**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-QSB**

 

**ý****  QUARTERLY REPORT PURSUANT TO SECTION 13 OR15(d) OFTHE SECURITIES EXCHANGE ACT OF 1934**

 

**Forthe quarterly period ended June 30, 2003**

 

**o****  TRANSITION REPORT PURSUANT TO SECTION 13 OR15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**Forthe Transition Period from       to**

 

**CommissionFile No. 0-25020**

 

**HERITAGEOAKS BANCORP**

(Exact name of registrant asspecified in charter)

 

**STATEOF CALIFORNIA**

(State or other jurisdiction ofincorporation or organization)

 

**77-0388249**

(I.R.S. Employer IdentificationCode)

 

**54512th STREET, PASO ROBLES, CA 93446**

(Address of principal office)

 

**(805)239-5200**

(Registrant’s telephone number,including area code)

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding twelve (12) months (or for such shorter period thatthe registrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past ninety (90) days.

YES  ý   NO  o

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in Exchange Act Rule 12b-2).

Yes  o  No  ý

 

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

 

No par value Common Stock – 2,956,251 shares outstanding at July 9,2003.

## ** **

## ** **

----

 

## **TABLE OF CONTENTS**

 
| Part 1. Financial Information   |                                                                                                 |
|---------------------------------|------------------------------------------------------------------------------------------------------|
|                            |
|                            | Item 1. Financial Statements                                                                         |
|                            |                                                                                                 |
|                            | Consolidated Balance Sheets                                                                          |
|                            | Consolidated Statements of Operations (Un-audited)                                                   |
|                            | Consolidated Statements of Cash Flows  (Un-audited)                                                  |
|                            | Consolidated Statement of Changes in  Stockholders’ Equity (Un-audited)                         |
|                            | Notes to Consolidated Financial Statements (Un-audited)                                              |
|                            |                                                                                                 |
|                            | Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of  Operations |
|                            |                                                                                                 |
|                            | Item  3.  Controls and Procedures                                                               |
|                            |                                                                                                 |
| Part 2.  Other Information |
|                            |
|                            | Item 6.  Exhibits and Reports on Form 8-K                                                            |
|                            |
| Signatures                      |
|                            |
| Certifications                  |
|                            |
| Exhibits                        |
|                                 |                                                                                                      |  |

 

2

----

 

**PART 1. FINANCIALINFORMATION**

 

**Item 1. Financial Statements**

 

**HERITAGE OAKS BANCORP**

**CONSOLIDATED BALANCE SHEETS**

 
|                                                                                                                                                              |   | **31-Dec-02** |        | **30-Jun-03**   |   |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------|-------------|-----------------|--------|
|                                                                                                                                                              |   |          |        | **(Unaudited)** |   |
| ASSETS                                                                                                                                                            |   |          |        |            |   |
| Cash and due from banks                                                                                                                                           |   | $             | 23,513,631  |            | $      | 31,791,939 |   |
| Federal funds sold                                                                                                                                                |   | 37,040,000    |        | 34,100,000      |   |
|                                                                                                                                                              |   |          |        |            |   |
| Total cash and cash equivalents                                                                                                                                   |   | 60,553,631    |        | 65,891,939      |   |
|                                                                                                                                                              |   |          |        |            |   |
| Interest bearing deposits other banks                                                                                                                             |   | 497,000       |        | 497,000         |   |
|                                                                                                                                                              |   |          |        |            |   |
| Securities Available for sale                                                                                                                                     |   | 65,396,494    |        | 48,596,993      |   |
| Federal Home Loan Bank Stock, at cost                                                                                                                             |   | 1,950,900     |        | 1,661,900       |   |
| Loans Held For Sale                                                                                                                                               |   | 8,166,011     |        | 9,265,851       |   |
| Loans, net                                                                                                                                                        |   | 187,311,368   |        | 209,553,394     |   |
|                                                                                                                                                              |   |          |        |            |   |
| Property, premises and equipment, net                                                                                                                             |   | 4,542,591     |        | 4,599,687       |   |
| Cash surrender value life insurance                                                                                                                               |   | 5,415,500     |        | 6,369,284       |   |
| Deferred Tax Assets                                                                                                                                               |   | 1,170,783     |        | 1,192,645       |   |
| Core Deposit Intangible                                                                                                                                           |   | 358,557       |        | 338,262         |   |
| Other assets                                                                                                                                                      |   | 1,900,477     |        | 1,786,045       |   |
|                                                                                                                                                              |   |          |        |            |   |
| TOTAL ASSETS                                                                                                                                                      |   | $             | 337,263,312 |            | $      | 349,753,000 |   |
|                                                                                                                                                              |   |          |        |            |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                         |   |          |        |            |   |
| LIABILITIES                                                                                                                                                       |   |          |        |            |   |
| Deposits:                                                                                                                                                         |   |          |        |            |   |
| Demand, non-interest bearing                                                                                                                                      |   | $             | 106,556,079 |            | $      | 136,415,759 |   |
| Savings, NOW, and money market deposits                                                                                                                           |   | 112,567,856   |        | 106,630,414     |   |
| Time deposits of $100,000 or more                                                                                                                                 |   | 8,154,256     |        | 8,801,836       |   |
| Time deposits under $100,000                                                                                                                                      |   | 36,900,414    |        | 37,757,986      |   |
| Total deposits                                                                                                                                                    |   | 264,178,605   |        | 289,605,995     |   |
|                                                                                                                                                              |   |          |        |            |   |
| Other borrowed money                                                                                                                                              |   | 38,000,000    |        | 28,500,000      |   |
| Securities Sold under Agreement to Repurchase                                                                                                                     |   | 257,737       |        | 127,409         |   |
| Company Obligated Preferred Securities of Subsidiary Trust Holding  Floating Rate Junior Subordinated Deferred Interest Debentures                                |   | 8,000,000     |        | 8,000,000       |   |
| Other liabilities                                                                                                                                                 |   | 7,013,500     |        | 1,679,141       |   |
| Total liabilities                                                                                                                                                 |   | 317,449,842   |        | 327,912,545     |   |
|                                                                                                                                                              |   |          |        |            |   |
| Stockholders’ equity                                                                                                                                         |   |          |        |            |   |
| Common stock, no par value; 20,000,000 shares authorized; issued and  outstanding 2,924,810 and 2,956,251 for December 31, 2002 and June 30, 2003,  respectively. |   | 9,703,022     |        | 11,486,997      |   |
| Accumulated other comprehensive income                                                                                                                            |   | 562,359       |        | 709,565         |   |
| Retained earnings                                                                                                                                                 |   | 9,548,089     |        | 9,643,893       |   |
| Total stockholders’ equity                                                                                                                                   |   | 19,813,470    |        | 21,840,455      |   |
|                                                                                                                                                              |   |          |        |            |   |
| TOTAL LIABILITIES & STOCKHOLDERS’ EQUITY                                                                                                                 |   | $             | 337,263,312 |            | $      | 349,753,000 |   |

 

----

(1)  These numbers have been derived from theaudited financial statements.

 

Seenotes to condensed financial statements

 

3

----

 

**HERITAGE OAKS BANCORP**

**CONSOLIDATED STATEMENTS OF INCOME**

**For the three months ended June 30,**

 
|                                                      |   | **2002**        |      | **2003**        |   |
|-----------------------------------------------------------|--------|-----------------|-----------|-----------------|--------|
|                                                      |   | **(Unaudited)** |      | **(Unaudited)** |   |
| Interest Income:                                          |   |            |      |            |   |
|                                                      |   |            |      |            |   |
| Interest and fees on loans                                |   | $               | 3,162,626 |            | $      | 3,856,499 |   |
| Investment securities                                     |   | 589,529         |      | 544,519         |   |
| Federal funds sold and commercial paper                   |   | 63,877          |      | 40,088          |   |
| Time certificates of deposit                              |   | 1,530           |      | 3,181           |   |
| Total interest income                                     |   | 3,817,562       |      | 4,444,287       |   |
|                                                      |   |            |      |            |   |
| Interest Expense:                                         |   |            |      |            |   |
|                                                      |   |            |      |            |   |
| Now accounts                                              |   | 61,374          |      | 31,846          |   |
| MMDA accounts                                             |   | 42,463          |      | 130,410         |   |
| Savings accounts                                          |   | 12,092          |      | 11,456          |   |
| Time deposits of $100,000 or more                         |   | 38,346          |      | 41,475          |   |
| Other time deposits                                       |   | 279,455         |      | 217,278         |   |
| Other borrowed funds                                      |   | 394,514         |      | 408,673         |   |
| Total interest expense                                    |   | 828,244         |      | 841,138         |   |
|                                                      |   |            |      |            |   |
| Net Interest Income Before Prov. for Possible Loan Losses |   | 2,989,318       |      | 3,603,149       |   |
| Provision for loan losses                                 |   | 150,000         |      | 125,000         |   |
| Net interest income after provision for loan losses       |   | 2,839,318       |      | 3,478,149       |   |
|                                                      |   |            |      |            |   |
| Non-interest Income:                                      |   |            |      |            |   |
| Service charges on deposit accounts                       |   | 326,365         |      | 411,638         |   |
| Other income                                              |   | 471,520         |      | 515,540         |   |
| Total Non-interest Income                                 |   | 797,885         |      | 927,178         |   |
|                                                      |   |            |      |            |   |
| Non-interest  Expense:                               |   |            |      |            |   |
| Salaries and employee benefits                            |   | 1,284,100       |      | 1,518,718       |   |
| Occupancy and equipment                                   |   | 410,089         |      | 429,187         |   |
| Other expenses                                            |   | 983,345         |      | 1,031,863       |   |
| Total Noninterest Expenses                                |   | 2,677,534       |      | 2,979,768       |   |
| Income before provision for income taxes                  |   | 959,669         |      | 1,425,559       |   |
| Provision for applicable income taxes                     |   | 328,249         |      | 546,269         |   |
| Net Income                                                |   | $               | 631,420   |            | $      | 879,290 |   |
|                                                      |   |            |      |            |   |
| Earnings per share: (See note #4)                         |   |            |      |            |   |
| Basic                                                     |   | $               | 0.22      |            | $      | 0.30 |   |
| Fully Diluted                                             |   | $               | 0.20      |            | $      | 0.28 |   |

 

See notes to condensedfinancial statements

 

4

----

 

**HERITAGE OAKS BANCORP**

**CONSOLIDATED STATEMENTS OF INCOME**

**For the six months ended June 30,**

** **
|                                                      |   | **2002**        |      | **2003**        |   |
|-----------------------------------------------------------|--------|-----------------|-----------|-----------------|--------|
|                                                      |   | **(Unaudited)** |      | **(Unaudited)** |   |
| Interest Income:                                          |   |            |      |            |   |
|                                                      |   |            |      |            |   |
| Interest and fees on loans                                |   | $               | 6,270,975 |            | $      | 7,531,362 |   |
| Investment securities                                     |   | 860,153         |      | 1,081,033       |   |
| Federal funds sold and commercial paper                   |   | 102,237         |      | 107,022         |   |
| Time certificates of deposit                              |   | 2,320           |      | 6,281           |   |
| Total interest income                                     |   | 7,235,685       |      | 8,725,698       |   |
|                                                      |   |            |      |            |   |
| Interest Expense:                                         |   |            |      |            |   |
|                                                      |   |            |      |            |   |
| Now accounts                                              |   | 121,040         |      | 68,564          |   |
| MMDA accounts                                             |   | 71,855          |      | 275,231         |   |
| Savings accounts                                          |   | 23,329          |      | 22,755          |   |
| Time deposits of $100,000 or more                         |   | 78,602          |      | 83,424          |   |
| Other time deposits                                       |   | 593,688         |      | 455,096         |   |
| Other borrowed funds                                      |   | 447,931         |      | 873,000         |   |
| Total interest expense                                    |   | 1,336,445       |      | 1,778,070       |   |
|                                                      |   |            |      |            |   |
| Net Interest Income Before Prov. for Possible Loan Losses |   | 5,899,240       |      | 6,947,628       |   |
| Provision for loan losses                                 |   | 285,000         |      | 250,000         |   |
| Net interest income after provision for loan losses       |   | 5,614,240       |      | 6,697,628       |   |
|                                                      |   |            |      |            |   |
| Non-interest Income:                                      |   |            |      |            |   |
| Service charges on deposit accounts                       |   | 642,578         |      | 802,111         |   |
| Investment securities gains, net                          |   | 0               |      | 56,988          |   |
| Other income                                              |   | 937,423         |      | 969,359         |   |
| Total Non-interest Income                                 |   | 1,580,001       |      | 1,828,458       |   |
|                                                      |   |            |      |            |   |
| Non-interest  Expense:                               |   |            |      |            |   |
| Salaries and employee benefits                            |   | 2,541,161       |      | 3,022,018       |   |
| Occupancy and equipment                                   |   | 849,739         |      | 818,690         |   |
| Other expenses                                            |   | 1,965,030       |      | 2,007,783       |   |
| Total Noninterest Expenses                                |   | 5,355,930       |      | 5,848,491       |   |
| Income before provision for income taxes                  |   | 1,838,311       |      | 2,677,595       |   |
| Provision for applicable income taxes                     |   | 638,670         |      | 973,736         |   |
| Net Income                                                |   | $               | 1,199,641 |            | $      | 1,703,859 |   |
|                                                      |   |            |      |            |   |
| Earnings per share: (See note #4)                         |   |            |      |            |   |
| Basic                                                     |   | $               | 0.42      |            | $      | 0.58 |   |
| Fully Diluted                                             |   | $               | 0.38      |            | $      | 0.54 |   |

 

See notes to condensedfinancial statements

 

5

----

 

**HERITAGE OAKS BANCORP**

**CONSOLIDATED STATEMENTS OF CASHFLOWS**

**Periods ended June 30,**

** **
|                                                                                |   | **2002**        |       | **2003**        |   |
|-------------------------------------------------------------------------------------|--------|-----------------|------------|-----------------|--------|
|                                                                                |   | **(Unaudited)** |       | **(Unaudited)** |   |
| **Cash Flows from Operating Activities**                                            |   |            |       |            |   |
| Net  income                                                                         |   | $               | 1,199,641  |            | $      | 1,703,859 |   |
| Adjustments  to reconcile net income to net cash provided by operating activities   |   |            |       |            |   |
| Net  cash provided by operating activities                                          |   |            |       |            |   |
| Depreciation  and amortization                                                      |   | 309,979         |       | 309,706         |   |
| Provision  for possible loan losses                                                 |   | 285,000         |       | 250,000         |   |
| Provision  for possible unfunded loan losses                                        |   | 0               |       | 25,000          |   |
| Realized  gain on sales of available-for-sale securities, net                       |   | 0               |       | (56,988         | )      |
| Gain  on sales of property, premise and equipment                                   |   | 17,332          |       | 0               |   |
| Amortization  of premiums/discounts on investment securities, net                   |   | 11,010          |       | 263,812         |   |
| Amortization  of intangible assets                                                  |   | 23,302          |       | 20,295          |   |
| (Increase)/decrease  in loans held for sale                                         |   | 401,125         |       | (1,099,840      | )      |
| (Increase)/decrease  in deferred tax asset                                          |   | 102,832         |       | (120,000        | )      |
| Net  increase in cash surrender value of life insurance                             |   | (131,923        | )          | (123,784        | )      |
| (Increase)/decrease  in other assets                                                |   | (369,738        | )          | 114,432         |   |
| Increase/(decrease)  in other liabilities                                           |   | 392,428         |       | (5,359,359      | )      |
| **NET CASH PROVIDED BY/(USED IN) OPERATING ACTIVITIES**                             |   | 2,240,988       |       | (4,072,867      | )      |
| **Cash Flows From Investing Activities**                                            |   |            |       |            |   |
| Purchase  of securities available-for-sale                                          |   | (41,537,414     | )          | (11,133,751     | )      |
| Proceeds  from sales of securities available-for-sale                               |   | 0               |       | 12,364,963      |   |
| Proceeds  from principal reductions and maturities of securities available-for-sale |   | 2,596,330       |       | 15,606,808      |   |
| Proceeds  from sale of FHLB stock                                                   |   | 0               |       | 289,000         |   |
| Purchase  of life insurance policies                                                |   | 0               |       | (830,000        | )      |
| Increase  in loans, net                                                             |   | (10,960,125     | )          | (22,492,026     | )      |
| Purchase  of property, premises and equipment, net                                  |   | (211,169        | )          | (366,802        | )      |
| **NET CASH USED IN INVESTING ACTIVITIES**                                           |   | (50,112,378     | )          | (6,561,808      | )      |
| **Cash Flows From Financing Activities**                                            |   |            |       |            |   |
| Increase  in deposits, net                                                          |   | $               | 21,672,479 |            | $      | 25,427,390 |   |
| Net  increase/(decrease) in other borrowings                                        |   | 36,398,426      |       | (9,630,328      | )      |
| Proceeds  from sale of Trust Preferred Securities                                   |   | 8,000,000       |       | 0               |   |
| Proceeds  from exercise of stock options                                            |   | 111,004         |       | 179,173         |   |
| Cash  paid in lieu of fractional shares                                             |   | (6,405          | )          | (3,252          | )      |
| **NET CASH PROVIDED BY FINANCING ACTIVITIES**                                       |   | 66,175,504      |       | 15,972,983      |   |
| **Net Increase in Cash and Cash Equivalents**                                       |   | 18,304,114      |       | 5,338,308       |   |
| **Cash and Cash Equivalents**, Beginning of year                                    |   | 20,398,048      |       | 60,553,631      |   |
| **Cash and Cash Equivalents**, End of year                                          |   | $               | 38,702,162 |            | $      | 65,891,939 |   |
|                                                                                |   |            |       |            |   |
| **Supplemental Disclosures of Cash Flow Information**                               |   |            |       |            |   |
| Interest  paid                                                                      |   | $               | 1,207,461  |            | $      | 1,867,673 |   |
| Income  taxes paid                                                                  |   | $               | 785,000    |            | $      | 930,000 |   |
|                                                                                |   |            |       |            |   |
| **Supplemental Disclosures of Non-Cash Flow Information**                           |   |            |       |            |   |
| Change  in other comprehensive income                                               |   | $               | 344,332    |            | $      | 147,206 |   |

 

See notes to condensed financial statements

 

6

----

 

**HERITAGE OAKS BANCORP**

**CONSOLIDATED STATEMENTS OF STOCKHOLDERS’EQUITY**

**June 30, 2003 and June 30, 2002**

**(Unaudited)**

** **
|                                                                               |   | **Shares  Outstanding** |       | **Common  Stock** |           | **Retained  Earnings** |   | **Accumulated  Other  Comprehensive  Income** |       | **Total  Stockholders’  Equity** |        |
|------------------------------------------------------------------------------------|--------|-------------------------|------------|-------------------|----------------|------------------------|--------|-----------------------------------------------|------------|---------------------------------------|-------------|
| **Balance January 1, 2003**                                                        |   | 2,785,533               |       | $                 | 9,703,022      |                   | $      | 9,548,089                                     |       | $                                     | 562,359     |   | $ | 19,813,470 |   |
|                                                                               |   |                    |       |              |           |                   |   |                                          |       |                                  |        |
| Exercise of Stock Options                                                          |   | 31,670                  |       | 179,173           |           | 0                      |   |                                          |       | 179,173                               |        |
|                                                                               |   |                    |       |              |           |                   |   |                                          |       |                                  |        |
| Stock dividend- 5%                                                                 |   | 139,048                 |       | 1,604,802         |           | (1,604,802             | )      |                                          |       | 0                                     |        |
| Cash paid to Shareholders’ in Lieu of fractional shares on 5% Stock  Dividend |   |                    |       |              |           | (3,253                 | )      |                                          |       | (3,253                                | )           |
|                                                                               |   |                    |       |              |           |                   |   |                                          |       |                                  |        |
| Comprehensive Income                                                               |   |                    |       |              |           |                   |   |                                          |       |                                  |        |
| Net Income                                                                         |   |                    |       |              |           | 1,703,859              |   |                                          |       | 1,703,859                             |        |
| Unrealized Security Holding Gains/(Losses) ‘(net of $120,933 tax)             |   |                    |       |              |           |                   |   | 181,400                                       |       | 181,400                               |        |
| Less reclasification   adjustment for gain (net of $22,795 tax)               |   |                    |       |              |           |                   |   | (34,194                                       | )          | (34,194                               | )           |
|                                                                               |   |                    |       |              |           |                   |   |                                          |       |                                  |        |
| Total other comprehensive Income                                                   |   |                    |       |              |           |                   |   |                                          |       | 1,885,259                             |        |
|                                                                               |   |                    |       |              |           |                   |   |                                          |       |                                  |        |
| **Balance June 30, 2003**                                                          |   | **2,956,251**           | ** ** | **$**             | **11,486,997** | ** **             | **$**  | **9,643,893**                                 | ** ** | **$**                                 | **709,565** | ** ** | **$** | **21,840,455** | ** ** |

 
|                                                                               |   | **Shares  Outstanding** |       | **Common  Stock** |          | **Retained  Earnings** |   | **Other  Comprehensive  Income** |       | **Total  Stockholders’  Equity** |        |
|------------------------------------------------------------------------------------|--------|-------------------------|------------|-------------------|---------------|------------------------|--------|----------------------------------|------------|---------------------------------------|-------------|
|                                                                               |   |                    |       |              |          |                   |   |                             |       |                                  |        |
| Balance January 1, 2002                                                            |   | 1,362,774               |       | $                 | 7,535,495     |                   | $      | 8,496,122                        |       | $                                     | (154,836    | ) | $ | 15,876,781 |   |
|                                                                               |   |                    |       |              |          |                   |   |                             |       |                                  |        |
| Exercise of Stock Options                                                          |   | 22,958                  |       | 111,004           |          | 0                      |   |                             |       | 111,004                               |        |
|                                                                               |   |                    |       |              |          |                   |   |                             |       |                                  |        |
| Stock dividend- 5%                                                                 |   | 67,880                  |       | 1,680,849         |          | (1,680,849             | )      |                             |       | 0                                     |        |
| Cash paid to Shareholders’ in Lieu of fractional shares on 5% Stock  Dividend |   |                    |       |              |          | (6,405                 | )      |                             |       | (6,405                                | )           |
|                                                                               |   |                    |       |              |          |                   |   |                             |       |                                  |        |
| Stock Split- 2 for 1                                                               |   | 1,453,613               |       |              |          |                   |   |                             |       |                                  |        |
|                                                                               |   |                    |       |              |          |                   |   |                             |       |                                  |        |
| Comprehensive Income                                                               |   |                    |       |              |          |                   |   |                             |       |                                  |        |
| Net Income                                                                         |   |                    |       |              |          | 1,199,641              |   |                             |       | 1,199,641                             |        |
| Unrealized Security Holding Gains/(Losses) ‘(net of $126,330 tax)             |   |                    |       |              |          |                   |   | 344,332                          |       | 344,332                               |        |
|                                                                               |   |                    |       |              |          |                   |   |                             |       |                                  |        |
| Total other comprehensive Income                                                   |   |                    |       |              |          |                   |   |                             |       | 1,543,973                             |        |
|                                                                               |   |                    |       |              |          |                   |   |                             |       |                                  |        |
| **Balance June 30, 2002**                                                          |   | **2,907,225**           | ** ** | **$**             | **9,327,348** | ** **             | **$**  | **8,008,509**                    | ** ** | **$**                                 | **189,496** | ** ** | **$** | **17,525,353** | ** ** |

 

7

----

 

**Note1.****                             CONSOLIDATEDFINANCIAL STATEMENTS**

 

In the opinion of Management, the un-auditedconsolidated condensed financial statements contain all (consisting of onlynormal recurring adjustments) adjustments necessary to present fairly HeritageOaks Bancorp’s (the “Company”) consolidated financial position at June 30, 2003and results of cash flows for the six months ended June 30, 2002 and 2003 andthe results of operation for the three and six months ended June 30, 2002 and2003.

 

Certain information and footnote disclosuresnormally presented in financial statements prepared in accordance withgenerally accepted accounting principles have been omitted. These interimconsolidated condensed financial statements should be read in conjunction withthe consolidated financial statements and notes thereto included in theCompany’s 2002 Annual Report to shareholders. The results for the three and sixmonths ended June 30, 2002 and 2003 may not necessarily be indicative of theoperating results for the full year.

 

### **Note 2.**                             INVESTMENTSECURITIES

 

In accordance with SFAS No. 115 “Accountingfor Certain Investments in Debt and Equity Securities”, which addresses theaccounting for investments in equity securities that have a readilydeterminable fair values and for investments in all debt securities, securitiesare classified in three categories and accounted for as follows: debit andequity securities that the Company has the positive intent and ability to holdto maturity are classified as held-to-maturity and are measured at amortizedcost; debt and equity securities bought and held principally for the purpose ofselling in the near term are classified as trading securities and are measuredat fair value, with the unrealized gains and losses included in earnings; debtand equity securities not classified as either held-to-maturity or tradingsecurities are deemed as available-for-sale and are measured at fair value,with the unrealized gains and losses, net of applicable taxes, reported in aseparate component of stockholders’ equity. Any gains and losses on sales ofinvestments are computed on a specific identification basis.

 

The amortized cost and fair values of investment securities availablefor sale at June 30, 2003 and

December 31, 2002 were: 

 
| **June 30, 2003**                                        |   | **Amortized  Cost** |           | **Gross  Unrealized  Gains** |   | **Gross  Unrealized  Losses** |       | **Fair  Value** |        |
|----------------------------------------------------------|--------|---------------------|----------------|------------------------------|--------|-------------------------------|------------|-----------------|-------------|
|                                                     |   |                |           |                         |   |                          |       |            |        |
| Obligations of U.S. government agencies and corporations |   | $                   | 592,844        |                         | $      | —                        |       | $               | (16,316     | ) | $ | 576,528 |   |
| Mortgage-backed securities                               |   | 36,858,038          |           | 665,212                      |   | (1,160                        | )          | 37,522,090      |        |
| Obligations of State and Political Subdivisions          |   | 9,954,865           |           | 534,872                      |   | 0                             |       | 10,489,737      |        |
| Other Securities                                         |   | 8,638               |           | 0                            |   | 0                             |       | 8,638           |        |
| **TOTAL**                                                |   | **$**               | **47,414,385** | ** **                   | **$**  | **1,200,084**                 | ** ** | **$**           | **(17,476** | **)** | **$** | **48,596,993** | ** ** |

 
| **December 31, 2002**                                    |   | **Amortized  Cost** |           | **Gross  Unrealized  Gains** |   | **Gross  Unrealized  Losses** |       | **Fair  Value** |        |
|----------------------------------------------------------|--------|---------------------|----------------|------------------------------|--------|-------------------------------|------------|-----------------|-------------|
|                                                     |   |                |           |                         |   |                          |       |            |        |
| Obligations of U.S. government agencies and corporations |   | $                   | 816,521        |                         | $      | 562                           |       | $               | (18,469     | ) | $ | 798,614 |   |
| Mortgage-backed securities                               |   | 54,480,395          |           | 777,972                      |   | (4,342                        | )          | 55,254,025      |        |
| Obligations of State and Political Subdivisions          |   | 9,153,674           |           | 247,715                      |   | (66,172                       | )          | 9,335,217       |        |
| Other Securities                                         |   | 8,638               |           | 0                            |   | 0                             |       | 8,638           |        |
| **TOTAL**                                                |   | **$**               | **64,459,228** | ** **                   | **$**  | **1,026,249**                 | ** ** | **$**           | **(88,983** | **)** | **$** | **65,396,494** | ** ** |

 

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### **Note 3.**                             LOANSAND ALLOWANCE FOR LOAN LOSSES

 

Major classifications of loans were:

** **
|                                    |   | **December 31,  2002** |        | **June 30,  2003** |   |
|-----------------------------------------|--------|------------------------|-------------|--------------------|--------|
|                                    |   |                   |        |               |   |
| Commercial, financial, and agricultural |   | $                      | 40,373,350  |               | $      | 39,574,493 |   |
| Real estate-construction                |   | 30,773,530             |        | 31,414,420         |   |
| Real estate-mortgage                    |   | 116,758,894            |        | 139,699,456        |   |
| Installment loans to individuals        |   | 2,290,874              |        | 1,981,024          |   |
| All other loans (including overdrafts)  |   | 272,607                |        | 162,081            |   |
|                                    |   | 190,469,255            |        | 212,831,474        |   |
|                                    |   |                   |        |               |   |
| Less - deferred loan fees, net          |   | (821,668               | )           | (763,119           | )      |
| Less - reserve for possible loan losses |   | (2,336,219             | )           | (2,514,961         | )      |
|                                    |   |                   |        |               |   |
| Total loans                             |   | $                      | 187,311,368 |               | $      | 209,553,394 |   |
|                                    |   |                   |        |               |   |
| Loans Held For Sale                     |   | $                      | 8,166,011   |               | $      | 9,265,851 |   |

 

Concentration of CreditRisk

At June 30, 2003, approximately $171.1million of the Bank’s loan portfolio was collateralized by various forms ofreal estate. Such loans are generally made to borrowers located in San LuisObispo and Santa Barbara Counties. The Bank attempts to reduce itsconcentration of credit risk by making loans which are diversified by projecttype. While Management believes that the collateral presently securing thisportfolio is adequate, there can be no assurances that significantdeterioration in the California real estate market would not expose the Bank tosignificantly greater credit risk.

 

At June 30, 2003, the Bank was contingentlyliable for letters of credit accommodations made to its customer totalingapproximately $1.3 million and un-disbursed loan commitments in the approximateamount of $80.7 million. The Bank makes commitments to extend credit in thenormal course of business to meet the financing needs of its customers.Commitments to extend credit are agreement to lend to a customer as long asthere is no violation of any condition established in the contract. Commitmentsgenerally have fixed expiration dates or other termination clauses and mayrequire payment of a fee. Since many of the commitments are expected to expirewithout being drawn upon, the total outstanding commitment amount does notnecessarily represent future cash requirements. Standby letters of creditwritten are conditional commitments issued by the Bank to guarantee theperformance of a customer to a third party. The credit risk involved in issuingletters of credit is essentially the same as that involve in extending loanfacilities to customers. The Bank anticipates no losses as a result of suchtransactions.

 

Allowance for LoanLosses

An allowance for loan losses has beenestablished by management to provide for those loans that may not be repaid intheir entirety for a variety of reasons. The allowance is maintained at a levelconsidered by management to be adequate to provide for probable incurredlosses. The allowance is increased by provisions charged to earnings and isreduced by charge-offs, net of recoveries. The provision for loan losses isbased upon past loan loss experience and management’s evaluation of the loanportfolio under current economic conditions. Loans are charged to the allowancefor loan losses when, and to the extent, they are deemed by management to beun-collectible. The allowance for loan losses is composed of allocations forspecific loans and a historical portion for all other loans.

 

9

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An analysis of the changes in the reserve for possible loan losses isas follows:

 
|                                       |   | **December 31,  2002** |      | **June 30,  2003** |   |
|--------------------------------------------|--------|------------------------|-----------|--------------------|--------|
|                                       |   |                   |      |               |   |
| Balance at beginning of year               |   | $                      | 1,744,070 |               | $      | 2,336,219 |   |
| Additions charged to operating expense     |   | 545,000                |      | 250,000            |   |
| Loans charged off                          |   | (81,405                | )         | (145,000           | )      |
| Recoveries of loans previously charged off |   | 128,554                |      | 73,742             |   |
| Balance at end of year                     |   | $                      | 2,336,219 |               | $      | 2,514,961 |   |

 

The Bank recognizes that credit losses willbe experienced and the risk of loss will vary with, among other things, generaleconomic conditions; the type of loan being made; the creditworthiness of theborrower over the term of the loan and in the case of a collateralized loan,the quality of the collateral for such loan. The allowance for loan lossrepresents the Bank’s estimate of the allowance necessary to provide forprobable incurred losses in the portfolio. In making this determination, theBank analyzes the ultimate collectibility of the loans in its portfolio byincorporating feedback provided by internal loan staff, an independent loanreview function, and information provided by examinations performed byregulatory agencies. The Bank makes monthly evaluations as to the adequacy ofthe allowance for loan losses.

 

The analysis of the allowance for loan losses is comprised of threecomponents; specific credit allocation; general portfolio allocation; andsubjectively by determined allocation. Effective January 1, 1995, the Bankadopted Statement of Financial Accounting Standards No.114, Accounting byCreditors for Impairment of a Loan (SFAS 114), as amended by SFAS No. 118,Accounting by Creditors for Impairment of a Loan - Income Recognition andDisclosures. These pronouncements provide that when it is probable that acreditor will be unable to collect all amounts due in accordance with the termsof the loan that such loan is deemed impaired. Impaired loans are accounted fordifferently in that the amount of the impairment is measured and reflected inthe records of the creditor. Theallowance for credit losses related to loans that are identified for evaluationin accordance with Statement 114 is based on discounted cash flows using theloan’s initial effect interest rate or the fair value of the collateral forcertain collateral dependent loans. As a result of the Statement 114Evaluation, $145,000 was charged against the allowance for loan losses duringthe second quarter of 2003.The general portfolio allocation consists of anassigned reserve percentage based on the credit rating of the loan. Thesubjective portion is determined based on loan history and the Bank’sevaluation of various factors including current economic conditions and trendsin the portfolio including delinquencies and impairment, as well as changes inthe composition of the portfolio.

 

The allowance for loan losses is based onestimate, and ultimate losses will vary from current estimates. These estimatesare reviewed monthly, and as adjustments, either positive or negative, becomenecessary, a corresponding increase or decrease is made in the provision forloan losses. The methodology used to determine the adequacy of the allowancefor possible loan losses for the second quarter of 2003 is consistent withprior periods.

 

The Bank’s provision for loan losses was$250,000 for the six months ending June 30, 2003, compared to $300,000 for thesame period in 2002. However, the Bank also has reserved $25,000 in 2003 as aprovision for possible loan loss in conjunction with off balance sheet loancommitments.

 

The allowance for loan losses as a percentageof total net loans was 1.20% as of June 30, 2003 and 1.23% as of December 31,2002. Management believes that the allowance for credit losses at June 30, 2003is prudent and warranted, based on information currently available.

 

Non-Accrual andNon-Performing Loans

Loan on non-accrual status totaled $1,345,755and $800,033 at December 31, 2002 and June 30, 2003, respectively. Typically,these loans have adequate collateral protection and/or personal guaranties toprovide a source of repayment to the Bank. Most of the loans on non-accrual arerelated to several commercial loans that

 

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are being addressed by specific workout plansat this time. Interest income that would have been recognized on non-accrualloans if they had performed in accordance with the terms of the loans wasapproximately $134,508 and $44,164 for the period ended December 31, 2002 andJune 30, 2003, respectively.

 

Non-performing loans include non-accrualloans and accruing loans that are 90 days or more delinquent. The Bank had noloans that were 90 days or more delinquent and still accruing interest atDecember 31, 2002 and June 30, 2003.

 

Non-performing loans were .40% and .23% oftotal assets as of December 31, 2002 and June 30, 2003, respectively. Theallowance for loan loss to non-performing loans was 1.74x and 3.14x at December31, 2002 and June 30, 2003, respectively.

 

### **Note 4.**                             EARNINGSPER SHARE

 

Basic earnings per share are based on theweighted average number of shares outstanding before any dilution from commonstock equivalents. Diluted earnings per share reflects the potential dilutionthat could occur if securities or other contracts to issue common stock wereexercised or converted into common stock or resulted in the issuance of commonstock that then shares in the earnings of the entity.

 

On July 19, 2002, the Company announced thatthe Board of Directors of the Company approved a two-for-one stock split. Therecord date for the stock split was August 2, 2002 and the pay date was August15, 2002. Holders of shares of common stock of Heritage Oaks Bancorp wereissued one additional share of common stock for each share of common stockowned on the record date of August 2, 2002.

 

On March 4, 2003, the Company announced thatthe Board of Directors of the Company approved a 5% stock dividend. The recorddate for the stock dividend was March 14, 2003 and the pay date was March 28,2003.

 

Share information has been retroactivelyadjusted for the two-for-one stock split in August 2002 and the 5% stockdividend in March 2003.

 

Earnings per share and total number of sharesused for calculating basic earnings per share for the three months ended June30, 2002 and 2003, were $.22 and $.30 and 2,838,145 and 2,939,471, respectively.Earnings per share and total number of shares used for calculating dilutedearnings per share for the three months ended June 30, 2002 and 2003, were $.20and $.28 and 3,145,005 and 3,137,036, respectively.

 

Earnings per share and total number of sharesused for calculating basic earnings per share for the six months ended June 30,2002 and 2003, were $.42 and $.58 and 2,878,991and 2,932,661, respectively.Earnings per share and total number of shares used for calculating dilutedearnings per share for the six months ended June 30, 2002 and 2003, were $.38and $.54 and 3,149,822 and 3,138,878, respectively.

 

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The following table illustrates the effect on net income and earningsper share if the Company had applied the fair value recognition provision ofSFAS 123, Accounting for Stock Based Compensation, to stock based employeecompensation:

 
|                                                       |   | **Three Months Ended** |    | **Six Months Ended** |   |
|------------------------------------------------------------|--------|------------------------|---------|----------------------|--------|
|                                                       |   | **June 30, 2002**      |    | **June 30, 2003**    |   | **June 30, 2002** |   | **June 30, 2003** |   |
| Net  income:                                               |   |                   |    |                 |   |   |   |   |   |
| As  reported                                               |   | $                      | 631,420 |                 | $      | 879,290 |   | $ | 1,199,641 |   | $ | 1,703,859 |   |
| Stock-based  compensation using the intrinsic value method |   | —                 |    | —               |   | — |   | — |   |
| Stock-based  compensation that would have been reported    |   | —                 |    | —               |   | — |   | — |   |
| using  the fair value method of SFAS 123                   |   | (14,792                | )       | (22,546              | )      | (50,273 | ) | (57,387 | ) |
| Pro  forma net income                                      |   | $                      | 616,628 |                 | $      | 856,744 |   | $ | 1,149,368 |   | $ | 1,646,472 |   |
|                                                       |   |                   |    |                 |   |   |   |   |   |
| Weighted  Average Shares Outstanding - Basic               |   | 2,838,145              |    | 2,939,471            |   | 2,878,991 |   | 2,932,661 |   |
| Weighted  Average Shares Outstanding - Diluted             |   | 3,145,005              |    | 3,137,036            |   | 3,149,822 |   | 3,138,878 |   |
|                                                       |   |                   |    |                 |   |   |   |   |   |
| Basic  Earnings per share                                  |   |                   |    |                 |   |   |   |   |   |
| As  reported                                               |   | $                      | 0.22    |                 | $      | 0.30 |   | $ | 0.42 |   | $ | 0.58 |   |
| Pro  forma                                                 |   | $                      | 0.22    |                 | $      | 0.29 |   | $ | 0.40 |   | $ | 0.56 |   |
|                                                       |   |                   |    |                 |   |   |   |   |   |
| Earnings  per share - assuming dilution                    |   |                   |    |                 |   |   |   |   |   |
| As  reported                                               |   | $                      | 0.20    |                 | $      | 0.28 |   | $ | 0.38 |   | $ | 0.54 |   |
| Pro  forma                                                 |   | $                      | 0.20    |                 | $      | 0.27 |   | $ | 0.36 |   | $ | 0.52 |   |

 

### **Note 5.**                             PREMISE

 

On July 26, 2002, the Bank purchased a parcelof land (approximately 2 acres) on the corner of Niblick and South River Roadsin Paso Robles, Ca. The purchase price was $900,000. On February12, 2003, the Bank and HBE Corporation entered into a Construction Agreementfor the branch office building that will be located on this parcel of land. It is the intent of the Bank to build a full servicebranch on this parcel and to relocate the existing “Woodland” office, that iscurrently located at 171 Niblick Road, Paso Robles, Ca.  The Bank anticipates that the building willbe approximately 5,000 square feet in size and will open sometime in the firstquarter of 2004. The cost of construction is estimated to be approximately $1.8million.

 

On July 3, 2003, the Bank closed escrow to purchase real propertylocated at 500 13th Street, Paso Robles, Ca. This property islocated directly adjacent to the Bank’s Headquarters. The purchase price was$1.1 million. It is the Bank’s intention to either remodel and expand theexisting building or to build a new structure on the site to allow for theconsolidation of all Administrative functions of the Bank within the newfacility. The Bank anticipates that this project will be complete in the fourthquarter of 2004 or first quarter of 2005.

 

### **Note 6.**                             ISSUANCEOF TRUST PREFERRED SECURITIES

 

On April 10, 2002, the Company completed its offering of trustpreferred securities in the amount of $8.0 million. The securities were issuedby a special purpose business trust formed by the Company and were sold to apooled investment vehicle sponsored by Sandler O’Neill & Partners, L.P. andSalomon Smith Barney Inc. in a private transaction. The securities were soldpursuant to an applicable exemption from registration under the Securities Actof 1933, as amended (the “Act”), and have not been registered under the Act.  Sandler O’Neill assisted the Company in theplacement of the trust preferred securities. The securities may not be offeredor sold in the United States absent registration or an applicable exemptionfrom registration requirements.

 

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The $8.0 million in trust preferred securities have a floating rate ofinterest, which is reset semi-annually, equal to 6-month LIBOR plus 3.70%.  The floating rate, however, may not exceed11.0% for the first five years. The $8.0 million accounts for approximately 4%of the increase in total assets.

 

As the result of the issuance of $8.0 million in trust preferredsecurities, on April 11, 2002, the Company down-streamed $5.2 million to theBank in the form of Tier I Capital. This enabled the Bank to implement aninvestment strategy whereby the Bank borrowed $38 million from the Federal HomeLoan Bank (FHLB) and purchased approximately $40 million in investmentsecurities. The purchased investment securities serve as collateral for the borrowing.On February 22, 2003, the Bank repaid $9.5 million of the borrowing.

### ** **

### **Note 7.**                             RECENTLEGISLATIVE ACTIVITYSARBANES-OXLEY ACT OF 2002

 

On July 30, 2002, President Bush signed into law the Sarbanes-Oxley Actof 2002 (the “Act”).

 

On August 28, 2002, in accordance with Section 302 of the Act, theSecurities and Exchange Commission (the “SEC”) adopted final rules that requirean issuer’s principal executive and principal financial officer to certify thecontents, including the financial and other information, of the issuer’squarterly and annual reports. The rules became effective on August 29, 2002. Inaddition, the SEC adopted previously proposed rules requiring issuers tomaintain, and regularly evaluate the effectiveness of control and procedures designedto ensure that the information required in reports filed under the SecuritiesExchange Act of 1934 is recorded, processed, summarized and reported on atimely basis.

 

A separate provision of the Act (section 906) creates an independentCEO and CFO certification obligation that took effect immediately upon signingthe Act into law and impacted periodic reporting beginning with the June 30,2002 10-QSB. The certification in section 906 provides for a statement that anyperiodic report containing financial statements fully complies with Section13(a) or 15 (d) of the Exchange Act and that the information contained in theperiodic report fairly presents, in all material respects, the financialcondition and results of operation of the public company.

 

The SEC has also adopted new Exchange Act Rules 13a-14 and 15d-14 thatrequire an issuer to establish and maintain an overall system of disclosurecontrols and procedures that are adequate to meet its Exchange Act reportingobligations.

 

**Note8.****                             RecentAccounting Pronouncements**

 

At its August 7, 2002 Board meeting, the FASBapproved, in principle, Statement 147 which will replace certain paragraphs inStatement 72, “Accounting for Certain Acquisitions of Banking or ThriftInstitutions”. The new guidance was effective on September 30, 2002. Therequirement in Statement 72 to recognize (and amortize) an “unidentifiableintangible asset” when more liabilities are acquired than assets, such as in abranch purchase that is a business combination, will no longer apply.Previously recorded core deposit intangibles must continue to be amortized.

 

The Bank acquired four branch offices fromWestamerica Bank in November 2001. The premium, net  of fair value for certain assets acquired, was fully accountedfor as core deposit intangibles. This core deposit intangible has and willcontinue to be amortized over a period of ten years.

 

Core Deposit Intangible and Goodwill in theapproximate amount of $4.5 million will be created as the result of therecently announced merger transaction with Hacienda Bank (refer to Management’sDiscussion and Analysis, Recent Events). Once finalized, the ultimate amount ofintangible created may vary depending on the fair value assessment of assetsand liabilities acquired on the purchase date.

 

In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement133 on Derivative Instruments and Hedging Activities.”  SFAS No. 149 amends and clarifies accountingfor derivative instruments, including certain derivative instruments embeddedin other contracts and loan commitments that relate to the origination ofmortgage loans held for sale, and for hedging activities under SFAS No.133.  SFAS No. 149

 

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is generally effective for contracts entered into or modified afterJune 30, 2003.  The adoption of SFAS No.149 will not have a material impact on the financial condition or operatingresults of the Company.

 

In May 2003, the FASB issued SFAS No. 150, “Accounting for CertainFinancial Instruments with Characteristics of both Liabilities andEquity.”  SFAS No. 150 establishesstandards for how an issuer classifies and measures certain financialinstruments with characteristics of both liabilities and equity.  It requires that an issuer classify a financialinstrument that is within its scope as a liability (or an asset in somecircumstances.)  Many of thoseinstruments were previously classified as equity.  SFAS No. 150 is generally effective for financial instrumentsentered into or modified after May 31, 2003, and otherwise is effective at thebeginning of the first interim period beginning after June 15, 2003.  The adoption of SFAS No. 150 did not have amaterial impact on the financial condition or operating results of the Company.

 

**Note9.****                             Reclassifications**

 

Certain amounts in the 2002 financial statements have been reclassifiedto conform to the 2003 presentation.

 

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**Certain statementscontained in this Quarterly Report on Form 10-QSB (“Quarterly Report”),including, without limitation, statements containing the words “believes”,“anticipates”, “intends”, “expects”, and words of similar impact, constitute“forward-looking statements” within the meaning of Section 27A of theSecurities Act of 1933 and Section 21E of the Securities and Exchange Act of1934. Such forward-looking statements involve known and unknown risks,uncertainties and other factors that may cause the actual results, performanceor achievements of the Company to be materially different from any futureresults, performance or achievements expressed or implied by suchforward-looking statements. Such factors include, among others, the following:general economic and business conditions in those areas in which the Companyoperates, demographic changes, competition, fluctuations in interest rates,changes in business strategy or development plans, changes in governmentalregulation, credit quality, the availability of capital to fund the expansionof the Company’s business, economic, political and global changes arising fromthe terrorist attacks of September 11, 2001 and their aftermath and otherfactors referenced in the Company’s filings with the SEC. (Refer to theCompany’s December 31, 2002 10-KSB, ITEM 1. Description of Business.) TheCompany disclaims any obligation to update any such factors or to publiclyannounce the results of any revisions to any of the forward-looking statementscontained herein to reflect future events or developments.**

 

**ITEM 2.****     MANAGEMENT’S DISCUSSION AND ANALYSISOF FINANCIAL CONDITION  AND RESULTS OFOPERATIONS**

 

Heritage Oaks Bancorp (the “Company”)commenced operations on November 15, 1994 with the acquisition of Heritage OaksBank (the “Bank”).  Each shareholder ofthe Bank received one share of stock in the Company in exchange for each shareof Heritage Oaks Bank stock owned.  TheBank became a wholly owned subsidiary of the Company.  The Bank is the only active financial subsidiary owned by theCompany. In April 2002, the Company formed Heritage Oaks Capital Trust I (the“Trust”). The Trust is a statutory business trust formed under the laws of theState Of Delaware and is wholly-owned by the Company. In July 2003, the Companyformed Heritage Oaks Merger Corp. to facilitate the acquisition of Hacienda Bankas a wholly owned subsidiary of the Company.

 

**RECENT EVENTS**

 

Acquisition Announced

On June 11, 2003, Heritage Oaks Bancorp (the“Company”), a California corporation, and Hacienda Bank (the “Seller”), aCalifornia Banking corporation, entered into an Agreement to Merge and Plan ofReorganization (“Agreement”). Subject to the terms and conditions of theAgreement and the Agreement of Merger, at the Effective time, Seller willbecome a wholly owned subsidiary of the Company in accordance with the proceduresspecified in the California Financial Code (CFC) and the California GeneralCorporation Law (CGCL) by merging with a wholly owned subsidiary of theCompany, Heritage Oaks Merger Corp. Seller will be the Surviving Bank in theMerger.

 

The Agreement provides that shareholdersof Hacienda Bank will have the election of receiving Heritage Oaks Bancorpcommon stock, cash or a combination in return for their shares of Hacienda Bankstock, provided that cash must constitute not less than 25% nor more than 35%of the total consideration issued in the merger. Hacienda Bank shareholders whoelect stock will receive 0.5208 in Heritage Oaks Bancorp stock. Hacienda Bankshareholders who elect cash will receive $6.50 cash per share which is subjectto possible upward adjustment up to $6.75 per share based on changes in theprice of Heritage Oaks Bancorp stock preceding the effective date of thetransaction. The transaction is valued at approximately $9.7 million.  It represents approximately 1.71 timesHacienda Bank book value at December 31, 2002 and 22.8 times 2002earnings.  The merger is structured tobe tax-free and is intended to be accounted for as a purchase.  Heritage Oaks Bancorp expects thetransaction to close late in the fourth quarter 2003 and is expected to beaccretive to earnings in 2004.

 

The Merger requires the affirmative approvalof the holder of the outstanding shares of the Company and the Seller.

 

Subject to the terms and conditions of this Agreement and the Agreement of Merger, at the Effective Time,

 

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Heritage Oaks Merger Corp. (HOMC), will be merged into Seller in accordance withthe procedures specified in the California General Corporation Law (GCL).  Seller will be the Surviving Bank in the Merger.

 

The name of the Surviving Bank shall be“Hacienda Bank.”  Upon the consummationof the Merger, the separate corporate existence of HOMC shall cease:  All assets, rights, franchises, titles andinterests of Seller and HOMC in and to every type of property (real, personaland mixed, including all the right, title and interest to HOMC’s names, tradenames, service marks and the like) and choses in action shall be transferred toand vested in Seller by virtue of the Merger without any deed or other transfer,and Seller, without order or action on the part of any court or otherwise,shall hold and enjoy all rights of property, franchises and interests in thesame manner and to the same extent that such rights, franchises and interestswere held by Seller and HOMC at the effective time of the Merger.  At the Effective Time, Seller shall beliable for all liabilities of Seller and HOMC, and all debts, liabilities,obligations and contracts of Seller and HOMC, whether matured or un-matured,accrued, absolute, contingent or otherwise, and whether or not reflected orreserved against on balance sheets, books of accounts or records of Seller andBank, shall be those of Seller; and all rights of creditors or other obligeesand all liens on property of Seller and HOMC shall be preserved unimpaired.

 

Hacienda Bank, Heritage Oaks Bank and Heritage Oaks Bancorp are allwell-capitalized as of June 30, 2003 and will remain well-capitalized on theeffective date of the transaction.

 

On July 15, 2003, the Company received a commitment letter from PacificCoast Bankers Bank for a revolving line of credit in the amount of $3.5million. The Company will pledge 339,332 shares or 51% of its stock in HeritageOaks Bank as collateral. The funds will be used in the acquisition of HaciendaBank for payment to shareholders who elect cash and/or Tier I capital in theform of Surplus to its financial subsidiaries.

 

Property Purchased

On July 3, 2003, the Bank closed escrow to purchase real propertylocated at 500 13th Street, Paso Robles, Ca. This property islocated directly adjacent to the Bank’s Headquarters. The purchase price is$1.1 million. It is the Bank’s intention to either remodel and expand theexisting building or to build a new structure on the site to allow for theconsolidation of all Administrative functions of the Bank within the newfacility. The Bank anticipates that this project will be complete in the fourthquarter of 2004 or first quarter of 2005.

 

**CRITICAL ACCOUNTINGPOLICIES**

 

The Company’s significant accounting policiesare set forth in note 1 of the consolidated financial statements as of December31, 2002 which was filed on Form 10-KSB. Of these significant accountingpolicies, the Company considers its policy regarding the allowance for loanlosses to be its most critical accounting policy, because it requiresmanagement’s most subjective and complex judgments.  In addition, changes in economic conditions can have asignificant impact on the allowance for loan losses and therefore the provisionfor loan losses and results of operations. The Company has developedappropriate policies and procedures for assessing the adequacy of the allowancefor loan losses, recognizing that this process requires a number of assumptionsand estimates with respect to its loan portfolio. The Company’s assessments maybe impacted in future periods by changes in economic conditions, the impact ofregulatory examinations, and the discovery of information with respect toborrowers, which is not known to management at the time of the issuance of theconsolidated financial statements. Refer to “Note 3. Allowances for LoanLosses” found elsewhere in this document for a detailed explanation of theCompany’s assessment.

 

**FINANCIAL CONDITION**

 

As of June 30, 2003, total consolidatedassets of Heritage Oaks Bancorp were $349.8 million compared to $337.3 millionat December 31, 2002. This represents an increase of 3.7%. The components ofthis increase are discussed below.

 

##### Cash and Due From Banks

Total cash and due from banks at June 30, 2003 was $31.8 million, anincrease of 35.2% from $23.5

 

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million at December 31, 2002. This line item will vary depending oncash letters from the previous night and actual cash on hand in the branches.The balance in the Fed account had a closing balance of $16.1 million to meetthe target for Reserve Requirements.

 

##### Loans

Total net loans at June 30, 2003 were $209.6 million compared to $187.3million at December 31, 2002. This represents an increase of 11.9%. For the sixmonths ending June 30, 2003, commercial, financial and agriculture loansdecreased by $.8 million or 2.0%, realestate-construction loans increased by $.6 million or 2.1%, realestate-mortgage loans increased by $22.9 million or 19.7% and installment loansto individuals decreased by $.3 million or 13.5%.

 

The modest decrease in agricultural loans isattributed to the refinance of several development loans through the Farmer Macprogram. This program is a long-term mortgage product that offers low interestrates on producing agricultural real estate. We continue to use this product topayoff our development loans and also to finance homes on acreage. With thecurrent oversupply of wine grapes, vineyard development has decreasedsignificantly hence new development loan requests have also diminished.  Commercial loan growth has been impacted bythe economic slowdown with most companies hesitant to request funds for plantexpansion, new equipment, etc.

 

The small increase in realestate-construction loans can be attributed to several large constructionprojects financed in 2002 that are continuing to fund and to new projectsfinanced in 2003. They include a condominium project in the amount of $5.3million that will payoff as units are sold; an office building in the amount ofnearly $4 million, another office building for $3.8 million, a hotel for $4million, a hotel for $2.4 million, two medical offices totaling $3.3 million, astrip center in the amount of $4.4 million and a RV park in the amount of $1.6million. Many of the properties are pre-leased prior to construction startup.Upon completion of construction, the properties for which the Bank is willingto offer permanent financing are granted loans with monthly principal andinterest payments based on a term of not more than fifteen years with not morethan a twenty-five year amortization. These loans have a variable rate ofinterest that may be fixed for the initial two to three years.

 

The large increase in real estate-mortgageloans is attributed primarily to several construction loans converting toamortizing loans as indicated above and to approximately $10 million in newcommercial real estate loans.  Theyinclude an office/retail building for $3.3 million, light industrial buildingsfor $1.9 million, vacation rentals for $1.4 million, a motel for $.6 millionand numerous $200-500,000 property loans.

 

There are two categories of loanconcentration at June 30, 2003. These categories are reported monthly to theBank’s Director Loan Committee. The two categories are 1) construction and landloans and 2) motel/hotel loans. Construction and land loans total approximately$35.0 million. This represents 134.09% of the Bank’s Tier 1 capital. Theprojects are spread throughout our market area and range from single familyresidences to large commercial projects. The largest project representsapproximately 12% of the total construction and land loans outstanding.Construction projects are inspected regularly to ensure progress is in linewith funds drawn on specific loans. Motel /hotel loans total approximately$39.4 million and represent 143.05% of the Bank’s Tier 1 capital. These loansare also spread throughout our market area with no concentration in any onecommunity. All motel/hotel loans are performing as agreed with zerodelinquencies. The majority of operators have indicated that occupancy ratesare between 60%-70% representing a decrease of about 3%-7%. However, daily roomrates are up. The overall effect on profits and cash flow has been minimal and hashad no impact on the customer’s ability to repay

 

Loans held for sale were $9.3 million at June30, 2003 compared to $8.2 million at December 31, 2002. Typically, loans heldfor sale are sold within 45 days of funding.

 

##### Securities

The Company manages its securities portfolioto provide a source of both liquidity and earnings. The Bank has anasset/liability committee that develops current investment policies based uponits operating needs and market circumstance. The Bank’s investment policy isformally reviewed and approved annually by its board of directors. Theasset/liability committee of the Bank is responsible for reporting andmonitoring

 

17

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compliance with the investment policy.Reports are provided to the Bank’s board of directors on a regular basis.

 

Securities available-for-sale are carried atfair value, with related unrealized net gains or losses, net of deferred incometaxes, recorded as an adjustment to equity capital as accumulated other comprehensiveincome. As of June 30, 2003, accumulated other comprehensive income was$709,565 compared to $562,359 at December 31, 2002.

 

Securities available-for-sale decreased to$48.6 million at June 30, 2003 from $65.4 million at December 31, 2002. Thisrepresents a decrease of $16.8 million or 25.7%. With the interest rateenvironment remaining at historic lows, prepayments on Mortgage BackedSecurities (MBS) have accelerated to nearly $16 million during the first sixmonths of 2003. During the first quarter of 2003, the Bank sold two MBSsecurities with principal outstanding balances of approximately $7.4 millionand one Collateralized Mortgage Obligation (CMO) in the amount of approximately$5 million. These securities were replaced with two CMO securities in the totalamount of approximately $11 million. These transactions were executed as theresult of an analysis on interest rate sensitivity and to better position theinvestment portfolio for future interest rate movements of either up or down.

 

As the result of the issuance of $8.0 million in trust preferredsecurities, in April 2002, the Company down-streamed $5.2 million to the Bankin the form of Tier I Capital. This enabled the Bank to implement an investmentstrategy whereby the Bank borrowed $38 million from the Federal Home Loan Bank(FHLB) and purchased approximately $40 million in investment securities. Thepurchased investment securities serve as collateral for the borrowing. The Bankmade this decision knowing that it would improve the return on average equityby increasing the net interest income in absolute terms even though it wouldreduce the return on average assets and the net interest margin as apercentage. Prior to investing, the Bank performed extensive due diligence inassessing the interest rate and market value risk of this strategy includingthe performance in various interest rate scenarios of up and down 100, 200 and300 basis points. Management believes that variances up to 300 basis pointswould not have a material effect on the overall interest rate and market valuerisk to the Company.

 

At June 30, 2003, available-for-sale securities in the portfolioincluded obligations of state and political subdivisions, obligations of USgovernment agencies and corporations and mortgaged backed securities issued byvarious agencies.

 

All fixed and adjustable rate mortgage pools contain a certain amountof risk related to the uncertainty of prepayments of the underlying mortgages.Interest rate changes have a direct impact upon prepayment rates. The Bank usescomputer simulation models to test the average life, duration, marketvolatility and yield volatility of adjustable rate mortgage pools under variousinterest rate assumptions to monitor volatility. Stress tests are performedquarterly.

 

##### Federal Funds Sold

Federal funds sold were $34.1 million at June30, 2003 compared to $37 million at December 31, 2002. The decrease of $2.9million is the direct result of the Bank repaying $9.5 million in borrowings tothe Federal Home Loan Bank (FHLB) on February 22, 2003. The primary reason forretaining these large over night investments is due to the volatile nature ofcertain deposit relationships that are related to the current robust mortgagebusiness. These relationships are discussed in more detail under “Deposits andBorrowed Funds”.

 

##### Deposits and Borrowed Funds

Total deposits were $289.6 million at June30, 2003 compared to $264.2 million at December 31, 2002. This represents anincrease of $25.4 million or 9.6%.

 

Demand deposits of $136.4 million at June 30, 2003 increased $29.9million or 28.0% compared to $106.6 million at December 31, 2002. This growthis attributed to the Bank’s presence within its primary market area, continuedmarketing efforts and three volatile account relationships. Demand depositbalances held by three, long time customers of the Bank that transact inmortgage related business

 

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accounts for approximately 27% of total deposits and 57% of DemandDeposits. The balances in these accounts were $77.1 million at June 30, 2003compared to $59.6 million at December 31, 2002. This represents an increase of$17.5 million or 22.7%. These volatile account relationships are included inthe volatile liability dependency report that the Bank produces on a monthlybasis. Management and the Board of Directors of the Bank are keenly aware thatif and when the mortgage market conditions change, these balances will benegatively impacted. This is the primary reason for the large balancesmaintained in over night investing in Federal Funds Sold.

 

Savings, NOW and money market deposits were $106.6 million at June 30,2003 compared to $112.6 million at December 31, 2002. This represents adecrease of $5.9 million or 5.3%. Savings accounts increased by $.5 million,while NOW and money market accounts decreased by $2.6 million and $3.9 million,respectively. In August 2002, the Bank began to offer a personal insured moneymarket account with the intent to raise deposits that otherwise generallyreside in non-financial investment companies. The Bank offered a competitiveintroductory rate and has been successful in increasing these balances fromapproximately $33.3 million at December 31, 2002 to $34.1 million at June 30,2003. The already existing business insured money market account productdecreased by $4.7 million for the period ending June 30, 2003 compared toDecember 31, 2002.

 

Time deposits of >$100,000 increased by $.6 million or 7.9%. Timedeposits of <$100,000 increased by $.9 million or 2.3%.

 

Core deposits (time deposits less than$100,000, demand, and savings) gathered in the local communities served by theBank continue to be the Bank’s primary source of funds for loans andinvestments.  Core deposits of $280.8million represented 97.0% of total deposits at June 30, 2003. The Company doesnot purchase funds through deposit brokers.

 

The Bank has established borrowing lines with the Federal Home LoanBank (FHLB) of approximately $13.0 million and $30.9 million secured by loansand securities, respectively. At June 30, 2003, the Bank had borrowings of$28.5 million against those lines. The $28.5 million borrowing consists of $9.5million maturing in April 2004 and $19 million maturing in April 2005. OnFebruary 22, 2003, the Bank repaid $9.5 million to the FHLB that matured onApril 24, 2003. The cost of the pre-payment penalty plus lost opportunityincome in the form of Fed Funds Sold resulted in less than $500 of cost to theBank.

 

The Bank utilizes securities sold under repurchase agreements as asource of funds.  The Bank had $127,409in securities sold under repurchase agreements at June 30, 2003 compared to$257,737 at December 31, 2002.

 

##### Capital Resources

 

On March 4, 2003, the Company announced thatthe Board of Directors of the Company approved a 5% stock dividend. The recorddate for the stock dividend was March 14, 2003 and the pay date was March 28,2003. A press release was issued on March 4, 2003.

 

On July 19, 2002, the Board of Directors of the Company declared a twofor one (2 for 1) stock split.  Therecord date for the stock split was August 2, 2002 and the pay date was August15, 2002.  Holders of shares of commonstock of Heritage Oaks Bancorp were issued one additional share of common stockfor each share of common owned on the record date of August 2, 2002. A PressRelease was issued on July 19, 2002.

 

In April 2002, the Company completed its offering of trust preferredsecurities in the amount of $8.0 million. The securities were issued by aspecial purpose business trust formed by the Company and were sold to a pooledinvestment vehicle sponsored by Sandler O’Neill & Partners, L.P. andSalomon Smith Barney Inc. in a private transaction. The securities were soldpursuant to an applicable exemption from registration under the Securities Actof 1933, as amended (the “Act”), and have not been registered under theAct.  Sandler O’Neill assisted theCompany in the placement of the trust preferred securities. The securities maynot be offered or sold in the United States absent registration or anapplicable exemption

 

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from registration requirements.

 

The $8.0 million in trust preferred securities have a floating rate ofinterest, which is reset semi-annually, equal to 6-month LIBOR plus 3.70%.  The floating rate, however, may not exceed11.0% for the first five years.

 

The Company is reflecting the trust preferred securities as financingdebt on its consolidated balance sheet.

 

If the Company elects to defer interest payments pursuant to terms ofthe agreement, then the Company may not (i) declare or pay any dividends ordistributions on, or redeem, purchase, acquire or make a liquidation paymentwith respect to any of the Company’s capital stock, or (ii) make any payment ofprincipal of or premium, if any, or interest on or repay, repurchase or redeemany debt securities of the Company that rank pari passu with or junior ininterest to the Debt Securities, **otherthan,**among other items**,**adividend in the form of stock, warrants, options or other rights in the samestock as that on which the dividend is being paid or ranks pari passu with orjunior to such stock. The prohibition on payment of dividends and payments onpari passu or junior debt also applies in the case of an event of default underthe agreements.

 

The Company used the proceeds from the sale of the securities forgeneral corporate purposes, including the repayment of outstanding indebtednessof $1.8 million on April 11, 2002 and capital contributions to the Bank forfuture growth.

 

The Company issued a press release announcing the sale on April 10,2002.

 

The Company’s total stockholders equity was $21,840,455 at June 30,2003 compared to $19,813,470 at December 31, 2002. The increase in capital wasfrom net income of $1,703,859, $179,173 from stock options exercised, $116,142net change in other comprehensive income related to unrealized security holdinggain, $31,064 net change in other comprehensive income related to realizedsecurity gains, net of tax and $3,253 in cash paid in lieu of fractional sharesas the result of the 5% stock dividend distributed on March 28, 2003.

 

On July 15, 2003, the Company received a commitment letter from PacificCoast Bankers Bank for a revolving line of credit in the amount of $3.5million. The Company will pledge approximately 339,332 shares or 51% of itsstock in Heritage Oaks Bank as collateral. The funds will be used in theacquisition of Hacienda Bank for payment to shareholders who elect cash and/orTier I capital in the form of Surplus to its financial subsidiaries.

 

Capital ratios for commercial banks in the United States are generallycalculated using several different formulas. These calculations are referred to as the “Leverage Ratio” and two “riskbased” calculations known as: “Tier One Risk Based Capital Ratio” and the“Total Risk Based Capital Ratio.”  These standards were developed through joint efforts of bankingauthorities from 12 different countries around the world.  The standards essentially take into accountthe fact that different types of assets have different levels of riskassociated with them.  Further, theytake into account the off-balance sheet exposures of banks when assessingcapital adequacy.

 

The Leverage Ratio calculation simply divides common stockholdersequity (reduced by any Goodwill a bank may have) by the total average assets ofthe bank.  In the Tier One Risk BasedCapital Ratio, the numerator is the same as the leverage ratio, but thedenominator is the total “risk-weighted assets” of the bank.  Risk weighted assets are determined bysegregating all the assets and off balance sheet exposures into different riskcategories and weighing them by a percentage ranging from 0% (lowest risk) to100% (highest risk).  The Total RiskBased Capital Ratio again uses “risk-weighted assets” in the denominator, butexpands the numerator to include other capital items besides equity such as alimited amount of the loan loss reserve, long-term capital debt, preferredstock and other instruments.

 

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Summarizedbelow are the Bank’s and Company’s capital ratios at June 30, 2003:

** **
|                               |   | **Regulatory Standard**     |   |                  |   |                    |   |
|------------------------------------|--------|-----------------------------|--------|-----------------------|--------|-------------------------|--------|
|                               |   | **Adequately  Capitalized** |   | **Well  Capitalized** |   | **Heritage Oaks  Bank** |   | **Heritage Oaks  Bancorp** |   |
| Leverage  Ratio                    |   | 4.00                        | %      | 5.00                  | %      | 8.33                    | %      | 8.05 | % |
|                               |   |                        |   |                  |   |                    |   |   |   |
| Tier  One Risk Based Captial Ratio |   | 4.00                        | %      | 6.00                  | %      | 10.67                   | %      | 10.70 | % |
|                               |   |                        |   |                  |   |                    |   |   |   |
| Total  Risk Based Captial Ratio    |   | 8.00                        | %      | 10.00                 | %      | 11.71                   | %      | 12.41 | % |

 

For the Company, approximately $6.3 million and $1.7 million of the trustpreferred securities are accounted for as Tier I and Tier II Capital,respectively, for purposes of calculating Regulatory Capital.

 

**RESULTS OF OPERATIONSFOR THE THREE and SIX MONTHS ENDED JUNE 30, 2002 AND 2003**

 

Net income for the three months endingJune 30, 2003 was $879,290, compared to $631,420 for the same period in 2002.This represents an increase of $247,870 or 39.3%. Per share earnings on adiluted basis for the three months ending June 30, 2003 and 2002 were $.28 and$.20, respectively. Basic per share earnings for the three months ending June30, 2003 and 2002 were $.30 and $.22, respectively.

 

Net income for the six months endingJune 30, 2003 was $1,703,859, compared to $1,199,641 for the same period in2002. This represents an increase of $504,218 or 42.0%. Per share earnings on adiluted basis for the six months ending June 30, 2003 and 2002 were $.54 and$.38, respectively. Basic per share earnings for the six months ending June 30,2003 and 2002 were $.58 and $.42, respectively.

 

The following discussion highlights thecomponents of the significant increase in earnings.

 

# **NetInterest Income**

Net interest income, the primary component ofthe net earnings of a financial institution, refers to the difference betweenthe interest paid on deposits and borrowings, and the interest earned on loansand investments.  The net interestmargin is the amount of net****interestincome expressed as a percentage of average earning assets.  Factors considered in the analysis of netinterest income are the composition and volume of earning assets andinterest-bearing liabilities, the amount of non-interest bearing liabilitiesand non-accrual loans, and changes in market interest rates.

 

For the six months ended June 30, 2003 theCompany reported a net interest margin of 4.84% compared to 5.53% for the sameperiod in 2002. The average yield on earning assets decreased by 71 basispoints while the average cost of interest bearing liabilities increased by 4basis points. This decrease in net interest margin is the direct result of the50 basis point decrease in prime rate in November 2002. On June 25, 2003, theFederal Reserve Bank took additional action and prime rate decreased by 25basis points. While the impact of the 50 basis point decrease in the fourthquarter of 2002 is evidenced by the lower net interest margin for the first sixmonths of 2003, there could be further, albeit at a lesser amount,  decrease in the net interest margin due tothe recent 25 basis point cut in prime. With the volume of earning assetscontinuing to increase, the Company anticipates that while the net interestmargin may narrow, the amount of net interest income will rise.

 

Net interest income for the three monthsending June 30, 2003 was $3,603,149 compared to $2,989,318 for the same periodin 2002. This represents an increase of $613,831 or 20.5%. Interest income was$4,444,287 and $3,817,562 for the three months ending June 30, 2003 and 2002,respectively. Increased interest income was primarily the result of higheraverage loan and investment securities balances outstanding for the comparativeperiods of time.  Interest expense forthis three month period was $841,138 at June 30, 2003 compared to $828,244 atJune 30, 2002. This represents an increase of $12,894 or 1.6%. Approximately$4,500 of this increase is the result of a $4 million, 30 day advance from

 

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the FHLB on May 9, 2003.

 

Net interest income for the six monthsending June 30, 2003 was $6,947,628 compared to $5,899,240 for the sameperiod in 2002. This represents an increase of $1,048,388 or 17.8%. Interestincome was $8,725,698 and $7,235,685 for the six months ending June 30, 2003and 2002, respectively. Increased interest income was primarily the result ofhigher average loan and investment securities balances outstanding for thecomparative periods of time.  Interestexpense for this six month period was $1,778,070 at June 30, 2003 compared to$1,336,445 at June 30, 2002. Interest expense increased due to the borrowing withthe FHLB and interest on the trust preferred securities that began in April2002.

 

The table below sets forth the averagebalance sheet information, interest income and expense, average yields andrates and net interest income and margin for the six months ended June 30, 2003and 2002.

 

**AVERAGE BALANCE SHEET INFORMATION FOR JUNE 30,**

 

**(dollars in thousands)**

 
|                                             |   | **2002**             |       | **2003**                 |       |
|--------------------------------------------------|--------|----------------------|------------|--------------------------|------------|
|                                             |   | **Average  Balance** |       | **Avg Yield  Rate Paid** |       | **Amount  Interest** |   | **Average  Balance** |   | **Avg Yield  Rate Paid** |   | **Amount  Interest** |   |
| Interest  Earning Assets:                        |   |                 | ** ** |                     | ** ** |   | ** ** |   | ** ** |   | ** ** |   | ** ** |
| Time  deposits with other banks                  |   | $                    | 99         |                     | 4.07       | % | $ | 2 |   | $ | 497 |   | 2.43 | % | $ | 6 |   |
| Investment  securities taxable                   |   | 30,186               |       | 4.84                     | %          | 724 |   | 48,323 |   | 3.58 | % | 858 |   |
| Investment  securities non-taxable               |   | 5,795                |       | 4.84                     | %          | 139 |   | 9,859 |   | 4.56 | % | 223 |   |
| Federal  funds sold                              |   | 12,451               |       | 1.62                     | %          | 100 |   | 17,042 |   | 1.27 | % | 107 |   |
| Loans  (1) (2)                                   |   | 164,748              |       | 7.68                     | %          | 6,271 |   | 211,403 |   | 7.18 | % | 7,532 |   |
|                                             |   |                 |       |                     |       |   |   |   |   |   |   |   |   |
| Total  interest earning assets                   |   | 213,279              |       | 6.84                     | %          | 7,236 |   | 287,124 |   | 6.13 | % | 8,726 |   |
|                                             |   |                 |       |                     |       |   |   |   |   |   |   |   |   |
| Allowance  for possible loan losses              |   | -1,946               |       |                     |       |   |   | -2,481 |   |   |   |   |   |
| Non-earning  assets:                             |   |                 |       |                     |       |   |   |   |   |   |   |   |   |
| Cash  and due from banks                         |   | 17,042               |       |                     |       |   |   | 20,279 |   |   |   |   |   |
| Property,  premises and equipment                |   | 3,585                |       |                     |       |   |   | 4,582 |   |   |   |   |   |
| Other  assets                                    |   | 8,918                |       |                     |       |   |   | 9,562 |   |   |   |   |   |
|                                             |   |                 |       |                     |       |   |   |   |   |   |   |   |   |
| TOTAL  ASSETS                                    |   | $                    | 240,878    |                     |       |   |   |   | $ | 319,066 |   |   |   |   |   |
|                                             |   |                 |       |                     |       |   |   |   |   |   |   |   |   |
| Interest  -bearing liabilities:                  |   |                 |       |                     |       |   |   |   |   |   |   |   |   |
| Savings/NOW/money  market                        |   | 77,738               |       | 0.56                     | %          | 216 |   | 109,828 |   | 0.67 | % | 367 |   |
| Time  deposits                                   |   | 46,980               |       | 2.88                     | %          | 672 |   | 45,950 |   | 2.36 | % | 538 |   |
| Other  borrowings                                |   | 19,427               |       | 4.65                     | %          | 448 |   | 32,191 |   | 5.47 | % | 873 |   |
|                                             |   |                 |       |                     |       |   |   |   |   |   |   |   |   |
| Total  interest-bearing liabilities              |   | 144,145              |       | 1.87                     | %          | 1,336 |   | 187,969 |   | 1.91 | % | 1,778 |   |
|                                             |   |                 |       |                     |       |   |   |   |   |   |   |   |   |
| Non-interest  bearing liabilities:               |   |                 |       |                     |       |   |   |   |   |   |   |   |   |
| Demand  deposits                                 |   | 74,806               |       |                     |       |   |   | 98,570 |   |   |   |   |   |
| Other  liabilities                               |   | 1,480                |       |                     |       |   |   | 3,649 |   |   |   |   |   |
|                                             |   |                 |       |                     |       |   |   |   |   |   |   |   |   |
| Total  liabilities                               |   | 220,431              |       |                     |       |   |   | 290,188 |   |   |   |   |   |
|                                             |   |                 |       |                     |       |   |   |   |   |   |   |   |   |
| Trust  Preferred Securities                      |   | 4,000                |       |                     |       |   |   | 8,000 |   |   |   |   |   |
|                                             |   |                 |       |                     |       |   |   |   |   |   |   |   |   |
| Stockholders’  equity                       |   |                 |       |                     |       |   |   |   |   |   |   |   |   |
| Common  stock                                    |   | 8,708                |       |                     |       |   |   | 10,835 |   |   |   |   |   |
| Retained  earnings                               |   | 7,840                |       |                     |       |   |   | 9,476 |   |   |   |   |   |
| Valuation  Allowance Investments                 |   | (101                 | )          |                     |       |   |   | 567 |   |   |   |   |   |
|                                             |   |                 |       |                     |       |   |   |   |   |   |   |   |   |
| Total  stockholders’ equity                 |   | 16,447               |       |                     |       |   |   | 20,878 |   |   |   |   |   |
|                                             |   |                 |       |                     |       |   |   |   |   |   |   |   |   |
| TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY |   | $                    | 240,878    |                     |       |   |   |   | $ | 319,066 |   |   |   |   |   |
|                                             |   |                 |       |                     |       |   |   |   |   |   |   |   |   |
| Net  Interest Income                             |   |                 |       |                     |       | $ | 5,900 |   |   |   |   |   | $ | 6,948 |   |
| Net  Interest Margin (3)                         |   |                 |       | 5.53                     | %          |   |   |   |   | 4.84 | % |   |   |

 

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**(1)****         ****Nonaccrual loans have beenincluded in total loans.**

**(2)****         ****Loan fees of $327,048 and$406,908 for 2002 and 2003, respectively, have been included in the interestincome computation.**

**(3)****         ****Net interest margin has beencalculated by dividing the annulaized net interest income by total earningassets.**

** **

The hypothetical impacts of sudden interest rate movements applied tothe Bank’s asset and liability

 

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balances are modeled monthly. The results of this movement indicate howmuch of the Bank’s net interest income is “at risk” from various sudden ratechanges. Although interest rates normally would not change in this suddenmanner, this exercise is valuable in identifying risk exposures. The resultsfor the Bank’s June 30, 2003 balances indicate that the Bank’s net interestincome at risk over a one year time horizon from a 1% and 2% rate movement arewithin the Bank’s policy guidelines for such sudden changes.

 
|                          |   | **Rates Down  2%** |   | **Rates Down  1%** |   | **Rates Up  1%** |   | **Rates Up  2%** |   |
|-------------------------------|--------|--------------------|--------|--------------------|--------|------------------|--------|------------------|--------|
|                          |   |               |   |               |   |             |   |             |   |
| Change in Net Interest Income |   | (8.27              | )%     | (4.56              | )%     | 6.13             | %      | 13.16            | %      |

 

It is important to note that the above tableis a summary of several forecasts and actual results may vary. The forecastsare based on estimates and assumptions of management that may turn out to bedifferent and may change over time. Factors effecting these estimates andassumptions include, but are not limited to 1) competitor behavior, 2) economicconditions both locally and nationally, 3) actions taken by the Federal ReserveBoard, 4) customer behavior and 5) management’s responses.  Changes that vary significantly from theassumptions and estimates may have significant effects on the Bank’s netinterest income. Therefore, the results of this analysis should not be reliedupon as indicative of actual future results.

 

Non-interest Income

 

Non-interest income for the three months ending June 30, 2003was $927,178 compared to $797,885 for the same period in 2002. That representsan increase of $129,293 or 16.2%. Non-interest income for the six monthsending June 30, 2003 was $1,828,458 compared to $1,580,001 for the sameperiod in 2002. That represents an increase of $248,457 or 15.7%.

 

Income from service charges on deposit accounts income was $411,638 forthe three months ending June 30, 2003 compared to $326,365 for the sameperiod in 2002. Income from service charges on deposit accounts income was$802,111 for the six months ending June 30, 2003 compared to $642,578for the same period in 2002. The increase for both periods reported is theresult of 1) a revised service charge schedule that became effective in August2002 and 2) overall deposit growth.

 

Bankcard merchant fees were $23,803 for the three months endingJune 30, 2003 compared to $35,822 for the same period in 2002. Bankcardmerchant fees were $42,435 for the six months ending June 30, 2003compared to $62,985 for the same period in 2002. When the Bank sold themerchant portfolio in September 1999, the compensation provisions called forpayment of certain basis points on the gross sales. In September 2002, pursuantto the agreement, the basis points paid to the Bank were reduced. This willcontinue until August 2004 at which time the compensation will be renegotiated.Management does not believe that this change in revenue stream will have amaterial impact on the Company

 

Mortgage origination fees were $239,272 for the three months endingJune 30, 2003 compared to $131,353 for the same period in 2002. Mortgageorigination fees were $429,234 for the six months ending June 30, 2003compared to $273,381 for the same period in 2002. The impact of the very robustre-finance market has had a favorable impact to this revenue stream.

** **

Non-Interest  Expense

 

Non-interest expense was $2,979,768 and $2,677,534for the three months ending June 30, 2003 and 2002, respectively. Thisrepresents an increase of $302,234 or 11.3%. Non-interest expense was$5,848,491 and $5,355,930 for the six months ending June 30, 2003 and2002, respectively. This represents an increase of $492,561 or 9.2%.

 

Salaries and employee benefits expense were$1,518,718 and $1,284,100 for the three months ending June 30, 2003 and2002, respectively. This represents an increase of $234,618 or 18.3%. Salariesand

 

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employee benefits expense were $3,022,018 and$2,541,161 for the six months ending June 30, 2003 and 2002,respectively. This represents an increase of $480,857 or 18.9%.

 

As the result of the Company’s growth,salaries have increased with the addition of, but not limited to, a ComplianceOfficer, Training Officer, two Credit Analysts and additional support staff forloan and deposit related activity. Approximately $264,000 of the six monthending reported figure is in salary costs. The remainder of the variance isattributed to, but not limited to, increases in employee benefits categoriessuch as Group Health Insurance, Bonus and training.

 

Occupancy and equipment costs were $429,187and $410,089 for the three months ending June 30, 2003 and 2002,respectively. This represents an increase of $19,098 or 4.7%. Occupancy andequipment costs were $818,690 and $849,739 for the six months endingJune 30, 2003 and 2002, respectively. This represents a decrease of $31,049 or3.7%. There was a small decrease in nearly every line item (i.e. Rental Costs,Small FF&E Purchases, Miscellaneous Computer Purchases, FFE Depreciation,etc) within this category that accounts for the overall decrease. No one lineitem had a significant variance.

 

Expense associated with all othernon-interest expense categories was $1,031,863 and $983,345 for the threemonths ending June 30, 2203 and 2002, respectively. This represents anincrease of $48,518 or 4.9%. Expense associated with all other non-interest expensecategories was $2,007,783 and $1,965,030 for the six months ending June30, 2203 and 2002, respectively. This represents an increase of $42,753 or2.2%.

 

# **LocalEconomy**

The economy in the Company’s service area is based primarily onagriculture, tourism, light industry, oil and retail trade. Services supportingthese industries have also developed in the areas of medical, financial andeducational. The population in the two county areas comprising the Company’sservice area, according to the U.S. Bureau of the Census, was estimated at July2001 to be approximately 655,600. San Luis Obispo County represents about 38%of this total with Santa Barbara County accounting for the remainingapproximately 62%. The moderate climate allows a year round growing season fornumerous vegetable and fruits. Vineyards and cattle ranches also contributelargely to the local economy. Vineyards in production have grown significantlyover the past several years throughout the Company’s service area. Access tonumerous recreational activities, including lakes, mountains and beaches,provide a relatively stable tourist industry from many areas including the LosAngeles/Orange County basin, the San Francisco Bay area and the San JoaquinValley. Principally due to the diversity of the various industries in theCompany’s service area, the area, while not immune from economic fluctuations,does tend to enjoy a more stable level of economic activity from many otherareas of California.

 

The Central Coast’s leadingindustry is the production of wine grapes and production of premium qualitywines. Over the past two years, production of new vineyard land has led to anover capacity of wine grapes.  Excessproduction of wine grapes has led to a decrease in prices of grapes sold and insome cases, the inability of farmers to sell grapes at any price.  Wineries on the other hand are purchasinggrapes at existing contract prices and in some cases, below contract prices.Wineries are becoming select in the quality of grapes purchases, asking farmersto thin crops to produce a higher quality fruit.

 

TheBank recognized in 2000 that there would be over capacity in the production ofwine grapes in our market area. As a result, efforts were made to move asignificant portion of the vineyard development loan portfolio out of the Bankand into the government sponsored Farmer Mac program. Because of these actionson the part of the Bank, it is the opinion of Management that there would notbe any negative impact from the current state of the wine grape industry.

 

# **Liquidity**

The objective of liquidity management is to ensure the continuousavailability of funds to meet the demands of depositors, investors andborrowers.  Asset liquidity is primarilyderived from loan payments and the maturity of other earning assets.  Liquidity from liabilities is obtainedprimarily from the receipt of new deposits. The Bank’s Asset Liability Committee (ALCO) is responsible for managingthe on-and off-balance sheet commitments to meet the needs of customers whileachieving the Bank’s financial

 

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objectives. ALCO meets regularly to assess the projected fundingrequirements by reviewing historical funding patterns, current and forecastedeconomic conditions, and individual customer funding needs.  Deposits generated from Bank customers serveas the primary source of liquidity.  TheBank has credit arrangements with correspondent banks that serve as a secondaryliquidity source in the amount of $5 million. During the first six months of2003 the average amount of borrowing on these lines was $22,099.

 

As of July 1999, the bank became a member of the Federal Home Loan Bankof San Francisco. Certain securities and loans are pledged as collateral. Theaverage funds borrowed through these facilities during the first six months of2003 was $32.0 million.

 

The Bank manages its liquidity by maintaining a majority of itsinvestment portfolio in federal funds sold and other liquid investments.  At June 30, 2003, the ratio of liquid assetsto deposits and other liabilities was 20.8%. The ratio of net loans todeposits, another key liquidity ratio, was 72.4% at June 30, 2003.

 

# **Inflation**

The assets and liabilities of a financial institution are primarilymonetary in nature.  As such they representobligations to pay or receive fixed and determinable amounts of money that arenot affected by future changes in prices. Generally, the impact of inflation on a financial institution isreflected by fluctuations in interest rates, the ability of customers to repaydebt and upward pressure on operating expenses.  During the two-year period ended December 31, 2002 and throughthe first six months of 2003 the fluctuation in interest rates creatingnarrowing net interest margins has been significant to the Bank’s financialposition and results of operations. However, inflation has not been a factor inthe customer’s ability to repay debt or in upward pressure on operationexpenses.

 

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#### **Item 3**. Controls and Procedures

 

Background ofBank’s and Company’s Internal Controls/Audits

The Bank is the sole financialsubsidiary of the Company. The Bank has in place extensive policies andoperating procedures for loans, operations, accounting and compliance. Loans areaudited twice a year for asset quality by an external firm not affiliated withthe Bank’s CPA. An external compliance audit of loan regulations is scheduledto be performed annually by an external audit company that is not affiliatedwith the Bank’s CPA. All other compliance regulations are audited at leastannually by the internal auditor. Operating policies and procedures are auditedat least annually by the internal auditor. All audits, whether internal orexternal are reported directly to the Audit Committee of the Bank andsubsequently to the Audit Committee and Board of Directors of the Company.

 

The Audit Committees of theBank and Company maintain an audit calendar prepared by the internal auditorfor planning purposes. This audit calendar is submitted to the Board of theBank and the Company for approval. Annually the Company engages an externalCertified Public Accounting firm to perform an independent audit conducted inaccordance with generally accepted auditing standards.

 

Monthly certifications areperformed by various departments and are reviewed and approved by a member ofSenior Management. These certifications document that the assets andliabilities of the Bank, as well as other non-balance sheet areas (i.e.cashiers check supplies, safekeeping, etc) are in balance. Departmentcertifications are due by the 10th business day of the followingmonth. Many balance sheet accounts are balanced daily in the normal routine ofprocessing transactions that are applied to the un-posted general ledger accounts.

 

The Bank has in place arigorous training program that is fully documented and active throughout theyear. Regular training includes compliance with regulations, product knowledgeand operating policies and procedures. Training is also provided for all newproducts or changes in methods of operation.

 

The Officers Loan Committeemeets on a weekly basis as does Senior Management. The meetings provide anenvironment for current and meaningful communication between the variousdepartments of the Bank and is a forum to discuss material actions and/orevents.

 

Daily, the CEO and CFO reviewthe Bank’s consolidated balance sheet and income statement for unusualpostings. The relative non-complex and stable nature of the Bank’s businessallows for these officers to detect anomalies and question them that same day.Because of this daily scrutiny, inadvertent material entries are correctedimmediately and rarely occur on the last day of the month or quarter. Suchanomalies are generally the case of a miss-encoded item that the department isalready aware and not that of intentional misrepresentation. Historically,quarterly changes to the Bank’s balance sheet have been re-slotting ofun-posted account loan and deposit amounts and suspense items to the appropriatecategories within the general ledger. These entries, whether or not material,are researched and submitted to the Controller for adjustment within generalledger accounts for Call Report purposes.

 

Formation ofDisclosure Controls and Procedures Officer Committee

The Disclosure Controls andProcedures Officer Committee (the “Committee”) has the responsibility forconsidering the materiality of information (a material fact) and determiningdisclosure obligations on a timely basis. The Committee has implementeddisclosure controls and procedures that meet the standards established by thenew rules. These controls and procedures will be reviewed and adopted by theaudit committee of the Company and the Bank. The Committee will consist ofmembers of the Officer Planning Meeting that meets weekly.

 

Control andProcedures

The Committee meets on the last Thursday of the quarter. Members are toprovide information that is documented within the Quarterly Control andProcedures Report. This report contains attestations and, where applicable,documentation in regard to the following:

 

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1.                                                   InternalControls have been reviewed within the past 90 days

2.                                                   Concernabout weaknesses in internal control

3.                                                   Eventsthat may require disclosure

4.                                                   InternalFraud/Defalcation

5.                                                   PotentialMaterial Losses

6.                                                   NewOff-Balance Sheet Arrangements

7.                                                   MaterialAmounts not reflected on the general ledger

8.                                                   Materialtrends in operation of any Bank unit

 

The report is completed, signed and presented to the CEO and CFO priorto completing the first draft of the quarterly 10-QSB.  Because material issues may occur betweenregularly scheduled quarterly meetings, this report is to be generated by theappropriate Officers at anytime when warranted. The CEO and CFO will consultwith the Company’s Disclosure Policy Committee to determine any action that isnecessary.

 

Evaluation of disclosure controls andprocedures

(a) Within 90 days prior to the date of this report, the Company carried outan evaluation, under the supervision and with the participation of itsmanagement, including the Company’s Chief Executive Officer and Chief FinancialOfficer, of the effectiveness of the design and operation of the Company’sdisclosure controls and procedures pursuant to Exchange Act Rule 13a-14.Based upon that evaluation, the Chief Executive Officer and Chief FinancialOfficer concluded that the Company’s disclosure controls and procedures areeffective in timely alerting them to material information relating to theCompany (including its consolidated subsidiaries) required to be included inthe Company’s periodic SEC filings.

 

 (b) Subsequent to the date of this evaluation, there have been no changes inthe Company’s internal controls or in other factors that could significantlyaffect these controls, and no discoveries of any significant deficiencies ormaterial weaknesses in such controls that would require the Company to takecorrective actions.

 

#### **PART 2.  OTHER INFORMATION**

 

ITEM 6.     EXHIBITS AND REPORTS ON FORM 8-K
| (a)                                  Exhibits: |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **Exhibit 10.33**                                                                                                                                                                                                   |   | Executive Salary Continuation Agreement dated July 1, 2003 between  Heritage Oaks Bank and Mark Stasinis, filed with the SEC in the Company’s  10-QSB reported for June 30, 2003. |
| **Exhibit 10.34**                                                                                                                                                                                                   |   | Executive Salary Continuation Agreement dated July 1, 2003 between  Heritage Oaks Bank and Kelley Stolz, filed with the SEC in the Company’s  10-QSB reported for June 30, 2003. |
| **Exhibit 10.35**                                                                                                                                                                                                   |   | Executive Salary Continuation Agreement dated July 1, 2003 between  Heritage Oaks Bank and Paul Deline, filed with the SEC in the Company’s  10-QSB reported for June 30, 2003. |
| **Exhibit 10.36**                                                                                                                                                                                                   |   | Executive Salary Continuation Agreement dated July 1, 2003 between  Heritage Oaks Bank and Mitch Massey, filed with the SEC in the Company’s  10-QSB reported for June 30, 2003. |
|                                                                                                                                                                                                                |   |   |
| **Exhibit 31.1**                                                                                                                                                                                                    |   | Certification of Chief Executive Officer pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002 |
|                                                                                                                                                                                                                |   |   |
| **Exhibit 31.2**                                                                                                                                                                                                    |   | Certification of Chief Financial Officer pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002 |
|                                                                                                                                                                                                                |   |   |
| **Exhibit 32.1**                                                                                                                                                                                                    |   | Certification of Chief Executive Officer |
|                                                                                                                                                                                                                |   | pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
|                                                                                                                                                                                                                |   |   |
| **Exhibit 32.2**                                                                                                                                                                                                    |   | Certification of Chief Financial Officer |
|                                                                                                                                                                                                                |   | pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |

 

(b)                                Reports on Form 8-K:

 

The Company filed the announcement of an Agreement to Merge and Plan ofReorganization

 

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Form 8-K, Item 5 with the SEC on June 12, 2003.

 

The Company filed the announcement of second quarter 2003 earnings onregistration Form 8-K, Item 9 with the SEC on July 9, 2003.

 

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SIGNATURES

 

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

 

HERITAGE OAKS BANCORP

 
| DATE: July 25, 2003 |                     |
|---------------------|--------------------------|
|                |                     |
|                | /s/ Lawrence P. Ward     |   |
|                | Lawrence P. Ward         |
|                | President                |
|                | Chief Executive Officer  |
|                |                     |
|                |                     |
|                | /s/ Margaret A. Torres   |   |
|                | Margaret A. Torres       |
|                | Chief Financial Officer  |
|                | Executive Vice President |
|                     |                          |  |  |

 

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# **WHERE YOU CAN FIND MORE INFORMATION**

 

Under the Securities Exchange Act of 1934 Sections 13 and 15(d),periodic and current reports must be filed with the SEC. The Companyelectronically files the following reports with the SEC: Form 10-K (AnnualReport), Form 10-Q (Quarterly Report), Form 8-K (Report of Unscheduled MaterialEvents), and Form DEF 14A (Proxy Statement). The Company may file additional forms.The SEC maintains an Internet site, www.sec.gov, in which all forms filedelectronically may be accessed. Additionally, all forms filed with the SEC andadditional shareholder information is available free of charge on the Company’swebsite: www.heritageoaksbank.com

 

The Company posts these reports to its website as soon as reasonablypracticable after filing them with the SEC. None of the information on or hyperlinked from the Company’s website isincorporated into this Annual Report on Form 10-QSB.

 

###### **ExhibitIndex**

 
| Exhibit 10.33 |   | Executive Salary Continuation Agreement dated July 1, 2003 between  Heritage Oaks Bank and Mark Stasinis, filed with the SEC in the Company’s  10-QSB reported for June 30, 2003. |
|---------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Exhibit 10.34 |   | Executive Salary Continuation Agreement dated July 1, 2003 between  Heritage Oaks Bank and Kelley Stolz, filed with the SEC in the Company’s  10-QSB reported for June 30, 2003.  |
| Exhibit 10.35 |   | Executive Salary Continuation Agreement dated July 1, 2003 between  Heritage Oaks Bank and Paul Deline, filed with the SEC in the Company’s  10-QSB reported for June 30, 2003.   |
| Exhibit 10.36 |   | Executive Salary Continuation Agreement dated July 1, 2003 between  Heritage Oaks Bank and Mitch Massey, filed with the SEC in the Company’s  10-QSB reported for June 30, 2003.  |
|          |   |                                                                                                                                                                                   |
| Exhibit 31.1  |   | Certification of Chief Executive Officer pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002                                                                                    |
| Exhibit 31.2  |   | Certification of Chief Financial Officer pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002                                                                                    |
|          |   |                                                                                                                                                                                   |
| Exhibit 32.1  |   | Certification of Chief Executive Officer, pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002                                                                                   |
| Exhibit 32.2  |   | Certification of Chief Financial Officer, pursuant to Section 906 the  the Sarbanes-Oxley Act of 2002                                                                                  |

 

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