HERITAGE COMMERCE CORP - Quarter Report: 2009 September (Form 10-Q)

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

FORM 10-Q


(MARK ONE)
ý		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2009
OR
o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to

Commission file number 000-23877

Heritage Commerce Corp
(Exact name of Registrant as Specified in its Charter)


California (State or Other Jurisdiction of Incorporation or Organization)		77-0469558 (I.R.S. Employer Identification No.)
150 Almaden Boulevard, San Jose, California (Address of Principal Executive Offices)		95113 (Zip Code)

(408) 947-6900
(Registrant's Telephone Number, Including Area Code)

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

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 ý NO o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). YES o NO o

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act.


Large accelerated filer o		Accelerated filer ý		Non-accelerated filer o (Do not check if a smaller reporting company)		Smaller reporting company o

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

The Registrant had 11,820,509 shares of common stock outstanding on October 22, 2009.

Table of Contents

Heritage Commerce Corp and Subsidiaries
Quarterly Report on Form 10-Q
Table of Contents



PART I. FINANCIAL INFORMATION
Item 1.	Consolidated Financial Statements (unaudited):	3
	Consolidated Balance Sheets	3
	Consolidated Statements of Operations	4
	Consolidated Statements of Changes in Shareholders' Equity	5
	Consolidated Statements of Cash Flows	6
	Notes to Consolidated Financial Statements	7
Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	20
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	54
Item 4.	Controls and Procedures	54
PART II. OTHER INFORMATION
Item 1.	Legal Proceedings	55
Item 1A.	Risk Factors	55
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	72
Item 3.	Defaults Upon Senior Securities	72
Item 4.	Submission of Matters to a Vote of Security Holders	72
Item 5.	Other Information	72
Item 6.	Exhibits	73
SIGNATURES		74
EXHIBIT INDEX		75

Table of Contents

Part I—FINANCIAL INFORMATION

ITEM 1—CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Heritage Commerce Corp

Consolidated Balance Sheets (Unaudited)

					September 30, 2009			December 31, 2008

					(Dollars in thousands)
Assets
Cash and due from banks					$	42,105		$	29,996
Federal funds sold						150			100

				Total cash and cash equivalents		42,255			30,096
Securities available-for-sale, at fair value						96,618			104,475
Loans held-for-sale, at lower of cost or market, including deferred costs						21,976			—
Loans, including deferred costs						1,081,568			1,248,631
Allowance for loan losses						(28,976	)		(25,007	)

			Loans, net			1,052,592			1,223,624
Federal Home Loan Bank and Federal Reserve Bank stock, at cost						8,444			7,816
Company owned life insurance						41,897			40,649
Premises and equipment, net						9,182			9,517
Goodwill						43,181			43,181
Intangible assets						3,750			4,231
Accrued interest receivable and other assets						47,715			35,638

			Total assets		$	1,367,610		$	1,499,227

Liabilities and Shareholders' Equity
Liabilities:
	Deposits
		Demand, noninterest bearing			$	250,515		$	261,337
		Demand, interest bearing				139,919			134,814
		Savings and money market				324,611			344,767
		Time deposits, under $100				43,559			45,615
		Time deposits, $100 and over				134,533			171,269
		Time deposits-CDARS				41,418			11,666
		Time deposits-brokered				181,819			184,582

				Total deposits		1,116,374			1,154,050
	Notes payable to subsidiary grantor trusts					23,702			23,702
	Securities sold under agreement to repurchase					25,000			35,000
	Note payable					—			15,000
	Other short-term borrowings					—			55,000
	Accrued interest payable and other liabilities					29,111			32,208

			Total liabilities			1,194,187			1,314,960
Shareholders' equity:
	Preferred stock, no par value; 10,000,000 shares authorized; 40,000 shares outstanding (liquidation preference of $1,000 per share plus accrued dividends)					39,846			39,846
	Discount on preferred stock					(1,687	)		(1,946	)
	Common stock, no par value; 30,000,000 shares authorized; 11,820,509 shares outstanding					79,884			78,854
	Retained earnings					57,563			70,986
	Accumulated other comprehensive loss					(2,183	)		(3,473	)

			Total shareholders' equity			173,423			184,267

			Total liabilities and shareholders' equity		$	1,367,610		$	1,499,227

See notes to consolidated financial statements

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Heritage Commerce Corp

Consolidated Statements of Operations (Unaudited)

		Three Months Ended September 30,						Nine Months Ended September 30,

		2009			2008			2009			2008
		(Dollars in thousands, except per share data)
Interest income:
	Loans, including fees	$	14,727		$	17,919		$	44,619		$	53,524
	Securities, taxable		753			1,250			2,702			4,137
	Securities, non-taxable		1			17			9			64
	Interest bearing deposits in other financial institutions		14			1			21			10
	Federal funds sold		—			10			—			56

Total interest income			15,495			19,197			47,351			57,791
Interest expense:
	Deposits		3,228			4,911			10,652			15,285
	Notes payable to subsidiary grantor trusts		476			527			1,463			1,610
	Repurchase agreements		168			264			638			674
	Note payable		—			100			82			184
	Other short-term borrowings		—			349			53			920

Total interest expense			3,872			6,151			12,888			18,673

Net interest income before provision for loan losses			11,623			13,046			34,463			39,118
Provision for loan losses			7,129			1,587			28,253			11,037

Net interest income after provision for loan losses			4,494			11,459			6,210			28,081
Noninterest income:
	Gain on sale of loans		643			—			643			—
	Service charges and fees on deposit accounts		557			505			1,665			1,457
	Increase in cash surrender value of life insurance		420			416			1,248			1,232
	Servicing income		382			491			1,210			1,347
	Other		348			276			808			958

Total noninterest income			2,350			1,688			5,574			4,994
Noninterest expense:
	Salaries and employee benefits		5,730			5,665			17,831			17,694
	Occupancy and equipment		1,005			1,348			2,893			3,511
	Professional fees		691			468			2,833			2,112
	Deposit insurance premiums and regulatory assessments		631			238			2,590			626
	Low income housing investment expense		217			208			642			661
	Insurance		203			148			393			397
	Software subscriptions		203			291			616			703
	Data processing		196			252			686			751
	Provision for off-balance sheet credit risk		173			(40	)		166			(53	)
	Client services		146			196			450			629
	Amortization of intangible assets		160			176			481			565
	Director fees		141			141			436			408
	Advertising and promotion		96			186			320			609
	Other		1,152			1,120			3,848			3,361

Total noninterest expense			10,744			10,397			34,185			31,974

Income (loss) before income taxes			(3,900	)		2,750			(22,401	)		1,101
Income tax expense (benefit)			(1,824	)		309			(10,990	)		39

Net income (loss)		$	(2,076	)	$	2,441		$	(11,411	)	$	1,062
Dividends and discount accretion on preferred stock			(599	)		—			(1,776	)		—

Net income (loss) allocable to common shareholders		$	(2,675	)	$	2,441		$	(13,187	)	$	1,062

Earnings (loss) per common share:
	Basic	$	(0.23	)	$	0.21		$	(1.12	)	$	0.09
	Diluted	$	(0.23	)	$	0.21		$	(1.12	)	$	0.09

See notes to consolidated financial statements

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HERITAGE COMMERCE CORP

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (UNAUDITED)

NINE MONTHS ENDED SEPTEMBER 30, 2009 and 2008

		Preferred Stock					Common Stock									Accumulated Other Comprehensive Loss

		Preferred Stock					Common Stock						Retained Earnings						Total Shareholders' Equity			Comprehensive Income (Loss)
		Amount		Discount			Shares			Amount			Retained Earnings						Total Shareholders' Equity			Comprehensive Income (Loss)
		(Dollars in thousands, except share data)
Balance, January 1, 2008		$	—	$	—			12,774,926		$	92,414		$	73,298		$	(888	)	$	164,824
Cumulative effect adjustment upon adoption of EITF 06-4, net of deferred income taxes (See Note 2)			—		—			—			—			—			(3,182	)		(3,182	)
Net income			—		—			—			—			1,062			—			1,062		$	1,062
Net change in unrealized gain on securities available-for-sale and interest-only strips, net of reclassification adjustment and deferred income taxes			—		—			—			—			—			336			336			336
Decrease in pension liability, net of deferred income taxes			—		—			—			—			—			40			40			40

	Total comprehensive income																			—		$	1,438

Amortization of restricted stock award			—		—			—			116			—			—			116
Dividends declared on common stock, $0.24 per share			—		—			—			—			(2,872	)		—			(2,872	)
Commom stock repurchased			—		—			(1,007,749	)		(17,655	)		—			—			(17,655	)
Stock option expense			—		—			—			1,034			—			—			1,034
Stock options exercised, including related tax benefits			—		—			53,332			581			—			—			581

Balance, September 30, 2008		$	—	$	—			11,820,509		$	76,490		$	71,488		$	(3,694	)	$	144,284

Balance, January 1, 2009		$	39,846	$	(1,946	)		11,820,509		$	78,854		$	70,986		$	(3,473	)	$	184,267
Net loss			—		—			—			—			(11,411	)		—			(11,411	)	$	(11,411	)
Net change in unrealized gain/loss on securities available-for-sale and interest-only strips, net of reclassification adjustment and deferred income taxes			—		—			—			—			—			593			593			593
Net decrease in pension and other postretirement obligations, net of deferred income taxes			—		—			—			—			—			697			697			697

	Total comprehensive loss																					$	(10,121	)

Amortization of restricted stock award			—		—			—			115			—			—			115
Cash dividends accrued on preferred stock			—		—			—			—			(1,517	)		—			(1,517	)
Accretion of discount on preferred stock			—		259			—			—			(259	)		—			—
Cash dividend declared on common stock, $0.02 per share			—		—			—			—			(236	)		—			(236	)
Stock option expense			—		—			—			985			—			—			985
Income tax effect of restricted stock award vesting			—		—			—			(70	)		—			—			(70	)

Balance, September 30, 2009		$	39,846	$	(1,687	)		11,820,509		$	79,884		$	57,563		$	(2,183	)	$	173,423

See notes to consolidated financial statements

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Heritage Commerce Corp

Consolidated Statements of Cash Flows (Unaudited)

			Nine Months Ended September 30,

			2009			2008
			(Dollars in thousands)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss)			$	(11,411	)	$	1,062
Adjustments to reconcile net (loss) income to net cash provided by operating activities:
Depreciation and amortization				604			807
Loss on sale of securities available-for-sale				7			—
Provision for loan losses				28,253			11,037
Stock option expense				985			1,034
Amortization of intangible assets				481			565
Amortization of restricted stock award				115			116
Amortization (accretion) of discounts and premiums on securities				(324	)		442
Gain on sale of foreclosed assets				(106	)		—
Gain on sale of SBA loans				(643	)		—
Net change in SBA loans originated for sale				(15,056	)		—
Increase in cash surrender value of life insurance				(1,248	)		(1,232	)
Effect of changes in:
		Accrued interest receivable and other assets		(10,456	)		2,246
		Accrued interest payable and other liabilities		(1,943	)		(1,435	)

Net cash provided by (used in) operating activities				(10,742	)		14,642

CASH FLOWS FROM INVESTING ACTIVITIES:
Net change in loans				116,417			(215,637	)
Sales of SBA loans previously transferred to held-for-sale				15,369			—
Net change in SBA loans previously transferred to held-for-sale				(1,140	)		—
Purchases of securities available-for-sale				(69,271	)		(19,957	)
Maturities/Paydowns/Calls of securities available-for-sale				69,815			47,209
Proceeds from sale of securities available-for-sale				8,552			—
Purchase of company-owned life insurance				—			(361	)
Purchase of premises and equipment				(269	)		(817	)
Purchase of Federal Home Loan Bank snd Federal Reserve Bank stock				(628	)		(277	)
Proceeds from sale of foreclosed assets				3,505			902

Net cash provided by (used in) investing activities				142,350			(188,938	)

CASH FLOWS FROM FINANCING ACTIVITIES:
Net change in deposits				(37,676	)		121,958
Exercise of stock options				—			581
Income tax effect of restricted stock award vesting				(70	)		—
Common stock repurchased				—			(17,655	)
Payment of cash dividends—common stock				(236	)		(2,872	)
Payment of cash dividends—preferred stock				(1,467	)		—
Payment of other liability				—			(91	)
Net change in other short-term borrowings				(55,000	)		35,000
Net change in note payable				(15,000	)		—
Net change in securities sold under agreement to repurchase				(10,000	)		24,100

Net cash provided by (used in) financing activities				(119,449	)		161,021

Net increase (decrease) in cash and cash equivalents				12,159			(13,275	)
Cash and cash equivalents, beginning of period				30,096			49,093

Cash and cash equivalents, end of period			$	42,255		$	35,818

Supplemental disclosures of cash flow information:
	Cash paid during the period for:
		Interest	$	13,215		$	19,220
		Income taxes	$	1,250		$	1,858
Supplemental schedule of non-cash investing and financing activities:
		Transfer of portfolio loans to loans held-for-sale	$	20,506		$	—
		Loans transferred to foreclosed assets	$	5,856		$	830

See notes to consolidated financial statements

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HERITAGE COMMERCE CORP

Notes to Consolidated Financial Statements

September 30, 2009

(Unaudited)

1) Basis of Presentation

The unaudited consolidated financial statements of Heritage Commerce Corp (the "Company") and its wholly owned subsidiary, Heritage Bank of Commerce ("HBC"), have been prepared pursuant to the rules and regulations for reporting on Form 10-Q. Accordingly, certain information and notes required by accounting principles generally accepted in the United States of America ("GAAP") for annual financial statements are not included herein. The interim statements should be read in conjunction with the consolidated financial statements and notes that were included in the Company's Form 10-K for the year ended December 31, 2008. The Company has also established the following unconsolidated subsidiary grantor trusts: Heritage Capital Trust I; Heritage Statutory Trust I; Heritage Statutory Trust II; and Heritage Commerce Corp Statutory Trust III which are Delaware Statutory business trusts formed for the exclusive purpose of issuing and selling trust preferred securities. On June 20, 2007, the Company completed its acquisition of Diablo Valley Bank ("DVB"). DVB was merged into HBC on the acquisition date.

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

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

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

The results for the three and nine months ended September 30, 2009 are not necessarily indicative of the results expected for any subsequent period or for the entire year ending December 31, 2009.

Adoption of New Accounting Standards

In February 2008, the FASB issued Staff Position ("FSP") 157-2, "Effective Date of FASB Statement No. 157." This FSP delays the effective date of FAS 157 for all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value on a recurring basis (at least annually) to fiscal years beginning after November 15, 2008, and interim periods within those fiscal years. On October 10, 2008 the FASB issued FSP 157-3, "Determining the Fair Value of a Financial Asset When the Market for that Asset Is Not Active," which illustrates key considerations in determining the fair value of a financial asset when the market for that asset is not active. FSP 157-3 provides clarification for how to consider various inputs in determining fair value under current market conditions consistent with the principles of FAS 157. FSP 157-3 became effective upon issuance. Adoption of these FSPs has not impacted the Company.

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HERITAGE COMMERCE CORP

Notes to Consolidated Financial Statements (Continued)

September 30, 2009

(Unaudited)

1) Basis of Presentation (Continued)

In December 2007, FASB issued Statement 141 (revised 2007), "Business Combinations," which establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in an acquiree, including the recognition and measurement of goodwill acquired in a business combination. This Statement is effective for fiscal years beginning on or after December 15, 2008. The adoption of this standard did not impact the Company's financial statements.

In December 2007, FASB issued Statement 160, "Noncontrolling Interests in Consolidated Financial Statements." This statement is intended to improve the relevance, comparability, and transparency of the financial information that a reporting entity provides in its consolidated financial statements by establishing accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. This Statement is effective for fiscal years and interim periods within those fiscal years beginning on or after December 15, 2008. The adoption of this standard did not impact the Company's financial statements.

In March 2008, FASB issued Statement 161, "Disclosures about Derivative Instruments and Hedging Activities, an Amendment of FASB Statement No. 133." This statement changes the disclosure requirements for derivative instruments and hedging activities. Entities are required to provide enhanced disclosures about (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for under Statement 133 and its related interpretations, and (c) how derivative instruments and related hedged items affect an entity's financial position, financial performance, and cash flows. This Statement is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. The adoption of this standard did not impact the Company's financial statements.

In June 2008, the FASB issued FASB Staff Position EITF 03-6-1—"Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities" ("FSP EITF 03-6-1"). This FSP addresses whether instruments granted in share-based payment transactions are participating securities prior to vesting and, therefore, need to be included in the earnings allocation in computing earnings per share ("EPS") under the two-class method of FASB Statement No. 128, "Earnings Per Share." FSP EITF 03-6-1 provides that unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and shall be included in the computation of EPS pursuant to the two-class method. This FSP is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those years. All prior-period EPS data presented shall be adjusted retrospectively to conform with the provisions of this FSP. Upon adoption of FSP EITF 03-6-1 in 2009, the Company began including non-vested restricted stock award shares in the computation of basic EPS. Previously, non vested restricted stock awards were excluded from the basic EPS computation and included in the diluted EPS computation. The 2008 EPS data presented has been adjusted retrospectively to conform with the provisions of this FSP, although this change in computation did not involve a sufficient number of shares to change basic and diluted EPS from the amounts previously reported.

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HERITAGE COMMERCE CORP

Notes to Consolidated Financial Statements (Continued)

September 30, 2009

(Unaudited)

1) Basis of Presentation (Continued)

In April 2009, the FASB issued FSP 115-2 & 124-2, "Recognition and Presentation of Other Than Temporary Impairments." The FSP eliminates the requirement for the issuer to evaluate whether it has the intent and ability to hold an impaired investment until maturity. Conversely, the new FSP requires the issuer to recognize an other than temporary impairment ("OTTI") if the issuer intends to sell the impaired security or the issuer will be required to sell the security prior to recovery. In the event that the sale of the security in question prior to its maturity is not probable but the entity does not expect to recover its amortized cost basis in that security, then the entity will be required to recognize an OTTI. In the event that the recovery of the security's cost basis prior to maturity is not probable and an OTTI is recognized, the FSP provides that any component of the OTTI relating to a decline in the creditworthiness of the debtor should be reflected in earnings, with the remainder being recognized in Other Comprehensive Income. Conversely, in the event that the issuer determines that sale of the security in question prior to recovery is probable, then the entire OTTI will be recognized in earnings. The FSP is effective for interim and annual reporting periods ending after June 15, 2009. The adoption of this standard did not have a material impact on the Company's financial statements.

In April 2009, the FASB issued FSP 157-4, "Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly." The FSP provides additional guidance for determining fair value based on observable transactions. The FSP provides that if evidence suggests that an observable transaction was not executed orderly that little, if any, weight should be assigned to this indication of an asset's or liability's fair value. Conversely, if evidence suggests that the observable transaction was executed orderly then the transaction price of the observable transaction may be appropriate to use in determining the fair value of the asset/liability in question, with appropriate weighting given to this indication based on facts and circumstances. Finally, if there is no way for the entity to determine whether the observable transaction was executed orderly, relatively less weight should be ascribed to this indicator of fair value. The FSP is effective for interim and annual reporting periods ending after June 15, 2009. The adoption of this standard did not have a material impact on the Company's financial statements.

In April 2009, the FASB issued FSP 107-1 & APB 28-1, "Interim Disclosures about Fair Value of Financial Instruments." The FSP provides that publicly traded companies must provide information concerning the fair value of its financial instruments whenever it issues summarized financial information for interim reporting periods. In periods after initial adoption, this FSP requires comparative disclosures only for periods ending after initial adoption. The FSP is effective for interim reporting periods ending after June 15, 2009. The adoption of this FSP on June 30, 2009 resulted in additional disclosures which are presented in Note 6 of the Company's consolidated financial statements.

In May 2009, the FASB issued Statement No. 165, "Subsequent Events." Statement 165 sets forth guidance concerning the recognition or disclosure of events or transactions that occur subsequent to the balance sheet date but prior to the release of the financial statements. The statement also defines "available to be issued" financial statements as financial statements that are complete and in a format that complies with GAAP and have received all the required approvals, for example from the board of directors. The statement sets forth that management of a public company must evaluate subsequent

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HERITAGE COMMERCE CORP

Notes to Consolidated Financial Statements (Continued)

September 30, 2009

(Unaudited)

1) Basis of Presentation (Continued)

events for recognition and/or disclosure through the date of issuance, whereas private companies need only evaluate subsequent events through the date the financial statements became available to be issued. The statement also delineates between and defines the recognition and disclosure requirements for Recognized Subsequent Events and Non-Recognized Subsequent Events. Recognized Subsequent Events provide additional evidence about conditions that existed as of the balance sheet date and will be recognized in the entity's financial statements. Non-Recognized Subsequent Events provide evidence about conditions that did not exist as of the balance sheet date and if material will warrant disclosure of the nature of the subsequent event and the financial impact. An entity shall disclose the date through which subsequent events have been evaluated and whether that date is the date the financial statements were issued or available to be issued. This statement is effective for interim and annual reporting periods ending after June 15, 2009. The Company has evaluated subsequent events through the date of issuance of these financial statements on October 28, 2009. The adoption of this standard did not have a material impact on the Company's financial statements.

Newly Issued, but not yet Effective Accounting Standards

In June 2009, the FASB issued Statement No. 166, "Accounting for the Transfer of Financial Assets—an Amendment of FASB Statement No. 140." Statement 166 removes the concept of a special purpose entity ("SPE") from Statement 140 and removes the exception from applying FASB Interpretation No. 46(R), "Consolidation of Variable Interest Entities," to qualifying SPEs. It limits the circumstances in which a transferor derecognizes a financial asset. The statement amends the requirements for the transfer of a financial asset to meet the requirements for "sale" accounting. The statement is effective for all interim and annual periods beginning after November 15, 2009. The Company is currently evaluating the impact of Statement 166 on its financial position and results of operations.

In June 2009, the FASB issued Statement No. 167, "Amendments to FASB Interpretation No. 46(R)." This Statement amends Interpretation 46(R) to require an enterprise to perform an analysis to determine whether the enterprise's variable interest gives it a controlling financial interest in the variable interest entity. The statement is effective for all interim and annual periods beginning after November 15, 2009. The Company does not expect adoption of Statement 167 to have a material impact on the Company's financial statements.

On July 1, 2009, the FASB's GAAP Codification became effective as the sole authoritative source of GAAP. This codification was issued under FASB Statement No. 168, "The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles—a replacement of FASB Statement No. 162." This Codification reorganizes current GAAP for non-governmental entities into a topical index to facilitate accounting research and to provide users additional assurance that they have referenced all related literature pertaining to a given topic. Existing GAAP prior to the Codification was not altered in compilation of the GAAP Codification. Statement 168 is effective for all interim and annual periods ending after September 15, 2009.

Table of Contents

HERITAGE COMMERCE CORP

Notes to Consolidated Financial Statements (Continued)

September 30, 2009

(Unaudited)

2) Reclassification of Cumulative Effect Adjustment

As allowed by SEC Staff Accounting Bulletin No. 108 ("SAB 108"), the Company reclassified a cumulative effect adjustment of $3.2 million from retained earnings to accumulated other comprehensive income as of January 1, 2008. Total shareholders' equity remains unchanged due to this reclassification. The reclassification does not affect assets, liabilities, net income or loss, or cash flows for any period.

In September 2006, the Financial Accounting Standards Board ("FASB") Emerging Issues Task Force ("EITF") finalized Issue No. 06-4, "Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements." This issue requires that a liability be recorded over the average life expectancy when a split-dollar life insurance agreement continues after a participant's employment or retirement. The required accrued liability is based on either the post-employment benefit cost for the continuing life insurance or the future death benefit depending on the contractual terms of the underlying agreement. The Company adopted EITF 06-4 on January 1, 2008. The adoption of EITF 06-4 resulted in a cumulative effect adjustment to retained earnings of $3.2 million, net of deferred income taxes, at January 1, 2008. The Company has determined that this adjustment should have been made to accumulated other comprehensive income instead of retained earnings.

3) Earnings Per Share

Basic earnings per share is computed by dividing net income, less dividends and discount accretion on preferred stock, by the weighted average common shares outstanding. Diluted earnings per share reflects potential dilution from outstanding stock options and common stock warrants, using the treasury stock method. Due to the Company's net loss in 2009, all stock options and warrants were excluded from the computation of diluted earnings (loss) per share. There were 984,962 and 846,672 stock options for the three and nine months ended September 30, 2008, respectively, considered to be antidilutive and excluded from the computation of diluted earnings per share. For each of the periods presented, net income (loss) is the same for basic and diluted earnings (loss) per share. Reconciliation of weighted average shares used in computing basic and diluted earnings (loss) per share is as follows:

	Three Months Ended September 30,				Nine Months Ended September 30,

	2009		2008		2009		2008
Weighted average common shares outstanding—used in computing basic earnings (loss) per share		11,820,509		11,810,091		11,820,509		12,063,710
Dilutive effect of stock options and warrants outstanding, using the treasury stock method		N/A		17,121		N/A		37,103

Shares used in computing diluted earnings (loss) per share		11,820,509		11,827,212		11,820,509		12,100,813

Table of Contents

HERITAGE COMMERCE CORP

Notes to Consolidated Financial Statements (Continued)

September 30, 2009

(Unaudited)

September 30, 2009		Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Estimated Fair Value

		(Dollars in thousands)
Securities available-for-sale:
	U.S. Treasury	$	39,998	$	1	$	—		$	39,999
	U.S. Government Sponsored Entities		1,998		20		—			2,018
	Municipals—Tax Exempt		—		—		—			—
	Mortgage-Backed Securities—Residential		46,884		2,063		(3	)		48,944
	Collateralized Mortgage Obligations—Residential		5,414		243		—			5,657

Total securities available-for-sale		$	94,294	$	2,327	$	(3	)	$	96,618

December 31, 2008		Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Estimated Fair Value

		(Dollars in thousands)
Securities available-for-sale:
	U.S. Treasury	$	19,370	$	126	$	—		$	19,496
	U.S. Government Sponsored Entities		8,457		239		—			8,696
	Municipals—Tax Exempt		696		5		—			701
	Mortgage-Backed Securities—Residential		68,180		1,241		(385	)		69,036
	Collateralized Mortgage Obligations—Residential		6,370		198		(22	)		6,546

Total securities available-for-sale		$	103,073	$	1,809	$	(407	)	$	104,475

			September 30, 2009 Weighted Average Life

			Within One Year		After One and Within Five Years		After Five and Within TenYears		After Ten Years		Total
			(Dollars in thousands)
Securities available-for-sale (at fair value)
	U.S. Treasury		$	39,999	$	—	$	—	$	—	$	39,999
	U.S. Government Sponsored Entities			2,018		—		—		—		2,018
	Mortgage-Backed Securities—Residential			870		37,798		5,807		4,469		48,944
	Collateralized Mortgage Obligations—Residential			1,268		4,389		—		—		5,657

		Total Securities Available-for-Sale	$	44,155	$	42,187	$	5,807	$	4,469	$	96,618

		September 30, 2009			December 31, 2008

		(Dollars in thousands)
Loans held for sale		$	21,976		$	—
Loans held for investment
	Commercial	$	414,441		$	525,080
	Real estate—mortgage		405,486			405,530
	Real estate—land and construction		197,374			256,567
	Home equity		51,768			55,490
	Consumer		11,476			4,310

Loans			1,080,545			1,246,977
Deferred loan origination costs and fees, net			1,023			1,654

Loans, including deferred costs			1,081,568			1,248,631
Allowance for loan losses			(28,976	)		(25,007	)

Loans, net		$	1,052,592		$	1,223,624

	Nine Months Ended September 30,

	Nine Months Ended September 30,						For the Year Ended December 31, 2008
	2009			2008			For the Year Ended December 31, 2008
	(Dollars in thousands)
	(Dollars in thousands)
Balance, beginning of period	$	25,007		$	12,218		$	12,218
Loans charged-off		(25,253	)		(935	)		(2,806	)
Recoveries		969			3			58

Net charge-offs		(24,284	)		(932	)		(2,748	)
Provision for loan losses		28,253			11,037			15,537

Balance, end of period	$	28,976		$	22,323		$	25,007

		September 30, 2009		December 31, 2008

		(Dollars in thousands)
Period-end loans with no allocated allowance for loan losses		$	9,472	$	10,745
Period-end loans with allocated allowance for loan losses			45,792		50,805

	Total	$	55,264	$	61,550

	September 30, 2009		December 31, 2008

	(Dollars in thousands)
Loans past due over 90 days still on accrual	$	144	$	460
Nonaccrual loans	$	55,120	$	39,981

				Fair Value Measurements Using

		Balance		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Obeservable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
		(Dollars in thousands)
Assets:
*September 30, 2009*
	Available-for-sale securities	$	96,618	$	39,999	$	56,619	$	—
	I/O strip receivables	$	2,084	$	—	$	2,084	$	—
*December 31, 2008*
	Available-for-sale securities	$	104,475	$	19,496	$	84,979	$	—
	I/O strip receivables	$	2,248	$	—	$	2,248	$	—

		September 30, 2009				December 31, 2008

		Carrying Amounts		Estimated Fair Value		Carrying Amounts		Estimated Fair Value
		(Dollars in thousands)
*Assets*
	Cash and cash equivalents	$	42,255	$	42,255	$	30,096	$	30,096
	Securities available-for-sale		96,618		96,618		104,475		104,475
	Loans (including loans held-for-sale), net		1,074,568		1,082,073		1,223,624		1,222,761
	FHLB and FRB stock		8,444		N/A		7,816		N/A
	Accrued interest receivable		3,135		3,135		4,116		4,116
*Liabilities*
	Time deposits	$	401,329	$	404,383	$	413,132	$	417,163
	Other deposits		715,045		715,045		740,918		740,918
	Securities sold under agreement to repurchase		25,000		25,444		35,000		35,788
	Note payable		—		—		15,000		15,000
	Other short-term borrowings		—		—		55,000		55,000
	Notes payable to subsidiary grantor trusts		23,702		15,870		23,702		18,600
	Accrued interest payable		1,184		1,184		1,510		1,510

		For the Three Months Ended September 30, 2009							For the Three Months Ended September 30, 2008

NET INTEREST INCOME AND NET INTEREST MARGIN		Average Balance		Interest Income/ Expense		Average Yield/ Rate			Average Balance		Interest Income/ Expense		Average Yield/ Rate
		(Dollars in thousands)
Assets:
Loans, gross		$	1,149,250	$	14,727		5.08	%	$	1,231,931	$	17,919		5.79	%
Securities			100,439		754		2.98	%		119,582		1,267		4.22	%
Interest bearing deposits in other financial institutions			21,347		14		0.26	%		182		1		2.19	%
Federal funds sold			1,305		—		0.00	%		2,035		10		1.95	%

	Total interest earning assets		1,272,341		15,495		4.83	%		1,353,730		19,197		5.64	%

Cash and due from banks			24,665							34,234
Premises and equipment, net			9,276							9,185
Goodwill and other intangible assets			47,028							47,690
Other assets			58,644							54,895

	Total assets	$	1,411,954						$	1,499,734

Liabilities and shareholders' equity:
Deposits:
Demand, interest bearing		$	133,301		74		0.22	%	$	144,809		308		0.85	%
Savings and money market			332,922		589		0.70	%		415,826		1,624		1.55	%
Time deposits, under $100			43,527		240		2.19	%		33,893		224		2.63	%
Time deposits, $100 and over			141,401		646		1.81	%		170,045		1,138		2.66	%
Time deposits—brokered			234,424		1,679		2.84	%		165,000		1,617		3.90	%
Notes payable to subsidiary grantor trusts			23,702		476		7.97	%		23,702		527		8.85	%
Securities sold under agreement to repurchase			27,663		168		2.41	%		35,000		264		3.00	%
Note payable			—		—		N/A			14,315		100		2.78	%
Other short-term borrowings			272		—		0.00	%		63,674		349		2.18	%

	Total interest bearing liabilities		937,212		3,872		1.64	%		1,066,264		6,151		2.29	%

Demand, noninterest bearing			267,528							261,578
Other liabilities			31,016							28,574

	Total liabilities		1,235,756							1,356,416
Shareholders' equity:			176,198							143,318

	Total liabilities and shareholders' equity	$	1,411,954						$	1,499,734

Net interest income / margin				$	11,623		3.62	%			$	13,046		3.83	%

		Three Months Ended September 30, 2009 vs. 2008 Increase (Decrease) Due to Change In:

		Average Volume			Average Rate			Net Change
		(Dollars in thousands)
Income from interest earning assets:
	Loans, gross	$	(1,047	)	$	(2,145	)	$	(3,192	)
	Securities		(144	)		(369	)		(513	)
	Interest bearing deposits in other financial institutions		14			(1	)		13
	Federal funds sold		—			(10	)		(10	)

Total interest income from interest earnings assets		$	(1,177	)	$	(2,525	)	$	(3,702	)

Expense on interest bearing liabilities:
	Demand, interest bearing	$	(6	)	$	(228	)	$	(234	)
	Savings and money market		(145	)		(890	)		(1,035	)
	Time deposits, under $100		53			(37	)		16
	Time deposits, $100 and over		(130	)		(362	)		(492	)
	Time deposits—brokered		498			(436	)		62
	Notes payable to subsidiary grantor trusts		—			(51	)		(51	)
	Securities sold under agreement to repurchase		(45	)		(51	)		(96	)
	Note payable		—			(100	)		(100	)
	Other short-term borrowings		—			(349	)	$	(349	)

Total interest expense on interest bearing liabilities		$	225		$	(2,504	)	$	(2,279	)

Net interest income		$	(1,402	)	$	(21	)	$	(1,423	)

		For The Three Months Ended September 30,

		2009		Percent of Total			2008			Percent of Total
		(Dollars in thousands)
Salaries and employee benefits		$	5,730		53	%	$	5,665			54	%
Occupancy and equipment			1,005		9	%		1,348			13	%
Professional fees			691		6	%		468			5	%
Deposit insurance premiums and regulatory assessments			631		6	%		238			2	%
Low income housing investment expense			217		2	%		208			2	%
Insurance			203		2	%		148			1	%
Software subscriptions			203		2	%		291			3	%
Data processing			196		2	%		252			2	%
Provision for off-balance sheet credit risk			173		2	%		(40	)		0	%
Client services			146		1	%		196			2	%
Amortization of intangible assets			160		2	%		176			2	%
Director fees			141		1	%		141			1	%
Advertising and promotion			96		1	%		186			2	%
Other			1,152		11	%		1,120			11	%

	Total noninterest expense	$	10,744		100	%	$	10,397			100	%

			September 30,

			September 30,				December 31, 2008
			2009		2008		December 31, 2008
			(Dollars in thousands)
Securities available-for-sale (at fair value)
	U.S. Treasury		$	39,999	$	19,893	$	19,496
	U.S. Government Sponsored Entities			2,018		8,598		8,696
	Mortgage-Backed Securities—Residential			48,944		70,311		69,036
	Municipals—Tax Exempt			0		2,052		701
	Collateralized Mortgage Obligations—Residential			5,657		6,711		6,546

		Total Securities Available-for-Sale	$	96,618	$	107,565	$	104,475

			September 30, 2009 Weighted Average Life

			Within One Year					After One and Within Five Years					After Five and Within Ten Years					After Ten Years					Total
			Amount		Yield			Amount		Yield			Amount		Yield			Amount		Yield			Amount		Yield
			(Dollars in thousands)
Securities available-for-sale (at fair value)
	U.S. Treasury		$	39,999		0.08	%	$	—		—		$	—		—		$	—		—		$	39,999		0.08	%
	U.S. Government Sponsored Entities		$	2,018		5.21	%		—		—			—		—			—		—			2,018		5.21	%
	Mortgage-Backed Securities—Residential			870		3.09	%		37,798		4.78	%		5,807		4.52	%		4,469		4.57	%		48,944		4.70	%
	Collateralized Mortgage Obligations—Residential			1,268		2.37	%		4,389		5.89	%		—		—			—		—			5,657		5.11	%

		Total Securities Available-for-Sale	$	44,155		0.44	%	$	42,187		4.89	%	$	5,807		4.52	%	$	4,469		4.57	%	$	96,618		2.82	%

		September 30, 2009						September 30, 2008						December 31, 2008

		Balance			% to Total			Balance			% to Total			Balance			% to Total
		(Dollars in thousands)
Commercial		$	414,441			38	%	$	532,367			43	%	$	525,080			42	%
Real estate—mortgage			405,486			38	%		405,897			32	%		405,530			33	%
Real estate—land and construction			197,374			18	%		253,134			20	%		256,567			21	%
Home equity			51,768			5	%		51,981			4	%		55,490			4	%
Consumer			11,476			1	%		5,549			1	%		4,310			0	%

	Total loans		1,080,545			100	%		1,248,928			100	%		1,246,977			100	%
Deferred loan costs			1,023			—			1,412			—			1,654			—

	Loans, including deferred costs		1,081,568			100	%		1,250,340			100	%		1,248,631			100	%

Allowance for loan losses			(28,976	)					(22,323	)					(25,007	)

Loans, net		$	1,052,592					$	1,228,017					$	1,223,624

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

		(Dollars in thousands)
Commercial		$	302,125	$	48,152	$	64,164	$	414,441
Real estate—mortgage			131,599		218,480		55,407		405,486
Real estate—land and construction			187,985		9,389		—		197,374
Home equity			49,018		150		2,600		51,768
Consumer			11,217		259		—		11,476

	Loans	$	681,944	$	276,430	$	122,171	$	1,080,545

Loans with variable interest rates		$	599,798	$	92,778	$	62,606	$	755,182
Loans with fixed interest rates			82,146		183,652		59,565		325,363

	Loans	$	681,944	$	276,430	$	122,171	$	1,080,545

		September 30, 2009

		Balance		% of Total
		(Dollars in thousands)
Three months or less		$	114,842		32	%
Over three months through six months			72,445		20	%
Over six months through twelve months			79,745		23	%
Over twelve months			87,976		25	%

	Total	$	355,008		100	%

	September 30, 2009		December 31, 2008

	(Dollars in thousands)
Commitments to extend credit	$	324,035	$	414,312
Standby letters of credit		22,071		22,260

	$	346,106	$	436,572



Capital ratios
	Total risk-based capital	12.8	%	10.3	%	13.4	%	8.00	%
	Tier 1 risk-based capital	11.6	%	9.1	%	12.1	%	4.00	%
	Leverage(1)	10.1	%	8.5	%	11.3	%	4.00	%



Capital ratios
	Total risk-based capital	12.5	%	11.3	%	12.6	%	10.00	%	8.00	%
	Tier 1 risk-based capital	11.2	%	10.1	%	11.3	%	6.00	%	4.00	%
	Leverage(1)	9.8	%	9.4	%	10.5	%	5.00	%	4.00	%

		September 30, 2009												September 30, 2008

								Market Value as a % of Present Value of Assets												Market Value as a % of Present Value of Assets
		$ Change in Market Value			% Change in Market Value			MV Ratio			Change (bp)			$ Change in Market Value			% Change in Market Value			MV Ratio			Change (bp)
		(Dollars in thousands)
Change in rates
+200 bp		$	33,019			16.5	%		16.3	%		231		$	34,478			14.3	%		18.3	%		229
	0 bp	$	—			0.0	%		14.0	%		—		$	—			0.0	%		16.0	%		—
-200 bp		$	(44,925	)		(22.4	)%		10.9	%		(314	)	$	(66,638	)		(27.7	)%		11.6	%		(444	)

Exhibit			Description

	3.1		Heritage Commerce Corp Restated Articles of Incorporation, as amended (incorporated by reference to Exhibit 3.1 to the Registrant's Annual Report on Form 10-K filed on March 16, 2009)
	3.2		Heritage Commerce Corp Bylaws, as amended (incorporated by reference to Exhibit 3.2 to the Registrant's Annual Report or Form 10-K filed on March 16, 2009)
	4.1		Certificate of Determination for Fixed Rate Cumulative Perpetual Preferred Stock, Series A (incorporated by reference to Exhibit 3.1 to the Registrant's Form 8-K filed November 26, 2008)
	4.2		Warrant to Purchase Common Stock dated November 21, 2008 (incorporated by reference to Exhibit 4.2 to the Registrant's Form 8-K filed on November 26, 2008)
	12.1		Calculation of Ratio of Earnings to Fixed Charges and Ratio of Earnings to Fixed Charges and Preferred Stock Dividends
	31.1		Certification of Registrant's Chief Executive Officer Pursuant To Section 302 of the Sarbanes-Oxley Act of 2002
	31.2		Certification of Registrant's Chief Financial Officer Pursuant To Section 302 of the Sarbanes-Oxley Act of 2002
	32.1		Certification of Registrant's Chief Executive Officer Pursuant To 18 U.S.C. Section 1350
	32.2		Certification of Registrant's Chief Financial Officer Pursuant To 18 U.S.C. Section 1350


		Heritage Commerce Corp (Registrant)
October 28, 2009		/s/ WALTER T. KACZMAREK
Date		Walter T. Kaczmarek Chief Executive Officer
October 28, 2009		/s/ LAWRENCE D. MCGOVERN
Date		Lawrence D. McGovern Chief Financial Officer