctuations on earnings, the Company can provide no assurance that its management efforts will prevent earnings from being significantly and adversely impacted by changes in interest rates.

Premiums for Federal Deposit Insurance may increase. Bank failures in recent years have caused the FDIC’s deposit insurance fund to fall below the minimum balance required by law, forcing the FDIC to consider action to rebuild the fund. The FDIC had an emergency assessment as of June 30, 2009 that required banks to prepay three years of projected premiums. The amount paid will be amortized into expense by the Bank based on the actual quarterly assessment. In addition, the Dodd-Frank Act modified the base for FDIC insurance assessments so that assessments will now be based on the average consolidated total assets less tangible equity capital of a financial institution, rather than on deposits as in the past.

The Dodd-Frank Act also requires the FDIC to increase the reserve ratio of the Deposit Insurance Fund from 1.15% to 1.35% of insured deposits by 2020 and eliminates the requirement that the FDIC pay dividends to insured depository institutions when the reserve ratio exceeds certain thresholds. As a result of these changes and depending on the frequency and severity of bank failures, future increases in premiums or assessments could negatively affect our earnings.

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Disruptions in market conditions may adversely impact the fair value of available-for-sale investment securities. Generally Accepted Accounting Principles (GAAP) require the Company to carry its available-for-sale investment securities at fair value on its balance sheet. Unrealized gains or losses on these securities, reflecting the difference between the fair market value and the amortized cost, net of its tax effect, are reported as a component of shareholders’ equity. In certain instances GAAP requires recognition through earnings of declines in the fair value of securities that are deemed to be other than temporarily impaired. The disruptions that may be of most consequence to the Company include the financial condition of government sponsored enterprises and insurers of municipal bonds, which reduced market liquidity and fair value for the Company’s holdings of mortgage-backed securities and municipal bonds, respectively. Management expects continued volatility in the fair value of the Company’s available-for-sale investment securities and is not able to predict when or if any of its available-for-sale investment securities will become other than temporarily impaired.

Strong competition may reduce profitability. Along with larger national and regional banks and other local banks, the Company competes for customers with finance companies, brokerage firms, insurance companies, credit unions, and internet-based banks. Certain of these competitors have advantages over the Company in accessing funding and in providing various services, or, in the case of credit unions, are significantly tax advantaged. Major banks have substantially larger lending limits than the Company and can perform certain functions for their customers which the Company is not presently able to offer directly. Other existing single or multi-branch community banks, or new community bank start-ups, have marketing strategies similar to the Company’s and compete for the same management personnel and the same potential acquisition and merger candidates. Ultimately, competition can reduce our profitability, as well as make it more difficult to increase the size of our loan portfolio and deposit base.

Security breaches and technological disruptions could damage the Company’s reputation and profitability. The Company’s electronic banking activities expose it to possible liability and loss of reputation should an unauthorized party gain access to confidential customer information. Despite its considerable efforts and investment to provide the security and authentication necessary to effect secure transmission of data, the Company cannot fully guarantee that these precautions will protect its systems from future compromises or breaches of its security measures. Additionally, the Company outsources a large portion of its data processing to third parties which may encounter technological or other difficulties that may significantly affect the Company’s ability to process and account for customer transactions.

Loss of executive officers or key personnel could reduce the Company’s future profitability. The Company depends upon the skills and reputations of its executive officers and other key employees for its future success. The loss of any of these key persons could adversely affect the Company. No employment or non-compete agreements have been executed with any Company employee and therefore no assurance can be given that the Company will be able to retain its existing key personnel or that key personnel will not, upon leaving the Company’s employment, become employed by a competing institution.

We are in the process of deregistering under the Exchange Act, which will result in a reduction in the amount and frequency of publicly-available information about us.We are in the process of deregistering our common stock with the SEC and terminating our reporting obligations under the Securities and Exchange Act of 1934, as amended (the “Exchange Act”). Deregistration of our common stock will result in a reduction in the amount and frequency of publicly-available information about the Company and the Bank because we will no longer be required to file Exchange Act reports with the SEC, such as annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and proxy statements. However, the Company and the Bank make regulatory filings that are available at http://www.ffiec.gov and https://cdr/ffiec.gov, respectively, which would continue to be available after the Exchange Act deregistration. Our common stock is quoted on the OTC Bulletin Board, which does not require Exchange Act registration or that we meet the reporting requirements of the Exchange Act. We therefore expect that our common stock will continue to trade on the OTC Bulletin Board following deregistration, but there is no assurance that it will continue to do so.

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The trading volume of our common stock is limited.Our common stock is quoted on the OTC Bulletin Board and trading volume is modest. The limited trading market for our common stock may lead to exaggerated fluctuations in market prices and possible market inefficiencies, as compared to a more actively traded stock. It may also make it more difficult to dispose of our common stock at expected prices, especially for holders seeking to dispose of a large number of our stock.

Preferred Stock

On January 30, 2009, the Company entered into a letter agreement (the “Purchase Agreement”) with the United States Department of the Treasury (“Treasury”), pursuant to which the Company issued and sold (i) 7,700 shares of the Company’s Series B Preferred Stock and a warrant to purchase 385 shares of the Company’s Series C Preferred Stock for a combined purchase price of $7,700,000 and were recorded net of $25,783 in offering costs. The Treasury exercised the warrant immediately upon issuance.

On March 21, 2012, the Company repurchased all of the Series B and Series C Preferred stock from the Treasury for a total of $8,126,965, which includes the redemption of $8,085,000 plus accrued but unpaid dividends of $41,965. The repurchase of the preferred shares terminated the Company’s continuing obligations under the Purchase Agreement.

ITEM 1B – UNRESOLVED STAFF COMMENTS

The Company has no unresolved staff comments with the Securities and Exchange Commission.

ITEM 2 - PROPERTIES

The following table summarizes certain information about the Company’s main office and branch offices:

Office location	Year opened	Approximate square footage	Owned or leased
Visalia Branch and Administrative offices 701 W. Main Street Visalia, California	2009	18,700	Owned
Fresno Branch 7391 N.  Palm Avenue Fresno, California	2003	4,654	Leased
Woodlake Branch 232 North Valencia Woodlake, California	1998	5,000	Owned
Tipton Branch 174 South Burnett Tipton, California	1998	5,610	Owned
Tulare Branch 1901 E. Prosperity Tulare, California	2008	4,135	Owned

In February 2009, the Company purchased an 18,700 square foot office building to house both the Visalia Branch and Administration Offices. The new building was fully occupied in January 2010. The Company ended its lease agreements for its former administrative and Visalia branch facilities at the end of November 2009 and February 2010, respectively.

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The Fresno branch is leased under a noncancelable operating lease with a nonaffiliated third party with no option to extend. The primary operating area consists of approximately 4,654 square feet of space in a single-story building. The lease arrangement for the primary operating area is a “triple net lease” expiring September 30, 2017. Monthly rent under the lease is $7,911 through the fifth year and $9,541 for the last five years.

The Woodlake and Tipton branch offices were purchased from Bank of America in 1998. The Tulare Branch was constructed by the Company and opened in May 2008. It replaced the Tulare Loan Production Office which had operated in a leased facility.

At December 31, 2012, the total net book value of the Company’s land, buildings, leasehold improvements and equipment was approximately $8.0 million. Each of the Company’s facilities is considered to be in good condition and adequately covered by insurance.

The Company maintains insurance coverage on its premises, leaseholds and equipment, including business interruption and record reconstruction coverage. The branch properties and non-branch offices are adequate, suitable, in good condition and have adequate parking facilities for customers and employees. The Company and Bank are limited in their investments in real property under Federal and state banking laws. Generally, investments in real property are either for the Company and Bank use or are in real property and real property interests in the ordinary course of the Bank’s business.

ITEM 3 – LEGAL PROCEEDINGS

From time to time the Company may be subject to legal proceedings and claims in the ordinary course of business. These claims, even if not meritorious, could result in the expenditure of significant financial and managerial resources. Management is not aware of any legal proceedings or claims that it believes could materially harm the Company’s business or revenues.

ITEM 4 –MINE SAFETY DISCLOSURES

Not applicable.

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PART II

ITEM 5 – MARKET FOR COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

General

The Company’s common stock is traded on the OTC Bulletin Board under the symbol “VCBP.OB.” Historically, there has been a limited over-the-counter market for the Company’s common stock. Mcadams-Wright-Ragen Inc and Monroe Securities have acted as market makers for the Company’s common stock. These market makers have no obligation to make a market in the Company’s common stock, and they may discontinue making a market at any time.

The information in the following table indicates the high and low “bid” quotations for the Company’s common stock for each quarterly period since January 1, 2011, and is based upon information provided by market makers. These quotations reflect inter-dealer prices, without retail mark-up, mark-down, or commission, do not reflect actual transactions, which have been very sporadic, and do not include nominal amounts traded directly by shareholders or through other dealers who are not market makers. In addition, the quotations have been adjusted for 5% stock dividends paid in June 2011. There were no stock dividends paid in 2012.

	High and low bid quotations
	High		Low
2012
Fourth quarter	$	11.21	$	10.22
Third quarter		11.21		9.69
Second quarter		9.90		8.42
First quarter		8.86		6.74
2011
Fourth quarter	$	6.89	$	5.57
Third quarter		8.37		6.65
Second quarter		8.37		8.20
First quarter		8.39		7.03

As of January 29, 2013, there were 350 record holders of the Company’s common stock and approximately 448 beneficial holders.

On May 22, 2012, the Company declared a $0.04 cash dividend payable on June 28, 2012 for all shareholders of record on June 17, 2012 and on August 21, 2012, the Company declared a $0.04 cash dividend payable on September 27, 2012 for all shareholders of record on September 6, 2012. The Company also declared a $0.08 cash dividend on November 20, 2012, payable in December 2012 for all shareholders of record on December 6, 2012.

Holders of the Company’s common stock will be entitled to receive such cash dividends as may be declared by the board of directors out of funds legally available for that purpose. The Company is also subject to certain restrictions on dividends under the California General Corporation Law. Generally, California law permits the Company to pay dividends not exceeding its retained earnings. In the alternative, the Company may pay a greater amount as dividends if its tangible assets after the dividends would equal or exceed its liabilities and accrued dividends, if any, has agreed not to pay cash dividends if it is in default or deferring interest payments on trust preferred securities.

The Company’s ability to pay cash dividends will also depend to a large extent upon the amount of cash dividends paid by the Bank to the Company. The ability of the Bank to pay cash dividends will depend upon its earnings and financial condition. Under California law, a California-chartered bank may pay dividends not exceeding the lesser of its retained earnings or its net income for the last three fiscal years (less any previous dividends; provided, with the prior regulatory approval, a bank may pay dividends not exceeding the greatest of (a) its retained earnings, (b) its net income for the previous fiscal year or (c) its net income for the current fiscal year).

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The Company’s ability to pay dividends is also subject to certain covenants contained in the indentures related to its trust preferred securities. Dividends are issued in the sole discretion of the Bank’s board of directors. There can be no assurance as to when or whether a dividend will be paid or the amount of any dividend.

The Company paid 5% stock dividends in each year from 2000 to 2011, except for 2005 and 2010. The Company also issued a three-for-two stock split in September 2004.

Repurchases. On May 22, 2012, the Company’s Board of Directors authorized a common stock repurchase plan. The plan provides for the repurchase of up to $3,000,000 of the Company’s common stock. The number, price, and timing of the repurchase is at the Company’s sole discretion. The stock repurchase plan will expire on May 22, 2013. There were no shares repurchased during the year ended December 31, 2012.

22

Share repurchases are summarized in the following table:

Period	(a) Total number of shares purchased			(b) Average price paid per share			(c) Total number of shares purchased as part of publicly announced plans or programs		(d) Maximum number (or approximate dollar value) of shares that may yet be purchased under the plans or programs
November 2007		31,763	(1,3)	$	12.02	(1,3)		31,763	$	2,618,191
February 2008		53,673	(1,3)		13.10	(1,3)		53,673		1,914,690
March 2008		7,715	(1,3)		13.05	(1,3)		7,715		1,814,073
November 2008		1,876	(2,3)		9.02	(2,3)		1,876		1,797,154
Total		95,027		$	12.66			95,027	$	1,797,154

⁽¹⁾ Restated for June 2009 and 2008 stock dividends. No shares were repurchased in any month except those listed above.

⁽²⁾ Restated for June 2009 stock dividend.

⁽³⁾ Restated for June 2011 stock dividend.

Equity Compensation Plan Information

In 1997 and 2007, the Company established Stock Option Plans for which shares of stock are reserved for issuance to employees and directors under incentive and nonstatutory agreements. During 2012, incentive stock options for 5,276 shares of common stock and non-qualified stock options for 25,167 shares of common stock were exercised. There were 26,461 incentive and 65,500 nonqualified stock options granted during 2012. During 2011, there were 13,294 exercised incentive stock options and 6,649 nonqualified stock options exercised. There was 2,100 incentive stock options and 8,400 nonqualified stock options granted.

During the year ended December 31, 2011, there were 2,927 shares of restricted stock awarded. The restricted stock will vest two years from the date of grant. There was no restricted stock issued in 2012.

The information in the following table is provided as of the end of the fiscal year ended December 31, 2012, with respect to compensation plans (including individual compensation arrangements) under which equity securities are issuable:

Plan category	Column (a) Number of securities to be issued upon exercise of outstanding options, warrants and rights	Weighted- average exercise price of outstanding options, warrants and rights	Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in Column (a))
Equity compensation plans approved by security holders	183,695	$10.04	3,560
Equity compensation plans not approved by security holders	None	Not applicable.	None

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ITEM 6 – SELECTED FINANCIAL DATA

The following table presents a five year summary of selected financial information which should be read in conjunction with the Company’s consolidated financial statements and notes thereto included in Item 8, Financial Statements, and with the Management’s Discussion and Analysis of Financial Condition and Results of Operations which is included as Item 7. The financial information contained in the table is unaudited. The results of operations for 2012 are not necessarily indicative of the results of operations that may be expected for future years.

(dollars in thousands	As of and for the year ended December 31,
except share and per share data)	2012			2011			2010			2009			2008
Statement of Income
Interest income	$	14,687		$	15,643		$	16,212		$	16,929		$	17,784
Interest expense		1,080			1,666			2,619			4,089			5,719
Net interest income		13,607			13,977			13,593			12,840			12,065
Provision for loan losses		—			600			2,050			7,000			1,600
Net interest income after provision for
loan losses		13,607			13,377			11,543			5,840			10,465
Non-interest income		1,489			1,560			1,341			2,037			1,283
Non-interest expense		10,492			10,256			9,778			9,659			9,153
Income (loss) before income taxes (tax benefit)		4,604			4,681			3,106			(1,782	)		2,595
Income taxes (tax benefit)		1,371			1,577			943			(1,195	)		746
Net income (loss)		3,233			3,104			2,163			(587	)		1,849
Per Share Data (1):
Basic earnings (loss) per common share	$	1.13		$	0.97		$	0.65		$	(0.34	)	$	0.68
Diluted earnings (loss) per common share	$	1.12		$	0.97		$	0.65		$	(0.34	)	$	0.67
Cash dividends per common share	$	0.16		$	—		$	—		$	—		$	—
Book value per common share	$	13.46		$	12.50		$	11.80		$	11.17		$	11.60
Avg. common shares outstanding-basic		2,788,018			2,768,114			2,698,200			2,732,339			2,724,884
Avg. common shares outstanding-diluted		2,797,835			2,772,771			2,705,070			2,732,339			2,754,466
Total common shares outstanding		2,815,036			2,784,593			2,630,480			2,608,317			2,473,739
Balance Sheet
Available-for-sale
investment securities	$	53,001		$	56,705		$	50,823		$	42,566		$	42,018
Total loans, net		227,260			224,532			234,304			234,823			226,697
Allowance for loan and lease losses		5,192			5,469			6,699			6,231			3,244
Other real estate owned		—			1,141			—			—			—
Total assets		360,879			366,521			341,421			340,172			306,099
Total deposits		315,484			315,877			294,278			294,282			257,323
Total shareholders' equity		37,903			42,505			38,750			36,869			30,140
Selected Performance Ratios:
Return (loss) on average assets		0.92	%		0.90	%		0.63	%		(0.18	%)		0.62	%
Return (loss) on average equity		8.47	%		7.63	%		5.68	%		(1.53	%)		6.30	%
Net interest margin (2)		4.50	%		4.55	%		4.41	%		4.43	%		4.52	%
Average net loans as a percentage
of average deposits		74.7	%		78.8	%		81.6	%		85.3	%		89.7	%
Efficiency ratio		69.5	%		66.0	%		65.5	%		64.9	%		68.6	%

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Selected Financial Data (continued)

	As of and for the year ended December 31,
	2012			2011			2010			2009			2008
Selected Asset Quality Ratios:
Nonperforming assets to
total assets		1.2	%		1.9	%		2.0	%		2.2	%		1.6	%
Nonperforming loans to
total loans		1.9	%		2.5	%		2.9	%		3.1	%		2.2	%
Net loan charge-offs to
average loans		0.1	%		0.8	%		0.7	%		1.7	%		0.1	%
Allowance for loan and lease losses
to total loans		2.23	%		2.38	%		2.78	%		2.58	%		1.41	%
Allowance for loan and lease losses
to nonperforming loans		117.4	%		96.8	%		98.2	%		84.6	%		65.7	%
Capital Ratios:
Bank
Leverage		11.2	%		13.1	%		12.0	%		11.4	%		10.8	%
Tier 1 Risk-Based		15.5	%		17.6	%		16.2	%		14.8	%		12.6	%
Total Risk-Based		16.7	%		18.9	%		17.4	%		16.0	%		13.9	%
Consolidated
Leverage		11.3	%		13.1	%		12.1	%		11.4	%		10.9	%
Tier 1 Risk-Based		15.6	%		17.6	%		16.2	%		14.8	%		12.7	%
Total Risk-Based		16.9	%		18.9	%		17.5	%		16.0	%		14.0	%

Notes: (1) All share and per share data has been retroactively restated to reflect the 5% stock dividends issued in June 2011, June 2009, and June 2008. There was no stock dividend issued in 2010 or 2012.

(2) Interest income is not presented on a taxable-equivalent basis, however, the net interest margin was calculated on a taxable-equivalent basis by using a marginal tax rate of 34%

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ITEM 7 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis should be read together with the selected financial data appearing in Item 1, Business, and the financial statements and notes thereto appearing in Item 8, Financial Statements and Supplementary Data, included in this Annual Report on Form 10-K.

Overview

The Company is the holding company for Valley Business Bank, a California state chartered bank.  The Company’s principal business is to provide, through its banking subsidiary, financial services in its primary market area in California. The Company serves Tulare and Fresno Counties and the surrounding area through the Bank. The Company derives its income primarily from interest earned on loans, and, to a lesser extent, interest on investment securities, fees for services provided to deposit customers, and fees from the brokerage of loans. The Bank’s major operating expenses are the interest paid on deposits and borrowings, and general operating expenses, including salaries and employee benefits and, to a lesser extent, occupancy and equipment, data processing and operations. The Company does not currently conduct any operations other than through the Bank.

Critical Accounting Policies

The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The Company’s accounting policies are integral to understanding the financial results reported. The most complex of these accounting policies require management’s judgment to ascertain the valuation of assets, liabilities, commitments and contingencies. The Company has established detailed policies and internal control procedures that are intended to ensure valuation methods are well controlled and consistently applied from period to period. In addition, the policies and procedures are intended to ensure that the process for changing methodologies occurs in an appropriate manner. The accounting areas where management’s judgment is most likely to materially impact the Company’s financial results are:

Allowance for Loan and Lease Losses.The allowance for loan and lease losses (ALLL) is maintained to provide for estimated credit losses that it is probable the Company will incur as of the balance sheet date. Loans determined to be impaired are evaluated individually by management for determination of the specific loss, if any, that exists as of the balance sheet date. In addition, reserve factors are assigned to currently performing loans by loan type based on historical loss rates and adjusted for various qualitative factors such as economic and market conditions, concentrations and other trends within the loan portfolio. When management believes that additional reserves are needed, the ALLL is increased by recording a charge to operations through the provision for loan losses. The ALLL is decreased as loans are charged-off, net of recoveries.

Management believes the ALLL is a “critical accounting estimate” because management’s estimate of loan losses on loans not already identified as impaired; i.e., loans that are currently performing, requires management to carefully evaluate the pertinent facts and circumstances as of the balance sheet date to determine how much, if any, adjustment is required to the historical loss rate for each loan type. In addition, estimates of loan losses on currently performing loans are subject to change in future reporting periods as facts and circumstances change. For example, a continued decline in the California real estate market may result in management raising its estimate of loan losses if such estimated losses are considered probable at the balance sheet date. Furthermore, the FDIC and California Department of Financial Institutions, as an integral part of their examination process, review the ALLL. These agencies may require additions to the ALLL based on their judgment about information at the time of their examinations.

Management reviews the adequacy of the ALLL at least quarterly. Further information is provided in the “Provision for Loan Losses” and “Allowance for Loan and Lease Losses” sections of this discussion and analysis.

Available-for-Sale-Securities.Available-for-sale securities are required to be carried at fair value. Management believes this is a “critical accounting estimate” in that the fair value of a security is based on unadjusted quoted market prices or if quoted market prices are not available, fair values are extrapolated from the quoted prices of similar instruments. Changes in the fair value of available-for-sale securities impact the consolidated financial statements by increasing or decreasing assets and shareholders’ equity.

26

At least quarterly and more frequently when economic or market conditions warrant such an evaluation, investment securities are evaluated for impairment to determine whether a decline in their value is other than temporary. Management utilizes criteria such as the magnitude and duration of the decline and the intent and ability of the Company to retain its investment in the securities for a period of time sufficient to allow for an anticipated recovery in fair value, in addition to the reasons underlying the decline, to determine whether the loss in value is other than temporary. Once a decline in value is determined to be other-than-temporary, and we do not intend to sell the security or it is more likely than not that we will not be required to sell the security before recovery, only the portion of the impairment loss representing credit exposure is recognized as a charge to earnings, with the balance recognized as a charge to other comprehensive income. If management intends to sell the security or it is more likely than not that we will be required to sell the security before recovering its forecasted cost, the entire impairment loss is recognized as a charge to earnings.

Income Taxes.The Company files its income taxes on a consolidated basis with its subsidiary. The allocation of income tax expense (benefit) represents each entity's proportionate share of the consolidated provision for income taxes.

Deferred income taxes reflect the estimated future tax effects of temporary differences between the reported amount of assets and liabilities for financial reporting purposes and such amounts as measured by tax laws and regulations. Management believes this is a “critical accounting estimate” in that an estimate of future earnings is required to support its position that the benefit of the Company’s deferred tax assets will be realized. If future income should prove non-existent or less than the amount of the deferred tax assets within the tax years to which they may be applied, the asset may not be realized and the Company’s net income will be reduced.

When tax returns are filed, it is highly certain that some positions taken would be sustained upon examination by the taxing authorities, while others are subject to uncertainty about the merits of the position taken or the amount of the position that would be ultimately sustained. The benefit of a tax position is recognized in the financial statements in the period during which, based on all available evidence, management believes it is more likely than not that the position will be sustained upon examination, including the resolution of appeals or litigation processes, if any.  Tax positions taken are not offset or aggregated with other positions. Tax positions that meet the more-likely-than-not recognition threshold are measured as the largest amount of tax benefit that is more than 50 percent likely of being realized upon settlement with the applicable taxing authority. The portion of the benefits associated with tax positions taken that exceeds the amount measured as described above is reflected as a liability for unrecognized tax benefits in the accompanying balance sheet along with any associated interest and penalties that would be payable to the taxing authorities upon examination.

Results of Operations

Overview

The Company had net income of $3.2 million, or $1.12 earnings per diluted share, for the year ended December 31, 2012, compared to net income of $3.1 million, or $0.97 earnings per diluted share, for the year ended December 31, 2011. The Company had net income of $2.2 million, or $0.65 per diluted share, for the year ended December 31, 2010. The return on average assets was 0.92% for 2012, 0.90% for 2011, and 0.63% for 2010. The return on average shareholders’ equity for 2012, 2011, and 2010 was 8.47%, 7.63%, and 5.68%, respectively.

The increase in earnings for 2012 resulted from the provision for loan losses decreasing from $600 thousand in 2011 to none in 2012. This was partially offset by a decrease in net interest income. Net interest income decreased by $370 thousand due to decreases in volumes and yields on interest earning assets. Non-interest income decreased by $71 thousand due to decreases in gains from the sale of investment securities which were $152 thousand in 2012 compared to $290 thousand in 2011.

The Company’s non-interest expense increased by $236 thousand in 2012 due primarily to a $527 thousand increase in salaries and employee benefits offset by a $231 thousand decrease in FDIC assessments. The ratio of non-interest expense to net operating revenue (efficiency ratio) deteriorated to 69.5% for 2012 when compared to 66.0% for 2011, and 65.5% for 2010. This ratio reflects changes in non-interest expense as well as changes in revenue from interest and non-interest sources.

27

At December 31, 2012, the Company’s total assets were $360.9 million, a decrease of $5.6 million or 2% compared to December 31, 2011. Total loans, net of the ALLL, were $227.3 million at December 31, 2012, representing an increase of $2.7 million or 1% compared to December 31, 2011. Total deposits decreased $393 thousand or 0.1% from $315.9 at December 31, 2011 to $315.5 million at December 31, 2012.

At December 31, 2012, the Company’s Leverage ratio was 11.3% while its Tier 1 Risk-Based Capital ratio and Total Risk-Based Capital ratios were 15.6% and 16.9%, respectively. The Leverage, Tier 1 Risk-Based Capital and Total Risk-Based Capital ratios at December 31, 2011 were 13.1%, 17.6% and 18.9%, respectively. The decrease in the Company’s capital ratios in 2012 resulted from the repurchase of $8.1 million of preferred stock from the United States Department of Treasury offset by 2012 earnings.

A detailed presentation of the Company’s financial results as of, and for the years ended December 31, 2012, 2011, and 2010 follows.

Net Interest Income

The following table presents the Company’s average balance sheet, including weighted average yields calculated on a daily average basis and rates on a taxable-equivalent basis, for the years indicated:

	Average balances and weighted average yields and rates
	Years ended December 31,
	2012							2011							2010
			Interest		Average					Interest		Average					Interest		Average
	Average		Income/		Yield/			Average		Income/		Yield/			Average		Income/		Yield/
(dollars in thousands)	Balance		Expense		Cost			Balance		Expense		Cost			Balance		Expense		Cost
ASSETS
Due from banks	$	28,574	$	82		0.29	%	$	24,167	$	63		0.26	%	$	28,430	$	71		0.25	%
Available-for-sale investment securities:
Taxable		36,058		697		1.93	%		41,654		938		2.25	%		29,090		720		2.48	%
Exempt from Federal income taxes		19,173		769		6.08	%		17,144		699		6.18	%		15,139		628		6.29	%
Total securities (1)		55,231		1,466		3.37	%		58,798		1,637		3.40	%		44,229		1,348		3.78	%
Loans (2) (3)		227,617		13,139		5.77	%		232,370		13,943		6.00	%		243,134		14,793		6.08	%
Total interest-earning assets (1)		311,422		14,687		4.84	%		315,335		15,643		5.07	%		315,793		16,212		5.24	%
Noninterest-earning assets,    net of allowance for loan and lease losses		38,715							29,125							29,584
Total assets	$	350,137						$	344,460						$	345,377
LIABILITIES AND SHAREHOLDERS’ EQUITY
Deposits:
Interest bearing	$	124,475	$	483		0.39	%	$	120,258	$	547		0.45	%	$	122,509	$	709		0.58	%
Time deposits less than $100,000		20,377		140		0.69	%		21,437		192		0.90	%		24,459		339		1.39	%
Time deposits $100,000 or more		49,044		339		0.69	%		58,616		695		1.19	%		70,843		1,296		1.83	%
Total interest-bearing deposits		193,896		962		0.50	%		200,311		1,434		0.72	%		217,811		2,344		1.08	%
Short term borrowing		6		—		—			—		—		—			—		—		—
FHLB term borrowing		—		—		—			2,297		119		5.18	%		3,078		161		5.23	%
Junior subordinated deferrable interest debentures		3,093		118		3.82	%		3,093		113		3.65	%		3,093		114		3.69	%
Total interest-bearing liabilities		196,995		1,080		0.55	%		205,701		1,666		0.81	%		223,982		2,619		1.17	%
Noninterest bearing deposits		110,655							94,582							80,273
Other liabilities		4,335							3,519							3,066
Total liabilities		311,985							303,802							307,321
Shareholders’ equity		38,152							40,658							38,056
Total liabilities and shareholders’ equity	$	350,137						$	344,060						$	345,377
Net interest income and margin (1)			$	13,607		4.50	%			$	13,977		4.55	%			$	13,593		4.41	%

(1) Interest income is not presented on a taxable-equivalent basis, however, the average yield was calculated on a taxable-equivalent basis by using a marginal tax rate of 34%.

(2) Nonaccrual loans are included in total loans. Interest income is included on nonaccrual loans only to the extent cash payments have been received. There was $129, $209 and $315 interest received on a cash basis in 2012, 2011 and 2010, respectively. There was $14, $135, and $22 interest income reversed on nonaccrual loans for 2012, 2011, and 2010, respectively.

(3) Interest income includes net amortized loan fees of $489, $513, and $564 for 2012, 2011, and 2010, respectively.

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The following table sets forth a summary of the changes in interest income and interest expense from changes in average earning assets and interest-bearing liabilities (volume) and changes in average interest rates for the years indicated.

Changes in net interest income due to changes in volumes and rates

	2012 vs 2011									2011 vs 2010
	Increase (decrease) due to change in:									Increase (decrease) due to change in:
	Average			Average						Average			Average
	Volume			Rate (1)			Total			Volume			Rate (1)			Total
(In thousands)
Increase (decrease) in interest income:
Due from banks	$	11		$	8		$	19		$	(11	)	$	3		$	(8	)
Investment securities
Taxable		(126	)		(115	)		(241	)		311			(93	)		218
Exempt from Federal Income taxes		125			(55	)		70			126			(55	)		71
Total securities		(1	)		(170	)		(171	)		437			(148	)		289
Loans		(285	)		(519	)		(804	)		(655	)		(195	)		(850	)
Total interest income		(275	)		(681	)		(956	)		(229	)		(340	)		(569	)
(Decrease) increase  in interest expense:
Interest-bearing deposits		19			(83	)		(64	)		(13	)		(149	)		(162	)
Time deposits less than $100,000		(9	)		(43	)		(52	)		(42	)		(105	)		(147	)
Time certificates $100,000 or more		(113	)		(243	)		(356	)		(224	)		(377	)		(601	)
Total interest-bearing deposits		(103	)		(369	)		(472	)		(279	)		(631	)		(910	)
FHLB term borrowing		(119	)		—			(119	)		(41	)		(1	)		(42	)
Junior subordinated deferrable interest debentures		—			5			5			—			(1	)		(1	)
Total interest expense		(222	)		(364	)		(586	)		(320	)		(633	)		(953	)
(Decrease) increase in net interest income	$	(53	)	$	(317	)	$	(370	)	$	91		$	293		$	384

(1) Factors contributing to both changes in rate and volume have been attributed to changes in rates.

2012 compared to 2011. Total interest income decreased $956 thousand from $15.6 million in 2011 to $14.7 million in 2012 due to primarily to a 23 basis point decline in the yield earned on average interest-earning assets and a $3.9 million decrease in average interest earning assets. Average earning assets in 2012 were $311.4 million or 1% less than in 2011 due to decrease of $3.6 million or 6% in average investment securities and a decrease of $4.8 million or 2% in average loans outstanding. The average yield on loans was 5.77% and 6.00% for the years ended December 31, 2012 and 2011, respectively, while the average tax equivalent yield on investment securities was 3.37% and 3.40%, respectively. The decrease in average loans was due primarily to loan repayments in the categories of real estate construction and consumer loans. The decrease in weighted average yield on loans resulted primarily from competitive pressures for high quality loan customers.

Total interest expense decreased $586 thousand or 35% from $1.6 million in 2011 to $1.1 million in 2012. Average total interest-bearing deposits decreased by $6.4 million or 3% in 2012 and average noninterest-bearing deposits increased by $16.1 million or 17% in 2012. During 2012 and in line with market area trends, the Company aggressively lowered the interest rates paid on its interest-bearing deposits compared with rates paid in 2011.

Interest expense on short-term borrowings from the Federal Home Loan Bank of San Francisco (FHLB) decreased $119 thousand due to scheduled full repayment of this debt in early 2012.

As noted above, average non-interest bearing deposits increased with average balances of $110.7 million and $94.6 million in 2012 and 2011, respectively. These deposits represented 36% of average total deposits during 2012, compared with 32% of average total deposits during 2011.

Net interest income before provision for loan losses decreased to $13.6 million for 2012 from $14.0 million for 2011, a decrease of $370 thousand or 3%. The Company’s net interest margin on a tax equivalent basis for 2012 was 4.50% compared to 4.55% in 2011. The decrease in net interest income and net interest margin were due to a decrease in the average balances and average yields of investment securities and loans offset by reduced cost of deposits.

29

2011 compared to 2010. Total interest income decreased $569 thousand from $16.2 million in 2010 to $15.6 million in 2011 due primarily to a 17 basis point decline in the yield earned on average interest-earning assets and decreases in the average volume of loans. Average earning assets in 2011 were $458 thousand or 0.2% less than in 2010. A decrease of $4.3 million or 15% in due from banks and a decrease of $10.8 million or 4% in average loans outstanding were offset by a $14.6 million or 33% increase in average investments. The average yield on loans was 6.00% and 6.08% for the years ended December 31, 2011 and 2010, respectively, while the average tax equivalent yield on investment securities was 3.40% and 3.78%, respectively. The decrease in average loans was due to scheduled loan repayments and to a lessor extent loan charge-offs and foreclosures. The decrease was primarily in the categories of commercial and real-estate construction loans. The decrease in weighted average yield on loans resulted primarily from competitive environment for high quality loans. The decrease in average yield on investment securities resulted from normal portfolio cash overflows being replaced with lower yielding investments.

Total interest expense decreased $953 thousand or 36% from $2.6 million in 2010 to $1.6 million in 2011. Average total interest-bearing deposits decreased by $17.5 million or 8% in 2011 and average noninterest-bearing deposits increased by $14.3 million or 18% in 2011. During 2011 and in line with market area trends, the Company lowered the interest rates paid on its interest-bearing deposits compared with rates paid in 2010.

Interest expense on short-term borrowings from the Federal Home Loan Bank of San Francisco (FHLB) decreased $42 thousand due primarily to average volume of this debt being lowered from $3.1 million in 2010 to $2.3 in 2011. FHLB term borrowing decreased by $781 thousand due to scheduled repayments and maturities. There were no new FHLB term borrowings.

As noted above, non-interest bearing deposits increased with average balances of $94.6 million and $80.3 million in 2011 and 2010, respectively. These deposits represented 32% of average total deposits during 2011, compared with 27% of average total deposits during 2010.

Net interest income before provision for loan losses increased to $14.0 million for 2011 from $13.6 million for 2010, an increase of $384 thousand or 3%. The increase is primarily attributable total interest expense decreasing by $953 thousand in 2011 offset by total interest income increasing by $569 thousand.

The Company’s net interest margin on a tax equivalent basis for 2011 was 4.55% compared to 4.41% in 2010. The 14 basis point increase in net interest margin resulted from the decrease in average cost of average interest-bearing liabilities, offset by the decrease in yield on average interest-bearing assets.

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Provision for Loan Losses

The provision for loan losses, which is included in operations to support the required level of the allowance for loan and lease losses, is based on credit experience and management’s ongoing evaluation of loan portfolio risk and economic conditions. The provision for loan and lease losses was $600 thousand in 2011. There was no provision for loan loss recorded during 2012. The decrease in provision for loan losses in 2012 was primarily due to the achievement of a satisfactory level of loss reserves relative to the loan portfolio. See the sections below titled “Nonperforming Assets,” “Impaired Loans” and “Allowance for Loan and Lease Losses.” The Company recorded a provision for loan losses in 2010 of $2.1 million based on management’s assessment of the loan portfolio and related credit quality for that year.

Non-Interest Income

Non-interest income for 2012 totaled $1.5 million compared with $1.6 million in 2011 and $1.3 million in 2010. The components of non-interest income during each year were as follows:

Non-interest income

	Years Ended December 31,						Change during year
(in thousands)	2012		2011		2010		2012			2011
Service charges	$	687	$	704	$	768	$	(17	)	$	(64	)
Gain on sale of available-for-sale investment securities		152		290		34		(138	)		256
Gain on sale of other real estate		7		2		—		5			2
Mortgage loan brokerage fees		68		55		60		13			(5	)
Earnings on cash surrender value of life insurance policies		328		292		295		36			(3	)
Other		247		217		184		30			33
Total non-interest income	$	1,489	$	1,560	$	1,341	$	(71	)	$	219

2012 Compared to 2011.Non-interest income decreased by $71 thousand in 2012 as a result of a $152 thousand gain on sale of investment securities in 2012 compared to $290 thousand in 2011 and $17 thousand decrease in service charges compared to 2011, offset by an increase in earnings on cash surrender value of life insurance policies of $36 thousand.

2011 Compared to 2010.Non-interest income increased during 2011 primarily due to an increase in the gain on sale of available-for-sale investment securities which increased by $256 thousand in 2011 as the Company executed planned investment strategies. Income from service charges on deposit accounts decreased by $64 thousand in 2011 due mainly to a $12 thousand decrease in account analysis charges and a decrease of $57 thousand in NSF and overdraft charges based on lower transaction volumes. Earnings on bank-owned life insurance policies decreased by $3 thousand due to a decline in earnings performance. Continued weakness in the residential real estate market caused a $5 thousand decrease in mortgage loan brokerage fees in 2011. These decreases were offset by a $20 thousand increase in other fee income, primarily from loan referrals.

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Non-Interest Expense

The following table presents the major components of non-interest expense for the years indicated.

Non-interest expense

	Years Ended December 31,						Change during year
(in thousands)	2012		2011		2010		2012			2011
Salaries and employee benefits	$	6,206	$	5,679	$	5,248	$	527		$	431
Occupancy and equipment		1,375		1,354		1,334		21			20
Data processing		640		632		641		8			(9	)
Assessment and insurance		301		532		712		(231	)		(180	)
Professional and legal		433		449		439		(16	)		10
Operations		349		350		340		(1	)		10
Telephone and postal		222		234		234		(12	)		—
Advertising and business development		242		280		203		(38	)		77
Supplies		180		206		193		(26	)		13
Other real estate owned		41		—		—		41			—
Other expenses		503		540		434		(37	)		106
Total non-interest expense	$	10,492	$	10,256	$	9,778	$	236		$	478

2012 Compared to 2011.Non-interest expense in 2012 was $10.5 million, a increase of $236 thousand or 2% over the 2011 total of $10.3 million. The increase resulted from a $527 thousand or 9% increase in salaries and employee benefits due to increases in stock options expense, post retirement benefits expense and normal personnel and salary changes. In addition, there was a $21 thousand or 2% increase in occupancy and equipment expense related to upgrades in the technology platform. These were offset by a $231 thousand or 43% decrease in FDIC insurance expense which reflected adjustments made to implement FDIC’s revised methodology for calculating insurance premiums. Advertising and business development decreased by $38 thousand or 14% due to reduced television advertising in 2012 compared to 2011.

2011 Compared to 2010. Salaries and employee benefits increased by $431 thousand or 8% in 2011 due to increased incentive compensation payments and stock-related compensation expense. Advertising and business development increased by $77 thousand or 38% due to planned marketing expenditures considered necessary to support staff efforts to attract new business customers. Assessment and insurance costs decreased $180 thousand or 25% due to FDIC insurance premiums being calculated using revised methodology that is currently more favorable to the Company.

Provision for Income Taxes

The Company had a provision for income taxes of $1.4 million for 2012 compared to $1.6 million in 2011 and $943 thousand in 2010. The Company’s effective tax rate was 29.8% for 2012 compared to 34.2% and 30.4% in 2011 and 2010, respectively. The decrease in the effective tax rate in 2012 from 2011 is due to an increase in tax exempt income as a percentage of total pre-tax income in 2012 compared to 2011 mostly due to the creation of the San Joaquin Valley enterprise zone. Income tax reductions result from earnings from municipal investment securities, Bank owned life insurance policies and, for California only, enterprise zone tax exempt income and credits.

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Financial Condition

Investment Securities

The Company purchases investment securities to maintain liquidity and manage interest rate risk within board approved parameters, as well as to generate interest revenues. The investment security portfolio consists of obligations of U.S. Government sponsored entities and agencies, mortgage-backed securities of U.S. government sponsored enterprises, obligations of states and political subdivisions, and other investment grade securities. The Company’s investments in mortgage-backed securities typically provide both an increase in yields over U.S. Treasury and agency securities and cash flows for liquidity and reinvestment opportunities. Obligations of states and political subdivisions (municipal securities) typically provide attractive tax equivalent yields for the Company. Since the interest earnings on municipal securities are generally not taxable for Federal purposes the investment in municipal securities results in a reduction in the effective tax rate of the Company.

At December 31, 2012 and 2011, all investment securities were classified as available-for-sale. In classifying its investments as available-for-sale, securities are reported at fair value, with unrealized gains and losses excluded from earnings and reported, net of taxes, as accumulated other comprehensive income or loss within shareholders’ equity.

The percentage of investment portfolio balances in U.S. Government sponsored entities and agencies, mortgage-backed securities and obligations of states and political subdivisions to total investment securities were 11%, 52% and 37%, respectively, at December 31, 2012 versus, 11%, 54%, and 35%, respectively, at December 31, 2011. The decrease in investment securities during 2012 reflected the Company’s reluctance to purchase investment securities at historically low yields.

The following tables set forth the estimated market value of available-for-sale investment securities at the dates indicated:

	December 31, 2012
(in thousands)	Amortized Cost		Unrealized Gains		Unrealized Losses			Fair Value
U.S. Government sponsored entities and agencies	$	5,545	$	192	$	—		$	5,737
Mortgage-backed securities:
U.S. Government sponsored entities and agencies-residential		16,413		380		(3	)		16,790
Small Business Administration		10,547		354		—			10,901
Obligations of states and political subdivisions		18,696		899		(22	)		19,573
Total	$	51,201	$	1,825	$	(25	)	$	53,001

	December 31, 2011
(in thousands)	Amortized Cost		Unrealized Gains		Unrealized Losses			Fair Value
U.S. Government sponsored entities and agencies	$	5,868	$	177	$	(7	)	$	6,038
Mortgage-backed securities:
U.S. Government sponsored entities and agencies-residential		17,680		352		(15	)		18,017
Small Business Administration		12,345		285		—			12,630
Obligations of states and political subdivisions		19,428		644		(52	)		20,020
Total	$	55,321	$	1,458	$	(74	)	$	56,705

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Management periodically evaluates each investment security for other than temporary impairment, relying primarily on industry analyst reports, observation of market conditions, credit ratings of the security’s issuer and interest rate fluctuations. For investment securities that are considered impaired, management determines the reason for the unrealized loss by conducting additional research and analytical procedures on each security and whether the Company will be able to collect all amounts due according to the contractual terms. After evaluating the investment portfolio at December 31, 2012, management determined that it was probable that the Company would collect all contractual cash flows from each impaired security. Management further determined that the Company has the intent and ability to hold each impaired security until it is no longer impaired.

The following table summarizes the amounts and distribution of investment securities and their weighted average yields as of December 31, 2012. Expected maturities may differ from contractual maturities where the issuers of the securities have the right to call or prepay obligations without penalty.

	Maturities of securities available for sale
						After one					After five										Securities not
	Within					but within					but within					After					due at a specific
	one year					five years					ten years					ten years					date					Total
(dollars in thousands)	Amount		Yield			Amount		Yield			Amount		Yield			Amount		Yield			Amount		Yield			Amount		Yield
U.S. Government sponsored entities and agencies	$	—		—	%	$	3,743		1.78	%	$	1,008		3.84	%	$	986		3.62	%		—		—		$	5,737		1.48	%
Obligations of states and political subdivisions  (1)							341		7.36	%		2,085		6.08	%		17,147		4.64	%		—		—			19,573		5.28	%
Mortgage-backed securities:
U.S. Government sponsored entities and agencies		—		—			—		—			—					—		—			16,790		2.68	%		16,790		2.68	%
Small Business administration		—		—			—		—			—					—		—			10,901		1.57	%		10,901		1.57	%
Total	$	—		—	%	$	4,084		2.17	%	$	3,093		5.22	%	$	18,133		4.35	%	$	27,691		2.24	%	$	53,001		3.29	%

(1) Yields shown are not computed on a tax equivalent basis.

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Loan Portfolio

The Company’s lending activities are geographically concentrated in the South San Joaquin Valley, primarily in Tulare and Fresno counties. The Company offers both fixed and floating rate loans and obtains collateral in the form of real property, business assets and deposit accounts but looks to business and personal cash flows as the primary source of repayment. Retail loan products are offered primarily for the benefit of commercial business owners and professionals who typically maintain depository and other lending relationships with the Company.

The following table sets forth the breakdown of loans outstanding by type at the dates indicated by amount and percentage of the portfolio:

LOAN PORTFOLIO
(in thousands)	December 31, 2012					December 31, 2011					December 31, 2010					December 31, 2009					December 31, 2008
Commercial	$	41,270		18	%	$	39,379		17	%	$	46,294		19	%	$	49,443		21	%	$	58,325		25	%
Real estate – mortgage (1)		170,869		74	%		165,686		72	%		165,202		68	%		162,772		67	%		129,267		56	%
Real estate – construction		15,522		6	%		19,499		8	%		23,437		10	%		22,582		9	%		35,113		15	%
Agricultural		3,701		1	%		3,731		2	%		4,304		2	%		4,727		2	%		4,011		2	%
Consumer and other		1,509		1	%		2,051		1	%		2,153		1	%		1,937		1	%		3,566		2	%
Subtotal		232,871		100	%		230,346		100	%		241,390		100	%		241,461		100	%		230,282		100	%
Deferred loan fees, net		(418	)				(345	)				(387	)				(407	)				(341	)
Allowance for loan losses		(5,193	)				(5,469	)				(6,699	)				(6,231	)				(3,244	)
Total loans, net	$	227,260				$	224,532				$	234,304				$	234,823				$	226,697

(1) Consists primarily of commercial mortgage loans.

Loans outstanding at December 31, 2012 increased by $2.7 million or 1% compared to December 31, 2011. The increase occurred primarily in the categories of commercial and real estate-mortgage loans, offset by a decrease in real estate-construction loans. The increase in loans resulted mostly from the Company’s strong efforts to attract quality loans in the Company’s target markets. The decrease in real estate-construction was due to scheduled maturities, pay-downs, and reclassifications to real estate-mortgage upon funding take-out financing at the time of construction completion.

The following table presents the maturity distribution of the loan portfolio as of December 31, 2012. The table shows the distribution of such loans between those loans with fixed interest rates and those with floating (variable) interest rates. Floating rates generally fluctuate with changes in the prime rate. A majority of the Company’s floating rate loans have rate floors. Management considers the risk associated with fixed interest rate loans in its periodic analysis of interest rate risk.

	Maturity of loans
(in thousands)	Within one year		After one but within five years		After five years		Total
Commercial	$	19,110	$	15,964	$	6,196	$	41,270
Real estate – mortgage (1)		45,083		37,149		88,637		170,869
Real estate – construction		6,144		7,064		2,314		15,522
Agriculture		2,133		777		791		3,701
Consumer and other		1,165		309		35		1,509
Total	$	73,635	$	61,263	$	97,973	$	232,871
Loans with fixed interest rates	$	34,046	$	32,275	$	32,237	$	98,558
Loans with floating interest rates		39,589		28,988		65,736		134,313
Total	$	73,635	$	61,263	$	97,973	$	232,871

  (1) Consists primarily of commercial mortgage loans.

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Nonperforming Assets

Nonaccrual Loans.There were $4.4 million in nonaccrual loans at December 31, 2012. As of December 31, 2011 there were $5.6 million in nonaccrual loans. As of December 31, 2012 and 2011 the Company had 13 loans totaling $4.9 million and 11 loans totaling $3.8 million considered to be troubled debt restructures, respectively. There were no loans past due 90 days and still accruing interest at December 31, 2012 or 2011. Nonaccrual loans decreased during 2012 due to charge-offs, and borrower repayments.

Other Real Estate Owned (OREO).OREO represents real property taken by the Bank either through foreclosure or through a deed in lieu thereof from the borrower. OREO holdings included one property totaling $1.1 million at December 31, 2011. The property was acquired during 2011 and was comprised of commercial real estate. One additional real estate construction property totaling $364 thousand was acquired during 2012. Both properties were sold during 2012 for a gain of $7 thousand.

The following table sets forth the amount of the Company’s nonperforming assets as of the dates indicated:

For the Year Ended December 31,

(dollars in thousands)	2012			2011			2010			2009			2008
Nonaccrual loans	$	4,422		$	5,646		$	6,823		$	7,364		$	4,934
Loans past due 90 days or more
and still accruing		—			—						—			—
Total nonperforming loans		4,422			5,646			6,823			7,364			4,934
Other real estate owned		—			1,141			—			—			—
Total nonperforming assets	$	4,422		$	6,787		$	6,823		$	7,364		$	4,934
Interest income forgone on
nonaccrual loans	$	567		$	523		$	743		$	435		$	74
Interest income recorded on a
cash basis on nonaccrual loans	$	129		$	211		$	—		$	37		$	52
Nonperforming loans to total
loans		1.95	%		2.51	%		2.91	%		3.14	%		2.18	%
Nonperforming assets to total
assets		1.23	%		1.85	%		2.00	%		2.16	%		1.61	%

Generally, loans are placed on nonaccrual status when full collectibility of principal or interest is uncertain or when principal or interest is past due for 90 days (unless the loan is well secured and in the process of collection). At the time a loan is placed on nonaccrual status, interest previously accrued but not collected is reversed from interest income. There was $567 thousand and $523 thousand in foregone interest on nonaccrual loans during the years ended December 31, 2012 and 2011, respectively. Any interest or principal payments received on a nonaccrual loan are normally applied as a principal reduction unless the nonaccrual loan balance is deemed sufficiently collectible for cash payments to be recognized as income. There was $129 thousand interest income recognized on a cash basis for nonaccrual loans during 2012. Interest income recognized on a cash basis for nonaccrual loans totaled $211 thousand and $0 during the years ended December 31, 2011 and 2010, respectively. A nonaccrual loan may be restored to accrual status when none of its principal and interest is past due and unpaid, and certain other factors are satisfied. Classification of a loan as nonaccrual does not necessarily result in principal and interest becoming uncollectible in whole or in part. The Company is actively pursuing collection of all the contractual amounts due for the nonaccrual loans at December 31, 2012. Those collection efforts include but are not limited to identification of additional sources of collateral or borrower cash flows, modification of loan terms, and when necessary the foreclosure and sale of loan collateral.

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Impaired Loans.A loan is considered impaired when collection of all amounts due according to the original contractual terms is not probable. The category of impaired loans is not coextensive with the category of nonaccrual loans, although the two categories may overlap in part or in full. At December 31, 2012, 2011, and 2010, the recorded investment in loans that were considered to be impaired totaled, $8.0 million, $10.8 million and $11.5 million, respectively. The specific allowance for loan and lease losses for impaired loans at December 31, 2012, 2011 and 2010 totaled $591 thousand, $528 thousand and $1.8 million, respectively. The average recorded investment in impaired loans for the years ended December 31, 2012, 2011, and 2010 totaled $11.3 million, $11.9 million and $14.0 million, respectively.

Allowance for Loan and Lease Losses.The Company attempts to minimize credit risk through its underwriting and credit review policies. The Company’s credit review process includes internally prepared credit reviews as well as contracting with an outside firm to conduct periodic credit reviews. The Company’s management and lending officers evaluate the loss exposure of classified and impaired loans on a quarterly basis, or more frequently as loan conditions change. The Board of Directors, through the loan committee, reviews the asset quality of new and criticized loans on a monthly basis and reports the findings to the full Board of Directors. In management's opinion, this loan review system facilitates the early identification of potential criticized loans.

The ALLL is established through charges to earnings in the form of the provision for loan losses. Loan losses are charged to and recoveries are credited to the ALLL. The ALLL is maintained at a level deemed appropriate by management to provide for known and inherent risks in loans. The adequacy of the ALLL is based upon management's continuing assessment of various factors affecting the collectibility of loans; including current economic conditions, maturity of the portfolio, size of the portfolio, industry concentrations, borrower credit history, collateral, the existing ALLL, independent credit reviews, current charges and recoveries to the ALLL and the overall quality of the portfolio as determined by management, regulatory agencies, and independent credit review consultants retained by the Company. There is no precise method of predicting specific losses or amounts which may ultimately be charged off on particular segments of the loan portfolio. The collectibility of a loan is subjective to some degree, but must relate to the borrower’s financial condition, cash flow, quality of the borrower’s management expertise, collateral and guarantees, and state of the local economy.

The federal financial regulatory agencies issued an interagency policy statement in December 2006 on the ALLL along with supplemental frequently asked questions. When determining the adequacy of the ALLL, the Company follows these guidelines. The agencies issued the revised policy statement in view of today’s uncertain economic environment and the presence of concentrations in untested loan products in the loan portfolios of insured depository institutions. The policy statement has also been revised to conform to accounting principles generally accepted in the United States of America (“GAAP”) and other supervisory guidance. The policy statement reiterates that each institution has a responsibility for developing, maintaining and documenting a comprehensive, systematic, and consistently applied process appropriate to its size and the nature, scope, and risk of its lending activities for determining the amounts of the ALLL and the provision for loan and lease losses and states that each institution should ensure controls are in place to consistently determine the ALLL in accordance with GAAP, the institution’s stated policies and procedures, management’s best judgment and relevant supervisory guidance.

The policy statement also restates that insured depository institutions must maintain an ALLL at a level that is appropriate to cover estimated credit losses on individually evaluated loans determined to be impaired as well as estimated credit losses inherent in the remainder of the loan and lease portfolio (loans collectively evaluated for impairment), and that estimate of credit losses should reflect consideration of all significant factors that affect the collectibility of the portfolio as of the evaluation date. The policy statement states that prudent, conservative, but not excessive, loan loss allowances that represent management’s best estimate from within an acceptable range of estimated losses are appropriate. In addition, the Company incorporates the Securities and Exchange Commission Staff Accounting Bulletin No. 102, which represents the SEC staff’s view related to methodologies and supporting documentation for the ALLL that should be observed by all public companies in complying with the federal securities laws and the Commission’s interpretations.

The Company’s methodology for assessing the adequacy of the ALLL consists of several key elements, which include but are not limited to:

§ specific allocation for problem graded loans, if any (“impaired loans”),

§ general or formula allocation,

§ and discretionary allocation based on loan portfolio segmentation.

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Specific allocations are established based on management’s periodic evaluation of loss exposure inherent in impaired and other loans in which management believes that the collection of principal and interest under the original terms of the loan agreement are in question. For purposes of this analysis, loans are grouped by internal risk classifications which are “special mention”, “substandard”, “doubtful”, and “loss”. Special mention loans are currently performing but are potentially weak, as the borrower has begun to exhibit deteriorating trends, which if not corrected could jeopardize repayment of the loan and result in further downgrade. Substandard loans have well-defined weaknesses which, if not corrected, could jeopardize the full satisfaction of the debt. A loan classified as “doubtful” has critical weaknesses that make full collection of the obligation improbable. Classified loans, as defined by the Company, include loans categorized as substandard and doubtful. Loans classified as loss are immediately charged off.

Formula allocations are calculated by applying loss factors to outstanding loans with similar characteristics. Loss factors are based on the Company’s historical loss experience as adjusted for changes in the business cycle and on the internal risk grade of those loans and may be adjusted for significant factors that, in management's judgment, affect the collectibility of the portfolio as of the evaluation date. The formula allocation analysis incorporates loan losses over the over the most recent twelve quarters adjusted for changes in the business cycle. Loss factors are adjusted to recognize and quantify the estimated loss exposure resulting from changes in market conditions and trends in the Company’s loan portfolio.

The discretionary allocation is based upon management’s evaluation of various loan segment conditions that are not directly measured in the determination of the formula and specific allowances. The conditions may include, but are not limited to, general economic and business conditions affecting the key lending areas of the Company, credit quality trends, collateral values, loan volumes and concentrations, and other business conditions.

The ALLL totaled $5.2 million or 2.23% of total loans at December 31, 2012 compared to $5.5 million or 2.38% at December 31, 2011, and $6.7 million or 2.78% at December 31, 2010. The Company’s loan loss provisions recorded during 2011 and 2010 totaled $600 thousand, and $2.1 million, respectively. There was no loan loss provision recorded during 2012. The ALLL as of December 31, 2012, 2011 and 2010 related to specific reserves for impaired loans included approximately $591 thousand, $528 thousand, and $1.6 million, respectively. The remaining amount of the loan loss provisions for each year added to general reserves related to the overall trends in credit quality of the loan portfolio including an increase in the number and amount of classified and past due loans, and deterioration in the general economic environment in the Company’s primary market area. Management believes that the ALLL was adequate at December 31, 2012. However, no prediction of the ultimate level of loans charged off in future years can be made with any certainty.

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The following table provides certain information for the years indicated with respect to the Company’s ALLL as well as charge-off and recovery activity.

	For the Year Ended December 31,
	2012			2011			2010			2009			2008
(dollars in thousands)
Balance at beginning of period	$	5,469		$	6,699		$	6,231		$	3,244		$	1,758
Charge-offs:
Commercial		—			1,603			35			3,840			125
Agricultural		—			—			—			—			—
Real estate mortgage		233			158			1,530			173			5
Real estate construction		86			192			—			—			—
Consumer		100			—			28			—			12
Total charge-offs		419			1,953			1,593			4,013			142
Recoveries:
Commercial		143			23			11			—			27
Agricultural		—			—			—			—			—
Real estate mortgage		—			100			—			—			—
Real estate construction		—			—			—			—			—
Consumer		—			—			—			—			1
ToTotal recoveries		143			123			11			—			28
Net charge-offs		276			1,830			1,582			4,013			114
Provision for loan losses		—			600			2,050			7,000			1,600
Balance at end of period	$	5,193		$	5,469		$	6,699		$	6,231		$	3,244
Net charge-offs to average loans  outstanding		0.12	%		0.78	%		0.65	%		1.67	%		.05	%
Average loans outstanding	$	227,979		$	233,474		$	243,519		$	239,428		$	219,4311
Ending allowance to total loans outstanding		2.23	%		2.38	%		2.78	%		2.58	%		1.41	%

Deposits

Deposits are obtained primarily from local businesses and residents. The average deposits and the average rates paid for 2012, 2011, and 2010 are presented in the “Results of Operations” section under the heading “Net Interest Income.” Average total deposits for 2012 were $304.6 million compared to $294.9 million for 2011, an increase of $9.7 million or 3%. Average brokered deposits included in these totals were $6.6 million in 2011 and none in 2012.

The Company has utilized brokered deposits primarily as a way of diversifying its funding sources. Total brokered deposits at December 31, 2010 were $9.2 million. There were no brokered deposits at December 31, 2012 or 2011.

The Company’s deposits decreased from $315.9 million at December 31, 2011 to $315.5 at December 31, 2012, a decrease of $393 thousand or 0.12%. The decrease in deposits was due primarily to an $8.6 million or 6% decrease in non-interest bearing deposits and a $4.3 million or 6% decrease in time deposits offset by a $11.4 million or 10% increase in demand deposits.

39

The following chart sets forth the distribution of the Company’s average daily deposits for the periods indicated.

	For the Year ended December 31,
	2012				2011				2010
			Average				Average				Average
	Average		Yield/		Average		Yield/		Average		Yield/
(dollars in thousands)	Balance		Rate		Balance		Rate		Balance		Rate
Deposits:
Non-interest bearing deposits	$	110,655			$	94,582			$	80,273
Interest-bearing deposits:
Interest bearing demand deposits		36,716		0.38%		36,138		0.42%		39,534		0.53%
Money market accounts		74,391		0.43%		72,103		0.51%		72,887		0.65%
Savings		13,368		0.20%		12,017		0.23%		10,088		0.25%
Time deposits		69,421		0.69%		80,053		1.11%		95,302		1.72%
Total interest-bearing deposits		193,896		0.50%		200,311		0.72%		217,811		1.08%
Total deposits	$	304,551			$	294,893			$	298,084

The following table summarizes by time remaining to maturity, the amount of certificates of deposit issued in amounts of $100,000 or more as of December 31, 2012.

Maturities of certificates of deposit of $100,000 or more
(dollars in thousands)	Balance		Percent of total
Three months or less	$	15,844		33%
Over three months through nine months		21,142		45%
Over nine months through twelve months		7,458		16%
Over twelve months		2,751		6%
Total certificates of deposit of $100,000 and more	$	47,195		100%

Borrowings

Federal Home Loan Bank. The Company maintains a borrowing relationship with the Federal Home Loan Bank of San Francisco (FHLB) which offers both long-term and short-term borrowing facilities. The Company has qualifying loans as collateral for its borrowing lines as required by FHLB.

At December 31, 2012, term borrowing outstanding from the FHLB totaled $0 compared to $1.0 million at December 31, 2011. There was no new term borrowings during 2012 and the reduction from the prior year was attributable to scheduled principal repayments and maturities. Average total term borrowings from FHLB totaled $2.3 million at an average cost of 5.18% for 2011. There were no FHLB term borrowings for 2012.

There were no short-term borrowings from FHLB at December 31, 2012 or 2011.

Federal Reserve Discount Window.At December 31, 2012, the Bank could borrow approximately 60% of pledged loans from the Federal Reserve Bank of San Francisco. The Bank’s discount window borrowing line was approximately $55.8 million at December 31, 2012 and there were no outstanding borrowings.

Other Borrowing Arrangements. In addition to FHLB and FRB borrowing lines, the Company maintains a short-term unsecured borrowing arrangement with a correspondent bank to meet unforeseen cash needs. This borrowing line totaled $10.0 million at both December 31, 2012 and 2011. The borrowing line is utilized infrequently and there was no balance outstanding at either December 31, 2012 or 2011.

40

Junior Subordinated Deferrable Interest Debentures.During 2003, the Company formed Valley Commerce Trust I with a capital investment of $93 thousand for the sole purpose of issuing trust preferred securities. During the second quarter of 2003, Valley Commerce Trust I issued trust preferred securities for gross proceeds of $3.0 million and invested this amount plus the $93 thousand of capital proceeds in floating rate junior subordinated deferrable interest debentures issued by the Company. The Subordinated Debentures mature on April 7, 2033 and are repriced quarterly to an interest rate that is the sum of 3-month Libor plus 3.30%. The interest rate at December 31, 2012 and December 31, 2011 was 3.82% and 3.65%, respectively.

Trust preferred securities are includable in the Company’s Tier 1 capital for regulatory purposes subject to certain limitations. The action taken to form Valley Commerce Trust I and issue trust preferred securities was made for the purpose of enhancing the Company’s capital position and to provide for the continued growth of the Bank.

Off-Balance Sheet Items

As of December 31, 2012 and December 31, 2011, commitments to extend credit and letters of credit were the only financial instruments with off-balance sheet risk. As of December 31, 2012 and December 31, 2011, commitments to extend credit totaled $26.5 million and $31.8 million, respectively, and letters of credit totaled $485 thousand and $475 thousand, respectively. The Company has not entered into any contracts for financial derivative instruments such as futures, swaps, options or similar instruments.

Contractual Obligations

The Company’s contractual obligations are comprised of junior subordinated deferrable interest debentures, an operating lease for office space in Fresno through 2017, and post-retirement benefit plans.

Capital Resources

Federal regulations establish guidelines for calculating leverage and risk-based capital ratios. The guidelines for risk-based capital ratios, which apply to banks and bank holding companies, establish a systematic approach of assigning risk weights to assets and commitments making capital requirements more sensitive to differences in risk profiles. For these purposes, “Tier 1” capital consists of common equity, non-cumulative perpetual preferred stock, trust preferred securities subject to regulatory limitation, and minority interests in the equity accounts of consolidated subsidiaries and excludes goodwill and certain deferred tax assets. “Tier 2” capital consists of cumulative perpetual preferred stock, limited-life preferred stock, mandatory convertible securities, subordinated debt and (subject to a limit of 1.25% of risk-weighted assets) general loan loss reserves. In calculating the relevant ratio, a company’s assets and off-balance sheet commitments are risk-weighted; thus, for example, loans are included at 100% of their book value while assets considered less risky are included at a percentage of their book value (20%, for example, for U. S. Government Agency securities, and 0% for vault cash and U. S. Government Treasury securities).

41

The Board of Directors regularly reviews the Company’s capital ratios to ensure that capital exceeds the prescribed regulatory minimums and is otherwise adequate to meet future needs. The following table summarizes the Company’s risk-based capital ratios as of December 31, 2012 and December 31, 2011:

Capital and capital adequacy ratios

	Year ended December 31,
	2012				2011
(dollars in thousands)	Amount		Ratio		Amount		Ratio
Leverage Ratio
Valley Commerce Bancorp and Subsidiary	$	39,844		11.3%	$	44,691		13.1%
Minimum regulatory requirement	$	14,102		4.0%	$	13,626		4.0%
Valley Business Bank	$	39,509		11.2%	$	44,648		13.1%
Minimum requirement for “Well- Capitalized” institution	$	17,627		5.0%	$	17,032		5.0%
Minimum regulatory requirement	$	14,095		4.0%	$	13,621		4.0%
Tier 1 Risk-Based Capital Ratio
Valley Commerce Bancorp and Subsidiary	$	39,844		15.6%	$	44,691		17.6%
Minimum regulatory requirement	$	10,222		4.0%	$	10,145		4.0%
Valley Business Bank	$	39,509		15.5%	$	44,648		17.6%
Minimum requirement for “Well- Capitalized” institution	$	15,324		6.0%	$	15,214		6.0%
Minimum regulatory requirement	$	10,216		4.0%	$	10,142		4.0%
Total Risk-Based Capital Ratio
Valley Commerce Bancorp and Subsidiary	$	43,064		16.9%	$	45,060		18.9%
Minimum regulatory requirement	$	20,444		8.0%	$	20,290		8.0%
Valley Business Bank	$	42,727		16.8%	$	44,931		18.9%
Minimum requirement for “Well- Capitalized” institution	$	25,541		10.0%	$	25,356		10.0%
Minimum regulatory requirement	$	20,432		8.0%	$	20,285		8.0%

At December 31, 2012 and December 31, 2011, all of the Company’s capital ratios were in excess of minimum regulatory requirements, and Valley Business Bank exceeded the minimum requirements of a “well capitalized” institution.

In the second quarter of 2003, Valley Commerce Trust I issued $3.0 million of trust preferred securities. Trust preferred securities are includable in Tier 1 capital, subject to regulatory limitation. At December 31, 2012 and December 31, 2011, the entire $3.0 million was included in Tier 1 capital.

The Company’s average equity as a percentage of average assets was 10.9% for 2012 and 11.8% for 2011. Year-end shareholders’ equity as a percentage of year-end assets was 10.5% and 11.60% at December 31, 2012 and 2011, respectively. Changes in these ratios reflects 2012 income, offset by cash dividends paid on common stock and the repurchase of the Series B and Series C Preferred Stock from the United States Department of Treasury during 2012.

The Company issued a 5% stock dividend in 2011. There was no stock dividend issued during 2012. Stock splits and dividends are not dilutive to capital ratios. The Company paid cash dividends to shareholders in June 2012 and September 2012 in the amount of $111,384 for each period and in December 2012 in the amount of $222,768.

42

On May 22, 2012, the Company’s Board of Directors authorized a common stock repurchase plan. The plan provides for the repurchase of up to $3.0 million of the Company’s Common Stock. The number price and timing of the repurchase is at the Company’s sole discretion. The stock repurchase plan will expire on May 22, 2013. There were no shares repurchased during the year ended December 2012.

On March 21, 2012, pursuant to the American Recovery and Reinvestment Act of 2009 and following receipt of all necessary regulatory approvals, the Company repurchased the Series B and Series C Preferred Stock which was sold to the United States Department of Treasury in January 2009.  The purchase price was $8,085,000 comprised of 7,700 shares of Series B Preferred Stock at $1,000 per share and 385 shares of Series C Preferred Stock at $1,000 per share.  The Company had no preferred stock remaining after the transaction and made a pro-rated final dividend payment on the transaction date.  Because the preferred stock qualified as Tier 1 capital, the Company’s Tier 1 capital was reduced by an amount that approximated the purchase price. 

Liquidity Management

Liquidity is the ability to provide funds to meet customers’ loan and deposit needs and to fund operations in a timely and cost effective manner. The Company’s primary source of funds is deposits. On an ongoing basis, management anticipates funding needs for loans, asset purchases, maturing deposits, and other needs and initiates deposit promotions as needed. Management measures the Company’s liquidity position monthly through the use of short-term and medium-term internal liquidity calculations. These are monitored on an ongoing basis by the Board of Directors and the Company’s Asset Liability Management Committee.

The Company has a successful history of establishing and retaining deposit relationships with local business customers. It periodically utilizes collateralized borrowing lines and wholesale funding resources to supplement local deposit growth. These include borrowing lines with FHLB, FRB, and correspondent banks, and utilization of brokered time deposits. At December 31, 2012, the Company had available credit of $60.9 million from the FHLB, $55.8 million from the Federal Reserve Bank, and $10.0 million from correspondent banks.

The Company’s off-balance sheet financing arrangements are primarily limited to commitments to extend credit and standby letters of credit, which totaled $26.5 million and $485 thousand, respectively, at December 31, 2012. Management monitors these arrangements monthly in the overall assessment of the Company’s liquidity needs. The Company has no other off-balance sheet arrangements that are likely to have a material effect on its financial condition, results of operations, liquidity, capital expenditures or capital resources. The Company does not retain a repurchase option or contingent interest in any of its loan participations.

As discussed above, the Company’s wholly-owned subsidiary, Valley Commerce Trust I, issued trust preferred securities for gross proceeds of $3.0 million on April 7, 2003. Quarterly interest payments on these securities are considered in management’s normal evaluation of liquidity needs. Although the trust preferred securities do not mature until April 7, 2033, Valley Commerce Trust I has the option to redeem the trust preferred securities at any time after April 7, 2008. The Company will carefully evaluate the impact on capital and liquidity if and when consideration is given to redemption of trust preferred securities.

The Company’s strategic objectives include expanding through opening of loan production offices and acquiring productive assets from other institutions. The Company’s planning efforts consider the impact of known and anticipated cash outlays so that sufficient liquidity is maintained for both capital and operational needs.

43

ITEM 7A – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Not applicable.

ITEM 8 – FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The report of the independent registered public accounting firm and financial statements listed below are included herein:

		Page
I.	Report of Independent Registered Public Accounting Firms	45
II.	Consolidated Balance Sheets as of December 31, 2012 and 2011	47
III.	Consolidated Statements of Income for the years ended December 31, 2012, 2011 and 2010	48
IV.	Consolidated Statements of Comprehensive Income for the years ended  December 31, 2012, 2011 and 2010	49
V.	Consolidated Statements of Changes in Shareholders’ Equity for the years ended December 31, 2012, 2011 and 2010	50
VI.	Consolidated Statements of Cash Flows for the years ended December 31, 2012, 2011 and 2010	51
VII.	Notes to Consolidated Financial Statements	53

44

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Shareholders and Board of Directors

Valley Commerce Bancorp and Subsidiary

Visalia, California

We have audited the accompanying consolidated balance sheets of Valley Commerce Bancorp and subsidiary (the "Company") as of December 31, 2012 and 2011, and the related consolidated statements of income, comprehensive income, changes in shareholders' equity and cash flows for the years ended December 31, 2012 and 2011. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2012 and 2011, and the results of its operations and its cash flows for the years then ended in conformity with U.S. generally accepted accounting principles.

/s/  Crowe Horwath LLP

Sacramento, California

March 29, 2013

45

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Shareholders and

Board of Directors

Valley Commerce Bancorp

We have audited the accompanying consolidated statements of income, comprehensive income, changes in shareholders’ equity and cash flows of Valley Commerce Bancorp and subsidiary (the “Company”) for the year ended December 31, 2010.  These consolidated financial statements are the responsibility of the Company’s management.  Our responsibility is to express an opinion on these consolidated financial statements based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.  We believe that our audit provides a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated results of operations and cash flows of Valley Commerce Bancorp and subsidiary for the year ended December 31, 2010, in conformity with U.S. generally accepted accounting principles.

	/s/ Perry-Smith LLP
Sacramento, California
March 30, 2011

46

VALLEY COMMERCE BANCORP AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

December 31, 2012 and 2011

	2012		2011
ASSETS
Cash and due from banks	$	57,573,424	$	60,421,044
Available-for-sale investment securities, at fair value (Notes 3 and 4)		53,001,000		56,705,000
Loans, less allowance for loan and lease losses of $5,192,436
in 2012 and $5,468,758 in 2011 (Notes 3, 5, 8, and 10)		227,260,487		224,531,870
Bank premises and equipment, net (Note 6)		7,995,072		8,167,976
Cash surrender value of bank-owned life insurance (Note 15)		7,992,697		7,693,480
Other real estate owned		—		1,140,547
Accrued interest receivable and other assets (Note 13)		7,056,100		7,860,783
Total assets	$	360,878,780	$	366,520,700
LIABILITIES AND SHAREHOLDERS’ EQUITY
Deposits:
Non-interest bearing	$	120,900,110	$	128,453,106
Interest bearing (Note 7)		194,583,883		187,424,263
Total deposits		315,483,993		315,877,369
Accrued interest payable and other liabilities		4,398,621		4,044,919
Federal Home Loan Bank term borrowing (Note 8)		—		1,000,000
Junior subordinated deferrable interest debentures (Note 9)		3,093,000		3,093,000
Total liabilities		322,975,614		324,015,288
Commitments and contingencies (Note 10)
Shareholders’ equity (Note 11):
Serial preferred stock – no par value; 10,000,000
shares authorized; issued and outstanding none in 2012 and
7,700 shares Class B and 385 Class C warrants in 2011		—		7,898,800
Common stock – no par value; 30,000,000 shares
authorized; issued and outstanding 2,815,036
shares in 2012 and 2,784,593 shares in 2011		28,080,655		27,534,291
Retained earnings		8,763,327		6,257,800
Accumulated other comprehensive income, net of taxes (Note 4)		1,059,184		814,521
Total shareholders’ equity		37,903,166		42,505,412
Total liabilities and shareholders’ equity	$	360,878,780	$	366,520,700

The accompanying notes are an integral
part of these consolidated financial statements.

47

VALLEY COMERCE BANCORP AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF INCOME

For the Years Ended December 31, 2012, 2011 and 2010

	2012		2011		2010
Interest income:
Interest and fees on loans	$	13,139,294	$	13,943,059	$	14,792,871
Interest on investment securities:
Taxable		697,495		937,597		721,086
Exempt from Federal income taxes		768,742		699,280		627,502
Interest on deposits in banks		81,508		63,140		70,951
Total interest income		14,687,039		15,643,076		16,212,410
Interest expense:
Interest on deposits (Note 7)		961,783		1,434,143		2,343,620
Interest on short-term borrowings (Note 8)		173		118,612		161,088
Interest on junior subordinated deferrable interest
debentures (Note 9)		118,212		113,091		114,236
Total interest expense		1,080,168		1,665,846		2,618,944
Net interest income before provision for loan losses		13,606,871		13,977,230		13,593,466
Provision for loan losses (Note 5)		—		600,000		2,050,000
Net interest income after provision for loan losses		13,606,871		13,377,230		11,543,466
Non-interest income:
Service charges		686,749		703,412		768,489
Gain on sale of available-for-sale investment
securities, net (Note 4)		152,224		289,575		34,103
Gain on sale of  other real estate		6,981		—		—
Mortgage loan brokerage fees		68,571		55,418		59,702
Earnings on cash surrender value of life insurance
policies (Note 15)		327,973		292,427		294,734
Other		246,940		218,943		183,958
Total non-interest income		1,489,438		1,559,775		1,340,986
Non-interest expense:
Salaries and employee benefits (Note 5 and 15)		6,205,799		5,678,813		5,248,497
Occupancy and equipment (Note 6 and 10)		1,375,395		1,353,874		1,333,948
Other (Note 12)		2,911,209		3,223,339		3,196,039
Total non-interest expense		10,492,403		10,256,026		9,778,484
Income before provision for income taxes		4,603,906		4,680,979		3,105,968
Provision for income taxes (Note 13)		1,371,000		1,577,000		943,000
Net income	$	3,232,906	$	3,103,979	$	2,162,968
Dividends accrued and discount accreted
on preferred shares	$	93,209	$	417,344	$	420,817
Net income available to common shareholders	$	3,139,697	$	2,686,635	$	1,742,151
Basic earnings per common share (Note 11)	$	1.13	$	0.97	$	0.65
Diluted earnings per common share (Note 11)	$	1.12	$	0.97	$	0.65

The accompanying notes are an integral
part of these consolidated financial statements.

48

VALLEY COMERCE BANCORP AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

For the Years Ended December 31, 2012, 2011 and 2010

	2012			2011			2010
Net Income	$	3,232,906		$	3,103,979		$	2,162,968
Other Comprehensive Income:
Unrealized Gains (Losses) on Investment Securities:
Unrealized holding gains (losses) arising during the period		567,965			1,743,559			(42,135	)
Less: Reclassification adjustment for
realized gains included in net income		152,224			289,575			34,103
		415,741			1,453,984			(76,238	)
Tax effect		(171,078	)		(598,314	)		31,372
Other Comprehensive Income (Loss)		244,663			855,670			(44,866	)
Total Comprehensive Income	$	3,477,569		$	3,959,649		$	2,118,102

The accompanying notes are an integral
part of these consolidated financial statements.

49

VALLEY COMMERCE BANCORP AND SUBSIDIARY

CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY

For the Years Ended December 31, 2012, 2011 and 2010

														Accumulated
														Other
														Compre-			Total
	Preferred Stock						Common Stock							hensive			Share-
											Retained			Income (Loss)			holders’
	Shares			Amount			Shares		Amount		Earnings			(Net of Taxes)			Equity
Balance, January 1, 2010		8,085		$	7,744,800			2,608,317	$	25,953,290	$	3,166,732		$	3,717		$	36,868,539
Net income												2,162,968						2,162,968
Other comprehensive loss															(44,866	)		(44,866	)
Dividend and accretion on
preferred stock					77,000							(497,817	)					(420,817	)
Stock options exercised and related
tax benefit								22,163		146,808								146,808
Stock-based compensation expense										37,060								37,060
Balance, December 31, 2010		8,085		$	7,821,800			2,630,480	$	26,137,158	$	4,831,883		$	(41,149	)	$	38,749,692
Net income												3,103,979						3,103,979
Other comprehensive income															855,670			855,670
Dividend and accretion on
preferred stock					77,000							(494,346	)					(417,346	)
Stock dividend								131,243		1,181,187		(1,181,187	)
Cash paid for fractional shares												(2,529	)					(2,529	)
Restricted stock granted								2,927
Stock options exercised and related
tax benefit								19,943		117,000								117,000
Stock-based compensation expense										98,946								98,946
Balance, December 31, 2011		8,085		$	7,898,800			2,784,593	$	27,534,291	$	6,257,800		$	814,521		$	42,505,412
Net income												3,232,906						3,232,906
Other comprehensive income															244,663			244,663
Dividend and accretion
on preferred stock					186,200							(279,409	)					(93,209	)
Redemption of preferred stock		(8,085	)		(8,085,000	)												(8,085,000	)
Cash dividends $0.16 per
common share												(447,970	)					(447,970	)
Stock options exercised and related
tax benefit								30,443		272,248								272,248
Stock-based compensation expense										274,116								274,116
Balance, December 31, 2012		—		$	—			2,815,036	$	28,080,655	$	8,763,327		$	1,059,184		$	37,903,166

The accompanying notes are an integral
part of these consolidated financial statements.

50

VALLEY COMMERCE BANCORP AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

For the Years Ended December 31, 2012, 2011 and 2010

	2012			2011			2010
Cash flows from operating activities:
Net income	$	3,232,906		$	3,103,979		$	2,162,968
Adjustments to reconcile net income to net cash
provided by operating activities:
Provision for loan losses		—			600,000			2,050,000
Increase (decrease) in deferred loan origination fees, net		72,058			(40,744	)		(20,369	)
Depreciation		550,818			550,630			512,359
Gain on sale of available-for-sale investment securities, net		(152,224	)		(289,575	)		(34,103	)
Accretion of investment securities, net		546,447			435,387			322,693
Loss on disposition of premises and equipment		19,886			2,697			9,341
(Increase) decrease in deferred income taxes		(12,000	)		1,266,000			(448,000	)
Tax benefits on stock-based compensation		(59,639	)		(23,199	)		(1,682	)
Tax benefit from exercise of stock options		(17,924	)		—			(21,808	)
Increase in cash surrender value of bank owned life insurance		(299,217	)		(266,420	)		(272,189	)
Stock-based compensation expense		274,116			98,946			37,060
Gain from sale of other real estate		(6,981	)		—			—
Decrease (increase) in accrued interest receivable and other assets		836,646			(548,954	)		1,562,157
Increase in accrued interest payable and other liabilities		182,623			736,692			475,444
Net cash provided by operating activities		5,167,515			5,625,439			6,333,871
Cash flows from investing activities:
Proceeds from matured and called available-for-sale
investment securities		2,225,000			75,000			1,805,000
Proceeds from sales of available-for-sale investment securities		3,558,372			13,312,408			3,558,397
Purchases of available-for-sale investment securities		(10,228,351	)		(23,576,460	)		(20,718,236	)
Proceeds from principal repayments from available-for-sale
mortgage-backed securities		8,170,497			5,615,224			6,733,010
Net  (increase) decrease in loans		(3,165,175	)		8,072,637			(1,510,978	)
Redemption (purchase) of Federal Home Loan Bank stock, net		57,600			(95,600	)		(241,700	)
Purchase of premises and equipment		(430,300	)		(211,215	)		(990,482	)
Proceeds from sale of premises and equipment		32,500			600			—
Proceeds from sale of other real estate		1,512,028			—			—
Purchase of life insurance policies		—			(800,000	)		—
Net cash provided by (used in) investing activities		1,732,171			2,392,594			(11,364,989	)

(Continued)

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VALLEY COMMERCE BANCORP AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

For the Years Ended December 31, 2012, 2011 and 2010

	2012			2011			2010
Cash flows from financing activities:
Net increase in noninterest bearing and
interest-bearing deposits	$	3,893,374		$	34,177,329		$	12,675,112
Net decrease in time deposits		(4,286,750	)		(12,577,762	)		(12,679,455	)
Redemption of preferred stock		(8,085,000	)		—			—
Proceeds from exercised stock options		254,325			117,000			125,000
Benefit from exercise of stock options		17,924			—			21,808
Cash dividends paid on preferred stock		(93,209	)		(417,344	)		(420,817	)
Cash dividends paid on common stock		(447,970	)		—			—
Net decrease in Federal Home Loan Bank term borrowings		(1,000,000	)		(1,561,650	)		(1,100,349	)
Cash paid to repurchase fractional shares		—			(2,529	)		—
Net cash (used in) provided by financing activities		(9,747,306	)		19,735,044			(1,378,701	)
(Decrease) increase in cash and cash equivalents		(2,847,620	)		27,753,077			(6,409,819	)
Cash and cash equivalents at beginning of year		60,421,044			32,667,967			39,077,786
Cash and cash equivalents at end of year	$	57,573,424		$	60,421,044		$	32,667,967
Supplemental disclosure of cash flow information:
Cash paid during the year for:
Interest expense	$	1,116,686		$	1,681,774		$	2,661,335
Income taxes	$	900,000		$	845,000		$	780,000
Non-cash Financing Activity:
Net change in accrued dividends on preferred stock	$	(51,244	)	$	3,471		$	1,168
Real estate owned acquired through foreclosure	$	364,500		$	1,140,547		$	—

The accompanying notes are an integral
part of these consolidated financial statements.

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VALLEY COMMERCE BANCORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. THE BUSINESS OF VALLEY COMMERCE BANCORP

On February 2, 2002, Valley Commerce Bancorp (the "Company") was incorporated as a bank holding company for the purpose of acquiring Valley Business Bank (the "Bank”) in a bank holding company reorganization. This corporate structure gives the Company and the Bank greater flexibility to expand and diversify.

The Bank commenced operations in 1996 and operates branches in Visalia, Fresno, Woodlake, Tipton and Tulare. The Bank's primary source of revenue is generated from providing loans to customers who are predominately small and middle market businesses and individuals residing in the surrounding areas.

The Bank’s deposits are insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000 for all deposit categories. In addition, the Bank participated in the FDIC Transaction Account Guarantee Program (TAGP). Under the program, which expired on December 31, 2012, all noninterest-bearing transaction accounts were fully guaranteed by the FDIC without limitation.

The Dodd-Frank Wall Street Reform and Consumer Protection Act (DFA), signed into law on July 27, 2010, includes Section 343, which provided temporary unlimited coverage for noninterest-bearing transaction accounts at all FDIC–insured depository institutions. DFA Section 343 began December 31, 2010 and terminated on December 31, 2012. Both TAGP and DFA Section 343 coverage was in addition to and separate from the coverage under FDIC’s general deposit insurance rules.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Consolidation and Basis of Presentation

The consolidated financial statements include the accounts of the Company and the accounts of its wholly-owned subsidiary, Valley Business Bank. All significant intercompany balances and transactions have been eliminated.

Valley Commerce Trust I, a wholly-owned subsidiary formed for the exclusive purpose of issuing trust preferred securities, is not consolidated into the Company's consolidated financial statements because the Company is not the primary beneficiary of Valley Commerce Trust I and, accordingly, is accounted for under the equity method. The Company’s investment in the Trust is included in accrued interest receivable and other assets in the consolidated balance sheet. The junior subordinated debentures issued and guaranteed by the Company and held by the Trust are reflected as debt in the consolidated balance sheet.

The accounting and reporting policies of Valley Commerce Bancorp and subsidiary conform with accounting principles generally accepted in the United States of America and prevailing practices within the banking industry.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES(Continued)

Use of Estimates

The preparation of financial statements in conformity with U.S. generally accepted accounting principles, requires management to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates. The allowance for loan losses and fair values of financial instruments are particularly subject to change.

Segment Information

Management has determined that since all of the banking products and services offered by the Company are available in each branch of the Bank, all branches are located within the same economic environment and management does not allocate resources based on the performance of different lending or transaction activities, it is appropriate to aggregate the Bank branches and report them as a single operating segment. No customer accounts for more than 10 percent of revenues for the Company or the Bank.

Cash and Cash Equivalents

For the purpose of the statement of cash flows, cash, due from banks with original maturities fewer than 90 days, Federal funds sold, and the Federal Reserve Bank’s interest bearing Excess Balance Account (FRB-EBA) are considered to be cash equivalents. There was no cash held with other federally insured institutions in excess of FDIC insured limits as of December 31, 2012. Net cash flows are reported for customer loan and deposit transactions, interest bearing deposits in other financial institutions, changes in Federal Home Loan Bank term borrowings, and federal funds purchased.

Investment Securities

Investments are classified into one of the following categories:

·     Available-for-sale securities reported at fair value, with unrealized gains and losses excluded from earnings and reported, net of taxes, as accumulated other comprehensive income (loss) within shareholders' equity.

·     Held-to-maturity securities, which management has the positive intent and ability to hold, reported at amortized cost, adjusted for the accretion of discounts and amortization of premiums.

Management determines the appropriate classification of its investments at the time of purchase and may only change the classification in certain limited circumstances. As of December 31, 2012 and 2011 the Company did not have any investment securities classified as held-to-maturity or trading.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Gains or losses on the sale of securities are computed on the specific identification method. Interest earned on investment securities is reported in interest income, net of applicable adjustments for accretion of discounts and amortization of premiums. Premiums and discounts on securities are amortized or accreted on the cost to maturity or the straight line average method without anticipating prepayments, except for mortgage backed securities where prepayments are anticipated.

An investment security is impaired when its carrying value is greater than its fair value. Investment securities that are impaired are evaluated on at least a quarterly basis and more frequently when economic or market conditions warrant such an evaluation to determine whether such a decline in their fair value is other than temporary. Management utilizes criteria such as the magnitude and duration of the decline and the intent and ability of the Company to retain its investment in the securities for a period of time sufficient to allow for an anticipated recovery in fair value, in addition to the reasons underlying the decline, to determine whether the loss in value is other than temporary. The term "other than temporary" is not intended to indicate that the decline is permanent, but indicates that the prospects for a near-term recovery of value is not necessarily favorable, or that there is a lack of evidence to support a realizable value equal to or greater than the carrying value of the investment.

Once a decline in value is determined to be other than temporary, and management does not intend to sell the security or it is more likely than not that the Company will not be required to sell the security before recovery, only the portion of the impairment loss representing credit exposure is recognized as a charge to earnings, with the balance recognized as a charge to other comprehensive income. If management intends to sell the security or it is more likely than not that the Company will be required to sell the security before recovering its forecasted cost, the entire impairment loss is recognized as a charge to earnings.

Loans

Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are stated at principal balances outstanding, net of deferred loan fees and costs, and the allowance for loan losses. Interest is accrued daily based upon outstanding loan balances. However, when, in the opinion of management, loans are considered to be impaired and the future collectibility of interest and principal is in serious doubt, loans are placed on nonaccrual status and the accrual of interest income is suspended.

Interest income on mortgage and commercial loans is discontinued at the time the loan is 90 days delinquent unless the loan is well-secured and in process of collection. Consumer and credit card loans are typically charged off no later than 120 days past due. Past due status is based on the contractual terms of the loan. In all cases, loans are placed on nonaccrual or charged-off at an earlier date if collection of principal or interest is considered doubtful. A loan is moved to non-accrual status in accordance with the Company’s policy, typically after 90 days of non-payment.

All interest accrued but not received for loans placed on nonaccrual is reversed against interest income. Interest received on such loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

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VALLEY COMMERCE BANCORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Substantially all loan origination fees, commitment fees, direct loan origination costs and purchased premiums and discounts on loans are deferred and recognized as an adjustment of yield, to be amortized to interest income over the contractual term of the loan. The unamortized balance of deferred fees and costs is reported as a component of net loans.

The Company may acquire loans through a business combination or a purchase for which differences may exist between the contractual cash flows and the cash flows expected to be collected due, at least in part, to credit quality. When the Company acquires such loans, the yield that may be accreted (accretable yield) is limited to the excess of the Company's estimate of undiscounted cash flows expected to be collected over the Company's initial investment in the loan. The excess of contractual cash flows over cash flows expected to be collected may not be recognized as an adjustment to yield, loss, or a valuation allowance. Subsequent increases in cash flows expected to be collected generally are recognized prospectively through adjustment of the loan's yield over its remaining life. Decreases in cash flows expected to be collected are recognized as an impairment. The Company may not "carry over" or create a valuation allowance in the initial accounting for loans acquired under these circumstances. At December 31, 2012 and 2011, there were no loans being accounted for under this policy method.

Allowance for Loan and Lease Losses

The allowance for loan and lease losses (“allowance” or “ALLL”) is an estimate of probable credit losses inherent in the Company's loan portfolio that have been incurred as of the balance-sheet date. The allowance is established through a provision for loan losses which is charged to expense. Additions to the allowance are expected to maintain the adequacy of the total allowance after credit losses and loan growth. Credit exposures determined to be uncollectible are charged against the allowance. Cash received on previously charged off amounts is recorded as a recovery to the allowance. The overall allowance consists of two primary components, specific reserves related to loans individually evaluated for impairment and general reserves for inherent losses related to loans that are collectively evaluated for impairment.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due, including principal and interest, according to the contractual terms of the original agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed.

Loans determined to be impaired are individually evaluated for impairment. When a loan is impaired, the Company measures impairment based on the present value of expected future cash flows discounted at the loan's effective interest rate, except that as a practical expedient, it may measure impairment based on a loan's observable market price, or the fair value of the collateral if the loan is collateral dependent. A loan is collateral dependent if the repayment of the loan is expected to be provided solely by the underlying collateral.

A restructuring of a debt constitutes a troubled debt restructuring (TDR) if the Company for economic or legal reasons related to the debtor's financial difficulties grants a concession to the debtor that it would not otherwise consider. Restructured workout loans typically present an elevated level of credit risk as the borrowers are not able to perform according to the original contractual terms. Loans that are reported as TDRs are considered impaired and measured for impairment as described above. For troubled debt restructurings that subsequently default, the Company determines the amount of reserve in accordance with the accounting policy for the allowance for loan and lease losses.

The quarterly determination of the general reserve for loans that are collectively evaluated for impairment is based on estimates made by management, to include, but not limited to, consideration of historical losses by portfolio segment based on the actual loss history experienced by the Company over the most recent twelve quarters, internal asset classifications, and qualitative factors to include economic trends in the Company's service areas, industry trends and experience, geographic concentrations, estimated collateral values, the Company's underwriting policies, the character of the loan portfolio, and probable losses inherent in the portfolio taken as a whole.

The Company maintains a separate allowance for each portfolio segment (loan type). These portfolio segments include commercial, real estate - mortgage, real estate - construction (including land and development loans), agricultural, and consumer and other loans (principally home equity loans). The allowance attributable to each portfolio segment, which includes both impaired loans and loans that are collectively evaluated for impairment is combined to determine the Company's overall allowance, which is included on the consolidated balance sheet.

The Company assigns a risk rating to all loans except pools of homogeneous loans and periodically performs detailed reviews of all such loans over a certain threshold to identify credit risks and to assess the overall collectability of the portfolio. These risk ratings are also subject to examination by independent specialists engaged by the Company and the Company's regulators. During these internal reviews, management monitors and analyzes the financial condition of borrowers and guarantors, trends in the industries in which borrowers operate and the fair values of collateral securing these loans. These credit quality indicators are used to assign a risk rating to each individual loan. The risk ratings can be grouped into five major categories, defined as follows:

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Pass – A pass loan is a strong credit with no existing or known potential weaknesses deserving of management's close attention.

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

Substandard – A substandard loan is not adequately protected by the current sound worth and paying capacity of the borrower or the value of the collateral pledged, if any. Loans classified as substandard have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. Well defined weaknesses include a project's lack of marketability, inadequate cash flow or collateral support, failure to complete construction on time or the project's failure to fulfill economic expectations.They are characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected.

Doubtful –Loans classified 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 known facts, conditions and values, highly questionable and improbable.

Loss – Loans classified as loss are considered uncollectible and charged off immediately.

The general reserve component of the allowance also consists of reserve factors that are based on management's assessment of the following for each portfolio segment: (1) inherent credit risk, (2) historical losses and (3) other qualitative factors. These reserve factors are inherently subjective and are driven by the repayment risk associated with each portfolio segment described below.

Commercial – Commercial loans generally possess more inherent risk of loss than real estate portfolio segments because these loans are generally underwritten to existing cash flows of operating businesses which are subject to market competition and short term changes in economic and business cycles. Debt coverage is provided by business cash flows and economic trends influenced by local economic conditions are closely correlated to the credit quality of these loans.

Real estate - mortgage - mortgage loans generally possess a higher inherent risk of loss than other real estate portfolio segments, except land and construction loans. Adverse economic developments or an overbuilt market impact commercial real estate projects and may result in troubled loans. Trends in vacancy rates of commercial properties impact the credit quality of these loans. High vacancy rates reduce operating revenues and the ability for properties to produce sufficient cash flow to service debt obligations.

Real estate - construction – construction loans generally possess a higher inherent risk of loss than other real estate portfolio segments. A major risk arises from the necessity to complete projects within specified cost and time lines. Trends in the construction industry significantly impact the credit quality of these loans, as demand drives construction activity. In addition, trends in real estate values significantly impact the credit quality of these loans, as property values determine the economic viability of construction projects.

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VALLEY COMMERCE BANCORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Agricultural – Loans secured by crop production and livestock are especially vulnerable to two risk factors that are largely outside the control of Company and borrowers: commodity prices and weather conditions.

Consumer and other– The degree of risk in residential real estate lending depends primarily on the loan amount in relation to collateral value, the interest rate and the borrower's ability to repay in an orderly fashion. These loans generally possess a lower inherent risk of loss than other real estate portfolio segments. Economic trends determined by unemployment rates and other key economic indicators are closely correlated to the credit quality of these loans. Weak economic trends indicate that the borrowers' capacity to repay their obligations may be deteriorating.

Although management believes the allowance to be adequate, ultimate losses may vary from its estimates. At least quarterly, management and the Board of Directors reviews the adequacy of the allowance, including consideration of the relative risks in the portfolio, current economic conditions and other factors. If the Board of Directors and management determine that changes are warranted based on those reviews, the allowance is adjusted. In addition, the Company's primary regulators, the FDIC and California Department of Financial Institutions, as an integral part of their examination process, review the adequacy of the allowance. These regulatory agencies may require additions to the allowance based on their judgment about information available at the time of their examinations.

Reserve for Undisbursed Loan Commitments

The Company also maintains a separate reserve for undisbursed loan commitments. Management estimates anticipated losses using historical data and utilization assumptions. The reserve for undisbursed loan commitments totaled $40,000 at December 31, 2012 and 2011, respectively and is included in accrued interest payable and other liabilities on the consolidated balance sheets.

Other Real Estate Owned

Other real estate owned (OREO) consist of assets acquired through or instead of loan foreclosure are initially recorded at fair value less costs to sell, establishing a new cost basis. These assets are subsequently accounted for at lower of cost or fair value less estimated costs to sell. If fair value declines subsequent to foreclosure, a valuation allowance is recorded through expense. Operating costs after acquisition are expensed. The Company foreclosed on one commercial property in December 2011, resulting in $1,140,547 in other real estate owned at December 31, 2011. The Company foreclosed on one real estate construction property in May 2012 for $364,500. Both properties were sold in 2012 for gains totaling $6,981.

Bank Premises and Equipment

Land is carried at cost. Bank premises and equipment are carried at cost less accumulated depreciation. Depreciation is determined using the straight-line method over the estimated useful lives of the related assets. The useful lives of premises are estimated to be twenty to thirty years. The useful lives of furniture, fixtures and equipment are estimated to be two to ten years. Leasehold improvements are amortized over the life of the asset or the life of the related lease, whichever is shorter. When assets are sold or otherwise disposed of, the cost and related accumulated depreciation or amortization are removed from the accounts, and any resulting gain or loss is recognized in income or loss for the period. The cost of maintenance and repairs is charged to expense as incurred.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Bank Owned Life Insurance

The Company has purchased life insurance policies on certain key executives. Bank owned life insurance is recorded at the amount that can be realized under the insurance contract at the balance sheet date, which is the cash surrender value adjusted for other charges or other amounts due that are probable at settlement.

Investment in Federal Home Loan Bank Stock

As a member of the Federal Home Loan Bank (FHLB) System, the Bank is required to maintain an investment in the capital stock of the Federal Home Loan Bankbased on the level of borrowings and other factors, and may invest in additional amounts. The investment is carried at cost,classified as a restricted security, and periodically evaluated for impairment based on ultimate recovery of par value. Both cash and stock dividends are reported as income. At December 31, 2012 and 2011, Federal Home Loan Bank stock totaled $1,398,700 and $1,456,300, respectively. On the consolidated balance sheet, Federal Home Loan Bank stock is included in accrued interest receivable and other assets.

Income Taxes

The Company files its income taxes on a consolidated basis with its subsidiary. The allocation of income tax expense represents each entity's proportionate share of the consolidated provision for income taxes. Income tax expense is the total of the current year income tax due or refundable and the change in deferred tax assets and liabilities.

Deferred tax assets and liabilities are recognized for the tax consequences of temporary differences between the reported amount of assets and liabilities and their tax bases. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. On the consolidated balance sheet, net deferred tax assets are included in accrued interest receivable and other assets.

The determination of the amount of deferred income tax assets which are more likely than not to be realized is primarily dependent on projections of future earnings, which are subject to uncertainty and estimates that may change given economic conditions and other factors. The realization of deferred income tax assets is assessed and a valuation allowance is recorded if it is “more likely than not” that all or a portion of the deferred tax asset will not be realized. “More likely than not” is defined as greater than a 50% chance. All available evidence, both positive and negative is considered to determine whether, based on the weight of that evidence, a valuation allowance is needed. Based upon our analysis of available evidence, we have determined that it is “more likely than not” that all of our deferred income tax assets as of December 31, 2012 and 2011 will be fully realized and therefore no valuation allowance was recorded.

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VALLEY COMMERCE BANCORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Accounting for Uncertainty in Income Taxes

We use a comprehensive model for recognizing, measuring, presenting and disclosing in the financial statements tax positions taken or expected to be taken on a tax return. A tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded.

Interest expense and penalties associated with unrecognized tax benefits, if any, are classified as income tax expense in the consolidated statement of income.

Retirement Plans

Employee 401(k) and profit sharing plan expense is the amount of matching contributions. Deferred compensation and supplemental retirement plan expense allocates the benefits over years of service.

Earnings Per Common Share

Basic earnings per common share (EPS), which excludes dilution, is computed by dividing income available to common stockholders by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock, such as stock options, result in the issuance of common stock. The treasury stock method has been applied to determine the dilutive effect of stock options in computing diluted EPS.

Stock-Based Compensation

At December 31, 2012, the Company had two stock-based compensation plans, the Valley Commerce Bancorp Amended and Restated 1997 Stock Option Plan and the Valley Commerce Bancorp 2007 Equity Incentive Plan, which are more fully described in Note 11.

Compensation cost is recognized for stock options and restricted stock awards issued to employees, based on the fair value of these awards at the date of grant. A Black-Scholes model is utilized to estimate the fair value of stock options, while the market price of the Company’s common stock at the date of grant is used for restricted stock awards. The Company determines the fair value of the options previously granted on the date of grant using a Black-Scholes-Merton option pricing model that uses assumptions based on expected option life, expected stock volatility and the risk-free interest rate. The expected volatility assumptions used by the Company are based on the historical volatility of the Company’s common stock over the most recent period commensurate with the estimated expected life of the Company’s stock options. The Company bases its expected life assumption on its historical experience and on the terms and conditions of the stock options it grants to employees. The risk-free rate is based on the U.S. Treasury yield curve for the periods within the contractual life of the options in effect at the time of the grant. The Company also makes assumptions regarding estimated forfeitures that will impact the total compensation expenses recognized under the Plans.

Compensation cost is recognized over the required service period, generally defined as the vesting period. For awards with graded vesting, compensation cost is recognized on a straight-line basis over the requisite service period for the entire award.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Comprehensive Income

Comprehensive income consists of net income and other comprehensive income. Other comprehensive income includes unrealized gains and losses, net of tax, on securities available for sale. Accumulated other comprehensive income is recognized as separate components of equity.

Loss Contingencies

Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. Management does not believe there now are such matters that will have a material effect on the financial statements.

Fair Value of Financial Instruments

Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed in Footnote 3. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments, and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect these estimates.

Adoption of New Financial Accounting Standards

Indemnification asset recognized at the acquisition date

In October 2012, the Financial Accounting Standards Board (“FASB”) issued guidance on the subsequent accounting for an indemnification asset recognized at the acquisition date as a result of a government assisted acquisition of a financial institution. When an entity recognized such an indemnification asset and subsequently a change in the cash flows expected to be collected on the indemnification asset occurs as a result of a change in the cash flows expected to be collected on the indemnified asset, the guidance requires the entity to recognize the change in the measurement of the indemnification asset on the same basis as the indemnified assets. Any amortization of changes in value of the indemnification asset should be limited to the lesser of the term of the indemnification agreement and the remaining life of the indemnified assets. The amendments are effective for fiscal years beginning on or after December 15, 2012 and early adoption is permitted. The amendments are to be applies prospectively to any new indemnification assets acquired after the date of adoption and to indemnification assets existing as of the date of adoption arising from a government-assisted acquisition of a financial institution. Management does not anticipate that the effect of adopting this standard will have a material effect on the Company’s operating results or financial condition.

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VALLEY COMMERCE BANCORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Amendment to testing indefinite-lived intangible assets

In July 2012, the FASB amended existing guidance relating to testing indefinite-lived intangible assets for impairment. The amendment permits an assessment of qualitative factors to determine whether the existence of events and circumstances indicates that it is more likely than not that the indefinite-lived intangible asset is impaired. If, after assessing the totality of events and circumstances, it is concluded that it is not more likely than not that the indefinite-lived intangible asset is impaired, then no further action is required. However, after the same assessment, if it is concluded that it is more like than not that the indefinite-lived intangible asset is impaired, then a quantitative impairment test should be performed whereby the fair value of the indefinite-lived intangible asset is compared to the carrying amount. The amendments in this guidance are effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012. Early adoption is permitted. The effect of adopting this standard did not have a material effect on the Company’s operating results or financial condition.

Presentment of other Comprehensive Income

In June 2011, the FASB amended existing guidance and eliminated the option to present the components of other comprehensive income as part of the statement of changes in shareholder’s equity. The amendment requires the comprehensive income to be presented in either a single continuous statement or in two separate consecutive statements. The amendments in this guidance are effective as of the beginning of a fiscal reporting year, and interim periods within that year, that begins after December 15, 2011. The adoption of this amendment changed the presentation of the components of comprehensive income for the Company as part of the consolidated statement of shareholder’s equity.

Fair Value Measurement (Topic 820) Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.

In May 2011, the FASB issued an amendment to achieve common fair value measurement and disclosure requirements between U.S. and International accounting principles. Overall, the guidance is consistent with existing U.S. accounting principles; however, there are some amendments that change a particular principle or requirement for measuring fair value or for disclosing information about fair value measurements. The amendments in the guidance are effective for interim and annual reporting periods beginning after December 15, 2011. The effect of adopting this standard did not have a material effect on the Company’s operating results or financial condition.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

3. FAIR VALUE MEASUREMENTS

Fair Value Hierarchy

We group our assets and liabilities measured at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. Valuations within these levels are based upon:

Level 1: Quoted prices (unadjusted) or 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; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.

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.

The following methods and assumptions were used by management to estimate the fair value of its financial instruments:

Cash and cash equivalents: For cash and cash equivalents, the carrying amount is estimated to be fair value and are classified as Level 1.

Investment securities:The fair value of investment securities available for sale equals quoted market price, if available. If quoted market prices for identical securities are not available then fair value are estimated by independent sources using pricing models and/or quoted prices of investment securities with similar characteristics or discounted cash flows. The Company has categorized all of its investment securities available-for-sale as level 2, sinceU.S. Agency MBS are mainly priced in this manner. Changes in fair market value are recorded in other comprehensive income.

Loans and accrued interest receivable: For variable-rate loans that reprice frequently with no significant change in credit risk, fair values are based on carrying values resulting in a Level 3 classification. The fair values for other loans are estimated using discounted cash flow analyses, using interest rates currently being offered at each reporting date for loans with similar terms to borrowers of comparable creditworthiness. The carrying amount of accrued interest receivable approximates its fair value resulting in Level 3 classification. Impaired loans are valued at the lower of cost or fair value as described previously. The methods utilized to estimate the fair value of loans do not necessarily represent an exact price.

Federal Home Loan Bank stock: It was not practicable to determine the fair value of FHLB stock due to restrictions placed on its transferability.

Deposits and accrued interest payable: The fair values for demand deposits are, by definition, equal to the amount payable on demand at the reporting date represented by their carrying amount resulting in either a Level 2 classification. Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow analysis using interest rates offered at each reporting date by the Bank for certificates with similar remaining maturities resulting in a Level 2 classification. The carrying amount of accrued interest payable approximates its fair value.

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3. FAIR VALUE MEASUREMENTS(Continued)

FHLB advances and term borrowings: The fair values of fixed-rate borrowings are estimated by discounting their future cash flows using rates at each reporting date for similar instruments resulting in a Level 2 classification. The fair values of variable rate borrowings are based on carrying value.

Junior subordinated deferrable interest debentures: The fair value of junior subordinated deferrable interest debentures was determined based on the current market value for the like kind instruments of a similar maturity and structure, resulting in a Level 3 classification.

Commitments to extend credit: Commitments to extend credit are primarily for variable rate loans and standby letters of credit. For these commitments, there is no difference between the committed amounts and their fair values. Commitments to fund fixed rate loans and standby letters of credit are at rates which approximate fair value at each reporting date. The fair value of the commitments at each reporting date were not significant and not included in the accompanying table.

In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, the level in the fair value hierarchy within which the fair value measurement in its entirety falls has been determined based on the lowest level input that is significant to the fair value measurement in its entirety. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability.

Management monitors the availability of observable market data to assess the appropriate classification of financial instruments within the fair value hierarchy. Changes in economic conditions or model-based valuation techniques may require the transfer of financial instruments from one fair value level to another. In such instances, the transfer is reported at the beginning of the reporting period.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

3. FAIR VALUE MEASUREMENTS(Continued)

Fair Value of Financial Instruments

The estimated fair values of the Company's financial instruments are as follows:

			Fair Value Measurements at December 31, 2012 Using:
Financial assets:	Carrying Value		Level 1		Level 2		Level 3		Total Fair Value
Cash and cash equivalents	$	57,573,424	$	57,573,424	$	—	$	—	$	57,573,424
Investment securities		53,001,000		—		53,001,000		—		53,001,000
Loans, net		227,260,487		—		—		221,555,955		221,555,955
FHLB stock		1,398,700		—		—		—		N/A
Accrued interest receivable		1,181,958		—		409,114		772,844		1,181,958
Financial liabilities:
Deposits	$	315,483,993	$	248,719,232	$	66,896,661		—	$	315,615,893
Junior subordinated deferrable
interest debentures		3,093,000		—		—		873,773		873,773
Accrued interest payable		45,151		—		18,566		26,585		45,151

			Fair Value Measurements at December  31, 2011 Using:
Financial assets:	Carrying Value		Level 1		Level 2		Level 3		Total Fair Value
Cash and cash equivalents	$	60,421,044	$	60,421,044	$	—	$	—	$	60,421,044
Investment securities		56,705,000		—		56,705,000		—		56,705,000
Loans, net		224,531,870		—		—		221,237,510		221,237,510
FHLB stock		1,456,300		—		—		—		N/A
Accrued interest receivable		1,202,043		—		428,113		773,930		1,202,043
Financial liabilities:
Deposits	$	315,877,369	$	244,825,858	$	71,158,503	$	—	$	315,984,361
Short-term borrowings		1,000,000		—		1,075,000		—		1,075,000
Junior subordinated deferrable
interest debentures		3,093,000		—		—		804,180		804,180
Accrued interest payable		81,669		—		24,192		57,477		81,669

These estimates do not reflect any premium or discount that could result from offering the Company’s entire holdings of a particular financial instrument for sale at one time, nor do they attempt to estimate the value of anticipated future business related to the instruments. In addition, the tax ramifications related to the realization of unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in any of these estimates.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

3. FAIR VALUE MEASUREMENTS(Continued)

Fair Value Hierarchy (continued)

Management evaluates the significance of transfers between levels based upon the nature of the financial instrument and size of the transfer relative to total assets, total liabilities or total earnings.

The following tables present information about the Company’s assets and liabilities measured at fair value on a recurring and nonrecurring basis as of December 31, 2012 and 2011 (dollars in thousands):

Recurring Basis

	December 31, 2012
Description	Fair Value		Level 1		Level 2		Level 3
Available-for-sale investment securities
Debt securities:
U.S. Government sponsored entities and agencies	$	5,737,000	$	—	$	5,737,000	$	—
Mortgage-backed securities:
U.S. Government sponsored entities and agencies-residential		16,790,000		—		16,790,000		—
Small Business Administration		10,901,000		—		10,901,000		—
Obligations of states and political subdivisions		19,573,000		—		19,573,000		—
Total assets measured at fair value	$	53,001,000	$	—	$	53,001,000	$	—

	December 31, 2011
Description	Fair Value		Level 1		Level 2		Level 3
Available-for-sale investment securities
Debt securities:
U.S. Government sponsored entities and agencies	$	6,038,000	$	—	$	6,038,000	$	—
Mortgage-backed securities:
U.S. Government sponsored entities and agencies-residential		18,017,000		—		18,017,000		—
Small Business Administration		12,630,000		—		12,630,000		—
Obligations of states and political subdivisions		20,020,000		—		20,020,000		—
Total assets measured at fair value	$	56,705,000	$	—	$	56,705,000	$	—

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

3. FAIR VALUE MEASUREMENTS(Continued)

Fair values for Level 2 available-for-sale investment securities are based on quoted market prices for similar securities. During the years ended December 31, 2012 and 2011, there were no transfers in or out of Levels 1, 2 or 3.

The Company had no liabilities measured at fair value on a recurring basis as of December 31, 2012 or December 31, 2011.

Assets measured at fair value on a non-recurring basis as of December 31, 2012 and December 31, 2011 are summarized below:

	Fair Value Measurements at December 31, 2012 Using
			Quoted Prices in		Significant Other		Significant
			Active Markets for		Observable		Unobservable
			Identical Assets		Inputs		Inputs		Total
	Total Fair Value		(Level 1)		(Level 2)		(Level 3)		Losses
Assets:
Impaired loans:
Commercial	$	758,000	$	—	$	—	$	758,000	$	(88,000	)
Real estate – mortgage		2,313,000		—		—		2,313,000		(49,000	)
Real estate – construction		525,000		—		—		525,000		(75,000	)
	$	3,596,000	$	—	$	—	$	3,596,000	$	(212,000	)

	Fair Value Measurements at December 31, 2011 Using
			Quoted Prices in		Significant Other		Significant
			Active Markets for		Observable		Unobservable
			Identical Assets		Inputs		Inputs		Total
	Total Fair Value		(Level 1)		(Level 2)		(Level 3)		Losses
Assets:
Impaired loans:
Commercial	$	1,848,000	$	—	$	—	$	1,848,000	$	(397,000	)
Real estate – mortgage		1,917,000		—		—		1,917,000		(227,000	)
Real estate – construction		1,295,000		—		—		1,295,000		(61,000	)
Other real estate owned		1,141,000		—		—		1,141,000		—
	$	6,201,000	$	—	$	—	$	6,201,000	$	(685,000	)

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

3. FAIR VALUE MEASUREMENTS(Continued)

Impaired loans (loans which are not expected to repay all principal and interest amounts due in accordance with the original contractual terms) are measured at an observable market price (if available) or at the fair value of the loan’s collateral (if collateral dependent). Fair value of the loan’s collateral is determined by appraisals or independent valuation which is then adjusted for the estimated costs related to liquidation of the collateral. Management monitors the availability of observable market data to assess the appropriate classifications of financial instruments within the fair value hierarchy. Changes in economic conditions or model-based valuation techniques may require the transfer of financial instruments from one fair value level to another. Management’s ongoing review of appraisal information may also result in additional discounts or adjustments to the valuation based upon more recent market sales activity or more current appraisal information derived from properties of similar type and/or locale. A significant portion of the Bank’s impaired loans are measured using the estimated fair market value of the collateral less the estimated costs to sell. The Company has categorized its impaired loans as level 3. The Bank’s appraisal policy generally requires impaired loans to be appraised at six month intervals. Certain impaired loans with current appraisals have been discounted to liquidation value through additional market research of comparable properties, but are still included in Level 3 due to the inherent uncertainty of the appraisal process. Any fair value adjustments are recorded in the period incurred as provision for loan losses expense on the Consolidated Statement of Income. The recorded investment in impaired loans was $4,187,000 and $5,588,000 with a valuation allowance of $591,000 and $528,000, resulting in additional provision for loan losses of none and $600,000 at December 31, 2012 and December 31, 2011, respectively.

Other real estate owned is based on property appraisals at the time of transfer as appropriate thereafter, less estimated costs to sell. Estimated costs to sell other real estate were based on standard market factors. Management periodically reviews other real estate to determine whether the property continues to be carried at the lower of its recorded book value or estimated fair value, net of estimated costs to sell. The recorded investment in other real estate owned at December 31, 2011 was $1,141,000 with no related valuation allowance. There was no other real estate owned at December 31, 2012.

The following table presents quantitative information about Level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis atDecember 31, 2012 (dollars in thousands):

	Fair		Valuation	Significant		Range
Description	Value		Technique	Unobservable Input		(Weighted Average)
Impaired Loans:
Commercial	$	758	Sales Comparison	a.	Appraiser adjustments on sales comp  data		35%-75% (43%)
			Management estimates	b.	Management adjustments for depreciation in values depending on property types
Real Estate Mortgage	$	2,313	Sales Comparison	a.	Appraiser required adjustments on sales comparable data and / or applied a discounted cash flow approach as sales data is limited		30%-35% (32%)
			Management estimates	b.	Management adjustments for depreciation in values depending on property types
Real Estate Construction	$	525	Sales Comparison	a.	Appraiser adjustments on sales comparable data		31%-31% (31%)
			Management estimates	b.	Management adjustments for depreciation in values depending on property types

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

4. AVAILABLE-FOR-SALE INVESTMENT SECURITIES

The amortized cost and estimated fair value of available-for-sale investment securities at December 31, 2012 and 2011 consisted of the following:

	2012
			Gross		Gross			Estimated
	Amortized		Unrealized		Unrealized			Fair
	Cost		Gains		Losses			Value
Debt securities:
U.S. Government sponsored entities and agencies	$	5,544,809	$	192,191	$	—		$	5,737,000
Mortgage-backed securities:
U.S. Government sponsored entities and agencies-residential		16,413,277		380,508		(3,785	)		16,790,000
Small Business Administration		10,547,108		353,892		—			10,901,000
Obligations of states and political   subdivisions		18,696,003		898,613		(21,616	)		19,573,000
	$	51,201,197	$	1,825,204	$	(25,401	)	$	53,001,000

Net unrealized gains on available-for-sale investment securities totaling $1,799,803 were recorded, net of $740,619 in tax liabilities, as accumulated other comprehensive income within shareholders' equity at December 31, 2012.

	2011
			Gross		Gross			Estimated
	Amortized		Unrealized		Unrealized			Fair
	Cost		Gains		Losses			Value
Debt securities:
U.S. Government sponsored entities and agencies	$	5,867,720	$	177,121	$	(6,841	)	$	6,038,000
Mortgage-backed securities:
U.S. Government sponsored entities and agencies-residential		17,680,491		352,314		(15,805	)		18,017,000
Small Business Administration		12,345,495		284,505		—			12,630,000
Obligations of states and political subdivisions		19,427,232		643,745		(50,977	)		20,020,000
	$	55,320,938	$	1,457,685	$	(73,623	)	$	56,705,000

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(Continued)

4. AVAILABLE-FOR-SALE INVESTMENT SECURITIES (Continued)

Net unrealized gains on available-for-sale investment securities totaling $1,384,062 were recorded, net of $569,541 in tax liabilities, as accumulated other comprehensive income within shareholders' equity at December 31, 2011.

Proceeds and gross realized gains and losses from the sale of available-for-sale investment securities for the years ended December 31, 2012, 2011 and 2010 are as follow:

	2012		2011		2010
Proceeds	$	3,558,372	$	13,312,408	$	3,558,397
Gross gains	$	152,224	$	289,575	$	34,103
Gross losses	$	—	$	—	$	—

The tax provision related to these realized gains and losses was $62,640, $119,160, and $14,033.

Investment securities with unrealized losses at December 31, 2012 are summarized and classified according to the duration of the loss period as follows:

	Less than 12 Months					12 Months or More				Total
	Fair		Unrealized			Fair		Unrealized		Fair		Unrealized
	Value		Losses			Value		Losses		Value		Losses
Debt securities:
U.S. Government sponsored entities and agencies	$	—	$	—		$	—	$	—	$	—	$	—
Mortgage-backed securities:
U.S. Government sponsored entities and agencies-residential		1,491,000		(3,785	)		—		—		1,491,000		(3,785	)
Small Business administration		—		—			—		—		—		—
Obligations of states and political subdivisions		2,026,000		(21,616	)		—		—		2,026,000		(21,616	)
	$	3,517,000	$	(25,401	)	$	—	$	—	$	3,517,000	$	(25,401	)

Investment securities with unrealized losses at December 31, 2011 are summarized and classified according to the duration of the loss period as follows:

	Less than 12 Months					12 Months or More					Total
	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
	Value		Losses			Value		Losses			Value		Losses
Debt securities:
U.S. Government  sponsored entities and agencies	$	—	$	—		$	691,000	$	(6,841	)	$	691,000	$	(6,841	)
Mortgage-backed securities:
U.S. Government sponsored entities and agencies-residential		5,580,000		(15,805	)							5,580,000		(15,805	)
Small Business administration		—		—			—		—			—		—
Obligations of states and political subdivisions		1,087,000		(5,480	)		1,762,000		(45,497	)		2,849,000		(50,977	)
	$	6,667,000	$	(21,285	)	$	2,453,000	$	(52,338	)	$	9,120,000	$	(73,623	)

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

4. AVAILABLE-FOR-SALE INVESTMENT SECURITIES (Continued)

Residential Mortgage-backed Obligations

At December 31, 2012 the Company held 42 residential mortgage-backed obligations of which two were in a loss position for less than twelve months and none were in a loss position or had been in a loss position for twelve months or more. Management believes the unrealized losses on the Company's investments in residential mortgage obligations were caused primarily by limited market liquidity and perceived credit risk on the part of investors. The contractual cash flows of these investments are guaranteed by an agency of the U.S. government. Accordingly, it is expected that the securities will not be settled at a price less than the amortized cost of the Company's investment. Because the Company has the ability and intent to hold those investments until a recovery of fair value, which may be maturity, the Company does not consider those investments to be other-than-temporarily impaired at December 31, 2012.

Obligations of states and political subdivisions

At December 31, 2012 the Company held 50 obligations of states and political subdivision securities of which four were in a loss position for less than twelve months and none were in a loss position and had been in a loss position for twelve months or more. Management believes the unrealized losses on the Company's investments in obligations of states and political subdivision securities were due to changes in interest rates and the continued dislocation of the securities market. All of these securities have continued to pay as scheduled despite their impairment due to current market conditions. Because management believes that the Company has the ability and intent to hold those investments until a recovery of fair value, which may be maturity, and it is not more likely than not that the Company will be required to sell the securities before recovery of their amortized costs, the Company does not consider those investments to be other-than-temporarily impaired at December 31, 2012.

Obligations of states and political subdivisions with unrealized losses as of December 31, 2012 are summarized in the table below.

	Amortized		Market		Unrealized					State				Moody’s		S&P
Description	Cost		Value		(Loss)			Type		Issued		Issuer		Rating		Rating
DuPage ILL, HSD	$	586,887	$	581,495	$	(5,392	)		GO		IL		AGC		Aaa		AA-
Grand Lakes Util Dist		562,574		548,340		(14,234	)		GO		TX		AGC		Aa3		AA-
Mecklenburg, NC		557,560		555,585		(1,975	)		G02		NC		NA		Aa		AAA
Rocklin, CA USD		340,647		340,632		(15	)		ZGO		CA		FSA		Aa2		AA-
	$	2,047,668	$	2,026,052	$	(21,616	)

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

4. AVAILABLE-FOR-SALE INVESTMENT SECURITIES (Continued)

The amortized cost and estimated fair value of investment securities at December 31, 2012 by contractual maturity are shown below. Expected maturities will differ from contractual maturities because the issuers of the securities may have the right to call or prepay obligations with or without call or prepayment penalties.

			Estimated
	Amortized		Fair
	Cost		Value
Within one year	$	—	$	—
After one year through five years		3,979,542		4,084,000
After five years through ten years		3,011,671		3,093,000
After ten years		17,249,599		18,133,000
		24,240,812		25,310,000
Investment securities not due at a single maturity date:
Mortgage-backed securities		26,960,385		27,691,000
	$	51,201,197	$	53,001,000

At December 31, 2012, investment securities with a fair value of $45,136,000 were pledged to secure either public deposits or borrowing arrangements. At December 31, 2011, investment securities with a fair value of $38,367,000 were pledged to secure either public deposits or borrowing arrangements.

5. LOANS AND THE ALLOWANCE FOR LOAN AND LEASE LOSSES

Outstanding loans are summarized below:

	December 31,
	2012			2011
Commercial	$	41,270,395		$	39,379,268
Real estate – mortgage		170,868,701			165,685,966
Real estate - construction		15,521,971			19,499,158
Agricultural		3,700,775			3,730,466
Consumer and other		1,508,824			2,051,455
		232,870,666			230,346,313
Deferred loan fees, net		(417,743	)		(345,685	)
Allowance for loan and lease losses		(5,192,436	)		(5,468,758	)
	$	227,260,487		$	224,531,870

Certain loans were pledged to secure borrowing arrangements (see Note 8).

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(Continued)

5. LOANS AND THE ALLOWANCE FOR LOAN AND LEASE LOSSES (continued)

Salaries and employee benefits totaling $480,002, $518,630 and $495,765 have been deferred as loan origination costs during the years ended December 31, 2012, 2011 and 2010, respectively.

Changes in the allowance for loan losses were as follows:

	Year Ended December 31,
	2012			2011			2010
Balance, beginning of year	$	5,468,758		$	6,698,952		$	6,231,065
Provision for loan losses		—			600,000			2,050,000
Losses charged to allowance		(419,400	)		(1,953,028	)		(1,592,753	)
Recoveries		143,078			122,834			10,640
Balance, end of year	$	5,192,436		$	5,468,758		$	6,698,952

The following table shows the allocation of the allowance for loan losses at and for the year ended December 31, 2012 by portfolio segment and by impairment methodology:

				Real			Real					Consumer
				Estate -			Estate -					And
	Commercial			Mortgage			Construction			Agricultural		Other			Total
Allowance for Credit Losses:
Beginning balance:	$	1,561,397		$	640,051		$	3,149,076		$	45,320	$	72,914		$	5,468,758
Charge-offs		(950	)		(85,782	)		(233,095	)		—		(99,573	)		(419,400	)
Recoveries		143,078			—			—			—		—			143,078
Provision		1,350,959			(96,511	)		(1,474,787	)		54,680		165,659			—
Ending balance allocated to portfolio segments	$	3,054,484		$	457,758		$	1,441,194		$	100,000	$	139,000		$	5,192,436
Individually evaluated for impairment	$	311,938		$	74,758		$	204,194		$	—	$	—		$	590,890
Collectively evaluated for impairment	$	2,742,546		$	383,000		$	1,237,000		$	100,000	$	139,000		$	4,601,546
Total	$	3,054,484		$	457,758		$	1,441,194		$	100,000	$	139,000		$	5,192,436
Loans
Individually evaluated for impairment	$	1,937,986		$	4,798,330		$	1,245,176		$	—	$	—		$	7,981,492
Collectively evaluated for impairment	$	39,332,409		$	166,070,371		$	14,276,795		$	3,700,775	$	1,508,824		$	224,889,174
Total	$	41,270,395		$	170,868,701		$	15,521,971		$	3,700,775	$	1,508,824		$	232,870,666

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

5. LOANS AND THE ALLOWANCE FOR LOAN AND LEASE LOSSES (continued)

The following table shows the allocation of the allowance for loan and lease losses at and for the year ended December 31, 2011 by portfolio segment and by impairment methodology:

				Real			Real					Consumer
				Estate -			Estate -					And
	Commercial			Mortgage			Construction			Agricultural		Other			Total
Allowance for Credit Losses:
Beginning balance:	$	2,641,106		$	608,792		$	3,327,863		$	40,409	$	80,782		$	6,698,952
Charge-offs		(1,602,820	)		(158,008	)		(192,000	)		—		(200	)		(1,953,028	)
Recoveries		22,642			99,992			—			—		200			122,834
Provision		500,469			89,275			13,213			4,911		(7,868	)		600,000
Ending balance to portfolio segments	$	1,561,397		$	640,051		$	3,149,076		$	45,320	$	72,914		$	5,468,758
Individually evaluated for impairment	$	230,074		$	169,013		$	129,260		$	—	$	—		$	528,347
Collectively evaluated for impairment	$	1,331,323		$	471,038		$	3,019,816		$	45,320	$	72,914		$	4,940,411
Total	$	1,561,397		$	640,051		$	3,149,076		$	45,320	$	72,914		$	5,468,758
Loans
Individually evaluated for impairment	$	2,021,574		$	6,086,817		$	2,702,100		$	—	$	—		$	10,810,491
Collectively evaluated for impairment	$	37,357,694		$	159,599,149		$	16,797,058		$	3,730,466	$	2,051,455		$	219,535,822
Total	$	39,379,268		$	165,685,966		$	19,499,158		$	3,730,466	$	2,051,455		$	230,346,313

The following table shows the loan portfolio allocated by management's internal risk ratings at December 31, 2012:

	Commercial Credit Exposure
	Credit Risk Profile by Internally Assigned Grade
			Real Estate -		Real Estate -				Consumer
	Commercial		Mortgage		Construction		Agriculture		and Other		Total
Grade:
Pass	$	33,315,334	$	150,878,151	$	8,547,518	$	3,700,775	$	1,371,661	$	197,813,439
Watch		3,979,161		3,487,178		3,499,641		—		137,163		11,103,143
Special Mention		1,743,144		4,325,993		1,524,361		—		—		7,593,498
Substandard		2,232,756		12,177,379		1,950,451		—		—		16,360,586
Doubtful		—		—		—		—		—		—
Total	$	41,270,395	$	170,868,701	$	15,521,971	$	3,700,775	$	1,508,824	$	232,870,666

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

5. LOANS AND THE ALLOWANCE FOR LOAN AND LEASE LOSSES (continued)

The following table shows the loan portfolio allocated by management's internal risk ratings at December 31, 2011:

	Commercial Credit Exposure
	Credit Risk Profile by Internally Assigned Grade
	Commercial		Real Estate - Mortgage		Real Estate - Construction		Agriculture		Consumer and Other		Total
Grade:
Pass	$	30,098,949	$	140,475,243	$	7,585,992	$	3,730,466	$	1,905,542	$	183,796,192
Watch		713,005		479,319		8,107,973		—		145,913		9,446,210
Special Mention		5,335,791		7,486,780		1,381,626		—		—		14,204,197
Substandard		3,231,523		17,244,624		2,423,567		—		—		22,899,714
Doubtful		—		—		—		—		—		—
Total	$	39,379,268	$	165,685,966	$	19,499,158	$	3,730,466	$	2,051,455	$	230,346,313

The following table shows an aging analysis of the loan portfolio by the time past due at December 31, 2012:

	30-89 Days Past Due		90 Days And Still Accruing		Nonaccrual		Total Past Due		Current		Total
Commercial:
Commercial and  industrial	$	—	$	—	$	911,563	$	911,563	$	19,366,025	$	20,277,588
Commercial lines		—		—		—		—		19,154,594		19,154,594
Commercial guaranteed		—		—		—		—		1,838,213		1,838,213
Real Estate-Mortgage:
Mortgage 1-4 family		200,000		—		—		200,000		7,971,764		8,171,764
Real estate				—		2,994,306		2,994,306		151,425,429		154,419,735
Real estate - Ag		—		—		—		—		5,045,016		5,045,016
Home equity loans		—		—		—		—		3,232,186		3,232,186
Real Estate-Construction:
Construction		—		—		—		—		10,233,738		10,233,738
Construction 1-4 family		—		—		—		—		1,858,435		1,858,435
Construction loan others		—		—		516,180		516,180		2,913,618		3,429,798
Agricultural:
Agricultural		—		—		—		—		3,371,451		3,371,451
Agricultural capital assets		—		—		—		—		329,324		329,324
Consumer:
Auto		—		—		—		—		108,477		108,477
Consumer		—		—		—		—		133,653		133,653
Other		—		—		—		—		1,266,694		1,266,694
Total	$	200,000	$	—	$	4,422,049	$	4,622,049	$	228,248,617	$	232,870,666

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

5. LOANS AND THE ALLOWANCE FOR LOAN AND LEASE LOSSES (continued)

The following table shows an aging analysis of the loan portfolio by the time past due at December 31, 2011:

	30-89 Days Past Due		90 Days and Still Accruing		Nonaccrual		Total Past Due		Current		Total
Commercial:
Commercial and industrial	$	121,350	$	—	$	1,005,338	$	1,126,688	$	18,370,667	$	19,497,355
Commercial lines		—		—		—		—		17,900,083		17,900,083
Commercial guaranteed		—		—		—		—		1,981,830		1,981,830
Real Estate-Mortgage:
Mortgage 1-4 family		200,000		—		—		200,000		10,062,785		10,262,785
Real estate		218,970		—		2,806,287		3,025,256		145,824,876		148,850,132
Real estate - Ag		—		—		—		—		2,889,375		2,889,375
Home equity loans		—		—		—		—		3,683,674		3,683,374
Real Estate-Construction:
Construction		—		—		—		—		13,323,442		13,323,442
Construction 1-4 family		—		—		556,172		556,172		1,735,736		2,291,908
Construction loan others		—		—		1,278,332		1,278,332		2,605,476		3,883,808
Agricultural:
Agricultural		—		—		—		—		3,221,108		3,221,108
Agricultural capital    assets		—		—		—		—		509,358		509,358
Consumer:
Auto		—		—		—		—		103,046		103,046
Consumer		9,112		—		—		9,112		347,664		356,776
Other		—		—		—		—		1,591,633		1,591,633
Total	$	549,432	$	—	$	5,646,129	$	6,195,560	$	224,150,753	$	230,346,313

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

5. LOANS AND THE ALLOWANCE FOR LOAN AND LEASE LOSSES (continued)

The following table shows information related to impaired loans at December 31, 2012:

			Unpaid
	Recorded		Principal		Related
	Investment		Balance		Allowance
With no related allowance recorded:
Commercial	$	861,783	$	934,806	$	—
Real estate – mortgage		3,580,058		5,282,215		—
Real estate - construction		516,180		586,845		—
Agriculture		—		—		—
Consumer		—		—		—
With an allowance recorded:
Commercial	$	1,076,203	$	1,085,851	$	311,938
Real estate – mortgage		1,218,272		1,218,272		74,758
Real estate – construction		728,996		1,797,997		204,194
Agriculture		—		—		—
Consumer		—		—		—
Total:
Commercial	$	1,937,986	$	2,020,657	$	311,938
Real estate – mortgage		4,798,330		6,500,487		74,758
Real estate – construction		1,245,176		2,384,842		204,194
Agriculture		—		—		—
Consumer		—		—		—

The following table shows information related to impaired loans at December 31, 2011:

			Unpaid
	Recorded		Principal		Related
	Investment		Balance		Allowance
With no related allowance recorded:
Commercial	$	1,542,086	$	1,542,086	$	—
Real estate - mortgage		5,390,510		6,708,381		—
Real estate - construction		2,473,029		3,832,712		—
Agriculture		—		—		—
Consumer and other		—		—		—
With an allowance recorded:
Commercial	$	479,488	$	482,274	$	230,074
Real estate – mortgage		696,307		722,848		169,013
Real estate – construction		229,071		229,071		129,260
Agriculture		—		—		—
Consumer and other		—		—		—
Total:
Commercial	$	2,021,574	$	2,024,360	$	230,074
Real estate – mortgage		6,086,817		7,431,229		169,013
Real estate – construction		2,702,100		4,061,783		129,260
Agriculture		—		—		—
Consumer and other		—		—		—

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

5. ALLOWANCE FOR LOAN AND LEASE LOSSES (continued)

The following tables show information related to impaired loans for the year ended December 31, 2012:

	For the year ended December 31, 2012				For the year ended December 31, 2011
	Average		Interest		Average		Interest
	Recorded		Income		Recorded		Income
	Investment		Recognized		Investment		Recognized
With no related allowance recorded:
Commercial	$	936,408	$	1,382	$	1,800,980	$	148,062
Real estate – mortgage		5,371,495		61,045		6,766,248		190,869
Real estate – construction		840,847		129,389		3,836,729		103,874
Agriculture		—		—		—		—
Consumer and other		—		—		—		—
With an allowance recorded:
Commercial	$	1,095,016	$	63,278	$	517,255	$	33,544
Real estate – mortgage		1,230,534		78,965		733,200		24,814
Real estate – construction		1,904,451		104,100		231,745		11,702
Agriculture		—		—		—		—
Consumer and other		—		—		—		—
Total: (Impaired Loans only)
Commercial	$	2,031,424	$	64,660	$	2,318,235	$	181,606
Real estate – mortgage		6,602,029		140,010		7,499,448		215,683
Real estate – construction		2,745,298		233,489		4,068,474		115,576
Agriculture		—		—		—		—
Consumer and other		—		—		—		—

In the table above, the first column titled Recorded Investment includes the balance due on the loan less any interest payments received and applied to principal while on nonaccrual status and any partial charge offs. In the next column the Unpaid Principal Balance includes the actual contractual loan balance due from the borrower plus calculated accrued interest, which would normally be accrued and due, if the loan was not on nonaccrual status.

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(Continued)

5. LOANS AND THE ALLOWANCE FOR LOAN AND LEASE LOSSES (continued)

Troubled Debt Restructurings

The modifications and concessions granted to troubled debt restructures generally consist of 6 to 12 months’ deferral of principal payments or an interest rate reduction or a lengthened amortization, or a combination thereof. Of the thirteen loans identified as troubled debt restructures at December 31, 2012, six were granted deferral of principal payments, six had interest rate reductions and lengthened amortization and one had deferral of principal payment and a rate reduction. When a loan becomes a troubled debt restructure, it is normally placed in nonaccrual status until it is evident that the borrower will perform at the modified terms. The Company’s policy is to require satisfactory payments for a six month period before the loan will be considered for reinstatement to accrual status. The Company does not have commitments to lend additional funds to borrowers with loans whose terms have been modified in troubled debt restructurings.

Management identifies the early onset of borrower financial difficulties via the utilization of various indicators. Chief of these indicators would simply be the review of the borrower’s repayment pattern. When repayment patterns begin to exhibit practices that are less than what is allowed within the contractual allowance, an indication of early difficulties emerges. If this pattern continues, the Bank will document collection efforts via on-site visits to the borrower’s premises whereby providing further, observable input into the borrower’s financial condition. Furthermore, the Bank makes a consistent practice to require the submission of periodic interim and annual financial information of the borrowers, guarantors and co-signors. This information is obtained to determine the borrower’s historical debt serviceability and to make judgments’ concerning future repayment. Should financial information be denied, the Bank will utilize various options to encourage compliance. If the financial information and repayment practices with other lenders. remains uncollectable, the Bank will utilize the review of updated credit reports to determine debt levels

A summary of loan modifications that meet the definition of troubled debt restructurings and   the related reserves as of December 31, 2012 and December 31, 2011 is set forth below:

	December 31, 2012						December 31, 2011
	No. of  Loans		Amount		Specific loan loss reserves		No. of Loans		Amount		Specific loan loss reserves
Nonperforming Loans		7	$	2,913,257	$	59,765		5	$	2,031,624		85,528
Performing Loans		6		1,676,136		425,632		6		1,809,850		273,806
Total troubled debt restructured loans		13	$	4,859,394	$	485,397		11	$	3,841,474	$	359,334

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

5. ALLOWANCE FOR LOAN AND LEASE LOSSES (continued)

The following table presents loans by class modified as troubled debt restructuring that occurred during the year ended December 31, 2012 and 2011:

Modifications
During the Twelve
Months ended
December 31, 2012

		Pre- Modification		Post- Modification
		Outstanding Recorded		Outstanding Recorded
	Number of Contracts	Investments		Investments
Troubled Debt Restructuring:
Commercial	1	$	851,799	$	851,799
Real Estate - Mortgage	1		411,822		411,822
Real Estate-Construction	1		426,225		426,225

Modifications
During the Twelve
Months ended
December 31, 2011

		Pre- Modification		Post- Modification
		Outstanding Recorded		Outstanding Recorded
	Number of Contracts	Investments		Investments
Troubled Debt Restructuring:
Commercial	5	$	630,746	$	630,746
Real Estate - Mortgage	3		1,786,960		1,786,960
Real Estate-Construction	3		1,423,769		1,423,769

A loan is considered to be in payment default once it is 90 days contractually past due under the modified terms. There were no troubled debt restructuring that had a payment default during the year ended December 31, 2012.

The Bank has granted concessions on loans that do not meet the definition of a troubled debt restructure. The loan terms were modified due to competitive pressures. The customers involved were highly creditworthy and were determined by management to be likely and able to move their business to a competing financial institution if their loan terms were not modified.

The Company does not have commitments to lend additional funds to borrowers with loans whose terms have been modified in troubled debt restructurings.

Foregone interest on nonaccrual loans totaled $566,550, $522,896, and $1,153,000 for the years ended December 31, 2012, 2011, and 2010, respectively.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

6. PREMISES AND EQUIPMENT

Premises and equipment consisted of the following:

	December 31,
	2012			2011
Furniture and equipment	$	3,396,177		$	3,301,573
Premises		6,133,018			6,115,354
Leasehold improvements		207,342			207,342
Land		1,464,723			1,461,379
		11,201,260			11,085,648
Less accumulated
depreciation and amortization		(3,206,188	)		(2,917,672	)
	$	7,995,072		$	8,167,976

Depreciation and amortization included in occupancy and equipment expense totaled $550,818, $550,630 and $512,359 for the years ended December 31, 2012, 2011 and 2010, respectively.

7. INTEREST-BEARING DEPOSITS

Interest-bearing deposits consisted of the following:

	December 31,
	2012		2011
Savings	$	13,911,065	$	11,859,911
Money market		70,668,760		67,012,464
NOW accounts		43,239,297		37,500,377
Time, $100,000 or more		47,194,692		50,175,566
Other time		19,570,069		20,875,945
	$	194,583,883	$	187,424,263

Aggregate annual maturities of time deposits are as follows:

Year Ending
December 31,
2013	$	63,124,162
2014		3,575,658
2015		—
2016		64,941
	$	66,764,761

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

7. INTEREST-BEARING DEPOSITS (continued)

Interest expense recognized on interest-bearing deposits consisted of the following:

	Year Ended December 31,
	2012		2011		2010
Savings	$	26,631	$	28,290	$	24,718
Money market		317,602		369,172		473,263
NOW accounts		137,746		150,354		210,841
Time $100,000 or more		340,805		485,014		735,741
Brokered time, $100,000 or more		—		208,591		559,056
Other time		138,999		192,722		340,001
	$	961,783	$	1,434,143	$	2,343,620

At December 31, 2012, the contractual maturities of time deposits with a denomination of $100,000 and over were as follows: $15,844,177 in 3 months or less, $12,367,424 over 3 months through 6 months, $16,232,490 over 6 months through 12 months, and $2,750,601 over 12 months.

Deposit overdrafts reclassified as loan balances were $60,126 and $42,215 at December 31, 2012 and 2011, respectively.

8. BORROWING ARRANGEMENTS

Lines of Credit

The Bank had an unsecured line of credit with one correspondent bank in the amount of $10,000,000 at December 31, 2012 and at December 31, 2011. There were no borrowings outstanding under this borrowing arrangement as of December 31, 2012 and 2011.

Federal Home Loan Bank Advances and Term Borrowings

At December 31, 2012 and 2011 the Bank could borrow up to $60,106,000 or 66% and $49,021,000 or 49% of pledged real estate mortgage loans, respectively, from the Federal Home Loan Bank of San Francisco (FHLB). As of December 31, 2012 and 2011 the Bank did not have any investment securities pledged to secure FHLB borrowings. As of December 31, 2012 and 2011, the Bank had pledged loans with total carrying values of $93,105,000 and $88,537,000, respectively. At December 31, 2011 borrowings were comprised of $1 million of term borrowing fixed rate debt with an interest rate of 6.02% maturing on January 2, 2012. At December 31, 2012 there were no term borrowings.

Federal Reserve Discount Window Borrowing Arrangement

At December 31, 2012 the Bank could borrow up to 60% of pledged commercial loans from the Federal Reserve Bank of San Francisco under the discount window borrowing program. As of December 31, 2012, the Bank had pledged loans with total carrying values of $89,077,000 to achieve a credit line of $55,778,332. There were no borrowings with the Federal Reserve Bank of San Francisco at December 31, 2012 or 2011.

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(Continued)

9. JUNIOR SUBORDINATED DEFERRABLE INTEREST DEBENTURES

Valley Commerce Trust I is a Delaware business trust formed by the Company with capital of $93,000 for the sole purpose of issuing trust preferred securities fully and unconditionally guaranteed by the Company. Valley Commerce Trust I (the "Trust") has issued 3,000 Floating Rate Capital Trust Pass-Through Securities ("Trust Preferred Securities"), with a liquidation value of $1,000 per security, for gross proceeds of $3,000,000. The entire proceeds of the issuance were invested by the Trust in $3,093,000 of Floating Rate Junior Subordinated Deferrable Interest Debentures (the "Subordinated Debentures") issued by the Company, with identical maturity, repricing and payment terms as the Trust Preferred Securities. The Subordinated Debentures represent the sole assets of the Trust. The Subordinated Debentures mature on April 7, 2033, bear a current interest rate of 3.82% (based on 3-month LIBOR plus 3.30%), with repricing and payments due quarterly.

The Subordinated Debentures are redeemable by the Company on any January 7, April 7, July 7 or October 7 on or after April 7, 2008, subject to receipt by the Company of prior approval from the Federal Reserve Board of Governors. The redemption price is par plus accrued interest, except in the case of redemption under a special event which is defined in the debenture. The Trust Preferred Securities are subject to mandatory redemption to the extent of any early redemption of the junior subordinated debentures and upon maturity of the junior subordinated debentures on April 7, 2033.

Holders of the Trust Preferred Securities are entitled to a cumulative cash distribution on the liquidation amount of $1,000 per security at an initial rate per annum of 4.59%. For each successive period beginning on January 7, April 7, July 7 or October 7 of each year, the rate will be adjusted to equal the 3-month LIBOR plus 3.30%. As of December 31, 2012, the rate was 3.82%. The Trust has the option to defer payment of the distributions for a period of up to five years, as long as the Company is not in default on the payment of interest on the junior subordinated debentures. The Trust Preferred Securities were sold and issued in private transactions pursuant to an exemption from registration under the Securities Act of 1933, as amended. The Company has guaranteed, on a subordinated basis, distributions and other payments due on the Trust Preferred Securities.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

10. COMMITMENTS AND CONTINGENCIES

Leases

The Company leases its Fresno branch under a noncancelable operating lease which expires in September 2017. Future minimum lease payments, are as follows:

Year Ending
December 31,
2013	$	114,488
2014		114,488
2015		114,488
2016		114,488
2017		85,868
	$	543,820

Rental expense included in occupancy and equipment expense totaled $102,105, $102,105, and $140,438 for the years ended December 31, 2012, 2011 and 2010, respectively.

Federal Reserve Requirements

Banks are required to maintain reserves with the Federal Reserve Bank equal to a percentage of their reservable deposits. The Bank’s vault cash fulfilled its reserve requirement at December 31, 2012.

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(Continued)

10. COMMITMENTS AND CONTINGENCIES(Continued)

Financial Instruments With Off-Balance-Sheet Risk

The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business in order to meet the financing needs of its customers. These financial instruments include commitments to extend credit and letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized on the consolidated balance sheet.

The Company's exposure to credit loss in the event of nonperformance by the other party for commitments to extend credit and letters of credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and letters of credit as it does for loans included on the consolidated balance sheet.

The following financial instruments represent off-balance-sheet credit risk:

	December 31,
	2012		2011
Commitments to extend credit	$	26,538,768	$	31,769,844
Standby letters of credit	$	485,000	$	475,000

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since some of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management's credit evaluation of the borrower. Collateral held varies, but may include real property, bank deposits, debt or equity securities or business assets.

Standby letters of credit are conditional commitments written to guarantee the performance of a customer to a third party. These guarantees are primarily related to the purchases of inventory by commercial customers and are typically short-term in nature. Credit risk is similar to that involved in extending loan commitments to customers and, accordingly, evaluation and collateral requirements similar to those for loan commitments are used. The fair value of the liability related to the Company’s stand-by-letters of credit, which represents the fees received for issuing the guarantee, was not considered significant at December 31, 2012 or 2011. The Company recognizes these fees as revenue over the term of the commitment or when the commitment is used.

At December 31, 2012, consumer loan commitments represent approximately 10% of total commitments and are generally unsecured. Commercial loan commitments represent approximately 49% of total commitments and are generally secured by various assets of the borrower. Real estate loan commitments represent the remaining 41% of total commitments and are generally secured by property with a loan-to-value ratio not to exceed 80%.

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(Continued)

10. COMMITMENTS AND CONTINGENCIES(Continued)

Significant Concentrations of Credit Risk

The Company grants real estate mortgage, real estate construction, commercial, agricultural and consumer loans to customers throughout the cities of Visalia, Tulare, Fresno, Woodlake and Tipton, California.

Although the Company has a diversified loan portfolio, a substantial portion of its portfolio is secured by commercial and residential real estate. However, personal and business income represent the primary source of repayment for a majority of these loans.

Contingencies

The Company is subject to legal proceedings and claims which arise in the ordinary course of business. In the opinion of management, the amount of ultimate liability with respect to such actions will not materially affect the financial position or results of operations of the Company.

11. SHAREHOLDERS' EQUITY

Dividend Restrictions

The Company's ability to pay cash dividends is dependent on dividends paid to it by the Bank and limited by California corporation law. Under California law, the holders of common stock of the Company are entitled to receive dividends when and as declared by the Board of Directors, out of funds legally available, subject to certain restrictions. The California general corporation law prohibits the Company from paying dividends on its common stock unless: (i) its retained earnings, immediately prior to the dividend payment, equals or exceeds the amount of the dividend or (ii) immediately after giving effect to the dividend, the value of the corporation’s assets exceed the amount of its liabilities plus the amount of shareholders preferences, if any, .

Dividends from the Bank to the Company are restricted under California law to the lesser of the Bank's retained earnings or the Bank's net income for the latest three fiscal years, less dividends previously declared during that period, or, with the approval of the Department of Financial Institutions, to the greater of the retained earnings of the Bank, the net income of the Bank for its last fiscal year, or the net income of the Bank for its current fiscal year. As of December 31, 2012, the maximum amount available for dividend distribution under this restriction was approximately $7.6 million. In addition, the Company's ability to pay dividends is subject to certain covenants contained in the indentures relating to the Trust Preferred Securities issued by the business trust (see Note 9).

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

11. SHAREHOLDERS' EQUITY(Continued)

Earnings Per Common Share

A reconciliation of the numerators and denominators of the basic and diluted earnings per common share computations for the years ended December 31, 2012, 2011 and 2010 is as follows:

			Less			Net		Weighted
			Preferred			Income		Average Per
			Stock			Available to		Number of		Common
	Net		Dividends			Common		Shares		Share
	Income		And Accretion			Shareholders		Outstanding		Amount
December 31, 2012
Basic earnings per common share	$	3,232,906	$	(93,209	)	$	3,139,697		2,788,018	$	1.13
Effect of dilutive stock options									9,817
Diluted earnings per common share	$	3,232,906	$	(93,209	)	$	3,139,697		2,797,835	$	1.12
December 31, 2011
Basic earnings per common share	$	3,103,979	$	(417,344	)	$	2,686,635		2,768,114	$	0.97
Effect of dilutive stock options
									4,657
Diluted earnings per common share	$	3,103,979	$	(417,344	)	$	2,686,635		2,772,771	$	0.97
December 31, 2010
Basic earnings per common share	$	2,162,968	$	(420,817	)	$	1,742,151		2,698,200	$	0.65
Effect of dilutive stock options
									6,870
Diluted earnings per common share	$	2,162,968	$	(420,817	)	$	1,742,151		2,705,070	$	0.65

Shares of common stock issuable under stock options for which the exercise prices are greater than the average market prices are not included in the computation of diluted earnings per share due to their anti-dilutive effect. There were 157,253, 108,909 and 99,867 options excluded from the computation of diluted earnings per share for the years ended December 31, 2012, 2011 and 2010, respectively.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

11. SHAREHOLDERS' EQUITY(Continued)

Stock-Based Compensation

The Company has one active share based compensation plan. The purpose of the plan is to promote the long-term success of the Company and the creation of shareholder value. The Board of Directors also believes that the availability of stock options and other forms of stock awards will be a key factor in the ability of the Company to attract and retain qualified individuals. On May 15, 2007, the Company’s shareholders approved the Valley Commerce Bancorp 2007 Equity Incentive Plan (“Incentive Plan”). The Incentive Plan provides for awards of stock options, restricted stock awards, qualified performance based awards and stock grants. Under the Incentive Plan 183,695 shares of common stock are reserved for future grant and issuance, respectively, to employees and directors under incentive and nonstatutory agreements. No more options will be granted from the Valley Commerce Bancorp Amended and Restated 1997 Stock Option Plan.

The plans require that the option price may not be less than the fair market value of the stock at the date the option is granted, and that the stock must be paid in full at the time the option is exercised. Payment in full for the option price must be made in cash, with Company common stock previously acquired by the optionee and held by the optionee for a period of at least six months or by net exercise in which options are surrendered for their ‘in-the-money” value. The plans do not provide for the settlement of awards in cash and new shares are issued upon option exercise. The options expire on dates determined by the Board of Directors, but not later than ten years from the date of grant. Upon grant, options vest ratably over a one to five year period.

During the years ended December 31, 2012, 2011 and 2010, the Company recorded compensation expense of $274,116, $98,946, and $37,060, respectively. As a result of recognizing the compensation expense, the Company’s net income was reduced by $214,477, $75,746, and $36,395, for years ended December 31, 2012, 2011 and 2010, respectively.

As of December 31, 2012, there was $274,680 of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under Incentive and Stock Options Plans described more fully in Note 11. That cost is expected to be recognized over a weighted average period of 1.1 years.

During the twelve months ended December 31, 2011, the Company awarded 2,927 shares of restricted stock. The restricted stock will vest in two-years from the date of grant. There was no restricted stock awards during 2012 or 2010.

During the twelve months ended December 31, 2012, there were 26,461 incentive stock options and 65,500 non-qualified stock options granted to the Company’s officers and directors, respectively, at a price of $8.64 per option. There were 2,100 incentive stock options and 8,400 non-qualified stock options granted to the Company’s officers and directors, respectively, at a price of $7.81 per option during the twelve months ended December 31, 2011. There were no options granted during 2010.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

11. SHAREHOLDERS' EQUITY(Continued)

The fair value of each incentive and non-qualified stock option award granted is estimated on the grant date using the Black-Scholes option pricing model. Fair value of the stock options issued during the year ended December 31, 2012 and 2011 is based on the weighted-average assumptions shown in the table below.

	Twelve Months Ended			Twelve Months Ended
	December 31, 2012			December 31, 2011
Dividend yield	$	0.01			N/A
Expected option life		9.29 years			8.83 years
Expected volatility		50.5	%		46.9	%
Risk-free interest rate		0.82	%		1.23	%
Weighted average
fair value of options granted	$	4.88		$	5.02

The expected life of awards granted represents the period of time that awards are expected to be outstanding. Expected volatility is based on historical volatility of the Company’s stock and other factors. The risk-free interest rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time grant.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

11. SHAREHOLDERS' EQUITY(Continued)

Stock-Based Compensation (Continued)

A summary of the activity within the Plans follows:

	For the Years Ended December 31, 2012, 2011 and 2010
	Shares			Weighted Average Exercise Price		Weighted Average Remaining Contractual Term		Aggregate Intrinsic Value
Incentive:
Options outstanding at January 1, 2010		78,076		$	10.36
Options granted		—			—
Options transferred to nonstatutory		(13,443	)		9.04
Options exercised		—			—
Options cancelled		(3,992	)		12.20
Options outstanding at December 31, 2010		60,641			9.88
Options granted		2,100			7.81
Options exercised		(13,294	)		5.87
Options cancelled		(3,816	)		7.89
Options outstanding at December 31, 2011		45,631			11.12
Options granted		26,461			8.68
Options exercised		(5,276	)		6.47
Options cancelled		—			—
Options outstanding at December 31, 2012		66,816		$	10.52		6.28 years	$	53,074	(1)
Options vested or expected to vest at December 31, 2012		54,777		$	11.18		5.15 years	$	45,465	(1)
Options exercisable at December 31, 2012		50,716		$	11.13		5.34 years	$	24,899	(1)
Nonstatutory:
Options outstanding at January 1, 2010		92,362		$	8.67
Options granted		—			—
Options transferred from ISO		13,443			9.04
Options exercised		(23,271	)		5.37
Options cancelled		(15,731	)		6.05
Options outstanding at December 31, 2010		66,803			10.50
Options granted		8,400			7.81
Options exercised		(6,649	)		5.87
Options cancelled		—			—
Options outstanding at December 31, 2011		68,554			10.62
Options granted		65,500			8.63
Options exercised		(25,167	)		8.75
Options cancelled		—			—
Options outstanding at December 31, 2012		108,887		$	9.85		6.90 years	$	136,339	(2)
Options vested or expected to vest at December 31, 2012		99,941		$	10.04		4.53 years	$	82,951	(2)
Options exercisable at December 31, 2012		71,759		$	10.50		5.69 years	$	871,415	(2)

(1) 32,519 options are excluded from intrinsic value because they are not in the money.

(2) 25,943 options are excluded from intrinsic value because they are not in the money.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

11. SHAREHOLDERS' EQUITY(Continued)

Stock-Based Compensation (Continued)

The aggregate intrinsic value is calculated as the difference between the exercise price of the underlying awards and the quoted price of the Company’s common stock for options that were in-the-money at December 31, 2012. There were 30,443, 19,943 and 22,163 options exercised during the years ended December 31, 2012, 2011 and 2010, respectively. The total intrinsic value of options exercised during the years ended December 31, 2012, 2011, and 2010 was $67,665, $19,175 and $54,520, respectively. The total fair value of shares vested during the years ended December 31, 2012, 2011, and 2010 was $230,654, $88,127 and $56,163, respectively.

Cash received from option exercise for the years ended December 31, 2012, 2011, and 2010 was $254,325, $117,000 and $125,000, respectively. The total tax benefit of the options exercised in 2012, 2011, and 2010 was $17,924, $0 and $21,808, respectively.

Regulatory Capital

The Company and the Bank are subject to certain regulatory capital requirements administered by the Board of Governors of the Federal Reserve System and the Federal Deposit Insurance Corporation (FDIC). Failure to meet these 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 consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank's assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The Company's and the Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.

Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios of total and Tier 1 capital to risk-weighted assets and of Tier 1 capital to average assets. Each of these components is defined in the regulations. Management believes that the Company and the Bank met all their capital adequacy requirements as of December 31, 2012 and 2011.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

11. SHAREHOLDERS' EQUITY(Continued)

Regulatory Capital (Continued)

In addition, the most recent notification from the FDIC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth below. There are no conditions or events since that notification that management believes have changed the Bank's category.

	December 31,
	2012					2011
	Amount		Ratio			Amount		Ratio
Leverage Ratio
Valley Commerce Bancorp and Subsidiary	$	39,844,000		11.3	%	$	44,691,000		13.1	%
Minimum regulatory requirement	$	14,102,000		4.0	%	$	13,626,000		4.0	%
Valley Business Bank	$	39,509,000		11.2	%	$	44,648,000		13.1	%
Minimum requirement for “Well-Capitalized”
institution	$	17,627,000		5.0	%	$	17,032,000		5.0	%
Minimum regulatory requirement	$	14,095,000		4.0	%	$	13,621,000		4.0	%
Tier 1 Risk-Based Capital Ratio
Valley Commerce Bancorp and Subsidiary	$	39,844,000		15.6	%	$	44,691,000		17.6	%
Minimum regulatory requirement	$	10,222,000		4.0	%	$	10,145,000		4.0	%
Valley Business Bank	$	39,509,000		15.5	%	$	44,648,000		17.6	%
Minimum requirement for “Well-Capitalized”
institution	$	15,324,000		6.0	%	$	15,214,000		6.0	%
Minimum regulatory requirement	$	10,216,000		4.0	%	$	10,142,000		4.0	%
Total Risk-Based Capital Ratio
Valley Commerce Bancorp and Subsidiary	$	43,064,000		16.9	%	$	45,060,000		18.9	%
Minimum regulatory requirement	$	20,444,000		8.0	%	$	20,290,000		8.0	%
Valley Business Bank	$	42,727,000		16.8	%	$	44,931,000		18.9	%
Minimum requirement for “Well-Capitalized”
institution	$	25,541,000		10.0	%	$	25,356,000		10.0	%
Minimum regulatory requirement	$	20,432,000		8.0	%	$	20,285,000		8.0	%

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

11. SHAREHOLDERS' EQUITY(Continued)

Preferred Stock

On March 21, 2012, pursuant to the American Recovery and Reinvestment Act of 2009 and following receipt of all necessary regulatory approvals, the Company repurchased the Series B and Series C Preferred Stock which was sold to the United States Department of Treasury in January 2009. The purchase price was $8,085,000 comprised of 7,700 shares of Series B Preferred Stock at $1,000 per share and 385 shares of Series C Preferred stock at $1,000 per share. The Company had no preferred stock remaining after the transaction and made a pro-rated final dividend payment on the transaction date. Because the preferred stock qualified as Tier 1 Capital, The Company’s Tier 1 capital was reduced by an amount that approximated the purchase price.

Stock Repurchase

On May 22, 2012, the Company’s Board of Directors authorized a Common Stock repurchase plan. The plan provides for the repurchase of up to $3,000,000 of the Company’s Common Stock. The number, price and timing of the repurchase is at the Company’s sole discretion. The stock repurchase plan will expire on May 22, 2013. There were no shares repurchased during the year ended December 31, 2012.

Stock Dividends

On May 24, 2011 the Board of Directors declared a 5% stock dividend payable on June 28, 2011, respectively, to shareholders of record on June 14, 2011. There was no stock dividend in 2012. All per share and stock option data in the consolidated financial statements have been retroactively restated to reflect the stock dividend.

Cash Dividends

On May 22, 2012 the Board of Directors declared a $0.04 cash dividend payable on June 28, 2012 for all shareholders of record on June 17, 2012 and on August 21, 2012 the Board of Directors declared a $0.04 cash dividend payable on September 27, 2012 for all shareholders of record on September 6, 2012. On November 20, 2012 the Board of Directors declared a $0.08 cash dividend payable on December 27, 2012 for all shareholders of record on December 6, 2012.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

12. OTHER EXPENSES

Other expenses consisted of the following:

	Year Ended December 31,
	2012		2011		2010
Data processing	$	640,195	$	631,995	$	631,596
Assessment and insurance		301,270		532,553		711,565
Professional and legal		432,521		449,157		412,688
Operations		348,760		350,589		339,754
Telephone and postal		222,406		233,318		234,139
Promotional		241,668		280,209		229,451
Supplies		179,810		205,590		193,515
Other expenses		544,579		539,928		443,331
Total	$	2,911,209	$	3,223,339	$	3,196,039

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

13. INCOME TAXES

The provision for income taxes for the years ended December 31, 2012, 2011 and 2010 consisted of the following:

	Federal			State			Total
2012
Current	$	1,200,000		$	183,000		$	1,383,000
Deferred		7,000			(19,000	)		(12,000	)
Provision for income taxes	$	1,207,000		$	164,000		$	1,371,000
2011
Current	$	155,000		$	156,000		$	311,000
Deferred		960,000			306,000			1,266,000
Provision for income taxes	$	1,115,000		$	462,000		$	1,577,000
2010
Current	$	992,000		$	399,000		$	1,391,000
Deferred		(342,000	)		(106,000	)		(448,000	)
Provision for income taxes	$	650,000		$	293,000		$	943,000

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

13. INCOME TAXES(Continued)

Deferred tax assets (liabilities) consisted of the following:

	December 31,
	2012			2011
Deferred tax assets:
Allowance for loan losses	$	1,753,000		$	1,870,000
Deferred compensation		1,183,000			986,000
Intangible assets		2,000			20,000
Other		18,000			—
Total deferred tax assets		2,956,000			2,876,000
Deferred tax liabilities:
Loan costs		(304,000	)		(307,000	)
Premises and equipment		(383,000	)		(302,000	)
Unrealized gain on available-for-sale
investment securities		(741,000	)		(570,000	)
Future liability of state tax benefit		(116,000	)		(97,000	)
Other		—			(29,000	)
Total deferred tax liabilities		(1,544,000	)		(1,305,000	)
Net deferred tax assets	$	1,412,000		$	1,571,000

Management believes that it is more likely than not that it will realize the above deferred tax assets in future periods; therefore, no valuation allowance has been provided against its deferred tax assets.

The provision for income taxes differs from amounts computed by applying the statutory Federal income tax rate to operating income (loss) before income taxes. The items comprising these differences consisted of the following:

	Year Ended December 31,
	2012			2011			2010
	Rate			Rate			Rate
Federal income tax, at statutory rate		34.0%			34.0%			34.0%
State franchise tax, net of Federal tax effect		4.0%			7.2%			7.2%
Interest on obligations of states and political
subdivisions		(5.9%	)		(5.7%	)		(7.7%	)
Net increase in cash surrender value of
bank-owned life insurance		(2.2%	)		(1.9%	)		(3.0%	)
Other		(0.1%	)		0.1%			(0.1%	)
Total income tax expense		29.8%			33.7%			30.4%

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

13. INCOME TAXES(Continued)

The Company and its subsidiary file income tax returns in the U.S. federal and California jurisdictions. There are currently no pending U.S. federal, state, and local income tax or non-U.S. income tax examinations by tax authorities. With few exceptions, the Company is no longer subject to tax examinations by U.S. Federal taxing authorities for years ended before December 31, 2009, and by state and local taxing authorities for years ended before December 31, 2008.

The unrecognized tax benefits and the interest and penalties accrued by the Company as of December 31, 2012 and 2011 were not significant.

14. RELATED PARTY TRANSACTIONS

During the normal course of business, the Company enters into transactions with related parties, including executive officers and directors. The following is a summary of the aggregate activity involving related party borrowers during 2012:

Balance, January 1, 2012	$	7,900,804
Disbursements		2,582,591
Amounts repaid		(5,182,263	)
Balance, December 31, 2012	$	5,301,132
Undisbursed commitments to related
parties, December 31, 2012	$	296,758

15. EMPLOYEE BENEFIT PLANS

Employee Retirement Plan

The Company adopted the Valley Business Bank 401(k) Profit Sharing Plan, effective January 1, 1997. All employees that work 30 or more hours per week with more than 3 months of service are eligible to participate in the plan. Eligible employees may elect to make tax deferred contributions of their salary up to the maximum amount allowed by law. From April 1, 2006 to February 27, 2009, the Company matched 70% of the employees’ contributions, applicable to contributions of up to 6% of the employees’ annual salary. From February 28, 2009 to December 31, 2011 the Company matched 50% of the employees’ contributions, applicable to contributions of up to 6% of the employees annual salary. Company contributions vest at a rate of 20% annually. Beginning January 1, 2012, the Company made a Safe Harbor matching contribution equal to 100% of the employees elective deferral that does not exceed 1% compensation plus 50% of employees elective deferral between 1% to 6% of compensation. This Safe Harbor matching contribution is subject to a vesting schedule. After two years of service, an employee is 100% vested in the safe harbor match. For less than two years of service an employee is 0% vested in the Safe Harbor match. Bank contributions for the years ended December 31, 2012, 2011, and 2010 totaled $109,605, $75,325 and $70,066, respectively.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

15. EMPLOYEE BENEFIT PLANS(Continued)

Salary Continuation and Retirement Plans

Salary continuation plans are in place for three executives. Under these plans, the executives will receive monthly payments after retirement until death. These benefits are substantially equivalent to those available under split-dollar life insurance policies purchased by the Bank on the lives of the executives. In addition, the estimated present value of these future benefits, including the monthly payments and insurance premium costs, is accrued over the period from the effective dates of the plans until the participants' expected retirement dates. The expense recognized under these plans for the years ended December 31, 2012, 2011, and 2010 totaled $467,507, $193,392 and $125,587, respectively. Income earned on these policies, net of expenses, totaled $180,545, $141,505 and $145,367 for the years ended December 31, 2012, 2011 and 2010, respectively. Accrued compensation payable under the salary continuation plan totaled $2,638,381, $2,161,790 and $2,035,483 at December 31, 2012, 2011 and 2010, respectively.

In connection with these agreements, and non-executive officer retirement plans offering limited benefits, the Bank purchased single premium life insurance policies with cash surrender values totaling $7,992,697, $7,693,480, and $6,627,060 at December 31, 2012, 2011, and 2010, respectively. Income earned on these policies, net of expenses, totaled $327,973, $292,427 and $272,189 for the years ended December 31, 2012, 2011 and 2010, respectively. Income earned on these policies is not subject to Federal and state income tax.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

17. PARENT ONLY FINANCIAL STATEMENTS

CONDENSED BALANCE SHEETS

December 31, 2012 and 2011

	2012		2011
ASSETS
Cash and due from banks	$	16,903	$	136,099
Investment in bank subsidiary		40,568,271		45,462,209
Other assets		513,727		213,094
Total assets	$	41,098,901	$	45,811,402
LIABILITIES AND
SHAREHOLDERS’ EQUITY
Other liabilities	$	102,735	$	212,990
Junior subordinated debentures due to subsidiary grantor trust		3,093,000		3,093,000
Total liabilities		3,195,735		3,305,990
Shareholders’ equity:
Preferred stock		—		7,898,800
Common stock		28,080,655		27,534,291
Retained earnings		8,763,327		6,257,800
Accumulated other comprehensive income, net of taxes		1,059,184		814,521
Total shareholders’ equity		37,903,166		42,505,412
Total liabilities and shareholders’ equity	$	41,098,901	$	45,811,402

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

17. PARENT ONLY FINANCIAL STATEMENTS (Continued)

CONDENSED STATEMENTS OF INCOME

For the Years Ended December 31, 2012, 2011 and 2010

	2012			2011			2010
Income:
Dividends declared by bank subsidiary	$	8,985,000		$	600,000		$	740,000
Earnings from investment in Valley Commerce
Trust 1		3,553			3,400			3,435
Total income		8,988,553			603,400			743,435
Expenses:
Interest on junior subordinated deferrable interest debentures		118,212			113,091			114,236
Other expenses		709,091			623,196			502,558
Total expenses		827,303			736,287			616,794
Income (loss) before equity in undistributed
income (loss) of subsidiary		8,161,250			(132,887	)		126,641
(Excess distributions from) undistributed
equity in income from subsidiary		(5,209,344	)		2,931,866			1,789,327
Income before income taxes		2,951,906			2,798,979			1,915,968
Income tax benefit		281,000			306,000			247,000
Net income	$	3,232,906		$	3,103,979		$	2,162,968

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

17. PARENT ONLY FINANCIAL STATEMENTS (Continued)

STATEMENTS OF CASH FLOWS

For the Years Ended December 31, 2012, 2011 and 2010

	2012			2011			2010
Cash flows from operating activities:
Net income	$	3,232,906		$	3,103,979		$	2,162,968
Adjustments to reconcile net income to net cash
provided by operating activities:
Excess distributions from (undistributed equity
in) income of subsidiary		5,209,344			(2,931,866	)		(1,789,327	)
��            Stock-based compensation expense		203,372			46,056			8,566
Tax benefits on stock-based compensation		(17,924	)		—			(21,808	)
(Increase) decrease in other assets		(182,709	)		(3,560	)		5,530
(Decrease) increase in other liabilities		(110,255	)		84,542			(5,170	)
Net cash provided by operating activities		8,234,734			299,151			360,759
Cash flows from financing activities:
Redemption of preferred stock		(8,085,000	)		—			—
Cash paid for fractional shares		—			(2,529	)		—
Proceeds from the exercise of stock options		254,325			117,000			125,000
Tax benefits from stock-based compensation		17,924			—			21,808
Cash dividend paid on common stock		(447,970	)		—			—
Cash dividends paid on preferred stock		(93,209	)		(417,344	)		(420,818	)
Net cash used in financing activities		(8,353,930	)		(302,873	)		(274,010	)
(Decrease) increase in cash and cash equivalents		(119,196	)		(3,722	)		86,749
Cash and cash equivalents at beginning of year		136,099			139,821			53,072
Cash and cash equivalents at end of year	$	16,903		$	136,099		$	139,821

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Table of Contents

VALLEY COMMERCE BANCORP AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Continued)

18. QUARTERLY FINANCIAL DATA (unaudited)

	Interest		Net Interest		Net		Earnings Per Share
	Income		Income		Income		Basic		Diluted
2012
First quarter	$	3,734,186	$	3,450,718	$	858,839	$	0.28	$	0.28
Second quarter		3,665,803		3,387,316		892,415		0.32		0.32
Third quarter		3,628,458		3,362,845		839,352		0.30		0.30
Fourth quarter		3,658,592		3,405,992		642,300		0.23		0.23
2011
First quarter	$	3,892,654	$	3,435,440	$	624,964	$	0.20	$	0.20
Second quarter		3,868,939		3,427,015		859,282		0.27		0.27
Third quarter		4,007,263		3,557,996		826,339		0.26		0.26
Fourth quarter		3,874,220		3,556,779		793,394		0.25		0.25

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ITEM 9 – CHANGE IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

There is no information required to be disclosed under this Item.

ITEM 9A – CONTROLS AND PROCEDURES

Based on their evaluation as of the end of the period covered by this Annual Report on Form 10-K (as required by paragraph (b) of Rule 13a-15 under the Exchange Act, the Registrant’s principal executive officer and principal financial officer have concluded that the Registrant’s disclosure controls and procedures (as defined in Rules 13a-15(e) under the Exchange Act) were effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act was recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.

REPORT OF MANAGEMENT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

Management of Valley Commerce Bancorp and its subsidiary (the Company) is responsible for establishing and maintaining adequate internal control over financial reporting for the Company, as such term is defined in Rule 13a-15(f) under the Securities Exchange Act of 1934. The Company’s management, including the chief executive officer and chief financial officer, has assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2012, presented in conformity with accounting principles generally accepted in the United States of America. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control-Integrated Framework. Based on this assessment, management concluded that, as of December 31, 2012, the Company’s internal control over financial reporting was effective based on those criteria.

This annual report does not include an attestation report of the Company’s independent registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s independent registered public accounting firm pursuant to rules of the Securities and Exchange Commission that permit the Company to provide only management’s report in this annual report.

Disclosure controls and procedures

The Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness, as of December 31, 2012, of the design and operation of the Company’s disclosure controls and procedures pursuant to Rule 15d-15 of the Exchange Act. Based upon that evaluation, the Company’s principal executive and financial officers concluded that the Company’s disclosure controls and procedures were effective, as of December 31, 2012, in timely providing them with material information relating to the Company, as required to be disclosed by the Company in the reports that it files or submits under the Exchange Act, within the time periods specified in the Securities and Exchange Commission’s rules and forms.

Changes in internal controls

There was no change in the Company’s internal control over financial reporting identified in connection with the evaluation required by Rule 15d-15 that occurred during the year ended December 31, 2012 that has materially affected or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

ITEM 9B – OTHER INFORMATION

There is no information required to be disclosed under this Item.

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PART III

ITEM 10 - DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT.

Directors of the Company

Set forth below is certain information with respect to the directors of the Company.

Name	Age	Position With Company	Director Since	Principal Occupation, Business Experience During Past Five Years and Other Information
Walter A. Dwelle	67	Chairman and Director	19961	General Partner and Manager of Flyers Energy, LLC, an oil marketing and convenience store operator, since 1988.
				The Board nominated Mr. Dwelle based on his leadership abilities, long term ties to the local business community, and his broad business experience.  These attributes contribute to his effectiveness as the Chairman of the Board’s Executive Committee, and member of many of the Board’s committees.  As a founding director, he has acquired extensive banking knowledge and experience serving through varying economic climates, and leading the Company’s strategic planning efforts.
Donald A. Gilles	69	Director	19961	Retired; Previously President and CEO of Valley Commerce Bancorp and Valley Business Bank from 1996 to June 2010.
				The Board nominated Mr. Gilles in recognition of his extensive professional banking knowledge and experience. Mr. Gilles is a career banker with 28 years of executive banking experience in the Company’s primary marketing area, and has strong ties to the Bank’s customer base. As Chairman of the Compliance and Operational Risk Committee and Audit Committee, he enhances the Board’s ability to fulfill key oversight responsibilities. Mr. Gilles retired as President and CEO effective June 30, 2010.

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Name	Age	Position With Company	Director Since	Principal Occupation, Business Experience During Past Five Years and Other Information
Philip R. Hammond, Jr.	65	Director	19991	President of Philip R. Hammond Construction, a commercial property development firm, since 1976; Partner of Tetra Property Management Inc since 1998; and Partner of Hammond Vineyards since 1995.
				The Board has nominated Mr. Hammond based on his broad business experience and his leadership on key risk management issues as chairman of the Asset/ Liability Committee.  His professional engineering background, his extensive experience in the real estate industry, and his knowledge of the local construction market allow him to provide valuable insights to the Board concerning many aspects of the Bank’s construction and real estate lending.
Russell F. Hurley	62	Vice Chairman and Director	19961	Attorney and shareholder with the law firm of Dowling Aaron, Inc since July 2010; prior to that he was an attorney and shareholder with the law firm of Hurley & Laird from 1982 to 2010.
				The Board nominated Mr. Hurley based on his demonstrated leadership as Vice Chairman of the Board, member of the Board’s Executive and Audit Committees, and chairman of the Loan Committee; and for his experience as an attorney.  Having served as a director since the Bank’s opening, he has extensive knowledge of the Bank’s operations and has been with the Bank in varying economic climates.

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Name	Age	Position With Company	Director Since	Principal Occupation, Business Experience During Past Five Years and Other Information
Fred P. LoBue, Jr.	72	Secretary and Director	19961	Chairman of the Board of LoBue Bros., Inc., a commercial orange packing house operation, since 1998; Chief Financial Officer from 1977 to 2010; a retained consultant, since 2010, and a director of LoBue Bros., Inc. since 1982; and, since 1983, President and Chairman of Harvest Container Corp., a manufacturer of corrugated boxes.
				The Board nominated Mr. LoBue based on his corporate business knowledge and his leadership abilities.  As a founding director, Corporate Secretary, and member of the Board’s Executive, Audit, and 401K Trustee Committees, he has extensive knowledge of the Bank’s operations and has directed the Bank through varying economic climates.  His experience as an agri-business financial officer and direct involvement with significant issues affecting the local economy allows him to provide the Board with valuable insights.
Kenneth H. Macklin	61	Director	20001	Owner and President of H.R. Macklin & Sons, Inc., an agricultural service company involved in the placement of long-term farm loans, appraisals, farm management and real estate brokerage, since 1994; and since 1990 Partner in Vintage Equipment Company, a farm equipment operation and leasing company.
				The Board nominated Mr. Macklin based on his broad background in lending, finance and management, and his leadership as chairman of the Personnel/ Compensation Committee.  As owner of a firm providing financial and managerial services to the agricultural industry, he provides significant perspective to the Board on the agricultural real estate industry, and has strong ties to the business community in general.

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Name

Age
Position With
Company
Director
Since
Principal Occupation, Business Experience
During Past Five Years and Other Information

Barry R. Smith	67	Director	2006	Ophthalmologist and founding partner of Eye Surgical and Medical Associates, since 1987.
				The Board nominated Dr. Smith based on his general business background as owner of a professional medical practice.  He provides the Board with insights into the financial needs of health care businesses and, as a long term provider of medical services to the community, is closely tied to this important segment of the Bank’s customer base.
Allan W. Stone	57	President, CEO and Director	2010	President and CEO of Valley Commerce Bancorp and Valley Business Bank since June 30, 2010. Mr. Stone served the Company as Executive Vice President and Chief Credit Officer from 1998 to 2010, and also served as Chief Operating Officer from 2009 to 2010. Prior to that, he was Senior Vice President and Chief Credit Officer for Bank of Ventura from 1994 to 1998. The Board nominated Mr. Stone based on his extensive professional banking knowledge and experience and his ability to participate as director on key decisions affecting shareholder value. In addition, the Board believes that including the Company’s President and Chief Executive Officer on the Board assists the Board in keeping abreast of the Company’s operations and management.

¹ Includes service as a director of Bank of Visalia, the predecessor institution of the Company

There are no family relationships among any of the Company’s executive officers, directors or director nominees.

No director is or during the past ten years was a director of any company with a class of securities registered pursuant to section 12 of the Securities Exchange Act of 1934, as amended, or subject to the requirements of section 15(d) of such Act or of any company registered as an investment company under the Investment Company Act of 1940, as amended.

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Executive Officers of the Company

Set forth below is certain information with respect to the executive officers of the Company.

Name	Age	Position	Officer Since
Allan W. Stone	57	President and Chief Executive Officer	19981
Roy O. Estridge	58	EVP and Chief Financial Officer and Chief  Operating Officer	20021
William R. Kitchen	57	EVP and Chief Credit Officer	2010

¹ Includes services as an officer of Valley Business Bank, the predecessor institution of the Company. Prior to becoming President and Chief Executive Officer, Mr. Stone served as the Company’s Executive Vice President and Chief Credit Officer from 1998 to 2010, and also served as Chief Operating Officer from 2009 to 2010.

A brief summary of the background and business experience of the executive officers of the Company who have not previously been described is set forth below:

Roy O. Estridge has served as the Company’s Executive Vice President and Chief Operating Officer and Chief Financial Officer since July 2010. Prior to that he served as the Company’s Executive Vice President and Chief Financial Officer since 2002. Prior to that, he was Vice President and Chief Financial Officer for Valley AgCredit in Visalia, California from 1992 to 2002.

William R. Kitchen joined the Company as Executive Vice President and Chief Credit Officer in March 2010. Prior to that, he was Regional Vice President for Westamerica Bank (successor to County Bank) since 2009, Regional Vice President for County Bank (successor to Stockmen’s Bank) since 2007, and Executive Vice President for Stockmen’s Bank from 1997 to 2007.

Section 16(a) Beneficial Ownership Reporting Compliance.

Section 16(a) of the Exchange Act requires the Company’s directors, executive officers and 10% shareholders file reports of ownership and changes in ownership with the Securities and Exchange Commission. Such persons are also required to furnish us with copies of all Section 16(a) forms they file. Based upon a review of the Section 16(a) forms furnished to the Company during and with respect to the 2012 fiscal year, Mr. Hammond inadvertently failed to timely file one report on Form 4.

Code of Ethics

The Company has a code of ethics for its chief executive officer, chief financial officer and persons performing similar functions as described in the Sarbanes-Oxley Act of 2002 and the rules of the Securities and Exchange Commission. A copy of the code of ethics can be obtained, without cost, by writing to the Corporate Secretary, Valley Commerce Bancorp, 701 W. Main Street, Visalia, California 93291.

Audit Committee

The members of the Audit Committee of the Board of Directors are Donald A. Gilles, Committee Chairman, Walter A. Dwelle, Fred P. LoBue, Jr., and Russell F. Hurley. All members of the Audit Committee are deemed independent under the SEC rules. All members of the Audit Committee are deemed independent under the NASDAQ listing standards applicable to audit committee members other than Mr. Gilles who is not considered independent under this standard because he was employed by the Company during the last three years

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The Board of Directors has determined that Walter A. Dwelle, and Donald A. Gilles qualify for designation as a financial expert member of the Audit Committee for purposes of the Sarbanes-Oxley Act. Designation of a person as an audit committee financial expert does not result in the person being deemed an expert for any purpose, including under Section 11 of the Securities Act of 1933.

The designation does not impose on the person any duties, obligations or liability greater than those imposed on any other audit committee member or any other director and does not affect the duties, obligations or liability of any other member of the audit committee or board of directors.

The principal duties of the Audit Committee are the following: (i) engage a firm of independent certified public accountants on behalf of the Company; (ii) meet with the independent certified public accountants to review and approve the scope of their audit engagement and the fees related to such work; (iii) meet with the Company’s financial management, internal audit management and independent certified public accountants to review matters relating to internal control over financial reporting, the internal audit program, the Company’s accounting practices and procedures and other matters relating to the financial condition of the Company and its subsidiaries; and (iv) periodically report to the Board any conclusions or recommendations that the Audit Committee may have with respect to such matters. The Audit Committee met four times during 2012.

110

ITEM 11 - EXECUTIVE COMPENSATION

EXECUTIVE COMPENSATION

Executive Officers of the Company

Set forth below is certain information with respect to the Executive Officers of the Company.

Name	Age	Position	Officer Since
Allan W. Stone	57	President and Chief Executive Officer	19981
Roy O. Estridge	58	EVP and Chief Financial Officer and Chief  Operating Officer	20021
William R. Kitchen	57	EVP and Chief Credit Officer	2010

² Includes services as an officer of Bank of Visalia, the predecessor institution of the Company. Prior to becoming President and Chief Executive Officer, Mr. Stone served as the Company’s Executive Vice President and Chief Credit Officer from 1998 to 2010, and also served as Chief Operating Officer from 2009 to 2010.

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Summary Compensation Table

The following table sets forth information concerning the compensation of the Chief Executive Officer and our two other most highly compensated executive officers during 2012:

Name and Principal Position	Year	Salary ($)		Bonus ($)		Stock Awards ($)(2)		Stock Option Awards ($)(1)		Non-Equity Incentive Plan Compensation ($)	Changes in Pension Value and Nonqualified Deferred Compensation Earnings ($)	All Other Compensation ($)(3)		Total ($)
Allan W. Stone	2012	$	278,751	$	23,700	$	0	$	29,372	0	n/a	$	12,540	$	344,363
President and Chief Executive Officer	2011		202,761		0		14,997		0	0	n/a		12,418		230,176
Roy O. Estridge	2012	$	201,552	$	18,960	$	0	$	27,033	0	n/a	$	9,135	$	256,680
Executive Vice President and Chief Financial / Operating Officer	2011		192,318		16,483		0		4,078	0	n/a		6,931		219,810
William R. Kitchen	2012	$	156,000	$	17,775	$	0	$	9,568	0	n/a	$	7,024	$	190,367
Executive Vice President And Chief  CreditOfficer	2011		150,000		14,443		0		4,078	0	n/a		3,959		172,480

The amounts set forth in this column for 2012 include the following:

	Mr. Stone		Mr. Estridge		Mr. Kitchen
401(k) matching contribution	$	8,400	$	7,005	$	5,460
Membership dues		2,010		—		—
Life Insurance Plans		2,130		2,130		1,564
Total	$	12,540	$	9,135	$	7,024

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Outstanding Equity Awards at Fiscal Year-End

The following table sets forth information concerning the exercisable and unexercisable stock options and stock awards at December 31, 2012 held by the individuals named in the Summary Compensation Table:

	Option Awards								Stock Awards
Name	Number of securities underlying exercisable options (1)			Number of securities underlying unexercisable options (1)		Option exercise Price ($)		Option expiration date	Number of shares or units of stock that have not vested (#)			Market value of shares or units of stock that have not vested ($)
Allan W. Stone		1,004	(1)		—	$	9.95	02/17/2014		—			—
President and Chief Executive Officer		4,630	(1)		3,590		12.53	12/18/2017		—			—
		1,196	(4)		—		8.60	03/26/2022		—			—
		2,500	(4)		—		8.60	03/26/2022		—			—
		1,000	(2)		—		10.55	10/18/2022		1,877	(3)	$	14,997
		1,000	(2)		—		10.39	12/18/2022		—			—
Roy O. Estridge		1,004	(1)		—	$	9.95	02/17/2014		—			—
Executive Vice President and Chief		4,630	(1)		—		12.53	12/18/2017		—			—
Financial / Operating Officer		1,050	(2)		—		7.81	01/01/2021		—			—
		1,000	(2)		—		7.00	01/01/2022		—			—
		875	(4)		2,625		8.60	03/26/2022		—			—
		1,000	(2)		—		10.39	12/18/2022		—			—
William R. Kitchen		1,050	(2)		—	$	7.81	01/01/2021		—			—
Executive Vice President and		1,000	(2)		—		7.00	01/01/2022		—			—
Chief Credit Officer		1,000	(2)		—		10.39	12/18/2022		—			—

(1) The incentive options vest 20% annually from grant date in five equal installments on the anniversaries of grant date.

(2) The incentive options were 100% vested on date of grant.

(3) Restricted shares vest two years from date of grant.

(4) The incentive options vest 25% annually from grant date in four equal installments on the anniversaries of grant date.

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Option Exercises in 2012

The following table presents information regarding stock options exercised by each of the Executive Officers in 2012 and the aggregate dollar amount realized on exercise.

	Option Awards
Name	Number of shares acquired on exercise		Value realized on exercise ($) (1)
Allan W. Stone		—	$	—
Roy O. Estridge		5,276		22,856
William R. Kitchen		—		—

(1) The aggregate dollar value realized upon the exercise of an option represents the difference between the market price of the underlying shares on the date of exercise and the exercise price of the option.

Compensation Committee Interlocks and Insider Participation

No member of our Personnel/Compensation Committee serves as a member of the Board of Directors or Compensation Committee of any entity that has one or more executive officers serving as members of our Board of Directors or Personnel/Compensation Committee.

Director Compensation

Information concerning the compensation of the Company’s directors is included in Item 13.

ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

Security Ownership of Directors and Management

The following table sets forth information as of the record date pertaining to beneficial ownership of the Company’s common stock (the sole class of voting stock outstanding) by current directors of the Company, nominees to be elected to the Board of Directors, and all directors and executive officers of the Company as a group. As used throughout this Proxy Statement, the term “Executive Officer” refers to the President and Chief Executive Officer; the Executive Vice President and Chief Credit Officer and the Executive Vice President and Chief Financial Officer / Chief Operating Officer. The information in the following table has been obtained from the Company’s records, or from information furnished directly by the individual or entity to the Company.

114

For purposes of the following table, shares issuable pursuant to stock options which may be exercised within 60 days of the Record Date are deemed to be issued and outstanding and have been treated as outstanding in determining the amount and nature of beneficial ownership and in calculating the percentage of ownership of those individuals possessing such interest, but not for any other individuals.

Name and Address of Beneficial Owner1	Relationship with Company	Amount and  Nature of Beneficial Ownership2			Exercisable Options3		Percent of Class2
Walter A. Dwelle	Chairman and Director		115,685	4		7,502		4.10%
Roy O. Estridge	EVP, COO and CFO		14,835			9,559		—	5
Donald A. Gilles	Director		50,229			14,294		1.78%
Philip R. Hammond, Jr.	Director		77,599	6		7,502		2.75%
Russell F. Hurley	Vice Chairman and Director		54,304	7		7,502		1.92%
William R. Kitchen	EVP and CCO		10,200	8		3,050		—	5
Fred P. LoBue, Jr.	Secretary and Director		76,468	9		7,502		2.71%
Kenneth H. Macklin	Director		30,719	10		7,502		1.09%
Barry R. Smith	Director		28,459	11		16,455		1.01%
Allan W. Stone	President, CEO and Director		18,727	12		11,330		—	5
All directors and executive officers   as a group (10 in number)			477,225			92,198		16.42%

¹ Except as shown, the address for all persons is c/o Valley Commerce Bancorp, 701 W. Main Street, Visalia California, 93291.

² Includes shares beneficially owned as shown in the “Exercisable Options” column, both directly and indirectly together with associates. Subject to applicable community property laws and shared voting and investment power with a spouse, the persons listed have sole voting and investment power with respect to such shares unless otherwise noted. Listed amounts include stock dividends paid to shareholders in prior years.

³ Indicates number of shares subject to options exercisable at April 5, 2013.

⁴ Includes 42,309 shares held in a personal Individual Retirement Account.

⁵ Represents less than one percent of the outstanding shares of the Company’s Common Stock.

⁶ Includes 43,544 shares held by the Philip R. Hammond Construction Company Profit Sharing Plan.

⁷ Includes 25,648 shares held by Milru Ranch Company, of which he is a general partner, and 5,642 shares held in an Individual Retirement Account.

⁸ Includes 970 shares held in an Individual Retirement Account.

⁹ Includes 4,757 shares held in the name of Donna S. LoBue, his wife, and 19,773 shares held in an Individual Retirement Account.

¹⁰ Includes 12,532 shares held by Vintage Equipment Profit Sharing Plan.

¹¹ Includes505 shares held by the Barry Smith MD Pension Plan and 2,552 shares held by Eye Surgical & Medical Associates FBO Barry Smith.

¹² Includes 1,275 shares held in an Individual Retirement Account and 1,050 shares of restricted stock which vest on February 15, 2013 and 1,877 shares of restricted stock which vest on August 15, 2013.

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Principal Shareholders

No persons are known to management to own directly or indirectly, more than five percent of the Company’s issued and outstanding shares of common stock, except as follows:

Name and address of beneficial owner	Amount of Beneficial Ownership	Percent of Class
The Banc Fund Company, LLC 208 South LaSalle Street Chicago, Illinois 60604	196,782	6.99%

ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

Indebtedness of Directors and Management

Some of the Company’s directors and executive officers, as well as their immediate family and associates, are customers of, and have had banking transactions with, the Bank in the ordinary course of the Bank’s business, and the Company expects these persons to have such ordinary banking transactions with the Bank in the future. In the opinion of management of the Company, all loans and commitments to lend included in such transactions were made in the ordinary course of business on the same terms, including interest rates and collateral, as those prevailing for comparable transactions with other persons of similar creditworthiness, and do not involve more than the normal risk of collectibility or present other unfavorable features. While the Company does not have any limits on the aggregate amount it may lend to directors and executive officers as a group, loans to individual directors and officers must comply with the Company’s lending policies and statutory lending limits. In addition, prior approval of the Company’s Board of Directors is required for all such loans.

Transactions With Directors and Management

In 2012 there were no material transactions between the Company and any of the Company’s directors, executive officers, nominees for election as a director, or the immediate family or associates of any of the foregoing persons.

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Director Independence

The Board has determined that each of the Company’s directors is an independent director for purpose of the rules of NASDAQ, other than Mr. Stone, who is the Company’s President and Chief Executive Officer, and Mr. Gilles, who served as the Company’s President and Chief Executive Officer until June 2010.

Director Compensation

As the only director on the Company’s Board of Directors who also is an employee, Mr. Stone does not receive any additional compensation for his service as a member of the Company’s Board of Directors. The Company’s non-employee directors each receive an annual retainer fee of $7,500. In addition, each non-employee director also receives between $300 to $500 per meeting, depending on the committee and if they are a committee chairman or member. Total directors fees paid in 2012 were $210,175.

The following table summarizes 2012 compensation for non-employee directors:

Name	Fees earned or paid in cash ($)(1)		Option awards ($)(2)		Total ($)
Walter A. Dwelle	$	32,700	$	38,263	$	70,963
Thomas A. Gaebe (3)		3,075		—		3,075
Donald A. Gilles		33,600		38,263		71,863
Philip R. Hammond, Jr.		29,950		38,263		68,213
Russell F. Hurley		34,250		38,263		72,513
Fred P. LoBue, Jr.		26,300		38,263		64,563
Kenneth H. Macklin		29,200		38,263		67,463
Barry R. Smith		21,100		34,520		55,620
Allan W. Stone		—		55,480		55,480

(1) All director meeting fees are paid monthly. Total director meeting fees for 2012 were $155,800. The director retainer fees are paid quarterly. Total director retainer fees for 2012 were $54,375.

(2) Reflects fair market value of equity awards on the grant date determined in accordance with FASB ASC Topic 718. Assumptions used in the calculation of these amounts are included in Note 11 to the Company’s audited financial statements for 2012 included in our annual report on Form 10-K for the year ended December 31, 2012.

(3) Director Gaebe retired in May 2012.

As of December 31, 2012, the Company had 108,887 non-qualified stock options outstanding to directors of the Company, of which 71,759 were exercisable. All stock options were granted at an exercise price of not less than one hundred percent (100%) of the fair market value of the stock on the date of the grant. All option amounts are adjusted to reflect stock splits and stock dividends.

Each option granted expires no later than ten (10) years from the date the option was granted. The vesting of non-qualified stock options occurs at a rate of 20% at date of grant and 20% per year afterward for a 100% vesting after the completion of four years of service. The non-qualified stock options granted in 2012 and 2011 are either 100% vested or 25% vested on the date of grant.

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ITEM 14 - PRINCIPAL ACCOUNTANT FEES AND SERVICES

Independent Accountant Fees Billed During 2012 and 2011

Aggregate fees billed by Crowe Horwath LLP and Perry-Smith LLP to Valley Commerce Bancorp and Valley Business Bank for the years ended 2011 and 2010 are as follows:

	2012		2011
Audit Fees (1)	$	187,000	$	189,000
Audit-Related Fees (2)		2,000		1,000
Tax Fees (3)		22,000		26,000
All Other Fees (4)		—		4,000
Total	$	211,000	$	220,000

(1) Audit fees consist of fees for professional services rendered for the audit of the Company’s consolidated financial statements, review of consolidated financial statements included in the Company’s quarterly reports and services normally provided by the independent auditor in connection with statutory and regulatory filings or engagements.

(2) Audit-related represent fees for professional services such as technical accounting, consulting and research.

(3) Tax services consist of compliance fees for the preparation of tax returns and tax payment-planning services. Tax services also include fees relating to other tax advice, tax consulting and planning other than for tax compliance and preparation.

(4) All other fees consist primarily of consulting services.

PART IV

ITEM 15 - EXHIBITS

Exhibits required to be filed are listed on the “Exhibit Index” attached hereto, which is incorporated herein by reference.

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SIGNATURES

In accordance with Section 13 or 15(d) of the Exchange Act, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. 

VALLEY COMMERCE BANCORP
By:	/s/ Allan W. Stone Allan W. Stone President and Chief Executive Officer
By:	/s/ Roy O. Estridge Roy O. Estridge Executive Vice President, Chief Financial Officer and Chief Operating Officer
Date:	March 29, 2013

POWER OF ATTORNEY

KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Allan W. Stone or Roy O. Estridge as his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign any and all amendments to this Report on Form 10-K, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in connection therewith, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof.

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In accordance with the Exchange Act, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

Signature	Title	Date
/s/ Allan W. Stone Allan W. Stone	Director and Chief Executive Officer (Principal Executive Officer)	March 29, 2013
/s/ Roy O. Estridge Roy O. Estridge	Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer)	March 29, 2013
/s/ Walter A. Dwelle Walter A. Dwelle	Chairman and Director	March 29, 2013
/s/ Donald A. Gilles Donald A. Gilles	Director	March 29, 2013
/s/ Philip R. Hammond, Jr. Philip R. Hammond, Jr.	Director	March 29, 2013
/s/ Russell F. Hurley Russell F. Hurley	Vice Chairman and Director	March 29, 2013
/s/ Fred P. LoBue, Jr. Fred P. LoBue, Jr.	Secretary and Director	March 29, 2013
/s/ Kenneth H. Macklin Kenneth H. Macklin	Director	March 29, 2013
/s/ Barry R. Smith Barry R. Smith	Director	March 29, 2013

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EXHIBIT INDEX

Exhibit	Description of Document
3.1	Articles of Incorporation of the Company, as amended (1)
3.2	Bylaws of the Company (1)
4.3	Specimen Stock Certificate (2)
4.4	Certificate of Determination of Series A Junior Participating Preferred Stock(7)
4.5	Certificates of Determination of Fixed Rate Cumulative Perpetual Preferred Stock, Series B and C (6)
10.1	Valley Commerce Bancorp Amended and Restated 1997 Stock Option Plan (1,3)
10.2	Salary Continuation Agreement with William R. Kitchen (3)
10.3	Executive Supplemental Compensation Agreement with Donald A. Gilles  (1,3)
10.4	Executive Supplemental Compensation Agreement with Roy O. Estridge (1,3)
10.5	Executive Supplemental Compensation Agreement with Allan W. Stone (1,3)
10.6	Split Dollar Life Insurance Agreement with William R. Kitchen (3)
10.7	Valley Commerce Bancorp 2007 Equity Incentive Plan (4)
10.8	Indenture between Valley Commerce Bancorp and Wells Fargo Bank National Association as Trustee, Junior Subordinated Debt Securities Due April 7, 2033 (1)
10.9	Junior Subordinated Debt Security Due 2003 of Valley Commerce Bancorp (1)
10.10	Guaranty Agreement of Valley Commerce Bancorp in favor of Wells Fargo Bank National Association as Trustee (1)
10.11	Letter Agreement dated January 30, 2009 by and between Valley Commerce Bancorp, Inc. and the United States Department of the Treasury and Securities Purchase Agreement – Standard Terms attached thereto (6)
10.12	Side Letter Agreement between Valley Commerce Bancorp and the United States Department of the Treasury regarding authorized number of directors and amended Section 2.2 of Valley Commerce Bancorp by-laws (6)
10.13	Specimen form of Incentive Stock Option Agreement under the 2007 Equity Incentive Plan is included as Exhibit 10.7 to the Registrant’s 10-Q for December 31, 2007, which is incorporated by this reference herein.
10.14	Specimen form of Long Term Restricted Share Award Agreement is included as Exhibit 10.1 to the Registrant’s Form 8-K for March 30, 2011, which is incorporated by this reference herein (3)
21	Subsidiaries of the Company (1)
23.2	Consent of Independent Registered Public Accounting Firm dated March 30, 2012 (5)
24	Powers of Attorney (included on signature pages)
31	Rule 13a-14(a)/15d-14(a) Certifications
32	Section 1350 Certifications

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(1) Incorporated by reference to the same-numbered exhibit to the Company’s Registration Statement on Form SB-2, filed September 9, 2004.

(2) Incorporated by reference to the same-numbered exhibit to the Company’s Registration Statement on Form SB-2/A, filed October 27, 2004.

(3) Management contract or compensatory plan or arrangement.

(4) Incorporated by reference to the Company’s definitive proxy statement for its 2007 annual meeting of shareholders, filed on April 18, 2007.

(5) Incorporated by reference to the same-numbered exhibit to the Company’s Registration Statement on Form S-8, filed on March 27, 2009.

(6) Incorporated by reference to the exhibits included with the Form 8-K that was filed by the Company on February 5, 2009.

(7) Incorporated by reference to Exhibit A to the Exhibit 4 included with the Form 8-A that was filed by the Company on July 27, 2006.

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