** **

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

** **

**FORM 10-KSB**

 
| **ý** | **ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |
|------------|-------------------------------------------------------------------------------------------|
|       |                                                                                      |
|       | **For the  Year ended December 31, 2002**                                                 |

 

**OR**

 
| **o**  | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934**                                                                                                      |
|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                               |
|   | **For the  transition period  from             to             ** |

 

**Commission file number   0-25020**

 

**HERITAGE OAKS BANCORP**

(Exactname of registrant as specified in its charter)

 
| **State of California**                                                  |   | **77-0388249**                                           |
|--------------------------------------------------------------------------|--------|----------------------------------------------------------|
| (State or other jurisdiction of  employee incorporation or organization) |   | (I.R.S. Identification  No.)                        |
|                                                                     |   |                                                     |
| **545 12th Street, Paso Robles, California 93446**                       |   | **(805) 239-5200**                                       |
| (Address of principal executive offices) (Zip Code)                      |   | Registrant’s telephone  number, including area code |
|                                                                     |   |                                                     |
| Securities registered  pursuant to Section 12(b) of the Act: **None**    |
|                                                                     |   |                                                     |
| Securities registered  pursuant to Section 12(g) of the Act:             |
|                                                                          |        |                                                          |  |  |

 

| **Title of each class**      |   | **Name of each exchange on which registered** |   |
|------------------------------|--------|-----------------------------------------------|--------|
| Common Stock, (no par value) |   | None                                          |   |

 

Indicate by check mark whether theregistrant (1) has filed all reports required to be riled by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter period that the registrant was required to file such reports),and (2) has been subject to such filing requirements for the past 90 days.  Yes ý  No o

 

Indicate by check mark if disclosure ofdelinquent filers pursuant to Item 405 of Regulation S-B is not containedherein, and will not be contained, to the best of the registrant’s knowledge,in definitive proxy or information statements incorporated by reference in PartIII of this Form 10-KSB or any amendment to this Form 10-KSB  ý.

 

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

Yes o  No ý

 

Registrant’s revenue for 2002 was$19,498,529.  The aggregate market valueof the voting stock held by non-affiliates of the Registrant at February 1,2003 was $17,877,467. As of February 1, 2003, the Registrant had 2,785,533shares of Common Stock outstanding.

 

The following documents are incorporated byreference in Part III, Items 9 through 12 of Registrant’s definitive proxystatement for the 2003 annual meeting of shareholders.

 

Transitional Small Business DisclosureFormat (check one)        Yes o    No ý

 

 

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**TABLE OF CONTENTS**

 
| PART I                               |
|--------------------------------------|
|                                 |   |
| Item 1.                              | Description of  Business |
|                                 |   |
| Item 2.                              | Description of  Properties |
|                                 |   |
| Item 3.                              | Legal Proceedings |
|                                 |   |
| Item  4.                             | Submission  of Matters to a Vote of Security Holders |
|                                 |   |
| PART II                              |
|                                 |   |
| Item  5.                             | Market  for Registrant’s Common Equity and Related Stockholders Matters |
|                                 |   |
| Item  6.                             | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |
|                                 |   |
| **Item 7.**                          | **Financial Statements** |
|                                 |   |
| Item  8.                             | Changes  and Disagreements with Accountants on Accounting and Financial Disclosure |
|                                 |   |
| PART III                             |
|                                 |   |
| Item  9.                             | Directors,  Executive Officers, Promoters and Control Persons; |
|                                 |   |
| Item 10.                             | Executive Compensation |
|                                 |   |
| Item  11.                            | Security  Ownership of Certain Beneficial Owners and Management |
|                                 |   |
| Item  12.                            | Certain  Relationships and Related Transactions |
|                                 |   |
| Item 13.                             | Exhibits and  Reports on Form 8-K |
|                                 |   |
| Item 14.                             | Controls and  Procedures |
|                                 |   |
| Signatures                           |
|                                 |   |
| Certifications                       |
|                                 |   |
| Where You Can Find  More Information |

 

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**PART I**

 

## **Certain statements contained in this AnnualReport on Form 10-KSB (“Annual 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 the Securities Act of 1933 and Section 21Eof the Securities and Exchange Act of 1934. Such forward-looking statementsinvolve known and unknown risks, uncertainties and other factors that may causethe actual results, performance or achievements of the Company to be materiallydifferent from any future results, performance or achievements expressed orimplied by such forward-looking statements. Such factors include, among others,the following: general economic and business conditions in those areas in whichthe Company operates, demographic changes, competition, fluctuations ininterest rates, changes in business strategy or development plans, changes ingovernmental regulation, credit quality, the availability of capital to fundthe expansion of the Company’s business,**economic, political and global changesarising from the terrorist attacks of September 11, 2001 and their aftermathand otherfactors referenced in this report, including in “Item 1. Description ofBusiness-Factors that May Affect Future Results of Operations”. The Companydisclaims any obligation to update any such factors or to publicly announce theresults of any revisions to any of the forward-looking statements containedherein to reflect future events or developments.

 

#### **ITEM 1.  DESCRIPTIONOF BUSINESS**

## ** **

## **General**

 

Heritage Oaks Bancorp (the “Company”) is a California corporationorganized in 1994 to act as the bank holding company of Heritage Oaks Bank (the“Bank”). In 1994, the Company acquired all of the outstanding common stock ofthe Bank in a holding company formation transaction. The Bank is the only active financial subsidiary owned by the Company. InApril 2002, the Company formed Heritage Oaks Capital Trust I (the “Trust”). TheTrust is a statutory business trust formed under the laws of the State OfDelaware and is wholly owned by the Company. Other than holding theshares of the Bank, the Company conducts no significant activities, although itis authorized, with the prior approval of the Board of Governors of the FederalReserve System (the “Federal Reserve Board”), the Company’s principalregulator, to engage in a variety of activities which are deemed closely relatedto the business of banking. The Company has also caused to be incorporated asubsidiary, CCMS Systems, Inc. which is currently inactive and has not beencapitalized. The Company has no present plans to activate the proposedsubsidiary.

 

## **Banking Services**

 

TheBank was licensed by the California Department of Financial Institutions(“DFI”) and commenced operation in January 1983.  As a California state bank, the Bank is subject to primarysupervision, examination and regulation by the DFI and the Federal DepositInsurance Corporation (“FDIC”).  TheBank is also subject to certain other federal laws and regulations.  The deposits of the Bank are insured by theFDIC up to the applicable limits thereof. The Bank is not a member of theFederal Reserve System.  At December 31,2002, the Company had approximately $337.3 million in assets, $187.3 million innet loans, $264.2 million in deposits, and $19.8 million in stockholders’equity.

 

TheBank is headquartered in Paso Robles with a branch office in Paso Robles, twobranches in San Luis Obispo, one branch office in Cambria, one branch office inArroyo Grande, one branch office in Santa Maria, one branch office inAtascadero and one branch office in Morro Bay. The Bank conducts a commercialbanking business in San Luis Obispo County and Northern Santa Barbara County,including accepting demand, savings and time deposits, and making commercial,real estate, SBA, agricultural, credit card, and consumer loans. It also offersinstallment note collection, issues cashiers checks and money orders, sellstravelers checks, and provides bank-by-mail, night depository, safe depositboxes, and other customary banking services. The Bank does not offer trustservices or international banking services and does not plan to do so in thenear future.

 

The Bank’s operating policy since itsinception has emphasized small business, commercial and retail banking.  Most of the Bank’s customers are retailcustomers, farmers and small to medium-sized businesses.  The Bank takes real estate, listed andunlisted securities, savings and time deposits, automobiles, machinery andequipment as collateral for loans.  Theareas in which the Bank has directed virtually all of its lending activitiesare (i) commercial and agricultural loans, (ii) installment loans, (iii)construction loans, and (iv) other real estate loans or commercial loanssecured by real estate.  As of December31, 2002, these four categories accounted for approximately 21.2%, 1.2%,

 

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21.4% and 56.1% respectively, of the Bank’sloan portfolio.  As of December 31,2002,  $147.5 million or 77.5% of theBank’s  $190.5 million in gross loansconsisted of interim construction and other real estate secured loans,primarily for single family residences or for commercial development.Commercial and agricultural loans decreased $.2 million (approximately 0.5%)and other real estate loans or commercial loans secured by real estateincreased $16 million between year-end 2001 and year-end 2002. See “Item 6 –Management’s Discussion and Analysis of Financial Condition and Results ofOperations.”

 

Most of the Bank’s deposits are attracted bylocal promotional activities and advertising in the local media.  A material portion of the Bank’s deposits havenot been obtained from a single person or a few persons, the loss of any one ormore of which would have a materially adverse effect on the business of theBank. The Bank has deposit relationships with three, long time customers thatengage in mortgage related business, however, these volatile accountrelationships are included in the volatile liability dependency report that theBank produces on a monthly basis. Management and the Board of Directors of theBank are keenly aware that if and when the mortgage market conditions change,these relationships will be impacted. This is the primary reason for the largebalances maintained in over night investing in Federal Funds Sold.  As of December 31, 2002, the Bank hadapproximately 15,557 deposit accounts consisting of non-interest bearing(demand), interest-bearing demand and money market accounts with balancestotaling $200.3 million for an average balance per account ofapproximately  $12,879; 6,274 savingsaccounts with balances totaling $18.8 million for an average balance peraccount of approximately  $2,992; and1,603 time certificate of deposit accounts with balances totaling $45.1million, for an average balance per account of approximately  $28,106.

 

The principal sources of the Bank’s revenuesare (i) interest and fees on loans, (ii) interest on investments, (iii) servicecharges on deposit accounts and other charges and fees, (iv) mortgageorigination fees and (v) miscellaneous income. For the year ended December 31, 2002, these sources comprised 68.7%,13.5%, 7.3%, 3.9% and 6.6%, respectively, of the Bank’s total operating income.

 

During 2001, the Bank wasdivesting itself of the off-premise ATM Networks commonly referred to as HOAK(retail sites) and NANS (gaming sites). Due to narrowing profit margins, theBank began to scale back on these lines of business in 2000 and discontinuedoperation almost entirely in 2001. The HOAK sites were sold during the firstquarter of 2001, while the gaming sites consisted of two remaining locations asof  December 31, 2001. As of December31, 2002, there is one NANS site remaining. This last site is being sold in thefirst quarter of 2003. Please see “Item 6. Management’s Discussion and Analysisof Financial Condition and Results of Operations.”

 

TheBank has not engaged in any material research activities relating to thedevelopment of new services or the improvement of existing bank services,except as otherwise discussed herein. There has been no significant change in the types of services offered bythe Bank since its inception.  The Bankhas no present plans regarding “a new line of business” requiring theinvestment of a material amount of total assets.  Most of the Bank’s business originates from San Luis Obispo andNorthern Santa Barbara Counties and there is no emphasis on foreign sources andapplication of funds.  The Bank’sbusiness, based upon performance to date, does not appear to be seasonal.Management of the Bank is unaware of any material effect upon the Bank’scapital expenditures, earnings or competitive position as a result of federal,state or local environmental regulations.

 

The Bank holds no patents, licenses (otherthan licenses obtained from bank regulatory authorities), franchises orconcessions.

 

**StrategicDevelopments**

 

On July 16, 2001, the Bankand Westamerica Bank, a California banking corporation, entered into a BranchPurchase and Assumption Agreement (“Agreement” included as an Exhibit inCompany’s September 30, 2001 10-QSB), pursuant to which Heritage Oaks Bankpurchased the four Westamerica Bank Branches in San Luis Obispo County(“Branches”).  The Branches were  located in the cities of Arroyo Grande,Morro Bay, Paso Robles and San Luis Obispo. In addition, Heritage Oaks Bankacquired Westamerica Bank’s interest in the real estate of each of theBranches, whether they were owned or leased.

 

Under the Agreement, Heritage Oaks Bankassumed all deposit liabilities and other liabilities set forth in theAgreement and purchased certain of the assets of the Branches.  It did not purchase any of the loans of theBranches which  were retained byWestamerica Bank.  All employees of theBranches (except one loan officer designated by Westamerica) was offered employmentby Heritage Oaks Bank.On November 9, 2001, the transaction closed.

 

In April 2002, the Company completed itsoffering of trust preferred securities in the amount of $8.0 million. The

 

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securities were issued by a special purposebusiness trust formed by the Company and were sold to a pooled investmentvehicle sponsored by Sandler O’Neill & Partners, L.P. and Salomon SmithBarney Inc. in a private transaction. The securities were sold pursuant to anapplicable exemption from registration under the Securities Act of 1933, asamended (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.

 

The $8.0 million in trust preferredsecurities have a floating rate of interest, which is reset semi-annually,equal to 6-month LIBOR plus 3.70%.  Thefloating rate, however, may not exceed 11.0% for the first five years.

 

The Company is reflecting the trustpreferred securities as financing debt on its consolidated balance sheet.

 

OnJuly 26, 2002, the Bank purchased a parcel of land (approximately 2 acres) onthe corner of Niblick and South River Roads in Paso Robles, Ca. The purchaseprice was $900,000. It is the intent of the Bank to build a full service branchon this parcel and to relocate the existing “Woodland” office, that iscurrently located at 171 Niblick Road, Paso Robles, Ca. At this time, the Bankanticipates that the building will be approximately 5,000 square feet in sizeand will open sometime in the fourth quarter of 2003 or first quarter of 2004.

 

**Employees**

 

As of February 1, 2002, the Bank had a totalof 118 full-time equivalent employees. The management of the Bank believes that its employee relations aresatisfactory. The Company has only two salaried employees (the internal auditorand assistant).  The Company’s officersall hold similar positions at the Bank and receive compensation from the Bank.

 

**LocalEconomic Climate**

 

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 leading industry is the production of wine grapesand production of premium quality wines. Over the past two years, production ofnew vineyard land has led to an over capacity of wine grapes.  Excess production of wine grapes has led toa decrease in prices of grapes sold and in some cases, the inability of farmersto sell grapes at any price.  Winerieson the other hand are purchasing grapes at existing contract prices and in somecases, below contract prices. Wineries are becoming select in the quality ofgrapes purchases, asking farmers to thin crops to produce a higher qualityfruit.

 

The Bank recognized in 2000 that there would be over capacity in theproduction of wine grapes in our market area. As a result, efforts were made tomove a significant portion of the vineyard development loan portfolio out ofthe Bank and into the government sponsored Farmer Mac program. The Bank hasapproximately $1.6 million of remaining vineyard development loans on the booksat December 31, 2002. Because of these actions on the part of the Bank, it isthe opinion of Management that there would not be any negative impact from thecurrent state of the wine grape industry.

 

**Competition**

 

The banking and financialservices business in California generally, and in the Company’s service areaspecifically, is highly competitive. The increasingly competitive environmentis a result primarily of changes in regulation, changes in technology andproduct delivery systems, and the accelerating pace of consolidation amongfinancial services

 

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providers and theappearance of new banking organizations.

 

The Company’s business isconcentrated in its service area, which encompasses San Luis Obispo County andNorthern Santa Barbara County. In order to compete with other financialinstitutions in its service area, the Bank relies principally upon localadvertising programs; direct personal contact by officers, directors,employees, and shareholders; and specialized services such as courier pick-upand delivery of non-cash banking items. The Bank emphasizes to its customersthe advantages of dealing with a locally owned and community orientedinstitution. The Bank also seeks to provide special services and programs forindividuals in its primary service area who are employed in the agricultural,professional and business fields, such as loans for equipment, furniture, toolsof the trade or expansion of practices or businesses. Larger banks may have acompetitive advantage because of higher lending limits and major advertisingand marketing campaigns. They also perform services, such as trust services,international banking, discount brokerage and insurance services that the Bankis not authorized or prepared to offer currently. The Bank has madearrangements with its correspondent banks and with others to provide suchservices for its customers. For borrowers requiring loans in excess of theBank’s legal lending limits, the Bank has offered, and intends to offer in thefuture, such loans on a participating basis with its correspondent banks andwith other independent banks, retaining the portion of such loans which iswithin its lending limits. As of December 31, 2002, the Bank’s legal lendinglimits to a single borrower and such borrower’s related parties wereapproximately $4.1 million on an unsecured basis and approximately $6.9 millionon a fully secured basis, based on regulatory capital plus reserves of $27,578.

 

Commercial banks competewith savings and loan associations, credit unions, other financialinstitutions, securities brokerage firms, and other entities for funds. Forinstance, yields on corporate and government debt securities and other commercialpaper affect the ability of commercial banks to attract and hold deposits.Commercial banks also compete for loans with savings and loan associations,credit unions, consumer finance companies, mortgage companies and other lendinginstitutions.

 

# **The financial servicesindustry is undergoing rapid technological changes involving frequentintroductions of new technology-driven products and services that have furtherincreased competition.  There can alsobe no assurance that these technological improvements, if made, will increasethe Company’s operational efficiency or that the Company will be able toeffectively implement new technology-driven products and services or besuccessful in marketing these products and services to our customers.**

 

**Effect ofGovernment Policies and Recent Legislation**

 

Banking is a business thatdepends on rate differentials. In general, the difference between the interestrate paid by the Bank on its deposits and its other borrowings and the interestrate received by the Bank on loans extended to its customers and securitiesheld in the Bank’s portfolio comprise the major portion of the Bank’s earnings.These rates are highly sensitive to many factors that are beyond the control ofthe Bank. Accordingly, the earnings and growth of the Bank are subject to theinfluence of domestic and foreign economic conditions, including inflation, recessionand unemployment.

 

The commercial bankingbusiness is not only affected by general economic conditions but is alsoinfluenced by the monetary and fiscal policies of the federal government andthe policies of regulatory agencies, particularly the Federal Reserve Board.The Federal Reserve Board implements national monetary policies (withobjectives such as curbing inflation and combating recession) by its open-marketoperations in United States Government securities, by adjusting the requiredlevel of reserves for financial institutions subject to its reserverequirements and by varying the discount rates applicable to borrowings by depositoryinstitutions. The actions of the Federal Reserve Board in these areas influencethe growth of bank loans, investments and deposits and also affect interestrates charged on loans and paid on deposits. The nature and impact on theCompany of any future changes in monetary policies cannot be predicted.

 

From time to time,legislation is enacted which has the effect of increasing the cost of doingbusiness, limiting or expanding permissible activities or affecting thecompetitive balance between banks and other financial institutions. Proposalsto change the laws and regulations governing the operations and taxation ofbanks, bank holding companies and other financial institutions are frequentlymade in Congress, in the California legislature and before various bankregulatory and other professional agencies. See “Description ofBusiness-Financial Services Modernization Legislation and Sarbanes – Oxley Actof 2002”.

 

**General**

 

The Company and the Bankare extensively regulated under both federal and state law. Set forth below isa summary

 

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description of certain lawsthat relate to the regulation of the Company and the Bank. The description doesnot purport to be complete and is qualified in its entirety by reference to theapplicable laws and regulations.

 

**TheCompany**

 

The Company is a bankholding company within the meaning of the Bank Holding Company Act of 1956, asamended (the “Bank Holding Company Act”), and is registered as such with, andsubject to the supervision of, the Federal Reserve Board. The Company isrequired to file with the Federal Reserve Board quarterly and annual reportsand such additional information as the Federal Reserve Board may requirepursuant to the Bank Holding Company Act. The Federal Reserve Board may conductexaminations of bank holding companies and their subsidiaries.

 

The Company is required toobtain the approval of the Federal Reserve Board before it may acquire all orsubstantially all of the assets of any bank, or ownership or control of thevoting shares of any bank if, after giving effect to such acquisition ofshares, the Company would own or control more than 5% of the voting shares ofsuch bank. Prior approval of the Federal Reserve Board is also required for themerger or consolidation of the Company and another bank holding company.

 

The Company is prohibitedby the Bank Holding Company Act, except in certain statutorily prescribedinstances, from acquiring direct or indirect ownership or control of more than5% of the outstanding voting shares of any company that is not a bank or bankholding company and from engaging, directly or indirectly, in activities otherthan those of banking, managing or controlling banks or furnishing services toits subsidiaries. However, the Company may, subject to the prior approval ofthe Federal Reserve Board, engage in any, or acquire shares of companiesengaged in, activities that are deemed by the Federal Reserve Board to be soclosely related to banking or managing or controlling banks as to be a properincident thereto. See discussion under “Financial Modernization Act” below foradditional information.

 

The Federal Reserve Boardmay require that the Company terminate an activity or terminate control of orliquidate or divest subsidiaries or affiliates when the Federal Reserve Boarddetermines that the activity or the control or the subsidiary or affiliatesconstitutes a significant risk to the financial safety, soundness or stabilityof any of its banking subsidiaries. The Federal Reserve Board also has theauthority to regulate provisions of certain bank holding company debt,including authority to impose interest ceilings and reserve requirements onsuch debt. Under certain circumstances, the Company must file written noticeand obtain approval from the Federal Reserve Board prior to purchasing orredeeming its equity securities.

 

Under the Federal ReserveBoard’s regulations, a bank holding company is required to serve as a source offinancial and managerial strength to its subsidiary banks and may not conductits operations in an unsafe and unsound manner. In addition, it is the FederalReserve Board’s policy that in serving as a source of strength to itssubsidiary banks, a bank holding company should stand ready to use availableresources to provide adequate capital funds to its subsidiary banks duringperiods of financial stress or adversity and should maintain the financialflexibility and capital-raising capacity to obtain additional resources forassisting its subsidiary banks. A bank holding company’s failure to meet itsobligations to serve as a source of strength to its subsidiary banks willgenerally be considered by the Federal Reserve Board to be an unsafe andunsound banking practice or a violation of the Federal Reserve Board’sregulations or both.

 

The Company is subject tothe periodic reporting requirements of the Securities Exchange Act of 1934, asamended, and filed reports and proxy statements pursuant to such Act with theSecurities and Exchange Commission (the “SEC”)

 

**The Bank**

 

The Bank is chartered underthe laws of the State of California and its deposits are insured by the FDIC tothe extent provided by law. The Bank is subject to the supervision of, and isregularly examined by, the DFI and the FDIC. Such supervision and regulationinclude comprehensive reviews of all major aspects of the Bank’s business andcondition. Various requirements and restrictions under the laws of the UnitedStates and the State of California affect the operations of the Bank. Federaland California statutes relate to many aspects of the Bank’s operations,including reserves against deposits, interest rates payable on deposits, loans,investments, mergers and acquisitions, borrowings, dividends and locations ofbranch offices. Further, the Bank is required to maintain certain levels of capital.

 

If, as a result of anexamination of a bank, the FDIC or the DFI should determine that the financialcondition, capital resources, asset quality, earnings prospects, management,liquidity, or other aspects of the Bank’s operations are

 

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unsatisfactory or that theBank or its management is violating or has violated any law or regulation,various remedies are available to these regulatory agencies. Such remedies includethe power to enjoin “unsafe or unsound” practices, to require affirmativeaction to correct any conditions resulting from any violation or practice, toissue an administrative order that can be judicially enforced, to direct anincrease in capital, to restrict the growth of the Bank, to assess civilmonetary penalties, to remove officers and directors, and ultimately toterminate the Bank’s deposit insurance, which for a California chartered bankwould result in a revocation of the bank’s charter.

 

**CapitalStandards**

 

The Federal Reserve Boardand the FDIC have adopted risk-based minimum capital guidelines intended toprovide a measure of capital that reflects the degree of risk associated with abanking organization’s operations for both transactions reported on the balancesheet as assets and transactions, such as letters of credit and recoursearrangements, which are recorded as off balance sheet items. Under theseguidelines, nominal dollar amounts of assets and credit equivalent amounts ofoff balance sheet items are multiplied by one of several risk adjustment percentages,which range from 0% for assets with low credit risk, such as certain U.S.Treasury securities, to 100% for assets with relatively high credit risk, suchas business loans.

 

A banking organization’srisk-based capital ratios are obtained by dividing its qualifying capital byits total risk adjusted assets. The regulators measure risk-adjusted assets,which includes off balance sheet items, against both total qualifying capital(the sum of Tier 1 capital and limited amounts of Tier 2 capital) and Tier 1capital. Tier 1 capital consists primarily of common stock, retained earnings,non-cumulative perpetual preferred stock (cumulative perpetual preferred stockfor bank holding companies) and minority interests in certain subsidiaries,less most intangible assets. Tier 2 capital may consist of a limited amount ofthe allowance for possible loan and lease losses, cumulative preferred stock,long term preferred stock, eligible term subordinated debt and certain other instrumentswith some characteristics of equity. The inclusion of elements of Tier 2capital is subject to certain other requirements and limitations of the federalbanking agencies. The federal banking agencies require a minimum ratio ofqualifying total capital to risk-adjusted assets of 8% and a minimum ratio ofTier 1 capital to risk-adjusted assets of 4%.

 

In addition to therisked-based guidelines, federal banking regulators require bankingorganizations to maintain a minimum amount of Tier 1 capital to total assets,referred to as the leverage ratio. For a banking organization rated in the highestof the five categories used by regulators to rate banking organizations, theminimum leverage ratio of Tier 1 capital to total assets is 3%. For all bankingorganizations not rated in the highest category, the minimum leverage ratiomust be at least 4%. In addition to these uniform risk-based capital guidelinesand leverage ratios that apply across the industry, the regulators have thediscretion to set individual minimum capital requirements for specific institutionsat rates significantly above the minimum guidelines and ratios. Future changesin regulations or practices could further reduce the amount of capitalrecognized for purposes of capital adequacy. Such a change could affect theability of the Company to grow and could restrict the amount of profits, ifany, available for the payment of dividends.

 

The following tablepresents the amounts of the capital ratios for the Bank and the requirementsfor a well- capitalized company compared to its minimum regulatory capitalrequirements as of December 31, 2002:

 
|                    |   |                   |   | **Regulatory Requirements** |   |
|-------------------------|--------|------------------------|--------|-----------------------------|--------|
|                    |   | **Bank********Actual** |   | **Well-  Capitalized**      |   | **Minimum  Requirement** |   |
|                    |   |                   |   |                        |   |   |   |
| LEVERAGE RATIO          |   | 7.53                   | %      | 5.00                        | %      | 4.0 | % |
| TIER 1 RISK-BASED RATIO |   | 11.00                  | %      | 6.00                        | %      | 4.0 | % |
| TOTAL RISK-BASED RATIO  |   | 12.06                  | %      | 10.00                       | %      | 8.0 | % |

 

Under applicable regulatoryguidelines, the Bank was considered “Well Capitalized” at December 31, 2002.

 

In addition, the DFI hasauthority  to take possession of thebusiness and properties of a bank in the event that the tangible shareholders’equity of the bank is less than the greater of (i) 4% of the banks total assetsor (ii) $1,000,000

 

**PromptCorrective Action and Other Enforcement Mechanisms**

 

Federal banking agenciespossess broad powers to take corrective and other supervisory action to resolvethe problems of insured depository institutions, including but not limited tothose institutions that fall below one or more prescribed minimum capitalratios described above. An institution that, based upon its capital levels, isclassified as

 

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well capitalized,adequately capitalized, or undercapitalized may be treated as though it were inthe next lower capital category if the appropriate federal banking agency,after notice and opportunity for hearing, determines that an unsafe or unsoundcondition or an unsafe or unsound practice warrants such treatment. At eachsuccessive lower capital category, an insured depository institution is subjectto more restrictions. The federal banking agencies, however, may not treat asignificantly undercapitalized institution as critically undercapitalizedunless its capital ratio actually warrants such treatment.

 

In addition to measures taken under the prompt corrective actionprovisions, commercial banking organizations may be subject to potentialenforcement actions by the federal regulators for unsafe or unsound practicesin conducting their businesses or for violations of any law, rule, regulation,or any condition imposed in writing by the agency or any written agreement withthe agency. Enforcement actions may include the imposition of a conservator orreceiver, the issuance of a cease-and-desist order that can be judicially enforced,the termination of insurance of deposits (in the case of a depository institution),the imposition of civil money penalties, the issuance of directives to increasecapital, the issuance of formal and informal agreements, the issuance ofremoval and prohibition orders against institution-affiliated parties and the enforcementof such actions through injunctions or restraining orders based upon a judicialdetermination that the agency would be harmed if such equitable relief was notgranted.  Additionally, a holdingcompany’s inability to serve as a source of strength to its subsidiary bankingorganizations could serve as an additional basis for a regulatory actionagainst the holding company.

 

**Safety andSoundness Standards**

 

The Federal Deposit Insurance Corporation Improvement Act (“FDICIA”)imposes certain specific restrictions on transactions and requires federalbanking regulators to adopt overall safety and soundness standards fordepository institutions related to internal control, loan underwriting and documentationand asset growth.  Among other things,FDICIA limits the interest rates paid on deposits by undercapitalizedinstitutions, restricts the use of brokered deposits, limits the aggregateextensions of credit by a depository institution to an executive officer,director, principal shareholder or related interest, and reduces deposit insurancecoverage for deposits offered by undercapitalized institutions for deposits bycertain employee benefits accounts. The federal banking agencies may require aninstitution to submit to an acceptable compliance plan as well as have theflexibility to pursue other more appropriate or effective courses of actiongiven the specific circumstances and severity of an institution’s noncompliancewith one or more standards.

 

**Premiumsfor Deposit Insurance**

 

Through the Bank InsuranceFund (“BIF”), the FDIC insures the deposits of the Bank up to prescribed limitsfor each depositor. The amount of FDIC assessments paid by each BIF memberinstitution is based on its relative risk of default as measured by regulatorycapital ratios and other factors. Specifically, the assessment rate is based onthe institution’s capitalization risk category and supervisory subgroupcategory. An institution’s capitalization risk category is based on the FDIC’sdetermination of whether the institution is well capitalized, adequatelycapitalized or less than adequately capitalized. An institution’s supervisorysubgroup category is based on the FDIC’s assessment of the financial conditionof the institution and the probability that FDIC intervention or othercorrective action will be required.

 

The assessment rate currently ranges fromzero to 27 cents per $100 of domestic deposits. The FDIC may increase ordecrease the assessment rate schedule on a semi-annual basis. Due to continuedgrowth in deposits and some recent bank failures, the bank insurance fund isnearing its minimum ratio of 1.25% on insured deposits as mandated by law. Ifthe ratio drops below 1.25%, it is likely that the FDIC will be required toassess premiums on all banks for the first time since 1996. An increase in theassessment rate could have a material adverse effect on the Company’s earnings,depending on the amount of the increase. The FDIC is authorized to terminate adepository institution’s deposit insurance upon a finding by the FDIC that theinstitution’s financial condition is unsafe or unsound or that the institutionhas engaged in unsafe or unsound practices or has violated any applicable rule,regulation, order or condition enacted or imposed by the institution’sregulatory agency. The termination of deposit insurance for the Bank wouldresult in the revocation of the Bank’s charter and the cessation of itsoperations as a going concern.

 

All FDIC-insured depositoryinstitutions must pay an annual assessment to provide funds for the payment ofinterest on bonds issued by the Financing Corporation, a federal corporationchartered under the authority of the Federal Housing Finance Board. The bonds,commonly referred to as FICO bonds, were issued to capitalize the FederalSavings and Loan Insurance Corporation. The FICO assessments are adjustedquarterly to reflect changes in the assessment

 

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bases of the FDIC’s insurancefunds and do not vary depending on a depository institution’s capitalization orsupervisory evaluations.

 

**Sarbanes-Oxley Act of 2002**

 

On July 30, 2002,President Bush signed into law the Sarbanes-Oxley Act of 2002 (the “SOA”). Thestated goals of the SOA are to increase corporate responsibility, to providefor enhanced penalties for accounting and auditing improprieties at publiclytraded companies and to protect investors by improving the accuracy andreliability of corporate disclosures pursuant to the securities laws.

 

The SOA is the mostfar-reaching U.S. securities legislation enacted in some time. The SOAgenerally applies to all companies, both U.S. and non-U.S., that file or arerequired to file periodic reports with the SEC under the Securities ExchangeAct of 1934, (the “Exchange Act”). Given the extensive SEC role in implementingrules relating to many of the SOA’s new requirements, the final scope of theserequirements remains to be determined.

 

The SOA includes veryspecific additional disclosure requirements and new corporate governance rules,requires the SEC and securities exchanges to adopt extensive additionaldisclosure, corporate governance and other related rules and mandates furtherstudies of certain issues by the SEC. The SOA represents significant federalinvolvement in matters traditionally left to state regulatory systems, such asthe regulation of the accounting profession, and to state corporate law, suchas the relationship between a board of directors and management and between aboard of directors and its committees.

 

The SOA addresses,among other matters:

 

•           the creation of an independent accountingoversight board to oversee the audit of public companies and auditors whoperform such audits;

 

•                                          audit committees for all reporting companiesand expansion of the power of the audit committee, including the requirementsthat the audit committee: (i) have direct control of the outside auditor; (ii)be able to hire and fire the auditor; and (iii) approve all non-audit services;

 

•                                          auditor independence provisions whichrestrict non-audit services that independent accountants may provide to theiraudit clients;

 

•                                          certification of financial statements by thechief executive officer and the chief financial officer;

 

•                                          the forfeiture of bonuses or otherincentive-based compensation and profits from the sale of an issuer’ssecurities by directors and senior officers in the twelve month periodfollowing initial publication of any financial statements that later require restatement;

 

•                                          a prohibition on insider trading duringpension plan black out periods;

 

•                                          increased protection for whistleblowers andinformants;

 

•                                          disclosure of off-balance sheettransactions;

 

•                                          expedited filing requirements for ownershipreports by officers and directors;

 

•                                          disclosure of a code of ethics and filing aForm 8-K for a change or waiver of such code;

 

•                                          “real time” filing of periodic reports; and

 

•                                          various increased criminal penalties forviolations of securities laws.

 

The SOA contains provisions which becameeffective upon enactment on July 30, 2002, and provisions which will becomeeffective within 30 days to one year from enactment.  The SEC has been delegated the task of enacting rules to implementvarious provisions with respect to, among other matters, disclosure in periodicfilings pursuant to the Exchange Act. The Company has implemented procedures tocomply with the requirements for expanded disclosure of internal controls andthe certification of financial statements. A significant portion of the remaining items in the new legislation willbecome effective during 2003.  TheCompany is currently evaluating what impacts

 

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the new legislation and its implementingregulations will have upon its operations, including a likely increase incertain outside professional costs.

 

**FinancialServices Modernization Legislation**

 

On November 12, 1999,  the Gramm- Leach-Bliley Act of 1999 (the“Financial Services Modernization Act”) was signed into law. The FinancialServices Modernization Act is intended to modernize the banking industry byremoving barriers to affiliation among banks, insurance companies, thesecurities industry and other financial service providers. It providesfinancial organizations with the flexibility of structuring such affiliationsthrough a holding company structure or through a financial subsidiary of abank, subject to certain limitations. The Financial Services Modernization Actestablishes a new type of bank holding company, known as a financial holdingcompany, that may engage in an expanded list of activities that are “financialin nature,” which include securities and insurance brokerage, securitiesunderwriting, insurance underwriting and merchant banking. The Company has notsought “financial holding company” status and has no present plans to do so.

 

The Financial ServicesModernization Act also sets forth a system of functional regulation that makesthe Federal Reserve Board the “umbrella supervisor” for holding companies,while providing for the supervision of the holding company’s subsidiaries byother federal and state agencies. A bank holding company may not become afinancial holding company if any of its subsidiary financial institutions arenot well-capitalized or well-managed. Further, each bank subsidiary of theholding company must have received at least a satisfactory CommunityReinvestment Financial Services Modernization Act (CRA) rating. The FinancialServices Modernization Act also expands the types of financial activities anational bank may conduct through a financial subsidiary, addresses stateregulation of insurance, generally prohibits unitary thrift holding companiesorganized after May 4, 1999 from participating in new financial activities, providesprivacy protection for nonpublic customer information of financialinstitutions, modernizes the Federal Home Loan Bank system and makesmiscellaneous regulatory improvements. The Federal Reserve Board and theSecretary of the Treasury must coordinate their supervision regarding approvalof new financial activities to be conducted through a financial holding companyor through a financial subsidiary of a bank. While the provisions of the Financial Services Modernization Actregarding activities that may be conducted through a financial subsidiarydirectly apply only to national banks, those provisions indirectly apply tostate-chartered banks.

 

In addition, the Bank issubject to other provisions of the Financial Services Modernization Act,including those relating to CRA, privacy and safe-guarding confidentialcustomer information, regardless of whether the Company elects to become afinancial holding company or to conduct activities through a financialsubsidiary of the Bank. The Company does not, however, currently intend to filenotice with the Federal Reserve Board to become a financial holding company orto engage in expanded financial activities through a financial subsidiary ofthe Bank.

 

The Company and the Bank donot believe that the Financial Services Modernization Act will have a materialadverse effect on their operations in the near-term. However, to the extentthat it permits banks, securities firms, and insurance

companiesto affiliate, the financial services industry may experience furtherconsolidation. The Financial Services Modernization Act is intended to grant tocommunity banks certain powers as a matter of right that larger institutionshave accumulated on an ad hoc basis. Nevertheless, this act may have the resultof increasing the amount of competition that the Company and the Bank face fromlarger institutions and other types of companies offering financial products,many of which may have substantially more financial resources than the Companythe Bank.

 

**USA Patriot Act of 2001**

 

In October 2001, theUSA Patriot Act of 2001 was enacted in response to the terrorist attacks in NewYork, Pennsylvania and Washington D.C. which occurred on September 11,2001. The Patriot Act is intended to strengthen U.S. law enforcement’s and theintelligence communities’ abilities to work cohesively to combat terrorism on avariety of fronts. The potential impact of the Patriot Act on financialinstitutions of all kinds is significant and wide ranging. The Patriot Actcontains sweeping anti-money laundering and financial transparency laws andimposes various regulations, including standards for verifying clientidentification at account opening, and rules to promote cooperation amongfinancial institutions, regulators and law enforcement entities in identifyingparties that may be involved in terrorism or money laundering.

 

**Transactions between Affiliates**

 

Transactions betweena bank and its “affiliates” are quantitatively and qualitatively restrictedunder the Federal Reserve Act.  TheFederal Deposit Insurance Act applies Sections 23A and 23B to insured nonmemberbanks in the

 

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same manner and tothe same extent as if they were members of the Federal Reserve System.  The Federal Reserve Board has also recentlyissued Regulation W, which codifies prior regulations under Sections 23A and23B of the Federal Reserve Act and interpretative guidance with respect toaffiliate transactions.

 

Regulation Wincorporates the exemption from the affiliate transaction rules but expands theexemption to cover the purchase of any type of loan or extension of credit froman affiliate. Affiliates of a bank include, among other entities, the bank’sholding company and companies that are under common control with the bank.  The Company is considered to be an affiliateof the Bank.  In general, subject tocertain specified exemptions, a bank or its subsidiaries are limited in theirability to engage in “covered transactions” with affiliates:

 

•                                          to an amount equal to 10% of the bank’scapital and surplus, in the case of covered transactions with any oneaffiliate; and

 

•                                          to an amount equal to 20% of the bank’scapital and surplus, in the case of covered transactions with all affiliates.

 

In addition, a bankand its subsidiaries may engage in covered transactions and other specifiedtransactions only on terms and under circumstances that are substantially thesame, or at least as favorable to the bank or its subsidiary, as thoseprevailing at the time for comparable transactions with nonaffiliatedcompanies. A “covered transaction” includes:

 

•                                          a loan or extension of credit to anaffiliate;

 

•                                          a purchase of, or an investment in,securities issued by an affiliate;

 

•                                          a purchase of assets from an affiliate, withsome exceptions;

 

•                                          the acceptance of securities issued by anaffiliate as collateral for a loan or extension of credit to any party; and

 

•                                          the issuance of a guarantee, acceptance orletter of credit on behalf of an affiliate.

 

In addition, underRegulation W:

 

•                                          a bank and its subsidiaries may not purchasea low-quality asset from an affiliate;

 

•                                          coveredtransactions and other specified transactions between a bank or itssubsidiaries and an affiliate must be on terms and conditions that areconsistent with safe and sound banking practices; and

 

•                                          with some exceptions, each loan or extensionof credit by a bank to an affiliate must be secured by collateral with a marketvalue ranging from 100% to 130%, depending on the type of collateral, of theamount of the loan or extension of credit.

 

Regulation Wgenerally excludes all non-bank and non-savings association subsidiaries ofbanks from treatment as affiliates, except to the extent that the FederalReserve Board decides to treat these subsidiaries as affiliates.

 

**CommunityReinvestment Act**

 

The Bank is subject tocertain fair lending requirements and reporting obligations involving homemortgage lending operations and Community Reinvestment Act (“CRA”) activities.The CRA generally requires the federal banking agencies to evaluate the recordof a financial institution in meeting the credit needs of their localcommunities, including low and moderate income neighborhoods. In addition to substantialpenalties and corrective measures that may be required for a violation ofcertain fair lending laws, the federal banking agencies may take compliancewith such laws and CRA into account when regulating and supervising otheractivities.  When a bank holding companyapplies for approval to acquire a bank or other bank holding company, theFederal Reserve Board will review the assessment of each subsidiary bank of theapplicant bank holding company, and such records may be the basis for denyingthe application. A bank’s compliance with its CRA obligations is based on aperformance-based evaluation system which bases CRA ratings on an institution’slending service and investment performance, resulting in a rating by theappropriate bank regulatory agency of “outstanding”, “satisfactory”, “needs toimprove” or “substantial noncompliance.” At its last examination by the FDIC,the Bank received a CRA rating of “Satisfactory.”

 

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**FactorsThat May Affect Future Results of Operations**

 

**Inaddition to other information contained in this Annual Report, the followingrisks may affect the Company and/or the Bank. If any of these risks occur, theCompany’s or Bank’s business, financial condition or operation results could beadversely affected.**

 

***Dependence on Real Estate***

 

A significant portion ofthe loan portfolio of the Bank is dependent on real estate. At December 31,2002, real estate served as the principal source of collateral with respect toapproximately 77.5% percent of the Bank’s loan portfolio. A decline in currenteconomic conditions or rising interest rates could have an adverse effect onthe demand for new loans, the ability of borrowers to repay outstanding loans,the value of real estate and other collateral securing loans and the value ofreal estate owned by the Bank, as well as the Company’s financial condition andresults of operations in general and the market value of the Company’s commonstock. Acts of nature, including earthquakes, floods and draughts, which may cause uninsured damage and other loss ofvalue to real estate and crops that secures these loans, may also negativelyimpact the Company’s financial condition.

 

***Interest Rate Changes***

 

The earnings of the Companyand the Bank are substantially affected by changes in prevailing interestrates. Changes in interest rates affect the demand for new loans, the creditprofile of existing loans, the rates received on loans and securities and therates the Bank must pay on deposits and borrowings. The difference between therates the Bank receives on loans and securities and the rates it must pay ondeposits and borrowings is known as the interest rate spread. Given the Bank’scurrent volume and mix of interest-bearing liabilities and interest-earningassets, the Bank’s interest rate spread can be expected to increase when marketinterest rates are rising, and to decline when market interest rates aredeclining. Our analysis indicates that the decreases in the target federalfunds rate announced by the Federal Reserve Board throughout 2002 resulted in adecrease of 139 basis points in the Bank’s average interest rate spread fromthat of 2001. If interest rates continue to decline, competitive pressure andother factors may prevent us from making proportionate decreases in theinterest rates we pay on deposits, especially MMDA and NOW accounts, resultingin a larger decrease in our interest rate spread. Although the Bank believesits current level of interest rate sensitivity is reasonable, significantfluctuations in interest rates may have an adverse impact on our business,financial condition and results of operations.

 

***Competition***

 

Competition may adverselyaffect our performance. The financial services business in our market area ishighly competitive, and becoming more so due to changes in regulation,technological advances and the accelerating pace of consolidation amongfinancial service providers. We face competition both in attracting depositsand in making loans. We compete for loans principally through the interestrates and loan fees we charge and the efficiency and quality of the services weprovide. Increasing levels of competition in the banking and financial servicesbusinesses may reduce our market share or cause the prices we charge for ourservices to fall. Our results may differ in future periods depending on the natureor level of competition.

 

***Regulation***

 

We are subject togovernment regulation that could limit or restrict our activities, adverselyaffecting our operations. The financial services industry is heavily regulated.Federal and state regulation is designed to protect the deposits of consumers,not to benefit our shareholders. The regulations impose significant limitationson our operations, and may be changed at any time to impose significant newlimitations, possibly causing our results to vary significantly from pastresults. Government policy and regulation, particularly as implemented throughthe Federal Reserve System, significantly affects credit conditions for us.

 

In response to several well-publicizedcorporate and auditing scandals, the President signed the Sarbanes-Oxley Actinto law on July 29, 2002.  This actcalls for increased federal regulation of the accounting profession and imposesnew requirements upon boards of directors, audit committees and executive officersof public companies.  These requirementswill likely increase the accounting and legal costs of the Company. A number ofthe requirements of the Act are still subject to the finalization ofadministrative rule making by the SEC. The Company will be subject to many of these provisions of the Act andimplementing regulations

 

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***OperatingStrategies***

 

From time to time, the Company developslong-term financial performance goals to guide and measure the success of ouroperating strategies.  The Company canmake no assurance that we will be successful in achieving these long-term goalsor that our operating strategies will be successful.  Achieving success in these areas is dependent on a number offactors, many of which are beyond the Company’s direct control.  Factors that may adversely affect theCompany’s ability to attain its long-term financial performance goals include:

 

•                  Deterioration of  asset quality;

 

•                  Inability to control noninterest expense,including, but not limited to, rising employee and healthcare costs;

 

•                  Inability to increase noninterest income

 

•                  Inability to decrease reliance on revenuegenerated from assets;

 

•                  Ability to increase loan growth;

 

•                  Regulatory and other impediments associatedwith making acquisitions;

 

•                  Deterioration in general economicconditions, especially in the Company’s core markets;

 

•                  Decreases in the Company’s net interestmargin;

 

•                  Increases in competition; and

 

•                  Adverse regulatory or legislativedevelopments.

 

***Borrowers’ Failure to Perform***

 

A significant number of ourborrowers and guarantors may fail to perform their obligations as required bythe terms of their loans, resulting in losses for us. This risk increases whenthe economy is weak, as it has been recently. We have adopted underwriting andcredit policies, and loan monitoring procedures, including the establishmentand monitoring of allowances for credit losses. Management believes theseprovisions are reasonable and adequate, and will should keep credit losseswithin expected limits by assessing the likelihood of nonperformance, trackingloan performance and diversifying our credit portfolio. However, these policiesand procedures may not be adequate to prevent unexpected losses that couldmaterially and adversely affect our results of operations.

 

***Operations Risks***

 

TheBank is subject to certain operations risks, including, but not limited to,data processing system failures and errors, customer or employee fraud andcatastrophic failures resulting from terrorist acts or natural disasters. TheBank maintains a system of internal controls to mitigate against such occurrencesand maintains insurance coverage for such risks, but should such an event occurthat is not prevented or detected by the Bank’s internal controls, uninsured orin excess of applicable insurance limits, it could have a significant adverseimpact on the Company’s business, financial condition or results of operations.

 

# ***Geographic Concentration***

 

Ouroperations are located almost entirely in the Central Coast region of California.As a result of this geographic concentration, our results depend largely uponeconomic and business conditions in this region. A deterioration in economicand business conditions in our market area could have a material adverse impacton the quality of our loan portfolio and the demand for our products andservices, which in turn may have a material adverse effect on our results ofoperations.

 

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# ***War on Terrorism***

 

Theterrorist attacks of September 11, 2001, the ensuing worldwide war on terrorismand the possibility of war with Iraq and/or Korea may lead to unexpected shiftsin cash flows, deposit levels, and general economic activity. US bankingagencies have warned of the possible impact of such events on the capitalratios of banks.

 

***Company Cash Flow***

 

As a holdingcompany, a substantial portion of the Company’s cash flow typically comes fromdividends from the Bank.  Variousstatutory provisions restrict the amount of dividends the Bank can pay to theCompany without regulatory approval.

 

**ITEM 2.  DESCRIPTIONOF PROPERTIES**

 

The Bank and the Company occupy a permanentheadquarters facility that is located at 545 Twelfth Street, Paso Robles,Ca.  The purchase price for theheadquarter office, was approximately $1,000,000 for the building andland.  This building has approximately9,000 square feet of space and off-street parking.  The Bank has remodeled this building at an approximate cost of$300,000.

 

The Bank has a non-banking office, locatedat 600 Twelfth Street, Paso Robles (directly across from its presentheadquarters) that was purchased by the Bank on December 23, 1986, forapproximately $400,000 from an unaffiliated party.

 

In June of 1994, the Bank opened a branch at171 Niblick Rd., Paso Robles, Ca.  TheBank leases this 1,400 square foot branch for approximately $2,000 per month.On February 24, 2000, the Bank renewed the lease for an additional five-yearterm.

 

On June 26, 1997 the Bank executed a leasefor its branch office at 297 Madonna Road, San Luis Obispo.  The branch was previously located inpremises that were acquired from La Cumbre Savings, which lease expired in1997.  The new branch lease is for 6,200square feet of which the Bank subleases approximately 58% to another firm anduses 42%. The other firm pays 58% of the rent and expenses and the Bank pays42%.  The rent under the lease for theentire space is approximately $7,750 a month. In June, 2002, the rent re-pricedto 95% of the prevailing fair market value and increases each year thereafterat the greater of the consumer price index or 2.5% until the lease expires onJune 30, 2009.

 

The Bank opened a branch office at 1135Santa Rosa Street in downtown San Luis Obispo, Ca in April 1996.  The Bank is leasing a building containingapproximately 5,618 square feet for approximately $7,800 per month. Theoriginal lease expired on February 28, 2001 and the Bank executed its option toextend for a period of five years. As of January 2003, the Bank has obtainedtwo additional five year options to extend.

 

On February 21, 1997, the Bank acquired theCambria branch of Wells Fargo Bank located at 1276 Tamson Drive, Cambria. TheBank leases this 2,916 square foot branch for approximately $3,200 per month,subject to adjustments for cost of living increases and certainpass-throughs.  The lease will expire in2004 at which time the Bank has an option to renew the lease for two additionalfive-year terms.

 

On August 26, 1998, the Company purchasedproperty located at 9900 El Camino Real, Atascadero.  The purchase price was $271,160. The Company constructed a building with a total of 3,500 square feet offloor space.  The total cost ofimprovements was $440,765 plus furniture and fixtures.  On April 1, 1999, the Company entered into afive-year lease agreement, with three five-year options to renew, with the Bankat the rate of $4,725 per month or $1.35 per square foot. Comparatives wereobtained to ensure that the lease amount was at fair market value.

 

On November 1, 1998, the bank entered into a10-year lease with an unaffiliated party to lease property known as 1660 SouthBroadway, Santa Maria, Ca.  The leasecalls for monthly payments based on a triple net price of $1.15 per square footor approximately $5,395 per month.  Therent will adjust each November by the Consumer Price Index or a maximum of 6%.The lease will expire on October 31, 2008, with the banking having threefive-year options to renew.

 

On July 1, 2001 the bankentered into a 9-month lease with an unaffiliated party to lease propertylocated at 1360 Grand Avenue, Arroyo Grande, Ca. The lease calls for monthlypayments based on a triple net price of approximately $4,200 per month. TheBank did not renew or renegotiate this lease at its expiration. The short-termnature of this lease was due to the Bank’s knowledge that it was acquiring abranch office from Westamerica Bank (seller) that was

 

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in close proximity to theleased facility. On November 9, 2001, the seller conveyed title to the land andbuilding located at 1255 Grand Avenue, Arroyo Grande, Ca. The Bank consolidatedthe existing Bank branch into the newly acquired facility. The appraised fairvalue of the acquired location was $800,000.

 

On November 9, 2001, theBank also acquired from Westamerica Bank (seller), a branch office located at310 Morro Bay Blvd., Morro Bay, Ca. The seller conveyed title to the buildingat the closing. The appraised fair value of the acquired building was $200,000.The building is on leased land. The seller assigned and the Bank assumed thelease that expires on April 1, 2012. The monthly lease payment is $2,200.

 

OnJuly 26, 2002, the Bank purchased a parcel of land (approximately 2 acres) onthe corner of Niblick and South River Roads in Paso Robles, Ca. The purchaseprice was $900,000. It is the intent of the Bank to build a full service branchon this parcel and to relocate the existing “Woodland” office, that iscurrently located at 171 Niblick Road, Paso Robles, Ca. At this time, the Bank anticipatesthat the building will be approximately 5,000 square feet in size and will opensometime in the fourth quarter of 2003 or first quarter of 2004.

 

The Company believes itspresent facilities are adequate for its present needs.

 

**ITEM 3.  LEGAL PROCEEDINGS**

 

The Bank is, from time to time, subject tovarious pending and threatened legal actions which arise out of the normalcourse of its business.  Neither theCompany nor the Bank is a party to any pending material legal or administrativeproceedings (other than ordinary routine litigation incidental to the Company’sor the Bank’s business).

 

**ITEM 4.  SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS**

 

No matters were submitted to a vote of securityholders during the fourth quarter of 2002.

 

**PART II**

 

**ITEM 5.  MARKETFOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS**

 

Market Information

 

There is a limited over-the-counter marketfor the Company’s Common Stock.  TheCompany’s Common Stock is not listed on any exchange or market.  However, Maguire Investments, Inc., Hoefer& Arnett, Inc., The Seidler Companies, Sandler O’Neill & Partners andWedbush Morgan Securities make a market in the Company’s Common Stock.  Certain information concerning the CommonStock is reported on the NASDAQ electronic bulletin board under the symbol“HEOP.”

 

The information in the following tableindicates the high and low bid prices of the Company’s Common Stock for eachquarterly period during the last two years based upon information provided byMaguire Investments, Inc., Hoefer & Arnett, Inc., The Seidler Companies andWedbush Morgan Securities.  These pricesdo not include retail mark-ups, mark-downs or commission.

 
| **Quarter Ended** |   | **Bid Prices** |   |
|-------------------|--------|----------------|--------|
| **2002**          |   | **Low**        |   | **High** |   |
| March 31          |   | $              | 12.85  |   | $ | 12.85 |   |
| June 30           |   | 12.88          |   | 13.00 |   |
| September 30      |   | 12.80          |   | 13.20 |   |
| December 31       |   | 11.50          |   | 11.65 |   |
|              |   |           |   |   |   |
| **2001**          |   | **Low**        |   | **High** |   |
| March 31          |   | $              | 8.75   |   | $ | 8.50 |   |
| June 30           |   | 11.00          |   | 11.44 |   |
| September 30      |   | 11.50          |   | 12.25 |   |
| December 31       |   | 12.00          |   | 13.00 |   |

 

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| **2000**     |   | **Low** |   | **High** |   |
|--------------|--------|---------|--------|----------|--------|
| March 31     |   | $       | 7.32   |     | $      | 7.50 |   |
| June 30      |   | 6.68    |   | 7.00     |   |
| September 30 |   | 8.63    |   | 8.88     |   |
| December 31  |   | 8.63    |   | 8.88     |   |
|              |        |         |        |          |        |  |  |

 

***Prices listedabove have been adjusted to reflect the 2 for 1 stock split that was paid onAugust 15, 2002.***

 

Holders

 

As of February 1, 2003, there wereapproximately 674 holders of the Company’s Common Stock.  There are no other classes of equityoutstanding.

 

Dividends

 

The Company is a legal entity separate anddistinct from the Bank.  The Company’sshareholders are entitled to receive dividends when and as declared by itsBoard of Directors, out of funds legally available therefore, subject to therestrictions set forth in the California General Corporation Law (the“Corporation Law”).  The Corporation Lawprovides that a corporation may make a distribution to its shareholders if thecorporation’s retained earnings equal at least the amount  of the proposed distribution.  The Corporation Law also provides that, inthe event that sufficient retained earnings are not available for the proposeddistribution, a corporation may nevertheless make a distribution to itsshareholders if it meets two conditions, which generally stated are as follows:(i) the corporation’s assets equal at least 1-1/4 times its liabilities, and(ii) the corporation’s current assets equal at least its current liabilitiesor, if the average of the corporation’s earnings before taxes on income andbefore interest expenses for the two preceding fiscal years was less than theaverage of the corporation’s interest expenses for such fiscal years, then thecorporation’s current assets  must equalat least 1-1/4 times its current liabilities.

 

The ability of the Company to pay a cashdividend depends largely on the Bank’s ability to pay a cash dividend to theCompany.  The payment of cash dividendsby the Bank is subject to restrictions set forth in the California FinancialCode (the “Financial Code”).  TheFinancial Code provides that a bank may not make a cash distribution to itsshareholders in excess of the lesser of (a) the bank’s retained earnings; or(b) the bank’s net income for its last three fiscal years, less the amount ofany distributions made by the bank or by any majority-owned subsidiary of thebank to the shareholders of the bank during such period.  However, a bank may, with the approval ofthe DFI, make a distribution to its shareholders in an amount not exceeding thegreatest of (x) its retained earnings; (y) its net income for its last fiscalyear; or (z) its net income for its current fiscal year.  In the event that the DFI determines thatthe shareholders’ equity of a bank is inadequate or that the making of adistribution by the bank would be unsafe or unsound, the DFI may order the bankto refrain from making a proposed distribution.  The FDIC may also restrict the payment of dividends if suchpayment would be deemed unsafe or unsound or if after the payment of suchdividends, the Bank would be included in one of the “undercapitalized”categories for capital adequacy purposes pursuant to federal law. (See,  “Item 1 - Description of Business - PromptCorrective Action and Other Enforcement Mechanisms.”)  Additionally, while the Federal Reserve Board has no generalrestriction with respect to the payment of cash dividends by an adequatelycapitalized bank to its parent holding company, the Federal Reserve Boardmight, under certain circumstances, place restrictions on the ability of aparticular bank to pay dividends based upon peer group averages and theperformance and maturity of the particular bank, or object to management feesto be paid by a subsidiary bank to its holding company on the basis that suchfees cannot be supported by the value of the services rendered or are not theresult of an arm’s length transaction.

 

Under these provisions, the amount availablefor distribution from the Bank to the Company was approximately $7,093,999 atDecember 31, 2002.

 

17

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The following table outlines stock dividendactivity since 1999:

 
| **Stock Dividend Percentage** |   | **Record  Date**  |
|-------------------------------|--------|-------------------|
|                          |   |              |
| 4%                            |   | February 15, 1999 |
|                          |   |              |
| 5%                            |   | April 3, 2000     |
|                          |   |              |
| 5%                            |   | March 16, 2001    |
|                          |   |              |
| 5%                            |   | March 8, 2002     |
|                          |   |              |
| 2 for 1 Split                 |   | August 2, 2002    |
|                          |   |              |
| 5%                            |   | March 14, 2003    |

 

Whether dividends will be paid in the futurewill be determined by the Board of Directors after consideration of variousfactors. The Company’s profitability and regulatory capital ratios in additionto other financial conditions will be key factors considered by the Board ofDirectors in making such determinations regarding the payment of dividends bythe Company.

 

The following table summarizes informationas of December 31, 2002 relating to equity compensation plans of the Companypursuant to which grants of options, restricted stock or other rights toacquire shares may be granted from time to time:

 
| **Plan Category**                                          |   | **Plan  Year** |   | **Number of securities to  be issued upon exercise  of options** |   | **Weighted average  exercise price of  outstanding options** |       | **Number of  securities remaining  available for future  issuance** |        |
|------------------------------------------------------------|--------|----------------|--------|------------------------------------------------------------------|--------|--------------------------------------------------------------|------------|---------------------------------------------------------------------|-------------|
| Equity compensation plans approved by security holders     |   | 1990  1997     |   | 2,033  384,710                                                   |   | $                                                            | 4.43  5.78 |                                                                | -0  175,218 | - |
| Equity compensation plans not approved by security holders |   |           |   | -0                                                               | -      | -0                                                           | -          | -0                                                                  | -           |
| Total                                                      |   |           |   | 386,743                                                          |   | $                                                            | 5.77       |                                                                | 175,218     |   |

 

18

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**ITEM 6.  MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF****OPERATIONS**

 

The following is an analysis of thefinancial condition and results of operations of the Company for the two yearsended December 31, 2002.  The analysisshould be read in connection with the consolidated financial statements andnotes thereto appearing elsewhere in this report.

 

On November 15, 1994, the Company wasorganized as a holding company for the Bank. The Bank is the only activefinancial subsidiary owned by the Company.

 

**Strategic Developments**

 

The Company made astrategic decision commencing in 1999 to expand its full service branch officecoverage of its primary market area, realizing that during the first year, netearnings would be impacted by the growth of infrastructure. Two offices wereopened during the first quarter of 1999 and one during the first quarter of2000. The expected result was that net earnings in 1999 grew by only 6.3% fromthose in 1998, however, the ground work had been set to allow for significantgrowth without additional material overhead.

 

On July 16, 2001, the Bankand Westamerica Bank, a California banking corporation, entered into a BranchPurchase and Assumption Agreement (“Agreement” included as an Exhibit inCompany’s September 30, 2001 10-QSB), pursuant to which Heritage Oaks Bankpurchased the four Westamerica Bank Branches in San Luis Obispo County(“Branches”).  The Branches were  located in the cities of Arroyo Grande,Morro Bay, Paso Robles and San Luis Obispo. In addition, Heritage Oaks Bankacquired Westamerica Bank’s interest in the real estate of each of theBranches, whether they were owned or leased.

 

Under the Agreement, Heritage Oaks Bankassumed all deposit liabilities and other liabilities set forth in theAgreement and purchased certain of the assets of the Branches.  It did not purchase any of the loans of theBranches which  were retained byWestamerica Bank.  All employees of theBranches (except one loan officer designated by Westamerica) was offeredemployment by Heritage Oaks Bank.

 

OnNovember 9, 2001, the transaction closed. The branches located at 310 Morro BayBlvd., Morro Bay, California and 1255 Grand Avenue, Arroyo Grande, Californiacontinued to be operated. The branch located at 545 Higuera Street, San Luis Obispo,California was consolidated with the Heritage Oaks Bank branch located at 1135Santa Rosa Street, San Luis Obispo, California; and the branch located at 1204Spring Street, Paso Robles, California was consolidated with the Heritage OaksBank branch located at 545 Twelfth Street, Paso Robles, California.  Further, the Heritage Oaks Bank branchlocated at 1360 Grand Avenue, Arroyo Grande, California was consolidated withthe branch being acquired that is located at 1255 Grand Avenue, Arroyo Grande,California.

 

Beginning in January 2001and continuing through November 2002, actions by the Federal Reserve to cuttarget interest rates resulted in Prime Rate being cut from 9.50% to 4.25%.Historically, the largest source of income for the Bank is that which iscreated by net interest income. This reduction in rates, specifically as itrelates to 48% of the Bank’s average earning assets that adjust with Prime,made it very difficult to maintain the level of the Net Interest Margin for2002 that the Bank had experienced in the past. Despite the adverse interestrate environment, the Company was able to exceed prior year earnings.

 

On April 10, 2002, theCompany completed its offering of trust preferred securities in the amount of$8.0 million. The securities were issued by a special purpose business trustformed by the Company and were sold to a pooled investment vehicle sponsored bySandler O’Neill & Partners, L.P. and Salomon Smith Barney Inc. in a privatetransaction. The securities were sold pursuant to an applicable exemption fromregistration under the Securities Act of 1933, as amended (the “Act”), and havenot been registered under the Act. Sandler O’Neill assisted the Company in the placement of the trustpreferred securities. The securities may not be offered or sold in the UnitedStates absent registration or an applicable exemption from registrationrequirements.

 

The $8.0 million in trust preferredsecurities have a floating rate of interest, which is reset semi-annually,equal to 6-month LIBOR plus 3.70%.  Thefloating rate, however, may not exceed 11.0% for the first five years. The $8.0million accounts for approximately 4% of the increase in total assets.

 

As the result of the issuance of $8.0million in trust preferred securities, the Company down-streamed $5.2 millionto the Bank in the form of Tier I Capital. This enabled the Bank to implementan investment strategy of $38 million whereby the Bank borrowed $38 millionfrom the Federal Home Loan Bank (FHLB) and purchased approximately

 

19

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$40 million in investment securities. Thepurchased investment securities serve as collateral for the borrowing.

 

**Critical Accounting Policies**

 

##### **Our accounting policies are integral to understanding theresults reported. Accounting policies are described in detail in Note 1 of theNOTES TO CONSOLIDATED FINANCIAL STATEMENTS. Our most complex accountingpolicies require management’s judgment to ascertain the valuation of assets,liabilities, commitments and contingencies. We have established detailedpolicies and control procedures that are intended to ensure valuation methodsare well controlled and applied consistently from period to period. Inaddition, the policies and procedures are intended to ensure that the processfor changing methodologies occurs in an appropriate manner. A detaileddiscussion of critical accounting policies can be found within this documentunder “Provision and Allowance forCredit Losses” and “Investment Securities and Other Earning Assets”.**

 

**Earnings Overview**

 

The Company reported net income for 2002 of$2,739,220. This was a 16.8% increase from the $2,346,283 reported in2001.  Net income reported for 2001represented an increase of $102,263 or 4.6% more than 2000 net income of$2,244,020. Basic earnings per share were $.99, $.86 and $.84 at December 31,2002, 2001 and 2000, respectively. Diluted earnings per share were $.91, $.79and $.78 at December 31, 2002, 2001 and 2000, respectively. Earnings per sharein 2001 and 2000 have been adjusted to account for the 2 for 1 stock split witha record date of  August 2, 2002.

 
| **SELECTED FINANCIAL DATA** |   |
|-----------------------------|--------|

 
|                              |   | **December 31,** |    |
|-----------------------------------|--------|------------------|---------|
|                              |   | **2002**         |    | **2001** |   | **2000** |   |
| Return on Average Assets          |   | 0.98             | %       | 1.22 | % | 1.34 | % |
|                              |   |             |    |   |   |   |   |
| Return on Average Equity          |   | 15.56            | %       | 15.74 | % | 18.82 | % |
|                              |   |             |    |   |   |   |   |
| Average Equity to Average Assets  |   | 6.33             | %       | 7.74 | % | 7.11 | % |
|                              |   |             |    |   |   |   |   |
| Net Interest Margin               |   | 5.04             | %       | 6.43 | % | 6.78 | % |
|                              |   |             |    |   |   |   |   |
| Average Loans to Average Deposits |   | 77.63            | %       | 83.80 | % | 82.18 | % |
|                              |   |             |    |   |   |   |   |
| Net Income (in thousands)         |   | $                | 2,739   |   | $ | 2,346 |   | $ | 2,244 |   |
|                              |   |             |    |   |   |   |   |
| Average Assets (in thousands)     |   | $                | 278,332 |   | $ | 192,459 |   | $ | 167,661 |   |
|                              |   |             |    |   |   |   |   |
| Earnings Per Share:               |   |             |    |   |   |   |   |
| Basic                             |   | $                | 0.99    |   | $ | 0.86 |   | $ | 0.84 |   |
| Diluted                           |   | $                | 0.91    |   | $ | 0.79 |   | $ | 0.78 |   |

 

Earnings per share in 2001 and 2000 havebeen adjusted to account for the 2 for 1 stock split with a record date ofAugust 2, 2002.

 

**Net Interest Income and Interest Margin**

 

Net interest income, theprimary component of the net earnings of a financial institution, refers to thedifference between the interest paid on deposits and borrowings, and theinterest earned on loans and investments. The net interest margin is the amount of net interest income expressedas a percentage of average earning assets. Factors considered in the analysis of net interest income are thecomposition and volume of earning assets and interest-bearing liabilities, theamount of non-interest bearing liabilities and non–accrual loans, and changesin market interest rates.

 

Net interest income before provision forpossible loan losses for 2002 was $12,544,248, an increase of $1,513,035 or13.7% from  the $11,031,213 in2001.  The increase in net interestincome for 2002 compared to 2001 was attributable to a $77.1 million increasein average earning assets, a $26.4 million increase in non-interest bearingdemand deposits and a $51.1 million increase in average interest bearingliabilities. The significant growth in average earning assets compared to thelesser growth in average interest bearing liabilities helped to offset the declinein interest rates

 

20

----

 

throughout the year. The rate on averageearning assets decreased by 198 basis points from 2001 to that in 2002, whilethe rate paid on average interest bearing liabilities decreased 85 basis pointsfor the same period.  Averagenon-interest bearing demand deposits increased by $26.4 million in 2002. Otherlow cost deposits such as savings, now and money market accounts grew anaverage of $26.2 million with a weighted average rate of 0.84% in 2002. Theaverage higher cost time deposits decreased****$2.6 million with the average rate paidfalling from 4.82% in 2001 to 2.77% in 2002**.**

 

Total income on the loan portfolio increasedfrom $13,280,255 in 2001 to $13,399,144 in 2002. This modest increase of 0.90%in additional interest income was due to a combination of average loansoutstanding for the year increasing by almost $28.1 million and the averagerate earned for the year dropping from 9.11% to 7.71%.

 

Total income on investments increased from$1,181,098 in 2001 to $2,636,659. This increase of more than 123% is due to theadditional liquidity provided by deposit growth and the investment strategyimplemented as the result of the issuance of the $8 million in trust preferredsecurities.

 

The average yield on earning assets was6.45% for 2002 and 8.43% for 2001.  Theaverage yield on interest bearing liabilities was 2.08% for 2002, compared to2.93% for 2001.  The net interest marginwas 5.04% in 2002 compared to 6.43% in 2001.

 

The table below sets forth the averagebalance sheet information, interest income and expense, average yields andrates and net interest income and margin for the years ended December 31, 2002,2001 and 2000. The average balance of non-accruing loans has been included inloan totals.

 
|                                                                                                                                                                                |   | **2002**             |       | **2001**                 |       | **2000**             |       |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------|------------|--------------------------|------------|----------------------|------------|
| **(dollars in thousands)**                                                                                                                                                          |   | **Average  Balance** | ** ** | **Avg Yield  Rate Paid** | ** ** | **Amount  Interest** | ** ** | **Average  Balance** | ** ** | **Avg Yield  Rate Paid** | ** ** | **Amount  Interest** | ** ** | **Average  Balance** | ** ** | **Avg Yield  Rate Paid** | ** ** | **Amount  Interest** | ** ** |
| Interest Earning Assets:                                                                                                                                                            |   |                 |       |                     |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Time deposits with other banks                                                                                                                                                      |   | $                    | 169        |                     | 2.96       | %                    | $          | 5 |   | $ | 338 |   | 3.85 | % | $ | 13 |   | $ | 257 |   | 7.39 | % | $ | 19 |   |
| Investment securities taxable                                                                                                                                                       |   | 43,502               |       | 4.44                     | %          | 1,932                |       | 9,415 |   | 5.57 | % | 524 |   | 11,117 |   | 6.26 | % | 696 |   |
| Investment securities non-taxable                                                                                                                                                   |   | 6,358                |       | 4.72                     | %          | 300                  |       | 5,928 |   | 4.74 | % | 281 |   | 6,087 |   | 5.03 | % | 306 |   |
| Federal funds sold                                                                                                                                                                  |   | 24,799               |       | 1.61                     | %          | 400                  |       | 10,162 |   | 3.57 | % | 363 |   | 3,921 |   | 6.32 | % | 248 |   |
| Loans(1)(2)                                                                                                                                                                         |   | 173,861              |       | 7.71                     | %          | 13,399               |       | 145,757 |   | 9.11 | % | 13,280 |   | 123,794 |   | 10.26 | % | 12,700 |   |
|                                                                                                                                                                                |   |                 |       |                     |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total interest earning assets                                                                                                                                                       |   | 248,689              |       | 6.45                     | %          | 16,036               |       | 171,600 |   | 8.43 | % | 14,461 |   | 145,176 |   | 9.62 | % | 13,969 |   |
|                                                                                                                                                                                |   |                 |       |                     |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Allowance for possible loan losses                                                                                                                                                  |   | (2,088               | )          |                     |       |                 |       | (1,545 | ) |   |   |   |   | (1,344 | ) |   |   |   |   |
| Non-earning assets:                                                                                                                                                                 |   |                 |       |                     |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Cash and due from banks                                                                                                                                                             |   | 18,588               |       |                     |       |                 |       | 14,031 |   |   |   |   |   | 16,376 |   |   |   |   |   |
| Property, premises and equipment                                                                                                                                                    |   | 3,953                |       |                     |       |                 |       | 2,972 |   |   |   |   |   | 3,274 |   |   |   |   |   |
| Other assets                                                                                                                                                                        |   | 9,190                |       |                     |       |                 |       | 5,401 |   |   |   |   |   | 4,179 |   |   |   |   |   |
|                                                                                                                                                                                |   |                 |       |                     |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| TOTAL ASSETS                                                                                                                                                                        |   | $                    | 278,332    |                     |       |                 |       |   | $ | 192,459 |   |   |   |   |   | $ | 167,661 |   |   |   |   |   |
|                                                                                                                                                                                |   |                 |       |                     |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest -bearing liabilities:                                                                                                                                                      |   |                 |       |                     |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Savings/NOW/money market                                                                                                                                                            |   | 92,800               |       | 0.84                     | %          | 779                  |       | 66,562 |   | 1.45 | % | 964 |   | 58,077 |   | 2.37 | % | 1,376 |   |
| Time deposits                                                                                                                                                                       |   | 46,453               |       | 2.77                     | %          | 1,286                |       | 49,037 |   | 4.82 | % | 2,366 |   | 45,872 |   | 5.50 | % | 2,523 |   |
| Other borrowings                                                                                                                                                                    |   | 28,967               |       | 4.92                     | %          | 1,426                |       | 1,496 |   | 6.75 | % | 101 |   | 3,443 |   | 6.74 | % | 232 |   |
|                                                                                                                                                                                |   |                 |       |                     |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total interest-bearing liabilities                                                                                                                                                  |   | 168,220              |       | 2.08                     | %          | 3,491                |       | 117,095 |   | 2.93 | % | 3,431 |   | 107,392 |   | 3.85 | % | 4,131 |   |
|                                                                                                                                                                                |   |                 |       |                     |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Non-interest bearing liabilities:                                                                                                                                                   |   |                 |       |                     |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Demand deposits                                                                                                                                                                     |   | 84,702               |       |                     |       |                 |       | 58,350 |   |   |   |   |   | 46,680 |   |   |   |   |   |
| Other liabilities                                                                                                                                                                   |   | 1,803                |       |                     |       |                 |       | 2,113 |   |   |   |   |   | 1,664 |   |   |   |   |   |
|                                                                                                                                                                                |   |                 |       |                     |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total liabilities                                                                                                                                                                   |   | 254,725              |       |                     |       |                 |       | 177,558 |   |   |   |   |   | 155,736 |   |   |   |   |   |
|                                                                                                                                                                                |   |                 |       |                     |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Securities Sold under Agreement to Repurchase Company Obligated  Preferred Securities of Subsidiary Trust Holding Floating Rate Junior  Subordinated Deferrable Interest Debentures |   | 6,000                |       |                     |       |                 |       | 0 |   |   |   |   |   | 0 |   |   |   |   |   |
|                                                                                                                                                                                |   |                 |       |                     |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Stockholders’ equity                                                                                                                                                           |   |                 |       |                     |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Common stock                                                                                                                                                                        |   | 9,037                |       |                     |       |                 |       | 7,311 |   |   |   |   |   | 5,996 |   |   |   |   |   |
| Retained earnings                                                                                                                                                                   |   | 8,437                |       |                     |       |                 |       | 7,615 |   |   |   |   |   | 6,457 |   |   |   |   |   |
| Valuation Allowance Investments                                                                                                                                                     |   | 133                  |       |                     |       |                 |       | (25 | ) |   |   |   |   | (528 | ) |   |   |   |   |
|                                                                                                                                                                                |   |                 |       |                     |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total stockholders’ equity                                                                                                                                                     |   | 17,607               |       |                     |       |                 |       | 14,901 |   |   |   |   |   | 11,925 |   |   |   |   |   |
|                                                                                                                                                                                |   |                 |       |                     |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                     |   | $                    | 278,332    |                     |       |                 |       |   | $ | 192,459 |   |   |   |   |   | $ | 167,661 |   |   |   |   |   |
|                                                                                                                                                                                |   |                 |       |                     |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net Interest Income                                                                                                                                                                 |   |                 |       |                     |       | $                    | 12,545     |   |   |   |   |   | $ | 11,030 |   |   |   |   |   | $ | 9,838 |   |
| Net Interest Margin(3)                                                                                                                                                              |   |                 |       | 5.04                     | %          |                 |       |   |   | 6.43 | % |   |   |   |   | 6.78 | % |   |   |

 

----

| (1)    | Nonaccrual loans have  been included in total loans.                                                                            |
|--------|---------------------------------------------------------------------------------------------------------------------------------|
| (2)    | Loan fees of $753,$609  and $587 for 2002, 2001 and 2000, respectively, have been included in the  interest income computation. |
| (3)    | Net interest income has  been calculated by dividing the net interest income by total earning assets.                           |
|   | Note: All average  balances have been computed using daily balances.                                                            |

 

21

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|                                       |   | **RATE/VOLUME  ANALYSIS** |       |              |       |
|--------------------------------------------|--------|---------------------------|------------|-------------------|------------|
|                                       |   | **2002**                  |       | **2001**          |       | **2000** |   |
| **Increase (decrease) in:**                |   | **Average  Bal/Vol**      | ** ** | **Average  Rate** | ** ** | **Total** | ** ** | **Average  Bal/Vol** | ** ** | **Average  Rate** | ** ** | **Total** | ** ** | **Average  Bal/Vol** | ** ** | **Average  Rate** | ** ** | **Total** | ** ** |
|                                       |   |                      |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest income:                           |   |                      |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans(1)                                   |   | $                         | 2,558      |              | $          | (2,440 | ) | $ | 118 |   | $ | 2,279 |   | $ | (1,699 | ) | $ | 580 |   | $ | 3,620 |   | $ | 655 |   | $ | 4,275 |   |
| Investment securities taxable              |   | 1,898                     |       | (491              | )          | 1,407 |   | (107 | ) | (88 | ) | (195 | ) | (286 | ) | 45 |   | (241 | ) |
| Investment securities non-taxable(2):      |   | (10                       | )          | (1                | )          | (11 | ) | (8 | ) | (17 | ) | (25 | ) | (30 | ) | 24 |   | (6 | ) |
| Taxable equivalent adjustment(2):          |   | 31                        |       | (2                | )          | 29 |   | 4 |   | 8 |   | 12 |   | 10 |   | (8 | ) | 2 |   |
| Interest-bearing deposits                  |   | (6                        | )          | (1                | )          | (7 | ) | 6 |   | (1 | ) | 5 |   | (8 | ) | 5 |   | (3 | ) |
| Federal funds sold                         |   | 523                       |       | (485              | )          | 38 |   | 394 |   | (279 | ) | 115 |   | (23 | ) | 51 |   | 28 |   |
| Total                                      |   | 4,994                     |       | (3,420            | )          | 1,574 |   | 2,568 |   | (2,076 | ) | 492 |   | 3,283 |   | 772 |   | 4,055 |   |
|                                       |   |                      |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest expense:                          |   |                      |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Savings, now, money market                 |   | 380                       |       | (567              | )          | (187 | ) | 201 |   | (614 | ) | (413 | ) | 70 |   | 169 |   | 239 |   |
| Time deposits                              |   | (125                      | )          | (953              | )          | (1,078 | ) | 174 |   | (331 | ) | (157 | ) | 774 |   | 372 |   | 1,146 |   |
| Other borrowings                           |   | 1,852                     |       | (526              | )          | 1,326 |   | (130 | ) | — |   | (130 | ) | 150 |   | (5 | ) | 145 |   |
| Total                                      |   | 2,107                     |       | (2,046            | )          | 61 |   | 245 |   | (945 | ) | (700 | ) | 994 |   | 536 |   | 1,530 |   |
|                                       |   |                      |       |              |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Increase (decrease) in net Interest income |   | $                         | 2,887      |              | $          | (1,374 | ) | $ | 1,513 |   | $ | 2,323 |   | $ | (1,131 | ) | $ | 1,192 |   | $ | 2,289 |   | $ | 236 |   | $ | 2,525 |   |

 

----

| (1) |   | Loan fees of $753, $609  and $587 for 2002, 2001 and 2000, respectively have been included in the  interest income computation. |
|-----|--------|---------------------------------------------------------------------------------------------------------------------------------|
| (2) |   | Adjusted to a fully  taxable equivalent basis using a tax rate of 34%.                                                          |

 

Note A: Average balances of all categoriesin each period were included in the volume computations.

Note B: Average yield rates in each periodwere used in rate computations. Any change attributable to changes in bothvolume and rate which cannot be segregated has been allocated.

 

The hypothetical impacts of sudden interestrate movements applied to the Bank’s asset and liability balances are modeledmonthly. The results of this movement indicate how much of the Bank’s netinterest income is “at risk” from various sudden rate changes. Althoughinterest rates normally would not change in this sudden manner, this exerciseis valuable in identifying risk exposures. The results for the Bank’s December31, 2002 balances indicate that the Bank’s net interest income at risk over aone year time horizon from a 1% and 2% rate movement are within normalexpectations for such sudden changes.

 
|                          |   | **Rates Down 2%** |   | **Rates Down 1%** |   | **Rates Up 1%** |   | **Rates Up 2%** |   |
|-------------------------------|--------|-------------------|--------|-------------------|--------|-----------------|--------|-----------------|--------|
| Change in Net Interest Income |   | (6.44             | )%     | (3.25             | )%     | 3.75            | %      | 6.90            | %      |

 

It is important tonote that the above table is a summary of several forecasts and actual resultsmay vary. The forecasts are based on estimates and assumptions of managementthat may turn out to be different and may change over time. Factors effectingthese estimates and assumptions include, but are not limited to 1) competitorbehavior,           2) economic conditionsboth locally and nationally, 3) actions taken by the Federal Reserve Board, 4)customer behavior and 5) management’s responses.  Changes that vary significantly from the assumptions andestimates may have significant effects on the Bank’s net interest income.Therefore, the results of this analysis should not be relied upon as indicativeof actual future results.

 

**Non-InterestIncome**

 

Non-interest income consists of servicecharges on deposit accounts, bankcard merchant fees, automatic teller machines(“ATM”) transactions, mortgage origination fees and other fees.  Non-interest income for 2002 was $3,463,012compared to $4,680,575 for 2001. This represents a decrease of $1,217,563 or26.0%. During 2001, the Bank divested itself of the off premise ATM business.In eliminating this line of business, both non-interest income and non-interestexpense decreased. This will be discussed in more detail below.

 

Service charges on deposit accountsincreased to $1,432,530 in 2002 from $1,182,785 in 2001. This growth of$249,745 or 21.1% is the result of overall bank growth for the year,particularly in deposit accounts. The Bank implemented a new service charge schedulein August 2002 that accounted for approximately 60% of the increase.

 

Bankcard merchant fees were $123,493 in 2002compared to $122,602 in 2001. When the Bank sold the merchant portfolio inSeptember 1999, the compensation provisions called for payment of certain basispoints on the gross sales. In September 2002, pursuant to the agreement, thebasis points paid to the Bank were reduced. This will continue until

 

22

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August 2004 at which time the compensationwill be renegotiated. Management does not believe that this change in revenuestream will have a material impact on the Company as was demonstrated by therecord fourth quarter 2002 earnings.

 

Overall, the Bank has become less reliant onATM generated revenue than in previous years and in fact divested itself ofthis line of business entirely by the fourth quarter of 2002. The net earningsfrom all ATM operations before deducting for overhead expenses and salarieswere $39,262**,******$475,875 and****$1,031,720,for the years ended December 31, 2002, 2001 and 2000, respectively. Earnings in2002 were not material and Management does not believe that this change inrevenue stream will have an impact on the Company.

 

ATM transaction fees, ATMinterchange income, and ATM sponsorship fees were $128,207 and $2,017,507 forthe year 2002 and 2001, respectively. The Bank operated two networks referred to as the Gaming Network and theRetail Network.

 

The Gaming Network consisted of ATMplacements located in authorized California gaming sites and accounted forapproximately 100%of the gross revenue for ATMs in 2002. For the past severalyears, the number of Gaming contracts has decreased as the result of highlyaggressive competition. In order to retain certain sites, agreements wererenegotiated that narrowed the profit margin for the Bank. Because of narrowingprofit margins and risk associated with this line of business, beginning in thethird quarter of 2000 and continuing until the fourth quarter of 2002, theBank’s Service Agreements with all sites were not renewed and/or terminated.

 

The Retail Network consisted of ATMplacements in locations, such as malls and individual business sites throughoutthe United States. Because of the very narrow profit margins and the internalresources required to run this network, the Bank decided to sell thisparticular piece of business to a company who would have the economies of scaleto realize a greater profit margin. In November 2000, the Bank entered into anagreement to sell these location agreements, inclusive of their equipment. Thistransaction closed on March 31, 2001. The sale had minimal impact to the netearning in 2001 due to the expense of fully depreciating ATMs and otherexpenses associated with the sale.

 

Mortgage origination fees, net ofcommissions paid, generated gross revenue of $766,532 for 2002 compared to$577,333 in 2001. The Bank has been engaged in this line of business for anumber of years and increased the department’s resources in 2001 and 2002 toaccommodate the growing activity. In addition to keeping up with the  current demand due to the interest ratecycle, the Bank is positioning itself for future market penetration with salesrepresentation in all markets that the Bank services.  When interest rates shift upward, the Bank will have a fullyseasoned sales staff in place to continue to gain market share in mortgageoriginations. Also, when the accelerated activity begins to decline, therewould be limited fixed overhead in place to negatively impact earnings. Most ofthe expense associated with this line of business is variable in the form ofcommissions paid.

 

**Non-InterestExpenses**

 

Non-interest expense consists of salary andother compensation, occupancy and equipment, ATM network related expense andother expense. Non-interest expense for 2002 decreased to $11,073,572 from$11,386,136 in 2001. This represents a decrease of $312,564 or 2.8%.

 

Salaries and employee benefit expense were$5,385,710 and $4,494,137 for 2002 and 2001, respectively.  This represents an increase of $891,573 or19.8%. Approximately $514,000 or 58% of this increase is due to; 1) annualmerit increases in February 2002 that averaged 4% and; 2) an increase in staffthroughout the course of the year and the addition of the 16 Westamerica Bankemployees in November 2001. Group health costs increased 34.6% for 2002 overthat in 2001. This accounts for approximately 10% of the overall increase insalaries and employee benefits. The remainder of the increase is attributed toenhanced bonus payments and costs for education and training. Full timeequivalent employees were 118 for 2002 and 106 for 2001. The ratio of “assetsper employee”, one of the measures of operational efficiency, was****$2.8million****and$2.0 million for 2002 and 2001, respectively.

 

Occupancy, furniture and equipment expenseswere $1,666,010 during 2002, compared to $1,707,205 for 2001. This represents adecrease of $41,195 or 2.47%. There were no new facilities opened in 2002.

 

Other non-interest expense consists of ATM networkrelated, data processing and other operating expense. Other non-interestexpense was $4,021,852 for 2002, compared to $5,184,794 in 2001. Thisrepresents a decrease of $1,162,942 or 22.4%.

 

ATMnetwork related expense was $86,946 in 2002, compared to $1,541,632 in 2001.This significant decrease is evidence of the Bank exiting this line of businessentirely in 2002. See discussion of the ATM networks in “Non-Interest Income”,above.

 

23

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Dataprocessing expense was $1,415,803 in 2002 compared to $1,460,620 in 2001. Thisrepresents a decrease of $44,817 or 3.1%.

 

**Provisionfor Income Taxes**

 

The provision for income taxes was$1,649,468 for 2002, compared to $1,379,369 in 2001. The increase is commensuratewith growth in pre-tax income for the year 2002 from that of 2001. The Bank’seffective tax rate was 37.6% and 37.0% in 2002 and 2001, respectively.

 

**Provisionand Allowance for Credit Losses**

 

An allowance forloan losses has been established by management to provide for those loans thatmay not be repaid in their entirety for a variety of reasons. The allowance ismaintained at a level considered by management to be adequate to provide forprobable incurred losses. The allowance is increased by provisions charged toearnings and is reduced by charge-offs, net of recoveries. The provision forloan losses is based upon past loan loss experience and management’s evaluationof the loan portfolio under current economic conditions. Loans are charged tothe allowance for loan losses when, and to the extent, they are deemed bymanagement to be un-collectible. The allowance for loan losses is composed ofallocations for specific loans and a historical portion for all other loans.

 

The Bankrecognized that credit losses will be experienced and the risk of loss willvary with, among other things, general economic conditions; the type of loanbeing made; the creditworthiness of the borrower over the term of the loan andin the case of a collateralized loan, the quality of the collateral for suchloan. The allowance for loan loss represents the Bank’s estimate of theallowance necessary to provide for probable incurred losses in the portfolio.In making this determination, the Bank analyzes the ultimate collectibility ofthe loans in its portfolio by incorporating feedback provided by internal loanstaff, an independent loan review function, and information provided byexaminations performed by regulatory agencies. The Bank makes monthlyevaluations as to the adequacy of the allowance for loan losses.

 

The analysis of the allowance for loanlosses is comprised of three components; specific credit allocation; generalportfolio allocation; and subjectively by determined allocation. EffectiveJanuary 1, 1995, the Bank adopted Statement of Financial Accounting StandardsNo.114, Accounting by Creditors for Impairment of a Loan (SFAS 114), as amendedby SFAS No. 118, Accounting by Creditors for Impairment of a Loan - IncomeRecognition and Disclosures. These pronouncements provide that when it isprobable that a creditor will be unable to collect all amounts due inaccordance with the terms of the loan that such loan is deemed impaired.Impaired loans are accounted for differently in that the amount of theimpairment is measured and reflected in the records of the creditor. The allowance for credit losses related toloans that are identified for evaluation in accordance with Statement 114 isbased on discounted cash flows using the loan’s initial effect interest rate orthe fair value of the collateral for certain collateral dependent loans. Thegeneral portfolio allocation consists of an assigned reserve percentage basedon the credit rating of the loan. The subjective portion is determined based onloan history and the Bank’s evaluation of various factors including currenteconomic conditions and trends in the portfolio including delinquencies andimpairment, as well as changes in the composition of the portfolio.

 

The allowance forloan losses is based on estimate, and ultimate losses will vary from currentestimates. These estimates are reviewed monthly by the Bank’s Director’s LoanCommittee and full Board of Directors, and as adjustments, either positive ornegative, become necessary, a corresponding increase or decrease is made in theprovision for loan losses. The methodology used to determine the adequacy ofthe allowance for possible loan losses for the year 2002 is consistent withprior periods.

 

The Bank’sprovision for loan losses was $545,000 for 2002 compared to $600,000 for 2001. Net loan charge-offs (loans charged off, netof loans recovered) were ($47,149) in 2002 and $176,448 during 2001,respectively. The allowance for credit losses as a percent of total gross loansat year-end 2002 and 2001 was 1.23% and 1.10%, respectively.

 

Loans are placed on non-accrual when a loanis specifically determined to be impaired or when principal or interest isdelinquent for 90 days or more. Any unpaid interest previously accrued on thoseloans is reversed from income. Interest income generally is not recognized onspecific impaired loans unless the likelihood of further loss is remote.Interest payments received on such loans are applied as a reduction on the loanprincipal balance.

 

Loans onnon-accrual status totaled $1,345,755 and $1,494,602 at December 31, 2002 and2001, respectively.  Typically, theseloans have adequate collateral protection and/or personal guaranties to providea source of repayment

 

24

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to the Bank. Mostof the loans on non-accrual are related to several commercial loans that arebeing addressed by specific workout plans at this time. Interest income thatwould have been recognized on non-accrual loans if they had performed inaccordance with the terms of the loans was approximately $134,508 and $195,826for the period ended December 31, 2002 and 2001, respectively.

 

Non-performingloans include non-accrual loans and accruing loans that are 90 days or moredelinquent. The Bank had no loans that were 90 days or more delinquent atDecember 31, 2002 and December 31, 2001 that were still accruing interest.

 

The followingtable summarized the analysis of the allowance for loan losses as of December31, 2002, 2001 and 2000:

 
| **Analysis of Allowance for Loan Losses** |   |
|-------------------------------------------|--------|

 
|                                                                  |   | **2002**  |        | **2001**  |   | **2000**    |   |
|-----------------------------------------------------------------------|--------|-----------|-------------|-----------|--------|-------------|--------|
| Balance at Beginning of Period                                        |   | $         | 1,744,070   |      | $      | 1,320,518   |   | $ | 1,241,016 |   |
|                                                                  |   |      |        |      |   |        |   |
| Charge-offs:                                                          |   |      |        |      |   |        |   |
| Commercial, Fianacial and Agricultural                                |   | 76,345    |        | 155,933   |   | 454,085     |   |
| Real Estate- Construction                                             |   | —    |        | —    |   | —      |   |
| Real Estate-Mortgage                                                  |   | —    |        | —    |   | —      |   |
| Installment Loans to Individuals:                                     |   | —    |        | 22,341    |   | 4,370       |   |
| Money Plus                                                            |   | 5,060     |        | 2,458     |   | 465         |   |
| Credit Cards                                                          |   | —    |        | —    |   | —      |   |
| Other Installment                                                     |   | —    |        | —    |   | —      |   |
| Total charge-offs                                                     |   | 81,405    |        | 180,732   |   | 458,920     |   |
|                                                                  |   |      |        |      |   |        |   |
| Recoveries:                                                           |   |      |        |      |   |        |   |
| Commercial, Fianacial and Agricultural                                |   | 126,596   |        | 483       |   | 16,745      |   |
| Real Estate- Construction                                             |   | —    |        | —    |   | —      |   |
| Real Estate-Mortgage                                                  |   | —    |        | —    |   | —      |   |
| Installment Loans to Individuals:                                     |   | 500       |        | 2,256     |   | 488         |   |
| Money Plus                                                            |   | 1,458     |        | 1,545     |   | 2,189       |   |
| Credit Cards                                                          |   | —    |        | —    |   | —      |   |
| Other Installment                                                     |   | —    |        | —    |   | —      |   |
| Total recoveries                                                      |   | 128,554   |        | 4,284     |   | 19,422      |   |
| Net Charge-offs                                                       |   | (47,149   | )           | 176,448   |   | 439,498     |   |
| Additions Charged to Operations                                       |   | 545,000   |        | 600,000   |   | 519,000     |   |
| Balance at End of Period                                              |   | 2,336,219 |        | 1,744,070 |   | 1,320,518   |   |
|                                                                  |   |      |        |      |   |        |   |
| Gross Loans at End of Period                                          |   | $         | 190,469,255 |      | $      | 158,472,287 |   | $ | 135,488,020 |   |
|                                                                  |   |      |        |      |   |        |   |
| Ratio of Net Charge-offs During the Year to Average Loans outstanding |   | -0.03     | %           | 0.12      | %      | 0.44        | %      |
|                                                                  |   |      |        |      |   |        |   |
| Ratio of Reserves to Gross Loans                                      |   | 1.23      | %           | 1.10      | %      | 0.97        | %      |
|                                                                  |   |      |        |      |   |        |   |
| Ratio of Non-performing Loans to the Allowance for Credit Losses      |   | 57.60     | %           | 85.70     | %      | 75.01       | %      |

 

**LocalEconomy**

 

Theeconomy in the Company’s service area is based primarily on agriculture,tourism, light industry, oil and retail trade. Services supporting theseindustries 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

 

25

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years throughout the Company’s service area. Access to numerous recreationalactivities, including lakes, mountains and beaches, provide a relatively stabletourist industry from many areas including the Los Angeles/Orange County basin,the San Francisco Bay area and the San Joaquin Valley. Principally due to thediversity of the various industries in the Company’s service area, the area,while not immune from economic fluctuations, does tend to enjoy a more stablelevel of economic activity from many other areas of California.

 

The Central Coast’s leading industry is the production of wine grapesand production of premium quality wines. Over the past two years, production ofnew vineyard land has led to an over capacity of wine grapes.  Excess production of wine grapes has led to adecrease in prices of grapes sold and in some cases, the inability of farmersto sell grapes at any price.  Winerieson the other hand are purchasing grapes at existing contract prices and in somecases, below contract prices. Wineries are becoming select in the quality ofgrapes purchases, asking farmers to thin crops to produce a higher qualityfruit.

 

The Bank recognized in 2000 that there would be over capacity in theproduction of wine grapes in our market area. As a result, efforts were made tomove a significant portion of the vineyard development loan portfolio out ofthe Bank and into the government sponsored Farmer Mac program. Because of theseactions on the part of the Bank, it is the opinion of Management that therewould not be any negative impact from the current state of the wine grapeindustry.

 

**FINANCIAL CONDITION ANALYSIS**

 

Total assets of the Companywere $337,263,312 at December 31, 2002 compared to $214,884,674 at December 31,2001. That represents an increase of $122.4 million or 57.0%.

 

A significant portion of total assets is theBank’s gross loans that were $190,469,255 and $158,472,287 at December 31, 2002and 2001, respectively.  Approximately43% of gross loans at December 31, 2002 are adjustable rate loans compared to65% at December 31, 2001. The decrease in the percentage of adjustable rateloans is attributed to the nature of recently funded real estate secured loans,in that many have a term of ten to fifteen years with a rate that is fixed fortwo to three years then adjusts with the movement of prime. Nearly all theadjustable rate loans are tied to changes in the prime rate. If interest rateschange, the yield on these loans and other loans renewing during the one-yeartime frame will also change. The Bank anticipates a 1.00% increase in the primerate would increase net interest income approximately $402,503 a year and a1.00% decrease in the prime rate would decrease net interest income byapproximately $428,128 a year.

 

The following table summarizes thecomposition of the loan portfolio as of December 31, 2002, 2001 and 2000:

 

**COMPOSITION OF LOAN PORTFOLIO**

 
|                                   |   | **2002**    |        | **2001**    |   | **2000**    |   |
|----------------------------------------|--------|-------------|-------------|-------------|--------|-------------|--------|
|                                   |   | **Amount**  |        | **Percent** |   | **Amount**  |   | **Percent** |   | **Amount** |   | **Percent** |   |
| Commercial, Financial and Agricultural |   | 40,373,350  |        | 21.20       | %      | 40,608,210  |   | 25.62 | % | 42,931,015 |   | 31.69 | % |
|                                   |   |        |        |        |   |        |   |   |   |   |   |   |   |
| Real Estate- Construction              |   | 40,722,838  |        | 21.38       | %      | 23,449,044  |   | 14.80 | % | 18,599,452 |   | 13.73 | % |
|                                   |   |        |        |        |   |        |   |   |   |   |   |   |   |
| Real Estate-Mortgage                   |   | 106,809,586 |        | 56.08       | %      | 90,823,606  |   | 57.31 | % | 70,550,560 |   | 52.07 | % |
|                                   |   |        |        |        |   |        |   |   |   |   |   |   |   |
| Installment Loans to Individuals       |   | 2,290,874   |        | 1.20        | %      | 3,171,805   |   | 2.00 | % | 3,246,214 |   | 2.40 | % |
|                                   |   |        |        |        |   |        |   |   |   |   |   |   |   |
| All Other Loans (including overdrafts) |   | 272,607     |        | 0.14        | %      | 419,622     |   | 0.27 | % | 160,779 |   | 0.12 | % |
|                                   |   |        |        |        |   |        |   |   |   |   |   |   |   |
| Total Loans, Gross                     |   | 190,469,255 |        | 100.00      | %      | 158,472,287 |   | 100.00 | % | 135,488,020 |   | 100.00 | % |
|                                   |   |        |        |        |   |        |   |   |   |   |   |   |   |
| Deferred Loan Fees                     |   | (821,668    | )           |        |   | (578,332    | )      |   |   | (487,473 | ) |   |   |
| Reserve for Possible Loan Losses       |   | (2,336,219  | )           |        |   | (1,744,070  | )      |   |   | (1,320,518 | ) |   |   |
|                                   |   |        |        |        |   |        |   |   |   |   |   |   |   |
| Total Loans, Net                       |   | $           | 187,311,368 |        |   |        | $      | 156,149,885 |   |   |   | $ | 133,680,029 |   |   |   |
|                                   |   |        |        |        |   |        |   |   |   |   |   |   |   |
| Loans Held For Sale                    |   | $           | 8,166,011   |        |   |        | $      | 4,082,200 |   |   |   | $ | 2,474,542 |   |   |   |

 

Total gross loans grew approximately $32million or 20.2% in 2002. For the twelve months ending December 31, 2002,commercial, financial and agriculture loans decreased by $.2 million or .6%, real estate-construction loans increased by$17.3 million or 73.7%, real estate-mortgage loans increased by $16 million or17.6% and installment loans to individuals decreased by $.9 million or 27.8%.

 

26

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The small decreasein commercial, financial and agricultural loans is attributed to early pay-offactivity in commercial loans and the refinance of several development loansthrough the Farmer Mac program for the agricultural loans. Early pay-offs forcommercial loans were driven by the low interest rate environment thatsignificantly increased competition for this type of credit. The Farmer Macprogram is a long-term mortgage product that offers low interest rates onproducing agricultural real estate. We continue to use this product to payoffour development loans and also to finance homes on acreage.

 

The large increasein real estate-construction loans can be attributed to several largeconstruction projects financed since the beginning of 2002. They include acondominium project in the amount of $5.3 million that will payoff as units aresold; an office building in the amount of nearly $4 million, a hotel for $4million and two medical offices totaling $3.3 million. Upon completion ofconstruction, office and hostelry loans are termed out with monthly principaland interest payments based on not more than 25 year amortizations.

 

The large increasein real estate-mortgage loans can be attributed to several of the constructionloans moving into amortizing loans, several new large hotel loans and toincreased loan activity in nearly all our offices with numerous loans in the$500-1,000,000 range.

 

Loans held forsale were $8.2 million and $4.1 million at December 31, 2002 and 2001,respectively. This represents an increase of $4.1 million or 100%. Typically,loans held for sale are sold within 30 to 40 days of funding.

 

The following are the approximate maturitiesand sensitivity to change in interest rates for the loan portfolio at December31, 2002:

 
| **Loan Category  (in thousands)**      |   | **Due Within  One Year** | ** ** | **After One  Year but  Within Five** | ** ** | **After  Five Years** | ** ** | **Total**   | ** ** |
|----------------------------------------|--------|--------------------------|------------|--------------------------------------|------------|-----------------------|------------|-------------|------------|
| Commercial, Fianacial and Agricultural |   | $                        | 22,961,971 |                                 | $          | 10,555,076            |       | $           | 6,856,303  |   | $ | 40,373,350 |   |
|                                   |   |                     |       |                                 |       |                  |       |        |       |
| Real Estate- Construction              |   | 26,490,860               |       | 11,185,389                           |       | 3,046,589             |       | 40,722,838  |       |
|                                   |   |                     |       |                                 |       |                  |       |        |       |
| Real Estate-Mortgage                   |   | 40,514,739               |       | 23,405,820                           |       | 42,889,027            |       | 106,809,586 |       |
|                                   |   |                     |       |                                 |       |                  |       |        |       |
| Installment Loans to Individuals       |   | 579,988                  |       | 1,302,255                            |       | 408,631               |       | 2,290,874   |       |
|                                   |   |                     |       |                                 |       |                  |       |        |       |
| All Other Loans (including overdrafts) |   | 272,607                  |       | —                               |       | —                |       | 272,607     |       |
|                                   |   |                     |       |                                 |       |                  |       |        |       |
| Totals                                 |   | $                        | 90,820,165 |                                 | $          | 46,448,540            |       | $           | 53,200,550 |   | $ | 190,469,255 |   |
|                                   |   |                     |       |                                 |       |                  |       |        |       |
| Interest Rate Provision:               |   |                     |       |                                 |       |                  |       |        |       |
| Predetermined Rates                    |   | $                        | 34,576,803 |                                 | $          | 21,767,535            |       | $           | 52,688,377 |   | $ | 109,032,715 |   |
|                                   |   |                     |       |                                 |       |                  |       |        |       |
| Floating or Adjustable Rates           |   | 56,243,362               |       | 24,681,005                           |       | 512,173               |       | 81,436,540  |       |
|                                   |   |                     |       |                                 |       |                  |       |        |       |
| Totals                                 |   | $                        | 90,820,165 |                                 | $          | 46,448,540            |       | $           | 53,200,550 |   | $ | 190,469,255 |   |

 

Risk Elements:

 

Risk elements on loans are presented in thefollowing table for December 31:

 
|                                                                           |   | **2002**  |      | **2001**  |   | **2000**  |   |
|--------------------------------------------------------------------------------|--------|-----------|-----------|-----------|--------|-----------|--------|
| Non-Accrual Loans (Impaired Loans)                                             |   | $         | 1,345,755 |      | $      | 1,494,602 |   | $ | 991,230 |   |
| Accruing Loans Past Due 90 Days                                                |   | 0         |      | 0         |   | 0         |   |
| Restructured Loans                                                             |   | 1,197,730 |      | 1,309,538 |   | 194,914   |   |
| Interest Excluded on Non-Accrual Loans                                         |   | 134,506   |      | 195,826   |   | 115,603   |   |
| Interest Recognized on Non-Accrual Loans and Troubled Debt  Restructured Loans |   | 312,950   |      | 16,704    |   | 85,806    |   |
|                                                                                |        |           |           |           |        |           |        |  |  |  |

 

At December 31, 2002, the Bank had no foreignloans outstanding.  The Bank did nothave any concentrations of loans except as disclosed above.

 

The Banks management is responsible formonitoring loan performance that is done through various methods, including areview of loan delinquencies and personal knowledge of customers.  Additionally, the Bank, maintains both

 

27

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a “watch” list of loans that, for a varietyof reasons, management believes requires regular review as well as an internalloan classification process. Semi-annually, the loan portfolio is also reviewedby an experienced, outside loan reviewer not affiliated with the Bank.  A list of delinquencies, the watch list,loan grades and the outside loan review are reviewed regularly by the Board ofDirectors.  Except as set forth in thepreceding table, there are no loans which management has serious doubts as tothe borrowers ability to comply with present loan repayment terms.

 

The Bank has a non-accrual policy thatrequires a loan greater than 90 days past due to be placed on non-accrualstatus unless such loan is well-collateralized and in the process ofcollection.  When loans are placed onnon-accrual status, all uncollected interest accrued is reversed fromearnings.  Once on non-accrual status,interest on a loan is only recognized on a cash basis.  Loans may be returned to accrual status ifmanagement believes that all remaining principal and interest is fullycollectible and there has been at least six months of sustained repayment performancesince the loan was placed on non-accrual.

 

If a loans credit quality deteriorates tothe point that collection of principal is believed by management to be doubtfuland the value of collateral securing the obligation is sufficient the Bankgenerally takes steps to protect and liquidate the collateral.  Any loss resulting from the differencebetween the loan balance and the fair market value of the property isrecognized by a charge to the reserve for loan losses.  When the property is held for sale afterforeclosure, it is subject to a periodic appraisal.  If the appraisal indicates that the property will sell for lessthan its recorded value, the Bank recognizes the loss by a charge tonon-interest expense.

 

**Total Cashand Due from Banks**

 

Total cash and due from banks were$23,513,531 and $14,398,048 at December 31, 2002 and 2001, respectively.               This line item will varydepending on cash letters from the previous night and actual cash on hand inthe branches. The balance in the Fed account had a closing balance of $10.7million to meet the target for Reserve Requirements.

 

##### **Investment Securities and Other Earning Assets**

 

Other earning assets are comprised ofFederal Home Loan Bank stock, Federal Funds sold (funds lent on a short-termbasis to other banks), investments in securities and short-term interestbearing deposits at other financial institutions.  These assets are maintained for liquidity needs of the Bank,collateralization of public deposits, and diversification of the earning assetmix.

 

Other earning assets were $104.9 million and$28.4 million at December 31, 2002 and 2001, respectively. This represents anincrease of approximately $76.5 million or 269.4%.

 

The Companymanages its securities portfolio to provide a source of both liquidity andearnings. The Bank has an asset/liability committee that develops currentinvestment policies based upon its operating needs and market circumstance. TheBank’s investment policy is formally reviewed and approved annually by itsboard of directors. The asset/liability committee of the Bank is responsiblefor reporting and monitoring compliance with the investment policy. Reports areprovided to the Bank’s board of directors on a regular basis.

 

Securitiesavailable-for-sale are carried at fair value, with related unrealized net gainsor losses, net of deferred income taxes, recorded as an adjustment to equitycapital. As of December 31, 2002, net unrealized gains increased $717,195 froman unrealized loss of $154,836 at December 31, 2001 to an unrealized gain of$562,359.

 

Securitiesavailable-for-sale increased to $65.4 million at December 31, 2002 from $22.0million at December 31, 2001. This represents an increase of $43.4 million or197.3%. As the result ofthe issuance of $8.0 million in trust preferred securities, in April 2002, theCompany down-streamed $5.2 million to the Bank in the form of Tier I Capital.This enabled the Bank to implement an investment strategy whereby the Bankborrowed $38 million from the Federal Home Loan Bank (FHLB) and purchasedapproximately $40 million in investment securities. The purchased investmentsecurities serve as collateral for the borrowing. The Bank made this decisionknowing that it would improve the return on average equity by increasing thenet interest income in absolute terms even though it would reduce the return onaverage assets and the net interest margin as a percentage. Prior to investing,the Bank performed extensive due diligence in assessing the interest rate andmarket value risk of this strategy including the performance in variousinterest rate scenarios of up and down 100, 200 and 300 basis points. In regardto this strategy, Management believes that a 300 basis points variances wouldnot have a material effect on the overall interest rate and market value riskto the Company.

 

At December 31, 2002, available-for-salesecurities in the portfolio included obligations of state and politicalsubdivisions, obligations of US government agencies and corporations andmortgaged backed securities issued by various agencies.

 

28

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All fixed and adjustable rate mortgage poolscontain a certain amount of risk related to the uncertainty of prepayments ofthe underlying mortgages. Interest rate changes have a direct impact uponprepayment rates. The Bank uses computer simulation models to test the averagelife, duration, market volatility and yield volatility of adjustable ratemortgage pools under various interest rate assumptions to monitor volatility.Stress tests are performed quarterly.

 

The following table summarizes thecomposition of other earning assets at December 31:

 

**COMPOSITION OF OTHER EARNING ASSETS**

 
|                                      |   | **2002**   |        | **2001**    |   | **2000**   |   |
|-------------------------------------------|--------|------------|-------------|-------------|--------|------------|--------|
|                                      |   | **Amount** |        | **Percent** |   | **Amount** |   | **Percent** |   | **Amount** |   | **Percent** |   |
| Federal Home Loan Bank and other          |   | $          | 1,950,900   |        | 1.86   | %          | $      | 228,300 |   | 0.81 | % | $ | 381,600 |   | 1.78 | % |
|                                      |   |       |        |        |   |       |   |   |   |   |   |   |   |
| Available-for-Sale Investments            |   | 65,396,494 |        | 62.35       | %      | 22,028,996 |   | 77.69 | % | 16,212,505 |   | 75.79 | % |
|                                      |   |       |        |        |   |       |   |   |   |   |   |   |   |
| Federal Funds Sold                        |   | 37,040,000 |        | 35.32       | %      | 6,000,000  |   | 21.16 | % | 4,600,000 |   | 21.50 | % |
|                                      |   |       |        |        |   |       |   |   |   |   |   |   |   |
| Interest Bearing Deposits other fin inst. |   | 497,000    |        | 0.47        | %      | 99,000     |   | 0.35 | % | 198,000 |   | 0.93 | % |
|                                      |   |       |        |        |   |       |   |   |   |   |   |   |   |
| Total Other Earning Assets                |   | $          | 104,884,394 |        | 100.00 | %          | $      | 28,356,296 |   | 100.00 | % | $ | 21,392,105 |   | 100.00 | % |

 

The Amortized cost, fair value, andmaturites at December 31, 2002 are as follows:

 
|                                   |   | **Securities Available-for-Sale** |       |
|----------------------------------------|--------|-----------------------------------|------------|
|                                   |   | **Amortized  Cost**               |       | **Fair  Value** |   |
| Due in One Year or Less                |   | $                                 | 36,608     |   | $ | 36,685 |   |
|                                   |   |                              |       |   |   |
| Due after One Year through Five Years  |   | 1,784,190                         |       | 1,853,369 |   |
|                                   |   |                              |       |   |   |
| Due after Five Years through Ten Years |   | 4,315,044                         |       | 4,345,339 |   |
|                                   |   |                              |       |   |   |
| Due after Ten Years                    |   | 3,842,991                         |       | 3,907,076 |   |
|                                   |   |                              |       |   |   |
| Mortgage-backed Securities             |   | 54,480,395                        |       | 55,254,025 |   |
|                                   |   |                              |       |   |   |
| Total                                  |   | $                                 | 64,459,228 |   | $ | 65,396,494 |   |

 

##### **Deposits and Borrowed Funds**

 

Total depositswere approximately $264.2 million at December 31, 2002 compared to $195.6million at December 31, 2001. This represents an increase of $68.6 million or35.1%. Approximately$32.1 million or 46.7% of deposit growth is the result of increased demanddeposits held by three, long time customers of the Bank that engage in mortgagerelated activities. One of the relationships added additional account locationsduring the year that accounts for approximately $7 million of the increase.These volatile account relationships are included in the volatile liabilitydependency report that the Bank produces on a monthly basis. Management and theBoard of Directors of the Bank are keenly aware that if and when the mortgagemarket conditions change, these relationships will be impacted. This is theprimary reason for the large balances maintained in over night investing inFederal Funds Sold.

 

In August 2002, the Bank began to offer apersonal insured money market account with the intent to raise deposits thatotherwise generally reside in non-financial investment companies. The Bankoffered a competitive introductory rate and was successful in procuringapproximately $33.3 million in deposits by December 31, 2002.  The Bank believes that the declining returnsin the stock market in general are creating a “flight to safety” to FDICinsured deposits.  Time deposits of>$100,000 increased by approximately $1.0 million or 13.5%. However, time

 

29

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deposits of <$100,000 decreased byapproximately $5.1 million or 12.2%. The decrease in this category is due inpart to maturities during the year of higher rate time deposits that did notrenew at the lower rates. With increased liquidity as the result of non timedeposit growth, time deposits were priced such that Management was aware thatthese balances would decrease. In addition to this, management believes thatthere was some migration into the personal insured money market account duringthe final five months of 2002, however, the amount was not available toquantify.

Core deposits(time deposits less than $100,000, demand, and savings) gathered in the localcommunities served by the Bank continue to be the Bank’s primary source offunds for loans and investments.  Coredeposits of $219.1 million represented 82.9% of total deposits at December 31,2002. The Company does not purchase funds through deposit brokers.

 

At December 31,2001, the Company had a $1.9 million loan with Pacific Coast Bankers Bank thatwas paid in full upon the issuance of the trust preferred securities in April2002.

 

TheBank has established borrowing lines with the Federal Home Loan Bank (FHLB) ofapproximately $1.6 million and $37.1 million secured by loans and securities,respectively. At December 31, 2002, the Bank had borrowings of $38 millionagainst those lines. The $38 million borrowing consists of $9.5 millionmaturing in April 2003 and 2004 and $19 million maturing in April 2005.

 

TheBank utilizes securities sold under repurchase agreements as a source offunds.  The Bank had $257,737 insecurities sold under repurchase agreements at December 31, 2002 compared to$137,293 at December 31, 2001.

 

The following table sets forth informationfor the last two fiscal years regarding the composition of deposits at December31, and the average rates paid on each of these categories:

 

**COMPOSITION OF DEPOSITS**

 
|                        |   | **2002**    |        | **2001**               |       | **2000**    |       |
|-----------------------------|--------|-------------|-------------|------------------------|------------|-------------|------------|
|                        |   | **Balance** |        | **Average  Rate Paid** | ** ** | **Balance** | ** ** | **Average  Rate Paid** | ** ** | **Balance** | ** ** | **Average  Rate Paid** | ** ** |
| Non-Interest Bearing Demand |   | $           | 106,556,079 |                   | 0.00       | %           | $          | 69,824,137 |   | 0.00 | % | $ | 51,821,234 |   | 0.00 | % |
|                        |   |        |        |                   |       |        |       |   |   |   |   |   |   |
| Interest Bearing Demand     |   | 44,338,284  |        | 0.46                   | %          | 47,668,327  |       | 1.15 | % | 39,711,917 |   | 2.16 | % |
|                        |   |        |        |                   |       |        |       |   |   |   |   |   |   |
| Savings                     |   | 18,772,846  |        | 0.24                   | %          | 18,602,720  |       | 1.01 | % | 14,133,471 |   | 2.19 | % |
|                        |   |        |        |                   |       |        |       |   |   |   |   |   |   |
| Money Market                |   | 49,456,726  |        | 1.94                   | %          | 10,293,162  |       | 2.21 | % | 9,870,541 |   | 3.81 | % |
|                        |   |        |        |                   |       |        |       |   |   |   |   |   |   |
| Time Deposits               |   | 45,054,670  |        | 2.77                   | %          | 49,196,419  |       | 4.82 | % | 52,159,727 |   | 5.50 | % |
|                        |   |        |        |                   |       |        |       |   |   |   |   |   |   |
| Total Deposits              |   | $           | 264,178,605 |                   | 0.92       | %           | $          | 195,584,765 |   | 2.65 | % | $ | 167,696,890 |   | 3.75 | % |

 

Set forth is a maturity schedule of domestictime certificates of deposit of $100,000 and over at December 31, 2002:

 

**TIMEDEPOSITS $100,000 AND OVER:**

(dollars in thousands)

 
| Less than 3 months |   | $      | 3,512  |   |
|--------------------|--------|--------|--------|--------|
| 3 to 12 months     |   | 3,119  |   |
| Over 1 year        |   | 2,030  |   |
|               |   |   |   |
| Total              |   | $      | 8,661  |   |

 

**Capital**

 

The Company’s total stockholders equity was$19,813,470 at December 31, 2002 compared to $15,876,781 at December 31,2001.  The increase in capital during2002 was due to net income of $2,739,220, $6,405 cash paid to stockholders in lieu of fractional shares on a 5%stock dividend paid March 29, 2002, stock options exercised in the amount of $486,679and an increase in accumulated other comprehensive income of $717,195.

 

30

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In April 2002, the Company completed itsoffering of trust preferred securities in the amount of $8.0 million. Thesecurities were issued by a special purpose business trust formed by theCompany and were sold to a pooled investment vehicle sponsored by SandlerO’Neill & Partners, L.P. and Salomon Smith Barney Inc. in a privatetransaction. The securities were sold pursuant to an applicable exemption fromregistration under the Securities Act of 1933, as amended (the “Act”), and havenot been registered under the Act. Sandler O’Neill assisted the Company in the placement of the trustpreferred securities. The securities may not be offered or sold in the UnitedStates absent registration or an applicable exemption from registrationrequirements.

 

The $8.0 million in trust preferredsecurities have a floating rate of interest, which is reset semi-annually,equal to 6-month LIBOR plus 3.70%.  Thefloating rate, however, may not exceed 11.0% for the first five years.

 

The Company is reflecting the trustpreferred securities as financing debt on its consolidated balance sheet.

 

If the Company elects to defer interestpayments pursuant to terms of the agreement, then the Company may not (i)declare or pay any dividends or distributions on, or redeem, purchase, acquireor make a liquidation payment with respect to any of the Company’s capitalstock, or (ii) make any payment of principal of or premium, if any, or intereston or repay, repurchase or redeem any debt securities of the Company that rankpari passu with or junior in interest to the Debt Securities, **other than,**among other items**,**a dividend in the form of stock,warrants, options or other rights in the same stock as that on which thedividend is being paid or ranks pari passu with or junior to such stock. Theprohibition on payment of dividends and payments on pari passu or junior debtalso applies in the case of an event of default under the agreements.

 

TheCompany used the proceeds from the sale of the securities for general corporatepurposes, including the repayment of outstanding indebtedness of $1.9 millionon April 11, 2002 and capital contributions to the Bank for future growth.

 

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

 

OnJuly 19, 2002, the Board of Directors of the Company declared a two for one (2for 1) stock split.  The record date forthe stock split was August 2, 2002 and the pay date was August 15, 2002.  Holders of shares of common stock ofHeritage Oaks Bancorp were issued one additional share of common stock for eachshare of common owned on the record date of August 2, 2002.

 

A Press Release was issued on July 19, 2002.

 

Capital ratios for commercial banks in theUnited States are generally calculated using three different formulas.  These calculations are referred to as the“Leverage Ratio” and two “risk based” calculations known as: “Tier One RiskBased Capital Ratio” and the “Total Risk Based Capital Ratio.” These standardswere developed through joint efforts of banking authorities from 12 differentcountries around the world.  Thestandards essentially take into account the fact that different types of assetshave different levels of risk associated with them.  Furthermore, they take into account the off-balance sheetexposures of banks when assessing capital adequacy.

 

The Leverage Ratio calculation simplydivides common stockholders’ equity (reduced by any goodwill a bank may have)by the total assets of the bank.  In theTier One Risk Based Capital Ratio, the numerator is the same as the leverageratio, but the denominator is the total “risk-weighted assets” of thebank.  Risk weighted assets aredetermined by segregating all the assets and off balance sheet exposures intodifferent risk categories and weighting them by a percentage ranging from 0%(lowest risk) to 100% (highest risk). The Total Risk Based Capital Ratio again uses “risk-weighted assets” inthe denominator, but expands the numerator to include other capital itemsbesides equity such as a limited amount of the loan loss reserve, long-termcapital debt, preferred stock and other instruments.

 

Summarized below are the Bank’s andCompany’s capital ratios at December 31, 2002.

 
|                 |   | **Minimum  Regulatory  Capital Requirements** |   | **Heritage  Oaks Bank** | ** ** | **Heritage  Oaks Bancorp** | ** ** |
|----------------------|--------|-----------------------------------------------|--------|-------------------------|------------|----------------------------|------------|
|                 |   |                                          |   |                    |       |                       |       |
| Leverage Ratio       |   | 4.00                                          | %      | 7.53                    | %          | 7.66                       | %          |
| Tier I Risk Weighted |   | 4.00                                          | %      | 11.00                   | %          | 11.19                      | %          |
| Total Risk Based     |   | 8.00                                          | %      | 12.06                   | %          | 13.00                      | %          |

 

31

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For the Company, approximately $6.3 millionand $1.7 million of the trust preferred securities are accounted for as Tier Iand Tier II Capital, respectively, for purposes of calculating RegulatoryCapital.

 

**Liquidity**

 

The objective of liquidity management is toensure the continuous availability of funds to meet the demands of depositors,investors and borrowers.  Assetliquidity is primarily derived from loan payments and the maturity of otherearning assets.  Liquidity fromliabilities is obtained primarily from the receipt of new deposits.  The Bank’s Asset Liability Committee (ALCO)is responsible for managing the on-and off-balance sheet commitments to meetthe needs of customers while achieving the Bank’s financial objectives.  ALCO meets regularly to assess the projectedfunding requirements by reviewing historical funding patterns, current andforecasted economic 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 $5,000,000. As of December 31,2002, the Bankhad no borrowings against credit arrangements with these correspondent banks.The Bank became a member of the Federal Home Loan Bank (FHLB) in July 1999. Asof December 31,2002, the Bank had borrowings of $38 million with no other fundsavailable for borrowing without pledging additional collateral.

 

The Bank manages its liquidity bymaintaining a majority of its investment portfolio in federal funds sold andother liquid investments.  At December31, 2002, the ratio of liquid assets not pledged for collateral and otherpurposes to deposits and other liabilities was 20.8% compared to 19.6% in 2001.The ratio of net loans to deposits, another key liquidity ratio, was 70.9% atyear-end 2002 compared to 79.8% at December 31, 2001.

 

**Inflation**

 

The assets and liabilities of a financialinstitution are primarily monetary in nature. As such they represent obligations to pay or receive fixed anddeterminable amounts of money that are not affected by future changes inprices.  Generally, the impact ofinflation on a financial institution is reflected by fluctuations in interestrates, the ability of customers to repay debt and upward pressure on operatingexpenses.  The effect on inflationduring the three-year period ended December 31, 2002 has been significant tothe Bank’s financial position or results of operations in regard to fluctuationin interest rates creating narrowing net interest margins. However, inflationhas not been a factor in the customers ability to repay debt or in upwardpressure on operation expenses.

 

**RecentAccounting Developments**

 

OnJuly 20, 2001, the FASB issued SFAS No. 141 “Business Combinations”(“SFAS No.141”), requiring that all business combinations within the scope of thestatement be accounted for using the purchase method. Previously, thepooling-of-interests method was required whenever certain criteria were met.Because those criteria did not distinguish economically dissimilartransactions, similar business combinations were accounted for using differentmethods that produced dramatically different financial statement results. SFASNo. 141 requires separate recognition of intangible assets apart from goodwillif they meet one of two criteria, the contractual-legal criterion or theseparability criterion. SFAS No. 141 also requires the disclosure of theprimary reasons for a business combination and the allocation of the purchase pricepaid to the assets acquired and liabilities assumed by major balance sheetcaption.

 

Theprovisions of SFAS No. 141 apply to all business combinations initiated afterJune 30, 2001. SFAS No. 141 also applies to all business combinations accountedfor using the purchase method for which the date of acquisition is July 1, 2001or later.

 

Asa portion of our business strategy is to pursue acquisition opportunities so asto expand our market presence and maintain growth levels, the change inaccounting could have an impact on our ability to realize those businessstrategies.

 

Managementbelieves that this accounting change will not have an impact on the existingcore deposit intangible created as the result of the acquisition of branchesfrom Westamerica Bank.

 

On July 20, 2001, the FASB also issued SFASNo. 142 “Goodwill and Other Intangible Assets” (“SFAS No. 142”). It addressedhow intangible assets that are acquired individually or within a group ofassets should be accounted

 

32

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for in the financial statements upon theiracquisition. SFAS No. 142 adopts a more aggregate view of goodwill and basesthe accounting on the units of the combined entity into which an acquiredentity is aggregated. SFAS No. 142 also prescribes that goodwill and intangibleassets that have indefinite useful lives will not be amortized but rathertested at least annually for impairment. Intangible assets that have definitelives will continue to be amortized over their useful lives, but no longer withthe constraint of the 40 year ceiling. SFAS No. 142 provides specific guidancefor the testing of goodwill for impairment which may require re-measurement ofthe fair value of the reporting unit. Additional ongoing financial statement disclosuresare also required.

 

The provisions of the statement must beapplied starting at the beginning of the first fiscal year beginning afterDecember 15, 2001. For the Company, that means as of January 1, 2002. Theprinciples of SFAS No. 142 must be applied to all goodwill and other intangibleassets recognized in the financials at that date. Impairment losses are to bereported as resulting from a change in accounting principle.

 

Management believes that this accountingchange will not have an impact on the existing core deposit intangible createdas the result of the acquisition of the branches from Westamerica Bank.

 

SECStaff Accounting Bulletin No. 102 “Selected Loan Loss Allowance Methodology andDocumentation Issues” (“SAB No. 102”) was released on July 10, 2001. Itexpresses certain of the staff’s views on the development, documentation andapplication of a systematic methodology as required by Financial ReportingRelease No. 28, Accounting for Loan Losses by Registrants Engaged in LendingActivities, for determining allowances for loan and lease losses in accordancewith generally accepted accounting principles. In particular, SAB No. 102focuses on the documentation the staff normally would expect registrants toprepare and maintain in support of their allowances for loan losses. We have asystematic methodology for determining an appropriate allowance for loanlosses, consistently followed and supported by written documentation andpolicies and procedures. In light of SAB No. 102, however, our methodology anddocumentation is currently in the process of review. Any resulting changes arenot expected to have a material impact on the financial statements.

 

Thisdiscussion should be read in conjunction with the consolidated financialstatements of the Company, including the notes thereto, appearing elsewhere inthis report.

 

33

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**ITEM 7.  FINANCIALSTATEMENTS**

 

**HERITAGE OAKSBANCORP AND SUBSIDIARIES**

 

**DECEMBER 31, 2002, 2001, AND 2000**

 

**Contents**

 
| **Independent Auditors’  Report**          |
|-------------------------------------------------|
|                                            |   |
| **Financial  Statements**                       |
|                                            |   |
|                                            | Consolidated  Balance Sheets  December 31, 2002 and 2001 |
|                                            |   |
|                                            | Consolidated Statements  of Income  For the Years Ended December 31, 2002, 2001, and 2000 |
|                                            |   |
|                                            | Consolidated  Statement of Changes in Stockholders’ Equity  For the Years Ended December 31, 2002, 2001, and 2000 |
|                                            |   |
|                                            | Consolidated  Statements of Cash Flows  For the Years Ended December 31, 2002, 2001, and 2000 |
|                                            |   |
| **Notes to  Consolidated Financial Statements** |

 

34

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**IndependentAuditors’ Report**

 

Board of Directors and Stockholders

Heritage Oaks Bancorp and Subsidiaries

Paso Robles, California

 

We have audited the accompanying consolidated balance sheets ofHeritage Oaks Bancorp and Subsidiaries as of December 31, 2002 and 2001, andthe related consolidated statements of income and changes in stockholders’equity and statements of cash flows for each of the three years in the periodended December 31, 2002.  Theseconsolidated financial statements are the responsibility of the Company’smanagement.  Our responsibility is toexpress an opinion on these consolidated financial statements based on ouraudits.

 

We conducted our audits in accordance with auditing standards generallyaccepted in the United States of America. Those standards require that we plan and perform the audits to obtainreasonable assurance about whether the consolidated financial statements arefree of material misstatement.  An auditincludes examining, on a test basis, evidence supporting the amounts and disclosuresin the consolidated financial statements. An audit also includes assessing the accounting principles used andsignificant estimates made by management, as well as evaluating the overallconsolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to abovepresent fairly, in all material respects, the financial position of HeritageOaks Bancorp as of December 31, 2002 and 2001, the results of their operationsand changes in their stockholders’ equity and their cash flows for each of thethree years in the period ended December 31, 2002, in conformity withaccounting principles generally accepted in the United States of America.

 

 
| /s/ Vavrinek, Trine, Day & Co. |   |
|------------------------------------|--------|
| Rancho Cucamonga, California       |
| January 10, 2003                   |

 

35

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##### **HERITAGE OAKS BANCORP ANDSUBSIDIARIES**

**CONSOLIDATEDBALANCE SHEETS**

**DECEMBER 31, 2002 AND 2001**

 
|                                                                                                                                             |   | **2002**    |        | **2001**    |       |
|--------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------|-------------|-------------|------------|
|                                                                                                                                             |   |        |        |        |       |
| **Assets**                                                                                                                                       |   |        |        |        |       |
| Cash and due from banks                                                                                                                          |   | $           | 23,513,631  |        | $          | 14,398,048 |   |
| Federal funds sold                                                                                                                               |   | 37,040,000  |        | 6,000,000   |       |
| Total Cash and Cash Equivalents                                                                                                                  |   | 60,553,631  |        | 20,398,048  |       |
| Interest-bearing deposits in other financial institutions                                                                                        |   | 497,000     |        | 99,000      |       |
| Investment securities Available-for-sale                                                                                                         |   | 65,396,494  |        | 22,028,996  |       |
| Federal Home Loan Bank Stock, at cost                                                                                                            |   | 1,950,900   |        | 228,300     |       |
| Loans held for sale                                                                                                                              |   | 8,166,011   |        | 4,082,200   |       |
| Loans, net of deferred fees and allowance for loan losses of  $3,157,887 and $2,322,402 at December 31, 2002 and 2001, respectively              |   | 187,311,368 |        | 156,149,885 |       |
| Property premises and equipment, net                                                                                                             |   | 4,542,591   |        | 3,620,769   |       |
| Net deferred tax asset                                                                                                                           |   | 1,170,783   |        | 1,257,991   |       |
| Cash surrender value of life insurance                                                                                                           |   | 5,415,500   |        | 5,143,613   |       |
| Intangible assets                                                                                                                                |   | 358,557     |        | 402,156     |       |
| Other assets                                                                                                                                     |   | 1,900,477   |        | 1,473,716   |       |
| Total Assets                                                                                                                                     |   | $           | 337,263,312 |        | $          | 214,884,674 |   |
|                                                                                                                                             |   |        |        |        |       |
| **Liabilities  and Stockholders’ Equity**                                                                                                   |   |        | ** **  |        | ** ** |
|                                                                                                                                             |   |        | ** **  |        | ** ** |
| Liabilities                                                                                                                                      |   |        |        |        |       |
| Deposits                                                                                                                                         |   |        |        |        |       |
| Demand non-interest bearing                                                                                                                      |   | 106,556,079 |        | 69,824,137  |       |
| Savings, NOW and money market deposits                                                                                                           |   | 112,567,856 |        | 76,564,209  |       |
| Time deposits of $100,000 or more                                                                                                                |   | 8,154,256   |        | 7,181,312   |       |
| Time deposits under $100,000                                                                                                                     |   | 36,900,414  |        | 42,015,107  |       |
| Total Deposits                                                                                                                                   |   | 264,178,605 |        | 195,584,765 |       |
| FHLB advances and other borrowings                                                                                                               |   | 38,000,000  |        | —      |       |
| Securities sold under agreement to repurchase                                                                                                    |   | 257,737     |        | 137,293     |       |
| Notes payable                                                                                                                                    |   | —      |        | 1,894,811   |       |
| Company obligated preferred securities of subsidiary trust holding  floating rate junior subordinated deferrable interest debentures             |   | 8,000,000   |        | —      |       |
| Other liabilities                                                                                                                                |   | 7,013,500   |        | 1,391,024   |       |
| Total Liabilities                                                                                                                                |   | 317,449,842 |        | 199,007,893 |       |
|                                                                                                                                             |   |        |        |        |       |
| **COMMITMENTS AND CONTINGENCIES**(Note #14)                                                                                                      |   |        |        |        |       |
|                                                                                                                                             |   |        |        |        |       |
| Stockholders’ Equity                                                                                                                        |   |        |        |        |       |
| Common stock, no par value; 20,000,000 shares authorized; 2,785,533  and 2,725,056 shares issued and outstanding for 2002 and 2001, respectively |   | 9,703,022   |        | 7,535,495   |       |
| Retained earnings                                                                                                                                |   | 9,548,089   |        | 8,496,122   |       |
| Accumulated other comprehensive income                                                                                                           |   | 562,359     |        | (154,836    | )          |
| Total Stockholders’ Equity                                                                                                                  |   | 19,813,470  |        | 15,876,781  |       |
| Total Liabilities and Stockholders’ Equity                                                                                                  |   | $           | 337,263,312 |        | $          | 214,884,674 |   |

 

The accompanying notes are an integral part of these financialstatements.

 

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**HERITAGE OAKS BANCORP AND SUBSIDIARIES**

##### **CONSOLIDATED STATEMENTS OF INCOME**

**FOR THE YEARS ENDED DECEMBER 31, 2002, 2001, AND 2000**

 
|                                                           |   | **2002**   |       | **2001**   |   | **2000**   |   |
|----------------------------------------------------------------|--------|------------|------------|------------|--------|------------|--------|
| **Interest Income**                                            |   |       |       |       |   |       |   |
| Interest and fees on loans                                     |   | $          | 13,399,144 |       | $      | 13,280,255 |   | $ | 12,699,866 |   |
| Interest on Investment Securities                              |   |       |       |       |   |       |   |
| Obligations of U.S. Government Agencies                        |   | 1,872,111  |       | 500,701    |   | 669,617    |   |
| Obligations of State and Political Subdivisions                |   | 300,292    |       | 281,079    |   | 305,674    |   |
| Interest on time deposits with other banks                     |   | 9,009      |       | 16,202     |   | 18,805     |   |
| Interest on Federal funds sold                                 |   | 400,385    |       | 362,567    |   | 248,283    |   |
| Interest on other securities                                   |   | 54,576     |       | 20,549     |   | 26,680     |   |
| Total Interest Income                                          |   | 16,035,517 |       | 14,461,353 |   | 13,968,925 |   |
|                                                           |   |       |       |       |   |       |   |
| **Interest Expense**                                           |   |       |       |       |   |       |   |
| Interest on savings, NOW and money market deposits             |   | 779,070    |       | 963,797    |   | 1,376,114  |   |
| Interest on time deposits in denominations of $100,000 or more |   | 182,788    |       | 210,744    |   | 382,506    |   |
| Interest on time deposits under $100,000                       |   | 1,103,264  |       | 2,154,795  |   | 2,139,906  |   |
| Other                                                          |   | 1,426,147  |       | 100,804    |   | 232,096    |   |
| Total Interest Expense                                         |   | 3,491,269  |       | 3,430,140  |   | 4,130,622  |   |
| Net interest income before provision for possible loan losses  |   | 12,544,248 |       | 11,031,213 |   | 9,838,303  |   |
| Provision for Possible Loan Losses                             |   | 545,000    |       | 600,000    |   | 519,000    |   |
|                                                           |   | 11,999,248 |       | 10,431,213 |   | 9,319,303  |   |
| **Non-interest Income**                                        |   |       |       |       |   |       |   |
| Service charges on deposit accounts                            |   | 1,432,530  |       | 1,182,785  |   | 1,082,757  |   |
| Investment securities loss, net                                |   | (18,653    | )          | (1,606     | )      | (2,188     | )      |
| Other                                                          |   | 2,049,135  |       | 3,499,396  |   | 4,602,858  |   |
| Total Non-interest Income                                      |   | 3,463,012  |       | 4,680,575  |   | 5,683,427  |   |
| **Non-interest Expenses**                                      |   |       |       |       |   |       |   |
| Salaries and employee benefits                                 |   | 5,385,710  |       | 4,494,137  |   | 4,115,549  |   |
| Equipment expenses                                             |   | 710,890    |       | 879,202    |   | 908,859    |   |
| Occupancy expenses                                             |   | 955,120    |       | 828,003    |   | 799,535    |   |
| Other expenses                                                 |   | 4,021,852  |       | 5,184,794  |   | 5,691,580  |   |
| Total Non-interest Expenses                                    |   | 11,073,572 |       | 11,386,136 |   | 11,515,523 |   |
| Income Before Provision for Income Taxes                       |   | 4,388,688  |       | 3,725,652  |   | 3,487,207  |   |
| Provision for Income Taxes                                     |   | 1,649,468  |       | 1,379,369  |   | 1,243,187  |   |
| Net Income                                                     |   | $          | 2,739,220  |       | $      | 2,346,283  |   | $ | 2,244,020 |   |
|                                                           |   |       |       |       |   |       |   |
| Earnings Per Share                                             |   |       |       |       |   |       |   |
| Basic                                                          |   | $          | 0.99       |       | $      | 0.86       |   | $ | 0.84 |   |
| Diluted                                                        |   | $          | 0.91       |       | $      | 0.79       |   | $ | 0.78 |   |

 

The accompanying notes are an integral part of these financial statements.

 

37

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**HERITAGE OAKS BANCORP AND SUBSIDIARIES**

**CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY**

**FOR THE YEARS ENDED DECEMBER 31, 2002, 2001, AND 2000**

 
|                                                                         |   | **Common Stock** | ** ** | **Comprehensive  Income** | ** ** | **Retained  Earnings** | ** ** | **Accumulated  Other  Comprehensive  Income** |       | **Total  Stockholders’  Equity** | ** ** |
|------------------------------------------------------------------------------|--------|------------------|------------|---------------------------|------------|------------------------|------------|-----------------------------------------------|------------|---------------------------------------|------------|
| **Number of  Shares**                                                        |   | **Amount**       |
|                                                                         |   |             | ** ** |                      | ** ** |                   | ** ** |                                          | ** ** |                                  |       |   | ** ** |
| **Balance, January 1, 2000**                                                 |   | 1,144,282        |       | $                         | 5,288,179  |                   |       |                                          | $          | 5,912,823                             |       | $ | (658,840 | ) | $ | 10,542,162 |   |
| Exercise of stock options                                                    |   | 23,265           |       | 155,274                   |       |                   |       |                                          |       |                                  |       | 155,274 |   |
| Stock dividends paid - 5%                                                    |   | 57,452           |       | 861,780                   |       |                   |       | (861,780                                      | )          |                                  |       | — |   |
| Cash paid to stockholders in lieu of fractional shares on 5% stock  dividend |   |             |       |                      |       |                   |       | (3,923                                        | )          |                                  |       | (3,923 | ) |
| Comprehensive income                                                         |   |             |       |                      |       |                   |       |                                          |       |                                  |       |   |   |
| Net income                                                                   |   |             |       |                      |       | $                      | 2,244,020  |                                          | 2,244,020  |                                  |       |   | 2,244,020 |   |
| Unrealized security holding gains (net of $374,790 tax)                      |   |             |       |                      |       | 515,996                |       |                                          |       | 515,996                               |       | 515,996 |   |
| Less reclassification adjustments for losses (net of $780 tax)               |   |             |       |                      |       | 1,480                  |       |                                          |       | 1,480                                 |       | 1,480 |   |
| Total comprehensive income                                                   |   |             |       |                      |       | $                      | 2,761,496  |                                          |       |                                  |       |   |   |   |
| **Balance, December 31, 2000**                                               |   | 1,224,999        |       | 6,305,233                 |       |                   |       | 7,291,140                                     |       | (141,364                              | )          | 13,455,009 |   |
| Exercise of stock options                                                    |   | 11,442           |       | 93,641                    |       |                   |       |                                          |       |                                  |       | 93,641 |   |
| Stock dividends paid - 5%                                                    |   | 61,439           |       | 1,136,621                 |       |                   |       | (1,136,621                                    | )          |                                  |       | — |   |
| Cash paid to stockholders in lieu of fractional shares on 5% stock  dividend |   |             |       |                      |       |                   |       | (4,680                                        | )          |                                  |       | (4,680 | ) |
| Comprehensive income                                                         |   |             |       |                      |       |                   |       |                                          |       |                                  |       |   |   |
| Net income                                                                   |   |             |       |                      |       | 2,346,283              |       | 2,346,283                                     |       |                                  |       | 2,346,283 |   |
| Unrealized security holding losses (net of $9,579 tax)                       |   |             |       |                      |       | (14,483                | )          |                                          |       | (14,483                               | )          | (14,483 | ) |
| Less reclassification adjustments for losses (net of $595 tax)               |   |             |       |                      |       | 1,011                  |       |                                          |       | 1,011                                 |       | 1,011 |   |
| Total comprehensive income                                                   |   |             |       |                      |       | $                      | 2,332,811  |                                          |       |                                  |       |   |   |   |
| **Balance, December 31, 2001**                                               |   | 1,297,880        |       | 7,535,495                 |       |                   |       | 8,496,122                                     |       | (154,836                              | )          | 15,876,781 |   |
| Exercise of stock options                                                    |   | 60,477           |       | 486,679                   |       |                   |       |                                          |       |                                  |       | 486,679 |   |
| Stock dividends paid - 5%                                                    |   | 64,648           |       | 1,680,848                 |       |                   |       | (1,680,848                                    | )          |                                  |       | — |   |
| Cash paid to stockholders in lieu of fractional shares on 5% stock dividend  |   |             |       |                      |       |                   |       | (6,405                                        | )          |                                  |       | (6,405 | ) |
| Two-for-one stock split                                                      |   | 1,362,528        |       |                      |       |                   |       |                                          |       |                                  |       |   |   |
| Comprehensive income                                                         |   |             |       |                      |       |                   |       |                                          |       |                                  |       |   |   |
| Net income                                                                   |   |             |       |                      |       | 2,739,220              |       | 2,739,220                                     |       |                                  |       | 2,739,220 |   |
| Unrealized security holding gains (net of $470,670 tax)                      |   |             |       |                      |       | 706,003                |       |                                          |       | 706,003                               |       | 706,003 |   |
| Less reclassification adjustments for losses (net of $7,461 tax)             |   |             |       |                      |       | 11,192                 |       |                                          |       | 11,192                                |       | 11,192 |   |
| Total comprehensive income                                                   |   |             |       |                      |       | $                      | 3,456,415  |                                          |       |                                  |       |   |   |   |
| **Balance, December 31, 2002**                                               |   | 2,785,533        |       | $                         | 9,703,022  |                   |       |                                          | $          | 9,548,089                             |       | $ | 562,359 |   | $ | 19,813,470 |   |

 

The accompanying notes are an integral part of these financialstatements.

 

38

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**HERITAGEOAKS BANCORP AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**FOR THE YEARS ENDED DECEMBER 31, 2002, 2001, AND 2000**

** **
|                                                                                                |   | **2002**    |      | **2001**    |   | **2000**    |   |
|-----------------------------------------------------------------------------------------------------|--------|-------------|-----------|-------------|--------|-------------|--------|
| **Cash Flows from Operating Activities**                                                            |   |        |      |        |   |        |   |
| Net income                                                                                          |   | $           | 2,739,220 |        | $      | 2,346,283   |   | $ | 2,244,020 |   |
| Adjustments to reconcile net income to net cash provided by operating  activities                   |   |        |      |        |   |        |   |
| Net cash provided by operating activities                                                           |   |        |      |        |   |        |   |
| Depreciation and amortization                                                                       |   | 651,531     |      | 825,590     |   | 711,120     |   |
| Provision for possible loan losses                                                                  |   | 545,000     |      | 600,000     |   | 519,000     |   |
| Provision for possible losses on unfunded loan commitments                                          |   | 40,000      |      | —      |   | —      |   |
| Realized loss on sales of available-for-sale securities, net                                        |   | 18,653      |      | 1,606       |   | 2,188       |   |
| Amortization of premiums/discounts on investment securities, net                                    |   | 239,548     |      | (124,138    | )      | (148,180    | )      |
| Amortization of core deposit intangibles                                                            |   | 43,598      |      | 20,054      |   | 12,027      |   |
| Gain on sale of property, premises and equipment, net                                               |   | (211        | )         | (279,375    | )      | —      |   |
| Net increase in cash surrender value of life insurance                                              |   | (271,887    | )         | (124,064    | )      | (63,762     | )      |
| FHLB Dividends received                                                                             |   | (54,300     | )         | —      |   | —      |   |
| Increase in loans held for sale                                                                     |   | (4,083,811  | )         | (1,607,658  | )      | (2,354,160  | )      |
| Increase in deferred tax asset                                                                      |   | (390,922    | )         | (250,255    | )      | (205,339    | )      |
| (Increase)/decrease in other assets                                                                 |   | (383,162    | )         | 205,412     |   | (617,194    | )      |
| Increase/(decrease) in other liabilities                                                            |   | 5,538,878   |      | (515,156    | )      | 639,566     |   |
|                                                                                                |   |        |      |        |   |        |   |
| **NET CASH PROVIDED BY OPERATING ACTIVITIES**                                                       |   | 4,632,135   |      | 1,098,299   |   | 739,286     |   |
|                                                                                                |   |        |      |        |   |        |   |
| **Cash Flows From Investing Activities**                                                            |   |        |      |        |   |        |   |
| Purchase of securities available-for-sale                                                           |   | (3,337,276  | )         | —      |   | (4,838      | )      |
| Purchase of mortgage-backed securities available-for-sale                                           |   | (59,756,404 | )         | (10,174,446 | )      | —      |   |
| Purchase of Federal Home Loan Bank stock                                                            |   | (1,668,300  | )         | —      |   | —      |   |
| Proceeds from sales of securities available-for-sale                                                |   | —      |      | 714,000     |   | 1,011,512   |   |
| Proceeds from principal reductions and maturities of securities  available-for-sale                 |   | 26,000      |      | 1,138,087   |   | 933,726     |   |
| Proceeds from principal reductions and maturities of mortgage-backed  securities available-for-sale |   | 20,637,306  |      | 2,759,246   |   | 1,563,335   |   |
| Net change in interest bearing deposits in other financial  institutions                            |   | (398,000    | )         | 99,000      |   | 177,255     |   |
| Purchase of life insurance policies                                                                 |   | —      |      | (3,650,000  | )      | —      |   |
| Increase in cash due to acquisition                                                                 |   | —      |      | 23,086,675  |   | —      |   |
| Recoveries on loans previously written off                                                          |   | 128,554     |      | 4,284       |   | 19,422      |   |
| Increase in loans, net                                                                              |   | (31,835,037 | )         | (23,074,140 | )      | (31,792,259 | )      |
| Proceeds from sale of property, premises and equipment                                              |   | 6,989       |      | 720,509     |   | —      |   |
| Purchase of property, premises and equipment, net                                                   |   | (1,580,131  | )         | (349,869    | )      | (346,646    | )      |
|                                                                                                |   |        |      |        |   |        |   |
| **NET CASH USED IN INVESTING ACTIVITIES**                                                           |   | (77,776,299 | )         | (8,726,654  | )      | (28,438,493 | )      |
|                                                                                                     |        |             |           |             |        |             |        |  |  |  |

 
|                                                          |   | **2002**    |       | **2001**   | ** ** | **2000**   | ** ** |
|---------------------------------------------------------------|--------|-------------|------------|------------|------------|------------|------------|
| **Cash Flows From Financing Activities**                      |   |        |       |       |       |       |       |
| Increase in deposits, net                                     |   | $           | 68,593,840 |       | $          | 2,919,804  |       | $ | 34,735,317 |   |
| Net increase/(decrease) in FHLB borrowings                    |   | 38,000,000  |       | —     |       | —     |       |
| Proceeds from issuance of trust preferred securities          |   | 8,000,000   |       | —     |       | —     |       |
| Net (decrease)/increase in notes payable                      |   | (1,894,811  | )          | 844,811    |       | (1,511,000 | )          |
| Net increase in securities sold under agreement to repurchase |   | 120,444     |       | 137,293    |       | —     |       |
| Proceeds from exercise of stock options                       |   | 486,679     |       | 93,641     |       | 155,274    |       |
| Cash paid in lieu of fractional shares                        |   | (6,405      | )          | (4,680     | )          | (3,923     | )          |
|                                                          |   |        |       |       |       |       |       |
| **NET CASH PROVIDED BY FINANCING ACTIVITIES**                 |   | 113,299,747 |       | 3,990,869  |       | 33,375,668 |       |
|                                                          |   |        |       |       |       |       |       |
| **Net Increase/(Decrease) in Cash and Cash Equivalents**      |   | 40,155,583  |       | (3,637,486 | )          | 5,676,461  |       |
|                                                          |   |        |       |       |       |       |       |
| **Cash and Cash Equivalents**, Beginning of year              |   | 20,398,048  |       | 24,035,534 |       | 18,359,073 |       |
|                                                          |   |        |       |       |       |       |       |
| **Cash and Cash Equivalents**, End of year                    |   | $           | 60,553,631 |       | $          | 20,398,048 |       | $ | 24,035,534 |   |
|                                                          |   |        |       |       |       |       |       |
| **Supplemental Disclosures of Cash Flow Information**         |   |        |       |       |       |       |       |
| Interest paid                                                 |   | $           | 3,279,981  |       | $          | 3,960,156  |       | $ | 3,734,904 |   |
| Income taxes paid                                             |   | $           | 1,960,000  |       | $          | 1,432,000  |       | $ | 1,595,000 |   |
|                                                          |   |        |       |       |       |       |       |
| **Supplemental Disclosures of Non-Cash Flow Information**     |   |        |       |       |       |       |       |
| Change in other comprehensive income                          |   | $           | 717,195    |       | $          | (13,472    | )          | $ | 517,476 |   |

 

The accompanying notes are an integral part of these financialstatements.

 

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**HERITAGE OAKS BANCORP ANDSUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**DECEMBER 31, 2002, 2001, AND 2000**

 

### **Note #1- Summary of Significant Accounting Policies**

 

The accounting and reporting policies of Heritage Oaks Bancorp (theCompany) and subsidiaries conform to accounting principles generally acceptedin the United States of America and to general practices within the bankingindustry.  A summary of the Company’ssignificant accounting and reporting policies consistently applied in thepreparation of the accompanying financial statements follows:

 

## **A.**        Principles ofConsolidation

 

The consolidatedfinancial statements include the Company and its wholly owned subsidiaries,Heritage Oaks Bank, Heritage Oaks Capital Trust I and CCMS Systems, Inc.  Intercompany balances and transactions have beeneliminated.

 

## **B.**          Nature of Operations

 

The Company has beenorganized as a single operating segment. Prior to 2002, the Company was organized with two primary operatingsegments, which consisted of the Bank and the Bank’s Electronic Funds Transfer(EFT) Department.  The segments wereidentified as such based upon the percentage of operating net income,management responsibility, and the types of products and services offered.  The Bank operates nine branches within SanLuis Obispo and Santa Barbara counties. The Bank offers traditional banking products such as checking, savingsand certificates of deposit, as well as mortgage loans and commercial andconsumer loans to customers who are predominately small to medium-sizedbusinesses and individuals.  The EFTDepartment had installed automatic teller machines located in retail outletsand gaming facilities and point of sale machines located in retailoutlets.  During 2001, the Bank divestedall of its retail automated teller machines and all but two of its gamingautomated teller machines.  As ofDecember 31, 2002, the EFT Department had one remaining machine at a gamingfacility.  Income was based upon totalcustomer usage of the machines and the applicable transaction charge.

 

## **C.**          Use of Estimates in the Preparationof Financial Statements

 

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during thereporting period.  Actual results coulddiffer from those estimates.

 

Estimates that areparticularly susceptible to significant change relate to the determination ofthe allowance for loan losses on loans and the valuation of real estateacquired in connection with foreclosures or in satisfaction of loans.  In connection with the determination of theallowances for losses on loans and foreclosed real estate, management obtainsindependent appraisals for significant properties.

 

40

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While management usesavailable information to recognize losses on loans and foreclosed real estate,future additions to the allowances may be necessary based on changes in localeconomic conditions.  In addition,regulatory agencies, as an integral part of their examination process,periodically review the Company’s allowances for losses on loans and foreclosedreal estate.  Such agencies may requirethe Company to recognize additions to the allowances based on their judgmentsabout information available to them at the time of their examination.  Because of these factors, it is reasonablypossible that the allowances for losses on loans and foreclosed real estate maychange.

 

## **D.**         Cash and Due From Banks

 

Banking regulations requirethat all banks maintain a percentage of their deposits as reserves in cash or ondeposit with the Federal Reserve Bank. The Bank complied with the reserve requirements as of December 31, 2002.

 

The Company maintainsamounts due from banks that exceed federally insured limits.  The Company has not experienced any lossesin such accounts.

 

## **E.**           Cash and Cash Equivalents

 

For purposes of reportingcash flows, cash and cash equivalents include cash, due from banks and federalfunds sold.  Generally, federal fundsare sold for one-day periods.

 

## **F.**           Investment Securities andMortgage-backed Securities

 

In accordance withStatement of Financial Accounting Standards (SFAS) No. 115, “*Accounting for Certain Investments in Debt and EquitySecurities,*” which addresses the accounting for investments inequity securities that have readily determinable fair values and forinvestments in all debt securities. Securities and mortgage-backed securities are classified in threecategories and accounted for as follows: debt, equity, and mortgage-backed securities that the Company has thepositive intent and ability to hold to maturity are classified asheld-to-maturity and are measured at amortized cost; debt and equity securitiesbought and held principally for the purpose of selling in the near term areclassified as trading securities and are measured at fair value, withunrealized gains and losses included in earnings; debt and equity securitiesnot classified as either held-to-maturity or trading securities are deemed asavailable-for-sale and are measured at fair value, with unrealized gains andlosses, net of applicable taxes, reported in a separate component ofstockholders’ equity.  Gains or losseson sales of investment securities and mortgage-backed securities are determinedon the specific identification method. Premiums and discounts are amortized or accreted using the interestmethod over the expected lives of the related securities.

 

41

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## **G.**          Loans and Interest onLoans

 

Loans are stated atunpaid principal balances, less the allowance for loan losses and net deferredloan fees and unearned discounts.  TheCompany recognizes loan origination fees to the extent they representreimbursement for initial direct costs, as income at the time of loan boarding.  The excess of fees over costs, if any, isdeferred and credited to income over the term of the loan.

 

In accordance with SFASNo. 114, (as amended by SFAS No. 118), “*Accountingby Creditors for Impairment of a Loan,*” those loans identified as“impaired” are measured on the present value of expected future cash flows,discounted at the loan’s effective interest rate or the fair value of thecollateral if the loan is collateral dependent.  A loan is impaired when it is probable the creditor will not beable to collect all contractual principal and interest payments due inaccordance with the terms of the loan agreement.

 

Loans are placed onnonaccrual when a loan is specifically determined to be impaired or whenprincipal or interest is delinquent for 90 days or more.  Any unpaid interest previously accrued onthose loans is reversed from income. Interest income generally is not recognized on specific impaired loansunless the likelihood of further loss is remote.  Interest payments received on such loans are applied as areduction of the loan principal balance.

 

All loans on nonaccrualare measured for impairment.  TheCompany applies the measurement provision of SFAS No. 114 to all loans in itsportfolio.  All loans are generally chargedoff at such time the loan is classified as a loss.

 

## **H.**         Loans Held for Sale

 

Loans held for sale arecarried at the lower of aggregate cost or market value, which is determined bythe specified value in the commitments. Net unrealized losses, if any, are recognized through a valuation allowanceby charges to income.

 

## **I.**              Allowance for Loan Losses

 

The allowance for loanlosses is maintained at a level which, in management’s judgment, is adequate toabsorb credit losses inherent in the loan portfolio.  The amount of the allowance is based on management’s evaluationof the collectibility of the loan portfolio, including the nature of theportfolio, credit concentrations, trends in historical loss experience,specific impaired loans, and economic conditions.  Allowances for impaired loans are generally determined based oncollateral values or the present value of estimated cash flows.  The allowance is increased by a provisionfor loan losses, which is charged to expense and reduced by charge-offs, net ofrecoveries.  Changes in the allowancerelating to impaired loans are charged or credited to the provision for loanlosses.  Because of uncertaintiesinherent in the estimation process, management’s estimate of credit lossesinherent in the loan portfolio and the related allowance may change.

 

42

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## **J.**             Property, Premises andEquipment

 

Land is carried at cost. Premises and equipment are carried at cost less accumulated depreciationand amortization.  Depreciation iscomputed using the straight-line method over the estimated useful lives, whichranges from three to ten years for furniture and fixtures and forty years forbuildings.  Leasehold improvements areamortized using the straight-line method over the estimated useful lives of theimprovements of the remaining lease term, whichever is shorter.  Expenditures for betterments or majorrepairs are capitalized and those for ordinary repairs and maintenance arecharged to operations as incurred. Total depreciation expense for the reporting periods ending December 31,2002, 2001, and 2000 were approximately $652,000, $826,000, and $711,000,respectively.

 

## **K.**         Intangible Assets

 

Core deposit intangiblesrepresent the intangible value of depositor relationships resulting fromdeposit liabilities assumed in acquisitions. Core deposit intangibles are being amortized over ten years.  Intangibles are evaluated periodically forother than temporary impairment.  Shouldsuch an assessment indicate that the undiscounted value of an intangible may beimpaired, the net book value of the intangible would be written down to the netestimated recoverable value.

 

## **L.**           Income Taxes

 

Provisionsfor income taxes are based on amounts reported in the statements of income(after exclusion of non-taxable income such as interest on state and municipalsecurities) and include deferred taxes on temporary differences in therecognition of income and expense for tax and financial statementpurposes.  Deferred taxes are computedon the liability method as prescribed in SFAS No. 109, “Accounting for IncomeTaxes.”

 

## **M.**      Disclosure about Fair Value of Financial Instruments

 

SFAS No. 107 specifies the disclosure of the estimatedfair value of financial instruments. The Company’s estimated fair value amounts have been determined by theCompany using available market information and appropriate valuationmethodologies.

 

However, considerable judgment is required to developthe estimates of fair value. Accordingly, the estimates are not necessarily indicative of the amountsthe Company could have realized in a current market exchange.  The use of different market assumptionsand/or estimation methodologies may have a material effect on the estimatedfair value amounts.

 

Although management is not aware of any factors thatwould significantly affect the estimated fair value amounts, such amounts havenot been comprehensively revalued for purposes of these financial statementssince the balance sheet date and, therefore, current estimates of fair valuemay differ significantly from the amounts presented in the accompanying notes.

 

43

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## **N.**         Financial Instruments

 

In the ordinary course of business, the Company hasentered into off-balance sheet financial instruments consisting of comments toextend credit, commercial letters of credit, and standby letters of credit asdescribed in Note #21.  Such financialinstruments are recorded in the financial statements when they are funded orrelated fees are incurred or received.

## ** **

## **O.**         Comprehensive Income

 

## **Beginning in 1998, the Companyadopted SFAS No. 130, “*ReportingComprehensive Income*,*”*whichrequires the disclosure of comprehensive income and its components.  Changes in unrealized gain (loss) onavailable-for-sale securities net of income taxes is the only component ofaccumulated other comprehensive income for the Company.**

 

## **P.**           Accounting for HeritageOaks Capital Trust I

 

Heritage OaksCapital Trust I is a statutory business trust created for the exclusive purposeof issuing and selling Capital Securities and using the proceeds to acquire theFloating Rate Junior Subordinated Deferrable Interest debentures issued by theCompany.

 

For financialreporting purposes, Heritage Oaks Capital Trust I is treated as a subsidiary ofHeritage Oaks Bancorp and, accordingly, the accounts are included in the consolidatedfinancial statements of the Company. The Capital Securities are presented as a separate line item in theconsolidated balance sheet under the caption “Company Obligated Floating RateJunior Subordinated Deferrable Interest Debentures.”  For financial reporting purposes, the Company records thedividend distributions payable on the Trust Securities as interest expense inthe consolidated statement of income.

 

## **Q.**         Reclassifications

 

Certain amounts in the2001 and 2000 financial statements have been reclassified to conform to the2002 presentation.

 

## **R.**          Earnings Per Share (EPS)

 

Basic EPS excludesdilution and is computed by dividing income available to common stockholders bythe weighted-average number of common shares outstanding for the period.  Diluted EPS 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 shared in the earnings of the entity.

 

44

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## **S.**           Stock-Based Compensation

 

SFASNo. 123, *“Accountingfor Stock-Based Compensation,”* encourages, but does not require,companies to record compensation cost for stock-based employee compensationplans at fair value.  The Company haschosen to continue to account for stock-based compensation using the intrinsicvalue method prescribed in Accounting Principles Board (“APB”) Opinion No. 25, *“Accountingfor Stock Issued to Employees,”* and related Interpretations.  Accordingly, compensation cost for stockoptions is measured as the excess, if any, of the quoted market price of theCompany’s stock at the date of the grant over the amount an employee must payto acquire the stock.

 

Had compensation cost for the Company’s stock optionplans been determined based on the fair value at the grant dates for awardsunder those plans consistent with the method of SFAS No. 123, the Company’s netincome and earnings per share would have been reduced to the pro forma amount indicatedbelow:

 
|                                                                                            |   | **2002** |      | **2001** |   | **2000**  |   |
|-------------------------------------------------------------------------------------------------|--------|----------|-----------|----------|--------|-----------|--------|
| Net income:                                                                                     |   |     |      |     |   |      |   |
| As reported                                                                                     |   | $        | 2,739,220 |     | $      | 2,346,283 |   | $ | 2,244,020 |   |
| Stock-based compensation using the intrinsic value method                                       |   | —   |      | —   |   | —    |   |
| Stock-based compensation that would have been reported using the fair  value method of SFAS 123 |   | (111,518 | )         | (107,861 | )      | (94,984   | )      |
| Pro forma net income                                                                            |   | $        | 2,627,702 |     | $      | 2,238,422 |   | $ | 2,149,036 |   |
|                                                                                            |   |     |      |     |   |      |   |
| Basic earnings per share:                                                                       |   |     |      |     |   |      |   |
| As reported                                                                                     |   | $        | 0.99      |     | $      | 0.86      |   | $ | 0.84 |   |
| Pro forma                                                                                       |   | 0.95     |      | 0.82     |   | 0.80      |   |
|                                                                                            |   |     |      |     |   |      |   |
| Diluted earnings per share:                                                                     |   |     |      |     |   |      |   |
| As reported                                                                                     |   | $        | 0.91      |     | $      | 0.79      |   | $ | 0.78 |   |
| Pro forma                                                                                       |   | 0.87     |      | 0.76     |   | 0.75      |   |

 

## **T.**          New AccountingPronouncements

 

In August 2001, theFinancial Accounting Standards Board (“FASB”) issued SFAS No. 143, *“Accounting for Asset Retirement Obligations,”*which requires the Company to record the fair value of an asset retirementobligation as a liability in the period in which it incurs a legal obligationassociated with the retirement of long-term assets.  SFAS No. 143 is effective for the Company in 2003; however,management does not believe adoption will have a material impact on theCompany’s financial statements.

 

45

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### **Note #2- Investment Securities**

 

At December 31, 2002 and 2001, the investment securities portfolio wascomprised of securities classified as available-for-sale, in accordance withSFAS No. 115, resulting in investment securities available-for-sale beingcarried at fair value and investment securities held-to-maturity being carriedat cost, adjusted for amortization of premiums and accretions of discounts, andfair market value adjustments for securities transferred fromavailable-for-sale.

 

The amortized cost and fair values of investment securities available-for-saleat December 31, 2002, were:

 
|                                                     |   | **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               |       | —                       |       | —                        |       | 8,638          |       |
| Total                                                    |   | $                   | 64,459,228 |                         | $          | 1,026,249                     |       | $              | (88,983    | ) | $ | 65,396,494 |   |

 

The amortized cost and fair values of investment securitiesavailable-for-sale at December 31, 2001, were:

 
|                                                     |   | **Amortized  Cost** |       | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
|----------------------------------------------------------|--------|---------------------|------------|------------------------------|------------|-------------------------------|------------|----------------|------------|
| Obligations of U.S. Government agencies and corporations |   | $                   | 979,772    |                         | $          | —                        |       | $              | (35,199    | ) | $ | 944,573 |   |
| Mortgage-backed securities                               |   | 15,574,820          |       | 26,449                       |       | (222,406                      | )          | 15,378,863     |       |
| Obligations of state and political subdivisions          |   | 5,723,827           |       | 81,670                       |       | (108,575                      | )          | 5,696,922      |       |
| Other securities                                         |   | 8,638               |       | —                       |       | —                        |       | 8,638          |       |
| Total                                                    |   | $                   | 22,287,057 |                         | $          | 108,119                       |       | $              | (366,180   | ) | $ | 22,028,996 |   |

 

There were no investment securities held-to-maturity at December 31,2001 and December 31, 2002.

 

46

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The amortized cost and fair values of investment securities available-for-saleat December 31, 2002, by contractual maturity are shown below.  Actual maturities may differ fromcontractual maturities because borrowers may have the right to call or prepayobligations with or without call or prepayment penalties.

 
|                                   |   | **Securities  Available-for-Sale** |       |
|----------------------------------------|--------|------------------------------------|------------|
|                                   |   | **Amortized  Cost**                | ** ** | **Fair Value** |   |
| Due in one year or less                |   | $                                  | 36,608     |   | $ | 36,685 |   |
| Due after one year through five years  |   | 1,784,190                          |       | 1,853,369 |   |
| Due after five years through ten years |   | 4,315,044                          |       | 4,345,339 |   |
| Due after ten years                    |   | 3,842,991                          |       | 3,907,076 |   |
| Mortgage-backed securities             |   | 54,480,395                         |       | 55,254,025 |   |
| Total Securities                       |   | $                                  | 64,459,228 |   | $ | 65,396,494 |   |

 

Proceeds from sales, maturities and principal reductions of investmentsecurities available-for-sale during 2002, 2001, and 2000, were $26,000,$1,852,087, and $1,945,238, respectively. There were no gross gains or losses reported during 2002.  In 2001, gross gains and losses on thesesales were $286 and $1,892, respectively. In 2000, gross losses on these sales were $2,188; there were no grossgains.

 

Proceeds from sales and maturities and principal reductions ofmortgage-backed securities in 2002, 2001, and 2000, were $20,637,306,$2,759,246, and $1,563,335, respectively. In 2002, gross gains and losses on these sales were $1,250 and $19,903,respectively.  There were no gross gainsor losses on these sales during 2001 and 2000. Unrealized gains/(losses) on investment securities and mortgage-backedsecurities included in shareholders’ equity net of tax at December 31, 2002,2001, and 2000 were $562,359, ($154,836), and ($141,364), respectively.

 

Securities having a carrying value and a fair value of approximately$46,343,000 and $8,850,000 at December 31, 2002 and 2001, respectively, werepledged to secure public deposits and for other purposes as required by law.

 

47

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### **Note #3- Loans**

 

Major classifications of loans were:

 
|                                   |   | **2002**    |        | **2001**    |   |
|----------------------------------------|--------|-------------|-------------|-------------|--------|
| Commercial, financial and agricultural |   | $           | 40,373,350  |        | $      | 40,608,210 |   |
| Real Estate - construction             |   | 40,722,838  |        | 23,449,044  |   |
| Real Estate - mortgage                 |   | 106,809,586 |        | 90,823,606  |   |
| Installment loans to individuals       |   | 2,290,874   |        | 3,171,805   |   |
| All other loans (including overdrafts) |   | 272,607     |        | 419,622     |   |
|                                   |   | 190,469,255 |        | 158,472,287 |   |
| Less:  Deferred loan fees         |   | (821,668    | )           | (578,332    | )      |
| Less:  Allowance for loan  losses |   | (2,336,219  | )           | (1,744,070  | )      |
| Total Loans                            |   | $           | 187,311,368 |        | $      | 156,149,885 |   |
|                                   |   |        |        |        |   |
| Loans held for sale                    |   | $           | 8,166,011   |        | $      | 4,082,200 |   |

 

Concentration of Credit Risk

 

At December 31, 2002, approximately $147,532,424 ofthe Bank’s loan portfolio was collateralized by various forms of realestate.  Such loans are generally madeto borrowers located in San Luis Obispo County.  The Bank attempts to reduce its concentration of credit risk bymaking loans which are diversified by project type.  While management believes that the collateral presently securingthis portfolio is adequate, there can be no assurances that significantdeterioration in the California real estate market would not expose the Bank tosignificantly greater credit risk.

 

The following is a summary of the investment in impaired loans, therelated allowance for loan losses, and income recognized thereon as of December31:

 
|                                              |   | **2002** |      | **2001**  |   | **2000**  |   |
|---------------------------------------------------|--------|----------|-----------|-----------|--------|-----------|--------|
| Impaired loans with a valuation allowance         |   | $        | 1,325,755 |      | $      | 203,154   |   | $ | 905,313 |   |
| Impaired loans without a valuation allowance      |   | 20,000   |      | 1,291,448 |   | 85,917    |   |
| Total impaired loans                              |   | $        | 1,345,755 |      | $      | 1,494,602 |   | $ | 991,230 |   |
|                                              |   |     |      |      |   |      |   |
| Valuation allowance related to impaired loans     |   | $        | 724,549   |      | $      | 148,104   |   | $ | 314,633 |   |
|                                              |   |     |      |      |   |      |   |
| Average recorded investment in impaired loans     |   | $        | —    |      | $      | 842,631   |   | $ | 731,963 |   |
|                                              |   |     |      |      |   |      |   |
| Cash receipts applied to reduce principal balance |   | $        | 519,758   |      | $      | 317,000   |   | $ | 654,797 |   |
|                                              |   |     |      |      |   |      |   |
| Interest income recognized for cash payments      |   | $        | 312,950   |      | $      | —    |   | $ | — |   |

 

The provisions of SFAS No. 114 and SFAS No. 118 permit the valuationallowance reported above to be determined on a loan-by-loan basis or byaggregating loans with similar risk characteristics.  Because the loans currently identified as impaired have uniquerisk characteristics, the valuation allowance was determined on a loan-by-loanbasis.

 

48

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Nonaccruing loans totaled approximately $1,346,000 and $1,495,000 atDecember 31, 2002 and 2001, respectively. As of December 31, 2002 and 2001, all loans on nonaccrual wereclassified as impaired.  If interest onnonaccrual loans had been recognized at the original interest rates, interestincome would have increased $134,508, $195,826, and $115,603, in 2002, 2001,and 2000, respectively.  No additionalfunds are committed to be advanced in connection with impaired loans.

 

At December 31, 2002 and 2001, the Bank had no loans past due 90 daysor more in interest or principal and still accruing interest.

 

At December 31, 2002, loans totaling approximately $1,172,000 wereclassified as troubled debt restructurings.

 

**Note #4- Allowance for Loan Losses**

 

Transactions in the allowance for loan losses are summarized asfollows:

 
|                                       |   | **2002** |      | **2001** |   | **2000**  |   |
|--------------------------------------------|--------|----------|-----------|----------|--------|-----------|--------|
| Balance, Beginning of Year                 |   | $        | 1,744,070 |     | $      | 1,320,518 |   | $ | 1,241,016 |   |
| Additions charged to operating expense     |   | 545,000  |      | 600,000  |   | 519,000   |   |
| Loans charged off                          |   | (81,405  | )         | (180,732 | )      | (458,920  | )      |
| Recoveries of loans previously charged off |   | 128,554  |      | 4,284    |   | 19,422    |   |
| Balance, End of Year                       |   | $        | 2,336,219 |     | $      | 1,744,070 |   | $ | 1,320,518 |   |

 

### **Note #5- Property, Premises and Equipment**

 

Property, premises and equipment consisted of the following:

 
|                                                   |   | **2002**  |      | **2001**  |   |
|--------------------------------------------------------|--------|-----------|-----------|-----------|--------|
| Land                                                   |   | $         | 1,991,427 |      | $      | 1,090,783 |   |
| Building and improvements                              |   | 3,620,270 |      | 3,569,876 |   |
| Furniture and equipment                                |   | 2,769,986 |      | 4,035,637 |   |
| Construction in progress                               |   | 345,901   |      | —    |   |
|                                                   |   | 8,727,584 |      | 8,696,296 |   |
| Less:  Accumulated depreciation  and amortization |   | 4,184,993 |      | 5,075,527 |   |
| Total                                                  |   | $         | 4,542,591 |      | $      | 3,620,769 |   |

 

During 2002, the Bank purchased land for future development of a PasoRobles, California branch.

 

49

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The Company leases land, buildings, and equipment under noncancelableoperating leases expiring at various dates through 2009.  The following is a schedule of futureminimum lease payments based upon obligations at year-end.

 
| **Year  Ending  December 31,** |   | **Amount** |      |
|--------------------------------|--------|------------|-----------|
| 2003                           |   | $          | 410,203   |   |
| 2004                           |   | 342,017    |      |
| 2005                           |   | 300,264    |      |
| 2006                           |   | 215,523    |      |
| 2007                           |   | 192,192    |      |
| More than 5 years              |   | 741,231    |      |
| Total                          |   | $          | 2,201,430 |   |

 

The leases contain options to extend for periods from five to tenyears.  The cost of such rentals is notincluded above.  Total expenditurescharged for leases for the reporting periods ended December 31, 2002, 2001, and2000, were approximately $423,000, $382,000, and  $492,000, respectively.

 

### **Note #6- Intangible Assets**

###  

### Intangible assets consisted of core depositintangibles with a net carrying value of $358,557 and $402,156 as of December31, 2002 and 2001, respectively. Amortization expense for the periods ended December 31, 2002, 2001, and2000 was $43,598, $20,054, and $12,027, respectively.  The estimated future amortization expense for each of the nextfive years is $46,591.

 

### **Note #7- Time Deposit Liabilities**

 

At December 31, 2002, the Bank had time certificates of deposit withmaturity distributions as follows:

 
| **Year  Ending  December 31,** |   |      |       |
|--------------------------------|--------|-----------|------------|
| 2003                           |   | $         | 32,937,061 |   |
| 2004                           |   | 7,062,522 |       |
| 2005                           |   | 1,401,065 |       |
| 2006                           |   | 3,654,022 |       |
|                           |   | $         | 45,054,670 |   |

 

50

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**Note #8- FHLB Advances**

 

During 2002, the Bank entered into borrowingagreements with the FHLB.  The Bank hadoutstanding balances of $38,000,000 under these agreements at December 31, 2002with a weighted average interest rate of 3.28%.  Of the FHLB advances, $9,500,000 mature in 2003, $9,500,000mature in 2004, and $19,000,000 mature in 2005.  FHLB held certain investment securities of the Bank as collateralfor those borrowings.  The maximumoutstanding at any month-end was $38,000,000 during 2002.

 

The Bank has pledged approximately $4,689,000in loans to the FHLB.

 

### **Note #9- Securities Sold Under Agreements to Repurchase**

 

Securities sold under agreements to repurchase, which are classified assecured borrowings, generally mature within one to four days from thetransaction date.  Securities sold underagreements to repurchase are reflected at the amount of cash received inconnection with the transaction.  As ofDecember 31, 2002 and 2001, the Bank had $257,735 and $137,293 in Securitiessold under agreements to repurchase.

 

### **Note#10 - Other Borrowed Money**

 

Interest expense on federal funds purchased was $317, $382, and$15,875, and interest expense on securities sold under agreements to repurchasewas $6,658, $587, and $18,779, for the years ended December 31, 2002, 2001, and2000, respectively.

 

The Bank has a fed funds borrowing line with a correspondent bank.  The credit limit available on that line is$5,000,000.

 

### **Note#11 - Notes Payable**

 

On September 11, 1998, the Bancorp obtained a revolving line of creditin the amount of $2,000,000 through Pacific Coast Bankers’ Bank.  The note was secured by 339,332 shares ofthe Bank’s stock.  The note wasscheduled to mature on August 15, 2006, and bore interest at a variablerate of 1.00 percent over the Wall Street Journal prime rate.  The note was paid off during 2002.  The outstanding principal balance atDecember 31, 2001, was $1,894,811.

 

51

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**Note#12 - Trust Preferred Securities**

 

On April 10, 2002, Heritage Oaks Capital Trust I, a wholly ownedsubsidiary of Heritage Oaks Bancorp, issued $8,000,000 of Floating Rate CapitalSecurities.  The trust invested thegross proceeds from the offering in Floating Rate Junior SubordinatedDeferrable Interest Debentures issued by Heritage Oaks Bancorp. Thesubordinated debentures were issued concurrent with the issuance of the CapitalSecurities. Heritage Oaks Bancorp will pay the interest on the juniorsubordinated debentures to the Trust, which represents the sole revenue andsole source of dividend distributions by the trust to the holders of theCapital Securities.  Heritage OaksBancorp has guaranteed, on a subordinated basis, payment of the Trust’sobligation.  Heritage Oaks Bancorp hasthe right, assuming no default has occurred, to defer payments of interest onthe junior subordinated debentures at any time for a period not to exceed 10consecutive semi-annual periods.  TheCapital Securities will mature on April 22, 2032 but can be called at any timecommencing on April 22, 2007 at par.

 

**Note #13- Income Taxes**

 

The current and deferred amounts of the provision (benefit) for incometaxes were:

 
|                      |   | **Year Ending December 31,** |      |
|---------------------------|--------|------------------------------|-----------|
|                      |   | **2002**                     |      | **2001** |   | **2000** |   |
| Federal Income Tax        |   |                         |      |   |   |   |   |
| Current                   |   | $                            | 1,390,414 |   | $ | 1,251,241 |   | $ | 966,100 |   |
| Deferred                  |   | (246,546                     | )         | (264,940 | ) | (74,141 | ) |
| Total Federal Taxes       |   | 1,143,868                    |      | 986,301 |   | 891,959 |   |
|                      |   |                         |      |   |   |   |   |
| State Franchise Tax       |   |                         |      |   |   |   |   |
| Current                   |   | 650,536                      |      | 470,734 |   | 375,906 |   |
| Deferred                  |   | (144,936                     | )         | (77,666 | ) | (24,678 | ) |
| Total State Franchise Tax |   | 505,600                      |      | 393,068 |   | 351,228 |   |
| Total Income Taxes        |   | $                            | 1,649,468 |   | $ | 1,379,369 |   | $ | 1,243,187 |   |

 

The principal items giving rise to deferred taxes were:

 
|                                               |   | **2002** |     | **2001** |   | **2000** |   |
|----------------------------------------------------|--------|----------|----------|----------|--------|----------|--------|
| Use of different depreciation for tax purposes     |   | $        | (98,246  | )        | $      | (15,603  | )      | $ | (11,330 | ) |
| Difference in loan loss provision for tax purposes |   | (191,311 | )        | (173,656 | )      | (32,596  | )      |
| Differences arising from changes in accruals       |   | (101,925 | )        | (114,510 | )      | (32,819  | )      |
| Other, net                                         |   | —   |     | (38,837  | )      | (22,074  | )      |
| Total                                              |   | $        | (391,482 | )        | $      | (342,606 | )      | $ | (98,819 | ) |

 

52

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The provision for taxes on income differed from the amounts computedusing the federal statutory tax rate of 34 percent is as follows:

 
|                                                  |   | **2002**   |      | **2001**    |   | **2000**   |   |
|-------------------------------------------------------|--------|------------|-----------|-------------|--------|------------|--------|
|                                                  |   | **Amount** |      | **Percent** |   | **Amount** |   | **Percent** |   | **Amount** |   | **Percent** |   |
| Tax provision at federal statutory tax rate           |   | $          | 1,492,154 |        | 34.0   |       | $      | 1,266,722 |   | 34.0 |   | $ | 1,185,650 |   | 34.0 |   |
| State income taxes, net of federal income tax benefit |   | 333,696    |      | 7.6         |   | 259,425    |   | 7.0 |   | 231,810 |   | 6.7 |   |
| Tax exempt income and other, Net                      |   | (176,382   | )         | (4.0        | )      | (146,778   | )      | (4.0 | ) | (174,273 | ) | (5.0 | ) |
| Total Tax Provision                                   |   | $          | 1,649,468 |        | 37.6   |       | $      | 1,379,369 |   | 37.0 |   | $ | 1,243,187 |   | 35.7 |   |

 

The net deferred tax asset is determined as follows:

 
|                                                                 |   | **2002**           |   | **2001** |   |
|----------------------------------------------------------------------|--------|--------------------|--------|----------|--------|
|                                                                 |   | **(In Thousands)** |   |
|                                                                 |   |               |   |     |   |
| Deferred Tax Assets                                                  |   |               |   |     |   |
| Reserves for loan losses                                             |   | $                  | 820    |     | $      | 629 |   |
| Fixed assets                                                         |   | 120                |   | 22       |   |
| Accruals                                                             |   | 606                |   | 504      |   |
| Investment securities valuation                                      |   | —             |   | 103      |   |
| Total Deferred tax assets arising from cumulative timing differences |   | 1,546              |   | 1,258    |   |
| Valuation allowance*                                                 |   | —             |   | —   |   |
| Total Deferred Tax Assets                                            |   | $                  | 1,546  |     | $      | 1,258 |   |

 
|                            |   | **2002** |   | **2001** | ** ** |
|---------------------------------|--------|----------|--------|----------|------------|
|                            |   |     |   |     |       |
| Deferred Tax Liabilities        |   |     |   |     |       |
| Investment securities valuation |   | $        | 375    |     | $          | — |   |
| Total Deferred Tax Liabilities  |   | 375      |   | —   |       |
| Net Deferred Tax Assets         |   | $        | 1,171  |     | $          | 1,258 |   |

 

----

* The valuation allowance is estimated based upon amounts less thanlikely of future realization.  There wasno change in the valuation allowance for the 2002 year.

 

53

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**Note #14- Commitments and Contingencies**

 

The Company is involved in various litigation.  In the opinion of management and theCompany’s legal counsel, the disposition of all such litigation pending willnot have a material effect on the Company’s financial statements.

 

At December 31, 2002 and 2001, the Bank was contingently liable forletters of credit accommodations made to its customers totaling approximately$1,535,000 and $1,506,000, respectively. At December 31, 2002 and 2001, the Bank had undisbursed loan commitmentsin the amount of $65,254,000 and $53,549,000, respectively.  The Bank makes commitments to extend creditin the normal course of business to meet the financing needs of its customers.  Commitments to extend credit are agreementsto lend to a customer as long as there is no violation of any conditionestablished in the contract. Commitments generally have fixed expiration dates or other terminationclauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawnupon, the total outstanding commitment amount does not necessarily representfuture cash requirements.  Standbyletters of credit written are confidential commitments issued by the Bank toguarantee the performance of a customer to a third party.  The credit risk involved in issuing lettersof credit is essentially the same as that involved in extending loans tocustomers.  The Bank anticipates no lossesas a result of such transactions.

 

**Note #15- Regulatory Matters**

 

The Company (on a consolidated basis) and the Bank are subject tovarious regulatory capital requirements administered by federal bankingagencies.  Failure to meet minimumcapital requirements can initiate certain mandatory, and possibly additionaldiscretionary, actions by regulators that, if undertaken, could have a directmaterial effect on the Company’s and the Bank’s financial statements.  Under capital adequacy guidelines and theregulatory framework for prompt corrective action, the Company and the Bankmust meet specific capital guidelines that involve quantitative measures of theCompany’s and the Bank’s assets, liabilities and certain off-balance sheetitems as calculated under regulatory accounting practices.  The Company’s and the Bank’s capital amountsand classification are also subject to qualitative judgments by the regulatorsabout components, risk weightings and other factors.  Prompt corrective action provisions are not applicable to bankholding companies.

 

Quantitative measures established by regulation to ensure capitaladequacy require the Company and the Bank to maintain minimum amounts andratios (set forth in the table below) of total and Tier 1 capital (as definedin the regulations) to risk-weighted assets (as defined) and of Tier 1 capital (asdefined) to average assets (as defined). Management believes, as of December 31, 2002, that the Company and theBank meets all capital adequacy requirements to which it is subject.

 

As of the most recent notification from the Federal Deposit InsuranceCorporation categorized the Bank as well capitalized under the regulatoryframework for prompt corrective action. There are no conditions or events since that notification thatmanagement believes have changed the Bank’s category.  To be categorized as well-capitalized, the Bank must maintainminimum capital ratios as set forth in the table

 

54

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below.  The following table alsosets forth the Company’s and the Bank’s actual regulatory capital amounts andratios (dollar amounts in thousands):

 
|                                    |   |                   |       |                                |       | **Capital  Needed**                                                     |       |
|-----------------------------------------|--------|------------------------|------------|-------------------------------------|------------|-------------------------------------------------------------------------|------------|
|                                    |   | **Actual  Regulatory** | ** ** | **For  Capital  Adequacy Purposes** | ** ** | **To Be Well  Capitalized Under  Prompt Corrective  Action Provisions** | ** ** |
|                                    |   | **Capital  Amount**    |       | **Ratio**                           | ** ** | **Capital  Amount**                                                     | ** ** | **Ratio** | ** ** | **Capital  Amount** | ** ** | **Ratio** | ** ** |
| **As of December 31, 2002**             |   |                   |       |                                |       |                                                                    |       |   |   |   |   |   |   |
| Total capital to risk-weighted assets:  |   |                   |       |                                |       |                                                                    |       |   |   |   |   |   |   |
| Company                                 |   | $                      | 29,268     |                                | 13.00      | %                                                                       | $          | 18,012 |   | 8.0 | % | N/A |   | N/A |   |
| Bank                                    |   | 27,016                 |       | 12.06                               | %          | 17,920                                                                  |       | 8.0 | % | $ | 22,400 |   | 10.0 | % |
|                                    |   |                   |       |                                |       |                                                                    |       |   |   |   |   |   |   |
| Tier 1 capital to risk-weighted assets: |   |                   |       |                                |       |                                                                    |       |   |   |   |   |   |   |
| Company                                 |   | 25,192                 |       | 11.19                               | %          | 9,006                                                                   |       | 4.0 | % | N/A |   | N/A |   |
| Bank                                    |   | 24,640                 |       | 11.00                               | %          | 8,960                                                                   |       | 4.0 | % | 13,440 |   | 6.0 | % |
|                                    |   |                   |       |                                |       |                                                                    |       |   |   |   |   |   |   |
| Tier 1 capital to average assets:       |   |                   |       |                                |       |                                                                    |       |   |   |   |   |   |   |
| Company                                 |   | 25,192                 |       | 7.66                                | %          | 13,153                                                                  |       | 4.0 | % | N/A |   | N/A |   |
| Bank                                    |   | 24,640                 |       | 7.53                                | %          | 13,087                                                                  |       | 4.0 | % | 16,358 |   | 5.0 | % |
|                                    |   |                   |       |                                |       |                                                                    |       |   |   |   |   |   |   |
| **As of December 31, 2001**             |   |                   |       |                                |       |                                                                    |       |   |   |   |   |   |   |
| Total capital to risk-weighted assets:  |   |                   |       |                                |       |                                                                    |       |   |   |   |   |   |   |
| Company                                 |   | $                      | 17,373     |                                | 9.72       | %                                                                       | $          | 14,303 |   | 8.0 | % | N/A |   | N/A |   |
| Bank                                    |   | 18,109                 |       | 10.17                               | %          | 14,249                                                                  |       | 8.0 | % | $ | 17,811 |   | 10.0 | % |
|                                    |   |                   |       |                                |       |                                                                    |       |   |   |   |   |   |   |
| Tier 1 capital to risk-weighted assets: |   |                   |       |                                |       |                                                                    |       |   |   |   |   |   |   |
| Company                                 |   | 15,629                 |       | 8.74                                | %          | 7,151                                                                   |       | 4.0 | % | N/A |   | N/A |   |
| Bank                                    |   | 16,365                 |       | 9.19                                | %          | 7,125                                                                   |       | 4.0 | % | 10,687 |   | 6.0 | % |
|                                    |   |                   |       |                                |       |                                                                    |       |   |   |   |   |   |   |
| Tier 1 capital to average assets:       |   |                   |       |                                |       |                                                                    |       |   |   |   |   |   |   |
| Company                                 |   | 15,629                 |       | 7.44                                | %          | 8,403                                                                   |       | 4.0 | % | N/A |   | N/A |   |
| Bank                                    |   | 16,365                 |       | 7.81                                | %          | 8,382                                                                   |       | 4.0 | % | 10,477 |   | 5.0 | % |

 

55

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**Note #16- Salary Continuation Plan**

 

The Bank established a salary continuation planagreement with the President, Chief Financial Officer, Chief Lending Officer,Chief Administrative Officer and Senior Vice Presidents, as authorized by theBoard of Directors.  This agreementprovides for annual cash payments for a period not to exceed 15 years, payableat age 60-65, depending on the agreement. In the event of death prior to retirement age, annual cash paymentswould be made to the beneficiaries for a determined number of years.  The present values of the Company’sliability under this Agreement were approximately $493,000 and $347,000 atDecember 31, 2002 and 2001, respectively, and are included in other liabilitiesin the Company’s Consolidated Financial Statements.  The Company maintains life insurance policies, which are intendedto fund all costs of the plan.  The cashsurrender values of these life insurance policies totaled approximately$5,416,000 and $5,144,000, at December 31, 2002 and 2001, respectively.

 

**Note #17 - Employee Benefit Plans**

 

401(k)Pension Plan

During 1994, the Bank established a savingsplan for employees which allows participants to make contributions by salarydeduction equal to 15 percent or less of their salary pursuant to section401(k) of the Internal Revenue Code. Employee contributions are matched up to 25 percent of the employee’scontribution.  Employees vestimmediately in their own contributions and they vest in the Bank’s contributionbased on years of service.  Expenses ofthe savings plan were $64,413, $57,528, and $48,843, for the years endedDecember 31, 2002, 2001, and 2000, respectively.

 

# **Employee StockOwnership Plan**

The Company sponsors an employee stockownership plan (ESOP) that covers all employees who have completed 12consecutive months of service, are over 21 years of age and work a minimum of1,000 hours per year.  The amount of theannual contribution to the ESOP is at the discretion of the Board ofDirectors.  The contributions made tothis plan were approximately $162,000 in 2002, $125,000 in 2001, and $157,000in 2000.

 

### **Note#18 - Stock Option Plans**

 

At December 31, 2002, the Company had two stock option plans, which aredescribed below.

 

The Company adopted the Company’s 1990 stock option plan, which is atandem stock option plan permitting options to be granted either as “IncentiveStock Options” or as Non-Qualified Stock options under the Internal RevenueCode.  All outstanding options weregranted at prices which equal the fair market value on the day of grant.  Options granted vest at a rate of 25 percentper year for four years and expire no later than ten years from the date ofgrant.  The plan provided for issuanceof up to 334,404 shares (after giving retroactive effect for five percent stockdividends in 2000, 2001, and 2002, and a two-for-one stock split in 2002) ofthe Company’s unissued common stock and is subject to the specific approval ofthe Board of Directors.  The Company’s1990 stock option plan expired in July 2000.

 

No options were granted during 2000, 2001, or 2002.

 

56

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The following tables summarize information about the 1990 stock optionplan outstanding at December 31, 2002.

 
|                                                           |   | **2002**   |   | **2001**                                |       | **2000**   |       |
|----------------------------------------------------------------|--------|------------|--------|-----------------------------------------|------------|------------|------------|
|                                                           |   | **Shares** |   | **Weighted-  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** |
| Outstanding at beginning of year                               |   | 34,071     |   | $                                       | 1.75       |       | 49,521     |   | $ | 1.74 |   | 100,602 |   | $ | 1.78 |   |
| Granted                                                        |   |       |   |                                    |       |       |       |   |   |   |   |   |   |
| Cancelled                                                      |   | —     |   | $                                       | —     |       | —     |   | $ | — |   | (897 | ) | $ | 4.43 |   |
| Exercised                                                      |   | (32,038    | )      | $                                       | 1.59       |       | (15,450    | ) | $ | 1.71 |   | (50,184 | ) | $ | 1.78 |   |
| Outstanding at end of year                                     |   | 2,033      |   | $                                       | 4.43       |       | 34,071     |   | $ | 1.75 |   | 49,521 |   | $ | 1.74 |   |
|                                                           |   |       |   |                                    |       |       |       |   |   |   |   |   |   |   |   |   |
| Options available for granting at end of year                  |   | —     |   |                                    |       |       | —     |   |   |   |   | — |   |   |   |   |
| Options exercisable at year-end                                |   | 2,033      |   | $                                       | 4.43       |       | 34,071     |   | $ | 1.75 |   | 48,846 |   | $ | 1.71 |   |
| Weighted-average fair value of options granted during the year |   | —     |   |                                    |       |       | —     |   |   |   |   | — |   |   |   |   |

 
| **Options  Outstanding** |   | **Options  Exercisable** |       |
|--------------------------|--------|--------------------------|------------|
| **Exercise  Price**      |   | **Number  Outstanding**  | ** ** | **Weighted-  Average  Remaining  Contractual Life** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** |
|                     |   |                     |       |   |   |   |   |   |   |   |   |
| $                        | 4.43   |                     | 2,033      |   | 4.53 |   | $ | 4.43 |   | 2,033 |   | $ | 4.43 |   |
|                          |        |                          |            |  |  |  |  |  |  |  |  |  |  |  |

 

The Company adopted the Company’s 1997 stock option plan, which is atandem stock option plan permitting options to be granted either as “IncentiveStock Options” or as “Non-Qualified Stock Options” under the Internal RevenueCode.  All outstanding options weregranted at prices which equal the fair market value on the day of thegrant.  Options granted vest at a rateof 20 percent per year for five years, and expire no later than ten years fromthe date of grant.  The plan providesfor issuance of up to 387,783 shares (after giving retroactive effect for fivepercent stock dividends in 2000, 2001, and 2002, and a two-for-one stock splitin 2002) of the Company’s unissued common stock and is subject to the specificapproval of the Board of Directors.

 

During 1999, the Board of Directors approved an amendment to the 1997Stock Option Plan.  Under thisamendment, the plan provides for issuance of up to 109,428 additional shares(after giving retroactive effect for five percent stock dividends in 2000,2001, and 2002, and a two-for-one stock split in 2002) of the Company’s commonstock.

 

57

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The fair value of each option granted was estimated on the date ofgrant using the Black-Scholes option pricing model with the followingassumptions for 2002, 2001 and 2000, respectively:  risk-free rates of 3.73 percent, 5.25 percent and 5.17 percent,dividend yields of 0 percent for all years presented, expected life of 8 years,nine years and eight years; and volatility of 26 percent, 26 percent and 28percent.

 

The following summarizes information about the 1997 stock option planoutstanding at December 31, 2002.  Thesetables have been retroactively adjusted for the 5 percent stock dividends in2000, 2001, and 2002, and a two-for-one stock split in 2002.

 
|                                                           |   | **2002**   |   | **2001**                                |       | **2000**   |       |
|----------------------------------------------------------------|--------|------------|--------|-----------------------------------------|------------|------------|------------|
|                                                           |   | **Shares** |   | **Weighted-  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** |
| Outstanding at beginning of year                               |   | 415,858    |   | $                                       | 5.41       |       | 432,765    |   | $ | 5.36 |   | 373,486 |   | $ | 5.11 |   |
| Granted                                                        |   | 17,500     |   | $                                       | 11.79      |       | 13,230     |   | $ | 7.94 |   | 69,458 |   | $ | 6.72 |   |
| Cancelled                                                      |   | (20,209    | )      | $                                       | 4.71       |       | (20,645    | ) | $ | 6.50 |   | (7,961 | ) | $ | 5.58 |   |
| Exercised                                                      |   | (28,439    | )      | $                                       | 4.77       |       | (9,492     | ) | $ | 4.43 |   | (2,218 | ) | $ | 4.93 |   |
| Outstanding at end of year                                     |   | 384,710    |   | $                                       | 5.78       |       | 415,858    |   | $ | 5.41 |   | 432,765 |   | $ | 5.36 |   |
|                                                           |   |       |   |                                    |       |       |       |   |   |   |   |   |   |
| Options available for grant end of year                        |   | 175,218    |   |                                    |       | 172,509    |       |   |   | 165,094 |   |   |   |
| Options exercisable at year-end                                |   | 291,953    |   | $                                       | —     |       | 252,573    |   | $ | 10.33 |   | 182,921 |   | $ | 4.74 |   |
| Weighted-average fair value of options granted during the year |   | $          | 4.69   |                                    |       |       | $          | 3.73 |   |   |   | $ | 3.07 |   |   |   |
|                                                                |        |            |        |                                         |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |

 
| **Options  Outstanding** |   | **Options  Exercisable** |       |
|--------------------------|--------|--------------------------|------------|
| **Exercise  Price**      |   | **Number  Outstanding**  | ** ** | **Weighted-  Average  Remaining  Contractual Life** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** |
| $4.43 -$  6.85      |   | 275,878                  |       | 5.05 |   | $ | 4.91 |   | 244,544 |   | $ | 4.69 |   |
| $7.18 -$10.96            |   | 108,832                  |       | 7.03 |   | $ | 7.98 |   | 47,409 |   | $ | 7.16 |   |
|                     |   | 384,710                  |       |   |   |   |   | 291,953 |   |   |   |

 

58

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### **Note#19 - Related Party Transactions**

 

The Bank has entered into loan and deposit transactions with certaindirectors and executive officers of the Company.  These loans were made and deposits were taken in the ordinarycourse of the Bank’s business and, in management’s opinion, were made atprevailing rates and terms.

 

An analysis of loans to directors and executive officers is as follows:

 
|                                   |   | **2002**   |      | **2001**  |   |
|----------------------------------------|--------|------------|-----------|-----------|--------|
| Outstanding Balance, Beginning of Year |   | $          | 2,815,280 |      | $      | 211,821 |   |
| Additional loans made                  |   | 2,557,574  |      | 2,703,959 |   |
| Repayments                             |   | (3,901,259 | )         | (100,500  | )      |
| Outstanding Balance, End of Year       |   | $          | 1,471,595 |      | $      | 2,815,280 |   |

 

Deposits from related parties held by the Bank at December 31, 2002 and2001 amounted to approximately $2,816,000 and $1,275,000, respectively.

 

### **Note#20 - Restriction on Transfers of Funds to Parent**

 

There are legal limitations on the ability of the Bank to provide fundsto the Company.  Dividends declared bythe Bank may not exceed, in any calendar year, without approval of the StateBanking Department, net income for the year and the retained net income for thepreceding two years.  Section 23A of theFederal Reserve Act restricts the Bank from extending credit to the Company andother affiliates amounting to more than 20 percent of its contributed capitaland retained earnings.

 

59

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**Note #21- Fair Value of Financial Instruments**

 

The fair value of a financial instrument is the amount at which theasset or obligation could be exchanged in a current transaction between willingparties, other than a forced or liquidation sale.  Fair value estimates are made at a specific point in time basedon relevant market information and information about the financialinstrument.  These estimates do notreflect any premium or discount that could result from offering for sale at onetime the entire holdings or a particular financial instrument.  Because no market value exists for asignificant portion of the financial instruments, fair value estimates arebased on judgments regarding future expected loss experience, current economicconditions, risk characteristics of various financial instruments, and otherfactors.  These estimates are subjectivein nature, involve uncertainties and matters of judgment and, therefore, cannotbe determined with precision.  Changesin assumptions could significantly affect the estimates.

 

Fair value estimates are based on financial instruments both on and offthe balance sheet without attempting to estimate the value of anticipatedfuture business and the value of assets and liabilities that are not consideredfinancial instruments.  Additionally,tax consequences related to the realization of the unrealized gains and lossescan have a potential effect on fair value estimates and have not beenconsidered in many of the estimates.

 

The estimated fair value of financial instruments at December 31 issummarized as follows:

 
|                                       |   | **2002**             |       | **2001**       |       |
|--------------------------------------------|--------|----------------------|------------|----------------|------------|
|                                       |   | **Carrying  Amount** |       | **Fair Value** | ** ** | **Carrying  Amount** | ** ** | **Fair Value** | ** ** |
| Assets                                     |   |                 |       |           |       |   |   |   |   |
| Cash and cash equivalents                  |   | $                    | 60,553,631 |           | $          | 60,553,631 |   | $ | 20,398,048 |   | $ | 20,398,048 |   |
| Investment bearing deposits                |   | 497,000              |       | 497,000        |       | 99,000 |   | 99,000 |   |
| Investments and mortgage-backed securities |   | 65,396,494           |       | 65,396,494     |       | 22,028,996 |   | 22,028,996 |   |
| FHLB stock                                 |   | 1,950,900            |       | 1,950,900      |       | 228,300 |   | 228,300 |   |
| Loans receivable, net                      |   | 189,647,587          |       | 193,006,599    |       | 157,893,955 |   | 158,052,664 |   |
| Loans held for sale                        |   | 8,166,011            |       | 8,166,011      |       | 4,082,200 |   | 4,082,200 |   |
| Accrued interest receivable                |   | 1,106,044            |       | 1,106,044      |       | 810,165 |   | 810,165 |   |
|                                       |   |                 |       |           |       |   |   |   |   |
| Liabilities                                |   |                 |       |           |       |   |   |   |   |
| Non-interest bearing deposits              |   | 106,556,079          |       | 106,556,079    |       | 69,824,137 |   | 69,824,137 |   |
| Interest bearing deposits                  |   | 157,622,526          |       | 158,257,303    |       | 125,760,628 |   | 126,366,674 |   |
| FHLB advances                              |   | 38,000,000           |       | 38,300,619     |       | — |   | — |   |
| Notes payable                              |   | —               |       | —         |       | 1,894,811 |   | 1,894,811 |   |
| Trust Preferred Securities                 |   | 8,000,000            |       | 8,061,879      |       | — |   | — |   |
| Accrued interest payable                   |   | 565,430              |       | 565,430        |       | 354,142 |   | 354,142 |   |
|                                            |        |                      |            |                |            |  |  |  |  |  |  |  |  |

 
|                                                                                      |   | **Notional  Amount** |       | **Cost to Cede  or Assume** | ** ** | **Notional  Amount** | ** ** | **Cost to Cede  or Assume** | ** ** |
|-------------------------------------------------------------------------------------------|--------|----------------------|------------|-----------------------------|------------|----------------------|------------|-----------------------------|------------|
| Off-Balance Sheet Instruments Commitments to extend credit and standby  letters of credit |   | $                    | 66,789,000 |                        | $          | 667,890              |       | $                           | 55,054,000 |   | $ | 550,540 |   |
|                                                                                           |        |                      |            |                             |            |                      |            |                             |            |  |  |  |  |

 

60

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The following methods and assumptions were used by the Company inestimating fair value disclosures:

 

•               Cashand Cash Equivalents

 

The carrying amountsreported in the balance sheet for cash and cash equivalents approximate thoseassets’ fair values due to the short-term nature of the assets.

 

•               InterestBearing Deposits

 

Fair values for timedeposits are estimated using a discounted cash flow analysis that appliesinterest rates currently being offered on certificates to a schedule ofaggregated contractual maturities on such time deposits.

 

•               Investmentand Mortgage-Backed Securities

 

Fair values are basedupon quoted market prices, where available.

 

•               Loansand Loans Held for Sale

 

For variable-rate loansthat reprice frequently and with no significant change in credit risk, fairvalues are based on carrying amounts. The fair values for other loans (for example, fixed rate commercial realestate and rental property mortgage loans and commercial and industrial loans)are estimated using discounted cash flow analysis, based on interest ratescurrently being offered for loans with similar terms to borrowers of similarcredit quality.  Loan fair valueestimates include judgments regarding future expected loss experience and riskcharacteristics.  The carrying amount ofaccrued interest receivable approximates its fair value.

 

•               Deposits

 

The fair values disclosedfor demand deposits (for example, interest-bearing checking accounts andpassbook accounts) are, by definition, equal to the amount payable on demand atthe reporting date (that is, their carrying amounts).  The fair values for certificates of deposit are estimated using adiscounted cash flow calculation that applies interest rates currently beingoffered on certificates to a schedule of aggregated contractual maturities onsuch time deposits.  The carrying amountof accrued interest payable approximates fair value.

 

•               FHLBAdvances and Trust Preferred Securities

 

The fair value disclosedfor FHLB advances and Trust Preferred Securities is determined by discountingcontractual cash flows at current market interest rates for similarinstruments.

 

61

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•               NotesPayable

 

The fair value disclosedfor notes payable is based on carrying amounts.  The note is a variable-rated note that reprices frequently.

 

•               Off-balanceSheet Instruments

 

Fair values of loancommitments and financial guarantees are based upon fees currently charged toenter similar agreements, taking into account the remaining terms of theagreement and the counterparties’ credit standing.

 

**Note #22- Earnings Per Share (EPS)**

 

The following is a reconciliation of net income and shares outstandingto the income and number of shares used to compute EPS.  Share information has been retroactivelyadjusted for the stock dividend as discussed in Note #25.

 
|                                                  |   | **2002**        |      | **2001**   |       | **2000**        |       |
|-------------------------------------------------------|--------|-----------------|-----------|------------|------------|-----------------|------------|
|                                                  |   | **Net  Income** |      | **Shares** | ** ** | **Net  Income** | ** ** | **Shares** | ** ** | **Net  Income** | ** ** | **Shares** | ** ** |
| Net income as reported                                |   | $               | 2,739,220 |       |       |            | $          | 2,346,283 |   |   |   | $ | 2,244,020 |   |   |   |
| Shares outstanding at year-end                        |   |            |      | 2,785,533  |       |            |       | 2,725,056 |   |   |   | 2,572,006 |   |
| Impact of weighting shares purchased during  the year |   |            |      | (11,025    | )          |            |       | (4,133 | ) |   |   | (19,310 | ) |
| Used in Basic EPS                                     |   | 2,739,220       |      | 2,774,508  |       | 2,346,283       |       | 2,720,923 |   | 2,244,020 |   | 2,552,696 |   |
| Dilutive effect of outstanding stock  options         |   |            |      | 245,937    |       |            |       | 238,132 |   |   |   | 172,261 |   |
| Used in Dilutive EPS                                  |   | $               | 2,739,220 |       | 3,020,445  |            | $          | 2,346,283 |   | 2,959,055 |   | $ | 2,244,020 |   | 2,724,957 |   |

 

62

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**Note #23- Other Income/Expense**

 

The following is a breakdown of fees and other income and expenses forthe years ended December 31, 2002, 2001, and 2000:

 
|                                                        |   | **2002**  |      | **2001**  |   | **2000**  |   |
|-------------------------------------------------------------|--------|-----------|-----------|-----------|--------|-----------|--------|
| Fees and Other Income                                       |   |      |      |      |   |      |   |
| ATM transaction fees                                        |   | $         | 106,759   |      | $      | 1,744,404 |   | $ | 2,896,700 |   |
| ATM interchange income                                      |   | 21,448    |      | 270,390   |   | 695,017   |   |
| ATM sponsorship fees                                        |   | —    |      | 2,713     |   | 17,785    |   |
| Bankcard merchant fees                                      |   | 123,493   |      | 122,602   |   | 110,483   |   |
| VISA checkard interchange income                            |   | 366,259   |      | 290,503   |   | 222,695   |   |
| Mortgage broker fees                                        |   | 766,532   |      | 577,333   |   | 318,360   |   |
| Earnings on cash surrender value of life insurance policies |   | 303,554   |      | 138,575   |   | 72,434    |   |
| Other                                                       |   | 361,090   |      | 352,876   |   | 269,384   |   |
|                                                        |   | $         | 2,049,135 |      | $      | 3,499,396 |   | $ | 4,602,858 |   |
|                                                        |   |      |      |      |   |      |   |
| Other Expenses                                              |   |      |      |      |   |      |   |
| Data processing                                             |   | $         | 1,415,803 |      | $      | 1,460,620 |   | $ | 1,327,397 |   |
| Advertising and promotional                                 |   | 380,152   |      | 327,618   |   | 323,433   |   |
| Regulatory fees                                             |   | 61,633    |      | 77,813    |   | 64,598    |   |
| Other professional fees and outside services                |   | 416,016   |      | 367,007   |   | 266,172   |   |
| Legal fees and other litigation expenses                    |   | 105,645   |      | 231,047   |   | 210,838   |   |
| Stationery and supplies                                     |   | 230,755   |      | 188,394   |   | 193,921   |   |
| Director fees                                               |   | 165,520   |      | 215,755   |   | 188,728   |   |
| ATM costs at gaming sites                                   |   | 88,915    |      | 1,157,934 |   | 1,374,108 |   |
| ATM costs at retail sites                                   |   | 31        |      | 383,698   |   | 1,203,674 |   |
| Other                                                       |   | 1,157,382 |      | 774,908   |   | 538,711   |   |
| Total                                                       |   | $         | 4,021,852 |      | $      | 5,184,794 |   | $ | 5,691,580 |   |

 

63

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**Note #24- Operating Segments**

 

In June 1997, the Financial Accounting Standards Board (FASB) issuedStatement No. 131, “*Disclosuresabout Segments of an Enterprise and Related Information*,” which the Company has adoptedduring 1998.  During 2002, the Companyhad one primary reportable segment. Prior to 2002, the Company had two primary reportable segments.  The segments were reported herein apply tothe Bank and the Bank’s EFT Department. The segments are identified as such based upon the percentage ofoperating net income, management responsibility, and the types of products andservices offered.

 

The segments consisted of the Bank and four separately classifiedcomponents within the EFT Department referred to as networks.  The Bank offers traditional banking productssuch as checking, savings, and certificates of deposit, as well as mortgage,commercial, and consumer loans.  As ofDecember 31, 2001, the EFT Department had installed automated teller machineslocated in retail outlets and gaming facilities.  Income was based upon total customer usage of the machines andthe applicable transaction charge. Income is allocated to the Bank via contractual agreement.  The Company measures segment profit asoperating net income which is defined as income before provision for incometaxes.

 

During 2001, the Company divested all of its retail automated tellermachines and all but two of its gaming automated teller machines.  Total sales proceeds were $533,700.

 

Presented below is comparative financial information relating to theCompany’s operating segments:

 
|                                    |   | **EFT  Department** |      | **Bank**    | ** ** | **Total  Operating  Segments** | ** ** |
|-----------------------------------------|--------|---------------------|-----------|-------------|------------|--------------------------------|------------|
| **Fiscal Year Ended December 31, 2001** |   |                |      |        |       |                           |       |
| Revenues                                |   | $                   | 2,324,062 |        | $          | 16,817,865                     |       | $ | 19,141,927 |   |
| Depreciation and amortization           |   | 181,525             |      | 628,196     |       | 809,721                        |       |
| Operating income                        |   | 367,276             |      | 2,056,903   |       | 2,424,179                      |       |
| Total assets                            |   | 249,080             |      | 213,675,935 |       | 213,925,015                    |       |
|                                         |        |                     |           |             |            |                                |            |  |  |  |

 

64

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**Note #25 - Stock Dividends and StockSplits**

 

On March 21, 2000 the Board of Directors declared afive percent stock dividend payable on April 17, 2000 to stockholders ofrecord on April 3, 2000.  Cash was paidin lieu of fractional shares at the rate of $15.00 per share and amounted to$3,923.

 

On March 2, 2001 the Board of Directors declared afive percent stock dividend payable on March 30, 2001 to stockholders of recordon March 16, 2001.  Cash was paid inlieu of fractional shares at the rate of $18.25 per share and amounted to$4,680.

 

On February 22, 2002, the Board of Directorsdeclared a five percent stock dividend payable on March 29, 2002 tostockholders of record on March 8, 2002. Cash was paid in lieu of fractional shares at the rate of $26.00 pershare and amounted to $6,405.

 

On July 19, 2002, the Board of Directorsdeclared a two-for-one stock split payable on August 15, 2002 to stockholdersof record on August 2, 2002.

 

All references in financial statements andnotes to financial statements to number of shares, per share amounts, andmarket prices of the Company’s common stock have been restated to reflect the increasednumber of shares outstanding.

 

**Note #26- Acquisition of Assets and Liabilities**

 

During November 2001, the Bank acquired certain assets and liabilitiesof four branches of WestAmerica Bank. Total assets acquired were $24,968,071, which consisted of $1,144,164 inland, building, leasehold improvements and other fixed assets, and $23,086,675in cash.  In addition, the Bank alsoassumed $24,968,071 of deposits.  TheBank paid a premium of $737,232 for the deposits.  Subsequent to the purchase date, the Bank consolidated thedeposits of three of the acquired branches with existing Heritage Oaks Bankdeposits.  In conjunction with thetransfer of the deposits, the Bank sold the land and building of one of the acquiredbranches for $525,000, resulting in a gain of $22,348.  The Bank negotiated the termination of thelease on another of the acquired branches, and is allowing the lease to lapseon the third branch.  As a result of thedispositions and the recording of the remaining acquired branch at fair value,the original premium paid was written down to $406,587, and is being amortizedover 10 years.

 

65

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**Note #27- Condensed Financial Information of Heritage Oaks Bancorp (Parent Company)**

 
|                                                                                                                                 |   | **2002**   |       | **2001**   |   |
|--------------------------------------------------------------------------------------------------------------------------------------|--------|------------|------------|------------|--------|
| **Assets**                                                                                                                           |   |       |       |       |   |
| Cash                                                                                                                                 |   | $          | 154,657    |       | $      | 11,194 |   |
| Federal Funds Sold                                                                                                                   |   | 740,000    |       | —     |   |
| Prepaid and other assets                                                                                                             |   | 541,449    |       | 493,965    |   |
| Property and premises                                                                                                                |   | 654,844    |       | 669,556    |   |
| Investment in subsidiaries                                                                                                           |   | 25,809,040 |       | 16,611,738 |   |
|                                                                                                                                 |   |       |       |       |   |
| Total Assets                                                                                                                         |   | $          | 27,899,990 |       | $      | 17,786,453 |   |
|                                                                                                                                 |   |       |       |       |   |
| **Liabilities and Stockholders’ Equity**                                                                                        |   |       |       |       |   |
| Notes payable                                                                                                                        |   | —     |       | 1,894,811  |   |
| Company obligated preferred securities of subsidiary trust holding  floating rate junior subordinated deferrable interest debentures |   | 8,000,000  |       | —     |   |
| Other liabilities                                                                                                                    |   | 86,520     |       | 14,861     |   |
|                                                                                                                                 |   |       |       |       |   |
| Total Liabilities                                                                                                                    |   | 8,086,520  |       | 1,909,672  |   |
|                                                                                                                                 |   |       |       |       |   |
| Stockholders’ Equity                                                                                                            |   |       |       |       |   |
| Common stock                                                                                                                         |   | 9,703,022  |       | 7,535,495  |   |
| Retained earnings                                                                                                                    |   | 10,110,448 |       | 8,341,286  |   |
|                                                                                                                                 |   |       |       |       |   |
| Total Stockholders’ Equity                                                                                                      |   | 19,813,470 |       | 15,876,781 |   |
| Total Liabilities and Stockholders’ Equity                                                                                      |   | $          | 27,899,990 |       | $      | 17,786,453 |   |

 

66

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**Statements of Income**

 
|                                          |   | **2002**  |      | **2001**  |   | **2000**  |   |
|-----------------------------------------------|--------|-----------|-----------|-----------|--------|-----------|--------|
| **Income**                                    |   |      |      |      |   |      |   |
| Equity in undisbursed income of subsidiary    |   | $         | 3,032,107 |      | $      | 2,424,180 |   | $ | 2,287,712 |   |
| Interest income                               |   | 16,651    |      | —    |   | —    |   |
| Other                                         |   | 56,700    |      | 56,700    |   | 56,700    |   |
| Total Income                                  |   | 3,105,458 |      | 2,480,880 |   | 2,344,412 |   |
| **Expense**                                   |   |      |      |      |   |      |   |
| Salary expense                                |   | 70,920    |      | 57,348    |   | 41,194    |   |
| Equipment expense                             |   | 14,712    |      | 14,712    |   | 14,712    |   |
| Other professional fees and outside  services |   | 27,678    |      | 22,733    |   | 16,084    |   |
| Interest expense                              |   | 384,068   |      | 85,601    |   | 35,856    |   |
| Other                                         |   | 72,392    |      | 8,334     |   | 22,908    |   |
| Total Expense                                 |   | 569,770   |      | 188,728   |   | 130,754   |   |
| Total Operating Income                        |   | 2,535,688 |      | 2,292,152 |   | 2,213,658 |   |
|                                          |   |      |      |      |   |      |   |
| Tax benefit of parent                         |   | (203,532  | )         | (54,131   | )      | (30,362   | )      |
|                                          |   |      |      |      |   |      |   |
| Net Income                                    |   | $         | 2,739,220 |      | $      | 2,346,283 |   | $ | 2,244,020 |   |

 

67

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**Statements of Cash Flows**

**For the Years Ended December 31,2002, 2001, and 2000**

 
|                                                                                              |   | **2002**   |      | **2001**   |   | **2000**   |   |
|---------------------------------------------------------------------------------------------------|--------|------------|-----------|------------|--------|------------|--------|
| **Cash Flows From Operating Activities**                                                          |   |       |      |       |   |       |   |
| Net income                                                                                        |   | $          | 2,739,220 |       | $      | 2,346,283  |   | $ | 2,244,020 |   |
| Adjustments to Reconcile Net Income to Net Cash Provided By/(Used  in)  Operating Activities |   |       |      |       |   |       |   |
| Depreciation                                                                                      |   | 14,712     |      | 14,712     |   | 14,712     |   |
| Increase in other assets                                                                          |   | (47,484    | )         | (70,854    | )      | (87,007    | )      |
| Increase in other liabilities                                                                     |   | 71,659     |      | 10,271     |   | 457        |   |
| Undistributed income of subsidiary                                                                |   | (3,032,107 | )         | (2,424,180 | )      | (2,287,712 | )      |
| Net Cash Used In Operating Activities                                                             |   | (254,000   | )         | (123,768   | )      | (115,530   | )      |
|                                                                                              |   |       |      |       |   |       |   |
| **Cash Flows From Investing Activities**                                                          |   |       |      |       |   |       |   |
| Increase in investment in subsidiaries                                                            |   | (5,448,000 | )         | (1,500,000 | )      | (800,000   | )      |
|                                                                                              |   |       |      |       |   |       |   |
| **Cash Flows From Financing Activities**                                                          |   |       |      |       |   |       |   |
| Cash dividends received                                                                           |   | —     |      | 650,000    |   | —     |   |
| Cash paid in lieu of fractional shares                                                            |   | (6,405     | )         | (4,680     | )      | (3,923     | )      |
| Increase (decrease) in notes payable                                                              |   | (1,894,811 | )         | 844,811    |   | 700,000    |   |
| Issuance of Trust Preferred Securities                                                            |   | 8,000,000  |      |       |   |       |   |
| Proceeds from the exercise of options                                                             |   | 486,679    |      | 93,641     |   | 155,274    |   |
| Net Cash Provided By Financing Activities                                                         |   | 6,585,463  |      | 1,583,772  |   | 851,351    |   |
|                                                                                              |   |       |      |       |   |       |   |
| **Net Increase/(Decrease) in Cash and Cash Equivalents**                                          |   | 883,463    |      | (39,996    | )      | (64,179    | )      |
| **Cash and Cash Equivalents**, Beginning of Year                                                  |   | 11,194     |      | 51,190     |   | 115,369    |   |
|                                                                                              |   |       |      |       |   |       |   |
| **Cash and Cash Equivalents**, End of Year                                                        |   | $          | 894,657   |       | $      | 11,194     |   | $ | 51,190 |   |

 

68

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**ITEM 8.   CHANGES WITH ACCOUNTANTSON ACCOUNTING AND FINANCIAL DISCLOSURE**

 

None

 

**PARTIII**

 

**ITEM 9.  DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS;COMPLIANCE WITH****SECTION16(a) OF THE EXCHANGE ACT**

 

The information required byItem 9 of Form 10-KSB is incorporated by reference from the informationcontained in the Company’s Proxy Statement for the 2003 Annual Meeting ofShareholders which will be filed pursuant to Regulation 14A.

 

**ITEM 10.               EXECUTIVE COMPENSATION**

 

The information required byItem 10 of Form 10-KSB is incorporated by reference from the informationcontained in the Company’s Proxy Statement for the 2003 Annual Meeting ofShareholders which will be filed pursuant to Regulation 14A.

 

**ITEM11.               SECURITY OWNERSHIP OFCERTAIN BENEFICIAL OWNERS AND MANAGEMENT**

 

The information required byItem 11 of Form 10-KSB is incorporated by reference from the informationcontained in the Company’s Proxy Statement for the 2003 Annual Meeting ofShareholders which will be filed pursuant to Regulation 14A.

 

**ITEM12.               CERTAIN RELATIONSHIPSAND RELATED TRANSACTIONS**

 

Theinformation required by Item 12 of Form 10-KSB is incorporated by referencefrom the information contained in the Company’s Proxy Statement for the 2003Annual Meeting of Shareholders which will be filed pursuant to Regulation 14A.

 

**ITEM 13.               EXHIBITS AND REPORTS ON FORM 8-K**

 

**(a) Exhibits:**

 
| **(2.1)**  |   | **Branch Purchase and Assumption Agreement  and Real Property Purchase Agreement  entered into between Westamerica Bank and Heritage Oaks Bank, dated July 16,  2001 filed with the SEC in the Company’s 10-QSB for the period ending June  30, 2001.** |
|------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |   |                                                                                                                                                                                                                                                              |
| **(3.1a)** |   | **Articles of Incorporation incorporated by reference  from Exhibit 3.1a to Registration Statement on Form S-4 No. 33-77504 filed  with the SEC on April, 1994.**                                                                                                 |
|       |   |                                                                                                                                                                                                                                                              |
| **(3.1b)** |   | **Amendment to the Articles of Incorporation filed with  the Secretary of State**                                                                                                                                                                                 |

 

69

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|        |   | **on October 16, 1997 filed with the SEC in the  Company’s 10-KSB for the year endiing December 31, 1997.**                                                                                  |
|-------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |   |                                                                                                                                                                                              |
| **(3.2)**   |   | **Heritage Oaks Bancorp Bylaws as amended November 16,  2000 filed with the SEC in the Company’s 10-KSB for the year ended December  31, 2000.**                                             |
|        |   |                                                                                                                                                                                              |
| **(4.1)**   |   | **Specimen form of Heritage Oaks Bancorp stock  certificate incorporated by reference from Exhibit 4.1 to Registration  Statement on Form S-4 No. 33-77504 filed with the SEC on April 8, 1994.** |
|        |   |                                                                                                                                                                                              |
| **(10.1)**  |   | **1990 Stock Option Plan incorporated by reference from  Exhibit 10.2 to Registration Statement on Form S-4 No. 33-77504, filed with  the SEC on April 8, 1994.**                                 |
|        |   |                                                                                                                                                                                              |
| **(10.2)**  |   | **Form of Stock Option Agreement incorporated by reference  from Exhibit 4.2 to Registration Statement on Form S-4 No. 33-77504, filed  with the SEC on April 8, 1994.**                          |
|        |   |                                                                                                                                                                                              |
| **(10.3)**  |   | **Lawrence P. Ward Employment Letter Agreement, dated  February 28, 2002, filed with the SEC in the Company’s 10-KSB Report for the  year ended December 31, 2001.**                         |
|        |   |                                                                                                                                                                                              |
| **(10.4)**  |   | **401(k) Pension and Profit Sharing Plan filed with the  SEC in the Company’s 10K Report for the year ended December 31, 1994.**                                                             |
|        |   |                                                                                                                                                                                              |
| **(10.5)**  |   | **Heritage Oaks Bancorp 1995 Bonus Plan, filed with the  SEC in the Company’s 10K Report for the year ended December 31, 1994.**                                                             |
|        |   |                                                                                                                                                                                              |
| **(10.6)**  |   | **Salary Continuation Agreement with Lawrence P. Ward,  filed with the SEC in the Company’s 10-QSB Report for the quarter ended March  31, 2001.**                                           |
|        |   |                                                                                                                                                                                              |
| **(10.7)**  |   | **Salary Continuation Agreement with Gwen R. Pelfrey,  filed with the SEC in the Company’s 10K Report for the year ended December  31, 1994.**                                               |
|        |   |                                                                                                                                                                                              |
| **(10.8)**  |   | **Woodland Shopping Center Lease, filed with the SEC in  the Company’s 10K Report for the year ended December 31, 1994.**                                                                    |
|        |   |                                                                                                                                                                                              |
| **(10.9)**  |   | **1135 Santa Rosa Street Lease, filed with the SEC in  the Company’s 10KSB Report for the year ended December 31, 1995.**                                                                    |
|        |   |                                                                                                                                                                                              |
| **(10.10)** |   | **Lease Agreement for Cambria Branch Office dated  February 21, 1997 filed with the SEC in the Company’s 10KSB reported for the  year ended December 31,1996.**                              |

 

70

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| **(10.11)** |   | **1997 Stock Option Plan incorporated by reference from  Exhibit 4a to Registration Statement on Form S-8 No.333-31105 filed with the  SEC on July 11, 1997 as amended, incorporated by reference, from Registration  Statement on Form S-8, File No. 333-83235 filed with the SEC on July 20,  1999.** |
|-------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |   |                                                                                                                                                                                                                                                                                                    |
| **(10.12)** |   | **Form of Stock Option Agreement incorporated by  reference from Exhibit 4b to Registration Statement on Form S-8 No. 333-31105  filed with the SEC on July 11, 1997.**                                                                                                                                 |
|        |   |                                                                                                                                                                                                                                                                                                    |
| **(10.13)** |   | **Madonna Road Lease filed with the SEC in the  Company’s 10KSB for the year ended December 31, 1997.**                                                                                                                                                                                            |
|        |   |                                                                                                                                                                                                                                                                                                    |
| **(10.14)** |   | **Santa Maria lease commencing November 1, 1998.**                                                                                                                                                                                                                                                      |
|        |   |                                                                                                                                                                                                                                                                                                    |
| **(10.15)** |   | **Master data processing agreement with Mid West  payment Systems, Inc. commencing October 1, 1998.**                                                                                                                                                                                                   |
|        |   |                                                                                                                                                                                                                                                                                                    |
| **(10.16)** |   | **Salary Continuation Agreement with Margaret A.  Torres, filed with the SEC in the Company’s 10KSB Report for the year ended  December 31, 1999.**                                                                                                                                                |
|        |   |                                                                                                                                                                                                                                                                                                    |
| **(10.17)** |   | **Salary Continuation Agreement with Paul Tognazzini,  filed with the SEC in the Company’s 10-KSB Report for the year ended December  31, 2001.**                                                                                                                                                  |
|        |   |                                                                                                                                                                                                                                                                                                    |
| **(10.18)** |   | **Atascadero Branch Lease entered into on March 31,  1999. filed with the SEC in the Company’s 10-KSB reported for the year ended  December 31,1999.**                                                                                                                                             |
|        |   |                                                                                                                                                                                                                                                                                                    |
| **(10.19)** |   | **Service Bureau Processing Agreement entered into  between Alltel Information Services, Inc. and Heritage Oaks Bank, dated  August 1, 1999. Filed with the SEC in the Company’s 10-KSB reported for the  year ended December 31, 1999.**                                                          |
|        |   |                                                                                                                                                                                                                                                                                                    |
| **(10.20)** |   | **ASSET PURCHASE AGREEMENT entered into between  Travelex America, Inc. and Heritage Oaks Bank, dated November 21 , 2000 filed  with the SEC in the Company’s 10-KSB reported for the year ended December 31,  2000.**                                                                             |
|        |   |                                                                                                                                                                                                                                                                                                    |
| **(10.21)** |   | **Change in Terms Agreement and Business Loan Agreement  entered into between the Company and Pacific Coast Banker’s Bank on November  8, 2000, filed with the SEC in the Company’s 10-KSB reported for the year  ended December 31, 2001.**                                                  |
|        |   |                                                                                                                                                                                                                                                                                                    |
| **(10.22)** |   | **Executive Salary Continuation Agreement dated  February 1, 2002 between Heritage Oaks Bank and Margaret A. Torres, filed  with the SEC in the Company’s 10-QSB reported for March 31, 2002.**                                                                                                    |

 

71

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| **(10.23)** |                                                                         | **Executive Salary Continuation Agreement dated  February  1, 2002 between Heritage  Oaks Bank and Paul Tognazzini, filed with the SEC in the Company’s 10-QSB  reported for March 31, 2002.**                       |
|-------------|------------------------------------------------------------------------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |                                                                         |                                                                                                                                                                                                                           |
| **(10.24)** |                                                                         | **Executive Salary Continuation Agreement dated  February 1, 2002 between Heritage Oaks Bank and Gwen R. Pelfrey, filed with  the SEC in the Company’s 10-QSB reported for March 31, 2002.**                              |
|        |                                                                         |                                                                                                                                                                                                                           |
| **(10.25)** |                                                                         | **Executive Salary Continuation Agreement dated  February 1, 2002 between Heritage Oaks Bank and Gloria Brady, filed with the  SEC in the Company’s 10-QSB reported for March 31, 2002.**                                 |
|        |                                                                         |                                                                                                                                                                                                                           |
| **(10.26)** |                                                                         | **Executive Salary Continuation Agreement dated  February 1, 2002 between Heritage Oaks Bank and Joe Carnevali, filed with the  SEC in the Company’s 10-QSB reported for March 31, 2002.**                                |
|        |                                                                         |                                                                                                                                                                                                                           |
| **(10.27)** |                                                                         | **Executive Salary Continuation Agreement dated  February 1, 2002 between Heritage Oaks Bank and Donna Breuer, filed with the  SEC in the Company’s 10-QSB reported for March 31, 2002.**                                 |
|        |                                                                         |                                                                                                                                                                                                                           |
| **(10.28)** |                                                                         | **Executive Salary Continuation Agreement dated  February 1, 2002 between Heritage Oaks Bank and Chris Sands, filed with the  SEC in the Company’s 10-QSB reported for March 31, 2002.**                                  |
|        |                                                                         |                                                                                                                                                                                                                           |
| **(10.29)** |                                                                         | **Money Access Services Processing Agreement for ATM  processing, signed on October 3, 2002, filed with the SEC in the Company’s  10QSB reported for September 30, 2002.**                                                |
|        |                                                                         |                                                                                                                                                                                                                           |
| **(10.30)** |                                                                         | **Heritage Oaks Bancorp Employee Stock Ownership Plan,  Summary Plan Description, filed with the SEC in the Company’s 10-KSB reported  for December 31, 2002.**                                                           |
|        |                                                                         |                                                                                                                                                                                                                           |
| **(10.31)** |                                                                         | **Heritage Oaks Bancorp Employee Stock Ownership Plan,  Summary of Material Modifications to the Summary Plan Description dated July  2002, filed with the SEC in the Company’s 10-KSB reported for December 31,  2002.** |
|        |                                                                         |                                                                                                                                                                                                                           |
| **(21)**    |                                                                         | **Subsidiaries of Heritage Oaks Bancorp. Heritage Oaks  Bank is the only financial subsidiary of Heritage Oaks Bancorp.**                                                                                                      |
|        |                                                                         |                                                                                                                                                                                                                           |
| **(23)**    |                                                                         | **Consent of Independent Accountants**                                                                                                                                                                                         |
|        |                                                                         |                                                                                                                                                                                                                           |
| **99.1**    | **Certification Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002** |
|        |                                                                         |                                                                                                                                                                                                                           |
| **99.2**    | **Certification Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002** |

 

72

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**(b) Reports on Form 8-K:**

** **

**The Company filed the thirdquarter press release of earnings for September 30, 2002 on Form 8-K with theSEC on October 8, 2002.**

 

**ITEM 14. CONTROLS** AND PROCEDURES

 

(a)  Within 90 days prior to the date of thisreport, the Company carried out an evaluation, under the supervision and withthe participation of its management, including the Company’s Chief ExecutiveOfficer and Chief Financial Officer, of the effectiveness of the design andoperation of the Company’s disclosure controls and procedures pursuant toExchange Act Rule 13a-14. Based upon that evaluation, the Chief ExecutiveOfficer and Chief Financial Officer concluded that the Company’s disclosurecontrols and procedures are effective in timely alerting them to materialinformation relating to the Company (including its consolidated subsidiaries)required to be included in the Company’s periodic SEC filings.

 

(b)  Subsequent to the date ofthis evaluation, there have been no changes in the Company’s internal controlsor in other factors that could significantly affect these controls, and nodiscoveries of any significant deficiencies or material weaknesses in suchcontrols that would require the Company to take corrective actions.

 

73

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**SIGNATURES**

 

**Pursuant to the requirements of Section 13 of the SecuritiesExchange Act of 1934, the Company has duly caused this report to be signed onits behalf by the undersigned thereunto duly authorized.**

 

**HERITAGE OAKS BANCORP**

 
| **By:**                                   | **/s/ Lawrence P. Ward**                    |        | **By:**            | **/s/ Margaret A. Torres** |
|-------------------------------------------|---------------------------------------------|-------------|--------------------|----------------------------|
| **LAWRENCE P. WARD**                      | **MARGARET A. TORRES**                      |
| **President and Chief Executive Officer** | **Executive Vice Pres and Chief Financial** |
|                                      |                                        | **Officer** |
| **Dated:**                                | **March 18, 2003**                          | **Dated:**  | **March 18, 2003** |

 

**Pursuant to the requirements of the Securities Exchange Actof 1934, this report has been signed below by the following persons on behalfof the Registrant and in the capacities and on the dates indicated.**

 
| **/s/ B.R. Bryant**        |   | **Chairman of the Board of Directors**      |   | **March 18, 2003** |
|----------------------------|--------|---------------------------------------------|--------|--------------------|
| **B.R. BRYANT**            |   |                                        |   |               |
|                       |   |                                        |   |               |
| **/s/ Donald H. Campbell** |   | **Vice Chairman of the Board of Directors** |   | **March 18, 2003** |
| **DONALD H. CAMPBELL**     |   |                                        |   |               |
|                       |   |                                        |   |               |
| **/s/ Kenneth Dewar**      |   | **Director**                                |   | **March 18, 2003** |
| **KENNETH DEWAR**          |   |                                        |   |               |
|                       |   |                                        |   |               |
| **/s/ Dolores T. Lacey**   |   | **Director**                                |   | **March 18, 2003** |
| **DOLORES T. LACEY**       |   |                                        |   |               |
|                       |   |                                        |   |               |
| **/s/ Merle F. Miller**    |   | **Director**                                |   | **March 18, 2003** |
| **MERLE F. MILLER**        |   |                                        |   |               |
|                       |   |                                        |   |               |
| **/s/ Michael Morris**     |   | **Director**                                |   | **March 18, 2003** |
| **MICHAEL MORRIS**         |   |                                        |   |               |
|                       |   |                                        |   |               |
| **/s/ Ole K. Viborg**      |   | **Director**                                |   | **March 18, 2003** |
| **OLE K. VIBORG**          |   |                                        |   |               |
|                       |   |                                        |   |               |
| **/s/ Lawrence P. Ward**   |   | **Director**                                |   | **March 18, 2003** |
| **LAWRENCE P. WARD**       |   |                                        |   |               |
|                       |   |                                        |   |               |
| **/s/ David Weyrich**      |   | **Director**                                |   | **March 18, 2003** |
| **DAVID WEYRICH**          |   |                                        |   |               |

 

74

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CERTIFICATIONS

 

I, Lawrence P. Ward, Chief ExecutiveOfficer, certify that:

 
|   | 1.     |   | I have reviewed this  annual report on Form 10-KSB of Heritage Oaks Bancorp;                                                                                                                                                                                                                                                 |
|--------|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |   |                                                                                                                                                                                                                                                                                                                         |
|   | 2.     |   | Based on my knowledge,  this annual report does not contain any untrue statement of a material fact  or omit to state a material fact necessary to make the statements made, in  light of the circumstances under which such statements were made, not  misleading with respect to the period covered by this annual report; |
|   |   |   |                                                                                                                                                                                                                                                                                                                         |
|   | 3.     |   | Based on my knowledge,  the financial statements, and other financial information included in this  annual report, fairly present in all material respects the financial  condition, results of operations and cash flows of the registrant as of, and  for, the periods presented in this annual report;                    |
|   |   |   |                                                                                                                                                                                                                                                                                                                         |
|   | 4.     |   | The registrant’s other  certifying officers and I are responsible for establishing and maintaining  disclosure controls and procedures (as defined in Exchange Act Rules 13a-14  and 15d-14) for the registrant and we have:                                                                                            |

 
|   | a) |   | designed such disclosure  controls and procedures to ensure that material information relating to the  registrant, including its consolidated subsidiaries, is made known to us by  others within those entities, particularly during the period in which this  annual report is being prepared; |
|--------|----|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | b) |   | evaluated the  effectiveness of the registrant’s disclosure controls and procedures as of a  date within 90 days prior to filing date of this annual report (the  “Evaluation Date”); and                                                                                         |
|   | c) |   | presented in this annual  report our conclusions about the effectiveness of the disclosure controls and  procedures based on our evaluation as of the Evaluation Date;                                                                                                                           |

 
|   | 5. |   | The registrant’s other  certifying officers and I have disclosed, based on our most recent  evaluation, to the registrant’s auditors and audit committee of registrant’s  board of directors (or persons performing the equivalent function); |
|--------|----|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 
|   | a) |   | all significant  deficiencies in the design or operation of internal controls which could  adversely affect the registrant’s ability to record, process, summarize and  report financial data and have identified for the registrant’s auditors any  material weaknesses in internal controls; and |
|--------|----|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | b) |   | any fraud, whether or not  material, that involves management or other employees who have a significant  role in the registrant’s internal controls; and                                                                                                                                                |

 
|   | 6. |   | The registrant’s other  certifying officers and I have indicated in this annual report whether or not  there were significant changes in internal controls or in other factors that  could significantly affect internal controls subsequent to the date of our most  recent evaluation, including any corrective actions with regard to  significant deficiencies and material weaknesses. |
|--------|----|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

 
| Date:  March 18, 2003 |                    |
|----------------------------|-------------------------|
|                       | /s/ Lawrence P. Ward    |   |
|                       | Lawrence P. Ward        |
|                       | Chief Executive Officer |

 

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CERTIFICATIONS

 

I, Margaret A. Torres, Chief FinancialOfficer, certify that:

 
|   | 1.     |   | I have reviewed this  annual report on Form 10-KSB of Heritage Oaks Bancorp;                                                                                                                                                                                                                                                 |
|--------|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |   |                                                                                                                                                                                                                                                                                                                         |
|   | 2.     |   | Based on my knowledge,  this annual report does not contain any untrue statement of a material fact  or omit to state a material fact necessary to make the statements made, in  light of the circumstances under which such statements were made, not  misleading with respect to the period covered by this annual report; |
|   |   |   |                                                                                                                                                                                                                                                                                                                         |
|   | 3.     |   | Based on my knowledge,  the financial statements, and other financial information included in this  annual report, fairly present in all material respects the financial  condition, results of operations and cash flows of the registrant as of, and  for, the periods presented in this annual report;                    |
|   |   |   |                                                                                                                                                                                                                                                                                                                         |
|   | 4.     |   | The registrant’s other  certifying officers and I are responsible for establishing and maintaining  disclosure controls and procedures (as defined in Exchange Act Rules 13a-14  and 15d-14) for the registrant and we have:                                                                                            |

 
|   | i.     |   | designed such disclosure  controls and procedures to ensure that material information relating to the  registrant, including its consolidated subsidiaries, is made known to us by  others within those entities, particularly during the period in which this  annual report is being prepared; |
|--------|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |   |                                                                                                                                                                                                                                                                                             |
|   | ii.    |   | evaluated the  effectiveness of the registrant’s disclosure controls and procedures as of a  date within 90 days prior to filing date of this annual report (the  “Evaluation Date”); and                                                                                         |
|   |   |   |                                                                                                                                                                                                                                                                                             |
|   | iii.   |   | presented in this annual  report our conclusions about the effectiveness of the disclosure controls and  procedures based on our evaluation as of the Evaluation Date;                                                                                                                           |

 
|   | 5. |   | The registrant’s other  certifying officers and I have disclosed, based on our most recent evaluation,  to the registrant’s auditors and audit committee of registrant’s board of  directors (or persons performing the equivalent function); |
|--------|----|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 
|   | i.     |   | all significant  deficiencies in the design or operation of internal controls which could  adversely affect the registrant’s ability to record, process, summarize and  report financial data and have identified for the registrant’s auditors any  material weaknesses in internal controls; and |
|--------|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |   |                                                                                                                                                                                                                                                                                                         |
|   | ii.    |   | any fraud, whether or not  material, that involves management or other employees who have a significant  role in the registrant’s internal controls; and                                                                                                                                                |

 
|   | 6. |   | The registrant’s other  certifying officers and I have indicated in this annual report whether or not  there were significant changes in internal controls or in other factors that  could significantly affect internal controls subsequent to the date of our  most recent evaluation, including any corrective actions with regard to  significant deficiencies and material weaknesses. |
|--------|----|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

 
| Date:     March  18, 2003 |                    |
|----------------------------------------------------|-------------------------|
|                                               | /s/ Margaret A. Torres  |   |
|                                               | Margaret A. Torres      |
|                                               | Chief Financial Officer |

 

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# **WHERE YOU CAN FIND MORE INFORMATION**

 

Under the Securities Exchange Act of 1934Sections 13 and 15(d), periodic and current reports must be filed with the SEC.The Company electronically files the following reports with the SEC: Form 10-K(Annual Report), Form 10-Q (Quarterly Report), Form 8-K (Report of Unscheduled Material Events), and Form DEF 14A (ProxyStatement). The Company may file additional forms. The SEC maintains anInternet site, www.sec.gov, in which all forms filed electronically may beaccessed. Additionally, all forms filed with the SEC and additional shareholderinformation is available free of charge on the Company’s website:www.heritageoaksbank.com

 

The Company posts these reports to itswebsite as soon as reasonably practicable after filing them with the SEC.  None of the information on or hyperlinkedfrom the Company’s website is incorporated into this Annual Report on Form10-K.

 

**EXHIBIT INDEX**

 
| **Exhibit  Sequential  Number** |   | **Description**                                                                                                                              |
|---------------------------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------|
|                            |   |                                                                                                                                         |
| **10.30**                       |   | **Heritage Oaks Bancorp Employee Stock Ownership Plan,  Summary Plan Description**                                                           |
|                            |   |                                                                                                                                         |
| **10.31**                       |   | **Heritage Oaks Bancorp Employee Stock Ownership Plan,  Summary of Material Modifications to the Summary Plan Description dated July  2002** |
|                            |   |                                                                                                                                         |
| **23**                          |   | **Consent of Independent Accountants**                                                                                                       |
|                            |   |                                                                                                                                         |
| **99.1**                        |   | **Certification Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002**                                                                 |
|                            |   |                                                                                                                                         |
| **99.2**                        |   | **Certification Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002**                                                                 |

 

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