**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-KSB**

 

|                                           | **ý****  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934**                      |
|------------------------------------------------|---------------------------------------------------------------------------------------------------------------------------------|
|                                           |                                                                                                                            |
|                                           | **for the Year ended December 31, 2003**                                                                                        |
|                                           |
| **OR**                                         |
|                                           |
|                                           | **o****  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934**                       |
|                                           |                                                                                                                            |
|                                           | **For the transition period  from               to** |
|                                           |
| **Commission  file number  0-25020** |

** **

**Heritage Oaks Bancorp**

(Exactname of registrant as specified in its charter)

 
| **State of  California**                                                  |   | **77-0388249**                                           |
|---------------------------------------------------------------------------|--------|----------------------------------------------------------|
| (State or other  jurisdiction of  employee incorporation or organization) |   | (I.R.S. Identification  No.)                             |
|                                                                      |   |                                                     |
| **545 12th  Street, Paso Robles, California 93446**                       |   | **(805)  239-5200**                                      |
| (Address of principal  executive offices) (Zip Code)                      |   | Registrant’s telephone  number, including area code |

 

Securities registered pursuant to Section 12(b) of the Act: **None**

 

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

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

 

Indicate by check mark whether 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.

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in Exchange Act Rule 12b-2). Yes o  No ý

 

Registrant’s revenue for 2003 was $21.971 million. The aggregate marketvalue of the voting stock held by non-affiliates of the Registrant at February1, 2004 was $47.8 million. As of February 1, 2004, the Registrant had 3,606,559shares of Common Stock outstanding.

 

The following documents are incorporated by reference in Part III,Items 9 through 12 and Item 14 of Registrant’s definitive proxy statement forthe 2004 annual meeting of shareholders.

 

Transitional Small Business Disclosure Format (checkone)     Yes o    No ý

 

 

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**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 RelatedStockholders  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                                |   |
|       |                                                                                                              |   |
| Item 8A.   | Controls and  Procedures                                                                                          |   |
|       |                                                                                                              |   |
| PART III   |                                                                                                              |
|       |                                                                                                              |   |
| Item 9.    | Directors, Executive  Officers, Promoters and Control Persons; Compliance With Section 16(a) of the  Exchange Act |   |
|       |                                                                                                              |   |
| Item 10.   | Executive  Compensation                                                                                           |   |
|       |                                                                                                              |   |
| Item 11.   | Security Ownership  of Certain Beneficial Owners and Management                                                   |   |
|       |                                                                                                              |   |
| Item 12.   | Certain  Relationships and Related Transactions                                                                   |   |
|       |                                                                                                              |   |
| Item 13.   | Exhibits and  Reports on Form 8-K                                                                                 |   |
|       |                                                                                                              |   |
| Item 14.   | Principal  Accountant Fees and Services                                                                           |   |
|       |                                                                                                              |   |
| Signatures |                                                                                                              |

 

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PARTI

 

**Certain statementscontained in this Annual Report on Form 10-KSB (“Annual Report”), including,without limitation, statements containing the words “believes”, “anticipates”,“intends”, “expects”, and words of similar impact, constitute “forward-lookingstatements” within the meaning of Section 27A of the Securities Act of 1933 andSection 21E of the Securities and Exchange Act of 1934. Such forward-lookingstatements involve known and unknown risks, uncertainties and other factorsthat may cause the actual results, performance or achievements of the Companyto be materially different from any future results, performance or achievementsexpressed or implied by such forward-looking statements. Such factors include,among others, the following: general economic and business conditions in thoseareas in which the Company operates, demographic changes, competition,fluctuations in interest rates, changes in business strategy or developmentplans, changes in governmental regulation, credit quality, the availability ofcapital to fund the expansion of the Company’s business, economic, politicaland global changes arising from the war on terrorism and other factorsreferenced in this report, including in “Item 1. Description ofBusiness-Factors that May Affect Future Results of Operations”. The Companydisclaims any obligation to update any such factors or to publicly announce theresults of any revisions to any of the forward-looking statements containedherein to reflect future events or developments.**

 

ITEM 1.          DESCRIPTION OF BUSINESS

 

Where You Can Find More Information

 

Under the Securities Exchange Act of 1934 Sections 13 and 15(d),periodic and current reports must be filed with the SEC. The Companyelectronically files the following reports with the SEC: Form 10-KSB (AnnualReport), Form 10-QSB (Quarterly Report), Form 8-K (Report of UnscheduledMaterial Events), and Form DEF 14A (Proxy Statement). The Company may fileadditional forms. The SEC maintains an Internet site, www.sec.gov, in which allforms filed electronically may be accessed. Additionally, all forms filed withthe SEC and additional shareholder information is available free of charge onthe Company’s website: www.heritageoaksbank.com

 

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

 

The Company also posts it’s Committee Charters, Code of Ethics, Code ofConduct and Corporate Governance Guidelines on the Company website.

 

General

 

Heritage Oaks Bancorp (the “Company”) is a California corporationorganized in 1994 to act as a holding company of Heritage Oaks Bank(“Heritage”). In 1994, the Company acquired all of the outstanding common stockof Heritage in a holding company formation transaction.

 

In April 2002, the Company formed Heritage Oaks Capital Trust I (the“Trust”). The Trust is a statutory business trust formed under the laws of theState of Delaware. The Trust is a wholly-owned, non-financial, non-consolidatedsubsidiary of the Company.

 

On June 11, 2003, the Company entered into an Agreement to Merge andPlan of Reorganization (the “Agreement”) with Hacienda Bank (“Hacienda”), asamended on August 8, 2003, pursuant to which, among other things, (i) HeritageOaks Merger Corp would merge with and into Hacienda, and (ii) Hacienda wouldbecome a wholly-owned subsidiary of the Company. In accordance with the termsof the Agreement, as amended, the merger was completed on October 31,2003.  After the merger, the Companybecame a two-bank holding company owning all of the shares of both Heritage andHacienda. In connection with the Agreement and the merger, Messrs. Mark Fugateand Alex Simas, previous members of Hacienda’s board of directors, were addedto the board of directors of the Company.

 

Other than holding the shares of Heritage and Hacienda, the Companyconducts no significant activities, although it is authorized, with the priorapproval of the Board of Governors of the Federal Reserve System (the “FederalReserve

 

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Board”), the Company’sprincipal regulator, to engage in a variety of activities which are deemedclosely related to the business of banking. The Company has also caused to beincorporated a subsidiary, CCMS Systems, Inc. which is currently inactive andhas not been capitalized. The Company has no present plans to activate theproposed subsidiary.

 

Banking Services

 

Heritage was licensed by the California Department of FinancialInstitutions (“DFI”) and commenced operation in January 1983.  As a California state bank, Heritage issubject to primary supervision, examination and regulation by the DFI and theFederal Deposit Insurance Corporation (“FDIC”).  Heritage is also subject to certain other federal laws andregulations.  The deposits of Heritageare insured by the FDIC up to the applicable limits thereof. Heritage is not amember of the Federal Reserve System.

 

Hacienda commenced operations as a national banking association inJanuary 1988. Hacienda converted to a state-chartered bank in December 1997 andis a member of the Federal Reserve System. As a California state bank, Haciendais subject to primary supervision, examination and regulation by the DFI andthe Federal Reserve Board. Hacienda is also subject to certain other federallaws and regulations. The deposits of Hacienda are insured by the FDIC up tothe applicable limits thereof.

 

At December 31, 2003, the Company had approximately $442 million inconsolidated assets, $274 million in net consolidated loans, $366 million inconsolidated deposits, and $32.3 million in stockholders’ equity.

 

Heritage is headquartered in Paso Robles, Ca.  with a branch office in Paso Robles, two branches in San LuisObispo, one branch office in Cambria, one branch office in Arroyo Grande, onebranch office in Santa Maria, one branch office in Atascadero and one branchoffice in Morro Bay. Hacienda is headquartered in Santa Maria, Ca.  with three branch offices in Santa Maria.Heritage and Hacienda (the “Banks”) conduct a commercial banking business inSan Luis Obispo County and Northern Santa Barbara County, including acceptingdemand, savings and time deposits, and making commercial, real estate, SBA,agricultural, credit card, and consumer loans. They also offer installment notecollection, issue cashiers checks and money orders, sell travelers checks, andprovide bank-by-mail, night depository, safe deposit boxes, and other customarybanking services. The Banks do not offer trust services or internationalbanking services and do not plan to do so in the near future.

 

The Banks’ operating policies since inception have emphasized smallbusiness, commercial and retail banking. Most of the Banks’ customers are retail customers, farmers and small tomedium-sized businesses. The Banks take real estate, listed and unlistedsecurities, savings and time deposits, automobiles, machinery and equipment ascollateral for loans. The areas in which the Banks have directed virtually allof the lending activities are (i) commercial and agricultural loans, (ii)installment loans, (iii) construction loans, and (iv) other real estate loansor commercial loans secured by real estate. As of December 31, 2003, these four categories accounted forapproximately 17.6%, 1.9%, 17.2% and 63.2% respectively, of the Banks’ loanportfolios.  As of December 31, 2003,$223.6 million or 80.4% of the Banks’ $278.1 million in gross loans consistedof interim construction and other real estate secured loans, primarily forsingle family residences or for commercial development. Commercial andagricultural loans increased $8.6 million or 21.4% and other real estate loansor commercial loans secured by real estate increased $69 million or 65% betweenyear-end 2002 and year-end 2003. See “Item 6 – Management’s Discussion andAnalysis of Financial Condition and Results of Operations.”

 

Most of the Banks’ deposits are attracted by local promotionalactivities and advertising in the local media. A material portion of the Bank’s deposits have not been obtained from asingle person or a few persons, the loss of any one or more of which would havea materially adverse effect on the business of the Banks. Heritage has depositrelationships with three, long time customers that engage in mortgage relatedbusiness, however, these volatile account relationships are included in thevolatile liability dependency report that Heritage produces on a monthly basis.These three deposit relationships had average deposit balances of $57.8 millionin 2003 compared to $48.2 million in 2002. Management and the Board of Directors of Heritage are keenly aware thatas the mortgage market conditions change, these relationships will be impacted.This is the primary reason for the large balances maintained in over nightinvesting in Federal Funds Sold.  As ofDecember 31, 2003, the Banks had approximately 19,351 deposit accountsconsisting of non-interest bearing (demand), interest-bearing demand and moneymarket accounts with balances totaling $258.9 million for an average balanceper account of approximately  $13thousand; 8,612 savings accounts with balances totaling $32.3 million for anaverage balance per account of approximately $4 thousand; and 2,308 time certificate of deposit accounts withbalances totaling $75.2 million, for an average balance per account ofapproximately  $33 thousand.

 

The principal sources of the Company’s consolidated revenues are (i)interest and fees on loans, (ii) interest on

 

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investments, (iii) servicecharges on deposit accounts and other charges and fees, (iv) mortgageorigination fees and (v) miscellaneous income. For the year ended December 31,2003, these sources comprised 72.5%, 10.2%, 9.7%, 4.0% and 3.6%, respectively,of the Company’s total operating income.

 

The Company has not engaged in any material research activitiesrelating to the development of new services or the improvement of existing bankservices, except as otherwise discussed herein.  There has been no significant change in the types of servicesoffered by the Banks’ since their inception. The Company has no present plans regarding“a new line of business” requiring the investment of a material amount of totalassets.  Most of the Company’s businessoriginates from San Luis Obispo and Northern Santa Barbara Counties and thereis no emphasis on foreign sources and application of funds. The Company’sbusiness, based upon performance to date, does not appear to be seasonal.Management of the Company is unaware of any material effect upon the Company’scapital expenditures, earnings or competitive position as a result of federal,state or local environmental regulations.

 

Heritage holds service marks issued by the U.S. Patent and TrademarkOffice for the “Acorn” design, the “Oakley” design and “Deeply Rooted in YourHometown”:

 

Developments

 

BranchAcquisitions

 

On July 16, 2001, Heritage and Westamerica Bank, a California bankingcorporation, entered into a Branch Purchase and Assumption Agreement(“Agreement” included as an Exhibit in Company’s September 30, 2001 10-QSB),pursuant to which Heritage purchased the four Westamerica Bank Branches in SanLuis Obispo County (“Branches”).  TheBranches were located in the cities of Arroyo Grande, Morro Bay, Paso Roblesand San Luis Obispo. In addition, Heritage acquired Westamerica Bank’s interestin the real estate of each of the Branches, whether they were owned or leased.

 

Under the Agreement, Heritage Oaks Bank assumed all deposit liabilitiesand other liabilities set forth in the Agreement and purchased certain of theassets of the Branches.  It did notpurchase any of the loans of the Branches which were retained by WestamericaBank.  All employees of the Branches(except one loan officer designated by Westamerica) were offered employment byHeritage. On November 9, 2001, the transaction closed.

 

JuniorSubordinated Debentures

 

On April 10, 2002, the Company issued $8,248,000 of Floating RateJunior Subordinated Deferrable Interest Debentures “ (the “debt securities”) toHeritage Oaks Capital Trust I, a statutory trust created under the laws of theState of Delaware.  These debt securitiesare subordinated to effectively all borrowings of the Company and are due andpayable on April 22, 2032.  Interest ispayable quarterly on these debt securities at 6-Month LIBOR plus 3.7% for aneffective rate of 4.92% as of December 31, 2003.  The floating rate, however, may not exceed 11.0% for the firstfive years. The debt securities can be called at any time commencing on April22, 2007, at par.  The debt securitiescan also be redeemed at par if certain events occur that impact the taxtreatment, regulatory treatment or the capital treatment of the issuance.  The Company also purchased a 3% minorityinterest totaling $248,000 in Heritage Oaks Capital Trust I.  The balance of the equity of Heritage OaksCapital Trust I is comprised of mandatorily redeemable preferred securities andis included in other assets.

 

The securities were issued by a special purpose business trust formedby the Company and were sold to a pooled investment vehicle sponsored bySandler O’Neill & Partners, L.P. and Salomon Smith Barney Inc. in a privatetransaction. The securities were sold pursuant to an applicable exemption fromregistration under the Securities Act of 1933, as amended (the “Act”), and havenot been registered under the Act. Sandler O’Neill assisted the Company in the placement of the trustpreferred securities. The securities may not be offered or sold in the UnitedStates absent registration or an applicable exemption from registrationrequirements.  See, “Factors That MayAffect Future Results of Operations - Trust Preferred Securities.”

 

FacilitiesExpansion

 

On July 26, 2002, Heritage purchased a parcel of land (approximately 2acres) on the corner of Niblick and South River Roads in Paso Robles, Ca. Thepurchase price was $900,000. In February 2003, Heritage entered into aConstruction Agreement with HBE Financials Facilities to construct a 5,000square foot full service branch. The “turn-key” price for the construction is$1.8 million. Heritage relocated the existing “Woodland” branch office, that waslocated at 171 Niblick Road, Paso Robles, Ca. The new facility opened onFebruary 17, 2004.

 

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On July 3, 2003, Heritageclosed escrow to purchase real property located at 500 13th Street,Paso Robles, Ca. This property is located directly adjacent to Heritage’sHeadquarters. The purchase price was $1.1 million. It is Heritage’s intentionto build a new structure on the site to allow for the consolidation of alladministrative functions of Heritage within the new facility. Heritageanticipates that this project will be complete in the second quarter of 2005.

 

BankAcquisition

 

On June 11, 2003, the Company entered into an Agreement with Hacienda ,as amended on August 8, 2003, pursuant to which, among other things, (i)Heritage Oaks Merger Corp would merge with and into Hacienda, and (ii) Haciendawould become a wholly-owned subsidiary of the Company. In accordance with theterms of the Agreement, as amended, the merger was completed on October 31,2003.  After the merger, the Companybecame a two-bank holding company owning all of the shares of both Heritage andHacienda.

 

The shareholders of Hacienda who elected cash received cash for theirshares based on a value of $6.75 per share; those who elected stock received..5208 shares of the Company common stock for each share of Hacienda commonstock, and those that elected for a combination of the two received theappropriate allocations of the elections made. The amount of cash and theCompany common stock was subject to certain allocation procedures designed toensure that at least 75% of the total consideration paid to holders of Haciendacommon stock was paid in the Company common stock. Since elections were madefor more than the maximum stock amount, Hacienda shareholders who elected stockhad a pro-rata reduction in the amount of stock they received and received cashfor the difference. The amount of cash paid was approximately $2.6 million andthere were 602,485 shares of the Company’s common stock issued.

 

In connection with the Agreement and the merger, Messrs. Mark Fugateand Alex Simas, previous directors of Hacienda’s board of directors, were addedto the board of directors of the Company.

 

Earthquake

 

On December 22, 2003, a 6.5 magnitude earthquake rocked the CaliforniaCentral Coast. The earthquake was centered in San Simeon, an area approximately20 miles west of Paso Robles where the Company is headquartered. There was thetragic loss of two lives in Paso Robles. The greatest amount of property damagewas centered in downtown Paso Robles. The Company did not sustain anystructural damage to its facilities and there were no injuries to any employeesor their families. City officials reacted quickly and obtained disaster statusfrom state and federal agencies. Business’ in the downtown area experienced amoderate decline in activity, however, the area has already begun to rebuildand things are getting back to normal. Within days after the earthquake, theCompany performed an assessment as to any financial impact it could expectregarding effect to customers and their ability to repay any outstanding debt.The assessment revealed that there was no expected material impact to theCompany.

 

Employees

 

As of February 1, 2004, Heritage and Hacienda had 134 and 30 full-timeequivalent employees, respectively. The Company has only two salaried employees(the internal auditor and assistant). The Chief Executive Officer, ChiefFinancial Officer and Chief Administrative Officer of the Company hold similarpositions at both Heritage and Hacienda. Compensation for these three officersis paid by Heritage and billed back to Hacienda through the means of a ServiceAgreement between the Banks.

 

The Company believes that the work conditions, wages, and benefits itoffers to its employees are competitive with those offered by other employersin this area and in this industry. If employees have concerns about workconditions or compensation, they are strongly encouraged to voice theseconcerns openly and directly to their supervisors.

 

Our experience has shown that when employees deal openly and directlywith supervisors, the work environment can be excellent, communications can beclear, and attitudes can be positive. We believe that the Company amplydemonstrates its commitment to employees by responding effectively to anyconcerns. The Banks conduct weekly “Staff Meetings” that include, but are notlimited to, current events within the banks and community, training on productsand services, introduction of new employees and acknowledgement of staffmembers who have performed in an exemplary manner.

 

Our intent is to have the most knowledgeable employees in our marketarea.

 

The Company recently updated and distributed its “Employee Handbook”that is designed to acquaint employees with the Company and to provideinformation about working conditions, employee benefits and the policiesaffecting their

 

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employment. It describes manyof the employee responsibilities and outlines programs developed by the Companyto benefit the employee. The main objective is to provide a work environmentthat is conducive to both personal and professional growth.

 

In 1999, Heritage put into action a Corporate Culture Survey thatallows employee to respond anonymously to nearly 100 questions regardingcommunication, training, management effectiveness and many other pertinentareas. This survey is conducted annually during the fourth quarter. The resultsof the survey provide Senior Management and the Board with information thatassists in future endeavors to address areas where there is an opportunity toimprove. During the past five years, the overall “rating” has shown measuredimprovement. Senior Management and the Board of Directors consider this to beone of the most important achievements for the Company. This program wasimplemented for Hacienda in February 2004.

 

Local Economic Climate

 

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

 

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

 

Heritage recognized in 2000 that there would be over capacity in theproduction of wine grapes in our market area. As a result, efforts were made tomove a significant portion of the vineyard development loan portfolio out ofHeritage and into the government sponsored Farmer Mac program. Heritage hasapproximately $1.8 million of remaining vineyard development loans on the booksat December 31, 2003. Because of these actions on the part of Heritage, it isthe opinion of Management that there would not be any negative impact from thecurrent state of the wine grape industry.

 

Competition

 

Banking and financial services business in California generally, and inthe Company’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 newbanking organizations.

 

The Company’s business is concentrated in its service area, whichencompasses San Luis Obispo County and Northern Santa Barbara County. In orderto compete with other financial institutions in its service area, the Banksrely principally upon local advertising programs; direct personal contact byofficers, directors, employees, and shareholders; and specialized services suchas courier pick-up and delivery of non-cash banking items. The Banks emphasizeto customers the advantages of dealing with a locally owned and communityoriented institution. The Banks also seek to provide special services andprograms for individuals in its primary service area who are employed in theagricultural, professional and business fields, such as loans for equipment, furniture,tools of the trade or expansion of practices or businesses. Larger banks mayhave a competitive advantage because of higher lending limits and majoradvertising and marketing campaigns. They also perform services, such as trustservices, international banking, discount brokerage and insurance services thatthe Banks are not authorized or prepared to offer currently. The Banks havemade arrangements with correspondent banks and with others to provide suchservices for its customers. For borrowers requiring loans in excess of eitherBank’s legal lending limits, the Banks have offered, and intend to offer in thefuture, such loans on a participating basis with correspondent banks and withother independent banks, retaining the portion of such loans which is withinits lending limits. As of December 31, 2003, Heritage and Hacienda’s legal

 

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lending limits to a single borrower and such borrower’s related partieswas approximately $4.7 million and $2.0 million on an unsecured basis andapproximately $7.9 million and $3.3 million on a fully secured basis,respectively. These calculations are based on regulatory capital plus reservesof $31.5 million and $13.4 million, respectively for Heritage and Hacienda.

 

Commercial banks compete with savings and loan associations, creditunions, other financial institutions, securities brokerage firms, and otherentities for funds. For instance, yields on corporate and government debtsecurities and other commercial paper affect the ability of commercial banks toattract and hold deposits. Commercial banks also compete for loans with savingsand loan associations, credit unions, consumer finance companies, mortgagecompanies and other lending institutions.

 

The financial services industry is undergoing rapid technologicalchanges involving frequent introductions of new technology-driven products andservices that have further increased competition.  There can also be no assurance that these technologicalimprovements, if made, will increase the Company’s operational efficiency orthat the Company will be able to effectively implement new technology-drivenproducts and services or be successful in marketing these products and servicesto our customers.

 

Effect of Government Policies and Recent Legislation

 

Banking is a business that depends on rate differentials. In general,the difference between the interest rate paid by the Company on deposits andother borrowings and the interest rate received by the Company on loans extendedto its customers and securities held in the portfolio comprise the majorportion of the Company’s earnings. These rates are highly sensitive to manyfactors that are beyond the control of the Company . Accordingly, the earningsand growth of the Company are subject to the influence of domestic and foreigneconomic conditions, including inflation, recession and unemployment.

 

The commercial banking business is not only affected by generaleconomic conditions but is also influenced by the monetary and fiscal policiesof the federal government and the policies of regulatory agencies, particularlythe Federal Reserve Board. The Federal Reserve Board implements nationalmonetary policies (with objectives such as curbing inflation and combatingrecession) by its open-market operations in United States Governmentsecurities, by adjusting the required level of reserves for financialinstitutions subject to its reserve requirements and by varying the discountrates applicable to borrowings by depository institutions. The actions of theFederal Reserve Board in these areas influence the growth of bank loans,investments and deposits and also affect interest rates charged on loans andpaid on deposits. The nature and impact on the Company of any future changes inmonetary policies cannot be predicted.

 

From time to time, legislation is enacted which has the effect ofincreasing the cost of doing business, limiting or expanding permissibleactivities or affecting the competitive balance between banks and otherfinancial institutions. Proposals to change the laws and regulations governingthe operations and taxation of banks, bank holding companies and otherfinancial institutions are frequently made in Congress, in the Californialegislature and before various bank regulatory and other professional agencies.See “Supervision and Regulation-Financial Services Modernization Legislationand Sarbanes – Oxley Act of 2002”.

 

Supervision and Regulation

 

General

 

The Company and the Banks are extensively regulated under both federaland state law. Set forth below is a summary description of certain laws thatrelate to the regulation of the Company and the Banks. The description does notpurport to be complete and is qualified in its entirety by reference to theapplicable laws and regulations.

 

TheCompany

 

The Company is a bank holding company within the meaning of the BankHolding Company Act of 1956, as amended (the “Bank Holding Company Act”), andis registered as such with, and subject to the supervision of, the FederalReserve Board. The Company is required to file with the Federal Reserve Boardquarterly and annual reports and such additional information as the FederalReserve Board may require pursuant to the Bank Holding Company Act. The FederalReserve Board may conduct examinations of bank holding companies and theirsubsidiaries.

 

The Company is required to obtain the approval of the Federal ReserveBoard before it may acquire all or substantially

 

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all of the assets of any bank, or ownership or control of the votingshares of any bank if, after giving effect to such acquisition of shares, theCompany would own or control more than 5% of the voting shares of such bank.Prior approval of the Federal Reserve Board is also required for the merger orconsolidation of the Company and another bank holding company.

 

The Company is prohibited by the Bank Holding Company Act, except incertain statutorily prescribed instances, from acquiring direct or indirectownership or control of more than 5% of the outstanding voting shares of anycompany that is not a bank or bank holding company and from engaging, directlyor indirectly, in activities other than those of banking, managing orcontrolling banks or furnishing services to its subsidiaries. However, theCompany may, subject to the prior approval of the Federal Reserve Board, engagein any, or acquire shares of companies engaged in, activities that are deemedby the Federal Reserve Board to be so closely related to banking or managing orcontrolling banks as to be a proper incident thereto. See discussion under“Financial Modernization Act” below for additional information.

 

The Federal Reserve Board may require that the Company terminate anactivity or terminate control of or liquidate or divest subsidiaries oraffiliates when the Federal Reserve Board determines that the activity or thecontrol or the subsidiary or affiliates constitutes a significant risk to thefinancial safety, soundness or stability of any of its banking subsidiaries.The Federal Reserve Board also has the authority to regulate provisions ofcertain bank holding company debt, including authority to impose interestceilings and reserve requirements on such debt. Under certain circumstances,the Company must file written notice and obtain approval from the FederalReserve Board prior to purchasing or redeeming its equity securities.

 

Under the Federal Reserve Board’s regulations, a bank holding companyis required to serve as a source of financial and managerial strength to itssubsidiary banks and may not conduct its operations in an unsafe and unsoundmanner. In addition, it is the Federal Reserve Board’s policy that in servingas a source of strength to its subsidiary banks, a bank holding company shouldstand ready to use available resources to provide adequate capital funds to itssubsidiary banks during periods of financial stress or adversity and shouldmaintain the financial flexibility and capital-raising capacity to obtainadditional resources for assisting its subsidiary banks. A bank holdingcompany’s failure to meet its obligations to serve as a source of strength toits subsidiary banks will generally be considered by the Federal Reserve Boardto be an unsafe and unsound banking practice or a violation of the FederalReserve Board’s regulations or both.

 

The Company is subject to the periodic reporting requirements of theSecurities Exchange Act of 1934, as amended, and files reports and proxystatements pursuant to such Act with the Securities and Exchange Commission(the “SEC”)

 

TheBanks

 

Heritage and Hacienda are chartered under the laws of the State ofCalifornia and their deposits are insured by the FDIC to the extent provided bylaw. Heritage is subject to the supervision of, and is regularly examined by,the DFI and the FDIC. Hacienda is a member bank of the Federal Reserve Systemand is subject to the supervision of, and is regularly examined by, the DFI andthe Federal Reserve Board (FRB).  Forboth banks, such supervision and regulation include comprehensive reviews ofall major aspects of the Banks’ business and condition. Various requirementsand restrictions under the laws of the United States and the State ofCalifornia affect the operations of the Banks. Federal and California statutesrelate to many aspects of the Banks’ operations, including reserves againstdeposits, interest rates payable on deposits, loans, investments, mergers andacquisitions, borrowings, dividends and locations of branch offices. Further,the Banks are required to maintain certain levels of capital.

 

If, as a result of an examination of a bank, the FDIC, Federal ReserveBoard or the DFI   should determine thatthe financial condition, capital resources, asset quality, earnings prospects,management, liquidity, or other aspects of a bank’s operations areunsatisfactory or that a bank or its respective management is violating or hasviolated any law or regulation, various remedies are available to theseregulatory agencies. Such remedies include the power to enjoin “unsafe orunsound” practices, to require affirmative action to correct any conditionsresulting from any violation or practice, to issue an administrative order thatcan be judicially enforced, to direct an increase in capital, to restrictgrowth, to assess civil monetary penalties, to remove officers and directors,and ultimately to terminate deposit insurance, which for a California charteredbank would result in a revocation of the bank’s charter.

 

CapitalStandards

 

The Federal Reserve Board and the FDIC have adopted risk-based minimumcapital guidelines intended to provide a measure of capital that reflects thedegree of risk associated with a banking organization’s operations for both

 

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transactions reported on the balance sheet as assets and transactions,such as letters of credit and recourse arrangements, which are recorded as offbalance sheet items. Under these guidelines, nominal dollar amounts of assetsand credit equivalent amounts of off balance sheet items are multiplied by oneof several risk adjustment percentages, which range from 0% for assets with lowcredit risk, such as certain U.S. Treasury securities, to 100% for assets withrelatively high credit risk, such as business loans.

 

A banking organization’s risk-based capital ratios are obtained bydividing its qualifying capital by its total risk adjusted assets. Theregulators 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%.

 

In addition to the risked-based guidelines, federal banking regulatorsrequire banking organizations to maintain a minimum amount of Tier 1 capital tototal assets, referred to as the leverage ratio. For a banking organizationrated in the highest of the five categories used by regulators to rate bankingorganizations, the minimum leverage ratio of Tier 1 capital to total assets is3%. For all banking organizations not rated in the highest category, theminimum leverage ratio must be at least 4%. In addition to these uniformrisk-based capital guidelines and leverage ratios that apply across theindustry, the regulators have the discretion to set individual minimum capitalrequirements for specific institutions at rates significantly above the minimumguidelines and ratios. Future changes in regulations or practices could furtherreduce the amount of capital recognized for purposes of capital adequacy. Sucha change could affect the ability of the Company to grow and could restrict theamount of profits, if any, available for the payment of dividends.

 

The following table presents the amounts of the capital ratios for theCompany and the Banks and the requirements for a well- capitalized companycompared to its minimum regulatory capital requirements as of December 31,2003:

 
|                 |   | **Minimum  Regulatory  Capital Requirements** |   | **Heritage  Oaks Bancorp** |   | **Heritage  Oaks Bank** |   | **Hacienda  Bank** |   |
|----------------------|--------|-----------------------------------------------|--------|----------------------------|--------|-------------------------|--------|--------------------|--------|
|                 |   |                                          |   |                       |   |                    |   |               |   |
| Leverage Ratio       |   | 4.00                                          | %      | 8.30                       | %      | 8.61                    | %      | 7.21               | %      |
| Tier I Risk Weighted |   | 4.00                                          | %      | 10.15                      | %      | 10.82                   | %      | 9.57               | %      |
| Total Risk Based     |   | 8.00                                          | %      | 11.14                      | %      | 11.78                   | %      | 10.65              | %      |

 

Under applicable regulatory guidelines, the Banks were considered “WellCapitalized” at December 31, 2003.

 

Under applicable regulatory guidelines, the Company’s trust preferredsecurities issued by our subsidiary capital trust qualify as Tier 1 capital upto a maximum limit of 25% of Tier 1 capital. Any additional portion of the trust preferred securities would qualifyas Tier II capital.  As of December 31,2003, the subsidiary trust had $8 million in trust preferred securitiesoutstanding, of which $8 million qualify as Tier 1 capital.  See “Factors That May Affect Future Resultsof Operations - Trust Preferred Securities.”

 

In addition, the DFI has authority to take possession of the businessand properties of a bank in the event that the tangible shareholders’ equity ofa Bank is less than the greater of (i) 4% of the banks total assets or (ii)$1,000,000.

 

PromptCorrective Action and Other Enforcement Mechanisms

 

Federal banking agencies possess broad powers to take corrective andother supervisory action to resolve the problems of insured depositoryinstitutions, including but not limited to those institutions that fall belowone or more prescribed minimum capital ratios described above. An institutionthat, based upon its capital levels, is classified as well capitalized,adequately capitalized, or undercapitalized may be treated as though it were inthe next lower capital category if the appropriate federal banking agency,after notice and opportunity for hearing, determines that an unsafe or unsoundcondition or an unsafe or unsound practice warrants such treatment. At eachsuccessive lower capital category, an insured depository institution is subjectto more restrictions. The federal banking agencies, however, may not treat asignificantly undercapitalized institution as critically undercapitalizedunless its capital ratio actually warrants

 

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such treatment.

 

In addition to measures taken under the prompt corrective actionprovisions, commercial banking organizations may be subject to potentialenforcement actions by the federal regulators for unsafe or unsound practicesin conducting their businesses or for violations of any law, rule, regulation,or any condition imposed in writing by the agency or any written agreement withthe agency. Enforcement actions may include the imposition of a conservator orreceiver, the issuance of a cease-and-desist order that can be judiciallyenforced, the termination of insurance of deposits (in the case of a depositoryinstitution), the imposition of civil money penalties, the issuance ofdirectives to increase capital, the issuance of formal and informal agreements,the issuance of removal and prohibition orders against institution-affiliatedparties and the enforcement of such actions through injunctions or restrainingorders based upon a judicial determination that the agency would be harmed ifsuch equitable relief was not granted. Additionally, a holding company’s inability to serve as a source ofstrength to its subsidiary banking organizations could serve as an additionalbasis for a regulatory action against the holding company.

 

Safetyand Soundness Standards

 

The Federal Deposit Insurance Corporation Improvement Act (“FDICIA”)imposes certain specific restrictions on transactions and requires federalbanking regulators to adopt overall safety and soundness standards fordepository institutions related to internal control, loan underwriting anddocumentation and asset growth.  Amongother things, FDICIA limits the interest rates paid on deposits byundercapitalized institutions, restricts the use of brokered deposits, limitsthe aggregate extensions of credit by a depository institution to an executiveofficer, director, principal shareholder or related interest, and reducesdeposit insurance coverage for deposits offered by undercapitalizedinstitutions for deposits by certain employee benefits accounts. The federalbanking agencies may require an institution to submit to an acceptablecompliance plan as well as have the flexibility to pursue other moreappropriate or effective courses of action given the specific circumstances andseverity of an institution’s noncompliance with one or more standards.

 

Premiumsfor Deposit Insurance

 

Through the Bank Insurance Fund (“BIF”), the FDIC insures the depositsof the Banks up to the prescribed limits for each depositor. The amount of FDICassessments paid by each BIF member institution is based on its relative riskof default as measured by regulatory capital ratios and other factors.Specifically, the assessment rate is based on the institution’s capitalizationrisk category and supervisory subgroup category. An institution’scapitalization risk category is based on the FDIC’s determination of whetherthe institution is well capitalized, adequately capitalized or less thanadequately capitalized. An institution’s supervisory subgroup category is basedon the FDIC’s assessment of the financial condition of the institution and theprobability that FDIC intervention or other corrective action will be required.

 

The assessment rate currently ranges from zero to 27 cents per $100 ofdomestic deposits. The FDIC may increase or decrease the assessment rateschedule on a semi-annual basis. Due to continued growth in deposits and somerecent bank failures, the bank insurance fund is nearing its minimum ratio of1.25% on insured deposits as mandated by law. If the ratio drops below 1.25%,it is likely that the FDIC will be required to assess premiums on all banks forthe first time since 1996. An increase in the assessment rate could have amaterial adverse effect on the Company’s earnings, depending on the amount ofthe increase. The FDIC is authorized to terminate a depository institution’sdeposit insurance upon a finding by the FDIC that the institution’s financialcondition is unsafe or unsound or that the institution has engaged in unsafe orunsound practices or has violated any applicable rule, regulation, order orcondition enacted or imposed by the institution’s regulatory agency. Thetermination of deposit insurance for the Banks would result in the revocationof the Bank’s charter and the cessation of its operations as a going concern.

 

All FDIC-insured depository institutions must pay an annual assessmentto provide funds for the payment of interest on bonds issued by the FinancingCorporation, a federal corporation chartered under the authority of the FederalHousing Finance Board. The bonds, commonly referred to as FICO bonds, wereissued to capitalize the Federal Savings and Loan Insurance Corporation. TheFICO assessments are adjusted quarterly to reflect changes in the assessmentbases of the FDIC’s insurance funds and do not vary depending on a depositoryinstitution’s capitalization or supervisory evaluations.

 

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Sarbanes-OxleyAct of 2002

 

On July 30, 2002, President Bush signed into law the Sarbanes-Oxley Actof 2002 (the “SOA”). The stated goals of the SOA are to increase corporateresponsibility, to provide for enhanced penalties for accounting and auditingimproprieties at publicly traded companies and to protect investors byimproving the accuracy and reliability of corporate disclosures pursuant to thesecurities laws.

 

The SOA is the most far-reaching U.S. securities legislation enacted insome time. The SOA generally applies to all companies, both U.S. and non-U.S.,that file or are required to file periodic reports with the SEC under theSecurities Exchange Act of 1934, (the “Exchange Act”). Given the extensive SECrole in implementing rules relating to many of the SOA’s new requirements, thefinal scope of these requirements remains to be determined.

 

The SOA includes very specific additional disclosure requirements andnew corporate governance rules, requires the SEC and securities exchanges toadopt extensive additional disclosure, corporate governance and other relatedrules and mandates further studies of certain issues by the SEC. The SOArepresents significant federal involvement in matters traditionally left tostate regulatory systems, such as the regulation of the accounting profession,and to state corporate law, such as the relationship between a board ofdirectors and management and between a board of directors and its committees.

 

The SOA addresses, among other matters:

 

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

 

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

 

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

 

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

 

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

 

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

 

•                                increased protection for whistleblowers andinformants;

 

•                                disclosure of off-balance sheet transactions;

 

•                                expedited filing requirements for ownershipreports by officers and directors;

 

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

 

•                                “real time” filing of periodic reports; and

 

•                                various increased criminal penalties forviolations of securities laws.

 

The SOA contains provisions which became effective upon enactment onJuly 30, 2002, and provisions which will become effective within 30 days to oneyear from enactment.  The SEC has beendelegated the task of enacting rules to implement various provisions withrespect to, among other matters, disclosure in periodic filings pursuant to theExchange Act. The Company has implemented procedures to comply with therequirements for expanded disclosure of internal controls and the certificationof financial statements.  The Company iscurrently evaluating what impacts the new legislation and its implementingregulations will have upon its operations, including a likely increase incertain outside professional costs.

 

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FinancialServices Modernization Legislation

 

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

 

The Financial Services Modernization Act also sets forth a system offunctional regulation that makes the Federal Reserve Board the “umbrellasupervisor” for holding companies, while providing for the supervision of theholding company’s subsidiaries by other federal and state agencies. A bankholding company may not become a financial holding company if any of itssubsidiary financial institutions are not well-capitalized or well-managed.Further, each bank subsidiary of the holding company must have received atleast a satisfactory Community Reinvestment Financial Services ModernizationAct (CRA) rating. The Financial Services Modernization Act also expands thetypes of financial activities a national bank may conduct through a financialsubsidiary, addresses state regulation of insurance, generally prohibitsunitary thrift holding companies organized after May 4, 1999 from participatingin new financial activities, provides privacy protection for nonpublic customerinformation of financial institutions, modernizes the Federal Home Loan Banksystem and makes miscellaneous regulatory improvements. The Federal ReserveBoard and the Secretary of the Treasury must coordinate their supervisionregarding approval of new financial activities to be conducted through afinancial holding company or through a financial subsidiary of a bank.  While the provisions of the FinancialServices Modernization Act regarding activities that may be conducted through afinancial subsidiary directly apply only to national banks, those provisionsindirectly apply to state-chartered banks.

 

In addition, the Banks are subject to other provisions of the FinancialServices Modernization Act, including those relating to CRA, privacy andsafe-guarding confidential customer information, regardless of whether theCompany elects to become a financial holding company or to conduct activitiesthrough a financial subsidiary of the Banks. The Company does not, however,currently intend to file notice with the Federal Reserve Board to become afinancial holding company or to engage in expanded financial activities througha financial subsidiary of the Banks.

 

The Company and the Banks do not believe that the Financial ServicesModernization Act will have a material adverse effect on their operations inthe near-term. However, to the extent that it permits banks, securities firms,and insurance companies to affiliate, the financial services industry mayexperience further consolidation. The Financial Services Modernization Act isintended to grant to community banks certain powers as a matter of right thatlarger institutions have accumulated on an ad hoc basis. Nevertheless, this actmay have the result of increasing the amount of competition that the Companyfaces from larger institutions and other types of companies offering financialproducts, many of which may have substantially more financial resources thanthe Company.

 

USAPatriot Act of 2001

 

In October 2001, the USA Patriot Act of 2001 was enacted in response tothe terrorist attacks in New York, Pennsylvania and Washington D.C. whichoccurred on September 11, 2001. The Patriot Act is intended to strengthen U.S.law enforcement’s and the intelligence communities’ abilities to work cohesivelyto combat terrorism on a variety of fronts. The potential impact of the PatriotAct on financial institutions of all kinds is significant and wide ranging. ThePatriot Act contains sweeping anti-money laundering and financial transparencylaws and imposes various regulations, including standards for verifying clientidentification at account opening, and rules to promote cooperation amongfinancial institutions, regulators and law enforcement entities in identifyingparties that may be involved in terrorism or money laundering.

 

Part of the USA Patriot Act is the International Money LaunderingAbatement and Financial Anti-Terrorism Act of 2001 (“IMLA”).  IMLA authorizes the Secretary of theTreasury, in consultation with the heads of other government agencies, to adoptspecial measures applicable to banks, bank holding companies, and/or otherfinancial institutions.  These measuresmay include enhanced recordkeeping and reporting requirements for certainfinancial transactions that are of primary money laundering concern, duediligence requirements concerning the beneficial ownership of certain types ofaccounts, and restrictions or prohibitions on certain types of accounts withforeign financial institutions.

 

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Among its other provisions, IMLA requires each financial institutionto: (i) establish an anti-money laundering program; (ii) establish duediligence policies, procedures and controls with respect to its private bankingaccounts and correspondent banking accounts involving foreign individuals andcertain foreign banks; and (iii) avoid establishing, maintaining,administering, or managing correspondent accounts in the United States for, oron behalf of, a foreign bank that does not have a physical presence in anycountry.  In addition, IMLA contains aprovision encouraging cooperation among financial institutions, regulatoryauthorities and law enforcement authorities with respect to individuals,entities and organizations engaged in, or reasonably suspected of engaging in,terrorist acts or money laundering activities. IMLA expands the circumstances under which funds in a bank account maybe forfeited and requires covered financial institutions to respond undercertain circumstances to requests for information from federal banking agencieswithin 120 hours.  IMLA also amends theBHCA and the Bank Merger Act to require the federal banking agencies toconsider the effectiveness of a financial institution’s anti-money launderingactivities when reviewing an application under these acts.

 

Transactionsbetween Affiliates

 

Transactions between a bank and its “affiliates” are quantitatively andqualitatively restricted under the Federal Reserve Act.  The Federal Reserve Board issued RegulationW on October 31, 2002, which comprehensively implements Sections 23A and 23B ofthe Federal Reserve Act.  Sections 23Aand 23B and Regulation W restrict loans by a depository institution to itsaffiliates, asset purchases by a depository institution from its affiliates, andother transactions between a depository institution and its affiliates.  Regulation W unifies in one public documentthe Federal Reserve Board’s interpretations of Section 23A and 23B.  Regulation W had an effective date of April1, 2003.

 

CommunityReinvestment Act

 

The Banks are subject to certain fair lending requirements andreporting obligations involving home mortgage lending operations and CommunityReinvestment Act (“CRA”) activities. The CRA generally requires the federalbanking agencies to evaluate the record of a financial institution in meetingthe credit needs of their local communities, including low and moderate incomeneighborhoods. In addition to substantial penalties and corrective measuresthat may be required for a violation of certain fair lending laws, the federalbanking agencies may take compliance with such laws and CRA into account whenregulating and supervising other activities. When a bank holding company applies for approval to acquire a bank orother bank holding company, the Federal Reserve Board will review theassessment of each subsidiary bank of the applicant bank holding company, andsuch records may be the basis for denying the application. A bank’s compliancewith its CRA obligations is based on a performance-based evaluation systemwhich bases CRA ratings on an institution’s lending service and investmentperformance, 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, Heritage received a CRArating of “Satisfactory.” At its last examination by the FRB, Hacienda receiveda CRA rating of “Satisfactory”.

 

Privacy

 

Federal banking rules limit the ability of banks and other financialinstitutions to disclose non-public information about consumers tononaffiliated third parties.  Pursuantto these rules, financial institutions must provide:

 

•                  initial notices to customers about theirprivacy policies, describing the conditions under which they may disclosenon-public information to nonaffiliated 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.

 

These privacy provisions affect how consumer information is transmittedthrough diversified financial companies and conveyed to outside vendors.  We have implemented our privacy policies inaccordance with the law.

 

In recent years, a number of states have implemented their own versionsof privacy laws.  For example, in 2003,California adopted standards that are more restrictive than federal law,allowing bank customers the opportunity to bar financial companies from sharinginformation with their affiliates.

 

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InteragencyGuidance on Response Programs to Protect Against Identity Theft

 

On August 12, 2003, the Federal bank and thrift regulatory agenciesrequested public comment on proposed guidance that would require financialinstitutions to develop programs to respond to incidents of unauthorized accessto customer information, including procedures for notifying customers undercertain circumstances.  The proposed guidance:

 

•                                interprets previously issued interagencycustomer information security guidelines that require financial institutions toimplement information security programs designed to protect their customers’information; and

 

•                                describes the components of a responseprogram and sets a standard for providing notice to customers affected byunauthorized access to or use of customer information that could result insubstantial harm or inconvenience to those customers, thereby reducing the riskof losses due to fraud or identity theft.

 

Factors That May Affect Future Results of Operations

 

In addition to other information contained in this Annual Report, thefollowing risks may affect the Company and/or the Banks. If any of these risksoccur, the Company’s or Banks’ business, financial condition or operationresults could be adversely affected.

 

Dependenceon Real Estate

 

A significant portion of the loan portfolio of the Banks is dependenton real estate. At December 31, 2003, real estate served as the principalsource of collateral with respect to approximately 80.4% percent of thecombined Banks’ loan portfolios. A decline in current economic conditions orrising interest rates could have an adverse effect on the demand for new loans,the ability of borrowers to repay outstanding loans, the value of real estateand other collateral securing loans and the value of real estate owned by theBanks, as well as the Company’s financial condition and results of operationsin general and the market value of the Company’s common stock. Acts of nature,including earthquakes,  floods anddraughts, which may cause uninsured damage and other loss of value to realestate and crops that secures these loans, may also negatively impact theCompany’s financial condition. See, “Item 6. -Management’s Discussion andAnalysis- Financial Condition Analysis, Loans”.

 

InterestRate Changes

 

The earnings of the Company 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 Company must pay on deposits and borrowings. Thedifference between the rates the Banks receive on loans and securities and therates they must pay on deposits and borrowings is known as the interest ratespread. Given the Company’s current volume and mix of interest-bearingliabilities and interest-earning assets, the Company’s interest rate spread canbe expected to increase when market interest rates are rising, and to declinewhen market interest rates are declining. Our analysis indicates that thedecrease in the target federal funds rate announced by the Federal ReserveBoard in 2003 resulted in a decrease of 68 basis points in the Company’saverage interest rate spread from that of 2002. If interest rates continue todecline, competitive pressure and other factors may prevent us from makingproportionate decreases in the interest rates we pay on deposits, especiallyMMDA and NOW accounts, resulting in a larger decrease in our interest rate spread.Although the Company believes the current level of interest rate sensitivity isreasonable, significant fluctuations in interest rates may have an adverseimpact on our business, financial condition and results of operations.

 

Competition

 

Competition may adversely affect our performance. The financialservices business in our market area is highly competitive, and becoming moreso due to changes in regulation, technological advances and the acceleratingpace of consolidation among financial service providers. We face competitionboth in attracting deposits and in making loans. We compete for loansprincipally through the interest rates and loan fees we charge and theefficiency and quality of the services we provide. Increasing levels ofcompetition in banking and financial services businesses may reduce our marketshare or cause the prices we charge for our services to fall. Our results maydiffer in future periods depending on the nature or level of competition.

 

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Regulation

 

The Company is subject to government regulation that could limit orrestrict our activities, adversely affecting our operations. The financialservices industry is heavily regulated. Federal and state regulation isdesigned to protect the deposits of consumers, not to benefit our shareholders.The regulations impose significant limitations on our operations, and may bechanged at any time to impose significant new limitations, possibly causing ourresults to vary significantly from past results. Government policy andregulation, particularly as implemented through the Federal Reserve System,significantly affects credit conditions for us.

 

In response to several well-publicized corporate and auditing scandals,the President signed the Sarbanes-Oxley Act into law on July 29, 2002.  This act calls for increased federalregulation of the accounting profession and imposes new requirements uponboards of directors, audit committees and executive officers of publiccompanies. These requirements will likely increase the accounting and legalcosts of the Company.

 

OperatingStrategies

 

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

 

•                  Deterioration of asset quality;

 

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

 

•                  Inability to increase non-interest income

 

•                  Inability to decrease reliance on revenuegenerated from assets;

 

•                  Ability to increase loan growth;

 

•                  Regulatory and other impediments associatedwith making acquisitions;

 

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

 

•                  Decreases in the Company’s net interestmargin;

 

•                  Increases in competition; and

 

•                  Adverse regulatory or legislativedevelopments.

 

Borrowers’Failure to Perform

 

A significant number of our borrowers and guarantors may fail toperform their obligations as required by the terms of their loans, resulting inlosses for us. This risk increases when the economy is weak. We have adoptedunderwriting and credit policies, and loan monitoring procedures, including theestablishment and monitoring of allowances for credit losses. Managementbelieves these provisions are reasonable and adequate, and should keep creditlosses within expected limits by assessing the likelihood of nonperformance,tracking loan performance and diversifying our credit portfolio. However, thesepolicies and procedures may not be adequate to prevent unexpected losses thatcould materially and adversely affect our results of operations.

 

OperationsRisks

 

The Banks are subject to certain operations risks, including, but notlimited to, data processing system failures and errors, customer or employeefraud and catastrophic failures resulting from terrorist acts or naturaldisasters. The

 

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Banks maintain a system of internal controls to mitigate against suchoccurrences and maintains insurance coverage for such risks, but should such anevent occur that is not prevented or detected by the Banks’ internal controls,uninsured or in excess of applicable insurance limits, it could have asignificant adverse impact on the Company’s business, financial condition orresults of operations.

 

GeographicConcentration

 

Our operations are located almost entirely in the Central Coast regionof California. As a result of this geographic concentration, our results dependlargely upon economic and business conditions in this region. 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.

 

Waron Terrorism

 

The terrorist attacks of September 11, 2001, the ensuing worldwide waron terrorism and the war with Iraq may lead to unexpected shifts in cash flows,deposit levels, and general economic activity. US banking agencies have warnedof the possible impact of such events on the capital ratios of banks.

 

CompanyCash Flow

 

As a holding company, a substantial portion of the Company’s cash flowtypically comes from dividends from the Banks. Various statutory provisionsrestrict the amount of dividends the Banks can pay to the Company withoutregulatory approval.

 

TrustPreferred Securities

 

In accordance with the provisions of Financial Accounting StandardBoard (“FASB”) Interpretation No. (“FIN”) 46, “Consolidation of VariableInterest Entities” (“FIN 46”), we have deconsolidated the subsidiary trustwhich has issued Trust Preferred Securities for Heritage Oaks Bancorp, and itsfinancial position and results of operations are not included in ourconsolidated financial position and results of operations.  Accordingly, the Trust Preferred Securitieswhich had previously been reported as a liability have been replaced by thesubordinated debt issued by Heritage Oaks Bancorp to the trust.

 

Under applicable regulatory guidelines, a portion of the TrustPreferred Securities will qualify as Tier I capital, and the remaining portionwill qualify as Tier II Capital.  Underapplicable regulatory guidelines, $8 million of the outstanding Trust PreferredSecurities qualify as Tier I Capital at December 31, 2003.  On July 2, 2003, the Federal Reserve Boardissued Supervisory Letter (SR 03-13) which preserves the historical capitaltreatment of trust preferred securities as Tier I Capital despite thedeconsolidation of these securities. That Supervisory Letter remained in effect at December 31, 2003, and wecontinue to include these securities in our Tier I Capital.  There remains the potential that thisdetermination by the Federal Reserve Board may change at a later date.

 

If Tier I Capital treatment for our Trust Preferred Securities weredisallowed, there would be a reduction in our consolidated capital ratios.  The following table shows as of December 31,2003 (1) Heritage Oaks Bancorp’s current capital position, (2) our pro formacapital position if the Federal Reserve Board granted Tier II status to ourTrust Preferred Securities, (3) our pro forma capital position if the FederalReserve Board excludes entirely our Trust Preferred Securities from capital and(4) the minimum regulatory capital requirements for well capitalized status.

 
|   |                                                                    | **Leverage  ratio** |   | **Tier I  risk-based  capital ratio** |   | **Total  risk-based  capital ratio** |   |
|--------|-------------------------------------------------------------------------|---------------------|--------|---------------------------------------|--------|--------------------------------------|--------|
|   |                                                                    |                |   |                                  |   |                                 |   |
| (1)    | Heritage Oaks Bancorp                                                   |                | 8.30   | %                                     | 10.15  | %                                    | 11.14  | % |
| (2)    | Assuming Trust Preferred Securities only qualified as Tier II Capital   |                | 6.28   | %                                     | 7.68   | %                                    | 11.14  | % |
| (3)    | Assuming Trust Preferred Securities are excluded entirely from  capital |                | 6.28   | %                                     | 7.68   | %                                    | 8.67   | % |
| (4)    | Minimum regulatory requirements for adequately-capitalized status       |                | 4.00   | %                                     | 4.00   | %                                    | 8.00   | % |

 

17

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As the table shows, the Company would remain “adequately-capitalized”in the event that the Federal Reserve Board elected to change its position withregards to Tier I and Tier II capital treatment of Trust Preferred Securities.If Tier I capital treatment were disallowed, the Company may be able to redeemthe Trust Preferred Securities pursuant to their terms, and have the ability toidentify and obtain alternative sources of capital.

 

ITEM 2. DESCRIPTION OF PROPERTIES

 

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

 

Heritage has a non-banking office, located at 600 Twelfth Street, PasoRobles (directly across from its present headquarters) that was purchased byHeritage on December 23, 1986, for approximately $400,000 from an unaffiliatedparty.

 

In June of 1994, Heritage opened a branch at 171 Niblick Rd., PasoRobles, Ca.  Heritage leases this 1,400square foot branch for approximately $2,000 per month. On February 24, 2000,Heritage renewed the lease for an additional five-year term. On February 17,2004, the branch customer base was relocated to 1400 South River Road and theexisting facility currently houses an ATM and administrative offices.

 

On June 26, 1997 Heritage executed a lease for its branch office at 297Madonna Road, San Luis Obispo.  Thebranch was previously located in premises that were acquired from La CumbreSavings, which lease expired in 1997. The new branch lease is for 6,200 square feet of which Heritagesubleases approximately 58% to another firm and uses 42%. The other firm pays58% of the rent and expenses and Heritage pays 42%.  The rent under the lease for the entire space is approximately$7,750 a month. In June, 2002, the rent re-priced to 95% of the prevailing fairmarket value and increases each year thereafter at the greater of the consumerprice index or 2.5% until the lease expires on June 30, 2009.

 

Heritage opened a branch office at 1135 Santa Rosa Street in downtownSan Luis Obispo, Ca in April 1996. Heritage is leasing a building containing approximately 5,618 squarefeet for approximately $7,800 per month. The original lease expired on February28, 2001 and Heritage executed its option to extend for a period of five years.As of January 2003, Heritage has obtained two additional five year options toextend.

 

On February 21, 1997, Heritage acquired the Cambria branch of WellsFargo Bank located at 1276 Tamson Drive, Cambria. Heritage leases this 2,916square foot branch for approximately $3,200 per month, subject to adjustmentsfor cost of living increases and certain pass-throughs. In December 2003,Heritage exercised an option to extend the lease for an additional five yearsand there is one additional five year option to extend remaining in the lease.

 

On August 26, 1998, the Company purchased property located at 9900 ElCamino Real, Atascadero.  The purchaseprice was $271,160.  The Companyconstructed a building with a total of 3,500 square feet of floor space.  The total cost of improvements was $440,765plus furniture and fixtures.  On April1, 1999, the Company entered into a five-year lease agreement, with threefive-year options to renew, with Heritage at the rate of $4,725 per month or$1.35 per square foot. Comparatives were obtained to ensure that the leaseamount was at fair market value.

 

On November 1, 1998, Heritage entered into a 10-year lease with anunaffiliated party to lease property known as 1660 South Broadway, Santa Maria,Ca.  The lease calls for monthlypayments based on a triple net price of $1.15 per square foot or approximately$5,395 per month.  The rent will adjusteach November by the Consumer Price Index or a maximum of 6%. The lease willexpire on October 31, 2008, with Heritage having three five-year options torenew.

 

On July 1, 2001 Heritage entered into a 9-month lease with anunaffiliated party to lease property located at 1360 Grand Avenue, ArroyoGrande, Ca. The lease calls for monthly payments based on a triple net price ofapproximately $4,200 per month. Heritage did not renew or renegotiate thislease at its expiration. The short-term nature of this lease was due toHeritage’s knowledge that it was acquiring a branch office from WestamericaBank (seller) that was in close proximity to the leased facility. On November9, 2001, the seller conveyed title to the land and building located at 1255 GrandAvenue, Arroyo Grande, Ca. Heritage consolidated the existing Bank branch intothe newly acquired facility. The appraised fair value of the acquired locationwas $800,000.

 

On November 9, 2001, Heritage also acquired from Westamerica Bank(seller), a branch office located at 310 Morro

 

18

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Bay Blvd., Morro Bay, Ca. The seller conveyed title to the building atthe closing. The appraised fair value of the acquired building was $200,000.The building is on leased land. The seller assigned and Heritage assumed thelease that expires on April 1, 2012. The monthly lease payment is $2,200.

 

On July 26, 2002, Heritage purchased a parcel of land (approximately 2acres) on the corner of Niblick and South River Roads in Paso Robles, Ca. Thepurchase price was $900,000. In February 2003, Heritage entered into aConstruction Agreement with HBE Financials Facilities to construct a 5,000square foot full service branch. The “turn-key” price for the construction is$1.8 million. Heritage relocated the existing “Woodland” branch office,  located at 171 Niblick Road, Paso Robles,Ca. to the new facility on February 17, 2004.

 

On July 3, 2003, Heritage closed escrow to purchase real propertylocated at 500 13th Street, Paso Robles, Ca. This property islocated directly adjacent to Heritage’s Headquarters. The purchase price was$1.1 million. It is Heritage’s intention to build a new structure on the siteto allow for the consolidation of all Administrative functions of Heritagewithin the new facility. Heritage anticipates that this project will becomplete in the second quarter of 2005.

 

Hacienda leases the premises located 361 Town Center West Santa Maria,California 93458 which is Hacienda’s headquarters office.  The Town Center West office is a two storydesign of approximately 14,000 square feet.  Hacienda’s lease expires July 31, 2012 in which Hacienda makes leasepayments of $15,382 per month.  Haciendaalso subleases part of the 2nd floor of the Town Center West officeto one lessee.  The sublease haspayments of $2,475 per month and expires October 1, 2006.

 

Hacienda owns the premises located at 2239 South Broadway, Santa Maria,California 93455, which is Hacienda’s South Broadway office. The South Broadwayoffice consists of approximately 3,700 net square feet which include drive-upfacilities and parking for approximately 30 vehicles.  The cost of the land and premises was approximately $2.2 millionand was opened in July 2002.

 

Hacienda also leases premises located at 1125 East Clark Ave, SantaMaria, California, 93455 which is Hacienda’s Oak Knolls office.  The Oak Knolls office consists ofapproximately 4,600 square feet. Hacienda’s lease expires on June 30, 2008, and current lease paymentsare $5,721 per month.  Hacienda also hasan option to extend the term for an additional five-year period and also twoadditional two-year periods.

 

The Company believes its present facilities are adequate for itspresent needs. The Company believes that the insurance coverage on allproperties is adequate.

 

ITEM 3. LEGAL PROCEEDINGS

 

The Banks are, from time to time, subject to various pending andthreatened legal actions which arise out of the normal course of itsbusiness.  Neither the Company nor theBanks are a party to any pending material legal or administrative proceedings(other than ordinary routine litigation incidental to the Company’s or theBanks’ business).

 

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS

 

On October 21, 2003, the Company held a special meeting ofshareholders. At the meeting, shareholders were asked to vote on the proposalto approve the principal terms of the merger and merger agreement pursuant towhich Hacienda Bank would become a wholly-owned subsidiary of the Company. Theshareholders approved the transaction by a majority vote. Of the shares voted,the number of votes “for” the transaction was 2,255,910 or 75.8%, the number ofvotes “against” the transaction was 17,676 or .60% and the number of abstainingvotes was 1,790 or .1% of the outstanding shares, respectively.

 

PART II

 

ITEM 5.          MARKETFOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

 

Market Information

 

There is a limited over-the-counter market for the Company’s CommonStock.  The Company’s Common Stock isnot listed on any exchange or market. However, Maguire Investments, Inc., Hoefer & Arnett, Inc., TheSeidler Companies, Sandler O’Neill & Partners and Wedbush Morgan Securitiesmake a market in the Company’s Common Stock. Certain information concerning the Common Stock is reported on theNASDAQ electronic bulletin board under the symbol

 

19

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“HEOP.OB”.

 

The information in the following table indicates the high and low bidprices of the Company’s Common Stock for each quarterly period during the lastthree years based upon information provided by Maguire Investments, Inc.,Hoefer & Arnett, Inc., The Seidler Companies and Wedbush MorganSecurities.  These prices do not includeretail mark-ups, mark-downs or commission.

 
| **Quarter Ended** |   | **Bid Prices** |       |
|-------------------|--------|----------------|------------|
| **2003**          |   | **Low**        |       | **High** |   |
| March 31          |   | $              | 10.60      |   | $ | 13.00 |   |
| June 30           |   | 11.00          |       | 13.25 |   |
| September 30      |   | 11.70          |       | 13.95 |   |
| December 31       |   | 13.55          |       | 18.00 |   |
|              |   |           |       |   |   |
| **2002**          |   | **Low**        | ** ** | **High** | ** ** |
| March 31          |   | $              | 12.85      |   | $ | 12.85 |   |
| June 30           |   | 12.88          |       | 13.00 |   |
| September 30      |   | 12.80          |       | 13.20 |   |
| December 31       |   | 11.50          |       | 11.65 |   |
|              |   |           |       |   |   |
| **2001**          |   | **Low**        | ** ** | **High** | ** ** |
| March 31          |   | $              | 8.75       |   | $ | 8.50 |   |
| June 30           |   | 11.00          |       | 11.44 |   |
| September 30      |   | 11.50          |       | 12.25 |   |
| December 31       |   | 12.00          |       | 13.00 |   |

 

Prices listed above have been adjusted to reflect all stock dividendand split activity.

 

Holders

 

As of February 1, 2004, there were approximately 1,434 holders of theCompany’s Common Stock.  There are noother classes of equity outstanding.

 

Dividends

 

The Company is a legal entity separate and distinct from the Banks. TheCompany’s shareholders are entitled to receive dividends when and as declaredby its Board of Directors, out of funds legally available therefore, subject tothe restrictions set forth in the California General Corporation Law (the“Corporation Law”).  The Corporation Lawprovides that a corporation may make a distribution to its shareholders if thecorporation’s retained earnings equal at least the amount of the proposeddistribution.  The Corporation Law alsoprovides that, in the event that sufficient retained earnings are not availablefor the proposed distribution, a corporation may nevertheless make adistribution to its shareholders if it meets two conditions, which generallystated are as follows: (i) the corporation’s assets equal at least 1-1/4 timesits liabilities, and (ii) the corporation’s current assets equal at least itscurrent liabilities or, if the average of the corporation’s earnings beforetaxes on income and before interest expenses for the two preceding fiscal yearswas less than the average of the corporation’s interest expenses for suchfiscal years, then the corporation’s current assets must equal at least 1-1/4times its current liabilities. Refer to “Item 6. Management’s Discussion andAnalysis of Financial condition and Results of Operations” on juniorsubordinated debenture limitations on dividends.

 

The ability of the Company to pay a cash dividend and to service thedebt on its junior subordinated debenture depends largely on the Banks’ abilityto pay a cash dividend to the Company. The payment of cash dividends by the Banks is subject to restrictionsset forth in the California Financial Code (the “Financial Code”).  The Financial Code provides that a bank maynot make a cash distribution to its shareholders in excess of the lesser of (a)bank’s retained earnings; or (b) bank’s net income for its last three fiscalyears, less the amount of any distributions made by the bank or by anymajority-owned subsidiary of the bank to the shareholders of the bank duringsuch period.  However, a bank may, withthe approval of the DFI, make a distribution to its shareholders in an amountnot exceeding the greatest of (x) its retained earnings; (y) its net income forits last fiscal year; or (z) its net income for its current fiscal year.  In the

 

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event that the DFI determines that the shareholders’ equity of a bankis inadequate or that the making of a distribution by the bank would be unsafeor unsound, the DFI may order the bank to refrain from making a proposeddistribution.  The FDIC may alsorestrict the payment of dividends if such payment would be deemed unsafe orunsound or if after the payment of such dividends, the bank would be includedin one of the “undercapitalized” categories for capital adequacy purposespursuant 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 fromHeritage and Hacienda to the Company was approximately $8,640,865 and $107,970,respectively at December 31, 2003.

 

The following table outlines stock dividend activity since 1999:

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

 

Whether dividends will be paid in the future will be determined by theBoard of Directors after consideration of various factors. The Company’sprofitability and regulatory capital ratios in addition to other financialconditions will be key factors considered by the Board of Directors in makingsuch determinations regarding the payment of dividends by the Company.

 

The following table summarizes information as of December 31, 2003relating to equity compensation plans of the Company pursuant to which grantsof options, restricted stock or other rights to acquire shares may be grantedfrom time to time:

 
| **Plan Category**                                           |   | **Plan  Year** | ** ** | **Number of  securities to  be issued upon exercise  of options** | ** ** | **Weighted  average  exercise price of  outstanding options** | ** ** | **Number of  securities remaining  available for future  issuance** | ** ** |
|-------------------------------------------------------------|--------|----------------|------------|-------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|---------------------------------------------------------------------|------------|
| Equity compensation plans approved by  security holders     |   | 1990           |       | 2,134                                                             |       | $4.22                                                         |       | -0-                                                                 |       |
|                                                        | 1997   |           | 447,622    |                                                              | $6.44      |                                                          | 67,832     |                                                                |
| Equity compensation plans not  approved by security holders |   |           |       | -0-                                                               |       | -0-                                                           |       | -0-                                                                 |       |
| Total                                                       |   |           |       | 449,756                                                           |       | $                                                             | 6.43       |                                                                | 67,832     |   |
|                                                             |        |                |            |                                                                   |            |                                                               |            |                                                                     |            |  |

 

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ITEM6.          MANAGEMENT’S DISCUSSION AND ANALYSISOF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The following is an analysis of the financial condition and results ofoperations of the Company for the two years ended December 31, 2003.  The analysis should be read in connectionwith the consolidated financial statements and notes thereto appearingelsewhere in this report.

 

Executive Summary

 

The table below provides selected financial data that highlights theCompany’s performance results for the three years ending December 31, 2001,2002 and 2003.

 

**SELECTED FINANCIAL DATA**

 
|                              |   | **December  31,** |    |
|-----------------------------------|--------|-------------------|---------|
|                              |   | **2001**          |    | **2002** |   | **% Change  2001 to 2002** |   | **2003** |   | **% Change  2002 to 2003** |   |
| Return on Average Assets          |   | 1.22              | %       | 0.98 | % | -19.67 | % | 1.05 | % | 7.14 | % |
|                              |   |              |    |   |   |   |   |   |   |   |   |
| Return on Average Equity          |   | 15.74             | %       | 15.56 | % | -1.14 | % | 15.52 | % | -0.26 | % |
|                              |   |              |    |   |   |   |   |   |   |   |   |
| Average Equity to Average Assets  |   | 7.74              | %       | 6.33 | % | -18.22 | % | 6.76 | % | 6.79 | % |
|                              |   |              |    |   |   |   |   |   |   |   |   |
| Net Interest Margin               |   | 6.43              | %       | 5.04 | % | -21.62 | % | 4.82 | % | -4.37 | % |
|                              |   |              |    |   |   |   |   |   |   |   |   |
| Efficiency Ratio*                 |   | 72.47             | %       | 69.18 | % | -4.54 | % | 67.13 | % | -2.96 | % |
|                              |   |              |    |   |   |   |   |   |   |   |   |
| Average Loans to Average Deposits |   | 83.80             | %       | 77.63 | % | -7.36 | % | 81.74 | % | 5.29 | % |
|                              |   |              |    |   |   |   |   |   |   |   |   |
| Net Income (in thousands)         |   | $                 | 2,346   |   | $ | 2,739 |   | 16.75 | % | $ | 3,596 |   | 31.29 | % |
|                              |   |              |    |   |   |   |   |   |   |   |   |
| Average Assets (in thousands)     |   | $                 | 192,459 |   | $ | 278,332 |   | 44.62 | % | $ | 342,923 |   | 23.21 | % |
|                              |   |              |    |   |   |   |   |   |   |   |   |
| Earnings Per Share:               |   |              |    |   |   |   |   |   |   |   |   |
| Basic                             |   | $                 | 0.82    |   | $ | 0.94 |   | 14.63 | % | $ | 1.18 |   | 25.53 | % |
| Diluted                           |   | $                 | 0.76    |   | $ | 0.86 |   | 13.16 | % | $ | 1.10 |   | 27.91 | % |

 

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*The efficiency ratio is defined as total non-interest expense as apercent of the combined net interest income plus non-interest income.

 

In order to understand our performance over the last three years, wemust begin our discussion with the Net Interest Margin (NIM). Beginning inJanuary 2001 and continuing through July 2003, actions by the Federal Reserveto cut target interest rates resulted in the Prime Rate being reduced from9.50% to 4.00%. Historically, the largest source of income for the Company isthat which is created by net interest income. This reduction in rates,specifically as it relates to a) 30% of the Company’s gross loan portfolio thatadjust with Prime and other indices and b) securities in the Investmentportfolio that react to rate fluctuations, made it very difficult to maintainthe level of the NIM for 2002 and 2003 that the Company had experienced in thepast. Despite this interest rate environment, the Company was able to exceed prioryear earnings and EPS by growing average earning assets and reducing theEfficiency Ratio year over year.

 

In 1999, Heritage put into action a Corporate Culture Survey thatallows employee to respond anonymously to nearly 100 questions regarding communication,training, management effectiveness and many other pertinent areas. This surveyis conducted annually during the fourth quarter. The results of the surveyprovide Senior Management and the Board with information that assists in futureendeavors to address areas where there is an opportunity to improve.

 

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During the past five years, the overall “rating” has shown measuredimprovement. Senior Management and the Board of Directors consider this to beone of the most important achievements for the Company. This program wasimplemented for Hacienda in February 2004.

 

In April 2002, the Company implemented an investment strategy byborrowing $38 million from the Federal Home Loan Bank (FHLB) and investing $40million in mortgage backed securities. This strategy has worked well to providereal dollars to the bottom line and assist to maintain a desirable Return onAverage Equity (ROE).  However, Returnon Average Assets (ROA) suffered somewhat in 2002 by the instantaneous increasein total assets that is typical with this type of strategy. Management believesthat ROE weighs more heavily than ROA in terms of measuring performance for theshareholder. This investment strategy has been winding down with the acceleratedpre-payments experienced in Mortgaged Backed Securities (“MBS”) as the resultof long term rates declining at a greater pace than Federal Reserve Boardactions to reduce rates. The Company has reduced the borrowing with the FHLB by$9.5 million to react to this change.

 

Certainly one of the most notable recent events by the Company was theacquisition of Hacienda Bank that took place on October 31, 2003. Hacienda hadapproximately $90 in assets at December 31, 2003. This acquisition was the culminationof many years effort to have a greater presence in the city of Santa Maria. Inreviewing market share data (provided by the FDIC as of June every year) withinthe Company’s primary service area of San Luis Obispo and Northern SantaBarbara counties, it was very clear that the city of Santa Maria with 28% ofthe total deposit base provided opportunity for growth. In order to obtain moremarket share, the Company needed a greater presence than the existing onebranch office that was opened in 1999. The Company views this acquisition as apositive step to enhancing market share and shareholder return. It isanticipated that the acquisition will be accretive to earnings in 2004.

 

The Company continues to focus on increased market share in each citywithin its primary market area. In 2002, marketing plans were initiated toreach the long term goal of at least a pro rata share of deposits in eachmarket. Measured calling programs for both lending and operational staff havebeen implemented utilizing among other resources a Customer RelationshipManagement (CRM) system. While competition remains robust in the Central Coastwith numerous independent banks headquartered here and the typical plethora ofmajor financial institutions, the Company believes that our unique corporateculture that concentrates on our staff will ultimately be our best tool toaccomplish our market share goals.

 

Critical Accounting Policies

 

Our accounting policies are integral to understanding the resultsreported. Accounting policies are described in detail in Note 1 of the NOTES TOCONSOLIDATED FINANCIAL STATEMENTS. Our most complex accounting policies requiremanagement’s judgment to ascertain the valuation of assets, liabilities,commitments and contingencies. We have established detailed policies andcontrol procedures that are intended to ensure valuation methods are wellcontrolled and applied consistently from period to period. In addition, thepolicies and procedures are intended to ensure that the process for changingmethodologies occurs in an appropriate manner. The following is a briefdescription of our current accounting policies involving significant managementvaluation judgments.

 

Allowance for Loan and Lease Losses

 

The allowance for loan and lease losses represents management’s bestestimate of losses inherent in the existing loan portfolio. The allowance forloan and lease losses is increased by the provision for loan and lease lossescharged to expense and reduced by loans charged-off, net of recoveries. Theallowance for loan and lease losses is determined based on management’sassessment of several factors: reviews and evaluation of individual loans,changes in the nature and volume of the loan portfolio, current economicconditions and the related impact on specific borrowers and industry groups,historical loan loss experiences and the level of classified and nonperformingloans.

 

Loans are considered impaired if, based on current information andevents, it is probable that we will be unable to collect the scheduled paymentsof principal or interest when due according to the contractual terms of theloan agreement. The measurement of impaired loans is generally based on thepresent value of expected future cash flows discounted at the historicaleffective interest rate stipulated in the loan agreement, except that allcollateral-dependent loans are measured for impairment based on the fair valueof the collateral. In measuring the fair value of the collateral, managementuses assumptions and methodologies consistent with those that would be utilizedby unrelated third parties.

 

Changes in the financial condition of individual borrowers, economicconditions, historical loss experience and the

 

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condition of the various marketsin which collateral may be sold may all affect the required level of theallowance for loan and lease losses and the associated provision for loan andlease losses.

 

Securities Available forSale

 

The fair value of mostsecurities that are designated available for sale are based on quoted marketprices. If quoted market prices are not available, fair values are extrapolatedfrom the quoted prices of similar instruments.

 

Goodwill and OtherIntangible Assets

 

As discussed in Note 6 ofthe NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, we assess goodwill and otherintangible assets each year for impairment. This assessment involves estimatingcash flows for future periods. If the future cash flows were materially lessthan the recorded goodwill and other intangible assets balances, we would berequired to take a charge against earnings to write down the assets to thelower value.

 

Deferred Tax Assets

 

We use an estimate of futureearnings to support our position that the benefit of our deferred tax assets willbe realized. If future income should prove nonexistent or less than the amountof the deferred tax assets within the tax years to which they may be applied,the asset may not be realized and our net income will be reduced. Our deferredtax assets are described further in Note 9 of the NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS.

 

Supplemental EmployeeCompensation Benefits Agreements

 

As described in Note 12 ofthe NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, we have entered intosupplemental employee compensation benefits agreements with certain executiveand senior officers. The measurement of the liability under these agreementsincludes estimates involving life expectancy, length of time before retirement,and expected benefit levels. Should these estimates prove materially wrong, wecould incur additional or reduced expense to provide the benefits.

 

Earnings Overview

 

When viewing data for theyear 2003, it is important to keep in mind that Hacienda was acquired by theCompany on October 31, 2003. Income and expense for Hacienda that is includedin the Company consolidation is for the months of November and December 2003only. Hacienda contributed $108 thousand to the net after-tax income of theCompany in 2003.

 

The Company reported netincome for 2003 of $3.6 million compared to $2.7 million for 2002. Thisrepresents an increase of 31.3% and was accomplished by increasing averageearning assets and lowering the efficiency ratio by 205 basis points.  Net income reported for 2002 represented anincrease of 16.7% more than 2001 net income of $2.3 million. Basic earnings pershare were $1.18, $.94 and $.82 at December 31, 2003, 2002 and 2001,respectively. Diluted earnings per share were $1.10, $.86 and $.76 at December31, 2003, 2002 and 2001, respectively.

 

Net Interest Income andInterest Margin

 

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

 

The tables below sets forthchanges from 2002 to 2003 for average interest earning assets and theirrespective average yields. Due to the declining yields on earning assets, theCompany had to increase average earning assets for the year in order to augmentnet interest income. The Company was able to grow the loan portfolio withcontinued market penetration by a team of seasoned loan officers who arecompensated for production. Loan underwriting criteria was not compromisedwhile accomplishing this. The tax-exempt portion of the investment portfoliowas also increased while giving up only 24 basis points in the average yield.The Company has significant room to grow in tax-exempts before bumping upagainst the Alternative Minimum Tax issue with the IRS. The taxable investmentportfolio continued to experience accelerated pre-payments throughout the yearwhich made it difficult to maintain the outstanding

 

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balances. The yield on average taxable investments dropped 90 basispoints for 2003 from 2002 due to these prepayments.

 
|                              |   | **Average  Balance** |   |     |   |           |   |
|-----------------------------------|--------|----------------------|--------|----------|--------|----------------|--------|
| **(dollars in thousands)**        |   | **2002**             |   | **2003** |   | **$ Variance** |   | **% Variance** |   |
| Interest  Earning Assets:         |   |                 |   |     |   |           |   |   |   |
| Time deposits with other banks    |   | $                    | 169    |     | $      | 661            |   | $ | 492 |   | 291.12 | % |
| Investment securities taxable     |   | 43,502               |   | 42,353   |   | (1,149         | )      | -2.64 | % |
| Investment securities non-taxable |   | 6,358                |   | 10,129   |   | 3,771          |   | 59.31 | % |
| Federal funds sold                |   | 24,799               |   | 25,602   |   | 803            |   | 3.24 | % |
| Loans                             |   | 173,861              |   | 226,707  |   | 52,846         |   | 30.40 | % |
|                              |   |                 |   |     |   |           |   |   |   |
| Total interest earning assets     |   | 248,689              |   | 305,452  |   | 56,763         |   | 22.82 | % |
|                                   |        |                      |        |          |        |                |        |  |  |  |  |  |

 
|                              |   | **Average  Yield** | ** ** |     | ** ** |
|-----------------------------------|--------|--------------------|------------|----------|------------|
|                              |   | **2002**           | ** ** | **2003** | ** ** | **Variance** | ** ** |
| Interest Earning Assets:          |   |               |       |     |       |   |   |
| Time deposits with other banks    |   | 2.96               | %          | 1.97     | %          | -0.99 | % |
| Investment securities taxable     |   | 4.44               | %          | 3.54     | %          | -0.90 | % |
| Investment securities non-taxable |   | 4.72               | %          | 4.48     | %          | -0.24 | % |
| Federal funds sold                |   | 1.61               | %          | 1.09     | %          | -0.53 | % |
| Loans                             |   | 7.71               | %          | 7.03     | %          | -0.68 | % |
|                              |   |               |       |     |       |   |   |
| Total interest earning assets     |   | 6.45               | %          | 5.95     | %          | -0.50 | % |

 

The tables below sets forth changes from 2002 to 2003 for averageinterest bearing liabilities and their respective average rates paid. TheCompany continues to enjoy a low cost of funds, specifically in regard tointerest bearing deposits. The ability to attract low cost deposits is part ofthe Company’s marketing plans that have been in place for numerous years. Theaverage rate paid on “Other Borrowing” increased in 2003 due to the maturityschedule for borrowing related to the FHLB that was initiated in April 2002.Heritage borrowed $9.5 million, $9.5 million and $19 million from the FHLB withmaturities in April 2003, 2004 and 2005, respectively and at the rate of 2.63%,3.71% and 4.35%, respectively. In October 2003, the Company requested the fulldisbursement of a $3.5 million line of credit with Pacific Coast Bankers Bankto assist in the acquisition of Hacienda. The details of this transaction canbe found in the “Capital” section of this item.

 
|                               |   | **Average  Balance** |   |     |   |           |   |
|------------------------------------|--------|----------------------|--------|----------|--------|----------------|--------|
| **(dollars in thousands)**         |   | **2002**             |   | **2003** |   | **$ Variance** |   | **% Variance** |   |
| Interest  -bearing liabilities:    |   |                 |   |     |   |           |   |   |   |
| Savings/NOW/money market           |   | 92,800               |   | 116,965  |   | 24,165         |   | 26.04 | % |
| Time deposits                      |   | 46,453               |   | 51,049   |   | 4,596          |   | 9.89 | % |
| Other Borrowings                   |   | 28,967               |   | 31,396   |   | 2,429          |   | 8.39 | % |
| Long Term Debt                     |   | 6,000                |   | 8,000    |   | 2,000          |   | 33.33 | % |
|                               |   |                 |   |     |   |           |   |   |   |
| Total interest-bearing liabilities |   | 174,220              |   | 207,410  |   | 33,190         |   | 19.05 | % |

 
|                               |   | **Average  Rate Paid** | ** ** |     | ** ** |         | ** ** |
|------------------------------------|--------|------------------------|------------|----------|------------|--------------|------------|
|                               |   | **2002**               | ** ** | **2003** |       | **Variance** | ** ** | **%****Variance** | ** ** |
| Interest  -bearing liabilities:    |   |                   |       |     |       |         |       |   |   |
| Savings/NOW/money market           |   | 0.84                   | %          | 0.53     | %          | -0.31        | %          | -36.34 | % |
| Time deposits                      |   | 2.77                   | %          | 2.21     | %          | -0.56        | %          | -20.32 | % |
| Other Borrowings                   |   | 3.70                   | %          | 4.10     | %          | 0.40         | %          | 10.87 | % |
| Long Term Debt                     |   | 5.92                   | %          | 5.31     | %          | -0.61        | %          | -10.31 | % |
|                               |   |                   |       |     |       |         |       |   |   |
| Total interest-bearing liabilities |   | 2.00                   | %          | 1.67     | %          | -0.33        | %          | -16.68 | % |

 

25

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The table below sets forth the average balance sheet information,interest income and expense, average yields and rates and net interest incomeand margin for the years ended December 31, 2001, 2002 and 2003. The averagebalance of non-accruing loans has been included in loan totals.

 
|                                            |   | **2001**             |    | **2002**                 |   | **2003**             |   |
|-------------------------------------------------|--------|----------------------|---------|--------------------------|--------|----------------------|--------|
| **(dollars in thousands)**                      |   | **Average  Balance** |    | **Avg Yield  Rate Paid** |   | **Amount  Interest** |   | **Average  Balance** |   | **Avg Yield  Rate Paid** |   | **Amount  Interest** |   | **Average  Balance** |   | **Avg Yield  Rate Paid** |   | **Amount  Interest** |   |
| Interest Earning Assets:                        |   |                 |    |                     |   |                 |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Time deposits with other banks                  |   | $                    | 338     |                     | 3.85   | %                    | $      | 13 |   | $ | 169 |   | 2.96 | % | $ | 5 |   | $ | 661 |   | 1.97 | % | $ | 13 |   |
| Investment securities taxable                   |   | 9,415                |    | 5.58                     | %      | 525                  |   | 43,502 |   | 4.44 | % | 1,931 |   | 42,353 |   | 3.54 | % | 1,499 |   |
| Investment securities non-taxable               |   | 5,928                |    | 4.74                     | %      | 281                  |   | 6,358 |   | 4.72 | % | 300 |   | 10,129 |   | 4.48 | % | 454 |   |
| Federal funds sold                              |   | 10,162               |    | 3.56                     | %      | 362                  |   | 24,799 |   | 1.61 | % | 400 |   | 25,602 |   | 1.09 | % | 278 |   |
| Loans (1) (2)                                   |   | 145,757              |    | 9.11                     | %      | 13,280               |   | 173,861 |   | 7.71 | % | 13,399 |   | 226,707 |   | 7.03 | % | 15,930 |   |
|                                            |   |                 |    |                     |   |                 |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total interest earning assets                   |   | 171,600              |    | 8.43                     | %      | 14,461               |   | 248,689 |   | 6.45 | % | 16,035 |   | 305,452 |   | 5.95 | % | 18,174 |   |
|                                            |   |                 |    |                     |   |                 |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Allowance for possible loan losses              |   | (1,545               | )       |                     |   |                 |   | (2,088 | ) |   |   |   |   | (3,164 | ) |   |   |   |   |
| Non-earning assets:                             |   |                 |    |                     |   |                 |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Cash and due from banks                         |   | 14,031               |    |                     |   |                 |   | 18,588 |   |   |   |   |   | 22,750 |   |   |   |   |   |
| Property, premises and equipment                |   | 2,972                |    |                     |   |                 |   | 3,953 |   |   |   |   |   | 6,011 |   |   |   |   |   |
| Other assets                                    |   | 5,401                |    |                     |   |                 |   | 9,190 |   |   |   |   |   | 11,874 |   |   |   |   |   |
|                                            |   |                 |    |                     |   |                 |   |   |   |   |   |   |   |   |   |   |   |   |   |
| TOTAL ASSETS                                    |   | $                    | 192,459 |                     |   |                 |   |   | $ | 278,332 |   |   |   |   |   | $ | 342,923 |   |   |   |   |   |
|                                            |   |                 |    |                     |   |                 |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest -bearing liabilities:                  |   |                 |    |                     |   |                 |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Savings/NOW/money market                        |   | 66,562               |    | 1.45                     | %      | 964                  |   | 92,800 |   | 0.84 | % | 779 |   | 116,965 |   | 0.53 | % | 625 |   |
| Time deposits                                   |   | 49,037               |    | 4.82                     | %      | 2,365                |   | 46,453 |   | 2.77 | % | 1,286 |   | 51,049 |   | 2.21 | % | 1,126 |   |
| Other Borrowings                                |   | 1,496                |    | 6.75                     | %      | 101                  |   | 28,967 |   | 3.70 | % | 1,071 |   | 31,396 |   | 4.10 | % | 1,287 |   |
| Long Term Debt                                  |   | 0                    |    | 0.00                     | %      | 0                    |   | 6,000 |   | 5.92 | % | 355 |   | 8,000 |   | 5.31 | % | 425 |   |
|                                            |   |                 |    |                     |   |                 |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total interest-bearing liabilities              |   | 117,095              |    | 2.93                     | %      | 3,430                |   | 174,220 |   | 2.00 | % | 3,491 |   | 207,410 |   | 1.67 | % | 3,463 |   |
|                                            |   |                 |    |                     |   |                 |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Non-interest bearing liabilities:               |   |                 |    |                     |   |                 |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Demand deposits                                 |   | 58,350               |    |                     |   |                 |   | 84,702 |   |   |   |   |   | 109,349 |   |   |   |   |   |
| Other liabilities                               |   | 2,113                |    |                     |   |                 |   | 1,803 |   |   |   |   |   | 2,995 |   |   |   |   |   |
|                                            |   |                 |    |                     |   |                 |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total liabilities                               |   | 177,558              |    |                     |   |                 |   | 260,725 |   |   |   |   |   | 319,754 |   |   |   |   |   |
|                                            |   |                 |    |                     |   |                 |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Stockholders’ equity                       |   |                 |    |                     |   |                 |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Common stock                                    |   | 7,311                |    |                     |   |                 |   | 9,037 |   |   |   |   |   | 12,649 |   |   |   |   |   |
| Retained earnings                               |   | 7,615                |    |                     |   |                 |   | 8,437 |   |   |   |   |   | 10,143 |   |   |   |   |   |
| Valuation Allowance Investments                 |   | (25                  | )       |                     |   |                 |   | 133 |   |   |   |   |   | 377 |   |   |   |   |   |
|                                            |   |                 |    |                     |   |                 |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total stockholders’ equity                 |   | 14,901               |    |                     |   |                 |   | 17,607 |   |   |   |   |   | 23,169 |   |   |   |   |   |
|                                            |   |                 |    |                     |   |                 |   |   |   |   |   |   |   |   |   |   |   |   |   |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY |   | $                    | 192,459 |                     |   |                 |   |   | $ | 278,332 |   |   |   |   |   | $ | 342,923 |   |   |   |   |   |
|                                            |   |                 |    |                     |   |                 |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net Interest Income                             |   |                 |    |                     |   | $                    | 11,031 |   |   |   |   |   | $ | 12,544 |   |   |   |   |   | $ | 14,711 |   |
| Net Interest Margin (3)                         |   |                 |    | 6.43                     | %      |                 |   |   |   | 5.04 | % |   |   |   |   | 4.82 | % |   |   |
|                                                 |        |                      |         |                          |        |                      |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1)   Nonaccrual loans have been included in totalloans.

(2)   Loan fees of $609, $753 and $754 for 2001,2002 and 2003, respectively, have been included in the interest income computation.

(3)   Net interest income has been calculated bydividing the net interest income by total earning assets.

Note:All average balances have been computed using daily balances.

 

26

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**RATE/VOLUME ANALYSIS**

 
|                                 |   | **2001**             |   | **2002**          |   | **2003**  |   |
|--------------------------------------|--------|----------------------|--------|-------------------|--------|-----------|--------|
| **Increase (decrease) in:**          |   | **Average  Bal/Vol** |   | **Average  Rate** |   | **Total** |   | **Average  Bal/Vol** |   | **Average  Rate** |   | **Total** |   | **Average  Bal/Vol** |   | **Average  Rate** |   | **Total** |   |
|                                 |   |                 |   |              |   |      |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest income:                     |   |                 |   |              |   |      |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans (1)                            |   | $                    | 2,279  |              | $      | (1,699    | )      | $ | 580 |   | $ | 2,559 |   | $ | (2,441 | ) | $ | 118 |   | $ | 3,794 |   | $ | (1,263 | ) | $ | 2,531 |   |
| Investment securities taxable        |   | (107                 | )      | (88               | )      | (195      | )      | 1,898 |   | (492 | ) | 1,406 |   | (51 | ) | (381 | ) | (432 | ) |
| Investment securities non-taxable (2 |   | (8                   | )      | (17               | )      | (25       | )      | (11 | ) | 1 |   | (10 | ) | 270 |   | (36 | ) | 234 |   |
| Taxable equivalent adjustment (2):   |   | 4                    |   | 8                 |   | 12        |   | 31 |   | (2 | ) | 29 |   | (92 | ) | 12 |   | (80 | ) |
| Interest-bearing deposits            |   | 6                    |   | (1                | )      | 5         |   | (5 | ) | (2 | ) | (7 | ) | 15 |   | (7 | ) | 8 |   |
| Federal funds sold                   |   | 394                  |   | (279              | )      | 115       |   | 523 |   | (485 | ) | 38 |   | 13 |   | (135 | ) | (122 | ) |
| Total                                |   | 2,568                |   | (2,076            | )      | 492       |   | 4,995 |   | (3,421 | ) | 1,574 |   | 3,949 |   | (1,810 | ) | 2,139 |   |
|                                 |   |                 |   |              |   |      |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest expense:                    |   |                 |   |              |   |      |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Savings, now, money market           |   | 201                  |   | (614              | )      | (413      | )      | 381 |   | (566 | ) | (185 | ) | 203 |   | (357 | ) | (154 | ) |
| Time deposits                        |   | 174                  |   | (331              | )      | (157      | )      | (125 | ) | (954 | ) | (1,079 | ) | 128 |   | (288 | ) | (160 | ) |
| Other borrowings                     |   | (130                 | )      | —            |   | (130      | )      | 1,854 |   | (884 | ) | 970 |   | 88 |   | 128 |   | 216 |   |
| Long term borrowings                 |   | —               |   | —            |   | —    |   | — |   | 355 |   | 355 |   | 119 |   | (49 | ) | 70 |   |
| Total                                |   | 245                  |   | (945              | )      | (700      | )      | 2,110 |   | (2,049 | ) | 61 |   | 538 |   | (566 | ) | (28 | ) |
|                                 |   |                 |   |              |   |      |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Increase (decrease) in net           |   |                 |   |              |   |      |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest income                      |   | $                    | 2,323  |              | $      | (1,131    | )      | $ | 1,192 |   | $ | 2,885 |   | $ | (1,372 | ) | $ | 1,513 |   | $ | 3,411 |   | $ | (1,244 | ) | $ | 2,167 |   |

 

----

(1) Loan fees of $609, $753and $754 for 2001, 2002 and 2003, respectively have been included in theinterest income computation.

(2) Adjusted to a fullytaxable equivalent basis using a tax rate of 34%.

 

Note A: Average balances ofall categories in each period were included in the volume computations.

Note B: Average yield ratesin each period were used in rate computations. Change attributable to bothvolume and rate have been allocated in proportion to the relationship betweentheir absolute dollar amounts.

 

The hypothetical impacts of sudden interest rate movements applied tothe Company’s asset and liability balances are modeled monthly. The results ofthis movement indicate how much of the Company’s net interest income is “atrisk” from various rate changes over a one year horizon. This exercise isvaluable in identifying risk exposures. The results for the Company’s December31, 2003 balances indicate that the net interest income at risk over a one yeartime horizon from a 1% and 2% rate movement are within the Company’s policyguidelines for such changes.

 
|                          |   | **Rates Down  2%** |   | **Rates Down  1%** |   | **Rates Up  1%** |   | **Rates Up  2%** |   |
|-------------------------------|--------|--------------------|--------|--------------------|--------|------------------|--------|------------------|--------|
| Change in Net Interest Income |   | (10.25             | )%     | (6.59              | )%     | 7.47             | %      | 15.30            | %      |

 

It is important to note that the above table is a summary of severalforecasts and actual results may vary. The forecasts are based on estimates andassumptions of management that may turn out to be different and may change overtime. Factors effecting these estimates and assumptions include, but are notlimited to 1) competitor behavior,    2)economic conditions both locally and nationally, 3) actions taken by theFederal Reserve Board, 4) customer behavior and 5) management’s responses.  Changes that vary significantly from theassumptions and estimates may have significant effects on the Company’s netinterest income. Therefore, the results of this analysis should not be reliedupon as indicative of actual future results.

 

Non-Interest Income

 

The table below sets forth changes from 2002 to 2003 for non-interestincome.

 
| **(amount in thousands)  Fees and Other Income** |   | **2002** |   | **2003** |   | **$****Variance** |   | **%****Variance** |   |
|--------------------------------------------------|--------|----------|--------|----------|--------|-------------------|--------|-------------------|--------|
| Service Charges on Deposit Accounts              |   | $        | 1,433  |     | $      | 1,723             |   | $                 | 290    |   | 20.2 | % |
| ATM/Debit Card Transaction/Interchange Fees      |   | 494      |   | 406      |   | (88               | )      | -17.8             | %      |
| Bankcard Merchant Fees                           |   | 123      |   | 100      |   | (23               | )      | -18.7             | %      |
| Mortgage Broker Fees                             |   | 767      |   | 880      |   | 113               |   | 14.7              | %      |
| Earnings on Cash Surrender Value Life Ins        |   | 304      |   | 264      |   |              |   |              |   |
| Other                                            |   | 342      |   | 364      |   | 22                |   | 6.4               | %      |
|                                             |   |     |   |     |   |              |   |              |   |
|                                             | Total  |     | $      | 3,463    |   | $                 | 3,737  |              | $      | 274 |   | 7.9% |   |
|                                                  |        |          |        |          |        |                   |        |                   |        |  |  |  |  |

 

27

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Increases in Service Charges on Deposit Accounts are the direct effectof deposit growth in 2003.

 

The decrease in ATM/Debit Card related fees was impacted by thecessation of off-site ATMs in 2002 that generated $128 thousand in revenue thatyear. The offset to this was a decrease in processing expense of approximately$89 thousand the same year. Bancard Merchant Fees decreased due to thescheduled change in compensation as the result of Heritage selling its bancardportfolio in 1999. Pursuant to the sales agreement, compensation provisionscalled for certain basis points payment based on gross sales. In September2002, the basis points paid to Heritage were reduced.

 

Mortgage Broker Fees increased due to the robust refinancing andpurchase markets in the first half of 2003. This activity waned during thesecond half of the year due to rising long term rates that have a direct impactto mortgage rates. Management reports that during the first two months of 2004,the mortgage origination pipeline has begun to increase due, once again, tolong term rates coming down. Management is very aware that the revenuegenerated by this line of business is impacted by rate volatility and that in arising rate environment there will be a decrease in activity. To mitigatematerial decreases in net revenue from this line of business, Management hastaken steps to ensure that fixed costs are minimal due to commission basedremuneration. In addition, the Company has been positioning itself throughout2002 and 2003 for future market penetration with sales representation in allmarkets that it services. A concerted marketing effort is in place to capturemore of the mortgage origination business in the Company’s primary market areaeven in a rising rate environment.

 

Non-Interest Expenses

 

The table below sets forth changes from 2002 to 2003 for non-interestexpense.

 
| **(amount in thousands)**                     |   | **2002** |   | **2003** |   | **$****Variance** |   | **%****Variance** |   |
|-----------------------------------------------|--------|----------|--------|----------|--------|-------------------|--------|-------------------|--------|
| Other Expenses                                |   |     |   |     |   |              |   |              |   |
| Salaries and Employee Benefits                |   | $        | 5,386  |     | $      | 6,498             |   | $                 | 1,112  |   | 20.6 | % |
| Occupany and Equipment                        |   | 1,666    |   | 1,757    |   | 91                |   | 5.5               | %      |
| Data Processing                               |   | 1,416    |   | 1,581    |   | 165               |   | 11.7              | %      |
| Advertising and promotional                   |   | 380      |   | 361      |   | (19               | )      | -5.0              | %      |
| Regulatory fees                               |   | 62       |   | 86       |   | 24                |   | 38.7              | %      |
| Other professional fees and outside  services |   | 416      |   | 432      |   | 16                |   | 3.8               | %      |
| Legal fees and other litigation expense       |   | 106      |   | 52       |   | (54               | )      | -50.9             | %      |
| Loan Department Costs                         |   | 204      |   | 255      |   | 51                |   | 25.0              | %      |
| Stationery and supplies                       |   | 231      |   | 249      |   | 18                |   | 7.8               | %      |
| Director fees                                 |   | 165      |   | 152      |   | (13               | )      | -7.9              | %      |
| ATM costs at gaming sites                     |   | 89       |   | 0        |   | (89               | )      | -100.0            | %      |
| Other                                         |   | 953      |   | 1,002    |   | 49                |   | 5.1               | %      |
|                                          |   |     |   |     |   |              |   |              |   |
|                                          | Total  |     | $      | 11,074   |   | $                 | 12,425 |              | $      | 1,351 |   | 12.2 | % |
|                                               |        |          |        |          |        |                   |        |                   |        |  |  |  |  |

 

Salary/Related Expense

 

Salaries and employee related expense incurred the greatest dollarincrease of any non-interest expense category during 2003. Full time equivalent(FTE) employees increased from 118 at December 31, 2002 to 164 at December 31,2003. The acquisition of Hacienda accounted for 30 FTE while Heritage increasedby 16 FTE. Of the 16 that were added for Heritage, 4 were in the MortgageOrigination Department (3 of whom are commission based employees), 7 for thenewly expanded Woodland Branch Office facility and the remaining 5 were due togeneral growth. Nearly $253 thousand of the increase in 2003 is the result oftwo months salary/related cost for Hacienda.

 

There has been much media attention related to the cost of doingbusiness in the State of California. Workers Compensation Insurance costs for the Company tripled on therenewal date in July 2003 from approximately $75 thousand per year to $220thousand per year. Some of the increase was due to an expanding payroll,however, not to the extent that the premium increased. California legislatorsare currently working on changes to workers compensation insurance that wouldaddress the large premium increases experienced in 2003.

 

Another area that increasedin 2003 was in regard to incentive based pay. “Pay for performance” is asignificant part of

 

28

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the Company’s CorporateCulture and has served the Company well to provide above average return to theshareholders. All employees participate either on a monthly, quarterly orannual basis. Expense for all bonus based compensation increased by $196thousand in 2003 compared to 2002.  Grouphealth benefit costs increased by approximately $110 thousand in 2003 comparedto 2002.

 

Data Processing Expense

 

The increase in dataprocessing expense of $165 thousand was due to overall customer growth and theinclusion of Hacienda’s data processing expense of $103 thousand for the last twomonths of the year.

 

Provision for Income Taxes

 

The provision for incometaxes was 37.6% and 37.1% of net pre-tax income for years ended December 31,2002 and 2003, respectively.

 

Provision and Allowance forCredit Losses

 

An allowance for loan losseshas been established by management to provide for those loans that may not berepaid in their entirety for a variety of reasons. The allowance is maintainedat a level considered by management to be adequate to provide for probableincurred losses. The allowance is increased by provisions charged to earningsand is reduced by charge-offs, net of recoveries. The provision for loan lossesis based upon past loan loss experience and management’s evaluation of the loanportfolio under current economic conditions. Loans are charged to the allowancefor loan losses when, and to the extent, they are deemed by management to beun-collectible. The allowance for loan losses is composed of allocations forspecific loans and a historical portion for all other loans.

 

The Banks recognize thatcredit losses will be experienced and the risk of loss will vary with, amongother things, general economic conditions; the type of loan being made; thecreditworthiness of the borrower over the term of the loan and in the case of acollateralized loan, the quality of the collateral for such loan. The allowancefor loan loss represents the Banks’ estimate of the allowance necessary toprovide for probable incurred losses in the portfolio. In making thisdetermination, the Banks analyze the ultimate collectibility of the loans inthe portfolios by incorporating feedback provided by internal loan staff, anindependent loan review function, and information provided by examinationsperformed by regulatory agencies. The Banks make monthly evaluations as to theadequacy of the allowance for loan losses.

 

The analysis of theallowance for loan losses is comprised of three components; specific creditallocation; general portfolio allocation; and subjectively by determinedallocation. Effective January 1, 1995 and November 1, 2003, Heritage andHacienda, respectively, adopted Statement of Financial Accounting StandardsNo.114, Accounting by Creditors for Impairment of a Loan (SFAS 114), as amendedby SFAS No. 118, Accounting by Creditors for Impairment of a Loan - IncomeRecognition and Disclosures. These pronouncements provide that when it isprobable that a creditor will be unable to collect all amounts due inaccordance with the terms of the loan that such loan is deemed impaired.Impaired loans are accounted for differently in that the amount of theimpairment is measured and reflected in the records of the creditor. Theallowance for credit losses related to loans that are identified for evaluationin accordance with Statement 114 is based on discounted cash flows using theloan’s initial effective interest rate or the fair value of the collateral forcertain collateral dependent loans. The general portfolio allocation consistsof an assigned reserve percentage based on the credit rating of the loan. Thesubjective portion is determined based on loan history and the Banks’evaluation of various factors including current economic conditions and trendsin the portfolio including delinquencies and impairment, as well as changes inthe composition of the portfolio.

 

The allowance for loanlosses is based on estimate, and ultimate losses will vary from currentestimates. These estimates are reviewed monthly by each of the Banks’respective Director’s Loan Committee and full Board of Directors, and as adjustments,either positive or negative, become necessary, a corresponding increase ordecrease is made in the provision for loan losses. The methodology used todetermine the adequacy of the allowance for possible loan losses for the year2003 is consistent with prior periods.

 

Heritage’s provision forloan losses was $350 thousand for 2003 compared to $545 thousand for 2002.Hacienda added $20 thousand in 2003. Net loan charge-offs (loans charged off,net of loans recovered) were $233 thousand in 2003 and ($47 thousand) during2002, respectively. The allowance for credit losses as a percent of total grossloans at year-end 2002 and 2001 was 1.10% and 1.23%, respectively.

 

Loans are placed onnon-accrual when a loan is specifically determined to be impaired or whenprincipal or interest is delinquent for 90 days or more. Any unpaid interestpreviously accrued on those loans is reversed from income. Interest incomegenerally is not recognized on specific impaired loans unless the likelihood offurther loss is remote.

 

29

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Interest payments received on such loans are applied as a reduction onthe loan principal balance.

 

Loans on non-accrual statustotaled $1.5 million and $1.3 million at December 31, 2003 and 2002,respectively.   All non-accrual loansare in Heritage and there were no non-accrual loans in Hacienda at December 31,2003. Typically, these loans have adequate collateral protection and/orpersonal guaranties to provide a source of repayment to Heritage. Most of theloans on non-accrual are related to several commercial loans that are beingaddressed by specific workout plans at this time. Interest income that wouldhave been recognized on non-accrual loans if they had performed in accordancewith the terms of the loans was approximately $135 thousand and $132 thousandfor the period ended December 31, 2002 and 2003, respectively.

 

Non-performing loans includenon-accrual loans and accruing loans that are 90 days or more delinquent. TheBanks had $21 thousand in loans that were 90 days or more delinquent and stillaccruing interest at December 31, 2003 and none at December 31, 2002.

 

The following tablesummarized the analysis of the allowance for loan losses as of December 31,1999, 2000, 2001, 2002 and 2003:

 

**Analysisof Allowance for Loan Losses(in thousands)**

 
|                                                                   |   | **1999** |    | **2000** | ** ** | **2001** | ** ** | **2002** | ** ** | **2003** | ** ** |
|------------------------------------------------------------------------|--------|----------|---------|----------|------------|----------|------------|----------|------------|----------|------------|
| Balance at Beginning of Period                                         |   | $        | 1,070   |     | $          | 1,241    |       | $        | 1,321      |     | $          | 1,744 |   | $ | 2,336 |   |
| Balance of Hacienda Bank at Beginning of  Period                       |   |     |    |     |       | —   |       | —   |       | 597      |       |
| Charge-offs:                                                           |   |     |    |     |       |     |       |     |       |     |       |
| Commercial, Fianacial and Agricultural                                 |   | 8        |    | 454      |       | 156      |       | 76       |       | 463      |       |
| Real Estate- Construction                                              |   | —   |    | —   |       | —   |       | —   |       | —   |       |
| Real Estate-Mortgage                                                   |   | —   |    | —   |       | —   |       | —   |       | —   |       |
| Installment Loans to Individuals:                                      |   |     |    | 4        |       | 22       |       | —   |       | —   |       |
| Money Plus                                                             |   | 6        |    | 1        |       | 3        |       | 5        |       | 3        |       |
| Credit Cards                                                           |   | —   |    | —   |       | —   |       | —   |       | —   |       |
| Other Installment                                                      |   | —   |    | —   |       | —   |       | —   |       | —   |       |
| Total charge-offs                                                      |   | 14       |    | 459      |       | 181      |       | 81       |       | 466      |       |
|                                                                   |   |     |    |     |       |     |       |     |       |     |       |
| Recoveries:                                                            |   |     |    |     |       |     |       |     |       |     |       |
| Commercial, Fianacial and Agricultural                                 |   | 19       |    | 17       |       | —   |       | 127      |       | 232      |       |
| Real Estate- Construction                                              |   | —   |    | —   |       | —   |       | —   |       | —   |       |
| Real Estate-Mortgage                                                   |   | —   |    | —   |       | —   |       | —   |       | —   |       |
| Installment Loans to Individuals:                                      |   | —   |    | 1        |       | 2        |       | —   |       | 1        |       |
| Money Plus                                                             |   | —   |    | 2        |       | 2        |       | 1        |       | —   |       |
| Credit Cards                                                           |   | —   |    | —   |       | —   |       | —   |       | —   |       |
| Other Installment                                                      |   | 1        |    | —   |       | —   |       | —   |       | —   |       |
| Total recoveries                                                       |   | 20       |    | 20       |       | 4        |       | 128      |       | 233      |       |
| Net Charge-offs                                                        |   | (6       | )       | 439      |       | 177      |       | (47      | )          | 233      |       |
| Additions Charged to Operations                                        |   | 165      |    | 519      |       | 600      |       | 545      |       | 370      |       |
| Balance at End of Period                                               |   | 1,241    |    | 1,321    |       | 1,744    |       | 2,336    |       | 3,070    |       |
|                                                                   |   |     |    |     |       |     |       |     |       |     |       |
| Gross Loans at End of Period                                           |   | $        | 104,153 |     | $          | 135,488  |       | $        | 158,472    |     | $          | 190,469 |   | $ | 278,135 |   |
|                                                                   |   |     |    |     |       |     |       |     |       |     |       |
| Ratio of Net Charge-offs During the Year to  Average Loans outstanding |   | 0.01     | %       | 0.44     | %          | 0.12     | %          | -0.03    | %          | 0.10     | %          |
|                                                                   |   |     |    |     |       |     |       |     |       |     |       |
| Ratio of Reserves to Gross Loans                                       |   | 1.19     | %       | 0.97     | %          | 1.10     | %          | 1.23     | %          | 1.10     | %          |
|                                                                   |   |     |    |     |       |     |       |     |       |     |       |
| Ratio of Non-performing Loans to the  Allowance for Credit Losses      |   | 72.91    | %       | 75.01    | %          | 85.70    | %          | 57.62    | %          | 50.20    | %          |

 

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**Allocation of the Allowance forLoan Losses**

 
|                                   |   | **1999**   |   | **2000**           |   | **2001**   |   | **2002**           |   | **2003**   |   |
|----------------------------------------|--------|------------|--------|--------------------|--------|------------|--------|--------------------|--------|------------|--------|
|                                   |   | **Amount** |   | **% Total  Loans** |   | **Amount** |   | **% Total  Loans** |   | **Amount** |   | **% Total  Loans** |   | **Amount** |   | **% Total  Loans** |   | **Amount** |   | **% Total  Loans** |   |
| Commercial, Fianacial and Agricultural |   | $          | 458    |               | 37     | %          | $      | 418                |   | 32         | %      | $ | 447 |   | 26 | % | $ | 495 |   | 21 | % | $ | 541 |   | 18 | % |
|                                   |   |       |   |               |   |       |   |               |   |       |   |   |   |   |   |   |   |   |   |   |   |
| Real Estate- Construction              |   | 152        |   | 12                 | %      | 181        |   | 14                 | %      | 258        |   | 15 | % | 499 |   | 21 | % | 527 |   | 17 | % |
|                                   |   |       |   |               |   |       |   |               |   |       |   |   |   |   |   |   |   |   |   |   |   |
| Real Estate-Mortgage                   |   | 597        |   | 48                 | %      | 688        |   | 52                 | %      | 1,000      |   | 57 | % | 1,310 |   | 56 | % | 1,941 |   | 63 | % |
|                                   |   |       |   |               |   |       |   |               |   |       |   |   |   |   |   |   |   |   |   |   |   |
| Installment Loans to Individuals       |   | 33         |   | 3                  | %      | 31         |   | 2                  | %      | 35         |   | 2 | % | 28 |   | 1 | % | 57 |   | 2 | % |
|                                   |   |       |   |               |   |       |   |               |   |       |   |   |   |   |   |   |   |   |   |   |   |
| All Other Loans (including overdrafts) |   | 1          |   | 0                  | %      | 2          |   | 0                  | %      | 5          |   | 0 | % | 3 |   | 0 | % | 4 |   | 0 | % |
|                                   |   |       |   |               |   |       |   |               |   |       |   |   |   |   |   |   |   |   |   |   |   |
| Total                                  |   | $          | 1,241  |               | 100    | %          | $      | 1,320              |   | 100        | %      | $ | 1,744 |   | 100 | % | $ | 2,336 |   | 100 | % | $ | 3,070 |   | 100 | % |

 

Local Economy

 

The economy in the Company’sservice area is based primarily on agriculture, tourism, light industry, oiland retail trade. Services supporting these industries have also developed inthe areas of medical, financial and educational. The population in the twocounty areas comprising the Company’s service area, according to the U.S.Bureau of the Census, was estimated at July 2001 to be approximately655,600. San Luis Obispo County represents about 38% of this total with SantaBarbara County accounting for the remaining approximately 62%. The moderateclimate allows a year round growing season for numerous vegetable and fruits. Vineyardsand cattle 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.

 

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

 

Heritage recognized in 2000that there would be over capacity in the production of wine grapes in ourmarket area. As a result, efforts were made to move a significant portion ofthe vineyard development loan portfolio out of Heritage and into the governmentsponsored Farmer Mac program. Because of these actions on the part of Heritage,it is the opinion of Management that there would not be any negative impactfrom the current state of the wine grape industry.

 

On December 22, 2003, a6.5 magnitude earthquake rocked the Central Coast. The earthquake was centeredin San Simeon, an area approximately 20 miles west of Paso Robles where theCompany is headquartered. There was the tragic loss of two lives in PasoRobles. The greatest amount of property damage was centered in downtown PasoRobles. The Company did not sustain any structural damage to its facilities andthere were no injuries to any employees or their families. City officialsreacted quickly and obtained disaster status from state and federal agencies.Business’ in the downtown area experienced a moderate decline in activity,however, the area has already begun to rebuild and things are getting back tonormal. Within days after the earthquake, the Company performed an assessmentas to any financial impact it could expect regarding effect to customers andtheir ability to repay any outstanding debt. The assessment revealed that therewas no material impact to the Company.

 

FINANCIAL CONDITION ANALYSIS

 

Total assets of the Companywere $441.9 million at December 31, 2003 compared to $337.5 million atDecember 31, 2002. This represents an increase of $104.4 million or 31%.The acquisition of Hacienda on October 31, 2003 accounted forapproximately $90 million of the growth in total assets. Without theacquisition, the Company’s growth in total assets was 4.3%. There are severalfactors that impacted the seemingly anemic growth. In February 2003,Heritage repaid some of the FHLB borrowing that created an immediate decreasein total assets of $9.5 million. In addition, Heritage has three volatiledeposit relationships with companies in the mortgage origination industry. Thedeposit balances in these collective relationships decreased by $6.8 millionfrom December 31, 2002 to December 31,

 

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2003. (Refer to “Depositsand Borrowed Funds” contained within this section.)

 

Loans

 

A significant portion oftotal assets is the Company’s gross loans that were $278.1million and $190.5million at December 31, 2003 and 2002, respectively.  Approximately 30% of gross loans atDecember 31, 2003 are adjustable rate loans compared to 43% atDecember 31, 2002. The decrease in the percentage of adjustable rate loansis attributed to the nature of recently funded real estate secured loans, inthat many have a term of ten to fifteen years with a rate that is fixed for twoto three years then adjusts with the movement of prime or other indices. Ifinterest rates change, the yield on these loans and other loans renewing duringthe one-year time frame will also change. The Company has an Asset/LiabilityManagement system that models various interest rate environments for all ratesensitive assets and liabilities.  In a100 basis point increase action by the FRB, the model indicate that the netinterest income would increase by approximately $1.4 million while a 100 basispoint decline would decrease net interest income by $1.2 million.

 

The table below sets forththe composition of the loan portfolio as of December 31, 1999, 2000, 2001,2002 and 2003.

 

**COMPOSITION OF LOAN PORTFOLIO**

(in thousands)

 
|                                   |   | **1999**   |    | **2000**    |   | **2001**   |   | **2002**    |   | **2003**   |   |
|----------------------------------------|--------|------------|---------|-------------|--------|------------|--------|-------------|--------|------------|--------|
|                                   |   | **Amount** |    | **Percent** |   | **Amount** |   | **Percent** |   | **Amount** |   | **Percent** |   | **Amount** |   | **Percent** |   | **Amount** |   | **Percent** |   |
| Commercial, Financial and Agricultural |   | $          | 38,420  |        | 36.89  | %          | $      | 42,931      |   | 31.69      | %      | $ | 40,608 |   | 25.62 | % | $ | 40,373 |   | 21.20 | % | $ | 49,024 |   | 17.63 | % |
|                                   |   |       |    |        |   |       |   |        |   |       |   |   |   |   |   |   |   |   |   |   |   |
| Real Estate- Construction              |   | 12,741     |    | 12.23       | %      | 18,599     |   | 13.73       | %      | 23,449     |   | 14.80 | % | 40,723 |   | 21.38 | % | 47,720 |   | 17.16 | % |
|                                   |   |       |    |        |   |       |   |        |   |       |   |   |   |   |   |   |   |   |   |   |   |
| Real Estate-Mortgage                   |   | 50,064     |    | 48.07       | %      | 70,551     |   | 52.07       | %      | 90,824     |   | 57.31 | % | 106,810 |   | 56.08 | % | 175,880 |   | 63.24 | % |
|                                   |   |       |    |        |   |       |   |        |   |       |   |   |   |   |   |   |   |   |   |   |   |
| Installment Loans to Individuals       |   | 2,786      |    | 2.67        | %      | 3,246      |   | 2.40        | %      | 3,172      |   | 2.00 | % | 2,291 |   | 1.20 | % | 5,173 |   | 1.86 | % |
|                                   |   |       |    |        |   |       |   |        |   |       |   |   |   |   |   |   |   |   |   |   |   |
| All Other Loans (including overdrafts) |   | 142        |    | 0.14        | %      | 161        |   | 0.12        | %      | 419        |   | 0.26 | % | 272 |   | 0.14 | % | 338 |   | 0.12 | % |
|                                   |   |       |    |        |   |       |   |        |   |       |   |   |   |   |   |   |   |   |   |   |   |
| Total Loans, Gross                     |   | 104,153    |    | 100.00      | %      | 135,488    |   | 100.00      | %      | 158,472    |   | 100.00 | % | 190,469 |   | 100.00 | % | 278,135 |   | 100.00 | % |
|                                   |   |       |    |        |   |       |   |        |   |       |   |   |   |   |   |   |   |   |   |   |   |
| Deferred Loan Fees                     |   | (486       | )       |        |   | (487       | )      |        |   | (578       | )      |   |   | (822 | ) |   |   | (1,014 | ) |   |   |
| Reserve for Possible Loan Losses       |   | (1,241     | )       |        |   | (1,321     | )      |        |   | (1,744     | )      |   |   | (2,336 | ) |   |   | (3,070 | ) |   |   |
|                                   |   |       |    |        |   |       |   |        |   |       |   |   |   |   |   |   |   |   |   |   |   |
| Total Loans, Net                       |   | $          | 102,426 |        |   |       | $      | 133,680     |   |       |   | $ | 156,150 |   |   |   | $ | 187,311 |   |   |   | $ | 274,051 |   |   |   |
|                                   |   |       |    |        |   |       |   |        |   |       |   |   |   |   |   |   |   |   |   |   |   |
| Loans Held For Sale                    |   | $          | 120     |        |   |       | $      | 2,475       |   |       |   | $ | 4,082 |   |   |   | $ | 8,166 |   |   |   | $ | 4,402 |   |   |   |

 

The following table setsforth changes from 2002 to 2003 for the loan portfolio categories.

 
| **(in thousands)**                     |   | **2002** |    | **2003** |   | **$ Variance** |   | **% Variance** |   | **Hacienda** |       |
|----------------------------------------|--------|----------|---------|----------|--------|----------------|--------|----------------|--------|--------------|------------|
| Commercial, Financial and Agricultural |   | $        | 40,373  |     | $      | 49,024         |   | $              | 8,651  |         | 21.43      | % | **$** | **12,314** | ** ** |
|                                   |   |     |    |     |   |           |   |           |   |         |       |
| Real Estate- Construction              |   | 40,723   |    | 47,720   |   | 6,997          |   | 17.18          | %      | **8,577**    | ** ** |
|                                   |   |     |    |     |   |           |   |           |   |         |       |
| Real Estate-Mortgage                   |   | 106,810  |    | 175,880  |   | 69,070         |   | 64.67          | %      | **27,146**   | ** ** |
|                                   |   |     |    |     |   |           |   |           |   |         |       |
| Installment Loans to Individuals       |   | 2,291    |    | 5,173    |   | 2,882          |   | 125.80         | %      | **3,372**    | ** ** |
|                                   |   |     |    |     |   |           |   |           |   |         |       |
| All Other Loans (including overdrafts) |   | 272      |    | 338      |   | 66             |   | 24.26          | %      | **157**      | ** ** |
|                                   |   |     |    |     |   |           |   |           |   |         |       |
| Total Loans, Gross                     |   | 190,469  |    | 278,135  |   | 87,666         |   | 46.03          | %      | **51,566**   | ** ** |
|                                   |   |     |    |     |   |           |   |           |   |         |       |
| Deferred Loan Fees                     |   | (822     | )       | (1,014   | )      | (192           | )      | 23.36          | %      | **(143**     | **)**      |
| Reserve for Possible Loan Losses       |   | (2,336   | )       | (3,070   | )      | (734           | )      | 31.42          | %      | **(615**     | **)**      |
|                                   |   |     |    |     |   |           |   |           |   |         |       |
| Total Loans, Net                       |   | $        | 187,311 |     | $      | 274,051        |   | $              | 86,740 |         | 46.31      | % | **$** | **50,808** | ** ** |
|                                   |   |     |    |     |   |           |   |           |   |         |       |
| Loans Held For Sale                    |   | $        | 8,166   |     | $      | 4,402          |   | $              | (3,764 | )            | -46.09     | % | **$** | **—** | ** ** |

 

When discussing the changesto the loan portfolio for 2003, Management believes that it is helpful to showthe impact of the Hacienda acquisition (noted above in the column titled“Hacienda”) at December 31, 2003.

 

The increase in commercial,financial and agricultural loans is attributed primarily to the addition of theHacienda loans in 2003.  Several largeagricultural loans at Heritage were paid off in 2003 through refinance atanother

 

32

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agricultural lender at lowerrates.  The Farmer Mac program was alsoused to payoff several other agricultural loans during the year. The Farmer Macprogram is a long-term mortgage product that offers low interest rates onproducing agricultural real estate. Demand for this product has slowed considerably but it is still a goodsource to payoff our development loans and also to finance homes on acreage.

 

The increase in realestate-construction loans can be attributed to several large new constructionprojects and to the addition of Hacienda loans.  New loans include a beach front residence for $2.75 million; atrack development for $5.6 million; an office/ vacation rental for $2.7 millionand numerous $.5 to $1 million loans. Several construction loans paid off during 2003 as borrowers refinancedthrough mortgage brokers and out of the area lenders. Construction loans aretypically granted for a one year period and then, with income properties, areamortized over not more than 25 years with 10 to 15 year maturities.

 

The large increase in realestate-mortgage loans is attributed to several of the construction loans movinginto amortizing loans, two new large hotel loans, numerous new commercialproperty loans including a office building for $4 million, a mixed use (office,restaurant) for $3.3 million, a light industrial for $2 million and stripcenter for $1.8 million.  The Haciendaloans also contributed a substantial amount to the category.

 

The Bank presently has aconcentration of loans in construction/land and hotels in the amount of $40.4million and $36.1 million, respectively. The construction/land loans are spreadthroughout our market area and have consistently performed in a satisfactorymanner.  The hotel loans are also madeto clients throughout our market.  Theseloans have also typically paid as agreed. Heritage presently has one out of thearea hotel participation loan that is in default and could result inforeclosure.  This loan in the amount of$1 million is on non-accrual status and the balance represents 2.6% of allhotel loans for the Company.

 

Loans held for sale consistof mortgage originations that have already been sold pursuant to CorrespondentMortgage Loan Agreements. There is no interest rate risk associated with theseloans as the commitments are in place at the time that the Banks fund them.Settlement from the correspondents is typically within 30 to 45 days.

 

At December 31, 2003,the Banks had no foreign loans outstanding. The Banks did not have any concentrations of loans except as disclosedabove.

 

The Banks’ management isresponsible for monitoring loan performance that is done through variousmethods, including a review of loan delinquencies and personal knowledge ofcustomers.  Additionally, the Banks,maintain both a “watch” list of loans that, for a variety of reasons,management believes requires regular review as well as an internal loanclassification process. Semi-annually, the loan portfolio is also reviewed byan experienced, outside loan reviewer not affiliated with the Banks.  A list of delinquencies, the watch list,loan grades and the outside loan review are reviewed regularly by each Banks’Boards of Directors.  Except as setforth in the preceding table, there are no loans which management has seriousdoubts as to the borrower’s ability to comply with present loan repaymentterms.

 

The Banks have a non-accrualpolicy that requires a loan greater than 90 days past due to be placed onnon-accrual status unless such loan is well-collateralized and in the processof collection.  When loans are placed onnon-accrual status, all uncollected interest accrued is reversed fromearnings.  Once on non-accrual status,interest on a loan is only recognized on a cash basis.  Loans may be returned to accrual status ifmanagement believes that all remaining principal and interest is fullycollectible and there has been at least six months of sustained repaymentperformance since the loan was placed on non-accrual.

 

If a loans credit qualitydeteriorates to the point that collection of principal is believed bymanagement to be doubtful and the value of collateral securing the obligationis sufficient the Banks generally take steps to protect and liquidate thecollateral.  Any loss resulting from thedifference between the loan balance and the fair market value of the propertyis recognized by a charge to the reserve for loan losses.  When the property is held for sale afterforeclosure, it is subject to a periodic appraisal.  If the appraisal indicates that the property will sell for lessthan its recorded value, Heritage recognizes the loss by a charge to non-interestexpense.

 

Total Cash and Due fromBanks

 

Total cash and due frombanks were $40.4 million and $23.5 million at December 31, 2003 and 2002,respectively.  This line item will varydepending on cash letters from the previous night and actual cash on hand inthe branches. Cash letter balances were approximately $17 million and balanceswith FRB were approximately $16.7 million to meet the target for ReserveRequirements.

 

33

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Investment Securities andOther Earning Assets

 

Other earning assets arecomprised of Federal Home Loan Bank and FRB stock, Federal Funds sold (fundslent on a short-term basis to other banks), investments in securities andshort-term interest bearing deposits at other financial institutions.  These assets are maintained for liquidityneeds of the Banks, collateralization of public deposits, and diversificationof the earning asset mix.

 

**COMPOSITION OF OTHER EARNINGASSETS**

(in thousands)

 
|                                        |   | **2001**   |   | **2002**    |   | **2003**   |   |
|---------------------------------------------|--------|------------|--------|-------------|--------|------------|--------|
|                                        |   | **Amount** |   | **Percent** |   | **Amount** |   | **Percent** |   | **Amount** |   | **Percent** |   |
| Federal Home Loan Bank, FRB and other stock |   | $          | 228    |        | 1      | %          | $      | 1,951 |   | 2 | % | $ | 1,959 |   | 2 | % |
|                                        |   |       |   |        |   |       |   |   |   |   |   |   |   |
| Available-for-Sale Investments              |   | 22,029     |   | 78          | %      | 65,396     |   | 62 | % | 54,956 |   | 58 | % |
|                                        |   |       |   |        |   |       |   |   |   |   |   |   |   |
| Federal Funds Sold                          |   | 6,000      |   | 21          | %      | 37,040     |   | 35 | % | 36,740 |   | 39 | % |
|                                        |   |       |   |        |   |       |   |   |   |   |   |   |   |
| Interest Bearing Deposits other fin inst.   |   | 99         |   | 0           | %      | 497        |   | 0 | % | 498 |   | 1 | % |
|                                        |   |       |   |        |   |       |   |   |   |   |   |   |   |
| Total Other Earning Assets                  |   | $          | 28,356 |        | 100    | %          | $      | 104,884 |   | 100 | % | $ | 94,153 |   | 100 | % |

 

The Company manages itssecurities portfolio to provide a source of both liquidity and earnings. TheBanks have an asset/liability committee that develops current investmentpolicies based upon its operating needs and market circumstance. The Banks’investment policies are formally reviewed and approved annually by therespective board of directors. The asset/liability committees of the Banks areresponsible for reporting and monitoring compliance with the investment policy.Reports are provided to Banks’ boards of directors on a regular basis.

 

Securitiesavailable-for-sale are carried at fair value, with related unrealized net gainsor losses, net of deferred income taxes, recorded as an adjustment to equitycapital. As of December 31, 2003, net unrealized gains in the portfoliowere $98 thousand compared to $562 thousand at December 31, 2002. Theportfolio decreased in size and value due to lower interest rates on long terminstruments that caused accelerated pre-payment speeds in Mortgage BackedSecurities (MBS) and Collateralized Mortgage Obligations (CMOs). As cash flowscome into the Banks in the form of accelerated pre-payments, they are beingused predominantly to fund loan demand.

 

In April 2002, Heritageimplemented an investment strategy whereby it borrowed $38 million from theFederal Home Loan Bank (FHLB) and purchased approximately $40 million ininvestment securities. The purchased investment securities serve as collateralfor the borrowing. Heritage made this decision knowing that it would improvethe return on average equity by increasing the net interest income in absoluteterms even though it would reduce the return on average assets and the netinterest margin as a percentage. Prior to investing, Heritage performedextensive due diligence in assessing the interest rate and market value risk ofthis strategy including the performance in various interest rate scenarios ofup and down 100, 200 and 300 basis points. In regard to this strategy,Management believes that 300 basis points variance would not have a materialeffect on the overall interest rate and market value risk to the Company.Nearly two years later, this has proven to be a conservatively successfulstrategy.

 

At December 31, 2003,available-for-sale securities in the portfolio included obligations of stateand political subdivisions, obligations of US government agencies andcorporations and mortgaged backed securities issued by various agencies.

 

All fixed and adjustablerate mortgage pools contain a certain amount of risk related to the uncertaintyof prepayments of the underlying mortgages. Interest rate changes have a directimpact upon prepayment rates. Heritage uses computer simulation models to testthe average life, duration, market volatility and yield volatility ofadjustable rate mortgage pools under various interest rate assumptions tomonitor volatility. Stress tests are performed quarterly.

 

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TheAmortized cost, fair value, and maturites at December 31, 2003 are asfollows:

 

(in thousands)

 
|                                  |   | **Securities  Available-for-Sale** |   |
|---------------------------------------|--------|------------------------------------|--------|
|                                  |   | **Amortized  Cost**                |   | **Fair  Value** |   |
| Due in One Year or Less               |   | $                                  | 1,824  |   | $ | 1,832 |   |
|                                  |   |                               |   |   |   |
| Due after One Year through Five Years |   | 1,861                              |   | 1,917 |   |
|                                  |   |                               |   |   |   |
| Due after Five Years through TenYears |   | 4,681                              |   | 4,744 |   |
|                                  |   |                               |   |   |   |
| Due after TenYears                    |   | 4,447                              |   | 4,594 |   |
|                                  |   |                               |   |   |   |
| Mortgage-backed Securities            |   | 41,980                             |   | 41,869 |   |
|                                  |   |                               |   |   |   |
| Total                                 |   | $                                  | 54,793 |   | $ | 54,956 |   |

 

Deposits and Borrowed Funds

 

The following table setsforth information for the last three fiscal years regarding the composition ofdeposits at December 31, and the average rates paid on each of thesecategories:

 

**COMPOSITION OF DEPOSITS**

(inthousands)

 
|                        |   | **2001**    |    | **2002**               |   | **2003**    |   |
|-----------------------------|--------|-------------|---------|------------------------|--------|-------------|--------|
|                        |   | **Balance** |    | **Average  Rate Paid** |   | **Balance** |   | **Average  Rate Paid** |   | **Balance** |   | **Average  Rate Paid** |   |
| Non-Interest Bearing Demand |   | $           | 69,824  |                   | 0.00   | %           | $      | 106,556 |   | 0.00 | % | $ | 137,859 |   | 0.00 | % |
|                        |   |        |    |                   |   |        |   |   |   |   |   |   |   |
| Interest Bearing Demand     |   | 47,668      |    | 1.15                   | %      | 44,338      |   | 0.46 | % | 63,479 |   | 0.16 | % |
|                        |   |        |    |                   |   |        |   |   |   |   |   |   |   |
| Savings                     |   | 18,603      |    | 1.01                   | %      | 18,773      |   | 0.24 | % | 32,315 |   | 0.32 | % |
|                        |   |        |    |                   |   |        |   |   |   |   |   |   |   |
| Money Market                |   | 10,293      |    | 2.21                   | %      | 49,457      |   | 1.94 | % | 57,619 |   | 1.02 | % |
|                        |   |        |    |                   |   |        |   |   |   |   |   |   |   |
| Time Deposits               |   | 49,197      |    | 4.82                   | %      | 45,054      |   | 2.77 | % | 75,167 |   | 2.21 | % |
|                        |   |        |    |                   |   |        |   |   |   |   |   |   |   |
| Total Deposits              |   | $           | 195,585 |                   | 2.65   | %           | $      | 264,178 |   | 0.92 | % | $ | 366,439 |   | 0.73 | % |

 

Set forth is a maturityschedule of domestic time certificates of deposit of $100,000 and over atDecember 31, 2003:

 

**TIME DEPOSITS $100,000 AND OVER:**

(dollars in thousands)

 
| Less than 3 months |   | $      | 7,709  |   |
|--------------------|--------|--------|--------|--------|
| 3 to 12 months     |   | 11,469 |   |
| Over 1 year        |   | 4,516  |   |
|               |   |   |   |
| Total              |   | $      | 23,694 |   |

 

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Thefollowing table sets forth changes from 2002 to 2003 for deposit categories.

 
|                        |   | **2002** |    | **2003** |   | **$ Variance** |   | **% Variance** |    | **Hacienda** |       |
|-----------------------------|--------|----------|---------|----------|--------|----------------|--------|----------------|---------|--------------|------------|
| Non-Interest Bearing Demand |   | $        | 106,556 |     | $      | 137,859        |   | $              | 31,303  |         | 29.38      | % | **$** | **19,458** | ** ** |
|                        |   |     |    |     |   |           |   |           |    |         |       |
| Interest Bearing Demand     |   | 44,338   |    | 63,479   |   | 19,141         |   | 43.17          | %       | **13,160**   | ** ** |
|                        |   |     |    |     |   |           |   |           |    |         |       |
| Savings                     |   | 18,773   |    | 32,315   |   | 13,542         |   | 72.14          | %       | **11,899**   | ** ** |
|                        |   |     |    |     |   |           |   |           |    |         |       |
| Money Market                |   | 49,457   |    | 57,619   |   | 8,162          |   | 16.50          | %       | **7,973**    | ** ** |
|                        |   |     |    |     |   |           |   |           |    |         |       |
| Time Deposits               |   | 45,054   |    | 75,167   |   | 30,113         |   | 66.84          | %       | **27,900**   | ** ** |
|                        |   |     |    |     |   |           |   |           |    |         |       |
| Total Deposits              |   | $        | 264,178 |     | $      | 366,439        |   | $              | 102,261 |         | 38.71      | % | **$** | **80,390** | ** ** |

 

When discussing the changesto total deposits for 2003, Management believes that it is helpful to show theimpact of the Hacienda acquisition (noted above in the column titled“Hacienda”) at December 31, 2003.

 

The Company has been able toincrease deposits due to a well planned marketing strategy and incentive basedcompensation that has been in place for several years. Like all goodstrategies, this one is fluid and is subject to the changing dynamics withinthe Company’s balance sheet and staffing along with changes in its primarymarket area. Friendly competition between the branch offices to increasedeposit totals has been in place for two years. The branch offices are allgiven goals for each deposit category type and results are measured monthly.Lending and Operational staff work together to meet or beat their goals. Thisprogram has generated a significant amount of pride for the entire staff andresulted in growth for the Company.

 

The deposits of Haciendablended in well to continue with the favorable mix of the various deposit typesfor the Banks. The level of CDs at Hacienda constitutes approximately 34.7% oftheir total deposits. Management intends to work toward lowering the percentageof CDs on Hacienda’s balance sheet to mirror that of the Company prior to theacquisition. At December 31, 2002, consolidated balances in CDs accountedfor approximately 17.1% of total deposits compared to 20.5% atDecember 31, 2003.

 

For the Company,non-interest bearing demand deposits provide 37.6% of total deposits and grewby approximately $31.3 million or 29.47% in 2003. Heritage has three depositrelationships that it considers to be volatile. These deposits are held bythree, long time customers of Heritage that engage in mortgage relatedactivities. The volatile nature of these relationships was evidenced by adecrease of $6.7 million in account balances from December 31, 2002 toDecember 31, 2003. The slowdown in mortgage related activity had a directimpact on the deposit balances held by these entities. These volatile accountrelationships are included in the volatile liability dependency report thatHeritage produces on a monthly basis. Management and the Board of Directors ofHeritage are keenly aware that as the mortgage market conditions change, theserelationships will be impacted.

 

In August 2002,Heritage began to offer a personal insured money market account with the intentto raise deposits that otherwise generally reside in non-financial investmentcompanies. Heritage offered a competitive introductory rate and was successfulin procuring approximately $33.3 million in deposits by December 31, 2002.Balances in this product type have been enhanced by the acquisition ofHacienda.

 

Core deposits (time depositsless than $100,000, demand, and savings) gathered in the local communitiesserved by the Company continue to be the primary source of funds for loans andinvestments.  Core deposits of $219.1million represented 93.5% of total deposits at December 31, 2003. TheCompany does not purchase funds through deposit brokers.

 

In October 2003, theCompany executed a Promissory Note with Pacifica Coast Bankers Bank for a revolvingline of credit in the amount of $3.5 million. The note was obtained to assistwith the cash and capital needs for the acquisition of Hacienda. The Companypledged 339,332 shares (50%) of Heritage stock as collateral for the loan. Thenote is revolving in nature for the first two years. The terms of the note callfor quarterly interest only payments for the first two years with subsequentprincipal and interest payments for eight years on a fully amortized basis. Theinterest rate on the note is 4.0% and is variable and moves with prime. AtDecember 31, 2003, the Company

 

36

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had $3.5 million outstandingon this loan. Under the terms of the agreement, the Company will not incur anyadditional debt over $2 million exclusive of inter-company debt and existingdebt without the prior written consent of PCBB.  In addition, Heritage must be “well” capitalized on an on-goingbasis as defined by Regulators.

 

The Banks have establishedrespective borrowing lines with the Federal Home Loan Bank (FHLB). Hacienda hasan existing borrowing capacity of $1.4 million collateralized by loans.Hacienda has no borrowings with the FHLB at December 31, 2003.

 

At December 31, 2003,Heritage had borrowings with the FHLB of $9.5 million and $19 millioncollateralized by loans and securities, respectively. The $28.5 million inborrowing consists of $9.5 million maturing in April 2004 and $19 millionmaturing in April 2005. At December 31, 2003, Heritage has a remainingborrowing capacity with existing collateral of approximately $1.9 million and$13.1 million secured by loans and securities, respectively.

 

Heritage utilizes securitiessold under repurchase agreements as a source of funds.  Heritage had $460 thousand in securitiessold under repurchase agreements at December 31, 2003 compared to $258thousand at December 31, 2002.

 

Capital

 

The Company’s totalstockholders equity was $32.3 million at December 31, 2003 compared to$19.8 million at December 31, 2002. The increase in capital during 2003 was due to net income of $3.6million,  $4 thousand cash paid tostockholders in lieu of fractional shares on a 5% stock dividend paidMarch 28, 2003, stock options exercised in the amount of $583 thousand,stock sold in the amount of $66 thousand, $8.7 million in Hacienda acquisitionand a decrease in accumulated other comprehensive income of $464 thousand.

 

On April 10, 2002, theCompany issued $8,248,000 of Floating Rate Junior Subordinated DeferrableInterest Debentures “ (the “debt securities”) to Heritage Oaks Capital Trust I,a statutory trust created under the laws of the State of Delaware.  These debt securities are subordinated toeffectively all borrowings of the Company and are due and payable onApril 22, 2032.  Interest is payablequarterly on these debt securities at 6-Month LIBOR plus 3.7% for an effectiverate of 4.92% as of December 31, 2003. The debt securities can be called at any time commencing onApril 22, 2007, at par.  The debtsecurities can also be redeemed at par if certain events occur that impact thetax treatment, regulatory treatment or the capital treatment of theissuance.  The Company also purchased a3% minority interest totaling $248,000 in Heritage Oaks Capital Trust I.  The balance of the equity of Heritage OaksCapital Trust I is comprised of mandatorily redeemable preferred securities andis included in other assets.

 

Under FASB Interpretation(FIN) No. 46, *“Consolidation of VariableInterest Entities, an interpretation of ARB No. 51,”* the Company is not allowed to consolidateHeritage Oaks Capital Trust I into the Company’s financial statements.  Prior to the issuance of FIN No. 46, bankholding companies typically consolidated these entities.  The Federal Reserve Board had ruled thatcertain mandatorily redeemable preferred securities of a consolidated entityqualified as Tier 1 Capital.  TheFederal Reserve Board is evaluating the capital impact from FIN No. 46 but hasnot issued any final ruling.  As ofDecember 31, 2003, the Company has included the net junior subordinateddebt in its Tier1 Capital for regulatory capital purposes.  See, “Item 1 – Business - Factors That MayAffect Future Results of Operations - Trust Preferred Securities.”

 

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

 

The Company used theproceeds from the sale of the securities for general corporate purposes,including the repayment of outstanding indebtedness of $1.9 million onApril 11, 2002 and capital contributions to Heritage for future growth.

 

Management believes thatorganic growth in 2004 for the Company can be accomplished without furtherborrowing for capital or cash flow purposes. At December 31, 2003, theCompany had sufficient cash to service

 

37

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the $3.5 million PCBB loanand $8.2 million in junior subordinated debenture interest payments forapproximately five quarters without dividends from subsidiaries. The combinedsubsidiary capacity to provide cash to the Company, while remaining“well-capitalized”, was $4.6 million at December 31, 2003.

 

Capital ratios forcommercial banks in the United States are generally calculated using threedifferent formulas.  These calculationsare referred to as the “Leverage Ratio” and two “risk based” calculations knownas: “Tier One Risk Based Capital Ratio” and the “Total Risk Based CapitalRatio.”   These standards were developedthrough joint efforts of banking authorities from 12 different countries aroundthe world.  The standards essentiallytake into account the fact that different types of assets have different levelsof risk associated with them. Furthermore, they take into account the off-balance sheet exposures ofbanks when assessing capital adequacy.

 

The Leverage Ratiocalculation simply divides common stockholders’ equity (reduced by any goodwilla bank may have) by the total assets of Heritage.  In the Tier One Risk Based Capital Ratio, the numerator is thesame as the leverage ratio, but the denominator is the total “risk-weightedassets” of Heritage.  Risk weightedassets are determined by segregating all the assets and off balance sheetexposures into different risk categories and weighting them by a percentageranging from 0% (lowest risk) to 100% (highest risk).  The Total Risk Based Capital Ratio again uses “risk-weightedassets” in the denominator, but expands the numerator to include other capitalitems besides equity such as a limited amount of the loan loss reserve,long-term capital debt, preferred stock and other instruments.

 

Summarized below are theCompany’s and the Banks’ capital ratios at December 31, 2003.

 
|                 |   | **Minimum  Regulatory  Capital Requirements** |   | **Heritage  Oaks Bancorp** |   | **Heritage  Oaks Bank** |   | **Hacienda  Bank** |   |
|----------------------|--------|-----------------------------------------------|--------|----------------------------|--------|-------------------------|--------|--------------------|--------|
|                 |   |                                          |   |                       |   |                    |   |               |   |
| Leverage Ratio       |   | 4.00                                          | %      | 8.30                       | %      | 8.61                    | %      | 7.21               | %      |
| Tier I Risk Weighted |   | 4.00                                          | %      | 10.15                      | %      | 10.82                   | %      | 9.57               | %      |
| Total Risk Based     |   | 8.00                                          | %      | 11.14                      | %      | 11.78                   | %      | 10.65              | %      |

 

For the Company, all $8million of the trust preferred securities are accounted for as Tier I and TierII Capital, respectively, for purposes of calculating Regulatory Capital.

 

Liquidity

 

The objective of liquiditymanagement is to ensure the continuous availability of funds to meet thedemands of depositors, investors and borrowers.  Asset liquidity is primarily derived from loan payments and thematurity of other earning assets. Liquidity from liabilities is obtained primarily from the receipt of newdeposits. The Banks’ Asset Liability Committees (ALCO) are responsible formanaging the on-and off-balance sheet commitments to meet the needs ofcustomers while achieving the Banks’ financial objectives.  ALCO meets regularly to assess the projectedfunding requirements by reviewing historical funding patterns, current andforecasted economic conditions and individual customer funding needs.  Deposits generated from Bank customers serveas the primary source of liquidity.  TheBanks have credit arrangements with correspondent banks that serve as asecondary liquidity source in the amount of $7 million for Heritage and $2.2million for Hacienda. At of December 31,2003, the Banks had no borrowingsagainst credit arrangements with these correspondent banks. The Banks aremembers of the FHLB and have collateralized borrowing capacities remaining of$15 million and $1.4 million for Heritage and Hacienda, respectively.

 

The Banks manages liquidityby maintaining a majority of the investment portfolio in federal funds sold andother liquid investments.  AtDecember 31, 2003, the ratio of liquid assets not pledged for collateraland other purposes to deposits and other liabilities was 28.1% compared to20.8% in 2002. The ratio of net loans to deposits, another key liquidity ratio,was 76.0% at December 31, 2003 compared to 70.9% at December 31,2002.

 

Inflation

 

The assets and liabilitiesof a financial institution are primarily monetary in nature.  As such they represent obligations to pay orreceive fixed and determinable amounts of money that are not affected by futurechanges in prices.  Generally, theimpact of inflation on a financial institution is reflected by fluctuations ininterest rates, the ability of customers to repay debt and upward pressure onoperating expenses.  The effect oninflation during the three-year period ended December 31, 2003 has beensignificant to the Company’s financial position or results of operations inregard to fluctuation in interest rates creating narrowing net interestmargins. However, inflation has not been a factor in the customers ability torepay debt or in upward pressure on operation expenses.

 

38

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Recent AccountingDevelopments

 

On July 20, 2001, theFASB issued SFAS No. 141 “Business Combinations”(“SFAS No. 141”), requiringthat all business combinations within the scope of the statement be accountedfor using the purchase method. Previously, the pooling-of-interests method wasrequired whenever certain criteria were met. Because those criteria did notdistinguish economically dissimilar transactions, similar business combinationswere accounted for using different methods that produced dramatically differentfinancial statement results. SFAS No. 141 requires separate recognition ofintangible assets apart from goodwill if they meet one of two criteria, thecontractual-legal criterion or the separability criterion. SFAS No. 141 alsorequires the disclosure of the primary reasons for a business combination andthe allocation of the purchase price paid to the assets acquired andliabilities assumed by major balance sheet caption.

 

The provisions of SFAS No.141 apply to all business combinations initiated after June 30, 2001. SFASNo. 141 also applies to all business combinations accounted for using thepurchase method for which the date of acquisition is July 1, 2001 orlater.

 

Core deposit intangibles(CDI) were $2.1 million and $.3 million at December 31, 2003 as the resultof the Company’s acquisition of Hacienda in 2003 and the branch acquisition byHeritage in 2001, respectively. Amortization of the CDI created in the branchacquisition by Heritage did not have a material impact on future earnings.Amortization of the CDI in the Hacienda acquisition was factored into pro formaearnings during the due diligence period before the acquisition. Theacquisition is budgeted to be accretive to earnings per share in 2004 andfuture years.

 

On July 20, 2001, theFASB also issued SFAS No. 142 “Goodwill and Other Intangible Assets” (“SFAS No.142”). It addressed how intangible assets that are acquired individually orwithin a group of assets should be accounted for in the financial statements upontheir acquisition. SFAS No. 142 adopts a more aggregate view of goodwill andbases the 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 statementmust be applied starting at the beginning of the first fiscal year beginningafter December 15, 2001. For the Company, that means as of January 1,2002. The principles of SFAS No. 142 must be applied to all goodwill and otherintangible assets recognized in the financials at that date. Impairment lossesare to be reported as resulting from a change in accounting principle. At thetime of implementation, this accounting pronouncement did not have a materialeffect on the Company.

 

With the acquisition ofHacienda in 2003, the Company will engage a third party to perform impairmenttesting on an annual basis. The budget for Hacienda in 2004 mirrors the proforma used during the acquisition process. To date, albeit for only two months,Hacienda has performed according to budget. The Company is constantlymonitoring all factors to react to any issue that may create an impairment..

 

In August 2002, theFASB approved, in principle, Statement 147 which will replace certainparagraphs in Statement 72, “Accounting for Certain Acquisitions of Banking orThrift Institutions”. The new guidance was effective on September 30,2002. The requirements in Statement 72 to recognize (and amortize) an“unidentifiable intangible asst” when more liabilities are acquired than assets,such as in a branch purchase that is a business combination, will no longerapply. Previously recorded core deposit intangibles must continue to beamortized.

 

In April 2003, the FASBissued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments andHedging Activities.”  SFAS No. 149amends and clarifies accounting for derivative instruments, including certainderivative instruments embedded in other contracts and loan commitments thatrelate to the origination of mortgage loans held for sale, and for hedgingactivities under SFAS No. 133.  SFAS No.149 is generally effective for contracts entered into or modified afterJune 30, 2003.  The adoption ofSFAS No. 149 did not have a material impact on the financial condition oroperating results of the Company.

 

In May 2003, the FASB issuedSFAS No. 150, “Accounting for Certain Financial Instruments withCharacteristics of both Liabilities and Equity.”  SFAS No. 150 establishes standards for how an issuer classifiesand measures

 

39

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certain financialinstruments with characteristics of both liabilities and equity.  It requires that an issuer classify afinancial instrument that is within its scope as a liability (or an asset insome circumstances.)  Many of thoseinstruments were previously classified as equity.  SFAS No. 150 is generally effective for financial instrumentsentered into or modified after May 31, 2003, and otherwise is effective at thebeginning of the first interim period beginning after June 15, 2003.  The adoption of SFAS No. 150 did not have amaterial impact on the financial condition or operating results of the Company.

 

SEC Staff AccountingBulletin No. 102 “Selected Loan Loss Allowance Methodology and DocumentationIssues” (“SAB No. 102”) was released on July 10, 2001. It expressescertain of the staff’s views on the development, documentation and applicationof a systematic methodology as required by Financial Reporting Release No. 28,Accounting for Loan Losses by Registrants Engaged in Lending Activities, fordetermining allowances for loan and lease losses in accordance with generallyaccepted accounting principles. In particular, SAB No. 102 focuses on thedocumentation the staff normally would expect registrants to prepare andmaintain in support of their allowances for loan losses. We have a systematicmethodology for determining an appropriate allowance for loan losses,consistently followed and supported by written documentation and policies andprocedures. In light of SAB No. 102, however, our methodology and documentationis currently in the process of review. Any resulting changes are not expectedto have a material impact on the financial statements.

 

This discussion should beread in conjunction with the consolidated financial statements of the Company,including the notes thereto, appearing elsewhere in this report.

 

Off-Balance sheetArrangements

 

In the ordinary course ofbusiness, the Company has entered into off-balance sheet financial instrumentsconsisting of commitments to extend credit, commercial letter of credit, andstandby letter of credit. Such financial instruments are recorded in thefinancial statement when they are funded or related fees are incurred orreceived.

 

40

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ITEM7. FINANCIAL STATEMENTS

 

**HERITAGE OAKS BANCORP AND SUBSIDIARIES**

 

**DECEMBER 31, 2003, 2002, AND 2001**

 

**Contents**

 
| **Independent Auditors’ Report**                                                                                       |   |
|-----------------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                        |   |
| **Financial Statements**                                                                                                    |   |
|                                                                                                                        |   |
| Consolidated Balance Sheets  December 31, 2003 and 2002                                                                |   |
|                                                                                                                        |   |
| Consolidated Statements of Income  For the Years Ended December 31, 2003, 2002, and 2001                               |   |
|                                                                                                                        |   |
| Consolidated Statement of Changes in  Stockholders’ Equity  For the Years Ended December 31, 2003, 2002, and 2001 |   |
|                                                                                                                        |   |
| Consolidated Statements of Cash Flows  For the Years Ended December 31, 2003, 2002, and 2001                           |   |
|                                                                                                                        |   |
| **Notes to Consolidated Financial Statements**                                                                              |   |

 

41

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**IndependentAuditors’ Report**

 

Board ofDirectors and Stockholders

Heritage OaksBancorp and Subsidiaries

Paso Robles,California

 

We haveaudited the accompanying consolidated balance sheets of Heritage Oaks Bancorpand Subsidiaries (the “Company”) as of December 31, 2003 and 2002, and therelated consolidated statements of income and changes in stockholders’ equityand statements of cash flows for each of the three years in the period endedDecember 31, 2003.  Theseconsolidated financial statements are the responsibility of the Company’smanagement.  Our responsibility is toexpress an opinion on these consolidated financial statements based on ouraudits.

 

We conductedour audits in accordance with auditing standards generally accepted in theUnited States of America.  Thosestandards require 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, 2003 and 2002, 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, 2003, in conformity with accountingprinciples generally accepted in the United States of America.

 

 
| /s/  Vavrinek, Trine, Day & Co., LLP |   |
|------------------------------------------|--------|
| Rancho  Cucamonga, California            |
| January 30,  2004                   |

 

**HERITAGE OAKS BANCORP ANDSUBSIDIARIES**

 

Theaccompanying notes are an integral part of these financial statements.

 

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**CONSOLIDATED BALANCE SHEETS**

**DECEMBER 31, 2003 AND 2002**

**(Amounts in thousands, exceptshare data)**

 
|                                                                                                                                              |   | **2003** |    | **2002** |   |
|---------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------|---------|----------|--------|
| **Assets**                                                                                                                                        |   |     |    |     |   |
| Cash and due from banks                                                                                                                           |   | $        | 40,374  |     | $      | 23,514 |   |
| Federal funds sold                                                                                                                                |   | 36,740   |    | 37,040   |   |
| Total Cash and Cash Equivalents                                                                                                                   |   | 77,114   |    | 60,554   |   |
| Interest-bearing deposits in other  financial institutions                                                                                        |   | 498      |    | 497      |   |
| Investment securities Available-for-sale                                                                                                          |   | 54,956   |    | 65,396   |   |
| Federal Home Loan Bank and Federal Reserve  Bank Stock, at cost                                                                                   |   | 1,959    |    | 1,951    |   |
| Loans held for sale                                                                                                                               |   | 4,402    |    | 8,166    |   |
| Loans, net of deferred fees and allowance  for loan losses of $3,070 and $2,336 at December 31, 2003 and 2002,  respectively                 |   | 274,051  |    | 187,311  |   |
| Property premises and equipment, net                                                                                                              |   | 9,874    |    | 4,543    |   |
| Net deferred tax asset                                                                                                                            |   | 1,971    |    | 1,171    |   |
| Cash surrender value of life insurance                                                                                                            |   | 6,859    |    | 5,415    |   |
| Goodwill                                                                                                                                          |   | 4,905    |    | —   |   |
| Intangible assets                                                                                                                                 |   | 2,442    |    | 359      |   |
| Other assets                                                                                                                                      |   | 2,917    |    | 2,148    |   |
| Total Assets                                                                                                                                      |   | $        | 441,948 |     | $      | 337,511 |   |
| **Liabilities  and Stockholders’ Equity**                                                                                                    |   |     |    |     |   |
| Liabilities                                                                                                                                       |   |     |    |     |   |
| Deposits                                                                                                                                          |   |     |    |     |   |
| Demand non-interest bearing                                                                                                                       |   | $        | 137,859 |     | $      | 106,556 |   |
| Savings, NOW and money market deposits                                                                                                            |   | 153,413  |    | 112,568  |   |
| Time deposits of $100 or more                                                                                                                     |   | 23,694   |    | 8,154    |   |
| Time deposits under $100                                                                                                                          |   | 51,473   |    | 36,900   |   |
| Total Deposits                                                                                                                                    |   | 366,439  |    | 264,178  |   |
| FHLB advances and other borrowings                                                                                                                |   | 28,500   |    | 38,000   |   |
| Securities sold under agreement to  repurchase                                                                                                    |   | 460      |    | 258      |   |
| Notes payable                                                                                                                                     |   | 3,500    |    | —   |   |
| Junior subordinated debentures                                                                                                                    |   | 8,248    |    | 8,248    |   |
| Other liabilities                                                                                                                                 |   | 2,513    |    | 7,014    |   |
| Total Liabilities                                                                                                                                 |   | 409,660  |    | 317,698  |   |
| COMMITMENTS AND CONTINGENCIES (Notes #5 and  #10)                                                                                                 |   |     |    |     |   |
|                                                                                                                                              |   |     |    |     |   |
| Stockholders’ Equity                                                                                                                         |   |     |    |     |   |
| Common stock, no par value; 20,000,000  shares authorized; 3,604,497 and 2,924,541 shares issued and outstanding for  2003 and 2002, respectively |   | 20,649   |    | 9,703    |   |
| Retained earnings                                                                                                                                 |   | 11,541   |    | 9,548    |   |
| Accumulated other comprehensive income                                                                                                            |   | 98       |    | 562      |   |
| Total Stockholders’ Equity                                                                                                                   |   | 32,288   |    | 19,813   |   |
| Total Liabilities and Stockholders’ Equity                                                                                                   |   | $        | 441,948 |     | $      | 337,511 |   |

 

Theaccompanying notes are an integral part of these financial statements.

 

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**HERITAGE OAKS BANCORP ANDSUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF INCOME**

**FOR THE YEARS ENDEDDECEMBER 31, 2003, 2002, AND 2001**

**(Dollars in thousands, except pershare amounts)**

 
|                                                           |   | **2003** |   | **2002** |   | **2001** |   |
|----------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| **Interest Income**                                            |   |     |   |     |   |     |   |
| Interest and fees on loans                                     |   | $        | 15,930 |     | $      | 13,399   |   | $ | 13,280 |   |
| Interest on Investment Securities                              |   |     |   |     |   |     |   |
| Obligations of U.S. Government Agencies                        |   | 1,408    |   | 1,872    |   | 501      |   |
| Obligations of State and Political  Subdivisions               |   | 454      |   | 300      |   | 281      |   |
| Interest on time deposits with other banks                     |   | 13       |   | 5        |   | 13       |   |
| Interest on Federal funds sold                                 |   | 278      |   | 400      |   | 362      |   |
| Interest on other securities                                   |   | 91       |   | 59       |   | 24       |   |
| Total Interest Income                                          |   | 18,174   |   | 16,035   |   | 14,461   |   |
|                                                           |   |     |   |     |   |     |   |
| **Interest Expense**                                           |   |     |   |     |   |     |   |
| Interest on savings, NOW and money market  deposits            |   | 625      |   | 779      |   | 964      |   |
| Interest on time deposits in denominations  of $100 or more    |   | 204      |   | 183      |   | 211      |   |
| Interest on time deposits under $100                           |   | 922      |   | 1,103    |   | 2,154    |   |
| Other                                                          |   | 1,712    |   | 1,426    |   | 101      |   |
| Total Interest Expense                                         |   | 3,463    |   | 3,491    |   | 3,430    |   |
| Net interest income before provision for  possible loan losses |   | 14,711   |   | 12,544   |   | 11,031   |   |
| Provision for Possible Loan Losses                             |   | 370      |   | 545      |   | 600      |   |
|                                                           |   | 14,341   |   | 11,999   |   | 10,431   |   |
| **Noninterest Income**                                         |   |     |   |     |   |     |   |
| Fees and service charges                                       |   | 1,723    |   | 1,433    |   | 1,183    |   |
| Investment securities gain/(loss), net                         |   | 60       |   | (19      | )      | (2       | )      |
| Other                                                          |   | 2,014    |   | 2,049    |   | 3,499    |   |
| Total Noninterest Income                                       |   | 3,797    |   | 3,463    |   | 4,680    |   |
| **Noninterest Expenses**                                       |   |     |   |     |   |     |   |
| Salaries and employee benefits                                 |   | 6,498    |   | 5,386    |   | 4,494    |   |
| Equipment expenses                                             |   | 675      |   | 711      |   | 879      |   |
| Occupancy expenses                                             |   | 1,082    |   | 955      |   | 828      |   |
| Other expenses                                                 |   | 4,170    |   | 4,022    |   | 5,185    |   |
| Total Noninterest Expenses                                     |   | 12,425   |   | 11,074   |   | 11,386   |   |
| Income Before Provision for Income Taxes                       |   | 5,713    |   | 4,388    |   | 3,725    |   |
| Provision for Income Taxes                                     |   | 2,117    |   | 1,649    |   | 1,379    |   |
| Net Income                                                     |   | $        | 3,596  |     | $      | 2,739    |   | $ | 2,346 |   |
|                                                           |   |     |   |     |   |     |   |
| Earnings Per Share                                             |   |     |   |     |   |     |   |
| Basic                                                          |   | $        | 1.18   |     | $      | 0.94     |   | $ | 0.82 |   |
| Diluted                                                        |   | $        | 1.10   |     | $      | 0.86     |   | $ | 0.76 |   |

 

Theaccompanying notes are an integral part of these financial statements.

 

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**HERITAGE OAKS BANCORP ANDSUBSIDIARIES**

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

**FOR THE YEARS ENDEDDECEMBER 31, 2003, 2002, AND 2001**

**(Amounts in thousands, exceptshare data)**

 
|                                                                         |   | **Common Stock** |   | **Comprehensive  Income** |   | **Retained  Earnings** |   | **Accumulated  Other  Comprehensive  Income** |   | **Total  Stockholders’  Equity** |   |
|------------------------------------------------------------------------------|--------|------------------|--------|---------------------------|--------|------------------------|--------|-----------------------------------------------|--------|---------------------------------------|--------|
| **Number of  Shares**                                                        |   | **Amount**       |
| **Balance, January 1, 2001**                                            |   | 1,224,999        |   | $                         | 6,305  |                   |   |                                          | $      | 7,291                                 |   | $ | (142 | ) | $ | 13,454 |   |
| Exercise of stock options                                                    |   | 11,442           |   | 94                        |   |                   |   |                                          |   |                                  |   | 94 |   |
| Stock dividends paid - 5%                                                    |   | 61,439           |   | 1,137                     |   |                   |   | (1,137                                        | )      |                                  |   | — |   |
| Cash paid to stockholders in lieu of  fractional shares on 5% stock dividend |   |             |   |                      |   |                   |   | (4                                            | )      |                                  |   | (4 | ) |
| Comprehensive income                                                         |   |             |   |                      |   |                   |   |                                          |   |                                  |   |   |   |
| Net income                                                                   |   |             |   |                      |   | $                      | 2,346  |                                          | 2,346  |                                  |   |   | 2,346 |   |
| Unrealized security holding losses (net of  $10 tax)                         |   |             |   |                      |   | (14                    | )      |                                          |   | (14                                   | )      | (14 | ) |
| Less reclassification adjustments for  losses (net of $1 tax)                |   |             |   |                      |   | 1                      |   |                                          |   | 1                                     |   | 1 |   |
| Total comprehensive income                                                   |   |             |   |                      |   | $                      | 2,333  |                                          |   |                                  |   |   |   |   |
| **Balance, December 31, 2001**                                          |   | 1,297,880        |   | 7,536                     |   |                   |   | 8,496                                         |   | (155                                  | )      | 15,877 |   |
| Exercise of stock options                                                    |   | 60,477           |   | 486                       |   |                   |   |                                          |   |                                  |   | 486 |   |
| Stock dividends paid - 5%                                                    |   | 64,648           |   | 1,681                     |   |                   |   | (1,681                                        | )      |                                  |   | — |   |
| Cash paid to stockholders in lieu of  fractional shares on 5% stock dividend |   |             |   |                      |   |                   |   | (6                                            | )      |                                  |   | (6 | ) |
| Two-for-one stock split                                                      |   | 1,362,528        |   |                      |   |                   |   |                                          |   |                                  |   |   |   |
| Comprehensive income                                                         |   |             |   |                      |   |                   |   |                                          |   |                                  |   |   |   |
| Net income                                                                   |   |             |   |                      |   | $                      | 2,739  |                                          | 2,739  |                                  |   |   | 2,739 |   |
| Unrealized security holding gains (net of  $471 tax)                         |   |             |   |                      |   | 706                    |   |                                          |   | 706                                   |   | 706 |   |
| Less reclassification adjustments for  losses (net of $8 tax)                |   |             |   |                      |   | 11                     |   |                                          |   | 11                                    |   | 11 |   |
| Total comprehensive income                                                   |   |             |   |                      |   | $                      | 3,456  |                                          |   |                                  |   |   |   |   |
| **Balance, December 31, 2002**                                          |   | 2,785,533        |   | 9,703                     |   |                   |   | 9,548                                         |   | 562                                   |   | 19,813 |   |
| Exercise of stock options                                                    |   | 72,471           |   | 583                       |   |                   |   |                                          |   |                                  |   | 583 |   |
| Stock issued in connection with purchase of  Hacienda Bank                   |   | 602,485          |   | 8,698                     |   |                   |   |                                          |   |                                  |   | 8,698 |   |
| Sale of stock                                                                |   | 5,000            |   | 66                        |   |                   |   |                                          |   |                                  |   | 66 |   |
| Cash paid to stockholders in lieu of  fractional shares on 5% stock dividend |   |             |   |                      |   |                   |   | (4                                            | )      |                                  |   | (4 | ) |
| 5% stock dividend                                                            |   | 139,008          |   | 1,599                     |   |                   |   | (1,599                                        | )      |                                  |   | — |   |
| Comprehensive income                                                         |   |             |   |                      |   |                   |   |                                          |   |                                  |   |   |   |
| Net income                                                                   |   |             |   |                      |   | $                      | 3,596  |                                          | 3,596  |                                  |   |   | 3,596 |   |
| Unrealized security holding losses (net of  $287 tax)                        |   |             |   |                      |   | (428                   | )      |                                          |   | (428                                  | )      | (428 | ) |
| Less reclassification adjustments for gains  (net of $24 tax)                |   |             |   |                      |   | (36                    | )      |                                          |   | (36                                   | )      | (36 | ) |
| Total comprehensive income                                                   |   |             |   |                      |   | $                      | 3,132  |                                          |   |                                  |   |   |   |   |
| **Balance, December 31, 2003**                                          |   | 3,604,497        |   | $                         | 20,649 |                   |   |                                          | $      | 11,541                                |   | $ | 98 |   | $ | 32,288 |   |

 

Theaccompanying notes are an integral part of these financial statements.

 

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**HERITAGE OAKS BANCORP ANDSUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**FOR THE YEARS ENDEDDECEMBER 31, 2003, 2002, AND 2001**

**(Dollars in thousands)**

 
|                                                                                |   | **2003** |   | **2002** |   | **2001** |   |
|-------------------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| **Cash Flows  from Operating Activities**                                           |   |     |   |     |   |     |   |
| Net income                                                                          |   | $        | 3,596  |     | $      | 2,739    |   | $ | 2,346 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities   |   |     |   |     |   |     |   |
| Net cash provided by operating activities                                           |   |     |   |     |   |     |   |
| Depreciation and amortization                                                       |   | 661      |   | 652      |   | 825      |   |
| Provision for possible loan losses                                                  |   | 370      |   | 545      |   | 600      |   |
| Provision for possible losses on unfunded  loan commitments                         |   | 50       |   | 40       |   | —   |   |
| Realized (gain)/loss on sales of  available-for-sale securities, net                |   | (60      | )      | 19       |   | 2        |   |
| Amortization of premiums/discounts on  investment securities, net                   |   | 451      |   | 239      |   | (124     | )      |
| Amortization of core deposit intangibles                                            |   | 41       |   | 43       |   | 20       |   |
| Gain on sale of property, premises and  equipment, net                              |   | —   |   | —   |   | (279     | )      |
| Gain on sale of loans held for sale                                                 |   | (632     | )      | (571     | )      | (243     | )      |
| Net increase in cash surrender value of  life insurance                             |   | (264     | )      | (272     | )      | (124     | )      |
| FHLB Dividends received                                                             |   | (87      | )      | (54      | )      | —   |   |
| Loans originated for sale                                                           |   | (107,505 | )      | (82,209  | )      | (46,873  | )      |
| Proceeds from sale of loans held for sale                                           |   | 111,901  |   | 78,696   |   | 45,508   |   |
| Increase in deferred tax asset                                                      |   | (363     | )      | (391     | )      | (250     | )      |
| (Increase)/decrease in other assets                                                 |   | 212      |   | (82      | )      | 230      |   |
| Increase/(decrease) in other liabilities                                            |   | (5,195   | )      | 5,539    |   | (515     | )      |
|                                                                                |   |     |   |     |   |     |   |
| **NET CASH PROVIDED BY OPERATING ACTIVITIES**                                       |   | 3,176    |   | 4,933    |   | 1,123    |   |
|                                                                                |   |     |   |     |   |     |   |
| **Cash Flows From Investing Activities**                                            |   |     |   |     |   |     |   |
| Purchase of securities available-for-sale                                           |   | (1,633   | )      | (3,337   | )      | —   |   |
| Purchase of mortgage-backed securities  available-for-sale                          |   | (27,487  | )      | (59,757  | )      | (10,174  | )      |
| Net purchase of Federal Home Loan Bank and  Federal Reserve Bank stock              |   | (6       | )      | (1,668   | )      | —   |   |
| Proceeds from sale of Federal Home Loan  Bank stock                                 |   | 338      |   | —   |   | —   |   |
| Proceeds from sale of securities  available-for-sale                                |   | —   |   | —   |   | 714      |   |
| Proceeds from sales of mortgage-backed  securities                                  |   | 12,365   |   | 5,406    |   | —   |   |
| Proceeds from principal reductions and maturities  of securities available-for-sale |   | 757      |   | 26       |   | 1,138    |   |
| Proceeds from principal reductions and  maturities of mortgage-backed securities    |   | 27,387   |   | 15,231   |   | 2,759    |   |
| Net change in interest-bearing deposits in  other financial institutions            |   | 99       |   | (398     | )      | 99       |   |
| Purchase of life insurance policies                                                 |   | (1,180   | )      | —   |   | (3,650   | )      |
| Increase in cash due to acquisition                                                 |   | 22,703   |   | —   |   | 23,086   |   |
| Recoveries on loans previously written off                                          |   | 233      |   | 129      |   | 4        |   |
| Increase in loans, net                                                              |   | (35,465  | )      | (31,835  | )      | (23,074  | )      |
| Proceeds from sale of property, premises  and equipment                             |   | —   |   | 7        |   | 721      |   |
| Purchase of property, premises and  equipment, net                                  |   | (3,158   | )      | (1,580   | )      | (350     | )      |
|                                                                                |   |     |   |     |   |     |   |
| **NET CASH USED IN INVESTING ACTIVITIES**                                           |   | (5,047   | )      | (77,776  | )      | (8,727   | )      |
|                                                                                     |        |          |        |          |        |          |        |  |  |  |

 

The accompanying notes are anintegral part of these financial statements.

 

46

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|                                                                   |   | **2003** |   | **2002** |   | **2001** |   |
|------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| **Cash Flows From Financing Activities**                               |   |     |   |     |   |     |   |
| Increase in deposits, net                                              |   | $        | 23,788 |     | $      | 68,594   |   | $ | 2,920 |   |
| Net increase/(decrease) in FHLB borrowings                             |   | (9,500   | )      | 38,000   |   | —   |   |
| Proceeds from issuance of trust preferred  securities                  |   | —   |   | 8,000    |   | —   |   |
| Net (decrease)/increase in notes payable                               |   | 3,500    |   | (1,895   | )      | 845      |   |
| Net increase in securities sold under  agreement to repurchase         |   | 202      |   | 120      |   | 137      |   |
| Proceeds from exercise of stock options                                |   | 379      |   | 186      |   | 69       |   |
| Proceeds from sale of stock                                            |   | 66       |   | —   |   | —   |   |
| Cash paid in lieu of fractional shares                                 |   | (4       | )      | (6       | )      | (5       | )      |
|                                                                   |   |     |   |     |   |     |   |
| **NET CASH PROVIDED BY FINANCING ACTIVITIES**                          |   | 18,431   |   | 112,999  |   | 3,966    |   |
|                                                                   |   |     |   |     |   |     |   |
| **Net Increase/(Decrease) in Cash and Cash Equivalents**               |   | 16,560   |   | 40,156   |   | (3,638   | )      |
|                                                                   |   |     |   |     |   |     |   |
| **Cash and Cash Equivalents**, Beginning of year                       |   | 60,554   |   | 20,398   |   | 24,036   |   |
|                                                                   |   |     |   |     |   |     |   |
| **Cash and Cash Equivalents**, End of year                             |   | $        | 77,114 |     | $      | 60,554   |   | $ | 20,398 |   |
|                                                                   |   |     |   |     |   |     |   |
| **Supplemental Disclosures of Cash Flow Information**                  |   |     |   |     |   |     |   |
| Interest paid                                                          |   | $        | 14,900 |     | $      | 3,280    |   | $ | 3,960 |   |
| Income taxes paid                                                      |   | $        | 2,250  |     | $      | 1,960    |   | $ | 1,432 |   |
|                                                                   |   |     |   |     |   |     |   |
| **Supplemental Disclosures of Non-Cash Flow Information**              |   |     |   |     |   |     |   |
| Change in other comprehensive income                                   |   | $        | (464   | )        | $      | 717      |   | $ | (13 | ) |
| Tax benefit of stock options exercised                                 |   | $        | 204    |     | $      | 300      |   | $ | 25 |   |
|                                                                   |   |     |   |     |   |     |   |
| **Supplemental Disclosures**                                           |   |     |   |     |   |     |   |
| Net change in assets/liabilities due to  acquisition of Hacienda Bank  |   |     |   |     |   |     |   |
| Increase in interest-bearing deposits in  other financial institutions |   | $        | 100    |     | $      | —   |   | $ | — |   |
| Increase in investments                                                |   | $        | 2,121  |     | $      | —   |   | $ | — |   |
| Increase in net loans                                                  |   | $        | 51,878 |     | $      | —   |   | $ | — |   |
| Increase in FHLB stock                                                 |   | $        | 253    |     | $      | —   |   | $ | — |   |
| Increase in premises and equipment                                     |   | $        | 2,834  |     | $      | —   |   | $ | — |   |
| Increase in goodwill and other intangible  assets                      |   | $        | 7,029  |     | $      | —   |   | $ | — |   |
| Increase in other assets                                               |   | $        | 901    |     | $      | —   |   | $ | — |   |
| Increase in demand, money market and  savings deposits                 |   | $        | 48,678 |     | $      | —   |   | $ | — |   |
| Increase in time certificates of deposit                               |   | $        | 29,795 |     | $      | —   |   | $ | — |   |
| increase in other liabilities                                          |   | $        | 644    |     | $      | —   |   | $ | — |   |

 

Theaccompanying notes are an integral part of these financial statements.

 

47

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**HERITAGEOAKS BANCORP AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSDECEMBER 31, 2003, 2002, AND 2001(Dollars in thousands, except per share amounts)**

 

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

 

The accounting and reportingpolicies of Heritage Oaks Bancorp (the Company) and subsidiaries conform toaccounting principles generally accepted in the United States of America and togeneral practices within the banking industry. A summary of the Company’s significant accounting and reporting policiesconsistently applied in the preparation of the accompanying financialstatements follows:

 

Principles of Consolidation

 

The consolidated financialstatements include the Company and its wholly owned subsidiaries, Heritage OaksBank (“Heritage”), Hacienda Bank (“Hacienda”) (collectively, “the Banks”) andCCMS Systems, Inc.  Inter-companybalances and transactions have been eliminated.

 

Nature of Operations

 

The Company has beenorganized as a single operating segment. Prior to 2002, the Company was organized with two primary operatingsegments, which consisted of Heritage and the Heritage’s Electronic FundsTransfer (EFT) Department.  The segmentswere identified as such based upon the percentage of operating net income,management responsibility, and the types of products and services offered.  The Banks operate twelve branches within SanLuis Obispo and Northern Santa Barbara counties.  The Banks offer traditional banking products such as checking,savings and certificates of deposit, as well as mortgage loans and commercialand consumer 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, Heritage divestedall of its retail automated teller machines and all but two of its gamingautomated teller machines.  As ofDecember 31, 2002, the EFT Department had no remaining machines at agaming facility.  Income was based upontotal customer usage of the machines and the applicable transaction charge.

 

Investment inNon-consolidated Subsidiary

 

The Company accounts for itsinvestments in its wholly owned special purpose entity, Heritage Oaks CapitalTrust I (the “Trust”), using the equity method under which the subsidiary’s netearnings are recognized in the Company’s statements of income.  Prior to December 31, 2003, theaccounts of the Trust were included in the consolidated financial statements ofthe Company.  Pursuant to the Company’sadoption of the transition guidance of FIN 46R for investments in specialpurpose entities, the Company deconsolidated the Trust from its financialstatements as of December 31, 2003.

 

Use of Estimates in thePreparation of Financial Statements

 

The preparation of financialstatements in conformity with accounting principles generally accepted in theUnited States of America requires management to make estimates and assumptionsthat affect the reported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities at the date of the financial statements andthe reported amounts of revenues and expenses during the reporting period.  Actual results could differ from thoseestimates.

 

48

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

 

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

 

Cash and 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 Banks complied with the reserve requirements as of December 31,2003.

 

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

 

Cash and Cash Equivalents

 

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

 

Investment Securities andMortgage-backed Securities

 

In accordance with Statementof Financial Accounting Standards (SFAS) No. 115, “*Accountingfor Certain Investments in Debt and Equity Securities,*” which addresses the accounting forinvestments in equity securities that have readily determinable fair values andfor investments 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 of stockholders’equity.  Gains or losses on sales ofinvestment securities and mortgage-backed securities are determined on thespecific identification method. Premiums and discounts are amortized or accreted using the interestmethod over the expected lives of the related securities.

 

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Loans and Interest on Loans

 

Loans receivable thatmanagement has the intent and ability to hold for the foreseeable future oruntil maturity or payoff are reported at their outstanding unpaid principalbalances reduced by any charge-offs of specific valuation accounts and net ofany deferred fees or costs on originated loans, or unamortized premiums ordiscounts on purchased loans.

 

Loan origination fees andcertain direct origination costs are capitalized and recognized as anadjustment of the yield of the related loan.

 

Loans on which the accrualof interest has been discontinued are designated as non-accrual loans.  The accrual of interest on loans isdiscontinued when principal or interest is past due 90 days based oncontractual terms of the loan or when, in the opinion of management, there isreasonable doubt as to collectibility. When loans are placed on non-accrual status, all interest previouslyaccrued but not collected is reversed against current period interestincome.  Interest income generally isnot recognized on specific impaired loans unless the likelihood of further lossis remote.  Interest payments receivedon such loans are applied as a reduction to the loan principal balance.  Interest accruals are resumed on such loansonly when they are brought current with respect to interest and principal andwhen, in the judgment of management, the loans are estimated to be fully collectibleas to all principal and interest.

 

The Company considers a loanto be impaired when it is probable that the Company will be unable to collectall amounts due (principal and interest) according to the contractual terms ofthe loan agreement.  Measurement ofimpairment is based on the expected future cash flows of an impaired loan whichare to be discounted at the loan’s effective interest rate, or measured byreference to an observable market value, if one exists, or the fair value ofthe collateral for a collateral-dependent loan.  The Company selects the measurement method on a loan-by-loanbasis except that collateral-dependent loans for which foreclosure is probableare measured at the fair value of the collateral.  The Bank recognizes interest income on impaired loans based onits existing methods of recognizing interest income on non-accrual loans.

 

All loans are generallycharged off at such time the loan is classified as a loss.

 

Loans Held for Sale

 

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

 

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Allowance for Loan Losses

 

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

 

Property, Premises andEquipment

 

Land is carried atcost.  Premises and equipment arecarried at cost less accumulated depreciation and amortization.  Depreciation is computed using thestraight-line method over the estimated useful lives, which ranges from threeto ten years for furniture and fixtures and forty years for buildings.  Leasehold improvements are amortized usingthe straight-line method over the estimated useful lives of the improvements ofthe remaining lease term, whichever is shorter.  Expenditures for betterments or major repairs are capitalized andthose for ordinary repairs and maintenance are charged to operations asincurred.  Total depreciation expensefor the reporting periods ending December 31, 2003, 2002, and 2001 wereapproximately $661, $652, and $825, respectively.

 

Goodwill and IntangibleAssets

 

The Company has engaged inthe acquisition of financial institutions and the assumption of deposits andpurchase of assets from other financial institutions.  The Company has paid premiums on these acquisitions, and such premiumsare recorded as intangible assets, in the form of goodwill or core depositintangible assets.

 

Goodwill represents theexcess of the purchase price over the estimated fair value of the net assetsacquired.  In accordance with theprovisions of SFAS 142, goodwill is not being amortized whereas identifiableintangible assets with finite lives are amortized over their useful lives.  On an annual basis, the Company is requiredto test goodwill for impairment.

 

Core deposit intangiblesrepresent the intangible value of depositor relationships resulting fromdeposit liabilities assumed in acquisitions. Core deposit intangibles are being amortized over six and tenyears.  Intangibles are evaluatedperiodically for other than temporary impairment.  Should such an assessment indicate that the undiscounted value ofan intangible may be impaired, the net book value of the intangible would bewritten down to the net estimated recoverable value.

 

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Income Taxes

 

Provisions for income taxesare based on amounts reported in the statements of income (after exclusion ofnon-taxable income such as interest on state and municipal securities) andinclude deferred taxes on temporary differences in the recognition of incomeand expense for tax and financial statement purposes.  Deferred taxes are computed on the liability method as prescribedin SFAS No. 109, “Accounting for Income Taxes.”

 

Advertising Costs

 

The Company expenses thecosts of advertising in the period incurred.

 

Disclosure about Fair Valueof Financial Instruments

 

SFAS No. 107 specifies thedisclosure of the estimated fair value of financial instruments.  The Company’s estimated fair value amountshave been determined by the Company using available market information and appropriatevaluation methodologies.

 

However, considerablejudgment is required to develop the estimates of fair value.  Accordingly, the estimates are notnecessarily indicative of the amounts the Company could have realized in acurrent market exchange.  The use ofdifferent market assumptions and/or estimation methodologies may have amaterial effect on the estimated fair value amounts.

 

Although management is notaware of any factors that would significantly affect the estimated fair valueamounts, such amounts have not been comprehensively revalued for purposes ofthese financial statements since the balance sheet date and, therefore, currentestimates of fair value may differ significantly from the amounts presented inthe accompanying notes.

 

Financial Instruments

 

In the ordinary course ofbusiness, the Company has entered into off-balance sheet financial instrumentsconsisting of commitments to extend credit, commercial letters of credit, andstandby letters of credit as described in Note #11.  Such financial instruments are recorded in the financialstatements when they are funded or related fees are incurred or received.

 

Comprehensive Income

 

Beginning in 1998, theCompany adopted SFAS No. 130, “*Reporting ComprehensiveIncome*,*”*which requires thedisclosure of comprehensive income and its components.  Changes in unrealized gain (loss) onavailable-for-sale securities net of income taxes is the only component ofaccumulated other comprehensive income for the Company.

 

Reclassifications

 

Certain amounts in the 2002and 2001 financial statements have been reclassified to conform to the 2003presentation.

 

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Earnings Per Share (EPS)

 

Basic EPS excludes dilutionand is computed by dividing income available to common stockholders by theweighted-average number of common shares outstanding for the period.  Diluted EPS reflects the potential dilutionthat could occur if securities or other contracts to issue common stock wereexercised or converted into common stock or resulted in the issuance of commonstock that then shared in the earnings of the entity.

 

Stock-Based Compensation

 

SFAS No. 123, *“Accountingfor Stock-Based Compensation,”*encourages, but does not require, companies to record compensation cost forstock-based employee compensation plans at fair value.  The Company has chosen to continue toaccount for stock-based compensation using the intrinsic value methodprescribed in Accounting Principles Board (“APB”) Opinion No. 25, *“Accountingfor Stock Issued to Employees,”*and related Interpretations. Accordingly, compensation cost for stock options is measured as theexcess, if any, of the quoted market price of the Company’s stock at the dateof the grant over the amount an employee must pay to acquire the stock.

 

Had compensation cost forthe Company’s stock option plans been determined based on the fair value at thegrant dates for awards under those plans consistent with the method of SFAS No.123, the Company’s net income and earnings per share would have been reduced tothe pro forma amount indicated below:

 
|                                                                                            |   | **2003** |   | **2002** |   | **2001** |   |
|-------------------------------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Net income:                                                                                     |   |     |   |     |   |     |   |
| As reported                                                                                     |   | $        | 3,596  |     | $      | 2,739    |   | $ | 2,346 |   |
| Stock-based compensation using the  intrinsic value method                                      |   | —   |   | —   |   | —   |   |
| Stock-based compensation that would have  been reported using the fair value method of SFAS 123 |   | (75      | )      | (111     | )      | (108     | )      |
| Pro forma net income                                                                            |   | $        | 3,521  |     | $      | 2,628    |   | $ | 2,238 |   |
|                                                                                            |   |     |   |     |   |     |   |
| Basic earnings per share:                                                                       |   |     |   |     |   |     |   |
| As reported                                                                                     |   | $        | 1.18   |     | $      | 0.94     |   | $ | 0.82 |   |
| Pro forma                                                                                       |   | 1.15     |   | 0.90     |   | 0.78     |   |
|                                                                                            |   |     |   |     |   |     |   |
| Diluted earnings per share:                                                                     |   |     |   |     |   |     |   |
| As reported                                                                                     |   | $        | 1.10   |     | $      | 0.86     |   | $ | 0.76 |   |
| Pro forma                                                                                       |   | 1.08     |   | 0.83     |   | 0.72     |   |

 

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Current AccountingPronouncements

 

In April 2003, FASB issued SFASNo. 149, “Amendment of Statement 133 on Derivative Instruments and HedgingActivities.”  SFAS No. 149 amends andclarifies accounting for derivative instruments, including certain derivativeinstruments embedded in other contracts and loan commitments that relate to theorigination of mortgage loans held for sale, and for hedging activities afterJune 30, 2003; however, management does not believe adoption will have amaterial impact on the Bank’s financial statements.

 

In May 2003, FASB issuedSFAS No. 150, *“Accounting for Certain FinancialInstruments with Characteristics of both Liabilities and Equity.”*  SFAS No. 150 establishes standards for how an issuer classifies andmeasures certain financial instruments with characteristics of both liabilitiesand equity.  SFAS No. 150 requires anissuer to classify a financial instrument that is within its scope as aliability.  Many of those instrumentswere previously classified as equity. SFAS No. 150 is generally effective for financial instruments enteredinto or modified after May 31, 2003, and otherwise effective at the beginningof the first interim period beginning after June 15, 2003; however,management does not believe adoption will have a material impact on the Bank’sfinancial statements.

 

In January 2003, FASBissued FASB Interpretation No. 46, “*Consolidation of VariableInterest Entities, an Interpretation of ARB NO. 51”**(“FIN 46”)* and in December 2003, FASB issued arevision *(“FIN 46R”)*.  FIN 46 and FIN46R address therequirements for consolidation by business enterprises of variable interestentities.  Subsidiary business trustsformed by bank holding companies to issue trust preferred securities and lendthe proceeds to the parent holding company have been determined to not meet thedefinition of a variable interest entity and therefore must be deconsolidatedfor financial reporting purposes.  Bankholding companies have previously consolidated these entities and reported thetrust preferred securities as liabilities in the consolidated financialstatements.  The Company has deconsolidatedits trust preferred securities as of December 31, 2003, which did not havea material impact on the Company’s financial statements.

 

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**Note #2 - Investment Securities**

 

At December 31, 2003and 2002, 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 adjustedfor amortization 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, 2003,were:

 
|                                                      |   | **Amortized  Cost** |   | **Gross  Unrealized  Gains** |   | **Gross  Unrealized  Losses** |   | **Fair Value** |   |
|-----------------------------------------------------------|--------|---------------------|--------|------------------------------|--------|-------------------------------|--------|----------------|--------|
| Obligations of U.S. Government  agencies and corporations |   | $                   | 2,484  |                         | $      | 22                            |   | $              | (24    | ) | $ | 2,482 |   |
| Mortgage-backed securities                                |   | 41,980              |   | 197                          |   | (308                          | )      | 41,869         |   |
| Obligations of state and political  subdivisions          |   | 10,320              |   | 365                          |   | (89                           | )      | 10,596         |   |
| Other securities                                          |   | 9                   |   | —                       |   | —                        |   | 9              |   |
| Total                                                     |   | $                   | 54,793 |                         | $      | 584                           |   | $              | (421   | ) | $ | 54,956 |   |

 

The amortized cost and fairvalues of investment securities available-for-sale at December 31, 2002,were:

 
|                                                      |   | **Amortized  Cost** |   | **Gross  Unrealized  Gains** |   | **Gross  Unrealized  Losses** |   | **Fair Value** |   |
|-----------------------------------------------------------|--------|---------------------|--------|------------------------------|--------|-------------------------------|--------|----------------|--------|
| Obligations of U.S. Government agencies and  corporations |   | $                   | 817    |                         | $      | —                        |   | $              | (18    | ) | $ | 799 |   |
| Mortgage-backed securities                                |   | 54,480              |   | 778                          |   | (4                            | )      | 55,254         |   |
| Obligations of state and political  subdivisions          |   | 9,154               |   | 247                          |   | (66                           | )      | 9,335          |   |
| Other securities                                          |   | 8                   |   | —                       |   | —                        |   | 8              |   |
| Total                                                     |   | $                   | 64,459 |                         | $      | 1,025                         |   | $              | (88    | ) | $ | 65,396 |   |

 

There were no investmentsecurities held-to-maturity at December 31, 2003 and December 31,2002.

 

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The amortized cost and fairvalues of investment securities available-for-sale at December 31, 2003,by contractual maturity are shown below. Actual maturities may differ fromcontractual maturities because borrowers may have the right to call or prepayobligations with or without call or prepayment penalties.

 
|                                   |   | **Securities  Available-for-Sale** |   |
|----------------------------------------|--------|------------------------------------|--------|
|                                   |   | **Amortized  Cost**                |   | **Fair Value** |   |
| Due in one year or less                |   | $                                  | 1,824  |   | $ | 1,832 |   |
| Due after one year through five years  |   | 1,861                              |   | 1,917 |   |
| Due after five years through ten years |   | 4,681                              |   | 4,744 |   |
| Due after ten years                    |   | 4,447                              |   | 4,594 |   |
| Mortgage-backed securities             |   | 41,980                             |   | 41,869 |   |
| Total Securities                       |   | $                                  | 54,793 |   | $ | 54,956 |   |

 

Proceeds from sales,maturities and principal reductions of investment securities available-for-saleduring 2003, 2002, and 2001, were $757, $26 and $1,852 respectively.  In 2003, gross gains and losses $3 and $0,respectively.  There were no gross gainsor losses reported during 2002.  In2001, gross gains and losses on these sales were $0 and $2, respectively.

 

Proceeds from sales andmaturities and principal reductions of mortgage-backed securities in 2003,2002, and 2001, were $27,387, $20,637, and $2,759, respectively.  In 2003 and 2002, gross gains and losses onthese sales were $57 and $0, and $1 and $20, respectively.  There were no gross gains or losses on thesesales during 2001.  Unrealizedgains/(losses) on investment securities and mortgage-backed securities includedin shareholders’ equity net of tax at December 31, 2003, 2002, and 2001were $98, $562, and ($155), respectively.

 

Securities having a carryingvalue and a fair value of approximately $44,101 and $46,343 atDecember 31, 2003 and 2002, respectively, were pledged to secure publicdeposits and for other purposes as required by law.

 

At its November 2003meeting, the FASB’s Emerging Issues Task Force (“EITF”) reached a consensusrequiring certain disclosures for impaired securities as described in EITFIssue No. 03-1, *“The Meaning ofOther-Than-Temporary Impairment and Its Application to Certain Investments.”*

 

As of December 31,2003, we had temporarily impaired securities with a fair value of $3,508 andunrealized losses of ($51).  Thesesecurities have been impaired for twelve months or more as of December 31,2003.  These securities are defined as impaireddue to declines in fair values resulting from increases in market interestrates.  None of the securities haveexhibited a decline in value as a result of changes in credit risk.Furthermore, we have the ability to hold these securities until maturity, andtherefore do not expect to realize losses on any of these securities. As such,management does not consider the impairments on these securities to beother-than-temporary.

 

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**Note #3 - Loans**

 

Major classifications ofloans were:

 
|                                   |   | **2003** |    | **2002** |   |
|----------------------------------------|--------|----------|---------|----------|--------|
| Commercial, financial and agricultural |   | $        | 49,024  |     | $      | 40,373 |   |
| Real Estate - construction             |   | 47,720   |    | 30,773   |   |
| Real Estate - other                    |   | 175,880  |    | 116,759  |   |
| Installment loans to individuals       |   | 5,173    |    | 2,291    |   |
| All other loans (including overdrafts) |   | 338      |    | 273      |   |
|                                   |   | 278,135  |    | 190,469  |   |
| Less:  Deferred loan fees         |   | (1,014   | )       | (822     | )      |
| Less:  Allowance for loan losses  |   | (3,070   | )       | (2,336   | )      |
| Total Loans                            |   | $        | 274,051 |     | $      | 187,311 |   |
|                                   |   |     |    |     |   |
| Loans held for sale                    |   | $        | 4,402   |     | $      | 8,166 |   |

 

Concentration of Credit Risk

 

At December 31, 2003and 2002, approximately $223,600 and $147,533 of the Banks’ loan portfolio wascollateralized by various forms of real estate.  Such loans are generally made to borrowers located in San LuisObispo County and Northern Santa Barbara County.  The Banks attempt to reduce their concentration of credit risk bymaking loans which are diversified by project type.  While management believes that the collateral presently securingthis portfolio is adequate, there can be no assurances that significantdeterioration in the California real estate market would not expose the Banksto significantly greater credit risk.

 

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

 
|                                               |   | **2003** |   | **2002** |   | **2001** |   |
|----------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Impaired loans with a valuation allowance          |   | $        | 1,475  |     | $      | 1,326    |   | $ | 203 |   |
| Impaired loans without a valuation  allowance      |   | 158      |   | 20       |   | 1,292    |   |
| Total impaired loans                               |   | $        | 1,633  |     | $      | 1,346    |   | $ | 1,495 |   |
|                                               |   |     |   |     |   |     |   |   |   |   |
| Valuation allowance related to impaired  loans     |   | $        | 528    |     | $      | 725      |   | $ | 148 |   |
|                                               |   |     |   |     |   |     |   |
| Average recorded investment in impaired  loans     |   | $        | 1,100  |     | $      | 1,526    |   | $ | 843 |   |
|                                               |   |     |   |     |   |     |   |
| Cash receipts applied to reduce principal  balance |   | $        | 132    |     | $      | 520      |   | $ | 317 |   |
|                                               |   |     |   |     |   |     |   |
| Interest income recognized for cash  payments      |   | $        | 25     |     | $      | 313      |   | $ | — |   |

 

The provisions of SFAS No.114 and SFAS No. 118 permit the valuation allowance reported above to bedetermined on a loan-by-loan basis or by aggregating loans with similar riskcharacteristics.  Because the loanscurrently identified as impaired have unique risk characteristics, thevaluation allowance was determined on a loan-by-loan basis.

 

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Non-accruing loans totaledapproximately $1,586 and $1,346 at December 31, 2003 and 2002,respectively.  As of December 31,2003 and 2002, all loans on non-accrual were classified as impaired.  If interest on non-accrual loans had beenrecognized at the original interest rates, interest income would have increased$132, $135, and $196, in 2003, 2002, and 2001, respectively.  No additional funds are committed to beadvanced in connection with impaired loans.

 

At December 31, 2003and 2002, the Bank had $21 and $0, respectively, in loans past due 90 days ormore and still accruing interest.

 

At December 31, 2003,loans totaling approximately $1,072 of which $1,000 are included in non-accrualloans, were classified as troubled debt restructurings.

 

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

 

Transactions in theallowance for loan losses are summarized as follows:

 
|                                       |   | **2003** |   | **2002** |   | **2001** |   |
|--------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Balance, Beginning of Year                 |   | $        | 2,336  |     | $      | 1,744    |   | $ | 1,321 |   |
| Additions charged to operating expense     |   | 370      |   | 545      |   | 600      |   |
| Loans charged off                          |   | (466     | )      | (81      | )      | (181     | )      |
| Recoveries of loans previously charged off |   | 233      |   | 128      |   | 4        |   |
| Credit from purchase of Hacienda Bank      |   | 597      |   | —   |   | —   |   |
| Balance, End of Year                       |   | $        | 3,070  |     | $      | 2,336    |   | $ | 1,744 |   |

 

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

 

Property, premises andequipment consisted of the following:

 
|                                             |   | **2003** |   | **2002** |   |
|--------------------------------------------------|--------|----------|--------|----------|--------|
| Land                                             |   | $        | 2,598  |     | $      | 1,992 |   |
| Building and improvements                        |   | 7,455    |   | 3,620    |   |
| Furniture and equipment                          |   | 5,031    |   | 2,770    |   |
| Construction in progress                         |   | 2,051    |   | 346      |   |
|                                             |   | 17,135   |   | 8,728    |   |
| Less: Accumulated depreciation and  amortization |   | 7,261    |   | 4,185    |   |
| Total                                            |   | $        | 9,874  |     | $      | 4,543 |   |

 

During 2002, the Bankpurchased land for future development of a Paso Robles, California branch forapproximately $1,000. The branch opened on February 17, 2004. Totalremaining construction commitments related to this project totaledapproximately $150, as of December 31, 2003.

 

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The Company leases land,buildings, and equipment under non-cancelable operating leases expiring atvarious dates through 2012. The following is a schedule of future minimumlease payments based upon obligations at year-end.

 
| **Year Ending  December 31,** |   | **Amount** |   |
|------------------------------------|--------|------------|--------|
| 2004                               |   |       | $      | 634 |   |
| 2005                               |   |       | 636    |   |
| 2006                               |   |       | 539    |   |
| 2007                               |   |       | 510    |   |
| 2008                               |   |       | 463    |   |
| More than 5 years                  |   |       | 1,013  |   |
| Total                              |   |       | $      | 3,795 |   |

 

The leases contain optionsto extend for periods from five to twenty years.  Options to extend which have been exercised and the related leasecosts are included above.  Total expenditurescharged for leases for the reporting periods ended December 31, 2003, 2002,and 2001, were approximately $435, $423, and $382, respectively.

 

**Note #6 - Intangible Assets**

 

Intangible assets consistedof core deposit intangibles subject to amortization with a net carrying valueof $2,442 and $359, net of $89 and $48 accumulated amortization as ofDecember 31, 2003 and 2002, respectively. Amortization expense for the periods ended December 31, 2003, 2002,and 2001 was $41, $43, and $20, respectively. The estimated future amortization expense for the next five years is$421 for 2004, $573 for 2005, $300 for 2006, $354 for 2007, and $388 for 2008.

 

**Note #7 - Time Deposit Liabilities**

 

At December 31, 2003,the Banks had time certificates of deposit with maturity distributions asfollows:

 
| **Year Ending  December 31,** |   |   |   |
|------------------------------------|--------|--------|--------|
| 2004                               |   |   | $      | 52,031 |   |
| 2005                               |   |   | 14,660 |   |
| 2006                               |   |   | 6,970  |   |
| 2006                               |   |   | 1,300  |   |
| 2007                               |   |   | 206    |   |
|                               |   |   | $      | 75,167 |   |

 

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**Note #8 - Borrowings**

 

The Banks have borrowinglines with correspondent banks totaling $9,200.

 

Federal Home Loan Bank(FHLB) Advances

 

The Banks entered intoborrowing agreements with the FHLB.  TheBanks had outstanding balances of $28,500 under these agreements atDecember 31, 2003 with a weighted average interest rate of 4.15%.  Of the FHLB advances, $9,500 mature in 2004,and $19,000 mature in 2005.  FHLB heldcertain investment securities and loans of the Banks as collateral for thoseborrowings.  In addition, the maximumoutstanding at any month-end was $38,000 during 2003.  At December 31, 2003, the Banks had additional borrowingcapacity of $16,400 with FHLB.

 

The Company has pledgedapproximately $24,878 in loans to the FHLB.

 

Securities Sold UnderAgreements to Repurchase

 

Securities sold underagreements to repurchase, which are classified as secured borrowings, generallymature within one to four days from the transaction date.  Securities sold under agreements torepurchase are reflected at the amount of cash received in connection with thetransaction.  As of December 31,2003 and 2002, the Banks had $460 and $258 in Securities sold under agreementsto repurchase.  Interest expenserecorded was $2, $7 and $1 for the years ended December 31, 2003, 2002,and 2001, respectively.

 

Notes Payable

 

During 1998, the Companyobtained a revolving line of credit in the amount of $2,000 through PacificCoast Bankers’ Bank.  The note wassecured by 339,332 shares of Heritage’s stock. The note was scheduled to mature on August 15, 2006, and boreinterest at a variable rate of 1.00 percent over the Wall Street Journal primerate.  The outstanding principal balanceat December 31, 2001, was $1,895. The note was paid off during 2002.

 

On October 10, 2003,the Company obtained a revolving line of credit in the amount of $3,500 throughPacific Coast Bankers Bank (PCBB).  Theline is secured by 51% of the outstanding shares of Heritage’s stock.  The line bears interest at the Wall StreetJournal prime rate.  Interest paymentsare due quarterly. The line is scheduled to mature on October 10, 2005 atwhich time the line converts to an eight-year term loan maturing onOctober 10, 2013.  Principal andinterest payments are due quarterly. Under the terms of the agreement, the Company will not incur anyadditional debt over $2,000 exclusive of the inter-company debt and existingdebt without prior written consent of PCBB. In addition, Heritage must be “well” capitalized on an on-going basis asdefined by the Regulators.

 

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Junior SubordinatedDebentures

 

On April 10, 2002, theCompany issued $8,248 of Floating Rate Junior Subordinated Deferrable InterestDebentures “ (the “debt securities”) to Heritage Oaks Capital Trust I, astatutory trust created under the laws of the State of Delaware.  These debt securities are subordinated toeffectively all borrowings of the Company and are due and payable onApril 22, 2032.  Interest ispayable quarterly on these debt securities at 6-Month LIBOR plus 3.7% for aneffective rate of 4.92% as of December 31, 2003.  The debt securities can be called at any time commencing onApril 22, 2007, at par.  The debtsecurities can also be redeemed at par if certain events occur that impact thetax treatment or the capital treatment of the issuance.  The Company also purchased a 3% minorityinterest totaling $248 in Heritage Oaks Capital Trust I.  The balance of the equity of Heritage OaksCapital Trust I is comprised of mandatorily redeemable preferred securities andis included in other assets.

 

Under FASB Interpretation(FIN) No. 46, *“Consolidation of VariableInterest Entities, an interpretation of ARB No. 51,”* the Company is not allowed to consolidateHeritage Oaks Capital Trust I into the Company’s financial statements.  Prior to the issuance of FIN No. 46, Bankholding companies typically consolidated these entities.  The Federal Reserve Board had ruled that certainmandatorily redeemable preferred securities of a consolidated entity qualifiedas Tier 1 Capital.  The Federal ReserveBoard is evaluating the capital impact from FIN No. 46 but has not issued anyfinal ruling.  As of December 31,2003, the Company has included the net junior subordinated debt in its Tier1Capital for regulatory capital purposes.

 

**Note #9 - Income Taxes**

 

The current and deferredamounts of the provision (benefit) for income taxes were:

 
|                      |   | **Year  Ending December 31,** |   |
|---------------------------|--------|------------------------------------|--------|
|                      |   | **2003**                           |   | **2002** |   | **2001** |   |
| Federal Income Tax        |   |                               |   |   |   |   |   |
| Current                   |   | $                                  | 1,611  |   | $ | 1,390 |   | $ | 1,251 |   |
| Deferred                  |   | (82                                | )      | (247 | ) | (265 | ) |
| Total Federal Taxes       |   | 1,529                              |   | 1,143 |   | 986 |   |
|                      |   |                               |   |   |   |   |   |
| State Franchise Tax       |   |                               |   |   |   |   |   |
| Current                   |   | 630                                |   | 651 |   | 471 |   |
| Deferred                  |   | (42                                | )      | (145 | ) | (78 | ) |
| Total State Franchise Tax |   | 588                                |   | 506 |   | 393 |   |
| Total Income Taxes        |   | $                                  | 2,117  |   | $ | 1,649 |   | $ | 1,379 |   |

 

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The principal items givingrise to deferred taxes were:

 
|                                               |   | **2003** |   | **2002** |   | **2001** |   |
|----------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Use of different depreciation for tax  purposes    |   | $        | (59    | )        | $      | (98      | )      | $ | (16 | ) |
| Difference in loan loss provision for tax purposes |   | (57      | )      | (191     | )      | (174     | )      |
| Differences arising from changes in  accruals      |   | (8       | )      | (102     | )      | (114     | )      |
| Other, net                                         |   | —   |   | —   |   | (39      | )      |
| Total                                              |   | $        | (124   | )        | $      | (391     | )      | $ | (343 | ) |

 

The provision for taxes onincome differed from the amounts computed using the federal statutory tax rateof 34 percent is as follows:

 
|                                                   |   | **2003**   |   | **2002**    |   | **2001**   |   |
|--------------------------------------------------------|--------|------------|--------|-------------|--------|------------|--------|
|                                                   |   | **Amount** |   | **Percent** |   | **Amount** |   | **Percent** |   | **Amount** |   | **Percent** |   |
| Tax provision at federal statutory tax rate            |   | $          | 1,942  |        | 34.0   |       | $      | 1,492 |   | 34.0 |   | $ | 1,267 |   | 34.0 |   |
| State income taxes, net of federal income  tax benefit |   | 388        |   | 6.8         |   | 333        |   | 7.6 |   | 259 |   | 7.0 |   |
| Tax exempt income and other, Net                       |   | (213       | )      | (3.7        | )      | (176       | )      | (4.0 | ) | (147 | ) | (4.0 | ) |
| Total Tax Provision                                    |   | $          | 2,117  |        | 37.1   |       | $      | 1,649 |   | 37.6 |   | $ | 1,379 |   | 37.0 |   |

 

The net deferred tax assetis determined as follows:

 
|                                                                  |   | **2003** |   | **2002** |   |
|-----------------------------------------------------------------------|--------|----------|--------|----------|--------|
| Deferred Tax Assets                                                   |   |     |   |     |   |
| Reserves for loan losses                                              |   | $        | 1,050  |     | $      | 820 |   |
| Fixed assets                                                          |   | 250      |   | 120      |   |
| Accruals                                                              |   | 709      |   | 606      |   |
| Investment securities valuation                                       |   | 67       |   | —   |   |
| Net operating loss carryforward                                       |   | 590      |   | —   |   |
| Total Deferred tax assets arising from  cumulative timing differences |   | 2,666    |   | 1,546    |   |
| Valuation allowance*                                                  |   | —   |   | —   |   |
| Total Deferred Tax Assets                                             |   | $        | 2,666  |     | $      | 1,546 |   |
| Deferred Tax Liabilities                                              |   |     |   |     |   |
| Fair value adjustment for purchased assets                            |   | $        | 695    |     | $      | — |   |
| Investment securities valuation                                       |   | —   |   | 375      |   |
| Total Deferred Tax Liabilities                                        |   | 695      |   | 375      |   |
| Net Deferred Tax Assets                                               |   | $        | 1,971  |     | $      | 1,171 |   |

 

----

*The valuation allowance isestimated based upon amounts less than likely of future realization.  There was no change in the valuationallowance for the 2003 year.

 

The Company acquired a $2.2million net operating loss (NOL) as part of the transaction with Hacienda. Therealization of the NOL is limited for federal tax purposes and suspended forstate tax purposes under current tax law. Any amount not utilized for federal tax purposes will expire on variousyears through 2014.

 

62

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**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.

 

In the normal course ofbusiness, the Banks enter into financial commitments to meet the financingneeds of their customers.  Thesefinancial commitments include commitments to extend credit and standby lettersof credit.  Those instruments involve,to varying degrees, elements of credit and interest rate risk not recognized inthe statement of financial position.

 

The Banks’ exposure to loanloss in the event of nonperformance on commitments to extend credit and standbyletters of credit is represented by the contractual amount of thoseinstruments.  The Banks use the same creditpolicies in making commitments as they do for loans reflected in theconsolidated financial statements.

 

As of December 31, 2003and 2002, the Banks had the following outstanding financial commitments whosecontractual amount represents credit risk:

 
|                         |   | **2003** |   | **2002** |   |
|------------------------------|--------|----------|--------|----------|--------|
|                         |   |     |   |     |   |
| Commitments to extend credit |   | $        | 93,127 |     | $      | 65,254 |   |
| Standby letters of credit    |   | 3,372    |   | 1,535    |   |
|                         |   | $        | 96,499 |     | $      | 66,789 |   |

 

Commitments to extend creditare agreements to lend to a customer as long as there is no violation of anycondition established in the contract. Standby letters of credit are conditional commitments to guarantee theperformance of a Bank customer to a third party.  Since many of the commitments and standby letters of credit areexpected to expire without being drawn upon, the total amounts do not necessarilyrepresent future cash requirements.  TheBanks evaluate each customer’s credit worthiness on a case-by-case basis.  The amount of collateral obtained if deemednecessary by the Banks is based on management’s credit evaluation of thecustomer.

 

**Note #11 - Regulatory Matters**

 

The Company (on aconsolidated basis) and the Banks 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 Banks’ financial statements. Under capital adequacy guidelines and the regulatory framework forprompt corrective action, the Company and the Banks must meet specific capitalguidelines that involve quantitative measures of the Company’s and the Banks’assets, liabilities and certain off-balance sheet items as calculated underregulatory accounting practices.  The Company’sand the Banks’ 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 measuresestablished by regulation to ensure capital adequacy require the Company andthe Banks to maintain minimum amounts and ratios (set forth in the table below)of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets(as defined) and of Tier 1 capital (as defined) to average assets (asdefined).  Management believes, as ofDecember 31, 2003, that the Company and the Banks meet all capitaladequacy requirements to which it is subject.

 

63

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As of the most recentnotification, the Federal Deposit Insurance Corporation categorized the Bank aswell-capitalized under the regulatory framework for prompt correctiveaction.  There are no conditions orevents since that notification that management believes have changed the Bank’scategory.  To be categorized aswell-capitalized, the Banks must maintain minimum capital ratios as set forthin the table below.  The following tablealso sets forth the Company’s and the Banks’ actual regulatory capital amountsand ratios:

 

64

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|                                    |   |                   |   |                                |   | **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, 2003**        |   |                   |   |                                |   |                                                                    |   |   |   |   |   |   |   |
| Total capital to risk-weighted assets:  |   |                   |   |                                |   |                                                                    |   |   |   |   |   |   |   |
| Company                                 |   | $                      | 36,042 |                                | 11.14  | %                                                                       | $      | 25,886 |   | 8.0 | % | N/A |   | N/A |   |
| Heritage Oaks Bank                      |   | 31,061                 |   | 11.78                               | %      | 21,088                                                                  |   | 8.0 | % | $ | 26,360 |   | 10.0 | % |
| Hacienda Bank                           |   | 6,389                  |   | 10.65                               | %      | 4,798                                                                   |   | 8.0 | % | $ | 5,998 |   | 10.0 | % |
|                                    |   |                   |   |                                |   |                                                                    |   |   |   |   |   |   |   |   |
| Tier 1 capital to risk-weighted assets: |   |                   |   |                                |   |                                                                    |   |   |   |   |   |   |   |
| Company                                 |   | 32,845                 |   | 10.15                               | %      | 12,943                                                                  |   | 4.0 | % | N/A |   | N/A |   |
| Heritage Oaks Bank                      |   | 28,516                 |   | 10.82                               | %      | 10,544                                                                  |   | 4.0 | % | 15,816 |   | 6.0 | % |
| Hacienda Bank                           |   | 5,737                  |   | 9.57                                | %      | 2,399                                                                   |   | 4.0 | % | 3,599 |   | 6.0 | % |
|                                    |   |                   |   |                                |   |                                                                    |   |   |   |   |   |   |   |
| Tier 1 capital to average assets:       |   |                   |   |                                |   |                                                                    |   |   |   |   |   |   |   |
| Company                                 |   | 32,845                 |   | 8.30                                | %      | 15,823                                                                  |   | 4.0 | % | N/A |   | N/A |   |
| Heritage Oaks Bank                      |   | 28,516                 |   | 8.61                                | %      | 13,242                                                                  |   | 4.0 | % | 16,552 |   | 5.0 | % |
| Hacienda Bank                           |   | 5,737                  |   | 7.21                                | %      | 3,183                                                                   |   | 4.0 | % | 3,979 |   | 5.0 | % |
|                                    |   |                   |   |                                |   |                                                                    |   |   |   |   |   |   |   |
| **As of December 31, 2002**        |   |                   |   |                                |   |                                                                    |   |   |   |   |   |   |   |
| Total capital to risk-weighted assets:  |   |                   |   |                                |   |                                                                    |   |   |   |   |   |   |   |
| Company                                 |   | $                      | 29,268 |                                | 13.00  | %                                                                       | $      | 18,012 |   | 8.0 | % | N/A |   | N/A |   |
| Bank                                    |   | 27,016                 |   | 12.06                               | %      | 17,920                                                                  |   | 8.0 | % | $ | 22,400 |   | 10.0 | % |
|                                    |   |                   |   |                                |   |                                                                    |   |   |   |   |   |   |   |   |
| Tier 1 capital to risk-weighted assets: |   |                   |   |                                |   |                                                                    |   |   |   |   |   |   |   |
| Company                                 |   | 25,192                 |   | 11.19                               | %      | 9,006                                                                   |   | 4.0 | % | N/A |   | N/A |   |
| Bank                                    |   | 24,640                 |   | 11.00                               | %      | 8,960                                                                   |   | 4.0 | % | 13,440 |   | 6.0 | % |
|                                    |   |                   |   |                                |   |                                                                    |   |   |   |   |   |   |   |
| Tier 1 capital to average assets:       |   |                   |   |                                |   |                                                                    |   |   |   |   |   |   |   |
| Company                                 |   | 25,192                 |   | 7.66                                | %      | 13,153                                                                  |   | 4.0 | % | N/A |   | N/A |   |
| Bank                                    |   | 24,640                 |   | 7.53                                | %      | 13,087                                                                  |   | 4.0 | % | 16,358 |   | 5.0 | % |

 

As disclosed in Note #8,Borrowings - Junior Subordinated Debentures, subject to percentage limitations,the proceeds from the issuance of trust preferred securities are consideredTier 1 capital by the Company for regulatory purposes.  However, as a result of the issuance of FIN46 and FIN 46R, the trust subsidiary is not consolidated in these financialstatements and therefore the proceeds received by the Company from the trustsubsidiary is reported as subordinated debt. The Federal Reserve Board has indicated that it would review theregulatory implications of this change in financial reporting thatdeconsolidates these trust subsidiaries and the continued inclusion of theseamounts in regulatory capital.   TheFederal Reserve Board has advised bank holding companies to continue to reportthe amount of the trust preferred securities in regulatory reports as aminority interest and thereby the amount has been included in Tier 1 capital.

 

65

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**Note #12 - Salary Continuation Plan**

 

The Company established asalary continuation plan agreement with the President, Chief Financial Officer,Chief Lending Officer, Chief Administrative Officer and certain Senior VicePresidents, as authorized by the Board of Directors.  This agreement provides for annual cash payments for a period notto exceed 15 years, payable at age 60-65, depending on the agreement.  In the event of death prior to retirementage, annual cash payments would be made to the beneficiaries for a determinednumber of years.  The present values ofthe Company’s liability under this Agreement were approximately $695 and $493at December 31, 2003 and 2002, respectively, and are included in otherliabilities in the Company’s Consolidated Financial Statements.  The Company maintains life insurance policies,which are intended to fund all costs of the plan.  The cash surrender values of these life insurance policiestotaled approximately $6,859 and $5,415, at December 31, 2003 and 2002,respectively.

 

**Note #13 - Employee Benefit Plans**

 

401(k) Pension Plan

 

During 1994, the Companyestablished a savings plan for employees which allows participants to makecontributions by salary deduction equal to 15 percent or less of their salarypursuant to section 401(k) of the Internal Revenue Code.  Employee contributions are matched up to 25percent of the employee’s contribution. Employees vest immediately in their own contributions and they vest inthe Company’s contribution based on years of service.  Expenses of the savings plan were approximately $74, $64, and$58, for the years ended December 31, 2003, 2002, and 2001, respectively.

 

Employee Stock OwnershipPlan

 

The Company sponsors anemployee stock ownership plan (ESOP) that covers all employees who havecompleted 12 consecutive months of service, are over 21 years of age and work aminimum of 1,000 hours per year.  Theamount of the annual contribution to the ESOP is at the discretion of the Boardof Directors.  The contributions made tothis plan were approximately $162 in 2003, $125 in 2002, and $157 in 2001.

 

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**Note #14 - Stock Option Plans**

 

At December 31, 2003,the Company had two stock option plans, which are described below.

 

The Company adopted theCompany’s 1990 stock option plan, which is a tandem stock option planpermitting options to be granted either as “Incentive Stock Options” or asNon-Qualified Stock options under the Internal Revenue Code.  All outstanding options were granted atprices 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 350,075 shares of the Company’s un-issued common stock and is subjectto the specific approval of the Board of Directors.  The Company’s 1990 stock option plan expired in July 2000.

 

No options were grantedduring 2001, 2002, or 2003.

 

The following tablessummarize information about the 1990 stock option plan outstanding atDecember 31, 2003.

 
|                                                            |   | **2003**   |   | **2002**                                |   | **2001**   |    |
|-----------------------------------------------------------------|--------|------------|--------|-----------------------------------------|--------|------------|---------|
|                                                            |   | **Shares** |   | **Weighted-  Average  Exercise  Price** |   | **Shares** |    | **Weighted-  Average  Exercise  Price** |   | **Shares** |   | **Weighted-  Average  Exercise  Price** |   |
| Outstanding at beginning of year                                |   | 2,134      |   | $                                       | 4.22   |       | 35,774  |   | $ | 1.67 |   | 51,996 |   | $ | 1.66 |   |
| Granted                                                         |   |       |   |                                    |   |       |    |   |   |   |   |   |   |
| Cancelled                                                       |   | —     |   | $                                       | — |       | —  |   | $ | — |   | — |   | $ | — |   |
| Exercised                                                       |   | —     |   | $                                       | — |       | (33,640 | ) | $ | 1.51 |   | (16,222 | ) | $ | 1.63 |   |
| Outstanding at end of year                                      |   | 2,134      |   | $                                       | 4.22   |       | 2,134   |   | $ | 4.22 |   | 35,774 |   | $ | 1.67 |   |
|                                                            |   |       |   |                                    |   |       |    |   |   |   |   |   |   |
| Options available for granting at end of  year                  |   | —     |   |                                    |   | —     |    |   |   | — |   |   |   |
| Options exercisable at year-end                                 |   | 2,134      |   | $                                       | 4.22   |       | 2,134   |   | $ | 4.22 |   | 35,774 |   | $ | 1.67 |   |
| Weighted-average fair value of options  granted during the year |   | —     |   |                                    |   | —     |    |   |   | — |   |   |   |

 
| **Options  Outstanding** |   | **Options  Exercisable** |   |
|--------------------------|--------|--------------------------|--------|
| **Exercise  Price**      |   | **Number  Outstanding**  |   | **Weighted-  Average  Remaining  Contractual Life** |   | **Weighted-  Average  Exercise  Price** |   | **Number  Exercisable** |   | **Weighted-  Average  Exercise  Price** |   |
|                     |   |                     |   |   |   |   |   |   |   |   |   |
| $                        | 4.22   |                     | 2,134  |   | 3.53 |   | $ | 4.22 |   | 2,134 |   | $ | 4.22 |   |
|                          |        |                          |        |  |  |  |  |  |  |  |  |  |  |  |

 

The Company adopted the Company’s 1997 stock option plan, which is atandem stock option plan permitting options to be granted either as “IncentiveStock Options” or as “Non-Qualified Stock Options” under the Internal RevenueCode.  All outstanding options weregranted at prices which equal the fair market value on the day of thegrant.  Options granted vest at a rateof 20 percent per year for five years, and expire no later than ten years fromthe date of grant.  The plan providesfor issuance of up to 407,173 shares of the Company’s un-issued common stockand is subject to the specific approval of the Board of Directors.

 

67

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During 1999, the Board ofDirectors approved an amendment to the 1997 Stock Option Plan.  Under this amendment, the plan provides forissuance of up to 241,288 additional shares of the Company’s common stock.

 

The fair value of eachoption granted was estimated on the date of grant using the Black-Scholesoption pricing model with the following assumptions for 2003, 2002, and 2001,respectively:  risk-free rates of 4.58percent, 3.73 percent, and 5.25 percent dividend yields of 0 percent for allyears presented, expected life of 10 years, 8 years, and nine years; andvolatility of 24 percent, 26 percent, 26 percent.

 

The following summarizesinformation about the 1997 stock option plan outstanding at December 31,2003.

 
|                                                            |   | **2003**   |   | **2002**                                |   | **2001**   |    |
|-----------------------------------------------------------------|--------|------------|--------|-----------------------------------------|--------|------------|---------|
|                                                            |   | **Shares** |   | **Weighted-  Average  Exercise  Price** |   | **Shares** |    | **Weighted-  Average  Exercise  Price** |   | **Shares** |   | **Weighted-  Average  Exercise  Price** |   |
| Outstanding at beginning of year                                |   | 403,946    |   | $                                       | 5.50   |       | 436,651 |   | $ | 5.15 |   | 454,403 |   | $ | 5.11 |   |
| Granted                                                         |   | 128,043    |   | $                                       | 8.77   |       | 18,375  |   | $ | 11.23 |   | 13,892 |   | $ | 7.56 |   |
| Cancelled                                                       |   | (11,896    | )      | $                                       | 7.55   |       | (21,219 | ) | $ | 4.49 |   | (21,677 | ) | $ | 6.19 |   |
| Exercised                                                       |   | (72,471    | )      | $                                       | 5.23   |       | (29,861 | ) | $ | 4.54 |   | (9,967 | ) | $ | 4.22 |   |
| Outstanding at end of year                                      |   | 447,622    |   | $                                       | 6.44   |       | 403,946 |   | $ | 5.50 |   | 436,651 |   | $ | 5.15 |   |
|                                                            |   |       |   |                                    |   |       |    |   |   |   |   |   |   |
| Options available for grant end of year                         |   | 67,832     |   |                                    |   | 183,979    |    |   |   | 181,134 |   |   |   |
| Options exercisable at year-end                                 |   | 373,247    |   | $                                       | 5.73   |       | 306,551 |   | $ | 4.85 |   | 265,202 |   | $ | 9.84 |   |
| Weighted-average fair value of options  granted during the year |   | $          | 6.48   |                                    |   |       | $       | 4.47 |   |   |   | $ | 3.56 |   |   |   |
|                                                                 |        |            |        |                                         |        |            |         |  |  |  |  |  |  |  |  |  |  |  |  |

 
| **Options  Outstanding** |   | **Options  Exercisable** |   |
|--------------------------|--------|--------------------------|--------|
| **Exercise  Price**      |   | **Number  Outstanding**  |   | **Weighted-  Average  Remaining  Contractual Life** |   | **Weighted-  Average  Exercise  Price** |   | **Number  Exercisable** |   | **Weighted-  Average  Exercise  Price** |   |
| $4.22 - $6.84            |   | 315,956                  |   | 4.55 |   | $ | 5.19 |   | 284,766 |   | $ | 5.05 |   |
| $7.20 - $9.70            |   | 86,156                   |   | 6.82 |   | $ | 7.68 |   | 82,672 |   | $ | 7.69 |   |
| $10.71 - $13.95          |   | 45,510                   |   | 9.14 |   | $ | 12.73 |   | 5,809 |   | $ | 11.31 |   |
|                     |   | 447,622                  |   |   |   |   |   | 373,247 |   |   |   |

 

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**Note #15 - Related Party Transactions**

 

The Banks have entered intoloan and deposit transactions with certain directors and executive officers ofthe Banks and the Company.  These loanswere made and deposits were taken in the ordinary course of the Banks’ businessand, in management’s opinion, were made at prevailing rates and terms.

 

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

 
|                                   |   | **2003** |   | **2002** |   |
|----------------------------------------|--------|----------|--------|----------|--------|
| Outstanding Balance, Beginning of Year |   | $        | 1,472  |     | $      | 2,815 |   |
| Additional loans made                  |   | 3,348    |   | 2,558    |   |
| Acquisition of Hacienda Bank           |   | 4,380    |   | —   |   |
| Repayments                             |   | (2,849   | )      | (3,901   | )      |
| Outstanding Balance, End of Year       |   | $        | 6,351  |     | $      | 1,472 |   |

 

Deposits from relatedparties held by the Banks at December 31, 2003 and 2002 amounted toapproximately $5,276 and $2,816, respectively.

 

**Note #16 - Restriction on Transfers of Funds to Parent**

 

There are legal limitationson the ability of the Banks to provide funds to the Company.  Dividends declared by each of the Banks maynot exceed, in any calendar year, without approval of the California Departmentof Financial Institutions (DFI), its respective net income for the year and theretained net income for the preceding two years.  Section 23A of the Federal Reserve Act restricts the Banksfrom extending credit to the Company and other affiliates amounting to morethan 20 percent of its contributed capital and retained earnings.

 

69

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

 

The fair value of afinancial instrument is the amount at which the asset or obligation could beexchanged in a current transaction between willing parties, other than a forcedor liquidation sale.  Fair valueestimates are made at a specific point in time based on relevant marketinformation and information about the financial instrument.  These estimates do not reflect any premiumor discount that could result from offering for sale at one time the entireholdings or a particular financial instrument. Because no market value exists for a significant portion of thefinancial instruments, fair value estimates are based on judgments regardingfuture expected loss experience, current economic conditions, riskcharacteristics of various financial instruments, and other factors.  These estimates are subjective in nature,involve uncertainties and matters of judgment and, therefore, cannot bedetermined with precision.  Changes inassumptions could significantly affect the estimates.

 

Fair value estimates arebased on financial instruments both on and off the balance sheet withoutattempting to estimate the value of anticipated future business and the valueof assets and liabilities that are not considered financial instruments.  Additionally, tax consequences related tothe realization of the unrealized gains and losses can have a potential effecton fair value estimates and have not been considered in many of the estimates.

 

The estimated fair value offinancial instruments at December 31 is summarized as follows:

 
|                                                        |   | **2003**             |   | **2002**                     |       |
|-------------------------------------------------------------|--------|----------------------|--------|------------------------------|------------|
|                                                        |   | **Carrying  Amount** |   | **Fair Value**               |       | **Carrying  Amount** |   | **Fair Value** |   |
| Assets                                                      |   |                 |   |                         |       |   |   |   |   |
| Cash and cash equivalents                                   |   | $                    | 77,114 |                         | $          | 77,114 |   | $ | 60,554 |   | $ | 60,554 |   |
| Interest-bearing deposits                                   |   | 498                  |   | 498                          |       | 497 |   | 497 |   |
| Investments and mortgage-backed securities                  |   | 54,956               |   | 54,956                       |       | 65,396 |   | 65,396 |   |
| FHLB stock                                                  |   | 1,959                |   | 1,959                        |       | 1,951 |   | 1,951 |   |
| Loans receivable, net                                       |   | 277,121              |   | 278,131                      |       | 189,648 |   | 193,007 |   |
| Loans held for sale                                         |   | 4,402                |   | 4,402                        |       | 8,166 |   | 8,166 |   |
| Accrued interest receivable                                 |   | 1,485                |   | 1,485                        |       | 1,106 |   | 1,106 |   |
|                                                        |   |                 |   |                         |       |   |   |   |   |
| Liabilities                                                 |   |                 |   |                         |       |   |   |   |   |
| Noninterest-bearing deposits                                |   | 137,859              |   | 137,859                      |       | 106,556 |   | 106,556 |   |
| Interest-bearing deposits                                   |   | 228,580              |   | 228,914                      |       | 157,623 |   | 158,257 |   |
| FHLB advances                                               |   | 28,500               |   | 28,560                       |       | 38,000 |   | 38,043 |   |
| Securities sold under repurchase agreements                 |   | 460                  |   | 460                          |       | 258 |   | 258 |   |
| Notes payable                                               |   | 3,500                |   | 3,500                        |       | — |   | — |   |
| Junior Subordinated Debentures                              |   | 8,248                |   | 8,248                        |       | 8,248 |   | 8,248 |   |
| Accrued interest payable                                    |   | 506                  |   | 506                          |       | 565 |   | 565 |   |
|                                                        |   |                 |   |                         |       |   |   |   |   |
|                                                        |   | **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 |   | $                    | 96,499 |                         | $          | 965 |   | $ | 66,789 |   | $ | 668 |   |

 

70

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

 

•                  Cash and Cash Equivalents

 

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

 

•                  Interest Bearing Deposits

 

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

 

•                  Investment and Mortgage-Backed Securities

 

Fair values are based uponquoted market prices, where available.

 

•                  Loans and Loans Held for Sale

 

For variable-rate loans thatre-price frequently and with no significant change in credit risk, fair valuesare based on carrying amounts.  The fairvalues for other loans (for example, fixed rate commercial real estate and rentalproperty mortgage loans and commercial and industrial loans) are estimatedusing discounted cash flow analysis, based on interest rates currently beingoffered for loans with similar terms to borrowers of similar creditquality.  Loan fair value estimatesinclude judgments regarding future expected loss experience and riskcharacteristics.  The carrying amount ofaccrued interest receivable approximates its fair value.

 

•                  Deposits

 

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

 

•                  FHLB Advances

 

The fair value disclosed forFHLB advances is determined by discounting contractual cash flows at currentmarket interest rates for similar instruments.

 

71

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•                  Securities Sold Under Agreement to Repurchase

 

The carrying amountsreported in the balance sheets for securities sold under agreement torepurchase approximate those liabilities’ fair values due to the short-termnature of the liabilities.

 

•                  Notes Payable and Junior SubordinatedDebentures

 

The fair value disclosed fornotes payable and junior subordinated debentures is based on carryingamounts.  The notes are variable-ratednotes that re-price frequently.

 

•                  Off-balance Sheet Instruments

 

Fair values of commitmentsto extend credit and standby letters of credit are based upon fees currentlycharged to enter into similar agreements, taking into account the remainingterms of the agreement and the counterparties’ credit standing.

 

**Note #18 - Earnings Per Share (EPS)**

 

The following is areconciliation of net income and shares outstanding to the income and number ofshares used to compute EPS.  Shareinformation has been retroactively adjusted for the stock dividend as discussedin Note #21.

 
|                                                  |   | **2003**        |   | **2002**   |      | **2001**        |   |
|-------------------------------------------------------|--------|-----------------|--------|------------|-----------|-----------------|--------|
|                                                  |   | **Net  Income** |   | **Shares** |      | **Net  Income** |   | **Shares** |   | **Net  Income** |   | **Shares** |   |
| Net income as reported                                |   | $               | 3,596  |       |      |            | $      | 2,739 |   |   |   | $ | 2,346 |   |   |   |
| Shares outstanding at year-end                        |   |            |   | 3,604,497  |      |            |   | 2,924,541 |   |   |   | 2,861,309 |   |
| Impact of weighting shares purchased during  the year |   |            |   | (546,183   | )         |            |   | (11,307 | ) |   |   | (4,340 | ) |
| Used in Basic EPS                                     |   | 3,596           |   | 3,058,314  |      | 2,739           |   | 2,913,234 |   | 2,346 |   | 2,856,969 |   |
| Dilutive effect of outstanding stock  options         |   |            |   | 211,377    |      |            |   | 258,234 |   |   |   | 250,039 |   |
| Used in Dilutive EPS                                  |   | $               | 3,596  |       | 3,269,691 |            | $      | 2,739 |   | 3,171,468 |   | $ | 2,346 |   | 3,107,008 |   |

 

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

 

The following is a breakdownof fees and other income and expenses for the years ended December 31,2003, 2002, and 2001:

 
|                                                         |   | **2003** |   | **2002** |   | **2001** |   |
|--------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Fees and Other Income                                        |   |     |   |     |   |     |   |
| ATM/Debit Card Transaction/Interchange Fees                  |   | $        | 406    |     | $      | 494      |   | $ | 2,018 |   |
| Bankcard merchant fees                                       |   | 100      |   | 123      |   | 123      |   |
| Mortgage broker fees                                         |   | 880      |   | 767      |   | 577      |   |
| Earnings on cash surrender value of life  insurance policies |   | 264      |   | 304      |   | 138      |   |
| Other                                                        |   | 364      |   | 361      |   | 643      |   |
|                                                         |   | $        | 2,014  |     | $      | 2,049    |   | $ | 3,499 |   |
|                                                         |   |     |   |     |   |     |   |
| Other Expenses                                               |   |     |   |     |   |     |   |
| Data processing                                              |   | $        | 1,581  |     | $      | 1,416    |   | $ | 1,461 |   |
| Advertising and promotional                                  |   | 361      |   | 380      |   | 327      |   |
| Regulatory fees                                              |   | 86       |   | 62       |   | 78       |   |
| Other professional fees and outside  services                |   | 432      |   | 416      |   | 367      |   |
| Legal fees and other litigation expenses                     |   | 52       |   | 106      |   | 231      |   |
| Loan department costs                                        |   | 255      |   | 204      |   | 205      |   |
| Stationery and supplies                                      |   | 249      |   | 231      |   | 188      |   |
| Director fees                                                |   | 152      |   | 165      |   | 216      |   |
| ATM costs at gaming sites                                    |   | —   |   | 89       |   | 1,158    |   |
| ATM costs at retail sites                                    |   | —   |   | —   |   | 384      |   |
| Other                                                        |   | 1,002    |   | 953      |   | 570      |   |
| Total                                                        |   | $        | 4,170  |     | $      | 4,022    |   | $ | 5,185 |   |

 

73

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**Note #20 - Operating Segments**

 

In June 1997, theFinancial Accounting Standards Board (FASB) issued Statement No. 131, “*Disclosuresabout Segments of an Enterprise and Related Information*,” which the Company adopted during1998.  Beginning in 2002, the Companyhad one primary reportable segment. Prior to 2002, the Company had two primary reportable segments.  The segments were reported herein apply toHeritage and the Heritage’s EFT Department. The segments were identified as such based upon the percentage ofoperating net income, management responsibility, and the types of products andservices offered.

 

The segments consisted ofHeritage and four separately classified components within the EFT Departmentreferred to as networks.  As ofDecember 31, 2001, the EFT Department had installed automated tellermachines located in retail outlets and gaming facilities.  Income was based upon total customer usageof the machines and the applicable transaction charge.  Income was allocated to Heritage viacontractual agreement.  The Companymeasured segment profit as operating net income which is defined as incomebefore provision for income taxes.

 

During 2001, the Company divestedall of its retail automated teller machines and all but two of its gamingautomated teller machines.  Total salesproceeds were $534.

 

Presented below iscomparative financial information relating to the Company’s operating segments:

 
|                                         |   | **EFT  Department** |   | **Bank** |   | **Total  Operating  Segments** |   |
|----------------------------------------------|--------|---------------------|--------|----------|--------|--------------------------------|--------|
| **Fiscal Year Ended December 31, 2001** |   |                |   |     |   |                           |   |
| Revenues                                     |   | $                   | 2,324  |     | $      | 16,818                         |   | $ | 19,142 |   |
| Depreciation and amortization                |   | 182                 |   | 628      |   | 810                            |   |
| Operating income                             |   | 367                 |   | 2,057    |   | 2,424                          |   |
| Total assets                                 |   | 249                 |   | 213,676  |   | 213,925                        |   |
|                                              |        |                     |        |          |        |                                |        |  |  |  |

 

74

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**Note #21 - Stock Dividends and Stock Splits**

 

On March 2, 2001 theBoard of Directors declared a five percent stock dividend payable onMarch 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 $5.

 

On February 22, 2002,the Board of Directors declared a five percent stock dividend payable onMarch 29, 2002 to stockholders of record on March 8, 2002.  Cash was paid in lieu of fractional sharesat the rate of $26.00 per share and amounted to $6.

 

On July 19, 2002, theBoard of Directors declared a two-for-one stock split payable onAugust 15, 2002 to stockholders of record on August 2, 2002.

 

On March 7, 2003, theBoard of Directors declared a five percent stock dividend payable onMarch 28, 2003 to stockholders of record on March 14, 2003.  Cash was paid in lieu of fractional sharesat the rate of $11.50 per share and amounted to $3.

 

All references in financialstatements and notes to financial statements to number of shares, per shareamounts, and market prices of the Company’s common stock have been restated toreflect the increased number of shares outstanding.

 

**Note #22 - Acquisition of Assets and Liabilities**

 

During November 2001,the Bank acquired certain assets and liabilities of four branches ofWestamerica Bank.  Total assets acquiredwere $24,968, which consisted of $1,144 in land, building, leasehold improvementsand other fixed assets, and $23,087 in cash. In addition, the Bank also assumed $24,968 of deposits.  The Bank paid a premium of $737 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, resulting in a gain of$22.  The Bank negotiated thetermination of the lease on another of the acquired branches, and is allowingthe lease to lapse on the third branch. As a result of the dispositions and the recording of the remainingacquired branch at fair value, the original premium paid was written down to$407, and is being amortized over 10 years.

 

On October 31, 2003,the Company acquired of 100 percent of the outstanding common shares ofHacienda.  The results of HaciendaBank’s operations have been included in the consolidated financial statementssince that date.  Hacienda Bank is acommunity bank that offers a full range of commercial banking services andoperates three branches in Santa Maria, California.  As a result of the acquisition, the combined organization isexpected to be able to offer customers a broader array of services andproducts.

 

75

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The aggregate purchase pricewas $11,301, including $2,603 of cash and common stock valued at $8,698.  The value of the 602,485 common sharesissued was determined by multiplying the number of outstanding common shares ofHacienda Bank by 75% and the conversion ratio of .5208.  The result of this calculation was added tothe fair value of the outstanding stock options issued in connection with theacquisition.

 

The following tablesummarizes the estimated fair values of the assets acquired and liabilitiesassumed at the date of acquisition based upon third-party valuations of certainintangible assets:

 
|                         |   | **At  October 31,  2003** |   |
|------------------------------|--------|--------------------------------|--------|
| Cash and cash equivalents    |   | $                              | 22,703 |   |
| Investments                  |   | 2,474                          |   |
| Loans                        |   | 51,878                         |   |
| Premises and equipment       |   | 2,834                          |   |
| Intangible assets            |   | 2,124                          |   |
| Goodwill                     |   | 4,905                          |   |
| Other assets                 |   | 899                            |   |
| Total Assets Acquired        |   | 87,817                         |   |
|                         |   |                           |   |
| Noninterest-bearing deposits |   | (17,457                        | )      |
| Interest-bearing deposits    |   | (61,017                        | )      |
| Other liabilities            |   | (645                           | )      |
| Net Assets Acquired          |   | $                              | 8,698  |   |

 

The $2,124 of acquiredintangible assets was assigned to core deposit intangibles that are subject toamortization and has an estimated average useful life of six years.

 

The following un-audited proforma combined results of operations assumes that the acquisition occurred onJanuary 1, 2002:

 
|                      |   | **For the  Year Ended  December 31,** |   |
|---------------------------|--------|--------------------------------------------|--------|
|                      |   | **2003**                                   |   | **2002** |   |
| Revenues                  |   | $                                          | 26,563 |   | $ | 24,907 |   |
| Net Income                |   | 2,925                                      |   | 3,550 |   |
|                      |   |                                       |   |   |   |
| Earnings per Common Share |   |                                       |   |   |   |
| Basic                     |   | $                                          | 1.01   |   | $ | 1.05 |   |
| Diluted                   |   | $                                          | 0.95   |   | $ | 0.98 |   |

 

These pro forma amounts arebased upon certain assumptions and estimates which the Company believes arereasonable.  The pro forma consolidatedresults of operations do not purport to be indicative of the results whichwould actually have been obtained had the acquisition occurred on the datesindicated or which may be obtained in the future.

 

76

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**HERITAGE OAKS BANCORP AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER 31, 2003, 2002, AND 2001**

**(Dollars in thousands)**

 

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

 
|                                            |   | **2003** |   | **2002** |   |
|-------------------------------------------------|--------|----------|--------|----------|--------|
| **Assets**                                      |   |     |   |     |   |
| Cash                                            |   | $        | 290    |     | $      | 403 |   |
| Federal funds sold                              |   | 650      |   | 740      |   |
| Prepaid and other assets                        |   | 639      |   | 541      |   |
| Property and premises                           |   | 618      |   | 655      |   |
| Investment in subsidiaries                      |   | 41,944   |   | 25,809   |   |
|                                            |   |     |   |     |   |
| Total Assets                                    |   | $        | 44,141 |     | $      | 28,148 |   |
|                                            |   |     |   |     |   |
| **Liabilities and Stockholders’ Equity**   |   |     |   |     |   |
| Notes payable                                   |   | $        | 3,500  |     | $      | — |   |
| Junior subordinated debentures                  |   | 8,248    |   | 8,248    |   |
| Other liabilities                               |   | 105      |   | 87       |   |
|                                            |   |     |   |     |   |
| Total Liabilities                               |   | 11,853   |   | 8,335    |   |
|                                            |   |     |   |     |   |
| Stockholders’ Equity                       |   |     |   |     |   |
| Common stock                                    |   | 20,649   |   | 9,703    |   |
| Retained earnings                               |   | 11,639   |   | 10,110   |   |
|                                            |   |     |   |     |   |
| Total Stockholders’ Equity                 |   | 32,288   |   | 19,813   |   |
| Total Liabilities and Stockholders’ Equity |   | $        | 44,141 |     | $      | 28,148 |   |

 

77

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**Statements of Income**

 
|                                          |   | **2003** |   | **2002** |   | **2001** |   |
|-----------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| **Income**                                    |   |     |   |     |   |     |   |
| Equity in undisbursed income of  subsidiaries |   | $        | 3,943  |     | $      | 3,032    |   | $ | 2,424 |   |
| Interest income                               |   | 21       |   | 16       |   | —   |   |
| Other                                         |   | 57       |   | 57       |   | 57       |   |
| Total Income                                  |   | 4,021    |   | 3,105    |   | 2,481    |   |
| **Expense**                                   |   |     |   |     |   |     |   |
| Salary expense                                |   | 77       |   | 71       |   | 57       |   |
| Equipment expense                             |   | 15       |   | 15       |   | 15       |   |
| Other professional fees and outside  services |   | 56       |   | 28       |   | 23       |   |
| Interest expense                              |   | 449      |   | 384      |   | 86       |   |
| Other                                         |   | 69       |   | 72       |   | 8        |   |
| Total Expense                                 |   | 666      |   | 570      |   | 189      |   |
| Total Operating Income                        |   | 3,355    |   | 2,535    |   | 2,292    |   |
|                                          |   |     |   |     |   |     |   |
| Tax benefit of parent                         |   | (241     | )      | (204     | )      | (54      | )      |
|                                          |   |     |   |     |   |     |   |
| Net Income                                    |   | $        | 3,596  |     | $      | 2,739    |   | $ | 2,346 |   |

 

78

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**Statements of Cash Flows**

 
|                                                                                        |   | **2003** |   | **2002** |   | **2001** |   |
|---------------------------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| **Cash Flows From Operating Activities**                                                    |   |     |   |     |   |     |   |
| Net income                                                                                  |   | $        | 3,596  |     | $      | 2,739    |   | $ | 2,346 |   |
| Adjustments to Reconcile Net Income to Net  Cash Provided By/(Used in) Operating Activities |   |     |   |     |   |     |   |
| Depreciation                                                                                |   | 15       |   | 15       |   | 15       |   |
| Increase in other assets                                                                    |   | 129      |   | (48      | )      | (71      | )      |
| Increase in other liabilities                                                               |   | 18       |   | 72       |   | 10       |   |
| Undistributed income of subsidiaries                                                        |   | (3,943   | )      | (3,032   | )      | (2,424   | )      |
| Net Cash Used In Operating Activities                                                       |   | (185     | )      | (254     | )      | (124     | )      |
|                                                                                        |   |     |   |     |   |     |   |
| **Cash Flows From Investing Activities**                                                    |   |     |   |     |   |     |   |
| Contribution to subsidiaries                                                                |   | (3,960   | )      | (5,448   | )      | (1,500   | )      |
| Net Cash Used In Investing Activities                                                       |   | (3,960   | )      | (5,448   | )      | (1,500   | )      |
|                                                                                        |   |     |   |     |   |     |   |
| **Cash Flows From Financing Activities**                                                    |   |     |   |     |   |     |   |
| Cash dividends received                                                                     |   | —   |   | —   |   | 650      |   |
| Cash paid in lieu of fractional shares                                                      |   | (4       | )      | (6       | )      | (5       | )      |
| Increase/(decrease) in notes payable                                                        |   | 3,500    |   | (1,895   | )      | 845      |   |
| Issuance of junior subordinated debentures                                                  |   | —   |   | 8,248    |   | —   |   |
| Proceeds from the sale of stock                                                             |   | 67       |   | —   |   | —   |   |
| Proceeds from the exercise of options                                                       |   | 379      |   | 487      |   | 94       |   |
| Net Cash Provided By Financing Activities                                                   |   | 3,942    |   | 6,834    |   | 1,584    |   |
|                                                                                        |   |     |   |     |   |     |   |
| **Net Increase/(Decrease) in Cash and Cash Equivalents**                                    |   | (203     | )      | 1,132    |   | (40      | )      |
| **Cash and Cash Equivalents**, Beginning of Year                                            |   | 1,143    |   | 11       |   | 51       |   |
|                                                                                        |   |     |   |     |   |     |   |
| **Cash and Cash Equivalents**, End of Year                                                  |   | $        | 940    |     | $      | 1,143    |   | $ | 11 |   |

 

79

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ITEM 8.  CHANGES WITHACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

None

 

ITEM8A.                                           CONTROLS AND PROCEDURES

 

(a)  Within 90 days prior to the date of thisreport, the Company carried out an evaluation, under the supervision and withthe participation of its management, including the Company’s Chief ExecutiveOfficer and Chief Financial Officer, of the effectiveness of the design andoperation of the Company’s disclosure controls and procedures pursuant toExchange Act Rule 13a-15. Based upon that evaluation, the Chief ExecutiveOfficer and Chief Financial Officer concluded that the Company’s disclosurecontrols and procedures are effective.

 

(b)  During the quarter ended December 31,2003, there have been no changes in our internal controls over financialreporting that has materially affected, or are reasonably likely to materiallyaffect, these controls.

 

PART III

 

ITEM 9.     DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS ANDCONTROL PERSONS; COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT

 

The information required byItem 9 of Form 10-KSB is incorporated by reference from the informationcontained in the Company’s Proxy Statement for the 2004 Annual Meeting ofShareholders which will be filed pursuant to Regulation 14A.

 

ITEM 10.                                               EXECUTIVE COMPENSATION

 

The information required byItem 10 of Form 10-KSB is incorporated by reference from the informationcontained in the Company’s Proxy Statement for the 2004 Annual Meeting ofShareholders which will be filed pursuant to Regulation 14A.

 

ITEM 11.                                               SECURITY OWNERSHIP OF CERTAIN BENEFICIALOWNERS AND MANAGEMENT

 

The information required byItem 11 of Form 10-KSB is incorporated by reference from the informationcontained in the Company’s Proxy Statement for the 2004 Annual Meeting ofShareholders which will be filed pursuant to Regulation 14A.

 

ITEM 12.                                               CERTAIN RELATIONSHIPS AND RELATEDTRANSACTIONS

 

The information required byItem 12 of Form 10-KSB is incorporated by reference from the informationcontained in the Company’s Proxy Statement for the 2004 Annual Meeting ofShareholders which will be filed pursuant to Regulation 14A.

 

ITEM 13.                                               EXHIBITS AND REPORTS ON FORM 8-K

 

(a) Exhibits:

 
| (2.1a) | Branch Purchase and  Assumption Agreement and Real Property Purchase Agreement entered into  between Westamerica Bank and Heritage Oaks Bank, dated July 16, 2001  filed with the SEC in the Company’s 10-QSB for the period ending  June 30, 2001. |
|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

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| (2.1b)  | Agreement to Merge and  Plan of Reorganization, dated June 11, 2003, filed with the SEC in the  Company’s 8-K of June 12, 2003.                                                       |
|---------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|    |                                                                                                                                                                                                 |
| (3.1a)  | Articles of Incorporation  incorporated by reference from Exhibit 3.1a to Registration Statement on Form  S-4 No. 33-77504 filed with the SEC on April, 1994.                                        |
|    |                                                                                                                                                                                                 |
| (3.1b)  | Amendment to the Articles  of Incorporation filed with the Secretary of State on October 16, 1997  filed with the SEC in the Company’s 10-KSB for the year ending  December 31, 1997. |
|    |                                                                                                                                                                                                 |
| (3.2)   | The Company Bylaws as  amended November 16, 2000 filed with the SEC in the Company’s 10-KSB for  the year ended December 31, 2000.                                                    |
|    |                                                                                                                                                                                                 |
| (4.1)   | Specimen form of The  Company stock certificate incorporated by reference from Exhibit 4.1 to  Registration Statement on Form S-4 No. 33-77504 filed with the SEC on  April 8, 1994.            |
|    |                                                                                                                                                                                                 |
| (10.1)  | 1990 Stock Option Plan  incorporated by reference from Exhibit 10.2 to Registration Statement on Form  S-4 No. 33-77504, filed with the SEC on April 8, 1994.                                   |
|    |                                                                                                                                                                                                 |
| (10.2)  | Form of Stock Option  Agreement incorporated by reference from Exhibit 4.2 to Registration  Statement on Form S-4 No. 33-77504, filed with the SEC on April 8, 1994.                            |
|    |                                                                                                                                                                                                 |
| (10.3)  | Lawrence P. Ward  Employment Letter Agreement, dated February 28, 2002, filed with the SEC  in the Company’s 10-KSB Report for the year ended December 31, 2001.                      |
|    |                                                                                                                                                                                                 |
| (10.4)  | 401(k) Pension and Profit  Sharing Plan filed with the SEC in the Company’s 10K Report for the year  ended December 31, 1994.                                                              |
|    |                                                                                                                                                                                                 |
| (10.5)  | The Company 1995 Bonus  Plan, filed with the SEC in the Company’s 10K Report for the year ended  December 31, 1994.                                                                        |
|    |                                                                                                                                                                                                 |
| (10.6)  | Salary Continuation  Agreement with Lawrence P. Ward, filed with the SEC in the Company’s 10-QSB  Report for the quarter ended March 31, 2001.                                             |
|    |                                                                                                                                                                                                 |
| (10.7)  | Salary Continuation  Agreement with Gwen R. Pelfrey, filed with the SEC in the Company’s 10K  Report for the year ended December 31, 1994.                                                 |
|    |                                                                                                                                                                                                 |
| (10.8)  | Woodland Shopping Center  Lease, filed with the SEC in the Company’s 10K Report for the year ended  December 31, 1994.                                                                     |
|    |                                                                                                                                                                                                 |
| (10.9)  | 1135 Santa Rosa Street  Lease, filed with the SEC in the Company’s 10KSB Report for the year ended  December 31, 1995.                                                                     |
|    |                                                                                                                                                                                                 |
| (10.10) | Lease Agreement for  Cambria Branch Office dated February 21, 1997 filed with the SEC                                                                                                           |

 

81

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|    | in the Company’s 10KSB  reported for the year ended December 31,1996.                                                                                                                                                                                                                                |
|---------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|    |                                                                                                                                                                                                                                                                                                           |
| (10.11) | 1997 Stock Option Plan  incorporated by reference from Exhibit 4a to Registration Statement on Form  S-8 No. 333-31105 filed with the SEC on July 11, 1997 as amended,  incorporated by reference, from Registration Statement on Form S-8, File No.  333-83235 filed with the SEC on July 20, 1999. |
|    |                                                                                                                                                                                                                                                                                                           |
| (10.12) | Form of Stock Option  Agreement incorporated by reference from Exhibit 4b to Registration Statement  on Form S-8 No. 333-31105 filed with the SEC on July 11, 1997.                                                                                                                                       |
|    |                                                                                                                                                                                                                                                                                                           |
| (10.13) | Madonna Road Lease filed  with the SEC in the Company’s 10KSB for the year ended December 31,  1997.                                                                                                                                                                                                 |
|    |                                                                                                                                                                                                                                                                                                           |
| (10.14) | Santa Maria lease  commencing November 1, 1998.                                                                                                                                                                                                                                                           |
|    |                                                                                                                                                                                                                                                                                                           |
| (10.15) | Master data processing  agreement with Mid West payment Systems, Inc. commencing October 1,  1998.                                                                                                                                                                                                        |
|    |                                                                                                                                                                                                                                                                                                           |
| (10.16) | Salary Continuation  Agreement with Margaret A. Torres, filed with the SEC in the Company’s 10KSB  Report for the year ended December 31, 1999.                                                                                                                                                      |
|    |                                                                                                                                                                                                                                                                                                           |
| (10.17) | Salary Continuation  Agreement with Paul Tognazzini, filed with the SEC in the Company’s 10-KSB  Report for the year ended December 31, 2001.                                                                                                                                                        |
|    |                                                                                                                                                                                                                                                                                                           |
| (10.18) | Atascadero Branch Lease  entered into on March 31, 1999. filed with the SEC in the Company’s  10-KSB reported for the year ended December 31,1999.                                                                                                                                              |
|    |                                                                                                                                                                                                                                                                                                           |
| (10.19) | Service Bureau Processing  Agreement entered into between Alltel Information Services, Inc. and Heritage  Oaks Bank, dated August 1, 1999. Filed with the SEC in the Company’s  10-KSB reported for the year ended December 31, 1999.                                                           |
|    |                                                                                                                                                                                                                                                                                                           |
| (10.20) | ASSET PURCHASE AGREEMENT  entered into between Travelex America, Inc. and Heritage Oaks Bank, dated  November 21 , 2000 filed with the SEC in the Company’s 10-KSB reported  for the year ended December 31, 2000.                                                                              |
|    |                                                                                                                                                                                                                                                                                                           |
| (10.21) | Change in Terms Agreement  and Business Loan Agreement entered into between the Company and Pacific  Coast Banker’s Bank on November 8, 2000, filed with the SEC in the  Company’s 10-KSB reported for the year ended December 31, 2001.                                                   |
|    |                                                                                                                                                                                                                                                                                                           |
| (10.22) | Executive Salary  Continuation Agreement dated February 1, 2002 between Heritage Oaks Bank  and Margaret A. Torres, filed with the SEC in the Company’s 10-QSB reported  for March 31, 2002.                                                                                                    |
|    |                                                                                                                                                                                                                                                                                                           |
| (10.23) | Executive Salary  Continuation Agreement dated February 1, 2002 between Heritage Oaks Bank  and Paul Tognazzini, filed with the SEC in the Company’s 10-QSB reported for  March 31, 2002.                                                                                                       |

 

82

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| (10.24) | Executive Salary  Continuation Agreement dated February 1, 2002 between Heritage Oaks Bank  and Gwen R. Pelfrey, filed with the SEC in the Company’s 10-QSB reported for  March 31, 2002.                   |
|---------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|    |                                                                                                                                                                                                                       |
| (10.25) | Executive Salary  Continuation Agreement dated February 1, 2002 between Heritage Oaks Bank  and Gloria Brady, filed with the SEC in the Company’s 10-QSB reported for  March 31, 2002.                      |
|    |                                                                                                                                                                                                                       |
| (10.26) | Executive Salary  Continuation Agreement dated February 1, 2002 between Heritage Oaks Bank  and Joe Carnevali, filed with the SEC in the Company’s 10-QSB reported for  March 31, 2002.                     |
|    |                                                                                                                                                                                                                       |
| (10.27) | Executive Salary  Continuation Agreement dated February 1, 2002 between Heritage Oaks Bank  and Donna Breuer, filed with the SEC in the Company’s 10-QSB reported for  March 31, 2002.                      |
|    |                                                                                                                                                                                                                       |
| (10.28) | Executive Salary  Continuation Agreement dated February 1, 2002 between Heritage Oaks Bank  and Chris Sands, filed with the SEC in the Company’s 10-QSB reported for  March 31, 2002.                       |
|    |                                                                                                                                                                                                                       |
| (10.29) | Money Access Services  Processing Agreement for ATM processing, signed on October 3, 2002,  filed with the SEC in the Company’s 10QSB reported for September 30,  2002.                                     |
|    |                                                                                                                                                                                                                       |
| (10.30) | The Company Employee Stock  Ownership Plan, Summary Plan Description, filed with the SEC in the Company’s  10-KSB reported for December 31, 2002.                                                                |
|    |                                                                                                                                                                                                                       |
| (10.31) | The Company Employee Stock  Ownership Plan, Summary of Material Modifications to the Summary Plan  Description dated July 2002, filed with the SEC in the Company’s 10-KSB  reported for December 31, 2002. |
|    |                                                                                                                                                                                                                       |
| (10.32) | A Construction Agreement  dated February 12, 2003 between Heritage Oaks Bank and HBE financial  Facilities, a Division of HBE Corporation, filed with the SEC in the  Company’s 10-QSB for March 31, 2003.  |
|    |                                                                                                                                                                                                                       |
| (10.33) | Executive Salary  Continuation Agreement dated July 1, 2003 between Heritage Oaks Bank and  Mark Stasinis, filed with the SEC in the Company’s 10-QSB reported for  June 30, 2003.                          |
|    |                                                                                                                                                                                                                       |
| (10.34) | Executive Salary  Continuation Agreement dated July 1, 2003 between Heritage Oaks Bank and  Kelley Stolz, filed with the SEC in the Company’s 10-QSB reported for  June 30, 2003.                           |
|    |                                                                                                                                                                                                                       |
| (10.35) | Executive Salary Continuation  Agreement dated July 1, 2003 between Heritage Oaks Bank and Paul Deline,  filed with the SEC in the Company’s 10-QSB reported for June 30, 2003.                             |
|    |                                                                                                                                                                                                                       |
| (10.36) | Executive Salary  Continuation Agreement dated July 1, 2003 between Heritage Oaks Bank and  Mitch Massey, filed with the SEC in the Company’s 10-QSB reported for  June 30, 2003.                           |
|    |                                                                                                                                                                                                                       |
| (10.37) | Employment Agreement with  David Duarte, President and Chief Operating Officer of Hacienda Bank, dated  September 5, 2003 and filed with the SEC in the Company’s 10-QSB  reported for September 30, 2003.  |

 

83

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| (10.38)                  | Promissory Note executed  on October 3, 2003 for $3.5 million with Pacific Coast Bankers Bank,  filed with the SEC in the Company’s 10-QSB reported for September 30,  2003.                                      |
|--------------------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                     |                                                                                                                                                                                                                             |
| (10.39)                  | Employment Agreement with  Lawrence P. Ward, President and Chief Executive Officer of Heritage Oaks  Bank, dated February 1, 2004 and filed with the SEC in the Company’s  10-KSB reported for December 31, 2003. |
|                     |                                                                                                                                                                                                                             |
| (10.40)                  | Executive Salary  Continuation Agreement dated November 1, 2003 between Hacienda Bank and  David Duarte, filed with the SEC in the Company’s 10-KSB reported for  December 31, 2003.                              |
|                     |                                                                                                                                                                                                                             |
| (21)                     | Subsidiaries of the  Company. Heritage Oaks Bank and Hacienda Bank are the only financial  subsidiaries of the Company.                                                                                                          |
|                     |                                                                                                                                                                                                                             |
| (23)                     | Consent of Independent  Accountants                                                                                                                                                                                              |
|                     |                                                                                                                                                                                                                             |
| (31.1)                   | Certification of Chief  Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of  2002                                                                                                                        |
|                     |                                                                                                                                                                                                                             |
| (31.2)                   | Certification of Chief  Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of  2002                                                                                                                        |
|                     |                                                                                                                                                                                                                             |
| (32.1)                   | Certification of Chief  Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of  2002                                                                                                                        |
|                     |                                                                                                                                                                                                                             |
| (32.2)                   | Certification of Chief  Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of  2002                                                                                                                        |
|                     |                                                                                                                                                                                                                             |
| (b) Reports on Form 8-K: |
|                     |                                                                                                                                                                                                                             |
|                     | The third quarter press  release of earnings for September 30, 2003 for the Company was filed on  Form 8-K, Items 7. and 9. with the SEC on October 9, 2003.                                                           |
|                     |                                                                                                                                                                                                                             |
|                     | The announcement of the  finalization of the acquisition of Hacienda Bank, whereby Hacienda Bank  became a subsidiary of the Company, was filed on Form 8-K Items 2. and 7.  with the SEC on November 3, 2003.              |
|                     |                                                                                                                                                                                                                             |
| ITEM  14.                | PRINCIPAL ACCOUNTANT FEES  AND SERVICES                                                                                                                                                                                          |

 

The information required byItem 14 of Form 10-KSB is incorporated by reference from the informationcontained in the Company’s Proxy Statement for the 2004 Annual Meeting ofShareholders which will be filed pursuant to Regulation 14A.

 

84

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SIGNATURES

 

Pursuant to the requirementsof Section 13 of the Securities Exchange Act of 1934, the Company has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 
| THE COMPANY                            |                                             |   |
|----------------------------------------|--------------------------------------------------|--------|
|                                   |                                             |   |
| By:                                    | /s/ Lawrence P. Ward                             |   | By: | /s/ Margaret A. Torres |   |
| LAWRENCE P. WARD                       | MARGARET A. TORRES                               |
| President and Chief  Executive Officer | Executive Vice Pres and  Chief Financial Officer |
| Dated:                                 | March 17, 2004                              | Dated: | March 17, 2004 |
|                                        |                                                  |        |  |  |  |  |

 

Pursuant to the requirementsof the Securities Exchange Act of 1934, this report has been signed below bythe following persons on behalf of the Registrant and in the capacities and onthe dates indicated.

 
| /s/ B.R. Bryant        |   |                      | Chairman of the Board |   | March 17, 2004 |
|------------------------|--------|---------------------------|-----------------------|--------|---------------------|
| B.R. BRYANT            |   |                      |                  |   |
|                   |   |                      |                  |   |
| /s/ Donald H. Campbell |   |                      | Vice Chairman         |   | March 17, 2004 |
| DONALD H. CAMPBELL     |   | of the Board of Directors |                  |   |
|                   |   |                      |                  |   |
| /s/ Kenneth Dewar      |   |                      | Director              |   | March 17, 2004 |
| KENNETH DEWAR          |   |                      |                  |   |
|                   |   |                      |                  |   |
| /s/ Mark C. Fugate     |   |                      | Director              |   | March 17, 2004 |
| MARK C. FUGATE         |   |                      |                  |   |
|                   |   |                      |                  |   |
| /s/ Dolores T. Lacey   |   |                      | Director              |   | March 17, 2004 |
| DOLORES T. LACEY       |   |                      |                  |   |
|                   |   |                      |                  |   |
| /s/ Merle F. Miller    |   |                      | Director              |   | March 17, 2004 |
| MERLE F. MILLER        |   |                      |                  |   |
|                   |   |                      |                  |   |
| /s/ Michael Morris     |   |                      | Director              |   | March 17, 2004 |
| MICHAEL MORRIS         |   |                      |                  |   |
|                   |   |                      |                  |   |
| /s/ Alex Simas         |   |                      | Director              |   | March 17, 2004 |
| ALEX SIMAS             |   |                      |                  |   |
|                   |   |                      |                  |   |
| /s/ Ole K. Viborg      |   |                      | Director              |   | March 17, 2004 |
| OLE K. VIBORG          |   |                      |                  |   |
|                   |   |                      |                  |   |
| /s/ Lawrence P. Ward   |   |                      | Director              |   | March 17, 2004 |
| LAWRENCE P. WARD       |   |                      |                  |   |

 

85

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EXHIBIT INDEX

 
| **Exhibit  Sequential  Number** |   | **Description**                                                                                                                                                                                                                  |
|---------------------------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                            |   |                                                                                                                                                                                                                             |
| (10.39)                         |   | Employment Agreement with  Lawrence P. Ward, President and Chief Executive Officer of Heritage Oaks  Bank, dated February 1, 2004 and filed with the SEC in the Company’s  10-KSB reported for December 31, 2003. |
|                            |   |                                                                                                                                                                                                                             |
| (10.40)                         |   | Executive Salary  Continuation Agreement dated July 1, 2003 between Hacienda Bank and  David Duarte, filed with the SEC in the Company’s 10-KSB reported for  December 31, 2003.                                  |
|                            |   |                                                                                                                                                                                                                             |
| 23                              |   | Consent of Independent  Accountants                                                                                                                                                                                              |
|                            |   |                                                                                                                                                                                                                             |
| 31.1                            |   | Certification of Chief  Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of  2002                                                                                                                        |
|                            |   |                                                                                                                                                                                                                             |
| 31.2                            |   | Certification of Chief  Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of  2002                                                                                                                        |
|                            |   |                                                                                                                                                                                                                             |
| 32.1                            |   | Certification of Chief  Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                                                                                                         |
|                            |   |                                                                                                                                                                                                                             |
| 32.2                            |   | Certification of Chief  Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of  2002                                                                                                                        |

 

86

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