Oak Valley Bancorp - Annual Report: 2008 (Form 10-K)

Table of Contents

 

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K

 

 

OAK VALLEY BANCORP

(Exact name of registrant as specified in its charter)

 

 

(209) 848-2265

(Registrant’s telephone number including area code)

 

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

 

 

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

 

None

(Title of class)

 

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

Yes  o

No  x

 

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

Act.

Yes  o

No  x

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file

such reports), and (2) has been subject to such filing requirements for the past 90 days.           Yes  x                                          No  o

 

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

 

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

 

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

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes  o

No  x

 

As of December 31, 2008, the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was $37,480,902 based on the closing price.

 

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

 

 

DOCUMENTS INCORPORATED BY REFERENCE

 

 

 

Table of Contents

 

TABLE OF CONTENTS

 

PART I		3
ITEM 1 -	DESCRIPTION OF BUSINESS	3
ITEM 1A -	RISK FACTORS	16
ITEM 1B -	UNRESOLVED STAFF COMMENTS	16
ITEM 2 -	DESCRIPTION OF PROPERTY	16
ITEM 3 -	LEGAL PROCEEDINGS	16
ITEM 4 -	SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS	16
PART II		17
ITEM 5 -	MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUERS PURCHASES OF EQUITY SECURITIES.	17
ITEM 6 -	SELECTED CONSOLIDATED FINANCIAL DATA	18
ITEM 7-	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	19
ITEM 8 -	FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA	51
ITEM 9 -	CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE	51
ITEM 9A -	CONTROLS AND PROCEDURES	51
ITEM 9B-	OTHER INFORMATION	51
PART III		52
ITEM 10 -	DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE	52
ITEM 11 -	EXECUTIVE COMPENSATION	57
ITEM 12 -	SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS	60
ITEM 13 -	CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE	62
ITEM 14 -	PRINCIPAL ACCOUNTANT FEES AND SERVICES	63
PART IV		64
ITEM 15 -	EXHIBITS AND FINANCIAL STATEMENTS	64
SIGNATURES		66

 

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PART I

 

ITEM 1.  BUSINESS OF OAK VALLEY BANCORP

 

Overview of the Business

 

Oak Valley Bancorp was incorporated on April 1, 2008 in California for the purpose of becoming Oak Valley Community Bank’s parent bank holding company. Effective July 3, 2008, Oak Valley Bancorp acquired all of the outstanding capital stock of Oak Valley Community Bank. The principal office of Oak Valley Bancorp is located at 125 North Third Avenue, Oakdale, California 95361 and its principal telephone is (209) 848-2265.

 

Oak Valley Bancorp is authorized to issue 50,000,000 shares of common stock, without par value, of which 7,661,627 are issued and outstanding, and 10,000,000 shares of preferred stock, without par value, of which 13,500 Series A preferred stock shares are issued or outstanding.

 

Oak Valley Community Bank commenced operations in May 1991.  We are an insured bank under the Federal Deposit Insurance Act and are a member of the Federal Reserve.  Since its formation, the Bank has provided basic banking services to individuals and business enterprises in Oakdale, California and the surrounding areas. The focus of the Bank is to offer a range of commercial banking services designed for both individuals and small to medium-sized businesses in the two main areas of service of the Bank: the Central Valley and the Eastern Sierras.

 

The Bank offers a complement of business checking and savings accounts for its business customers.  The Bank also offers commercial and real estate loans, as well as lines of credit.  Real estate loans are generally of a short-term nature for both residential and commercial purposes.  Longer-term real estate loans are generally made with adjustable interest rates and contain normal provisions for acceleration.  The Bank introduced a mortgage-lending program, Community Bank Lending Exchange (“CBLX”), at the beginning of 2003.  At December 31, 2008, the Bank has originated $205 million in loans for funding by CBLX.

 

The Bank also offers other services for both individuals and businesses including online banking, remote deposit capture, merchant services, night depository, extended hours, traveler’s checks, wire transfer of funds, note collection, and automated teller machines in a national network.  The Bank does not currently offer international banking or trust services although the Bank may make such services available to the Bank’s customers through financial institutions with which the Bank has correspondent banking relationships.  The Bank does not offer stock transfer services nor does it directly issue credit cards.

 

Expansion

 

Branch Expansion.    Over the past few years, our network of branches and loan production offices have been expanded geographically. As of December 31, 2008, we maintained twelve full-service branch offices (in addition to our main office). Beginning in October 1995, we started our geographic expansion outside of Oakdale, by opening a Loan Production Office in Sonora, California. We subsequently  opened a branch in Sonora and branches in Modesto.  In September 2000, we expanded into the Eastern Sierra, opening a branch in Bridgeport, California under the name Eastern Sierra Community Bank.  Since that time we have added branches in Mammoth Lakes and Bishop. During 2005 and through the first part of 2006, we aggressively increased our presence in the Central Valley, by opening branches.  In March 2007 our corporate headquarters expanded by adding an adjacent historical building located in downtown Oakdale to its complex.  We intend to continue our growth strategy in future years through the opening of additional branches and loan production offices as our needs and resources permit.

 

Bank Holding Company Reorganization.  Effective July 3, 2008, we entered into a bank holding company reorganization, whereby each of the Bank’s outstanding shares of common stock converted into an equal number of shares of common stock in Oak Valley Bancorp, which currently owns the Bank as its wholly-owned subsidiary. Management believes that operating the Bank within a holding company structure will, among other things, provide greater operating flexibility than is currently enjoyed by Oak Valley Community Bank; facilitate the acquisition of related businesses as opportunities arise; improve the Bank’s ability to diversify; enhance the Bank’s ability to remain competitive in the future with other companies in the financial services industry that are organized in a holding company structure; and improve the Bank’s ability to raise capital to support growth.  The reorganization was approved by the vote of the majority of the issued and outstanding shares of common stock.

 

Business Segments

 

We operate in two primary business segments: Retail Banking and Commercial Banking.  We determine operating results of each segment based on an internal management system that allocates certain expenses to each segment.  These segments are described in additional detail below:

 

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Retail Banking.  The Bank offers a range of checking and savings accounts, including NOW and Super NOW accounts, overdraft protection, passbook savings accounts, certificates of deposit, money market certificates, and Individual Retirement Accounts (“IRA”).  To satisfy the lending needs of individuals in its service area, the Bank offers real estate and home equity financing, as well as consumer, automobile, and home improvement loans.

 

Commercial Banking.  The Bank offers a range of deposit and lending services to business customers.  More specifically, the Bank offers a variety of commercial loans for virtually any business, professional, or agricultural need. These include short-term working capital, operating lines of credit, equipment purchases, leasehold improvements, commercial real estate acquisitions or refinancing.  Currently, virtually all of the Bank’s business relationships are with customers located in the San Joaquin, Stanislaus, Tuolumne, Inyo and Mono Counties.

 

Primary Market Area

 

We conduct business from our main office in Oakdale, a city of approximately 19,300 located in Stanislaus County, California. Oakdale is approximately 15 miles from Modesto and sits at the foothills of the Sierra Nevada Mountains, at the edge of the California Central Valley agricultural area.  Through our branches, we serve customers in the Central Valley, from Fresno to Sacramento, and in foothill locations. We also reach into the Highway 395 corridor in the Eastern Sierras and in the towns of Bishop, Mammoth and Bridgeport.  Our lending activities are primarily focused in the counties of Stanislaus and San Joaquin and other surrounding counties within the Central Valley.  The Central Valley area has a total population of over 3 million.

 

The Central Valley area has the highest concentration of agricultural workforce in California, primarily operating in farming, forestry, or fishing.  The unemployment rates of the California Central Valley area, throughout the counties that are within the Bank’s primary market areas, have historically been higher than the national average.  The effects of the national housing crisis and credit crunch, and the effects of the national economic slowdown and cutbacks in consumer spending have contributed to an increase in the unemployment rate within our primary market area since last year. The number of job losses in the Central Valley are soaring and the unemployment rate is nearing 20 percent in some cities. Riverbank’s unemployment rate is 19.8 percent, the unemployment rate in Patterson is 18.5 percent, and in Stockton the unemployment rate is 15.8 percent.  Similar upward trends in job losses have been observed in Merced, Tuolumne, Calaveras and Mariposa Counties as well.  The commercial real estate market in the Central Valley area is experiencing a sizable decline due to the slowing demand from buyers directly affected by the housing market downturn.  Vacancies rates for retail, office and industrial spaces have risen since 2007 and will continue to rise in 2009.  Economic forecasts indicate that the impact from local housing market has impacted jobs, primarily related to construction, credit and related services and may continue to increase moving forward.

 

Despite the economic challenges that we are currently experiencing in the markets in which we operate, we believe that we operate in areas of the country that have sound economic fundamentals, driven by a variety of factors, which will provide us with continued lending and growth opportunities in the future.  Some of these factors includes the significant role of the agriculture industry in the creation of jobs through direct employment or related services; a developed network of transportation infrastructure including interstate freeways, nearby deep water ports, two major railroad providing local intermodal yards, and access to international airports in the Bay Area.  The California transportation commissioners announced on the March 11, 2009 that it will spend $46.7 million of state stimulus money to replace two aging bridges on Highway 99 in Merced County.  Such improvement of local infrastructure coupled with an inventory of available and affordable industrial land and buildings, dependable and affordable labor, and a quality of life and low cost of living,  could lead to population growth in the California Central Valley. These projects could also help to create new employment opportunities in the area.

 

Lending Activities

 

General.    Our loan policies set forth the basic guidelines and procedures by which we conduct our lending operations. These policies address the types of loans available, underwriting and collateral requirements, loan terms, interest rate and yield considerations, compliance with laws and regulations and our internal lending limits. Our Board of Directors reviews and approves our loan policies on an annual basis. We supplement our own supervision of the loan underwriting and approval process with periodic loan audits by experienced external loan specialists who review credit quality, loan documentation and compliance with laws and regulations. We engage in a full complement of lending activities, including:

 

· commercial real estate loans,

 

· commercial business lending and trade finance,

 

· Small Business Administration lending, and

 

· consumer loans, including automobile loans, home mortgages, credit lines and other personal loans.

 

As part of our efforts to achieve long-term stable profitability and respond to a changing economic environment in the California

 

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Central Valley, we constantly evaluate a variety of options to augment our traditional focus by broadening the services and products we provide. Possible avenues of growth include more branch locations, expanded days and hours of operation and new types of lending.

 

Loan Procedures.    Loan applications may be approved by the Director Loan Committee of our Board of Directors, or by our management or lending officers, to the extent of their loan authority. Our Board of Directors authorizes our lending limits. Our President and Chief Credit Officer are responsible for evaluating the authority limits for individual credit officers and recommending lending limits for all other officers to the board of directors for approval.

 

We grant individual lending authority to our President, Chief Credit Officer, and to some department managers. Our highest management lending authority is combined administrative lending authority for unsecured and secured lending of $1,500,000, which requires the approval of our President or Chief Credit Officer. Loans for which direct and indirect borrower liability exceeds an individual’s lending authority are referred to our Board of Directors Loan Committee.

 

At December  31, 2008, our authorized legal lending limits were $9.5 million for unsecured loans plus an additional $15.9 million for specific secured loans. Legal lending limits are calculated in conformance with California law, which prohibits a bank from lending to any one individual or entity or its related interests an aggregate amount which exceeds 15% of primary capital plus the allowance for loan losses on an unsecured basis, plus an additional 10% on a secured basis. Our primary capital plus allowance for loan losses at December 31, 2008 totaled $63.6 million.

 

We seek to mitigate the risks inherent in our loan portfolio by adhering to certain underwriting practices. The review of each loan application includes analysis of the applicant’s prior credit history, income level, cash flow and financial condition, tax returns, cash flow projections, and the value of any collateral to secure the loan, based upon reports of independent appraisers and audits of accounts receivable or inventory pledged as security. In the case of real estate loans over a specified amount, the review of collateral value includes an appraisal report prepared by an independent, Bank-approved, appraiser.

 

Real Estate Loans.    We offer commercial real estate loans to finance the acquisition of new or the refinancing of existing commercial properties, such as shopping centers, office buildings, industrial buildings, warehouses, hotels, automotive industry facilities and multiple dwellings. At December 31, 2008, real estate loans constituted 83% of our loan portfolio, of which 63% were commercial loans.

 

Commercial real estate loans typically have 10-year maturities with up to 25-year amortization of principal and interest and loan-to-value ratios of not more than 75% of the appraised value or purchase price, whichever is lower. We usually impose a prepayment penalty during the period within 3 to 5 years of the date of the loan.

 

Construction loans are comprised of loans on commercial, residential and income producing properties that generally have terms of 1 year, with options to extend for additional periods to complete construction and to accommodate the lease-up period. We usually require 15% equity capital investment by the developer and loan to value ratios of not more than 75% of anticipated completion value.

 

Miniperm loans finance the purchase and/or ownership of commercial properties, including owner-occupied and income producing properties. We also offer miniperm loans as take-out financing with our construction loans. Miniperm loans are generally made with an amortization schedule ranging from 20 to 25 years, with a lump sum balloon payment due in 3 to 5 years.

 

Equity lines of credit are revolving lines of credit collateralized by junior deeds of trust on residential real properties. They generally bear a rate of interest that floats with our base rate or the prime rate, and have maturities of 10 years. From time to time, we purchase participation interests in loans made by other financial institutions. These loans are subject to the same underwriting criteria and approval process as loans made directly by us.

 

Our real estate loans are typically collateralized by first or junior deeds of trust on specific commercial properties and equity lines of credit, and are subject to corporate or individual guarantees from financially capable parties, as available. The properties collateralizing real estate loans are principally located in our primary market areas of the California Central Valley and the Eastern Sierra.  Real estate loans typically bear an interest rate that floats with our base rate, prime rate or another established index.

 

Our real estate portfolio is subject to certain risks, including (i) downturns in the California economy, (ii) interest rate increases, (iii) reduction in real estate values in the California Central Valley, (iv) increased competition in pricing and loan structure, and (v) environmental risks, including natural disasters.  As a result of the high concentration of the real estate loan in our loan portfolio, the current difficulties in the real estate markets could cause significant increases in nonperforming loans, which would reduce our profits.  A decline in real estate values could cause some of our mortgage loans to become inadequately collateralized, which would expose us to a greater risk of loss.  Additionally, a decline in real estate values could adversely affect our portfolio of commercial real estate loans and could result in a decline in the origination of such loans.  However, we strive to reduce the exposure to such risks and seek to continue to maintain high quality in our real estate loans by (a) reviewing each loan request and each loan renewal individually, (b) using a dual signature approval system for the approval of each loan request for loans over a certain dollar amount, (c) adhering to written loan policies, including, among other factors, minimum collateral requirements, maximum loan-to-value

 

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ratio requirements, cash flow requirements and personal guarantees, (d) performing secondary appraisals from time to time, (e) conducting external independent credit review, and (f) conducting environmental reviews, where appropriate. We review each loan request on the basis of our ability to recover both principal and interest in view of the inherent risks.   We monitor and stress test our entire portfolio, evaluating debt coverage ratios and loan-to-value ratios, on a quarterly basis.  We monitor trends and evaluate exposure derived from simulated stressed market conditions.  The portfolio is stratified by owner classification (either owner occupied or non-owner occupied), product type, geography and size.

 

As of December 31, 2008, the aggregate loan-to-value of the entire commercial real estate portfolio was 54.9%.  Historical data suggests that the Bank continues to maintain strong LTV, which may serve as a cushion against precipitous reductions in real estate values.  Non-owner occupied real estate comprises 50.3% of the Bank’s total commitments, as of December 31, 2008.  The loan-to-value on the non-owner occupied segment was 51.4%, as of December 31, 2008.  The highest concentration by product type is office space, which comprised 16.7% of total loan commitments outstanding, as of December 31, 2008.  Our portfolio diversity in terms of both product types and geographic distribution, combined with strong debt coverage ratios, a low aggregate loan-to-value and a high percentage of owner-occupied properties, significantly mitigate the risks associated with excessive commercial real estate concentration. These elements contribute strength to our overall real estate portfolio despite the current weakness in the real estate market.

 

         Commercial Business Lending.    We offer commercial loans to sole proprietorships, partnerships and corporations, with an emphasis on the real estate related industry. These commercial loans include business lines of credit and commercial term loans to finance operations, to provide working capital or for specific purposes, such as to finance the purchase of assets, equipment or inventory. Since a borrower’s cash flow from operations is generally the primary source of repayment, our policies provide specific guidelines regarding required debt coverage and other important financial ratios.

 

Lines of credit are extended to businesses or individuals based on the financial strength and integrity of the borrower and are secured primarily by real estate, accounts receivable and inventory, and have a maturity of one year or less. Such lines of credit bear an interest rate that floats with our base rate, the prime rate, LIBOR or another established index.

 

Commercial term loans are typically made to finance the acquisition of fixed assets, refinance short-term debts or to finance the purchase of businesses. Commercial term loans generally have terms from one to five years. They may be collateralized by the asset being acquired or other available assets and bear interest rates which either floats with the Bank’s base rate, prime rate, LIBOR or another established index or is fixed for the term of the loan.

 

We also provide other banking services tailored to the small business market. We have focused recently on diversifying our loan portfolio, which has led to an increase in commercial real estate and commercial business loans to small and medium sized businesses.

 

Our portfolio of commercial loans is also subject to certain risks, including (i) downturns in the California economy, (ii) interest rate increases; and (iii) the deterioration of a borrower’s or guarantor’s financial capabilities. We attempt to reduce the exposure to such risks through (a) reviewing each loan request and renewal individually, (b) requiring a dual signature approval system, (c) mandating strict adherence to written loan policies, and (d) performing external independent credit review. In addition, we monitor loans based on short-term asset values on a monthly or quarterly basis. In general, during the term of the relationship, we receive and review the financial statements of  our borrowing customers on an ongoing basis, and we promptly respond to any deterioration that we note.

 

Small Business Administration Lending Services.    Small Business Administration, or SBA, lending, forms an important part of our business. Our SBA lending service places an emphasis on minority-owned businesses. Our SBA market area includes the geographic areas encompassed by our full-service banking offices in the California Central Valley and in the Eastern Sierra. Our SBA Loan Department has attained “Preferred Lender” status, which permits us to approve SBA guaranteed loans directly. As an SBA Preferred Lender, we provide quicker and more efficient service to our clientele, enabling them to obtain SBA loans in order to acquire new businesses, expand existing businesses, and acquire locations in which to do business, without having to go through the time consuming SBA approval process.

 

Although our participation in the SBA program is subject to the legislative power of Congress and the continued maintenance of our approved status by the SBA, we have no reason to believe that this program (and our participation therein) will not continue, particularly in view of the lengthy duration of the SBA program nationally.

 

Consumer Loans.    Consumer loans include personal loans, auto loans, home improvement loans, home mortgage loans, revolving lines of credit and other loans typically made by banks to individual borrowers. We provide consumer loan products in an effort to diversify our product line.

 

Our consumer loan portfolio is subject to certain risks, including:

 

· amount of credit offered to consumers in the market,

 

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· interest rate increases, and

 

· consumer bankruptcy laws which allow consumers to discharge certain debts.

 

We attempt to reduce the exposure to such risks through the direct approval of all consumer loans by:

 

· reviewing each loan request and renewal individually,

 

· using a dual signature system of approval,

 

· strictly adhering to written credit policies and,

 

· performing external independent credit review.

 

Deposit Activities and Other Sources of Funds

 

Our primary sources of funds are deposits and loan repayments. Scheduled loan repayments are a relatively stable source of funds, whereas deposit inflows and outflows and unscheduled loan prepayments (which are influenced significantly by general interest rate levels, interest rates available on other investments, competition, economic conditions and other factors) are not as stable. Customer deposits also remain a primary source of funds, but these balances may be influenced by adverse market changes in the industry. We may resort to other borrowings, on an as needed basis, as follows:

 

· on a short-term basis to compensate for reductions in deposit inflows at less than projected levels, and

 

· on a longer-term basis to support expanded lending activities and to match the maturity of repricing intervals of assets.

 

We offer a variety of accounts for depositors, which are designed to attract both short-term and long-term deposits. These accounts include certificates of deposit, or “CDs”, regular savings accounts, money market accounts, checking and negotiable order of withdrawal, or “NOW”, accounts, installment savings accounts, and individual retirement accounts, or “IRAs”. These accounts generally earn interest at rates established by management based on competitive market factors and management’s desire to increase or decrease certain types or maturities of deposits. As needs arise, we augment these customer deposits with brokered deposits. The more significant deposit accounts offered by us are described below:

 

Certificates of Deposit.    We offer several types of CDs with a maximum maturity of five years. The substantial majority of our CDs have a maturity of one to twelve months and typically pay simple interest credited monthly or at maturity.

 

Regular Savings Accounts.    We offer savings accounts that allow for unlimited deposits and withdrawals, provided that depositors maintain a $100 minimum balance. Interest is compounded daily and credited quarterly.

 

Money Market Account.    Money market accounts pay a variable interest rate that is tiered depending on the balance maintained in the account. Minimum opening balances vary. Interest is compounded daily and paid monthly.

 

Checking and NOW Accounts.    Checking and NOW accounts are generally non-interest and interest bearing accounts, respectively, and may include service fees based on activity and balances. NOW accounts pay interest, but require a higher minimum balance to avoid service charges.

 

Federal Home Loan Bank Borrowings.    To supplement our deposits as a source of funds for lending or investment, we borrow funds in the form of advances from the Federal Home Loan Bank. We regularly make use of Federal Home Loan Bank advances as part of our interest rate risk management, primarily to extend the duration of funding to match the longer term fixed rate loans held in the loan portfolio as part of our growth strategy.

 

As a member of the Federal Home Loan Bank system, we are required to invest in Federal Home Loan Bank stock based on a predetermined formula. Federal Home Loan Bank stock is a restricted investment security that can only be sold to other Federal Home Loan Bank members or redeemed by the Federal Home Loan Bank. As of December 31, 2008, we owned $3,803,700 in FHLB stock.

 

Advances from the Federal Home Loan Bank are typically secured by our entire real estate loan portfolio, which includes residential and commercial loans.  At December 31, 2008, our borrowing limit with the Federal Home Loan Bank was approximately $107 million.

 

Internet Banking

 

Since August 1, 2001, we have offered Internet banking service, which allows our customers to access their deposit accounts through the Internet. Customers are able to obtain transaction history and account information, transfer funds between accounts and

 

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make on-line bill payments. We intend to improve and develop our Internet banking products and delivery channels as the need arises and our resources permit.

 

Other Services

 

We also offer ATM machines located at branch offices, and customer access to an ATM network.

 

Marketing

 

Our business plan relies principally upon local advertising and promotional activity and upon personal contacts by our directors, officers and shareholders to attract business and to acquaint potential customers with our personalized services. We emphasize a high degree of personalized client service in order to be able to provide for each customer’s banking needs. Our marketing approach emphasizes the advantages of dealing with an independent, locally-managed and state chartered bank to meet the particular needs of consumers, professionals and business customers in the community. Our management continually evaluates all of our banking services with regard to their profitability and efforts and makes determinations based on these evaluations whether to continue or modify our business plan, where appropriate.

 

We do not currently have any plans to develop any new lines of business which would require a material amount of capital investment on our part.

 

Competition

 

Regional Branch Competition.    We consider our primary service area to be composed of the counties of San Joaquin, Stanislaus, Tuolumne, Inyo and Mono Counties.  The banking business in California generally, and in our primary service area, specifically, is competitive with respect to both loans and deposits and is dominated by a relatively small number of major banks which have many offices operating over wide geographic areas.  These include Wachovia, Wells Fargo Bank, Bank of America and Bank of the West. We compete for deposits and loans principally with these banks, as well as with savings and loan associations, thrift and loan associations, credit unions, mortgage companies, insurance companies, offerors of money market accounts and other lending institutions.

 

Among the advantages certain of these institutions have over us are their ability to finance extensive advertising campaigns and to allocate their investment assets to regions of highest yield and demand, their ability to offer certain services, such as international banking and trust services which are not offered directly by the Bank and, the ability by virtue of their greater total capitalization, to have substantially higher lending limits than we do.   In addition, as a result of increased consolidation and the passage of interstate banking legislation there is and will continue to be increased competition among banks, savings and loan associations and credit unions for the deposit and loan business of individuals and businesses.

 

In addition to competing with savings institutions, commercial banks compete with other financial markets for funds.  For instance, yields on corporate and government debt securities and other commercial paper affect the ability of commercial banks to attract and hold deposits.  Commercial banks also compete for available funds with money market funds.

 

As of June 30, 2008, our primary service areas contained one hundred seventy-five (175) banking offices, with approximately $10.5 billion in total deposits.  As of June 30, 2008, we had total deposits of approximately $358 million, which represented approximately 3.42% of the total deposits in the Bank’s primary service area.  There can be no assurance that the Bank will maintain its competitive position against current and potential competitors, especially those with greater resources than the Bank.  The deposits of the four (4) largest competing banks averaged approximately $112 million per office as of June 30, 2008.

 

In order to compete with major financial institutions in our primary service areas, we use to the fullest extent the flexibility that our independent status permits.  This includes an emphasis on specialized services, local promotional activity, and personal contacts by our officers, directors and employees.  In the event that there are customers whose needs exceed our lending limits, we may arrange for such loans on a participation basis with other financial institutions.  We also assist customers who require other services that we do not offer by obtaining such services from correspondent banks.  However, no assurance can be given that our continued efforts to compete with other financial institutions will be successful.

 

Other Competitive Factors.    Large commercial bank competitors have, among other advantages, the ability to finance wide-ranging and effective advertising campaigns and to allocate their investment resources to areas of highest yield and demand. Many of the major banks operating in our market area, such as Wells Fargo Bank and Bank of America, offer certain services that we do not offer directly (but some of which we offer through correspondent institutions). By virtue of their greater total capitalization, such banks also have substantially higher lending limits (restricted to a percentage of the bank’s total shareholders’ equity, depending upon the nature of the loan transaction) than we do.

 

In addition to other banks, our competitors include savings institutions, credit unions, and numerous non-banking institutions, such as finance companies, leasing companies, insurance companies, brokerage firms, and investment banking firms. In recent years,

 

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increased competition has also developed from specialized finance and non-finance companies that offer money market and mutual funds, wholesale finance, credit card, and other consumer finance services, including on-line banking services and personal finance software. Strong competition for deposit and loan products affects the rates of those products as well as the terms on which they are offered to customers.

 

The more general competitive trends in the industry include increased consolidation and competition. Strong competitors, other than financial institutions, have entered banking markets with focused products targeted at highly profitable customer segments. Many of these competitors are able to compete across geographic boundaries and provide customers increasing access to meaningful alternatives to banking services in nearly all significant products areas. Mergers between financial institutions have placed additional pressure on banks within the industry to streamline their operations, reduce expenses, and increase revenues to remain competitive. Competition has also intensified due to the federal and state interstate banking laws, which permit banking organizations to expand geographically, and the California market has been particularly attractive to out-of-state institutions. The Financial Modernization Act, which has made it possible for full affiliations to occur between banks and securities firms, insurance companies, and other financial companies, is also expected to intensify competitive conditions.

 

Technological innovations have also resulted in increased competition in the financial services industry. Such innovations have, for example, made it possible for non-depository institutions to offer customers automated transfer payment services that were previously considered traditional banking products. In addition, many customers now expect a choice of several delivery systems and channels, including telephone, mail, home computer, ATMs, self-service branches and/or in-store branches.

 

Business Concentration.    No individual or single group of related accounts is considered material in relation to our total assets or deposits, or in relation to our overall business. However, approximately 83% of our loan portfolio held for investment at December 31, 2008 consisted of real estate-related loans, including construction loans, miniperm loans, real estate mortgage loans and commercial loans secured by real estate. Moreover, our business activities are currently focused primarily in Central California, with the majority of our business concentrated in San Joaquin, Stanislaus, Tuolumne, Inyo and Mono Counties.  Consequently, our results of operations and financial condition are dependent upon the general trends in the Central California economies and, in particular, the residential and commercial real estate markets. In addition, the concentration of our operations in Central California exposes us to greater risk than other banking companies with a wider geographic base in the event of catastrophes, such as earthquakes, fires and floods in this region.

 

Employees

 

As of December 31, 2008, we had 123 employees (101 full-time employees and 22 part-time employees). None of our employees are currently represented by a union or covered by a collective bargaining agreement. Management believes its employee relations are satisfactory.

 

Bank Holding Company Regulation

 

Upon effectiveness of the bank holding company  reorganization on July 2, 2008, we became subject to regulation under the Bank Holding Company Act of 1956, as amended (“BHCA”) which subjects Oak Valley Bancorp to Federal Reserve Board reporting and examination requirements.  Under the Federal Reserve Board’s regulations, a bank holding company is required to serve as a source of financial and managerial strength to its subsidiary banks.

 

The BHCA regulates the activities of holding companies including acquisitions, mergers, and consolidations and, together with the Gramm-Leach Bliley Act of 1999, the scope of allowable banking activities.

 

Government Policies, Legislation, and Regulatory Initiatives

 

The banking and financial services business in which we engage is highly regulated. Such regulation is intended, among other things, to protect depositors insured by the FDIC and the entire banking system. The commercial banking business is also influenced by the monetary and fiscal policies of the federal government and the policies of the Board of Governors of the Federal Reserve System, also known as the Federal Reserve Board. The Federal Reserve Board implements national monetary policies (with objectives such as curbing inflation and combating recession) by its open-market operations in United States Government securities, by adjusting the required level of reserves for financial intermediaries subject to its reserve requirements and by varying the discount rates applicable to borrowings by depository institutions. The actions of the Federal Reserve Board in these areas influence the growth of bank loans, investments and deposits and also affects interest rates charged on loans and paid on deposits. Indirectly such actions may also impact the ability of non-bank financial institutions to compete with us. The nature and impact of any future changes in monetary policies cannot be predicted.

 

The laws, regulations and policies affecting financial services businesses are continuously under review by Congress and state legislatures and federal and state regulatory agencies. From time to time, legislation is enacted which has the effect of increasing the cost of doing business, limiting or expanding permissible activities or affecting the competitive balance between banks and other financial intermediaries. Proposals to change the laws and regulations governing the operations and taxation of banks, bank holding

 

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companies and other financial intermediaries are frequently made in Congress, in the California legislature and by various bank regulatory agencies and other professional agencies. Changes in the laws, regulations or policies that impact us cannot necessarily be predicted, but they may have a material effect on our business and earnings.

 

As a California state-chartered bank whose accounts are insured by the FDIC up to a maximum of $250,000 (as approved on October 10, 2008 by the FDIC through the end of 2009), the Bank is subject to regulation, supervision and regular examination by the California Department of Financial Institutions and the FDIC. In addition, although we are not a member of the Federal Reserve System, we are subject to certain regulations of the Board of Governors of the Federal Reserve System. The regulations of these agencies govern most aspects of our business, including the filing of periodic reports, and activities relating to dividends, investments, loans, borrowings, capital requirements, certain check-clearing activities, branching, mergers and acquisitions, reserves against deposits, and numerous other areas. Supervision, legal action and examination of us by the FDIC is generally intended to protect depositors and is not intended for the protection of our shareholders.

 

The following discussion of statutes and regulations affecting banks is only a summary and does not purport to be complete. This discussion is qualified in its entirety by reference to such statutes and regulations. No assurance can be given that the referenced statutes or regulations will not change in the future.

 

Capital Adequacy Requirements

 

The federal banking agencies have adopted risk-based minimum capital guidelines intended to provide a measure of capital that reflects the degree of risk associated with a banking organization’s operations for both transactions reported on the balance sheet as assets and transactions which are recorded as off balance sheet items. Under these guidelines, nominal dollar amounts of assets and credit equivalent amounts of off balance sheet items are multiplied by one of several risk adjustment percentages, which range from 0% for assets with low credit risk, such as federal banking agencies, to 100% for assets with relatively high credit risk. The higher the category, the more risk a bank is subject to and thus the more capital that is required.

 

The guidelines divide a bank’s capital into two tiers. Tier I includes common equity, retained earnings, certain non-cumulative perpetual preferred stock, and minority interests in equity accounts of consolidated subsidiaries. Goodwill and other intangible assets (except for mortgage servicing rights and purchased credit card relationships, subject to certain limitations) are subtracted from Tier I capital. Tier II capital includes, among other items, cumulative perpetual and long-term, limited-life preferred stock, mandatory convertible securities, certain hybrid capital instruments, term subordinated debt and the allowance for loan losses (subject to certain limitations). Certain items are required to be deducted from Tier II capital. Banks must maintain a total risk-based ratio of 8%, of which at least 4% must be Tier I capital. As of December 31, 2008 and 2007, our Total Risk-Based Capital Ratios were 13.3% and 11.1%, respectively, and our Tier 1 Risk-Based Capital Ratios were 12.1% and 10.0%, respectively.

 

In addition to the risk-based guidelines, federal banking regulators require banking organizations to maintain a minimum amount of Tier 1 capital to total average assets, referred to as the leverage ratio. Banks that have received the highest rating of the five categories used by regulators to rate banks and are not anticipating or experiencing any significant growth must maintain a ratio of Tier 1 capital (net of all intangibles) to adjusted total assets, or “Leverage Capital Ratio”, of at least 3%. All other institutions are required to maintain a leverage ratio of at least 100 to 200 basis points above the 3% minimum, for a minimum of 4% to 5%. Pursuant to federal regulations, banks must maintain capital levels commensurate with the level of risk to which they are exposed, including the volume and severity of problem loans. As of December 31, 2008 and 2007, our Leverage Capital Ratios were 11.8% and 9.4%, respectively.

 

Federal banking regulators may set capital requirements higher than the minimums described above for financial institutions whose circumstances warrant it. For example, a financial institution experiencing or anticipating significant growth may be expected to maintain capital positions substantially above the minimum supervisory levels without significant reliance on intangible assets.

 

Prompt Corrective Action Provisions

 

Federal law requires each federal banking agency to take prompt corrective action to resolve the problems of insured financial institutions, including but not limited to those that fall below one or more prescribed minimum capital ratios. The federal banking agencies have by regulation defined the following five capital categories:

 

· “well capitalized” (Total Risk-Based Capital Ratio of 10%; Tier 1 Risk-Based Capital Ratio of 6%; and Leverage Ratio of 5%),

 

· “adequately capitalized” (Total Risk-Based Capital Ratio of 8%; Tier 1 Risk-Based Capital Ratio of 4%; and Leverage Ratio of 4% or 3% if the institution receives the highest rating from its primary regulator),

 

· “undercapitalized” (Total Risk-Based Capital Ratio of less than 8%; Tier 1 Risk-Based Capital Ratio of less than 4%; or Leverage Ratio of less than 4% or 3% if the institution receives the highest rating from its primary regulator),

 

· “significantly undercapitalized” (Total Risk-Based Capital Ratio of less than 6%; Tier 1 Risk-Based Capital Ratio of less than

 

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3%; or Leverage Ratio less than 3%), and

 

· “critically undercapitalized” (tangible equity to total assets less than 2%).

 

A bank may be treated as though it were in the next lower capital category if, after notice and the opportunity for a hearing, the appropriate federal agency finds an unsafe or unsound condition or practice so warrants, but no bank may be treated as “critically undercapitalized” unless its actual capital ratio warrants such treatment.

 

At each successively lower capital category, an insured bank is subject to increased restrictions on its operations. For example, a bank is generally prohibited from paying management fees to any controlling persons or from making capital distributions, if to do so would make the bank “undercapitalized.” Asset growth and branching restrictions apply to undercapitalized banks, which are required to submit written capital restoration plans meeting specified requirements (including a guarantee by the parent holding company, if any). “Significantly undercapitalized” banks are subject to broad regulatory authority, including among other things, capital directives, forced mergers, restrictions on the rates of interest they may pay on deposits, restrictions on asset growth and activities, and prohibitions on paying certain bonuses without FDIC approval. Even more severe restrictions apply to critically undercapitalized banks. Most importantly, except under limited circumstances, the appropriate federal banking agency is required to appoint a conservator or receiver for an insured bank not later than 90 days after the bank becomes critically undercapitalized.

 

In addition to measures taken under the prompt corrective action provisions, insured banks may be subject to potential actions by federal regulators for unsafe or unsound practices in conducting their businesses or for violations of any law, rule, regulation or any condition imposed in writing by the agency or any written agreement with the agency. Enforcement actions may include the issuance of cease and desist orders, termination of insurance of deposits (in the case of a bank), the imposition of civil money penalties, the issuance of directives to increase capital, formal and informal agreements, or removal and prohibition orders against “institution-affiliated” parties.

 

Dividends

 

The payment of cash dividends by the Bank to Oak Valley Bancorp is subject to restrictions set forth in the California Financial Code (the “Code”).  Prior to any distribution from the Bank to Oak Valley Bancorp, a calculation is made to ensure compliance with the provisions of the Code and to ensure that the Bank remains within capital guidelines set forth by the DFI and the FDIC. In the event that the intended distribution from the Bank to Oak Valley Bancorp exceeds the restriction in the Code, advance approval from DFI is required. While advance approval may be required from the DFI for up to three years if we terminate our participation in the U.S. Treasury Capital Purchase Program, Management does not believe that these regulations will limit dividends from the Bank to meet the operating requirements of Bancorp for the foreseeable future. See Note 19 to the Consolidated Financial Statements in Item 8 of this report.

 

As long as the U.S. Treasury holds an equity position in us, we are restricted from increasing our dividends per common share without prior approval from the U.S. Treasury until December 5, 2011. We are also precluded from paying any dividends on common shares if we are in arrears on payment of dividends on preferred shares which are payable quarterly at an annual rate of 5%.

 

Safety and Soundness Standards

 

Federal banking agencies have also adopted guidelines establishing safety and soundness standards for all insured depository institutions. Those guidelines relate to internal controls, information systems, internal audit systems, loan underwriting and documentation, compensation and interest rate exposure. In general, the standards are designed to assist the federal banking agencies in identifying and addressing problems at insured depository institutions before capital becomes impaired. If an institution fails to meet these standards, the appropriate federal banking agency may require the institution to submit a compliance plan and institute enforcement proceedings, if an acceptable compliance plan is not submitted.

 

Premiums for Deposit Insurance

 

 Our deposits are insured by the FDIC to the maximum amount permitted by law which is currently $250,000 per depositor. On October 14, 2008, the FDIC announced the Temporary Transaction Account Guarantee Program to strengthen confidence in the banking system. The new rule also allows, at the participating FDIC-insured institutions’ option, full deposit insurance coverage for non-interest bearing transaction accounts regardless of the dollar amount until December 31, 2009.  We have elected to participate in the program by paying a 10 basis point surcharge on the non-interest bearing transaction accounts over $250,000.  In addition, the FDIC has finalized a new premium rate structure and has imposed a uniform increase in minimum assessment from five cents to twelve cents annually for every $100 of domestic deposits on institutions that are assigned to the lowest risk category for the first calendar quarter of 2009.  Effective April 1, 2009, assessment rates will be adjusted to differentiate for risk. Banks in the best risk category will pay a base rate from twelve to sixteen cents per $100 of deposits. Further, on February 27, 2009, the FDIC announced the imposition of a 20-basis-point emergency special assessment on all insured depository institutions on June 30, 2009 (will be collected on September 30, 2009). The rule also gives the FDIC the ability to impose future emergency special assessments of up to 10

 

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basis points if necessary.

 

Community Reinvestment Act

 

We are subject to certain requirements and reporting obligations involving the Community Reinvestment Act, or “CRA”. The CRA generally requires federal banking agencies to evaluate the record of financial institutions in meeting the credit needs of local communities, including low and moderate-income neighborhoods. The CRA further requires that a record be kept of whether a financial institution meets its community credit needs, which record will be taken into account when evaluating applications for, among other things, domestic branches, consummating mergers or acquisitions, or holding company formations. In measuring a bank’s compliance with its CRA obligations, the regulators now utilize a performance-based evaluation system which bases CRA ratings on the bank’s actual lending service and investment performance, rather than on the extent to which the institution conducts needs assessments, documents community outreach activities or complies with other procedural requirements. In connection with its assessment of CRA performance, the FDIC assigns a rating of “outstanding,” “satisfactory,” “needs to improve” or “substantial noncompliance.” We were last examined for CRA compliance in August 15, 2005 and received a satisfactory CRA Assessment Rating.

 

Anti-Money Laundering Regulations

 

A series of banking laws and regulations beginning with the Bank Secrecy Act in 1970 require banks to prevent, detect, and report illicit or illegal financial activities to the federal government to prevent money laundering, international drug trafficking, and terrorism. Under the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001, financial institutions are subject to prohibitions against specified financial transactions and account relationships as well as enhanced due diligence and “know your customer” standards in their dealings with high risk customers, foreign financial institutions, and foreign individuals and entities.  We have extensive controls to comply with these requirements.

 

Privacy and Data Security

 

The Gramm-Leach Bliley Act (“GLBA”) of 1999 imposed requirements on financial institutions with respect to consumer privacy.  The GLBA generally prohibits disclosure of consumer information to non-affiliated third parties unless the consumer has been given the opportunity to object and has not objected to such disclosure.  Financial institutions are further required to disclose their privacy policies to consumers annually.  The GLBA also directs federal regulators, including the FDIC, to prescribe standards for the security of consumer information.  We are subject to such standards, as well as standards for notifying consumers in the event of a security breach.  We must disclose our privacy policy to consumers and permit consumers to “opt out” of having non-public customer information disclosed to third parties.  We are required to have an information security program to safeguard the confidentiality and security of customer information and to ensure proper disposal.  Customers must be notified when unauthorized disclosure involves sensitive customer information that may be misused.

 

Other Consumer Protection Laws and Regulations

 

Bank regulatory agencies are increasingly focusing on compliance with consumer protection laws and regulations. Examination and enforcement has become intense, and banks have been advised to monitor compliance carefully with various consumer protection laws and their implementing regulations. For example, the federal Interagency Task Force on Fair Lending issued a policy statement on discrimination in home mortgage lending describing three methods that federal agencies will use to prove discrimination: overt evidence of discrimination, evidence of disparate treatment, and evidence of disparate impact. In addition to CRA and fair lending requirements, we are subject to numerous other federal consumer protection statutes and regulations. Due to heightened regulatory concern related to compliance with consumer protection laws and regulations generally, we may incur additional compliance costs or be required to expend additional funds for investments in the local communities we serve.

 

Interstate Banking and Branching The Riegle-Neal

 

The Interstate Banking and Branching Efficiency Act of 1994, or “Interstate Banking Act,” regulates the interstate activities of banks and bank holding companies and establishes a framework for nationwide interstate banking and branching. Since June 1, 1997, a bank in one state has generally been permitted to merge with a bank in another state without the need for explicit state law authorization. However, states were given the ability to prohibit interstate mergers of banks in their own state by “opting-out” (enacting state legislation prohibiting such mergers) prior to June 1, 1997.

 

Since 1995, adequately capitalized and managed bank holding companies have been permitted to acquire banks located in any state, subject to two exceptions: first, any state may still prohibit bank holding companies from acquiring a bank which is less than five years old; and second, no interstate acquisition can be consummated by a bank holding company if the acquirer would control more than 10% of the deposits held by insured depository institutions nationwide or 30% or more of the deposits held by insured depository institutions in any state in which the target bank has branches.

 

A bank may establish and operate de novo branches in any state in which the bank does not maintain a branch, if that state has

 

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enacted legislation to expressly permit all out-of-state banks to establish branches in that state.

 

In 1995, California enacted legislation to implement important provisions of the Interstate Banking Act and to repeal California’s previous interstate banking laws, which were largely preempted by the Interstate Banking Act.

 

The changes effected by the Interstate Banking Act and California laws have increased competition in our market by permitting out-of-state financial institutions to enter our market areas directly or indirectly. We believe that the Interstate Banking Act has contributed to the accelerated consolidation of the banking industry. Although many large out-of-state banks have already entered the California market as a result of this legislation, it is not possible to predict the precise impact of this legislation on us and the competitive environment in which we operate.

 

USA Patriot Act of 2001

 

On October 26, 2001, President Bush signed the USA Patriot Act of 2001, or “Patriot Act”. The Patriot Act was enacted in response to the terrorist attacks in New York, Pennsylvania and Washington, D.C. on September 11, 2001, and is intended to strengthen U.S. law enforcement’s and the intelligence community’s ability to work cohesively to combat terrorism on a variety of fronts. The potential impact of the Patriot Act on financial institutions is significant and wide ranging. The Act contains sweeping anti-money laundering and financial transparency laws and requires various regulations, including:

 

· due diligence requirements for financial institutions that administer, maintain, or manage private bank accounts or correspondent accounts for non-U.S. persons,

 

· standards for verifying customer identification at account opening,

 

· rules to promote cooperation among financial institutions, regulators, and law enforcement entities in identifying parties that may be involved in terrorism or money laundering,

 

· reports by non-financial trades and business filed with the Treasury Department’s Financial Crimes Enforcement Network for transactions exceeding $10,000, and

 

· filing of suspicious activities reports if they believe a customer may be violating U.S. laws and regulations.

 

Currently we are unable to quantify the impact the Patriot Act has had or may in the future have on our financial condition or results of operations.

 

The Sarbanes-Oxley Act of 2002

 

On July 30, 2002, President Bush signed into law The Sarbanes-Oxley Act of 2002, or “Sarbanes-Oxley Act”. The Sarbanes-Oxley Act addresses accounting oversight and corporate governance matters relating to the operations of public companies. During 2003, the Commission issued a number of regulations under the directive of the Sarbanes-Oxley Act significantly increasing public company governance-related obligations and filing requirements, including:

 

· the establishment of an independent public oversight of public company accounting firms by a board that will set auditing, quality and ethical standards for and have investigative and disciplinary powers over such accounting firms,

 

· the enhanced regulation of the independence, responsibilities and conduct of accounting firms which provide auditing services to public companies,

 

· the increase of penalties for fraud related crimes,

 

· the enhanced disclosure, certification, and monitoring of financial statements, internal financial controls and the audit process, and

 

· the enhanced and accelerated reporting of corporate disclosures and internal governance.

 

Furthermore, in November 2003, in response to the directives of the Sarbanes-Oxley Act, Nasdaq adopted substantially expanded corporate governance criteria for the issuers of securities quoted on the Nasdaq markets. The new Nasdaq rules govern, among other things, the enhancement and regulation of corporate disclosure and internal governance of listed companies and of the authority, role and responsibilities of their boards of directors and, in particular, of “independent” members of such boards of directors, in the areas of nominations, corporate governance, compensation and the monitoring of the audit and internal financial control processes.

 

The Sarbanes-Oxley Act, the Commission rules promulgated thereunder, and the new Nasdaq governance requirements have required the Bank to review its current procedures and policies to determine whether they comply with the new legislation and its

 

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implementing regulations. Oak Valley Bancorp will be primarily responsible for ensuring compliance with Sarbanes-Oxley and the Nasdaq governance rules, as applicable. Although the impact these new requirements will have upon the Oak Valley Bancorp’s and the Bank’s operations is not entirely clear, the Bank has already experienced an increase in expenditures associated with certain outside professional costs necessary for compliance.

 

The Emergency Economic Stabilization Act of 2008 and its Related Government Policies, Legislations, and Regulations

 

Dramatic negative developments in the latter half of 2007 in the subprime mortgage market and the securitization markets for such loans, together with volatility in oil prices and other factors, have resulted in uncertainty in the financial markets in general and a related economic downturn, which continued through 2008 and is anticipated to continue through 2009. Dramatic declines in the housing market, with decreasing home prices and increasing delinquencies and foreclosures, have negatively impacted the credit performance of mortgage and construction loans and resulted in significant write-downs of assets by many financial institutions. In addition, the values of real estate collateral supporting many commercial and residential loans have declined and may continue to decline. General downward economic trends, reduced availability of commercial credit and increasing unemployment have negatively impacted the credit performance of commercial and consumer credit, resulting in additional write-downs. Concerns over the stability of the financial markets and the economy have resulted in decreased lending by many financial institutions to their customers and to each other. This market turmoil and tightening of credit has led to increased commercial and consumer delinquencies, lack of customer confidence, increased market volatility and widespread reduction in general business activity. Competition among depository institutions for deposits has increased significantly. Bank and bank holding company stock prices have been negatively affected as has the ability of banks and bank holding companies to raise capital or borrow in the debt markets compared to recent years. Bank regulators have been very aggressive in responding to concerns and trends identified in examinations, and this has resulted in the increased issuance of formal and informal enforcement orders and other supervisory actions requiring action to address credit quality, liquidity and risk management and capital adequacy, as well as other safety and soundness concerns.

 

On October 3, 2008, the Emergency Economic Stabilization Act of 2008 (“EESA”) was enacted to restore confidence and stabilize the volatility in the U.S. banking system and to encourage financial institutions to increase their lending to customers and to each other. Initially introduced as the Troubled Asset Relief Program (“TARP”), the EESA authorized the United States Department of the Treasury (“U.S. Treasury”) to purchase from financial institutions and their holding companies up to $700 billion in mortgage loans, mortgage-related securities and certain other financial instruments, including debt and equity securities issued by financial institutions and their holding companies. Initially, $350 billion was made immediately available to the U.S. Treasury. On January 15, 2009, the remaining $350 billion was released to the U.S. Treasury.

 

On October 14, 2008, the U.S. Treasury announced its intention to inject capital into nine large U.S. financial institutions under the TARP Capital Purchase Program (the “TARP CPP”), and since has injected capital into many other financial institutions, including the Company. The U.S. Treasury initially allocated $250 billion towards the TARP CPP

 

In order to participate in the TARP CPP, financial institutions were required to adopt certain standards for executive compensation and corporate governance. These standards generally apply to the Chief Executive Officer, Chief Financial Officer and the three next most highly compensated senior executive officers. The standards include (1) ensuring that incentive compensation for named senior executives does not encourage unnecessary and excessive risks that threaten the value of the financial institution; (2) required clawback of any bonus or incentive compensation paid to a senior executive based on statements of earnings, gains or other criteria that are later proven to be materially inaccurate; (3) prohibition on making golden parachute payments to senior executives; and (4) agreement not to deduct for tax purposes executive compensation in excess of $500,000 for each senior executive. The Company has complied with these requirements and will continue to comply.

 

The bank regulatory agencies, U.S. Treasury and the Office of Special Inspector General, also created by the EESA, have issued guidance and requests to the financial institutions that participated in the TARP CPP to document their plans and use of TARP CPP funds and their plans for addressing the executive compensation requirements associated with the TARP CPP. The Company has received and responded to that request.

 

On February 17, 2009, the American Recovery and Reinvestment Act of 2009 (“ARRA”) was signed into law by President Obama. The ARRA includes a wide variety of programs intended to stimulate the economy and provide for extensive infrastructure, energy, health, and education needs. In addition, the ARRA imposes certain new executive compensation and corporate expenditure limits on all current and future TARP recipients, including the Company, until the institution has repaid the U.S. Treasury, which is now permitted under the ARRA without penalty and without the need to raise new capital, subject to the U.S. Treasury’s consultation with the recipient’s appropriate regulatory agency.

 

The ARRA executive compensation standards are more stringent than those currently in effect under the TARP CPP or those previously proposed by the U.S. Treasury. The new standards include (but are not limited to); (i) prohibitions on bonuses, retention awards and other incentive compensation, other than restricted stock grants which do not fully vest during the TARP CPP period up to one-third of an employee’s total annual compensation, (ii) prohibitions on golden parachute payments for departures, (iii) an expanded clawback of bonuses, retention awards, and incentive compensation if payment is based on materially inaccurate statements of earnings, revenues, gains or other criteria, (iv) prohibitions on compensation plans that encourage manipulation of reported earnings, (v) retroactive review of bonuses, retention awards and other compensation previously provided by TARP CPP recipients if found by

 

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the U.S. Treasury to be inconsistent with the purposes of TARP CPP or otherwise contrary to public interest, (vi) required establishment of a company-wide policy regarding “excessive or luxury expenditures,” and (vii) inclusion in a participant’s proxy statements for annual shareholder meetings of a nonbinding “Say on Pay” shareholder vote on the compensation of executives.

 

On February 23, 2009, the U.S. Treasury and the Federal bank regulatory agencies issued a Joint Statement providing further guidance with respect to the Capital Assistance Program announced February 10, 2009, including: (i) that should the “stress test” assessments of the major banks initiated February 25, 2009 indicate that an additional capital buffer is warranted, institutions will have an opportunity to turn first to private sources of capital otherwise; the temporary capital buffer will be made available from the government; (ii) such additional government capital will be in the form of mandatory convertible preferred shares, which would be converted into common equity shares only as needed over time to keep banks in a well-capitalized position and can be retired under improved financial conditions before the conversion becomes mandatory; and (iii) previous capital injections under the TARP CPP will also be eligible to be exchanged for the mandatory convertible preferred shares. The conversion of preferred shares to common equity shares would enable institutions to maintain or enhance the quality of their capital by increasing their tangible common equity capital ratios; however, such conversions would necessarily dilute the interests of existing shareholders.

 

On February 25, 2009, the first day the Capital Assistance Program was initiated, the U.S. Treasury released the actual terms of the program, stating that the purpose of the Capital Assistance Program is to restore confidence throughout the financial system that the nation’s largest banking institutions have a sufficient capital cushion against larger than expected future losses, should they occur due to a more severe economic environment, and to support lending to creditworthy borrowers. Under the terms of the Capital Assistance Program, eligible U.S. banking institutions with assets in excess of $100 billion on a consolidated basis are required to participate in coordinated supervisory assessments, which are forward-looking “stress test” assessments to evaluate the capital needs of the institution under a more challenging economic environment. Should this assessment indicate the need for the bank to establish an additional capital buffer to withstand more stressful conditions, these institutions may access the Capital Assistance Program immediately as a means to establish any necessary additional buffer or they may delay the Capital Assistance Program funding for six months to raise the capital privately. Eligible U.S. banking institutions with assets below $100 billion may also obtain capital from the Capital Assistance Program. The Capital Assistance Program is an additional program from the TARP CPP and is open to eligible institutions regardless of whether they participated in the TARP CPP.  The deadline to apply to participate in the Capital Assistance Program is May 25, 2009. Recipients of capital under the Capital Assistance Program will be subject to the same executive compensation requirements as if they had received TARP CPP.

 

Environmental Regulations

 

In the course of our business, we may foreclose and take title to real estate, and could be subject to environmental liabilities with respect to these properties. We may be held liable to a governmental entity or to third parties for property damage, personal injury, investigation and clean-up costs incurred by these parties in connection with environmental contamination, or may be required to investigate or clean up hazardous or toxic substances, or chemical releases at a property. The costs associated with investigation or remediation activities could be substantial. In addition, as the owner or former owner of a contaminated site, we may be subject to common law claims by third parties based on damages and costs resulting from environmental contamination emanating from the property. If we ever become subject to significant environmental liabilities, our business, financial condition, liquidity and results of operations could be materially and adversely affected.

 

Other Pending and Proposed Legislation

 

Other legislative and regulatory initiatives which could affect us and the banking industry, in general, are pending and additional initiatives may be proposed or introduced before the United States Congress, the California legislature and other governmental bodies in the future. Such proposals, if enacted, may further alter the structure, regulation and competitive relationship among financial institutions, and may subject us to increased regulation, disclosure and reporting requirements. In addition, the various banking regulatory agencies often adopt new rules and regulations to implement and enforce existing legislation. We cannot predict whether, or in what form, any such legislation or regulations may be enacted or the extent to which our business would be affected thereby.

 

Available Information

 

The Company maintains an Internet website at http://www.ovcb.com.  The Company makes available its annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to such reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, and other information related to the Company free of charge, through this site as soon as reasonably practicable after it electronically files those documents with, or otherwise furnishes them to, the SEC. The Company’s internet website and the information contained therein or connected thereto are not intended to be incorporated into this annual report on Form 10-K.

 

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ITEM 1A.  RISK FACTORS

 

Not applicable.

 

ITEM 1B.  UNRESOLVED STAFF COMMENTS

 

None.

 

ITEM 2. PROPERTIES

 

Our main office is located in a complex at 125 North Third Avenue, Oakdale, CA 95361, in downtown Oakdale.  The building has an automated teller machine and onsite parking.  The Bank’s complex occupies approximately 20,000 square feet of space.

 

Property Location and Address		Square Footage		Monthly Rent		Lease Expiration Date		Lease Extension Options
Oakdale, 125 N. 3rd Ave.		9,600		n/a*		n/a*		n/a
Oakdale, 338 F Street		9,860				3/2017		three, 5-year term extensions
Sonora		2,500				4/2010		n/a
Modesto, 12th & I Street		4,500				3/2016		two, 5-year term extensions
Bridgeport		2,875		n/a*		n/a*		n/a
Mammoth Lakes		1,856		n/a*		n/a*		n/a
Bishop		3,680				8/2014		two, 5-year term extensions
Modesto Dale		4,500				3/2015		two, 5-year term extensions
Turlock		2,400				1/2015		two, 5-year term extensions
Patterson		2,100		n/a*		n/a*		n/a*
Escalon		3,500				4/2021		two, 5-year term extensions
Ripon		1,800				1/2011		two, 5-year term extensions
Stockton		8,000				12/2022		two, 5-year term extensions

 

* The Bank owns this property.

 

Management has determined that all of its premises are adequate for its present and anticipated level of business.

 

ITEM 3. LEGAL PROCEEDINGS

 

From time to time, the Company is a party to claims and legal proceedings arising in the ordinary course of business. Our management evaluates its exposure to these claims and proceedings individually and in the aggregate and provides for potential losses on such litigation if the amount of the loss is estimable and the loss is probable.

 

We believe that there are no material litigation matters at the current time. Although the results of such litigation matters and claims cannot be predicted with certainty, we believe that the final outcome of any such claims and proceedings will not have a material adverse impact on the Company’s financial position, liquidity, or results of operations.

 

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

No matters were submitted to our shareholders during the fourth quarter of the year ended December 31, 2008 covered by this report.

 

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PART II

 

ITEM 5. MARKET PRICE OF AND DIVIDENDS ON THE REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.

 

Price Range of Common Stock

 

The common stock of the Bank was traded on The NASDAQ OTCBB under the symbol “OVYB” until January 14, 2009.  On January 15, 2009 our common stock began trading on The NASDAQ Capital Market under the symbol “OVLY.”  The following table sets forth the high and low closing bid prices (which reflect prices between dealers and do not include retail markup, markdown or commission and may not represent actual transactions) for the current year and the three calendar years ended December 31, 2008, 2007 and 2006, respectively.  From time to time, during the periods indicated, trading activity in our common stock was infrequent.  The source of the quotes is The Nasdaq Stock Market, LLC.

 

		Closing Sale Price(1)(2)
For Calendar Quarter Ended		High		Low
June 30, 2006		16.75		13.35
September 30, 2006		16.00		12.75
December 31, 2006		14.75		12.55
March 31, 2007		13.03		10.80
June 30, 2007		11.35		10.90
September 30, 2007		11.00		9.17
December 31, 2007		10.05		7.52
March 31, 2008		8.49		8.49
June 30, 2008		8.00		6.50
September 30, 2008		7.50		6.30
December 31, 2008		7.00		3.55

 

On March 27, 2009 the closing price of our common stock was $4.25 per share; and there were approximately 545 shareholders of record of the common stock and 7,661,627 outstanding shares of common stock.

 

(1) Figures in the table have been retroactively adjusted to reflect a three-for-two stock split in January 2005 and a three-for-two stock split in January 2006.

 

(2) Figure through June 30, 2008 refer to Bank common stock prices.

 

Dividends

 

Our ability to pay any cash dividends will depend not only upon our earnings during a specified period, but also on our meeting certain capital requirements.

 

Shareholders are entitled to receive dividends only when and if dividends are declared by our Board of Directors. Although we have paid dividends in the past, it is no guarantee that we will continue paying cash dividends in the future.

 

Prior to the bank holding company reorganization in 2008, the Bank has historically declared and paid a dividend on its common stock every year since 1996.  Dividends for the year ended December 31, 2008, 2007 and 2006 were $0.075, $0.19 and $0.19 per share of common stock, respectively.

 

The following table shows stock splits declared for the four years ended December 31, 2008:

 

Declaration Date		Payable Date		Record Date		Type
November 17, 2004		January 14, 2005		January 3, 2005		Three-for-two stock split
November 16, 2005		January 17, 2006		January 3, 2006		Three-for-two stock split

 

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Equity Compensation Plan Information

 

The following table provides information as of December 31, 2008 with respect to shares of our common stock that are  issued and currently outstanding under the Bank’s 1998 Restated Stock Option Plan (the “1998 Restated Stock Option Plan”), and the number of shares that are authorized to be issued under the Company’s 2008 Stock Option Plan (the “2008 Equity Plan”) Figures in the table have been retroactively adjusted to reflect three-for-two stock splits in August 2005 and 2006.

 

		A		B			C
Plan Category		Number of Securities to be Issued Upon Exercise of Outstanding Options		Weighted Average Exercise Price of Outstanding Options			Number of Securities Remaining Available for Future Issuance Under 2008 Equity Plan (Excluding Securities Reflected in Column A)
Equity Compensation Plans Approved by Shareholders		420,455		$	6.97		1,500,000
Equity Compensation Plans Not Approved by Shareholders				Not applicable			0
Total		420,455		$	6.97		1,500,000

 

Recent Sales of Unregistered Securities

 

On December 5, 2008, the Company completed the sale to the U.S. Treasury of $13.5 million of preferred stock and warrants as part of the TARP CPP pursuant to an exemption under Section 4(2) of the Securities Act of 1933, as amended.  Pursuant to the terms of  such offering, the Company issued and sold to the U.S. Treasury (i) 13,500 shares of the Company’s Series A Fixed Rate Cumulative Perpetual Preferred Stock, having a liquidation preference of $1,000 per share and (ii) a warrant to purchase up to 350,346 shares of the Company’s common stock, no par value. Under the terms of the TARP CPP, the Company is prohibited from increasing dividends on its common stock, and from making certain repurchases of equity securities, including its common stock, without the U.S. Treasury’s consent.  Furthermore, as long as the preferred stock issued to the U.S. Treasury is outstanding, dividend payments and repurchases or redemptions relating to certain equity securities, including the Company’s common stock, are prohibited until all accrued and unpaid dividends are paid on such preferred stock, subject to certain limited exceptions. Restrictions related to the payment of dividends on common stock are disclosed under “Dividends” of the section above of this Form 10-K.

 

ITEM 6.  SELECTED CONSOLIDATED FINANCIAL DATA

 

Not applicable.

 

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ITEM 7.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION

 

Forward-Looking Statements

 

This discussion of financial results includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, (the “1933 Act”) and Section 21E of the Securities Exchange Act of 1934, as amended, (the “1934 Act”). Those sections of the 1933 Act and 1934 Act provide a “safe harbor” for forward-looking statements to encourage companies to provide prospective information about their financial performance so long as they provide meaningful, cautionary statements identifying important factors that could cause actual results to differ significantly from projected results.

 

Our forward-looking statements include descriptions of plans or objectives of Management for future operations, products or services, and forecasts of our revenues, earnings or other measures of economic performance. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. They often include the words “believe,” “expect,” “intend,” “estimate” or words of similar meaning, or future or conditional verbs such as “will,” “would,” “should,” “could” or “may.”

 

Forward-looking statements are based on Management’s current expectations regarding economic, legislative, and regulatory issues that may impact our earnings in future periods. A number of factors - many of which are beyond Management’s control - could cause future results to vary materially from current Management’s expectations. Such factors include, but are not limited to, general economic conditions, the current financial turmoil in the United States and abroad, changes in interest rates, deposit flows, real estate values and competition; changes in accounting principles, policies or guidelines; changes in legislation or regulation; and other economic, competitive, governmental, regulatory and technological factors affecting our operations, pricing, products and services. Forward-looking statements speak only as of the date they are made. We do 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.

 

The following discussion explains the significant factors affecting our operations and financial position for the periods presented, and includes the statistical disclosures required by Securities and Exchange Commission Guide 3 (“Statistical Disclosure by Bank Holding Companies”).  The discussion should be read in conjunction with our financial statements and the notes related thereto which appear elsewhere in this registration statement.

 

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Introduction

 

Effective July 3, 2008, Oak Valley Community Bank became a subsidiary of Oak Valley Bancorp, a newly established bank holding company. Oak Valley Bancorp operates Oak Valley Community Bank as a community bank in the general commercial banking business, with our primary market encompassing the California Central Valley around Oakdale and Modesto, and the Eastern Sierras.  As such, unless otherwise noted, all references are about Oak Valley Community Bank.

 

In the bank holding company reorganization, each outstanding shares of common stock of the bank was exchange for an equal number of shares of common stock of Oak Valley Bancorp, which now owns the Bank as its wholly-owned subsidiary. Management believes that operating the Bank within a holding company structure will, among other things:

 

· provide greater operating flexibility than is currently enjoyed by us.

 

· facilitate the acquisition of related businesses as opportunities arise.

 

· improve our ability to diversify.

 

· enhance our ability to remain competitive in the future with other companies in the financial services industry that are organized in a holding company structure.

 

· enhance our ability to raise capital to support growth.

 

As of December 31, 2008, we had approximately $508 million in total assets, $422 million in total loans, and $378 million in total deposits.

 

Over the past few years, our network of branches and loan production offices have been expanded geographically. We currently maintain twelve full-service offices.  We intend to continue our growth strategy in future years through the opening of additional branches and loan production offices as our needs and resources permit.

 

2008 Key Performance Indicators

 

We believe the following were key indicators of our performance for operations during 2008:

 

· our total assets increased to $508 million at the end of 2008, or an increase of 11.9%, from $454 million at the end of 2007.

 

· our total deposits increased slightly to $378 million at the end of 2008, or an increase of 0.2%, from $377 million at the end of 2007.

 

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· our total net loans grew to $422 million at the end of 2008, or an increase of 10.3%, from $382 million at the end of 2007.

 

· our ratio of total non-performing loans to total loans decreased to 1.1% at December 31, 2008 from 2.4% at December 31, 2007.  Management deems that the size of the ratio of non-performing assets to total loans is moderate and manageable, and reserves have been taken appropriately.

 

· net interest income increased $1.7 million or 8.9% in 2008 compared to 2007, mainly as a result of an increase in the net interest margin from 4.53% to 4.72% and an increase in average earning assets of $16.5 million.

 

· provision for loan losses increased $1.6 million or 294% to $2.2 million in 2008 compared to $555,000 in 2007.

 

· total noninterest income increased to $2.52 million in 2008, or an increase of 14.8%, from $2.20 million in 2007. We primarily attribute this increase to our efforts to expand our deposit account base and diversify our non-interest revenue sources.

 

· total noninterest expense increased from $14.2 million in 2007 to $17.9 million in 2008, reflecting the expanded personnel and premises associated with our business growth, including the recent opening of new branch offices.  Another primary component of the increase was market value write downs on other real estate owned of $1.6 million.

 

These items, as well as other factors, contributed to the decrease in net income available to common shareholders for 2008 to $2.10 million from $3.93 million in 2007, which translates into $0.27 per diluted common share in 2008 and $0.52 per diluted common share in 2007.

 

2009 Outlook

 

As we begin our strategic business plan for 2009, we are continuing to pursue opportunities for growth in our existing markets, as well as opportunities to expand into new markets through   de novo   branching. Further, we expect that our portfolio of unsecured business loans and consumer loans will overall experience additional growth in 2009 as a result of target marketing efforts in these areas.

 

In 2009, we are continuing to focus on loan and account growth and managing our net interest margin, while attempting to control expenses and credit losses and manage our business to achieve our net income and other objectives. We are also continuing to utilize strategies to control other operating expenses. These efforts are important for us to continue to attract new accounts and grow loans. However, we will continue to strive to be more efficient and focus on controlling the growth of these expenses so that they grow more slowly than the growth in loans.

 

Although interest rates decreased in 2008, we have maintained a stable net interest margin with continued growth in net interest income, which we expect to continue in 2009. In light of current difficult economic conditions, protracted low interest

 

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rates or a further decrease in interest rates will likely pressure our net interest margin downwards. This will in turn decrease the growth rate and net interest income. Should interest rates increase later in 2009, our yield on earnings assets is likely to increase and we could then determine to increase the interest rates we pay on our deposit accounts or change our promotional or other interest rates on new deposits in marketing activation programs to attempt to achieve a certain net interest margin. Any increases in the rates we charge on accounts could have an effect on our efforts to attract new customers and grow loans, particularly with the continuing competition in the commercial and consumer lending industry. The economies and real estate markets in our primary market areas will continue to be significant determinants of the quality of our assets in future periods and, thus, our results of operations, liquidity and financial condition. Current economic indicators suggest that the national economy and the economies in our primary market areas are facing a downturn but the length and severity of it are difficult to predict.

 

For 2009, management remains focused on the above challenges and opportunities and other factors affecting the business similar to the factors driving 2008 results as discussed in this section.

 

Critical Accounting Policies

 

The discussion and analysis of our financial condition and results of operations is based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and judgments that effect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities at the date of our financial statements. Actual results may differ from these estimates under different assumptions or conditions.

 

Asset Impairment Judgments

 

Certain of our assets are carried in our statements of financial condition at fair value or at the lower of cost or fair value. Valuation allowances are established when necessary to recognize impairment of such assets. We periodically perform analyses to test for impairment of various assets. In addition to our impairment analyses related to loans, another significant impairment analysis relates to other than temporary declines in the value of our securities.

 

Our available for sale portfolio is carried at estimated fair value, with any unrealized gains and losses, net of taxes, reported as accumulated other comprehensive income in stockholders” equity. We conduct a periodic review and evaluation of the securities portfolio to determine if the value of any security has declined below its carrying value and whether such decline is other than temporary. If such decline is deemed other than temporary, we would adjust the carrying amount of the security by writing down the security to fair market value through a charge to current period income. The market values of our securities are significantly affected by changes in interest rates.

 

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In general, as interest rates rise, the market value of fixed-rate securities will decrease; as interest rates fall, the market value of fixed-rate securities will increase. With significant changes in interest rates, we evaluate our intent and ability to hold the security for a sufficient time to recover the recorded principal balance. Estimated fair values for securities are based on published or securities dealers” market values.

 

Allowance for Loan Losses

 

Accounting for allowance for loan losses involves significant judgment and assumptions by management and is based on historical data and management’s view of the current economic environment. At least on a quarterly basis, our management reviews the methodology and adequacy of allowance for loan losses and reports its assessment to the Board of Directors for its review and approval.

 

We base our allowance for loan losses on an estimation of probable losses inherent in our loan portfolio. Our methodology for assessing loan loss allowances are intended to reduce the differences between estimated and actual losses and involves a detailed analysis of our loan portfolio, in three phases:

 

· the specific review of individual loans,

 

· the segmenting and review of loan pools with similar characteristics in accordance with SFAS No. 5, “Accounting for Contingencies,” and

 

· our judgmental estimate based on various subjective factors:

 

    The first phase of our methodology involves the specific review of individual loans to identify and measure impairment. We evaluate each loan by use of a risk rating system, except for homogeneous loans, such as automobile loans and home mortgages. Specific risk rated loans are deemed impaired if all amounts, including principal and interest, will likely not be collected in accordance with the contractual terms of the related loan agreement. Impairment for commercial and real estate loans is measured either based on the present value of the loan’s expected future cash flows or, if collection on the loan is collateral dependent, the estimated fair value of the collateral, less selling and holding costs.

 

The second phase involves the segmenting of the remainder of the risk rated loan portfolio into groups or pools of loans, together with loans with similar characteristics, for evaluation in accordance with SFAS No. 5. We determine the calculated loss ratio to each loan pool based on its historical net losses and benchmark it against the levels of other peer banks.

 

In the third phase, we consider relevant internal and external factors that may affect the collectability of loan portfolio and each group of loan pool. The factors considered are, but are not limited to:

 

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· concentration of credits,

 

· nature and volume of the loan portfolio,

 

· delinquency trends,

 

· non-accrual loan trend,

 

· problem loan trend,

 

· loss and recovery trend,

 

· quality of loan review,

 

· lending and management staff,

 

· lending policies and procedures,

 

· economic and business conditions, and

 

· other external factors.

 

Our management estimates the probable effect of such conditions based on our judgment, experience and known or anticipated trends. Such estimation may be reflected as an additional allowance to each group of loans, if necessary. Management reviews these conditions with our senior credit officers. To the extent that any of these conditions is evidenced by a specifically identifiable problem credit or portfolio segment as of the evaluation date, managements’ estimate of the effect of such condition may be reflected as a specific allowance applicable to such credit or portfolio segment. Where any of these conditions is not evidenced by a specific, identifiable problem credit or portfolio segment as of the evaluation date, management’s evaluation of the inherent loss related to such condition is reflected in the unallocated allowance

 

Central to our credit risk management and our assessment of appropriate loss allowance is our loan risk rating system. Under this system, the originating credit officer assigns borrowers an initial risk rating based on a thorough analysis of each borrower’s financial capacity in conjunction with industry and economic trends. Approvals are made based upon the amount of inherent credit risk specific to the transaction and are reviewed for appropriateness by senior line and credit administration personnel. Credits are monitored by line and credit administration personnel for deterioration in a borrower’s financial condition which may impact the ability of the borrower to perform under the contract. Although management has allocated a portion of the allowance to specific loans, specific loan pools, and off-balance sheet credit exposures (which are reported separately as part of other liabilities), the adequacy of the allowance is considered in its entirety.

 

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Non-Accrual Loan Policy

 

Interest on loans is credited to income as earned and is accrued only if deemed collectible. Accrual of interest is discontinued when a loan is over 90 days delinquent or if management believes that collection is highly uncertain. Generally, payments received on nonaccrual loans are recorded as principal reductions. Interest income is recognized after all principal has been repaid or an improvement in the condition of the loan has occurred that would warrant resumption of interest accruals.

 

Stock-Based Compensation

 

Effective January 1, 2006, the Bank adopted the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123R,   Share Based Payments.  SFAS No. 123R requires companies to recognize in the income statement the grant-date fair value of stock options and other equity-based forms of compensation issued to employees over the employees” requisite service period (generally the vesting period).  The Bank  uses straight-line recognition of expenses for awards with graded vesting.  The Bank utilizes a binomial pricing model for all grants. Expected volatility is based on the historical volatility of the price of the Bank’s stock. The Bank uses historical data to estimate option exercise and stock option forfeiture rates within the valuation model. The expected term of options granted for the binomial model is derived from applying a historical suboptimal exercise factor to the contractual term of the grant. For binomial pricing, the risk-free rate for periods is equal to the U.S. Treasury yield at the time of grant and commensurate with the contractual term of the grant.

 

Other Real Estate Owned

 

Other real estate owned, which represents real estate acquired through foreclosure, or deed in lieu of foreclosure in satisfaction of commercial and real estate loans, is carried at the lower of cost or estimated fair value less the estimated selling costs of the real estate. The fair value of the property is based upon a current appraisal. The difference between the fair value of the real estate collateral and the loan balance at the time of transfer is recorded as a loan charge off if fair value is lower. Subsequent to foreclosure, management periodically performs valuations and the OREO property is carried at the lower of carrying value or fair value, less costs to sell. The  determination of a property’s estimated fair value incorporates (1) revenues projected to be realized from disposal of the property, (2) construction and renovation costs, (3) marketing and transaction costs, and (4) holding costs (e.g., property taxes, insurance and homeowners” association dues). Any subsequent declines in the fair value of the OREO property after the date of transfer are recorded through a write-down of the asset. Any subsequent operating expenses or income, reduction in estimated fair values, and gains or losses on disposition of such properties are charged or credited to current operations.

 

Impact of SAB No. 108

 

In September 2006, the SEC’s Office of the Chief Accountant and Divisions of Corporation Finance and Investment Management released SAB No. 108,

 

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“Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”), that provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. The SEC staff believes that registrants should quantify errors using both a balance sheet and an income statement approach and evaluate whether either approach results in quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. This pronouncement was effective for fiscal years ending after November 15, 2006. The Company initially adopted SAB 108 in conjunction with the filing of this Form 10. This change in accounting policy was retrospectively applied in accordance with Statement of Financial Accounting Standards No. 154, Accounting Changes and Error Corrections.  The adoption of SAB 108 had no material impact on the Company’s financial position, results of operations, or cash flows, although we made certain adjustments that resulted in a decrease of net income of $43,227 for the year ended December 31, 2007 (a decrease of $0.01 in basic and diluted earnings per share), and $105,102 for the year ended December 31, 2006 (a decrease of $0.01 in basic and diluted earnings per share), respectively.   See note 1 to the December 31, 2008 financial statements for further discussion.

 

Overview

 

We recorded net income available to common shareholders for the year ended December 31, 2008 of $2,098,010 or $0.27 per diluted common share compared to $3,925,121 or $0.52 per diluted common share for the year ended December 31, 2007. The decrease in net income available to common shareholders for the year ended December 31, 2008 was primarily due to an increase of $3,652,424 in non-interest expense, which included a market value write down on other real estate owned of $1,553,881, and an increase in the provision for loan loss of $1,633,139.  Partially offsetting these factors was an increase in net interest income of $1,684,248, an increase in non-interest income of $324,798 and a decrease in income tax provision of $1,513,225.

 

Results of Operation

 

Net Interest Income and Net Interest Margin

 

Our primary source of revenue is net interest income, which is the difference between interest and fees derived from earning assets and interest paid on liabilities obtained to fund those assets. Our net interest income is affected by changes in the level and mix of interest-earning assets and interest- bearing liabilities, referred to as volume changes. Our net interest income is also affected by changes in the yields earned on assets and rates paid on liabilities, referred to as rate changes. Interest rates charged on our loans are affected principally by the demand for such loans, the supply of money available for lending purposes and competitive factors. Those factors are, in turn, affected by general economic conditions and other factors beyond our control, such as federal

 

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economic policies, the general supply of money in the economy, legislative tax policies, the governmental budgetary matters, and the actions of the Federal Reserve Board.

 

Net interest income increased $1.7 million or 8.9% to $20.5 million for the year ended December 31, 2008, compared to $18.8 million in 2007.  Net interest spread and net interest margin were 4.33% and 4.72%, respectively, for the year ended December 31, 2008, compared to 3.87% and 4.53%, respectively, for the year ended December 31, 2007. The increase in the net interest margin in 2008 was principally attributable to the change in the deposit mix from high cost certificates of deposit to lower cost core deposit accounts which caused the rate on interest-bearing liabilities to decrease faster than the rate on earning assets.  Changes in volume resulted in an increase in net interest income of $830,000 for the year of 2008 compared to the year 2007, and changes in interest rates and the mix resulted in an increase in net interest income of $938,000 for the year 2008 versus the year 2007.

 

For a detailed analysis of interest income and interest expense, see the “Average Balance Sheets” and the “Rate/Volume Analysis” below.

 

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		Distribution, Yield and Rate Analysis of Net Income
		For the Years Ended December 31,
		2008								2007
		Average Balance			Interest Income/ Expense			Avg Rate/ Yield		Average Balance			Interest Income/ Expense			Avg Rate/ Yield
Assets:
Earning assets:
Gross loans (1) (2)		$	400,821		$	27,638		6.90	%	$	381,316		$	30,175		7.91	%
Securities of U.S. government agencies		2,450			73			2.98	%	8,322			405			4.86	%
Other investment securities (2)		31,489			1,600			5.08	%	26,687			1,278			4.79	%
Federal funds sold		1,227			18			1.47	%	3,122			159			5.10	%
Interest-earning deposits		37			2			4.36	%	76			4			5.56	%
Total interest-earning assets		436,024			29,331			6.73	%	419,523			32,021			7.63	%
Total noninterest earning assets		16,256								26,771
Total Assets		$	452,280							$	446,294
Liabilities and Shareholders’ Equity:
Interest-bearing liabilities:
Money market deposits		149,202			3,578			2.40	%	125,574			4,539			3.62	%
NOW deposits		54,160			386			0.71	%	53,634			565			1.05	%
Savings deposits		15,563			259			1.66	%	16,745			558			3.33	%
Time certificates of $100,000 or more		40,172			1,576			3.92	%	66,006			3,432			5.20	%
Other time deposits		44,846			1,441			3.21	%	49,118			2,133			4.34	%
Other borrowings		59,666			1,492			2.50	%	34,384			1,779			5.17	%
Total interest-bearing liabilities		363,609			8,732			2.40	%	345,461			13,006			3.76	%
Noninterest-bearing liabilities:
Noninterest-bearing deposits		61,554								58,468
Other liabilities		3,131								3,543
Total noninterest-bearing liabilities		64,685								62,011
Shareholders’ equity		23,986								38,822
Total liabilities and shareholders’ equity		$	452,280							$	446,294
Net interest income					$	20,599							$	19,015
Net interest spread (3)								4.33	%							3.87	%
Net interest margin (4)								4.72	%							4.53	%

 

(1)       Loan fees have been included in the calculation of interest income. Loan fees were approximately $1,024,000 and $1,331,000 for the years ended December 31, 2008, and 2007, respectively.

(2)       Yields on municipal securities and loans have been adjusted to their fully-taxable equivalents, based on a federal marginal tax rate of 34.0%.

 

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(3) Represents the average rate earned on interest-earning assets less the average rate paid on interest-bearing liabilities.

(4) Represents net interest income as a percentage of average interest-earning assets.

 

Rate/Volume Analysis

 

The following table below sets forth certain information regarding changes in interest income and interest expense of Oak Valley Community Bank  for the periods indicated. For each category of earning assets and interest bearing liabilities, information is provided on changes attributable to (i) changes in volume (change in average volume multiplied by old rate); and (ii) changes in rates (change in rate multiplied by old average volume). Changes in rate/volume (change in rate multiplied by the change in volume) have been allocated to the changes due to volume and rate in proportion to the absolute value of the changes due to volume and rate prior to the allocation.

 

		Rate/Volume Analysis of Net Interest Income
		For the Year Ended December 31,									For the Year Ended December 31,
		2008 vs. 2007									2007 vs. 2006
		Increases (Decreases)									Increases (Decreases)
		Due to Change In									Due to Change In
		Volume			Rate			Total			Volume			Rate			Total
Interest income:
Net loans (1)		$	1,543		$	(4,078	)	$	(2,535	)	$	2,831		$	356		$	3,187
Securities of U.S. government agencies		(286		)	(46		)	(332		)	(77		)	(38		)	(115		)
Other Investment securities		230			91			321			(48		)	81			33
Federal funds sold		(97		)	(45		)	(142		)	36			(1		)	35
Interest-earning deposits		(2		)	0			(2		)	(1		)	3			2
Total interest income		1,388			(4,078		)	(2,690		)	2,741			401			3,142
Interest expense:
Money market deposits		$	854		$	(1,816	)	$	(962	)	$	272		$	232		$	504
Super NOW deposits		6			(184		)	(178		)	51			(29		)	22
Savings deposits		(39		)	(260		)	(299		)	(147		)	54			(93		)
Time certificates of $100,000 or more		(1,343		)	(512		)	(1,855		)	(222		)	467			245
Other time deposits		(185		)	(506		)	(691		)	(128		)	42			(86		)
Other borrowings		1,308			(1,597		)	(289		)	818			234			1,052
Total interest expense		601			(4,875		)	(4,274		)	644			1,000			1,644
Change in net interest income		$	787		$	797		$	1,584		$	2,097		$	(599	)	$	1,498

 

(1)       Loan fees have been included in the calculation of interest income. Loan fees were

 

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approximately $1,024,000 and $1,331,000 for the years ended December 31, 2008 and 2007, respectively.

 

Provision for Loan Losses

 

The provision for loan losses was $2,188,139 for the year ended December 31, 2008, compared to $555,000 for the year 2007.  Nonperforming loans were $4.72 million at December 31, 2008 and $9.81 million at December 31, 2007, or 1.10% and 2.54%, respectively, of total loans. Nonperforming loans are primarily in nonperforming real estate construction and development loans. The allowance for loan losses was $5.57 million and $4.51 million at December 31, 2008 and 2007, or 1.30% and 1.16%, respectively, of total loans. Net charge-offs were $1,110,000 in 2008 compared to $397,000 in 2007.  The increase in net charge-offs in 2008 was primarily due to the economic downturn and the effect on the housing market.

 

The Bank maintains the allowance for loan losses at a level that it considers to be adequate to provide for credit losses inherent in its loan portfolio. Management determines the level of the allowance by performing a quarterly analysis that considers concentrations of credit, past loss experience, current economic conditions, the amount and composition of the loan portfolio (including nonperforming and potential problem loans), estimated fair value of underlying collateral, and other information relevant to assessing the risk of loss inherent in the loan portfolio. As a result of management’s analysis, a range of the potential amount of the allowance for loan losses is determined.

 

The Bank will continue to monitor the adequacy of the allowance for loan losses and make additions to the allowance in accordance with the analysis referred to above. Because of uncertainties inherent in estimating the appropriate level of the allowance for loan losses, actual results may differ from management’s estimate of credit losses and the related allowance.

 

The following table sets forth the amount of total loans outstanding (excluding unearned income) and the percentage distributions in each category, as of the dates indicated.

 

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		Distribution of Loans and Percentage Composition of Loan Portfolio Amount Outstanding as of December 31,
		2008			2007			2006			2005			2004
		(Dollars in Thousands)
Commercial real estate		$	268,742		$	208,309		$	233,110		$	212,901		$	175,641
Commercial		37,302			45,497			41,077			31,349			22,156
Real estate construction		73,321			83,173			60,269			37,717			36,457
Agriculture		25,917			31,430			27,527			22,390			13,016
Residential real estate and consumer		22,895			19,400			16,409			13,752			11,225
Unearned income		(1,035		)	(1,038		)	(1,233		)	(1,345		)	(1,188		)
Total loans, net of unearned income		427,142			386,771			377,160			$	316,764		$	257,307
Participation loans sold and serviced by the Bank		$	9,759		$	1,314		$	3,488		$	3,838		$	3,872
Commercial real estate		62.9		%	53.9		%	61.8		%	67.2		%	68.3		%
Commercial		8.7		%	11.8		%	10.9		%	9.9		%	8.6		%
Real estate construction		17.2		%	21.5		%	16.0		%	11.9		%	14.2		%
Agriculture		6.1		%	8.1		%	7.3		%	7.1		%	5.1		%
Residential real estate and consumer		5.3		%	5.0		%	4.4		%	4.3		%	4.4		%
Unearned income		(0.2		)%	(0.3		)%	(0.3		)%	(0.4		)%	(0.5		)%
Total loans, net of unearned income		100.0		%	100.0		%	100.0		%	100.0		%	100.0		%

 

The following table shows the contractual maturity distribution and repricing intervals of the outstanding loans in our portfolio, as of December 31, 2008. In addition, the table shows the distribution of such loans between those with variable or floating interest rates and those with fixed or predetermined interest rates.

 

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		Loan Maturities and Repricing Schedule At December 31, 2008
		Within			After One But Within			After
(Dollars in thousands)		One Year			Five Years			Five Years			Total
Commercial real estate		$	51,315		$	178,999		$	38,428		$	268,742
Commercial		21,934			12,719			2,649			37,302
Real estate construction		61,193			12,113			15			73,321
Agriculture		18,374			6,375			1,168			25,917
Residential real estate and consumer		1,040			6,301			15,554			22,895
Unearned income		(372		)	(523		)	(140		)	(1,035		)
Total loans, net of unearned income		$	153,484		$	215,984		$	57,674		$	427,142
Loans with variable (floating) interest rates		$	119,490		$	151,650		$	37,732		$	308,872
Loans with predetermined (fixed) interest rates		$	33,994		$	64,333		$	19,943		$	118,270

 

The majority of the properties taken as collateral are located in Northern California. We employ strict guidelines regarding the use of collateral located in less familiar market areas. The recent decline in Northern California real estate value is offset by the low loan-to-value ratios in our commercial real estate portfolio and high percentage of owner-occupied properties.

 

Nonperforming Assets

 

Nonperforming assets consist of loans on non-accrual status, loans 90 days or more past due and still accruing interest, loans restructured, where the terms of repayment have been renegotiated resulting in a reduction or deferral of interest or principal, and other real estate owned (“OREO”).

 

Loans are generally placed on non-accrual status when they become 90 days past due, unless management believes the loan is adequately collateralized and in the process of collection. The past due loans may or may not be adequately collateralized, but collection efforts are continuously pursued. Loans may be restructured by management when a borrower has experienced some changes in financial status, causing an inability to meet the original repayment terms, and where we believe the borrower will eventually overcome those circumstances and repay the loan in full. OREO consists of properties acquired by foreclosure or similar means and which management intends to offer for sale.

 

The Bank had nonperforming loans of $4.72 million at December 31, 2008, as compared to $9.81 million at December 31, 2007 and no nonperforming loans at December 31, 2006, 2005 and 2004, respectively.  The ratio of nonperforming loans over total loans was 1.10% and 2.54% at December 31, 2008 and 2007, respectively, as compared with 0.0% in the prior three year-end periods.

 

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In addition, the Bank held two residential development OREO properties with a market value of $2.75 million as of December 31, 2008.  The Bank did not possess any OREO during any of the year-end periods from 2004 through 2007.

 

Management believes that the reserve provided for nonperforming loans, together with the tangible collateral, were adequate as of December 31, 2008. See “Allowance for Loan Losses” below for further discussion. Except as disclosed above, as of December 31, 2008, management was not aware of any material credit problems of borrowers that would cause it to have serious doubts about the ability of a borrower to comply with the present loan payment terms. However, no assurance can be given that credit problems may exist that may not have been brought to the attention of management.

 

The following table provides information with respect to the components of our nonperforming assets as of the dates indicated.  (The figures in the table are net of the portion guaranteed by the U.S. Government):

 

Nonperforming Assets

 

		At December 31,
		2008			2007			2006			2005			2004
		(Dollars in Thousands)
Nonaccrual loans(1)
Commercial real estate		$	2,115		$	1,127		$	0		$	0		$	0
Commercial		0			0			0			0			0
Real estate construction		1,963			7,960			0			0			0
Agriculture		0			0			0			0			0
Residential real estate and consumer		0			0			0			0			0
Total		$	4,078		$	9,087		0			$	0		0
Loans 90 days or more past due and still accruing (as to principal or interest):
Commercial real estate		$	0		$	0		$	0		$	0		$	0
Commercial		0			0			0			0			4
Real estate construction		643			721			0			0			0
Agriculture		0			0			0			0			1
Residential real estate and consumer		0			0			0			0			0
Total		643			721			0			0			5
Restructured loans(2)
Commercial real estate		$	0		$	0		$	0		$	0		$	0
Commercial		0			0			0			0			0
Real estate construction		0			0			0			0			0
Agriculture		0			0			0			0			0
Residential real estate and consumer		0			0			0			0			0
Total		0			0			0			0			0
Total nonperforming loans		4,721			9,808			0			0			5
Other real estate owned		2,746			0			0			0			0
Total nonperforming assets		$	7,467		$	9,808		$	0		$	0		$	0
Nonperforming loans as a percentage of total loans		1.10		%	2.54		%	0.00		%	0.00		%	0.00		%
Nonperforming assets as a percentage of total loans and other real estate owned		1.74		%	2.54		%	0.00		%	0.00		%	0.00		%
Allowance for loan losses as a percentage of nonperforming loans		117.97		%	45.95		%	—			—			—

 

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