HERITAGE COMMERCE CORP - Quarter Report: 2021 March (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION


	Washington, D.C. 20549

	FORM 10-Q


(MARK ONE)
☒	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2021
OR
☐	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to

Commission file number 000-23877

Heritage Commerce Corp

(Exact name of Registrant as Specified in its Charter)

California (State or Other Jurisdiction of Incorporation or Organization)	77-0469558 (I.R.S. Employer Identification No.)
224 Airport Parkway, San Jose, California (Address of Principal Executive Offices)	95110 (Zip Code)

(408) 947-6900

(Registrant’s Telephone Number, Including Area Code)

N/A

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

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


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

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

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

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

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

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

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

The Registrant had 60,102,831 shares of Common Stock outstanding on April 28, 2021

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HERITAGE COMMERCE CORP

QUARTERLY REPORT ON FORM 10-Q

TABLE OF CONTENTS

		Page No.
Cautionary Note on Forward-Looking Statements		3

Part I. FINANCIAL INFORMATION

Item 1.	Consolidated Financial Statements (unaudited)	6

	Consolidated Balance Sheets	6

	Consolidated Statements of Income	7

	Consolidated Statements of Comprehensive Income	8

	Consolidated Statements of Changes in Shareholders’ Equity	9

	Consolidated Statements of Cash Flows	10

	Notes to Unaudited Consolidated Financial Statements	11

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	41

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	69

Item 4.	Controls and Procedures	69

PART II. OTHER INFORMATION

Item 1.	Legal Proceedings	70

Item 1A.	Risk Factors	70

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	70

Item 3.	Defaults Upon Senior Securities	70

Item 4.	Mine Safety Disclosures	70

Item 5.	Other Information	70

Item 6.	Exhibits	71

SIGNATURES		72

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Cautionary Note Regarding Forward-Looking Statements

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

These forward-looking statements are subject to various risks and uncertainties that may be outside our control and our actual results could differ materially from our projected results. Risks and uncertainties that could cause our financial performance to differ materially from our goals, plans, expectations and projections expressed in forward-looking statements include those set forth in our filings with the Securities and Exchange Commission (“SEC”), Item 1A of the Heritage Commerce Corp’s (“the Company”) Annual Report on Form 10-K for the year ended December 31, 2020, and the following:

●

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

●

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

●

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

●

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

●

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

●

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

●

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

●

our ability to achieve loan growth and attract deposits;

●

risks associated with concentrations in real estate related loans;

●

the relative strength or weakness of the commercial and real estate markets where our borrowers are located, including related asset and market prices;

●

credit related impairment charges to our securities portfolio;

●

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

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●

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

●

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

●

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

●

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

●

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

●

possible adjustment of the valuation of our deferred tax assets;

●

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

●

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

●

risks of loss of funding of Small Business Administration (“SBA”) or SBA loan programs, or changes in those programs;

●

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

●

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

●

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

●

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

●

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

●

availability of and competition for acquisition opportunities;

●

risks resulting from domestic terrorism;

●

risks resulting from social unrest and protests;

●

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

●

changes in governmental policy and regulation, including measures taken in response to economic, business, political and social conditions, such as the SBA Paycheck Protection Program (“PPP”), the Federal Reserve Board's efforts to provide liquidity to the financial system and provide credit to private commercial and municipal borrowers, and other programs designed to address the effects of the COVID-19 pandemic;

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●

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

●

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

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

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Part I—FINANCIAL INFORMATION

ITEM 1—CONSOLIDATED FINANCIAL STATEMENTS

HERITAGE COMMERCE CORP

CONSOLIDATED BALANCE SHEETS

(Unaudited)


	March 31,		December 31,
	2021		2020

	(Dollars in thousands)
Assets
Cash and due from banks	$	36,534	$	30,598
Other investments and interest-bearing deposits in other financial institutions		1,406,520		1,100,475
Total cash and cash equivalents		1,443,054		1,131,073
Securities available-for-sale, at fair value		196,718		235,774
Securities held-to-maturity, at amortized cost, net of allowance for credit losses of $52 at March 31, 2021
and $54 at December 31, 2020 (fair value of $311,196 at March 31, 2021 and $304,927 at December 31, 2020)		306,535		297,389
Loans held-for-sale - SBA, at lower of cost or fair value, including deferred costs		2,834		1,699
Loans, net of deferred fees		2,704,707		2,619,261
Allowance for credit losses on loans		(44,296)		(44,400)
Loans, net		2,660,411		2,574,861
Federal Home Loan Bank, Federal Reserve Bank stock and other investments, at cost		33,526		33,522
Company-owned life insurance		77,421		77,523
Premises and equipment, net		10,220		10,459
Goodwill		167,631		167,631
Other intangible assets		15,931		16,664
Accrued interest receivable and other assets		87,109		87,519
Total assets	$	5,001,390	$	4,634,114

Liabilities and Shareholders' Equity
Liabilities:
Deposits:
Demand, noninterest-bearing	$	1,813,962	$	1,661,655
Demand, interest-bearing		1,101,807		960,179
Savings and money market		1,189,566		1,119,968
Time deposits - under $250		42,596		45,027
Time deposits - $250 and over		102,508		103,746
CDARS - interest-bearing demand, money market and time deposits		28,663		23,911
Total deposits		4,279,102		3,914,486
Subordinated debt, net of issuance costs		39,786		39,740
Accrued interest payable and other liabilities		100,839		101,999
Total liabilities		4,419,727		4,056,225

Shareholders' equity:
Preferred stock, no par value; 10,000,000 shares authorized; none issued and outstanding
at March 31, 2021 and December 31, 2020		—		—
Common stock, no par value; 100,000,000 shares authorized;
59,932,334 shares issued and outstanding at March 31, 2021 and
59,917,457 shares issued and outstanding at December 31, 2020		494,617		493,707
Retained earnings		98,314		94,899
Accumulated other comprehensive loss		(11,268)		(10,717)
Total shareholders' equity		581,663		577,889
Total liabilities and shareholders' equity	$	5,001,390	$	4,634,114

See notes to consolidated financial statements (unaudited).

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HERITAGE COMMERCE CORP

CONSOLIDATED STATEMENTS OF INCOME

(Unaudited)


	Three Months Ended
	March 31,
	2021		2020

	(Dollars in thousands, except per share amounts)
Interest income:
Loans, including fees	$	33,836	$	34,782
Securities, taxable		1,728		3,948
Securities, exempt from Federal tax		429		511
Other investments, interest-bearing deposits
in other financial institutions and Federal funds sold		768		1,701
Total interest income		36,761		40,942

Interest expense:
Deposits		1,232		1,785
Subordinated debt		571		577
Total interest expense		1,803		2,362

Net interest income before provision for credit losses on loans		34,958		38,580
Provision for (recapture of) credit losses on loans		(1,512)		13,270
Net interest income after provision for credit losses on loans		36,470		25,310

Noninterest income:
Service charges and fees on deposit accounts		601		969
Gain on sales of SBA loans		550		67
Increase in cash surrender value of life insurance		456		458
Servicing income		182		183
Gain on sales of securities		—		100
Gain on the disposition of foreclosed assets		—		791
Other		512		625
Total noninterest income		2,301		3,193

Noninterest expense:
Salaries and employee benefits		13,958		14,203
Occupancy and equipment		2,274		1,772
Professional fees		1,719		1,435
Other		5,293		8,364
Total noninterest expense		23,244		25,774
Income before income taxes		15,527		2,729
Income tax expense		4,323		868
Net income	$	11,204	$	1,861

Earnings per common share:
Basic	$	0.19	$	0.03
Diluted	$	0.19	$	0.03

See notes to consolidated financial statements (unaudited).

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HERITAGE COMMERCE CORP

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited)


	Three Months Ended
	March 31,
	2021		2020

		(Dollars in thousands)
Net income	$	11,204	$	1,861
Other comprehensive income (loss):
Change in net unrealized holding (losses) gains on available-for-sale
securities and I/O strips		(849)		7,177
Deferred income taxes		247		(2,081)
Change in net unamortized unrealized gain on securities available-for-
sale that were reclassified to securities held-to-maturity		(13)		(13)
Deferred income taxes		4		4
Reclassification adjustment for gains realized in income		—		(100)
Deferred income taxes		—		29
Change in unrealized (losses) gains on securities and I/O strips, net of
deferred income taxes		(611)		5,016

Change in net pension and other benefit plan liability adjustment		89		75
Deferred income taxes		(29)		(22)
Change in pension and other benefit plan liability, net of
deferred income taxes		60		53
Other comprehensive (loss) income		(551)		5,069

Total comprehensive income	$	10,653	$	6,930

See notes to consolidated financial statements (unaudited).

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HERITAGE COMMERCE CORP

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

(Unaudited)


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

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

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

See notes to consolidated financial statements (unaudited).

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HERITAGE COMMERCE CORP

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)


	Three Months Ended
	March 31,
	2021		2020

	(Dollars in thousands)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	11,204	$	1,861
Adjustments to reconcile net income to net cash provided by operating activities:
Amortization of discounts and premiums on securities		1,071		553
Gain on sale of securities available-for-sale		—		(100)
Gain on sale of SBA loans		(550)		(67)
Proceeds from sale of SBA loans originated for sale		5,632		916
SBA loans originated for sale		(6,217)		(2,212)
Provision for (recapture of) credit losses on loans		(1,512)		13,270
Increase in cash surrender value of life insurance		(456)		(458)
Depreciation and amortization		243		229
Amortization of other intangible assets		733		858
Stock option expense, net		132		148
Amortization of restricted stock awards, net		458		348
Amortization of subordinated debt issuance costs		46		46
Gain on proceeds from company-owned life insurance		(66)		—
Effect of changes in:
Accrued interest receivable and other assets		623		(3,258)
Accrued interest payable and other liabilities		(1,085)		(2,412)
Net cash provided by operating activities		10,256		9,722

CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of securities held-to-maturity		(40,366)		—
Maturities/paydowns/calls of securities available-for-sale		37,765		11,811
Maturities/paydowns/calls of securities held-to-maturity		30,601		17,600
Proceeds from sales of securities available-for-sale		—		26,513
Net change in loans		(84,038)		(20,030)
Changes in Federal Home Loan Bank stock and other investments		(4)		(3,497)
Purchase of premises and equipment		(4)		(1,004)
Proceeds from redemption of company-owned life insurance		624		—
Net cash (used in) provided by investing activities		(55,422)		31,393

CASH FLOWS FROM FINANCING ACTIVITIES:
Net change in deposits		364,616		(48,129)
Net change in short-term borrowings		—		(328)
Exercise of stock options		320		1,106
Payment of cash dividends		(7,789)		(7,737)
Net cash provided by (used in) financing activities		357,147		(55,088)
Net increase (decrease) in cash and cash equivalents		311,981		(13,973)
Cash and cash equivalents, beginning of period		1,131,073		457,370
Cash and cash equivalents, end of period	$	1,443,054	$	443,397

Supplemental disclosures of cash flow information:
Interest paid	$	1,242	$	1,824
Income taxes paid (refunds), net		(149)		(159)

Supplemental schedule of non-cash activity:
Recording of right to use assets in exchange for lease obligations	$	—	$	25,066

See notes to consolidated financial statements (unaudited).

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HERITAGE COMMERCE CORP

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2021

(Unaudited)

1) Basis of Presentation

The unaudited consolidated financial statements of Heritage Commerce Corp (the “Company” or “HCC”) and its wholly owned subsidiary, Heritage Bank of Commerce (“HBC”), have been prepared pursuant to the rules and regulations for reporting on Form 10-Q. Accordingly, certain information and notes required by accounting principles generally accepted in the United States of America (“GAAP”) for annual financial statements are not included herein. The interim statements should be read in conjunction with the consolidated financial statements and notes that were included in the Company’s Form 10-K for the year ended December 31, 2020.

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

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

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ significantly from these estimates. Material estimates that are particularly susceptible to significant change include the determination of the allowance for credit losses and any impairment of goodwill or intangible assets. It is reasonably possible the Company’s estimate of the allowance for credit losses and evaluation of impairment of goodwill or intangible assets could change as a result of the continued impact of the COVID-19 pandemic on the economy. The resulting change in these estimates could be material to the Company’s consolidated financial statements.

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

COVID-19

Capital and Liquidity

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

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

Asset Valuation

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

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

Reclassifications

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

Adoption of New Accounting Standards

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

Accounting Guidance Issued But Not Yet Adopted

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

●

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

●

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

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

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

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

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

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

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

2) Earnings Per Share

Basic earnings per common share is computed by dividing net income by the weighted average common shares outstanding. Diluted earnings per share reflect potential dilution from outstanding stock options using the treasury stock method. There were 1,019,481 and 908,276 weighted average stock options outstanding for the three months ended March 31, 2021, and 2020, respectively, considered to be antidilutive and excluded from the computation of diluted earnings per share. A reconciliation of these factors used in computing basic and diluted earnings per common share is as follows:


	Three Months Ended
	March 31,
	2021		2020

	(Dollars in thousands, except per share amounts)
Net income	$	11,204	$	1,861

Weighted average common shares outstanding for basic
earnings per common share		59,926,816		59,286,927
Dilutive potential common shares		477,397		907,098
Shares used in computing diluted earnings per common share		60,404,213		60,194,025

Basic earnings per share	$	0.19	$	0.03
Diluted earnings per share	$	0.19	$	0.03

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

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


	Three Months Ended March 31, 2021 and 2020
			Unamortized
			Unrealized
	Unrealized		Gain on
	Gains (Losses) on		Available-
	Available-		for-Sale		Defined
	for-Sale		Securities		Benefit
	Securities		Reclassified		Pension
	and I/O		to Held-to-		Plan
	Strips		Maturity		Items(1)		Total

	(Dollars in thousands)
Beginning balance January 1, 2021, net of taxes	$	3,929	$	261	$	(14,907)	$	(10,717)
Other comprehensive loss before reclassification,
net of taxes		(602)		—		(53)		(655)
Amounts reclassified from other comprehensive income (loss),
net of taxes		—		(9)		113		104
Net current period other comprehensive income (loss),
net of taxes		(602)		(9)		60		(551)

Ending balance March 31, 2021, net of taxes	$	3,327	$	252	$	(14,847)	$	(11,268)

Beginning balance January 1, 2020, net of taxes	$	1,602	$	298	$	(11,678)	$	(9,778)
Other comprehensive income before reclassification,
net of taxes		5,096		—		4		5,100
Amounts reclassified from other comprehensive income (loss),
net of taxes		(71)		(9)		49		(31)
Net current period other comprehensive income (loss),
net of taxes		5,025		(9)		53		5,069

Ending balance March 31, 2020, net of taxes	$	6,627	$	289	$	(11,625)	$	(4,709)

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

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	Amounts Reclassified from
	AOCI
	Three Months Ended
	March 31,				Affected Line Item Where
Details About AOCI Components	2021		2020		Net Income is Presented

	(Dollars in thousands)
Unrealized gains on available-for-sale securities
and I/O strips	$	—	$	100	Gain on sales of securities
		—		(29)	Income tax expense
		—		71	Net of tax
Amortization of unrealized gain on securities available-
for-sale that were reclassified to securities
held-to-maturity		13		13	Interest income on taxable securities
		(4)		(4)	Income tax expense
		9		9	Net of tax

Amortization of defined benefit pension plan items ⁽¹⁾
Prior transition obligation and acturial losses ⁽²⁾		1		15
Prior service cost and actuarial losses ⁽³⁾		(161)		(85)
		(160)		(70)	Other noninterest expense
		47		21	Income tax benefit
		(113)		(49)	Net of tax
Total reclassification for the period	$	(104)	$	31

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

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

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

4) Securities

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


			Gross		Gross		Allowance		Estimated
	Amortized		Unrealized		Unrealized		for Credit		Fair
March 31, 2021	Cost		Gains		(Losses)		Losses		Value

	(Dollars in thousands)
Securities available-for-sale:
Agency mortgage-backed securities	$	146,894	$	4,615	$	—	$	—	$	151,509
U.S. Treasury		44,902		307		—		—		45,209
Total	$	191,796	$	4,922	$	—	$	—	$	196,718

			Gross		Gross		Estimated		Allowance
	Amortized		Unrecognized		Unrecognized		Fair		for Credit
March 31, 2021	Cost		Gains		(Losses)		Value		Losses

	(Dollars in thousands)
Securities held-to-maturity:
Agency mortgage-backed securities	$	242,747	$	4,943	$	(1,634)	$	246,056	$	—
Municipals - exempt from Federal tax		63,840		1,300		—		65,140		(52)
Total	$	306,587	$	6,243	$	(1,634)	$	311,196	$	(52)

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

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

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

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

Securities with unrealized losses at March 31, 2021 and December 31, 2020, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position are as follows:


	Less Than 12 Months				12 Months or More				Total
	Fair		Unrealized		Fair		Unrealized		Fair		Unrealized
March 31, 2021	Value		(Losses)		Value		(Losses)		Value		(Losses)

	(Dollars in thousands)
Securities held-to-maturity:
Agency mortgage-backed securities	$	69,687	$	(1,634)	$	—	$	—	$	69,687	$	(1,634)
Total	$	69,687	$	(1,634)	$	—	$	—	$	69,687	$	(1,634)


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

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

There were no holdings of securities of any one issuer, other than the U.S. Government and its sponsored entities, in an amount greater than 10% of shareholders’ equity. At March 31, 2021, the Company held 395 securities (113 available-for-sale and 282 held-to-maturity), of which ten had fair value below amortized cost. At March 31, 2021, there were $69,687,000 of agency mortgage-backed securities held-to-maturity, at amortized cost, with an unrealized loss for less than 12 months. The total unrealized loss for securities less than 12 months was ($1,634,000) at March 31, 2021. The unrealized loss was due to higher interest rates in comparison to when the security was purchased. The issuer is of high credit quality and all principal amounts are expected to be paid when securities mature. The fair value is expected to recover as the securities approach their maturity date and/or market rates decline. The Company does not believe that it is more likely than not that the Company will be required to sell a security in an unrealized loss position prior to recovery in value. Therefore, the Company does not consider these debt securities to have credit-related losses as of March 31, 2021.

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


	Three Months Ended
	March 31,
	2021		2020

	(Dollars in thousands)
Proceeds	$	—	$	26,513
Gross gains		—		100
Gross losses		—		—

The amortized cost and estimated fair values of securities as of March 31, 2021 are shown by contractual maturity below. The expected maturities will differ from contractual maturities if borrowers have the right to call or pre-pay obligations with or without call or pre-payment penalties. Securities not due at a single maturity date are shown separately.


	Available-for-sale
	Amortized		Estimated
	Cost		Fair Value

	(Dollars in thousands)
Due 3 months or less	$	24,979	$	25,049
Due after 3 months through one year		19,923		20,160
Agency mortgage-backed securities		146,894		151,509
Total	$	191,796	$	196,718


	Held-to-maturity
	Amortized		Estimated
	Cost		Fair Value

	(Dollars in thousands)
Due after 3 months through one year	$	496	$	500
Due after one through five years		11,107		11,412
Due after five through ten years		33,139		33,704
Due after ten years		19,098		19,524
Agency mortgage-backed securities		242,747		246,056
Total	$	306,587	$	311,196

Securities with amortized cost of $40,821,000 and $40,238,000 as of March 31, 2021 and December 31, 2020 were pledged to secure public deposits and for other purposes as required or permitted by law or contract.

The table below presents a rollforward by major security type for the three months ended March 31, 2021 of the allowance for credit losses on debt securities held-to-maturity held at period end:


		Municipals
		(Dollars in thousands)
Beginning balance January 1, 2021	$	54
Provision for (recapture of) credit losses		(2)
Ending balance March 31, 2021	$	52

For the three months ended March 31, 2021, there was a reduction of $2,000 to the allowance for credit losses on the Company’s held-to-maturity municipal investment securities portfolio. This reduction was the result of a reduction in municipal securities amortized balances resulting from regular payments. The bond ratings for the Company’s municipal investment securities at March 31, 2021 were consistent with the ratings at December 31, 2020.

5) Loans and Allowance for Credit Losses on Loans

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

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

Commercial

Commercial loans primarily rely on the identified cash flows of the borrower for repayment and secondarily on the underlying collateral provided by the borrower. However, the cash flows of the borrowers may not be as expected and the collateral securing these loans may vary in value. Most commercial loans are secured by the assets being financed or other business assets such as accounts receivable, inventory or equipment and may incorporate a personal guarantee; however, some loans may be unsecured. Included in commercial loans are $349,744,000 of SBA Paycheck Protection Program ("PPP") loans at March 31, 2021 and $290,679,000 at December 31, 2020. No allowance for credit losses has been recorded for PPP loans as they are fully guaranteed by the SBA.

Commercial Real Estate (“CRE”)

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

Land and Construction

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

Home Equity

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

Multifamily

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

Residential Mortgages

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

Consumer and Other

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

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


	March 31,		December 31,
	2021		2020

	(Dollars in thousands)
Loans held-for-investment:
Commercial	$	909,442	$	846,386
Real estate:
CRE - owner occupied		568,637		560,362
CRE - non-owner occupied		700,117		693,103
Land and construction		159,504		144,594
Home equity		104,303		111,885
Multifamily		168,917		166,425
Residential mortgages		82,181		85,116
Consumer and other		19,872		18,116
Loans		2,712,973		2,625,987
Deferred loan fees, net		(8,266)		(6,726)
Loans, net of deferred fees		2,704,707		2,619,261
Allowance for credit losses on loans		(44,296)		(44,400)
Loans, net	$	2,660,411	$	2,574,861

Changes in the allowance for credit losses on loans were as follows for the three months ended March 31, 2021:


			CRE		CRE
			Owner		Non-owner		Land &		Home		Multi-		Residential		Consumer
	Commercial		Occupied		Occupied		Construction		Equity		Family		Mortgage		and Other		Total

	(Dollars in thousands)
Beginning of period balance	$	11,587	$	8,560	$	16,416	$	2,509	$	1,297	$	2,804	$	943	$	284	$	44,400
Charge-offs		(263)		—		—		—		—		—		—		—		(263)
Recoveries		813		4		—		816		23		—		—		15		1,671
Net recoveries		550		4		—		816		23		—		—		15		1,408
Provision for (recapture of) credit losses on loans		(537)		(196)		15		(571)		(149)		(53)		(25)		4		(1,512)
End of period balance	$	11,600	$	8,368	$	16,431	$	2,754	$	1,171	$	2,751	$	918	$	303	$	44,296

Changes in the allowance for loan losses were as follows for the three months ended March 31, 2020:



			Owner		Non-owner		Land &		Home		Multi-		Residential		Consumer
	Commercial		Occupied		Occupied		Construction		Equity		Family		Mortgage		and Other		Total

	(Dollars in thousands)
Beginning of period balance	$	10,453	$	3,825	$	3,760	$	2,621	$	2,244	$	57	$	243	$	82	$	23,285
Adoption of Topic 326		(3,663)		3,169		7,912		(1,163)		(923)		1,196		435		1,607		8,570
Balance at adoption on January 1, 2020		6,790		6,994		11,672		1,458		1,321		1,253		678		1,689		31,855
Charge-offs		(670)		—		—		—		—		—		—		(3)		(673)
Recoveries		209		—		—		19		23		—		—		—		251
Net (charge-offs) recoveries		(461)		—		—		19		23		—		—		(3)		(422)
Provision for credit losses on loans		6,472		743		3,973		1,126		402		369		30		155		13,270
End of period balance	$	12,801	$	7,737	$	15,645	$	2,603	$	1,746	$	1,622	$	708	$	1,841	$	44,703

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

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The decrease in the allowance for credit losses on loans and related provision for the quarter ended March 31, 2021, was primarily due to a ($233,000) decrease in specific reserves for individually evaluated loans, offset by a $129,000 increase in the reserve for pooled loans, compared to December 31, 2020. The lack of change from December 31, 2020 in the allowance for credit losses for pooled loans is largely the result of improvements in the economic factors used in our methodology offset by qualitative adjustments for risks such as collateral values, concentrations of credit risk (geographic, large borrower, and industry), economic conditions, changes in underwriting standards, experience and depth of lending staff, trends in delinquencies, and the level of criticized loans to address asset-specific risks and current conditions that were not fully considered by the macroeconomic variables driving the quantitative estimate.

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


	March 31, 2021
						Restructured
	Nonaccrual		Nonaccrual			and Loans
	with no Specific		with Specific			over 90 Days
	Allowance for		Allowance for			Past Due
	Credit		Credit			and Still
	Losses		Losses			Accruing	Total

	(Dollars in thousands)
Commercial	$	443	$	1,542	$	51	$	2,036
Real estate:
CRE - Owner Occupied		1,824		—		—		1,824
Home equity		177		—		—		177
Multifamily		1,149		—		—		1,149
Consumer and other		407		—		—		407
Total	$	4,000	$	1,542	$	51	$	5,593


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

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

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


	March 31, 2021
	30 - 59		60 - 89		90 Days or
	Days		Days		Greater		Total
	Past Due		Past Due		Past Due		Past Due		Current		Total

	(Dollars in thousands)
Commercial	$	2,036	$	596	$	222	$	2,854	$	906,588	$	909,442

Real estate:
CRE - Owner Occupied		—		—		1,156		1,156		567,481		568,637
CRE - Non-Owner Occupied		—		732		—		732		699,385		700,117
Land and construction		—		—		—		—		159,504		159,504
Home equity		—		—				—		104,303		104,303
Multifamily		—		—		—		—		168,917		168,917
Residential mortgages		—		—		—		—		82,181		82,181
Consumer and other		200		—		407		607		19,265		19,872
Total	$	2,236	$	1,328	$	1,785	$	5,349	$	2,707,624	$	2,712,973


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

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

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

Past due loans 30 days or greater totaled $5,349,000 and $6,229,000 at March 31, 2021 and December 31, 2020, respectively, of which $1,762,000 and $1,918,000 were on nonaccrual, at March 31, 2021 and December 31, 2020, respectively. At March 31, 2021, there were also $3,780,000 of loans less than 30 days past due included in nonaccrual loans held-for-investment. At December 31, 2020, there were also $5,870,000 loans less than 30 days past due included in nonaccrual loans held-for-investment. Management’s classification of a loan as “nonaccrual” is an indication that there is reasonable doubt as to the full recovery of principal or interest on the loan. At that point, the Company stops accruing interest income, and reverses any uncollected interest that had been accrued as income. The Company begins recognizing interest income only as cash interest payments are received and it has been determined the collection of all outstanding principal is not in doubt.

Credit Quality Indicators

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

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The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, and other factors. The Company analyzes loans individually by classifying the loans as to credit risk. This analysis is performed on a quarterly basis. Nonclassified loans generally include those loans that are expected to be repaid in accordance with their contractual loan terms. Loans categorized as special mention have potential weaknesses that may, if not checked or corrected, weaken the credit or inadequately protect the Company’s position at some future date. These loans pose elevated risk, but their weaknesses do not yet justify a substandard classification. Classified loans are those loans that are assigned a substandard, substandard-nonaccrual, or doubtful risk rating using the following definitions:

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

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

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

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

Loss. Loans classified as loss are considered uncollectable or of so little value that their continuance as assets is not warranted. This classification does not necessarily mean that a loan has no recovery or salvage value; but rather, there is much doubt about whether, how much, or when the recovery would occur. Loans classified as loss are immediately charged off against the allowance for credit losses on loans. Therefore, there is no balance to report as of March 31, 2021 and December 31, 2020.

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

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

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														Revolving
														Loans
		Term Loans Amortized Cost Basis by Originated Period												Amortized
											2016 and			Cost
	3/31/2021		12/31/2020		12/31/2019		12/31/2018		12/31/2017		Prior			Basis		Total

	(Dollars in thousands)
Commercial:
Pass	$	259,251	$	261,842	$	26,830	$	19,734	$	11,886	$	12,564	$	297,276	$	889,383
Special Mention		1,285		3,009		237		662		512		356		1,129		7,190
Substandard		1,536		4,016		-		18		664		24		4,626		10,884
Substandard-Nonaccrual		93		1,705		54		-		-		133		-		1,985
Total		262,165		270,572		27,121		20,414		13,062		13,077		303,031		909,442

CRE - Owner Occupied:
Pass		38,277		162,257		74,000		68,832		39,719		152,293		15,277		550,655
Special Mention		4,826		3,136		684		1,504		777		1,103		-		12,030
Substandard		-		2,551		-		397		735		445		-		4,128
Substandard-Nonaccrual		-		1,794		-		-		-		30		-		1,824
Total		43,103		169,738		74,684		70,733		41,231		153,871		15,277		568,637

CRE - Non-Owner Occupied:
Pass		44,004		163,183		125,162		60,061		95,435		182,444		1,941		672,230
Special Mention		-		7,864		-		2,542		610		8,597		-		19,613
Substandard		-		6,387		-		1,402		-		485		-		8,274
Substandard-Nonaccrual		-		-		-		-		-		-		-		-
Total		44,004		177,434		125,162		64,005		96,045		191,526		1,941		700,117

Land and construction:
Pass		52,362		82,020		16,309		-		-		1,331		6,123		158,145
Special Mention		-		-		-		-		-		-		-		-
Substandard		1,359		-		-		-		-		-		-		1,359
Substandard-Nonaccrual		-		-		-		-		-		-		-		-
Total		53,721		82,020		16,309		-		-		1,331		6,123		159,504

Home equity:
Pass		-		-		-		69		-		-		103,047		103,116
Special Mention		-		-		-		-		-		-		-		-
Substandard		-		-		-		-		-		143		867		1,010
Substandard-Nonaccrual				112		-		-		-		-		65		177
Total		-		112		-		69		-		143		103,979		104,303

Multifamily:
Pass		6,297		32,732		37,809		17,127		22,499		38,449		900		155,813
Special Mention		-		-		-		-		-		11,071		-		11,071
Substandard				884		-		-		-		-		-		884
Substandard-Nonaccrual		-		-		1,149		-		-		-		-		1,149
Total		6,297		33,616		38,958		17,127		22,499		49,520		900		168,917

Residential mortgage:
Pass		711		13,321		9,988		3,200		6,139		40,771		-		74,130
Special Mention				5,081		-		1,630				-		-		6,711
Substandard		-		-		-		-		-		1,340		-		1,340
Substandard-Nonaccrual		-		-		-		-		-		-		-		-
Total		711		18,402		9,988		4,830		6,139		42,111		-		82,181

Consumer and other:
Pass		28		8		480		1,471		18		1,076		16,384		19,465
Special Mention		-		-		-		-		-		-		-		-
Substandard		-		-		-		-		-		-		-		-
Substandard-Nonaccrual		-		-				407		-		-		-		407
Total		28		8		480		1,878		18		1,076		16,384		19,872

Total loans	$	410,029	$	751,902	$	292,702	$	179,056	$	178,994	$	452,655	$	447,635	$	2,712,973

Risk Grades:
Pass	$	400,930	$	715,363	$	290,578	$	170,494	$	175,696	$	428,928	$	440,948	$	2,622,937
Special Mention		6,111		19,090		921		6,338		1,899		21,127		1,129		56,615
Substandard		2,895		13,838		-		1,817		1,399		2,437		5,493		27,879
Substandard-Nonaccrual		93		3,611		1,203		407		-		163		65		5,542
Grand Total	$	410,029	$	751,902	$	292,702	$	179,056	$	178,994	$	452,655	$	447,635	$	2,712,973

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The following table presents the amortized cost basis of collateral-dependent loans by loan classification at March 31, 2021:


	Collateral Type
	Real
	Estate		Business
	Property		Assets		Unsecured			Total

	(Dollars in thousands)
Commercial	$	27	$	1,481	$	34	$	1,542
Total	$	27	$	1,481	$	34	$	1,542

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


	Collateral Type
	Real
	Estate		Business
	Property		Assets		Unsecured		Total

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

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

The book balance of troubled debt restructurings at March 31, 2021 was $642,000, which included $462,000 of nonaccrual loans and $180,000 of accruing loans. The book balance of troubled debt restructurings at December 31, 2020 was $674,000, which included $468,000 of nonaccrual loans and $206,000 of accruing loans. Approximately $335,000 and $352,000 in specific reserves were established with respect to these loans as of March 31, 2021 and December 31, 2020, respectively.

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


	During the Three Months Ended
	March 31, 2021
				Pre-modification		Post-modification
		Number		Outstanding		Outstanding
		of		Recorded		Recorded
Troubled Debt Restructurings:		Contracts		Investment		Investment

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


	During the Three Months Ended
	March 31, 2020
				Pre-modification		Post-modification
		Number		Outstanding		Outstanding
		of		Recorded		Recorded
Troubled Debt Restructurings:		Contracts		Investment		Investment

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

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There was one new loan with total recorded investment of $3,000 that was modified as a troubled debt restructuring during the three months ended March 31, 2021.

During the three months ended March 31, 2021, there were no new loans modified as troubled debt restructurings in which the amount of principal or accrued interest owed from the borrower was forgiven or which resulted in a charge-off or change in the allowance for credit losses on loans.

A loan is considered to be in payment default when it is 30 days contractually past due under the modified terms. There were no defaults on troubled debt restructurings, within twelve months following the modification, during the three months ended March 31, 2021 and 2020.

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

On March 22, 2020 and April 7, 2020 (revised), the U.S. banking agencies issued the Interagency Statement on Loan Modifications and Reporting for Financial Institutions Working with Customers Affected by the Coronavirus. The statement describes accounting for COVID-19-related loan modifications, including clarifying the interaction between current accounting rules and the temporary relief provided by the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”). Section 541 of the Consolidated Appropriations Act extends this relief to the earlier of January 1, 2022 or 60 days after the national emergency termination date.

The Bank made accommodations for initial payment deferrals for a number of customers with a window of up to 90 days, with the potential of an additional 90 days of payment deferral (180 days maximum) upon application. The Bank also waived all customary applicable fees. Of the loans for which deferrals were originally granted, nearly all have returned to regular payment status. Section 541 of the Consolidated Appropriations Act extends this relief to the earlier of January 1, 2022 or 60 days after the national emergency termination date.

The following table shows the remaining deferments at March 31, 2021 by category:


	Underlying Collateral
		Business		Real
		Assets		Estate		Total

	(Dollar in thousands)
Initial Deferments⁽¹⁾	$	-	$	4,102	$	4,102
2nd Deferments⁽²⁾		3,146		724		3,870
Total	$	3,146	$	4,826	$	7,972

⁽¹⁾Initial deferments were generally for 3 months
⁽²⁾ 2nd deferments were for an additional 3 months

6) Goodwill and Other Intangible Assets

Goodwill

At March 31, 2021, the carrying value of goodwill was $167,631,000, which included $13,044,000 of goodwill related to its acquisition of Bay View Funding, $32,619,000 from its acquisition of Focus Business Bank, $13,819,000 from its acquisition of Tri-Valley Bank, $24,271,000 from its acquisition of United American Bank and $83,878,000 from Presidio Bank.

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

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includes the determination of the carrying value of the Company’s reporting units, including the existing goodwill and intangible assets, and estimating the fair value of each reporting unit.

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

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


	March 31,		December 31,
	2021		2020

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

Other Intangible Assets

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


	March 31, 2021
	Gross
	Carrying		Accumulated
	Amount		Amortization		Total

	(Dollars in thousands)
Core deposit intangibles	$	25,023	$	(9,860)	$	15,163
Customer relationship and brokered relationship intangibles		1,900		(1,218)		682
Below market leases		770		(684)		86
Total	$	27,693	$	(11,762)	$	15,931


	December 31, 2020
	Gross
	Carrying		Accumulated
	Amount		Amortization		Total

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

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Estimated amortization expense for future years is as follows:



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

		(Dollars in thousands)
2021 remaining	$	2,122	$	143	$	(2)	$	2,263
2022		2,447		190		(2)		2,635
2023		2,217		190		(2)		2,405
2024		2,023		159		5		2,187
2025		1,795		—		18		1,813
Thereafter		4,559		—		69		4,628
	$	15,163	$	682	$	86	$	15,931

Impairment testing of the intangible assets is performed at the individual asset level. Impairment exists if the carrying amount of the asset is not recoverable and exceeds its fair value at the date of the impairment test. For intangible assets, estimates of expected future cash flows (cash inflows less cash outflows) that are directly associated with an intangible asset are used to determine the fair value of that asset. Management makes certain estimates and assumptions in determining the expected future cash flows from core deposit and customer relationship intangibles including account attrition, expected lives, discount rates, interest rates, servicing costs and other factors. Significant changes in these estimates and assumptions could adversely impact the valuation of these intangible assets. If an impairment loss exists, the carrying amount of the intangible asset is adjusted to a new cost basis. The new cost basis is then amortized over the remaining useful life of the asset. Based on its assessment, management concluded that there was no impairment of intangible assets at March 31, 2021 and December 31, 2020.

7) Income Taxes

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

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

The Company had net deferred tax assets of $26,226,000, and $28,221,000, at March 31, 2021 and December 31, 2020, respectively. After consideration of the matters in the preceding paragraph, the Company determined that it is more likely than not that the net deferred tax assets at March 31, 2021 and December 31, 2020 will be fully realized in future years.

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


	March 31,		December 31,
	2021		2020

	(Dollars in thousands)
Low income housing investments	$	5,037	$	5,246
Future commitments	$	596	$	596

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

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For tax purposes, the Company had low income housing tax credits of $210,000 for both the three months ended March 31, 2021 and March 31, 2020, and low income housing investment expense of $209,000 and $211,000, respectively. The Company recognized low income housing investment expense as a component of income tax expense.

8) Beneft Plans

Supplemental Retirement Plan

The Company has a supplemental retirement plan (the “Plan”) covering some current and some former key employees and directors. The Plan is a nonqualified defined benefit plan. Benefits are unsecured as there are no Plan assets. The following table presents the amount of periodic cost recognized for the periods indicated:


	Three Months Ended
	March 31,
	2021		2020

	(Dollars in thousands)
Components of net periodic benefit cost:
Service cost	$	120	$	123
Interest cost		190		231
Amortization of prior service cost		25		—
Amortization of net actuarial loss		136		85
Net periodic benefit cost	$	471	$	439

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

Split-Dollar Life Insurance Benefit Plan

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


	March 31,		December 31,
	2021		2020

	(Dollars in thousands)
Change in projected benefit obligation:
Projected benefit obligation at beginning of year	$	9,689	$	8,198
Interest cost		55		246
Actuarial loss		7		1,245
Projected benefit obligation at end of period	$	9,751	$	9,689


	March 31,		December 31,
	2021		2020

	(Dollars in thousands)
Net actuarial loss	$	5,201	$	5,170
Prior transition obligation		947		970
Accumulated other comprehensive loss	$	6,148	$	6,140


	Three Months Ended
	March 31,
	2021		2020

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

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9) Fair Value

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

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

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

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

Financial Assets and Liabilities Measured on a Recurring Basis

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

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


			Fair Value Measurements Using
					Significant
			Quoted Prices in		Other		Significant
			Active Markets for		Observable		Unobservable
			Identical Assets		Inputs		Inputs
	Balance		(Level 1)		(Level 2)		(Level 3)

	(Dollars in thousands)
Assets at March 31, 2021
Available-for-sale securities:
Agency mortgage-backed securities	$	151,509	$	—	$	151,509	$	—
U.S. Treasury		45,209		45,209		—		—
I/O strip receivables		296		—		296		—

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

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

Assets and Liabilities Measured on a Non-Recurring Basis

The fair value of collateral dependent loans individually evaluated with specific allocations of the allowance for loan losses is generally based on recent real estate appraisals. The appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value. There were no material collateral dependent loans carried at fair value on a non-recurring basis at March 31, 2021 or December 31, 2020.

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Foreclosed assets are valued at the time the loan is foreclosed upon and the asset is transferred to foreclosed assets. The fair value is based primarily on third party appraisals, less costs to sell. The appraisals may utilize a single valuation approach or a combination of approaches including the comparable sales and income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are typically significant and result in a Level 3 classification of the inputs for determining fair value. At March 31, 2021 and December 31, 2020, there were no foreclosed assets on the balance sheet.

The carrying amounts and estimated fair values of financial instruments at March 31, 2021 are as follows:


			Estimated Fair Value
					Significant
			Quoted Prices in		Other		Significant
			Active Markets for		Observable		Unobservable
	Carrying		Identical Assets		Inputs		Inputs
	Amounts		(Level 1)		(Level 2)		(Level 3)		Total

	(Dollars in thousands)
Assets:
Cash and cash equivalents	$	1,443,054	$	1,443,054	$	—	$	—	$	1,443,054
Securities available-for-sale		196,718		45,209		151,509		—		196,718
Securities held-to-maturity		306,535		—		311,196		—		311,196
Loans (including loans held-for-sale), net		2,663,245		—		2,834		2,666,973		2,669,807
FHLB stock, FRB stock, and other
investments		33,526		—		—		—		N/A
Accrued interest receivable		9,974		264		1,516		8,194		9,974
I/O strips receivables		296		—		296		—		296
Liabilities:
Time deposits	$	150,657	$	—	$	150,872	$	—	$	150,872
Other deposits		4,128,445		—		4,128,445		—		4,128,445
Subordinated debt		39,786		—		40,586		—		40,586
Accrued interest payable		1,060		—		1,060		—		1,060

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


			Estimated Fair Value
					Significant
			Quoted Prices in		Other		Significant
			Active Markets for		Observable		Unobservable
	Carrying		Identical Assets		Inputs		Inputs
	Amounts		(Level 1)		(Level 2)		(Level 3)		Total

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

10) Equity Plan

The Company maintained an Amended and Restated 2004 Equity Plan (the “2004 Plan”) for directors, officers, and key employees. The 2004 Plan was terminated on May 23, 2013. On May 23, 2013, the Company’s shareholders

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approved the 2013 Equity Incentive Plan (the “2013 Plan”). On May 21, 2020, the shareholders approved an amendment to the Heritage Commerce Corp 2013 Equity Incentive Plan to increase the number of shares available from 3,000,000 to 5,000,000 shares. The equity plans provide for the grant of incentive and nonqualified stock options and restricted stock. The equity plans provide that the option price for both incentive and nonqualified stock options will be determined by the Board of Directors at no less than the fair value at the date of grant. Options granted vest on a schedule determined by the Board of Directors at the time of grant. Generally options vest over four years. All options expire no later than ten years from the date of grant. Restricted stock is subject to time vesting. For the three months ended March 31, 2021, the Company granted no shares of nonqualified stock options and no shares of restricted stock. The fair vlue of restricted stock awards that vested was $284,900 as of March 31, 2021. There were 2,464,613 shares available for the issuance of equity awards under the 2013 Plan as of March 31, 2021.

Stock option activity under the equity plans is as follows:


				Weighted
		Weighted		Average
		Average		Remaining	Aggregate
	Number	Exercise		Contractual	Intrinsic
Total Stock Options	of Shares	Price		Life (Years)	Value
Outstanding at January 1, 2021	2,546,821	$	9.30
Granted	—	$	—
Exercised	(49,235)	$	6.50
Forfeited or expired	(22,193)	$	12.65
Outstanding at March 31, 2021	2,475,393	$	9.33	5.24	$	8,697,205
Vested or expected to vest	2,326,869			5.24	$	8,175,373
Exercisable at March 31, 2021	2,013,678			4.51	$	7,924,165

Information related to the equity plans for the periods indicated:


	Three Months Ended
	March 31,
	2021		2020
Intrinsic value of options exercised	$	167,420	$	1,346,186
Cash received from option exercise	$	319,862	$	1,105,991
Tax benefit (expense) realized from option exercises	$	(1,539)	$	14,471
Weighted average fair value of options granted		N/A	$	1.59

As of March 31, 2021, there was $747,000 of total unrecognized compensation cost related to nonvested stock options granted under the equity plans. That cost is expected to be recognized over a weighted-average period of approximately 2.47 years.

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


	Three Months Ended
	March 31,
	2021	2020
Expected life in months(1)	N/A	72
Volatility(1)	N/A	24	%
Weighted average risk-free interest rate(2)	N/A	1.52	%
Expected dividends(3)	N/A	4.49	%

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

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

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

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Restricted stock activity under the equity plans is as follows:


		Weighted
		Average Grant
	Number	Date Fair
Total Restricted Stock Award	of Shares	Value
Nonvested shares at January 1, 2021	298,700	$	10.83
Granted	—	$	—
Vested	(25,012)	$	11.39
Forfeited or expired	(34,358)	$	10.23
Nonvested shares at March 31, 2021	239,330	$	12.26

As of March 31, 2021, there was $1,389,000 of total unrecognized compensation cost related to nonvested restricted stock awards granted under the equity plans. The cost is expected to be recognized over a weighted-average period of approximately 1.57 years.

11) Subordinated Debt

On May 26, 2017, the Company completed an underwritten public offering of $40,000,000 aggregate principal amount of its fixed-to-floating rate subordinated notes (“Subordinated Debt”) due June 1, 2027. The Subordinated Debt initially bears a fixed interest rate of 5.25% per year. Commencing on June 1, 2022, the interest rate on the Subordinated Debt resets quarterly to the three-month LIBOR rate plus a spread of 336.5 basis points, payable quarterly in arrears. Interest on the Subordinated Debt is payable semi-annually on June 1st and December 1st of each year through June 1, 2022 and quarterly thereafter on March 1st, June 1st, September 1st and December 1st of each year through the maturity date or early redemption date. The Subordinated Debt, net of unamortized issuance costs of $214,000, totaled $39,786,000 at March 31, 2021. The Company, at its option, may redeem the Subordinated Debt, in whole or in part, on any interest payment date on or after June 1, 2022 without a premium. See “LIBOR Transition and Phase–Out” above.

12) Capital Requirements

The Company and its subsidiary bank are subject to various regulatory capital requirements administered by the banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory—and possibly additional discretionary—actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements and operations. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and HBC must meet specific capital guidelines that involve quantitative measures of assets, liabilities, and certain off balance sheet items as calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. There are no conditions or events since March 31, 2021, that management believes have changed the categorization of the Company or HBC as “well-capitalized.”

The Company’s consolidated capital ratios and the HBC’s capital ratios exceeded the regulatory guidelines for a well-capitalized financial institution under the Basel III regulatory requirements at March 31, 2021.

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

Quantitative measures established by regulation to help ensure capital adequacy require the Company and HBC to maintain minimum amounts and ratios (set forth in the tables below) of total, Tier 1 capital, and common equity Tier 1 capital (as defined in the regulations) to risk weighted assets (as defined), and of Tier 1 capital to average assets (as defined). Management believes that, as of March 31, 2021 and December 31, 2020, the Company and HBC met all capital adequacy guidelines to which they were subject.

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The Company’s consolidated capital amounts and ratios are presented in the following table, together with capital adequacy requirements, under the Basel III regulatory requirements as of March 31, 2021 and December 31, 2020.


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

	(Dollars in thousands)
As of March 31, 2021
Total Capital	$	489,116	16.5	%	$	310,806	10.5	%
(to risk-weighted assets)
Tier 1 Capital	$	415,545	14.0	%	$	251,605	8.5	%
(to risk-weighted assets)
Common Equity Tier 1 Capital	$	415,545	14.0	%	$	207,204	7.0	%
(to risk-weighted assets)
Tier 1 Capital	$	415,545	9.1	%	$	183,165	4.0	%
(to average assets)

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


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

		(Dollars in thousands)
As of December 31, 2020
Total Capital	$	483,870	16.5	%	$	307,067	10.5	%
(to risk-weighted assets)
Tier 1 Capital	$	410,307	14.0	%	$	248,578	8.5	%
(to risk-weighted assets)
Common Equity Tier 1 Capital	$	410,307	14.0	%	$	204,711	7.0	%
(to risk-weighted assets)
Tier 1 Capital	$	410,307	9.1	%	$	180,281	4.0	%
(to average assets)

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

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HBC’s actual capital amounts and ratios are presented in the following table, together with capital adequacy requirements, under the Basel III regulatory requirements as of March 31, 2021, and December 31, 2020.


									Required For
									Capital
					To Be Well-Capitalized				Adequacy
					Under Basel III PCA Regulatory				Purposes
	Actual				Requirements				Under Basel III
	Amount		Ratio		Amount		Ratio		Amount		Ratio⁽¹⁾

	(Dollars in thousands)
As of March 31, 2021
Total Capital	$	467,424	15.8	%	$	295,791	10.0	%	$	310,580	10.5	%
(to risk-weighted assets)
Tier 1 Capital	$	433,639	14.7	%	$	236,633	8.0	%	$	251,422	8.5	%
(to risk-weighted assets)
Common Equity Tier 1 Capital	$	433,639	14.7	%	$	192,264	6.5	%	$	207,054	7.0	%
(to risk-weighted assets)
Tier 1 Capital	$	433,639	9.5	%	$	228,845	5.0	%	$	183,076	4.0	%
(to average assets)

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


									Required For
									Capital
					To Be Well-Capitalized				Adequacy
					Under Basel III PCA Regulatory				Purposes
	Actual				Requirements				Under Basel III
	Amount		Ratio		Amount		Ratio		Amount		Ratio⁽¹⁾

		(Dollars in thousands)
As of December 31, 2020
Total Capital	$	461,933	15.8	%	$	292,258	10.0	%	$	306,871	10.5	%
(to risk-weighted assets)
Tier 1 Capital	$	428,109	14.6	%	$	233,806	8.0	%	$	248,419	8.5	%
(to risk-weighted assets)
Common Equity Tier 1 Capital	$	428,109	14.6	%	$	189,968	6.5	%	$	204,580	7.0	%
(to risk-weighted assets)
Tier 1 Capital	$	428,109	9.5	%	$	225,263	5.0	%	$	180,211	4.0	%
(to average assets)

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

The Subordinated Debt, net of unamortized issuance costs, totaled $39,786,000 at March 31, 2021, and qualifies as Tier 2 capital for the Company under the guidelines established by the Federal Reserve Bank.

Under California General Corporation Law, the holders of common stock are entitled to receive dividends when and as declared by the Board of Directors, out of funds legally available. The California Financial Code provides that a state licensed bank may not make a cash distribution to its shareholders in excess of the lesser of the following: (i) the bank’s retained earnings; or (ii) the bank’s net income for its last three fiscal years, less the amount of any distributions made by the bank to its shareholders during such period. However, a bank, with the prior approval of the Commissioner of the California Department of Financial Protection and Innovation (“DFPI”) may make a distribution to its shareholders of an amount not to exceed the greater of (i) a bank’s retained earnings; (ii) its net income for its last fiscal year; or (iii) its net income for the current fiscal year. Also with the prior approval of the Commissioner of the DBO and the shareholders of the bank, the bank may make a distribution to its shareholders, as a reduction in capital of the bank. In the event that the Commissioner determines that the shareholders’ equity of a bank is inadequate or that the making of a distribution by a bank would be unsafe or unsound, the Commissioner may order a bank to refrain from making such a proposed distribution. As March 31, 2021, HBC would not be required to obtain regulatory approval, and the amount available for cash dividends is $43,173,000. Similar restrictions applied to the amount and sum of loan advances and other transfers of

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funds from HBC to the parent company. HBC distributed to HCC dividends of $8,000,000, during the first quarter of 2021.

13) Commitments and Loss Contingencies

Loss Contingencies

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

●

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

●

In January and February 2019, Double Jump, Inc. and a number of its affiliates (collectively, the “DC Solar Debtors”) each commenced bankruptcy cases in the United States Bankruptcy Court of Nevada. The chapter 7 trustee of the DC Solar Debtors has indicated that it may bring an adversary action against Heritage related to our former deposit relationships with the DC Solar Debtors and their sponsored investment funds.

●

In November 2020, a former and a then-current bank employee purporting to represent a class of Bank employees, alleged in a lawsuit that the Bank violated the California Labor Code and California Business and Professions Code, by failing to permit required meal and rest breaks, by failing to provide accurate wage statements, among other claims. The lawsuit seeks unspecified penalties under the California Private Attorneys General Act (“PAGA”) in addition to other monetary payments. The case is in the early phase. In late December 2020 the same former and a then-current bank employees filed a lawsuit asserting as individual employees causes of action against the Bank for gender discrimination, retaliation, constructive discharge of the former employee, and sexual harassment, among other claims. Plaintiffs allege denial of promotional opportunities, and harassment and discrimination by Bank employees and customers of the Bank. This case is also in an early phase. In February 2021, the Bank was notified of another set of PAGA and potential class claims alleged by letter to the California Labor and Workforce Development Agency transmitted on behalf of another former Bank employee. The notice to the California Labor and Workforce Development Agency, which is a prerequisite to a PAGA filing, alleged the same claims, class, and relief request that are the subject of the lawsuit filed in November 2020, and disclosed no new claims. We intend to vigorously defend the filed class and PAGA complaint, the action filed by the employees as individuals, and any subsequent related class action and PAGA filing.

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

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

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Off-Balance Sheet Arrangements

In the normal course of business the Company makes commitments to extend credit to its customers as long as there are no violations of any conditions established in the contractual arrangements. These commitments are obligations that represent a potential credit risk to the Company, but are not reflected on the Company’s consolidated balance sheets. Total unused commitments to extend credit were $1,097,017,000 at March 31, 2021, and $1,114,193,000 at December 31, 2020. Unused commitments represented 40% outstanding gross loans at March 31, 2021, 41% at March 31, 2020, and 42% at December 31, 2020.

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


	March 31, 2021						December 31, 2020
	Fixed		Variable				Fixed		Variable
	Rate		Rate		Total		Rate		Rate		Total

	(Dollars in thousands)
Unused lines of credit and commitments
to make loans	$	104,963	$	970,861	$	1,075,824	$	121,560	$	970,614	$	1,092,174
Standby letters of credit		3,036		18,157		21,193		3,049		18,970		22,019
	$	107,999	$	989,018	$	1,097,017	$	124,609	$	989,584	$	1,114,193

For the three months ended March 31, 2021, there was an increase of $53,000 to the allowance for credit losses on the Company’s off-balance sheet credit exposures. The increase in the allowance for credit losses for off-balance sheet credit exposures in the first three months of 2021 was driven by an increase in the estimated loss factors for the unused loan commitments. The allowance for credit losses on the Company’s off-balance sheet credit exposures was $1,131,000 at March 31, 2021 and $1,078,000 at December 31, 2020.

14) Revenue Recognition

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

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

The Company currently accounts for sales of foreclosed assets in accordance with Topic 360-20. In most cases the Company will seek to engage a real estate agent for the sale of foreclosed assets immediately upon foreclosure.

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However, in some cases, where there is clear demand for the property in question, the Company may elect to allow for a marketing period on no more than six months to attempt a direct sale of the property. We generally recognize the sale, and any associated gain or loss, of a real estate property when control of the property transfers. Any gains or losses from the sale are recorded to noninterest income/expense.

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


	Three Months Ended
	March 31,
	2021		2020

	(Dollars in thousands)
Noninterest Income In-scope of Topic 606:
Service charges and fees on deposit accounts	$	601	$	969
Gain on the disposition of foreclosed assets		—		791
Total noninterest income in-scope of Topic 606		601		1,760
Noninterest Income Out-of-scope of Topic 606		1,700		1,433
Total noninterest income	$	2,301	$	3,193

15) Noninterest Expense

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


	Three Months Ended
	March 31,
	2021		2020

	(Dollars in thousands)
Salaries and employee benefits	$	13,958	$	14,203
Occupancy and equipment		2,274		1,772
Professional fees		1,719		1,435
Amortization of intangible assets		733		858
Insurance expense		663		518
Data processing		534		976
Software subscriptions		476		889
Other		2,887		5,123
Total noninterest expense	$	23,244	$	25,774

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


	Three Months Ended
	March 31,		March 31,
	2021		2020

	(Dollars in thousands)
Salaries and employee benefits	$	—	$	356
Other		58		2,068
Total merger-related costs	$	58	$	2,424

Noninterest expense for the first quarter of 2021 included approximately $1,476,000 in severance expense, partially offset by $766,000 in deferred origination costs on Round 2 PPP loans.

16) Leases

The Company recognizes the following for all leases, at the commencement date: (1) a lease liability, which is a lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis; and (2) a right-of-use (“ROU”) asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. The Company is impacted as a lessee of the offices and real estate used for operations. The Company's lease agreements include options to renew at the Company's option. No lease extensions are reasonably certain to be exercised, therefore it was not considered in the calculation of the ROU asset and lease liability. As of March 31, 2021, operating lease ROU assets, included in other assets, and lease liabilities, included in other liabilities, totaled $37,405,000.

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


		March 31,

		2021		2020

	(Dollars in thousands)
Operating Lease Cost (Cost resulting from lease payments)	$	1,671	$	1,769
Operating Lease - Operating Cash Flows (Fixed Payments)	$	1,186	$	1,190
Operating Lease - ROU assets	$	37,405	$	38,098
Operating Lease - Liabilities	$	37,405	$	38,098
Weighted Average Lease Term - Operating Leases		8.17 years		8.64 years
Weighted Average Discount Rate - Operating Leases		4.49%		4.52%

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


	(Dollars in thousands)
2021	$	4,189
2022		6,210
2023		5,597
2024		5,267
2025		4,853
Thereafter		18,947
Total undiscounted cash flows		45,063
Discount on cash flows		(7,658)
Total lease liability	$	37,405

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17) Business Segment Information

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


	Three Months Ended March 31, 2021
	Banking⁽¹⁾		Factoring		Consolidated

	(Dollars in thousands)

Interest income	$	34,111	$	2,650	$	36,761
Intersegment interest allocations		211		(211)		—
Total interest expense		1,803		—		1,803
Net interest income		32,519		2,439		34,958
Provision for (recapture of) credit losses on loans		(1,463)		(49)		(1,512)
Net interest income after provision		33,982		2,488		36,470
Noninterest income		2,160		141		2,301
Noninterest expense		21,897		1,347		23,244
Intersegment expense allocations		106		(106)		—
Income before income taxes		14,351		1,176		15,527
Income tax expense		3,975		348		4,323
Net income	$	10,376	$	828	$	11,204

Total assets	$	4,933,350	$	68,040	$	5,001,390
Loans, net of deferred fees	$	2,656,178	$	48,529	$	2,704,707
Goodwill	$	154,587	$	13,044	$	167,631

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

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	Three Months Ended March 31, 2020
	Banking⁽¹⁾		Factoring		Consolidated

	(Dollars in thousands)
Interest income	$	38,065	$	2,877	$	40,942
Intersegment interest allocations		284		(284)		—
Total interest expense		2,362		—		2,362
Net interest income		35,987		2,593		38,580
Provision for credit losses on loans		12,874		396		13,270
Net interest income after provision		23,113		2,197		25,310
Noninterest income		3,023		170		3,193
Noninterest expense		24,183		1,591		25,774
Intersegment expense allocations		129		(129)		—
Income before income taxes		2,082		647		2,729
Income tax expense		677		191		868
Net income	$	1,405	$	456	$	1,861

Total assets	$	4,009,344	$	68,818	$	4,078,162
Loans, net of deferred fees	$	2,499,837	$	54,074	$	2,553,911
Goodwill	$	154,327	$	13,044	$	167,371

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

18) Subsequent Events

On April 22, 2021, the Company announced that its Board of Directors declared a $0.13 per share quarterly cash dividend to holders of common stock. The dividend will be payable on May 27, 2021, to shareholders of record at close of business day on May 13, 2021.

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

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

CRITICAL ACCOUNTING POLICIES

Critical accounting policies are discussed in our Form 10-K for the year ended December 31, 2020. There have been no changes in the Company's application of critical accounting policies since December 31, 2020.

EXECUTIVE SUMMARY

This summary is intended to identify the most important matters on which management focuses when it evaluates the financial condition and performance of the Company. When evaluating financial condition and performance, management looks at certain key metrics and measures. The Company’s evaluation includes comparisons with peer group financial institutions and its own performance objectives established in the internal planning process.

The primary activity of the Company is commercial banking. The Company’s operations are located entirely in the general San Francisco Bay Area of California in the counties of Alameda, Contra Costa, Marin, San Benito, San Francisco, San Mateo, and Santa Clara. The Company’s market includes the cities of Oakland, San Francisco and San Jose and the headquarters of a number of technology based companies in the region known commonly as Silicon Valley. The Company’s customers are primarily closely held businesses and professionals.

Performance Overview

For the three months ended March 31, 2021, net income was $11.2 million, or $0.19 per average diluted common share, compared to $1.9 million, or $0.03 per average diluted common share, for the three months ended March 31, 2020. The Company’s annualized return on average tangible assets was 0.99% and annualized return on average tangible equity was 11.50% for the three months ended March 31, 2021, compared to 0.19% and 1.91%, respectively, for the three months ended March 31, 2020. First quarter 2021 results included the recapture of ($1.5) million of provision for credit losses on loans, compared to a provision for credit losses on loans of $13.3 million for the first quarter of 2020.

Coronavirus (COVID-19)

In response to economic stimulus laws passed by Congress in 2020 and 2021, Heritage Bank of Commerce has now funded two rounds of Small Business Administration (“SBA”) Payment Protection Program (“PPP”) loans. At March 31, 2021, after accounting for loan payoffs and SBA loan forgiveness, Round 1 PPP loans were $170.4 million and Round 2 PPP loans were $179.3 million. In total the Bank had $349.7 million in outstanding PPP loan balances at quarter-end. These loans generated $784,000 in interest income, $3.4 million in net deferred fee revenue ($2.4 million from loans forgiven or paid off and $969,000 from net deferred fees), and $766,000 in deferred origination costs on Round 2 PPP loans during the first quarter of 2021. At March 31, 2021, the PPP loan portfolio had remaining deferred fees of ($8.8) million and deferred costs of $1.1 million.

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The following table shows the remaining deferments at March 31, 2021 by category:


	Underlying Collateral
		Business		Real
		Assets		Estate		Total

	(Dollar in thousands)
Initial Deferments⁽¹⁾	$	-	$	4,102	$	4,102
2nd Deferments⁽²⁾		3,146		724		3,870
Total	$	3,146	$	4,826	$	7,972

⁽¹⁾Initial deferments were generally for 3 months
⁽²⁾ 2nd deferments were for an additional 3 months

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

●

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

●

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

●

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

In addition to its portfolio of SBA PPP loans, the Bank also has a portfolio of SBA 7(a) loans totaling $45.9 million as of April 12, 2021 (the most recent available data). As part of the SBA’s Coronavirus debt relief efforts, beginning in April of 2020, the SBA commenced a program to cover payments of principal, interest and any associated fees for these borrowers. The following table reflects the status of these SBA 7(a) loans as of April 12, 2021:


			Number
		Dollars	of Loans

		(Dollars in thousands)
SBA 7(a) loans (monthly payments are made
through the Economic Aid Act)	$	25,265	150
Payments Not Made / NSF / Returned		1,547	17
Due dates later in the month		12	2
New loans / No payment due		330	3
CARES		18,774	85
Total Portfolio	$	45,928	257

The CARES Act was recently amended to include $3.5 billion of extended debt relief payments for SBA borrowers. The program will initially provide for 3 payments of principal and interest to a maximum of $9,000 per month under various criteria and then an additional 5 payments for borrowers considered “underserved” as defined in the amended legislation.

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Credit Quality and Performance

At March 31, 2021, nonperforming assets (“NPAs”) declined by ($6.5) million, or (54%), to $5.6 million, compared to $12.1 million at March 31, 2020, and decreased by ( $2.3) million, or (29%) from $7.9 million at December 31, 2020. The decrease in NPAs at March 31, 2021, compared to March 31, 2020 and December 31, 2020, was primarily from the sale of properties which resulted in the payoff of loans, and from other paid down loans, partially offset by new credits that went on NPA status during the first quarter of 2021. Classified assets decreased to $33.4 million, or 0.67% of total assets, at March 31, 2021, compared to $39.6 million, or 0.97% of total assets, at March 31, 2020, and $34.0 million, or 0.73% of total assets, at December 31, 2020.

During the first quarter of 2021, there was a recapture of ($1.5) million in the provision for credit losses on loans, primarily due to recoveries on previously charged-off loans and improvements in economic forecast, compared to a $13.3 provision for credit losses on loans taken in the first quarter of 2020, and a recapture of ($1.3) million in the provision for credit losses on loans taken in the fourth quarter of 2020. The higher provision for credit losses on loans for the first quarter of 2020 was driven primarily by a significantly deteriorated economic outlook resulting from the Coronavirus pandemic. Generally, the economic factors used for the calculation of the current expected credit losses forecast an improving economy through 2021 compared to forecasts used in 2020. Ongoing impacts of the Current Expected Credit Losses (“CECL”) rate methodology will be dependent upon changes in economic conditions and forecasts, originated and acquired loan portfolio composition, portfolio duration, and other factors.

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


	% of Total		% of Total		% of Total
	Loans at		Loans at		Loans at
HIGHER RISK SECTORS	March 31, 2021		March 31, 2020		December 31, 2020
Health care and social assistance:
Offices of dentists	2.06	%	1.63	%	2.01	%
Offices of physicians (except mental health specialists)	0.89	%	0.70	%	0.81	%
Other community housing services	0.24	%	0.11	%	0.28	%
All others	1.99	%	1.84	%	2.15	%
Total health care and social assistance	5.18	%	4.28	%	5.25	%
Retail trade:
Gasoline stations with convenience stores	2.54	%	1.98	%	2.16	%
All others	2.16	%	2.18	%	2.34	%
Total retail trade	4.70	%	4.16	%	4.50	%
Accommodation and food services:
Full-service restaurants	1.56	%	0.86	%	1.30	%
Limited-service restaurants	0.64	%	0.63	%	0.57	%
Hotels (except casino hotels) and motels	0.86	%	0.94	%	0.95	%
All others	0.75	%	0.52	%	0.68	%
Total accommodation and food services	3.81	%	2.95	%	3.50	%
Educational services:
Elementary and secondary schools	0.58	%	0.15	%	0.58	%
Education support services	0.46	%	0.15	%	0.45	%
All others	0.24	%	0.17	%	0.19	%
Total educational services	1.28	%	0.47	%	1.22	%
Arts, entertainment, and recreation	1.40	%	1.09	%	1.34	%
Purchased participations in micro loan portfolio	0.50		0.95		0.60	%
Total higher risk sectors	16.87	%	13.90	%	16.41	%

The increase in higher risk sector loans at March 31, 2021 and December 31, 2020, compared to March 31, 2020, was primarily due to the addition of PPP loans after the first quarter of 2020.

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Factoring Activities - Bay View Funding

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


	March 31,		March 31,
	2021		2020

	(Dollars in thousands)
Total factored receivables at period-end	$	48,529	$	54,074
Average factored receivables for the three months ended	$	48,094	$	47,470
Total full time equivalent employees at period-end		30		35

First Quarter 2021 Highlights

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

●

Net interest income, before provision for credit losses on loans, decreased (9%) to $35.0 million for the first quarter of 2021, compared to $38.6 million for the first quarter of 2020, primarily due to decreases in the prime rate, and decreases in yields on investment securities and overnight funds, partially offset by interest income and fees on PPP loans.

●

The fully tax equivalent (“FTE”) net interest margin contracted 103 basis points to 3.22% for the first quarter of 2021, from 4.25% for the first quarter of 2020, primarily due to declines in the average yields on loans, investment securities, and overnight funds, partially offset by a decline in the cost of interest-bearing liabilities and interest income and fees on PPP loans.

●

The average yield on the loan portfolio decreased to 5.24% for the first quarter of 2021, compared to 5.57% for the first quarter of 2020, primarily due to a decline in the prime rate and new average balances of lower yielding PPP loans, partially offset by interest income and fees on PPP loans.

●

In aggregate, the original total net purchase discount on loans from the Focus Business Bank, Tri-Valley Bank, United American Bank, and Presidio Bank loan portfolios was $25.2 million. In aggregate, the remaining net purchase discount on total loans acquired was $11.0 million at March 31, 2021.

●

The average cost of total deposits was 0.12% for the first quarter of 2021, compared to 0.22% for the first quarter of 2020.

●

There was a recapture of ($1.5) million in the provision for credit losses on loans in the first quarter of 2021, primarily due to recoveries on previously charged-off loans and improvements in economic forecast, compared to a $13.3 provision for credit losses on loans taken in the first quarter of 2020.

●

Total noninterest income was $2.3 million for the first quarter of 2021, compared to $3.2 million for the first quarter of 2020, primarily due to a gain on the disposition of foreclosed assets and from higher service charges and fees on deposit accounts for the first quarter of 2020.

●

The efficiency ratio for the first quarter of 2021 was 62.38%, compared to 61.70% for the first quarter of 2020.

●

Income tax expense for the first quarter of 2021 was $4.3 million, compared to $868,000 for the first quarter of 2020. The effective tax rate for the first quarter of 2021 was 27.8%, compared to 31.8% for the first quarter of 2020.

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

●

Cash, other investments and interest-bearing deposits in other financial institutions and securities available-for-sale, at fair value, increased 101% to $1.64 billion at March 31, 2021, from $817.0 million at March 31, 2020, and increased 20% from $1.37 billion at December 31, 2020.

●

At March 31, 2021, securities held-to-maturity, at amortized cost, totaled $306.5 million, compared to $348.0 million at March 31, 2020, and $297.4 million, at December 31, 2020.

●

Loans, excluding loans held-for-sale, increased $150.8 million or 6%, to $2.70 billion at March 31, 2021, compared to $2.55 billion at March 31, 2020, and increased $85.4 million or 3%, to $2.70 billion at March 31, 2021, compared to $2.62 billion at December 31, 2020. Total loans at March 31, 2021 included $349.7 million of PPP loans, compared to $290.7 million at December 31, 2020. Total loans at March 31, 2021, excluding PPP loans, increased $26.4 million from December 31, 2020.

●

NPAs were $5.6 million, or 0.11% of total assets, at March 31, 2021, compared to $12.1 million, or 0.30% of total assets, at March 31, 2020, and $7.9 million, or 0.17% of total assets, at December 31, 2020.

●

Classified assets decreased to $33.4 million, or 0.67% of total assets, at March 31, 2021, compared to $39.6 million, or 0.97% of total assets, at March 31, 2020, and $34.0 million, or 0.73% of total assets, at December 31, 2020.

●

Net recoveries totaled $1.4 million for the first quarter of 2021, compared to net charge-offs of $422,000 for the first quarter of 2020, and net recoveries of $326,000 for the fourth quarter of 2020.

●

The allowance for credit losses on loans (“ACLL”) at March 31, 2021 was $44.3 million, or 1.64% of total loans, representing 791.99% of total nonperforming loans. The ACLL at March 31, 2020 was $44.7 million, or 1.75% of total loans, representing 369.81% of total nonperforming loans. The ACLL at December 31, 2020 was $44.4 million, or 1.70% of total loans, representing 564.24% of total nonperforming loans. The ACLL total loans, excluding PPP loans, was 1.88% at March 31, 2021, and 1.91% at December 31, 2020. There were no PPP loans at March 31, 2020.

●

Total deposits increased $912.5 million, or 27%, to 4.28 billion at March 31, 2021, compared to $3.37 billion at March 31, 2020. Total deposits increased $364.6 million, or 9%, from $3.91 billion at December 31, 2020.

●

Deposits, excluding all time deposits and CDARS deposits, increased $901.3 million, or 28%, to $4.11 billion at March 31, 2021, compared to $3.20 billion at March 31, 2020. Deposits, excluding all time deposits and CDARS deposits, at March 31, 2021 increased $363.5 million, or 10%, compared to $3.74 billion at December 31, 2020.

●

The ratio of noncore funding (which consists of time deposits of $250,000 and over, CDARS deposits, brokered deposits, securities under an agreement to repurchase, subordinated debt, and short-term borrowings) to total assets was 3.42% at March 31, 2021, compared to 3.71% at March 31, 2020, and 3.61% at December 31, 2020.

●

The loan to deposit ratio was 63.21% at March 31, 2021, compared to 75.86% at March 31, 2020, and 66.91% at December 31, 2020.

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●

The Company’s consolidated capital ratios exceeded regulatory guidelines and the HBC’s capital ratios exceeded the regulatory guidelines for a well-capitalized financial institution under the Basel III regulatory requirements at March 31, 2021.




							Well-capitalized
	Heritage			Heritage			Financial Institution			Basel III Minimum
	Commerce			Bank of			Basel III PCA Regulatory			Regulatory
Capital Ratios	Corp			Commerce			Guidelines			Requirement(1)
Total Capital		16.5	%		15.8	%		10.0	%		10.5	%
Tier 1 Capital		14.0	%		14.7	%		8.0	%		8.5	%
Common Equity Tier 1 Capital		14.0	%		14.7	%		6.5	%		7.0	%
Tier 1 Leverage		9.1	%		9.5	%		5.0	%		4.0	%

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

RESULTS OF OPERATIONS

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

Net Interest Income and Net Interest Margin

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

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

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Distribution, Rate and Yield


	Three Months Ended						Three Months Ended
	March 31, 2021						March 31, 2020
			Interest		Average				Interest		Average
	Average		Income /		Yield /		Average		Income /		Yield /
	Balance		Expense		Rate		Balance		Expense		Rate

	(Dollars in thousands)
Assets:
Loans, gross ⁽¹⁾⁽²⁾	$	2,620,334	$	33,836	5.24	%	$	2,513,725	$	34,782	5.57	%
Securities — taxable		436,858		1,728	1.60	%		670,299		3,948	2.37	%
Securities — exempt from Federal tax⁽³⁾		66,513		542	3.30	%		80,369		647	3.24	%
Other investments, interest-bearing deposits
in other financial institutions and Federal funds sold		1,296,258		768	0.24	%		400,758		1,701	1.71	%
Total interest earning assets		4,419,963		36,874	3.38	%		3,665,151		41,078	4.51	%
Cash and due from banks		40,823						44,539
Premises and equipment, net		10,369						8,607
Goodwill and other intangible assets		184,017						187,505
Other assets		118,706						127,349
Total assets	$	4,773,878					$	4,033,151
Liabilities and shareholders’ equity:
Deposits:
Demand, noninterest-bearing	$	1,712,903					$	1,438,944

Demand, interest-bearing		1,026,210		479	0.19	%		800,800		542	0.27	%
Savings and money market		1,137,837		572	0.20	%		920,422		914	0.40	%
Time deposits — under $100		15,900		9	0.23	%		18,777		22	0.47	%
Time deposits — $100 and over		130,843		171	0.53	%		132,314		305	0.93	%
CDARS — interest-bearing demand, money
market and time deposits		25,260		1	0.02	%		16,555		2	0.05	%
Total interest-bearing deposits		2,336,050		1,232	0.21	%		1,888,868		1,785	0.38	%
Total deposits		4,048,953		1,232	0.12	%		3,327,812		1,785	0.22	%

Subordinated debt, net of issuance costs		39,757		571	5.82	%		39,571		577	5.86	%
Short-term borrowings		44		—	0.00	%		331		—	0.00	%
Total interest-bearing liabilities		2,375,851		1,803	0.31	%		1,928,770		2,362	0.49	%
Total interest-bearing liabilities and demand,
noninterest-bearing / cost of funds		4,088,754		1,803	0.18	%		3,367,714		2,362	0.28	%
Other liabilities		105,967						86,386
Total liabilities		4,194,721						3,454,100
Shareholders’ equity		579,157						579,051
Total liabilities and shareholders’ equity	$	4,773,878					$	4,033,151

Net interest income / margin				35,071	3.22	%				38,716	4.25	%
Less tax equivalent adjustment				(113)						(136)
Net interest income			$	34,958					$	38,580

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

(2)	Yield amounts earned on loans include fees and costs. The accretion of net deferred loan fees into loan interest income was $3,689,000 for the first quarter of 2021 (of which $3,401,000 was from PPP loans), compared to $139,000 for the first quarter of 2020.

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

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Volume and Rate Variances

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


	Three Months Ended March 31,
	2021 vs. 2020
	Increase (Decrease)
	Due to Change in:
	Average		Average		Net
	Volume		Rate		Change

	(Dollars in thousands)
Income from the interest earning assets:
Loans, gross	$	1,357	$	(2,303)	$	(946)
Securities — taxable		(916)		(1,304)		(2,220)
Securities — exempt from Federal tax⁽¹⁾		(112)		7		(105)
Other investments, interest-bearing deposits
in other financial institutions and Federal funds sold		531		(1,464)		(933)
Total interest income on interest-earning assets		860		(5,064)		(4,204)

Expense from the interest-bearing liabilities:
Demand, interest-bearing		104		(167)		(63)
Savings and money market		118		(460)		(342)
Time deposits — under $100		(2)		(11)		(13)
Time deposits — $100 and over		(2)		(132)		(134)
CDARS — interest-bearing demand, money market
and time deposits		—		(1)		(1)
Subordinated debt, net of issuance costs		3		(9)		(6)
Short-term borrowings		—		—		—
Total interest expense on interest-bearing liabilities		221		(780)		(559)
Net interest income	$	639	$	(4,284)		(3,645)
Less tax equivalent adjustment						23
Net interest income					$	(3,622)

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

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The Company’s fully tax equivalent (“FTE”) net interest margin, expressed as a percentage of average earning assets, contracted 103 basis points to 3.22% for the first quarter of 2021, from 4.25% for the first quarter of 2020, primarily due to declined average yields on loans, investment securities, and overnight funds, partially offset by a decline in the cost of interest-bearing liabilities and interest income and fees on PPP loans.

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


	Three Months Ended						Three Months Ended
	March 31, 2021						March 31, 2020
	Average		Interest		Average		Average		Interest		Average
	Balance		Income		Yield		Balance		Income		Yield

	(Dollars in thousands)
Loans, core bank and asset-based lending	$	2,225,342	$	25,581	4.66	%	$	2,422,020	$	30,104	5.00	%
PPP loans		319,168		784	1.00	%		—		—	N/A
PPP fees, net		—		3,401	4.32	%		—		—	N/A
Bay View Funding factored receivables		48,094		2,650	22.35	%		47,470		2,877	24.38	%
Residential mortgages		22,194		119	2.17	%		33,075		230	2.80	%
Purchased CRE loans		17,162		172	4.06	%		27,340		249	3.66	%
Loan fair value mark / accretion		(11,626)		1,129	0.21	%		(16,180)		1,322	0.22	%
Total loans (includes loans held-for-sale)	$	2,620,334	$	33,836	5.24	%	$	2,513,725	$	34,782	5.57	%


	Three Months Ended						For the Quarter Ended
	March 31, 2021						December 31, 2020
	Average		Interest		Average		Average		Interest		Average
	Balance		Income		Yield		Balance		Income		Yield

	(Dollars in thousands)
Loans, core bank and asset-based lending	$	2,225,342	$	25,581	4.66	%	$	2,256,944	$	26,348	4.64	%
PPP loans		319,168		784	1.00	%		313,335		787	1.00	%
PPP fees, net		—		3,401	4.32	%		—		1,935	2.46	%
Bay View Funding factored receivables		48,094		2,650	22.35	%		50,720		2,856	22.40	%
Residential mortgages		22,194		119	2.17	%		24,955		118	1.88	%
Purchased CRE loans		17,162		172	4.06	%		20,854		176	3.36	%
Loan fair value mark / accretion		(11,626)		1,129	0.21	%		(12,017)		687	0.12	%
Total loans (includes loans held-for-sale)	$	2,620,334	$	33,836	5.24	%	$	2,654,791	$	32,907	4.93	%

The average yield on the total loan portfolio increased to 5.24% for the first quarter of 2021 compared to 4.93% for the fourth quarter of 2020, primarily due to higher fees from PPP loans and an increase in the accretion of the loan purchase discount into interest income from acquired loans.

The average cost of total deposits was 0.12% for the first quarter of 2021, compared to 0.22% for the first quarter of 2020.

Net interest income, before provision for credit losses on loans, decreased (9%) to $35.0 million for the first quarter of 2021, compared to $38.6 million for the first quarter of 2020, primarily due to decreases in the prime rate, and yields on investment securities and overnight funds, partially offset by interest income and fees on PPP loans.

Provision for Credit Losses on Loans

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

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credit losses on loans and level of allowance for each period are dependent upon many factors, including loan growth, net charge-offs, changes in the composition of the loan portfolio, delinquencies, management’s assessment of the quality of the loan portfolio, the valuation of problem loans and the general economic conditions in the Company’s market area. The provision for credit losses on loans and level of allowance for each period are also dependent on forecast data for the state of California including GDP and unemployment projections provided by the California Economic Forecast (“CEF”, www.CaliforniaForecast.com).

There was a recapture of ($1.5) million in provision for credit losses on loans for the first quarter of 2021, primarily due to recoveries on previously charged-off loans and improvements in economic forecast, compared to a $13.3 million provision for credit losses on loans for the first quarter of 2020. Provisions for credit losses on loans are charged to operations to bring the allowance for credit losses on loans to a level deemed appropriate by the Company based on the factors discussed under “Credit Quality and Performance” and “Allowance for Credit Losses on Loans.”

Noninterest Income



					Increase
	Three Months Ended				(decrease)
	March 31,				2021 versus 2020
	2021		2020		Amount		Percent

	(Dollars in thousands)
Service charges and fees on deposit accounts	$	601	$	969	$	(368)	(38)	%
Gain on sales of SBA loans		550		67		483	721	%
Increase in cash surrender value of life insurance		456		458		(2)	0	%
Servicing income		182		183		(1)	(1)	%
Gain on sales of securities		—		100		(100)	(100)	%
Gain on the disposition of foreclosed assets		—		791		(791)	(100)	%
Other		512		625		(113)	(18)	%
Total	$	2,301	$	3,193	$	(892)	(28)	%

Historically, a portion of the Company’s noninterest income has been associated with its SBA lending activity, as gains on the sale of loans sold in the secondary market and servicing income from loans sold with servicing rights retained. For the first quarter of 2021, SBA loan sales resulted in a $550,000 gain, compared to a $67,000 gain on sales of SBA loans for the first quarter of 2020.

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

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Noninterest Expense

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



					Increase
	Three Months Ended				(Decrease)
	March 31,				2021 versus 2020
	2021		2020		Amount		Percent

	(Dollars in thousands)
Salaries and employee benefits	$	13,958	$	13,847	$	111	1	%
Occupancy and equipment		2,274		1,772		502	28	%
Professional fees		1,719		1,435		284	20	%
Amortization of intangible assets		733		858		(125)	(15)	%
Insurance expense		663		518		145	28	%
Data processing		534		976		(442)	(45)	%
Software subscriptions		476		889		(413)	(46)	%
Other, excluding merger-related costs		2,829		3,055		(226)	(7)	%
Total noninterest expense, excluding merger-related costs		23,186		23,350		(164)	(1)	%
Salaries and employee benefits merger-related costs (1)		—		356		(356)	(100)	%
Other merger-related costs (2)		58		2,068		(2,010)	(97)	%
Total noninterest expense, including merger-related costs	$	23,244	$	25,774	$	(2,530)	(10)	%

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

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

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


	Three Months Ended March 31,
			Percent of				Percent of
	2021		Total		2020		Total

	(Dollars in thousands)
Salaries and employee benefits	$	13,958	60	%	$	13,847	54	%
Occupancy and equipment		2,274	10	%		1,772	7	%
Professional fees		1,719	7	%		1,435	6	%
Amortization of intangible assets		733	3	%		858	3	%
Insurance expense		663	3	%		518	2	%
Data processing		534	2	%		976	4	%
Software subscriptions		476	2	%		889	3	%
Other, excluding merger-related costs		2,829	13	%		3,055	12	%
Total noninterest expense, excluding merger-related costs		23,186	100	%		23,350	91	%
Salaries and employee benefits merger-related costs (1)		—	—			356	1	%
Other merger-related costs (2)		58	0	%		2,068	8	%
Total noninterest expense, including merger-related costs	$	23,244	100	%	$	25,774	100	%

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

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

Total noninterest expense for the first quarter of 2021 decreased to $23.2 million, compared to $25.8 million for the first quarter of 2020, primarily due to lower merger-related costs, partially offset by higher severance expense during the first quarter of 2021. Noninterest expense for the first quarter of 2021 included approximately $1.5 million in severance expense, partially offset by $766,000 in deferred origination costs on Round 2 PPP loans. Full time equivalent employees were 325, and 337, and 331, at March 31, 2021, March 31, 2020, and December 31, 2020, respectively

Income Tax Expense

The Company computes its provision for income taxes on a quarterly basis. The effective tax rate is determined by applying the Company’s statutory income tax rates to pre-tax book income as adjusted for permanent differences

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between pre-tax book income and actual taxable income. These permanent differences include, but are not limited to, increases in the cash surrender value of life insurance policies, interest on tax-exempt securities, certain expenses that are not allowed as tax deductions, and tax credits.

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


	March 31,
	2021		2020
Effective income tax rate	27.8	%	31.8	%

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

The Company’s Federal and state income tax expense for the first quarter of 2021 was $4.3 million, compared to $868,000 for the first quarter of 2020.

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

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

The Company had net deferred tax assets of $26.2 million at March 31, 2021, $27.7 million at March 31, 2020, and $28.2 million at December 31, 2020. After consideration of the matters in the preceding paragraph, the Company determined that it is more likely than not that the net deferred tax assets at March 31, 2021, March 31, 2020, and December 31, 2020 will be fully realized in future years.

FINANCIAL CONDITION

At March 31, 2021, total assets increased 23% to $5.00 billion, compared to $4.08 billion at March 31, 2020, and increased 8% from $4.63 billion at December 31, 2020.

Securities available-for-sale, at fair value, were $196.7 million at March 31, 2021, a decrease of (47%) from $373.6 million at March 31, 2020, and a decrease of (17%) from $235.8 million at December 31, 2020. Securities held-to-maturity, at amortized cost, were $306.5 million at March 31, 2021, a decrease of (12%) from $348.0 million at March 31, 2020, and an increase of 3% from $297.4 million at December 31, 2020.

Loans, excluding loans held-for-sale, increased $150.8 million, or 6%, to $2.70 billion at March 31, 2021, compared to $2.55 billion at March 31, 2020, and increased $85.4 million, or 3%, to $2.70 billion at March 31, 2021, compared to $2.62 billion at December 31, 2020. Total loans at March 31, 2021 included $349.7 million of PPP loans, compared to $290.7 million at December 31, 2020. Total loans at March 31, 2021, excluding PPP loans, increased $26.4 million, from December 31, 2020.

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excluding all time deposits and CDARS deposits, increased $901.3 million, or 28%, to $4.11 billion at March 31, 2021, compared to $3.20 billion at March 31, 2020. Deposits, excluding all time deposits and CDARS deposits increased $363.5 million, or 10%, compared to $3.74 billion at December 31, 2020.

Securities Portfolio

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


	March 31,				December 31,
	2021		2020		2020

	(Dollars in thousands)
Securities available-for-sale (at fair value):
Agency mortgage-backed securities	$	151,509	$	251,836	$	175,326
U.S. Treasury		45,209		121,734		60,448
Total	$	196,718	$	373,570	$	235,774
Securities held-to-maturity (at amortized cost):
Agency mortgage-backed securities	$	242,747	$	270,211	$	228,652
Municipals — exempt from Federal tax		63,840		77,888		68,791
Total	$	306,587	$	348,099	$	297,443

The following table summarizes the weighted average life and weighted average yields of securities at March 31, 2021:


	Weighted Average Life
					After One and				After Five and
	Within One				Within Five				Within Ten				After Ten
	Year or Less				Years				Years				Years				Total
	Amount		Yield		Amount		Yield		Amount		Yield		Amount		Yield		Amount		Yield

	(Dollars in thousands)
Securities available-for-sale (at fair value):
Agency mortgage-backed securities	$	876	2.15	%	$	150,633	1.67	%	$	—	N/A		$	—	N/A		$	151,509	1.67	%
U.S. Treasury		45,209	2.83	%		—	N/A			—	N/A			—	N/A			45,209	2.83	%
Total	$	46,085	2.83	%	$	150,633	1.67	%	$	—	N/A		$	—	N/A		$	196,718	1.94	%

Securities held-to-maturity (at amortized cost):
Agency mortgage-backed securities	$	—	N/A	%	$	162,867	1.60	%	$	20,351	1.50	%	$	59,529	1.82	%	$	242,747	1.65	%
Municipals — exempt from Federal tax (1)		34,984	3.22	%		28,206	3.35	%		450	3.82	%		200	3.80	%		63,840	3.28	%
Total	$	34,984	3.22	%	$	191,073	1.86	%	$	20,801	1.55	%	$	59,729	1.82	%	$	306,587	1.99	%

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

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

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

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

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

Loans

The Company’s loans represent the largest portion of invested assets, substantially greater than the securities portfolio or any other asset category, and the quality and diversification of the loan portfolio is an important consideration when reviewing the Company’s financial condition. Gross loans, excluding loans held-for-sale, represented 54% of total assets at March 31, 2021, represented 63% at March 31, 2020, and represented 57% at December 31, 2020. The ratio of loans to deposits was 63.21% at March 31, 2021, compared to 75.86% at March 31, 2020, and 66.91% at December 31, 2020.

Loan Distribution

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


	March 31, 2021				March 31, 2020				December 31, 2020
	Balance		% to Total		Balance		% to Total		Balance		% to Total

	(Dollars in thousands)
Commercial	$	559,698	20	%	$	696,168	27	%	$	555,707	21	%
SBA PPP loans		349,744	13	%		—	0	%		290,679	11	%
Real estate:
CRE - owner occupied		568,637	21	%		539,465	21	%		560,362	21	%
CRE - non-owner occupied		700,117	26	%		748,245	29	%		693,103	27	%
Land and construction		159,504	6	%		153,321	6	%		144,594	6	%
Home equity		104,303	4	%		117,544	5	%		111,885	4	%
Multifamily		168,917	6	%		170,292	7	%		166,425	6	%
Residential mortgages		82,181	3	%		95,808	4	%		85,116	3	%
Consumer and other		19,872	1	%		33,326	1	%		18,116	1	%
Total Loans		2,712,973	100	%		2,554,169	100	%		2,625,987	100	%
Deferred loan fees, net		(8,266)	—			(258)	—			(6,726)	—
Loans, net of deferred fees		2,704,707	100	%		2,553,911	100	%		2,619,261	100	%
Allowance for credit losses on loans		(44,296)				(44,703)				(44,400)
Loans, net	$	2,660,411			$	2,509,208			$	2,574,861

The Company’s loan portfolio is concentrated in commercial loans, (primarily manufacturing, wholesale, and services oriented entities), and commercial real estate, with the remaining balance in land development and construction, home equity, purchased residential mortgages, and consumer loans. The Company does not have any concentrations by industry or group of industries in its loan portfolio, however, 66% of its gross loans were secured by real property at March 31, 2021, compared to 72% at March 31, 2020, and 67% at December 31, 2020. While no specific industry concentration is considered significant, the Company’s bank lending operations are substantially located in areas that are dependent on the technology and real estate industries and their supporting companies.

The Company has established concentration limits in its loan portfolio for commercial real estate loans, commercial loans, construction loans and unsecured lending, among others. The Company uses underwriting guidelines to assess the borrower’s historical cash flow to determine debt service, and we further stress test the debt service under higher interest rate scenarios. Financial and performance covenants are used in commercial lending to allow the Company to react to a borrower’s deteriorating financial condition should that occur.

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

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The Company is an active participant in the SBA and U.S. Department of Agriculture guaranteed lending programs, and has been approved by the SBA as a lender under the Preferred Lender Program. The Company regularly makes such guaranteed loans (collectively referred to as “SBA loans”). The guaranteed portion of these loans is typically sold in the secondary market depending on market conditions. When the guaranteed portion of an SBA loan is sold, the Company retains the servicing rights for the sold portion. During the three months ended March 31, 2021, loans were sold resulting in a gain on sales of SBA loans of $550,000, compared to $67,000 for the three months ended March 31, 2020.

The Company’s factoring receivables are from the operations of Bay View Funding whose primary business is purchasing and collecting factored receivables. Factored receivables are receivables that have been transferred by the originating organization and typically have not been subject to previous collection efforts. These receivables are acquired from a variety of companies, including but not limited to service providers, transportation companies, manufacturers, distributors, wholesalers, apparel companies, advertisers, and temporary staffing companies. The portfolio of factored receivables is included in the Company’s commercial loan portfolio. The average life of the factored receivables was 35 days for the first three months of 2021, compared to 37 days for the first three months of 2020. The balance of the purchased receivables was $48.5 million at March 31, 2021, compared to $54.1 million at March 31, 2020 and $47.2 million at December 31, 2020.

The commercial loan portfolio, excluding PPP loans, decreased ($136.5) million, or (20%), to $559.7 million at March 31, 2021, from $696.2 million at March 31, 2020 and increased $4.0 million, or 1%, from $555.7 million at December 31, 2020. Commericial and industrial (“C&I”) line usage was 28% at March 31, 2021, compared to 36% at March 31, 2020 and 28% at December 31, 2020.

In addition, the Company had $349.7 million in PPP loans at March 31, 2021, compared to $290.7 million at December 31, 2020. The Company did not have any PPP loans at March 31, 2020.

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

The CRE owner-occupied loan portfolio increased $29.1 million, or 5%, to $568.6 million at March 31, 2021, from $539.5 million at March 31, 2020, and increased $8.3 million, or 1%, from $560.3 million at December 31, 2020. CRE non-owner occupied loans decreased ($48.1) million, or (6%), to $700.1 million, compared to $748.2 million at March 31, 2020, and increased $7.0 million, or 1% from $693.1 million at December 31, 2020. At March 31, 2021, 45% of the CRE loan portfolio was secured by owner-occupied real estate.

The Company’s land and construction loans are primarily to finance the development/construction of commercial and single family residential properties. The Company utilizes underwriting guidelines to assess the likelihood of repayment from sources such as sale of the property or availability of permanent mortgage financing prior to making the construction loan. Construction loans are provided only in our market area, and the Company has extensive controls for the disbursement process. Land and construction loans increased $6.2 million, or 4%, to $159.5 million at March 31, 2021, compared to $153.3 million at March 31, 2020, and increased $14.9 million, or 10%, from $144.6 million at December 31, 2020.

The Company makes home equity lines of credit available to its existing customers. Home equity lines of credit are underwritten initially with a maximum 75% loan to value ratio. Home equity lines of credit decreased ($13.2) million, or (11%), to $104.3 million at March 31, 2021, compared to $117.5 million at March 31, 2020, and decreased ($7.6) million, or (7%), from $111.9 million at December 31, 2020.

Multifamily loans decreased ($1.4) million, or (1%), to $168.9 million, at March 31, 2021, compared to $170.3 million at March 31, 2020, and increased $2.5 million, or 1%, from $166.4 million at December 31, 2020.

Residential mortgage loans decreased ($13.6) million, or (14%), to $82.2 million at March 31, 2021, compared to $95.8 million at March 31, 2020, and decreased ($2.9) million, or (3%) from $85.1 million at December 31, 2020.

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Consumer and other loans decreased ($13.4) million, or (40%), to $19.9 million at March 31, 2021, compared to $33.3 million at March 31, 2020, and increased $1.8 million, or 10% from $18.1 million at December 31, 2020.

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

With certain exceptions, state chartered banks are permitted to make extensions of credit to any one borrowing entity totaling up to 15% of the bank’s capital and reserves for unsecured loans and up to 25% of the bank’s capital and reserves for secured loans. For HBC, these lending limits were $96.6 million and $161.0 million at March 31, 2021, respectively.

Loan Maturities

The following table presents the maturity distribution of the Company’s loans (excluding loans held-for-sale) as of March 31, 2021. The table shows the distribution of such loans between those loans with predetermined (fixed) interest rates and those with variable (floating) interest rates. Floating rates generally fluctuate with changes in the prime rate as reflected in the Western Edition of The Wall Street Journal. As of March 31, 2021, approximately 40% of the Company’s loan portfolio consisted of floating interest rate loans. Excluding fixed-rate PPP loans, approximately 46% of the Company’s loan portfolio consisted of floating interest rate loans as of March 31, 2021.


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

	(Dollars in thousands)
Commercial	$	427,548	$	79,433	$	52,717	$	559,698
SBA PPP loans		—		349,744		—		349,744
Real estate:
CRE - owner occupied		124,559		141,410		302,668		568,637
CRE - non-owner occupied		230,809		179,349		289,959		700,117
Land and construction		140,149		9,058		10,297		159,504
Home equity		104,187		—		116		104,303
Multifamily		3,568		55,297		110,052		168,917
Residential mortgages		1,542		23,496		57,143		82,181
Consumer and other		11,337		6,838		1,697		19,872
Loans	$	1,043,699	$	844,625	$	824,649	$	2,712,973

Loans with variable interest rates	$	984,640	$	33,066	$	80,023	$	1,097,729
SBA PPP loans with fixed interest rates		—		349,744		—		349,744
Other loans with fixed interest rates		59,059		461,815		744,626		1,265,500
Loans	$	1,043,699	$	844,625	$	824,649	$	2,712,973

Loan Servicing

As of March 31, 2021 and 2020, $80.2 million and $86.2 million, respectively, in SBA loans were serviced by the Company for others. Activity for loan servicing rights was as follows:


	Three Months Ended
	March 31,
	2021		2020

	(Dollars in thousands)
Beginning of period balance	$	531	$	583
Additions		123		17
Amortization		(48)		(61)
End of period balance	$	606	$	539

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Loan servicing rights are included in accrued interest receivable and other assets on the unaudited consolidated balance sheets and reported net of amortization. There was no valuation allowance as of March 31, 2021and 2020, as the fair value of the assets was greater than the carrying value.

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


	Three Months Ended
	March 31,
	2021		2020

	(Dollars in thousands)
Beginning of period balance	$	305	$	503
Unrealized holding loss		(9)		(45)
End of period balance	$	296	$	458

Credit Quality and Allowance for Credit Losses on Loans

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

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

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

Nonperforming assets are comprised of the following: loans for which the Company is no longer accruing interest; restructured loans which have been current under six months; loans 90 days or more past due and still accruing interest (although they are generally placed on nonaccrual when they become 90 days past due, unless they are both well-secured and in the process of collection); and foreclosed assets. Past due loans 30 days or greater totaled $5.3 million and $6.2 million at March 31, 2021 and December 31, 2020, respectively, of which $1.8 million were on nonaccrual at March 31, 2021 and $1.9 million at December 31, 2020. At March 31, 2021, there were also $3.8 million loans less than 30 days past due included in nonaccrual loans held-for-investment. At December 31, 2020, there were also $5.9 million loans less than 30 days past due included in nonaccrual loans held-for-investment.

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

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


	March 31,						December 31,
	2021			2020			2020

	(Dollars in thousands)
Nonaccrual loans — held-for-investment	$	5,542		$	11,646		$	7,788
Restructured and loans 90 days past due and
still accruing		51			442			81
Total nonperforming loans		5,593			12,088			7,869
Foreclosed assets		—			—			—
Total nonperforming assets	$	5,593		$	12,088		$	7,869

Nonperforming assets as a percentage of loans
plus foreclosed assets		0.21	%		0.47	%		0.30	%
Nonperforming assets as a percentage of total assets		0.11	%		0.30	%		0.17	%

Nonperforming assets were $5.6 million, or 0.11% of total assets, at March 31, 2021, compared to $12.1 million, or 0.30% of total assets, at March 31, 2020, and $7.9 million, or 0.17% of total assets, at December 31, 2020.

The following table presents the amortized cost basis of nonperforming loans and loans past due over 90 days and still accruing at March 31, 2021:



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

	(Dollars in thousands)
Commercial	$	443	$	1,542	$	51	$	2,036
Real estate:
CRE - Owner Occupied		1,824		—		—		1,824
Home equity		177		—		—		177
Multifamily		1,149		—		—		1,149
Consumer and other		407		—		—		407
Total	$	4,000	$	1,542	$	51	$	5,593

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



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

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

Loans with a well-defined weakness, which are characterized by the distinct possibility that the Company will sustain a loss if the deficiencies are not corrected, are categorized as “classified.” Classified loans include all loans considered as substandard, substandard-nonaccrual, and doubtful and may result from problems specific to a borrower’s business or from economic downturns that affect the borrower’s ability to repay or that cause a decline in the value of the

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underlying collateral (particularly real estate). Loans held-for-sale are carried at the lower of cost or estimated fair value, and are not allocated an allowance for loan losses.

The following table presents the amortized cost basis of collateral-dependent loans by loan classification at March 31, 2021:


		Collateral Type
		Real
		Estate		Business
		Property		Assets		Unsecured		Total

	(Dollars in thousands)
Commercial	$	27	$	1,481	$	34	$	1,542
Total	$	27	$	1,481	$	34	$	1,542

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


		Collateral Type
		Real
		Estate		Business
		Property		Assets		Unsecured		Total

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

Classified loans increased to $33.4 million, or 0.67% of total assets, at March 31, 2021, compared to $39.6 million, or 0.97% of total assets, at March 31, 2020 and decreased from $34.0 million, or 0.73% of total assets at December 31, 2020. Deferrals included in classified assets total $2.2 million at March 31, 2021.

In order to determine whether a borrower is experiencing financial difficulty, an evaluation is performed of the probability that the borrower will be in payment default on any of its debt in the foreseeable future without the modification. This evaluation is performed in accordance with the Company’s underwriting policy.

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Beginning January 1, 2020, we calculated allowance for credit losses on loans using CECL methodology. As of January 1, 2020, the Company increased the allowance for credit losses on loans by $8.6 million since the Topic 326 covers credit losses over the expected life of a loan as well as considering future changes in macroeconomic conditions.

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

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

Loans are charged-off against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance for credit losses on loans.

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

Commercial

Commercial loans primarily rely on the identified cash flows of the borrower for repayment and secondarily on the underlying collateral provided by the borrower. However, the cash flows of the borrowers may not be as expected and the collateral securing these loans may vary in value. Most commercial loans are secured by the assets being financed or other business assets such as accounts receivable, inventory or equipment and may incorporate a personal guarantee; however, some loans may be unsecured. Included in commercial loans are $349.7 million of PPP loans at March 31, 2021 and $290.7 million at December 31, 2020. No allowance for credit losses has been recorded for PPP loans as they are fully guaranteed by the SBA. No allowance for credit losses has been recorded for PPP loans as they are fully guaranteed by the SBA.

Commercial Real Estate

Land and Construction

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Home Equity

Multifamily

Residential Mortgages

Consumer and Other

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

On an ongoing basis, we have engaged an outside firm to perform independent credit reviews of our loan portfolio. The Federal Reserve Board and the California Department of Financial Protection and Innovation (“DFPI”) also review the allowance for credit losses on loans as an integral part of the examination process. Based on information currently available, management believes that the allowance for credit losses on loans is adequate. However, the loan portfolio can be adversely affected if California economic conditions and the real estate market in the Company’s market area were to weaken further. Also, any weakness of a prolonged nature in the technology industry would have a negative impact on the local market. The effect of such events, although uncertain at this time, could result in an increase in the level of nonperforming loans and increased loan losses, which could adversely affect the Company’s future growth and profitability. No assurance of the ultimate level of credit losses can be given with any certainty.

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


	Three Months Ended March 31, 2021
			CRE		CRE
			Owner		Non-owner		Land &		Home		Multi-		Residential		Consumer
	Commercial		Occupied		Occupied		Construction		Equity		Family		Mortgages		and Other		Total

	(Dollars in thousands)
Beginning of period balance	$	11,587	$	8,560	$	16,416	$	2,509	$	1,297	$	2,804	$	943	$	284	$	44,400
Charge-offs		(263)		-		-		-		-		-		-		-		(263)
Recoveries		813		4		-		816		23		-		-		15		1,671
Net (charge-offs) recoveries		550		4		-		816		23		-		-		15		1,408
Provision for (recapture of) credit losses on loans		(537)		(196)		15		(571)		(149)		(53)		(25)		4		(1,512)
End of period balance	$	11,600	$	8,368	$	16,431	$	2,754	$	1,171	$	2,751	$	918	$	303	$	44,296


	Three Months Ended March 31, 2020
			CRE		CRE
			Owner		Non-owner		Land &		Home		Multi-		Residential		Consumer
	Commercial		Occupied		Occupied		Construction		Equity		Family		Mortgages		and Other		Total

	(Dollars in thousands)
Beginning of period balance	$	10,453	$	3,825	$	3,760	$	2,621	$	2,244	$	57	$	243	$	82	$	23,285
Adoption of Topic 326		(3,663)		3,169		7,912		(1,163)		(923)		1,196		435		1,607		8,570
Balance at adoption on January 1, 2020		6,790		6,994		11,672		1,458		1,321		1,253		678		1,689		31,855
Charge-offs		(670)		-		-		-		-		-		-		(3)		(673)
Recoveries		209		-		-		19		23		-		-		-		251
Net (charge-offs) recoveries		(461)		-		-		19		23		-		-		(3)		(422)
Provision for credit losses on loans		6,472		743		3,973		1,126		402		369		30		155		13,270
End of period balance	$	12,801	$	7,737	$	15,645	$	2,603	$	1,746	$	1,622	$	708	$	1,841	$	44,703

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

Allocation of Allowance for Credit Losses on Loans


	March 31,
	2021				2020				December 31, 2020
			Percent				Percent				Percent
			of Loans				of Loans				of Loans
			in each				in each				in each
			category				category				category
			to total				to total				to total
	Allowance		loans		Allowance		loans		Allowance		loans

	(Dollars in thousands)
Commercial	$	11,600	33	%	$	12,801	27	%	$	11,587	32	%
Real estate:
CRE - owner occupied		8,368	21	%		7,737	21	%		8,560	21	%
CRE - non-owner occupied		16,431	26	%		15,645	29	%		16,416	27	%
Land and construction		2,754	6	%		2,603	6	%		2,509	6	%
Home equity		1,171	4	%		1,746	5	%		1,297	4	%
Multifamily		2,751	6	%		1,622	7	%		2,804	6	%
Residential mortgages		918	3	%		708	4	%		943	3	%
Consumer and other		303	1	%		1,841	1	%		284	1	%
Total	$	44,296	100	%	$	44,703	100	%	$	44,400	100	%

The allowance for credit losses on loans totaled $44.3 million, or 1.64% of total loans at March 31, 2021. The allowance for credit losses on loans was $44.7 million, or 1.75% of total loans at March 31, 2020, and $44.4 million, or 1.70% of total loans at December 31, 2020. The allowance for credit losses on loans was 791.99% of nonperforming loans at March 31, 2021, compared to 369.81% of nonperforming loans at March 31, 2020, and 564.24% of nonperforming loans at December 31, 2020. The allowance for credit losses on loans to total loans, excluding PPP loans, was 1.88% at March 31, 2021, and 1.91% at December 31, 2020. There were no PPP loans at March 31, 2020. The Company had net recoveries of $1.4 million, or (0.22%) of average loans, for the first quarter of 2021, compared to net charge-offs of $422,000, or 0.07% of average loans, for the first quarter of 2020 and net recoveries of $326,000, or (0.05%) of average loans for the fourth quarter of 2020.

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The following table shows the drivers of change in ACLL under CECL for the first quarter ended March 31, 2021:


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

Leases

The Company recognizes the following for all leases, at the commencement date: (1) a lease liability, which is a lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis; and (2) a right-of-use (“ROU”) asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. While the new standard impacts lessors and lessees, the Company is impacted as a lessee of the offices and real estate used for operations. The Company's lease agreements include options to renew at the Company's discretion. The extensions are not reasonably certain to be exercised, therefore it was not considered in the calculation of the ROU asset and lease liability. Total assets and total liabilities were $37.4 million on its consolidated statement of financial condition at March 31, 2021, as a result of recognizing right-of-use assets, included in other assets, and lease liabilities, included in other liabilities, related to non-cancelable operating lease agreements for office space.

Deposits

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

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


	March 31, 2021				March 31, 2020				December 31, 2020
	Balance		% to Total		Balance		% to Total		Balance		% to Total

	(Dollars in thousands)
Demand, noninterest-bearing	$	1,813,962	42	%	$	1,444,534	42	%	$	1,661,655	42	%
Demand, interest-bearing		1,101,807	26	%		810,425	24	%		960,179	24	%
Savings and money market		1,189,566	28	%		949,076	28	%		1,119,968	29	%
Time deposits — under $250		42,596	1	%		51,009	2	%		45,027	1	%
Time deposits — $250 and over		102,508	2	%		96,540	3	%		103,746	3	%
CDARS — interest-bearing demand,
money market and time deposits		28,663	1	%		15,055	1	%		23,911	1	%
Total deposits	$	4,279,102	100	%	$	3,366,639	100	%	$	3,914,486	100	%

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

Total deposits increased $912.5 million, or 27%, to $4.28 billion at March 31, 2021, compared to $3.37 billion at March 31, 2020. Total deposits increased $364.6 million, or 9%, from $3.91 billion at December 31, 2020. Deposits, excluding all time deposits and CDARS deposits, increased $901.3 million, or 28%, to $4.11 billion at March 31, 2021, compared to $3.20 billion at March 31, 2020. Deposits, excluding all time deposits and CDARS deposits, increased $363.5 million, or 10%, compared to $3.74 billion at December 31, 2020.

At March 31, 2021, the $28.7 million CDARS deposits comprised $21.4 million of interest-bearing demand deposits, $1.7 million of money market accounts and $5.6 million of time deposits. At March 31, 2020, the $15.1 million CDARS deposits comprised $10.7 of million of interest-bearing demand deposits, $1.7 million of money market accounts

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and $2.7 million of time deposits. At December 31, 2020, the $23.9 million CDARS deposits comprised $18.6 million of interest-bearing demand deposits, $663,000 of money market accounts and $4.6 million of time deposits.

The following table indicates the contractual maturity schedule of the Company’s time deposits of $250,000 and over, and all CDARS time deposits as of March 31, 2021:


	Balance		% of Total

	(Dollars in thousands)
Three months or less	$	43,480	40	%
Over three months through six months		21,354	20	%
Over six months through twelve months		34,718	32	%
Over twelve months		8,509	7	%
Total	$	108,061	100	%

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

Return on Equity and Assets

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


	Three Months Ended
	March 31,
	2021		2020
Return on average assets	0.95	%	0.19	%
Return on average tangible assets	0.99	%	0.19	%
Return on average equity	7.85	%	1.29	%
Return on average tangible equity	11.50	%	1.91	%
Average equity to average assets ratio	12.13	%	14.36	%

Liquidity and Asset/Liability Management

The Company’s liquidity position supports its ability to maintain cash flows sufficient to fund operations, meet all of its financial obligations and commitments, and accommodate unexpected sudden changes in balances of loans and deposits in a timely manner. At various times the Company requires funds to meet short term cash requirements brought about by loan growth or deposit outflows, the purchase of assets, or repayment of liabilities. An integral part of the Company’s ability to manage its liquidity position appropriately is derived from its large base of core deposits which are generated by offering traditional banking services in its service area and which have historically been a stable source of funds.

The Company manages liquidity to be able to meet unexpected sudden changes in levels of its assets or deposit liabilities without maintaining excessive amounts of balance sheet liquidity. Excess balance sheet liquidity can negatively impact the Company’s interest margin. In order to meet short term liquidity needs the Company utilizes overnight Federal funds purchase arrangements and other borrowing arrangements with correspondent banks, solicits brokered deposits if cost effective deposits are not available from local sources, and maintains collateralized lines of credit with the FHLB and FRB. In addition, the Company can raise cash for temporary needs by selling securities under agreements to repurchase and selling securities available for sale.

One of the measures of liquidity is the loan to deposit ratio. The loan to deposit ratio was 63.21% at March 31, 2021, compared to 75.86% at March 31, 2020, and 66.91% at December 31, 2020.

FHLB and FRB Borrowings and Available Lines of Credit

HBC has off-balance sheet liquidity in the form of Federal funds purchase arrangements with correspondent banks, including the FHLB and FRB. HBC can borrow from the FHLB on a short-term (typically overnight) or long-term

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(over one year) basis. HBC had no overnight borrowings from the FHLB at March 31, 2021, March 31, 2020, and December 31, 2020. HBC had $226.5 million of loans pledged to the FHLB as collateral on an available line of credit of $158.6 million at March 31, 2021, none of which was outstanding. HBC also had $2.6 million of securities pledged to the FHLB as collateral on an available line of credit of $2.4 million at March 31, 2021, none of which was outstanding.

HBC can also borrow from the FRB’s discount window. HBC had $905.2 million of loans pledged to the FRB as collateral on an available line of credit of $522.6 million at March 31, 2021, none of which was outstanding.

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

The Company has a $10.0 million line of credit with a correspondent bank, of which none was outstanding at March 31, 2021.

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

Capital Resources

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

On May 26, 2017, the Company completed an underwritten public offering of $40.0 million aggregate principal amount of its fixed-to-floating rate subordinated notes (“Subordinated Debt”) due June 1, 2027. The Subordinated Debt initially bears a fixed interest rate of 5.25% per year. Commencing on June 1, 2022, the interest rate on the Subordinated Debt resets quarterly to the three-month LIBOR rate plus a spread of 336.5 basis points, payable quarterly in arrears. Interest on the Subordinated Debt is payable semi-annually on June 1st and December 1st of each year through June 1, 2022 and quarterly thereafter on March 1st, June 1st, September 1st and December 1st of each year through the maturity date or early redemption date. The Company, at its option, may redeem the Subordinated Debt, in whole or in part, on any interest payment date on or after June 1, 2022 without a premium.

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

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


	March 31,			March 31,			December 31,
	2021			2020			2020

	(Dollars in thousands)
Capital components:
Common Equity Tier 1 capital	$	415,545		$	394,598		$	410,307
Additional Tier 1 capital		—			—			—
Tier 1 Capital		415,545			394,598			410,307
Tier 2 Capital		73,571			73,580			73,563
Total Capital	$	489,116		$	468,178		$	483,870

Risk-weighted assets	$	2,960,057		$	3,158,386		$	2,924,448
Average assets for capital purposes	$	4,579,125		$	3,835,661		$	4,507,032

Capital ratios:
Total Capital		16.5	%		14.8	%		16.5	%
Tier 1 Capital		14.0	%		12.5	%		14.0	%
Common equity Tier 1 Capital		14.0	%		12.5	%		14.0	%
Tier 1 Leverage(1)		9.1	%		10.3	%		9.1	%

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


	March 31,			March 31,			December 31,
	2021			2020			2020

	(Dollars in thousands)
Capital components:
Common Equity Tier 1 capital	$	433,639		$	410,050		$	428,109
Additional Tier 1 capital		—			—			—
Tier 1 Capital		433,639			410,050			428,109
Tier 2 Capital		33,785			33,980			33,824
Total Capital	$	467,424		$	444,030		$	461,933

Risk-weighted assets	$	2,957,908		$	3,154,321		$	2,922,577
Average assets for capital purposes	$	4,576,901		$	3,831,638		$	4,505,265

Capital ratios:
Total Capital		15.8	%		14.1	%		15.8	%
Tier 1 Capital		14.7	%		13.0	%		14.6	%
Common Equity Tier 1 Capital		14.7	%		13.0	%		14.6	%
Tier 1 Leverage(1)		9.5	%		10.7	%		9.5	%

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

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




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

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

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

At March 31, 2021, the Company’s consolidated capital ratio exceeded regulatory guidelines and HBC’s capital ratios exceed the highest regulatory capital requirement of “well-capitalized” under Basel III prompt corrective action provisions. Quantitative measures established by regulation to help ensure capital adequacy require the Company and HBC to maintain minimum amounts and ratios of total risk-based capital, Tier 1 capital, and common equity Tier 1 (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital to average assets (as defined). Management believes that, as of March 31, 2021, March 31, 2020, and December 31, 2020, the Company and HBC met all capital adequacy guidelines to which they were subject. There are no conditions or events since March 31, 2021, that management believes have changed the categorization of the Company or HBC as well-capitalized.

At March 31, 2021, the Company had total shareholders’ equity of $581.7 million, compared to $571.4 million at March 31, 2020, and $577.9 million at December 31, 2020. At March 31, 2021, total shareholders’ equity included $494.6 million in common stock, $98.3 million in retained earnings, and ($11.3) million of accumulated other comprehensive loss. The book value per share was $9.71 at March 31, 2021, compared to $9.59 at March 31, 2020, and $9.64 at December 31, 2020. The tangible book value per share was $6.64 at March 31, 2021, compared to $6.46 at March 31, 2020, and $6.57 at December 31, 2020.

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


ACCUMULATED OTHER COMPREHENSIVE LOSS	March 31,		December 31,		March 31,
(in $000's, unaudited)	2021		2020		2020
Unrealized gain on securities available-for-sale	$	3,113	$	3,709	$	6,299
Remaining unamortized unrealized gain on securities
available-for-sale transferred to held-to-maturity		252		261		289
Split dollar insurance contracts liability		(6,148)		(6,140)		(4,850)
Supplemental executive retirement plan liability		(8,699)		(8,767)		(6,775)
Unrealized gain on interest-only strip from SBA loans		214		220		328
Total accumulated other comprehensive loss	$	(11,268)	$	(10,717)	$	(4,709)

Market Risk

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

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

Interest Rate Management

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

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

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

Interest rate changes do not affect all categories of assets and liabilities equally or at the same time. Varying interest rate environments can create unexpected changes in prepayment levels of assets and liabilities, which may have a significant effect on the net interest margin and are not reflected in the interest sensitivity analysis table. Because of these factors, an interest sensitivity GAP report may not provide a complete assessment of the exposure to changes in interest rates.

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

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The following table sets forth the estimated changes in the Company’s annual net interest income that would result from the designated instantaneous parallel shift in interest rates noted, as of March 31, 2021. Computations of prospective effects of hypothetical interest rate changes are based on numerous assumptions including relative levels of market interest rates, loan prepayments and deposit decay, and should not be relied upon as indicative of actual results.


	Increase/(Decrease) in
	Estimated Net
	Interest Income
	Amount		Percent

	(Dollars in thousands)
Change in Interest Rates (basis points)
+400	$	67,910	56.0	%
+300	$	51,007	42.1	%
+200	$	34,104	28.1	%
+100	$	17,127	14.1	%
0		—	—
−100	$	(11,672)	(9.6)	%
−200	$	(23,178)	(19.1)	%

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

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

ITEM 3—QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

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

ITEM 4—CONTROLS AND PROCEDURES

Disclosure Control and Procedures

The Company has carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of March 31, 2021. As defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), disclosure controls and procedures are controls and procedures designed to reasonably assure that information required to be disclosed in our reports filed or submitted under the Exchange Act are recorded, processed, summarized and reported on a timely basis. Disclosure controls are also designed to reasonably assure that such information is accumulated and communicated to our management, including the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. Based upon their evaluation, our Chief Executive Officer and Chief Financial Officer concluded the Company’s disclosure controls were effective at March 31, 2021, the period covered by this report on Form 10-Q.

During the three months ended March 31, 2021, there were no changes in our internal controls over financial reporting that materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.

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Part II—OTHER INFORMATION

ITEM 1—LEGAL PROCEEDINGS

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

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

ITEM 1A—RISK FACTORS

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

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

None

ITEM 3—DEFAULTS UPON SENIOR SECURITIES

None

ITEM 4—MINE SAFETY DISCLOSURES

None

ITEM 5—OTHER INFORMATION

None

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ITEM 6—EXHIBITS


Exhibit		Description
3.1		Heritage Commerce Corp Restated Articles of Incorporation, (incorporated by reference to Exhibit 3.1 to the Registrant’s Annual Report on Form 10-K filed on March 16, 2009)
3.2		Certificate of Amendment of Articles of Incorporation of Heritage Commerce Corp as filed with the California Secretary of State on June 1, 2010 (incorporated by reference to Exhibit 3.2 to the Registrant’s Registration Statement on Form S-1 filed July 23, 2010).
3.3		Certificate of Amendment of Articles of Incorporation of Heritage Commerce Corp as filed with the Secretary of State on August 29, 2019 (incorporated by reference to Exhibit 3.3 to the Registrant’s Quarterly Report on Form 10-Q filed on November 11, 2019)
3.4		Heritage Commerce Corp Bylaws, as amended (incorporated by reference to the Registrant’s Current Report on Form 8-K filed on June 28, 2013)
31.1		Certification of Registrant’s Chief Executive Officer Pursuant To Section 302 of the Sarbanes-Oxley Act of 2002
31.2		Certification of Registrant’s Chief Financial Officer Pursuant To Section 302 of the Sarbanes-Oxley Act of 2002
32.1		Certification of Registrant’s Chief Executive Officer Pursuant To 18 U.S.C. Section 1350
32.2		Certification of Registrant’s Chief Financial Officer Pursuant To 18 U.S.C. Section 1350
101.INS		XBRL Instance Document Instance Document - the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document
101.SCH		XBRL Taxonomy Extension Schema
101.CAL		XBRL Taxonomy Extension Calculation Linkbase
101.DEF		XBRL Taxonomy Extension Definition Linkbase
101.LAB		XBRL Taxonomy Extension Label Linkbase
101.PRE		XBRL Taxonomy Extension Presentation Linkbase
104.		The cover page from Heritage Commerce Corp's Quarterly Report on Form 10-Q for the quarter ended March 31, 2021, formatted in Inline XBRL

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	Heritage Commerce Corp (Registrant)

Date: May 7, 2021	/s/ wALTER T. KACZMAREK
	Walter T. Kaczmarek
	Chief Executive Officer

Date: May 7, 2021	/s/ Lawrence D. mcgovern
	Lawrence D. McGovern
	Chief Financial Officer