** **

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

** **

**FORM 10-KSB**

 

**ý****                                ****ANNUAL REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

** **

**for the Year ended December 31, 2001**

** **

**OR**

** **

**o****                                ****TRANSITION REPORT PURSUANTTO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the transition period from                                    to**

** **

**Commission file number                      0-25020**

 

**HERITAGEOAKS BANCORP**

(Exactname of registrant as specified in its charter)

 

| **State of California**                             |   | **77-0388249**                    |
|-----------------------------------------------------|--------|-----------------------------------|
| (State or other jurisdiction of                     |   | (I.R.S. Identification  No.) |
| employee incorporation or organization)             |   |                              |
|                                                |   |                              |
| **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 the registrant (1) has filed all reportsrequired to be riled by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. Yes ý No o

 

Indicate by check mark if disclosure of delinquent filers pursuant toItem 405 of Regulation S-B is not contained herein, and will not be contained,to the best of the registrant’s knowledge, in definitive proxy or informationstatements incorporated by reference in Part III of this Form 10-KSB or anyamendment to this Form 10-KSB  ý.

 

Registrant’s revenue for 2001 was $19,141,928.  The aggregate market value of the voting stock held bynon-affiliates of the Registrant at February 1, 2002 was  $16,261,900.  As of February 1, 2002, the Registrant had 1,297,880 shares ofCommon Stock outstanding.

 

The following documents are incorporated by reference in Part III, Items9 through 12 of Registrant’s definitive proxy statement for the 2002 annualmeeting of shareholders.

 

Transitional Small Business Disclosure Format (check one)         Yes o    No ý

 

 

 

 

**TABLE OFCONTENTS**

 

 
| 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                                                            |   |   |

 

 

 

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**PART I**

 

## **Certain statements contained in this Annual Reporton Form 10-KSB (“Annual Report”), including, without limitation, statementscontaining the words “believes”, “anticipates”, “intends”, “expects”, and wordsof similar impact, constitute “forward-looking statements” within the meaningof Section 27A of the Securities Act of 1933 and Section 21E of the Securitiesand Exchange Act of 1934. Such forward-looking statements involve known andunknown risks, uncertainties and other factors that may cause the actualresults, performance or achievements of the Company to be materially differentfrom any future results, performance or achievements expressed or implied bysuch forward-looking statements. Such factors include, among others, thefollowing: general economic and business conditions in those areas in which theCompany operates, demographic changes, competition, fluctuations in interestrates, changes in business strategy or development plans, changes in governmentalregulation, credit quality, the availability of capital to fund the expansionof the Company’s business,**economic, political and global changes arising from the terroristattacks of September 11, 2001 and their aftermath and other factors referenced in this report, including in “Item 1.Description of Business-Factors that May Affect Future Results of Operations”.The Company disclaims any obligation to update any such factors or to publiclyannounce the results of any revisions to any of the forward-looking statementscontained herein to reflect future events or developments.

 

#### **ITEM 1.       DESCRIPTION OF BUSINESS**

## ** **

## **General**

 

Heritage Oaks Bancorp (the “Company”) is aCalifornia corporation organized in 1994 to act as the bank holding company ofHeritage Oaks Bank (the “Bank”).    In1994, the Company acquired all of the outstanding common stock of the Bank in aholding company formation transaction. Other than holding the shares of the Bank, the Company conducts nosignificant activities, although it is authorized, with the prior approval ofthe Board of Governors of the Federal Reserve System (the “Federal ReserveBoard”), the Company’s principal regulator, to engage in a variety ofactivities which are deemed closely related to the business of banking.

 

## **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 31,2001, the Company had approximately $214.9 million in assets, $156.1 million innet loans, $195.6 million in deposits, and $15.9 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 located in Santa Maria, one branch located inAtascadero and one branch located 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 offers installment note collection,issues cashiers checks and money orders, sells travelers checks, and providesbank-by-mail, night depository, safe deposit boxes, and other customary bankingservices. The Bank does not offer trust services or international bankingservices and does not plan to do so in the near future.

 

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The Bank’s operating policy since its inception has emphasized smallbusiness, commercial and retail banking. Most of the Bank’s customers are retail customers, farmers and small tomedium-sized businesses.  The Bank takesreal estate, listed and unlisted securities, savings and time deposits,automobiles, machinery and equipment as collateral for loans.  The areas in which the Bank has directedvirtually all of its lending activities are (i) commercial and agriculturalloans, (ii) installment loans, (iii) construction loans, and (iv) other realestate loans or commercial loans secured by real estate.  As of December 31, 2001, these fourcategories accounted for approximately 25.6%, 2.0%, 14.8% and 57.3%respectively, of the Bank’s loan portfolio. As of December 31, 2001,  $114.3million or 72.11% of the Bank’s  $158.5million in gross loans consisted of interim construction and real estate loans,primarily for single family residences or for commercial development.Commercial and agricultural loans decreased $2.3 million (approximately 6%) andother real estate loans or commercial loans secured by real estate increased$20.3 million between year-end 2000 and year-end 2001. See “Item 6 —Management’s Discussion and Analysis of Financial Condition and Results ofOperations.”

 

Mostof the Bank’s deposits are attracted by local promotional activities andadvertising in the local media.  Amaterial portion of the Bank’s deposits have not been obtained from a singleperson or a few persons, the loss of any one or more of which would have amaterially adverse effect on the business of the Bank.  As of December 31, 2001, the Bank had approximately14,049 deposit accounts consisting of non-interest bearing (demand),interest-bearing demand and money market accounts with balances totaling $127.8million for an average balance per account of approximately  $9,097; 4,932 savings accounts with balancestotaling $18.6 million for an average balance per account of approximately  $3,771; and 1,815 time certificate ofdeposit accounts with balances totaling $49.2 million, for an average balanceper account of approximately  $27,107.

 

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) ATM transactionfees, sponsorship fees and interchange income, (v) mortgage origination feesand (vi) miscellaneous income.  For theyear ended December 31, 2001, these sources comprised 69.4%, 6.2%, 6.2%, 10.5%,3.0% and 4.7%, respectively, of the Bank’s total operating income.

 

In 2000, the Bank had approximately 65 cashdispensing machines for the purpose of dispensing cash, 15 of which were onNative American lands where bingo games and other gaming operations areconducted, with the remaining 50 at other commercial locations, and at theBank’s 8 offices. In November 2000, the Bank entered into a sales agreement todivest itself of 36 of the sites at other commercial locations. The sale wasfinalized by March 31, 2001 as reported in the 10-QSB for that period. Theremaining commercial locations were closed prior to the end of the thirdquarter in 2001. Of the 15 Native American sites, only two remain as of thiswriting. The Bank expects to process these two sites through the end of therespective agreement terms. Please see “Item 6. Management’s Discussion andAnalysis of Financial Condition and Results of Operations.”

 

TheCompany has also caused to be incorporated a proposed subsidiary, CCMS Systems,Inc. which is currently inactive and has not been capitalized.  The Company has no present plans to activatethe proposed subsidiary.

 

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 anymaterial effect upon the Bank’s capital expenditures, earnings or competitiveposition 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.

 

**Strategic Developments**

 

OnJuly 16, 2001, the Bank and Westamerica Bank, a California Banking corporation,entered into a Branch Purchase and Assumption Agreement (“Agreement” includedas an Exhibit in Company’s September 30, 2001 10-QSB), pursuant to whichHeritage Oaks Bank purchased the four Westamerica Bank Branches in San LuisObispo County (“Branches”).  TheBranches were located in the cities of Arroyo Grande, Morro Bay, Paso Roblesand San Luis Obispo. In addition, Heritage Oaks Bank  acquired Westamerica Bank’s interest in the real estate of eachof the Branches, whether they were owned or leased.

 

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Under the Agreement, Heritage Oaks Bankassumed all deposit liabilities of approximately $25 million and otherliabilities set forth in the Agreement and purchased certain of the assets ofthe Branches.  It did not purchase anyof the loans of the Branches that were retained by Westamerica Bank.  All employees of the Branches (except one loanofficer designated by Westamerica) was offered employment 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 LuisObispo, California was consolidated with the Heritage Oaks Bank branch locatedat 1135 Santa Rosa Street, San Luis Obispo, California; and the branch locatedat 1204 Spring Street, Paso Robles, California was consolidated with theHeritage Oaks Bank branch located at 545 Twelfth Street, Paso Robles,California.  Further, the Heritage OaksBank branch located at 1360 Grand Avenue, Arroyo Grande, California wasconsolidated with the branch being acquired that is located at 1255 GrandAvenue, Arroyo Grande, California.

 

OnMarch 31, 2001, the Bank finalized the divestiture of the ATM Network locatedin retail sites throughout the United States, By the end of the fourth quarterof 2001, all but two site were discontinued in the ATM Gaming Network locatedon American Indian land. Due to narrowing profit margins, the Bank began toscale back on these lines of business in 2000 and discontinued operation almostentirely in 2001.

 

**Employees**

 

As of February 1, 2001, the Bank had a totalof 106 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.

 

**Local Economic Climate**

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 and educational.The Bank’s service area is San Luis Obispo County and Northern Santa BarbaraCounty. The population in the two county areas , according to the U.S. Bureauof the Census, was estimated at July 1999 to be approximately 644,000. San LuisObispo County represents about 37% of this total with Santa Barbara Countyaccounting for the remaining approximately 63%. The moderate climate allows ayear round growing season for numerous vegetable and fruits. Vineyards andcattle ranches also contribute largely to the local economy. Vineyards inproduction have grown significantly over the past several years throughout theCompany’s service area. Access to numerous recreational activities, includinglakes, mountains and beaches, provide a relatively stable tourist industry frommany areas including the Los Angeles/Orange County basin, the San Francisco Bayarea and the San Joaquin Valley. Principally due to the diversity of thevarious industries in the Company’s service area, the area, while not immunefrom economic fluctuations, does tend to enjoy a more stable level of economicactivity from many other areas of California.

 

**Competition**

Thebanking and financial services business in California generally, and in theCompany’s service area specifically, is highly competitive. The increasinglycompetitive environment is a result primarily of changes in regulation, changesin technology and product delivery systems, and the accelerating pace ofconsolidation among financial services providers and the appearance of new bankingorganizations.

 

TheCompany’s business is concentrated in its service area, which encompasses SanLuis Obispo County and Northern Santa Barbara County. In order to compete withother financial institutions in its service area, the Bank relies principallyupon local advertising programs; direct personal contact by officers,directors, employees, and shareholders; and specialized services such as courierpick-up and delivery of non-cash banking items. The Bank emphasizes to itscustomers the 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

 

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independentbanks, retaining the portion of such loans which is within its lending limits.As of December 31, 2001, the Bank’s legal lending limits to a single borrowerand such borrower’s related parties were $2,643,128 on an unsecured basis and$4,405,213 on a fully secured basis, based on regulatory capital plus reservesof  $17,620,851.

 

Commercialbanks compete with savings and loan associations, credit unions, otherfinancial institutions, securities brokerage firms, and other entities forfunds. For instance, yields on corporate and government debt securities andother commercial paper affect the ability of commercial banks to attract andhold deposits. Commercial banks also compete for loans with savings and loanassociations, credit unions, consumer finance companies, mortgage companies andother lending institutions.

 

Inrecent years competition for cash dispensing machines on Native American landsin connection with gaming operations has greatly increased. Further competitionfor ATM machines at retail sites has also increased creating reduced profitmargins. This trend has led the Bank to divest itself of this line of business.See “Item 6. Management’s Discussion and Analysis of Financial Condition andResults of Operations”, below.

 

**Effect of GovernmentPolicies and Recent Legislation**

Bankingis a business that depends on rate differentials. In general, the differencebetween the interest rate paid by the Bank on its deposits and its other borrowingsand the interest rate received by the Bank on loans extended to its customersand securities held in the Bank’s portfolio comprise the major portion of theBank’s earnings. These rates are highly sensitive to many factors that arebeyond the control of the Bank. Accordingly, the earnings and growth of theBank are subject to the influence of domestic and foreign economic conditions,including inflation, recession and unemployment.

 

Thecommercial banking business is not only affected by general economic conditionsbut is also influenced by the monetary and fiscal policies of the federal governmentand the policies of regulatory agencies, particularly the Federal ReserveBoard. The Federal Reserve Board implements national monetary policies (withobjectives such as curbing inflation and combating recession) by itsopen-market operations in United States Government securities, by adjusting therequired level 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.

 

Fromtime to time, legislation is enacted which has the effect of increasing thecost of doing business, limiting or expanding permissible activities or affectingthe competitive balance between banks and other financial institutions.Proposals to change the laws and regulations governing the operations and taxationof banks, bank holding companies and other financial institutions arefrequently made in Congress, in the California legislature and before variousbank regulatory and other professional agencies. See “Description ofBusiness-Financial Services Modernization Legislation”.

 

**General**

TheCompany and the Bank are extensively regulated under both federal and statelaw. Set forth below is a summary description of certain laws that relate tothe regulation of the Company and the Bank. The description does not purport tobe complete and is qualified in its entirety by reference to the applicablelaws and regulations.

 

**The Company**

TheCompany is a bank holding company within the meaning of the Bank HoldingCompany Act of 1956, as amended (the “Bank Holding Company Act”), and is registeredas such with, and subject to the supervision of, the Federal Reserve Board. TheCompany is required to file with the Federal Reserve Board quarterly and annualreports and such additional information as the Federal Reserve Board mayrequire pursuant to the Bank Holding Company Act. The Federal Reserve Board mayconduct examinations of bank holding companies and their subsidiaries.

 

TheCompany is required to obtain the approval of the Federal Reserve Board beforeit may acquire all or substantially all of the assets of any bank, or ownershipor control of the voting shares of any bank if, after giving effect to suchacquisition of shares, the Company would own or control more than 5% of thevoting shares of such bank. Prior approval of the Federal Reserve Board is alsorequired for the merger or consolidation of the Company and another bankholding company.

 

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TheCompany is prohibited by the Bank Holding Company Act, except in certainstatutorily prescribed instances, from acquiring direct or indirect ownershipor control of more than 5% of the outstanding voting shares of any company thatis not a bank or bank holding company and from engaging, directly or indirectly,in activities other than those of banking, managing or controlling banks orfurnishing services to its subsidiaries. However, the Company may, subject tothe prior approval of the Federal Reserve Board, engage in any, or acquireshares of companies engaged in, activities that are deemed by the FederalReserve Board to be so closely related to banking or managing or controllingbanks as to be a proper incident thereto. See discussion under “FinancialModernization Act” below for additional information.

 

TheFederal Reserve Board may require that the Company terminate an activity orterminate control of or liquidate or divest subsidiaries or affiliates when theFederal Reserve Board determines that the activity or the control or thesubsidiary or affiliates constitutes a significant risk to the financialsafety, soundness or stability of any of its banking subsidiaries. The FederalReserve Board also has the authority to regulate provisions of certain bankholding company debt, including authority to impose interest ceilings andreserve requirements on such debt. Under certain circumstances, the Companymust file written notice and obtain approval from the Federal Reserve Boardprior to purchasing or redeeming its equity securities.

 

Underthe Federal Reserve Board’s regulations, a bank holding company is required toserve as a source of financial and managerial strength to its subsidiary banksand may not conduct its operations in an unsafe and unsound manner. Inaddition, it is the Federal Reserve Board’s policy that in serving as a sourceof strength to its subsidiary banks, a bank holding company should stand readyto use available resources to provide adequate capital funds to its subsidiarybanks during periods of financial stress or adversity and should maintain thefinancial flexibility and capital-raising capacity to obtain additional resourcesfor assisting its subsidiary banks. A bank holding company’s failure to meetits obligations 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.

 

TheCompany is subject to the periodic reporting requirements of the SecuritiesExchange Act of 1934, as amended, and filed reports and proxy statements pursuantto such Act with the Securities and Exchange Commission (the “SEC”)

 

**The Bank**

TheBank is chartered under the laws of the State of California and its depositsare insured by the FDIC to the extent provided by law. The Bank is subject tothe supervision of, and is regularly examined by, the DFI and the FDIC. Suchsupervision and regulation include comprehensive reviews of all major aspectsof the Bank’s business and condition. Various requirements and restrictionsunder the laws of the United States and the State of California affect the operationsof the Bank. Federal and California statutes relate to many aspects of theBank’s operations, including reserves against deposits, interest rates payableon deposits, loans, investments, mergers and acquisitions, borrowings,dividends and locations of branch offices. Further, the Bank is required to maintaincertain levels of capital.

 

If,as a result of an examination of a bank, the FDIC   or the DFI   shoulddetermine that the financial condition, capital resources, asset quality, earningsprospects, management, liquidity, or other aspects of the Bank’s operations areunsatisfactory or that the Bank or its management is violating or has violatedany law or regulation, various remedies are available to these regulatoryagencies. Such remedies include the power to enjoin “unsafe or unsound”practices, to require affirmative action to correct any conditions resultingfrom any violation or practice, to issue an administrative order that can bejudicially enforced, to direct an increase in capital, to restrict the growthof the Bank, to assess civil monetary penalties, to remove officers anddirectors, and ultimately to terminate the Bank’s deposit insurance, which fora California chartered bank would result in a revocation of the bank’s charter.

 

**Capital Standards**

TheFederal Reserve Board and the FDIC have adopted risk-based minimum capitalguidelines intended to provide a measure of capital that reflects the degree ofrisk associated with a banking organization’s operations for both transactionsreported on the balance sheet as assets and transactions, such as letters ofcredit and recourse arrangements, which are recorded as off balance sheetitems. Under these guidelines, nominal dollar amounts of assets and creditequivalent amounts of off balance sheet items are multiplied by one of severalrisk adjustment percentages, which range from 0% for assets with low creditrisk, such as certain U.S. Treasury securities, to 100% for assets with relativelyhigh credit risk, such as business loans.

 

Abanking organization’s risk-based capital ratios are obtained by dividing itsqualifying capital by its total risk adjusted

 

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assets.The regulators measure risk-adjusted assets, which includes off balance sheetitems, against both total qualifying capital (the sum of Tier 1 capital andlimited amounts of Tier 2 capital) and Tier 1 capital. Tier 1 capital consistsprimarily of common stock, retained earnings, non-cumulative perpetualpreferred stock (cumulative perpetual preferred stock for bank holdingcompanies) and minority interests in certain subsidiaries, less most intangibleassets. Tier 2 capital may consist of a limited amount of the allowance forpossible loan and lease losses, cumulative preferred stock, long term preferredstock, eligible term subordinated debt and certain other instruments with somecharacteristics of equity. The inclusion of elements of Tier 2 capital issubject to certain other requirements and limitations of the federal bankingagencies. The federal banking agencies require a minimum ratio of qualifyingtotal capital to risk-adjusted assets of 8% and a minimum ratio of Tier 1capital to risk-adjusted assets of 4%.

 

Inaddition to the risked-based guidelines, federal banking regulators requirebanking organizations 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 the discretionto set individual minimum capital requirements for specific institutions atrates significantly above the minimum guidelines and ratios. Future changes inregulations or practices could further reduce the amount of capital recognizedfor purposes of capital adequacy. Such a change could affect the ability of theCompany to grow and could restrict the amount of profits, if any, available forthe payment of dividends.

 

Thefollowing table presents the amounts of the capital ratios for the Bank and therequirements for a well- capitalized company compared to its minimum regulatorycapital requirements as of December 31, 2001:

 
|                     |   |            |   | **Regulatory Requirements** |   |
|--------------------------|--------|-----------------|--------|-----------------------------|--------|
|                     |   | **Bank Actual** |   | **Well-Capitalized**        |   | **Minimum   Requirement** |   |
| LEVERAGE RATIO           |   | 7.81            | %      | 5.00                        | %      | 4.0 | % |
| TIER 1  RISK-BASED RATIO |   | 9.19            | %      | 6.00                        | %      | 4.0 | % |
| TOTAL RISK-BASED  RATIO  |   | 10.17           | %      | 10.00                       | %      | 8.0 | % |

 

Underapplicable regulatory guidelines, the Bank was considered “Well Capitalized” atDecember 31, 2001.

 

Inaddition, the DFI has authority  to takepossession of the business and properties of a bank in the event that thetangible shareholders’ equity of the bank is less than the greater of (i) 4% ofthe banks total assets or (ii) $1,000,000

 

**Prompt Corrective Actionand Other Enforcement Mechanisms**

Federalbanking agencies possess broad powers to take corrective and other supervisoryaction to resolve the problems of insured depository institutions, includingbut not limited to those institutions that fall below one or more prescribedminimum capital ratios described above. An institution that, based upon itscapital levels, is classified as well capitalized, adequately capitalized, orundercapitalized may be treated as though it were in the next lower capitalcategory if the appropriate federal banking agency, after notice andopportunity for hearing, determines that an unsafe or unsound condition or anunsafe or unsound practice warrants such treatment. At each successive lowercapital category, an insured depository institution is subject to morerestrictions. The federal banking agencies, however, may not treat asignificantly undercapitalized institution as critically undercapitalizedunless its capital ratio actually warrants such treatment.

 

Inaddition to measures taken under the prompt corrective action provisions,commercial banking organizations may be subject to potential enforcement actionsby the federal regulators for unsafe or unsound practices in conducting theirbusinesses or for violations of any law, rule, regulation, or any conditionimposed in writing by the agency or any written agreement with the agency.Enforcement actions may include the imposition of a conservator or receiver,the issuance of a cease-and-desist order that can be judicially enforced, thetermination 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.

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**Safety and Soundness Standards**

 

TheFederal Deposit Insurance Corporation Improvement Act (“FDICIA”) imposescertain specific restrictions on transactions and requires federal bankingregulators to adopt overall safety and soundness standards for depositoryinstitutions 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.

 

**Premiums for DepositInsurance**

Throughthe Bank Insurance Fund (“BIF”), the FDIC insures the deposits of the Bank upto prescribed limits for each depositor. The amount of FDIC assessments paid byeach BIF member institution is based on its relative risk of default asmeasured by regulatory capital ratios and other factors. Specifically, theassessment rate is based on the institution’s capitalization risk category andsupervisory subgroup category. An institution’s capitalization risk category isbased on the FDIC’s determination of whether the institution is wellcapitalized, adequately capitalized or less than adequately capitalized. Aninstitution’s supervisory subgroup category is based on the FDIC’s assessmentof the financial condition of the institution and the probability that FDICintervention or other corrective action will be required.

 

Theassessment rate currently ranges from zero to 27 cents per $100 of domesticdeposits. The FDIC may increase or decrease the assessment rate schedule on asemi-annual basis. An increase in the assessment rate could have a material adverseeffect on the Company’s earnings, depending on the amount of the increase. TheFDIC is authorized to terminate a depository institution’s deposit insuranceupon a finding by the FDIC that the institution’s financial condition is unsafeor unsound or that the institution has engaged in unsafe or unsound practicesor has violated any applicable rule, regulation, order or condition enacted orimposed by the institution’s regulatory agency. The termination of depositinsurance for the Bank would result in the revocation of the Bank’s charter andthe cessation of its operations as a going concern.

 

AllFDIC-insured depository institutions must pay an annual assessment to providefunds for the payment of interest on bonds issued by the Financing Corporation,a federal corporation chartered under the authority of the Federal HousingFinance Board. The bonds, commonly referred to as FICO bonds, were issued tocapitalize the Federal Savings and Loan Insurance Corporation. The FICOassessments are adjusted quarterly to reflect changes in the assessment basesof the FDIC’s insurance funds and do not vary depending on a depositoryinstitution’s capitalization or supervisory evaluations.

 

**Financial Services ModernizationLegislation**

**General**

 

OnNovember 12, 1999,  the Gramm-Leach-Bliley Act of 1999 (the “Financial Services Modernization Act”) wassigned into law. The Financial Services Modernization Act repeals the twoaffiliation provisions of the Glass-Steagall Act: Section 20, which restrictedthe affiliation of Federal Reserve Member Banks with firms “engagedprincipally” in specified securities activities; and Section 32, whichrestricts officer, director, or employee interlocks between a member bank andany company or person “primarily engaged” in specified securities activities.In addition, the Financial Services Modernization Act also contains provisionsthat expressly preempt any state law restricting the establishment of financialaffiliations, primarily related to insurance. The general effect of the law isto establish a comprehensive framework to permit affiliations among commercialbanks, insurance companies, securities firms, and other financial serviceproviders by revising and expanding the BHCA framework to permit a holdingcompany system to engage in a full range of financial activities through a newentity known as a Financial Holding

Company.

 

9

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Thelaw also:

•                  broadens the activities that may beconducted by national banks, banking subsidiaries of bank holding companies,and their financial subsidiaries;

•                  provides an enhanced framework forprotecting the privacy of consumer information;

•                  adopts a number of provisions related to thecapitalization, membership, corporate governance, and other measures designedto modernize the Federal Home Loan Bank system;

•                  modifies the laws governing theimplementation of the Community Reinvestment Act; and

•                  addresses a variety of other legal andregulatory issues affecting both day-to-day operations and long-term activitiesof financial institutions.

TheCompany and the Bank do not believe that the Financial Services ModernizationAct will have a material adverse effect on their operations in the near-term.However, to the extent that it permits banks, securities firms, and insurancecompanies to 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 Company andthe Bank.

 

**Financial Holding Companies**

 

Bankholding companies that elect to become a financial holding company mayaffiliate with securities firms and insurance companies and engage in otheractivities that are financial in nature or are incidental or complementary toactivities that are financial in nature. The Company has not yet elected tobecome a financial holding company.

 

“Financialin nature” activities include: securities underwriting; securities dealing andmarket making; sponsoring mutual funds and investment companies; insuranceunderwriting and agency; merchant banking; and activities that the Federal Reserve,in consultation with the Secretary of the Treasury, determines from time totime to be so closely related to banking or managing or controlling banks as tobe a proper incident thereto.

 

Abank holding company must meet three requirements before becoming a financialholding company: all of the bank holding company’s depository institutionsubsidiaries must be (1) well capitalized, (2) well managed, and (3) incompliance with the Community Reinvestment Act (except in limitedcircumstances). In addition, the bank holding company must file with theFederal Reserve Board a declaration of its election to become a financialholding company, including a certification that its depository institutionsubsidiaries meet the foregoing criteria.

 

Failureto comply with the financial holding company requirements could lead todivestiture of subsidiary banks or require all activities of the company toconform to those permissible for a bank holding company. No Federal ReserveBoard approval is required for a financial holding company to acquire a company(other than a bank holding company, bank or savings association) engaged inactivities that are financial in nature or incidental to activities that arefinancial in nature, as determined by the Federal Reserve Board.

 

**Privacy**

 

Underthe Financial Services Modernization Act, federal banking regulators arerequired to adopt rules that will limit the ability of banks and other financialinstitutions to disclose non-public information about consumers to nonaffiliatedthird parties. These limitations will require disclosure of privacy policies toconsumers and, in some circumstances, will allow consumers to prevent disclosureof certain personal information to a nonaffiliated third party. Federal bankingregulators issued final rules on May 10, 2000. Pursuant to the rules, financialinstitutions must provide:

•                  initial notices to customers about theirprivacy policies, describing the conditions under which they may

•                  disclose nonpublic personal information tononaffiliated third parties and affiliates;

•                  annual notices of their privacy policies tocurrent customers; and

•                  a reasonable method for customers to “optout” of disclosures to nonaffiliated third parties.

Therules were effective November 13, 2000, but compliance was optional until July1, 2001. These privacy provisions affect how consumer information is transmitted through diversifiedfinancial companies and conveyed to outside vendors. It is not possible at thistime to assess the impact of the privacy provisions on the Company’s financialcondition or results of operations.

 

10

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**Consumer Protection Rules—Sale of Insurance**

 

InDecember 2000, pursuant to the requirements of the Financial ServicesModernization Act, the federal bank and thrift regulatory agencies adoptedconsumer protection rules for the sale of insurance products by depositoryinstitutions. The rule became effective on April 1, 2001 and applies to anydepository institution or any person selling, soliciting, advertising, oroffering insurance products or annuities to a consumer at an office of theinstitution or on behalf of the institution. The regulation requires oral andwritten disclosure, before the completion of the sale of an insurance productor annuity, that such product:

•                  is not a deposit or other obligation of, orguaranteed by, the depository institution or its affiliate;

•                  is not insured by the FDIC or any otheragency of the United States, the depository institution or its affiliates; and

•                  has certain risks of investment, includingthe possible loss of value.

Thedepository institution may not condition an extension of credit on the consumer’spurchase of an insurance product or annuity from the depository institution orfrom any of its affiliates, or on the consumer’s agreement not to obtain, or aprohibition on the consumer from obtaining, an insurance product or annuityfrom an unaffiliated entity. Furthermore, to the extent practicable, adepository institution must keep insurance and annuity sales activitiesphysically segregated from the areas where retail deposits are routinelyaccepted from the general public. Finally, the rule addresses cross marketingand referral fees.

 

 

**Safeguarding Confidential Customer Information**

 

 In January 2000, the banking agencies adoptedguidelines requiring financial institutions to establish an informationsecurity program to:

•                  identify and assess the risks that maythreaten customer information;

•                  develop a written plan containing policiesand procedures to manage and control these risks;

•                  implement and test the plan; and

•                  adjust the plan on a continuing basis toaccount for changes in technology, the sensitivity of customer information andinternal or external threats to information security.

Eachinstitution may implement a security program appropriate to its size andcomplexity and the nature and scope of its operations. The guidelines areeffective July 1, 2001.

 

**Community Reinvestment Act**

TheBank is subject to certain fair lending requirements and reporting obligationsinvolving home mortgage lending operations and Community Reinvestment Act(“CRA”) activities. The CRA generally requires the federal banking agencies toevaluate the record of a financial institution in meeting the credit needs oftheir local communities, including low and moderate income neighborhoods. Inaddition to substantial penalties and corrective measures that may be requiredfor a violation of certain fair lending laws, the federal banking agencies maytake compliance with such laws and CRA into account when regulating andsupervising other activities.  When abank holding company applies for approval to acquire a bank or other bank holdingcompany, the Federal Reserve Board will review the assessment of eachsubsidiary bank of the applicant bank holding company, and such records may bethe basis for denying the application. A bank’s compliance with its CRAobligations is based on a performance-based evaluation system which bases CRAratings on an institution’s lending service and investment performance,resulting in a rating by the appropriate bank regulatory agency of“outstanding”, “satisfactory”, “needs to improve” or “substantialnoncompliance.” At its last examination by the FDIC, the Bank received a CRArating of “Satisfactory.”

 

**Factors That May AffectFuture Results of Operations**

**In addition to other information contained in this AnnualReport, the following risks may affect the Company and/or the Bank. If any ofthese risks occur, the Company’s or Bank’s business, financial condition oroperation results could be adversely affected.**

 

11

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***Dependence on Real Estate***

 

Asignificant portion of the loan portfolio of the Bank is dependent on realestate. At December 31, 2001, real estate served as the principal source ofcollateral with respect to approximately 72.11% percent of the Bank’s loanportfolio. A decline in current economic conditions or rising interest ratescould have an adverse effect on the demand for new loans, the ability ofborrowers to repay outstanding loans, the value of real estate and other collateralsecuring loans and the value of real estate owned by the Bank, as well as theCompany’s financial condition and results of operations in general and the marketvalue of the Company’s common stock. Acts of nature, including earthquakes,  floods and draughts, which may cause uninsureddamage and other loss of value to real estate and crops that secures theseloans, may also negatively impact the Company’s financial condition.

 

***Interest Rate Changes***

 

Theearnings of the Company and the Bank are substantially affected by changes inprevailing interest rates. Changes in interest rates affect the demand for newloans, the credit profile of existing loans, the rates received on loans andsecurities and the rates the Bank must pay on deposits and borrowings. Thedifference between the rates the Bank receives on loans and securities and therates it must pay on deposits and borrowings is known as the interest rate spread.Given the Bank’s current volume and mix of interest-bearing liabilities andinterest-earning assets, the Bank’s interest rate spread can be expected to increasewhen market interest rates are rising, and to decline when market interestrates are declining. Our analysis indicates that the decreases in the targetfederal funds rate announced by the Federal Reserve Board throughout 2001resulted in a decrease of 35 basis points in the Bank’s average interest ratespread from that of 2000. If interest rates continue to decline, competitivepressure and other factors may prevent us from making proportionate decreasesin the interest rates we pay on deposits, especially MMDA and NOW accounts,resulting in a larger decrease in our interest rate spread. Although the Bankbelieves its current level of interest rate sensitivity is reasonable,significant fluctuations in interest rates may have an adverse impact on ourbusiness, financial condition and results of operations.

 

***Competition***

 

Competitionmay adversely affect our performance. The financial services business in ourmarket area is highly competitive, and becoming more so due to changes inregulation, technological advances and the accelerating pace of consolidationamong financial service providers. We face competition both in attractingdeposits and in making loans. We compete for loans principally through theinterest rates and loan fees we charge and the efficiency and quality of the serviceswe provide. Increasing levels of competition in the banking and financialservices businesses may reduce our market share or cause the prices we chargefor our services to fall. Our results may differ in future periods depending onthe nature or level of competition.

 

***Regulation***

 

Weare subject to government regulation that could limit or restrict ouractivities, adversely affecting our operations. The financial services industryis heavily regulated. Federal and state regulation is designed to protect thedeposits of consumers, not to benefit our shareholders. The regulations imposesignificant limitations on our operations, and may be changed at any time toimpose significant new limitations, possibly causing our results to varysignificantly from past results. Government policy and regulation, particularlyas implemented through the Federal Reserve System, significantly affects creditconditions for us.

 

 

 

***Borrowers’ Failure to Perform***

 

Asignificant number of our borrowers and guarantors may fail to perform theirobligations as required by the terms of their loans, resulting in losses forus. This risk increases when the economy is weak, as it has been recently. Wehave adopted underwriting and credit policies, and loan monitoring procedures,including the establishment and monitoring of allowances for credit losses. Managementbelieves these provisions are reasonable and adequate, and will should keepcredit losses within expected limits by assessing the likelihood ofnonperformance, tracking loan performance and diversifying our creditportfolio. However, these policies and procedures may not be adequate toprevent unexpected losses that could materially and adversely affect ourresults 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. The

 

12

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Bankmaintains 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 ofCalifornia. As a result of this geographic concentration, our results depend largelyupon economic and business conditions in this region. A deterioration ineconomic and business conditions in our market area could have a materialadverse impact on the quality of our loan portfolio and the demand for ourproducts and services, which in turn may have a material adverse effect on ourresults of operations.

 

# ***War on Terrorism***

 

Theterrorist attacks of September 11, 2001 and ensuing worldwide war on terrorismmay lead to unexpected shifts in cash flows, deposit levels, and generaleconomic activity. US banking agencies have warned of the possible impact ofsuch events on the capital ratios of banks.

 

In addition, the USA PATRIOT Act, whichbecame effective December 25, 2001 as part of the war on terrorism, imposessubstantial new responsibilities on banks for preventing, detecting andreporting flows of funds to terrorist organizations. The act also directs theTreasury Department to prepare detailed regulations for these purposes, such asnew recordkeeping requirements, verification standards for customeridentification and sharing information with the government. The full impact ofthe new law and its implementing regulations on the Bank and the Company cannotbe predicted at this time.

 

 

**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 and land.  This building has approximately 9,000 squarefeet 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/month until June 26, 2002. The rent isthen re-priced in year six of the lease to 95% of the prevailing fair marketvalue and increases each year thereafter at the greater of the consumer priceindex or 2.5% until the lease expires on June 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.

 

On February 21, 1997, the Bank acquired theCambria branch of Wells Fargo Bank located at 1276 Tamson Drive, Cambria. The Bankleases 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.

 

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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.

 

OnJuly 1, 2001 the bank entered into a 9-month lease with an unaffiliated partyto lease property located at 1360 Grand Avenue, Arroyo Grande, Ca. The leasecalls for monthly payments based on a triple net price of approximately $4,200per month. The Bank will not renew or renegotiate this lease at its expiration.The short-term nature of this lease was due to the Bank’s knowledge that it wasacquiring a branch office from Westamerica Bank (seller) that was in closeproximity to the leased facility. On November 9, 2001, the seller conveyedtitle to the land and building located at 1255 Grand Avenue, Arroyo Grande, Ca.The Bank consolidated the existing Bank branch into the newly acquiredfacility. The appraised fair value of the acquired location was $800,000.

 

OnNovember 9, 2001, the Bank also acquired from Westamerica Bank (seller), abranch office located at 310 Morro Bay Blvd., Morro Bay, Ca. The sellerconveyed title to the building at the closing. The appraised fair value of theacquired building was $200,000. The building is on leased land. The sellerassigned and the Bank assumed the lease that expires on April 1, 2012. Themonthly lease payment is $2,200. For a further description of this transaction,see “Item 6. Management’s Discussion and Analysis of Financial Condition andResults of Operations”.

 

TheCompany believes its present 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 security holders during thefourth quarter of 2001.

 

**PART II**

 

**ITEM  5. MARKET FOR COMMON EQUITY AND RELATEDSTOCKHOLDER 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., Pacific Crest Securities and Sutro & Co. make a marketin the Company’s Common Stock.  Certaininformation concerning the Common Stock is reported on the NASDAQ electronicbulletin 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., Pacific Crest Securitiesand Sutro & Co.  These prices do notinclude retail mark-ups, mark-downs or commission.

 

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| **Quarter Ended** |   | **Bid Prices** |   |
|-------------------|--------|----------------|--------|
|              |   |           |   |   |   |
| **2001**          |   | **Low**        |   | **High** |   |
| March 31          |   | $              | 17.50  |   | $ | 19.00 |   |
| June 30           |   | 22.00          |   | 22.88 |   |
| September 30      |   | 23.00          |   | 24.50 |   |
| December 31       |   | 24.00          |   | 26.00 |   |
|              |   |           |   |   |   |
| **2000**          |   | **Low**        |   | **High** | ** ** |
| March 31          |   | $              | 14.63  |   | $ | 15.00 |   |
| June 30           |   | 13.35          |   | 14.00 |   |
| September 30      |   | 17.25          |   | 17.75 |   |
| December 31       |   | 17.25          |   | 17.75 |   |
|              |   |           |   |   |   |
| **1999**          |   | **Low**        |   | **High** | ** ** |
| March 31          |   | $              | 16.25  |   | $ | 16.25 |   |
| June 30           |   | 16.25          |   | 17.00 |   |
| September 30      |   | 16.00          |   | 16.75 |   |
| December 31       |   | 15.75          |   | 16.75 |   |

 

Holders

 

As of February 1, 2002, there wereapproximately 580 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 the restrictionsset forth in the California General Corporation Law (the “CorporationLaw”).  The Corporation Law providesthat 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.

 

On September 11, 1998, Heritage Oaks Bancorpexecuted a Promissory Note for a $2 million line of credit with Pacific CoastBankers’ Bank (“PCBB”).  In November2001, pursuant to the terms of the note, this line of credit was converted to afully amortized note. Pursuant to the Conditions of the Note, the Company mustobtain written approval from PCBB prior to declaring a cash dividend.

 

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 thegreater 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 available for distribution from theBank to the Company was approximately $4,743,852 at December 31, 2001.

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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     |

 

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.

 

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**ITEM 6.  MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL 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, 2001.  The analysisshould be read in connection with the consolidated financial statements andnotes thereto appearing elsewhere in this report.

 

 On November 15, 1994, the Company was organized as a holdingcompany for the Bank. The Bank is the only active subsidiary owned by theCompany.

 

**Earnings Overview**

 

The Company reported netincome for 2001 of $2,346,283. This was a 4.56% increase from the $2,244,020reported in 2000.  Net income reportedfor 2000 represented an increase of $813,092 or 56.8% more than 1999 net incomeof $1,430,928. Basic earnings per share were $1.81, $1.76 and $1.15 at December31, 2001, 2000 and 1999, respectively. Diluted earnings per share were $1.66,$1.64 and $1.04 at December 31, 2001, 2000 and 1999, respectively.

 

The Company made a strategic decision commencing in 1999 to expand itsfull service branch office coverage of its primary market area, realizing thatduring the first year, net earnings would be impacted by the growth ofinfrastructure. Two offices were opened during the first quarter of 1999 andone during the first quarter of 2000. The expected result was that net earningsin 1999 grew by only 6.3% from those in 1998, however, the ground work had beenset to allow for significant growth without additional overhead.

 

OnJuly 16, 2001, the Bank and Westamerica Bank, a California banking corporation,entered into a Branch Purchase and Assumption Agreement (“Agreement” includedas an Exhibit in Company’s September 30, 2001 10-QSB), pursuant to whichHeritage Oaks Bank purchased the four Westamerica Bank Branches in San LuisObispo County (“Branches”).  TheBranches were  located in the cities ofArroyo Grande, Morro Bay, Paso Robles and San Luis Obispo. In addition,Heritage Oaks Bank acquired Westamerica Bank’s interest in the real estate ofeach of the Branches, 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 LuisObispo, California was consolidated with the Heritage Oaks Bank branch locatedat 1135 Santa Rosa Street, San Luis Obispo, California; and the branch locatedat 1204 Spring Street, Paso Robles, California was consolidated with theHeritage Oaks Bank branch located at 545 Twelfth Street, Paso Robles,California.  Further, the Heritage OaksBank branch located at 1360 Grand Avenue, Arroyo Grande, California wasconsolidated with the branch being acquired that is located at 1255 GrandAvenue, Arroyo Grande, California.

 

Beginning in January 2001 and continuing through December 2001, actionsby the Federal Reserve to cut target interest rates resulted in Prime Rateliterally being cut in half from 9.50% to 4.75%. Historically, the largestsource of income for the Bank is that which is created by net interest income.This reduction in rates, specifically as it relates to 65% of the Bank’saverage earning assets that adjust with Prime, made it very difficult tomaintain the level of the Net Interest Margin for 2001 that the Bank hadexperienced in the past. Despite the adverse interest rate environment, theCompany was able to exceed prior year earnings.

 

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**SELECTED FINANCIAL DATA**

 
|                              |   | **December 31,** |    |
|-----------------------------------|--------|------------------|---------|
|                              |   | **2001**         |    | **2000** |   | **1999** |   |
| Return on Average Assets          |   | 1.22             | %       | 1.34 | % | 1.07 | % |
|                              |   |             |    |   |   |   |   |
| Return on Average Equity          |   | 17.26            | %       | 20.03 | % | 14.87 | % |
|                              |   |             |    |   |   |   |   |
| Average Equity to Average Assets  |   | 7.74             | %       | 7.11 | % | 7.78 | % |
|                              |   |             |    |   |   |   |   |
| Net Interest Margin               |   | 6.43             | %       | 6.78 | % | 6.42 | % |
|                              |   |             |    |   |   |   |   |
| Average Loans to Average Deposits |   | 83.08            | %       | 82.18 | % | 71.20 | % |
|                              |   |             |    |   |   |   |   |
| Net Income (in thousands)         |   | $                | 2,346   |   | $ | 2,244 |   | $ | 1,431 |   |
|                              |   |             |    |   |   |   |   |
| Average Assets (in thousands)     |   | $                | 192,459 |   | $ | 167,661 |   | $ | 134,296 |   |
|                              |   |             |    |   |   |   |   |
| Earnings Per Share:               |   |             |    |   |   |   |   |
| Basic                             |   | $                | 1.81    |   | $ | 1.76 |   | $ | 1.15 |   |
| Diluted                           |   | $                | 1.66    |   | $ | 1.64 |   | $ | 1.04 |   |
|                              |   |             |    |   |   |   |   |

 

**NetInterest Income and Interest Margin**

 

Net interest income, the primary component of the net earnings of afinancial institution, refers to the difference between the interest paid ondeposits and borrowings, and the interest earned on loans and investments.  The net interest margin is the amount of netinterest income expressed as a percentage of average earning assets.  Factors considered in the analysis of netinterest income are the composition and volume of earning assets andinterest-bearing liabilities, the amount of non-interest bearing liabilitiesand non—accrual loans, and changes in market interest rates.

 

Net interest income before provision for possible loan losses for 2001was $11,031,213, an increase of $1,192,910 or 12.1% from  the $9,838,303 in 2000.  The increase in net interest income for 2001compared to 2000 was attributable to a $26.4 million increase in averageearning assets, a $11.7 million increase in non-interest bearing deposits andonly a $9.7 million increase in average interest bearing liabilities. Thesignificant growth in average earning assets compared to the lesser growth inaverage interest bearing liabilities helped to offset the material decline ininterest rates throughout the year. The rate on average earning assetsdecreased by 119 basis points from 2000 to that in 2001, while the rate paid onaverage interest bearing liabilities decreased 92 basis points for the sameperiod.  Average non-interest bearingdemand deposits increased by $11.7 million in 2001. Other low cost deposits suchas savings, now and money market accounts grew an average of $8.5 million witha weighted average rate of 1.45% in 2001. The higher cost time depositsincreasedan average of $3.2 million with the average rate paid falling from5.50% in 2000 to 4.82% in 2001**.**

 

Total income on the loan portfolio increased from $12,699,866 in 2000 to$13,280,255 in 2001. This modest increase of 4.6% in additional interest incomewas due to a combination of average loans outstanding for the year increasingby almost $22 million and the average rate earned for the year dropping from10.26% to 9.11%.

 

The average yield on earning assets was 8.43% for 2001 and 9.62% for2000.  The average yield on interestbearing liabilities was 2.93% for 2001, compared to 3.85% for 2000.  The net interest margin was 6.43% in 2001compared to 6.78% in 2000.

 

The table on the following page sets forth the average balance sheetinformation, interest income and expense, average yields and rates and netinterest income and margin for the years ended December 31, 2001, 2000 and1999. The average balance of non-accruing loans has been included in loantotals.

 

18

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|                                             |   | **2001**                   |    | **2000**                |   | **1999**            |   |
|--------------------------------------------------|--------|----------------------------|---------|-------------------------|--------|---------------------|--------|
|                                             |   | **Average Balance**        |    | **Avg Yield Rate Paid** |   | **Amount Interest** |   | **Average Balance** |   | **Avg Yield Rate Paid** |   | **Amount Interest** |   | **Average Balance** |   | **Avg Yield Rate Paid** |   | **Amount Interest** |   |
|                                             |   | **(dollars in thousands)** |    |
| Interest Earning Assets:                         |   |                       |    |                    |   |                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Time  deposits with other banks                  |   | $                          | 338     |                    | 3.85   | %                   | $      | 13 |   | $ | 257 |   | 7.39 | % | $ | 19 |   | $ | 409 |   | 5.38 | % | $ | 22 |   |
| Investment  securities taxable                   |   | 9,415                      |    | 5.57                    | %      | 524                 |   | 11,117 |   | 6.26 | % | 696 |   | 15,977 |   | 5.86 | % | 937 |   |
| Investment  securities non-taxable               |   | 5,928                      |    | 4.74                    | %      | 281                 |   | 6,087 |   | 5.03 | % | 306 |   | 6,505 |   | 4.77 | % | 310 |   |
| Federal  funds sold                              |   | 10,162                     |    | 3.57                    | %      | 363                 |   | 3,921 |   | 6.32 | % | 248 |   | 4,390 |   | 5.01 | % | 220 |   |
| Loans  (1) (2)                                   |   | 145,757                    |    | 9.11                    | %      | 13,280              |   | 123,794 |   | 10.26 | % | 12,700 |   | 86,578 |   | 9.73 | % | 8,425 |   |
|                                             |   |                       |    |                    |   |                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total  interest earning assets                   |   | 171,600                    |    | 8.43                    | %      | 14,461              |   | 145,176 |   | 9.62 | % | 13,969 |   | 113,859 |   | 8.71 | % | 9,914 |   |
|                                             |   |                       |    |                    |   |                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Allowance  for possible loan losses              |   | (1,545                     | )       |                    |   |                |   | (1,344 | ) |   |   |   |   | (1,150 | ) |   |   |   |   |
| Non-earning  assets:                             |   |                       |    |                    |   |                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Cash  and due from banks                         |   | 14,031                     |    |                    |   |                |   | 16,376 |   |   |   |   |   | 14,984 |   |   |   |   |   |
| Property,  premises and equipment                |   | 2,972                      |    |                    |   |                |   | 3,274 |   |   |   |   |   | 3,045 |   |   |   |   |   |
| Other  assets                                    |   | 5,401                      |    |                    |   |                |   | 4,179 |   |   |   |   |   | 3,558 |   |   |   |   |   |
|                                             |   |                       |    |                    |   |                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| TOTAL  ASSETS                                    |   | $                          | 192,459 |                    |   |                |   |   | $ | 167,661 |   |   |   |   |   | $ | 134,296 |   |   |   |   |   |
|                                             |   |                       |    |                    |   |                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest  —bearing liabilities:             |   |                       |    |                    |   |                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Savings/NOW/money  market                        |   | 66,562                     |    | 1.45                    | %      | 964                 |   | 58,077 |   | 2.37 | % | 1,376 |   | 54,717 |   | 2.08 | % | 1,137 |   |
| Time  deposits                                   |   | 49,037                     |    | 4.82                    | %      | 2,366               |   | 45,872 |   | 5.50 | % | 2,523 |   | 29,370 |   | 4.69 | % | 1,377 |   |
| Other  borrowings                                |   | 1,496                      |    | 6.75                    | %      | 101                 |   | 3,443 |   | 6.74 | % | 232 |   | 1,267 |   | 6.87 | % | 87 |   |
|                                             |   |                       |    |                    |   |                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total  interest-bearing liabilities              |   | 117,095                    |    | 2.93                    | %      | 3,431               |   | 107,392 |   | 3.85 | % | 4,131 |   | 85,354 |   | 3.05 | % | 2,601 |   |
|                                             |   |                       |    |                    |   |                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Non-interest  bearing liabilities:               |   |                       |    |                    |   |                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Demand  deposits                                 |   | 58,350                     |    |                    |   |                |   | 46,680 |   |   |   |   |   | 37,472 |   |   |   |   |   |
| Other  liabilities                               |   | 2,113                      |    |                    |   |                |   | 1,664 |   |   |   |   |   | 1,343 |   |   |   |   |   |
|                                             |   |                       |    |                    |   |                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total  liabilities                               |   | 177,558                    |    |                    |   |                |   | 155,736 |   |   |   |   |   | 124,169 |   |   |   |   |   |
|                                             |   |                       |    |                    |   |                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Stockholders’  equity                       |   |                       |    |                    |   |                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Common  stock                                    |   | 7,311                      |    |                    |   |                |   | 5,996 |   |   |   |   |   | 5,148 |   |   |   |   |   |
| Retained  earnings                               |   | 7,615                      |    |                    |   |                |   | 6,457 |   |   |   |   |   | 5,299 |   |   |   |   |   |
| Valuation  Allowance Investments                 |   | (25                        | )       |                    |   |                |   | (528 | ) |   |   |   |   | (320 | ) |   |   |   |   |
|                                             |   |                       |    |                    |   |                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total  stockholders’ equity                 |   | 14,901                     |    |                    |   |                |   | 11,925 |   |   |   |   |   | 10,127 |   |   |   |   |   |
|                                             |   |                       |    |                    |   |                |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                             |   |                       |    |                    |   |                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY |   | $                          | 192,459 |                    |   |                |   |   | $ | 167,661 |   |   |   |   |   | $ | 134,296 |   |   |   |   |   |
|                                             |   |                       |    |                    |   |                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net  Interest Income                             |   |                       |    |                    |   | $                   | 11,030 |   |   |   |   |   | $ | 9,838 |   |   |   |   |   | $ | 7,313 |   |
| Net  Interest Margin (3)                         |   |                       |    | 6.43                    | %      |                |   |   |   | 6.78 | % |   |   |   |   | 6.42 | % |   |   |
|                                                  |        |                            |         |                         |        |                     |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

| (1)    |   | Nonaccrual loans have been  included in total loans.                                                                            |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                            |
| (2)    |   | Loan fees of $609, $587and  $483 for 2001, 2000 and 1999, 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.                                                            |

 

**RATE/VOLUME ANALYSIS**

 
|                                    |   | **2001**    |   | **2000**    |   | **1999**  |   |
|-----------------------------------------|--------|-------------|--------|-------------|--------|-----------|--------|
|                                    |   | **Average** |   | **Average** |   |      |   | **Average** |   | **Average** |   |   |   | **Average** |   | **Average** |   |   |   |
|                                    |   | **Bal/Vol** |   | **Rate**    |   | **Total** |   | **Bal/Vol** |   | **Rate** |   | **Total** |   | **Bal/Vol** |   | **Rate** |   | **Total** |   |
| Increase  (decrease) in:                |   |        |   |        |   |      |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest  income:                       |   |        |   |        |   |      |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans  (1)                              |   | $           | 2,279  |        | $      | (1,699    | )      | $ | 580 |   | $ | 3,620 |   | $ | 655 |   | $ | 4,275 |   | $ | 2,180 |   | $ | (215 | ) | $ | 1,965 |   |
| Investment  securities taxable          |   | (107        | )      | (88         | )      | (195      | )      | (286 | ) | 45 |   | (241 | ) | (93 | ) | (28 | ) | (121 | ) |
| Investment  securities non-taxable (2): |   | (8          | )      | (17         | )      | (25       | )      | (30 | ) | 24 |   | (6 | ) | 90 |   | (3 | ) | 87 |   |
| Taxable  equivalent adjustment (2):     |   | 4           |   | 8           |   | 12        |   | 10 |   | (8 | ) | 2 |   | (31 | ) | 1 |   | (30 | ) |
| Interest-bearing  deposits              |   | 6           |   | (1          | )      | 5         |   | (8 | ) | 5 |   | (3 | ) | (1 | ) | (1 | ) | (2 | ) |
| Federal  funds sold                     |   | 394         |   | (279        | )      | 115       |   | (23 | ) | 51 |   | 28 |   | 34 |   | (10 | ) | 24 |   |
| Total                                   |   | 2,568       |   | (2,076      | )      | 492       |   | 3,283 |   | 772 |   | 4,055 |   | 2,179 |   | (256 | ) | 1,923 |   |
|                                    |   |        |   |        |   |      |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest  expense:                      |   |        |   |        |   |      |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Savings,  now, money market             |   | 201         |   | (614        | )      | (413      | )      | 70 |   | 169 |   | 239 |   | 146 |   | (151 | ) | (5 | ) |
| Time  deposits                          |   | 174         |   | (331        | )      | (157      | )      | 774 |   | 372 |   | 1,146 |   | 178 |   | (139 | ) | 39 |   |
| Other  borrowings                       |   | (130        | )      | —      |   | (130      | )      | 150 |   | (5 | ) | 145 |   | 9 |   | 14 |   | 23 |   |
| Total                                   |   | 245         |   | (945        | )      | (700      | )      | 994 |   | 536 |   | 1,530 |   | 333 |   | (276 | ) | 57 |   |
|                                    |   |        |   |        |   |      |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Increase  (decrease) in net             |   |        |   |        |   |      |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest  income                        |   | $           | 2,323  |        | $      | (1,131    | )      | $ | 1,192 |   | $ | 2,289 |   | $ | 236 |   | $ | 2,525 |   | $ | 1,846 |   | $ | 20 |   | $ | 1,866 |   |
|                                    |   |        |   |        |   |      |   |   |   |   |   |   |   |   |   |   |   |   |   |

----

| (1)                                                                                                                                                                                     |   | Loan fees of $609, $587 and  $483 for 2001, 2000 and 1999, 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 categories in each period were included in the volume computations.                                                                                    |
| Note B: Average yield rates in  each period were used in rate computations. Any change attributable to  changes in both volume and rate which cannot be segregated has been  allocated. |

 

19

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**Non-Interest Income**

 

Non-interest income consists of service charges on deposit accounts,bankcard merchant fees, automatic teller machines (“ATM”) transactions,mortgage origination fees and other fees. Non-interest income for 2001 was $4,680,575 compared to $5,683,427 for2000. This represents a decrease of $1,002,852 or 17.7%. During 2001, the Bankdivested itself of the off premise ATM business. In eliminating this line ofbusiness, both non-interest income and non-interest expense decreased. Thiswill be discussed in more detail below.

 

Service charges on deposit accounts increased to $1,182,785 in 2001 from$1,082,757 in 2000. This growth of 9.2% is the result of overall bank growthfor the year.

 

Bankcard merchant fees were $122,602 in 2001 compared to $110,483 in2000, representing an improvement of 11%.

 

Overall, the Bank has become less reliant on ATM generated revenue thanin previous years and in fact divested itself of this line of business nearlyentirely by the fourth quarter of 2001. The net earnings from all ATMoperations before deducting for overhead expenses and salaries were $475,875**,******$1,031,719 and****$1,053,720, for the yearsended December 31, 2001, 2000 and 1999, respectively.

 

ATM transaction fees, ATM interchange income, and ATM sponsorship feeswas $2,017,507 and $3,609,502 for the year 2001 and 2000, respectively.  The Bank operated two networks referred toas the Gaming Network and the Retail Network.

 

The Gaming Network consisted of ATM placements located in authorized Californiagaming sites and accounted for approximately 71%of the gross revenue for ATMsin 2001. For the past several years, the number of Gaming contracts hasdecreased as the result of highly aggressive competition. In order to retaincertain sites, agreements were renegotiated that narrowed the profit margin forthe Bank. Because of narrowing profit margins and risk associated with thisline of business, beginning in the third quarter of 2000 and continuing untilthe third quarter of 2001, the Bank’s Service Agreement with all but two siteswere not renewed and/or terminated

 

The Retail Network consists of ATM placements in locations, such asmalls and individual business sites throughout the United States. Because ofthe very narrow profit margins and the internal resources required to run thisnetwork, the Bank decided to sell this particular piece of business to acompany who would have the economies of scale to realize a greater profitmargin. In November 2000, the Bank entered into an agreement to sell theselocation agreements, inclusive of their equipment.  This transaction closed on March 31, 2001. Revenue generated bythe Retail Network accounted for approximately 29% of the gross revenue forATMs in 2001. The sale had minimal impact to the net earning in 2001 due to theexpense of fully depreciating ATMs and other expenses associated with the sale.It is anticipated that there will be no impact to ongoing net income for theBank.

 

Mortgage origination fees generated for 2001 were $577,333 compared to$318,360 in 2000. The declining interest rate environment during 2001 createdrobust mortgage loan activity, specifically in the re-finance arena. The Bankhas been engaged in this line of business for a number of years and increasedthe department’s resources in 2001 to accommodate the growing activity. Most ofthe expense associated with this line of business is variable in the form ofcommissions paid. If and when the accelerated activity begins to decline, therewould be limited fixed overhead in place to negatively impact earnings.

 

**Non-Interest Expenses**

 

Non-interest expense consists of salary and other compensation,occupancy and equipment and other expense. Non-interest expense for 2001decreased to $11,386,136 from $11,515,523 in 2000. This represents a decreaseof $129,387 or 1.1%.

 

Salaries and employee benefit expense were $4,494,137 and $4,115,549 for2001 and 2000 respectively.  Thisrepresents an increase of 9.20%. This increase is due to; 1) annual meritincreases in February 2001 that averaged 4%; 2) an increase in staff throughoutthe course of the year and the addition of the Westamerica Bank employees inNovember 2001 and; 3) a 17% increase in group health costs. Full timeequivalent employees were 106 for 2001 and 93 for 2000. The ratio of “assetsper employee”, one of the measures of operational efficiency, was****$2,027,214****and$1,979,441 for 2001 and 2000, respectively.

 

Occupancy, furniture and equipment expenses were $ 1,707,205 during2001, compared to $1,708,394 for 2000. This represents a nominal decrease of$1,189 or .07%. The only new facility opened during the year was the acquiredMorro Bay branch in November 2001.

 

20

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Other non-interest expense consists of ATM network related, dataprocessing and other operating expense. Other non-interest expense was$5,184,794 for 2001, compared to $5,691,580 in 2000. This represents a decreaseof $506,786 or 8.9%.

 

ATM network related expense was $1,541,632 in2001, compared to $2,577,782 in 2000. This represents a decrease of $1,036,150or 40.2%. By the end of the third quarter 2001, the Bank had divested itself ofthis line of business. See discussion of the ATM networks in “Non-InterestIncome”, above.

 

Data processing expense was $1,460,620 in 2001compared to $1,327,397 in 2000. This represents an increase of $133,223 or10.0%.  The 34.7% growth in the Bank’sdemand deposit base along with the 20.2% increase in interest bearing depositaccounts (excluding Certificates of Deposit) for the year 2001 is the primaryfactor for the increase in associated processing fees for services performed bythird party vendors.

 

**Provision for Income Taxes**

 

The provision for income taxes was $1,379,369 for 2001, compared to$1,243,187 in 2000. The increase is commensurate with growth in pre-tax incomefor the year 2001 from that of 2000. The Bank’s effective tax rate was 37.0%and 35.6% in 2001 and 2000, respectively.

 

**Provision and Allowance for Credit Losses**

 

The allowance for credit losses is based upon management’s evaluation ofthe adequacy of the existing allowance for outstanding loans. This allowance isincreased by provisions charged to expense and reduced by loan charge-offs netof recoveries. Management determines an appropriate provision based upon loangrowth during the period, a comprehensive grading and review formula for loansoutstanding and historical loss experience. In addition, management periodically reviews the condition of the loanportfolio including the value of security interest related to portfolio loansand the economic circumstances that may affect the value of portfolio loans todetermine the adequacy of the allowance. The evaluation of the allowance is reviewed by management and reportedon an ongoing basis to the Bank’s  LoanCommittee, Audit Committee and Board of Directors.  A provision for credit losses of $600,000 and $519,000 wasexpensed for 2001 and 2000, respectively. Net loan charge-offs (loans chargedoff, net of loans recovered) were $176,448 in 2001 and $439,498 during 2000,respectively. The allowance for credit losses as a percent of total gross loansat year-end 2001 and 2000 was 1.10% and 0.97%, respectively. Monitoring of allcredits enables management to analyze any inherent risks in the portfolio thatmay result from changes in economic conditions.

 

The followingtable summarizes the analysis of the allowance for loan losses as of December31, 2001, 2000 and 1999:

** **

**Analysis of Allowance for LoanLosses**

 
|                                                                   |   | **2001**  |        | **2000**  |   | **1999**    |   |
|------------------------------------------------------------------------|--------|-----------|-------------|-----------|--------|-------------|--------|
| Balance at Beginning of Period                                         |   | $         | 1,320,518   |      | $      | 1,241,016   |   | $ | 1,069,535 |   |
|                                                                   |   |      |        |      |   |        |   |
| Charge-offs:                                                           |   |      |        |      |   |        |   |
| Commercial, Fianacial and Agricultural                                 |   | 155,933   |        | 454,085   |   | 7,623       |   |
| Real Estate— Construction                                         |   | —    |        | —    |   | —      |   |
| Real Estate-Mortgage                                                   |   | —    |        | —    |   | —      |   |
| Installment Loans to Individuals:                                      |   | 22,341    |        | 4,370     |   |        |   |
| Money Plus                                                             |   | 2,458     |        | 465       |   | 6,592       |   |
| Credit Cards                                                           |   | —    |        | —    |   | —      |   |
| Other Installment                                                      |   | —    |        | —    |   | —      |   |
| Total charge-offs                                                      |   | 180,732   |        | 458,920   |   | 14,215      |   |
|                                                                   |   |      |        |      |   |        |   |
| Recoveries:                                                            |   |      |        |      |   |        |   |
| Commercial, Fianacial and Agricultural                                 |   | 483       |        | 16,745    |   | 19,682      |   |
| Real Estate— Construction                                         |   | —    |        | —    |   | —      |   |
| Real Estate-Mortgage                                                   |   | —    |        | —    |   | —      |   |
| Installment Loans to Individuals:                                      |   | 2,256     |        | 488       |   | —      |   |
| Money Plus                                                             |   | 1,545     |        | 2,189     |   | —      |   |
| Credit Cards                                                           |   | —    |        | —    |   | —      |   |
| Other Installment                                                      |   | —    |        | —    |   | 514         |   |
| Total recoveries                                                       |   | 4,284     |        | 19,422    |   | 20,196      |   |
| Net Charge-offs                                                        |   | 176,448   |        | 439,498   |   | (5,981      | )      |
| Additions Charged to Operations                                        |   | 600,000   |        | 519,000   |   | 165,500     |   |
| Balance at End of Period                                               |   | 1,744,070 |        | 1,320,518 |   | 1,241,016   |   |
|                                                                   |   |      |        |      |   |        |   |
| Gross Loans at End of Period                                           |   | $         | 158,472,287 |      | $      | 135,488,020 |   | $ | 104,152,682 |   |
|                                                                   |   |      |        |      |   |        |   |
| Ratio of Net Charge-offs During the Year to  Average Loans outstanding |   | 0.12      | %           | 0.44      | %      | —0.01  | %      |
|                                                                   |   |      |        |      |   |        |   |
| Ratio of Reserves to Gross Loans                                       |   | 1.10      | %           | 0.97      | %      | 1.19        | %      |
|                                                                   |   |      |        |      |   |        |   |
| Ratio of Non-performing Loans to the Allowance for  Credit Losses      |   | 85.70     | %           | 75.01     | %      | 72.91       | %      |

 

21

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The Bank adopted SFAS No. 114 (as amended by SFAS No. 118), “Accountingby Creditors for Impairment of a Loan” on January 1, 1996.  In accordance with SFAS No. 114, those loansidentified as “impaired” are measured on the present value of expected futurecash flows, discounted at the loans effective interest rate or the fair valueof the collateral if the loan is collateral dependent. A loan is impaired when itis probable the creditor will not be able to collect all contractual principaland interest payments due in accordance with terms of the loan agreement.

 

Loans are placed on non-accrual when a loan is specifically determinedto be impaired or when principal or interest is delinquent for 90 days or more.Any unpaid interest previously accrued on those loans is reversed from income.Interest income generally is not recognized on specific impaired loans unlessthe likelihood of further loss is remote. Interest payments received on suchloans are applied as a reduction on the loan principal balance.

 

Included in non-performing loans are two loans totaling $1,128,081 thataccount for approximately 75% of the total. Even though these two loans are on a non-accrual status, management doesnot believe that there will be any loss of the principal due to presentcollateral value.

 

In evaluating the allowance for the credit losses, management takes intoconsideration the composition of its loan portfolio, loan growth during theperiod, risk and collectibility of loans, and economic conditions.  The allowance is maintained at a sufficientlevel to cover all potential loan charge-offs in addition to a cumulative,annual amount based upon the factors outlined above.  Management utilizes an internal loan classification system tograde portfolio loans as a part of its analysis of the adequacy of theallowance.  In addition, managementperiodically reviews the condition of the loan portfolio including the value ofsecurity interests related to the portfolio loan to determine the adequacy ofthe allowance.  The evaluation of theadequacy of the allowance is reviewed by management and reported on an ongoingbasis to the Bank’s Loan Committee, Audit Committee and Board of Directors.

 

**Local Economy**

 

Theeconomy in the Company’s trade area is based primarily on agriculture, tourism,light industry, oil and retail trade. Services supporting these industries havealso developed in the areas of medical, financial and educational. The populationin the two county areas comprising the Company’s trade area, according to theU.S. Bureau of the Census, was estimated at July 1999 to be approximately644,000. San Luis Obispo County represents about 37% of this total with SantaBarbara County accounting for the remaining approximately 63%. The moderateclimate allows a year round growing season for numerous vegetable and fruits.Vineyards and cattle ranches also contribute largely to the local economy.Vineyards in production have grown significantly over the past several yearsthroughout the Company’s trade 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 trade 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 Bank’s branch locations have been strategically placed throughoutthe Central Coast. In addition to the relatively new full service branchesopened in Santa Maria and Atascadero during the first quarter of 1999,  Arroyo Grande in January 2000, the Bank,through acquisition in November 2001, has a full service branch office in MorroBay.

 

**FINANCIALCONDITION ANALYSIS**

 

Totalassets of the Company were $214,884,674 at December 31, 2001 compared to$184,088,025 at December 31, 2000. That represents an increase of $30.8 millionor 16.7%, including $25 million in assets acquired from the purchase of theBranches from WestAmerica Bank in November 2001. None of the assets acquiredfrom WestAmerica were loans.

 

 

A significant portion of total assets is the Bank’s gross loans thatwere $158,472,287 and $135,488,020 at December 31, 2001 and 2000,respectively.  Approximately 65% ofgross loans at December 31, 2001 are adjustable rate loans. 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 $592,151 a year and a1.00% decrease in the prime rate would decrease net interest income byapproximately  $557,794 a year.

 

 

 

22

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The following table summarizes the composition of the loan portfolio asof December 31, 2001, 2000 and 1999:

 

**COMPOSITION OF LOAN PORTFOLIO**

 
|                                   |   | **2001**    |        | **2000**    |   | **1999**    |   |
|----------------------------------------|--------|-------------|-------------|-------------|--------|-------------|--------|
|                                   |   | **Amount**  |        | **Percent** |   | **Amount**  |   | **Percent** |   | **Amount** |   | **Percent** |   |
| Commercial, Financial and Agricultural |   | 40,608,210  |        | 25.62       | %      | 42,931,015  |   | 31.69 | % | $ | 38,419,611 |   | 36.89 | % |
|                                   |   |        |        |        |   |        |   |   |   |   |   |   |   |
| Real Estate— Construction         |   | 23,449,044  |        | 14.80       | %      | 18,599,452  |   | 13.73 | % | 12,741,477 |   | 12.23 | % |
|                                   |   |        |        |        |   |        |   |   |   |   |   |   |   |
| Real Estate-Mortgage                   |   | 90,823,606  |        | 57.31       | %      | 70,550,560  |   | 52.07 | % | 50,063,714 |   | 48.07 | % |
|                                   |   |        |        |        |   |        |   |   |   |   |   |   |   |
| Installment Loans to Individuals       |   | 3,171,805   |        | 2.00        | %      | 3,246,214   |   | 2.40 | % | 2,786,034 |   | 2.67 | % |
|                                   |   |        |        |        |   |        |   |   |   |   |   |   |   |
| All Other Loans (including overdrafts) |   | 419,622     |        | 0.27        | %      | 160,779     |   | 0.12 | % | 141,846 |   | 0.14 | % |
|                                   |   |        |        |        |   |        |   |   |   |   |   |   |   |
| Total Loans, Gross                     |   | 158,472,287 |        | 100.00      | %      | 135,488,020 |   | 100.00 | % | 104,152,682 |   | 100.00 | % |
|                                   |   |        |        |        |   |        |   |   |   |   |   |   |   |
| Deferred Loan Fees                     |   | (578,332    | )           |        |   | (487,473    | )      |   |   | (485,474 | ) |   |   |
| Reserve for Possible Loan Losses       |   | (1,744,070  | )           |        |   | (1,320,518  | )      |   |   | (1,241,016 | ) |   |   |
|                                   |   |        |        |        |   |        |   |   |   |   |   |   |   |
| Total Loans, Net                       |   | $           | 156,149,885 |        |   |        | $      | 133,680,029 |   |   |   | $ | 102,426,192 |   |   |   |
|                                   |   |        |        |        |   |        |   |   |   |   |   |   |   |
| Loans Held For Sale                    |   | $           | 4,082,200   |        |   |        | $      | 2,474,542 |   |   |   | $ | 120,382 |   |   |   |

 

Net loans totaled $156,149,885 at December 31, 2001, compared to$133,680,029 at December 31, 2000. This represents an increase of 16.8%. Loansincreased during the year as the result of; 1) continued marketing efforts bywell-established loan officers; and 2) a strong Bank image within its primarymarket area. The largest growth was in the real estate loan related area atapproximately a $20.3 million increase.

 

The following are the approximate maturities andsensitivity to change in interest rates for the loans at December 31, 2001:

 
| Loan Category                          | ** ** | **Due  Within   One Year** | ** ** | **After  One   Year but   Within Five** | ** ** | **After  Five   Years** | ** ** | **Total** | ** ** |
|----------------------------------------|------------|----------------------------|------------|-----------------------------------------|------------|-------------------------|------------|-----------|------------|
|                                   |       | **(in thousands)**         |       |
| Commercial, Fianacial and Agricultural |       | $                          | 27,646     |                                    | $          | 8,752                   |       | $         | 4,210      |   | $ | 40,608 |   |
|                                   |       |                       |       |                                    |       |                    |       |      |       |
| Real Estate— Construction         |       | 17,970                     |       | 4,267                                   |       | 1,212                   |       | 23,449    |       |
|                                   |       |                       |       |                                    |       |                    |       |      |       |
| Real Estate-Mortgage                   |       | 45,059                     |       | 22,753                                  |       | 23,011                  |       | 90,823    |       |
|                                   |       |                       |       |                                    |       |                    |       |      |       |
| Installment Loans to Individuals       |       | 1,089                      |       | 1,745                                   |       | 338                     |       | 3,172     |       |
|                                   |       |                       |       |                                    |       |                    |       |      |       |
| All Other Loans (including overdrafts) |       | 420                        |       | —                                  |       | —                  |       | 420       |       |
|                                   |       |                       |       |                                    |       |                    |       |      |       |
| Totals                                 |       | $                          | 92,184     |                                    | $          | 37,517                  |       | $         | 28,771     |   | $ | 158,472 |   |
|                                   |       |                       |       |                                    |       |                    |       |      |       |
| Interest Rate Provision:               |       |                       |       |                                    |       |                    |       |      |       |
| Predetermined Rates                    |       | $                          | 18,154     |                                    | $          | 9,290                   |       | $         | 28,251     |   | $ | 55,695 |   |
|                                   |       |                       |       |                                    |       |                    |       |      |       |
| Floating or Adjustable Rates           |       | 74,030                     |       | 28,227                                  |       | 520                     |       | 102,777   |       |
|                                   |       |                       |       |                                    |       |                    |       |      |       |
| Totals                                 |       | $                          | 92,184     |                                    | $          | 37,517                  |       | $         | 28,771     |   | $ | 158,472 |   |

 

Risk Elements:

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

 
|                                                                           |   | **2001**  |      | **2000** |   | **1999** |   |
|--------------------------------------------------------------------------------|--------|-----------|-----------|----------|--------|----------|--------|
| Non-Accrual Loans (Impaired Loans)                                             |   | $         | 1,494,602 |     | $      | 991,230  |   | $ | 904,773 |   |
| Accruing Loans Past Due 90 Days                                                |   | 0         |      | 0        |   | 0        |   |
| Restructured Loans                                                             |   | 1,309,538 |      | 194,914  |   | 251,729  |   |
| Interest Excluded on Non-Accrual Loans                                         |   | 142,952   |      | 112,012  |   | 91,207   |   |
| Interest Recognized on Non-Accrual Loans and  Troubled Debt Restructured Loans |   | 16,704    |      | 85,806   |   | 165,000  |   |
|                                                                                |        |           |           |          |        |          |        |  |  |  |

 

23

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At December 31, 2001, the Bank had no foreign loans outstanding.  The Bank did not have any concentrations ofloans except as disclosed above.

 

The Banks management is responsible for monitoring loan performance thatis done through various methods, including a review of loan delinquencies andpersonal knowledge of customers. Additionally, the Bank, maintains both a “watch” list of loans that, fora variety of reasons, management believes requires regular review as well as aninternal loan classification process. Semi-annually, the loan portfolio is alsoreviewed by an experienced, outside loan reviewer not affiliated with theBank.  A list of delinquencies, thewatch list, loan grades and the outside loan review are reviewed regularly bythe Board of Directors.  Except as setforth in the preceding table, there are no loans which management has seriousdoubts as to the borrowers ability to comply with present loan repayment terms.

 

The Bank has a non-accrual policy that requires a loan greater than 90days past due to be placed on non-accrual status unless such loan iswell-collateralized and in the process of collection.  When loans are placed on non-accrual status, all uncollectedinterest accrued is reversed from earnings. Once on non-accrual status, interest on a loan is only recognized on acash basis.  Loans may be returned toaccrual status if management believes that all remaining principal and interestis fully collectible and there has been at least six months of sustained repaymentperformance since the loan was placed on non-accrual.

 

If a loans credit quality deteriorates to the point that collection ofprincipal is believed by management to be doubtful and the value of collateralsecuring the obligation is sufficient the Bank generally takes steps to protectand liquidate the collateral.  Any lossresulting from the difference between the loan balance and the fair marketvalue of the property is recognized by a charge to the reserve for loanlosses.  When the property is held forsale after foreclosure, it is subject to a periodic appraisal.  If the appraisal indicates that the propertywill sell for less than its recorded value, the Bank recognizes the loss by acharge to non-interest expense.

 

**Total Cash and Due from Banks**

 

Total cash and due from banks decreased from $19,435,534 at December 31,2000 to $14,398,048 at December 31, 2001. This decrease is a direct result of the elimination of the ATM Networks.

 

**Other Earning Assets**

 

Other earning assets are comprised of Federal Home Loan Bank stock,Federal Funds sold (funds lent on a short-term basis to other banks),investment securities and short-term interest bearing deposits at otherfinancial institutions.  These assetsare maintained for short-term liquidity needs of the Bank, collateralization ofpublic deposits, and diversification of the earning asset mix.

 

Other earning assets increased to $28,356,296 at December 31, 2001compared to $21,392,105 at December 31, 2000. This represents an increase ofapproximately $6.9 million or 32.6%. When the branch acquisition was finalizedon November 9, 2001, the Bank invested approximately $10 million in zerorisk-weighted securities. Other earning assets represented 15.1% of the earningasset portfolio at December 31, 2001, compared to 13.6% in 2000.

 

**COMPOSITION OF OTHER EARNINGASSETS**

 
|                                      |   | **2001**   |             | **2000**    |   | **1999**   |   |
|-------------------------------------------|--------|------------|------------------|-------------|--------|------------|--------|
|                                      |   | **Amount** |             | **Percent** |   | **Amount** |   | **Percent** |   | **Amount** |   | **Percent** |   |
| Federal Home Loan Bank and other          |   | $          | 228,300          |        | 0.81   | %          | $      | 381,600 |   | 1.78 | % | $ | 395,300 |   | 1.92 | % |
|                                      |   |       |             |        |   |       |   |   |   |   |   |   |   |
| Available-for-Sale Investments            |   | 22,028,996 |             | 77.69       | %      | 16,212,505 |   | 75.79 | % | 18,663,504 |   | 90.45 | % |
|                                      |   |       |             |        |   |       |   |   |   |   |   |   |   |
| Federal Funds Sold                        |   | 6,000,000  |             | 21.16       | %      | 4,600,000  |   | 21.50 | % | 1,200,000 |   | 5.82 | % |
|                                      |   |       |             |        |   |       |   |   |   |   |   |   |   |
| Interest Bearing Deposits other fin inst. |   | 99,000     |             | 0.34        | %      | 198,000    |   | 0.93 | % | 375,255 |   | 1.81 | % |
|                                      |   |       |             |        |   |       |   |   |   |   |   |   |   |
| Total Other Earning Assets                |   | $          |  28,356,296 |        | 100.00 | %          | $      |  21,392,105 |   | 100.00 | % | $ |  20,634,059 |   | 100.00 | % |

 

24

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The Amortized cost,fair value, and maturites at December 31, 2001 are as follows:

 
|                                   |   | **Securities Available-for-Sale** |       |
|----------------------------------------|--------|-----------------------------------|------------|
|                                   |   | **Amortized**                     |       | **Fair** |   |
|                                   |   | **Cost**                          |       | **Value** |   |
| Due in One Year or Less                |   | $                                 | 34,604     |   | $ | 34,674 |   |
|                                   |   |                              |       |   |   |
| Due after One Year through Five Years  |   | 2,113,825                         |       | 2,130,656 |   |
|                                   |   |                              |       |   |   |
| Due after Five Years through Ten Years |   | 946,256                           |       | 967,255 |   |
|                                   |   |                              |       |   |   |
| Due after Ten Years                    |   | 3,617,552                         |       | 3,517,546 |   |
|                                   |   |                              |       |   |   |
| Mortgage-backed Securities             |   | 15,574,820                        |       | 15,378,864 |   |
|                                   |   |                              |       |   |   |
| Total                                  |   | $                                 | 22,287,057 |   | $ | 22,028,996 |   |

 

**Deposits**

 

Total deposits were $195,584,765 at December 31, 2001, compared to$167,696,890 at December 31, 2000. This represents an increase of $27.9 millionor 16.6%. The branch acquisition that closed on November 9, 2001 accounted forapproximately $25 million of this increase for the year and of that amount,approximately $9.9 million was in Time Deposits. The table below indicates thatTime Deposits actually decreased by $ 2.9 million during 2001. During thecourse of the year 2001, Management was keenly aware of the narrowing net interestmargin and systematically lowered the rates on Time Deposits, knowing full wellthat there would be a decrease in this deposit category.

 

The following table sets forth information for the last two fiscal yearsregarding the composition of deposits at December 31, and the average ratespaid on each of these categories:

 

**COMPOSITION OF DEPOSITS**

 
|                        |   | **2001**    |        | **2000**      |   | **1999**    |   |
|-----------------------------|--------|-------------|-------------|---------------|--------|-------------|--------|
|                        |   |        |        | **Average**   |   |        |   | **Average** |   |   |   | **Average** |   |
|                        |   | **Balance** |        | **Rate Paid** |   | **Balance** |   | **Rate Paid** |   | **Balance** |   | **Rate Paid** |   |
| Non-Interest Bearing Demand |   | $           | 69,824,137  |          | 0.00   | %           | $      | 51,821,234 |   | 0.00 | % | $ | 39,901,884 |   | 0.00 | % |
|                        |   |        |        |          |   |        |   |   |   |   |   |   |   |
| Interest Bearing Demand     |   | 47,668,327  |        | 1.15          | %      | 39,711,917  |   | 2.16 | % | 35,058,015 |   | 1.85 | % |
|                        |   |        |        |          |   |        |   |   |   |   |   |   |   |
| Savings                     |   | 18,602,720  |        | 1.01          | %      | 14,133,471  |   | 2.19 | % | 13,537,416 |   | 2.18 | % |
|                        |   |        |        |          |   |        |   |   |   |   |   |   |   |
| Money Market                |   | 10,293,162  |        | 2.21          | %      | 9,870,541   |   | 3.81 | % | 6,655,897 |   | 3.11 | % |
|                        |   |        |        |          |   |        |   |   |   |   |   |   |   |
| Time Deposits               |   | 49,196,419  |        | 4.82          | %      | 52,159,727  |   | 5.50 | % | 37,808,361 |   | 4.69 | % |
|                        |   |        |        |          |   |        |   |   |   |   |   |   |   |
| Total Deposits              |   | $           | 195,584,765 |          | 2.65   | %           | $      | 167,696,890 |   | 3.75 | % | $ | 132,961,573 |   | 2.07 | % |

 

Set forth is amaturity schedule of domestic time certificales of deposit of $100,000 and overat December 31, 2001.

 
| **TIME  DEPOSITS $100,000 AND OVER:** |   |   |   |
|---------------------------------------|--------|--------|--------|
| **(dollars in thousands)**            |   |   |   |
|                                  |   |   |   |
| Less than 3 months                    |   | $      | 2,645  |   |
| 3 to 12 months                        |   | 4,003  |   |
| Over 1 year                           |   | 533    |   |
|                                  |   |   |   |
| Total                                 |   | $      | 7,181  |   |

 

**Capital**

 

The Company’s total stockholders equity was $15,876,781 at December 31,2001 compared to $13,455,009 at December 31, 2000.  The increase in capital during 2001 was due to net income of$2,346,283,  $4,680 cash paid tostockholders in lieu of fractional shares on a 5% stock dividend paid March 30,2001, stock options exercised in the amount of $93,641 and a decrease inaccumulated other comprehensive income of $13,472.

 

25

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

 

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

 

Summarized below are the Bank’s and Company’s capital ratios at December31, 2001.

 
|                              |   | **Minimum Regulatory Capital Requirements** |   | **Heritage Oaks Bank** |   | **Heritage********Oaks Bancorp** |   |
|-----------------------------------|--------|---------------------------------------------|--------|------------------------|--------|----------------------------------|--------|
| Leverage Ratio                    |   | 4.00                                        | %      | 7.81                   | %      | 7.44                             | %      |
| Tier One Risk Based Capital Ratio |   | 4.00                                        | %      | 9.19                   | %      | 8.74                             | %      |
| Total Risk Based Capital Ratio    |   | 8.00                                        | %      | 10.17                  | %      | 9.72                             | %      |

 

Generally speaking, the primary source of new capital will be generatedfrom retained earnings. However, to provide for instances when retainedearnings may not keep pace with asset growth, additional sources of capitalneed to be made available. To that end, on September 11, 1998, Heritage OaksBancorp executed a Promissory Note for a $2 million line of credit with PacificCoast Bankers’ Bank.  In November 2001,pursuant to the terms of the note, this line of credit was converted to a fullyamortized note. The characteristics of the note are as follows:

 

•  Collateralized with 339,332 shares ofHeritage Oaks Bank common stock

•  Maturity of August 15, 2006.

•  Payments to be fully amortized to maturitybased on outstanding balance owed.

•  Company must obtain written approval priorto incurring any additional debt

 

In addition to this , the Board of Directors is reviewing other sourcesof capital for the Company and the Bank.

 

 

**Liquidity**

 

The objective of liquidity management is to ensure the continuousavailability of funds to meet the demands of depositors, investors andborrowers.  Asset liquidity is primarilyderived from loan payments and the maturity of other earning assets.  Liquidity from liabilities is obtainedprimarily from the receipt of new deposits. The Bank’s Asset Liability Committee (ALCO) is responsible for managingthe on-and off-balance sheet commitments to meet the needs of customers whileachieving the Bank’s financial objectives. ALCO meets regularly to assess the projected funding requirements byreviewing historical funding patterns, current and forecasted economicconditions and individual customer funding needs.  Deposits generated from Bank customers serve as the primarysource of liquidity.  The Bank hascredit arrangements with correspondent banks that serve as a secondaryliquidity source in the amount of $5,000,000. The Bank became a member of theFederal Home Loan Bank (FHLB) in July 1999. As of December 31,2001, the Bankhad approximately $5,500,000 available for borrowing using certain securitiesand loans as collateral. As of December 31, 2001, the Bank did not have anyborrowings against any of these sources.

 

The Bank manages its liquidity by maintaining a majority of itsinvestment portfolio in federal funds sold and other liquid investments.  At December 31, 2001, the ratio of liquidassets not pledged for collateral and other purposes to deposits and otherliabilities was 19.6% compared to 14.2% in 2000. The ratio of gross loans todeposits, another key liquidity ratio, was 83.0% at year-end 2001 compared to82.3% at December 31, 2000.

 

 

**Inflation**

 

The assets and liabilities of a financial institution are primarilymonetary in nature.  As such theyrepresent obligations

 

26

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to pay or receive fixed and determinable amounts of money that are notaffected by future changes in prices. Generally, the impact of inflation on a financial institution isreflected by fluctuations in interest rates, the ability of customers to repaydebt and upward pressure on operating expenses.  The effect on inflation during the three-year period endedDecember 31, 2001 has not been significant to the Bank’s financial position orresults of operations.

 

**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 purchaseprice paid to the assets acquired and liabilities assumed by major balancesheet caption.

 

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 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 statementdisclosures are 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.

 

27

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**ITEM 7. FINANCIAL STATEMENTS**

 

**HERITAGEOAKS BANCORP AND SUBSIDIARIES**

 

 

**DECEMBER 31, 2001, 2000 AND 1999**

 

**Contents**

 

 

 
| **Independent Auditors’  Report**                                                                                |   |
|-----------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                  |   |
| **Financial  Statements**                                                                                             |   |
|                                                                                                                  |   |
| Consolidated Balance Sheets  December 31, 2001 and 2000                                                               |   |
|                                                                                                                  |   |
|                                                                                                                  |   |
| Consolidated  Statements of Income For the Years Ended December 31, 2001, 2000 and 1999                               |   |
|                                                                                                                  |   |
|                                                                                                                  |   |
| Consolidated  Statement of Changes in Stockholders’ Equity For the Years Ended December 31,  2001, 2000 and 1999 |   |
|                                                                                                                  |   |
|                                                                                                                  |   |
| Consolidated  Statements of Cash Flows For the Years Ended December 31, 2001, 2000 and 1999                           |   |
|                                                                                                                  |   |
|                                                                                                                  |   |
| **Notes to  Consolidated Financial Statements**                                                                       |   |
|                                                                                                                  |   |

 

28

----

 

 

**Independent Auditors’ Report**

 

 

 

Board of Directorsand Stockholders

Heritage OaksBancorp and Subsidiaries

Paso Robles,California

 

We have auditedthe accompanying consolidated balance sheets of Heritage Oaks Bancorp andSubsidiaries as of December 31, 2001 and 2000, and the related consolidated statementsof income and changes in stockholders’ equity and statements of cash flows foreach of the three years in the period ended December 31, 2001.  These consolidated financial statements arethe responsibility of the Company’s management.  Our responsibility is to express an opinion on these consolidatedfinancial statements based on our audits.

 

We conducted ouraudits in accordance with auditing standards generally accepted in the UnitedStates of America.  Those standardsrequire that we plan and perform the audits to obtain reasonable assuranceabout whether the consolidated financial statements are free of materialmisstatement.  An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe 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 above present fairly, in allmaterial respects, the financial position of Heritage Oaks Bancorp as ofDecember 31, 2001 and 2000, the results of their operations and changes intheir stockholders’ equity and their cash flows for each of the three years inthe period ended December 31, 2001, in conformity with accounting principlesgenerally accepted in the United States of America.

 

 

 
| /s/ Vavrinek, Trine, Day & Co., LLP |
|-----------------------------------------|
| Rancho Cucamonga,  California           |
| January 11, 2002                        |

 

 

29

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**HERITAGEOAKS BANCORP AND SUBSIDIARIES**

**CONSOLIDATED BALANCE SHEETS**

**DECEMBER 31, 2001 AND 2000**

** **
|                                                                                                                                              |   | **2001**    |        | **2000**    |       |
|---------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------|-------------|-------------|------------|
| **Assets**                                                                                                                                        |
| Cash and due from banks                                                                                                                           |   | $           | 14,398,048  |        | $          | 19,435,534 |   |
| Federal funds sold                                                                                                                                |   | 6,000,000   |        | 4,600,000   |       |
| Total Cash and Cash Equivalents                                                                                                                   |   | 20,398,048  |        | 24,035,534  |       |
| Interest-bearing deposits in other financial  institutions                                                                                        |   | 99,000      |        | 198,000     |       |
| Investment securities                                                                                                                             |   |        |        |        |       |
| Available-for-sale                                                                                                                                |   | 22,028,996  |        | 16,212,505  |       |
| Federal Home Loan Bank Stock, at cost                                                                                                             |   | 228,300     |        | 381,600     |       |
| Loans held for sale                                                                                                                               |   | 4,082,200   |        | 2,474,542   |       |
| Loans, net of deferred fees and allowance for  loan losses of $2,322,402 and $1,807,991 at December 31, 2001 and 2000, respectively               |   | 156,149,885 |        | 133,680,029 |       |
| Property premises and equipment, net                                                                                                              |   | 3,620,769   |        | 3,062,815   |       |
| Net deferred tax asset                                                                                                                            |   | 1,257,991   |        | 998,754     |       |
| Cash surrender value of life insurance                                                                                                            |   | 5,143,613   |        | 1,369,549   |       |
| Other assets                                                                                                                                      |   | 1,875,872   |        | 1,674,697   |       |
| Total Assets                                                                                                                                      |   | $           | 214,884,674 |        | $          | 184,088,025 |   |
|                                                                                                                                              |   |        |        |        |       |
| **Liabilities and Stockholders’  Equity**                                                                                                    |
|                                                                                                                                              |   |        | ** **  |        | ** ** |
| Liabilities                                                                                                                                       |   |        |        |        |       |
| Deposits                                                                                                                                          |   |        |        |        |       |
| Demand non-interest bearing                                                                                                                       |   | 69,824,137  |        | 51,821,234  |       |
| Savings, NOW and money market deposits                                                                                                            |   | 76,564,209  |        | 63,715,930  |       |
| Time deposits of $100,000 or more                                                                                                                 |   | 7,181,312   |        | 7,659,791   |       |
| Time deposits under $100,000                                                                                                                      |   | 42,015,107  |        | 44,499,935  |       |
| Total Deposits                                                                                                                                    |   | 195,584,765 |        | 167,696,890 |       |
| Notes payable                                                                                                                                     |   | 1,894,811   |        | 1,050,000   |       |
| Other liabilities                                                                                                                                 |   | 1,528,317   |        | 1,886,126   |       |
| Total Liabilities                                                                                                                                 |   | 199,007,893 |        | 170,633,016 |       |
|                                                                                                                                              |   |        |        |        |       |
| **COMMITMENTS AND CONTINGENCIES**(Note #10)                                                                                                       |   |        |        |        |       |
|                                                                                                                                              |   |        |        |        |       |
| Stockholders’ Equity                                                                                                                         |   |        |        |        |       |
| Common stock, no par value; 20,000,000 shares  authorized; 1,297,880 and 1,224,999 shares issued and outstanding for 2001  and 2000, respectively |   | 7,535,495   |        | 6,305,233   |       |
| Retained earnings                                                                                                                                 |   | 8,496,122   |        | 7,291,140   |       |
| Accumulated other comprehensive income                                                                                                            |   | (154,836    | )           | (141,364    | )          |
| Total Stockholders’ Equity                                                                                                                   |   | 15,876,781  |        | 13,455,009  |       |
| Total Liabilities and Stockholders’ Equity                                                                                                   |   | $           | 214,884,674 |        | $          | 184,088,025 |   |

 

The accompanying notes arean integral part of these financial statements.

 

30

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**HERITAGE OAKS BANCORP ANDSUBSIDIARIES**

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

**FOR THE YEARS ENDED DECEMBER 31,2001, 2000 AND 1999**

 
|                                                             |   | **2001**   |       | **2000**   |   | **1999**   |   |
|------------------------------------------------------------------|--------|------------|------------|------------|--------|------------|--------|
| **Interest  Income**                                             |   |       |       |       |   |       |   |
| Interest and fees on loans                                       |   | $          | 13,280,255 |       | $      | 12,699,866 |   | $ | 8,424,833 |   |
| Interest on Investment Securities                                |   |       |       |       |   |       |   |
| U.S. Treasury Securities                                         |   | —     |       | —     |   | 1,032      |   |
| Obligations of U.S. Government Agencies                          |   | 500,701    |       | 669,617    |   | 812,696    |   |
| Corporate Bonds, Mutual Funds, Commercial Paper                  |   | —     |       | —     |   | 110,467    |   |
| Obligations of State and Political Subdivisions                  |   | 281,079    |       | 305,674    |   | 310,436    |   |
| Interest on time deposits with other banks                       |   | 16,202     |       | 18,805     |   | 29,971     |   |
| Interest on Federal funds sold                                   |   | 362,567    |       | 248,283    |   | 220,170    |   |
| Interest on other securities                                     |   | 20,549     |       | 26,680     |   | 3,888      |   |
| Total Interest Income                                            |   | 14,461,353 |       | 13,968,925 |   | 9,913,493  |   |
|                                                             |   |       |       |       |   |       |   |
| **Interest Expense**                                             |   |       |       |       |   |       |   |
| Interest on savings, NOW and money market  deposits              |   | 963,797    |       | 1,376,114  |   | 1,136,841  |   |
| Interest  on time deposits in denominations of $ 100,000 or more |   | 210,744    |       | 382,506    |   | 292,401    |   |
| Interest on time deposits under $100,000                         |   | 2,154,795  |       | 2,139,906  |   | 1,084,896  |   |
| Other                                                            |   | 100,804    |       | 232,096    |   | 86,797     |   |
| Total Interest Expense                                           |   | 3,430,140  |       | 4,130,622  |   | 2,600,935  |   |
| Net interest income before provision for  possible loan losses   |   | 11,031,213 |       | 9,838,303  |   | 7,312,558  |   |
| Provision for Possible Loan Losses                               |   | 600,000    |       | 519,000    |   | 165,500    |   |
|                                                             |   | 10,431,213 |       | 9,319,303  |   | 7,147,058  |   |
| **Non-interest Income**                                          |   |       |       |       |   |       |   |
| Service charges on deposit accounts                              |   | 1,182,785  |       | 1,082,757  |   | 757,448    |   |
| Investment securities loss, net                                  |   | (1,606     | )          | (2,188     | )      | —     |   |
| Other                                                            |   | 3,499,396  |       | 4,602,858  |   | 4,686,793  |   |
| Total Non-interest Income                                        |   | 4,680,575  |       | 5,683,427  |   | 5,444,241  |   |
| **Non-interest Expenses**                                        |   |       |       |       |   |       |   |
| Salaries and employee benefits                                   |   | 4,494,137  |       | 4,115,549  |   | 3,562,023  |   |
| Equipment expenses                                               |   | 879,202    |       | 908,859    |   | 790,862    |   |
| Occupancy expenses                                               |   | 828,003    |       | 799,535    |   | 694,057    |   |
| Other expenses                                                   |   | 5,184,794  |       | 5,691,580  |   | 5,359,301  |   |
| Total Non-interest Expenses                                      |   | 11,386,136 |       | 11,515,523 |   | 10,406,243 |   |
| Income Before Provision for Income Taxes                         |   | 3,725,652  |       | 3,487,207  |   | 2,185,056  |   |
| Provision for Income Taxes                                       |   | 1,379,369  |       | 1,243,187  |   | 754,128    |   |
| Net Income                                                       |   | $          | 2,346,283  |       | $      | 2,244,020  |   | $ | 1,430,928 |   |
|                                                             |   |       |       |       |   |       |   |
| Earnings Per Share                                               |   |       |       |       |   |       |   |
| Basic                                                            |   | $          | 1.81       |       | $      | 1.76       |   | $ | 1.15 |   |
| Diluted                                                          |   | $          | 1.66       |       | $      | 1.64       |   | $ | 1.04 |   |

 

Theaccompanying notes are an integral part of these financial statements.

 

 

31

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**HERITAGE OAKS BANCORP ANDSUBSIDIARIES**

**CONSOLIDATEDSTATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY**

**FOR THE YEARS ENDED DECEMBER 31,2001, 2000 AND 1999**

** **
|                                                                         |   | **Common Stock**     |   |       |      |                     |      | ** **            |   | ** **                                       |   |
|------------------------------------------------------------------------------|--------|----------------------|--------|------------|-----------|--------------------------|-----------|-----------------------|--------|--------------------------------------------------|--------|
|                                                                         |   | **Number of Shares** |   | **Amount** |      | **Comprehensive Income** |      | **Retained Earnings** |   | **Accumulated Other Comprehensive  Income** |   | **Total Stockholders’ Equity** |   |
| **Balance,** January 1, 1999                                                 |   | 1,069,791            |   | $          | 4,470,170 |                     |      |                  | $      | 5,154,666                                        |   | $ | (188,166 | ) | $ | 9,436,670 |   |
| Exercise of stock options                                                    |   | 31,832               |   | 148,263    |      |                     |      |                  |   |                                             |   | 148,263 |   |
| Stock dividends paid — 4%                                               |   | 42,659               |   | 669,746    |      |                     |      | (669,746              | )      |                                             |   |   |   |
| Cash paid to stockholders in lieu of fractional  shares on 4% stock dividend |   |                 |   |       |      |                     |      | (3,025                | )      |                                             |   | (3,025 | ) |
| Comprehensive income                                                         |   |                 |   |       |      |                     |      |                  |   |                                             |   |   |   |
| Net income                                                                   |   |                 |   |       |      | 1,430,928                |      | 1,430,928             |   |                                             |   | 1,430,928 |   |
| Unrealized security holding losses (net of  $344,368 tax)                    |   |                 |   |       |      | (470,674                 | )         |                  |   | (470,674                                         | )      | (470,674 | ) |
| Total comprehensive income                                                   |   |                 |   |       |      | $                        | 960,254   |                  |   |                                             |   |   |   |   |
| **Balance,** December 31, 1999                                               |   | 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 |   |

 

The accompanying notes are an integral part of these financialstatements.

 

 

32

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

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**FOR THE YEARS ENDED DECEMBER 31,2001, 2000 AND 1999**

 

 
|                                                                                                |   | **2001**    |       | **2000**    |   | **1999**    |   |
|-----------------------------------------------------------------------------------------------------|--------|-------------|------------|-------------|--------|-------------|--------|
| **Cash Flows from Operating  Activities**                                                           |   |        |       |        |   |        |   |
| Net income                                                                                          |   | $           | 2,346,283  |        | $      | 2,244,020   |   | $ | 1,430,928 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities                   |   |        |       |        |   |        |   |
| Net cash provided by operating activities                                                           |   |        |       |        |   |        |   |
| Depreciation and amortization                                                                       |   | 825,590     |       | 711,120     |   | 658,998     |   |
| Provision for possible loan losses                                                                  |   | 600,000     |       | 519,000     |   | 165,500     |   |
| Realized loss on sales of available-for-sale  securities, net                                       |   | 1,606       |       | 2,188       |   | —      |   |
| Amortization of premiums/discounts on                                                               |   |        |       |        |   |        |   |
| investment securities, net                                                                          |   | (124,138    | )          | (148,180    | )      | (235,382    | )      |
| Gain on sale of property, premises and equipment,  net                                              |   | (279,375    | )          | —      |   | —      |   |
| Net increase in cash surrender value of life  insurance                                             |   | (124,064    | )          | (63,762     | )      | (67,393     | )      |
| (Increase)/decrease in loans held for sale                                                          |   | (1,607,658  | )          | (2,354,160  | )      | 1,534,383   |   |
| Increase in deferred tax asset                                                                      |   | (250,255    | )          | (205,339    | )      | (269,788    | )      |
| (Increase)/decrease in other assets                                                                 |   | 205,412     |       | (617,194    | )      | 394,118     |   |
| Increase/(decrease) in other liabilities                                                            |   | (357,809    | )          | 651,593     |   | (339,589    | )      |
|                                                                                                |   |        |       |        |   |        |   |
| **NET CASH PROVIDED BY OPERATING  ACTIVITIES**                                                      |   | 1,235,592   |       | 739,286     |   | 3,271,775   |   |
|                                                                                                |   |        |       |        |   |        |   |
| **Cash Flows From Investing  Activities**                                                           |   |        |       |        |   |        |   |
| Purchase of securities available-for-sale                                                           |   | —      |       | (4,838      | )      | (14,335,101 | )      |
| Purchase of mortgage-backed securities  available-for-sale                                          |   | (10,174,446 | )          | —      |   | (2,532,299  | )      |
| Proceeds from sales of securities available-for-sale                                                |   | 714,000     |       | 1,011,512   |   | 2,978,217   |   |
| Proceeds from principal reductions and  maturities of securities available-for-sale                 |   | 1,138,087   |       | 933,726     |   | 18,065,264  |   |
| Proceeds from principal reductions and  maturities of mortgage-backed securities available-for-sale |   | 2,759,246   |       | 1,563,335   |   | 4,815,584   |   |
| Net change in interest bearing deposits in other  financial institutions                            |   | 99,000      |       | 177,255     |   | 291,720     |   |
| Purchase of life insurance policies                                                                 |   | (3,650,000  | )          | —      |   | (217,818    | )      |
| Increase in cash due to acquisition                                                                 |   | 23,086,675  |       | —      |   | —      |   |
| Recoveries on loans previously written off                                                          |   | 4,284       |       | 19,422      |   | 20,196      |   |
| Increase in loans, net                                                                              |   | (23,074,140 | )          | (31,792,259 | )      | (32,808,847 | )      |
| Proceeds from sale of property, premises and  equipment                                             |   | 720,509     |       | —      |   | —      |   |
| Purchase of property, premises and equipment,  net                                                  |   | (349,869    | )          | (346,646    | )      | (1,638,902  | )      |
|                                                                                                |   |        |       |        |   |        |   |
| **NET CASH USED IN INVESTING  ACTIVITIES**                                                          |   | (8,726,654  | )          | (28,438,493 | )      | (25,361,986 | )      |
|                                                                                                |   |        |       |        |   |        |   |
| **Cash Flows From Financing  Activities**                                                           |   |        |       |        |   |        |   |
| Increase in deposits, net                                                                           |   | $           | 2,919,804  |        | $      | 34,735,317  |   | $ | 13,553,867 |   |
| Net increase/(decrease) in other borrowings                                                         |   | —      |       | (2,211,000  | )      | 2,211,000   |   |
| Net (decrease)/increase in notes payable                                                            |   | 844,811     |       | 700,000     |   | (400,000    | )      |
| Proceeds from exercise of stock options                                                             |   | 93,641      |       | 155,274     |   | 148,263     |   |
| Cash paid in lieu of fractional shares                                                              |   | (4,680      | )          | (3,923      | )      | (3,025      | )      |
|                                                                                                |   |        |       |        |   |        |   |
| **NET CASH PROVIDED BY FINANCING  ACTIVITIES**                                                      |   | 3,853,576   |       | 33,375,668  |   | 15,510,105  |   |
|                                                                                                |   |        |       |        |   |        |   |
| **Net (Decrease)/Increase in Cash  and Cash Equivalents**                                           |   | (3,637,486  | )          | 5,676,461   |   | (6,580,106  | )      |
|                                                                                                |   |        |       |        |   |        |   |
| **Cash and Cash Equivalents**, Beginning of year                                                    |   | 24,035,534  |       | 18,359,073  |   | 24,939,179  |   |
|                                                                                                |   |        |       |        |   |        |   |
| **Cash and Cash Equivalents**, End of year                                                          |   | $           | 20,398,048 |        | $      | 24,035,534  |   | $ | 18,359,073 |   |
|                                                                                                |   |        |       |        |   |        |   |
| **Supplemental Disclosures of  Cash Flow Information**                                              |   |        |       |        |   |        |   |
| Interest paid                                                                                       |   | $           | 3,960,156  |        | $      |        | $      | 2,649,170 |   |
| Income taxes paid                                                                                   |   | $           | 1,432,000  |        | $      | 1,595,000   |   | $ | 716,000 |   |
|                                                                                                |   |        |       |        |   |        |   |
| **Supplemental Disclosures of  Non-Cash Flow Information**                                          |   |        |       |        |   |        |   |
| Change in other comprehensive income                                                                |   | $           | (13,472    | )           | $      | 517,476     |   | $ | (470,674 | ) |
| Transfer of held-to-maturity securities to  avaliable-for-sale                                      |   | $           | —     |        | $      | —      |   | $ | 15,758,151 |   |

### The accompanying notesare an integral part of these financial statements.

 

33

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###  

### **HERITAGEOAKS BANCORP AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER 31, 2001, 2000 AND 1999**

 

### **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 consolidated financial statements include the Company and its whollyowned subsidiaries, Heritage Oaks Bank and CCMS Systems, Inc.  Intercompany balances and transactions havebeen eliminated.

 

B.          Nature ofOperations

 

The Bank has been organized with two primary operating segments, whichconsist of the Bank and the Bank’s Electronic Funds Transfer (EFT)Department.  The segments are identifiedas such based upon the percentage of operating net income, managementresponsibility, 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.  Income wasbased upon total customer usage of the machines and the applicable transactioncharge.

 

C.          Use ofEstimates

 

The preparation of financial statements in conformity with accountingprinciples generally accepted in the United States of America requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities and disclosure of contingent assets and liabilitiesat the date of the financial statements and the reported amounts of revenuesand expenses during the reporting period. Actual results could differ from those estimates.

 

Estimates that are particularly susceptible to significant change relateto the determination of the allowance for loan losses on loans and thevaluation of real estate acquired in connection with foreclosures or insatisfaction of loans.  In connectionwith the determination of the allowances for losses on loans and foreclosedreal estate, management obtains independent appraisals for significantproperties.

 

While management uses available information to recognize losses on loansand foreclosed real estate, future additions to the allowances may be necessarybased on changes in local economic conditions. In addition, regulatory agencies, as an integral part of theirexamination process, periodically review the Bank’s allowances for losses onloans and foreclosed real estate.  Suchagencies may require the Bank to recognize additions to the allowances based ontheir judgments about 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.

 

 

34

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## **D.**            Cashand Due From Banks

 

Banking regulations requirethat all banks maintain a percentage of their deposits as reserves in cash oron deposit with the Federal Reserve Bank. The Bank complied with the reserve requirements as of December 31, 2001.

 

The Bank maintains amountsdue from banks that exceed federally insured limits.  The Bank has not experienced any losses in such accounts.

 

## **E.**              Cashand 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

 

Inaccordance with Statement 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.

 

G.          Loans andInterest on Loans

 

Loans are stated at unpaid principal balances, less the allowance forloan losses and net deferred loan fees and unearned discounts.  The Bank recognizes loan origination fees tothe extent they represent reimbursement for initial direct costs, as income atthe time of loan boarding.  The excessof fees over costs, if any, is deferred and credited to income over the term ofthe loan.

 

In accordance with SFAS No. 114, (as amended by SFAS No. 118), “*Accounting by Creditors for Impairment of a Loan,*”those loans identified as “impaired” are measured on the present value ofexpected future cash flows, discounted at the loan’s effective interest rate orthe fair value of the collateral if the loan is collateral dependent.  A loan is impaired when it is probable thecreditor will not be able to collect all contractual principal and interestpayments due in accordance with the terms of the loan agreement.

 

35

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Loansare placed on nonaccrual when a loan is specifically determined to be impairedor when principal 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 nonaccrual are measured for impairment.  The Bank applies the measurement provisionof SFAS No. 114 to all loans in its portfolio. All loans are generally charged off at such time the loan is classifiedas a loss.

 

H.         Loans Held forSale

 

Loansheld for sale are carried at the lower of aggregate cost or market value, whichis determined by the specified value in the commitments.  Net unrealized losses, if any, arerecognized through a valuation allowance by charges to income.

 

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

 

The allowance for loan losses is maintained at a level which, inmanagement’s judgment, is adequate to absorb credit losses inherent in the loanportfolio.  The amount of the allowanceis based on management’s evaluation of the collectibility of the loanportfolio, including the nature of the portfolio, credit concentrations, trendsin historical loss experience, specific impaired loans, and economicconditions.  Allowances for impairedloans are generally determined based on collateral values or the present valueof estimated cash flows.  The allowanceis increased by a provision for loan losses, which is charged to expense andreduced by charge-offs, net of recoveries. Changes in the allowance relating to impaired loans are charged orcredited to the provision for loan losses. Because of uncertainties inherent in the estimation process,management’s estimate of credit losses inherent in the loan portfolio and therelated allowance may change.

 

## **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 31,2001, 2000 and 1999 were approximately $826,000, $711,000, and $659,000,respectively.

 

36

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## **K.**            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.”

 

## **L.**              ComprehensiveIncome

 

## **Beginning in 1998, the Bank adopted SFAS No. 130, “*Reporting Comprehensive Income*”, which requires the disclosure ofcomprehensive income and its components. Changes in unrealized gain (loss) on available-for-sale securities netof income taxes is the only component of accumulated other comprehensive incomefor the Bank.**

 

## **M.**         Reclassifications

 

Certainamounts in the 2000 and 1999 financial statements have been reclassified toconform to the 2001 presentation.

 

## **N.**            EarningsPer Share (EPS)

 

Basic EPS excludes dilution and is computed by dividing income availableto common stockholders by the weighted-average number of common sharesoutstanding for the period.  Diluted EPSreflects the potential dilution that could occur if securities or othercontracts to issue common stock were exercised or converted into common stockor resulted in the issuance of common stock that then shared in the earnings ofthe entity.

 

## **O.**            New Accounting Pronouncements

 

In June 2001, the FinancialAccounting Standards Board (“FASB”) issued Statement of Financial AccountingStandard (“SFAS”) No. 142, *“Accounting forGoodwill and Other Intangible Assets,”* effective starting withfiscal years beginning after December 15, 2001.  This standard establishes new accounting standards for goodwilland continues to require the recognition of goodwill as an asset but does notpermit amortization of goodwill as previously required by the AccountingPrinciples Board Opinion (“APB”) Opinion No. 17.  The standard also establishes a new method of testing goodwillfor impairment.  It requires goodwill tobe separately tested for impairment at a reporting unit level.  The amount of goodwill determined to beimpaired would be expensed to current operations.  Management believes that the adoption of the statement will nothave a material effect on the Company’s financial statements.  Amortizationexpense charged to operations for 2001, 2000 and 1999 was $20,054, $12,027 and$35,107, respectively.

 

37

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

 

At December 31, 2001 and2000, the investment securities portfolio was comprised of securitiesclassified as available-for-sale, in accordance with SFAS No. 115, resulting ininvestment securities available-for-sale being carried at fair value andinvestment securities held-to-maturity being carried at cost, adjusted foramortization of premiums and accretions of discounts, and fair market valueadjustments for securities transferred from available-for-sale.

 

The amortized cost and fairvalues of investment securities available-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.

 

 

The amortized cost and fair values of investment securitiesavailable-for-sale at December 31, 2000, were:

 
| ** **                                                | ** ** | **Amortized    Cost** | ** ** | **Gross    Unrealized   Gains** | ** ** | **Gross    Unrealized   Losses** | ** ** | **Fair  Value** | ** ** |
|-----------------------------------------------------------|------------|-----------------------|------------|---------------------------------|------------|----------------------------------|------------|-----------------|------------|
| Obligations of U.S. Government agencies and  corporations |       | $                     | 2,392,808  |                            | $          | —                           |       | $               | (76,721    | ) | $ | 2,316,087 |   |
| Mortgage-backed securities                                |       | 7,958,658             |       | 6,468                           |       | (239,825                         | )          | 7,725,301       |       |
| Obligations of state and political subdivisions           |       | 6,088,006             |       | 90,786                          |       | (16,313                          | )          | 6,162,479       |       |
| Other securities                                          |       | 8,638                 |       | —                          |       | —                           |       | 8,638           |       |
| Total                                                     |       | $                     | 16,448,110 |                            | $          | 97,254                           |       | $               | (332,859   | ) | $ | 16,212,505 |   |

 

 

38

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The amortized cost and fairvalues of investment securities available-for-sale at December 31, 2001, bycontractual maturity are shown below. Actual maturities may differ from contractual maturities because borrowersmay have the right to call or prepay obligations with or without call orprepayment penalties.
| ** **                             | ** ** | **Securities    Available-for-Sale** | ** ** |
|----------------------------------------|------------|--------------------------------------|------------|
| ** **                             | ** ** | **Amortized    Cost**                | ** ** | **Fair  Value** | ** ** |
| Due in one year or less                |       | $                                    | 34,604     |   | $ | 34,674 |   |
| Due after one year through five years  |       | 2,113,825                            |       | 2,130,656 |   |
| Due after five years through ten years |       | 946,256                              |       | 967,255 |   |
| Due after ten years                    |       | 3,617,552                            |       | 3,517,548 |   |
| Mortgage-backed securities             |       | 15,574,820                           |       | 15,378,863 |   |
| Total Securities                       |       | $                                    | 22,287,057 |   | $ | 22,028,996 |   |

 

Proceeds from sales andmaturities of investment securities available-for-sale during 2001, 2000 and1999, were $714,000, $1,011,512, and $2,978,217, respectively.  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.  There were no gross gains orlosses in 1999.

 

Proceeds from sales and maturities and principal reductions ofmortgage-backed securities in 2001, 2000, and 1999, were $2,759,246,$1,563,335, and $4,815,584, respectively. There were no gross gains or losses on these sales during 2001 and2000.  Unrealized losses on investmentsecurities and mortgage-backed securities included in shareholders’ equity netof tax at December 31, 2001, 2000 and 1999 were $154,836, $141,364, and$658,840, respectively.

 

Securities having a carrying value and a fair value of approximately$8,850,000 and $10,687,000 at December 31, 2001 and 2000, respectively, werepledged to secure public deposits and for other purposes as required by law.

 

39

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|                                   |   | **2001**    |        | **2000**    |   |
|----------------------------------------|--------|-------------|-------------|-------------|--------|
| Commercial, financial and agricultural |   | $           | 40,608,210  |        | $      | 42,931,015 |   |
| Real Estate — construction        |   | 23,449,044  |        | 18,599,452  |   |
| Real Estate — mortgage            |   | 90,823,606  |        | 70,550,560  |   |
| Installment loans to individuals       |   | 3,171,805   |        | 3,246,214   |   |
| All other loans (including overdrafts) |   | 419,622     |        | 160,779     |   |
|                                   |   | 158,472,287 |        | 135,488,020 |   |
| Less:   Deferred loan fees        |   | (578,332    | )           | (487,473    | )      |
| Less:   Allowance for loan losses |   | (1,744,070  | )           | (1,320,518  | )      |
| Total Loans                            |   | $           | 156,149,885 |        | $      | 133,680,029 |   |
|                                   |   |        |        |        |   |
| Loans held for sale                    |   | $           | 4,082,200   |        | $      | 2,474,542 |   |

 

Concentration of CreditRisk

 

AtDecember 31, 2001, approximately $114,273,000 of the Bank’s loan portfolio wascollateralized by various forms of real estate.  Such loans are generally made to borrowers located in San LuisObispo County.  The Bank attempts toreduce its concentration of credit risk by making loans which are diversifiedby project type.  While managementbelieves that the collateral presently securing this portfolio is adequate,there can be no assurances that significant deterioration in the Californiareal estate market would not expose the Bank to significantly greater creditrisk.

 

The following is a summaryof the investment in impaired loans, the related allowance for loan losses, andincome recognized thereon as of December 31:

 
|                                               |   | **2001**  |      | **2000** |   | **1999** |   |
|----------------------------------------------------|--------|-----------|-----------|----------|--------|----------|--------|
| Impaired loans with a valuation allowance          |   | $         | 203,154   |     | $      | 905,313  |   | $ | 904,773 |   |
| Impaired loans without a valuation allowance       |   | 1,291,448 |      | 85,917   |   | —   |   |
| Total impaired loans                               |   | $         | 1,494,602 |     | $      | 991,230  |   | $ | 904,773 |   |
| Valuation allowance related to impaired loans      |   | $         | 148,104   |     | $      | 314,633  |   | $ | 122,847 |   |
|                                               |   |      |      |     |   |     |   |
| Average recorded investment in impaired loans      |   | $         | 842,631   |     | $      | 731,963  |   | $ | 914,298 |   |
|                                               |   |      |      |     |   |     |   |
| Cash receipts applied to reduce principal  balance |   | $         | 317,000   |     | $      | 654,797  |   | $ | 28,691 |   |
|                                               |   |      |      |     |   |     |   |
| Interest income recognized for cash payments       |   | $         | —    |     | $      | —   |   | $ | — |   |

 

The provisions of SFAS No. 114 and SFAS No. 118 permit the valuation allowancereported above to be determined on a loan-by-loan basis or by aggregating loanswith similar risk characteristics. Because the loans currently identified as impaired have unique riskcharacteristics, the valuation allowance was determined on a loan-by-loanbasis.

 

40

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Nonaccruing loans totaled $1,495,000 and $991,230 at December 31, 2001and 2000, respectively.  As of December31, 2001 and 2000, all loans on nonaccrual were classified as impaired.  If interest on nonaccrual loans had beenrecognized at the original interest rates, interest income would have increased$195,826, $115,603, and $91,207, in 2001, 2000 and 1999, respectively.  No additional funds are committed to beadvanced in connection with impaired loans.

 

At December 31, 2001 and2000, the Bank had no loans past due 90 days or more in interest or principaland still accruing interest.

 

At December 31, 2001, loanstotaling approximately $310,000 were classified as troubled debt restructurings.

 

 

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

 

Transactions in theallowance for loan losses are summarized as follows:

 
|                                       |   | **2001** |      | **2000** |   | **1999**  |   |
|--------------------------------------------|--------|----------|-----------|----------|--------|-----------|--------|
| Balance, Beginning of Year                 |   | $        | 1,320,518 |     | $      | 1,241,016 |   | $ | 1,069,535 |   |
| Additions charged to operating expense     |   | 600,000  |      | 519,000  |   | 165,500   |   |
| Loans charged off                          |   | (180,732 | )         | (458,920 | )      | (14,215   | )      |
| Recoveries of loans previously charged off |   | 4,284    |      | 19,422   |   | 20,196    |   |
| Balance, End of Year                       |   | $        | 1,744,070 |     | $      | 1,320,518 |   | $ | 1,241,016 |   |

 

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

 

Property, premises and equipment consisted of the following:

 
|                                                   |   | **2001**  |      | **2000**  |   |
|--------------------------------------------------------|--------|-----------|-----------|-----------|--------|
| Land                                                   |   | $         | 1,090,783 |      | $      | 668,877 |   |
| Building and improvements                              |   | 3,569,876 |      | 3,047,432 |   |
| Furniture and equipment                                |   | 4,035,637 |      | 4,024,113 |   |
|                                                   |   | 8,696,296 |      | 7,740,422 |   |
| Less:   Accumulated depreciation and amortization |   | 5,075,527 |      | 4,677,607 |   |
| Total                                                  |   | $         | 3,620,769 |      | $      | 3,062,815 |   |

 

41

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The Company leases land,buildings, and equipment under noncancelable operating leases expiring at variousdates through 2009.  The following is aschedule of future minimum lease payments based upon obligations at year-end.

 
| **Year Ending   December 31,** | ** ** | **Amount** | ** ** |
|--------------------------------|------------|------------|------------|
| 2002                           |       | $          | 365,700    |   |
| 2003                           |       | 353,100    |       |
| 2004                           |       | 333,852    |       |
| 2005                           |       | 300,774    |       |
| 2006                           |       | 216,951    |       |
| More than 5 years              |       | 526,920    |       |
| Total                          |       | $          | 2,097,297  |   |

 

Total expenditures chargedfor leases for the reporting periods ended December 31, 2001, 2000 and 1999,were approximately $382,000,  $492,000,and $346,000, respectively.

 

 

### **Note #6 - Time Deposit Liabilities**

 

At December 31, 2001, theBank had time certificates of deposit with maturity distributions as follows:

 
| **Year Ending   December 31,** | ** ** | ** ** | ** ** |
|--------------------------------|------------|------------|------------|
| 2002                           |       | $          | 38,383,298 |   |
| 2003                           |       | 10,524,661 |       |
| 2004                           |       | 158,429    |       |
| 2005                           |       | 108,954    |       |
| 2006                           |       | 21,077     |       |
|                           |       | $          | 49,196,419 |   |

 

**Note #7 - Other Borrowed Money**

 

Interest expense on federalfunds purchased was $382, $15,875, and $752 and interest expense on securitiessold under agreements to repurchase was $0, $18,779, and $42,430, for the yearsended December 31, 2001, 2000 and 1999, respectively.

 

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

 

The Bank has pledged approximately $4,689,000 in loans to the FederalReserve Bank for a borrowing line at the federal discount window.

 

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### **Note #8 - Notes Payable**

 

On September 11, 1998, theBancorp obtained a revolving line of credit in the amount of $2,000,000 throughPacific Coast Bankers’ Bank (“PCBB”). The note is secured by 339,332 shares ofthe Bank’s stock.  The note maturesAugust 15, 2006, and bears interest at a variable rate of 1.00 percentover the Wall Street Journal prime rate. The outstanding principal balance at December 31, 2001 and 2000,was $1,894,811 and $1,050,000, respectively, and the current interest rate was5.75 percent.  Payments on the note willbe fully amortizing to maturity, based on the outstanding balance owed. TheCompany is required to obtain written approval from PCBB

prior to declaring any cash dividend.

 

**Note #9 -Income Taxes**

 

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

 
|                      |   | **Year Ending December 31,** |      |
|---------------------------|--------|------------------------------|-----------|
|                      |   | **2001**                     |      | **2000** |   | **1999** |   |
| Federal Income Tax        |   |                         |      |   |   |   |   |
| Current                   |   | $                            | 1,251,241 |   | $ | 966,100 |   | $ | 655,522 |   |
| Deferred                  |   | (264,940                     | )         | (74,141 | ) | (133,240 | ) |
| Total Federal Taxes       |   | 986,301                      |      | 891,959 |   | 522,282 |   |
|                      |   |                         |      |   |   |   |   |
| State Franchise Tax       |   |                         |      |   |   |   |   |
| Current                   |   | 470,734                      |      | 375,906 |   | 276,364 |   |
| Deferred                  |   | (77,666                      | )         | (24,678 | ) | (44,518 | ) |
| Total State Franchise Tax |   | 393,068                      |      | 351,228 |   | 231,846 |   |
| Total Income Taxes        |   | $                            | 1,379,369 |   | $ | 1,243,187 |   | $ | 754,128 |   |

 

The principal items giving rise to deferred taxes were:

 
|                                                |   | **2001** |     | **2000** |   | **1999** |   |
|-----------------------------------------------------|--------|----------|----------|----------|--------|----------|--------|
| Use of different depreciation for tax purposes      |   | $        | (15,603  | )        | $      | (11,330  | )      | $ | (29,948 | ) |
| Difference in loan loss provision for tax  purposes |   | (173,656 | )        | (32,596  | )      | (67,855  | )      |
| Differences arising from changes in accruals        |   | (114,510 | )        | (32,819  | )      | (83,831  | )      |
| Other, net                                          |   | (38,837  | )        | (22,074  | )      | 3,876    |   |
| Total                                               |   | $        | (342,606 | )        | $      | (98,819  | )      | $ | (177,758 | ) |

 

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

 
|                                                   |   | **2001**   |      | **2000**    |   | **1999**   |   |
|--------------------------------------------------------|--------|------------|-----------|-------------|--------|------------|--------|
|                                                   |   | **Amount** |      | **Percent** |   | **Amount** |   | **Percent** |   | **Amount** |   | **Percent** |   |
| Tax provision at federal statutory tax rate            |   | $          | 1,266,722 |        | 34.0   |       | $      | 1,185,650 |   | 34.0 |   | $ | 742,919 |   | 34.0 |   |
|                                                   |   |       |      |        |   |       |   |   |   |   |   |   |   |
| State income taxes, net of federal income tax  benefit |   | 259,425    |      | 7.0         |   | 231,810    |   | 6.7 |   | 153,019 |   | 7.0 |   |
| Tax exempt income and other, Net                       |   | (146,778   | )         | (4.0        | )      | (174,273   | )      | (5.0 | ) | (141,810 | ) | (6.5 | ) |
| Total Tax Provision                                    |   | $          | 1,379,369 |        | 37.0   |       | $      | 1,243,187 |   | 35.7 |   | $ | 754,128 |   | 34.5 |   |

 

 

43

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The net deferred tax assetis determined as follows:

 
|                                                                  |   | **2001**           |   | **2000** |   |
|-----------------------------------------------------------------------|--------|--------------------|--------|----------|--------|
|                                                                  |   | **(In Thousands)** |   |
| Deferred Tax Assets                                                   |   |               |   |     |   |
| Reserves for loan losses                                              |   | $                  | 629    |     | $      | 456 |   |
| Fixed assets                                                          |   | 22                 |   | 6        |   |
| Accruals                                                              |   | 504                |   | 443      |   |
| Investment securities valuation                                       |   | 103                |   | 94       |   |
|                                                                  |   |               |   |     |   |
| Total Deferred tax assets arising from  cumulative timing differences |   | 1,258              |   | 999      |   |
| Valuation allowance*                                                  |   | —             |   | —   |   |
| Net Deferred Tax Asset                                                |   | $                  | 1,258  |     | $      | 999 |   |

----

*The valuation allowance isestimated based upon amounts less than likely of future realization.  There was no change in the valuationallowance for the 2001 year.

 

 

**Note #10 -Commitments and Contingencies**

 

The Company is involved invarious litigation.  In the opinion ofmanagement and the Company’s legal counsel, the disposition of all suchlitigation pending will not have a material effect on the Company’s financialstatements.

 

At December 31, 2001 and 2000, the Bank was contingently liable forletters of credit accommodations made to its customers totaling $1,505,881 and$861,969, respectively.  At December 31,2001 and 2000, the Bank had undisbursed loan commitments in the amount of$53,548,595 and $43,834,315, respectively. The Bank makes commitments to extend credit in the normal course ofbusiness 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 nolosses as a result of such transactions.

 

44

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**Note #11 - Regulatory Matters**

 

The Company (on aconsolidated basis) and the Bank are subject to various regulatory capitalrequirements administered by federal banking agencies.  Failure to meet minimum capital requirementscan initiate certain mandatory, and possibly additional discretionary, actionsby regulators that, if undertaken, could have a direct material effect on theCompany’s and the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework forprompt corrective action, the Company and the Bank must meet specific capitalguidelines that involve quantitative measures of the Company’s and the Bank’sassets, liabilities and certain off-balance sheet items as calculated underregulatory accounting practices.  TheCompany’s and the Bank’s capital amounts and classification are also subject toqualitative judgments by the regulators about components, risk weightings andother factors.  Prompt corrective actionprovisions are not applicable to bank holding 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, 2001, 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 Insurance Corporationcategorized the Bank as well capitalized under the regulatory framework forprompt corrective action.  There are noconditions or events since that notification that management believes havechanged the Bank’s category.  To becategorized as well-capitalized, the Bank must maintain minimum capital ratiosas set forth in the table below.  Thefollowing table also sets forth the Company’s and the Bank’s actual regulatorycapital amounts and ratios (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, 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 | % |
|                                    |       |                  |       |                                |       |                                                                     |       |   |   |   |   |   |   |
| As of December 31, 2000                 |       |                  |       |                                |       |                                                                     |       |   |   |   |   |   |   |
| Total capital to risk-weighted assets:  |       |                  |       |                                |       |                                                                     |       |   |   |   |   |   |   |
| Company                                 |       | 14,903                |       | 10.26                               | %          | 11,616                                                                   |       | 8.0 | % | N/A |   | N/A |   |
| Bank                                    |       | 14,799                |       | 10.03                               | %          | 11,806                                                                   |       | 8.0 | % | 14,757 |   | 10.0 | % |
|                                    |       |                  |       |                                |       |                                                                     |       |   |   |   |   |   |   |
| Tier 1 capital to risk-weighted assets: |       |                  |       |                                |       |                                                                     |       |   |   |   |   |   |   |
| Company                                 |       | 13,582                |       | 9.35                                | %          | 5,808                                                                    |       | 4.0 | % | N/A |   | N/A |   |
| Bank                                    |       | 13,478                |       | 9.13                                | %          | 5,903                                                                    |       | 4.0 | % | 8,854 |   | 6.0 | % |
| .                                       |       |                  |       |                                |       |                                                                     |       |   |   |   |   |   |   |
| Tier 1 capital to average assets:       |       |                  |       |                                |       |                                                                     |       |   |   |   |   |   |   |
| Company                                 |       | 13,582                |       | 7.56                                | %          | 7,184                                                                    |       | 4.0 | % | N/A |   | N/A |   |
| Bank                                    |       | 13,478                |       | 7.53                                | %          | 7,156                                                                    |       | 4.0 | % | 8,945 |   | 5.0 | % |
|                                         |            |                       |            |                                     |            |                                                                          |            |  |  |  |  |  |  |  |  |  |

 

 

45

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**Note #12 - Salary Continuation Plan**

 

TheBank established a salary continuation plan agreement with the President, ChiefFinancial Officer, Chief Lending Officer, and Chief Administrative Officer, asauthorized by the Board of Directors. This agreement provides for annual cash payments for a period not toexceed 15 years, beginning at retirement age 60.  In the event of death prior to retirement age, annual cashpayments would be made to the beneficiaries for a determined number ofyears.  The present values of theCompany’s liability under this Agreement were $347,072 and $243,560 at December31, 2001 and 2000, respectively, and are included in other liabilities in theCompany’s Consolidated Financial Statements. The Company maintains life insurance policies, which are intended tofund all costs of the plan.  The cashsurrender values of these life insurance policies totaled $5,143,613 and$1,369,549, at December 31, 2001 and 2000, respectively.

 

 

**Note #13 —401(k) Pension Plan**

 

During 1994, the Bank established a savings plan for employees whichallows participants to make contributions by salary deduction equal to 15percent or less of their salary pursuant to section 401(k) of the InternalRevenue Code.  Employee contributionsare matched up to 25 percent of the employee’s contribution.  Employees vest immediately in their owncontributions and they vest in the Bank’s contribution based on years ofservice.  Expenses of the savings planwere $57,528, $48,843, and $35,924, for the years ended December 31, 2001, 2000and 1999, respectively.

 

 

### **Note #14 - Stock Option Plans**

 

At December 31, 2001, the Bank had two stockoption plans, which are described below. The Bank applies APB Opinion 25 and related interpretations inaccounting for the stock option plans. Accordingly, no compensation costs have been recognized.  Had compensation costs for these plans beendetermined on the fair value at the grant dates consistent with the methodprescribed by SFAS No. 123, the Company’s net income and earnings per sharewould have been adjusted to the pro forma amounts indicated below:

 
|                      |   |         |   | **2001**  |      | **2000**  |   | **1999**  |   |
|---------------------------|--------|--------------|--------|-----------|-----------|-----------|--------|-----------|--------|
| Net Income                |   | As  reported |   | $         | 2,346,283 |      | $      | 2,244,020 |   | $ | 1,430,928 |   |
|                      |   | Pro forma    |   | 2,238,422 |      | 2,149,036 |   | 1,373,874 |   |
|                      |   |         |   |      |      |      |   |      |   |
| Earnings per share        |   | As  reported |   | 1.81      |      | 1.76      |   | 1.15      |   |
|                      |   | Pro forma    |   | 1.72      |      | 1.69      |   | 1.11      |   |
|                      |   |         |   |      |      |      |   |      |   |
| Earnings per share — |   | As  reported |   | 1.66      |      | 1.64      |   | 1.04      |   |
| assuming dilution         |   | Pro  forma   |   | 1.59      |      | 1.58      |   | 1.00      |   |
|                      |   |         |   |      |      |      |   |      |   |
|                           |        |              |        |           |           |           |        |           |        |  |  |  |

 

46

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The Company adopted the Bank’s 1990 stock option plan, which is a tandemstock option plan permitting options to be granted either as “Incentive StockOptions” 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 158,764 shares (after giving retroactive effect for a 4 percent stockdividend in 1999, and 5 percent stock dividends in 2000 and 2001) of theCompany’s unissued common stock and is subject to the specific approval of theBoard of Directors.  The Bank’s 1990stock option plan expired in July 2000.

 

No options were granted during 1999, 2000, or 2001.

 

The following tables summarize information about the 1990 stock optionplan outstanding at December 31, 2001.

 
|                                                            |   | **2001**   |   | **2000**      |   | **1999**   |    |
|-----------------------------------------------------------------|--------|------------|--------|---------------|--------|------------|---------|
|                                                            |   |       |   | **Weighted-** |   |       |    | **Weighted-** |   |   |   | **Weighted-** |   |
|                                                            |   |       |   | **Average**   |   |       |    | **Average** |   |   |   | **Average** |   |
|                                                            |   |       |   | **Exercise**  |   |       |    | **Exercise** |   |   |   | **Exercise** |   |
|                                                            |   | **Shares** |   | **Price**     |   | **Shares** |    | **Price** |   | **Shares** |   | **Price** |   |
| Outstanding at beginning of year                                |   | 23,582     |   | $             | 3.66   |       | 47,906  |   | $ | 3.74 |   | 80,001 |   | $ | 3.74 |   |
| Granted                                                         |   |       |   |          |   |       |    |   |   |   |   |   |   |
| Cancelled                                                       |   | —     |   | $             | — |       | (427    | ) | $ | 9.30 |   | (968 | ) | $ | 9.31 |   |
| Exercised                                                       |   | (7,357     | )      | $             | 3.60   |       | (23,897 | ) | $ | 3.73 |   | (31,126 | ) | $ | 3.48 |   |
| Outstanding at end of year                                      |   | 16,225     |   | $             | 3.68   |       | 23,582  |   | $ | 3.66 |   | 47,906 |   | $ | 3.74 |   |
|                                                            |   |       |   |          |   |       |    |   |   |   |   |   |   |
| Options available for granting at end of year                   |   | —     |   |          |   | —     |    |   |   | 1,075 |   |   |   |
| Options exercisable at year-end                                 |   | 16,225     |   | $             | 3.70   |       | 23,260  |   | $ | 3.59 |   | 46,628 |   | $ | 3.60 |   |
| 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** | ** ** |
| $                       | 3.34       |                      | 15,257     |   | 1.09 |   | $ | 3.34 |   | 15,257 |   | $ | 3.34 |   |
| $                       | 9.31       |                      | 968        |   | 5.53 |   | $ | 9.31 |   | 968 |   | $ | 9.31 |   |
|                    |       | 16,225                    |       |   |   |   |   | 16,225 |   |   |   |

 

47

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The Company adopted the Bank’s 1997 stock option plan, which is a tandemstock option plan permitting options to be granted either as “Incentive StockOptions” or as “Non-Qualified Stock Options” under the Internal Revenue Code.  All outstanding options were granted atprices which equal the fair market value on the day of the grant.  Options granted vest at a rate of 20 percentper year for five years, and expire no later than ten years from the date ofgrant.  The plan provides for issuanceof up to 184,659 shares (after giving retroactive effect for a 4 percent stockdividend in 1999, and 5 percent stock dividends in 2000 and 2001) of theCompany’s unissued common stock and is subject to the specific approval of theBoard of Directors.

 

During 1999, the Board of Directors approvedan amendment to the 1997 Stock Option Plan. Under this amendment, the plan provides for issuance of up to 109,428additional shares (after giving retroactive effect for 5 percent stockdividends in 2000 and 2001) of the Company’s common stock.

 

The fair value of each option granted wasestimated on the date of grant using the Black-Scholes option pricing modelwith the following assumptions for 2001, 2000 and 1999, respectively:  risk-free rates of 5.25 percent, 5.17percent and 6.60 percent, dividend yields of 0 percent for all years presented,expected life of nine years, eight years and eight years; and volatility of 26percent, 28 percent and 30 percent.

 

The following summarizes information about the 1997 stock option planoutstanding at December 31, 2001.  Thesetables have been retroactively adjusted for the 5 percent stock dividend in2000 and the 5 percent stock dividend in 2001.

 
|                                                            |       | **2001**   |       | **2000**                                    |       | **1999**   |       |
|-----------------------------------------------------------------|------------|------------|------------|---------------------------------------------|------------|------------|------------|
| ** **                                                      | ** ** | **Shares** | ** ** | **Weighted-    Average   Exercise   Price** | ** ** | **Shares** | ** ** | **Weighted-    Average   Exercise   Price** | ** ** | **Shares** | ** ** | **Weighted-    Average   Exercise   Price** | ** ** |
| Outstanding at beginning of year                                |       | 206,078    |       | $                                           | 11.26      |       | 177,850    |   | $ | 10.73 |   | 149,627 |   | $ | 9.50 |   |
| Granted                                                         |       | 6,300      |       | $                                           | 16.67      |       | 33,075     |   | $ | 14.11 |   | 39,139 |   | $ | 14.83 |   |
| Cancelled                                                       |       | (9,831     | )          | $                                           | 13.64      |       | (3,791     | ) | $ | 11.71 |   | (6,880 | ) | $ | 9.31 |   |
| Exercised                                                       |       | (4,520     | )          | $                                           | 9.31       |       | (1,056     | ) | $ | 10.36 |   | (4,036 | ) | $ | 9.44 |   |
| Outstanding at end of year                                      |       | 198,027    |       | $                                           | 11.36      |       | 206,078    |   | $ | 11.26 |   | 177,850 |   | $ | 10.73 |   |
|                                                            |       |       |       |                                        |       |       |       |   |   |   |   |   |   |
| Options available for grant end of year                         |       | 82,148     |       |                                        |       | 78,617     |       |   |   | 107,901 |   |   |   |
| Options exercisable at year-end                                 |       | 120,273    |       | $                                           | 10.33      |       | 87,105     |   | $ | 9.95 |   | 52,605 |   | $ | 8.99 |   |
| Weighted-average fair value of options granted  during the year |       | $          | 7.84       |                                        |       |       | $          | 6.45 |   |   |   | $ | 7.72 |   |   |   |
|                                                                 |            |            |            |                                             |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

48

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| **Options Outstanding** |       | **Options Exercisable**   |       |
|-------------------------|------------|---------------------------|------------|
| **Exercise   Price**    | ** ** | **Number    Outstanding** | ** ** | **Weighted—    Average   Remaining   Contractual Life** | ** ** | **Weighted—    Average   Exercise   Price** | ** ** | **Number    Exercisable** | ** ** | **Weighted—    Average   Exercise   Price** | ** ** |
| $9.31                   |       | 122,955                   |       | 5.53 |   | $ | 9.31 |   | 97,019 |   | $ | 9.31 |   |
| $12.86  — $14.83   |       | 62,341                    |       | 7.56 |   | $ | 14.39 |   | 21,416 |   | $ | 14.51 |   |
| $15.08  — $16.67   |       | 12,731                    |       | 8.67 |   | $ | 16.25 |   | 1,838 |   | $ | 15.62 |   |
|                    |       | 198,027                   |       |   |   |   |   | 120,273 |   |   |   |

 

 

### **Note #15 - Related Party Transactions**

 

The Bank has entered intoloan and deposit transactions with certain directors and executive officers ofthe Company.  These loans were made anddeposits were taken in the ordinary course of the Bank’s business and, inmanagement’s opinion, were made at prevailing rates and terms.

 

An analysis of loans todirectors and executive officers is as follows:

 
|                                   |   | **2001**  |      | **2000** |   |
|----------------------------------------|--------|-----------|-----------|----------|--------|
| Outstanding Balance, Beginning of Year |   | $         | 211,821   |     | $      | 292,540 |   |
| Additional loans made                  |   | 2,703,959 |      | 350,000  |   |
| Repayments                             |   | (100,500  | )         | (430,719 | )      |
| Outstanding Balance, End of Year       |   | $         | 2,815,280 |     | $      | 211,821 |   |
|                                   |   |      |      |     |   |

 

Deposits from relatedparties held by the Bank at December 31, 2001 and 2000 amounted toapproximately $1,275,000, and $1,684,000, respectively.

 

 

### **Note #16 - 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.

 

49

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**Note #17 - Fair Value of Financial Instruments**

 

SFAS No. 107, “*Disclosures About Fair Value of Financial Instruments*,” requires disclosure of fair valueinformation about all financial instruments, whether or not recognized in thebalance sheet.  In cases where quotedmarket prices are not available, fair values are based on estimates usingpresent value or other valuation techniques. Those techniques are significantly affected by the assumptions used,including the discount rate and estimates of future cash flows.  In that regard, the derived fair valueestimates cannot be substantiated by comparison to independent markets and, inmany cases, could not be realized in immediate settlement of theinstruments.  SFAS No. 107 excludescertain financial instruments and all nonfinancial instruments from itsdisclosure requirements.  Accordingly,the aggregate fair value amounts presented do not represent the underlying valueof the Bank.

 

The following tablepresents the carrying amounts and fair values of financial instruments atDecember 31, 2001 and 2000.  SFASNo. 107, “*Disclosures about Fair Value ofFinancial Instruments*,” definesthe fair value of a financial instrument as the amount at which the instrumentcould be exchanged in a current transaction between willing parties, other thanin a forced or liquidation sale.

 
|                                                        |       | **2001**               |       | **2000**                     |       |
|-------------------------------------------------------------|------------|------------------------|------------|------------------------------|------------|
| ** **                                                  | ** ** | **Carrying    Amount** | ** ** | **Fair  Value**              | ** ** | **Carrying    Amount** | ** ** | **Fair  Value** | ** ** |
| Assets                                                      |       |                   |       |                         |       |   |   |   |   |
| Cash and cash equivalents                                   |       | $                      | 20,398,048 |                         | $          | 20,398,048 |   | $ | 24,035,534 |   | $ | 24,035,534 |   |
| Investment bearing deposits                                 |       | 99,000                 |       | 99,000                       |       | 198,000 |   | 198,000 |   |
| Investment and mortgage-backed securities                   |       | 22,028,996             |       | 22,028,996                   |       | 16,594,105 |   | 16,594,105 |   |
| Loans receivable                                            |       | 157,893,955            |       | 158,052,664                  |       | 135,000,547 |   | 132,435,464 |   |
| Loans held for sale                                         |       | 4,082,200              |       | 4,082,200                    |       | 2,474,542 |   | 2,474,542 |   |
| Accrued interest receivable                                 |       | 810,165                |       | 810,165                      |       | 1,107,598 |   | 1,107,598 |   |
|                                                        |       |                   |       |                         |       |   |   |   |   |
| Liabilities                                                 |       |                   |       |                         |       |   |   |   |   |
| Non-interest bearing deposits                               |       | 69,824,137             |       | 69,824,137                   |       | 51,821,234 |   | 51,821,234 |   |
| Interest bearing deposits                                   |       | 125,760,628            |       | 126,366,674                  |       | 115,875,656 |   | 116,134,080 |   |
| Notes payable                                               |       | 1,894,811              |       | 1,894,811                    |       | 1,050,000 |   | 1,050,000 |   |
| Accrued interest payable                                    |       | 377,528                |       | 377,528                      |       | 907,544 |   | 907,544 |   |
|                                                        |       |                   |       |                         |       |   |   |   |   |
| ** **                                                  | ** ** | **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 |       | 55,054,476             |       | 550,545                      |       | 44,696,284 |   | 446,963 |   |
|                                                        |       |                   |       |                         |       |   |   |   |   |
|                                                             |            |                        |            |                              |            |  |  |  |  |  |  |  |  |

 

 

50

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The following methods andassumptions were used by the Bank in estimating fair value disclosures:

 

•               Cash and CashEquivalents

 

Thecarrying amounts reported in the balance sheet for cash and cash equivalentsapproximate those assets’ fair values due to the short-term nature of theassets.

 

•               InterestBearing Deposits

 

Fair values for time deposits are estimated using a discounted cash flowanalysis that applies interest rates currently being offered on certificates toa schedule of aggregated contractual maturities on such time deposits.

 

•               Investment andMortgage-Backed Securities

 

Fairvalues are based upon quoted market prices, where available.

 

•               Loans andLoans Held for Sale

 

Forvariable-rate loans that reprice frequently and with no significant change incredit risk, fair values are based on carrying amounts.  The fair values for other loans (forexample, fixed rate commercial real estate and rental property mortgage loansand commercial and industrial loans) are estimated using discounted cash flowanalysis, based on interest rates currently being offered for loans withsimilar terms to borrowers of similar credit quality.  Loan fair value estimates include judgments regarding futureexpected loss experience and risk characteristics.  The carrying amount of accrued interest receivable approximatesits fair value.

 

•               Deposits

 

The fair values disclosed for demand deposits (for example,interest-bearing checking accounts and passbook accounts) are, by definition,equal to the amount payable on demand at the reporting date (that is, theircarrying amounts).  The fair values forcertificates of deposit are estimated using a discounted cash flow calculationthat applies interest rates currently being offered on certificates to aschedule of aggregated contractual maturities on such time deposits.  The carrying amount of accrued interest payableapproximates fair value.

 

•               Long-term Debt— Notes Payable

 

The fair value disclosed for notes payable is based on carryingamounts.  The note is a variable-ratednote that reprices frequently.

 

•               Off-balanceSheet Instruments

 

Fair values of loan commitments and financial guarantees are based uponfees currently charged to enter similar agreements, taking into account theremaining terms of the agreement and the counterparties’ credit standing.

 

51

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**Note #18 -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 #21.

 
|                                                  |       | **2001**          |       | **2000**   |       | **1999**          |       |
|-------------------------------------------------------|------------|-------------------|------------|------------|------------|-------------------|------------|
| ** **                                            | ** ** | **Net    Income** | ** ** | **Shares** | ** ** | **Net    Income** | ** ** | **Shares** | ** ** | **Net    Income** | ** ** | **Shares** | ** ** |
| Net income as reported                                |       | $                 | 2,346,283  |       |       |              | $          | 2,244,020 |   |   |   | $ | 1,430,928 |   |   |   |
| Shares outstanding at year-end                        |       |              |       | 1,297,880  |       |              |       | 1,224,999 |   |   |   | 1,201,496 |   |
| Impact of weighting shares purchased during the  year |       |              |       | (1,968     | )          |              |       | (9,195 | ) |   |   | (19,203 | ) |
| Used in Basic EPS                                     |       | 2,346,283         |       | 1,295,912  |       | 2,244,020         |       | 1,215,804 |   | 1,430,928 |   | 1,182,293 |   |
| Dilutive effect of outstanding stock options          |       |              |       | 113,396    |       |              |       | 82,029 |   |   |   | 126,237 |   |
| Used in Dilutive EPS                                  |       | $                 | 2,346,283  |       | 1,409,308  |              | $          | 2,244,020 |   | 1,297,833 |   | $ | 1,430,928 |   | 1,308,530 |   |
|                                                  |       |              |       |       |       |              |       |   |   |   |   |   |   |

 

 

**Note #19 -Other Income/Expense**

 

The following is a breakdown of fees and other income and expenses forthe years ended December 31, 2001, 2000 and 1999:

 
|                                         |   | **2001**  |      | **2000**  |   | **1999**  |   |
|----------------------------------------------|--------|-----------|-----------|-----------|--------|-----------|--------|
| Fees and Other Income                        |   |      |      |      |   |      |   |
| ATM transaction fees                         |   | $         | 1,744,404 |      | $      | 2,896,700 |   | $ | 2,421,635 |   |
| ATM interchange income                       |   | 270,390   |      | 695,017   |   | 629,711   |   |
| ATM sponsorship fees                         |   | 2,713     |      | 17,785    |   | 82,501    |   |
| Bankcard merchant fees                       |   | 122,602   |      | 110,483   |   | 623,930   |   |
| Mortgage broker fees                         |   | 577,333   |      | 318,360   |   | 290,940   |   |
| Other                                        |   | 781,954   |      | 564,513   |   | 638,076   |   |
|                                         |   | $         | 3,499,396 |      | $      | 4,602,858 |   | $ | 4,686,793 |   |
|                                         |   |      |      |      |   |      |   |
| Other Expenses                               |   |      |      |      |   |      |   |
| Data processing                              |   | 1,460,620 |      | 1,327,397 |   | 930,861   |   |
| Advertising and promotional                  |   | 327,618   |      | 323,433   |   | 301,388   |   |
| Regulatory fees                              |   | 77,813    |      | 64,598    |   | 50,517    |   |
| Other professional fees and outside services |   | 367,007   |      | 266,172   |   | 392,174   |   |
| Legal fees and other litigation expenses     |   | 208,314   |      | 210,838   |   | 142,515   |   |
| Stationery and supplies                      |   | 188,394   |      | 193,921   |   | 169,908   |   |
| Bankcard merchant expense                    |   | —    |      | —    |   | 573,324   |   |
| Director fees                                |   | 215,755   |      | 188,728   |   | 174,645   |   |
| ATM costs at gaming sites                    |   | 1,157,934 |      | 1,374,108 |   | 1,149,478 |   |
| ATM costs at retail sites                    |   | 383,698   |      | 1,203,674 |   | 930,649   |   |
| Other                                        |   | 797,641   |      | 538,711   |   | 543,842   |   |
| Total                                        |   | $         | 5,184,794 |      | $      | 5,691,580 |   | $ | 5,359,301 |   |
|                                         |   |      |      |      |   |      |   |

 

 

52

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**Note #20 - Operating Segments**

 

In June 1997, the FinancialAccounting Standards Board (FASB) issued Statement No. 131, “*Disclosures about Segments of an Enterprise andRelated Information*,”which the Bank has adopted during 1998. The Company has two primary reportable segments.  The segments reported herein apply to theBank and the Bank’s EFT Department.  Thesegments are identified as such based upon the percentage of operating netincome, management responsibility, and the types of products and servicesoffered.

 

The segments consist 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 has installed two automated tellermachines located in retail outlets and gaming facilities.  Income is based upon total customer usage ofthe machines and the applicable transaction charge.  Income is allocated to the Bank via contractual agreement.  The Bank measures segment profit asoperating net income which is defined as income before provision for incometaxes.

 

During 2001, the Bank 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 theBank’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                       |       |
|                                     |       |                  |       |        |       |                              |       |
| ** **                               | ** ** | **EFT    Department** | ** ** | **Bank**    | ** ** | **Total    Operating   Segments** |       |
| **Fiscal Year Ended December 31,  2000** |       |                  |       |        |       |                              |       |
| Revenues                                 |       | 3,654,553             |       | 15,997,798  |       | 19,652,351                        |       |
| Depreciation and amortization            |       | 99,864                |       | 596,544     |       | 696,408                           |       |
| Operating income                         |       | 491,542               |       | 1,796,260   |       | 2,287,802                         |       |
| Total assets                             |       | 4,415,253             |       | 178,980,170 |       | 183,395,423                       |       |
|                                     |       |                  |       |        |       |                              |       |
| ** **                               | ** ** | **EFT    Department** | ** ** | **Bank**    | ** ** | **Total    Operating   Segments** |       |
| **Fiscal Year Ended December 31,  1999** |       |                  |       |        |       |                              |       |
| Revenues                                 |       | 4,152,475             |       | 11,205,259  |       | 15,357,734                        |       |
| Depreciation and amortization            |       | 133,222               |       | 657,640     |       | 790,862                           |       |
| Operating income                         |       | 958,484               |       | 1,383,796   |       | 2,342,280                         |       |
| Total assets                             |       | 6,700,862             |       | 139,515,240 |       | 146,216,102                       |       |
|                                     |       |                  |       |        |       |                              |       |
|                                          |            |                       |            |             |            |                                   |            |  |  |  |

 

 

53

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**Note #21 - Dividends**

 

OnJanuary 28, 1999, the Board of Directors declared a 4 percent stock dividendpayable on February 26, 1999 to stockholders of record on February 15,1999.  Cash was paid in lieu offractional shares at the rate of $15.70 per share and amounted to $3,025.

 

On March 21, 2000 the Board of Directors declared a 5 percent stock dividendpayable on April 17, 2000 to stockholders of record on April 3, 2000.  Cash was paid in lieu of fractional sharesat the rate of $15.00 per share and amounted to $3,923.

 

On March 2, 2001 the Board of Directors declared a 5 percent stockdividend payable on

March 30, 2001 to stockholders of record on March 16, 2001.  Cash was paid in lieu of fractional sharesat the rate of $18.25 per share and amounted to $4,680.

 

 

**Note #22 - Acquisitionof Assets and Liabilities**

 

During November 2001, the Bank acquiredcertain assets and liabilities of four branches of WestAmerica Bank.  Total assets acquired were $24,968,071,which consisted of $1,144,164 in land, building, leasehold improvements andother fixed assets, and $23,086,675 in cash. In addition, the Bank also assumed $24,968,071 of deposits.  The Bank paid a premium of $737,232 for thedeposits.  Subsequent to the purchasedate, the Bank consolidated the deposits of three of the acquired branches withexisting Heritage Oaks Bank deposits. In conjunction with the transfer of the deposits, the Bank sold the landand building of one of the acquired branches for $525,000, resulting in a gainof $22,348.  The Bank negotiated thetermination of the lease on another of the acquired branches, and is allowing thelease to lapse on the third branch.  Asa result of the dispositions and the recording of the remaining acquired branchat fair value, the original premium paid was written down to $406,587, and isbeing amortized over 10 years.

 

 

54

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**Note #23 -Condensed Financial Information of Heritage Oaks Bancorp (Parent Company)**

 

**Balance Sheets**

 
|                                            |   | **2001**   |       | **2000**   |   |
|-------------------------------------------------|--------|------------|------------|------------|--------|
| **Assets**                                      |   |       |       |       |   |
| Cash                                            |   | $          | 11,194     |       | $      | 51,190 |   |
| Prepaid and other assets                        |   | 493,965    |       | 423,111    |   |
| Property and premises                           |   | 669,556    |       | 684,268    |   |
| Investment in subsidiaries                      |   | 16,611,738 |       | 13,351,030 |   |
|                                            |   |       |       |       |   |
| Total Assets                                    |   | $          | 17,786,453 |       | $      | 14,509,599 |   |
|                                            |   |       |       |       |   |
| **Liabilities and Stockholders’  Equity**  |   |       |       |       |   |
| Notes payable                                   |   | 1,894,811  |       | 1,050,000  |   |
| Other liabilities                               |   | 14,861     |       | 4,590      |   |
|                                            |   |       |       |       |   |
| Total Liabilities                               |   | 1,909,672  |       | 1,054,590  |   |
|                                            |   |       |       |       |   |
| Stockholders’ Equity                       |   |       |       |       |   |
| Common stock                                    |   | 7,535,495  |       | 6,305,233  |   |
| Retained earnings                               |   | 8,341,286  |       | 7,149,776  |   |
|                                            |   |       |       |       |   |
| Total Stockholders’ Equity                 |   | 15,876,781 |       | 13,455,009 |   |
| Total Liabilities and Stockholders’ Equity |   | $          | 17,786,453 |       | $      | 14,509,599 |   |
|                                            |   |       |       |       |   |

 

 

55

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**Statements of Income**

** **
|                                         |   | **2001**  |      | **2000**  |   | **1999**  |   |
|----------------------------------------------|--------|-----------|-----------|-----------|--------|-----------|--------|
| **Income**                                   |   |      |      |      |   |      |   |
| Equity in undisbursed income of subsidiary   |   | $         | 2,424,180 |      | $      | 2,287,712 |   | $ | 1,523,690 |   |
| Other                                        |   | 56,700    |      | 56,700    |   | 42,525    |   |
| Total Income                                 |   | 2,480,880 |      | 2,344,412 |   | 1,566,215 |   |
| **Expense**                                  |   |      |      |      |   |      |   |
| Salary expense                               |   | 57,348    |      | 41,194    |   | 30,498    |   |
| Equipment expense                            |   | 14,712    |      | 14,712    |   | 13,180    |   |
| Other professional fees and outside services |   | 22,733    |      | 16,084    |   | 52,024    |   |
| Interest expense                             |   | 85,601    |      | 35,856    |   | 43,615    |   |
| Other                                        |   | 8,334     |      | 22,908    |   | 60,432    |   |
| Total Expense                                |   | 188,728   |      | 130,754   |   | 199,749   |   |
| Total Operating Income                       |   | 2,292,152 |      | 2,213,658 |   | 1,366,466 |   |
|                                         |   |      |      |      |   |      |   |
| Tax benefit of parent                        |   | (54,131   | )         | (30,362   | )      | (64,462   | )      |
|                                         |   |      |      |      |   |      |   |
| Net Income                                   |   | $         | 2,346,283 |      | $      | 2,244,020 |   | $ | 1,430,928 |   |
|                                         |   |      |      |      |   |      |   |

 

 

56

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|                                                                              |   | **2001**   |      | **2000**   |   | **1999**   |   |
|-----------------------------------------------------------------------------------|--------|------------|-----------|------------|--------|------------|--------|
| **Cash Flows From Operating  Activities**                                         |   |       |      |       |   |       |   |
| Net income                                                                        |   | $          | 2,346,283 |       | $      | 2,244,020  |   | $ | 1,430,928 |   |
| Adjustments to Reconcile Net Income to Net Cash  Provided By Operating Activities |   |       |      |       |   |       |   |
| Depreciation                                                                      |   | 14,712     |      | 14,712     |   | 13,180     |   |
| Increase in other assets                                                          |   | (70,854    | )         | (87,007    | )      | (49,381    | )      |
| Increase/(decrease) in other liabilities                                          |   | 10,271     |      | 457        |   | (8,916     | )      |
| Undistributed income of subsidiary                                                |   | (2,424,180 | )         | (2,287,712 | )      | (1,523,690 | )      |
| Net Cash Used In Operating Activities                                             |   | (123,768   | )         | (115,530   | )      | (137,879   | )      |
|                                                                              |   |       |      |       |   |       |   |
| **Cash Flows From Investing  Activities**                                         |   |       |      |       |   |       |   |
| Purchase of property and premises                                                 |   | —     |      | —     |   | (305,427   | )      |
|                                                                              |   |       |      |       |   |       |   |
| **Cash Flows From Financing  Activities**                                         |   |       |      |       |   |       |   |
| Cash dividends received                                                           |   | 650,000    |      | —     |   | 705,276    |   |
| Cash paid in lieu of fractional shares                                            |   | (4,680     | )         | (3,923     | )      | (3,025     | )      |
| Additional contributed capital                                                    |   | (1,500,000 | )         | (800,000   | )      | —     |   |
| Increase (decrease) in long-term borrowings                                       |   | 844,811    |      | 700,000    |   | (400,000   | )      |
| Proceeds from the exercise of options                                             |   | 93,641     |      | 155,274    |   | 148,263    |   |
| Net Cash Provided By Financing Activities                                         |   | 83,772     |      | 51,351     |   | 450,514    |   |
|                                                                              |   |       |      |       |   |       |   |
| **Net Increase/(Decrease) in Cash**                                               |   | (39,996    | )         | (64,179    | )      | 7,208      |   |
|                                                                              |   |       |      |       |   |       |   |
| **Cash**, Beginning of Year                                                       |   | 51,190     |      | 115,369    |   | 108,161    |   |
|                                                                              |   |       |      |       |   |       |   |
| **Cash**, End of Year                                                             |   | $          | 11,194    |       | $      | 51,190     |   | $ | 115,369 |   |
|                                                                              |   |       |      |       |   |       |   |

 

 

57

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**ITEM 8.**                                                  CHANGES WITH ACCOUNTANTS ON ACCOUNTINGAND FINANCIAL DISCLOSURE

**None.**

 

**PART III**

 

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

 

Theinformation required by Item 9 of Form 10-KSB is incorporated by reference fromthe information contained in the Company’s Proxy Statement for the 2002 AnnualMeeting of Shareholders which will be filed pursuant to Regulation 14A.

 

## **ITEM 10. EXECUTIVE COMPENSATION**

 

Theinformation required by Item 10 of Form 10-KSB is incorporated by referencefrom the information contained in the Company’s Proxy Statement for the 2002Annual Meeting of Shareholders which will be filed pursuant to Regulation 14A.

 

**ITEM 11.****  ****SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS ANDMANAGEMENT**

 

Theinformation required by Item 11 of Form 10-KSB is incorporated by referencefrom the information contained in the Company’s Proxy Statement for the 2002Annual Meeting of Shareholders which will be filed pursuant to Regulation 14A.

 

**ITEM 12. CERTAINRELATIONSHIPS AND 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 2002Annual Meeting of Shareholders which will be filed pursuant to Regulation 14A.

 

**ITEM 13. EXHIBITSAND REPORTS ON FORM 8-K**

 

**Exhibits:**

 

**(2.1)****                           ****              BranchPurchase and Assumption Agreement  andReal Property Purchase Agreement entered into between Westamerica Bank andHeritage Oaks Bank, dated July 16, 2001 filed with the SEC in the Company’s10-QSB for the period ending June 30, 2001.**

 

**(3.1a)****                     ****              Articlesof Incorporation incorporated by reference from Exhibit 3.1a to RegistrationStatement on Form S-4 No. 33-77504 filed with the SEC on April, 1994.**

 

**(3.1b)****                     ****              Amendmentto the Articles of Incorporation filed with the Secretary of State on October16, 1997 filed with the SEC in the Company’s 10-KSB for the year endiingDecember 31, 1997.**

 

58

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**(3.2)****                           ****              HeritageOaks Bancorp Bylaws as amended November 16, 2000 filed with the SEC in theCompany’s 10-KSB for the year ended December 31, 2000.**

 

**(4.1)****                           ****              Specimenform of Heritage Oaks Bancorp stock certificate incorporated by reference fromExhibit 4.1 to Registration Statement on Form S-4 No. 33-77504 filed with theSEC on April 8, 1994.**

 

**(10.1)****                    ****              1990Stock Option Plan incorporated by reference from Exhibit 10.2 to RegistrationStatement on Form S-4 No. 33-77504, filed with the SEC on April 8, 1994.**

 

**(10.2)****                    ****              Formof Stock Option Agreement incorporated by reference from Exhibit 4.2 toRegistration Statement on Form S-4 No. 33-77504, filed with the SEC on April 8,1994.**

 

**(10.3)****                    ****              LawrenceP. Ward Employment Letter Agreement, dated February 28, 2002, filed with theSEC 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 Reportfor the year ended December 31, 1994.**

 

**(10.5)****                    ****              HeritageOaks Bancorp 1995 Bonus Plan, filed with the SEC in the Company’s 10K Reportfor the year ended December 31, 1994.**

 

**(10.6)****                    ****              SalaryContinuation Agreement with Lawrence P. Ward, filed with the SEC in theCompany’s 10-QSB Report for the quarter ended March 31, 2001.**

 

**(10.7)****                    ****              SalaryContinuation Agreement with Gwen R. Pelfrey, filed with the SEC in theCompany’s 10K Report for the year ended December 31, 1994.**

 

**(10.8)****                    ****              WoodlandShopping Center Lease, filed with the SEC in the Company’s 10K Report for theyear ended December 31, 1994.**

 

**(10.9)****                    ****              1135Santa Rosa Street Lease, filed with the SEC in the Company’s 10KSB Report forthe year ended December 31, 1995.**

 

**(10.10)****             ****              LeaseAgreement for Cambria Branch Office dated February 21, 1997 filed with the SECin the Company’s 10KSB reported for the year ended December 31,1996.**

 

**(10.11)****             ****              1997Stock Option Plan incorporated by reference from Exhibit 4a to RegistrationStatement on Form S-8 No.333-31105 filed with the SEC on July 11, 1997 asamended, incorporated by reference, from Registration Statement on Form S-8,File No. 333-83235 filed with the SEC on July 20, 1999.**

 

59

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**(10.12)****             ****              Formof Stock Option Agreement incorporated by reference from Exhibit 4b toRegistration Statement on Form S-8 No. 333-31105 filed with the SEC on July 11,1997.**

 

**(10.13)****             ****              MadonnaRoad Lease filed with the SEC in the Company’s 10KSB for the year endedDecember 31, 1997.**

 

**(10.14)****             ****              SantaMaria lease commencing November 1, 1998.**

 

**(10.15)****             ****              Masterdata processing agreement with Mid West payment Systems, Inc. commencingOctober 1, 1998.**

 

**(10.16)****             ****              SalaryContinuation Agreement with Margaret A. Torres, filed with the SEC in theCompany’s 10KSB Report for the year ended December 31, 1999.**

 

**(10.17)****             ****              SalaryContinuation Agreement with Paul Tognazzini, filed with the SEC in theCompany’s 10-KSB Report for the year ended December 31, 2001.**

 

**(10.18)****             ****              AtascaderoBranch Lease entered into on March 31, 1999. filed with the SEC in theCompany’s 10-KSB reported for the year ended December 31,1999.**

 

**(10.19)****             ****              ServiceBureau Processing Agreement entered into between Alltel Information Services,Inc. and Heritage Oaks Bank, dated August 1, 1999. Filed with the SEC in theCompany’s 10-KSB reported for the year ended December 31, 1999.**

 

**(10.20)****             ****              ASSETPURCHASE AGREEMENT entered into between Travelex America, Inc. and HeritageOaks Bank, dated November 21 , 2000 filed with the SEC in the Company’s 10-KSBreported for the year ended December 31, 2000.**

 

**(10.21)****             ****              Changein Terms Agreement and Business Loan Agreement entered into between the Companyand Pacific Coast Banker’s Bank on November 8, 2000, filed with the SEC in theCompany’s 10-KSB reported for the year ended December 31, 2001.**

 

**(21)****                              ****              Subsidiariesof Heritage Oaks Bancorp. Heritage Oaks Bank is the only subsidiary of HeritageOaks Bancorp.**

 

**(23)****                              ****              Consentof Independent Accountants**

 

**(27)****                              ****              FinancialSchedule**

 

 

60

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**Reports on Form 8-K:**

** **

**As the result of the BranchPurchase and Assumption Agreement and Real Property Purchase Agreement thatclosed on November 9, 2001, the Company filed as reported under Item 2. withthe SEC Form 8-K.**

 

**Signatures**

 

**Pursuant to the requirements ofSection 13 of the Securities Exchange Act of 1934, the Company has duly caused thisreport to be signed on its behalf by the undersigned thereunto duly authorized.**

 

**HERITAGE OAKS BANCORP**

 

 
| **By:** | **/s/ Lawrence P. Ward** |   |
|---------|--------------------------|--------|

**LAWRENCE P. WARD**

**President and Chief Executiveofficer**

**Dated:      March 15, 2002**

 

 
| **By:** | **/s/Margaret A. Torres** |   |
|---------|---------------------------|--------|

**Executive Vice President and ChiefFinancial officer**

**Dated:      March 15, 2002**

 

**Pursuant to the requirements ofthe Securities Exchange Act of 1934, this report has been signed below by thefollowing persons on behalf of the Registrant and in the capacities and on thedates indicated.**

**Dated: March 21, 2001**

 
| **/s/ B.R. Bryant**        |   | **Chairman of the**    |   | **March 15, 2002** |
|----------------------------|--------|------------------------|--------|--------------------|
| **B.R. BRYANT**            |   | **Board of Directors** |   |               |
|                       |   |                   |   |               |
| **/s/ Donald H. Campbell** |   | **Vice Chairman**      |   | **March 15, 2002** |
| **DONALD H. CAMPBELL**     |   | **of the Board**       |   |               |
|                       |   | **of Directors**       |   |               |
|                       |   |                   |   |               |
| **/s/ Kenneth Dewar**      |   | **Director**           |   | **March 15, 2002** |
| **KENNETH DEWAR**          |   |                   |   |               |
|                       |   |                   |   |               |
| **/s/ Dolores T. Lacey**   |   | **Director**           |   | **March 15, 2002** |
| **DOLORES T. LACEY**       |   |                   |   |               |

 

61

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| **/s/ Merle F. Miller**  |   | **Director** |   | **March 15, 2002** |
|--------------------------|--------|--------------|--------|--------------------|
| **MERLE F. MILLER**      |   |         |   |               |
|                     |   |         |   |               |
| **/s/ Michael Morris**   |   | **Director** |   | **March 15, 2002** |
| **MICHAEL MORRIS**       |   |         |   |               |
|                     |   |         |   |               |
| **/s/ John Palla**       |   | **Director** |   | **March 15, 2002** |
| **JOHN  PALLA**     |   |         |   |               |
|                     |   |         |   |               |
| **/s/ Ole K. Viborg**    |   | **Director** |   | **March 15, 2002** |
| **OLE K. VIBORG**        |   |         |   |               |
|                     |   |         |   |               |
| **/s/ Lawrence P. Ward** |   | **Director** |   | **March 15, 2002** |
| **LAWRENCE P. WARD**     |   |         |   |               |
|                     |   |         |   |               |
| **/s/ David Weyrich**    |   | **Director** |   | **March 15, 2002** |
| **DAVID WEYRICH**        |   |         |   |               |

 

**EXHIBIT INDEX**

 
| **Exhibit**    |   |                                                                                                                                                                                                                                                   |
|----------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **Sequential** |   |                                                                                                                                                                                                                                                   |
| **Number**     |   | **Description**                                                                                                                                                                                                                                        |
|           |   |                                                                                                                                                                                                                                                   |
| **(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.**                                                                              |
|           |   |                                                                                                                                                                                                                                                   |
| **(10.17)**    |   | **Salary Continuation Agreement with Paul Tognazzini,  filed with the SEC in the Company’s 10-KSB Report for the year ended December  31, 2001.**                                                                                                 |
|           |   |                                                                                                                                                                                                                                                   |
| **(10.21)**    |   | **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.** |
|           |   |                                                                                                                                                                                                                                                   |
| **23**         |   | **Consent of Independent Accountants**                                                                                                                                                                                                                 |
|           |   |                                                                                                                                                                                                                                                   |
| **27**         |   | **Financial Data Schedule**                                                                                                                                                                                                                            |
|           |   |                                                                                                                                                                                                                                                   |

 

 

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