SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10 - K (x) ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [Fee Required] For the year ended: December 31, 1996 Commission File: 0-11090 NAPA NATIONAL BANCORP (Exact name of registrant as specified in its charter) California 94-2780134 (State of incorporation) (I.R.S. Identification No.) 901 Main Street, Napa, California, 94559 (Address of principal executive offices) Registrant's telephone number: (707) 257-2440 Securities registered pursuant to Section 12(b) of Act: None Securities registered pursuant to Section 12(g) of Act: Common Stock, Without Par Value (Title of Class) 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: 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 the 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. ( ) Aggregate market value of voting stock held by nonaffiliates of the registrant as of February 28, 1997: $2,564,000 Number of shares of Common Stock outstanding of the registrant's Common Stock, without par value, as of February 28, 1997 was 754,500. Fully diluted shares outstanding at this date was 906,050. DOCUMENTS INCORPORATED BY REFERENCE Portions of Registrant's Definitive Proxy Statement for Registrant's 1997 Annual Meeting of Shareholders is included in Part III, Items 10, 11, 12, and 13, are incorporated herein by reference. Registrant's Current Report on Form 8-K filed with the Commission on September 26, 1996 and amended October 23, 1996 is incorporated herein by reference in Part II, Item 9 herein. 1 TABLE OF CONTENTS PART I Item 1. Business Item 2. Properties Item 3. Legal Proceedings Item 4. Submission of Matters to a Vote of Security Holders PART II Item 5. Market for Registrant's Common Equity and Related Stockholder Matters Item 6. Selected Financial Data Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation Item 8. Financial Statements and Supplementary Data Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure PART III Item 10. Directors and Executive Officers of the Registrant Item 11. Executive Compensation Item 12. Security Ownership of Certain Beneficial Owners and Management Item 13. Certain Relationships and Related Transactions PART IV Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K SIGNATURES 2 PART I ITEM 1. BUSINESS. (A) GENERAL. Certain statements in this Annual Report on Form 10-K include forward- looking information within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and are subject to the "safe harbor" created by those sections. These forward-looking statements involve certain risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. Such risks and uncertainties include, but are not limited to, the following factors: competitive pressure in the banking industry increases significantly; changes in the interest rate environment reduce margins; general economic conditions, either nationally or regionally, are less favorable than expected, resulting in, among other things, a deterioration in credit quality and an increase in the provision for possible loan losses; changes in the regulatory environment; changes in business conditions, particularly in Napa County and the wine industry; volatility of rate sensitive deposits; operational risks including data processing system failures or fraud; asset/liability matching risks and liquidity risks; and changes in the securities markets. See also "Certain Additional Business Risks" included herein in Item 1 and other risk factors discussed elsewhere in this Report. Napa National Bancorp (the "Company") was incorporated in 1981 in the State of California and is headquartered in Napa, California. The Company is a bank holding company. Its subsidiary, Napa National Bank (the "Bank"), was organized as a national banking association in 1982. At December 31, 1996, the Company had consolidated assets of $113,827,000 and shareholders' equity of $7,971,000. The Bank is a full service commercial bank with three offices serving the Napa Valley area in Northern California. The Company itself does not engage in any business activities other than the ownership of the Bank and the ownership of Napa National Leasing Corporation, an inactive subsidiary authorized to engage in the leasing of equipment and other personal property (the "Leasing Company"). W. Clarke Swanson, Jr., Chairman of the Board and CEO, beneficially owns approximately 70% of the outstanding shares of Common Stock of the Company. The Company is registered under the Bank Holding Company Act of 1956, as amended. The Bank provides a wide range of commercial banking services to individuals, professionals and small- and medium-sized businesses in the Napa Valley area. The services provided include those typically offered by commercial banks, such as: checking, interest checking, savings, and time deposit accounts, commercial, construction, personal, home improvement, mortgage, automobile and other installment and term loans, travelers' checks, night depository facilities, wire transfers, merchant card services, courier service and automated teller machines. The Bank does not provide international banking or trust services but has arranged for its correspondent banks to offer these and other services to its customers on an as needed basis. 3 Individuals, small businesses and professionals, manufacturers, distributors, retailers, wineries, vineyard owners, real estate developers and the Bank's shareholders currently form the core of the Bank's customer and deposit base. In order to attract these customers, the Bank offers extensive personalized contact, specialized services and banking convenience, including Saturday banking hours. EXISTING LOCATIONS In addition to the Bank's head offices at 901 Main Street in Downtown Napa, the Bank has two branch offices, one in St. Helena and one in North Napa. All three facilities offer full service to the Bank's customers. See "Item 2. - Properties" herein. DEPOSITS Most of the Bank's deposits are obtained from individuals, professional firms and small- to medium-sized businesses from the Bank's service area. As of December 31, 1996, the Bank had a total of 9,580 accounts representing 6,292 demand accounts with an average balance of approximately $8,664 each, 2,106 savings accounts with an average balance of approximately $5,708 each, and 1,182 other time accounts with an average balance of approximately $30,489 each. OTHER BORROWINGS At December 31, 1996 and 1995, the Bank had no borrowed funds. LENDING ACTIVITIES The Bank concentrates its lending activities in four areas: commercial loans, short-term real estate and construction loans, mortgage loans, and loans to individuals or households, automobile and other personal expenditures. At December 31, 1996, these four loan categories accounted for approximately 66%, 11%, 6% and 17%, respectively, of the Bank's loan portfolio. Within these categories, $10,933,000, or 14%, of the loan portfolio, relates to the winery and vineyard segment of the agricultural industry with commitments to lend an additional $4,670,000. Under federal regulations applicable to national banks, at December 31, 1996, in general, the Bank cannot make loans to one borrower in excess of $1,390,000. For borrowers desiring loans in excess of the Bank's lending limit, the Bank may make such loans on a participation basis with other banks, without recourse to the Bank. In other cases, the Bank may refer such borrowers to larger banks or lending institutions. The interest rates charged for the various loans made by the Bank vary with the degree of risk, size and maturity of the loans involved and are generally affected by competition, governmental regulation and current money market rates. The Bank's construction and mortgage loans are not concentrated in any one category and include loans to individuals, partnerships and corporations. As of December 31, 1996, the Bank had gross loans outstanding of $79,695,000 and undisbursed loan commitments of $21,351,000. 4 COMMITMENTS AND LINES OF CREDIT The Bank makes contractual commitments to extend credit. Such commitments are usually made in the form of revolving lines of credit or term loans with one or more takedowns. Such commitments typically mature within one to three years. The Bank also extends standby letters of credit which support the obligations of Bank customers to third parties. At December 31, 1996, the Bank had $20,467,000 in commitments to extend credit and $865,000 in standby letters of credit. CORRESPONDENT BANKS At December 31, 1996, the Bank had correspondent relationships with Wells Fargo Bank, Bank of America National Trust and Savings Association, and Union Bank of California. These relationships are a result of the Bank's efforts to obtain a wide range of services for the Bank and its customers and, as a net seller of federal funds (overnight interbank loans), to minimize the risk of undue concentration of its resources with a few entities. The Bank does not currently serve, nor does it have plans to serve, as a correspondent to other banks. EMPLOYEES At December 31, 1996, the Bank employed 75 employees, including 26 officers and 12 part-time employees. At December 31, 1996, the Company employed one employee. (B) NAPA NATIONAL LEASING CORPORATION - COMPANY SUBSIDIARY This subsidiary was inactive during 1996. (C) SELECTED STATISTICAL INFORMATION The following tables present certain consolidated statistical information concerning the business of the Company and its subsidiaries. This information should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations", included herein at Item 7, and the Company's consolidated financial statements and the notes thereto included herein at Item 14. During 1996 and prior years, the Company did not own any tax-exempt securities. 5 DISTRIBUTION OF AVERAGE ASSETS, LIABILITIES AND SHAREHOLDERS' EQUITY The following table sets forth the distribution of consolidated average assets, liabilities and shareholders' equity for the years ended December 31, 1996 and 1995. Average balances have been computed using daily adjusted balances. YEAR ENDED DECEMBER 31, 1996 1995 AVERAGE AVERAGE BALANCE PERCENT BALANCE PERCENT (000'S) OF TOTAL (000'S) OF TOTAL ASSETS Cash and Due from Banks $ 6,100 5.9% $ 5,546 6.0% Interest-Bearing Deposits With Other Banks 4,210 4.0 4,356 4.7 Taxable Investment Securities 2,087 2.0 1,387 1.5 Federal Funds Sold 10,844 10.4 10,285 11.1 Loans, Net (1) 77,064 74.0 67,092 72.7 Premises and Equipment, Net 2,484 2.4 2,080 2.3 Other Assets and Accrued Interest Receivable 1,391 1.3 1,595 1.7 Total Assets $104,180 100.0% $92,341 100.0% LIABILITIES AND SHAREHOLDERS' EQUITY Deposits: Demand $ 19,284 18.5% $15,752 17.1% Interest-Bearing Transaction Accounts 27,970 26.8 24,682 26.7 Savings 12,071 11.6 12,151 13.2 Time 36,600 35.1 32,503 35.2 Total Deposits 95,925 92.0 85,088 92.2 Other Liabilities and Accrued Interest 487 0.5 540 0.5 Shareholders' Equity 7,768 7.5 6,713 7.3 Total Liabilities and Shareholders's Equity $104,180 100.0% $92,341 100.0% - -------------------- 1) Average loans include net deferred loan fees and non-accrual loans and are net of the allowance for loan losses. 6 INTEREST RATES AND DIFFERENTIALS The following table sets forth information concerning interest-earning assets and interest-bearing liabilities, respective average yields or rates, the amount of interest income or expense, and the net interest margin and the net interest spread. Loan fees of $409,000 in 1996 and $294,000 in 1995 are included, while non-accrual interest is excluded from computations of interest income and expense. YEAR ENDED DECEMBER 31, 1996 INTEREST AVERAGE INCOME/ AVERAGE BALANCE EXPENSE YIELD/ (000'S) (000'S) RATE INTEREST-EARNING ASSETS Loans, Net (1,2) $77,064 $8,277 10.74% Interest-Bearing Deposits With Other Banks 4,210 230 5.46 Taxable Investment Securities 2,087 119 5.70 Federal Funds Sold 10,844 547 5.04 Total Average Interest-Earning Assets $94,205 $9,173 9.74% INTEREST-BEARING LIABILITIES Deposits: Interest-Bearing Transaction Accounts $27,970 $ 563 2.01% Savings 12,071 275 2.28 Time 36,600 1,976 5.40 Total Average Interest-Bearing Liabilities $76,641 $2,814 3.67% Net Interest Income and Net Interest Margin (3) $6,359 6.75% Net Interest Spread (4) 6.07% 1) Average loans include net deferred loan fees and non-accrual loans and are net of allowance for loan losses. 2) Loan interest income includes loan fees of $409,000. 3) Net interest margin is computed by dividing net interest income by total average interest-earning assets. 4) Net interest spread represents the average yield earned on interest- earning assets less the average rate paid on interest-bearing liabilities. 7 YEAR ENDED DECEMBER 31, 1995 INTEREST AVERAGE INCOME/ AVERAGE BALANCE EXPENSE YIELD/ (000'S) (000'S) RATE INTEREST-EARNING ASSETS Loans, Net (1,2) $67,092 $7,515 11.20% Interest-Bearing Deposits With Other Banks 4,356 251 5.76 Taxable Investment Securities 1,387 83 5.98 Federal Funds Sold 10,285 583 5.67 Total Average Interest-Earning Assets $83,120 $8,432 10.14% INTEREST-BEARING LIABILITIES Deposits: Interest-Bearing Transaction Accounts $24,682 $ 517 2.09% Savings 12,151 292 2.40 Time 32,503 1,825 5.61 Total Average Interest-Bearing Liabilities $69,336 $2,634 3.80% Net Interest Income and Net Interest Margin (3) $5,798 6.98% Net Interest Spread (4) 6.34% 1) Average loans include net deferred loan fees and non-accrual loans and are net of allowance for loan losses. 2) Loan interest income includes loan fees of $294,000. 3) Net interest margin is computed by dividing net interest income by total average interest-earning assets. 4) Net interest spread represents the average yield earned on interest- earning assets less the average rate paid on interest-bearing liabilities. 8 RATE AND VOLUME ANALYSIS The following tables set forth, for the periods indicated, a summary of the changes in average interest bearing asset and liability balances (volume) and changes in average interest rates (rate). Where significant, the change in interest due to both volume and rate has been allocated to the change due to volume and rate in proportion to the relationship of absolute dollar amounts in each. Insignificant changes have been allocated solely to the change due to volume. YEAR ENDED DECEMBER 31, 1996 COMPARED TO YEAR ENDED DECEMBER 31, 1995 (IN 000'S) AVERAGE AVERAGE NET VOLUME RATE CHANGE INCREASE (DECREASE) IN INTEREST INCOME: Loans, Net $1,116 $(354) $762 Interest-Bearing Deposits With Other Banks (9) (12) (21) Taxable Investment Securities 42 (6) 36 Federal Funds Sold 32 (68) (36) Total Increase (Decrease) 1,181 (440) 741 INTEREST (DECREASE) IN INTEREST EXPENSE: Deposits: Interest-Bearing Transaction Accounts 68 (22) 46 Savings (2) (15) (17) Time 228 (77) 151 Total Increase (Decrease) 294 (114) 180 Change in Net Interest Income $ 887 $(326) $561 9 YEAR ENDED DECEMBER 31, 1995 COMPARED TO YEAR ENDED DECEMBER 31, 1994 (IN 000'S) AVERAGE AVERAGE NET VOLUME RATE CHANGE INCREASE (DECREASE) IN INTEREST INCOME: Loans, Net $896 $1,000 $1,896 Interest-Bearing Deposits With Other Banks 38 65 103 Taxable Investment Securities 19 17 36 Federal Funds Sold (18) 189 171 Total Increase 935 1,271 2,206 INTEREST (DECREASE) IN INTEREST EXPENSE: Deposits: Interest-Bearing Transaction Accounts (1) 48 47 Savings (37) 6 (31) Time 377 583 960 Total Increase 339 637 976 Change in Net Interest Income $596 $634 $1,230 10 INVESTMENT SECURITIES AND FEDERAL RESERVE STOCK The Bank's classification of its investment in debt and equity securities according to the provisions of SFAS 115 are as follows: DECEMBER 31, 1996 - INVESTMENT SECURITIES GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR COST GAINS LOSSES VALUE Held-to-Maturity Securities U.S. Treasury (HTM) $1,723,000 $27,000 $0 $1,750,000 DECEMBER 31, 1995 - INVESTMENT SECURITIES GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR COST GAINS LOSSES VALUE Held-to-Maturity Securities U.S. Treasury (HTM) $1,235,000 $15,000 $0 $1,250,000 The Company had Federal Reserve and Federal Home Loan Bank Stock totalling $554,000 and $197,000, at December 31, 1996 and 1995, respectively. Yields on securities have been calculated by dividing interest income, adjusted for amortization of any premium and accretion of any discount, by the book value of the related securities. The Company's Federal Reserve and Federal Home Loan Bank Stocks have no maturity and a weighted average yield of 6.0%. All of the Company's U.S. Treasury securities have a maturity of less than twelve months and a weighted average yield of 5.4%. LOAN PORTFOLIO The Company's primary service area is Napa County and the Carneros growing region of Sonoma County. The Company's portfolio of loans consists of real estate mortgage and construction loans, commercial and consumer loans. At December 31, 1996, the Company's real estate construction portfolio totaled $8,706,000. Real estate loans consisted of single family residences to developers and owner-builders with a history of successfully developing projects in the Company's market area. The loan-to-value ratio on each real estate construction loan required by the Company depends upon the amount of the loan, the nature of the property, whether the property is residential or commercial and whether or not it is owner occupied. For construction loans, the Company's policy is to require that the loan-to-value ratio generally be no more than 70% when the loan is initially made and that the borrower generally has no less than a 50% equity interest in the land. Substantially all of the real estate construction portfolio is secured by real estate located within the Company's service area. 11 Conventional real estate loans totaled $4,918,000 at December 31, 1996. The loan-to-value ratio required by the Company on conventional real estate loans depends upon the nature of the property and whether or not it is owner-occupied. For owner-occupied conventional real estate loans, the Company usually requires that the loan-to-value ratio be no more than 80% except when private mortgage insurance is required, whereupon the Company may allow the loan-to-value ratio to rise generally to no more than 85% when the loan is initially made. Generally, non-owner-occupied conventional real estate loans must have loan-to- value ratios not exceeding 70% when the loan is made. The entire real estate mortgage portfolio is generally secured by first or second deeds of trust. Substantially all of the secured property is located within the Company's service area. At December 31, 1996, commercial loans totaled $52,789,000. Commercial lending is primarily to professionals and companies with sales up to $10 million. The Company's lending relationships generally involve companies with sales of no more than $30 million. Substantially all of the commercial loan portfolio is secured, some of which may include real estate collateral. Such loans are not intended as permanent financing of real estate but are made for commercial purposes and are secured by commercial real estate. The Company evaluates such loans based upon the borrower's ability to service the debt through its business operations and does not rely primarily on the value of the real estate collateral for repayment. The remaining portfolio is secured by accounts receivables, inventory, equipment, stock and deposits held by the Company. Total consumer loans, including personal lines of credit, were $13,282,000 at December 31, 1996. Included in consumer loans to individuals are home equity lines of credit, totaling $9,066,000, which are secured primarily by second trust deeds on single family residences. The Company requires a debt-to-value ratio of not higher than 75% for most home equity loans when the loan is initially made. The remaining portfolio is collateralized by automobiles, computers and other equipment, and deposits held by the Company. Over 70% of the Company's consumer portfolio is secured. The Company had standby letters of credit outstanding of $865,000 and $646,000 at December 31, 1996 and December 31, 1995, respectively. In addition, the Company had commitments to fund real estate construction loans, commercial loans and consumer loans of $2,684,000, $17,670,000 and $997,000, respectively, at December 31, 1996. The Company did not have any loans related to lease financing activities in the loan portfolio at December 31, 1996. 12 The following table shows the composition of the Bank's loan portfolio by type of loan or borrower as of December 31, 1996 and 1995: DECEMBER 31, 1996 1995 (IN 000'S) Commercial $52,789 $48,407 Real Estate--Construction 8,706 7,850 Real Estate--Mortgage 4,918 4,729 Installment Loans and Leases 4,216 3,376 Personal Lines of Credit and Other 9,066 10,337 Total Loans 79,695 74,699 Less Allowance for Loan Losses (1,405) (1,325) Total Loans, Net $78,290 $73,374 In recent years, California commercial real estate markets in general have experienced some difficulties. While these developments have not, in the judgment of management, had a material adverse impact on the Bank's business, there can be no assurance that further softening of the California real estate market will not occur, nor can any assurance be given as to the effect of any such developments on the Bank's business. Further increases in interest rates could adversely impact real estate values or the ability of borrower to satisfy the material terms of such loans. During the beginning of 1997, the Napa Valley was subjected to severe weather conditions that resulted in some areas of the Valley flooding from high rain fall levels. Most of the flooding resulted in areas near the Napa River on dormant fields. Management believes that this flooding did not have a direct or material impact on the collateral underlying portions of the existing loan portfolio. LOAN CONCENTRATIONS At December 31, 1996, approximately $55,680,000, or 70% of the loan portfolio was secured by commercial or residential real estate. Concentrations of the Bank's lending activity in the real estate sector could have the effect of intensifying the impact on the Bank if there are any adverse changes in the real estate market in the Bank's lending area. The Bank is located in the Napa Valley and a significant amount of its loans are related to winery and vineyard operations. Loans related to winery and vineyard operations constituted approximately $10,933,000, or 14% of total loans at December 31, 1996, as compared to $6,913,000, or 9% of total loans, at December 31, 1995. A downturn in the wine industry in the Napa Valley or a disruption in wine production, which may result from extreme weather conditions, plant diseases or other natural causes, competition, changes in governmental regulatory or tax policies, or changes in consumer preferences, could have a significant adverse impact on the Company's results of operations and financial condition. 13 NONPERFORMING ASSETS The following table shows the Company's nonperforming assets by category as of December 31, 1996 and 1995: DECEMBER 31, 1996 1995 (In 000'S) Nonperforming assets: Nonaccrual Loans including loans past due 90 days $3,152 $1,447 Other Real Estate Owned 328 0 Total Nonperforming Assets $3,480 $1,447 Management analyzes each loan on a case by case basis to determine when, in management's opinion, interest should no longer be accrued. This occurs when management determines the ultimate collectibility of principal or interest to be unlikely or when loans become 90 days or more past due, unless they are well secured and in the process of collection or unless other circumstances exist which justify the treatment of the loan as fully collectible. When a loan is placed on nonaccrual status, unpaid interest is reversed and charged against current income. Interest income on nonaccrual loans at December 31, 1996 which would have been recognized during the year if the loans had been current in accordance with their original terms totaled $188,000 versus $291,000 for the same period in 1995. As of December 31, 1996 and 1995, other real estate owned totaled $328,000 and $0, respectively. It is the Company's policy to write foreclosed property down to the lower of fair market value less estimated selling costs or cost at the time it is reclassified into other real estate owned. Miscellaneous expenses relating to the property are charged to other noninterest expenses as incurred. As of the date of this filing, there were no other loans, other than those included in the table above, where known information concerning possible credit problems of borrowers caused management to have serious doubts as to the ability of the borrower to comply with the present loan repayment terms such that they may become nonperforming loans. See "Nonperforming Assets" herein. At December 31, 1996, pursuant to SFAS 114, the Company's total recorded investment in nonaccrual loans was $3,152,000, of which there was a related allowance for credit losses of $204,000. The average recorded investment in nonaccrual loans during 1996 was $2,123,000. Related interest income recognized on impaired loans during the year ended December 31, 1996, under the cash-basis method of accounting was approximately $44,000. 14 SUMMARY OF LOAN LOSS EXPERIENCE Inherent in the lending function is the fact that loan losses will be experienced and that the risk of loss will vary with the type of loan being made and the credit-worthiness of the borrower over the term of the loan. The Company has an allowance for loan losses which is maintained at a level estimated to be adequate to provide for losses that can be reasonably anticipated based upon specific loan conditions as determined by management, historical loan loss experience, the amount of past due and nonperforming loans, comments of third- party loan review consultants, prevailing economic conditions and other factors. While these factors are essentially judgmental and may not be reduced to a mathematical formula, it is management's view that the $1,405,000 allowance, which constitutes 1.76% of total loans at December 31, 1996, was adequate as an allowance against foreseeable losses from the loan portfolio. The allowance was $1,325,000, or 1.77%, of the total loan portfolio at December 31, 1995. The allowance is increased by charges to the provision for loan losses and reduced by net charge-offs. The continuing evaluation of the loan portfolio and assessment of current economic conditions will dictate future allowance levels. An analysis of the allowance for loan losses for the years ending December 31, 1996 and 1995 follows: DECEMBER 31, 1996 1995 (IN 000'S) ALLOWANCE FOR LOAN LOSSES: Balance, Beginning of Year $ 1,325 $ 1,050 Provision Charged to Expense 550 323 Loans Charged Off: Commercial (297) (20) Personal Lines of Credit and Other (177) (31) Real Estate Construction (70) 0 Total Loans Charged Off (544) (51) Recoveries: Commercial 71 0 Personal Lines of Credit and Other 3 3 Total Recoveries 74 3 Net Loans (Charged Off) Recovered (470) (48) Balance, End of year $ 1,405 $ 1,325 Average Gross Loans Outstanding During Period $78,861 $68,499 Total Gross Loans at End of Year $79,695 $74,699 RATIOS: Net Loans Charged Off to Average Loans Outstanding 0.60% 0.07% Net Loans Charged Off to Total Loans at End of Year 0.59% 0.06% Allowance for Loan Losses to Average Loans 1.78% 1.93% Allowance for Loan Losses to Total Loans at End of Year 1.76% 1.77% Net Loans Charged Off to Allowance for Loan Losses at End of Year 33.45% 3.62% Net Loans Charged Off to Provision for Loan Losses 85.45% 14.86% 15 The table set forth below shows a breakdown of the portfolio of loans at the dates indicated and the amount of the allowance that has been allocated as of those dates to each of the loan categories. Management believes that any breakdown or allocation of the allowance for possible loan losses into loan categories lends an appearance of exactness which does not exist, in that the reserve is ultimately utilized as a single unallocated allowance available for all loans. DECEMBER 31, 1996 DECEMBER, 31, 1995 PERCENT PERCENT OF LOANS OF LOANS IN EACH IN EACH CATEGORY CATEGORY AMOUNT OF TO TOTAL AMOUNT OF TO TOTAL ALLOWANCE LOANS ALLOWANCE LOANS (000'S) (000'S) Commercial $ 920 74% $ 731 62% Real Estate-Construction 119 10 123 11 Real Estate-Mortgage 162 13 119 10 Installment Loans and Leases 3 0 77 7 Personal Lines of Credit and Other 44 3 120 10 Unallocated 157 155 Total $1,405 100% $1,325 100% MATURITY DISTRIBUTION AND INTEREST RATE SENSITIVITY OF LOANS The following table shows the maturity distribution of the portfolio of loans and leases in thousands as of December 31, 1996 and sets forth the sensitivity to changes in interest rates by comparing total loans with fixed interest rates and total loans with floating or adjustable rates. AFTER ONE THROUGH AFTER ONE YEAR FIVE FIVE OR LESS YEARS YEARS TOTAL (In 000's) Commercial $50,363 $2,402 $ 24 $52,789 Real Estate-Construction 8,674 32 0 8,706 Real Estate-Mortgage 3,648 974 296 4,918 Installment Loans & Leases 2,090 2,126 0 4,216 Personal Lines of Credit & Other 9,011 55 0 9,066 Total $73,786 $5,589 $320 $79,695 Loans With Fixed Interest Rates $ 1,238 $3,890 $320 $ 5,448 Loans With Floating Interest Rates 72,548 1,699 0 74,247 Total $73,786 $5,589 $320 $79,695 16 DEPOSITS The following table reflects average balances and the average rates paid for the major categories of deposits for the years ended December 31, 1996 and 1995: YEAR ENDED DECEMBER 31, 1996 1995 AVERAGE AVERAGE AVERAGE AVERAGE BALANCE RATE BALANCE RATE (000'S) (000'S) Noninterest-Bearing Demand $19,284 0.00% $15,752 0.00% Interest-Bearing Transaction Accounts 27,970 2.01 24,682 2.09 Savings Deposits 12,071 2.28 12,151 2.40 Time Deposits over 100,000 9,987 5.20 7,551 5.19 Other Time Deposits 26,613 5.47 24,952 5.74 Total Deposits $95,925 3.67% $85,088 3.80% The following table sets forth, by time remaining to maturity, the domestic time deposits in amounts of $100,000 or more at December 31, 1996: Amount Maturing In: (000's) Three Months or Less $ 5,287 Over Three Through Twelve Months 4,224 Over Twelve Months 1,317 Total $10,828 SELECTED FINANCIAL RATIOS The following table sets forth certain financial ratios for the periods indicated (averages are computed using daily figures): YEAR ENDED DECEMBER 31, 1996 1995 Net income to: Average earning assets 0.94% 1.30% Average total assets 0.87 1.19 Average shareholders' equity 11.61 16.40 Average shareholders' equity to: Average total assets 7.46% 7.27% Average net loans 10.08 10.01 Average total deposits 8.10 7.92 Average earning assets to: Average total assets 92.15% 91.52% Average total deposits 100.08 99.67 Percent of average total deposits: Average net loans 80.33% 79.12% Average noninterest-bearing deposits 20.10 18.56 Average savings and other time deposits 50.74 52.38 Total interest expense to: Total gross interest income 30.68% 31.24% Dividend Pay-out Ratio 41.82% 0.00% 17 THE EFFECT OF GOVERNMENT POLICY ON BANKING The earnings and growth of the Bank are affected not only by local market area factors and general economic conditions, but also by government monetary and fiscal policies. For example, the Board of Governors of the Federal Reserve System ("FRB") influences the supply of money through its open market operations in U.S. Government securities and adjustments to the discount rates applicable to borrowings by depository institutions and others. Such actions influence the growth of loans, investments and deposits and also affect interest rates charged on loans and paid on deposits. The nature and impact of future changes in such policies on the business and earnings of the Bank cannot be predicted. Additionally, state and federal tax policies can impact banking organizations. Effective January 1, 1997, applicable California bank and corporation tax rates were reduced by 5% in order to keep California competitive with other western states. As a consequence of the extensive regulation of commercial banking activities in the United States, the business of the Company is particularly susceptible to being affected by the enactment of federal and state legislation which may have the effect of increasing or decreasing the cost of doing business, modifying permissible activities or enhancing the competitive position of other financial institutions. Any change in applicable laws or regulations may have a material adverse effect on the business and prospects of the Company. In response to various business failures in the savings and loan industry and in the banking industry, in December 1991, Congress enacted, and the President signed into law, the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"). FDICIA substantially revised the bank regulatory framework and deposit insurance funding provisions of the Federal Deposit Insurance Act and made revisions to several other federal banking statutes. Implementation of the various provisions of FDICIA is subject to the adoption of regulations by the various regulatory agencies, the manner in which the regulatory agencies implement those regulations and certain phase-in periods. REGULATION AND SUPERVISION OF BANK HOLDING COMPANIES The Company is a bank holding company subject to the Bank Holding Company Act of 1956, as amended ("BHCA"). The Company reports to, registers with, and may be examined by, the FRB. The FRB also has the authority to examine the Company's subsidiaries. The costs of any examination by the FRB are payable by the Company. The FRB has significant supervisory and regulatory authority over the Company and its affiliates. The FRB requires the Company to maintain certain levels of capital. See "Capital Standards." The FRB also has the authority to take enforcement action against any bank holding company that commits any unsafe or unsound practice, or violates certain laws, regulations or conditions imposed in writing by the FRB. See "Prompt Corrective Action and Other Enforcement Mechanisms." 18 Under the BHCA, a company generally must obtain the prior approval of the FRB before it exercises a controlling influence over a bank, or acquires directly or indirectly, more than 5% of the voting shares or substantially all of the assets of any bank or bank holding company. Thus, the Company is required to obtain the prior approval of the FRB before it acquires, merges or consolidates with any bank or bank holding company; any company seeking to acquire, merge or consolidate with the Company also would be required to obtain the approval of the FRB. The Company is generally prohibited under the BHCA from acquiring ownership or control of more than 5% of the voting shares of any company that is not a bank or bank holding company and from engaging directly or indirectly in activities other than banking, managing banks, or providing services to affiliates of the holding company. A bank holding company, with the approval of the FRB, may engage, or acquire the voting shares of companies engaged, in activities that the FRB has determined to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. A bank holding company must demonstrate that the benefits to the public of the proposed activity will outweigh the possible adverse effects associated with such activity. Pursuant to the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the "Interstate Banking and Branching Act"), a bank holding company became able to acquire banks in states other than its home state beginning September 29, 1995 without regard to the permissibility of such acquisitions under state law, but subject to any state requirement that the bank has been organized and operating for a minimum period of time, not to exceed five years, and the requirement that the bank holding company, prior to or following the proposed acquisition, controls no more than 10% of the total amount of deposits of insured depository institutions in the United States and no more than 30% of such deposits in that state (or such lesser or greater amount set by state law). The Interstate Banking and Branching Act also authorizes banks to merge across states lines, therefore creating interstate branches, beginning June 1, 1997. Under such legislation, each state has the opportunity to "opt out" of this provision, thereby prohibiting interstate branching in such states, or to "opt in" at an earlier time, thereby allowing interstate branching within that state prior to June 1, 1997. Furthermore, pursuant to such act, a bank is now able to open new branches in a state in which it does not already have banking operations, if the laws of such state permit such de novo branching. California enacted legislation to "opt in" to the Interstate Banking and Branching Act provisions regarding interstate branching, allowing a state bank chartered in a state other than California to acquire by merger or purchase, at any time after effectiveness of the Caldera, Weggeland, and Killea California Interstate Banking and Branching Act of 1995 ("IBBA"), a California bank or industrial loan company which is at least five (5) years old and thereby establish one or more California branch offices. However, the IBBA prohibits a state bank chartered in a state other than California from entering California by purchasing a California branch office of a California bank or industrial loan company without purchasing the entire entity or by establishing a de novo California branch office. See the section entitled "Recently Enacted Legislation" for additional information. Proposals to change the laws and regulations governing the banking industry are frequently introduced in Congress, in the state legislatures and before the various bank regulatory agencies. 19 The FRB generally prohibits a bank holding company from declaring or paying a cash dividend which would impose undue pressure on the capital of subsidiary banks or would be funded only through borrowing or other arrangements that might adversely affect a bank holding company's financial position. The FRB's policy is that a bank holding company should not continue its existing rate of cash dividends on its common stock unless its net income is sufficient to fully fund each dividend and its prospective rate of earnings retention appears consistent with its capital needs, asset quality and overall financial condition. Transactions between the Company and the Bank are subject to a number of other restrictions. FRB policies forbid the payment by bank subsidiaries of management fees which are unreasonable in amount or exceed the fair market value of the services rendered (or, if no market exists, actual costs plus a reasonable profit). Subject to certain limitations, depository institution subsidiaries of bank holding companies may extend credit to, invest in the securities of, purchase assets from, or issue a guarantee, acceptance, or letter of credit on behalf of, an affiliate, provided that the aggregate of such transactions with affiliates may not exceed 10% of the capital stock and surplus of the institution, and the aggregate of such transactions with all affiliates may not exceed 20% of the capital stock and surplus of such institution. The Company may only borrow from depository institution subsidiaries if the loan is secured by marketable obligations with a value of a designated amount in excess of the loan. Further, the Company may not sell a low-quality asset to a depository institution subsidiary. Generally, a bank holding company and its subsidiaries are prohibited from engaging in tie-in arrangements in connection with the extension of credit, sale or lease of property or furnishing of services unless the FRB permits an exception to the tying prohibitions pursuant to exemption authority available to it under applicable law. The FRB, however, has adopted a rule, effective September 2, 1994, amending the anti-tying provisions to permit a bank or bank holding company to offer a lower price on a loan, deposit or trust service (traditional bank product), or on securities brokerage services, on the condition that the customer obtain a traditional bank product from an affiliate. Additionally, as of January 23, 1995, a bank holding company, or a nonbank subsidiary, may offer lower prices on any of its products or services on the condition that the customer obtain another product or service from such company or any of its nonbank affiliates, provided that all products offered in the package arrangement are separately available for purchase. The Company is a bank holding company within the meaning of Section 3700 of the California Financial Code. As such the Company and the Bank are subject to examination by, and may be required to file reports with, the California Superintendent of Banks (the "Superintendent"). Regulations have not yet been proposed or adopted, and no other steps have been taken, to implement the Superintendent's power under this statute. 20 BANK REGULATION AND SUPERVISION As a national bank, the Bank is regulated, supervised and regularly examined by the Office of the Comptroller of the Currency ("OCC"). Deposit accounts at the Bank are insured by Bank Insurance Fund ("BIF"), as administered by the Federal Deposit Insurance Corporation ("FDIC"), to the maximum amount permitted by law. The Bank is also subject to applicable provisions of California law, insofar as such provisions are not in conflict with or preempted by federal banking law. The Bank is a member of the Federal Reserve System, and is also subject to certain regulations of the FRB dealing primarily with check clearing activities, establishment of banking reserves, Truth-in-Lending (Regulation Z), Truth-in-Savings (Regulation DD), and Equal Credit Opportunity (Regulation B). By comparison, California state-chartered banks are regulated by the California Superintendent of Banks (the "Superintendent"). Pursuant to AB 3351, which was adopted by the California legislature during 1996, all of the California state regulatory authorities for state-chartered depository institutions will be consolidated under a new state agency, the Department of Financial Institutions ("DFI") effective July 1, 1997. The newly created DFI combines the State Banking Department and the Department of Savings and Loan while regulatory oversight over industrial loan companies and credit unions will be shifted from the Department of Corporations to the DFI. During 1996 the California Interstate Banking and Branching Cleanup Act was enacted, which revised the Superintendent's assessment methodology for state-chartered banks in order to provide a better basis of comparison to the method used by the OCC. Under the new methodology, the average assessment for state banks will be approximately 39% of the OCC's annual charges for national bank supervision. During 1996, the OCC adopted a regulation to revise and streamline its procedures with respect to corporate activities of national banks, to be effective December 31, 1996. These revised standards allow the OCC to approve, on a case-by-case basis, the entry of bank operating subsidiaries into a business incidental to banking, including activities in which the parent bank is not permitted to engage. Such a standard allows a national bank to conduct an activity approved for a bank holding company through a bank operating subsidiary such as acting as an investment or financial advisor, leasing personal property and providing financial advice to customers. In general, these new standards will be available to well-capitalized or adequately capitalized national banks. CAPITAL STANDARDS The OCC and other federal banking agencies have risk-based capital adequacy guidelines intended to provide a measure of capital adequacy that reflects the degree of risk associated with a banking organization's operations for both transactions reported on the balance sheet as assets and transactions, such as letters of credit and recourse arrangements, which are recorded as off balance sheet items. Under these guidelines, nominal dollar amounts of assets and credit equivalent amounts of off balance sheet items are multiplied by one of several risk adjustment percentages, which range from 0% for assets with low credit risk, such as certain U.S. government securities, to 100% for assets with relatively higher credit risk, such as business loans. 21 In determining the capital level the Bank is required to maintain, the OCC does not, in all respects, follow generally accepted accounting principles ("GAAP") and has special rules which have the effect of reducing the amount of capital it will recognize for purposes of determining the capital adequacy of the Bank. These rules are called Regulatory Accounting Principles ("RAP"). In December 1993, the federal banking agencies issued an interagency policy statement on the allowance for loan and lease losses which, among other things, establishes certain benchmark ratios of loan loss reserves to classified assets. Future changes in OCC regulations or practices could further reduce the amount of capital recognized for purposes of capital adequacy. Such a change could affect the ability of the Company to grow and could restrict the amount of profits, if any, available for the payment of dividends. A banking organization's risk-based capital ratios are obtained by dividing its qualifying capital by its total risk-adjusted assets and off balance sheet items. The regulators measure risk-adjusted assets and off balance sheet items against both total qualifying capital (the sum of Tier 1 capital and limited amounts of Tier 2 capital) and Tier 1 capital. Tier 1 capital consists of common stock, retained earnings, noncumulative perpetual preferred stock, other types of qualifying preferred stock and minority interests in certain subsidiaries, less most other intangible assets and other adjustments. Net unrealized losses on available-for-sale equity securities with readily determinable fair value must be deducted in determining Tier 1 capital. Additionally as of April 1, 1995, for Tier 1 capital purposes, deferred tax assets that can only be realized if an institution earns sufficient taxable income in the future will be limited to the amount that the institution is expected to realize within one year, or ten percent of Tier 1 capital, whichever is less. Tier 2 capital may consist of a limited amount of the allowance for possible loan and lease losses, term preferred stock and other types of preferred stock not qualifying as Tier 1 capital, term subordinated debt and certain other instruments with some characteristics of equity. The inclusion of elements of Tier 2 capital are subject to certain other requirements and limitations of the federal banking agencies. Since December 31, 1992, the federal banking agencies have required a minimum ratio of qualifying total capital to risk-adjusted assets and off balance sheet items of 8%, and a minimum ratio of Tier 1 capital to adjusted average risk-adjusted assets and off balance sheet items of 4%. In addition to the risked-based guidelines, federal banking regulators require banking organizations to maintain a minimum amount of Tier 1 capital to adjusted average total assets, referred to as the leverage capital ratio. For a banking organization rated in the highest of the five categories used by regulators to rate banking organizations, the minimum leverage ratio of Tier 1 capital to total assets must be 3%. It is improbable, however, that an institution with a 3% leverage ratio would receive the highest rating by the regulators since a strong capital position is a significant part of the regulators' rating. For all banking organizations not rated in the highest category, the minimum leverage ratio must be at least 100 to 200 basis points above the 3% minimum. Thus, the effective minimum leverage ratio, for all practical purposes, must be at least 4% or 5%. In addition to these uniform risk-based capital guidelines and leverage ratios that apply across the industry, the regulators have the discretion to set individual minimum capital requirements for specific institutions at rates significantly above the minimum guidelines and ratios. 22 The following tables present the capital ratios for the Company and the Bank, compared to the standards for well-capitalized depository institutions, as of December 31, 1996 (amounts in thousands except percentage amounts). THE COMPANY WELL MINIMUM ACTUAL CAPITALIZED CAPITAL CAPITAL RATIO RATIO REQUIREMENT Leverage........... $7,971 7.21% 5.0% 4.0% Tier 1 Risk-Based.. 7,971 9.34 6.0 4.0 Total Risk-Based... 9,376 10.99 10.0 8.0 THE BANK WELL MINIMUM ACTUAL CAPITALIZED CAPITAL CAPITAL RATIO RATIO REQUIREMENT Leverage........... $7,862 7.11% 5.0% 4.0% Tier 1 Risk-Based.. 7,862 9.22 6.0 4.0 Total Risk-Based... 8,932 10.47 10.0 8.0 Banking agencies have recently adopted final regulations which mandate that regulators take into consideration concentrations of credit risk and risks from non-traditional activities, as well as an institution's ability to manage those risks, when determining the adequacy of an institution's capital. This evaluation will be made as a part of the institution's regular safety and soundness examination. Banking agencies also have recently adopted final regulations requiring regulators to consider interest rate risk (when the interest rate sensitivity of an institution's assets does not match the sensitivity of its liabilities or its off-balance-sheet position) in evaluation of a bank's capital adequacy. This final rule does not codify a measurement framework for assessing the level of a bank's interest rate risk exposure. The information and exposure estimates collected through a new proposed supervisory measurement process, described in the banking agencies' joint policy statement on interest rate risk, would be one quantitative factor used to determine the adequacy of an individual bank's capital for interest rate risk. The focus of that proposed process is on a bank's economic value exposure. Other quantitative factors include the bank's historical financial performance and its earnings exposure to interest rate movements. Examiners also will consider qualitative factors, including the adequacy of the bank's internal interest rate risk management. The banking agencies intend for this case-by-case approach for assessing a bank's capital adequacy for interest rate risk to be a transitional arrangement. The second step will consist of a proposed rule that would establish an explicit minimum capital charge for interest rate risk, based on the level of a bank's measured interest rate risk exposure. The banking agencies intend to implement this second step at some future date, after the banking agencies and the banking industry have gained more experience with the proposed supervisory measurement and assessment process. 23 PROMPT CORRECTIVE ACTION AND OTHER ENFORCEMENT MECHANISMS FDICIA requires each federal banking agency to take prompt corrective action to resolve the problems of insured depository institutions, including but not limited to those that fall below one or more prescribed minimum capital ratios. The law required each federal banking agency to promulgate regulations defining the following five categories in which an insured depository institution will be placed, based on the level of its capital ratios: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. In September 1992, the federal banking agencies issued uniform final regulations implementing the prompt corrective action provisions of FDICIA. An insured depository institution generally will be classified in the following categories based on capital measures indicated below: "WELL CAPITALIZED" "ADEQUATELY CAPITALIZED" ------------------ ------------------------ Total risk-based capital of 10%; Total risk-based capital of 8%; Tier 1 risk-based capital of 6%; and Tier 1 risk-based capital of 4%; and Leverage ratio of 5%. Leverage ratio of 4%. "UNDERCAPITALIZED" "SIGNIFICANTLY UNDERCAPITALIZED" ------------------ -------------------------------- Total risk-based capital less than Total risk-based capital less than 6%; 8%; Tier 1 risk-based capital less than Tier 1 risk-based capital less than 3%; or 4%; or Leverage ratio less than 3%. Leverage ratio less than 4%. "CRITICALLY UNDERCAPITALIZED" ----------------------------- Tangible equity to total assets less than 2%. An institution that, based upon its capital levels, is classified as "well capitalized," "adequately capitalized" or "undercapitalized" may be treated as though it were in the next lower capital category if the appropriate federal banking agency, after notice and opportunity for hearing, determines that an unsafe or unsound condition or an unsafe or unsound practice warrants such treatment. At each successive lower capital category, an insured depository institution is subject to more restrictions. The federal banking agencies, however, may not treat an institution as "critically undercapitalized" unless its capital ratio actually warrants such treatment. If an insured depository institution is undercapitalized, it will be closely monitored by the appropriate federal banking agency. Undercapitalized institutions must submit an acceptable capital restoration plan with a guarantee of performance issued by the holding company. Further restrictions and sanctions are required to be imposed on insured depository institutions that are critically undercapitalized. The most important additional measure is that the appropriate federal banking agency is required to either appoint a receiver for the institution within 90 days, or obtain the concurrence of the FDIC in another form of action. 24 In addition to measures taken under the prompt corrective action provisions, commercial banking organizations may be subject to potential enforcement actions by the federal regulators for unsafe or unsound practices in conducting their businesses or for violations of any law, rule, regulation or any condition imposed in writing by the agency or any written agreement with the agency. Enforcement actions may include the imposition of a conservator or receiver, the issuance of a cease-and-desist order that can be judicially enforced, the termination of insurance of deposits (in the case of a depository institution), the imposition of civil money penalties, the issuance of directives to increase capital, the issuance of formal and informal agreements, the issuance of removal and prohibition orders against institution-affiliated parties and the enforcement of such actions through injunctions or restraining orders based upon a judicial determination that the agency would be harmed if such equitable relief was not granted. Additionally, a holding company's inability to serve as a source of strength to its subsidiary banking organizations could serve as an additional basis for a regulatory action against the holding company. SAFETY AND SOUNDNESS STANDARDS FDICIA also implemented certain specific restrictions on transactions and required federal banking regulators to adopt overall safety and soundness standards for depository institutions related to internal control, loan underwriting and documentation and asset growth. Among other things, FDICIA limits the interest rates paid on deposits by undercapitalized institutions, restricts the use of brokered deposits, limits the aggregate extensions of credit by a depository institution to an executive officer, director, principal shareholder or related interest, and reduces deposit insurance coverage for deposits offered by undercapitalized institutions for deposits by certain employee benefits accounts. In addition to the statutory limitations, FDICIA originally required the federal banking agencies to prescribe, by regulation, standards for all insured depository institutions for such things as classified loans and asset growth. In 1994 FDICIA was amended to (a) authorize the agencies to establish safety and soundness standards by regulation or by guideline for all insured depository institutions; (b) give the agencies greater flexibility in prescribing asset quality and earnings standards and (c) eliminate the requirement that such standards apply to depository institution holding companies. On July 10, 1995 the federal banking agencies published Interagency Guidelines Establishing Standards for Safety and Soundness. By adopting the standards as guidelines, the agencies retained the authority to require an institution to submit to an acceptable compliance plan as well as the flexibility to pursue other more appropriate or effective courses of action given the specific circumstances and severity of an institution's noncompliance with one or more standards. 25 RESTRICTIONS ON DIVIDENDS AND OTHER DISTRIBUTIONS The power of the board of directors of an insured depository institution to declare a cash dividend or other distribution with respect to capital is subject to statutory and regulatory restrictions which limit the amount available for such distribution depending upon the earnings, financial condition and cash needs of the institution, as well as general business conditions. FDICIA prohibits insured depository institutions from paying management fees to any controlling persons or, with certain limited exceptions, making capital distributions, including dividends, if, after such transaction, the institution would be undercapitalized. Regulators also have authority to prohibit a depository institution from engaging in business practices which are considered to be unsafe or unsound, possibly including payment of dividends or other payments under certain circumstances even if such payments are not expressly prohibited by statute. The payment of dividends by a national bank is further restricted by additional provisions of federal law, which prohibit a national bank from declaring a dividend on its shares of common stock unless its surplus fund exceeds the amount of its common capital (total outstanding common shares times the par value per share). Additionally, if losses have at any time been sustained equal to or exceeding a bank's undivided profits then on hand, no dividend shall be paid. Moreover, even if a bank's surplus exceeded its common capital and its undivided profits exceed its losses, the approval of the OCC is required for the payment of dividends if the total of all dividends declared by a national bank in any calendar year would exceed the total of its net profits of that year combined with its retained net profits of the two preceding years, less any required transfers to surplus or a fund for the retirement of any preferred stock. A national bank must consider other business factors in determining the payment of dividends. The payment of dividends by the Bank is governed by the Bank's ability to maintain minimum required capital levels and an adequate allowance for loan losses. Regulators also have authority to prohibit a depository institution from engaging in business practices which are considered to be unsafe or unsound, possibly including payment of dividends or other payments under certain circumstances even if such payment are not expressly prohibited by statute. PREMIUMS FOR DEPOSIT INSURANCE AND ASSESSMENTS FOR EXAMINATIONS FDICIA established several mechanisms to increase funds to protect deposits insured by the Bank Insurance Fund ("BIF") administered by the FDIC. The FDIC also administers the Savings Association Insurance Fund ("SAIF"), which insures deposits in thrift institutions. The FDIC is authorized to borrow up to $30 billion from the United States Treasury; up to 90% of the fair market value of assets of institutions acquired by the FDIC as receiver from the Federal Financing Bank; and from depository institutions that are members of the BIF. Any borrowings not repaid by asset sales are to be repaid through insurance premiums assessed to member institutions. Such premiums must be sufficient to repay any borrowed funds within 15 years and provide insurance fund reserves of $1.25 for each $100 of insured deposits. FDICIA also provides authority for special assessments against insured deposits. No assurance can be given at this time as to what the future level of premiums will be. 26 As required by FDICIA, the FDIC adopted a transitional risk-based assessment system for deposit insurance premiums which became effective January 1, 1993. On November 14, 1995 the Board of Directors of the FDIC adopted a resolution to reduce to a range of 0 to 27 basis points the assessment rates applicable to deposits assessable by the BIF for the semiannual assessment period beginning January 1, 1996. The new assessment schedule would retain the risk based characteristics of the current system. On November 26, 1996 the FDIC decided to continue in effect the current BIF assessment rate schedule. The FDIC may make limited adjustments to the above rate schedule not to exceed an increase or decrease of 5 basis points without public notice and comment rulemaking. The amount of an adjustment adopted by the Board is to be determined by the following considerations: (a) the amount of assessment revenue necessary to maintain the reserve ratio at the designated reserve ratio and (b) the assessment schedule that would generate such amount of assessment revenue considering the risk profile of BIF members. In determining the relevant amount of assessment revenue, the Board is to consider BIF's expected operating expenses, case resolution expenditures and income, the effect of assessments on BIF members' earnings and capital, and any other factors the Board may deem appropriate. In 1996 Congress enacted the Deposit Insurance Funds Act ("Funds Act") in order to raise the level of SAIF reserves, and to reduce the possibility that bonds issued by the Financing Corporation ("FICO") would go into default. The FICO was a special purpose government corporation that issued $8.2 billion in bonds to recapitalize the Federal Savings and Loan Insurance Corporation. Interest on the FICO bonds was paid from the proceeds of assessment made on the deposits of SAIF members. Because of the almost $800 million needed to pay for the annual interest on the FICO bonds, the payments of SAIF members were not increasing the SAIF reserve to a sufficient level to allow the FDIC to reduce assessment rates (as had been done for BIF deposits), and SAIF members were employing certain strategies to either exit the system or transfer deposits to BIF coverage. Pursuant to the Funds Act, the FDIC imposed a special one-time assessment on all institutions that held SAIF assessable deposits as of March 31, 1995 of an estimated 65.7 cents per $100 of SAIF assessable deposits. Certain discounts and exemptions from the assessment were available. For example, BIF-member banks that had acquired SAIF-insured deposits from thrifts were generally entitled to a 20% discount on the special assessment if the bank satisfied certain statutory thresholds (the bank's acquired SAIF deposits, as adjusted, must be less than half of its total domestic deposits). Furthermore, beginning January 1, 1997, all FDIC-insured institutions will be assessed to cover the interest payments due on FICO bonds. For calendar years 1997 through 1999, BIF members will pay one-fifth the rate SAIF members will pay, and beginning in 2000 both types of institutions will pay the same rate. BIF members will be required to pay a FICO assessment of approximately 1.3 basis points for the first semiannual FICO assessment in 1997. 27 The Funds Act also authorized the FDIC to rebate assessments paid by BIF members if the BIF has reserves exceeding its designated reserve ratio of 1.25 percent of total estimated insured deposits. The adjusted BIF balance was $25.888 billion on June 30, 1996, a reserve ratio of 1.30 percent. The FDIC has expressed its view that the long-term needs of the BIF are a factor in setting the effective average BIF assessment rate, and that the FDIC is uncertain whether the current favorable conditions represent a long-term trend. COMMUNITY REINVESTMENT ACT AND FAIR LENDING DEVELOPMENTS The Bank is subject to certain fair lending requirements and reporting obligations involving home mortgage lending operations and Community Reinvestment Act ("CRA") activities. The CRA generally requires the federal banking agencies to evaluate the record of a financial institution in meeting the credit needs of their local communities, including low and moderate income neighborhoods. In addition to substantive penalties and corrective measures that may be required for a violation of certain fair lending laws, the federal banking agencies may take compliance with such laws and CRA into account when regulating and supervising other activities. On March 8, 1994, the federal Interagency Task Force on Fair Lending issued a policy statement on discrimination in lending. The policy statement describes the three methods that federal agencies will use to prove discrimination: overt evidence of discrimination, evidence of disparate treatment, and evidence of disparate impact. In 1996, new compliance and examination guidelines for the CRA were promulgated by each of the federal banking regulatory agencies, fully replacing the prior rules and regulatory expectations with new ones ostensibly more performance based than before to be fully phased in as of July 1, 1997. The guidelines provide for streamlined examinations of smaller institutions. RECENTLY ENACTED LEGISLATION On September 29, 1995 the IBBA became effective. The IBBA implemented the federal Interstate Banking and Branching Act. The main features of this legislation are (a) out-of-state banks that wish to establish a California branch office to conduct core banking business must first acquire an existing 5 year old California bank or industrial loan company by merger or purchase; (b) California state-chartered banks will be empowered to conduct various authorized branch-like activities on an agency basis through affiliated and unaffiliated insured depository institutions in California and other states and (c) the Superintendent will be authorized to approve an interstate acquisition or merger which would result in a deposit concentration exceeding 30% if the Superintendent finds that the transaction is consistent with public convenience and advantage. The legislation also contains extensive provisions governing intrastate and interstate (a) intra-industry sales, mergers and conversions between banks and between industrial loan companies and (b) inter-industry transactions involving banks, savings associations and industrial loan companies. 28 During 1996, new federal legislation amended the Comprehensive Environmental Response, Compensation, and Liability Act ("CERCLA") and the underground storage tank provisions of the Resource Conversation and Recovery Act ("RCRA") to provide lenders and fiduciaries with greater protections from environmental liability. The definition of "owner or operator" under CERCLA has been amended to exclude a lender who: (i) holds indicia of ownership in a property primarily to protect its security interest, but does not participate in the property's management or (i) forecloses on a property, or, after foreclosure, sells, re-leases (in the case of a lease finance transaction), or liquidates the property, maintains business activities, winds up operations, undertakes a response under CERCLA, or takes measures to preserve, protect or prepare property prior to sale or disposition, so long as the lender did not participate in the property's management prior to sale. In order to preserve these protections, a lender who forecloses on property must seek to sell, re- lease, or otherwise divest itself of the property at the earliest practicable, commercially reasonable time, and on reasonable terms. "Participation in management" is defined as actual participation in the management or operational affairs of the facility, not merely having the capacity to influence or the unexercised right to control operations. Similar changes have been made in RCRA. The California legislature adopted a similar bill to provide that, subject to numerous exceptions, a lender acting in the capacity of a lender shall not be liable under any state or local statute, regulation or ordinance, other than the California Hazardous Waste Control Law, to undertake a cleanup, pay damages, penalties or fines, or forfeit property as a result of the release of hazardous materials at or from the property. Under this bill a lender which had not participated in the management of the property prior to foreclosure may take actions similar to those set forth in the CERCLA and RCRA amendments without losing its immunity from liability. To preserve that immunity, after foreclosure, the lender must take commercially reasonable steps to divest itself of the property in a reasonably expeditious manner. PENDING LEGISLATION There are a number of pending legislative proposals to reform the Glass- Steagall Act to allow affiliations between banks and other firms engaged in "financial activities," including insurance companies and securities firms. Glass-Steagall reform will likely be affected by a bank insurance powers case decided during 1996 by the U.S. Supreme Court, which gives national banks greater opportunities to sell traditional insurance products, such as life, automobile, and property and casualty policies. In a similar recent case, the Court upheld an OCC determination that national banks may sell annuities. Certain other pending legislative proposals include bills to free withdrawals from individual retirement accounts from penalties for first-time home purchases and other purposes and eliminate most Community Reinvestment Act reporting requirements. While the effect of such proposed legislation and regulatory reform on the business of financial institutions cannot be accurately predicted at this time, it seems likely that a significant amount of consolidating in the banking industry will continue to occur throughout the remainder of the decade. 29 COMPETITION In the past, an independent bank's principal competitors for deposits and loans have been other banks (particularly major banks), savings and loan associations and credit unions. To a lesser extent, competition was also provided by thrift and loans, mortgage brokerage companies and insurance companies. Other institutions, such as brokerage houses, mutual fund companies, credit card companies, and even retail establishments have offered new investment vehicles which also compete with banks for deposit business. The direction of federal legislation in recent years seems to favor competition between different types of financial institutions and to foster new entrants into the financial services market, and it is anticipated that this trend will continue. The enactment of the Interstate Banking and Branching Act in 1994 as well as the California Interstate Banking and Branching Act of 1995 will likely increase competition within California. Regulatory reform, as well as other changes in federal and California law will also affect competition. While the impact of these changes, and of other proposed changes, cannot be predicted with certainty, it is clear that the business of banking in California will remain highly competitive. CERTAIN ADDITIONAL BUSINESS RISKS The Company's business, financial condition and operating results can be impacted by a number of factors, including but not limited to those set forth below, any one of which could cause the Company's actual results to vary materially from recent results or from the Company's anticipated future results. Shares of Company Common Stock eligible for future sale could have a dilutive effect on the market for Company Common Stock and could adversely affect the market price. The Articles of Incorporation of the Company authorize the issuance of 20,000,000 shares of common stock, and 1,000,000 shares of preferred stock of which approximately 754,500 shares of common stock and no shares of preferred stock were outstanding at December 31, 1996. As of December 31, 1996, outstanding options to purchase Common Stock were 164,800, and Common Stock available for grants under the Company's stock option plans was 85,200 shares. The loan portfolio of the Company is dependent on real estate. At December 31, 1996, real estate served as the principal source of collateral with respect to approximately 70% of the Company's loan portfolio. A worsening of current economic conditions or rising interest rates could have an adverse effect on the demand for new loans, the ability of borrowers to repay outstanding loans, the value of real estate and other collateral securing loans and the value of the available-for-sale investment portfolio, as well as the Company's financial condition and results of operations in general and the market value for Company Common Stock. Acts of nature, including earthquakes and floods, which may cause uninsured damage and other loss of value to real estate that secures these loans, may also negatively impact the Company's financial condition. 30 The Company is subject to certain operations risk, including, but not limited to, data processing system failures and errors and customer or employee fraud. The Company maintains a system of internal controls to mitigate against such occurrences and maintains insurance coverage for such risks, but should such an event occur that is not prevented or detected by the Company's internal controls, uninsured or in excess of applicable insurance limits, it could have a significant adverse impact on the Company's business, financial condition or results of operations. ITEM 2. PROPERTIES. The Bank maintains its main offices on leased premises at 901 Main Street in the Downtown part of Napa, California. The Company opened this banking facility in 1995. This property is a two story building with an adjacent paved ground level parking lot. The parking lot is approximately 10,860 square feet. The lease term runs from December 1, 1994 to November 30, 1999, with three five (5) year renewal options. The lease provides for inflationary increases in the monthly rental amount during the renewal periods and also contains options to purchase the facility at an agreed upon market value during certain defined periods. The base rent is $9,900.00 per month. The base rent is subject to an annual adjustment based on the Consumer Price Index beginning on the first day of January of every year of the first option renewal term beginning in the year 2001. The adjusted rental will not exceed an 8% increase over the adjusted rental of the preceding year nor will the adjusted rental be less than the original base rent. Rent paid for the Downtown Napa Office was approximately $119,000 during 1996. In addition, the Bank pays utilities, insurance and maintenance relating to the branch. The Company purchased its Claremont branch building for $558,000 in cash, including fees, on September 6, 1989. The building, comprised of approximately 5,000 square feet, was remodeled so that it could be put into service as a full service banking branch. The cost of the remodeling, security systems and necessary furniture and equipment was approximately $600,000. This Office was remodeled again in 1995 in order to accommodate the Bank's Electronic Data Processing and Customer Service Departments. The cost of this remodel was approximately $50,000. The Company leases the Bank's approximately 2,400 square foot branch office located at 1015 Adams Street in downtown St. Helena, California. The lease term ends in 1998, with two options to extend the term of the lease for five years each. Rent paid for the St. Helena office was approximately $61,000 during 1996. In addition, the Bank pays utilities, insurance and maintenance relating to the branch. ITEM 3. LEGAL PROCEEDINGS. As of December 31, 1996, neither the Company, the Bank nor the Leasing Company was a party to, nor was any of their property the subject of, any material pending legal proceedings, nor are any such proceedings known to be contemplated by governmental authorities. At the same date, the Bank was involved as plaintiff in ordinary routine litigation incidental to its business. 31 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matter was submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this report through the solicitation of proxies or otherwise. 32 PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The Company's Common Stock is not listed on any exchange or the National Association of Securities Dealers' Automated Quotation System; however, there has been limited trading in the Company's Common Stock which the company does not believe necessarily represents an established public trading market. To the Company's knowledge, no broker-dealers handle transactions of the Company's common stock. The following table sets forth, for the fiscal quarters indicated, the range of high and low sales prices, not including broker's commissions, based upon known information as reported by management. These figures may not include private transactions. Other than to this extent, there is no established public trading market in the Company's Common Stock. SALES PRICES OF THE COMPANY'S COMMON STOCK TRADING YEAR HIGH LOW VOLUME 1996 Fourth Quarter $14.50 $14.50 100 Third Quarter 14.50 14.50 19,755 Second Quarter 14.50 14.50 250 First Quarter 10.00 10.00 450 1995 Fourth Quarter $ 9.00 $ 8.00 1,600 Third Quarter 9.00 8.00 600 Second Quarter 9.00 8.00 16,845 First Quarter 9.00 8.00 6,450 Because the Company's Common Stock is not listed on any exchange, accurate trading volumes are difficult to ascertain. All known trades for 1996 involved purchases by the Company's Employee Stock Ownership Trust ("ESOT"). The ESOT purchased 19,855 shares in 1996. The ESOT did not purchase any shares of common stock in 1995. As of February 28, 1997, the outstanding shares of the Company's Common Stock were held of record by 353 shareholders. The last known trade of the Company's Common Stock occurred on December 11, 1996, for 100 shares. Price per share was $14.50. 33 During the third quarter of 1996, the Company's ESOT sent out a tender offer to purchase up to 20,000 shares of the Company's Common Stock. The price of the offer was set at $14.50 per share. From this offer, the ESOT purchased 19,354 shares of the Company's outstanding Common Stock. During the first quarter of 1996, the Company declared and paid a cash dividend of twelve and a half cents ($0.125) per share on outstanding stock. The first quarter dividend was based on 1995 earnings and amounted to $94,000. During the beginning of the second quarter of 1996, the Company declared a second cash dividend of twelve and a half cents ($0.125) per share. This cash dividend was based on the first quarter earnings of 1996 and was also $94,000. During the third quarter of 1996, the Bank paid a $100,000 cash dividend to the Company. This dividend allowed the Company to declare and pay another cash dividend of twelve and a half cents ($0.125) per share for a total of $94,000. In the fourth quarter of 1996, the Bank paid another $100,000 cash dividend to the Company, allowing it to again declared and issue a twelve and a half cents ($0.125) per share dividend. This fourth quarter dividend was based on third quarter earnings and was paid to shareholders on January 3, 1997. Total dividends paid by the Bank to the Company and from the Company to its shareholders for 1996 amounted to $200,000 and $378,000 respectively. 34 ITEM 6. SELECTED FINANCIAL DATA. The selected consolidated financial information for the Company presented below for the five years ended December 31, 1996 is derived from and should be read in conjunction with the consolidated financial statements of the Company and the notes thereto which are included in Item 14 of this Annual Report on Form 10-K. YEAR ENDED DECEMBER 31, 1996 1995 1994 1993 1992 (IN 000'S EXCEPT EARNINGS PER SHARE AND RATIOS) STATEMENT OF OPERATIONS Total interest income $9,173 $8,432 $6,226 $4,831 $4,734 Total interest expense 2,814 2,634 1,658 1,551 2,038 Provision for loan losses 550 323 149 198 207 Net interest income after provision for loan losses 5,809 5,475 4,419 3,082 2,489 Other income 806 800 627 594 554 Other expense 5,099 4,409 3,716 3,425 3,007 Income before income tax 1,516 1,866 1,330 251 36 Income tax provision (credit) 614 765 553 (249) 14 Extraordinary tax credit 0 0 0 0 (12) Net income 902 1,101 777 500 34 Net income/share 1.00 1.25 1.03 0.66 0.05 Cash Dividends Paid/share $ 0.50 $ 0 $ 0 $ 0 $ 0 Weighted Average Shares 906 882 755 755 755 BALANCE SHEET INFORMATION (AT PERIOD END): Total assets $113,827 $104,851 $86,477 $77,241 $63,454 Net loans 78,290 73,374 62,103 54,259 45,990 Total deposits 105,417 96,752 79,378 71,463 58,243 Shareholders' equity 7,971 7,447 6,346 5,569 5,069 Book value per common share outstanding $ 8.67 $ 8.44 $ 8.41 $ 7.38 $ 6.71 SELECTED FINANCIAL RATIOS: Net interest margin 6.75% 6.98% 6.25% 5.38% 4.76% Allowance for loan losses to average loans 1.78% 1.93% 1.78% 1.80% 1.50% Nonperforming loans to average loans 4.41% 2.11% 1.63% 0.72% 2.06% Net charge-offs to average loans 0.60% 0.07% 0.02% 0.06% 0.31% Average earning assets to total average assets 92.15% 91.52% 92.00% 91.66% 90.28% Primary capital ratio (1) N/A N/A N/A N/A N/A Total capital ratio (1) N/A N/A N/A N/A N/A Return on average assets .94% 1.30% 1.05% 0.81% 0.06% Return on average shareholders' equity 11.61% 16.40% 14.02% 9.77% 0.70% Average equity to average assets ratio 7.46% 7.27% 6.87% 7.58% 7.77% Leverage Ratio (2) 7.11% 7.16% 7.28% 7.04% 7.60% Total Risk based capital ratio 10.47% 10.40% 10.33% 9.84% 10.77% (1) As defined by regulatory guidelines. (2) Calculated based on the Bank's capital and average assets. 35 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION. The following analysis of the Company's financial condition for the years ended December 31, 1996 and 1995 and results of operation for each of the three years in the period ended December 31, 1996, should be read in conjunction with the Consolidated Financial Statements, related Notes thereto and other information presented elsewhere herein. Since the Company is a bank holding company whose principal asset is, and is expected to be, the capital stock of the Bank, the following relates principally to the financial condition and results of operations of the Bank. The consolidated financial statements of the Company are prepared in conformity with generally accepted accounting principles and prevailing practices within the banking industry. All material intercompany transactions and accounts have been eliminated. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Average balances, including such balances used in calculating certain financial ratios, are comprised of average daily balances. All dollar amounts are rounded, except earnings per share data. Certain statements in this Annual Report on Form 10-K include forward- looking information within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and are subject to the "safe harbor" created by those sections. These forward-looking statements involve certain risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. Such risks and uncertainties include, but are not limited to, the following factors: competitive pressure in the banking industry increases significantly; changes in the interest rate environment reduce margins; general economic conditions, either nationally or regionally, are less favorable than expected, resulting in, among other things, a deterioration in credit quality and an increase in the provision for possible loan losses; changes in the regulatory environment; changes in business conditions, particularly in Napa County and the wine industry; volatility of rate sensitive deposits; operational risks including data processing system failures or fraud; asset/liability matching risks and liquidity risks; and changes in the securities markets. See also "Certain Additional Business Risks" included in Item 1 herein and other risk factors discussed elsewhere in this Report. SUMMARY OF FINANCIAL RESULTS The Company recorded net income of $902,000, or $1.00 per share for the year ended December 31, 1996 compared to $1,101,000 or $1.25 per share, and $777,000 or $1.03 per share, for the year ended December 31, 1995 and 1994, respectively. 36 Net income declined in 1996 over 1995 by $199,000, or 18%. The primary reasons for this decline were due to an increase in the provision for loan losses of $227,000, or 70%, and increases in noninterest expenses of $690,000, or 16%. These increases were partially offset by an increase in net interest income of $561,000, or 10%, and decreases in taxes of $151,000, or 20%. The primary reasons for the improvement in operating results in 1995 as compared to 1994 are as follows: Net interest income increased by $1,230,000 or 27%. This growth was partially offset by an increase in the provision for loan losses of $174,000 or 116%. Total noninterest income increased by $173,000 or 28%. These improvements were also offset by an increase in total noninterest expense of $693,000 or 19%. Management is not aware of any trends, events or uncertainties that would have a material impact on the Company's liquidity, capital resources, or results of operations other than the early payoff of a purchased loan in January 1997 that resulted in a write off of $104,000 in unamortized premium. The loan was for commercial property in the Bank's service area that totalled approximately $1,752,000 at the time of payoff. NET INTEREST INCOME The Company's primary source of income is the difference between interest income and fees derived from earning assets and interest paid on liabilities incurred for the funding of those assets. This difference is referred to as "net interest income." Net interest income expressed as a percentage of average total earning assets is referred to as the "net interest margin" or "margin." For the period ended December 31, 1996, net interest income increased by $561,000, or 10%, over the same period of 1995. This number is a component of total interest income and total interest expense. The $11,085,000 increase in average earning assets in 1996 compared to 1995 contributed significantly to this increase in net interest income. Even though average earning assets increased significantly in 1996 over 1995, net interest income did not increase as dramatically due to a decline in the Bank's net interest margin from 6.98% for 1995 compared to 6.75% for 1996. Net interest income increased in 1995 by $1,230,000, or 27%, over 1994. Total interest income increased in 1995 by $2,206,000, or 35%, over 1994. This increase was offset by an increase in total interest expense of $976,000, or 59%. These results can be attributed to a number of factors, such as an increase in the net interest margin from 6.25% in 1994 to 6.98% in 1995 (based on period end earning assets). This rise in net interest margin was aided by increases in the prime interest rate during late 1994 and early 1995. Additionally, average earning assets increased by $10,056,000 or 14%, in 1995 over 1994 totals. As of December 31, 1996, total average earning assets were $94,205,000, an increase of $11,085,000, or 13%, from the 1995 level of $83,120,000. 37 PROVISION FOR LOAN LOSSES The provision for loan losses is based upon management's assessment of the amount that is necessary to maintain the allowance for loan losses at an adequate level. As further described in the "Allowance for Loan Losses" herein, management takes many factors into consideration when determining the provision including loan portfolio growth. The provision for loan losses was $550,000 at December 31, 1996 compared to $323,000 for 1995. This represents an increase of $227,000, or 70%, over the prior year. The increase in the provision was due to increases in both average loans and outstanding loan balances in 1996 over 1995 totals, projected loan growth, increases in non-performing loans, and management's ongoing assessment of the adequacy of the allowance for loan losses (See "Loans and Nonaccrual Loans" herein). During 1995, the provision for loan losses was $323,000 as compared to $149,000 for 1994. As of December 31, 1995, total net loans were $73,374,000 compared to $62,103,000 for the same period in 1994. This was an increase of $11,271,000, or 18% over the prior year. NONINTEREST INCOME Noninterest income consists primarily of service charges on deposit accounts, fees charged for other banking deposit and loan services, and merchant card processing income. Noninterest income remained relatively flat between 1996 and 1995, showing only a $6,000, or 1%, growth over the prior year. Service charges generated from deposit accounts continued to show growth due to both increases in the number of outstanding accounts and a continued emphasis on assessing service charges and other related fees. Additionally, the Bank's merchant card processing program continued to show gains in 1996 over earnings in 1995 Noninterest income increased in 1995 by $173,000, or 28%, over 1994 totals, primarily due to growth in deposit accounts and the related increase in service charge income, and a more aggressive policy of assessing service charges and other related fees. Additionally, the Bank's merchant card processing program was enhanced and expanded in early 1995 and showed a significant increase in earnings during 1995 over 1994 totals. NONINTEREST EXPENSE Total noninterest expense was $5,099,000 in 1996, representing an increase of $690,000, or 16%, over the 1995 total of $4,409,000. Total noninterest expense in 1995 was $693,000, or 19%, above 1994's total of $3,716,000. Net salaries and employee benefit expense was $2,722,000 in 1996, an increase of $461,000, or 20%, over 1995's total of $2,261,000. During 1996, the Bank grew by approximately five full time equivalent employees, two of which were senior officers. Additionally, salaries increased due to average bank-wide raises of approximately four percent which took place in March 1996. The Company did not accrue for incentive payouts in 1996 nor does it have plans on paying any bonuses for performance in said year. 38 Salaries and employee benefits were $2,261,000 in 1995, an increase of $297,000, or 15%, over 1994. This increase can be primarily attributed to an addition of approximately five full time equivalent employees during 1995. These staff increases were necessary to maintain an adequate service level given the overall growth within the company. Additionally, salaries also increased as a result of average bank-wide raises of five percent which took place in March 1995. Occupancy and furniture, fixtures and equipment expenses increased in 1996 by $107,000, or 14% over 1995 totals. This increase was due primarily to the Bank's branch/headquarters tenant improvements (see discussion below) and upgrades in electronic media throughout the Company. During April 1995, the Bank closed its original banking office located at 1500 Third Street, Napa, California and re-opened at 901 Main Street, Napa, California. At the end of June, the Bank relocated it primary lending services and headquarters into the completed facility. After relocation of the lending and administration staff from its previous location at 3263 Claremont Way, Napa, California, this facility began remodeling to accommodate the Bank's customer service and EDP departments. The remodeling of the Claremont facility was completed in July and these two departments were immediately relocated. With the completion of this move, the Bank was able to vacate the leased space which previously housed the Customer Service Center. At the end of the third quarter of 1995, the Bank had consolidated back into three locations, all offering full banking services. Occupancy and furniture, fixtures and equipment expenses for the twelve months ending December 31, 1995 increased by $164,000 or 27%, over the same period of 1994. These increases in costs were attributed primarily to the Bank's new branch/headquarters tenant improvements, and the costs of supporting its other locations. Professional fees increased in 1996 by $32,000, or 8%, over 1995 totals. This increase was due primarily to the additional use of outside consultants for both loan related legal reviews and audits and managerial issues. In 1995, professional and director fees increased by $241,000, or 137%, over 1994. This additional expense is primarily due to increases in consulting, legal and director fees. Beginning in January 1995, the Company approved a new director compensation plan which resulted in an increase of $63,000 over the prior year. Consulting fees increased in 1995 by $34,000, due to the outsourcing of a number of loan related reviews, audits and other similar procedures. The Company incurred additional legal expenses of $52,000 in 1995 over the same period of 1994. The competition for deposits and loans in the Company's service area warranted increased marketing and business development expenditures during 1996. Early in 1996, the Company hired an employee whose primary focus was marketing and sales support. This was done as a strategic move to enhance the Company's overall marketing materials and focus both within the branches and in the Company's service area. This focus resulted in an increase of $46,000, or 37%, in marketing expenses between 1996 and 1995. 39 The Company decreased its marketing and business development costs by $11,000, or 8%, during 1995 over the same period of 1994. This decrease was primarily due to the high profile marketing efforts incurred during the first quarter of 1995. Given the growth in loans and deposits resulting from these marketing efforts, management curtailed the Bank's marketing costs greatly during the remaining three quarters of 1995. Regulatory fees and related expenses decreased in 1996 by $70,000, or 34%, over the same period of 1995. The decrease was primarily due to changes in the annual Federal Deposit Insurance Corporation assessments that occurred in the latter half of 1995. This same change also contributed to the drop in expense in 1995 over 1994 totals. Stationery and supply expense for 1996 was $21,000, or 22%, higher than 1995. This increase was due to general growth in the Company and the enhanced marketing oriented materials used within the branches. In 1995, stationery and supply expense was $95,000, or 42%, higher than 1994. The increase in 1995 was due to significant one time expenses related to the numerous facility moves and relocations which incurred during 1995. Data processing expenses have shown a steady increase during the three years presented and have been in keeping with the overall growth of the Company. Additionally, the $16,000, or 15%, growth in 1996 over 1995 was also due to enhancements and upgrades made to the Company's personal computers. Other noninterest expense increased by $77,000, or 19%, in 1996 over 1995 totals. The increase was due primarily to increase in miscellaneous loan expenses and staff training and development. The increase between 1995 and 1994 was in keeping with the general growth of the Company. INCOME TAXES Income tax expense was 41% and 42% of pre-tax income for the years ending December 31, 1996 and 1995, respectively. EARNING ASSETS Total earning assets consist of investment securities, loans, federal funds sold and interest bearing deposits held in other institutions. Total earning assets increased from $95,267,000 at December 31, 1995 to $102,680,000 at December 31, 1996, an increase of $7,413,000, or 8%. LOANS AND NONACCRUAL LOANS Total loans, excluding the allowance for loan losses (see Notes 1 and 4 to the Consolidated Financial Statements included herein at Item 14, for further discussion of the allowance for loan losses), increased from $74,699,000 at December 31, 1995 to $79,695,000 at December 31, 1996. The increase of $4,996,000 represents a 7% increase in outstanding loans during 1996. The Bank experienced increases in all of its loan categories except for a slight decline in personal line of credit loans during the year under review. Management attributes these increases to more seasoned staff, both loan and deposit officers, which assisted with new loan generation and changes taking place in the Company's service area. 40 General economic and credit risks are inherent in the lending function and within particular types of lending categories. The Bank primarily makes four types of loans: Real estate construction, real estate mortgage, commercial and consumer loans. As discussed in "Item 1. Business - Loan Portfolio" herein, the Bank generally takes a collateralized position, with reasonable loan to value ratios on its loans (over 90% of the Bank's loan portfolio is collateralized). The primary source of collateral is real estate located within the Company's service area. An inherent risk in taking real estate as collateral is the possibility of declines in real estate market values. The Company's service area is Napa Valley, which is located approximately fifty miles northeast of the San Francisco Bay Area. Napa Valley is a very unique, and rather isolated area that has been able to sustain higher than average real estate market values. Approximately four years ago, given the economic trends and possibility of declining market values, the Company took a more conservative approach on its collateral base and began lowering its loan to value ratios on new loans. Even though the Company's loan portfolio is heavily secured by California real estate, management does not presently foresee any material impact on the Company's operations, given the low loan to value ratios. As of December 31, 1996, nonperforming loans were $3,152,000, an increase of $1,705,000, or 118%, over the December 31, 1995 balance of $1,447,000. Nonperforming loans at December 31, 1996 represent 4.0% of total average loans compared to 2.1% of total average loans for year end 1995. The growth in nonperforming loans between 1996 and 1995 is primarily due to a rise in bankruptcies in 1996 compared to 1995, and to the general growth in outstanding loan balances. The increase in nonperforming loans, in management's opinion, does not represent a material trend. As discussed in "Item 1 - Business, Loan Portfolio", in early 1997, the Company's service area was subjected to severe weather conditions that resulted in some flooding. Management believes that this flooding will not have a direct or material impact on either its existing loan portfolio or future growth. 41 On January 1, 1995, the Company adopted SFAS No. 114, "Accounting by Creditors for Impairment of a Loan" and SFAS No. 118, "Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosure". These statements address the accounting and reporting by creditors for impairment of certain loans. A loan is impaired when, based upon current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. These statements are applicable to all loans, uncollateralized as well as collateralized, except large groups of smaller-balance homogeneous loans that are collectively evaluated for impairment such as credit cards, residential mortgage and consumer installment loans, loans that are measured at fair value or at the lower of cost or fair value and leases. Impairment is measured based on the present value of expected future cash flows discounted at the loan's effective interest rate, except that as a practical expedient, the Company measures impairment based on a loan's observable market price or the fair value of the collateral if the loan is collateral dependent. Loans are measured for impairment as part of the Company's normal internal asset review process. Interest income is recognized on impaired loans in a manner similar to that of all loans. It is the Company's policy to place loans that are delinquent 90 days or more as to principal or interest on a nonaccrual of interest basis unless secured and in the process of collection, and to reverse from current income accrued but uncollected interest. Cash payments subsequently received on nonaccrual loans are recognized as income only where the future collection of principal is considered by management to be probable. At December 31, 1996, the Company's total recorded investment in impaired loans was $3,152,000, of which there is a related allowance for credit losses of $204,000. The average recorded investment in the impaired loans during 1996 was $2,123,000: the related amount of interest income recognized during the period that such loans were impaired recognized under the cash basis method of accounting was $44,000. Loans currently classified as special mention, substandard, doubtful or loss (See Item 1, "Business" herein) do not, in management's view, represent or result from trends or uncertainties which may have a material adverse effect on the entire loan portfolio, liquidity or capital resources. ALLOWANCE FOR LOAN LOSSES Inherent in the lending function is the fact that loan losses will be experienced and that the risk of loss will vary with the type of loan being made and the credit - worthiness of the borrower over the term of the loan. The Company maintains an allowance for possible loan losses at a level estimated to be adequate to provide for losses that can be reasonably anticipated based upon specific loan conditions as determined by management, and based upon management's assessment of historical loan loss experience, prevailing economic conditions and other factors including growth of the loan portfolio. While these factors are essentially judgmental and may not be reduced to a mathematical formula, it is management's view that the $1,405,000 allowance, approximately 1.76% of total loans outstanding at December 31, 1996, was adequate as an allowance against foreseeable losses in the portfolio at that time. The allowance was 1.77% of the loan portfolio at 42 December 31, 1995. The allowance is increased by charges to the provision for loan losses and reduced by net charge-offs. OTHER REAL ESTATE OWNED At December 31, 1996 and December 31, 1995, total other real estate owned was $328,000 and $0, respectively, which at December 31, 1996 consisted of two separate properties. DEPOSITS Deposits totaled $105,417,000 at December 31, 1996, an increase of $8,665,000, or 9%, from the December 31, 1995 balance of $96,752,000. In 1996, noninterest bearing transaction accounts grew by $6,660,000, or 35%, savings accounts decreased by $340,000, or 3%, and interest bearing transaction accounts grew $1,257,000, or 4%, over 1995 totals. Time certificates of deposit of $100,000 or more increased by $1,293,000, or 14%, and other time deposits decreased by $205,000, or 1%, during 1996. The overall growth in deposit accounts in 1996 was primarily due to a comprehensive marketing effort on the part of the Bank's staff and management, the introduction of new and enhanced deposit products and increases in deposit officers. Non-interest bearing demand deposits were 24% of total deposits at December 31, 1996, as compared to 20% at December 31, 1995. Time certificates of deposit were 36% of total deposits at December 31, 1996, and 39% for the same period of 1995. NEW ACCOUNTING PRONOUNCEMENTS Effective January 1, 1996, the Company adopted SFAS No. 123, "Accounting for Stock-Based Compensation", which establishes financial and reporting standards for stock-based compensation plans. The Company elected to continue accounting for stock-based employee compensation plans in accordance with APB Opinion No. 25, "Accounting for Stock Issued to Employees" and related interpretations, as SFAS 123 permits, and to follow the pro forma net income, pro forma earnings per share and stock-based compensation plan disclosure requirements set forth in SFAS 123. In March 1995, the Financial Accounting Standards Board issued SFAS No. 121, Accounting for Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of. SFAS No. 121 is effective for fiscal years beginning after December 15, 1995. This Statement requires that long-lived assets and certain identifiable intangibles to be held and used by an entity, be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The financial statement impact of adopting SFAS No. 121 has not been material. 43 ASSET-LIABILITY MANAGEMENT Asset-liability management is a process whereby the Bank, through its Asset and Liability Committee, monitors the maturities and repricing opportunities of the various components of the balance sheet and initiates strategies designed to maximize the net interest margin, while minimizing vulnerability to large fluctuations in interest rates. The Bank is currently moving towards a policy of maintaining a relative balance of asset and liability maturities within similar time frames, while permitting a moderate amount of short-term interest rate risk based on current interest rate projections, customers' credit demands and deposit preferences. At December 31, 1996, the Company's assets repricing in one year exceeded its liabilities repricing in one year by $21,612,000, or 19%, of total assets. This compares to $15,348,000, or 15% of total assets in 1995. The excess of assets repricing over liabilities repricing means that if interest rates decline, the Company's return on assets would be expected to decline more quickly than its cost of funds, thereby reducing the Company's net interest margin. However, as interest rates increase, the Company's return on assets would be expected to increase more quickly than its cost of funds. The following table represents the interest rate sensitivity profile of the Company's consolidated assets, liabilities and shareholders' equity as of December 31, 1996. Assets, liabilities and shareholders' equity are classified by the earliest possible repricing opportunity or maturity date, whichever first occurs. Assumptions used in constructing the table include the following: The loans that are in the "Interest Rate Sensitivity Over One Year But Within 5 Years" and "Nonrate Sensitive or Over 5 Years" columns are all fixed-rate loans and therefore mature in those time frames. The Bank's certificates of deposits are substantially all fixed-rate, therefore they are in the columns which represent the time frames in which they mature. All other interest-bearing accounts reprice overnight and are therefore in the "Interest Rate Sensitivity 0-90 Days" column. Included in noninterest bearing liabilities is $25,728,000 in demand deposit accounts. 44 INTEREST RATE SENSITIVITY NON-RATE 0-90 91-180 181-365 OVER 1 YEAR SENSITIVE DAYS DAYS DAYS BUT WITHIN OR OVER (0-3 MO) (3-6 MO) (6-12 MO) 5 YRS 5 YRS TOTAL ASSETS Time deposits-other financial institutions $ 594 $ 891 $ 2,673 $ $ $ 4,158 Federal funds sold 16,550 16,550 Investments 973 750 554 2,277 Loans 59,847 6,319 7,621 5,589 319 79,695 Noninterest-earning assets net of loan loss reserve 11,147 11,147 TOTAL ASSETS $77,964 $ 7,210 $11,044 $ 5,589 $ 12,020 $113,827 LIABILITIES AND SHAREHOLDERS' EQUITY Interest-bearing deposits: Time deposits over $100,000 $ 5,373 $ 3,138 $ 1,000 $ 1,231 $ $ 10,742 All other interest-bearing deposits 51,097 9,239 4,759 3,821 31 68,947 Total interest-bearing deposits 56,470 12,377 5,759 5,052 31 79,689 Noninterest-bearing liabilities 26,167 26,167 Shareholders' equity 7,971 7,971 TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $56,470 $12,377 $ 5,759 $ 5,052 $ 34,169 $113,827 INTEREST RATE SENSITIVITY GAP (1) $21,494 $(5,167) $ 5,285 $ 537 $(22,149) CUMULATIVE INTEREST RATE SENSITIVITY GAP $21,494 $16,327 $21,612 $22,149 - -------------------- 1 Interest rate sensitivity gap is the difference between interest rate sensitive assets and interest rate liabilities within the above time frames. 45 LIQUIDITY Liquidity refers to the Company's ability to maintain cash flow adequate to fund operations and meet obligations and other commitments on a timely basis. Management strives to maintain a level of liquidity sufficient to meet customer requirements for loan funding and deposit withdrawals. Liquidity requirements are evaluated by taking into consideration factors such as deposit concentrations, seasonality and maturities, loan demand, capital expenditures, and prevailing and anticipated economic conditions. As shown in the Consolidated Statements of Cash Flows ("Statement") for the years ended December 31, 1996, 1995 and 1994, the Company's usual and primary source of funds has been customer deposits and cash flow generated from operating activities. While the usual and primary sources are expected to continue to provide significant amounts of funds in the future, their mix, as well as those from other sources, will depend on future economic and other market conditions. In 1996, the Statement shows that operations and financing activities were sources of net cash inflows ($510,000 and $8,287,000, respectively) for the year. These sources were significant enough to increase the overall ending cash and cash equivalents from $21,886,000 at December 31, 1995 to $24,479,000 at December 31, 1996, an increase of $2,593,000. In 1995, the Statement shows that operations and financing activities were also sources of net cash inflows ($1,000,000 and $17,374,000, respectively) for the year. These sources increased ending cash and cash equivalents by $5,667,000, taking the total from $16,219,000 at December 31, 1994 to $21,886,000 at the end of 1995. In 1994, the Statement shows that operations and financing activities were sources of net cash inflow ($1,247,000 and $7,915,000 respectively) for the year. These sources were the primary reason for the small decrease in ending cash and cash equivalents from $17,284,000 at December 31, 1993 to $16,219,000 at the end of 1994. Liquidity is measure by various ratios, the most common being the liquidity ratio of cash less reserves, time deposits with other financial institutions, federal funds sold, and unpledged investment securities compared to total deposits. This ratio was 26% at both December 31, 1996 and December 31, 1995. Parent Company liquidity is maintained by cash flows stemming primarily from dividends from the bank. The amount of dividends from the Bank is subject to certain regulatory restrictions as discussed in Note 12 of the Notes to Consolidated Financial Statements. The Parent Company financial statements are presented in Note 16 of the Notes to Consolidated Financial Statements. CAPITAL ADEQUACY The Federal Reserve Bank and the Comptroller of the Currency have specified guidelines for the purpose of evaluating the capital adequacy of bank holding companies and banks. The table below summarizes the current requirements for 1996 and the Company's and the Bank's compliance therewith. 46 MINIMUM TIER 1 RISK TOTAL RISK LEVERAGE BASED CAPITAL BASED CAPITAL RATIO RATIO RATIO Regulatory Requirements for 1996 4.00% 4.00% 8.00% Consolidated Company Ratio at December 31, 1996 7.21% 9.34% 10.99% Bank Ratio at December 31, 1996 7.11% 9.22% 10.47% The capital levels of both the Bank and the Company at December 31, 1996 currently exceed the regulatory requirements for a "well capitalized" institution. Management anticipates that both the Company and the Bank will continue to exceed the regulatory minimums in the foreseeable future. Therefore, the Company and the Bank have adequate capital in order to expand in the future, either through loan generation or other means of expansion. As of the date of this report, management is not aware of any trends, events or uncertainties that will have, or are reasonable likely to have a material effect on the Company's liquidity, capital resources, or results of operations. Additionally, the Company is subject to no current recommendations by any regulatory authorities which, if implemented, would have such an effect. EFFECTS OF INFLATION The impact of inflation on a financial institution differs significantly from that exerted on an industrial concern, primarily because its assets and liabilities consist largely of monetary items. The most direct effect of inflation is higher interest rates. However, the Bank's earnings are affected by the spread between the yield on earning assets and rates paid on interest- bearing liabilities rather than the absolute level of interest rates. Additionally, there may be some upward pressure on the Company's operating expenses, such as adjustments in staff expense and occupancy expense, based upon consumer price indices. In the opinion of management, inflation has not had a material effect on the consolidated results of operations for the last three years. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. Consolidated Balance Sheets as of December 31, 1996 and 1995, and Consolidated Statements of Income, Statements of Shareholders' Equity and Statements of Cash Flows for each of the three years in the period ended December 31, 1996 are incorporated herein by reference to Item 14. 47 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. In September 1996, the Company retained Ernst & Young LLP to be the Company's auditors for the current year ending December 31, 1996. The Company's prior auditing firm was Deloitte & Touche LLP. Deloitte & Touche LLP had audited the Company's financial statements for the years ended December 31, 1988 through December 31, 1995. Deloitte & Touche LLP were dismissed in September 1996. The Company had no disagreements with Deloitte & Touche LLP on any matter of accounting principles or practices, financial statement disclosure, or auditing scope of procedures. The accountant's reports on financial statements for the past eight years did not contain an adverse opinion or a disclaimer of opinion, nor were they qualified or modified as to uncertainty, audit scope, or accounting principles. Registrant hereby incorporates by reference herein its report on Form 8-K filed on September 26, 1996 and amended on October 23, 1996. 48 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. As permitted by General Instruction G(3) to Form 10-K, the information called for by this Item is incorporated by reference from the section of the Registrant's 1997 definitive proxy statement entitled "Election of Directors," which proxy statement will be filed no later than April 30, 1997. ITEM 11. EXECUTIVE COMPENSATION. As permitted by General Instruction G(3) to Form 10-K, the information called for by this Item is incorporated by reference from the section of the Registrant's 1997 definitive proxy statement entitled "Remuneration and Other Information With Respect to Officers and Directors," which proxy statement will be filed no later than April 30, 1997. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. As permitted by General Instruction G(3) to Form 10-K, the information called for by this Item is incorporated by reference from the section of the Registrant's 1997 definitive proxy statement entitled "Security Ownership of Certain Beneficial Owners and Management," which proxy statement will be filed no later than April 30, 1997. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. As permitted by General Instruction G(3) to Form 10-K, the information called for by this Item is incorporated by reference form the section of the Registrant's 1997 definitive proxy statement entitled "Certain Relationships and Related Transactions," which proxy statement will be filed no later than April 30, 1997. 49 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) 1. Financial Statements. Reference Selected Financial Data Independent Auditors' Report Consolidated Financial Statements of Napa National Bancorp and Subsidiaries: - Consolidated Balance Sheets as of December 31, 1996 and 1995 - Consolidated Statements of Income for the Years Ended December 31, 1996, 1995 and 1994 - Consolidated Statements of Shareholders' Equity for the Years Ended December 31, 1996, 1995 and 1994 - Consolidated Statements of Cash Flows for the Years Ended December 31, 1996, 1995 and 1994 - Notes to Consolidated Financial Statements 2. Financial Statement Schedules. In accordance with the rules of Regulation S-X, schedules are not submitted because (a) they are not applicable to or required of the Company, or (b) the information required to be set forth therein is included in the financial statements or footnotes thereto. 3. Exhibits. See Index to Exhibits to this Form 10-K, for a list of the exhibits filed as a part of this report and incorporated herein by reference. (b) Reports on Form 8-K. During the fourth quarter of 1996, the Company filed an amended report on Form 8-K dated October 23, 1996, referred to in greater detail in Item 9 of this report titled "Changes in and Disagreements with Accountants on Accounting and Financial Disclosure". 50 [LETTERHEAD OF ERNST & YOUNG LLP] Report of Independent Auditors To the Shareholders and Board of Directors of Napa National Bancorp We have audited the accompanying consolidated balance sheet of Napa National Bancorp and subsidiaries as of December 31, 1996, and the related consolidated statements of income, changes in shareholders' equity and cash flows for the year then ended. These financial statements are the responsibility of the Napa National Bancorp's management. Our responsibility is to express an opinion on these financial statements based on our audit. The financial statements of Napa National Bancorp for the years ended December 31, 1995 and 1994, were audited by other auditors whose report dated March 22, 1996, expressed an unqualified opinion on those statements. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the 1996 consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Napa National Bancorp and subsidiaries at December 31, 1996, and the consolidated results of their operations and their cash flows for the year then ended in conformity with generally accepted accounting principles. /s/ Ernst & Young LLP February 14, 1997 51 [LETTERHEAD OF DELOITTE & TOUCHE LLP] INDEPENDENT AUDITORS' REPORT To the Shareholders and Board of Directors of Napa National Bancorp: We have audited the accompanying consolidated balance sheet of Napa National Bancorp and subsidiaries (the "Company") as of December 31, 1995, and the related consolidated statements of income, shareholder's equity and cash flows for each of the two years in the period ended December 31, 1995. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Napa National Bancorp and subsidiaries at December 31, 1995, and the results of their operations and their cash flows for each of the two years in the period ended December 31, 1995 in conformity with generally accepted accounting principles. /s/Deloitte & Touche LLP March 22, 1996 52 Napa National Bancorp and Subsidiaries Consolidated Balance Sheets DECEMBER 31 1996 1995 ---------------------- (Dollars In Thousands) ASSETS Cash and due from banks $ 7,929 $ 7,106 Federal funds sold 16,550 14,780 Interest-bearing time deposits - other financial institutions 4,158 4,356 Securities held to maturity (market value: 1996 - $2,304; 1995 - $1,447) 2,277 1,432 Loans: Commercial 52,789 48,407 Real estate Construction 8,706 7,850 Real Estate Mortgage 4,918 4,729 Installment 4,216 3,376 Personal lines of credit and other 9,066 10,337 ------------------------- Total loans 79,695 74,699 Less allowance for loan losses (1,405) (1,325) ------------------------- Loans - net 78,290 73,374 ------------------------- Premises and equipment, net 2,519 2,489 Accrued interest receivable 647 666 Other assets 1,457 648 ------------------------- Total assets $113,827 $104,851 ========================= LIABILITIES AND SHAREHOLDERS' EQUITY Liabilities: Deposits: Noninterest-bearing demand $ 25,728 $ 19,068 Interest-bearing: Savings 11,965 12,305 Transaction 29,317 28,060 Time, $100 and over 10,742 9,449 Other time 27,665 27,870 ------------------------- Total deposits 105,417 96,752 Accrued interest payable 378 528 Other liabilities 61 124 ------------------------- Total liabilities 105,856 97,404 ------------------------- Shareholders' equity: Preferred stock, no par value: authorized, 1,000,000 shares, no shares outstanding - - Common stock, no par value: authorized, 20,000,000 shares, 754,500 shares issued and outstanding 6,915 6,915 Retained earnings 1,056 532 ------------------------- Total shareholders' equity 7,971 7,447 ------------------------- Total liabilities and shareholders' equity $113,827 $104,851 ========================= See accompanying notes 53 Napa National Bancorp and Subsidiaries Consolidated Statements of Income YEARS ENDED DECEMBER 31 1996 1995 1994 ------------------------------------------------------------ (Dollars In Thousands, Except Share and Per Share Amounts) Interest income: Loans (including fees) $ 8,277 $ 7,515 $ 5,619 Federal funds sold 547 583 412 Time deposits with other 230 251 148 financial institutions Investment securities and Federal Reserve Bank stock 119 83 47 ------------------------------------------------------------ Total interest income 9,173 8,432 6,226 ------------------------------------------------------------ Interest expense: Deposits: Savings 275 292 323 Transaction 563 517 470 Time, $100 and over 519 392 237 Other time 1,457 1,433 628 ------------------------------------------------------------ Total interest expense 2,814 2,634 1,658 ------------------------------------------------------------ Net interest income 6,359 5,798 4,568 Provision for loan losses 550 323 149 ------------------------------------------------------------ Net interest income after 5,809 5,475 4,419 provision for loan losses ------------------------------------------------------------ Noninterest income: Service charges on deposit accounts 509 469 382 Other customer fees and charges 207 250 228 Other 90 81 17 ------------------------------------------------------------ Total noninterest income 806 800 627 ------------------------------------------------------------ Noninterest expense: Salaries and employee benefit 2,722 2,261 1,964 Occupancy 453 402 277 Professional fees 449 417 176 Equipment 436 380 341 Marketing and business development 170 124 135 Regulatory fees and related expenses 138 208 277 Stationery and supplies 116 95 67 Data processing 124 108 99 Other 491 414 380 ------------------------------------------------------------ Total noninterest expense 5,099 4,409 3,716 ------------------------------------------------------------ Income before provision for income taxes 1,516 1,866 1,330 Income taxes 614 765 553 ------------------------------------------------------------ Net income $ 902 $ 1,101 $ 777 ============================================================ Net income per common share $1.00 $1.25 $1.03 ============================================================ Weighted average number of shares outstanding during the year 906,050 882,300 754,500 ============================================================ See accompanying notes. 54 Napa National Bancorp and Subsidiaries Consolidated Statements of Changes in Shareholders' Equity Years ended December 31, 1996, 1995 and 1994 Retained Number of Earnings Shares Common (Accumulated Outstanding Stock Deficit) Total ---------------------------------------------- (Dollars in Thousands) Balance, January 1, 1994 754,500 $6,915 $(1,346) $5,569 Net income 777 777 ---------------------------------------------- Balance, December 31, 1994 754,500 6,915 (569) 6,346 Net income - - 1,101 1,101 ---------------------------------------------- Balance, December 31, 1995 754,500 6,915 532 7,447 Cash dividends paid ($.50 per share) - - (378) (378) Net income - - 902 902 ---------------------------------------------- Balance, December 31, 1996 754,500 $6,915 $ 1,056 $7,971 ============================================== See accompanying notes. 55 Napa National Bancorp and Subsidiaries Consolidated Statements of Cash Flows YEARS ENDED DECEMBER 31 1996 1995 1994 -------------------------------- (Dollars in Thousands) OPERATING ACTIVITIES Net income $ 902 $ 1,101 $ 777 Reconciliation of net income to net cash provided by operating activities: Depreciation and amortization on premises and equipment 437 325 273 Amortization of deferred loan fees and premiums on investment securities (376) (304) (241) Provision for loan losses 550 323 149 Deferred income taxes (31) (160) (114) Loss on sale of fixed assets - 2 - (Increase) decrease in accrued interest 19 (234) (134) receivable (Increase) decrease in other assets (778) 48 (7) (Decrease) increase in accrued interest payable and other liabilities (213) (101) 544 -------------------------------- Net cash provided by operating activities 510 1,000 1,247 INVESTING ACTIVITIES Loan originations, net of repayments (5,090) (11,298) (7,752) Net decrease (increase) in time deposits with other financial institutions 198 1 (2,278) Activity in securities held to maturity: Purchases (2,696) (487) (1,214) Maturities 2,207 475 500 Purchase of FRB and FHLB stock (356) (32) (19) Proceeds from sales of other real - - 612 estate owned Purchase of premises and equipment (467) (1,366) (76) -------------------------------- Net cash used by investing activities (6,204) (12,707) (10,227) FINANCING ACTIVITIES Net increase in deposits 8,665 17,374 7,915 Cash dividends paid to shareholders (378) - - -------------------------------- Net cash provided by financing activities 8,287 17,374 7,915 Increase (decrease) in cash and cash 2,593 5,667 (1,065) equivalents Cash and cash equivalents, beginning of year 21,886 16,219 17,284 -------------------------------- Cash and cash equivalents, end of year $24,479 $ 21,886 $ 16,219 ================================ SUPPLEMENTAL CASH FLOW INFORMATION: Interest paid $ 2,965 $ 2,241 $ 1,630 ================================ Income taxes paid (net of refunds received) $ 1,020 $ 1,472 $ 89 ================================ See accompanying notes. 56 Napa National Bancorp and Subsidiaries Notes to Consolidated Financial Statements December 31, 1996 (Dollars in Thousands) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION Napa National Bancorp is a bank holding company whose primary investment is Napa National Bank (the "Bank"). Napa National Bancorp's only other investment is in a wholly owned inactive leasing subsidiary. The Bank is a full service community commercial bank with three offices in the Napa Valley area in Northern California. The Bank's primary source of revenue is from providing loans to customers, who are predominantly individuals, professionals and small to medium sized businesses. PRINCIPLES OF CONSOLIDATION AND USE OF ESTIMATES IN PREPARATION OF FINANCIAL STATEMENTS The consolidated financial statements of Napa National Bancorp and subsidiaries (the "Company") are prepared in conformity with generally accepted accounting principles and prevailing practices within the banking industry. All material intercompany transactions and accounts have been eliminated. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts. These estimates are based on information available as of the date of the financial statements. Actual results could differ from those estimates. CASH AND CASH EQUIVALENTS Cash and cash equivalents include cash on hand, amounts due from banks, and federal funds sold. Generally, federal funds sold are sold for one business day. INVESTMENT SECURITIES Held-to-maturity securities are those securities which management has the ability and intent to hold to maturity. These securities are stated at cost, adjusted for amortization of premiums and accretions of discounts to maturity using methods approximating the interest method. All of the Bank's investment securities are classified as held-to-maturity. 57 Napa National Bancorp and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in Thousands) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) LOANS Loans are stated at the principal amount outstanding and net of any deferred loan origination fees or costs. Interest income on loans is accrued daily on a simple interest basis. The Bank places an asset on nonaccrual status when any installment of principal or interest is 90 days past due, unless well secured and in the process of collection, or when management determines that ultimate collection of principal or interest on a loan is unlikely. When a loan is placed on nonaccrual, all previously accrued but uncollected interest is reversed. Cash payments subsequently received on nonaccrual loans are recognized as income only where the collection of principal is considered by management as probable. Interest accruals are resumed on such loans only when they are brought fully current with respect to interest and principal and when, in the judgment of management, the loans are estimated to be fully collectible as to both principal and interest. ALLOWANCE FOR LOAN LOSSES The allowance for loan losses is a reserve established through a provision for loan losses which is charged to expense. Losses are charged against the allowance when management believes that the collectibility of the principal is unlikely. The allowance is maintained at an amount that management believes will be adequate to absorb losses inherent in existing loans and commitments to extend credit, based on evaluations of their collectibility and the Bank's prior loss experience. The evaluations take into consideration such factors as changes in the nature and volume of the portfolio, overall portfolio quality, loan concentrations, specific problem loans, and current economic conditions that may affect the borrowers' ability to repay. Effective January 1, 1995, the Company adopted Statement of Financial Accounting Standards No. 114 (SFAS 114), "Accounting by Creditors for Impairment of a Loan," as amended. Under SFAS 114, a loan is impaired when it is "probable" that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. SFAS 114 excludes large groups of smaller balance homogeneous loans that are collectively evaluated for impairment. The Company has defined one to four family loans and consumer loans as homogeneous loans. All homogeneous loans that are 90 days or more delinquent or are in foreclosure are automatically placed on nonperforming status. The adoption of SFAS 114 did not have a material effect on the Company's financial condition or results of operations 58 Napa National Bancorp and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in Thousands) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) PREMISES AND EQUIPMENT Premises and equipment are carried at cost less accumulated depreciation and amortization. Depreciation and amortization expenses are computed using the straight-line method over the shorter of estimated useful lives of the related assets (which are generally three to twenty years) or the lease terms. Maintenance and repair costs are expensed as incurred, whereas expenditures that improve or extend the service lives of assets are capitalized. OTHER REAL ESTATE OWNED Other real estate owned ("OREO"), which is recorded in other assets, includes properties acquired through foreclosure or in full or partial satisfaction of the related loan. OREO also includes loans where the Bank has obtained physical possession of the related collateral. OREO is carried at the lower of fair value, net of estimated selling and disposal costs, or cost. Fair value adjustments are made at the time that real estate is acquired through foreclosure or when full or partial satisfaction of the related loan is received. These fair value adjustments are treated as loan losses. INCOME TAXES The Company accounts for income taxes under the asset and liability method. Deferred taxes arise from the effect of temporary differences between the tax bases of assets and liabilities and their reported amounts in the financial statements, and from the effect of operating loss carryforwards on taxes payable in future years based on currently enacted tax law. Deferred tax assets are reduced by a valuation allowance if, based on available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. 59 Napa National Bancorp and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in Thousands) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) STOCK-BASED COMPENSATION Effective January 1, 1996, the Company adopted Statement of Financial Accounting Standards No. 123 (SFAS 123), "Accounting for Stock-Based Compensation," which establishes financial accounting and reporting standards for stock-based compensation plans. The Company elected to continue accounting for stock-based employee compensation plans in accordance with Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued To Employees" and related interpretations, as SFAS 123 permits, and to follow the pro forma net income, pro forma earnings per share and stock-based compensation plan disclosure requirements set forth in SFAS 123. NET INCOME PER COMMON SHARE Net income per common share is computed by dividing net income by the weighted average number of common shares and dilutive stock options outstanding during the year. RECLASSIFICATION Certain amounts in prior periods have been reclassified to conform to the 1996 presentation. 2. CASH AND DUE FROM BANKS The Bank is required to maintain reserves with the Federal Reserve Bank. The average reserves required for 1996 and 1995 were $952 and $703, respectively. 60 Napa National Bancorp and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in Thousands) 3. SECURITIES HELD TO MATURITY The amortized cost and fair value of investment securities held to maturity as of December 31, 1996 and 1995, are summarized as follows: December 31, 1996 Amortized Unrealized Unrealized Fair Cost Gains Losses Value --------------------------------------------- Securities of U.S. Government agencies $1,723 $ 27 $ - $1,750 Federal Reserve Bank stock 232 - - 232 Federal Home Loan Bank stock 322 - - 322 --------------------------------------------- Total $2,277 $ 27 $ - $2,304 ============================================= December 31, 1995 Amortized Unrealized Unrealized Fair Cost Gains Losses Value --------------------------------------------- Securities of U.S. Government agencies $1,235 $ 15 $ - $1,250 Federal Reserve Bank stock 197 - - 197 -------------------------------------------- Total $1,432 $ 15 $ - $1,447 ============================================= Total securities pledged under state regulation to secure deposits amounted to $1,723 and $1,235 at December 31, 1996 and 1995, respectively. The maturities of securities of U.S. Government agencies at December 31, 1996 are due within one year. There were no sales of investment securities in 1996, 1995 and 1994. 61 Napa National Bancorp and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in Thousands) 4. LOANS AND ALLOWANCE FOR LOAN LOSSES Loans are presented net of unearned income of $374 and $296 at December 31, 1996 and 1995, respectively. Nonaccrual loans past due 90 days or more as of December 31, 1996 and 1995, were approximately $3,152 and $1,447 respectively. The effect on interest income, had these loans been performing in accordance with contractual terms as of December 31, 1996 and 1995, would have been an increase of approximately $188 and $291, respectively. At December 31, 1996, the Company had approximately $3,152 of loans considered to be impaired in accordance with SFAS 114. These loans were evaluated for impairment primarily using the collateral method and required an allowance for credit losses measured in accordance with SFAS 114 of $204 . Average impaired loans during the year ended December 31, 1995 amounted to approximately $2,123. Related interest income recognized on impaired loans during the year ended December 31, 1996 was approximately $44. The activity in the allowance for loan losses for the years ended December 31, 1996, 1995 and 1994 is summarized as follows (in thousands): 1996 1995 1994 ----------------------------- Balance, beginning of year $1,325 $1,050 $ 912 Provision for loan losses 550 323 149 Loans charged off (544) (51) (12) Recoveries 74 3 1 ----------------------------- Balance, end of year $1,405 $1,325 $1,050 ============================= At December 31, 1996 and 1995, the Bank was servicing loans for the Federal Home Loan Mortgage Corporation with unpaid principal balances of $23,020 and $22,508, respectively. Servicing loans for others generally consists of collecting mortgage payments, maintaining escrow accounts, disbursing payments to investors and conducting foreclosures proceedings. Loan servicing income is recorded on the accrual basis and includes servicing fees from investors and certain charges collected from borrowers, such as late payment fees. Income from loan servicing amounted to $62, $51 and $60 for the years ended December 31, 1996, 1995 and 1994, respectively. 62 Napa National Bancorp and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in Thousands) 5. PREMISES AND EQUIPMENT Premises and equipment as of December 31, 1996 and 1995 consisted of the following: 1996 1995 ------------------- Equipment $ 1,674 $ 1,485 Bank premises 941 941 Furniture and fixtures 576 530 Leasehold improvements 1,155 923 Automobiles 39 39 ------------------- Total 4,385 3,918 Less accumulated depreciation and (1,866) (1,429) amortization ------------------- Total $ 2,519 $ 2,489 =================== Depreciation and amortization of $437, $325 and $273 was charged to expense for the years ended December 31, 1996, 1995 and 1994, respectively. The Company and Bank relocated its head office in 1995, which resulted in the retirement of $341 in fully depreciated assets during that year. 6. DEPOSITS The aggregate amount of time deposit accounts exceeding $100,000 was $10,742 and $9,449 at December 31, 1996 and 1995, respectively. At December 31, 1996, the scheduled maturities for all time deposits is as follows: 1997 $33,323 1998 4,882 1999 100 2000 102 2001 - Thereafter - ---------- $38,407 ========== 63 Napa National Bancorp and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in Thousands) 7. INCOME TAXES The provision for income taxes for the years ended December 31, 1996, 1995 and 1994 is summarized as follows: 1996 1995 1994 ----------------------- Current: Federal $ 471 $ 667 $ 486 State 174 258 181 ----------------------- Total 645 925 667 ----------------------- Deferred: Federal (26) (126) (75) State (5) (34) (39) ----------------------- Total deferred (31) (160) (114) ----------------------- Provision for income taxes $ 614 $ 765 $ 553 ======================= The temporary differences and tax carryforwards which created deferred tax assets and liabilities are detailed below: DECEMBER 31 1996 1995 1994 ----------------------- Deferred tax assets: Reserves not currently deductible $ 546 $ 545 $ 412 Losses not currently deductible 227 227 227 State taxes - 21 3 Deferred loan fees 36 18 33 Other 14 9 6 ----------------------- Gross deferred tax assets 823 820 681 Valuation allowance (170) (170) (170) ----------------------- Deferred tax assets 653 650 511 ----------------------- Deferred tax liabilities: Accrual to cash - - (15) Tax over book depreciation (13) (43) (49) State taxes (10) - - ----------------------- Gross deferred tax liabilities (23) (43) (64) ----------------------- Net deferred tax asset included in other assets $ 630 $ 607 $ 447 ======================= 64 Napa National Bancorp and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in Thousands) 7. INCOME TAXES (CONTINUED) Deferred tax assets are recognized to the extent that their realization is more likely than not. As of December 31, 1996, 1995 and 1994, the Bank was unable to conclude that the realization of the Company's deferred tax asset was more likely than not. Accordingly, a valuation allowance has been reflected at December 31, 1996, 1995 and 1994 to reduce the Bank's deferred tax assets to the amount likely to be realized. The difference between the statutory federal income tax rate and the Company's effective tax rate, expressed as a percentage of income before income taxes, is as follows: 1996 1995 1994 -------------------- Federal statutory income 34% 34% 35% tax rate State franchise tax, less federal income tax effect 7 8 7 -------------------- Effective income tax rate 41% 42% 42% ==================== 8. TRANSACTIONS WITH RELATED PARTIES The Company has had, and expects to have in the future, banking transactions, primarily loans, in the ordinary course of business with directors, executive officers and their associates. In accordance with Company policy, loans to related parties are granted on the same terms, including interest rates and collateral, as those prevailing at the same time for comparable transactions with others, and do not involve more than the normal risk of collectibility. Loans to related parties for the years ended December 31, 1996 and 1995, are as follows: 1996 1995 ----------------- Balance at beginning of year $ 1,135 $ 1,295 Additions 2,858 1,493 Payments (1,746) (1,653) Other (89) - ----------------- Balance at end of year $ 2,158 $ 1,135 ================= 65 Napa National Bancorp and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in Thousands) 8. TRANSACTIONS WITH RELATED PARTIES (CONTINUED) The Company also had commitments to extend credit to related parties of $337 at December 31, 1996. Other activity in the table above represents loans to directors or officers who left the Company during the year and are, therefore, not considered related parties for purposes of this disclosure. At December 31, 1996 and 1995, an affiliated company of a member of the Board of Directors had $779 and $445 (0.7% and 0.5% of total deposits), respectively, deposited with the Company. These deposits were on the same terms as those prevailing at the same time for comparable transactions with others. 9. FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK In the normal course of business, the Company is party to financial instruments with off-balance sheet risk to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. The instruments involve, to varying degrees elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheet. The contract or notional amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments. The Company's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit written is represented by the contractual amount of these instruments. At December 31, 1996, financial instruments whose contract amounts represent credit risk were as follows: 1996 1995 -------------------- Commitments to extend credit $20,467 $18,168 Standby letters of credit 865 646 -------------------- $21,332 $18,814 ==================== 66 Napa National Bancorp and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in Thousands) 9. FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK (CONTINUED) 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 many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company 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 counter-party. Collateral required varies but may include accounts receivable, inventory, property, plant and equipment, real estate and income producing commercial properties. Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. The credit risk involved in issuing standby letters of credit is essentially the same as that involved in extending loans to customer. At December 31, 1996, all standby letters of credit were secured by normal business assets in accordance with the Company's standard lending practices. 10. CONCENTRATION OF CREDIT RISK The Company grants residential, commercial, construction, agricultural and consumer loans to customers principally located in Napa County, California. Although the Company has a diversified loan portfolio, a substantial portion of its debtors' ability to honor their contracts is dependent on the economic conditions of the wine industry. At December 31, 1996, the Company's loans to companies in the wine industry were $10,933 with commitments to lend an additional $4,670. The Company requires that loan customers meet the collateral requirements described in Note 9 for commitments to extend credit. As of December 31, 1996 and 1995, the Company's real estate loans were collateralized primarily with real estate located in the Napa Valley area. As such, the ultimate collectibility of a substantial portion of the Company's loan portfolio is influenced by the overall condition of the Northern California real estate market. 67 Napa National Bancorp and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in Thousands) 11. COMMITMENTS AND CONTINGENCIES The Company and the Bank lease a portion of their banking and office facilities under noncancelable operating leases. Total minimum future rental payments under these operating leases at December 31, 1996, are as follows: 1997 $180 1998 154 1999 109 ---- Total $443 ==== Rental expense was $194, $201 and $155 for the years ended December 31, 1996, 1995 and 1994, respectively. The Company is involved in various legal actions arising from normal business activities. Management believes that the ultimate resolution of these actions will not have a material effect on the consolidated financial statements. 12. RESTRICTIONS ON RETAINED EARNINGS Under the U.S. National Bank Act and other federal laws, the Bank is subject to prohibitions on the payment of dividends in certain circumstances and to restrictions on the amount that it can pay without prior approval of the Office of the Comptroller of the Currency. Without the Comptroller's approval, dividends for a given year cannot exceed the Bank's retained net income for that year and retained net profits from the preceding two years. In addition, dividends may not be paid in excess of the Bank's undivided profits, subject to other applicable provisions of law. Based upon these restrictions, the Bank could have declared dividends for 1996 of $2,609 without prior regulatory approval. 68 Napa National Bancorp and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in Thousands) 13. REGULATORY MATTERS Napa National Bancorp and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory--and possibly additional discretionary--actions by regulators that, if undertaken, could have a direct material effect on the their financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, Napa National Bancorp and the Bank must meet specific capital guidelines that involve quantitative measures of the thier assets, liabilities, and certain off- balance-sheet items as calculated under regulatory accounting practices. 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 that minimum amounts and ratios (set forth in the table below) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined) be maintained. Management believes, as of December 31, 1996, that Napa National Bancorp and the Bank meet all capital adequacy requirements. As of December 31, 1996, the most recent notification from the Office of the Comptroller of the Currency categorized both Napa National Bancorp and the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized minimum total risk-based, Tier I risk- based, and Tier I leverage ratios as set forth in the table below must be maintained. There are no conditions or events since that notification that management believes have changed the institution's category. 69 Napa National Bancorp and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in Thousands) 13. REGULATORY MATTERS (CONTINUED) Napa National Bancorp and the Bank's actual capital amounts and ratios are presented in the following tables: DECEMBER 31, 1996 MINIMUM MINIMUM WELL-CAPITALIZED ACTUAL REQUIREMENT REQUIREMENT ---------------------------------------------------- CAPITAL RATIO CAPITAL RATIO CAPITAL RATIO ---------------------------------------------------- NAPA NATIONAL BANCORP: Leverage $7,971 7.21% $4,423 4.00% $5,528 5.00% Tier 1 risk-based 7,971 9.34 3,413 4.00 5,121 6.00 Total risk-based 9,376 10.99 6,825 8.00 8,531 10.00 NAPA NATIONAL BANK: Leverage 7,862 7.11 4,423 4.00 5,529 5.00 Tier 1 risk-based 7,862 9.22 3,411 4.00 5,115 6.00 Total risk-based 8,932 10.47 6,822 8.00 8,531 10.00 DECEMBER 31, 1995 MINIMUM MINIMUM WELL-CAPITALIZED ACTUAL REQUIREMENT REQUIREMENT ---------------------------------------------------- CAPITAL RATIO CAPITAL RATIO CAPITAL RATIO ---------------------------------------------------- NAPA NATIONAL BANCORP: Leverage $7,447 7.45% $3,998 4.00% $4,998 5.00% Tier 1 risk-based 7,447 9.51 3,132 4.00 4,698 6.00 Total risk-based 8,772 11.20 6,266 8.00 7,832 10.00 NAPA NATIONAL BANK: Leverage 7,156 7.16 4,000 4.00 4,997 5.00 Tier 1 risk-based 7,156 9.14 3,132 4.00 4,698 6.00 Total risk-based 8,139 10.40 6,263 8.00 7,826 10.00 70 Napa National Bancorp and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in Thousands) 14. STOCK OPTION PLAN AND STOCK OWNERSHIP PLAN The Company has a stock option plan that provides for issuance of incentive stock options (ISO) to certain officers and nonstatutory stock options to certain members of the Company's Board of Directors to purchase up to 250,000 shares of common stock. Each option entitles the holder to purchase one share of common stock. Outstanding options that expire at various dates through 2006 have been granted at a price of $8.00 to $15.35. This price approximates the market value of the stock at the dates the options were granted. The right to exercise options vests either immediately or at various rates in each year of future service. There were 85,200 options available for grant at December 31, 1996. Option information is summarized below: PRICE NONSTATUTORY NUMBER OF OPTIONS --------------------------------- PER SHARE 1996 1995 1994 -------------- --------------------------------- Shares under option at beginning of year $ 8.00 - $8.09 110,000 90,000 100,000 Options canceled $ 8.00 - - (20,000) Options granted $8.00 - $15.35 10,000 20,000 10,000 --------------------------------- Shares under option at end of year $8.00 - $15.35 120,000 110,000 90,000 ================================= Shares under option exercisable at end of year $8.00 - $15.35 102,500 95,000 90,000 ================================= PRICE ISO NUMBER OF OPTIONS --------------------------------- PER SHARE 1996 1995 1994 ------------------------------------------------- Shares under option at beginning of year $ 8.00 34,800 31,300 28,800 Options granted $8.00 - $15.35 11,000 3,500 7,500 Options canceled $ 8.00 (1,000) - (5,000) --------------------------------- Shares under option at end of year $8.00 - $15.35 44,800 34,800 31,300 ================================= Shares under option exercisable at end of year $8.00 - $15.35 32,400 32,800 29,800 ================================= 71 Napa National Bancorp and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in Thousands) 14. STOCK OPTION PLAN AND STOCK OWNERSHIP PLAN (CONTINUED) The table below reflects the Company's net income and net income per common share (under the Treasury Stock method), if compensation cost for the Company's stock plan had been determined based on the fair value at the grant date for awards under their plan. Since pro forma compensation cost relates to all periods over which the awards vest, the initial impact on pro forma net income may not be representative of compensation cost in subsequent years. 1996 1995 ----------------- Net income applicable to common stock $ 866 $1,070 Net income per common share $0.97 $ 1.20 Fair values of the options were estimated at the date of grant using the Black- Scholes option pricing model, which includes the following assumptions used for the stock options awarded during 1996 and 1995, respectively: risk-free weighted average interest rates of 6.52 percent and 5.77 percent; dividend yield of .16 percent and 0 percent; expected volatility of 5.6 percent and 1.9 percent; and expected option life for both 1996 and 1995 grants of 8.5 years. The weighted average grant date fair values of the options granted during 1996 and 1995 were $6.57 and $7.76 per share, respectively. The exercise price of each option approximates the market price of the Company's common stock on the date of grant. Expiration dates range from September 16, 1998 to December 16, 2006 for options outstanding at December 31, 1996. The Company also has an Employee Stock Ownership Trust (the "ESOT"), in which all employees of the Company are eligible to participate. The ESOT is a defined-contribution plan which invests in the common stock of the Company. A portion of these contributions is matched by the Company. The Company's matching contributions to the ESOT were $74, $60 and $23 for the years ended December 31, 1996, 1995 and 1994, respectively. 72 Napa National Bancorp and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in Thousands) 15. FAIR VALUE OF FINANCIAL INSTRUMENTS The estimated fair values of financial instruments amounts have been determined by using available market information and appropriate valuation methodologies. However, these estimated fair values are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in the market assumptions or estimation techniques could significantly affect the fair value estimates. Because of the limitations, the aggregate fair value amounts presented below are not necessarily indicative of the amounts that could be realized in a current market exchange. The carrying amounts and the estimated fair values of the Company financial instruments at December 31, 1996 are as follows: CARRYING ESTIMATED AMOUNT FAIR VALUE ---------------------- ASSETS Cash and cash equivalents $ 24,479 $ 24,479 (a) Interest-bearing time 4,158 4,158 deposits - other financial institutions (b) Securities held to maturity 2,277 2,304 (c) Loans - net (d) 78,290 78,253 LIABILITIES Deposits (e) 105,417 112,560 OFF-BALANCE SHEET FINANCIAL INSTRUMENTS (F) Commitments to extend credit 20,467 20,467 Commercial letters of credit 865 865 73 Napa National Bancorp and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in Thousands) 15. FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED) The carrying amounts and the estimated fair values of the Company financial instruments at December 31, 1995 are as follows: CARRYING ESTIMATED AMOUNT FAIR VALUE ---------------------- ASSETS Cash and cash equivalents (a) $21,886 $21,886 Interest-bearing time deposits - other financial institution 4,356 4,356 Securities held to maturity (c) 1,432 1,447 Loans - net (d) 73,374 73,302 LIABILITIES Deposits (e) 96,752 95,560 OFF-BALANCE SHEET FINANCIAL INSTRUMENTS (F) Commitments to extend credit 18,168 18,168 Commercial letters of credit 646 646 (a) Cash and cash equivalents: The carrying amount is a reasonable estimate of fair value. (b) Interest-bearing time deposits - other financial institutions: The carrying value is a reasonable estimate of fair value. (c) Securities held to maturity: Fair values of investment securities are based on quoted market prices or dealer quotes. If a quoted market price was not available, fair value was estimated using quoted market prices for similar securities. (d) Loans - net: Fair values for certain commercial construction, revolving consumer credit and other loans were estimated by discounting the future cash flows using current rates at which similar loans would be made to borrowers with similar credit ratings and maturities. Certain adjustable rate loans and leases have been valued at their carrying values, since the interest rate adjustment characteristics of the loan or lease effectively adjust the interest rate to maintain a market rate of return. 74 Napa National Bancorp and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in Thousands) 15. FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED) (e) Deposits: The fair value of noninterest-bearing, adjustable rate deposits and deposits without fixed maturity dates is the amount payable upon demand at the reporting date. The fair value of fixed-rate interest-bearing deposits with fixed maturity dates was estimated by discounting the cash flows using rates currently offered for deposits of similar remaining maturities. (f) Off-balance-sheet instruments: The fair value of commitments to extend credit is estimated using fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. The fair values of standby and commercial letters of credit are based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties, reduced by the remaining net deferred income associated with such obligations. 16. NAPA NATIONAL BANCORP (PARENT COMPANY ONLY) The condensed financial statements of Napa National Bancorp are as follows: BALANCE SHEETS AS OF DECEMBER 31, 1996 AND 1995 1996 1995 ------------------ ASSETS Cash $ 93 $ 278 Investments in subsidiaries 7,975 7,269 Accrued interest receivable and other assets 145 16 ------------------ Total assets $8,083 $7,563 ================== LIABILITIES Accrued expenses and other liabilities $ 112 $ 116 Shareholders' equity: Preferred stock, no par value: 1,000,000 shares authorized, no shares outstanding - - Common stock, no par value: 20,000,000 shares authorized, 754,500 shares issued and 6,915 6,915 outstanding Retained earnings 1,056 532 ------------------- Total shareholders' equity 7,971 7,447 ------------------- Total liabilities and shareholders' $8,083 $7,563 equity =================== 75 Napa National Bancorp and Subsidiaries Notes to Consolidated Financial Statements (continued) (Dollars in Thousands) 16. NAPA NATIONAL BANCORP (PARENT COMPANY ONLY) (CONTINUED) STATEMENTS OF INCOME FOR THE YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994 1996 1995 1994 ------------------------- Income: Interest income $ 3 $ 6 $ 6 Dividend from subsidiaries 200 - - Other income - 12 - ------------------------- Total income 203 18 6 ------------------------- Expenses: Salaries and employee benefits - 46 - Other expense 7 1 3 ------------------------- Total expenses 7 47 3 ------------------------- Income (Loss) before applicable taxes and equity in undistributed net income of subsidiaries 196 (29) Applicable Income Taxes - - - ------------------------- Income (Loss) before equity in undistributed net income of subsidiaries 196 (29) 3 Equity in undistributed net income of subsidiaries 706 1,130 774 ------------------------- Net income $ 902 $ 1,101 $ 777 ========================= STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994 1996 1995 1994 ------------------------- Operating activities: Net income $ 902 $ 1,101 $ 777 Reconciliation of net income to net cash provided (used) by operating activities: Equity in undistributed net income of subsidiaries (706) (1,130) (774) Decrease in accrued interest receivable 1 - - (Decrease) increase in accrued expenses and other liabilities, net (4) - - ------------------------- Net cash (used) provided by operating activities 193 (29) 3 Financing activities: Cash dividends paid to shareholders (378) - - ------------------------- Net cash (used) by financing activities (378) - - Net (decrease) increase in cash (185) (29) 3 Cash at beginning of year 278 308 305 ------------------------- Cash at end of year $ 93 $ 278 $ 308 ========================= 76 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Dated: March 26, 1997. NAPA NATIONAL BANCORP By /s/ Brian J. Kelly President/COO By /s/ Michael D. Irwin Chief Financial Officer (Principal Accounting Officer) POWER OF ATTORNEY KNOW ALL BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Brian J. Kelly and Michael D. Irwin jointly and severally, his attorneys-in-fact, each with the power of substitution, for him in any and all capacities, to sign any amendments to this Annual Report on Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. March 26, 1997 /s/ William A. Bacigalupi Director March 26, 1997 /s/ Dennis D. Groth Director March 26, 1997 /s/ E. James Hedemark Director March 26, 1997 /s/ Michael D. Irwin Director Chief Financial Officer (Principal Accounting Officer) March 26, 1997 /s/ Brian J. Kelly President and COO Director March 26, 1997 /s/ C. Richard Lemon Secretary and Director March 26, 1997 /s/ Joseph G. Peatman Director March 26, 1997 /s/ A. Jean Phillips Director March 26, 1997 /s/ George M. Schofield Director March 26, 1997 /s/ W. Clarke Swanson, Jr. Chairman of the Board and CEO INDEX TO EXHIBITS EXHIBIT NO. DESCRIPTION 3(i) Articles of Incorporation of the Registrant, as amended. 3(ii).1 Restated Bylaws of the Registrant. 4.1 A specimen copy of the certificates evidencing Common Stock. 10.1 Napa National Bancorp 1992 Stock Option Plan. 10.2 Form of Incentive Stock Option Agreement 10.3 Form of Nonstatutory Stock Option Agreement 16.1* Letter re change in certifying accountants. (Exhibit 16.1 to Form 8-K/A filed on October 23, 1996.) 21.1* Subsidiaries of the Registrant. 24.1 Power of Attorney (located on signature page hereof) 27 Financial Data Schedule 99.1* Registrant's Form 8-K filed on September 26, 1996, and amended on October 23, 1996. *Previously filed.