Table of Contents

 

 

 

**UNITEDSTATES****SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-K**

 

| x          | **ANNUAL  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE** |
|------------|---------------------------------------------------------------------|
| ** ** | **SECURITIES  EXCHANGE ACT OF 1934**                                |

** **

**For the fiscal year ended December 31, 2009**

** **

**OR**

 

| o          | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE** |
|------------|-------------------------------------------------------------------------|
| ** ** | **SECURITIES  EXCHANGE ACT OF 1934**                                    |

 

**OAKVALLEY BANCORP**

(Exact name of registrant as specified in its charter)

| **California**                                                  | ** ** | **26-2326676**                        |
|-----------------------------------------------------------------|------------|---------------------------------------|
| (State or other jurisdiction  of incorporation or organization) |       | (I.R.S. Employer  Identification No.) |

 

| **125 North Third Avenue****Oakdale, California** | ** ** | **95361**  |
|---------------------------------------------------|------------|------------|
| (Address of principal executive offices)          |       | (Zip Code) |

 

**(209) 848-2265**

(Registrant’s telephone number including area code)

 

Securitiesregistered pursuant to Section 12(b) of the Act:

 

| **Title  of each class** | ** ** | **Name  of each exchange on which registered** |
|--------------------------|------------|------------------------------------------------|
| Common Stock             |       | The NASDAQ Stock Market, LLC                   |

 

Securitiesregistered pursuant to Section 12(g) of the Act:

 

**None**

(Title of class)

 

Indicateby check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405of the Securities Act.
|   |   | Yes  o | No  x |
|--------|--------|------------------|-----------------|

 

Indicateby check mark if the registrant is not required to file reports pursuant to Section 13or Section 15(d) of the Exchange Act.
|   |   | Yes  o | No  x |
|--------|--------|------------------|-----------------|

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90days.          Yes  x                                          No  o

 

Indicateby check mark whether the registrant has submitted electronically and posted onits corporate Web site, if any, every Interactive Data File required to besubmitted and posted pursuant to Rule 405 of Regulation S-T (232.405 ofthis chapter during the preceding 12 months (or for such shorter period thatthe registrant was required to submit and post such files).      Yes  o                                          No  o

 

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to the bestof registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K.  o

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, a non-accelerated filer, or a smaller reporting company. Seedefinitions of “large accelerated filer,” “accelerated filer,” and “smallerreporting 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) |   |                        |

 

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

 

Asof December 31, 2009, theaggregate market value of the registrant’s common stock held by non-affiliatesof the registrant was $29,086,764 based on the closing price.

 

Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date.

 

| **Common Stock, No Par Value** | ** ** | **Outstanding at March 25, 2010** |
|----------------------------------------------------|------------|-------------------------------------------------------|
| [Common Stock, No par value per share]             |       | 7,681,877 shares                                      |

 

**DOCUMENTS INCORPORATED BY REFERENCE**

 

| **Document** | ** ** | **Parts  Into Which Incorporated** |
|--------------|------------|------------------------------------|
| NONE         |       |                               |

 

 

 

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Table of Contents

 

**TABLE OF CONTENTS**

 
| **PART I**   |                                                                                                                  |   |
|-------------------|-----------------------------------------------------------------------------------------------------------------------|--------|
| ITEM 1 -          | DESCRIPTION OF  BUSINESS                                                                                              |   |
| ITEM  1A -        | RISK  FACTORS                                                                                                         |   |
| ITEM 1B -         | UNRESOLVED STAFF  COMMENTS                                                                                            |   |
| ITEM 2 -          | PROPERTIES                                                                                                            |   |
| ITEM 3 -          | LEGAL PROCEEDINGS                                                                                                     |   |
| ITEM 4 -          | RESERVED                                                                                                              |   |
|              |                                                                                                                  |   |
| **PART II**  |                                                                                                                  |   |
| ITEM 5 -          | MARKET FOR  REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUERS PURCHASES  OF EQUITY SECURITIES. |   |
| ITEM 6 -          | SELECTED  CONSOLIDATED FINANCIAL DATA                                                                                 |   |
| ITEM 7-           | MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS                           |   |
| ITEM 8 -          | FINANCIAL  STATEMENTS AND SUPPLEMENTARY DATA                                                                          |   |
| ITEM 9 -          | CHANGES IN AND  DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE                                 |   |
| ITEM 9A(T) - | CONTROLS AND  PROCEDURES                                                                                              |   |
| ITEM 9B-          | OTHER INFORMATION                                                                                                     |   |
|              |                                                                                                                  |   |
| **PART III** |                                                                                                                  |   |
| ITEM 10 -         | DIRECTORS,  EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE                                                               |   |
| ITEM 11 -         | EXECUTIVE  COMPENSATION                                                                                               |   |
| ITEM 12 -         | SECURITY  OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER  MATTERS                      |   |
| ITEM 13 -         | CERTAIN  RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE                                            |   |
| ITEM 14 -         | PRINCIPAL  ACCOUNTANT FEES AND SERVICES                                                                               |   |
|              |                                                                                                                  |   |
| **PART IV**  |                                                                                                                  |   |
| ITEM 15 -         | EXHIBITS AND  FINANCIAL STATEMENTS                                                                                    |   |
|              |                                                                                                                  |   |
| **SIGNATURES**    |                                                                                                                  |

 

 

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**PART I**

 

**ITEM 1.  BUSINESS OF OAK VALLEY BANCORP**

 

**Overview of the Business**

 

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

 

OakValley Bancorp is authorized to issue 50,000,000 shares of common stock,without par value, of which 7,681,877 are issued and outstanding, and10,000,000 shares of preferred stock, without par value, of which 13,500 Series Apreferred stock shares are issued and outstanding.

 

OakValley Community Bank commenced operations in May 1991.  We are aninsured bank under the Federal Deposit Insurance Act and are a member of the FederalReserve.  Since its formation, the Bank has provided basic bankingservices to individuals and business enterprises in Oakdale, California and thesurrounding areas. The focus of the Bank is to offer a range of commercialbanking services designed for both individuals and small to medium-sizedbusinesses in the two main areas of service of the Bank: the Central Valley andthe Eastern Sierras.

 

TheBank offers a complement of business checking and savings accounts for itsbusiness customers.  The Bank also offers commercial and real estateloans, as well as lines of credit.  Real estate loans are generally of ashort-term nature for both residential and commercial purposes. Longer-term real estate loans are generally made with adjustable interest ratesand contain normal provisions for acceleration.  The Bank also offerstraditional residential mortgages through a partner financial institution underCommunity Bank Lending Exchange (“CBLX”).

 

TheBank also offers other services for both individuals and businesses includingonline banking, remote deposit capture, merchant services, night depository,extended hours, wire transfer of funds, note collection, and automated tellermachines in a national network.  The Bank does not currently offer internationalbanking or trust services although the Bank may make such services available tothe Bank’s customers through financial institutions with which the Bank hascorrespondent banking relationships.  The Bank does not offer stocktransfer services nor does it directly issue credit cards.

 

**Expansion**

 

*Branch Expansion.*    Overthe past few years, our network of branches and loan production offices havebeen expanded geographically. As of December 31, 2009, we maintainedtwelve full-service branch offices (in addition to our main office). Beginningin October 1995, we started our geographic expansion outside of Oakdale,by opening a Loan Production Office in Sonora, California. We subsequentlyopened a branch in Sonora and branches in Modesto.  In September 2000,we expanded into the Eastern Sierra, opening a branch in Bridgeport, Californiaunder the name Eastern Sierra Community Bank.  Since that time we haveadded branches in Mammoth Lakes and Bishop. During 2005 and through the firstpart of 2006, we aggressively increased our presence in the Central Valley, byopening branches.  In March 2007, our corporate headquarters expandedby adding an adjacent historical building located in downtown Oakdale to itscomplex.  We intend to continue our growth strategy in future yearsthrough the opening of additional branches and loan production offices as ourneeds and resources permit.

 

*Bank Holding Company Reorganization.*    EffectiveJuly 3, 2008, we entered into a bank holding company reorganization,whereby each of the Bank’s outstanding shares of common stock converted into anequal number of shares of common stock in Oak Valley Bancorp, which currentlyowns the Bank as its wholly-owned subsidiary. Management believes thatoperating the Bank within a holding company structure provides, among otherthings, greater operating flexibility than operating as a bank; facilitates theacquisition of related businesses as opportunities arise; improve the Bank’sability to diversify; enhances the Bank’s ability to remain competitive in thefuture with other companies in the financial services industry that areorganized in a holding company structure; and improve the Bank’s ability toraise capital to support growth.  The reorganization was approved by thevote of the majority of the issued and outstanding shares of common stock.

 

**Business Segments**

 

Weoperate in two primary business segments: Retail Banking and CommercialBanking.  We determine operating results of each segment based on aninternal management system that allocates certain expenses to eachsegment.  These segments are described inadditional detail below:

 

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*Retail Banking.*    TheBank offers a range of checking and savings accounts, including NOW accounts,money market accounts, overdraft protection, health savings accounts,certificates of deposit, and Individual Retirement Accounts (“IRA”).  Tosatisfy the lending needs of individuals in its service area, the Bank offersreal estate and home equity financing, as well as consumer, automobile, andhome improvement loans.

 

*Commercial Banking*.    TheBank offers a range of deposit and lending services to businesscustomers.  More specifically, the Bank offers a variety of commercialloans for virtually any business, professional, or agricultural need. Theseinclude short-term working capital, operating lines of credit, equipmentpurchases, leasehold improvements, construction, commercial real estateacquisitions or refinancing.  Currently, virtually all of the Bank’sbusiness relationships are with customers located in the San Joaquin,Stanislaus, Tuolumne, Inyo and Mono Counties.

 

**Primary Market Area**

 

Weconduct business from our main office in Oakdale, a city of approximately19,300 located in Stanislaus County, California. Oakdale is approximately 15miles from Modesto and sits at the foothills of the Sierra Nevada Mountains, atthe edge of the California Central Valley agricultural area.  Through ourbranches, we serve customers in the Central Valley, from Fresno to Sacramento,and in foothill locations. We also reach into the Highway 395 corridor in theEastern Sierras and in the towns of Bishop, Mammoth and Bridgeport. Approximately 88% of our loans and 84% of our deposits are generated from theCentral Valley.  The Central Valley areaincludes Stanislaus, San Joaquin and Tuolumne counties and has a totalpopulation of over 3 million.

 

**Lending Activities**

 

*General.*    Ourloan policies set forth the basic guidelines and procedures by which we conductour lending operations. These policies address the types of loans available,underwriting and collateral requirements, loan terms, interest rate and yieldconsiderations, compliance with laws and regulations and our internal lendinglimits. Our Board of Directors reviews and approves our loan policies on anannual basis. We supplement our own supervision of the loan underwriting andapproval process with periodic loan audits by experienced external loanspecialists who review credit quality, loan documentation and compliance withlaws 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, creditlines and other personal loans.

 

Aspart of our efforts to achieve long-term stable profitability and respond to achanging economic environment in the California Central Valley, we constantlyevaluate a variety of options to augment our traditional focus by broadeningthe services and products we provide. Possible avenues of growth include morebranch locations, expanded days and hours of operation and new types oflending.

 

*Loan Procedures.*    Loanapplications may be approved by the Director Loan Committee of our Board ofDirectors, or by our management or lending officers, to the extent of theirloan authority. Our Board of Directors authorizes our lending limits. OurPresident and Chief Credit Officer are responsible for evaluating the authoritylimits for individual credit officers and recommending lending limits for allother officers to the board of directors for approval.

 

Wegrant individual lending authority to our President, Chief Credit Officer, andto some department managers. Our highest management lending authority iscombined administrative lending authority for unsecured and secured lending of$1,500,000, which requires the approval of our President or Chief CreditOfficer. Loans for which direct and indirect borrower liability exceeds anindividual’s lending authority are referred to our Board of Directors LoanCommittee.

 

AtDecember  31, 2009, our authorized legal lending limits were$9.7 million for unsecured loans plus an additional $16.2 million forspecific secured loans. Legal lending limits are calculated in conformance withCalifornia law, which prohibits a bank from lending to any one individual orentity or its related interests an aggregate amount which exceeds 15% ofprimary capital plus the allowance for loan losses on an unsecured basis, plusan additional 10% on a secured basis. Our primary capital plus allowance forloan losses at December 31, 2009 totaled $67.7 million.

 

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Weseek to mitigate the risks inherent in our loan portfolio by adhering tocertain underwriting practices. The review of each loan application includesanalysis of the applicant’s prior credit history, income level, cash flow andfinancial condition, tax returns, cash flow projections, and the value of anycollateral to secure the loan, based upon reports of independent appraisers andaudits of accounts receivable or inventory pledged as security. In the case ofreal estate loans over a specified amount, the review of collateral valueincludes an appraisal report prepared by an independent, Bank-approved,appraiser.

 

*Real Estate Loans.*    Weoffer commercial real estate loans to finance the acquisition of new or therefinancing of existing commercial properties, such as shopping centers, officebuildings, industrial buildings, warehouses, hotels, automotive industryfacilities and multiple dwellings. At December 31, 2009, real estate loansconstituted 84% of our loan portfolio, of which 67% were commercial loans.

 

Commercialreal estate loans typically have 10-year maturities with up to 25-yearamortization of principal and interest and loan-to-value ratios of not morethan 75% of the appraised value or purchase price, whichever is lower. Weusually impose a prepayment penalty during the period within 3 to 5 years ofthe date of the loan.

 

Constructionloans are comprised of loans on commercial, residential and income producingproperties that generally have terms of 1 year, with options to extend foradditional periods to complete construction and to accommodate the lease-upperiod. We usually require 15% equity capital investment by the developer andloan to value ratios of not more than 75% of anticipated completion value.

 

Minipermloans finance the purchase and/or ownership of commercial properties, includingowner-occupied and income producing properties. We also offer miniperm loans astake-out financing with our construction loans. Miniperm loans are generallymade with an amortization schedule ranging from 20 to 25 years, with alump sum balloon payment due in 3 to 5 years.

 

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

 

Ourreal estate loans are typically collateralized by first or junior deeds oftrust on specific commercial properties and equity lines of credit, and aresubject to corporate or individual guarantees from financially capable parties,as available. The properties collateralizing real estate loans are principallylocated in our primary market areas of the California Central Valley and theEastern Sierra.  Real estate loans typically bear an interest rate thatfloats with our base rate, prime rate or another established index.

 

Ourreal estate portfolio is subject to certain risks, including (i) downturnsin the California economy, (ii) interest rate increases, (iii) reductionin real estate values in the California Central Valley, (iv) increasedcompetition in pricing and loan structure, and (v) environmental risks,including natural disasters.  As a result of the high concentration of thereal estate loan in our loan portfolio, the current difficulties in the realestate markets could cause significant increases in nonperforming loans, whichwould reduce our profits.  A decline in real estate values could causesome of our mortgage loans to become inadequately collateralized, which wouldexpose us to a greater risk of loss.  Additionally, a decline in real estatevalues could adversely affect our portfolio of commercial real estate loans andcould result in a decline in the origination of such loans.  However, westrive to reduce the exposure to such risks and seek to continue to maintainhigh quality in our real estate loans by (a) reviewing each loan requestand each loan renewal individually, (b) using a dual signature approvalsystem for the approval of each loan request for loans over a certain dollaramount, (c) adhering to written loan policies, including, among otherfactors, minimum collateral requirements, maximum loan-to-value ratiorequirements, cash flow requirements and personal guarantees, (d) performingsecondary appraisals from time to time, (e) conducting externalindependent credit review, and (f) conducting environmental reviews, whereappropriate. We review each loan request on the basis of our ability to recoverboth principal and interest in view of the inherent risks.   Wemonitor and stress test our entire portfolio, evaluating debt coverage ratiosand loan-to-value ratios, on a quarterly basis.  We monitor trends andevaluate exposure derived from simulated stressed market conditions.  Theportfolio is stratified by owner classification (either owner occupied ornon-owner occupied), product type, geography and size.

 

Asof December 31, 2009, the aggregate loan-to-value of the entire commercialreal estate portfolio was 54.9%.  Historical data suggests that the Bankcontinues to maintain strong LTV, which has served as a cushion against precipitousreductions in real estate values.  Non-owner occupied real estatecomprises 46.0% of the Bank’s total commitments, as of December 31,2009.  The loan-to-value on the non-owner occupied segment was 51.2%, asof December 31, 2009.  The highest concentration by product type isretail, which comprised 19.2% of total CRE loan commitments outstanding, as of December 31,2009.  Our portfolio diversity in terms of both product types andgeographic distribution, combined with strong debt coverage ratios, a lowaggregate loan-to-value and a high percentage of owner-occupied properties,significantly mitigate the risks associated with excessive commercial realestate concentration. These elements contribute strength to our overall realestate portfolio despite the current weakness in the real estate market.

 

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*Commercial Business Lending.*    Weoffer commercial loans to sole proprietorships, partnerships and corporations,with an emphasis on the real estate related industry. These commercial loansinclude business lines of credit and commercial term loans to financeoperations, to provide working capital or for specific purposes, such as tofinance the purchase of assets, equipment or inventory. Since a borrower’s cashflow from operations is generally the primary source of repayment, our policiesprovide specific guidelines regarding required debt coverage and other importantfinancial ratios.

 

Linesof credit are extended to businesses or individuals based on the financialstrength and integrity of the borrower and are secured primarily by realestate, accounts receivable and inventory, and have a maturity of one year orless. Such lines of credit bear an interest rate that floats with our baserate, the prime rate, LIBOR or another established index.

 

Commercialterm loans are typically made to finance the acquisition of fixed assets,refinance short-term debts or to finance the purchase of businesses. Commercialterm loans generally have terms from one to five years. They may becollateralized by the asset being acquired or other available assets and bearinterest 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.

 

Wealso provide other banking services tailored to the small business market. Wehave focused recently on diversifying our loan portfolio, which has led to anincrease in commercial real estate and commercial business loans to small andmedium sized businesses.

 

Ourportfolio of commercial loans is also subject to certain risks, including (i) downturnsin the California economy, (ii) interest rate increases; and (iii) thedeterioration of a borrower’s or guarantor’s financial capabilities. We attemptto reduce the exposure to such risks through (a) reviewing each loanrequest and renewal individually, (b) requiring a dual signature approvalsystem, (c) mandating strict adherence to written loan policies, and (d) performingexternal independent credit review. In addition, we monitor loans based onshort-term asset values on a monthly or quarterly basis. In general, during theterm of the relationship, we receive and review the financial statements of ourborrowing customers on an ongoing basis, and we promptly respond to anydeterioration that we note.

 

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

 

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

 

*Consumer Loans.*    Consumerloans include personal loans, auto loans, home improvement loans, home mortgageloans, revolving lines of credit and other loans typically made by banks toindividual borrowers. We provide consumer loan products in an effort todiversify our product line.

 

Ourconsumer loan portfolio is subject to certain risks, including:

 

· amount of credit offered to consumers in the market,

 

· interest rate increases, and

 

· consumer bankruptcy laws which allow consumers to discharge certaindebts.

 

Weattempt to reduce the exposure to such risks through the direct approval of allconsumer loans by:

 

· reviewing each loan request and renewal individually,

 

· using a dual signature system of approval,

 

· strictly adhering to written credit policies and,

 

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· performing external independent credit review.

 

**Deposit Activities and Other Sources of Funds**

 

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

 

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

 

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

 

Weoffer a variety of accounts for depositors, which are designed to attract bothshort-term and long-term deposits. These accounts include certificates ofdeposit, or “CDs”, regular savings accounts, money market accounts, checkingand negotiable order of withdrawal, or “NOW”, accounts, savings accounts,health savings accounts and individual retirement accounts, or “IRAs”. Theseaccounts generally earn interest at rates established by management based oncompetitive market factors and management’s desire to increase or decreasecertain types or maturities of deposits. As needs arise, we augment thesecustomer deposits with brokered deposits. The more significant deposit accountsoffered by us are described below:

 

*Certificates of Deposit.*    Weoffer several types of CDs with a maximum maturity of five years.  The substantial majority of our CDs have amaturity of one to twelve months and pay compounded interest typically creditedmonthly or at maturity.

 

*Regular Savings Accounts.*    Weoffer savings accounts that allow for unlimited ATM and in-branch deposits andwithdrawals. Interest is compounded daily and paid monthly.

 

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

 

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

 

*Federal Home Loan Bank Borrowings.*    Tosupplement our deposits as a source of funds for lending or investment, weborrow funds in the form of advances from the Federal Home Loan Bank. Weregularly make use of Federal Home Loan Bank advances as part of our interestrate risk management, primarily to extend the duration of funding to match thelonger term fixed rate loans held in the loan portfolio as part of our growthstrategy.

 

Asa member of the Federal Home Loan Bank system, we are required to invest inFederal Home Loan Bank stock based on a predetermined formula. Federal HomeLoan Bank stock is a restricted investment security that can only be sold toother Federal Home Loan Bank members or redeemed by the Federal Home Loan Bank.As of December 31, 2009, we owned $3,803,700 in FHLB stock.

 

Advancesfrom the Federal Home Loan Bank are typically secured by our entire real estateloan portfolio, which includes residential and commercial loans.  At December 31,2009, our borrowing limit with the Federal Home Loan Bank was approximately$118 million.

 

**Internet Banking**

 

SinceAugust 1, 2001, we have offered Internet banking service, which allows ourcustomers to access their deposit accounts through the Internet. Customers areable to obtain transaction history and account information, transfer fundsbetween accounts and make on-line bill payments. We intend to improve anddevelop our Internet banking products and delivery channels as the need arisesand our resources permit.

 

**Other Services**

 

Wealso offer ATMs located at branch offices as well as seven other ATMs atvarious off site locations, and customer access to an ATM network.

 

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**Marketing**

 

Ourmarketing relies principally upon local advertising and promotional activityand upon personal contacts by our directors, officers and shareholders toattract business and to acquaint potential customers with our personalizedservices. We emphasize a high degree of personalized client service in order tobe able to provide for each customer’s banking needs. Our marketing approachemphasizes the advantages of dealing with an independent, locally managed andstate chartered bank to meet the particular needs of consumers, professionalsand business customers in the community. Our management continually evaluatesall of our banking services with regard to their profitability and efforts andmakes determinations based on these evaluations whether to continue or modifyour business plan, where appropriate.

 

Wedo not currently have any plans to develop any new lines of business, whichwould require a material amount of capital investment on our part.

 

**Competition**

 

*Regional Branch Competition.*    Weconsider our primary service area to be composed of the counties of SanJoaquin, Stanislaus, Tuolumne, Inyo and Mono Counties.  The bankingbusiness in California generally, and in our primary service area,specifically, is competitive with respect to both loans and deposits and isdominated by a relatively small number of major banks which have many officesoperating over wide geographic areas.  These include Wells Fargo Bank,Bank of America, JP Morgan Chase Bank and Bank of the West. We compete fordeposits and loans principally with these banks, as well as with savings andloan associations, thrift and loan associations, credit unions, mortgagecompanies, insurance companies, offerors of money market accounts and otherlending institutions.

 

Amongthe advantages of these institutions is their ability to finance extensiveadvertising campaigns and to allocate their investment assets to regions ofhighest yield and demand, their ability to offer certain services, such asinternational banking and trust services which are not offered directly by theBank and, the ability by virtue of their greater total capitalization, to havesubstantially higher lending limits than we do.   In addition, as aresult of increased consolidation and the passage of interstate bankinglegislation there is and will continue to be increased competition among banks,savings and loan associations and credit unions for the deposit and loanbusiness of individuals and businesses.

 

Asof June 30, 2009, our primary service areas contained one hundredseventy-three (173) banking offices, with approximately $10.5 billion in totaldeposits.  As of June 30, 2009, we had total deposits ofapproximately $420 million, which represented approximately 4.00% of the totaldeposits in the Bank’s primary service area.  There can be no assurancethat the Bank will maintain its competitive position against current andpotential competitors, especially those with greater resources than theBank.  The deposits of the four (4) largest competing banks averagedapproximately $110 million per office as of June 30, 2009.

 

Inorder to compete with major financial institutions in our primary serviceareas, we use to the fullest extent the flexibility that our independent statuspermits.  This includes an emphasis on specialized services, localpromotional activity, and personal contacts by our officers, directors andemployees.  In the event that there are customers whose needs exceed ourlending limits, we may arrange for such loans on a participation basis withother financial institutions.  We also assist customers who require otherservices that we do not offer by obtaining such services from correspondentbanks.  However, no assurance can be given that our continued efforts tocompete with other financial institutions will be successful.

 

Inaddition to other banks, our competitors include savings institutions, creditunions, and numerous non-banking institutions, such as finance companies,leasing companies, insurance companies, brokerage firms, and investment bankingfirms. In recent years, increased competition has also developed fromspecialized finance and non-finance companies that offer money market andmutual funds, wholesale finance, credit card, and other consumer financeservices, including on-line banking services and personal finance software.Strong competition for deposit and loan products affects the rates of thoseproducts as well as the terms on which they are offered to customers.

 

*Other Competitive Factors.*    The moregeneral competitive trends in the industry include increased consolidation andcompetition. Strong competitors, other than financial institutions, haveentered banking markets with focused products targeted at highly profitablecustomer segments. Many of these competitors are able to compete acrossgeographic boundaries and provide customers increasing access to meaningful alternativesto banking services in nearly all significant products areas. Mergers betweenfinancial institutions have placed additional pressure on banks within theindustry to streamline their operations, reduce expenses, and increase revenuesto remain competitive. Competition has also intensified due to the federal andstate interstate banking laws, which permit banking organizations to expandgeographically, and the California market has been particularly attractive toout-of-state institutions. The Financial Modernization Act, which has made itpossible for full affiliations to occur between banks and securities firms,insurance companies, and other financial companies, is also expected tointensify competitive conditions.

 

Technologicalinnovations have also resulted in increased competition in the financialservices industry. Such innovations have, for example, made it possible fornon-depository institutions to offer customers automated transfer paymentservices that were 

 

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previouslyconsidered traditional banking products. In addition, many customers now expecta choice of several delivery systems and channels, including telephone, mail,home computer, ATMs, self-service branches and/or in-store branches.

 

*Business Concentration.*    Noindividual or single group of related accounts is considered material inrelation to our total assets or deposits, or in relation to our overallbusiness. However, approximately 84% of our loan portfolio held for investmentat December 31, 2009 consisted of real estate-related loans, includingconstruction loans, miniperm loans, real estate mortgage loans and commercialloans secured by real estate. Moreover, our business activities are currentlyfocused primarily in Central California, with the majority of our businessconcentrated in San Joaquin, Stanislaus, Tuolumne, Inyo and MonoCounties.  Consequently, our results of operations and financial conditionare 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 greaterrisk than other banking companies with a wider geographic base in the event ofcatastrophes, such as earthquakes, fires and floods in this region.

 

**Employees**

 

Asof December 31, 2009, we had 124 employees (104 full-time employees and 20part-time employees). None of our employees are currently represented by aunion or covered by a collective bargaining agreement.

 

**Bank Holding Company Regulation**

 

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

 

TheBHCA regulates the activities of holding companies including acquisitions,mergers, and consolidations and, together with the Gramm-Leach Bliley Act of1999, the scope of allowable banking activities.

 

**Government Policies, Legislation,and Regulatory Initiatives**

 

Thebanking and financial services business in which we engage is highly regulated.Such regulation is intended, among other things, to protect depositors insuredby the FDIC and the entire banking system. The commercial banking business isalso influenced by the monetary and fiscal policies of the federal governmentand the policies of the Board of Governors of the Federal Reserve System, alsoknown as the Federal Reserve Board. The Federal Reserve Board implementsnational monetary policies (with objectives such as curbing inflation andcombating recession) by its open-market operations in United States Governmentsecurities, by adjusting the required level of reserves for financialintermediaries subject to its reserve requirements and by varying the discountrates applicable to borrowings by depository institutions. The actions of theFederal Reserve Board in these areas influence the growth of bank loans, investmentsand deposits and affects interest rates charged on loans and paid on deposits.Indirectly such actions may also impact the ability of non-bank financialinstitutions to compete with us. The nature and impact of any future changes inmonetary policies cannot be predicted.

 

Thelaws, regulations and policies affecting financial services businesses arecontinuously under review by Congress and state legislatures and federal andstate regulatory agencies. From time to time, legislation is enacted which hasthe effect of increasing the cost of doing business, limiting or expandingpermissible activities or affecting the competitive balance between banks andother financial intermediaries. Proposals to change the laws and regulationsgoverning the operations and taxation of banks, bank holding companies andother financial intermediaries are frequently made in Congress, in theCalifornia legislature and by various bank regulatory agencies and otherprofessional agencies. Changes in the laws, regulations or policies that impactus cannot necessarily be predicted, but they may have a material effect on ourbusiness and earnings.

 

Asa California state-chartered bank whose accounts are insured by the FDIC up toa maximum of $250,000 (as approved on October 10, 2008 by the FDIC throughthe end of 2009 and later revised on May 20, 2009 to extend the coveragethrough December 31, 2013), the Bank is subject to regulation, supervisionand regular examination by the California Department of Financial Institutionsand the Federal Reserve Bank (FRB). As a member of the Federal Reserve System,we are subject to certain regulations of the Board of Governors of the FederalReserve System. The regulations of these agencies govern most aspects of ourbusiness, including the filing of periodic reports, and activities relating todividends, investments, loans, borrowings, capital requirements, certaincheck-clearing activities, branching, mergers and acquisitions, reservesagainst deposits, and numerous other areas. Supervision, legal action andexamination of us by the FRB is generally intended to protect depositors and isnot intended for the protection of our shareholders.

 

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Thefollowing discussion of statutes and regulations affecting banks is only asummary and does not purport to be complete. This discussion is qualified inits entirety by reference to such statutes and regulations. No assurance can begiven that the referenced statutes or regulations will not change in thefuture.

 

**Capital Adequacy Requirements**

 

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

 

Theguidelines divide a bank’s capital into two tiers. Tier I includes commonequity, 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 andpurchased credit card relationships, subject to certain limitations) aresubtracted from Tier I capital. Tier II capital includes, among other items,cumulative perpetual and long-term, limited-life preferred stock, mandatoryconvertible securities, certain hybrid capital instruments, term subordinateddebt 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 ratioof 8%, of which at least 4% must be Tier I capital. As of December 31,2009 and 2008, the Bank’s Total Risk-Based Capital Ratio was 13.6% and 13.3%,and our Tier 1 Risk-Based Capital Ratio was 12.3% and 12.1%, respectively.

 

Inaddition to the risk-based guidelines, federal banking regulators requirebanking organizations to maintain a minimum amount of Tier 1 capital to totalaverage assets, referred to as the leverage ratio. Banks that have received thehighest rating of the five categories used by regulators to rate banks and arenot anticipating or experiencing any significant growth must maintain a ratioof Tier 1 capital (net of all intangibles) to adjusted total assets, or “LeverageCapital Ratio”, of at least 3%. All other institutions are required to maintaina leverage ratio of at least 100 to 200 basis points above the 3% minimum, fora minimum of 4% to 5%. Pursuant to federal regulations, banks must maintaincapital levels commensurate with the level of risk to which they are exposed,including the volume and severity of problem loans. As of December 31,2009 and 2008, our Leverage Capital Ratios were 11.3% and 11.8%, respectively.

 

Federalbanking regulators may set capital requirements higher than the minimumsdescribed above for financial institutions whose circumstances warrant it. Forexample, a financial institution experiencing or anticipating significantgrowth may be expected to maintain capital positions substantially above theminimum supervisory levels without significant reliance on intangible assets.

 

**Prompt Corrective Action Provisions**

 

Federallaw requires each federal banking agency to take prompt corrective action toresolve the problems of insured financial institutions, including but notlimited to those that fall below one or more prescribed minimum capital ratios.The federal banking agencies have by regulation defined the following five capitalcategories:

 

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

 

· “adequately capitalized” (Total Risk-Based Capital Ratio of 8%; Tier 1Risk-Based Capital Ratio of 4%; and Leverage Ratio of 4% or 3% if theinstitution 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 than4% or 3% if the institution receives the highest rating from its primaryregulator),

 

· “significantly undercapitalized” (Total Risk-Based Capital Ratio ofless than 6%; Tier 1 Risk-Based Capital Ratio of less than 3%; or LeverageRatio less than 3%), and

 

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

 

Abank 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 agencyfinds an unsafe or unsound condition or practice so warrants, but no bank maybe treated as “critically undercapitalized” unless its actual capital ratiowarrants such treatment.

 

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Ateach successively lower capital category, an insured bank is subject toincreased restrictions on its operations. For example, a bank is generallyprohibited from paying management fees to any controlling persons or frommaking capital distributions, if to do so would make the bank “undercapitalized.”Asset growth and branching restrictions apply to undercapitalized banks, whichare required to submit written capital restoration plans meeting specified requirements(including a guarantee by the parent holding company, if any). “Significantlyundercapitalized” banks are subject to broad regulatory authority, includingamong other things, capital directives, forced mergers, restrictions on therates of interest they may pay on deposits, restrictions on asset growth andactivities, and prohibitions on paying certain bonuses without FRB approval.Even more severe restrictions apply to critically undercapitalized banks. Mostimportantly, except under limited circumstances, the appropriate federalbanking agency is required to appoint a conservator or receiver for an insuredbank not later than 90 days after the bank becomes criticallyundercapitalized.

 

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

 

**Dividends**

 

Thepayment of cash dividends by the Bank to Oak Valley Bancorp is subject torestrictions set forth in the California Financial Code (the “Code”).  Priorto any distribution from the Bank to Oak Valley Bancorp, a calculation is madeto ensure compliance with the provisions of the Code and to ensure that theBank remains within capital guidelines set forth by the DFI and the FRB. In theevent that the intended distribution from the Bank to Oak Valley Bancorpexceeds the restriction in the Code, advance approval from FRB is required.While advance approval may be required from the FRB for up to three years if weterminate our participation in the U.S. Treasury Capital Purchase Program,Management does not believe that these regulations will limit dividends fromthe Bank to meet the operating requirements of Bancorp for the foreseeablefuture. See Note 19 to the Consolidated Financial Statements in Item 8 of thisreport.

 

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

 

**Safety and Soundness Standards**

 

Federalbanking agencies have also adopted guidelines establishing safety and soundnessstandards for all insured depository institutions. Those guidelines relate tointernal controls, information systems, internal audit systems, loanunderwriting and documentation, compensation and interest rate exposure. Ingeneral, the standards are designed to assist the federal banking agencies inidentifying and addressing problems at insured depository institutions beforecapital becomes impaired. If an institution fails to meet these standards, theappropriate federal banking agency may require the institution to submit acompliance plan and institute enforcement proceedings, if an acceptablecompliance plan is not submitted.

 

**Premiums for Deposit Insurance**

 

Ourdeposits are insured by the FDIC to the maximum amount permitted by law, whichis currently $250,000 per depositor. On October 14, 2008, the FDICannounced the Temporary Transaction Account Guarantee Program to strengthenconfidence in the banking system. The program was subsequently extended throughJune 30, 2010.  The new rule alsoallows, at the participating FDIC-insured institutions’ option, full depositinsurance coverage for non-interest bearing transaction accounts regardless ofthe dollar amount until June 30, 2010. We have elected to participate in the program by paying a 10 basis pointsurcharge on the non-interest bearing transaction accounts over $250,000.  In addition, the FDIC has finalized a newpremium rate structure and has imposed a uniform increase in minimum assessmentfrom five cents to twelve cents annually for every $100 of domestic deposits oninstitutions that are assigned to the lowest risk category for the firstcalendar quarter of 2009.  Effective April 1,2009, assessment rates were adjusted to differentiate for risk. Banks in thebest risk category pay a base rate from twelve to sixteen cents per $100 ofdeposits. Further, on May 22, 2009, the FDIC adopted a final rule imposinga 5-basis-point emergency special assessment on all insured depositoryinstitutions on June 30, 2009 that was collected on September 30,2009. The rule also gave the FDIC the ability to impose future emergencyspecial assessments of up to 5 basis points if necessary until March 31,2010.

 

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** **

**Community Reinvestment Act**

 

Weare subject to certain requirements and reporting obligations involving theCommunity Reinvestment Act, or “CRA”. The CRA generally requires federalbanking agencies to evaluate the record of financial institutions in meetingthe credit needs of local communities, including low and moderate-incomeneighborhoods. The CRA further requires that a record be kept of whether afinancial institution meets its community credit needs, which record will betaken into account when evaluating applications for, among other things,domestic branches, consummating mergers or acquisitions, or holding companyformations. In measuring a bank’s compliance with its CRA obligations, the regulatorsnow utilize a performance-based evaluation system, which bases CRA ratings onthe bank’s actual lending service and investment performance, rather than onthe extent to which the institution conducts needs assessments, documentscommunity outreach activities or complies with other procedural requirements.In connection with its assessment of CRA performance, the FRB assigns a ratingof “outstanding,” “satisfactory,” “needs to improve” or “substantialnoncompliance.” We were last examined for CRA compliance in August 24,2009 and received an overall satisfactory CRA Assessment Rating.

 

**Anti-MoneyLaundering Regulations**

 

Aseries of banking laws and regulations beginning with the Bank Secrecy Act in1970 require banks to prevent, detect, and report illicit or illegal financialactivities to the federal government to prevent money laundering, internationaldrug trafficking, and terrorism. Under the Uniting and Strengthening America byProviding Appropriate Tools Required to Intercept and Obstruct Terrorism Act of2001, financial institutions are subject to prohibitions against specifiedfinancial transactions and account relationships as well as enhanced duediligence and “know your customer” standards in their dealings with high riskcustomers, foreign financial institutions, and foreign individuals andentities.  We have extensive controls tocomply with these requirements.

 

**Privacyand Data Security**

 

TheGramm-Leach Bliley Act (“GLBA”) of 1999 imposed requirements on financialinstitutions with respect to consumer privacy. The GLBA generally prohibits disclosure of consumer information tonon-affiliated third parties unless the consumer has been given the opportunityto object and has not objected to such disclosure.  Financial institutions are further requiredto disclose their privacy policies to consumers annually.  The GLBA also directs federal regulators,including the FRB, to prescribe standards for the security of consumerinformation.  We are subject to suchstandards, as well as standards for notifying consumers in the event of asecurity breach.  We must disclose ourprivacy policy to consumers and permit consumers to “opt out” of havingnon-public customer information disclosed to third parties.  We are required to have an informationsecurity program to safeguard the confidentiality and security of customerinformation and to ensure proper disposal. Customers must be notified when unauthorized disclosure involvessensitive customer information that may be misused.

 

**Other Consumer Protection Laws and Regulations**

 

Bankregulatory agencies are increasingly focusing on compliance with consumerprotection laws and regulations. Examination and enforcement has becomeintense, and banks have been advised to monitor compliance carefully withvarious consumer protection laws and their implementing regulations. Forexample, the federal Interagency Task Force on Fair Lending issued a policystatement on discrimination in home mortgage lending describing three methodsthat federal agencies will use to prove discrimination: overt evidence ofdiscrimination, evidence of disparate treatment, and evidence of disparateimpact. In addition to CRA and fair lending requirements, we are subject tonumerous other federal consumer protection statutes and regulations. Due toheightened regulatory concern related to compliance with consumer protectionlaws and regulations generally, we may incur additional compliance costs or berequired to expend additional funds for investments in the local communities weserve.

 

**Interstate Banking and Branching The Riegle-Neal**

 

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

 

Since1995, adequately capitalized and managed bank holding companies have beenpermitted to acquire banks located in any state, subject to two exceptions:first, any state may still prohibit bank holding companies from acquiring abank which is less than five years old; and second, no interstate acquisitioncan be consummated by a bank holding company if the acquirer would control morethan 10% of the deposits held by insured depository institutions nationwide or30% or more of the deposits held by insured depository institutions in anystate in which the target bank has branches.

 

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Abank may establish and operate*de novo*branches in any state in which the bank does not maintain a branch, if thatstate has enacted legislation to expressly permit all out-of-state banks toestablish branches in that state.

 

In1995, California enacted legislation to implement important provisions of theInterstate Banking Act and to repeal California’s previous interstate bankinglaws, which were largely preempted by the Interstate Banking Act.

 

Thechanges effected by the Interstate Banking Act and California laws haveincreased competition in our market by permitting out-of-state financialinstitutions to enter our market areas directly or indirectly. We believe thatthe Interstate Banking Act has contributed to the accelerated consolidation ofthe banking industry. Although many large out-of-state banks have alreadyentered the California market as a result of this legislation, it is notpossible to predict the precise impact of this legislation on us and thecompetitive environment in which we operate.

 

**USA Patriot Act of 2001**

 

OnOctober 26, 2001, President Bush signed the USA Patriot Act of 2001, or “PatriotAct”. The Patriot Act was enacted in response to the terrorist attacks in NewYork, Pennsylvania and Washington, D.C. on September 11, 2001, and isintended to strengthen U.S. law enforcement’s and the intelligence community’sability to work cohesively to combat terrorism on a variety of fronts. Thepotential impact of the Patriot Act on financial institutions is significantand wide ranging. The Act contains sweeping anti-money laundering and financialtransparency laws and requires various regulations, including:

 

· due diligence requirements for financial institutions that administer,maintain, or manage private bank accounts or correspondent accounts fornon-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 interrorism or money laundering,

 

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

 

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

 

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

 

**The Sarbanes-Oxley Act of 2002**

 

OnJuly 30, 2002, President Bush signed into law The Sarbanes-Oxley Act of2002, or “Sarbanes-Oxley Act”. The Sarbanes-Oxley Act addresses accountingoversight and corporate governance matters relating to the operations of publiccompanies. During 2003, the Commission issued a number of regulations under thedirective of the Sarbanes-Oxley Act significantly increasing public companygovernance-related obligations and filing requirements, including:

 

· the establishment of an independent public oversight of public companyaccounting firms by a board that will set auditing, quality and ethicalstandards for and have investigative and disciplinary powers over suchaccounting firms,

 

· the enhanced regulation of the independence, responsibilities andconduct of accounting firms which provide auditing services to publiccompanies,

 

· the increase of penalties for fraud related crimes,

 

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

 

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

 

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

 

TheSarbanes-Oxley Act, the Commission rules promulgated thereunder, and thenew Nasdaq governance requirements have required the Bank to review its currentprocedures and policies to determine whether they comply with the newlegislation and its implementing regulations. Oak Valley Bancorp will beprimarily responsible for ensuring compliance with Sarbanes-Oxley and theNasdaq governance rules, as applicable. Although the impact these newrequirements will have upon the Oak Valley Bancorp’s and the Bank’s operationsis not entirely clear, the Bank has already experienced an increase inexpenditures associated with certain outside professional costs necessary forcompliance.

 

**TheEmergency Economic Stabilization Act and its Related Government Policies,Legislations, and Regulations**

 

Dramaticnegative developments in the latter half of 2007 in the subprime mortgagemarket and the securitization markets for such loans, together with volatilityin oil prices and other factors, have resulted in uncertainty in the financialmarkets in general and a related economic downturn, which continued through2009 and is anticipated to continue through 2010. Dramatic declines in thehousing market, with decreasing home prices and increasing delinquencies andforeclosures, have negatively impacted the credit performance of mortgage and constructionloans and resulted in significant write-downs of assets by many financialinstitutions. In addition, the values of real estate collateral supporting manycommercial and residential loans have declined and may continue to decline.General downward economic trends, reduced availability of commercial credit andincreasing unemployment have negatively impacted the credit performance ofcommercial and consumer credit, resulting in additional write-downs. Concernsover the stability of the financial markets and the economy have resulted indecreased lending by many financial institutions to their customers and to eachother. This market turmoil and tightening of credit has led to increasedcommercial and consumer delinquencies, lack of customer confidence, increasedmarket volatility and widespread reduction in general business activity.Competition among depository institutions for deposits has increasedsignificantly. Bank and bank holding company stock prices have been negativelyaffected as has the ability of banks and bank holding companies to raisecapital or borrow in the debt markets compared to recent years. Bank regulatorshave been very aggressive in responding to concerns and trends identified in examinations,and this has resulted in the increased issuance of formal and informalenforcement orders and other supervisory actions requiring action to addresscredit quality, liquidity and risk management and capital adequacy, as well asother safety and soundness concerns.

 

OnOctober 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 theirlending to customers and to each other. Initially introduced as the TroubledAsset Relief Program (“TARP”), the EESA authorized the United States Departmentof the Treasury (“U.S. Treasury”) to purchase from financial institutions andtheir holding companies up to $700 billion in mortgage loans, mortgage-relatedsecurities and certain other financial instruments, including debt and equitysecurities issued by financial institutions and their holding companies.Initially, $350 billion was made immediately available to the U.S. Treasury. OnJanuary 15, 2009, the remaining $350 billion was released to the U.S.Treasury.

 

OnOctober 14, 2008, the U.S. Treasury announced its intention to injectcapital into nine large U.S. financial institutions under the TARP Capital PurchaseProgram (the “TARP CPP”), and since has injected capital into many otherfinancial institutions, including the Company. The U.S. Treasury initiallyallocated $250 billion towards the TARP CPP.

 

Inorder to participate in the TARP CPP, financial institutions were required toadopt certain standards for executive compensation and corporate governance.These standards generally apply to the Chief Executive Officer, Chief FinancialOfficer and the three next most highly compensated senior executive officers.The standards include (1) ensuring that incentive compensation for namedsenior executives does not encourage unnecessary and excessive risks thatthreaten the value of the financial institution; (2) required clawback ofany bonus or incentive compensation paid to a senior executive based onstatements of earnings, gains or other criteria that are later proven to bematerially inaccurate; (3) prohibition on making golden parachute paymentsto senior executives; and (4) agreement not to deduct for tax purposesexecutive compensation in excess of $500,000 for each senior executive. TheCompany has complied with these requirements and will continue to comply.

 

Thebank regulatory agencies, U.S. Treasury and the Office of Special InspectorGeneral, also created by the EESA, have issued guidance and requests to thefinancial institutions that participated in the TARP CPP to document theirplans and use of TARP CPP funds and their plans for addressing the executivecompensation requirements associated with the TARP CPP. The Company hasreceived and responded to that request.

 

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On February 17, 2009, the American Recovery andReinvestment Act of 2009 (“ARRA”) was signed into law by President Obama. TheARRA includes a wide variety of programs intended to stimulate the economy andprovide for extensive infrastructure, energy, health, and education needs. Inaddition, the ARRA imposes certain new executive compensation and corporateexpenditure limits on all current and future TARP recipients, including theCompany, until the institution has repaid the U.S. Treasury, which is nowpermitted under the ARRA without penalty and without the need to raise newcapital, subject to the U.S. Treasury’s consultation with the recipient’sappropriate regulatory agency.

 

The ARRA executive compensation standards that wentinto effect on September 14, 2009 are more stringent than those currentlyin 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 onbonuses, retention awards and other incentive compensation, other thanrestricted stock grants which do not fully vest during the TARP CPP period upto one-third of an employee’s total annual compensation, (ii) prohibitionson golden parachute payments for departures, (iii) an expanded clawback ofbonuses, retention awards, and incentive compensation if payment is based onmaterially inaccurate statements of earnings, revenues, gains or othercriteria, (iv) prohibitions on compensation plans that encouragemanipulation of reported earnings, (v) retroactive review of bonuses,retention awards and other compensation previously provided by TARP CPPrecipients if found by the U.S. Treasury to be inconsistent with the purposesof TARP CPP or otherwise contrary to public interest, (vi) requiredestablishment of a company-wide policy regarding “excessive or luxuryexpenditures,” and (vii) inclusion in a participant’s proxy statements forannual shareholder meetings of a nonbinding “Say on Pay” shareholder vote onthe compensation of executives.

 

**Environmental Regulations**

 

In the course of our business, we may foreclose andtake title to real estate, and could be subject to environmental liabilitieswith respect to these properties. We may be held liable to a governmentalentity or to third parties for property damage, personal injury, investigationand clean-up costs incurred by these parties in connection with environmentalcontamination, or may be required to investigate or clean up hazardous or toxicsubstances, or chemical releases at a property. The costs associated withinvestigation or remediation activities could be substantial. In addition, asthe owner or former owner of a contaminated site, we may be subject to common lawclaims by third parties based on damages and costs resulting from environmentalcontamination emanating from the property. If we ever become subject tosignificant 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 whichcould affect us and the banking industry, in general, are pending andadditional initiatives may be proposed or introduced before the United StatesCongress, the California legislature and other governmental bodies in thefuture. Such proposals, if enacted, may further alter the structure, regulationand competitive relationship among financial institutions, and may subject usto increased regulation, disclosure and reporting requirements. In addition,the various banking regulatory agencies often adopt new rules andregulations to implement and enforce existing legislation. We cannot predictwhether, or in what form, any such legislation or regulations may be enacted orthe extent to which our business would be affected thereby.

 

**Available Information**

 

The Company maintains an Internet website athttp://www.ovcb.com.  The Company makes available its annualreports on Form 10-K, quarterly reports on Form 10-Q, current reportson Form 8-K and amendments to such reports filed or furnished pursuant to Section 13(a) or15(d) of the Securities Exchange Act of 1934, as amended, and otherinformation related to the Company free of charge, through this site as soon asreasonably practicable after it electronically files those documents with, orotherwise furnishes them to, the SEC. The Company’s internet website and theinformation contained therein or connected thereto are not intended to beincorporated into this annual report on Form 10-K.

 

**ITEM 1A.  RISK FACTORS**

 

Not applicable.

 

**ITEM 1B.  UNRESOLVED STAFF COMMENTS**

 

None.

 

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**ITEM 2. PROPERTIES**

 

Our main office is located in a complex at 125 NorthThird Avenue, Oakdale, CA 95361, in downtown Oakdale.  The building has anautomated teller machine and onsite parking.  The Bank’s complex occupiesapproximately 20,000 square feet of space.

 
| **Property Location and  Address** | ** ** | **Square  Footage** | ** ** | **Lease  Expiration Date** | ** ** | **Lease  Extension Options** |
|----------------------------------------------|------------|---------------------|------------|---------------------------------|------------|-----------------------------------|
| ** **                                   | ** ** | ** **          | ** ** | ** **                      | ** ** | ** **                        |
| Oakdale, 125 N. 3rd Ave.                |       | 9,600               |       | n/a*                            |       | n/a*                              |
| Oakdale, 338 F Street                        |       | 9,860               |       | 3/2017                          |       | three, 5-year   term extensions   |
| Sonora, 14580 Mono Way                       |       | 2,500               |       | 4/2013                          |       | n/a                               |
| Modesto, 12th & I Street            |       | 4,500               |       | 3/2016                          |       | two, 5-year   term extensions     |
| Bridgeport, 166 Main  Street                 |       | 2,875               |       | n/a*                            |       | n/a*                              |
| Mammoth Lakes, 170  Mountain Blvd.           |       | 1,856               |       | n/a*                            |       | n/a*                              |
| Bishop, 351 North Main  Street               |       | 3,680               |       | 8/2014                          |       | two, 5-year  term extensions      |
| Modesto, 4120 Dale Road                      |       | 4,500               |       | 3/2015                          |       | two, 5-year  term extensions      |
| Turlock, 2001 Geer Road                      |       | 2,400               |       | 1/2015                          |       | two, 5-year  term extensions      |
| Patterson, 20 Plaza Circle                   |       | 2,100               |       | n/a*                            |       | n/a*                              |
| Escalon, 1910 McHenry Ave.                   |       | 3,500               |       | 4/2021                          |       | two, 5-year   term extensions     |
| Ripon, 150 North Wilma  Ave.                 |       | 1,800               |       | 1/2011                          |       | two, 5-year   term extensions     |
| Stockton, 2935 West  March Lane         |       | 8,000               |       | 12/2022                         |       | two, 5-year   term extensions     |

 

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*                 The Bank owns this property.

 

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

 

**ITEM 3. LEGAL PROCEEDINGS**

 

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

 

We believe that there are no material litigationmatters at the current time. Although the results of such litigation mattersand claims cannot be predicted with certainty, we believe that the finaloutcome of any such claims and proceedings will not have a material adverseimpact on the Company’s financial position, liquidity, or results ofoperations.

 

**ITEM 4.  RESERVED**

 

 

 

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**PART II**

 

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

 

**Price Range of Common Stock**

 

Our common stock is traded on the NASDAQ CapitalMarket under the symbol “OVLY.”  Thefollowing table sets forth the high and low closing bid prices (which reflectprices between dealers and do not include retail markup, markdown or commissionand may not represent actual transactions) for the current year and the threecalendar years ended December 31, 2009, 2008 and 2007, respectively. From time to time, during the periods indicated, trading activity in our commonstock was infrequent.  The source of the quotes is The Nasdaq StockMarket, LLC.

 
| ** **                                    | ** ** | **Closing Sale Price(1)** | ** ** |
|-----------------------------------------------|------------|-------------------------------------|------------|
| **For Calendar Quarter Ended** | ** ** | **High**                            | ** ** | **Low** | ** ** |
|                                          |       |                                |       |   |   |
| 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 |   |
| March 31, 2009                           |       | 6.00                                |       | 3.75 |   |
| June 30, 2009                            |       | 4.92                                |       | 2.75 |   |
| September 30, 2009                       |       | 5.10                                |       | 3.75 |   |
| December 31, 2009                        |       | 5.00                                |       | 4.10 |   |

----

*(1)*       Figures through June 30,2008 refer to Bank common stock prices.

 

On March 26, 2010, the closing price of ourcommon stock was $4.50 per share; and there were approximately 525 shareholdersof record of the common stock and 7,681,877 outstanding shares of common stock.

 

**Dividends**

 

Our ability to pay any cash dividends will dependnot only upon our earnings during a specified period, but also on our meetingcertain capital requirements.

 

Shareholders are entitled to receive dividends onlywhen and if dividends are declared by our Board of Directors. Although we havepaid dividends in the past, it is no guarantee that we will continue payingcash dividends in the future.

 

Prior to the bank holding company reorganization in2008, the Bank has historically declared and paid a dividend on its commonstock every year since 1996.  Dividends for the year ended December 31,2009, 2008 and 2007 were $0.025, $0.075 and $0.19 per share of common stock,respectively.

 

The following table shows stock splits declared forthe five years ended December 31, 2009:

 
| **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 31,2009 with respect to shares of our common stock that are issued and currentlyoutstanding under the Bank’s 1998 Restated Stock Option Plan (the “1998Restated Stock Option Plan”), and the number of shares that are authorized tobe issued under the Company’s 2008 Stock Option Plan (the “2008 Equity Plan”).  Figures in the table have been retroactivelyadjusted 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         |       | 385,762                                                                          |       | $                                                                | 7.08       |                                                                                                                                       | 1,497,500  |   |
| Equity Compensation Plans  Not Approved by Shareholders (1) |       | 350,346                                                                          |       | 5.78                                                             |       | 0                                                                                                                                          |       |
| Total                                                       |       | 736,108                                                                          |       | $                                                                | 6.46       |                                                                                                                                       | 1,497,500  |   |

----

*(1)*       Consists of a warrant issued to the U.S. Treasuryto purchase 350,346 shares of the Company’s common stock. The warrant isimmediately exercisable and has a 10-year term with an initial exercise priceof $5.78 pursuant to a Letter Agreement of Securities Purchase dated December 5,2008.

 

**ITEM 6.  SELECTED CONSOLIDATED FINANCIAL DATA**

 

Not applicable.

 

**ITEM 7.  MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

Thefollowing discussion of  financialcondition as of December 31, 2009 and 2008 and results of operations foreach of the years in the three-year period ended December 31, 2009 shouldbe read in conjunction with our consolidated financial statements and relatednotes thereto, included in this report. Average balances, including balances used in calculating certainfinancial ratios, are generally comprised of average daily balances.

 

**Forward-Looking Statements**

 

This discussion offinancial results includes forward-looking statements within the meaning of Section 27Aof the Securities Act of 1933, as amended, (the “1933 Act”) and Section 21Eof the Securities Exchange Act of 1934, as amended, (the “1934 Act”). Thosesections of the 1933 Act and 1934 Act provide a “safe harbor” forforward-looking statements to encourage companies to provide prospectiveinformation about their financial performance so long as they providemeaningful, cautionary statements identifying important factors that couldcause actual results to differ significantly from projected results.

 

Our forward-looking statementsinclude descriptions of plans or objectives of Management for futureoperations, products or services, and forecasts of our revenues, earnings orother measures of economic performance. Forward-looking statements can beidentified by the fact that they do not relate strictly to historical orcurrent 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 statementsare based on Management’s current expectations regarding economic, legislative,and regulatory issues that may impact our earnings in future periods. A numberof factors — many of which are beyond Management’s control — could cause futureresults to vary materially from current Management’s expectations. Such factorsinclude, but are not limited to, general economic conditions, the currentfinancial turmoil in the United States and abroad, changes in interest rates,deposit flows, real estate values and industry competition; changes inaccounting principles, policies or guidelines; changes in legislation orregulation; and other economic, competitive, governmental, regulatory andtechnological factors affecting our operations, pricing, products and services.Forward-looking statements speak only as of the date they are made. We do notundertake to update forward-looking statements to reflect circumstances orevents that occur after the date the forward-looking statements are made or toreflect the occurrence of unanticipated events.

 

**Introduction**

 

Ourcontinued focus on responsible community banking fundamentals and our strongcustomer relationships have enabled us to continue to remain profitable in2009, and have led to higher deposits, a core funding source for our steadyloan growth.

 

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As of December 31, 2009, we had approximately$525 million in total assets, $425 million in total loans, and $429 million intotal deposits.

 

We believe the following were key indicators of ourperformance for operations during 2009:

 

· our total assets increased to $525 millionat the end of 2009, or an increase of 3.3%, from $508 million at the end of2008.

 

· our total deposits increased to $429 millionat the end of 2009, or an increase of 13.5%, from $378 million at the end of2008.

 

· our total net loans decreased slightly to$418 million at the end of 2009, a decrease of 0.9%, from $422 million at theend of 2008.

 

· our ratio of total non-performing loans tototal loans increased to 3.4% at December 31, 2009 from 1.1% at December 31,2008.  Management considers that the sizeof the ratio of non-performing assets to total loans is moderate andmanageable, and reserves have been taken appropriately.

 

· net interest income increased $3.1 millionor 15.2% in 2009 compared to 2008, mainly as a result of an increase in the netinterest margin from 4.72% to 4.99% and an increase in average earning assetsof $45.6 million.

 

· provision for loan losses increased $3.7million or 168% to $5.9 million in 2009 compared to $2.2 million in 2008.

 

· total noninterest income increased to $2.64million in 2009, an increase of 4.7%, from $2.52 million in 2008. We primarilyattribute this increase to our efforts to expand our deposit account base anddiversify our non-interest revenue sources.

 

· total noninterest expense increased from$17.9 million in 2008 to $18.2 million in 2009, reflecting the increase in fairmarket value write downs on other real estate owned and increased assessmentsfrom regulatory agencies.

 

These items, as well as other factors, contributedto the decrease in net income available to common shareholders for 2009 to$1.16 million from $2.10 million in 2008, which translates into $0.15 perdiluted common share in 2009 and $0.27 per diluted common share in 2008.

 

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

 

**2010 Outlook**

 

As we begin our strategic business plan for 2010, weare continuing to pursue opportunities for growth in our existing markets, aswell as opportunities to expand into new markets through*  de novo*  branching. Further, we expect that ourportfolio of small business loans will overall experience additional growth in2010 as a result of targeted marketing efforts in this area.

 

In 2010, we are continuing to focus on loan andaccount growth and managing our net interest margin, while attempting tocontrol expenses and credit losses and manage our business to achieve our netincome and other objectives. We are also continuing to utilize strategies tocontrol other operating expenses. These efforts are important for us tocontinue to attract new accounts and grow loans. However, we will continue tostrive to be more efficient and focus on controlling the growth of theseexpenses so that they grow more slowly than the growth in loans.

 

Although interest rates remained flat at historiclows in 2009, we have increased our net interest margin with continued growthin net interest income, which we expect could slightly compress in 2010 ifinterest rates begin to increase.  Thispotential compression of net interest margin and net interest income would be alikely outcome if interest rates increase given that are balance sheet isliability sensitive to interest rate changes primarily due to the number ofloans currently at their contractual rate floors and competitive pressures toincrease deposit rates.  This could inturn result in a slower increase on the yield of earning assets compared to thecost of deposits and other funds. Ideally, if we experience an increase in our yield on earnings assets wecould then determine to increase the interest rates we pay on our depositaccounts or change our promotional or other interest rates on new deposits inmarketing activation programs to attempt to achieve a certain net interestmargin. In light of the current economic environment, it may not be possible tomanage the interest margin in this manner, as competitive pressures may dictatethat we increase deposit rates at a faster rate than the earning assetsincrease, thereby further compressing the net interest margin.  Any increases in the rates we charge onaccounts could have an effect on our efforts to attract new customers and growloans, particularly with the continuing competition 

 

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inthe commercial and consumer lending industry. The economies and real estatemarkets in our primary market areas will continue to be significantdeterminants of the quality of our assets in future periods and, thus, ourresults of operations, liquidity and financial condition. Current economicindicators suggest that the national economy and the economies in our primarymarket areas are facing a downturn but the length and severity of it aredifficult to predict.

 

For 2010, management remains focused on the abovechallenges and opportunities and other factors affecting the business similarto the factors driving 2009 results as discussed in this section.

 

***Holding Company***

 

Effective July 3, 2008, Oak Valley CommunityBank became a subsidiary of Oak Valley Bancorp, a newly established bankholding company. Oak Valley Bancorp operates Oak Valley Community Bank as acommunity bank in the general commercial banking business, with our primarymarket encompassing the California Central Valley around Oakdale and Modesto,and the Eastern Sierras.**** As such, unless otherwise noted, allreferences are about Oak Valley Community Bank.

 

In the bank holding company reorganization, alloutstanding shares of common stock of the bank were exchanged for an equalnumber of shares of common stock of Oak Valley Bancorp, which now owns the Bankas its wholly-owned subsidiary. Management believes that operating the Bankwithin a holding company structure, among other things:

 

· provides greater operating flexibility thanis currently enjoyed by us.

 

· facilitates the acquisition of relatedbusinesses as opportunities arise.

 

· improves our ability to diversify.

 

· enhances our ability to remain competitivein the future with other companies in the financial services industry that areorganized in a holding company structure.

 

·enhances our ability to raise capital to supportgrowth.

 

Thefinancial statements and discussion thereof contained in this report forperiods subsequent to the reorganization relate to the consolidated financialstatements of Oak Valley Bancorp. Periods prior to the reorganization relate to the Bank only.  The information is comparable as the solesubsidiary of Oak Valley Bancorp is the Bank.

 

**Critical Accounting Policies**

 

Criticalaccounting policies are those that are both most important to the portrayal ofour financial condition and results of operations and require management’s mostdifficult, subjective, or complex judgments, often as a result of the need tomake estimates about the effect of matters that are inherently uncertain.

 

The discussion and analysis of our financialcondition and results of operations is based upon our financial statements,which have been prepared in accordance with accounting principles generallyaccepted in the United States of America. The preparation of these financial statements requiresmanagement to make estimates and judgments that effect the reported amounts ofassets and liabilities, revenues and expenses, and related disclosures ofcontingent assets and liabilities at the date of our financial statements.Actual results may differ from these estimates under different assumptions orconditions. In addition, GAAP itself may change from one previously acceptablemethod to another method, although the economics of our transactions would bethe same.

 

Managementhas determined the following accounting policies to be critical:

 

***Asset Impairment Judgments***

 

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

 

Our available for sale portfolio is carried atestimated fair value, with any unrealized gains and losses, net of taxes,reported as accumulated other comprehensive income in stockholders” equity. Weconduct a periodic review and evaluation of the securities portfolio todetermine if the value of any security has declined below its carrying valueand whether such decline is other than temporary. If such decline is deemedother than temporary, we would adjust the carrying amount of the security bywriting down the 

 

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securityto fair market value through a charge to current period income. The marketvalues of our securities are significantly affected by changes in interestrates.

 

In general, as interest rates rise, the market valueof fixed-rate securities will decrease; as interest rates fall, the marketvalue of fixed-rate securities will increase. With significant changes ininterest rates, we evaluate our intent and ability to hold the security for asufficient time to recover the recorded principal balance. Estimated fairvalues for securities are based on published or securities dealers marketvalues. Market volatility is unpredictable and may impact such values.

 

***Allowance for Loan Losses***

 

Credit risk is inherent in the business of lendingand making commercial loans.  Accountingfor our allowance for loan losses involves significant judgment and assumptionsby management and is based on historical data and management’s view of thecurrent economic environment. At least on a quarterly basis, our managementreviews the methodology and adequacy of allowance for loan losses and reportsits assessment to the Board of Directors for its review and approval.

 

Theallowance for loan losses is an estimate of probable incurred losses withregard to our loans.  Our loan lossprovision for each period is dependent upon many factors, including loangrowth, net charge-offs, changes in the composition of the loans,delinquencies, management’s assessment of the quality of the loans, thevaluation of problem loans and the general economic conditions in our marketarea.  We base our allowance for loanlosses on an estimation of probable losses inherent in our loan portfolio.

 

Our methodology for assessing loan loss allowancesare intended to reduce the differences between estimated and actual losses andinvolves a detailed analysis of our loan portfolio, in three phases:

 

· the specific review of individual loans,

 

· the segmenting and review of loan pools withsimilar characteristics, and

 

· our judgmental estimate based on varioussubjective factors:

 

The first phase of our methodology involves thespecific review of individual loans to identify and measure impairment. Weevaluate each loan by use of a risk rating system, except for homogeneousloans, such as automobile loans and home mortgages. Specific risk rated loansare deemed impaired if all amounts, including principal and interest, willlikely not be collected in accordance with the contractual terms of the relatedloan agreement. Impairment for commercial and real estate loans is measuredeither 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 ofthe collateral, less selling and holding costs.

 

The second phase involves the segmenting of theremainder of the risk rated loan portfolio into groups or pools of loans, togetherwith loans with similar characteristics, for evaluation. We determine thecalculated loss ratio to each loan pool based on its historical net losses andbenchmark it against the levels of other peer banks.

 

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

 

· 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,

 

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· lending policies and procedures,

 

· economic and business conditions, and

 

· other external factors.

 

Our management estimates the probable effect of suchconditions based on our judgment, experience and known or anticipated trends.Such estimation may be reflected as an additional allowance to each group ofloans, if necessary. Management reviews these conditions with our senior creditofficers. To the extent that any of these conditions is evidenced by aspecifically identifiable problem credit or portfolio segment as of theevaluation date, managements estimate of the effect of such condition may bereflected as a specific allowance applicable to such credit or portfoliosegment. 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 isreflected in the unallocated allowance

 

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

 

It isthe policy of management to maintain the allowance for loan losses at a leveladequate for risks inherent in the overall loan portfolio, however, the loanportfolio can be adversely affected if the State of California’s economicconditions and its real estate market in our general market area were tofurther deteriorate or weaken. Additionally, further weakness of a prolongednature in the agricultural and general economy would have a negative impact onthe local market. The effect of such economic events, although uncertain andunpredictable at this time, could result in an increase in the levels of nonperformingloans and additional loan losses, which could adversely affect our futuregrowth and profitability. No assurance of the level of predicted credit lossescan be given with any certainty.

 

***Non-Accrual Loan Policy***

 

Interest on loans is credited to income as earnedand is accrued only if deemed collectible. Accrual of interest is discontinuedwhen a loan is over 90 days delinquent or if management believes thatcollection is highly uncertain. Generally, payments received on nonaccrualloans are recorded as principal reductions. Interest income is recognized afterall principal has been repaid or an improvement in the condition of the loanhas occurred that would warrant resumption of interest accruals.

 

***Stock-Based Compensation***

 

The Bank recognizes in the income statement thegrant-date fair value of stock options and other equity-based forms ofcompensation issued to employees over the employees” requisite service period(generally the vesting period).  TheBank  uses straight-line recognition ofexpenses for awards with graded vesting. The Bank utilizes a binomial pricing model for all grants. Expectedvolatility is based on the historical volatility of the price of the Bank’sstock. The Bank uses historical data to estimate option exercise and stockoption forfeiture rates within the valuation model. The expected term ofoptions granted for the binomial model is derived from applying a historicalsuboptimal exercise factor to the contractual term of the grant. For binomialpricing, the risk-free rate for periods is equal to the U.S. Treasury yield atthe time of grant and commensurate with the contractual term of the grant.

 

***Other Real Estate Owned***

 

Other real estate owned, which represents realestate acquired through foreclosure, or deed in lieu of foreclosure insatisfaction of commercial and real estate loans, is carried at the lower ofcost or estimated fair value less the estimated selling costs of the realestate. The fair value of the property is based upon a current appraisal. Thedifference between the fair value of the real estate collateral and the loanbalance at the time of transfer is recorded as a loan charge off if fair valueis lower. Subsequent to foreclosure, management periodically performsvaluations and the OREO property is carried at the lower of carrying value orfair value, less costs to sell. The determination of a property’s estimated fair value incorporates (1) revenuesprojected to be realized from disposal of the property, (2) constructionand renovation costs, (3) marketing and transaction costs, and (4) holdingcosts (e.g., property taxes, 

 

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insuranceand homeowners” association dues). Any subsequent declines in the fair value ofthe OREO property after the date of transfer are recorded through a write-downof the asset. Any subsequent operating expenses or income, reduction inestimated fair values, and gains or losses on disposition of such propertiesare charged or credited to current operations.

 

***Fair Value Measurements***

 

We use fair value measurements to record fair valueadjustments to certain assets and liabilities and to determine fair valuedisclosures. We base our fair values on the price that would be received tosell an asset or paid to transfer a liability in an orderly transaction betweenmarket participants at the measurement date. Securities available for sale,derivatives, and loans held for sale, if any, are recorded at fair value on arecurring basis. Additionally, from time to time, we may be required to recordcertain assets at fair value on a non-recurring basis, such as certain impairedloans held for investment and securities held to maturity  that are other-than-temporarily impaired.These non-recurring fair value adjustments typically involve write-downs ofindividual assets due to application of lower-of-cost or market accounting.

 

We have established and documented a process fordetermining fair value. We maximize the use of observable inputs and minimizethe use of unobservable inputs when developing fair value measurements.Whenever there is no readily available market data, Management uses its bestestimate and assumptions in determining fair value, but these estimates involveinherent uncertainties and the application of Management’s judgment. As aresult, if other assumptions had been used, our recorded earnings ordisclosures could have been materially different from those reflected in thesefinancial statements. For detailed information on our use of fair valuemeasurements and our related valuation methodologies, see Note 16 to theConsolidated Financial Statements in Item 8 of this Form 10-K.

 

**Recently Issued Accounting Standards**

 

*Accounting Standards Codification*. The Financial Accounting StandardsBoard’s (FASB) Accounting Standards Codification (ASC) became effective on July 1,2009. At that date, the ASC became FASB’s officially recognized source ofauthoritative U.S. generally accepted accounting principles (GAAP) applicableto all public and non-public non-governmental entities, superseding existingFASB, American Institute of Certified Public Accountants (AICPA), EmergingIssues Task Force (EITF) and related literature. Rules and interpretivereleases of the SEC under the authority of federal securities laws are alsosources of authoritative GAAP for SEC registrants. All other accountingliterature is considered non-authoritative. The switch to the ASC affects theaway companies refer to U.S. GAAP in financial statements and accountingpolicies. Citing particular content in the ASC involves specifying the uniquenumeric path to the content through the Topic, Subtopic, Section andParagraph structure.

 

*FASB ASC Topic 815, “Derivatives andHedging.”* Newauthoritative accounting guidance under ASC Topic 815, “Derivatives andHedging,” amends prior guidance to amend and expand the disclosure requirementsfor derivatives and hedging activities to provide greater transparency about (i) howand why an entity uses derivative instruments, (ii) how derivativeinstruments and related hedge items are accounted for under ASC Topic 815, and (iii) howderivative instruments and related hedged items affect an entity’s financialposition, results of operations and cash flows. To meet those objectives, thenew authoritative accounting guidance requires qualitative disclosures aboutobjectives and strategies for using derivatives, quantitative disclosures aboutfair value amounts of gains and losses on derivative instruments anddisclosures about credit-risk-related contingent features in derivativeagreements. The new authoritative accounting guidance under ASC Topic 815became effective for the Company on January 1, 2009 and did not have asignificant impact on the Company’s financial statements.

 

*FASB ASC Topic 820, “Fair ValueMeasurements and Disclosures.”*New authoritative accounting guidance under ASC Topic820,”Fair Value Measurements and Disclosures,” affirms that the objective offair value when the market for an asset is not active is the price that wouldbe received to sell the asset in an orderly transaction, and clarifies andincludes additional factors for determining whether there has been asignificant decrease in market activity for an asset when the market for thatasset is not active. ASC Topic 820 requires an entity to base its conclusionabout whether a transaction was not orderly on the weight of the evidence. Thenew accounting guidance amended prior guidance to expand certain disclosurerequirements. The Company adopted the new authoritative accounting guidanceunder ASC Topic 820 during the first quarter of 2009. Adoption of the newguidance did not significantly impact the Company’s financial statements.

 

Further new authoritative accounting guidance(Accounting Standards Update No. 2009-5) under ASC Topic 820 providesguidance for measuring the fair value of a liability in circumstances in whicha quoted price in an active market for the identical liability is notavailable. In such instances, a reporting entity is required to measure fairvalue utilizing a valuation technique that uses (i) the quoted price ofthe identical liability when traded as an asset, (ii) quoted prices forsimilar liabilities or similar liabilities when traded as assets, or (iii) anothervaluation technique that is consistent with the existing principles of ASCTopic 820, such as an income approach or market approach. The new authoritativeaccounting guidance also clarifies that when estimating the fair value of aliability, a reporting entity is not required to include a separate input oradjustment to other inputs relating to the existence of a 

 

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restrictionthat prevents the transfer of the liability. The forgoing new authoritativeaccounting guidance under ASC Topic 820 became effective for the Company’sfinancial statements beginning October 1, 2009 and did not have asignificant impact on the Company’s financial statements.

 

*FASB ASC Topic 320, “Investments —Debt and Equity Securities.”* New authoritative accounting guidance under ASC Topic320, “Investments — Debt and Equity Securities,” (i) changes existingguidance for determining whether an impairment is other than temporary to debtsecurities and (ii) replaces the existing requirement that the entity’smanagement assert it has both the intent and ability to hold an impairedsecurity until recovery with a requirement that management assert: (a) itdoes not have the intent to sell the security; and (b) it is more likelythan not it will not have to sell the security before recovery of its costbasis. Under ASC Topic 320, declines in the fair value of held-to-maturity andavailable-for-sale securities below their cost that are deemed to be other thantemporary are reflected in earnings as realized losses to the extent theimpairment is related to credit losses. The amount of the impairment related toother factors is recognized in other comprehensive income. The Company adoptedthe provisions of the new authoritative accounting guidance under ASC Topic 320during the second quarter of 2009. Adoption of the new guidance did notsignificantly impact the Company’s financial statements.

 

*FASBASC Topic 825 “Financial Instruments.”* New authoritative accounting guidance under ASC Topic825,”Financial Instruments,” requires an entity to provide disclosures aboutthe fair value of financial instruments in interim financial information and amendsprior guidance to require those disclosures in summarized financial informationat interim reporting periods. The new interim disclosures required under Topic825 are included in Note7 — Financial Instruments.

 

**Results of Operations**

 

TheCompany earns income from two primary sources. The first is net interestincome, which is interest income generated by earning assets less interestexpense on interest-bearing liabilities. The second is noninterest income,which primarily consists of deposit service charges and fees, the increase incash surrender value of life insurance, mortgage commissions and gains oncalled investment securities. The majority of the Company’s noninterestexpenses are operating costs that relate to providing a full range of banking servicesto our customers.

 

***Overview***

 

We recorded net income available to commonshareholders for the year ended December 31, 2009 of $1,158,000 or $0.15per diluted common share compared to $2,098,000 or $0.27 per diluted commonshare for the year ended December 31, 2008. The decrease in net incomeavailable to common shareholders for the year ended December 31, 2009 wasprimarily due to an increase of $3,674,000 in provision for loan losses, anincrease of $1,099,000 related to other real estate owned expenses andwritedowns and an increase in FDIC & DFI assessments of $653,000.  Partially offsetting these factors was anincrease in net interest income of $3,127,000, an increase in non-interestincome of $119,000 and a decrease in income tax provision of $619,000.

 

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Highlightsof the financial results are presented in the following table:

 
| ** **                                        | ** ** | **As of and for the years ended  December 31,** | ** ** |
|---------------------------------------------------|------------|------------------------------------------------------|------------|
| **(Dollars in thousands, except per share data)** | ** ** | **2009**                                             | ** ** | **2008** | ** ** | **2007** | ** ** |
| For the period:                                   |       |                                                 |       |   |   |   |   |
| Net income available to common shareholders       |       | $                                                    | 1,158      |   | $ | 2,098 |   | $ | 3,925 |   |
| Net income per common share                       |       |                                                 |       |   |   |   |   |
| Basic                                             |       | $                                                    | 0.15       |   | $ | 0.27 |   | $ | 0.53 |   |
| Diluted                                           |       | $                                                    | 0.15       |   | $ | 0.27 |   | $ | 0.52 |   |
| Return on average common equity                   |       | 2.51                                                 | %          | 4.77 | % | 10.11 | % |
| Return on average assets                          |       | 0.38                                                 | %          | 0.46 | % | 0.88 | % |
| Common stock dividend payout ratio                |       | 16.54                                                | %          | 27.38 | % | 36.81 | % |
| Efficiency ratio                                  |       | 68.04                                                | %          | 76.55 | % | 66.79 | % |
| At period end:                                    |       |                                                 |       |   |   |   |   |
| Book value per common share                       |       | $                                                    | 6.14       |   | $ | 5.81 |   | $ | 5.57 |   |
| Total assets                                      |       | $                                                    | 524,722    |   | $ | 508,203 |   | $ | 454,259 |   |
| Total gross loans                                 |       | $                                                    | 425,627    |   | $ | 428,177 |   | $ | 387,809 |   |
| Total deposits                                    |       | $                                                    | 429,210    |   | $ | 378,248 |   | $ | 377,348 |   |
| Net loan-to-deposit ratio                         |       | 97.34                                                | %          | 111.45 | % | 101.30 | % |

 

***Net Interest Income and Net Interest Margin***

 

Our primary source of revenue is net interestincome, which is the difference between interest and fees derived from earningassets and interest paid on liabilities obtained to fund those assets. Our netinterest income is affected by changes in the level and mix of interest-earningassets and interest- bearing liabilities, referred to as volume changes. Ournet interest income is also affected by changes in the yields earned on assetsand rates paid on liabilities, referred to as rate changes. Interest ratescharged on our loans are affected principally by the demand for such loans, thesupply of money available for lending purposes and competitive factors. Thosefactors are, in turn, affected by general economic conditions and other factorsbeyond our control, such as federal economic policies, the general supply ofmoney in the economy, legislative tax policies, the governmental budgetarymatters, and the actions of the Federal Reserve Board.

 

Net interest income increased $3.1 million or 15.2%to $23.6 million for the year ended December 31, 2009, compared to$20.5 million in 2008.  Net interestspread and net interest margin were 4.74% and 4.99%, respectively, for the yearended December 31, 2009, compared to 4.33% and 4.72%, respectively, forthe year ended December 31, 2008. The increase in the net interest marginin 2009 was attributable to several factors: 1) average gross loans increased by $26 million, 2) average investmentsecurities increased by $16 million, nearly all of which were tax-freemunicipal securities which increased the fully tax equivalent yield onsecurities by 102 basis points, 3) average core money market accounts grew by$54 million which have a lower cost than overall interest-bearing liabilitiesand 4) other borrowings, which are primarily comprised of FHLB advances maturedand repriced at significantly lower rates as evidenced by the reduction of $16million in the average balance.  All ofthese factors combined caused the rate on interest-bearing liabilities todecrease faster than the rate on earning assets.  Changes in volume resulted in an increase innet interest income of $1,890,000 for the year of 2009 compared to the year2008, and changes in interest rates and the mix resulted in an increase in netinterest income of $1,566,000 for the year 2009 versus the year 2008.  Management closely monitors both total netinterest income and the net interest margin.

 

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

 
| ** **                                       | ** ** | **Distribution, Yield and Rate  Analysis of Net Income  For the Years Ended December 31,** | ** ** |
|--------------------------------------------------|------------|--------------------------------------------------------------------------------------------|------------|
| ** **                                       | ** ** | **2009**                                                                                   | ** ** | **2008** | ** ** |
| ** **                                       | ** ** | **Average Balance**                                                                        | ** ** | **Interest Income/ Expense** | ** ** | **Avg Rate/ Yield** | ** ** | **Average Balance** | ** ** | **Interest Income/ Expense** | ** ** | **Avg Rate/ Yield** | ** ** |
| **Assets:**                                      |       |                                                                                       |       |   |   |   |   |   |   |   |   |   |   |
| Earning assets:                                  |       |                                                                                       |       |   |   |   |   |   |   |   |   |   |   |
| Gross loans (1) (2)                         |       | $                                                                                          | 426,748    |   | $ | 26,733 |   | 6.26% |   | $ | 400,821 |   | $ | 27,638 |   | 6.90% |   |
| Securities of U.S.  government agencies          |       | 1,641                                                                                      |       | 10 |   | 0.59% |   | 2,450 |   | 73 |   | 2.98% |   |
| Other investment securities  (2)                 |       | 48,551                                                                                     |       | 2,943 |   | 6.06% |   | 31,489 |   | 1,600 |   | 5.08% |   |
| Federal funds sold                               |       | 2,218                                                                                      |       | 5 |   | 0.23% |   | 1,227 |   | 18 |   | 1.47% |   |
| Interest-earning deposits                        |       | 2,455                                                                                      |       | 5 |   | 0.21% |   | 37 |   | 2 |   | 4.36% |   |
| Total interest-earning  assets                   |       | 481,613                                                                                    |       | 29,696 |   | 6.17% |   | 436,024 |   | 29,331 |   | 6.73% |   |
| Total noninterest earning  assets                |       | 38,858                                                                                     |       |   |   |   |   | 16,256 |   |   |   |   |   |
| Total Assets                                     |       | $                                                                                          | 520,471    |   |   |   |   |   | $ | 452,280 |   |   |   |   |   |
| **Liabilities  and Shareholders’ Equity:**  |       |                                                                                       |       |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  liabilities:                   |       |                                                                                       |       |   |   |   |   |   |   |   |   |   |   |
| Money market deposits                            |       | 183,314                                                                                    |       | 2,455 |   | 1.34% |   | 149,202 |   | 3,578 |   | 2.40% |   |
| NOW deposits                                     |       | 56,921                                                                                     |       | 267 |   | 0.47% |   | 54,160 |   | 386 |   | 0.71% |   |
| Savings deposits                                 |       | 13,851                                                                                     |       | 100 |   | 0.72% |   | 15,563 |   | 259 |   | 1.66% |   |
| Time certificates of  $100,000 or more           |       | 48,912                                                                                     |       | 1,156 |   | 2.36% |   | 40,172 |   | 1,576 |   | 3.92% |   |
| Other time deposits                              |       | 47,883                                                                                     |       | 978 |   | 2.04% |   | 44,846 |   | 1,441 |   | 3.21% |   |
| Other borrowings                                 |       | 44,071                                                                                     |       | 685 |   | 1.55% |   | 59,666 |   | 1,492 |   | 2.50% |   |
| Total interest-bearing  liabilities              |       | 394,952                                                                                    |       | 5,641 |   | 1.43% |   | 363,609 |   | 8,732 |   | 2.40% |   |
| Noninterest-bearing  liabilities:                |       |                                                                                       |       |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing  deposits                    |       | 62,874                                                                                     |       |   |   |   |   | 61,554 |   |   |   |   |   |
| Other liabilities                                |       | 2,957                                                                                      |       |   |   |   |   | 3,131 |   |   |   |   |   |
| Total noninterest-bearing  liabilities           |       | 65,831                                                                                     |       |   |   |   |   | 64,685 |   |   |   |   |   |
| Shareholders’ equity                        |       | 59,688                                                                                     |       |   |   |   |   | 23,986 |   |   |   |   |   |
| Total liabilities and  shareholders’ equity |       | $                                                                                          | 520,471    |   |   |   |   |   | $ | 452,280 |   |   |   |   |   |
| Net interest income                              |       |                                                                                       |       | $ | 24,055 |   |   |   |   |   | $ | 20,599 |   |   |   |
| Net interest spread (3)                          |       |                                                                                       |       |   |   | 4.74% |   |   |   |   |   | 4.33% |   |
| Net interest margin (4)                          |       |                                                                                       |       |   |   | 4.99% |   |   |   |   |   | 4.72% |   |

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*(1)*       Loan fees have been includedin the calculation of interest income.

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

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

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

 

The net interest rate spread in 2009 is consistentwith 2008, reflecting a decrease of fifty-six basis points in the yield oninterest-earning assets and a decline of ninety-seven basis points in the costof interest-bearing liabilities, reflecting a sharply declining interest rateenvironment. Market rate changes have a more immediate effect on deposit ratesthan on loan yields due to our fixed-rate loans. In addition, the largemajority of our variable loans are tied to the U.S. Treasury Constant MaturityIndices with repricing intervals between one year to five years.

 

Market rates are in part based on the FederalReserve Open Market Committee (“FOMC”) target Federal funds interest rate (theinterest rate banks charge each other for short-termborrowings).  The change in the Federal funds sold and purchasedrates is the result of target rate changes implemented by the FOMC.  In2008, there were seven downward adjustments to the target rate totaling 325basis points, bringing the target interest rate to a historic low with a rangeof 0% to 0.25% where it remained as of December 2009.

 

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***Rate/Volume Analysis***

 

The following table below sets forth certaininformation regarding changes in interest income and interest expense of theBank  for the periods indicated. For eachcategory of earning assets and interest bearing liabilities, information isprovided on changes attributable to (i) changes in volume (change inaverage volume multiplied by old rate); and (ii) changes in rates (changein rate multiplied by old average volume). Changes in rate/volume (change inrate multiplied by the change in volume) have been allocated to the changes dueto volume and rate in proportion to the absolute value of the changes due tovolume 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,** | ** ** |
| ** **                              | ** ** | **2009 vs. 2008**                                | ** ** | **2008 vs. 2007** | ** ** |
| ** **                              | ** ** | **Increases (Decreases)**                        | ** ** | **Increases (Decreases)** | ** ** |
| ** **                              | ** ** | **Due to Change In**                             | ** ** | **Due to Change In** | ** ** |
| ** **                              | ** ** | **Volume**                                       | ** ** | **Rate** | ** ** | **Total** | ** ** | **Volume** | ** ** | **Rate** | ** ** | **Total** | ** ** |
| **Interest  income:**                   |       |                                             |       |   |   |   |   |   |   |   |   |   |   |
| Net loans (1)                           |       | $                                                | 1,788      |   | $ | (2,694 | ) | $ | (905 | ) | $ | 1,543 |   | $ | (4,078 | ) | $ | (2,535 | ) |
| Securities of U.S.  government agencies |       | (24                                              | )          | (39 | ) | (63 | ) | (286 | ) | (46 | ) | (332 | ) |
| Other Investment securities             |       | 867                                              |       | 476 |   | 1,343 |   | 230 |   | 91 |   | 321 |   |
| Federal funds sold                      |       | 15                                               |       | (27 | ) | (13 | ) | (97 | ) | (45 | ) | (142 | ) |
| Interest-earning deposits               |       | 105                                              |       | (102 | ) | 3 |   | (2 | ) | 0 |   | (2 | ) |
| Total interest income                   |       | 2,751                                            |       | (2,386 | ) | 365 |   | 1,388 |   | (4,078 | ) | (2,690 | ) |
| **Interest  expense:**                  |       |                                             |       |   |   |   |   |   |   |   |   |   |   |
| Money market deposits                   |       | $                                                | 818        |   | $ | (1,940 | ) | $ | (1,122 | ) | $ | 854 |   | $ | (1,816 | ) | $ | (962 | ) |
| NOW deposits                            |       | 20                                               |       | (139 | ) | (119 | ) | 6 |   | (184 | ) | (178 | ) |
| Savings deposits                        |       | (28                                              | )          | (130 | ) | (159 | ) | (39 | ) | (260 | ) | (299 | ) |
| Time certificates of  $100,000 or more  |       | 343                                              |       | (764 | ) | (421 | ) | (1,343 | ) | (512 | ) | (1,855 | ) |
| Other time deposits                     |       | 98                                               |       | (561 | ) | (463 | ) | (185 | ) | (506 | ) | (691 | ) |
| Other borrowings                        |       | (390                                             | )          | (418 | ) | (807 | ) | 1,308 |   | (1,597 | ) | (289 | ) |
| Total interest expense                  |       | 861                                              |       | (3,952 | ) | (3,091 | ) | 601 |   | (4,875 | ) | (4,274 | ) |
| Change in net interest  income          |       | $                                                | 1,890      |   | $ | 1,566 |   | $ | 3,456 |   | $ | 787 |   | $ | 797 |   | $ | 1,584 |   |

----

*(1)**      *Loan fees havebeen included in the calculation of interest income.

 

***Provision for Loan Losses***

 

Creditrisk is inherent in the business of making loans. The Bank establishes an allowance for loan lossesthrough charges to earnings, which are shown in the statements of operations asthe provision for loan losses. Specifically identifiable and quantifiablelosses are promptly charged off against the allowance. The Bank maintains theallowance for loan losses at a level that it considers to be adequate toprovide for credit losses inherent in its loan portfolio. Management determinesthe level of the allowance by performing a quarterly analysis thatconsiders concentrations of credit, past loss experience, current economicconditions, the amount and composition of the loan portfolio (includingnonperforming and potential problem loans), estimated fair value of underlying collateral, and other informationrelevant to assessing the risk of loss inherent in the loan portfolio such asfor example loan growth, net charge-offs, changes in the composition of theloan portfolio, and delinquencies. As a result of management’sanalysis, a range of the potential amount of the allowance for loan losses isdetermined.

 

The provision for loan losses was $5,862,000 for theyear ended December 31, 2009, compared to $2,188,000 for the year end December 31,2008.  Nonperforming loans were $14.42million at December 31, 2009 and $4.72 million at December 31, 2009,or 3.39% and 1.10%, respectively, of total loans. Nonperforming loans areprimarily in nonperforming real estate construction and development loans. Theallowance for loan losses was $7.02 million and $5.57 million at December 31,2009 and 2008, or 1.65% and 1.30%, respectively, of total loans. Netcharge-offs were $4,411,000 in 2009 compared to $1,110,000 in 2008.  The increase in net charge-offs in 2009 wasprimarily due to the economic downturn and the effect on the housing market.

 

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The Bank will continue to monitor the adequacy ofthe allowance for loan losses and make additions to the allowance in accordancewith the analysis referred to above. Because of uncertainties inherent inestimating the appropriate level of the allowance for loan losses, actualresults may differ from management’s estimate of credit losses and the relatedallowance.

 

***Noninterest Income***

 

Noninterest income was $2.64 million for the yearended December 31, 2009, compared to $2.52 million for the year 2008.  In 2009, other income increased by $177,000,which was primarily attributable to gains on called available for salesecurities of $170,000 compared to no gains recorded in 2008.  Service charge income was $1.16 million forthe year 2009 compared to $1.30 million for the year 2008 as a result of adecrease in NSF fee income.  Thisdecrease was in spite of the increase in the aggregate number of DDA, Now,Money Market and Savings accounts of 11.3% to 18,476 at December 31, 2009as compared to 16,602 accounts as of December 31, 2008.  The Bank continues to evaluate its depositproduct offerings with the intention of continuing to expand its offerings tothe consumer and business depositors.

 

**NoninterestIncome**

**(Dollars inthousands)**

** **
| ** **                                          | ** ** | **For the Years Ended December 31,** | ** ** |
|-----------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                          | ** ** | **2009**                                                      | ** ** | **2008** | ** ** |
| ** **                                          | ** ** | **(Amount)**                                                  | ** ** | **(%)** | ** ** | **(Amount)** | ** ** | **(%)** | ** ** |
| Service charges on deposit  accounts                |       | $                                                             | 1,164      |   | 44.0% |   | $ | 1,299 |   | 51.5% |   |
| Earnings on cash surrender  value of life insurance |       | 408                                                           |       | 15.5% |   | 370 |   | 14.7% |   |
| Mortgaged Commissions                               |       | 140                                                           |       | 5.3% |   | 101 |   | 4.0% |   |
| Other income                                        |       | 929                                                           |       | 35.2% |   | 752 |   | 29.8% |   |
| Total                                               |       | $                                                             | 2,641      |   | 100.0% |   | $ | 2,522 |   | 100.0% |   |
|                                                |       |                                                          |       |   |   |   |   |   |   |
| Average assets                                      |       | $                                                             | 520,471    |   |   |   | $ | 452,280 |   |   |   |
| Noninterest income as a %  of average assets        |       |                                                          |       | 0.5% |   |   |   | 0.6% |   |

 

***Noninterest Expense***

 

The following table sets forth a summary ofnoninterest expenses for the periods indicated:

 

**NoninterestExpense**

**(Dollars inthousands)**

** **
| ** **                                     | ** ** | **For the Years Ended December 31,** | ** ** |
|------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                     | ** ** | **2009**                                                      | ** ** | **2008** | ** ** |
| ** **                                     | ** ** | **(Amount)**                                                  | ** ** | **(%)** | ** ** | **(Amount)** | ** ** | **(%)** | ** ** |
| Salaries and employee  benefits                |       | $                                                             | 7,781      |   | 42.7% |   | $ | 9,306 |   | 52.1% |   |
| Occupancy expenses                             |       | 2,717                                                         |       | 14.9% |   | 2,695 |   | 15.1% |   |
| Data processing fees                           |       | 894                                                           |       | 4.9% |   | 765 |   | 4.3% |   |
| OREO expenses                                  |       | 2,653                                                         |       | 14.6% |   | 1,554 |   | 8.7% |   |
| Assessments  (FDIC & DFI)             |       | 996                                                           |       | 5.5% |   | 344 |   | 1.9% |   |
| Other operating expenses                       |       | 3,177                                                         |       | 17.4% |   | 3,202 |   | 17.9% |   |
| Total                                          |       | $                                                             | 18,218     |   | 100.0% |   | $ | 17,866 |   | 100.0% |   |
|                                           |       |                                                          |       |   |   |   |   |   |   |
| Average assets                                 |       | $                                                             | 520,471    |   |   |   | $ | 452,280 |   |   |   |
| Noninterest expenses as a %  of average assets |       |                                                          |       | 3.5% |   |   |   | 4.0% |   |

 

Noninterest expense was $18.2 million for the yearended December 31, 2009, an increase of $352,000 or 2.0% compared to $17.9million for the year ended 2008.

 

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OREO expenses increased by $1.1 million to $2.7million in 2009, compared to $1.6 million in 2008 due to increased market valuewritedowns on owned properties which was dictated by a declining real estatemarket and the overhead costs associated with carrying those properties.

 

FDIC and DFI assessments increased by $652,000 to$996,000 in 2009 compared to $344,000 in 2008. The increase in FDIC insurancewas due to a higher FDIC assessment rate (which more than doubled from lastyear), and higher deposits.  Effective April 1, 2009, the FDICadopted a final rule revising its risk-based insurance assessment systemand effectively increasing the overall assessment rate. The new initial baseassessment rates for Risk Category 1 institutions range from twelve to sixteenbasis points, on an annualized basis.  The FDIC also imposed aspecial deposit insurance assessment of five basis points on all insuredinstitutions’ total assets minus Tier 1 capital at June 30, 2009 in orderto replenish the Deposit Insurance Fund. As a result, we recognized $235,000from this special assessment in 2009.  The increase of FDIC insurancein 2009 over 2008 is primarily due to an increase in the industry-wide FDICassessment rate and growth in our deposit level. In addition, in November 2008,we elected to participate in the FDIC Transaction Account Guarantee Program,which provides unlimited insurance coverage on non-interest-bearing transactionaccounts defined by the FDIC, on which we will pay a 10 basis point surchargeper $100 covered balances in excess of $250 thousand through 2009. The 10 basispoint surcharge on non-interest-bearing transaction accounts over $250 thousandwill increase to 15 basis points from January to June 2010, at whichtime the program expires.

 

Data processing costs increased in 2009 over 2008 by$129,000, reflecting the additional costs that related to the increased numberof deposit accounts.

 

The increase in occupancy expenses in 2009 from 2008of $22,000 was primarily related to contractual increases on our branch leases,as well as higher maintenance and repair costs.

 

Offsetting these increases was a decrease insalaries and employee benefits of $1.5 million as a result of management’seffort to operate more efficiently.  Alsocontributing to the decrease were deferred loan costs of $613,000 for the yearended 2009, which were recognized as credits to salary expense and will berecognized over the life of the loan.  Incomparison, there were no credits for deferred loan costs recognized in salaryexpense in 2008.

 

Other expenses recognized a slight decrease in 2009compared to 2008 of $25,000 as our core operations remained stable andmanagement remains committed to improving operating efficiency.

 

Management anticipates that noninterest expense willcontinue to increase as we continue to grow, even though management alsoestimates that the Bank’s administration as currently set up may be scalable tohandle a larger deposit base of up to around $1B in deposits.  However,management remains committed to cost-control and efficiency, and we expect tokeep these increases to a minimum relative to growth.

 

***Provision for Income Taxes***

 

We reported a provision for income taxes of$203,000, and $822,000 for the years 2009 and 2008 respectively.  The effective income tax rate on income fromcontinuing operations was 9.2% for the year ended December 31, 2009compared to 27.5% for the year 2008. These provisions reflect accruals for taxes at the applicable rates forfederal income tax and California franchise tax based upon reported pre-taxincome, and adjusted for the effects of all permanent differences betweenincome for tax and financial reporting purposes (such as earnings on qualifiedmunicipal securities, BOLI and certain tax-exempt loans).  The disparity between the effective tax ratesin 2009 as compared to 2008 is primarily due to tax credits from CaliforniaEnterprise Zones and low income housing projects as well as tax free-income onloans within these enterprise zones and municipal securities and loans thatcomprise a larger proportion of pre-tax income in 2009 as compared to prioryears. We have not been subject to an alternative minimum tax (“AMT”) duringthese periods.

 

**Financial Condition**

 

The Bank’s total assets were $524.7 million at December 31,2009 compared to $508.2 million at December 31, 2008, an increase of $16.5million or 3.3%. Net loans decreased $3.8 million, investments increased $9.3million, bank premises and equipment decreased $927,000 and interest receivableand other assets increased $692,000, while cash and cash equivalents increased$11.8 million.

 

Loans gross of the allowance for loan losses anddeferred fees were $425.6 million at December 31, 2009, compared to $428.2million at December 31, 2008, a decrease of $2.6 million or 0.6%. Thedecrease was primarily due to a decrease of $20.4 million or 28% in the realestate construction loans and a $1.4 million decrease in residential realestate and consumer loans.  These wereoffset by increases of $14.6 million, $0.9 million and $3.7 million incommercial real estate, commercial and agriculture loans, respectively.  

 

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Thecomposition of the loan portfolio categories remained relatively unchanged as apercentage of total loans, except for commercial real estate loans whichincreased from 62.9% at December 31, 2008 to 66.6% at December 31,2009.  This shift in the portfolio mixprimarily came from the real estate construction loans which saw a decreasefrom 17.2% at December 31, 2008 to 12.5% at December 31, 2009.

 

Deposits increased $51 million or 13.5% to $429.2million at December 31, 2009 compared to $378.2 million at December 31,2008. All deposit types increased except for time deposits which decreased by$8.5 million.  All other depositsincreased, including money market accounts which recognized a $45.6 millionincrease.  Demand, NOW and Savings eachincreased by $5.3 million, $3.9 million and $4.6 million, respectively.

 

Short-term borrowings decreased $23.3 million to$27.2 million at December 31, 2009, compared to $50.5 million at December 31,2008 and long-term debt decreased to $5.0 million at December 31, 2009,compared to $18.5 million at December 31, 2008. The decrease in short-termand long-term debt was due to the deposit growth of $51 million.  This allowed us to pay off matured  FHLB advances thus reducing our cost of fundsand improving our liquidity ratio. The Bank uses short-term borrowings,primarily short-term FHLB advances, to fund short-term liquidity needs andmanage net interest margin.

 

Equity increased $2.7 million or 4.7% to $60.7million at December 31, 2009, compared to $58.0 million at December 31,2008.  The Bank was selected toparticipate in the U.S. Treasury Capital Purchase Program (“TCPP”) whichresulted in the issuance of $13.5 million in preferred stock in December 2008.  The Bank intends to use the capital toincrease credit availability to local, creditworthy, businesses and consumers.The preferred stock shares have a 5% coupon for 5 years and 9% thereafter.Warrants to purchase 350,346 shares of common stock at a per share exerciseprice of $5.78 are attached and fully exercisable. The warrants expire 10 yearsafter the issuance date. The securities issued to the Treasury will beaccounted for as components of regulatory Tier 1 capital.  See Note 12 to the Consolidated FinancialStatements in Item 8 of this report for further discussion regarding ourparticipation in the TCPP.

 

***Investment Activities***

 

Investments are a key source of interest income.Management of our investment portfolio is set in accordance with strategiesdeveloped and overseen by our Investment Committee. Investment balances, includingcash equivalents and interest-bearing deposits in other financial institutions,are subject to change over time based on our asset/liability funding needs andinterest rate risk management objectives. Our liquidity levels take intoconsideration anticipated future cash flows and all available sources ofcredits and are maintained at levels management believes are appropriate toassure future flexibility in meeting anticipated funding needs.

 

*Cash Equivalents and Interest-bearing Deposits inother Financial Institutions*

 

The Bank holds federal funds sold, unpledgedavailable-for-sale securities and salable government guaranteed loans to helpmeet liquidity requirements and provide temporary holdings until the funds canbe otherwise deployed or invested.  As ofDecember 31, 2009, and 2008, we had $1.65 million and $765,000,respectively, in federal funds sold.

 

*Investment Securities*

 

Management of our investment securities portfoliofocuses on providing an adequate level of liquidity and establishing an interestrate-sensitive position, while earning an adequate level of investment incomewithout taking undue risk. Investment securities that we intend to hold untilmaturity are classified as held-to-maturity securities, and all otherinvestment securities are classified as available-for-sale.  Currently, all of our investment securitiesare classified as available-for-sale. The carrying values of available-for-saleinvestment securities are adjusted for unrealized gains or losses as avaluation allowance and any gain or loss is reported on an after-tax basis as acomponent of other comprehensive income.

 

Our investment securities holdings increased by $9.3million, or 22.5%, to $50.8 million at December 31, 2009, compared toholdings of $41.5 million at December 31, 2008.  Accordingly, total investment securities as apercentage of total assets increased to 9.7% as compared to 8.2% at December 31,2008.  As of December 31, 2009,$34.7 million of the investment securities were pledged to secure certaindeposits.

 

As of December 31, 2009, the total unrealizedloss on securities that were in a loss position for less than 12 continuousmonths was $9,000 with an aggregate fair value of $829,000.  The total unrealized loss on securities thatwere in a loss position for greater than 12 continuous months was $10,000 withan aggregate fair value of $1,579,000.

 

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The following table summarizes the book value andmarket value and distribution of our investment securities as of the datesindicated:

 

**InvestmentSecurities Portfolio**

** **
| ** **                              | ** ** | **As of December 31, 2009** | ** ** | **As of December 31, 2008** | ** ** | **As of December 31, 2007** | ** ** |
|-----------------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|
| **Dollars in Thousands**                | ** ** | **Amortized Cost**                              | ** ** | **Market Value**                                | ** ** | **Amortized Cost**                              | ** ** | **Market Value** | ** ** | **Amortized Cost** | ** ** | **Market Value** | ** ** |
| **Available-for-Sale:**                 |       |                                            |       |                                            |       |                                            |       |   |   |   |   |   |   |
| Securities of U.S.  government agencies |       | $                                               | 29,476     |                                            | $          | 30,985                                          |       | $ | 25,541 |   | $ | 26,085 |   | $ | 24,875 |   | $ | 24,962 |   |
| Collateralized mortgage  obligations    |       | 2,884                                           |       | 2,995                                           |       | 3,439                                           |       | 3,485 |   | 4,024 |   | 3,961 |   |
| Municipal securities                    |       | 12,328                                          |       | 13,557                                          |       | 9,971                                           |       | 9,902 |   | 2,343 |   | 2,400 |   |
| SBA Pools                               |       | 1,589                                           |       | 1,579                                           |       | 1,820                                           |       | 1,779 |   | 2,054 |   | 2,049 |   |
| Asset Backed Security                   |       | 82                                              |       | 83                                              |       | 198                                             |       | 198 |   | — |   | — |   |
| Mutual Fund                             |       | 1,546                                           |       | 1,566                                           |       | —                                          |       | — |   | — |   | — |   |
| Total investment securities             |       | $                                               | 47,905     |                                            | $          | 50,765                                          |       | $ | 40,969 |   | $ | 41,449 |   | $ | 33,296 |   | $ | 33,373 |   |

 

At December 31, 2009, two SBA pools make up thetotal amount of securities in an unrealized loss position for greater than 12months. Management periodically evaluates each available-for-sale investmentsecurity in an unrealized loss position to determine if the impairment istemporary or other than temporary. Management has determined that no investmentsecurity is other than temporarily impaired. The unrealized losses are duesolely to interest rate changes and the Bank does not intend to sell thesecurities and it is not likely that we will be required to sell the securitiesbefore the earlier of the forecasted recovery or the maturity of the underlyinginvestment security.  As of December 31,2009, we did not have any investment securities that constituted 10% or more ofthe stockholders’ equity of any third party issuer.

 

The following table summarizes the maturity andrepricing schedule of our investment securities at their amortized cost andtheir weighted average yields at December 31, 2009:

 

**InvestmentMaturities and Repricing Schedule**

**(Dollars inThousands)**

** **
| ** **                             | ** **               | ** **                    | ** **   | **After One But**     | ** **               | **After Five But**   | ** **   | ** **                    | ** **               | ** ** | ** **   |
|----------------------------------------|--------------------------|-------------------------------|--------------|---------------------------------|--------------------------|--------------------------------|--------------|-------------------------------|--------------------------|------------|--------------|
| ** **                             | ** **               | **Within One Year** | ** **   | **Within Five Years** | ** **               | **Within Ten Years** | ** **   | **After Ten Years** | ** **               | **Total**  | ** **   |
| ** **                             | ** **               | **Amount**                    | ** **   | **Yield**                       | ** **               | **Amount**                     | ** **   | **Yield**                     | ** **               | **Amount** | ** **   | **Yield** | ** ** | **Amount** | ** ** | **Yield** | ** ** | **Amount** | ** ** | **Yield** | ** ** |
| **Available-for-sale:**                |      |                          |    |                            |      |                           |    |                          |      |       |    |   |      |   |    |   |      |   |    |   |   |
| Securities of U.S. government agencies |                     | $                             | 0            |                            | 0.00                     | %                              | $            | 1,972                         |                     | 2.91       | %            | $ | 11,237 |   | 5.12 | % | $ | 16,267 |   | 5.08 | % | $ | 29,476 |   | 4.95 | % |
| Collateralized mortgage obligations    |                     | 0                             |         | 0.00                            | %                        | 0                              |         | 0.00                          | %                        | 0          |         | 0.00 | % | 2,884 |   | 5.21 | % | 2,884 |   | 4.21 | % |
| Municipal securities                   |                     | 510                           |         | 5.86                            | %                        | 764                            |         | 5.41                          | %                        | 9,539      |         | 5.73 | % | 1,515 |   | 5.88 | % | 12,328 |   | 6.71 | % |
| SBA Pools                              |                     | 0                             |         | 0.00                            |                     | 0                              |         | 0.00                          |                     | 0          |         | 0.00 |   | 1,589 |   | 0.59 |   | 1,589 |   | 0.59 | % |
| Asset Backed Security                  |                     | 0                             |         | 0.00                            | %                        | 82                             |         | 6.12                          | %                        | 0          |         | 0.00 | % | 0 |   | 0.00 | % | 82 |   | 6.12 | % |
| Mutual Fund                            |                     | 0                             |         | 0.00                            | %                        | 0                              |         | 0.00                          | %                        | 0          |         | 0.00 | % | 1,546 |   | 0.00 | % | 1,546 |   | 0.00 | % |
| Total Investment Securities            |                     | $                             | 510          |                            | 5.86                     | %                              | $            | 2,818                         |                     | 3.68       | %            | $ | 20,776 |   | 5.40 | % | $ | 23,801 |   | 4.40 | % | $ | 47,905 |   | 4.80 | % |

 

Interest income and yields in the above table havenot been adjusted to a fully tax equivalent basis.

 

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**Loans**

 

The following table sets forth the amount of totalloans outstanding (excluding unearned income) and the percentage distributionsin each category, as of the dates indicated.

 
| ** **                                                   | ** ** | **Distribution of Loans and  Percentage Composition of   Loan Portfolio Amount Outstanding as of December 31,** | ** ** |
|--------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                   | ** ** | **2009**                                                                                                        | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                         |       | **(Dollars in Thousands)**                                                                            |       |
|                                                         |       |                                                                                                            |       |   |   |   |   |   |   |   |   |
| Commercial real estate                                       |       | $                                                                                                               | 283,387    |   | $ | 268,742 |   | $ | 208,309 |   | $ | 233,110 |   | $ | 212,901 |   |
| Commercial                                                   |       | 38,160                                                                                                          |       | 37,302 |   | 45,497 |   | 41,077 |   | 31,349 |   |
| Real estate construction                                     |       | 52,952                                                                                                          |       | 73,321 |   | 83,173 |   | 60,269 |   | 37,717 |   |
| Agriculture                                                  |       | 29,660                                                                                                          |       | 25,917 |   | 31,430 |   | 27,527 |   | 22,390 |   |
| Residential real estate and  consumer                        |       | 21,468                                                                                                          |       | 22,895 |   | 19,400 |   | 16,409 |   | 13,752 |   |
| Unearned income                                              |       | (811                                                                                                            | )          | (1,035 | ) | (1,038 | ) | (1,233 | ) | (1,345 | ) |
|                                                         |       |                                                                                                            |       |   |   |   |   |   |   |   |   |
| Total loans, net of  unearned income                         |       | 424,816                                                                                                         |       | 427,142 |   | 386,771 |   | $ | 377,160 |   | $ | 316,764 |   |
|                                                         |       |                                                                                                            |       |   |   |   |   |   |   |   |   |
| Participation loans sold  and serviced by the Bank |       | $                                                                                                               | 14,907     |   | $ | 9,759 |   | $ | 1,314 |   | $ | 3,488 |   | $ | 3,838 |   |
|                                                         |       |                                                                                                            |       |   |   |   |   |   |   |   |   |
| Commercial real estate                                       |       | 66.6                                                                                                            | %          | 62.9 | % | 53.9 | % | 61.8 | % | 67.2 | % |
| Commercial                                                   |       | 9.0                                                                                                             | %          | 8.7 | % | 11.8 | % | 10.9 | % | 9.9 | % |
| Real estate construction                                     |       | 12.5                                                                                                            | %          | 17.2 | % | 21.5 | % | 16.0 | % | 11.9 | % |
| Agriculture                                                  |       | 7.0                                                                                                             | %          | 6.1 | % | 8.1 | % | 7.3 | % | 7.1 | % |
| Residential real estate and  consumer                        |       | 5.1                                                                                                             | %          | 5.3 | % | 5.0 | % | 4.4 | % | 4.3 | % |
| Unearned income                                              |       | (0.2                                                                                                            | )%         | (0.2 | )% | (0.3 | )% | (0.3 | )% | (0.4 | )% |
|                                                         |       |                                                                                                            |       |   |   |   |   |   |   |   |   |
| Total loans, net of  unearned income                         |       | 100.0                                                                                                           | %          | 100.0 | % | 100.0 | % | 100.0 | % | 100.0 | % |

 

Commercial real estate loans increased $14.6 millionin 2009 and $60.4 million in 2008. The reduced volume of growth in 2009 largelyreflected a decline in demand by qualified borrowers in our serving area. Ofthe commercial real estate loans at December 31, 2009, 63.9% are non-owneroccupied and 36.1% are owner occupied. Our commercial real estate loanportfolio is weighted towards term loans for which the primary source ofrepayment is cash flow from net operating income of the real estate property.The increase in commercial real estate loans in 2008 was mainly driven byincreased demand from existing customers.

 

Commercial loan growth of $0.9 million in 2009 ascompared to a decrease of $8.2 million between 2008 and 2007 was the result ofour reassessment of the commercial and industrial lending market, specificallyasset-based lines of credit. We have historically targeted well-establishedlocal businesses with strong guarantors that have proven to be resilient inperiods of economic stress.

 

Our residential loan portfolio includes no sub-primeloans, nor is it our normal practice to underwrite loans commonly referred toas “Alt-A mortgages”, the characteristics of which are loans lacking fulldocumentation, borrowers having low FICO scores or collateral compositionsreflecting high loan-to-value ratios. However, substantially all of ourresidential loans are indexed to Treasury Constant Maturity Rates and haveprovisions to reset five years after their origination dates.

 

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The following table summarizes our commercial realestate loan portfolio by the geographic location in which the property islocated as of December 31, 2009 and 2008:

 

**Commercial Real Estate LoansOutstanding by Geographic Location**

 
| **(Dollar in thousands)**                                         | ** ** | **December 31, 2009** | ** ** | **December 31, 2008**                | ** ** |
|-------------------------------------------------------------------|------------|----------------------------|------------|-------------------------------------------|------------|
| **Commercial real estate loans by geographic location  (County)** | ** ** | **Amount**                 | ** ** | **% of   Commercial real   estate loans** | ** ** | **Amount** | ** ** | **% of   Commercial real   estate loans** | ** ** |
| Stanislaus                                                        |       | $                          | 136,777    |                                      | 48.3       | % | $ | 132,509 |   | 49.3 | % |
| San Joaquin                                                       |       | 43,072                     |       | 15.2                                      | %          | 40.900 |   | 15.2 | % |
| Tuolumne                                                          |       | 21,340                     |       | 7.5                                       | %          | 21,228 |   | 7.9 | % |
| Alameda                                                           |       | 12,075                     |       | 4.3                                       | %          | 12,136 |   | 4.5 | % |
| Mono                                                              |       | 11,918                     |       | 4.2                                       | %          | 12,383 |   | 4.6 | % |
| Sacramento                                                        |       | 11,586                     |       | 4.1                                       | %          | 8,625 |   | 3.2 | % |
| Inyo                                                              |       | 9,605                      |       | 3.4                                       | %          | 9,354 |   | 3.5 | % |
| Merced                                                            |       | 9,055                      |       | 3.2                                       | %          | 9,191 |   | 3.4 | % |
| Los Angeles                                                       |       | 6,449                      |       | 2.3                                       | %          | 5,576 |   | 2.1 | % |
| Santa Clara                                                       |       | 4,121                      |       | 1.5                                       | %          | 4,323 |   | 1.6 | % |
| Other                                                             |       | 17,389                     |       | 6.0                                       | %          | 12,517 |   | 4.7 | % |
| **Total**                                                         |       | $                          | 283,387    |                                      | 100.0      | % | $ | 268,742 |   | 100.0 | % |

 

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Construction loansdecreased $20.4 million in 2009 and by $9.9 million in 2008, primarily due tothe successful completion and sell-through of construction development projectsbooked in prior years, a slow down in construction activity (primarilyresidential development), as well as a conscious effort to reduce ourconcentration in construction loans.  The table below shows ananalysis of construction loans by type and location. Non-owner-occupied landloans of $22.1 million at December 31, 2009 included loans for landsspecified for commercial development of $7.0 million and for residentialdevelopment of $15.1 million, the majority of which are located in Stanislauscounty.

 

**ConstructionLoans Outstanding by Type and Geographic Location**

 
| **(Dollar  in thousands)**                             | ** ** | **December 31, 2009** | ** ** | **December 31, 2008**    | ** ** |
|--------------------------------------------------------|------------|----------------------------|------------|-------------------------------|------------|
| **Construction loans by type**                         | ** ** | **Amount**                 | ** ** | **% of  Construction  Loans** | ** ** | **Amount** | ** ** | **% of  Construction  Loans** | ** ** |
| Single  family non-owner-occupied                      |       | $                          | 7,860      |                          | 14.8       | % | $ | 7,857 |   | 10.7 | % |
| Single  family owner-occupied                          |       | 761                        |       | 1.4                           | %          | 1,538 |   | 2.1 | % |
| Commercial  non-owner-occupied                         |       | 10,867                     |       | 20.5                          | %          | 20,366 |   | 27.8 | % |
| Commercial  owner-occupied                             |       | 8,217                      |       | 15.5                          | %          | 14,420 |   | 19.7 | % |
| Land  non-owner-occupied                               |       | 22,078                     |       | 41.8                          | %          | 26,481 |   | 36.1 | % |
| Land  owner-occupied                                   |       | 3,169                      |       | 6.0                           | %          | 2,659 |   | 3.6 | % |
| **Total**                                              |       | $                          | 52,952     |                          | 100.0      | % | $ | 73,321 |   | 100.0 | % |
|                                                   |       |                       |       |                          |       |   |   |   |   |
| **Construction loans by geographic location (County)** | ** ** | **Amount**                 | ** ** | **% of  Construction  Loans** | ** ** | **Amount** | ** ** | **% of  Construction  Loans** | ** ** |
| Stanislaus                                             |       | $                          | 17,271     |                          | 32.6       | % | $ | 28,073 |   | 38.3 | % |
| Mono                                                   |       | 10,814                     |       | 20.4                          | %          | 11,704 |   | 16.0 | % |
| Madera                                                 |       | 7,526                      |       | 14.2                          | %          | 8,119 |   | 11.1 | % |
| San  Joaquin                                           |       | 5,134                      |       | 9.7                           | %          | 12,085 |   | 16.5 | % |
| Tuolumne                                               |       | 4,821                      |       | 9.1                           | %          | 2,600 |   | 3.5 | % |
| Fresno                                                 |       | 4,236                      |       | 8.0                           | %          | 1,757 |   | 2.4 | % |
| Other                                                  |       | 3,150                      |       | 6.0                           | %          | 8,983 |   | 12.2 | % |
| **Total**                                              |       | $                          | 52,952     |                          | 100.0      | % | $ | 73,321 |   | 100.0 | % |

 

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***Loan Maturities***

 

Thefollowing table shows the contractual maturity distribution and repricingintervals of the outstanding loans in our portfolio, as of December 31,2009. In addition, the table shows the distribution of such loans between thosewith variable or floating interest rates and those with fixed or predeterminedinterest rates. Thelarge majority of the variable rate loans are tied to independent indices (suchas the Wall Street Journal prime rate or a Treasury Constant Maturity Rate).Substantially all loans with an original term of more than five years haveprovisions for the fixed rates to reset, or convert to a variable rate, afterone, three or five years.

 
| ** **                                      | ** ** | **Loan Maturities and Repricing Schedule  At December 31, 2009** | ** ** |
|-------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| **(Dollars in thousands)**                      | ** ** | **Within  One Year**                                                  | ** ** | **After One****But Within  Five Years** | ** ** | **After  Five  Years** | ** ** | **Total** | ** ** |
| ** **                                      | ** ** | ** **                                                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Commercial real estate                          |       | $                                                                     | 84,165     |   | $ | 161,483 |   | $ | 37,739 |   | $ | 283,387 |   |
| Commercial                                      |       | 26,759                                                                |       | 10,370 |   | 1,031 |   | 38,160 |   |
| Real estate construction                        |       | 42,421                                                                |       | 10,531 |   | 0 |   | 52,952 |   |
| Agriculture                                     |       | 10,967                                                                |       | 6,721 |   | 11,972 |   | 29,660 |   |
| Residential real estate and consumer            |       | 1,203                                                                 |       | 8,079 |   | 12,186 |   | 21,468 |   |
| Unearned income                                 |       | (316                                                                  | )          | (373 | ) | (122 | ) | (811 | ) |
| Total loans, net of unearned income             |       | $                                                                     | 165,199    |   | $ | 196,811 |   | $ | 62,806 |   | $ | 424,816 |   |
|                                            |       |                                                                  |       |   |   |   |   |   |   |
| Loans with variable (floating) interest rates   |       | $                                                                     | 127,226    |   | $ | 149,530 |   | $ | 36,828 |   | $ | 313,585 |   |
| Loans with predetermined (fixed) interest rates |       | $                                                                     | 37,973     |   | $ | 47,281 |   | $ | 25,978 |   | $ | 111,231 |   |

 

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

 

***Nonperforming Assets***

 

Financial institutionsgenerally have a certain level of exposure to credit quality risk, and couldpotentially receive less than a full return of principal and interest if adebtor becomes unable or unwilling to repay. Since loans are the most significantassets of the Company and generate the largest portion of its revenues, theCompany’s management of credit quality risk is focused primarily on loanquality. Banks have generally suffered their most severe earnings declines as aresult of customers’ inability to generate sufficient cash flow to servicetheir debts and/or downturns in national and regional economies which havebrought about declines in overall property values. In addition, certain debtsecurities that the Company may purchase have the potential of declining invalue if the obligor’s financial capacity to repay deteriorates.

 

Nonperformingassets consist of loans on non-accrual status, loans 90 days or more past dueand still accruing interest, loans restructured, where the terms of repaymenthave been renegotiated resulting in a reduction or deferral of interest orprincipal and other real estate owned (“OREO”).

 

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

 

TheBank had nonperforming loans of $14.42 million at December 31, 2009, ascompared to $4.72 million at December 31, 2008, $9.81 million at December 31,2007  and no nonperforming loans at December 31,2006, 2005, respectively.  The ratio of 

 

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nonperformingloans over total loans was 3.39%, 1.10% and 2.54% at December 31, 2009,2008 and 2007, respectively, as compared with 0.0% in 2006 and 2005.

 

Inaddition, the Bank held six OREO properties with a market value of $2.1 millionas of December 31, 2009 compared to two properties with a market value of$2.7 million at December 31, 2008. The Bank did not possess any OREO during any of the year-end periodsfrom 2005 through 2007.

 

Managementbelieves that the reserve provided for nonperforming loans, together with thetangible collateral, were adequate as of December 31, 2009. See “Allowancefor Loan Losses” below for further discussion. Except as disclosed above, as ofDecember 31, 2009, management was not aware of any material creditproblems of borrowers that would cause it to have serious doubts about theability 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 beenbrought to the attention of management, or that credit problems may arise.

 

Thefollowing table provides information with respect to the components of ournonperforming 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,**        | ** ** |
|-----------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                              | ** ** | **2009**                             | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                                              | ** ** | **(Dollars in Thousands)** | ** ** |
| ** **                                                                              | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Nonaccrual loans(1)**                                                                 |       |                                 |       |   |   |   |   |   |   |   |   |
| Commercial real estate                                                                  |       | $                                    | 835        |   | $ | 2,115 |   | $ | 1,127 |   | $ | 0 |   | $ | 0 |   |
| Commercial                                                                              |       | 488                                  |       | 0 |   | 0 |   | 0 |   | 0 |   |
| Real estate construction                                                                |       | 11,866                               |       | 1,963 |   | 7,960 |   | 0 |   | 0 |   |
| Agriculture                                                                             |       | 1,229                                |       | 0 |   | 0 |   | 0 |   | 0 |   |
| Residential real estate and consumer                                                    |       | 0                                    |       | 0 |   | 0 |   | 0 |   | 0 |   |
| Total                                                                                   |       | $                                    | 14,418     |   | $ | 4,078 |   | 9,087 |   | $ | 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                                                                |       | 0                                    |       | 643 |   | 721 |   | 0 |   | 0 |   |
| Agriculture                                                                             |       | 0                                    |       | 0 |   | 0 |   | 0 |   | 1 |   |
| Residential real estate and consumer                                                    |       | 0                                    |       | 0 |   | 0 |   | 0 |   | 0 |   |
| Total                                                                                   |       | 0                                    |       | 643 |   | 721 |   | 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                                                               |       | 14,418                               |       | 4,721 |   | 9,808 |   | 0 |   | 5 |   |
| Other real estate owned                                                                 |       | 2,150                                |       | 2,746 |   | 0 |   | 0 |   | 0 |   |
|                                                                                    |       |                                 |       |   |   |   |   |   |   |   |   |
| Total nonperforming assets                                                              |       | $                                    | 16,568     |   | $ | 7,467 |   | $ | 9,808 |   | $ | 0 |   | $ | 0 |   |
|                                                                                    |       |                                 |       |   |   |   |   |   |   |   |   |
| Nonperforming loans as a percentage of total loans                                      |       | 3.39                                 | %          | 1.10 | % | 2.54 | % | 0.00 | % | 0.00 | % |
| Nonperforming assets as a percentage of total loans  and other real estate owned   |       | 3.88                                 | %          | 1.74 | % | 2.54 | % | 0.00 | % | 0.00 | % |
| Allowance for loan losses as a percentage of  nonperforming loans                       |       | 48.69                                | %          | 117.97 | % | 45.95 | % | — |   | — |   |

----

*(1) *During the fiscal year endedDecember 31, 2009 and 2008, no interest income related to these loans wasincluded in net income while on nonaccrual status. Additional interest incomeof approximately $457,000 and $135,000 would have been recorded during the yearended December 31, 2009 and 2008, respectively, if these loans had beenpaid in accordance with their original terms.

 

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*(2) *A “restructured loan” is onethe terms of which were renegotiated to provide a reduction or deferral ofinterest or principal because of deterioration in the financial position of theborrower.

 

*Allowance for Loan Losses*

 

Inanticipation of credit risk inherent in our lending business, we set asideallowances through charges to earnings. Such charges are not only made for theoutstanding loan portfolio, but also for off-balance sheet items, such ascommitments to extend credits or letters of credit. The charges made for theoutstanding loan portfolio are credited to the allowance for loan losses,whereas charges for off-balance sheet items are credited to the reserve foroff-balance sheet items, which is presented as a component of otherliabilities. The provision for loan losses is discussed in the section entitled“Provision for Loan Losses” above.

 

Thebalance of our allowance for loan losses is Management’s best estimate of theremaining losses inherent in the portfolio. The ultimate adequacy of theallowance is dependent upon a variety of factors beyond our control, includingthe real estate market, changes in interest rate and economic and politicalenvironments.

 

Therapid growth of our loan portfolio in the past five years has required morereserves for probable loan losses. The allowance for loan losses increased by26.0%, or $1,451,000, to $7.02 million at December 31, 2009, as comparedwith $5.57 million at December 31, 2008. Such allowances were $4.57million, $4.34 million and $3.98 million at December 31, 2007, 2006 and2005, respectively. Due to loan growth and the current economic downturn’seffect on the financial stability of certain borrowers, the loan lossallowances have increased to maintain an adequate reserve as a percentage oftotal loans, as reflected in the ratios of 1.65%, 1.30%, 1.16%, 1.15% and 1.16%,at the end of 2009, 2008, 2007, 2006 and 2005, respectively.  Based on the current conditions of the loanportfolio, Management believes that the $7.02 million allowance for loan lossesat December 31, 2009 is adequate to absorb losses inherent in our loanportfolio. No assurance can be given, however, that adverse economic conditionsor other circumstances will not result in increased losses in the portfolio.

 

Inlight of the current weakness in the economic environment, and specifically inthe real estate construction sector, reserves have been increased to recognizesuch increased risk.  Diversification,low loan-to-values, strong credit quality and enhanced credit monitoringcontribute to a reduction in the portfolio’s overall risk, and help to offsetthe economic risk.  The impact of theincreasing economic weakness will continue to be monitored, and adjustments tothe provision for loan loss will be made accordingly.  As evidenced in 2009, the weak businessclimate adversely impacted the financial conditions of some of our clients andincreased our net loan charge-off to $4,411,000, compared to $1,110,000,$397,000, $13,000 and $1,000 in 2008, 2007, 2006 and 2005, respectively.

 

Managementreviews these conditions with our senior credit officers. To the extent thatany of these conditions is evidenced by a specifically identifiable problemcredit or portfolio segment as of the evaluation date, management’s estimate ofthe effect of such condition may be reflected as a specific allowanceapplicable to such credit or portfolio segment. Where any of these conditionsis not evidenced by a specific, identifiable problem credit or portfoliosegment as of the evaluation date, management’s evaluation of the inherent lossrelated to such condition is reflected in the unallocated allowance. Althoughmanagement has allocated a portion of the allowance to specific loancategories, the adequacy of the allowance is considered in its entirety.

 

Althoughmanagement believes the allowance at December 31, 2009 was adequate toabsorb losses from any known and inherent risks in the portfolio, no assurancecan be given that economic conditions which adversely affect our service areasor other variables will not result in increased losses in the loan portfolio inthe future.

 

Asof December 31, 2009, our allowance for loan losses consisted of amountsallocated to three phases of our methodology for assessing loan lossallowances, as follows (see details of methodology for assessing allowance forloan losses in the section entitled “Critical Accounting Policies”):

 
| ** **                                                               | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------------------------------|------------|-----------------------------------|------------|
| **Phase of Methodology (Dollars in Thousands)** | ** ** | **2009**                          | ** ** | **2008** | ** ** | **2007** | ** ** |
| Specific review of individual loans                                      |       | $                                 | 1,256      |   | $ | 769 |   | $ | 95 |   |
| Review of pools of loans with similar characteristics                    |       | $                                 | 3,808      |   | $ | 2,939 |   | $ | 2,784 |   |
| Judgmental estimate based on various subjective  factors                 |       | $                                 | 1,956      |   | $ | 1,862 |   | $ | 1,628 |   |

 

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*The Components of the Allowance for Loan Losses*

 

Asstated previously in “Critical Accounting Policies,” the overall allowanceconsists of a specific allowance for individually identified impaired loans, anallowance factor for categories of credits with similar characteristics andtrends, and an allowance for changing environmental factors.

 

Thefirst component, the specific allowance, results from the analysis ofidentified problem credits and the evaluation of sources of repayment includingcollateral, as applicable. Through Management’s ongoing loan grading process,individual loans are identified that have conditions that indicate the borrowermay be unable to pay all amounts due under the contractual terms. These loansare evaluated individually by Management and specified allowances for loanlosses are established when the discounted cash flows of future payments orcollateral value of collateral-dependent loans are lower than the recordedinvestment in the loan. Generally with problem credits that arecollateral-dependent, we obtain appraisals of the collateral at least annually.We may obtain appraisals more frequently if we believe the collateral value issubject to market volatility, if a specific event has occurred to the collateral(e.g. tentative map has been filed), or if we believe foreclosure isimminent.  Impaired loan balances increased from $4.1 million at December 31,2008 to $14.4 million at December 31, 2009.  The specificallowance totaled $1,256,000 and $769,000 at December 31, 2009 and 2008,respectively, as we charged off substantially all of our estimated lossesrelated to specifically identified impaired loans as the losses are identified.

 

Thesecond component, the allowance factor, is an estimate of the probable inherentlosses in each loan pool stratified by major categories or loans with similarcharacteristics in our loan portfolio. This analysis encompasses segmenting andreviewing loan grades by pool and current general economic and businessconditions. Confirmation of the quality of our grading process is obtained byindependent reviews conducted by consultants specifically hired for thispurpose and by various bank regulatory agencies. This analysis covers ourentire loan portfolio but excludes any loans that were analyzed individuallyfor specific allowances as discussed above. There are limitations to any creditrisk grading process. The number of loans makes it impractical to review everyloan every quarter. Therefore, it is possible that in the future some currentlyperforming loans not recently graded will not be as strong as their lastgrading and an insufficient portion of the allowance will have been allocatedto them. Grading and loan review often must be done without knowing whether allrelevant facts are at hand. Troubled borrowers may deliberately orinadvertently omit important information from reports or conversations withlending officers regarding their financial condition and the diminishedstrength of repayment sources.

 

Thetotal amount allocated for the second component is determined by applying lossestimation factors to outstanding loans. At December 31, 2009 and 2008,the allowance allocated by categories of credits totaled $3.8 million and $2.9million, respectively. The increase mainly related to increased allowancefactors for land loans related to the construction of residential subdivisions,commercial quick-qualifier loans and manufactured home loans, recognizingincreased risk for these types of loans, as well as loan growth.

 

Thethird component of the allowance for loan losses is an economic component thatis not allocated to specific loans or groups of loans, but rather is intendedto absorb losses caused by portfolio trends, concentration of credit, growth,and economic trends, as stated previously in “Critical Accounting Policies”. AtDecember 31, 2009 and 2008, the general valuation allowance, including theeconomic component, totaled $2.0 million and $1.9 million, respectively.Starting in late 2008, we witnessed financial difficulties experienced byborrowers in our market, where real estate sale prices have declined andholding periods have increased.  The U.S. economy is stillexperiencing significantly reduced business activity as a result of, amongother factors, disruptions in the financial system, dramatic declines in thehousing prices, and an increasing unemployment rate.  There have beensignificant reductions in spending by consumers and businesses. In response tothis, we have been proactive in evaluating reserve percentages for economic andother qualitative loss factors used to determine the adequacy of the allowancefor loan losses. The increase to the third component of the allowance for loanlosses reflected such evaluation.

 

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The table below summarizes,for the periods indicated, loan balances at the end of each period, the dailyaverages during the period, changes in the allowance for loan losses arisingfrom loans charged off, recoveries on loans previously charged off, additionsto the allowance and certain ratios related to the allowance for loan losses:

 

**Allowance for Loan Losses**

(in thousands)

 
| ** **                                                                       | ** ** | **2009** | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|----------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| ** **                                                                       |       |     |       |     |       |     |       |     |       |     |       |
| **Balances:**                                                                    |       |     |       |     |       |     |       |     |       |     |       |
| Average total loans outstanding during period                                    |       | $        | 426,748    |     | $          | 400,821  |       | $        | 381,316    |     | $          | 345,063 |   | $ | 276,277 |   |
| Total loans outstanding at end of period                                         |       | $        | 425,627    |     | $          | 428,177  |       | $        | 387,809    |     | $          | 378,393 |   | $ | 318,108 |   |
| **Allowance for loan losses:**                                                   |       |     |       |     |       |     |       |     |       |     |       |
| **Balances at beginning of period**                                              |       | $        | 5,569      |     | $          | 4,507    |       | $        | 4,341      |     | $          | 3,976 |   | $ | 3,272 |   |
|                                                                             |       |     |       |     |       |     |       |     |       |     |       |
| **Actual charge-offs:**                                                          |       |     |       |     |       |     |       |     |       |     |       |
| Commercial real estate                                                           |       | 0        |       | 0        |       | 0        |       | 0        |       | 0        |       |
| Commercial                                                                       |       | 871      |       | 11       |       | 0        |       | 0        |       | 1        |       |
| Real estate construction                                                         |       | 3,524    |       | 1,062    |       | 366      |       | 0        |       | 0        |       |
| Agriculture                                                                      |       | 0        |       | 0        |       | 0        |       | 0        |       | 0        |       |
| Residential real estate and consumer                                             |       | 24       |       | 42       |       | 35       |       | 15       |       | 0        |       |
| Total charge-offs                                                                |       | 4,419    |       | 1,115    |       | 402      |       | 15       |       | 1        |       |
|                                                                             |       |     |       |     |       |     |       |     |       |     |       |
| **Recoveries on loans previously  charged off**                                  |       |     |       |     |       |     |       |     |       |     |       |
| 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                                             |       | 8        |       | 5        |       | 5        |       | 2        |       | 0        |       |
| Total recoveries                                                                 |       | 8        |       | 5        |       | 5        |       | 2        |       | 0        |       |
|                                                                             |       |     |       |     |       |     |       |     |       |     |       |
| Net loan charge-offs/(recoveries)                                                |       | 4,411    |       | 1,110    |       | 397      |       | 13       |       | 1        |       |
|                                                                             |       |     |       |     |       |     |       |     |       |     |       |
| Provision for loan losses                                                        |       | 5,862    |       | 2,188    |       | 555      |       | 595      |       | 705      |       |
|                                                                             |       |     |       |     |       |     |       |     |       |     |       |
| Reclassification of reserve related to  off-balance-sheet commitments            |       | 0        |       | (16      | )          | 8        |       | (217     | )          | 0        |       |
|                                                                             |       |     |       |     |       |     |       |     |       |     |       |
| Balance at end of period                                                         |       | $        | 7,020      |     | $          | 5,569    |       | $        | 4,507      |     | $          | 4,341 |   | $ | 3,976 |   |
|                                                                             |       |     |       |     |       |     |       |     |       |     |       |
| Ratios:                                                                          |       |     |       |     |       |     |       |     |       |     |       |
| Net loan charge-offs/(recoveries) to average total  loans                        |       | 1.03     | %          | 0.28     | %          | 0.10     | %          | 0.00     | %          | 0.00     | %          |
| Allowance for loan losses to total loans at end of  period                       |       | 1.65     | %          | 1.30     | %          | 1.16     | %          | 1.15     | %          | 1.16     | %          |
| Net loan charge-offs (recoveries) to allowance for  loan losses at end of period |       | 62.83    | %          | 19.93    | %          | 8.81     | %          | 0.29     | %          | 0.02     | %          |
| Net loan charge-offs (recoveries) to provision for  loan losses                  |       | 75.25    | %          | 50.73    | %          | 71.57    | %          | 2.12     | %          | 0.10     | %          |

 

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Thetable below summarizes, for the periods indicated, the balance of the allowancefor loan losses and the percentage of each type of loan balance at the end ofeach period (See “Loan Portfolio” above for a description of each type of loanbalance):

 

**Allocation of the Allowance for Loan Losses**

 
| ** **                           | ** ** | **Amount Outstanding as of December 31,** | ** ** |
|--------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                           | ** ** | **2009**                                                           | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                           | ** ** | **(Dollars in Thousands)**                               | ** ** |
| **Applicable to:**                   |       |                                                               |       |   |   |   |   |   |   |   |   |
| Commercial real estate               |       | $                                                                  | 4,611      |   | $ | 3,329 |   | $ | 2,672 |   | $ | 2,755 |   | $ | 2,693 |   |
| Commercial                           |       | 670                                                                |       | 806 |   | 663 |   | 413 |   | 364 |   |
| Real estate construction             |       | 1,142                                                              |       | 997 |   | 837 |   | 885 |   | 691 |   |
| Agriculture                          |       | 347                                                                |       | 210 |   | 189 |   | 162 |   | 118 |   |
| Residential real estate and consumer |       | $                                                                  | 250        |   | $ | 227 |   | 147 |   | 126 |   | 110 |   |
| **Total Allowance**                  |       | $                                                                  | 7,020      |   | $ | 5,569 |   | $ | 4,507 |   | $ | 4,341 |   | $ | 3,976 |   |

 

**Other Earning Assets**

 

Forvarious business purposes, we make investments in earning assets other than theinterest-earning securities discussed above. Before 2007, the only otherearning assets held by us were insignificant amounts of Federal Home Loan Bankstock, Federal Reserve Bank stock and the cash surrender value on the BankOwned Life Insurances (“BOLI”). Balances of the Federal Home Loan Bank stock,Federal Reserve Bank stock and the BOLI cash surrender value as of December 31,2009 were $3.8 million, $1.2 million and $10.3 million, respectively.

 

During2007, we invested in a low-income housing tax credit funds (“LIHTCF”) topromote our participation in CRA activities. We committed to invest $1 million,over the next two to three years. We anticipate receiving the return followingthis two to three year period in the form of tax credits and tax deductionsover the next fifteen years.

 

Thebalances of other earning assets as of December 31, 2009 and December 31,2008 were as follows:

 
| **Dollars in Thousands** | ** ** | **Balance as of  December 31, 2009** | ** ** | **Balance as of  December 31, 2008** | ** ** |
|------------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|
| Type                               | ** ** | ** **                                               | ** ** | ** **                                               | ** ** |
| BOLI                               |       | $                                                        | 10,268     |                                                     | $          | 9,859 |   |
| LIHTCF                             |       | $                                                        | 769        |                                                     | $          | 846 |   |
| Federal Reserve Bank Stock         |       | $                                                        | 1,157      |                                                     | $          | 751 |   |
| Federal Home Loan Bank Stock       |       | $                                                        | 3,804      |                                                     | $          | 3,804 |   |

 

**Deposits and Other Sources of Funds**

 

*Deposits*

 

Totaldeposits at December 31, 2009, and 2008 were $429.2 million, and $378.2million, respectively, representing an increase of $51 million or 13.5%, in 2009.The average deposits for the years ended December 31, 2009 increased $48.3million or 13.2% to $413.8 million compared to $365.5 million at December 31,2008.

 

Depositsare the Bank’s primary source of funds. Due to strategic emphasis bymanagement, core deposits (consisting of DDA, NOW, Money Market and Savingsaccounts) increased by 20.7% in 2009 to $347.1 million at December 31,2009.  As a result, the percentage ofcore deposits to total deposits increased to 80.9% from 76.0% as of December 31,2009 as compared to December 31, 2008. The average rate paid on time deposits in denominations of $100,000 ormore was 2.36% and 3.92% for the years ended December 31, 2009 and 2008,respectively.  The composition and cost of the Company’sdeposit base are important components in analyzing the Company’s net interestmargin and balance sheet liquidity characteristics, both of which are discussedin greater detail in other sections herein. See “Net Interest Income and Net Interest Margin” for further discussion.

 

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The Company’s liquidityis impacted by the volatility of deposits or other funding instruments or, inother words, by the propensity of that money to leave the institution forrate-related or other reasons. Deposits can be adversely affected if economicconditions in California and the Company’s market area in particular, continueto weaken. Potentially, the most volatile deposits in a financial institutionare jumbo certificates of deposit, meaning time deposits with balances thatequal or exceed $100,000, as customers with balances of that magnitude aretypically more rate-sensitive than customers with smaller balances

 

Thefollowing tables summarize the distribution of average daily deposits and theaverage daily rates paid for the periods indicated:

 

**Distribution of Average Daily Deposits**

**(Dollars in Thousands)**

 
| ** **                                       | ** ** | **Average Deposits** | ** ** |
|--------------------------------------------------|------------|---------------------------|------------|
| ** **                                       | ** ** | **2009**                  | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                                       | ** ** | **Average**               | ** ** | **Average** | ** ** | **Average** | ** ** | **Average** | ** ** | **Average** | ** ** | **Average** | ** ** |
| **Dollars in Thousands**               | ** ** | **Balance**               | ** ** | **Rate** | ** ** | **Balance** | ** ** | **Rate** | ** ** | **Balance** | ** ** | **Rate** | ** ** |
| ** **                                       | ** ** | ** **                | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Demand, noninterest-bearing                      |       | $                         | 62,874     |   | 0.00 | % | $ | 61,554 |   | 0.00 | % | $ | 58,468 |   | 0.00 | % |
| Money market                                     |       | 183,314                   |       | 1.34 | % | 149,202 |   | 2.40 | % | 125,574 |   | 3.62 | % |
| NOW                                              |       | 56,921                    |       | 0.47 | % | 54,160 |   | 0.71 | % | 53,634 |   | 1.05 | % |
| Savings                                          |       | 13,851                    |       | 0.72 | % | 15,563 |   | 1.66 | % | 16,745 |   | 3.33 | % |
| Time certificates of deposit of $100,000 or more |       | 48,912                    |       | 2.36 | % | 40,172 |   | 3.92 | % | 66,007 |   | 5.20 | % |
| Other time deposits                              |       | 47,883                    |       | 2.04 | % | 44,846 |   | 3.21 | % | 49,118 |   | 4.34 | % |
| Total deposits                                   |       | $                         | 413,755    |   | 1.20 | % | $ | 365,497 |   | 1.98 | % | $ | 369,546 |   | 3.04 | % |

 

Thescheduled maturities of our time deposits in denominations of $100,000 orgreater at December 31, 2009 are, as follows:

 

**Maturities of Time Deposits of $100,000 or More**

**(Dollars in Thousands)**

 
| Three months or less                  |   | $      | 21,863 |   |
|---------------------------------------|--------|--------|--------|--------|
| Over three months through six months  |   | 12,574 |   |
| Over six months through twelve months |   | 8,055  |   |
| Over twelve months                    |   | 3,353  |   |
| Total                                 |   | $      | 45,845 |   |

 

Becauseour client base is comprised primarily of commercial and industrial accounts,individual account balances are generally higher than those ofconsumer-oriented banks.  Three of ourclients carry deposit balances of more than 1% of our total deposits, none ofwhich had a deposit balance of more than 3% of total deposits at December 31,2009.

 

Theonly brokered deposit the Bank holds are from CDARS, a certificate of depositprogram that exchanges funds with other network banks to offer full FDICinsurance coverage to the customer.  TheBank had $11.4 million and $15.5 million in brokered deposits as of December 31,2009 and 2008, respectively.

 

*FHLB Borrowings*

 

Althoughdeposits are the primary source of funds for our lending and investmentactivities and for general business purposes, we may obtain advances from theFederal Home Loan Bank of San Francisco (“FHLB”) as an alternative to retaildeposit funds. Our outstanding FHLB advances decreased by $36.8 million to$32.2 million at year-end 2009 compared to the prior year as a result of ouremphasis on managing non-relationship, high cost CDs.  See “LiquidityManagement” below for the details on the FHLB borrowings program.

 

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Thefollowing table is a summary of FHLB borrowings for fiscal years 2009 and 2008:

 
| **Dollars  in Thousands**                   | ** ** | **2009** | ** ** | **2008** | ** ** |
|---------------------------------------------|------------|----------|------------|----------|------------|
| Balance at year-end                         |       | $32,200  |       | $69,000  |       |
| Average balance during the year             |       | $44,038  |       | $59,441  |       |
| Maximum amount outstanding at any month-end |       | $79,000  |       | $79,100  |       |
| Average interest rate during the year       |       | 1.55     | %          | 2.50     | %          |
| Average interest rate at year-end           |       | 1.75     | %          | 1.51     | %          |

 

**Return on Equity and Assets**

 

Thefollowing table sets forth certain information regarding our return on equityand assets for the periods indicated:

 
| ** **                      | ** ** | **At December 31, 2009** | ** ** | **At December 31, 2008** | ** ** |
|---------------------------------|------------|-----------------------------------------|------------|-----------------------------------------|------------|
| Return on average assets        |       | 0.38                                    | %          | 0.46                                    | %          |
| Return on average common equity |       | 2.51                                    | %          | 4.77                                    | %          |
| Dividend payout ratio           |       | 16.54                                   | %          | 27.38                                   | %          |
| Equity to assets ratio          |       | 11.57                                   | %          | 11.41                                   | %          |

 

**Deferred Compensation Obligations**

 

Wemaintain a nonqualified, unfunded deferred compensation plan for certain keymanagement personnel.  Under this plan, participating employees maydefer compensation, which will entitle them to receive certain payments uponretirement, death, or disability.  The plan provides for paymentscommencing upon retirement and reduced benefits upon early retirement,disability, or termination of employment. At December 31, 2009 and 2008,our aggregate payment obligations under this plan totaled $7.6 million for bothperiods.

 

**Off-Balance Sheet Arrangements**

 

Duringthe ordinary course of business, we provide various forms of credit lines tomeet the financing needs of our customers. These commitments, which represent acredit risk to us, are not represented in any form on our balance sheets.

 

Asof December 31, 2009, and 2008, we had commitments to extend credit of$63.1 million and $63.1 million, respectively.  Obligations under standbyletters of credit were $2.8 million and $3.53 million, for 2009, and 2008,respectively, and there were no obligations under commercial letters of creditfor either period.

 

Theeffect on our revenues, expenses, cash flows and liquidity from the unusedportion of the commitments to provide credit cannot be reasonably predictedbecause there is no guarantee that the lines of credit will be used. For moreinformation regarding our off balance sheet arrangements, see Note 14-Commitments and Other Contingencies- to our 2009 year end financial statementslocated elsewhere in this report.

 

**ContractualObligations**

 

Thefollowing chart summarizes certain contractual obligations of the Bank as of December 31,2009 (dollars in thousands):

 
| **Contractual Obligations** | ** ** | **Less than 1  Year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **More than 5  years** | ** **   | **Total** | ** ** |
|----------------------------------|------------|---------------------------------|------------|--------------------|------------|--------------------|------------|----------------------------------|--------------|-----------|------------|
| FHLB borrowings                  |       | $                               | 27,200     |               | $          | 5,000              |       | $                                |    |      | $          |   |   | $ | 32,200 |   |
| Operating lease obligations      |       | 824                             |       | 1,616              |       | 1,584              |       | 3,052                            |         | 7,076     |       |
| Supplemental retirement plans    |       | 17                              |       | 51                 |       | 179                |       | 900                              |         | 1,147     |       |
| Time deposit maturities          |       | 73,894                          |       | 8,146              |       | 20                 |       | 0                                |         | 82,060    |       |
|                             |       |                            |       |               |       |               |       |                             |         |      |       |
| Total                            |       | $                               | 101,935    |               | $          | 14,813             |       | $                                | 1,783        |      | $          | 3,952 |   | $ | 122,483 |   |

 

Aspermitted or required under California law and to the maximum extent allowableunder that law, we have certain obligations to indemnify our current and formerofficers and directors for certain events or occurrences while the officer ordirector is, 

 

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orwas serving, at our request in such capacity. We also have the power to similarly indemnify our current and formerofficers.  These indemnificationobligations are valid as long as the director or officer acted in good faithand in a manner the person reasonably believed to be in, or not opposed to, ourbest interests, and with respect to any criminal action or proceeding, had noreasonable cause to believe his or her conduct was unlawful.  The maximum potential amount of futurepayments we could be required to make under these indemnification obligationsis unlimited; however, we have a director and officer insurance policy thatmitigates our exposure and enables us to recover a portion of any futureamounts paid.  We believe the estimatedfair value of these indemnification obligations is minimal.

 

**Liquidity and Asset/Liability Management**

 

Managementseeks to ascertain optimum and stable utilization of available assets andliabilities as a vehicle to attain our overall business plans and objectives.In this regard, management focuses on measurement and control of liquidityrisk, interest rate risk and market risk, capital adequacy, operation risk andcredit risk.

 

***Liquidity***

 

Liquidityto meet borrowers’ credit and depositors’ withdrawal demands is provided bymaturing assets, short-term liquid assets that can be converted to cash and theability to attract funds from depositors. Additional sources of liquidity mayinclude institutional deposits, advances from the FHLB and other short-termborrowings, such as federal funds purchased.

 

Sinceour deposit growth strategy emphasizes core deposit growth we have avoidedrelying on brokered deposits as a consistent source of funds.  The only brokered deposit the Bank holds arefrom CDARS, a certificate of deposit program that exchanges funds with other networkbanks to offer full FDIC insurance coverage to the customer.  TheBank had $11.4 million and $10.5 million in brokered deposits as of December 31,2009 and 2008, respectively.

 

AtDecember 31, 2009 and December 31, 2008, the Bank had total FHLBadvances outstanding of $32.2 million and $69.0 million, respectively.  At December 31, 2009 and December 31,2008, the Bank had sufficient collateral to borrow an additional $86.2 millionand $38.1 million, respectively.  Inaddition, the Bank had lines of credit to purchase overnight federal funds withits correspondent banks totaling $20 million. No advances were made on these lines of credit as of December 31,2009 and December 31, 2008.

 

OakValley Bancorp’s liquidity depends primarily on dividends paid to it as soleshareholder of the Bank. The Bank’s ability to pay dividends to Oak ValleyBancorp without regulatory approval will depend on whether the Bank will be ina position to pay dividends.

 

Maintenanceof adequate liquidity requires that sufficient resources be available at alltime to meet our cash flow requirements. Liquidity in a banking institution isrequired primarily to provide for deposit withdrawals and the credit needs ofits customers and to take advantage of investment opportunities as they arise.Liquidity management involves our ability to convert assets into cash or cashequivalents without incurring significant loss, and to raise cash or maintainfunds without incurring excessive additional cost. For this purpose, wemaintain a portion of our funds in cash and cash equivalents, loans andsecurities available for sale. Our liquid assets at December 31, 2009 and2008 totaled approximately $80.1 million and $60.9 million, respectively.  Our liquidity level measured as thepercentage of liquid assets to total assets was 15.26% and 12.0% at December 31,2009, and 2008, respectively.

 

Asa secondary source of liquidity, we rely on advances from the FHLB tosupplement our supply of lendable funds and to meet deposit withdrawalrequirements. Advances from the FHLB are typically secured by a portion of ourloan portfolio and stock issued by the FHLB. The FHLB determines limitations onthe amount of advances by assigning a percentage to each eligible loan categorythat will count towards the borrowing capacity. As of December 31, 2009, our borrowing capacity from the FHLB wasabout $118 million and the outstanding balance was $32.2 million, orapproximately 27% of our borrowing capacity. We also maintain two lines of credit with correspondent banks topurchase up to $20 million in federal funds.

 

***Capital Resources and Capital Adequacy Requirements***

 

Inthe past two years, our primary source of capital has been internally generatedoperating income through retained earnings. At December 31, 2009, totalshareholders’ equity increased to $60.7 million, representing an increase of$2.7 million from December 31, 2008. In December 2008, the Bank was selected to participate in the U.S.Treasury Capital Purchase Program which demonstrates the confidence the U.S.Treasury Department has in the stability of the Bank. The Bank issued $13.5million in preferred stock and intends to use the capital to increase creditavailability to local, creditworthy, businesses and consumers. The preferredstock shares have a 5% coupon for 5 years and 9% thereafter. Warrants topurchase 350,346 shares of common stock at a per share exercise 

 

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priceof $5.78 are attached and fully exercisable. The warrants expire 10 years afterthe issuance date. The securities issued to the Treasury are accounted for ascomponents of regulatory Tier 1 capital.

 

Asof December 31, 2009, we had no material commitments for capitalexpenditures other than the preferred stock dividend payments due to the U.S.Treasury Department.

 

Weare subject to various regulatory capital requirements administered by federalbanking agencies. Failure to meet minimum capital requirements can triggerregulatory actions that could have a material adverse effect on our financialstatements and operations. Under capital adequacy guidelines and the regulatoryframework for prompt corrective action, we must meet specific capitalguidelines that rely on quantitative measures of our assets, liabilities andcertain off-balance-sheet items as calculated under regulatory accountingpractices. Our capital amounts and classification are also subject toqualitative judgments by the regulators about components, risk weightings, andother factors. (See “Description of Business-Regulation and Supervision-CapitalAdequacy Requirements” herein for exact definitions and regulatory capitalrequirements.)

 

Asof December 31, 2009, we were qualified as a “well capitalized institution”under the regulatory framework for prompt corrective action. The followingtable presents the regulatory standards for well-capitalized institutions,compared to the Bank’s capital ratios as of the dates specified:

 
| ** **                             | ** ** | **Regulatory Well-  Capitalized Standards** | ** ** | **December 31, 2009** | ** ** | **December 31, 2008** | ** ** |
|----------------------------------------|------------|-------------------------------------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| Total capital to risk-weighted assets  |       | 10.0                                                  | %          | 13.6                            | %          | 13.3                            | %          |
| Tier I capital to risk-weighted assets |       | 6.0                                                   | %          | 12.3                            | %          | 12.1                            | %          |
| Tier I capital to average assets       |       | 5.0                                                   | %          | 11.3                            | %          | 11.8                            | %          |

 

**MarketRisk**

 

Market risk is the riskof loss of future earnings, fair values, or future cash flows that may resultfrom changes in the price of a financial instrument. The value of a financialinstrument may change as a result of changes in interest rates, foreigncurrency exchange rates, commodity prices, equity prices and other marketchanges that affect market risk sensitive instruments. Market risk isattributed to all market risk sensitive financial instruments, includingsecurities, loans, deposits and borrowings, as well as the Bank’s role as afinancial intermediary in customer-related transactions. The objective ofmarket risk management is to avoid excessive exposure of the Bank’s earningsand equity to loss and to reduce the volatility inherent in certain financialinstruments.

 

**InterestRate Management**

 

Market risk arises fromchanges in interest rates, exchange rates, commodity prices and equity prices.The Bank’s market risk exposure is primarily that of interest rate risk, and ithas established policies and procedures to monitor and limit earnings andbalance sheet exposure to changes in interest rates. The Bank does not engagein the trading of financial instruments, nor does the Bank have exposure tocurrency exchange rates.

 

The principal objectiveof interest rate risk management (often referred to as “asset/liabilitymanagement”) is to manage the financial components of the Bank in a manner thatwill optimize the risk/reward equation for earnings and capital in relation tochanging interest rates. The Bank’s exposure to market risk is reviewed on aregular basis by the Asset/Liability Committee. Interest rate risk is thepotential of economic losses due to future interest rate changes. Theseeconomic losses can be reflected as a loss of future net interest income and/ora loss of current fair market values. The objective is to measure the effect onnet interest income and to adjust the balance sheet to minimize the inherentrisk while at the same time maximizing income. Management realizes certainrisks are inherent, and that the goal is to identify and manage the risks.Management uses two methodologies to manage interest rate risk: (i) astandard GAP analysis; and (ii) an interest rate shock simulation model.

 

The planning of asset andliability maturities is an integral part of the management of an institution’snet interest margin. To the extent maturities of assets and liabilities do notmatch in a changing interest rate environment, the net interest margin maychange over time. Even with perfectly matched repricing of assets andliabilities, risks remain in the form of prepayment of loans or securities orin the form of delays in the adjustment of rates of interest applying to eitherearning assets with floating rates or to interest bearing liabilities. The Bankhas generally been able to control its exposure to changing interest rates bymaintaining primarily floating interest rate loans and a majority of its timecertificates with relatively short maturities.

 

Interest rate changes donot affect all categories of assets and liabilities equally or at the sametime. Varying interest rate environments can create unexpected changes inprepayment levels of assets and liabilities, which may have a significanteffect on the

 

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net interest margin andare not reflected in the interest sensitivity analysis table. Because of thesefactors, an interest sensitivity gap report may not provide a completeassessment of the exposure to changes in interest rates.

 

The Bank uses modelingsoftware for asset/liability management in order to simulate the effects ofpotential interest rate changes on the Bank’s net interest margin, and tocalculate the estimated fair values of the Bank’s financial instruments underdifferent interest rate scenarios. The program imports current balances,interest rates, maturity dates and repricing information for individualfinancial instruments, and incorporates assumptions on the characteristics ofembedded options along with pricing and duration for new volumes to project theeffects of a given interest rate change on the Bank’s interest income andinterest expense. Rate scenarios consisting of key rate and yield curveprojections are run against the Bank’s investment, loan, deposit and borrowedfunds portfolios. These rate projections can be shocked (an immediate andparallel change in all base rates, up or down) and ramped (an incrementalincrease or decrease in rates over a specified time period), based on currenttrends and econometric models or stable economic conditions (unchanged fromcurrent actual levels).

 

The Bank applies a marketvalue (“MV”) methodology to gauge its interest rate risk exposure as derivedfrom its simulation model. Generally, MV is the discounted present value of thedifference between incoming cash flows on interest-earning assets and otherinvestments and outgoing cash flows on interest-bearing liabilities and otherliabilities. The application of the methodology attempts to quantify interestrate risk as the change in the MV which would result from a theoretical 200basis point (1 basis point equals 0.01%) change in market interest rates. Botha 200 basis point increase and a 200 basis point decrease in market rates areconsidered.

 

At December 31,2009, it was estimated that the Bank’s MV would decrease 17.75% in the event ofa 200 basis point increase in market interest rates. The Bank’s MV at the samedate would increase 4.48% in the event of a 200 basis point decrease inapplicable interest rates.

 

Presented below, as of December 31,2009 and 2008, is an analysis of the Bank’s interest rate risk as measured bychanges in MV for instantaneous and sustained parallel shifts of applicableinterest rates:

 
| ** **          | ** ** | **2009**                                            | ** ** | **2008**                                   | ** ** |
|---------------------|------------|-----------------------------------------------------|------------|--------------------------------------------|------------|
| ** **          | ** ** | ** **                                          | ** ** | ** **                                 | ** ** | **Market Value as a % of********Present Value of Assets** | ** ** | ** ** | ** ** | ** ** | ** ** | **Market Value as a % of******** Present Value  of Assets** | ** ** |
| ** **          | ** ** | **$ ****Change********in Market********Value** | ** ** | **% Change********in Market********Value** | ** ** | **MV Ratio** | ** ** | **Change (bp)** | ** ** | **$ Change********in Market********Value** | ** ** | **% Change********in Market********Value** | ** ** | **MV Ratio** | ** ** | **Change (bp)** | ** ** |
| ** **          | ** ** | **(Dollars in thousands)**                          | ** ** |
| **Change in rates** |       |                                                |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| +200                |  bp   |                                                | $          | (13,223                                    | )          | (17.75 | )% | 11.99 | % | (197 | ) | $ | (15,915 | ) | (26.93 | )% | 8.78 | % | (283 | ) |
| +100                |  bp   |                                                | $          | (7,393                                     | )          | (9.92 | )% | 12.87 | % | (109 | ) | $ | (8,779 | ) | (14.86 | )% | 10.07 | % | (154 | ) |
| 0                   |  bp   |                                                | $          | —                                     |       | — | % | 13.96 | % | — |   | $ | — |   | — | % | 11.61 | % | — |   |
| -100                |  bp   |                                                | $          | 6,679                                      |       | 8.97 | % | 14.88 | % | 92 |   | $ | 11,339 |   | 19.19 | % | 13.51 | % | 190 |   |
| -200                |  bp   |                                                | $          | 3,334                                      |       | 4.48 | % | 14.16 | % | 20 |   | $ | 16,274 |   | 27.54 | % | 14.30 | % | 269 |   |

 

Management believes thatthe MV methodology overcomes three shortcomings of the typical maturity gapmethodology. First, it does not use arbitrary repricing intervals and accountsfor all expected future cash flows. Second, because the MV method projects cashflows of each financial instrument under different interest rate environments,it can incorporate the effect of embedded options on an institution’s interestrate risk exposure. Third, it allows interest rates on different instruments tochange by varying amounts in response to a change in market interest rates,resulting in more accurate estimates of cash flows.

 

However, as with anymethod of gauging interest rate risk, there are certain shortcomings inherentto the MV methodology. The model assumes interest rate changes areinstantaneous parallel shifts in the yield curve. In reality, rate changes arerarely instantaneous. The use of the simplifying assumption that short-term andlong-term rates change by the same degree may also misstate historic ratepatterns, which rarely show parallel yield curve shifts. Further, the modelassumes that certain assets and liabilities of

 

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similar maturity or periodto repricing will react in the same way to changes in rates. In reality,certain types of financial instruments may react in advance of changes inmarket rates, while the reaction of other types of financial instruments maylag behind the change in general market rates. When interest rates change,actual loan prepayments and actual early withdrawals from certificates maydeviate significantly from the assumptions used in the model. Finally, thismethodology does not measure or reflect the impact that higher rates may haveon adjustable-rate loan clients’ ability to service their debt. All of thesefactors are considered in monitoring the Bank’s exposure to interest rate risk.

 

**Impact of Inflation; Seasonality**

 

Inflationprimarily impacts us by its effect on interest rates. Our primary source ofincome is net interest income, which is affected by changes in interest rates.We attempt to limit the impact of inflation on our net interest margin throughmanagement of rate-sensitive assets and liabilities and the analysis ofinterest rate sensitivity. The effect of inflation on premises and equipment aswell as noninterest expenses has not been significant for the periods coveredin this report. Our business is generally not seasonal.

 

**ITEM 8.  FINANCIAL STATEMENTS ANDSUPPLEMENTARY DATA**

 

Ourconsolidated financial statements and the Independent Auditors’ Report appearon pages F-1 through F-31 of this Report and are incorporated into thisItem 8 by reference.

 

**ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTSON ACCOUNTING AND FINANCIAL DISCLOSURE**

 

None.

 

**ITEM 9A(T). CONTROLS AND PROCEDURES**

 

***Disclosure Control and Procedures***

 

The Company has carriedout an evaluation, under the supervision and with the participation of theCompany’s management, including the Chief Executive Officer and Chief FinancialOfficer, of the effectiveness of the design and operation of the Company’sdisclosure controls and procedures as of December 31, 2009. As defined in Rule 13a-15(e) underthe Securities Exchange Act of 1934, as amended (the “Exchange Act”),disclosure controls and procedures are controls and procedures designed toreasonably assure that information required to be disclosed in our reportsfiled or submitted under the Exchange Act are recorded, processed, summarized andreported on a timely basis. Disclosure controls are also designed to reasonablyassure that such information is accumulated and communicated to our management,including the Chief Executive Officer and Chief Financial Officer, asappropriate, to allow timely decisions regarding required disclosure. Basedupon their evaluation, our Chief Executive Officer and Chief Financial Officerconcluded that the Company’s disclosure controls were effective as of December 31,2009, the period covered by this report.

 

***Management’s Annual Report on Internal Control over Financial Reporting***

 

Management of the Companyis responsible for establishing and maintaining adequate internal control overfinancial reporting. As defined in Rule 13a-15(f) under the ExchangeAct, internal control over financial reporting is a process designed by, orunder the supervision of, a company’s principal executive and principalfinancial officers and effected by a company’s board of directors, managementand other personnel, to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. Itincludes those policies and procedures that:

 

·                  Pertain to the maintenance of records that inreasonable detail accurately and fairly reflect the transactions anddispositions of the assets of a company;

 

·                  Provide reasonable assurance that transactions arerecorded as necessary to permit preparation of financial statements inaccordance with generally accepted accounting principles, and that receipts andexpenditures of a company are being made only in accordance with authorizationsof management and the board of directors of the company; and

 

·                  Provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use or disposition of a company’sassets that could have a material effect on its financial statements.

 

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Because of the inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements. Also, projections of any evaluation of effectiveness tofuture periods are subject to the risk that controls may become inadequatebecause of changes in conditions, or that the degree of compliance with thepolicies or procedures may deteriorate.

 

The Company’s managementhas used the criteria established in *InternalControl — Integrated Framework* issued by the Committee ofSponsoring Organizations of the Treadway Commission (“COSO”) to evaluate theeffectiveness of the Company’s internal control over financial reporting.Management has selected the COSO framework for its evaluation as it is acontrol framework recognized by the SEC and the Public Company AccountingOversight Board, that is free from bias, permits reasonably consistentqualitative and quantitative measurement of the Company’s internal controls, issufficiently complete so that relevant controls are not omitted and is relevantto an evaluation of internal controls over financial reporting.

 

Based on our assessment,management has concluded that our internal control over financial reporting,based on criteria established in *InternalControl — Integrated Framework* issued by COSO was effective asof December 31, 2009.

 

This annual report doesnot include an attestation report of the Company’s registered public accountingfirm regarding internal control over financial reporting. Management’s reportwas not subject to attestation by the Company’s registered public accountingfirm pursuant to temporary rules of the Securities and Exchange Commissionthat permit the Company to provide only management’s report in this annualreport.

 

***Inherent Limitations on Effectiveness of Controls***

 

The Company’s management,including the Chief Executive Officer and Chief Financial Officer, does notexpect that our disclosure controls or our internal control over financialreporting will prevent or detect all errors and fraud. A control system, nomatter how well designed and operated, can provide only reasonable, notabsolute, assurance that the control system’s objectives will be met. Thedesign of a control system must reflect the fact that there are resourceconstraints, and the benefits of controls must be considered relative to theircosts. Further, because of the inherent limitations in all control systems, noevaluation of controls can provide absolute assurance that misstatements due toerror or fraud will not occur or that all control issues and instances offraud, if any, within the Company have been detected. These inherentlimitations include the realities that judgments in decision-making can befaulty and that breakdowns can occur because of simple error or mistake.Controls can also be circumvented by the individual acts of some persons, bycollusion of two or more people, or by management override of the controls. Thedesign of any system of controls is based in part on certain assumptions aboutthe likelihood of future events, and there can be no assurance that any designwill succeed in achieving its stated goals under all potential futureconditions. Projections of any evaluation of controls effectiveness to future periodsare subject to risks. Over time, controls may become inadequate because ofchanges in conditions or deterioration in the degree of compliance withpolicies or procedures.

 

***Changes in Internal Control over Financial Reporting***

 

There was nochange in our internal control over financial reporting that occurred duringthe quarter ended December 31, 2009 that has materially affected or isreasonably likely to materially affect our internal control over financialreporting.

 

**ITEM 9B. OTHER INFORMATION**

 

None.

 

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**PART III**

 

**ITEM 10.         DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE**

 

Theinformation required by this Item is incorporated by reference from our ProxyStatement to be filed prior to the 2010 Annual Meeting of Shareholders.** ** The Company and the Bank have adopted a Code of Ethics that applies toall staff including the Chief Executive Officer, and the Chief FinancialOfficer. A copy of the Code of Ethics will be provided to any person, withoutcharge, upon written request to Corporate Secretary, Oak Valley Bancorp, 125North Third Avenue, Oakdale, CA 95361.

 

**ITEM 11.         EXECUTIVE COMPENSATION**

 

Theinformation required by this Item is incorporated by reference from our ProxyStatement to be filed prior to the 2010 Annual Meeting of Shareholders.

 

**ITEM 12.****                          ****SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT ANDRELATED STOCKHOLDER MATTERS**

 

Theinformation required by this Item is incorporated by reference from our ProxyStatement to be filed prior to the 2010 Annual Meeting of Shareholders.

 

**ITEM 13.         CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTORINDEPENDENCE**

 

Theinformation required by this Item is incorporated by reference from our ProxyStatement to be filed prior to the 2010 Annual Meeting of Shareholders.

 

**ITEM 14.         PRINCIPAL ACCOUNTANT FEES AND SERVICES**

 

Theinformation required by this Item is incorporated by reference from our ProxyStatement to be filed prior to the 2010 Annual Meeting of Shareholders.

 

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** **

**PART IV**

 

**ITEM 15 — EXHIBITS, FINANCIAL STATEMENT SCHEDULES**

 

**(a)(1) FinancialStatements**

 

The Financial Statementsof the Company and the Report of Independent Registered Public Accounting Firmare set forth on pages F-1 through F-31.

 

**(a)(2) FinancialStatement Schedules**

 

All schedules to theFinancial Statements are omitted because of the absence of the conditions underwhich they are required or because the required information is included in theFinancial Statements or accompanying notes.

 

**(a)(3) Exhibits**

 

The exhibit list requiredby this Item is incorporated by reference to the Exhibit Index included inthis report. The warranties, representations and covenants contained in any ofthe agreements included herein or which appear as exhibits hereto should not berelied upon by buyers, sellers or holders of the Company’s securities and arenot intended as warranties, representations or covenants to any individual orentity except as specifically set forth in such agreement

 

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**SIGNATURES**

 

Pursuant to the requirements of Section 13 or15(d) of the Securities Exchange Act of 1934, as amended, the registranthas duly caused this report to be signed on its behalf by the undersigned,thereunto duly authorized, in Oakdale, California on March 30, 2010.

 

|   |   | **OAK VALLEY BANCORP**   a California corporation |
|--------|--------|--------------------------------------------------------|
|   |   |                                                   |
|   |   | By:                                                    | /s/  RONALD  C. MARTIN |
|   |   |                                                   | Ronald  C. Martin,*Chief Executive Officer* |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the registrant and inthe capacities and on the date indicated.

 

**POWER OF ATTORNEY**

 

KNOWALL MEN BY THESE PRESENTS, that each of the undersigned officers and directorsof the registrant hereby constitutes and appoints Ronald C. Martin and RichardA. McCarty, and each of them, as lawful attorney-in-fact and agent for each ofthe undersigned (with full power of substitution and resubstitution, for and inthe name, place and stead of each of the undersigned officers and directors),to sign and file with the Securities and Exchange Commission under theSecurities Exchange Act of 1934, as amended, any and all amendments,supplements and exhibits to this report and any and all other documents inconnection therewith, hereby granting unto said attorneys-in-fact, and each ofthem, full power and authority to do and perform each and every act and thingnecessary or desirable to be done in order to effectuate the same as fully andto all intents and purposes as each of the undersigned might or could do ifpersonally present, hereby ratifying and confirming all that saidattorneys-in-fact and agents, or any of them, or any of their substitutes, maydo or cause to be done by virtue hereof.

 
| **Signature**               | ** ** | **Title**  | ** ** | **Date**            |
|-----------------------------|------------|------------|------------|---------------------|
| ** **                  | ** ** | ** ** | ** ** | ** **          |
| /s/ DONALD BARTON           |       | Director   |       | March 30, 2010 |
| Donald Barton               |       |       |       |                |
|                        |       |       |       |                |
|                        |       |       |       |                |
| /s/ CHRISTOPHER M. COURTNEY |       | Director   |       | March 30, 2010 |
| Christopher M. Courtney     |       |       |       |                |
|                        |       |       |       |                |
|                        |       |       |       |                |
| /s/ JAMES L. GILBERT        |       | Director   |       | March 30, 2010 |
| James L. Gilbert            |       |       |       |                |
|                        |       |       |       |                |
|                        |       |       |       |                |
| /s/ THOMAS A. HAIDLEN       |       | Director   |       | March 30, 2010 |
| Thomas A. Haidlen           |       |       |       |                |
|                        |       |       |       |                |
|                        |       |       |       |                |
| /s/ MICHAEL Q. JONES        |       | Director   |       | March 30, 2010 |
| Michael Q. Jones            |       |       |       |                |
|                        |       |       |       |                |
|                        |       |       |       |                |
| /s/ RONALD C. MARTIN        |       | Director   |       | March 30, 2010 |
| Ronald C. Martin            |       |       |       |                |
|                        |       |       |       |                |
|                        |       |       |       |                |
| /s/ ROGER M. SCHRIMP        |       | Director   |       | March 30, 2010 |
| Roger M. Schrimp            |       |       |       |                |
|                        |       |       |       |                |
|                        |       |       |       |                |
| /s/ DANNY L. TITUS          |       | Director   |       | March 30, 2010 |
| Danny L. Titus              |       |       |       |                |
|                        |       |       |       |                |
|                        |       |       |       |                |
| /s/ RICHARD J. VAUGHAN      |       | Director   |       | March 30, 2010 |
| Richard J. Vaughan          |       |       |       |                |

 

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**INDEX TO FINANCIAL STATEMENTS**

 
| ** **                                                   | **PAGE**   |
|--------------------------------------------------------------|------------|
|                                                         |       |
| **REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING  FIRM** | F-2        |
|                                                         |       |
| **CONSOLIDATED FINANCIAL STATEMENTS**                        | ** ** |
| Balance sheets                                               | F-3        |
| Statements of earnings                                       | F-4        |
| Statements  of shareholders’ equity                     | F-5        |
| Statements  of cash flows                                    | F-6        |
|                                                         |       |
| Notes  to financial statements                               | F-8        |

 

 

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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

 

Tothe Board of Directors and Stockholders

OakValley Bancorp

 

We have audited theaccompanying consolidated balance sheets of Oak Valley Bancorp and subsidiary(the “Company”) as of December 31, 2009 and 2008 and the relatedconsolidated statements of earnings, shareholders’ equity, and cash flows forthe years ended December 31, 2009 and 2008. These financial statements arethe responsibility of the Company’s management. Our responsibility is toexpress an opinion on these financial statements based on our audits.

 

We conducted our auditsin accordance with the standards of the Public Company Accounting OversightBoard (United States). Those standards require that we plan and perform theaudit to obtain reasonable assurance about whether the financial statements arefree of material misstatement. The Company is not required to have, nor were weengaged to perform, an audit of its internal control over financialreporting.  Our audits includedconsideration of internal control over financial reporting as a basis fordesigning audit procedures that are appropriate in the circumstances, but notfor the purpose of expressing an opinion on the effectiveness of the Company’sinternal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting theamounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, thefinancial statements referred to above present fairly, in all materialrespects, the financial position of Oak Valley Bancorp and subsidiary as of December 31,2009 and 2008, and the results of their operations and their cash flows for theyears ended December 31, 2009 and 2008 in conformity with accountingprinciples generally accepted in the United States of America.

 

/s/ Moss Adams LLP

 

Stockton, California

March 31, 2010

 

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**OAK VALLEY BANCORP****BALANCE SHEETS**

** **
| ** **                                                                                                                                                                                     | ** ** | **December 31,** | ** **  | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|-------------|-----------------------|------------|
| ** **                                                                                                                                                                                     | ** ** | **2009**              | ** **  | **2008**              | ** ** |
| **ASSETS**                                                                                                                                                                                     |       |                  |        |                  |       |
|                                                                                                                                                                                           |       |                  |        |                  |       |
| Cash  and due from banks                                                                                                                                                                       |       | $                     | 20,003,548  |                  | $          | 9,072,860 |   |
| Federal  funds sold                                                                                                                                                                            |       | 1,645,000             |        | 765,000               |       |
| Cash  and cash equivalents                                                                                                                                                                     |       | 21,648,548            |        | 9,837,860             |       |
|                                                                                                                                                                                           |       |                  |        |                  |       |
| Securities  available for sale                                                                                                                                                                 |       | 50,765,314            |        | 41,448,877            |       |
| Loans,  net of allowance for loan loss of $7,020,222 in 2009 and $5,569,496 in 2008                                                                                                            |       | 417,795,686           |        | 421,572,911           |       |
| Bank  premises and equipment, net                                                                                                                                                              |       | 10,167,297            |        | 11,093,967            |       |
| Other  real estate owned (OREO)                                                                                                                                                                |       | 2,149,514             |        | 2,745,575             |       |
| Accrued  interest and other assets                                                                                                                                                             |       | 22,195,354            |        | 21,503,821            |       |
|                                                                                                                                                                                           |       |                  |        |                  |       |
|                                                                                                                                                                                           |       | $                     | 524,721,713 |                  | $          | 508,203,011 |   |
|                                                                                                                                                                                           |       |                  |        |                  |       |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                                                                                                  | ** ** | ** **            | ** **  | ** **            | ** ** |
|                                                                                                                                                                                           |       |                  |        |                  |       |
| Deposits                                                                                                                                                                                       |       | $                     | 429,210,284 |                  | $          | 378,248,467 |   |
| Accrued  interest and other liabilities                                                                                                                                                        |       | 2,619,178             |        | 2,968,465             |       |
| FHLB  advances                                                                                                                                                                                 |       | 32,200,000            |        | 69,000,000            |       |
|                                                                                                                                                                                           |       |                  |        |                  |       |
| Total  liabilities                                                                                                                                                                             |       | 464,029,462           |        | 450,216,932           |       |
|                                                                                                                                                                                           |       |                  |        |                  |       |
| Commitments  and contingencies (Note 14)                                                                                                                                                       |       |                  |        |                  |       |
|                                                                                                                                                                                           |       |                  |        |                  |       |
| Shareholders’  equity                                                                                                                                                                     |       |                  |        |                  |       |
| Preferred  stock, no par value; $1,000 per share liquidation preference, 10,000,000  shares authorized and 13,500 issued and outstanding at December 31, 2009  and December 31, 2008 |       | 12,847,297            |        | 12,680,649            |       |
| Common  stock, no par value; 50,000,000 shares authorized, 7,681,877 and 7,661,627  shares issued and outstanding at December 31, 2009 and 2008,  respectively                            |       | 23,933,440            |        | 23,863,331            |       |
| Additional  paid-in capital                                                                                                                                                                    |       | 1,997,747             |        | 1,925,224             |       |
| Retained  earnings                                                                                                                                                                             |       | 20,230,683            |        | 19,226,645            |       |
| Accumulated  other comprehensive income, net of tax                                                                                                                                            |       | 1,683,084             |        | 290,230               |       |
|                                                                                                                                                                                           |       |                  |        |                  |       |
| Total  shareholders’ equity                                                                                                                                                               |       | 60,692,251            |        | 57,986,079            |       |
|                                                                                                                                                                                           |       |                  |        |                  |       |
|                                                                                                                                                                                           |       | $                     | 524,721,713 |                  | $          | 508,203,011 |   |

 

*Seeaccompanying notes*

 

F-3

----

Table of Contents

 

**OAK VALLEY BANCORP****STATEMENTS OF EARNINGS**

 
| ** **                                           | ** ** | **YEAR ENDED DECEMBER 31,** | ** ** |
|------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                           | ** ** | **2009**                    | ** ** | **2008** | ** ** |
| INTEREST  INCOME                                     |       |                        |       |   |   |
| Interest  and fees on loans                          |       | $                           | 26,686,633 |   | $ | 27,611,325 |   |
| Interest  on securities available for sale           |       | 2,585,816                   |       | 1,615,951 |   |
| Interest  on federal funds sold                      |       | 5,117                       |       | 17,996 |   |
| Interest  on deposits with banks                     |       | 5,205                       |       | 1,887 |   |
| Total  interest income                               |       | 29,282,771                  |       | 29,247,159 |   |
|                                                 |       |                        |       |   |   |
| INTEREST  EXPENSE                                    |       |                        |       |   |   |
| Deposits                                             |       | 4,956,231                   |       | 7,240,037 |   |
| FHLB  advances                                       |       | 684,137                     |       | 1,484,525 |   |
| Federal  funds purchased                             |       | 419                         |       | 7,748 |   |
| Total  interest expense                              |       | 5,640,787                   |       | 8,732,310 |   |
|                                                 |       |                        |       |   |   |
| Net  interest income                                 |       | 23,641,984                  |       | 20,514,849 |   |
| PROVISION  FOR LOAN LOSSES                           |       | 5,862,012                   |       | 2,188,139 |   |
|                                                 |       |                        |       |   |   |
| Net  interest income after provision for loan losses |       | 17,779,972                  |       | 18,326,710 |   |
|                                                 |       |                        |       |   |   |
| NONINTEREST  INCOME                                  |       |                        |       |   |   |
| Service  charges on deposits                         |       | 1,163,515                   |       | 1,299,014 |   |
| Earnings  on cash surrender value of life insurance  |       | 408,628                     |       | 370,004 |   |
| Mortgage  commissions                                |       | 139,757                     |       | 100,857 |   |
| Other                                                |       | 929,483                     |       | 752,532 |   |
| Total  non-interest income                           |       | 2,641,383                   |       | 2,522,407 |   |
|                                                 |       |                        |       |   |   |
| NONINTEREST  EXPENSES                                |       |                        |       |   |   |
| Salaries  and employee benefits                      |       | 7,780,574                   |       | 9,305,601 |   |
| Occupancy  expenses                                  |       | 2,717,285                   |       | 2,694,684 |   |
| Data  processing fees                                |       | 894,056                     |       | 764,792 |   |
| OREO  expenses                                       |       | 2,653,205                   |       | 1,553,881 |   |
| Assessments  (FDIC & DFI)                   |       | 996,288                     |       | 343,610 |   |
| Other  operating expenses                            |       | 3,177,025                   |       | 3,202,675 |   |
| Total  non-interest expense                          |       | 18,218,433                  |       | 17,865,243 |   |
|                                                 |       |                        |       |   |   |
| Earnings  before provision for income taxes          |       | 2,202,922                   |       | 2,983,874 |   |
|                                                 |       |                        |       |   |   |
| PROVISION  FOR INCOME TAXES                          |       | 203,194                     |       | 822,045 |   |
| NET  EARNINGS                                        |       | $                           | 1,999,728  |   | $ | 2,161,829 |   |
|                                                 |       |                        |       |   |   |
| Preferred  stock dividends and accretion             |       | 841,644                     |       | 63,819 |   |
|                                                 |       |                        |       |   |   |
| NET  INCOME AVAILABLE TO COMMON SHAREHOLDERS         |       | $                           | 1,158,084  |   | $ | 2,098,010 |   |
|                                                 |       |                        |       |   |   |
| NET  EARNINGS PER COMMON SHARE                       |       | $                           | 0.15       |   | $ | 0.27 |   |
|                                                 |       |                        |       |   |   |
| NET  EARNINGS PER DILUTED COMMON SHARE               |       | $                           | 0.15       |   | $ | 0.27 |   |

 

*See accompanying notes*

 

F-4

----

Table ofContents

 

**OAK VALLEY BANCORP**

**STATEMENTS OF SHAREHOLDERS’ EQUITY**

** **
| ** **                                                                                       | ** **         | **YEARS ENDED DECEMBER 31, 2009 AND 2008** | ** **         |
|--------------------------------------------------------------------------------------------------|--------------------|--------------------------------------------|--------------------|
| ** **                                                                                       | ** **         | ** **                                 | ** **         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
| ** **                                                                                       | ** **         | ** **                                 | ** **         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Additional** | ** ** | ** ** | ** ** | ** ** | ** ** | **Other** | ** ** | **Total** | ** ** |
| ** **                                                                                       | ** **         | **Common Stock**                           | ** **         | **Preferred Stock** | ** ** | **Paid-in** | ** ** | **Retained** | ** ** | **Comprehensive** | ** ** | **Comprehensive** | ** ** | **Shareholders’** | ** ** |
| ** **                                                                                       | ** **         | **Shares**                                 | ** **         | **Amount** | ** ** | **Shares** | ** ** | **Amount** | ** ** | **Capital** | ** ** | **Earnings** | ** ** | **Income** | ** ** | **Income** | ** ** | **Equity** | ** ** |
| Balances,  January 1, 2008                                                                  |               | 7,607,780                                  |               | $ | 22,843,171 |   |   |   |   |   | $ | 1,748,380 |   | $ | 17,723,646 |   |   |   | $ | 46,193 |   | $ | 42,361,390 |   |
| Stock options exercised                                                                          |     | 53,847                                     |     | 186,922 |     |   |     |   |     |   |     |   |     |   |     |   |     | 186,922 |   |
| Issuance of preferred stock                                                                      |               |                                       |               |   |   | 13,500 |   | $ | 12,666,762 |   |   |   |   |   |   |   |   |   | 12,666,762 |   |
| Issuance of TCPP warrants                                                                        |               |                                       |               | 833,238 |   |   |   |   |   |   |   |   |   |   |   |   |   | 833,238 |   |
| Preferred stock accretion                                                                        |               |                                       |               |   |   |   |   | 13,887 |   |   |   | (13,887 | ) |   |   |   |   | 0 |   |
| Tax benefit of stock options exercised                                                           |               |                                       |               |   |   |   |   |   |   | 54,195 |   |   |   |   |   |   |   | 54,195 |   |
| Cash dividends ($0.075 per share)                                                                |               |                                       |               |   |   |   |   |   |   |   |   | (574,484 | ) |   |   |   |   | (574,484 | ) |
| Stock based compensation                                                                         |               |                                       |               |   |   |   |   |   |   | 122,649 |   |   |   |   |   |   |   | 122,649 |   |
| Cumulative effect of adopting ASC Topic 715                                                      |               |                                       |               |   |   |   |   |   |   |   |   | (70,459 | ) |   |   |   |   | (70,459 | ) |
| Comprehensive income                                                                             |               |                                       |               |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net changes in unrealized gain on  available-for-sale securities (net of income tax of $158,664) |               |                                       |               |   |   |   |   |   |   |   |   |   |   | 244,037 |   | 244,037 |   | 244,037 |   |
| Net income                                                                                       |               |                                       |               |   |   |   |   |   |   |   |   | 2,161,829 |   | 2,161,829 |   |   |   | 2,161,829 |   |
| Comprehensive income                                                                             |               |                                       |               |   |   |   |   |   |   |   |   |   |   | $ | 2,405,866 |   |   |   |   |   |
| Balances, December 31, 2008                                                                 |               | 7,661,627                                  |               | $ | 23,863,331 |   | 13,500 |   | $ | 12,680,649 |   | $ | 1,925,224 |   | $ | 19,226,645 |   |   |   | $ | 290,230 |   | $ | 57,986,079 |   |
| Stock options exercised                                                                          |               | 20,250                                     |               | $ | 70,109 |   |   |   |   |   |   |   |   |   |   |   |   |   | 70,109 |   |
| Preferred stock accretion                                                                        |               |                                       |               |   |   |   |   | $ | 166,648 |   |   |   | $ | (166,648 | ) |   |   |   |   | 0 |   |
| Preferred stock dividend payments                                                                |               |                                       |               |   |   |   |   |   |   |   |   | (637,500 | ) |   |   |   |   | (637,500 | ) |
| Cash dividends ($0.025 per share)                                                                |               |                                       |               |   |   |   |   |   |   |   |   | (191,542 | ) |   |   |   |   | (191,542 | ) |
| Stock based compensation                                                                         |               |                                       |               |   |   |   |   |   |   | 72,523 |   |   |   |   |   |   |   | 72,523 |   |
| Comprehensive income                                                                             |               |                                       |               |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net changes in unrealized gain on  available-for-sale securities (net of income tax of $988,188) |               |                                       |               |   |   |   |   |   |   |   |   |   |   | 1,392,854 |   | 1,392,854 |   | 1,392,854 |   |
| Net income                                                                                       |               |                                       |               |   |   |   |   |   |   |   |   | 1,999,728 |   | 1,999,728 |   |   |   | 1,999,728 |   |
| Comprehensive income                                                                             |               |                                       |               |   |   |   |   |   |   |   |   |   |   | $ | 3,392,582 |   |   |   |   |   |
| Balances, December 31, 2009                                                                 |               | 7,681,877                                  |               | $ | 23,933,440 |   | 13,500 |   | $ | 12,847,297 |   | $ | 1,997,747 |   | $ | 20,230,683 |   |   |   | $ | 1,683,084 |   | $ | 60,692,251 |   |
|                                                                                                  |                    |                                            |                    |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

*See accompanying notes*

 

F-5

----

 

**OAK VALLEY BANCORP**

**STATEMENTS OF CASH FLOWS**

 
| ** **                                                                                 | ** ** | **YEAR ENDED DECEMBER 31,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                                                 | ** ** | **2009**                    | ** ** | **2008** | ** ** |
|                                                                                       |       |                        |       |   |   |
| CASH  FLOWS FROM OPERATING ACTIVITIES:                                                     |       |                        |       |   |   |
| Net  income                                                                                |       | $                           | 1,999,728  |   | $ | 2,161,829 |   |
| Adjustments  to reconcile net earnings to net cash from operating activities:              |       |                        |       |   |   |
| Provision  for loan losses                                                                 |       | 5,862,012                   |       | 2,188,139 |   |
| Depreciation,  amortization and accretion, net                                             |       | 1,034,184                   |       | 1,116,198 |   |
| Stock-based  compensation expense                                                          |       | 72,523                      |       | 122,649 |   |
| Excess  tax benefits from stock-based payment arrangements                                 |       | 0                           |       | (54,195 | ) |
| Loss  on sale of premises and equipment                                                    |       | 0                           |       | 1,434 |   |
| OREO  Write downs and losses on sale                                                       |       | 2,352,113                   |       | 1,553,881 |   |
| Gain  on called available for sale securities                                              |       | (170,019                    | )          | 0 |   |
| Increase  in BOLI cash surrender value                                                     |       | (408,628                    | )          | (370,004 | ) |
| (Increase)  decrease in deferred tax asset                                                 |       | (2,144,694                  | )          | (122,630 | ) |
| Decrease  in accrued interest payable and other liabilities                                |       | (349,287                    | )          | (701,001 | ) |
| Decrease  (increase) in accrued interest receivable                                        |       | 152,027                     |       | (7,744 | ) |
| Decrease  (increase) in other assets                                                       |       | 1,650,071                   |       | (3,561,842 | ) |
| Net  cash from operating activities                                                        |       | 10,050,030                  |       | 2,326,714 |   |
|                                                                                       |       |                        |       |   |   |
| CASH  FLOWS FROM INVESTING ACTIVITIES:                                                     |       |                        |       |   |   |
| Purchases  of available for sale securities                                                |       | (16,945,222                 | )          | (15,606,409 | ) |
| Proceeds  from maturities, calls, and principal paydowns of securities available for  sale |       | 10,208,488                  |       | 7,947,699 |   |
| Net  increase in loans                                                                     |       | (4,978,802                  | )          | (44,242,599 | ) |
| Purchase  of BOLI policies                                                                 |       | 0                           |       | (4,740,000 | ) |
| Proceeds  from sale of OREO                                                                |       | 209,467                     |       | 0 |   |
| Net  purchases of premises and equipment                                                   |       | (136,157                    | )          | (2,117,820 | ) |
| Net  cash from investing activities                                                        |       | (11,642,226                 | )          | (58,759,129 | ) |
|                                                                                       |       |                        |       |   |   |
| CASH  FLOWS FROM FINANCING ACTIVITIES:                                                     |       |                        |       |   |   |
| FHLB  advanced funds                                                                       |       | 55,900,000                  |       | 269,863,000 |   |
| FHLB  payments                                                                             |       | (92,700,000                 | )          | (231,863,000 | ) |
| Federal  funds advances                                                                    |       | 9,135,000                   |       | 63,178,130 |   |
| Federal  funds payments                                                                    |       | (9,135,000                  | )          | (63,178,130 | ) |
| Proceeds  from sale of preferred stock                                                     |       | 0                           |       | 13,500,000 |   |
| Shareholder  cash dividends paid                                                           |       | (191,542                    | )          | (574,484 | ) |
| Preferred  stock dividend payment                                                          |       | (637,500                    | )          | 0 |   |
| Net  increase in demand deposits and savings accounts                                      |       | 59,504,414                  |       | 10,146,439 |   |
| Net  decrease in time deposits                                                             |       | (8,542,597                  | )          | (9,245,748 | ) |
| Excess  tax benefits from stock-based payment arrangements                                 |       | 0                           |       | 54,195 |   |
| Proceeds  from sale of common stock and exercise of stock options                          |       | 70,109                      |       | 186,922 |   |
| Net  cash from financing activities                                                        |       | 13,402,884                  |       | 52,067,324 |   |
|                                                                                       |       |                        |       |   |   |
| NET  INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                                      |       | 11,810,688                  |       | (4,365,091 | ) |
|                                                                                       |       |                        |       |   |   |
| CASH  AND CASH EQUIVALENTS, beginning of period                                            |       | 9,837,860                   |       | 14,202,951 |   |
|                                                                                            |            |                             |            |  |  |  |  |

 

F-6

----

 
| CASH  AND CASH EQUIVALENTS, end of period                        |   | $      | 21,648,548 |   | $      | 9,837,860 |   |
|------------------------------------------------------------------|--------|--------|------------|--------|--------|-----------|--------|
|                                                             |   |   |       |   |   |
| SUPPLEMENTAL  DISCLOSURES OF CASH FLOW INFORMATION:              |   |   |       |   |   |
| Cash  paid during the year for:                                  |   |   |       |   |   |
| Interest                                                         |   | $      | 6,003,735  |   | $      | 9,785,838 |   |
| Income  taxes                                                    |   | $      | 1,264,000  |   | $      | 1,160,000 |   |
|                                                             |   |   |       |   |   |
| NON-CASH  INVESTING ACTIVITIES:                                  |   |   |       |   |   |
| Real  estate acquired through foreclosure                        |   | $      | 1,965,519  |   | $      | 2,745,575 |   |
| Change  in unrealized gain/loss on available-for-sale securities |   | $      | 2,381,042  |   | $      | 402,701   |   |
|                                                             |   |   |       |   |   |
| NON-CASH  FINANCING ACTIVITIES:                                  |   |   |       |   |   |
| Tax  benefit from stock options exercised                        |   | $      | 0          |   | $      | 54,195    |   |
| Cumulative  effect of adopting ASC Topic 715                     |   | $      | 0          |   | $      | 119,842   |   |
| Accretion  of preferred stock                                    |   | $      | 166,648    |   | $      | 0         |   |

 

*Seeaccompanying notes*

 

F-7

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Table ofContents

 

**OAK VALLEY BANCORP**

**NOTES TO FINANCIAL STATEMENTS**

 

**NOTE 1 — SUMMARY OF ACCOUNTING POLICIES**

 

**IntroductoryExplanation**

 

OnJuly 3, 2008 (the “Effective Date”), a bank holding company reorganizationwas completed whereby Oak Valley Bancorp (“Bancorp”) became the parent holdingcompany for Oak Valley Community Bank ( the “Bank”).  On theEffective Date, a tax-free exchange was completed whereby each outstandingshare of the Bank was converted into one share of Bancorp and the Bank becamethe sole wholly-owned subsidiary of the holding company.

 

Theconsolidated financial statements include the accounts of Bancorp and itswholly-owned bank subsidiary. All material intercompany transactions have beeneliminated. In the opinion of Management, the consolidated financial statementscontain all adjustments necessary to present fairly the financial position,results of operations, changes in stockholders’ equity and cash flows.  Alladjustments are of a normal, recurring nature.

 

OakValley Community Bank (the “Bank”) is a California State chartered bank. TheBank was incorporated under the laws of the state of California on May 31,1990, and began operations in Oakdale on May 28, 1991. The Bank operatesbranches in Oakdale, Sonora, Bridgeport, Bishop, Mammoth Lakes, Modesto,Patterson, Turlock, Ripon, Stockton, and Escalon, California. The Bridgeport,Mammoth Lakes, and Bishop branches operate as a separate division, Eastern SierraCommunity Bank. The Bank’s primary source of revenue is providing loans tocustomers who are predominantly middle-market businesses.

 

Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions.  Theseestimates and assumptions affect the reported amounts of assets and liabilitiesat the date of the financial statements and the reported amounts of revenuesand expenses during the reporting period. Significant accounting estimates reflected in the Bank’s 2009 financialstatements include the allowance for loan losses, the valuation allowance fordeferred tax assets, the fair value of stock options and the determination,recognition and measurement of impaired loans. Actual results could differ from these estimates.

 

Asummary of the significant accounting policies applied in the preparation ofthe accompanying financial statements follows.

 

**Cash and cash equivalents —** The Bank has defined cashand cash equivalents to include cash, due from banks, certificates of depositwith maturities of three months or less, and federal funds sold. Generally,federal funds are sold for one-day periods. At times throughout the year,balances can exceed FDIC insurance limits.  Management believes the riskof loss is remote as these amounts are held by major financial institutions.

 

**Securities available for sale —**Available-for-sale securities consist of bonds, notes, and debentures notclassified as trading securities or held-to-maturity securities.Available-for-sale securities with unrealized holding gains and losses, net oftax, are reported as a net amount in a separate component of shareholders’equity, accumulated other comprehensive income, until realized. Gains andlosses on the sale of available-for-sale securities are determined using thespecific identification method. The amortization of premiums and accretion ofdiscounts are recognized as adjustments to interest income over the period to maturity.

 

Investments with fair values that are less than amortized cost areconsidered impaired.  Impairment mayresult from either a decline in the financial condition of the issuing entityor, in the case of fixed interest rate investments, from rising interest rates.At each consolidated financial statement date, management assesses eachinvestment to determine if impaired investments are temporarily impaired or ifthe impairment is other than temporary. This assessment includes adetermination of whether the Company intends to sell the security, or if it ismore likely than not that the Company will be required to sell the securitybefore recovery of its amortized cost basis less any current-period creditlosses. For debt securities that are considered other than temporarily impairedand that the Company does not intend to sell and will not be required to sellprior to recovery of the amortized cost basis, the amount of impairment isseparated into the amount that is credit related (credit loss component) andthe amount due to all other factors. The credit loss component is recognized inearnings and is calculated as the difference between the security’s amortizedcost basis and the present value of its expected future cash flows.  The remaining difference between the security’sfair value and the present value of the future expected cash flows is deemed tobe due to factors that are not credit related and is recognized in othercomprehensive income.

 

**Otherreal estate owned**— Real estate properties acquired through, or in lieu of, loan foreclosure areto be sold and are initially recorded at the lower of carrying amount of theloan or fair value of the property at the date of foreclosure less sellingcosts.  Subsequent to foreclosure,valuations are periodically performed and any subject revisions in the estimateof fair value are reported as adjustment to the carrying value of the realestate, provided the adjusted carrying amount does not exceed the originalamount at 

 

F-8

----

Table of Contents

 

**OAK VALLEY BANCORP**

**NOTES TO FINANCIAL STATEMENTS**

 

**NOTE 1 — SUMMARY OF ACCOUNTING POLICIES (CONTINUED)**

 

foreclosure.  Revenues and expenses from operations andchanges in the valuation allowance are included in other operatingexpenses.  As of December 31, 2009,the Bank owned six properties with fair value balances totaling $2,150,000 thatare considered other real estate owned.

 

**Loansand allowance for loan losses**— Loans are reported at theprincipal amount outstanding, net of unearned income, deferred loan fees, andthe allowance for loan losses. Unearned discounts on installment loans arerecognized as income over the terms of the loans. Interest on other loans iscalculated by using the simple interest method on the daily balance of theprincipal amount outstanding.

 

Loanfees net of certain direct costs of origination, which represent an adjustmentto interest yield, are deferred and amortized over the contractual term of theloan.

 

Loanson which the accrual of interest has been discontinued are designated asnon-accrual loans. Accrual of interest on loans is discontinued either whenreasonable doubt exists as to the full and timely collection of interest orprincipal or when a loan becomes contractually past due by ninety days or morewith respect to interest or principal. When a loan is placed on non-accrualstatus, all interest previously accrued, but not collected, is reversed againstcurrent period interest income. Income on such loans is then recognized only tothe extent that cash is received and where the future collection of principalis probable. Interest accruals are resumed on such loans only when they arebrought fully current with respect to interest and principal and when, in thejudgment of management, the loans are estimated to be fully collectible as toboth principal and interest.

 

Theallowance for loan losses is established through a provision for loan lossescharged to operations. Loans are charged against the allowance for loan losseswhen management believes that the collectability of the principal is unlikely.Subsequent recoveries of previously charged off amounts, if any, are creditedto the allowance.

 

Theallowance for loan losses is evaluated on a regular basis by management and isbased on management’s periodic review of the collectability of the loans inlight of historical experience, the nature and volume of the loan portfolio,adverse situations that may affect the borrower’s ability to repay, estimatedvalue of any underlying collateral, and prevailing economic conditions. Thisevaluation is inherently subjective, as it requires estimates that aresusceptible to significant revision as more information becomes available.

 

In addition, variousregulatory agencies, as an integral part of their examination process,periodically review the Bank’s allowance for loan losses. Such agencies mayrequire the Bank to recognize additional allowance based on their judgment aboutinformation available to them at the time of their examination.

 

Theallowance consists of specific, general, and unallocated components. Thespecific component relates to loans that are classified as impaired. Impairedloans, as defined, are measured based on the present value of expected futurecash flows discounted at the loan’s effective interest rate or the fair valueof the collateral if the loan is collateral dependent. The general componentrelates to non-impaired loans and is based on historical loss experienceadjusted for qualitative factors. An unallocated component is maintained tocover uncertainties that could affect management’s estimate of probable losses.The unallocated component of the allowance reflects the margin of imprecisioninherent in the underlying assumptions used in the methodologies for estimatingspecific and general losses in the portfolio.

 

TheBank considers a loan impaired when it is probable that all amounts ofprincipal and interest due, according to the contractual terms of the loanagreement, will not be collected, which is the same criteria used for thetransfer of loans to non-accrual status. Interest income is recognized onimpaired loans in the same manner as non-accrual loans. Factors considered bymanagement in determining impairment include payment status, collateral value,and the probability of collecting scheduled principal and interest paymentswhen due. Loans that experience insignificant payment delays and paymentshortfalls generally are not classified as impaired. Management determines thesignificance of payment delays and payment shortfalls on a case-by-case basis,taking into consideration all of the circumstances surrounding the loan and theborrower, including the length of the delay, the reasons for the delay, theborrower’s prior payment record, and the amount of the shortfall in relation tothe principal and interest owed.

 

Themethod for calculating the allowance for off-balance-sheet is based on anallowance percentage which is less than other outstanding loan types becausethey are at a lower risk level.  This allowance percentage is evaluated bymanagement periodically and is applied to the total undisbursed loan commitmentbalance to calculate the allowance for off-balance-sheet commitments.

 

F-9

----

Table ofContents

 

**OAK VALLEY BANCORP**

**NOTES TO FINANCIAL STATEMENTS**

 

**NOTE 1 — SUMMARY OF ACCOUNTING POLICIES (CONTINUED)**

 

**Premises and equipment —** Premises and equipment arestated at cost less accumulated depreciation and amortization. Depreciation andamortization are provided for in amounts sufficient to relate the cost ofdepreciable assets to operations over their estimated service lives using thestraight-line basis. The estimated lives used in determining depreciation are:

 
| Building                |   | 31.5         |   | years  |
|-------------------------|--------|--------------|--------|--------|
|                    |   |         |   |   |
| Equipment               |   | 3  – 12 |   | years  |
|                    |   |         |   |   |
| Furniture  and fixtures |   | 3  – 7  |   | years  |
|                    |   |         |   |   |
| Leasehold  improvements |   | 5  – 15 |   | years  |
|                    |   |         |   |   |
| Automobiles             |   | 3  – 5  |   | years  |

 

Leaseholdimprovements are amortized over the lesser of the useful life of the asset orthe remaining term of the lease. The straight-line method of depreciation isfollowed for all assets for financial reporting purposes, but acceleratedmethods are used for tax purposes. Deferred income taxes have been provided forthe resulting temporary differences.

 

**Income taxes —** Deferred income taxes areprovided for the temporary differences between the financial reporting basisand the tax basis of the Bank’s assets and liabilities. Deferred tax assets andliabilities are reflected at currently enacted income tax rates applicable tothe period in which the deferred tax assets or liabilities are expected to berealized or settled using the liability method. As changes in tax laws or ratesare enacted, deferred tax assets and liabilities are adjusted through theprovision for income taxes.

 

TheBank files income tax returns in the U.S. federal jurisdiction, and variousstates. With few exceptions, the Bank is no longer subject to U.S. federal orstate/local income tax examinations by tax authorities for years before 2004.

 

TheBank recognizes interest accrued and penalties related to unrecognized taxbenefits in tax expense. During the years ended December 31, 2009 and2008, the Bank recognized no unrecognized tax benefits or related interest andpenalties.

 

**Transfers of financial assets —** Transfers offinancial assets are accounted for as sales when control over the assets hasbeen surrendered. Control over transferred assets is deemed to be surrenderedwhen:  (1) the assets have been isolated from the Bank, (2) thetransferee obtains the right (free of conditions that contain it from takingadvantage of that right) to pledge or exchange the transferred assets, and (3) theBank does not maintain effective control over the transferred assets through anagreement to repurchase them before their maturity.

 

**Advertising costs —** The Bank expenses marketingcosts as they are incurred. Advertising expense was $136,000 and $126,000 forthe years ended December 31, 2009 and 2008, respectively.

 

**Comprehensive income — **Comprehensiveincome is comprised of net income and other comprehensive income. Othercomprehensive income includes items previously recorded directly to equity,such as unrealized gains and losses on securities available for sale.Comprehensive income is presented in the statement of shareholders’ equity. Forthe year ended December 31, 2009, $100,000 net of tax, was reclassifiedfrom comprehensive income into net income related to gains on called availablefor sale securities. No amounts were reclassified out of comprehensive incomeinto net income for the year ended December 31, 2008.

 

**Investment in limited partnership** —  During2007 the Bank acquired limited interests in a private limited partnership thatacquires affordable housing properties in California that generate Low IncomeHousing Tax Credits under Section 42 of the Internal Revenue Code of 1986,as amended.  The Bank’s limited partnership investment is accounted forunder the equity method.  The Bank’s noninterest expense associated withthe utilization of these tax credits for the year ended December 31, 2009and 2008 was $94,781 and $62,932, respectively.  The limited partnershipinvestment is expected to generate a total tax benefit of approximately $1.16million over the life of the investment for the combination of the tax creditsand deductions on noninterest expense.  The tax credits expire between2009 and 2022.  In 2008, a tax benefit of $140,000 was utilized for incometax purposes and an estimated amount of $132,000 will be utilized in2009.  The recorded investment in limited partnerships totaled $769,299and $845,500 at December 31, 2009 and 2008, respectively, and is reflectedas a component of accrued interest and other assets on the balance sheets.

 

**FederalHome Loan Bank Stock** —  Federal Home Loan Bank stockrepresents the Company’s investment in the stock of the Federal Home Loan Bankof San Francisco (“FHLB”) and is carried at par value, which reasonablyapproximates its fair value. While technically these are considered equitysecurities, there is no market for the FHLB stock. Therefore, the shares areconsidered as restricted investment securities. Management periodically evaluates FHLB stock for other-than-temporaryimpairment.  Management’s determinationof whether these investments are impaired is based on its assessment of theultimate recoverability of cost rather than by recognizing temporary declinesin value. The determination of whether a decline affects the ultimaterecoverability of cost is influenced by criteria such as (1) thesignificance of any decline in net assets of the FHLB as compared to thecapital stock amount for the FHLB and the length of time this situation haspersisted, (2) commitments by the FHLB to make payments required by law orregulation and the level of such payments in 

 

F-10

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Table ofContents

 

**OAK VALLEY BANCORP**

**NOTES TO FINANCIAL STATEMENTS**

 

**NOTE 1 — SUMMARY OF ACCOUNTING POLICIES (CONTINUED)**

 

relationto the operating performance of the FHLB, (3) the impact of legislativeand regulatory changes on institutions and, accordingly, the customer base ofthe FHLB, and (4) the liquidity position of the FHLB.

 

**Stock based compensation —**TheBank recognizes in the income statement the grant-date fair value of stockoptions and other equity-based forms of compensation issued to employees overthe employees’ requisite service period (generally the vesting period).  The bank uses the straight-line recognitionof expenses for awards with graded vesting.

 

Thefair value of each option grant is estimated as of the grant date using anoption-pricing model with the assumptions noted in the following table. TheBank utilizes a binomial pricing model for all grants. Expected volatility isbased on the historical volatility of the price of the Bank’s stock. The Bankuses historical data to estimate option exercise and stock option forfeiturerates within the valuation model. The expected term of options granted for thebinomial model is derived from applying a historical suboptimal exercise factorto the contractual term of the grant. For binomial pricing, the risk-free ratefor periods is equal to the U.S. Treasury yield at the time of grant andcommensurate with the contractual term of the grant.

 

Thefair value of each option is estimated on the date of grant using an optionspricing model with the following weighted average assumptions:

 
| ** **                        | ** ** | **YEAR ENDED DECEMBER 31,** | ** ** |
|-----------------------------------|------------|--------------------------------------------|------------|
| ** **                        | ** ** | **2009**                                   | ** ** | **2008** | ** ** |
| Pricing model                     |       | Binomial                                   |       | Binomial |   |
| Dividend yield                    |       | 1.82                                       | %          | 1.54 | % |
| Expected volatility               |       | 43.55                                      | %          | 36.25 | % |
| Risk-free interest rate           |       | 2.60                                       | %          | 4.22 | % |
| Expected option term              |       | 7.15 years                                 |       | 7.27 years |   |
| Stock-based compensation recorded |       | $                                          | 72,523     |   | $ | 122,649 |   |
|                                   |            |                                            |            |  |  |  |  |

 

**Reclassifications** — Certain prior yearamounts have been reclassified to conform to the current year presentation.There was no effect on net income or shareholders’ equity.

 

**Recently Issued Accounting Standards —**

 

ASCTopic 715, “Accounting for Deferred Compensation and Postretirement BenefitAspects of Endorsement Split Dollar Life Insurance Arrangements.”  ASCTopic 715 requires the recognition of a liability and related compensationexpense for bank owned life insurance policies with joint beneficiaryagreements that provide a benefit to an employee that extends topost-retirement periods.  Under ASC Topic 715, life insurance policiespurchased for the purpose of providing such benefits do not effectively settlean entity’s obligation to the employee.  Accordingly, the entity mustrecognize a liability and related compensation expense during the employee’sactive service period based on the future cost of insurance to be incurredduring the employee’s retirement.  If the entity has agreed to provide theemployee with a death benefit, then the liability for the future death benefitshould be recognized by following the guidance in ASC Topic 715, “Employer’sAccounting for Postretirement Benefits Other Than Pensions.”  The Companyadopted this pronouncement effective January 1, 2008. The impact to theCompany’s financial position, results of operations and cash flows was notmaterial.

 

*Accounting Standards Codification*. The Financial Accounting StandardsBoard’s (FASB) Accounting Standards Codification (ASC) became effective on July 1,2009. At that date, the ASC became FASB’s officially recognized source ofauthoritative U.S. generally accepted accounting principles (GAAP) applicableto all public and non-public non-governmental entities, superseding existingFASB, American Institute of Certified Public Accountants (AICPA), EmergingIssues Task Force (EITF) and related literature. Rules and interpretivereleases of the SEC under the authority of federal securities laws are alsosources of authoritative GAAP for SEC registrants. All other accountingliterature is considered non-authoritative. The switch to the ASC affects theaway companies refer to U.S. GAAP in financial statements and accountingpolicies. Citing particular content in the ASC involves specifying the uniquenumeric path to the content through the Topic, Subtopic, Section andParagraph structure.

 

*FASB ASC Topic 815, “Derivatives and Hedging.”* New authoritative accounting guidanceunder ASC Topic 815, “Derivatives and Hedging,” amends prior guidance to amendand expand the disclosure requirements for derivatives and hedging activitiesto provide greater transparency about (i) how and why an entity usesderivative instruments, (ii) how derivative instruments and related hedgeitems are accounted for under ASC Topic 815, and (iii) how derivativeinstruments and related hedged items affect an entity’s financial position,results of operations and cash flows. To meet those objectives, the newauthoritative accounting guidance requires qualitative disclosures aboutobjectives and strategies for using derivatives, quantitative disclosures aboutfair value amounts of gains 

 

F-11

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Table ofContents

 

**OAK VALLEY BANCORP**

**NOTES TO FINANCIAL STATEMENTS**

 

**NOTE 1 — SUMMARY OF ACCOUNTING POLICIES (CONTINUED)**

 

and losses on derivativeinstruments and disclosures about credit-risk-related contingent features inderivative agreements. The new authoritative accounting guidance under ASCTopic 815 became effective for the Company on January 1, 2009 and did nothave a significant impact on the Company’s financial statements.

 

*FASB ASC Topic 820, “Fair Value Measurements andDisclosures.”*Newauthoritative accounting guidance under ASC Topic 820,”Fair Value Measurementsand Disclosures,” affirms that the objective of fair value when the market foran asset is not active is the price that would be received to sell the asset inan orderly transaction, and clarifies and includes additional factors fordetermining whether there has been a significant decrease in market activityfor an asset when the market for that asset is not active. ASC Topic 820requires an entity to base its conclusion about whether a transaction was notorderly on the weight of the evidence. The new accounting guidance amendedprior guidance to expand certain disclosure requirements. The Company adoptedthe new authoritative accounting guidance under ASC Topic 820 during the firstquarter of 2009. Adoption of the new guidance did not significantly impact theCompany’s financial statements.

 

Furthernew authoritative accounting guidance (Accounting Standards Update No. 2009-5)under ASC Topic 820 provides guidance for measuring the fair value of aliability in circumstances in which a quoted price in an active market for theidentical liability is not available. In such instances, a reporting entity is requiredto measure fair value utilizing a valuation technique that uses (i) thequoted price of the identical liability when traded as an asset, (ii) quotedprices for similar liabilities or similar liabilities when traded as assets, or(iii) another valuation technique that is consistent with the existingprinciples of ASC Topic 820, such as an income approach or market approach. Thenew authoritative accounting guidance also clarifies that when estimating thefair value of a liability, a reporting entity is not required to include aseparate input or adjustment to other inputs relating to the existence of arestriction that prevents the transfer of the liability. The forgoing newauthoritative accounting guidance under ASC Topic 820 became effective for theCompany’s financial statements beginning October 1, 2009 and did not havea significant impact on the Company’s financial statements.

 

*FASB ASC Topic 320, “Investments — Debt and EquitySecurities.”* Newauthoritative accounting guidance under ASC Topic 320, “Investments - Debt andEquity Securities,” (i) changes existing guidance for determining whetheran impairment is other than temporary to debt securities and (ii) replacesthe existing requirement that the entity’s management assert it has both the intentand ability to hold an impaired security until recovery with a requirement thatmanagement assert: (a) it does not have the intent to sell the security;and (b) it is more likely than not it will not have to sell the securitybefore recovery of its cost basis. Under ASC Topic 320, declines in the fairvalue of held-to-maturity and available-for-sale securities below their costthat are deemed to be other than temporary are reflected in earnings asrealized losses to the extent the impairment is related to credit losses. Theamount of the impairment related to other factors is recognized in othercomprehensive income. The Company adopted the provisions of the newauthoritative accounting guidance under ASC Topic 320 during the second quarterof 2009. Adoption of the new guidance did not significantly impact the Company’sfinancial statements.

 

*FASB ASC Topic 825 “Financial Instruments.”* New authoritative accounting guidanceunder ASC Topic 825,”Financial Instruments,” requires an entity to providedisclosures about the fair value of financial instruments in interim financialinformation and amends prior guidance to require those disclosures insummarized financial information at interim reporting periods. The new interimdisclosures required under Topic 825 were included in the Company’s Form 10-Qbeginning June 30, 2009.

 

**NOTE 2 — CASH AND DUE FROM BANKS**

 

Cashand due from banks includes balances with the Federal Reserve Bank and othercorrespondent banks. The Bank is required to maintain specified reserves by theFederal Reserve Bank. The average reserve requirements are based on apercentage of the Bank’s deposit liabilities. In addition, the Federal ReserveBank requires the Bank to maintain a certain minimum balance at all times.  As of December 31, 2009 the Bank had abalance of $10,440,736 which is more than adequate to satisfy the reserverequirement.

 

F-12

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Table ofContents

 

**OAK VALLEY BANCORP**

**NOTES TO FINANCIAL STATEMENTS**

 

**NOTE 3 — SECURITIES**

 

Theamortized cost and estimated fair values of debt securities as of December 31,2009, are as follows:

 
| ** **                           | ** ** | **Amortized  Cost** | ** **       | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** |
|--------------------------------------|------------|---------------------|------------------|------------------------------|------------|-------------------------------|------------|-----------------|------------|
| Available-for-sale  securities:      |       |                |             |                         |       |                          |       |            |       |
| U.S.  agencies                       |       | $                   | 29,475,777       |                         | 1,511,122  |                          | $          | (2,181          | )          | $ | 30,984,718 |   |
| Collateralized  mortgage obligations |       | 2,883,988           |             | 110,758                      |       | —                        |       | 2,994,746       |       |
| Municipalities                       |       | 12,327,922          |             | 1,235,683                    |       | (6,454                        | )          | 13,557,151      |       |
| SBA  Pools                           |       | 1,588,867           |             | —                       |       | (9,519                        | )          | 1,579,348       |       |
| Asset-Back  Security                 |       | 81,867              |             | 707                          |       | —                        |       | 82,574          |       |
| Mutual  Fund                         |       | 1,546,465           |             | 20,312                       |       | —                        |       | 1,566,777       |       |
|                                 |       | $                   |  47,904,886 |                         | $          | 2,878,582                     |       | $               | (18,154    | ) | $ | 50,765,314 |   |
|                                      |            |                     |                  |                              |            |                               |            |                 |            |  |  |  |  |

 

The following tables detailthe gross unrealized losses and fair values aggregated by investment categoryand length of time that individual securities have been in a continuousunrealized loss position at December 31, 2009.

 
| ** **                             | ** ** | **Less than 12 months** | ** ** | **12 months or more** | ** ** | **Total**       | ** ** |
|----------------------------------------|------------|-------------------------|------------|-----------------------|------------|-----------------|------------|
| **Description of Securities**          | ** ** | **Fair  Value**         | ** ** | **Unrealized  Loss**  | ** ** | **Fair  Value** | ** ** | **Unrealized  Loss** | ** ** | **Fair  Value** | ** ** | **Unrealized  Loss** | ** ** |
|                                   |       |                    |       |                  |       |            |       |   |   |   |   |   |   |
| U.S.  agencies                         |       | $                       | 425,908    |                  | $          | (2,181          | )          | $ | — |   | — |   | $ | 425,908 |   | $ | (2,181 | ) |
| Collateralized  mortgage obligations   |       | —                  |       | —                |       | —          |       | — |   | — |   | — |   |
| Municipalities                         |       | 402,628                 |       | (6,454                | )          | —          |       | — |   | 402,628 |   | (6,454 | ) |
| SBA  Pools                             |       | —                  |       | —                |       | 1,579,348       |       | (9,519 | ) | 1,579,348 |   | (9,519 | ) |
| Asset  Backed Securities               |       | —                  |       | —                |       | —          |       | — |   | — |   | — |   |
| Total  temporarily impaired securities |       | $                       | 828,536    |                  | $          | (8,635          | )          | $ | 1,579,348 |   | $ | (9,519 | ) | $ | 2,407,884 |   | $ | (18,154 | ) |
|                                        |            |                         |            |                       |            |                 |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

AtDecember 31, 2009, two SBA pools make up the total amount of securities inan unrealized loss position for greater than 12 months. Management periodicallyevaluates each available-for-sale investment security in an unrealized lossposition to determine if the impairment is temporary or other than temporary.Management has determined that no investment security is other than temporarilyimpaired. The unrealized losses are due solely to interest rate changes and theBank does not intend to sell the securities and it is not likely that we willbe required to sell the securities before the earlier of the forecastedrecovery or the maturity of the underlying investment security.

 

F-13

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Table ofContents

 

**OAK VALLEY BANCORP**

**NOTES TO FINANCIAL STATEMENTS**

 

**NOTE 3 — SECURITIES (CONTINUED)**

 

Theamortized cost and estimated fair value of debt securities at December 31,2009, by contractual maturity or call date, are shown below. Expected maturitieswill differ from contractual maturities because borrowers may have the right tocall or prepay obligations with or without call or prepayment penalties.

 
| ** **                              | ** ** | **Amortized** | ** ** | **Fair**   | ** ** |
|-----------------------------------------|------------|---------------|------------|------------|------------|
| ** **                              | ** ** | **Cost**      | ** ** | **Value**  | ** ** |
| Available-for-sale  securities:         |       |          |       |       |       |
| Due  in one year or less                |       | $             | 510,000    |       | $          | 515,527 |   |
| Due  after one year through five years  |       | 4,351,241     |       | 4,787,740  |       |
| Due  after five years through ten years |       | 19,242,750    |       | 20,634,864 |       |
| Due  after ten years                    |       | 23,800,895    |       | 24,827,183 |       |
|                                    |       | $             | 47,904,886 |       | $          | 50,765,314 |   |

 

Theamortized cost and estimated fair values of debt securities as of December 31,2008, are as follows:

 
| ** **                          | ** ** | **Amortized Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross Unrealized  Losses** | ** ** | **Fair  Value** | ** ** |
|-------------------------------------|------------|-------------------------|------------|------------------------------|------------|-----------------------------------|------------|-----------------|------------|
| ** **                          | ** ** | ** **              | ** ** | ** **                   | ** ** | ** **                        | ** ** | ** **      | ** ** |
| Available-for-sale securities:      |       |                    |       |                         |       |                              |       |            |       |
| U.S. agencies                       |       | $                       | 25,540,641 |                         | $          | 609,957                           |       | $               | (65,680    | ) | $ | 26,084,918 |   |
| Collateralized mortgage obligations |       | 3,438,998               |       | 54,471                       |       | (8,861                            | )          | 3,484,608       |       |
| Municipalities                      |       | 9,970,961               |       | 14,829                       |       | (83,567                           | )          | 9,902,223       |       |
| SBA Pools                           |       | 1,820,810               |       | —                       |       | (41,682                           | )          | 1,779,128       |       |
| Asset-Back Security                 |       | 198,081                 |       | —                       |       | (81                               | )          | 198,000         |       |
|                                |       | $                       | 40,969,491 |                         | $          | 679,257                           |       | $               | (199,871   | ) | $ | 41,448,877 |   |

 

The following tables detailthe gross unrealized losses and fair values aggregated by investment categoryand length of time that individual securities have been in a continuousunrealized loss position at December 31, 2008.

 
| ** **                                 | ** ** | **Less than 12 months** | ** ** | **12 months or more** | ** ** | **Total** | ** ** |
|--------------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|-----------|------------|
| ** **                                 | ** ** | ** **                             | ** ** | **Unrealized**                       | ** ** | **Fair**  | ** ** | **Unrealized** | ** ** | ** ** | ** ** | **Unrealized** | ** ** |
| **Description of Securities**              | ** ** | **Fair Value**                         | ** ** | **Loss**                             | ** ** | **Value** | ** ** | **Loss** | ** ** | **Fair Value** | ** ** | **Loss** | ** ** |
|                                       |       |                                   |       |                                 |       |      |       |   |   |   |   |   |   |
| U.S. agencies                              |       | $                                      | 2,900,405  |                                 | $          | (13,962   | )          | $ | 3,067,267 |   | $ | (51,718 | ) | $ | 5,967,672 |   | $ | (65,680 | ) |
| Collateralized mortgage obligations        |       | 618,552                                |       | (2,109                               | )          | 1,085,704 |       | (6,752 | ) | 1,704,256 |   | (8,861 | ) |
| Municipalities                             |       | 9,357,996                              |       | (83,567                              | )          | —    |       | — |   | 9,357,996 |   | (83,567 | ) |
| SBA Pools                                  |       | —                                 |       | —                               |       | 1,626,502 |       | (41,682 | ) | 1,626,502 |   | (41,682 | ) |
| Asset Backed Securities                    |       | 198,000                                |       | (81                                  | )          | —    |       | — |   | 198,000 |   | (81 | ) |
| Total temporarily impaired securities |       | $                                      | 13,074,953 |                                 | $          | (99,719   | )          | $ | 5,779,473 |   | $ | (100,152 | ) | $ | 18,854,426 |   | $ | (199,871 | ) |

 

AtDecember 31, 2008, four U.S. agencies, one collateralized mortgageobligations and two SBA pools make up the total amount of securities in anunrealized loss position for greater than 12 months. Management periodicallyevaluates each available-for-sale investment security in an unrealized lossposition to determine if the impairment is temporary or other than temporary.Management has determined that no investment security is other than temporarilyimpaired. The unrealized losses are due solely to interest rate 

 

F-14

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Table ofContents

 

**OAK VALLEY BANCORP**

**NOTES TO FINANCIAL STATEMENTS**

 

**NOTE 3 — SECURITIES (CONTINUED)**

 

changesand the Bank does not intend to sell the securities and it is not likely thatwe will be required to sell the securities before the earlier of the forecastedrecovery or the maturity of the underlying investment security.

 

Realizedgains on called of available-for-sale securities during 2009 totaled $170,019and there were no gains or losses recorded in 2008. There were no sales ofavailable-for-sale securities during 2009 and 2008.

 

Securitiescarried at $34,545,513 and $30,117,814 at December 31, 2009 and 2008,respectively, were pledged to secure deposits of public funds.

 

**NOTE 4 — LOANS**

 

TheBank’s customers are primarily located in Stanislaus, San Joaquin, Tuolumne,Inyo, and Mono Counties. Approximately 63% of the Bank’s loans are commercialreal estate loans. Approximately 9% of the Bank’s loans are for general commercialuses including professional, retail, and small business. Additionally, 17% ofthe Bank’s loans are for real estate construction for residential andcommercial real estate. The remaining 11% are in agriculture, residential realestate, and consumer loans. Generally, real estate loans are collateralized byreal property while commercial and other loans are collateralized by funds ondeposit, business, or personal assets. Repayment of loans is generally expectedfrom cash flows of the borrower. Pre-approved permanent financing generallypays off construction loans.

 

Loantotals were as follows:

 
| ** **                            | ** ** | **YEARS ENDED DECEMBER 31,** | ** **  |
|---------------------------------------|------------|------------------------------|-------------|
| ** **                            | ** ** | **2009**                     | ** **  | **2008** | ** ** |
| Loans                                 |       |                         |        |   |   |
| Commercial  real estate               |       | $                            | 283,387,329 |   | $ | 268,741,826 |   |
| Commercial                            |       | 38,159,590                   |        | 37,302,286 |   |
| Real  estate construction             |       | 52,951,968                   |        | 73,321,446 |   |
| Agriculture                           |       | 29,659,656                   |        | 25,916,928 |   |
| Residential  real estate and consumer |       | 21,468,468                   |        | 22,894,644 |   |
|                                  |       |                         |        |   |   |
| Total  loans                          |       | 425,627,011                  |        | 428,177,130 |   |
|                                  |       |                         |        |   |   |
| Less:                                 |       |                         |        |   |   |
| Deferred  loan fees and costs, net    |       | (811,103                     | )           | (1,034,723 | ) |
| Allowance  for loan losses            |       | (7,020,222                   | )           | (5,569,496 | ) |
|                                  |       |                         |        |   |   |
| Net  loans                            |       | $                            | 417,795,686 |   | $ | 421,572,911 |   |

 

Changes in the allowance forloan losses were as follows:

 
| ** **                                                            | ** ** | **YEARS ENDED DECEMBER 31,** | ** ** |
|-----------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                            | ** ** | **2009**                     | ** ** | **2008** | ** ** |
|                                                                  |       |                         |       |   |   |
| Balance,  beginning of year                                           |       | $                            | 5,569,496  |   | $ | 4,506,753 |   |
| Provision  charged to operations                                      |       | 5,862,012                    |       | 2,188,139 |   |
| Loans  charged off                                                    |       | (4,419,335                   | )          | (1,114,534 | ) |
| Loan  recoveries                                                      |       | 8,049                        |       | 4,745 |   |
| Reclassification  of reserve related to off-balance-sheet commitments |       | —                       |       | (15,608 | ) |
| Balance,  end of year                                                 |       | $                            | 7,020,222  |   | $ | 5,569,496 |   |

 

F-15

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Table ofContents

 

**OAK VALLEY BANCORP**

**NOTES TO FINANCIAL STATEMENTS**

 

**NOTE 4 — LOANS (CONTINUED)**

 

Changesin the allowance off-balance-sheet commitments were as follows:

 
| ** **                                                   | ** ** | **YEARS ENDED DECEMBER 31,** | ** ** |
|--------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                   | ** ** | **2009**                                    | ** ** | **2008** | ** ** |
|                                                         |       |                                        |       |   |   |
| Balance, beginning of year                                   |       | $                                           | 175,331    |   | $ | 209,757 |   |
| Reclassification of reserves from allowance for  loan losses |       | —                                      |       | 15,608 |   |
| Provision Charged to Operations for Off Balance  Sheet       |       | (3,431                                      | )          | (50,034 | ) |
| Balance, end of year                                         |       | $                                           | 171,900    |   | $ | 175,331 |   |

 

Themethod for calculating the allowance for off-balance-sheet is based on anallowance percentage which is less than other outstanding loan types becausethey are at a lower risk level.  This allowance percentage is evaluated bymanagement periodically and is applied to the total undisbursed loan commitmentbalance to calculate the allowance for off-balance-sheet commitments.

 

Thetotal recorded investment in impaired loans at December 31, 2009, was$14,418,204. The average recorded investment in impaired loans was $10,201,716during 2009. The recorded investment in impaired loans that have a specificreserve was $11,628,542 at December 31, 2009. The recorded investment inimpaired loans that did not have a specific reserve was $2,789,662 at December 31,2009. The total specific reserve related to impaired loans and included in theallowance for loan losses was $1,256,329. No interest income was recognized onimpaired loans, while considered impaired during 2009. The total recordedinvestment in non-accrual loans was $14,418,204 at December 31,2009.  In addition, there were no loans past due greater than 90 days andstill accruing interest at December 31, 2009.  Additional interest income of approximately$457,000 would have been recorded during the year ended December 31, 2009,if these loans had been paid in accordance with their original terms.

 

Thetotal recorded investment in impaired loans at December 31, 2008, was$4,078,765. The average recorded investment in impaired loans was $4,294,356during 2008. The recorded investment in impaired loans that have a specificreserve was $3,322,670 at December 31, 2008. The recorded investment in impairedloans that did not have a specific reserve was $756,095 at December 31,2008. The total specific reserve related to impaired loans and included in theallowance for loan losses was $768,719. No interest income was recognized onimpaired loans, while considered impaired during 2008. The total recordedinvestment in non-accrual loans was $4,078,765 at December 31, 2008. In addition, there was one real estate construction loan with a principalbalance of $643,000 that was past due greater than 90 days and still accruinginterest at December 31, 2008. Additional interest income of approximately $135,000 would have beenrecorded during the year ended December 31, 2008, if these loans had beenpaid in accordance with their original terms.

 

AtDecember 31, 2009 and 2008, loans carried at $315,445,820 and$274,578,420, respectively, were pledged as collateral on advances from theFederal Home Loan Bank.

 

**NOTE 5 — PREMISES AND EQUIPMENT**

 

Majorclassifications of premises and equipment are summarized as follows:

 
| ** **                                     | ** ** | **DECEMBER 31,** | ** ** |
|------------------------------------------------|------------|-----------------------|------------|
| ** **                                     | ** ** | **2009**              | ** ** | **2008** | ** ** |
|                                           |       |                  |       |   |   |
| Land                                           |       | $                     | 4,023,703  |   | $ | 4,023,703 |   |
| Building                                       |       | 3,215,383             |       | 3,192,470 |   |
| Leasehold improvements                         |       | 3,604,173             |       | 3,604,173 |   |
| Furniture, fixtures, and equipment             |       | 6,022,324             |       | 5,909,567 |   |
|                                           |       | 16,865,583            |       | 16,729,913 |   |
|                                           |       |                  |       |   |   |
| Less accumulated depreciation and amortization |       | 6,698,286             |       | 5,635,946 |   |
|                                           |       |                  |       |   |   |
|                                           |       | $                     | 10,167,297 |   | $ | 11,093,967 |   |

 

Depreciationexpense was $1,062,828 and $1,131,038 for the years ended 2009 and 2008,respectively.

 

F-16

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Table ofContents

 

**OAK VALLEY BANCORP**

**NOTES TO FINANCIAL STATEMENTS**

 

**NOTE 6 — ACCRUED INTEREST AND OTHER ASSETS**

 

Otherassets are summarized as follows:

 
| ** **                                | ** ** | **DECEMBER 31,** | ** ** |
|-------------------------------------------|------------|-----------------------|------------|
| ** **                                | ** ** | **2009**              | ** ** | **2008** | ** ** |
| Interest income receivable on loans       |       | $                     | 1,465,832  |   | $ | 1,676,613 |   |
| Interest income receivable on investments |       | 268,500               |       | 209,746 |   |
| Net deferred tax asset                    |       | 3,364,054             |       | 2,554,700 |   |
| Federal Reserve Bank stock                |       | 1,157,050             |       | 750,550 |   |
| Federal Home Loan Bank stock              |       | 3,803,700             |       | 3,803,700 |   |
| Cash surrender value of life insurance    |       | 10,267,862            |       | 9,859,234 |   |
| Investment in limited partnership         |       | 769,299               |       | 845,500 |   |
| Prepaid expenses and other                |       | 1,099,057             |       | 1,803,778 |   |
|                                      |       | $                     | 22,195,354 |   | $ | 21,503,821 |   |

 

**NOTE 7 — DEPOSITS**

 

Deposittotals were as follows:

 
| ** **                    | ** ** | **DECEMBER 31,** | ** **  |
|-------------------------------|------------|-----------------------|-------------|
| ** **                    | ** ** | **2009**              | ** **  | **2008** | ** ** |
|                          |       |                  |        |   |   |
| Demand                        |       | $                     | 69,646,979  |   | $ | 64,276,737 |   |
| NOW accounts                  |       | 57,377,899            |        | 53,485,103 |   |
| Money market deposit accounts |       | 202,947,582           |        | 157,351,888 |   |
| Savings                       |       | 17,177,924            |        | 12,532,242 |   |
| Time, under $100,000          |       | 36,214,623            |        | 46,562,563 |   |
| Time, $100,000 and over       |       | 45,845,277            |        | 44,039,934 |   |
| Total deposits                |       | $                     | 429,210,284 |   | $ | 378,248,467 |   |

 

Certificatesof deposit issued and their remaining maturities at December 31, 2009, areas follows:

 
| **Year ending December 31,** | ** ** | ** ** | ** ** |
|---------------------------------------------|------------|------------|------------|
| 2010                                        |       | $          | 73,893,639 |   |
| 2011                                        |       | 5,789,235  |       |
| 2012                                        |       | 2,356,626  |       |
| 2013                                        |       | 2,593      |       |
| 2014                                        |       | 17,807     |       |
|                                        |       | $          | 82,059,900 |   |

 

F-17

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Table ofContents

 

**OAK VALLEY BANCORP**

**NOTES TO FINANCIAL STATEMENTS**

 

**NOTE 8 — FHLB ADVANCES**

 

AtDecember 31, 2009, the Bank had advances from the Federal Home Loan Bank (“FHLB”)totaling $32,200,000. Of the total advances outstanding, $27,200,000 representsterm advances due in 2010, $5,000,000 represents term advances due in 2011, andthere were no overnight open advances. The weighted average interest rate onthese advances was 1.75% and interest payments are due monthly. Unused andavailable advances totaled $86,181,360 at December 31, 2009.  Loanscarried at $315,445,820 as of December 31, 2009, were pledged ascollateral on advances from the Federal Home Loan Bank.

 

AtDecember 31, 2008, the Bank had advances from the Federal Home Loan Bank (“FHLB”)totaling $69,000,000. Of the total advances outstanding, $34,500,000 representsterm advances due in 2009, $18,500,000 represents term advances due in 2010,and $16,000,000 represents overnight open advances. The weighted averageinterest rate on these advances was 1.51% and interest payments are duemonthly. Unused and available advances totaled $38,130,625 at December 31,2008.  Loans carried at $274,578,420 at December 31, 2008, werepledged as collateral on advances from the Federal Home Loan Bank.

 

**NOTE 9 — INTEREST ON DEPOSITS**

 

Intereston deposits was comprised of the following:

 
| ** **                        | ** ** | **YEARS ENDED DECEMBER 31,** | ** ** |
|-----------------------------------|------------|---------------------------------------------|------------|
| ** **                        | ** ** | **2009**                                    | ** ** | **2008** | ** ** |
|                              |       |                                        |       |   |   |
| Savings and other deposits        |       | $                                           | 2,822,706  |   | $ | 4,210,099 |   |
| Time deposits of $100,000 or more |       | 1,151,690                                   |       | 1,578,851 |   |
| Other time deposits               |       | 981,835                                     |       | 1,451,088 |   |
|                              |       | $                                           | 4,956,231  |   | $ | 7,240,037 |   |

 

**NOTE 10 — INCOME TAXES**

 

Theprovision for income taxes consists of the following:

 
| ** ** | ** ** | **YEARS ENDED DECEMBER 31,** | ** ** |
|------------|------------|---------------------------------------------|------------|
| ** ** | ** ** | **2009**                                    | ** ** | **2008** | ** ** |
|       |       |                                        |       |   |   |
| Current    |       |                                        |       |   |   |
| Federal    |       | $                                           | 2,025,546  |   | $ | 802,797 |   |
| State      |       | 322,342                                     |       | 141,878 |   |
|       |       | 2,347,888                                   |       | 944,675 |   |
| Deferred   |       |                                        |       |   |   |
| Federal    |       | (1,575,946                                  | )          | (8,812 | ) |
| State      |       | (568,748                                    | )          | (113,818 | ) |
|       |       | (2,144,694                                  | )          | (122,630 | ) |
|       |       |                                        |       |   |   |
|       |       | $                                           | 203,194    |   | $ | 822,045 |   |

 

F-18

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Table ofContents

 

**OAK VALLEY BANCORP**

**NOTES TO FINANCIAL STATEMENTS**

 

**NOTE 10 — INCOME TAXES (CONTINUED)**

 

Thecomponents of the Bank’s deferred tax assets and liabilities (included inaccrued interest and other assets on the balance sheet), is shown below:

 
| ** **                                       | ** ** | **DECEMBER 31,** | ** ** |
|--------------------------------------------------|------------|------------------|------------|
| ** **                                       | ** ** | **2009**         | ** ** | **2008** | ** ** |
| Deferred tax assets:                             |       |             |       |   |   |
| Deferred loan fees                               |       | $                | 188        |   | $ | 220 |   |
| Allowance for loan losses                        |       | 2,836,387        |       | 1,812,672 |   |
| Accrued vacation                                 |       | 31,072           |       | 35,459 |   |
| Accrued salary continuation liability            |       | 472,092          |       | 371,895 |   |
| Deferred compensation                            |       | 70,184           |       | 107,166 |   |
| Split Dollar Life Insurance                      |       | —           |       | 128,395 |   |
| Nonaccrual loans                                 |       | 182,333          |       | 55,552 |   |
| Reserve for undisbursed commitments              |       | 70,744           |       | — |   |
| OREO expenses                                    |       | 1,373,362        |       | 517,202 |   |
| Holding company organization fees                |       | 53,919           |       | 57,988 |   |
| Other                                            |       | 80,197           |       | (144,586 | ) |
|                                             |       | 5,170,478        |       | 2,941,963 |   |
| Deferred tax liabilities:                        |       |             |       |   |   |
| Prepaid expenses                                 |       | (133,737         | )          | (170,093 | ) |
| FHLB dividends                                   |       | (220,188         | )          | (216,908 | ) |
| Accumulated depreciation                         |       | (124,683         | )          | (191,662 | ) |
| Deferred loan costs                              |       | (65,212          | )          | — |   |
| Stock Options                                    |       | (49,710          | )          | (50,301 | ) |
| Investment in limited partnership                |       | (1,243           | )          | (815 | ) |
| Accrued bonus                                    |       | (7,866           | )          | 7,757 |   |
| State income tax                                 |       | (26,719          | )          | 76,485 |   |
| Unrealized gain on securities available for sale |       | (1,177,066       | )          | (184,564 | ) |
|                                             |       | (1,806,424       | )          | (730,101 | ) |
|                                             |       |             |       |   |   |
| Net deferred income tax asset                    |       | $                | 3,364,054  |   | $ | 2,211,862 |   |

 

Managementhas assessed the realizability of deferred tax assets and believes it is morelikely than not that all deferred tax assets will be realized in the normalcourse of operations. Accordingly, these assets have not been reduced by avaluation allowance.

 

F-19

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Table ofContents

 

**OAK VALLEY BANCORP**

**NOTES TO FINANCIAL STATEMENTS**

 

**NOTE 10 — INCOME TAXES (CONTINUED)**

 

The effective tax rate for 2009 and 2008 differsfrom the current Federal statutory income tax rate as follows:

 
| ** **                                             | ** ** | **YEARS ENDED DECEMBER 31,** | ** ** |
|--------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                             | ** ** | **2009**                                    | ** ** | **2008** | ** ** |
|                                                   |       |                                        |       |   |   |
| Federal statutory income tax rate                      |       | 34.0                                        | %          | 34.0 | % |
| State taxes, net of federal tax benefit                |       | 7.2                                         | %          | 7.2 | % |
| Tax exempt interest on municipal securities and  loans |       | (12.3                                       | )%         | (1.1 | )% |
| Tax exempt earnings on bank owned life insurance       |       | (7.6                                        | )%         | (5.1 | )% |
| Stock based compensation                               |       | 1.3                                         | %          | 1.6 | % |
| Low income housing tax credit                          |       | (4.7                                        | )%         | (3.6 | )% |
| California enterprise zone tax credits and  deductions |       | (7.8                                        | )%         | (4.7 | )% |
| Other                                                  |       | (0.9                                        | )%         | (0.8 | )% |
| Effective tax rate                                     |       | 9.2                                         | %          | 27.5 | % |

 

OakValley Bancorp files a consolidated return in the U.S. Federal tax jurisdictionand a combined report in the State of California taxjurisdiction.  Prior to the formation of Bancorp in 2008, the Bankfiled in the U.S. Federal and California jurisdictions on a stand-alonebasis.  None of the entities are subject to examination by taxingauthorities for years before 2005 for U.S. Federal or for years before 2004 forCalifornia.

 

**NOTE 11 — STOCK OPTION PLAN**

 

During1991 the Bank’s Board of Directors approved a fixed stock option plan (the “Plan”,which was subsequently amended in 1998 and 2008) under which incentive andnon-qualified stock options may be granted to key employees and directors,respectively, to purchase up to thirty-five percent of the authorized andun-issued common stock of the Bank at a price equal to the fair market value onthe date of grant. The Plan provides that the options are exercisable in equalincrements over a five-year period from the date of grant or over any other scheduleapproved by the Board of Directors. All incentive stock options expire no laterthan ten years from the date of grant. The Plan was ratified by theshareholders at the Bank’s annual meeting in April 1992.

 

F-20

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Table ofContents

 

**OAK VALLEY BANCORP**

**NOTES TO FINANCIAL STATEMENTS**

 

**NOTE 11 — STOCK OPTION PLAN (CONTINUED)**

 

Asummary of the status of the Bank’s fixed stock option plan and changes duringthe year are presented below.

 
| ** **                       | ** ** | **DECEMBER 31, 2009** | ** ** |
|----------------------------------|------------|---------------------------------|------------|
| ** **                       | ** ** | ** **                      | ** ** | **Weighted-** | ** ** |
| ** **                       | ** ** | ** **                      | ** ** | **Average** | ** ** |
| ** **                       | ** ** | ** **                      | ** ** | **Exercise** | ** ** |
| ** **                       | ** ** | **Shares**                      | ** ** | **Price** | ** ** |
| Outstanding at beginning of year |       | 420,455                         |       | $ | 6.97 |   |
| Granted                          |       | 2,500                           |       | $ | 5.04 |   |
| Exercised                        |       | (20,250                         | )          | $ | 3.46 |   |
| Forfeited                        |       | (16,943                         | )          | $ | 8.44 |   |
|                             |       |                            |       |   |   |
| Outstanding at end of year       |       | 385,762                         |       | $ | 7.08 |   |

 
| ** **                                                     | ** ** | **DECEMBER 31,** | ** ** |
|----------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                     | ** ** | **2009**              | ** ** | **2008** | ** ** |
|                                                           |       |                  |       |   |   |
| Weighted-average fair value of options granted during the year |       | $                     | 1.83       |   | $ | 4.16 |   |
|                                                           |       |                  |       |   |   |
| Intrinsic value of options exercised                           |       | $                     | 14,940     |   | $ | 1,700,008 |   |
|                                                           |       |                  |       |   |   |
| Options exercisable at year end:                               |       | 354,062               |       | 343,005 |   |
|                                                           |       |                  |       |   |   |
| Weighted average exercise price                                |       | $                     | 6.69       |   | $ | 6.23 |   |
| Intrinsic value                                                |       | 108,264               |       | 412,074 |   |
| Weighted average remaining contractual life                    |       | 3.31 years            |       | 3.93 years |   |
|                                                           |       |                  |       |   |   |
| Options outstanding at year end:                               |       | 385,762               |       | 420,455 |   |
|                                                           |       |                  |       |   |   |
| Weighted average exercise price                                |       | $                     | 7.08       |   | $ | 6.97 |   |
| Intrinsic value                                                |       | 108,264               |       | 412,074 |   |
| Weighted average remaining contractual life                    |       | 3.61 years            |       | 4.43 years |   |

 

Taxbenefits totaling $600 were recorded in the statement of earnings during 2009related to the vesting of non-qualified stock options. As of December 31,2009, there was $89,880 of total unrecognized compensation cost related tonon-vested stock options which is expected to be recognized over aweighted-average period of 1.61 years.

 

Forthe year ended December 31, 2009, the Bank received $70,109 from theexercise of stock options and received no income tax benefits  related to the exercise of non-qualifiedemployee stock options and disqualifying dispositions in the exercise ofincentive stock options.

 

**NOTE 12 — TREASURY CAPITAL PURCHASE PROGRAM**

 

Inresponse to the stresses in the credit markets and to protect and recapitalizethe U.S. financial system, on October 3, 2008, the Emergency EconomicStabilization Act of 2008 (“EESA”) was signed into law.  EESAincludes the Treasury Capital Purchase Program (the “TCPP”), which was intendedto inject liquidity into, and stabilize the financial industry.  On December 1,2008, we received preliminary approval from the United States Department of theTreasury (the “U.S. Treasury”) to participate in the TCPP.  On December 5,the Bank issued to the U.S. Treasury 13,500 shares of senior preferred stockwith a zero par value and a $1,000 per share liquidation preference, along withwarrants to purchase 350,346 shares of common stock at a per share exerciseprice of $5.78, in exchange for aggregate consideration of $13.5million.  Dividends will be payable quarterly in arrears on February 15,May 15, August 15 and November 15 of each year with a 5% coupondividend rate for the first five years and 9% thereafter. If dividends on thesenior preferred shares are not paid in full for six dividend periods, the U.S.Treasury will have the right to elect two directors to our board until fulldividends have been paid for four consecutive dividend periods. The attachedwarrants are immediately exercisable and expire 10 years after the issuancedate. We must comply with restrictions on executive compensation 

 

F-21

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Table ofContents

 

**OAK VALLEY BANCORP**

**NOTES TO FINANCIAL STATEMENTS**

 

**NOTE 12 — TREASURY CAPITAL PURCHASE PROGRAM (CONTINUED)**

 

duringthe period that the U.S. Treasury holds an equity position in us through theTCPP.  Under the American Recovery and Reinvestment Act of 2009, wemay elect to repurchase the preferred stock at the original purchase price plusaccrued but unpaid dividends.

 

Theproceeds of $13.5 million were allocated between the preferred stock and thewarrants with $12.7 million allocated to preferred stock and $833 thousandallocated to the warrants, based on their relative fair value at the time ofissuance. The fair value of the preferred stock was estimated using discountedcash flows with a discount rate of 9%. The fair value of the warrants wasestimated using the Binomial option pricing model with the followingassumptions: 1) risk-free interest rate of 2.66% (the Treasury 10-year yieldrate as of warrant issuance date); 2) estimated life of ten years (contractualterm of the warrants); 3) volatility of 37.4%; and 4) dividend yield of 1.67%.The discount on the preferred stock (i.e., difference between the initialcarrying amount and the liquidation amount) is amortized over the five-yearperiod preceding the 9% perpetual dividend, using effective yield method.

 

**NOTE 13 — EARNINGS PER SHARE**

 

The Bank’s calculation ofearnings per share (“EPS”) including basic EPS, which does not consider theeffect of common stock equivalents and diluted EPS, which considers alldilutive common stock equivalents is as follows:

 
| ** **                                                              | ** ** | **YEAR ENDED DECEMBER 31, 2009** | ** ** |
|-------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                              | ** ** | **Income**                                           | ** ** | **Shares** | ** ** | **Per-Share** | ** ** |
| ** **                                                              | ** ** | **(Numerator)**                                      | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** |
|                                                                    |       |                                                 |       |   |   |   |   |
| Basic EPS:                                                              |       |                                                 |       |   |   |   |   |
| Net earnings available to common shareholders                           |       | $                                                    | 1,158,084  |   | 7,668,562 |   | $ | 0.15 |   |
|                                                                    |       |                                                 |       |   |   |   |   |
| Effect of dilutive securities:                                          |       |                                                 |       |   |   |   |   |
| Stock options                                                           |       | —                                               |       | 28,260 |   |   |   |
| Warrants                                                                |       | —                                               |       | — |   |   |   |
| Total dilutive shares                                                   |       |                                                 |       | 28,260 |   |   |   |
|                                                                    |       |                                                 |       |   |   |   |   |
| Diluted EPS:                                                            |       |                                                 |       |   |   |   |   |
| Net earnings available to common shareholders plus  assumed conversions |       | $                                                    | 1,158,084  |   | 7,696,822 |   | $ | 0.15 |   |

 

Anti-dilutiveoptions to purchase 240,187 shares of common stock in prices ranging from $4.58to $15.67 were outstanding during 2009. They were not included in thecomputation of diluted EPS because the options’ exercise price was greater thanthe average market price of the common shares. These options begin to expire in2015.  In addition, warrants issued tothe U.S. Treasury related to the Capital Purchase Program of 350,346 with aprice of $5.78 were antidilutive and not included in EPS because the warrants’exercise price was greater than the average market price of the common shares.

 
| ** **                                                              | ** ** | **YEAR ENDED DECEMBER 31, 2008** | ** ** |
|-------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                              | ** ** | **Income**                                           | ** ** | **Shares** | ** ** | **Per-Share** | ** ** |
| ** **                                                              | ** ** | **(Numerator)**                                      | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** |
|                                                                    |       |                                                 |       |   |   |   |   |
| Basic EPS:                                                              |       |                                                 |       |   |   |   |   |
| Net earnings available to common shareholders                           |       | $                                                    | 2,098,010  |   | 7,642,775 |   | $ | 0.27 |   |
|                                                                    |       |                                                 |       |   |   |   |   |
| Effect of dilutive securities:                                          |       |                                                 |       |   |   |   |   |
| Stock options                                                           |       | —                                               |       | 91,106 |   |   |   |
| Warrants                                                                |       | —                                               |       | 4,723 |   |   |   |
| Total dilutive shares                                                   |       |                                                 |       | 95,829 |   |   |   |
|                                                                    |       |                                                 |       |   |   |   |   |
| Diluted EPS:                                                            |       |                                                 |       |   |   |   |   |
| Net earnings available to common shareholders plus assumed  conversions |       | $                                                    | 2,098,010  |   | 7,738,604 |   | $ | 0.27 |   |

 

F-22

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Table ofContents

 

**OAK VALLEY BANCORP**

**NOTES TO FINANCIAL STATEMENTS**

 

**NOTE 13 — EARNINGS PER SHARE (CONTINUED)**

 

Anti-dilutiveoptions to purchase 254,875 shares of common stock in prices ranging from $7.20to $15.67 were outstanding during 2008. They were not included in thecomputation of diluted EPS because the options’ exercise price was greater thanthe average market price of the common shares. These options begin to expire in2015.

 

**NOTE 14 — COMMITMENTS AND CONTINGENCIES**

 

TheBank is obligated for rental payments under certain operating lease agreements,some of which contain renewal options and escalation clauses that provide forincreased rentals. Total rental expense for the years ended December 31,2009 and 2008, was $828,893 and $904,800, respectively.

 

AtDecember 31, 2009, the future minimum commitments under these operatingleases are as follows:

 
| **Year ending December 31,** | ** ** | ** ** | ** ** |
|---------------------------------------------|------------|------------|------------|
| 2010                                        |       | $          | 824,448    |   |
| 2011                                        |       | 800,644    |       |
| 2012                                        |       | 815,493    |       |
| 2013                                        |       | 802,456    |       |
| 2014                                        |       | 781,142    |       |
| Thereafter                                  |       | 3,051,929  |       |
|                                        |       | $          | 7,076,112  |   |

 

TheBank is a party to financial instruments with off-balance-sheet risk in thenormal course of business to meet the financing needs of its customers. Thesefinancial instruments include commitments to extend credit in the form of loansor through standby letters of credit. These instruments involve, to varyingdegrees, elements of credit and interest-rate risk in excess of the amountrecognized in the balance sheet. The contract amounts of those instrumentsreflect the extent of involvement the Bank has in particular classes offinancial instruments.

 

TheBank’s exposure to credit loss in the event of non-performance by the otherparty to the financial instrument for commitments to extend credit and standbyletters of credit is represented by the contractual amount of thoseinstruments. The Bank uses the same credit policies in making commitments andconditional obligations as it does for on-balance-sheet instruments.

 

Financialinstruments whose contract amounts represent credit risk:

 
| ** **                   | ** ** | **Contract** | ** ** |
|------------------------------|------------|--------------|------------|
| ** **                   | ** ** | **Amount**   | ** ** |
|                         |       |         |       |
| Undisbursed loan commitments |       | $            | 48,106,176 |   |
| Checking reserve             |       | 1,216,396    |       |
| Equity lines                 |       | 10,996,018   |       |
| Standby letters of credit    |       | 2,813,835    |       |
|                         |       | $            | 63,132,425 |   |

 

Commitmentsto extend credit are agreements to lend to a customer as long as there is noviolation of any condition established in the contract. Commitments generallyhave fixed expiration dates or other termination clauses and may requirepayment of a fee. Since many of the commitments are expected to expire withoutbeing drawn upon, the total commitment amounts do not necessarily representfuture cash requirements. The Bank evaluates each customer’s creditworthinesson a case-by-case basis. The amount of collateral obtained, if deemed necessaryby the Bank upon extension of credit, is based on management’s creditevaluation. Collateral held varies but may include accounts receivable,inventory, property, plant, equipment and income-producing commercialproperties.

 

Standbyletters of credit are conditional commitments issued by the Bank to guaranteethe performance of a customer to a third party. The credit risk involved inissuing letters of credit is essentially the same as that involved in extendingloan facilities to customers.

 

F-23

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Table ofContents

 

**OAK VALLEY BANCORP**

**NOTES TO FINANCIAL STATEMENTS**

 

**NOTE 15 — FINANCIAL INSTRUMENTS**

 

**Fair values of financial instruments —** The financialstatements include various estimated fair value information as of December 31,2009 and 2008. Such information, which pertains to the Bank’s financialinstruments, does not purport to represent the aggregate net fair value of theBank. Further, the fair value estimates are based on various assumptions,methodologies, and subjective considerations, which vary widely among differentfinancial institutions and which are subject to change. The following methodsand assumptions are used by the Bank.

 

*Cash and cash equivalents* — The carrying amounts ofcash and cash equivalents approximate their fair value.

 

*Securities (including mortgage-backed securities)* — Fair valuesfor securities are based on quoted market prices, where available. If quotedmarket prices are not available, fair values are based on quoted market pricesof comparable instruments.

 

*Loans receivable* — For variable-rate loansthat reprice frequently and have no significant change in credit risk, fairvalues are based on carrying values. The fair values for other loans (e.g.,real estate construction and mortgage, commercial, and installment loans) areestimated using discounted cash flow analyses, using interest rates currentlybeing offered for loans with similar terms to borrowers of similar creditquality.

 

*Deposit liabilities* — The fair values estimatedfor demand deposits (interest and non-interest checking, savings, and certaintypes of money market accounts) are, by definition, equal to the amount payableon demand at the reporting date (i.e. their carrying amounts). The carryingamounts for variable-rate, fixed-term money market accounts and certificates ofdeposit approximate their fair values at the reporting date. Fair values forfixed-rate certificates of deposit are estimated using a discounted cash flowcalculation that applies interest rates currently being offered on certificatesto a schedule of the aggregate expected monthly maturities on time deposits.

 

*Federal Home Loan Bank (FHLB) advances* — Ratescurrently available to the Bank for borrowings with similar terms and remainingmaturities are used to estimate the fair value of the existing debt.

 

*Accrued interest* — The carrying amounts ofaccrued interest approximate their fair value.

 

*Off-balance-sheet instruments* — Fair values for the Bank’soff-balance-sheet lending commitments are based on fees currently charged toenter into similar agreements, taking into account the remaining terms of theagreements and the credit standing of the counterparties.

 

Theestimated fair values of the Bank’s financial instruments at December 31,2009 were as follows:

 
| ** **                                   | ** ** | **Carrying** | ** ** | **Fair**     | ** ** |
|----------------------------------------------|------------|--------------|------------|--------------|------------|
| ** **                                   | ** ** | **Amount**   | ** ** | **Value**    | ** ** |
| **Financial assets:**                        |       |         |       |         |       |
|                                         |       |         |       |         |       |
| Cash and cash equivalents                    |       | $            | 21,648,548 |         | $          | 21,648,548 |   |
| Securities available for sale                |       | 50,765,314   |       | 50,765,314   |       |
| Loans                                        |       | 425,627,011  |       | 434,698,550  |       |
| Accrued interest receivable                  |       | 1,734,332    |       | 1,734,332    |       |
|                                         |       |         |       |         |       |
| **Financial liabilities:**                   |       |         |       |         |       |
|                                         |       |         |       |         |       |
| Deposits                                     |       | (429,210,284 | )          | (429,780,364 | )          |
| FHLB advance                                 |       | (32,200,000  | )          | (32,367,049  | )          |
| Accrued interest payable                     |       | (400,169     | )          | (400,169     | )          |
|                                         |       |         |       |         |       |
| **Off-balance-sheet assets  (liabilities):** |       |         |       |         |       |
|                                         |       |         |       |         |       |
| Commitments and standby letters of credit    |       |         |       | (631,324     | )          |
|                                              |            |              |            |              |            |  |  |

 

F-24

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Table ofContents

 

**OAK VALLEY BANCORP**

**NOTES TO FINANCIAL STATEMENTS**

 

**NOTE 15 — FINANCIAL INSTRUMENTS (CONTINUED)**

 

Theestimated fair values of the Bank’s financial instruments at December 31,2008 are as follows:

 
| ** **                                   | ** ** | **Carrying** | ** ** | **Fair**     | ** ** |
|----------------------------------------------|------------|--------------|------------|--------------|------------|
| ** **                                   | ** ** | **Amount**   | ** ** | **Value**    | ** ** |
| **Financial assets:**                        |       |         |       |         |       |
|                                         |       |         |       |         |       |
| Cash and cash equivalents                    |       | $            | 9,837,860  |         | $          | 9,837,860 |   |
| Securities available for sale                |       | 41,448,877   |       | 41,448,877   |       |
| Loans                                        |       | 428,177,130  |       | 429,344,847  |       |
| Accrued interest receivable                  |       | 1,886,359    |       | 1,886,359    |       |
|                                         |       |         |       |         |       |
| **Financial liabilities:**                   |       |         |       |         |       |
|                                         |       |         |       |         |       |
| Deposits                                     |       | (378,248,467 | )          | (378,041,128 | )          |
| FHLB advance                                 |       | (69,000,000  | )          | (69,103,323  | )          |
| Accrued interest payable                     |       | (763,117     | )          | (763,117     | )          |
|                                         |       |         |       |         |       |
| **Off-balance-sheet assets  (liabilities):** |       |         |       |         |       |
|                                         |       |         |       |         |       |
| Commitments and standby letters of credit    |       |         |       | (630,751     | )          |
|                                              |            |              |            |              |            |  |  |

 

**NOTE16 — FAIR VALUE MEASUREMENTS**

 

ASCTopic 820, Fair Value Measurements, which the Company adopted effective January 1,2008, defines fair value, establishes a framework for measuring fair value,establishes a three-level valuation hierarchy for disclosure of fair valuemeasurement and enhances disclosure requirements for fair value measurements.The valuation hierarchy is based upon the transparency of inputs to the valuationof an asset or liability as of the measurement date. The three levels aredefined as follow:

 

Level1:  Inputs to the valuation methodologyare quoted prices (unadjusted) for identical assets or liabilities in activemarkets.

 

Level2:  Inputs to the valuation methodologyinclude quoted prices for similar assets and liabilities in active markets andinputs that are observable for the asset or liability, either directly orindirectly, for substantially the full term of the financial instrument.

 

Level3:  Inputs to the valuation methodologyare unobservable and significant to the fair value measurement.

 

Incertain cases, the inputs used to measure fair value may fall into differentlevels of the fair value hierarchy.  Insuch cases, the level in the fair value hierarchy within which the fair valuemeasurement in its entirety falls has been determined based on the lowest levelinput that is significant to the fair value measurement in its entirety.  The Company’s assessment of the significanceof a particular input to the fair value measurement in its entirety requiresjudgment, and considers factors specific to the asset or liability.

 

Assetsand liabilities measured at fair value on a recurring and non-recurring basisfor the years ended December 31, 2009 and 2008 are summarized below:

 
| ** **                                                 | ** ** | **Fair Value Measurements at December 31, 2009 Using** | ** ** |
|------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------|------------|
| ** **                                                 | ** ** | **December 31,  2009**                                                               | ** ** | **Quoted Prices  in Active  Markets for  Identical Assets  (Level 1)** | ** ** | **Significant  Other  Observable  Inputs  (Level 2)** | ** ** | **Significant  Unobservable  Inputs  (Level 3)** | ** ** |
|                                                       |       |                                                                                      |       |   |   |   |   |   |   |
| Assets and liabilities measured on a recurring  basis:     |       |                                                                                      |       |   |   |   |   |   |   |
| Available-for-sale securities                              |       | $                                                                                         | 50,765,314 |   | $ |   |   | $ | 50,765,314 |   | $ | — |   |
|                                                       |       |                                                                                      |       |   |   |   |   |   |   |
| Assets and liabilities measured on a non-recurring  basis: |       |                                                                                      |       |   |   |   |   |   |   |
| Impaired Loans                                             |       | $                                                                                         | 10,372,613 |   | $ | — |   | $ | — |   | $ | 10,372,613 |   |
| Other real estate owned                                    |       | $                                                                                         | 2,149,514  |   | $ | — |   | $ | — |   | $ | 2,149,514 |   |

 

F-25

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Table ofContents

 

**OAK VALLEY BANCORP**

**NOTES TO FINANCIAL STATEMENTS**

 

**NOTE16 — FAIR VALUE MEASUREMENTS (CONTINUED)**

 
| ** **                                                 | ** ** | **Fair Value Measurements at December 31, 2008 Using** | ** ** |
|------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------|------------|
| ** **                                                 | ** ** | **December 31,  2008**                                                               | ** ** | **Quoted Prices  in Active  Markets for  Identical Assets  (Level 1)** | ** ** | **Significant  Other  Observable  Inputs  (Level 2)** | ** ** | **Significant  Unobservable  Inputs  (Level 3)** | ** ** |
|                                                       |       |                                                                                      |       |   |   |   |   |   |   |
| Assets and liabilities measured on a recurring  basis:     |       |                                                                                      |       |   |   |   |   |   |   |
| Available-for-sale securities                              |       | $                                                                                         | 41,448,877 |   | $ |   |   | $ | 41,448,877 |   | $ | — |   |
|                                                       |       |                                                                                      |       |   |   |   |   |   |   |
| Assets and liabilities measured on a non-recurring  basis: |       |                                                                                      |       |   |   |   |   |   |   |
| Impaired Loans                                             |       | $                                                                                         | 2,553,951  |   | $ | — |   | $ | — |   | $ | 2,553,951 |   |

 

Thefair value of securities available for sale equals quoted market price, ifavailable.  If quoted market prices arenot available, fair value is determined using quoted market prices for similarsecurities.  Changes in fair market valueare recorded in other comprehensive income net of tax.  ASC Topic 820 applies to loans measured forimpairment using the practical expedients permitted by ASC Topic 310,Accounting by Creditors for Impairment of a Loan, including impaired loansmeasured at an observable market price (if available), or at the fair value ofthe loan’s collateral (if the loan is collateral dependent). Fair value of theloan’s collateral, when the loan is dependent on collateral, is determined byappraisals or independent valuation which is then adjusted for the cost relatedto liquidation of the collateral. At December 31, 2009, impaired loans hada principal balance of $11,628,942, with a valuation allowance of $1,256,329.  Upon being classified as impaired, chargeoffs were taken to reduce the balance of each loan to an estimate of thecollateral fair market value less cost to dispose. This estimate was a level 3valuation.  There was no direct impact on the income statement.  Thecharge-offs were recorded as a debit to the allowance for loan losses.

 

**NOTE 17 — RELATED PARTY TRANSACTIONS**

 

TheBank, in the normal course of business, makes loans and receives deposits fromits directors, officers, principal shareholders, and their associates. Inmanagement’s opinion, these transactions are on substantially the same terms ascomparable transactions with other customers of the Bank. Loans to directors,officers, shareholders, and affiliates are summarized below:

 
| ** **                                      | ** ** | **YEARS ENDED DECEMBER 31,** | ** ** |
|-------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                      | ** ** | **2009**                                    | ** ** | **2008** | ** ** |
|                                            |       |                                        |       |   |   |
| Aggregate amount outstanding, beginning of year |       | $                                           | 9,483,708  |   | $ | 5,785,792 |   |
| New loans or advances during year               |       | 798,757                                     |       | 4,068,823 |   |
| Repayments during year                          |       | (1,036,748                                  | )          | (370,907 | ) |
|                                            |       |                                        |       |   |   |
| Aggregate amount outstanding, end of year       |       | $                                           | 9,245,717  |   | $ | 9,483,708 |   |

 

Relatedparty deposits totaled $6,207,318 and $9,518,344 at December 31, 2009 and2008, respectively.

 

**NOTE 18 — PROFIT SHARING PLAN**

 

Theprofit sharing plan to which both the Bank and eligible employees contributewas established in 1995. Bank contributions are voluntary and at the discretionof the Board of Directors. Contributions were approximately $275,000 and$296,000 for 2009 and 2008, respectively.

 

F-26

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Table ofContents

 

**OAK VALLEY BANCORP**

**NOTES TO FINANCIAL STATEMENTS**

 

**NOTE 19 — RESTRICTIONS ON RETAINED EARNINGS**

 

Under current CaliforniaState banking laws, the Bank may not pay cash dividends in an amount thatexceeds the lesser of retained earnings of the Bank or the Bank’s net earningsfor its last three fiscal years (less the amount of any distributions toshareholders made during that period). If the above requirements are not met,cash dividends may only be paid with the prior approval of the Commissioner ofthe Department of Financial Institutions, in an amount not exceeding the Bank’snet earnings for its last fiscal year or the amount of its net earnings for itscurrent fiscal year. Accordingly, the future payment of cash dividends willdepend on the Bank’s earnings and its ability to meet its capital requirements.

 

**NOTE 20 — OTHER POST-RETIREMENT BENEFIT PLANS**

 

TheBank has awarded certain officers a salary continuation plan (the “Plan”).Under the Plan, the participants will be provided with a fixed annualretirement benefit for 20 years after retirement. The Bank is also responsiblefor certain pre-retirement death benefits under the Plan. In connection withthe implementation of the Plan, the Bank purchased single premium lifeinsurance policies on the life of each of the officers covered under the Plan.The Bank is the owner and partial beneficiary of these life insurance policies.The assets of the Plan, under Internal Revenue Service regulations, are ownedby the Bank and are available to satisfy the Bank’s general creditors.

 

DuringDecember 2001, the Bank awarded its directors a director retirement plan (“DRP”).Under the DRP, the participants will be provided with a fixed annual retirementbenefit for ten years after retirement. The Bank is also responsible forcertain pre-retirement death benefits under the DRP. In connection with theimplementation of the DRP, the Bank purchased single premium life insurancepolicies on the life of each director covered under the DRP. The Bank is theowner and partial beneficiary of these life insurance policies. The assets ofthe DRP, under Internal Revenue Service regulations, are the property of theBank and are available to satisfy the Bank’s general creditors.

 

Futurecompensation under both plans is earned for services rendered throughretirement. The Bank accrues for the salary continuation liability based onanticipated years of service and vesting schedules provided under the plans.The Bank’s current benefit liability is determined based on vesting and thepresent value of the benefits at a corresponding discount rate. The discountrate used is an equivalent rate for investment-grade bonds with lives matchingthose of the service periods remaining for the salary continuation contracts,which average approximately 20 years. At December 31, 2009 and 2008,$1,147,125 and $903,657, respectively, has been accrued to date, based on adiscounted cash flow using a discount rate of 6%, and is included in otherliabilities.

 

TheBank entered into split-dollar life insurance agreements with certain officers.In connection with the implementation of the split-dollar agreements, the Bankpurchased single premium life insurance policies on the life of each of theofficers covered by the split-dollar life insurance agreements. The Bank is theowner of the policies and the partial beneficiary in an amount equal to thecash surrender value of the policies.

 

Thecombined cash surrender value of all Bank-owned life insurance policies was$10,267,862 and $9,859,234 at December 31, 2009 and 2008, respectively.The cash surrender value of the life insurance policies is included in otherassets (Note 6).

 

**NOTE 21 — REGULATORY MATTERS**

 

TheBank and the Company is subject to various regulatory capital requirementsadministered by federal and state banking agencies. Failure to meet minimumcapital requirements can initiate certain mandatory — and possiblyadditional discretionary — actions by regulators that, if undertaken, couldhave a direct material effect on the Bank’s financial statements. Under capitaladequacy guidelines and the regulatory framework for prompt corrective action,the Bank must meet specific capital guidelines that involve quantitative measuresof the Bank’s assets, liabilities, and certain off-balance-sheet items ascalculated under regulatory accounting practices. The Bank’s capital amountsand classifications are also subject to qualitative judgments by the regulatorsabout components, risk weightings, and other factors.

 

Quantitativemeasures established by regulation to ensure capital adequacy require the Bankto maintain minimum amounts and ratios (set forth in the table on the nextpage) of total and Tier I capital (as defined in the regulations) torisk-weighted assets (as defined), and of Tier I capital (as defined) toaverage assets (as defined). Management believes, as of December 31, 2009,that the Bank meets all capital adequacy requirements to which it is subject.

 

Asof December 31, 2009, the most recent notification from the FederalReserve Bank categorized the Bank as well capitalized under the regulatoryframework for prompt corrective action. To be categorized as well capitalized,the Bank must maintain minimum total 

 

F-27

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Table ofContents

 

**OAK VALLEY BANCORP**

**NOTES TO FINANCIAL STATEMENTS**

 

**NOTE 21 — REGULATORY MATTERS (CONTINUED)**

 

risk-based,Tier I risk-based, and Tier I leverage ratios as set forth in thefollowing table. There are no conditions or events since notification thatmanagement believes have changed the Bank’s category.

 

TheBank’s actual capital amounts and ratios at December 31, 2009 and 2008,are presented in the following table.

 
| ** **                                | ** ** | ** ** | ** ** | ** **                 | ** ** | **To be well**   | ** ** |
|-------------------------------------------|------------|------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                                | ** ** | ** ** | ** ** | ** **                 | ** ** | **capitalized under** | ** ** |
| ** **                                | ** ** | ** ** | ** ** | **For capital**       | ** ** | **prompt corrective** | ** ** |
| ** **                                | ** ** | **Actual** | ** ** | **adequacy purposes** | ** ** | **action provisions** | ** ** |
| ** **                                | ** ** | **Amount** | ** ** | **Ratio**                  | ** ** | **Amount**                 | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| **Capital ratios for Bank:**              |       |       |       |                       |       |                       |       |   |   |   |   |   |   |
| As of December 31, 2009              |       |       |       |                       |       |                       |       |   |   |   |   |   |   |
| Total capital (to Risk- Weighted Assets)  |       | $          | 64,821,000 |                       | 13.6       | %           | $          | 38,275,000 |   | >8.0 | %    | $ | 47,844,000 |   | >10.0 | % |
| Tier I capital (to Risk- Weighted Assets) |       | $          | 58,817,000 |                       | 12.3       | %                          | $          | 19,137,000 |   | >4.0 | % | $ | 28,706,000 |   | >6.0 | % |
| Tier I capital (to Average Assets)        |       | $          | 58,817,000 |                       | 11.3       | %                          | $          | 20,819,000 |   | >4.0 | % | $ | 26,024,000 |   | >5.0 | % |
|                                      |       |       |       |                       |       |                       |       |   |   |   |   |   |   |
| As of December 31, 2008              |       |       |       |                       |       |                       |       |   |   |   |   |   |   |
| Total capital (to Risk- Weighted Assets)  |       | $          | 63,379,000 |                       | 13.3       | %                          | $          | 38,206,000 |   | >8.0 | % | $ | 47,758,000 |   | >10.0 | % |
| Tier I capital (to Risk- Weighted Assets) |       | $          | 57,635,000 |                       | 12.1       | %                          | $          | 19,103,000 |   | >4.0 | % | $ | 28,655,000 |   | >6.0 | % |
| Tier I capital (to Average Assets)        |       | $          | 57,635,000 |                       | 11.8       | %                          | $          | 19,593,000 |   | >4.0 | % | $ | 24,492,000 |   | >5.0 | % |
|                                      |       |       |       |                       |       |                       |       |   |   |   |   |   |   |
| **Capital ratios for Bancorp:**           |       |       |       |                       |       |                       |       |   |   |   |   |   | ** ** |
| As of December 31, 2009              |       |       |       |                       |       |                       |       |   |   |   |   |   |   |
| Total capital (to Risk- Weighted Assets)  |       | $          | 65,014,000 |                       | 13.6       | %                          | $          | 38,284,640 |   | >8.0 | % | N/A |   | N/A |   |
| Tier I capital (to Risk- Weighted Assets) |       | $          | 59,009,000 |                       | 12.3       | %                          | $          | 19,142,320 |   | >4.0 | % | N/A |   | N/A |   |
| Tier I capital (to Average Assets)        |       | $          | 59,009,000 |                       | 11.3       | %                          | $          | 20,824,480 |   | >4.0 | % | N/A |   | N/A |   |
|                                      |       |       |       |                       |       |                       |       |   |   |   |   |   |   |
| As of December 31, 2008              |       |       |       |                       |       |                       |       |   |   |   |   |   |   |
| Total capital (to Risk- Weighted Assets)  |       | $          | 63,440,000 |                       | 13.3       | %                          | $          | 38,211,000 |   | >8.0 | % | N/A |   | N/A |   |
| Tier I capital (to Risk- Weighted Assets) |       | $          | 57,696,000 |                       | 12.1       | %                          | $          | 19,106,000 |   | >4.0 | % | N/A |   | N/A |   |
| Tier I capital (to Average Assets)        |       | $          | 57,696,000 |                       | 11.8       | %                          | $          | 19,594,000 |   | >4.0 | % | N/A |   | N/A |   |

 

F-28

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Table ofContents

 

**OAK VALLEY BANCORP**

**NOTES TO FINANCIAL STATEMENTS**

 

**NOTE 22 —****PARENT ONLY CONDENSED FINANCIALSTATEMENTS**

 

**CONDENSED BALANCE SHEET**

** **
| ** **                                                                                                                                                                                     | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                     | ** ** | **2009**              | ** ** | **2008**              | ** ** |
| **ASSETS**                                                                                                                                                                                     |       |                  |       |                  |       |
|                                                                                                                                                                                           |       |                  |       |                  |       |
| Cash                                                                                                                                                                                           |       | $                     | 70,109     |                  | $          | — |   |
| Investment  in bank subsidiary                                                                                                                                                                 |       | 60,499,830            |       | 57,925,039            |       |
| Other  assets                                                                                                                                                                                  |       | 122,312               |       | 61,040                |       |
|                                                                                                                                                                                           |       |                  |       |                  |       |
| Total  Assets                                                                                                                                                                                  |       | $                     | 60,692,251 |                  | $          | 57,986,079 |   |
|                                                                                                                                                                                           |       |                  |       |                  |       |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                                                                                                  |       |                  |       |                  |       |
|                                                                                                                                                                                           |       |                  |       |                  |       |
| Total  liabilities                                                                                                                                                                             |       | —                |       | —                |       |
|                                                                                                                                                                                           |       |                  |       |                  |       |
| Shareholders’  equity                                                                                                                                                                     |       |                  |       |                  |       |
| Preferred  stock, no par value; $1,000 per share liquidation preference, 10,000,000  shares authorized and 13,500 issued and outstanding at December 31, 2009  and December 31, 2008 |       | 12,847,297            |       | 12,680,649            |       |
| Common  stock, no par value; 50,000,000 shares authorized, 7,681,877 and 7,661,627  shares issued and outstanding at December 31, 2009 and 2008,  respectively                            |       | 23,933,440            |       | 23,863,331            |       |
| Additional  paid-in capital                                                                                                                                                                    |       | 1,997,747             |       | 1,925,224             |       |
| Retained  earnings                                                                                                                                                                             |       | 20,230,683            |       | 19,226,645            |       |
| Accumulated  other comprehensive income, net of tax                                                                                                                                            |       | 1,683,084             |       | 290,230               |       |
|                                                                                                                                                                                           |       |                  |       |                  |       |
| Total  shareholders’ equity                                                                                                                                                               |       | 60,692,251            |       | 57,986,079            |       |
|                                                                                                                                                                                           |       |                  |       |                  |       |
| Total  liabilities and shareholders’ equity                                                                                                                                               |       | $                     | 60,692,251 |                  | $          | 57,986,079 |   |

 

F-29

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Table ofContents

 

**OAK VALLEY BANCORP**

**NOTES TO FINANCIAL STATEMENTS**

 

**NOTE 22 —****PARENT ONLY CONDENSED FINANCIALSTATEMENTS (CONTINUED)**

 

**CONDENSED STATEMENT OF EARNINGS**

** **
| ** **                                                  | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                  | ** ** | **2009**                         | ** ** | **2008** | ** ** |
|                                                        |       |                             |       |   |   |
| INCOME                                                      |       |                             |       |   |   |
| Dividends  declared by subsidiary                           |       | $                                | 977,923    |   | $ | 711,929 |   |
| Total  income                                               |       | 977,923                          |       | 711,929 |   |
|                                                        |       |                             |       |   |   |
| EXPENSES                                                    |       |                             |       |   |   |
| Audit  expense                                              |       | —                           |       | 15,000 |   |
| Legal  expense                                              |       | 76,357                           |       | 128,320 |   |
| Other  operating expenses                                   |       | 72,525                           |       | 5,000 |   |
| Total  non-interest expense                                 |       | 148,882                          |       | 148,320 |   |
|                                                        |       |                             |       |   |   |
| Income  before equity in undistributed income of subsidiary |       | 829,041                          |       | 563,609 |   |
|                                                        |       |                             |       |   |   |
| Equity  in undistributed net income of subsidiary           |       | 1,109,415                        |       | 1,537,180 |   |
| Income  before income tax benefit                           |       | 1,938,456                        |       | 2,100,789 |   |
|                                                        |       |                             |       |   |   |
| Income  tax benefit                                         |       | 61,272                           |       | 61,040 |   |
|                                                        |       |                             |       |   |   |
| Net  Income                                                 |       | $                                | 1,999,728  |   | $ | 2,161,829 |   |
|                                                        |       |                             |       |   |   |
| Preferred  Stock dividends and accretion                    |       | 841,644                          |       | 63,819 |   |
|                                                        |       |                             |       |   |   |
| Net  income available to common shareholders                |       | $                                | 1,158,084  |   | $ | 2,098,010 |   |

 

F-30

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Table ofContents

 

**OAK VALLEY BANCORP**

**NOTES TO FINANCIAL STATEMENTS**

 

**NOTE 22 —****PARENT ONLY CONDENSED FINANCIALSTATEMENTS (CONTINUED)**

 

**CONDENSED STATEMENT OF CASHFLOWS**

** **
| ** **                                                                    | ** ** | **YEAR ENDED DECEMBER 31,** | ** ** |
|-------------------------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                                    | ** ** | **2009**                    | ** ** | **2008** | ** ** |
|                                                                          |       |                        |       |   |   |
| CASH  FLOWS FROM OPERATING ACTIVITIES:                                        |       |                        |       |   |   |
| Net  earnings                                                                 |       | $                           | 1,999,728  |   | $ | 2,161,829 |   |
| Adjustments  to reconcile net earnings to net cash from operating activities: |       |                        |       |   |   |
| Undistributed  net income of subsidiary                                       |       | (1,109,415                  | )          | (1,537,179 | ) |
| Increase  in other assets                                                     |       | (61,272                     | )          | (61,040 | ) |
| Net  cash from operating activities                                           |       | 829,041                     |       | 563,610 |   |
|                                                                          |       |                        |       |   |   |
| CASH  FLOWS FROM FINANCING ACTIVITIES:                                        |       |                        |       |   |   |
| Proceeds  from sale of Preferred Stock                                        |       | —                      |       | 13,500,000 |   |
| Capital  infusion into bank subsidiary                                        |       | —                      |       | (13,500,000 | ) |
| Dividends  paid                                                               |       | (829,041                    | )          | (574,484 | ) |
| Proceeds  from sale of common stock and exercise of stock options             |       | 70,109                      |       | 10,874 |   |
| Net  cash used in financing activities                                        |       | (758,931                    | )          | (563,610 | ) |
|                                                                          |       |                        |       |   |   |
| NET  INCREASE IN CASH AND CASH EQUIVALENTS                                    |       | 70,109                      |       | — |   |
|                                                                          |       |                        |       |   |   |
| CASH  AND CASH EQUIVALENTS, beginning of period                               |       | —                      |       | — |   |
|                                                                          |       |                        |       |   |   |
| CASH  AND CASH EQUIVALENTS, end of period                                     |       | $                           | 70,109     |   | $ | — |   |

 

F-31

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Table ofContents

 

**INDEX TO EXHIBITS**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                             |
|---------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1                 |       | Agreement  and Plan of Merger between the Registrant, Interim Oak Valley  Bancorp, Inc. and Oak Valley Community Bank*                                                                 |
|                |       |                                                                                                                                                                                        |
| 3.1                 |       | Articles  of Incorporation of Oak Valley Bancorp, Inc.*                                                                                                                                |
|                |       |                                                                                                                                                                                        |
| 3.2                 |       | First  Amendment to Articles of Incorporation of Oak Valley Bancorp, Inc.*                                                                                                             |
|                |       |                                                                                                                                                                                        |
| 3.3                 |       | Bylaws  of Oak Valley Bancorp, Inc.*                                                                                                                                                   |
|                |       |                                                                                                                                                                                        |
| 3.4                 |       | First  Amended and Restated Bylaws of Oak Valley Bancorp, Inc.**                                                                                                                       |
|                |       |                                                                                                                                                                                        |
| 3.5                 |       | Certificate  of Determination of Series A Preferred Stock of Oak Valley  Bancorp, Inc.**                                                                                          |
|                |       |                                                                                                                                                                                        |
| 3.6                 |       | Letter  Agreement between the United States Department of the Treasury and Oak Valley  Bancorp dated December 5, 2008**                                                                |
|                |       |                                                                                                                                                                                        |
| 10.1                |       | Oak  Valley Community Bank 1998 Restated Stock Option Plan*                                                                                                                                 |
|                |       |                                                                                                                                                                                        |
| 10.2                |       | Oak  Valley Community Bank Form of Director Retirement Agreement*                                                                                                                      |
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| 10.3                |       | Oak  Valley Community Bank Form of Salary Continuation Agreement*                                                                                                                      |
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| 10.4                |       | Securities  Purchase Agreement between Oak Valley Bancorp and the U.S. Treasury effective  December 4, 2008**                                                                          |
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| 11                  |       | Statement  Regarding Computation of Net Earnings per Share                                                                                                                                  |
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| 14                  |       | Code  of Ethics***                                                                                                                                                                          |
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| 21                  |       | Subsidiaries  of the Issuer*                                                                                                                                                                |
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| 23.1                |       | Consent  of Independent Registered Accounting Firm                                                                                                                                          |
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| 24                  |       | Power  of Attorney (included on the signature page of this report)                                                                                                                     |
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| 31.01               |       | Certification  of Chief Executive Officer pursuant to Exchange Act  Rules 13a-14(a) and 15d-14(a), as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002     |
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| 31.02               |       | Certification  of Chief Financial Officer pursuant to Exchange Act  Rules 13a-14(a) and 15d-14(a), as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002     |
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| 32.01               |       | Certifications  of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002 |

 

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*Incorporated by reference from the Form 10 filed on July 31, 2008

 

**Incorporated by reference from the Form 8-A filed on January 14, 2009

 

***Incorporated by reference from the Form 10-K filed on March 31, 2009

 

 

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