10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2005

OR

[  ] 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 000-23877

Heritage Commerce Corp

(Exact name of Registrant as Specified in its Charter)

California	77-0469558
(State or Other Jurisdiction of Incorporation or Organization)	(I.R.S. Employer Identification Number)

150 Almaden Boulevard

San Jose, California    95113

(Address of Principal Executive Offices including Zip Code)

(408) 947-6900

(Registrant's Telephone Number, Including Area Code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file reports), and (2) has been subject to such filing requirements for the past 90 days. YES [X] NO [   ]

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). YES [X] NO [   ]

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES [ ] NO [X]

APPLICABLE ONLY TO CORPORATE ISSUERS:

The Registrant had 11,795,617 shares of Common Stock outstanding on November 4, 2005.

Heritage Commerce Corp and Subsidiaries

Quarterly Report on Form 10-Q

Table of Contents

PART I. FINANCIAL INFORMATION	Page No.
Item 1. Condensed Consolidated Financial Statements (unaudited):	2
Condensed Consolidated Balance Sheets	2
Condensed Consolidated Income Statements	3
Condensed Consolidated Statement of Changes in Shareholders' Equity	4
Condensed Consolidated Statements of Cash Flows	5
Notes to Condensed Consolidated Financial Statements	6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of    Operations	11
Item 3. Quantitative and Qualitative Disclosures About Market Risk	32
Item 4. Controls and Procedures	32
PART II. OTHER INFORMATION
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	33
Item 6. Exhibits	33
Signatures	34

Part I -- FINANCIAL INFORMATION

ITEM 1.FINANCIAL STATEMENTS

Heritage Commerce Corp and Subsidiaries
Condensed Consolidated Balance Sheets (Unaudited)
	September 30,			December 31,
(Dollars in thousands)	2005			2004
Assets
Cash and due from banks	$	44,061		$	33,646
Federal funds sold		63,700			24,100
Total cash and cash equivalents		107,761			57,746
Securities available-for-sale, at fair value		209,415			232,809
Loans held for sale, at lower of cost or market		39,664			37,178
Loans, net of deferred costs		737,979			725,530
Allowance for loan and lease losses		(11,112	)		(12,497	)
Loans, net		726,867			713,033
Federal Home Loan Bank and Federal Reserve Bank stock		5,813			4,695
Company owned life insurance		33,016			26,303
Premises and equipment, net		2,695			3,183
Accrued interest receivable and other assets		35,360			33,226
Total assets	$	1,160,591		$	1,108,173
Liabilities and Shareholders' Equity
Liabilities:
Deposits
Demand, noninterest bearing	$	258,464		$	277,451
Demand, interest bearing		130,327			120,890
Savings and money market		397,070			357,318
Time deposits, under $100		37,685			38,295
Time deposits, $100 and over		113,609			104,719
Brokered deposits, $100 and over		38,039			19,862
Total deposits		975,194			918,535
Notes payable to subsidiary grantor trusts		23,702			23,702
Securities sold under agreement to repurchase		32,700			47,800
Accrued interest payable and other liabilities		21,938			19,557
Total liabilities		1,053,534			1,009,594
Shareholders' equity:
Preferred stock, no par value; 10,000,000
shares authorized; none outstanding		-			-
Common Stock, no par value; 30,000,000 shares authorized
shares outstanding: 11,779,858 at September 30, 2005 and
11,669,837 at December 31, 2004		67,219			67,409
Unearned restricted stock award		(842	)		-
Unallocated ESOP shares		-			(193	)
Accumulated other comprehensive loss		(2,602	)		(1,730	)
Retained earnings		43,282			33,093
Total shareholders' equity		107,057			98,579
Total liabilities and shareholders' equity	$	1,160,591		$	1,108,173
See notes to condensed consolidated financial statements

Heritage Commerce Corp and Subsidiaries
Condensed Consolidated Income Statement (Unaudited)
	Three Months Ended					Nine Months Ended
	September 30,					September 30,
				2004				2004
				(As Restated,				(As Restated,
(Dollars in thousands, except per share data)	2005			see Note 2)		2005		see Note 2)
Interest income:
Loans, including fees	$	14,109		$	11,240	$	39,677	$	31,745
Securities, taxable		1,725			1,788		5,319		4,686
Securities, non-taxable		50			56		155		241
Interest bearing deposits in other financial institutions		27			3		58		7
Federal funds sold		601			77		1,103		238
Total interest income		16,512			13,164		46,312		36,917
Interest expense:
Deposits		3,531			1,729		8,824		4,889
Subsidiary grantor trusts		543			492		1,581		1,455
Other		195			263		729		627
Total interest expense		4,269			2,484		11,134		6,971
Net interest income before provision for loan losses		12,243			10,680		35,178		29,946
Provision for loan losses		(494	)		254		313		1,392
Net interest income after provision for loan losses		12,737			10,426		34,865		28,554
Noninterest income:
Gain on sale of loans		702			920		2,160		2,285
Loan servicing income		510			426		1,368		1,105
Service charges and other fees on deposit accounts		332			415		1,120		1,385
Increase in cash surrender value of life insurance		331			236		887		798
Gain on sale of leased equipment		-			-		299		-
Equipment leasing		-			245		131		735
Gain on sale of securities available-for-sale		-			-		-		476
Mortgage brokerage fees		-			19		-		168
Other		306			375		1,112		1,054
Total noninterest income		2,181			2,636		7,077		8,006
Noninterest expense:
Salaries and employee benefits		4,375			4,301		14,040		14,477
Occupancy		779			875		2,471		2,789
Professional fees		511			670		1,232		1,986
Retirement plan expense		416			358		1,154		1,576
Client services		300			228		1,051		644
Amortization of low income housing projects		260			279		806		640
Advertising and promotion		290			364		802		862
Furniture and equipment		181			206		584		698
Data processing expense		167			170		508		492
Amortization of leased equipment		-			250		334		766
Other		1,199			1,059		3,684		3,289
Total noninterest expense		8,478			8,760		26,666		28,219
Income before income taxes		6,440			4,302		15,276		8,341
Income tax expense		2,245			1,210		5,087		2,509
Net income	$	4,195		$	3,092	$	10,189	$	5,832
Comprehensive income	$	3,138		$	5,441	$	9,317	$	5,482
Earnings per share:
Basic	$	0.36		$	0.26	$	0.86	$	0.50
Diluted	$	0.35		$	0.26	$	0.84	$	0.49
See notes to condensed consolidated financial statements

Heritage Commerce Corp and Subsidiaries
Condensed Consolidated Statement of Changes in Shareholders' Equity (Unaudited)
Nine Months Ended September 30, 2005
	Common Stock						Unearned Award Restricted			Unallocated ESOP		Accumlated Other Comprehensive			Retained		Total Shareholders'			Comprehensive
(Dollars in thousands, except shares)	Shares			Amount			Stock			Shares		Loss			Earnings		Equity			Income
Balance, January 1, 2005	11,669,837			$67,409			$              -			$         (193)		$             1,730)			$  33,093		$          98,579
Net Income		-			-			-								10,189		10,189		$	10,189
Net change in unrealized gain/loss on securities available-for-sale and Interest-Only strips, net of reclassification adjustment and taxes					-			-			-		(872	)		-		(872	)		(872	)
Total comprehensive income		-			-			-			-		-			-		-		$	9,317
ESOP shares released		-			284			-			193		-			-		477
Restricted stock award		51,000			926			(926	)		-		-			-		-
Amortization of restricted stock award		-			-			84			-		-			-		84
Redemption payment on commom stock		-			(12	)		-			-		-			-		(12	)
Common stock repurchased		(300,160	)		(5,732	)		-			-		-			-		(5,732	)
Stock options exercised		359,181			4,344			-			-		-			-		4,344
Balance, September 30, 2005		11,779,858		$	67,219		$	(842	)	$	-	$	(2,602	)	$	43,282	$	107,057
See notes to condensed consolidated financial statements

Heritage Commerce Corp and Subsidiaries
Condensed Consolidated Statements of Cash Flows (Unaudited)
	Nine Months Ended
	September 30,
				2004
				(As Restated,
(Dollars in thousands)	2005			see Note 2)
Cash Flows from Operating Activities
Net Income	$	10,189		$	5,832
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		798			1,081
Provision for loan and lease losses		313			1,392
Gain on sale of leased equipment		(299	)		-
Gain on sale of securities available for sale		-			(476	)
Non-cash compensation expense related to ESOP		477			358
Amortization of restricted stock award		84			-
Amortization/accreation of discounts and premiums on securities		688			785
Gain on sale of loans		(2,160	)		(2,285	)
Proceeds from sales of loans held for sale		36,690			45,205
Originations of loans held for sale		(60,727	)		(57,936	)
Maturities/paydowns/payoffs of loans held for sale		23,711			16,871
Increase in cash surrender value of life insurance		(887	)		(798	)
Change in:
Accrued interest receivable and other assets		(1,939	)		(4,683	)
Accrued interest payable and other liabilities		2,679			4,152
Net cash provided by operating activities		9,617			9,498
Cash Flows from Investing Activities
Net change in loans		(14,187	)		(63,925	)
Purchases of securities available for sale		(6,000	)		(117,735	)
Maturities/paydowns/calls of securities available for sale		27,292			18,605
Proceeds from sales of securities available for sale		-			22,641
Sale of leased equipment		389			-
Purchase of company owned life insurance		(5,825	)		-
Purchases of Federal Home Loan Bank stock		(1,118	)		(2,151	)
Purchases of premises and equipment		(312	)		(536	)
Net cash provided by (used in) investing activities		239			(143,101	)
Cash Flows from Financing Activities
Net increase in deposits		56,659			67,246
Net changes in securities sold under agreement to repurchase		(15,100	)		4,200
Issuance of common stock		4,344			3,667
Redemption of common stock		(5,744	)		(2,581	)
Net cash provided by financing activities		40,159			72,532
Net change in cash and cash equivalents		50,015			(61,070	)
Cash and cash equivalents, beginning of period		57,746			114,217
Cash and Cash Equivalents, End of Period	$	107,761		$	53,147
Supplemental disclosures of cash paid during the period for:
Interest	$	11,077		$	7,362
Income taxes	$	2,850		$	750
See notes to condensed consolidated financial statements

HERITAGE COMMERCE CORP AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

September 30, 2005

(Unaudited)

1)Basis of Presentation

The unaudited condensed consolidated financial statements of Heritage Commerce Corp (the “Company”) and its wholly owned subsidiary, Heritage Bank of Commerce (“HBC”), have been prepared pursuant to the rules and regulations for reporting on Form 10-Q. Accordingly, certain information and notes required by accounting principles generally accepted in the United States of America ("GAAP") for annual financial statements are not included herein. The interim statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Form 10-K for the year ended December 31, 2004. The Company has also established the following unconsolidated subsidiary grantor trusts: Heritage Capital Trust I; Heritage Statutory Trust I; Heritage Statutory Trust II; and Heritage Commerce Corp Statutory Trust III which are Delaware Statutory business trusts formed for the exclusive purpose of issuing and selling trust preferred securities.

HBC is a commercial bank serving customers located in Santa Clara, Alameda, and Contra Costa counties of California. No customer accounts for more than 10 percent of revenue for HBC or the Company. Management evaluates the Company’s performance as a whole and does not allocate resources based on the performance of different lending or transaction activities. Accordingly, the Company and its subsidiary operate as one business segment.

In the Company’s opinion, all adjustments necessary for a fair presentation of these condensed consolidated financial statements have been included and are of a normal and recurring nature.

The results for the three months and nine months ended September 30, 2005 are not necessarily indicative of the results expected for any subsequent period or for the entire year ending December 31, 2005.

Certain amounts in the September 30, 2004 three month and nine month ended condensed consolidated financial statements have been reclassified to conform to the 2005 presentation. Loan origination cost amortization of $371,000 and $1,039,000 in the condensed consolidated income statement for the three months and nine months ended September 30, 2004, respectively, was reclassified from noninterest expense to interest income on loans to conform to the 2005 presentation. The reclassification had no effect on income before income taxes or net income in the 2004 periods.

Service fees of $218,000 and $707,000 in the condensed consolidated income statement for the three months and nine months ended September 30, 2004, respectively, were reclassified from interest income on loans to noninterest income to conform to the 2005 presentation. The reclassification had no effect on income before income taxes or net income in the 2004 periods.

Servicing rights amortization of $190,000 and $577,000 in the condensed consolidated income statements for the three and nine months ended September 30, 2004, respectively, was reclassified from interest income to noninterest income to conform to the 2005 presentation. The reclassification had no effect on income before income taxes or net income in the 2004 periods.

2)   Restatement

Subsequent to the issuance of the Company's condensed consolidated financial statements for the nine months ended September 30, 2004, management determined that the nine months ended September 30, 2004 condensed consolidated financial statements should be restated as a result of the following accounting errors:

·   An asset which the Company had accounted for as a direct financing lease and classified as a part of the loan portfolio during the nine months of 2004 should have been accounted for as equipment subject to an operating lease. The after-tax income statement effect of correcting this error on the three and nine months ended September 30, 2004 was to increase income by $198,000 and $121,000, respectively.

·   The Company determined that its previous method of accounting for rent holidays and step-up rents in its facilities lease agreements was not appropriate and that it should have accounted for rent holidays and step-up rents on a straight-line basis. The after-tax income statement effect of correcting this error on the three and nine months ended September 30, 2004 was to increase income by $6,000 and $16,000, respectively.

The following is a summary of the significant effects of the restatement adjustments and reclassifications on the condensed consolidated income statements for the three and nine months ended September 30, 2004:

	Three Months Ended								Nine Months Ended
			Restatement								Restatement
	As		Adjustments						As		Adjustments
(Dollars in thousands, except per share data)	Previously Reported		and Reclassifications (1)				As Restated		Previously Reported		and Reclassifications (1)				As Restated
Interest income on loans, including fees	$	11,709	$	(469	)		$	11,240	$	33,135	$	(1,390	)		$	31,745
Total interest income		13,633		(469	)			13,164		38,307		(1,390	)			36,917
Net interest income before provision for loan losses		11,149		(469	)			10,680		31,336		(1,390	)			29,946
Provision for loan losses		600		(346	)			254		1,800		(408	)			1,392
Net interest income after provision for loan losses		10,549		(123	)			10,426		29,536		(982	)			28,554
Equipment leasing		-		245				245		-		735				735
Loan servicing income		616		(190	)			426		1,682		(577	)			1,105
Other noninterest income		157		218				375		347		707				1,054
Total noninterest income		2,363		273				2,636		7,141		865				8,006
Occupancy		883		(8	)			875		2,813		(24	)			2,789
Amortization of leased equipment		-		250				250		-		766				766
Loan origination costs		426		(426	)	(2)		-		1,194		(1,194	)	(2)		-
Total noninterest expense		8,889		(129	)			8,760		28,517		(298	)			28,219
Income before income taxes		4,023		279				4,302		8,160		181				8,341
Income tax expense		1,135		75				1,210		2,465		44				2,509
Net income		2,888		204				3,092		5,695		137				5,832
Earnings per share:
Basic	$	0.25	$	0.01			$	0.26	$	0.49	$	0.01			$	0.50
Diluted	$	0.24	$	0.02			$	0.26	$	0.48	$	0.01			$	0.49

(1) Includes reclassifications described in Note 1.

(2) $371,000 and $1,039,000 of loan origination costs for the three and nine months ended September 30, 2004, respectively, were reclassified to interest income on loans. $55,000 and $155,000 of loan origination costs for the three and nine months ended September 30, 2004, respectively, were reclassified to other noninterest expense.

3)Securities Available-for-Sale

The following table shows the gross unrealized losses and fair value of the Company’s securities with unrealized losses aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at September 30, 2005:

	Less Than 12 Months				12 Months or More				Total
	Fair		Unrealized		Fair		Unrealized		Fair		Unrealized
(Dollars in thousands)	Value		Losses		Value		Losses		Value		Losses
U.S. Treasury	$	5,934	$	66	$	5,984	$	16	$	11,918	$	82
U.S. Government Agencies		24,763		213		59,605		745		84,368		958
FHLMC and FNMA Mortgage-Backed Securities		25,320		382		61,533		2,261		86,853		2,643
Municipals - Tax Exempt		2,628		32		5,566		112		8,194		144
Collaterized Mortgage Obligations		3,282		8		11,154		279		14,436		287
Total	$	61,927	$	701	$	143,842	$	3,413	$	205,769	$	4,114

As of September 30, 2005, the Company held 98 securities, of which 81 had fair values below amortized cost. Forty-eight securities have been carried with an unrealized loss for over 12 months. Higher interest rates at September 30, 2005 resulted in lower market values for the period and were the primary reason that certain securities had unrealized losses. There was no security that sustained a downgrade in credit ratings. All principal amounts are expected to be paid when securities mature. The Company does not consider these securities to be other-than-temporarily impaired at September 30, 2005.

4)Stock-Based Compensation

The Company accounts for stock-based awards to employees using the intrinsic value method in accordance with Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees. No compensation expense has been recognized in the financial statements for employee stock option arrangements, as the Company’s stock option plan provides for the issuance of options at a price of no less than the fair market value at the date of the grant.

Statement of Financial Accounting Standards ("SFAS") No. 123, Accounting for Stock-Based Compensation, requires the disclosure of pro forma net income and earnings per share had the Company adopted the fair value method at the grant date of all stock options. Under SFAS No. 123, the fair value of stock-based awards to employees is calculated through the use of option pricing models, even though such models were developed to estimate the fair value of freely tradable, fully transferable options without vesting restrictions, which differ significantly from the Company's stock option awards. Those models also require subjective assumptions, which affect the calculated values. The Company's calculations were made using the Black-Scholes option pricing model with the following weighted average assumptions: expected life, 84 months; risk-free interest rate, 4.13% and 4.14% for September 30, 2005 and 2004; stock volatility of 17% and 28% in September 30, 2005 and 2004; and no dividends during the expected term. The Company's calculations are based on a multiple option valuation approach, and forfeitures are recognized as they occur.

In December 2004, the FASB issued SFAS No. 123 (revised 2004), "Share-Based Payment." This Statement requires that compensation costs related to share-based payment transactions be recognized in the financial statements. Measurement of the cost of employee service will be based on the grant-date fair value of the equity or liability instruments issued. That cost will be recognized over the period during which an employee is required to provide service in exchange for the award. Additionally, liability awards will be remeasured each reporting period. Statement 123R replaces SFAS No. 123, "Accounting for Stock-Based Compensation" and supersedes APB Opinion No. 25 "Accounting for Stock Issued to Employees". On April 14, 2005, the SEC issued rule 2005-57, which allows companies to delay implementation of the Statement to the beginning of the next fiscal year. The Company has not yet concluded on the method of adoption allowed by the Statement and is currently evaluating the impact of this accounting guidance on its financial condition and results of operations.

Subsequent to the issuance of the condensed consolidated financial statements for the three and nine months ended September 30, 2004, management determined that compensation expense for amortization of fair value of stock awards, net of tax for the three and nine months ended September 30, 2004 had been calculated incorrectly. Accordingly, the pro forma amounts presented in the table below have been restated. The effect was to decrease compensation expense for amortization of fair value of stock awards, net of taxes, $81,000 and $221,000, respectively, for the three and nine months ended September 30, 2004. Pro forma net income per common share increased $0.03 per basic and diluted share for the three and nine months ended September 30, 2004. The correction did not impact the Company's consolidated financial position, results of operations, or cash flows for any period presented.

The Company awarded 51,000 restricted shares of common stock to Walter T. Kaczmarek, President and Chief Executive Officer of the Company, pursuant to the terms of a Restricted Stock Agreement dated March 17, 2005. The grant price was $18.15. Under the terms of the Restricted Stock Agreement, the restricted shares will vest 25% per year at the end of years three, four, five and six, provided Mr. Kaczmarek is still with the Company. Compensation cost associated with the restricted stock issued is measured based on the market price of the stock at the grant date and is expensed on a straight-line basis over the service period. Restricted stock compensation expense for the three and nine months ended September 30, 2005 was $39,000 and $84,000, respectively.

Had compensation expense for the Company's stock options been determined under the requirements of SFAS No. 123 the Company's pro forma net income and earnings per common share would have been as follows:

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
(Dollars in thousands, except per share data)	2005			2004			2005			2004
Net income as reported	$	4,195		$	3,092		$	10,189		$	5,832
Less: Compensation expense for stock options determined
under fair value method		(119	)		(128	)		(348	)		(384	)
Pro forma net income	$	4,076		$	2,964		$	9,841		$	5,448
Net income per common share - basic
As reported	$	0.36		$	0.26		$	0.86		$	0.50
Pro forma	$	0.35		$	0.26		$	0.83		$	0.47
Net income per common share - diluted
As reported	$	0.35		$	0.26		$	0.84		$	0.49
Pro forma	$	0.34		$	0.25		$	0.81		$	0.46

5)Earnings Per Share

Basic earnings per share is computed by dividing net income by the weighted average common shares outstanding. Diluted earnings per share reflects potential dilution from outstanding stock options, using the treasury stock method. There were 33,957 and 11,557 stock options for three months ended September 30, 2005 and 2004 and 16,443 and 17,699 for nine months ended September 30, 2005 and 2004, respectively, considered to be antidilutive and excluded from the computation of diluted earnings per share. For each of the periods presented, net income is the same for basic and diluted earnings per share. Reconciliation of weighted average shares used in computing basic and diluted earnings per share is as follows:

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2005		2004		2005		2004
Weighted average common shares outstanding - used
in computing basic earnings per share		11,789,546		11,621,963		11,795,669		11,522,054
Dilutive effect of stock options outstanding,
using the treasury stock method		309,344		376,557		337,387		418,444
Shares used in computing diluted earnings per share		12,098,890		11,998,520		12,133,056		11,940,498

6)   Comprehensive Income

Comprehensive income includes net income and other comprehensive income, which represents the change in the Company’s net assets during the period from non-owner sources. The Company's sources of other comprehensive income are unrealized gains and losses on securities available-for-sale and I/O strips, which are treated like available-for-sale securities, and are presented net of tax. The Company's total comprehensive income was as follows:

	Three Months Ended					Nine Months Ended
	September 30,					September 30,
(Dollars in thousands)	2005			2004		2005			2004
Net income	$	4,195		$	3,092	$	10,189		$	5,832
Other comprehensive income (loss), net of tax:
Net unrealized holding gains (losses) on available-for-sale
securities and Interest-Only strips, during the period, net of tax		(1,057	)		2,349		(872	)		(20	)
Less: reclassification adjustment for net realized
gains, net of tax on available-for-sale securities
included in net income during the period		-			-		-			(330	)
Other comprehensive income (loss)		(1,057	)		2,349		(872	)		(350	)
Comprehensive income	$	3,138		$	5,441	$	9,317		$	5,482

7)   Supplemental Retirement Plan

The Company has a supplemental retirement plan covering current and former key executives and directors (Plan). The Plan is a nonqualified defined benefit plan. Benefits are unsecured as there are no Plan assets. The following table presents the amount of periodic cost recognized for the third quarter and nine months ended September 30, 2005 and 2004:

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
(Dollars in thousands)	2005		2004		2005		2004
Components of net periodic benefits cost
Service cost	$	205	$	118	$	616	$	354
Interest cost		123		97		343		291
Prior service cost		15		-		21		-
Amortization of loss		73		29		174		87
Net periodic cost	$	416	$	244	$	1,154	$	732

8)   Commitments and Contingencies

Financial Instruments with Off-Balance Sheet Risk

In the normal course of its business, HBC enters into financial instruments with off-balance sheet risk to meet the financing needs of its clients. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk, in excess of the amounts recognized in the balance sheets.

HBC's exposure to credit loss in the event of non-performance of the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments. HBC uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. Credit risk is the possibility that a loss may occur because a party to a transaction failed to perform according to the terms of the contract. HBC controls the credit risk of these transactions through credit approvals, limits, and monitoring procedures. Management does not anticipate any significant losses as a result of these transactions.

Commitments to extend credit as of September 30, 2005 and December 31, 2004 were as follows:

	September 30,		December 31,
(Dollars in thousands)	2005		2004
Commitments to extend credit	$	328,352	$	313,036
Standby letters of credit		8,065		5,256
	$	336,417	$	318,292

Commitments to extend credit are agreements to lend to a client as long as there is no violation of conditions established in the contract. Commitments generally have fixed expiration dates or other termination clauses. Since some of the commitments are expected to expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements. HBC evaluates each client's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by HBC upon the extension of credit, is based on management's evaluation of the borrower. Collateral held varies but may include cash, marketable securities, accounts receivable, inventory, property, plant and equipment, income-producing commercial properties, and/or residential properties.

Standby letters of credit are written with conditional commitments issued by HBC to guaranty the performance of a client to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to clients.

Claims

The Company is involved in certain legal actions arising from normal business activities. Management, based upon the advice of legal counsel, believes the ultimate resolution of all pending legal actions will not have a material effect on the financial statements of the Company.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following management discussion and analysis gives effect to the restatement and reclassifications in Notes 1 and 2 to the condensed consolidated financial statements.

Discussions of certain matters in this Report on Form 10-Q may constitute forward looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), and as such, may involve risks and uncertainties. Forward-looking statements, which are based on certain assumptions and describe future plans, strategies, and expectations, are generally identifiable by the use of words such as "believe", "expect", "intend", "anticipate", "estimate", "project", “assume”, “plan”, “predict”, “forecast” or similar expressions. These forward-looking statements relate to, among other things, expectations of the business environment in which the Company operates, projections of future performance, potential future performance, potential future credit experience, perceived opportunities in the market, and statements regarding the Company's mission and vision. The Company's actual results, performance, and achievements may differ materially from the results, performance, and achievements expressed or implied in such forward-looking statements due to a wide range of factors. These factors include, but are not limited to changes in interest rates, reducing interest margins or increasing interest rate risk, general economic conditions nationally or in the State of California, legislative and regulatory changes adversely affecting the business in which the Company operates, monetary and fiscal policies of the US Government, real estate valuations, the availability of sources of liquidity at a reasonable cost, competition in the financial services industry, the occurrence of events such as the terrorist acts of September 11, 2001, and other risks. All of the Company's operations and most of its customers are located in California. In addition, acts and threats of terrorism or the impact of military conflicts have increased the uncertainty related to the national and California economic outlook and could have an effect on the future operations of the Company or its customers, including borrowers. The Company does not undertake, and specifically disclaims any obligation, to update any forward-looking statements to reflect occurrences or unanticipated events or circumstances after the date of such statements.

EXECUTIVE SUMMARY

When evaluating financial condition and performance, management looks at certain key metrics and measures. The Company’s evaluation includes an analysis including comparisons with peer group financial institutions and with its own performance objectives established in the internal planning process.

The primary activity of the Company is commercial banking. The Company’s operations are located primarily in the southern and eastern regions of the general San Francisco Bay area of California. The largest city in this area is San Jose and the Company’s market includes the headquarters of a number of technology based companies in the region known commonly as Silicon Valley. The Company’s customers are primarily closely held businesses and professionals.

Through its asset and liability management process, the Company monitors a number of ratios to analyze the Company’s performance over time and also to compare the Company against similarly sized and situated companies in the banking industry. Management considers the following ratios to be important benchmarks for the Company’s performance and financial conditions:

·   Return on average assets: Net income as a percentage of average assets measures the earning power of the balance sheet. For the three months and nine months ended September 30, 2005, the return on average assets was 1.45% and 1.20%, respectively, compared to 0.80% for the year ended December 31, 2004.

·   Return on average equity: Net income as a percentage of average shareholders’ equity measures the return on invested capital. For the three months and nine months ended September 30, 2005, the return on average equity was 15.64% and 13.13%, respectively, compared to 9.04% for the year ended December 31, 2004.

·   Net interest margin: Net interest income as a percentage of average interest earning assets measures the earning power of interest earning assets funded by interest bearing liabilities. For the three months and nine months ended September 30, 2005, the net interest margin was 4.61% and 4.52%, respectively, compared to 4.24% for the year ended December 31, 2004.

·   Efficiency ratio: Non-interest expense divided by net interest income before provision for loan losses plus noninterest income measures the cost of producing revenue as a percentage of total revenue. For the three months and nine months ended September 30, 2005, the efficiency ratio was 58.78% and 63.11%, respectively, compared to 76.07% for the year ended December 31, 2004.

There is no single ratio or metric that summarizes the performance of the Company. The ratios above each take an element of the Company’s performance and quantify it so that it can be compared over time and benchmarked against other peer companies. Management uses these and other ratios and metrics in assessing and planning the Company’s performance.

The Company believes that the initiatives it undertook in 2004, coupled with increases in short term interest rates including the target Federal funds rate and the prime rate, has improved its performance year to date.

CRITICAL ACCOUNTING POLICIES

General

Heritage Commerce Corp’s financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The financial information contained within our consolidated financial statements is, to a significant extent, based on approximate measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. In certain instances, we use a discount factor and prepayment assumptions to determine the present value of assets and liabilities. A change in the discount factor or prepayment speeds could increase or decrease the values of those assets and liabilities which would result in either a beneficial or adverse impact to our financial results. We use historical loss factors as one factor in determining the inherent loss that may be present in our loan portfolio. Actual losses could differ significantly from the historical factors that we use. We apply Accounting Principles Board (APB) No. 25, “Accounting for Stock Issued to Employees” and related interpretations to account for our stock option plan awards. Other estimates that we use include the expected useful lives of our depreciable assets. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of our transactions would be the same, the timing of when the transactions would be recorded could change.

Allowance for Loan and Lease Losses

The allowance for loan and lease losses is an estimate of the losses that may be sustained in the Company’s loan portfolio. The allowance is based on two basic principles of accounting: (1) Statement of Financial Accounting Standards (SFAS) No. 5 “Accounting for Contingencies”, which requires that losses be accrued when they are probable of occurring and estimable and (2) SFAS No. 114, “Accounting by Creditors for Impairment of a Loan”, which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the impaired loan balance.

The Company’s allowance for loan and lease losses has three basic components: the formula allowance for various pools of loans, the specific allowance for individual impaired loans, and the unallocated allowance. Each of these components is determined based upon estimates that can and do change when the actual events occur. The formula allowance uses an historical loss view as an indicator of future losses and as a result formula losses could differ from the losses incurred in the future. The specific allowance uses various techniques to arrive at an estimate of loss. Historical loss information and fair market value of collateral are used to estimate those losses. The use of these values is inherently subjective and our actual losses could differ from the estimates. The unallocated allowance captures losses that are attributable to various economic events, industry or geographic sectors whose impact on the portfolio have occurred but have yet to be recognized in either the formula or specific allowances. For further information regarding our allowance for credit losses, see Allowance for loan and lease losses on page 26.

Loan Sales and Servicing

The amounts of gains recorded on sales of loans and the initial recording of servicing assets and interest only strips are based on the estimated fair values of the respective components. In recording the initial value of the servicing assets and the fair value of the interest-only (I/O) strips receivable, the Company uses estimates which are based on management’s expectations of future prepayment and discount rates. In evaluating the servicing assets, management used a discounted cash flow modeling technique, which requires estimates regarding the amount and timing of future cash flows, including assumptions about loan repayment rates and cost to service, as well as interest rate assumptions that contemplate the risks involved. For the quarter ended September 30, 2005, management’s estimate of constant prepayment rate (“CPR”) was 15% and the weighted average discount rate assumption was 9%. These prepayment and discount rates were based on current market conditions and historical market performance of pools of serviced loans. If actual prepayments with respect to sold loans occur more quickly than projected, the carrying value of the servicing assets may have to be adjusted through a charge to earnings. A corresponding decrease in the value of the I/O strip receivable would also be expected.

Stock Based Awards

Under APB No. 25, compensation cost for stock options is measured as the excess, if any, of the fair market value of the Company’s stock at the date of the grant over the amount required to be paid to the Company by the optionee upon exercising the option. Because the Company’s stock option plans provide for the issuance of options at a price of no less than the fair market value at the date of the grant, no compensation expense is required to be recognized for stock options on the date of grant.

In December 2004, the FASB issued SFAS No. 123 (revised 2004), "Share-Based Payment.” This Statement requires that compensation costs related to share-based payment transactions be recognized in the financial statements. Measurement of the cost of employee service will be based on the grant-date fair value of the equity or liability instruments issued. That cost will be recognized over the period during which an employee is required to provide service in exchange for the award. Additionally, liability awards will be remeasured each reporting period. Statement 123R replaces SFAS No. 123, "Accounting for Stock-Based Compensation" and supercedes APB Opinion No. 25 "Accounting for Stock Issued to Employees." On April 14, 2005, the SEC issued rule 2005-57, which allows companies to delay implementation of Statement 123R to the beginning of the next fiscal year. The Company has not yet concluded on the method of adoption allowed by Statement 123R and is currently evaluating the impact of this accounting guidance on its financial condition and results of operations.

RESULTS OF OPERATIONS

Overview

For the three and nine months ended September 30, 2005, consolidated net income was $4,195,000 and $10,189,000, respectively, compared to $3,092,000 and $5,832,000, respectively, for the three and nine months ended September 30, 2004, an increase of 36% and 75%, respectively. Earnings per diluted share were $0.35 and $0.84, respectively, for the three and nine months ended September 30, 2005, compared to $0.26 and $0.49, respectively, for the three and nine months ended September 30, 2004, an increase of 35% and 71%, respectively. The increase for the three months and nine months ended September 30, 2005 from the same periods in 2004 was attributed to increases in the volume of average earning assets and increases in key market interest rates in 2005. Annualized return on average assets and return on average equity for the three months ended September 30, 2005 were 1.45% and 15.64%, respectively, compared to 1.12% and 13.10%, for the same period in 2004. Annualized return on average assets and return on average equity for the nine months ended September 30, 2005 were 1.20% and 13.13%, respectively, compared to 0.74% and 8.43%, for the same period in 2004.

Net interest income increased $1,563,000, or 15%, and $5,232,000, or 17%, for the three and nine months ended September 30, 2005 compared to the same period in 2004. The Company's net interest margin was 4.61% and 4.52%, respectively, for the three and nine months ended September 30, 2005, an increase of 36 and 34 basis points from 4.25% and 4.18% respectively, for the three and nine months ended September 30, 2004. The increase in net interest margin for the three and nine months ended September 30, 2005 reflects an increase in the yield on earning assets of 99 and 80 basis points offset by a corresponding increase in the cost of interest bearing liabilities of 83 and 62 basis points. The increase in net interest income for the three and nine months ended September 30, 2005 compared to the same period in 2004 is the result of higher short-term interest rate increases and an increase in the volume of earning assets. The increase in net interest margin and volume of earning assets was primarily attributable to an increase in the average level of loans and securities in 2005 compared to the comparable periods in 2004. These increases were funded by an increase in interest bearing liabilities.

Total assets at September 30, 2005 were $1,160,591,000, an increase of $72,553,000, or 7%, from $1,088,038,000 as of September 30, 2004, and an increase of $52,418,000, or 5%, from total assets of $1,108,173,000 as of December 31, 2004. Total deposits at September 30, 2005 were $975,194,000, an increase of $72,538,000, or 8%, from $902,656,000 as of September 30, 2004, and an increase of $56,659,000, or 6%, from total deposits of $918,535,000 as of December 31, 2004.

Total loans at September 30, 2005 were $737,979,000, an increase of $13,767,000, or 2%, compared to $724,212,000 as of September 30, 2004, and an increase of $12,449,000, or 2%, from $725,530,000 as of December 31, 2004. The Company's allowance for loan and lease losses was $11,112,000, or 1.51% of total loans at September 30, 2005, compared to $12,973,000, or 1.79% of total loans, and $12,497,000, or 1.72% of total loans, at September 30, 2004 and December 31, 2004, respectively. The decrease in the overall level of the allowance of loan losses since December 31, 2004 is primarily attributable to the charge-off of one commercial loan in 2005, which was partially offset by the provisions made during the first and second quarter of 2005. Nonperforming assets including nonaccrual loans, loans past due 90 days or more and still accruing, restructured loans, foreclosed assets, and other real estate owned at September 30, 2005 were $2,715,000, compared to $2,637,000 at September 30, 2004 and $1,330,000 at December 31, 2004.

The Company's shareholders' equity at September 30, 2005 was $107,057,000, compared to $96,411,000 at September 30, 2004 and $98,579,000 as of December 31, 2004. The increase in shareholders’ equity from these prior periods was primarily attributable to net income and proceeds from the exercise of common stock options, partially offset by the repurchase of common stock. Book value per share increased to $9.09 at September 30, 2005, from $8.27 at September 30, 2004 and $8.45 at December 31, 2004. The Company's leverage capital ratio was 11.2% at September 30, 2005 compared to 10.6% at September 30, 2004 and 10.9% at December 31, 2004.

Net Interest Income and Net Interest Margin

Net interest income is the largest component of the Company's total revenue. Net interest income is the difference between the interest and fees earned on loans and investments and the interest paid on deposits and other liabilities. Net interest income depends on two factors: (1) the volume or balance of earning assets compared to the volume or balance of interest bearing deposits and liabilities, and (2) the interest rate earned on those interest earning assets compared with the interest rate paid on those interest bearing assets and liabilities. Net interest margin is net interest income expressed as a percentage of average earning assets. To maintain its net interest margin, the Company must manage the relationship between interest earned and paid.

The following table presents the Company’s average balance sheet, net interest income and the resultant yields and rates paid for the period presented:

	For the Three Months Ended							For the Three Months Ended
	September 30, 2005							September 30, 2004
			Interest		Average					Interest		Average
	Average		Income/		Yield/			Average		Income/		Yield/
(Dollars in thousands)	Balance		Expense		Rate			Balance		Expense		Rate
Assets:
Loans, gross	$	755,621	$	14,109		7.41	%	$	742,662	$	11,240		6.02	%
Securities		225,042		1,775		3.13	%		234,438		1,844		3.13	%
Interest bearing deposits in other financial institutions		3,379		27		3.17	%		1,026		3		1.16	%
Federal funds sold		69,007		601		3.46	%		22,282		77		1.37	%
Total interest earnings assets		1,053,049		16,512		6.22	%		1,000,408		13,164		5.23	%
Cash and due from banks		40,214							51,147
Premises and equipment, net		2,818							3,661
Other assets		51,708							45,591
Total assets	$	1,147,789						$	1,100,807
Liabilities and shareholders' equity:
Deposits:
Demand, interest bearing	$	131,037	$	441		1.34	%	$	116,053	$	134		0.46	%
Savings and money market		375,927		1,727		1.82	%		370,398		1,011		1.09	%
Time deposits, under $100		37,154		246		2.63	%		38,006		140		1.47	%
Time deposits, $100 and over		117,984		762		2.56	%		99,178		381		1.53	%
Brokered time deposits, $100 and over		38,084		355		3.70	%		5,745		63		4.36	%
Notes payable to subsidiary grantor trusts		23,702		543		9.09	%		23,702		492		8.26	%
Securities sold under agreement to repurchase		33,222		195		2.33	%		47,520		263		2.20	%
Total interest bearing liabilities		757,110	$	4,269		2.24	%		700,602	$	2,484		1.41	%
Demand, noninterest bearing		262,628							288,096
Other liabilities		21,633							18,189
Total liabilities		1,041,371							1,006,887
Shareholders' equity		106,418							93,920
Total liabilities and shareholders' equity	$	1,147,789						$	1,100,807
Net interest income / margin			$	12,243		4.61	%			$	10,680		4.25	%

Note: Yields and amounts earned on loans include loan fees of $428,000 and $362,000 for the three month periods ended September 30, 2005 and 2004, respectively. Interest income is reflected on an actual basis, not a fully taxable equivalent basis. Nonaccrual loans are included in the average balance calculation above.

	For the Nine Months Ended							For the Nine Months Ended
	September 30, 2005							September 30, 2004
			Interest		Average					Interest		Average
	Average		Income/		Yield/			Average		Income/		Yield/
(Dollars in thousands)	Balance		Expense		Rate			Balance		Expense		Rate
Assets:
Loans, gross	$	760,072	$	39,677		6.98	%	$	715,160	$	31,745		5.93	%
Securities		230,060		5,474		3.18	%		210,537		4,927		3.13	%
Interest bearing deposits in other financial institutions		2,889		58		2.68	%		1,223		7		0.76	%
Federal funds sold		47,699		1,103		3.09	%		30,056		238		1.06	%
Total interest earnings assets		1,040,720		46,312		5.95	%		956,976		36,917		5.15	%
Cash and due from banks		38,353							48,808
Premises and equipment, net		2,959							3,819
Other assets		49,088							41,020
Total assets	$	1,131,120						$	1,050,623
Liabilities and shareholders' equity:
Deposits:
Demand, interest bearing	$	130,424	$	1,127		1.16	%	$	110,909	$	368		0.44	%
Savings and money market		359,175		4,046		1.51	%		352,402		2,718		1.03	%
Time deposits, under $100		37,634		654		2.32	%		38,943		419		1.44	%
Time deposits, $100 and over		116,290		2,028		2.33	%		97,962		1,078		1.47	%
Brokered time deposits, $100 and over		35,478		969		3.65	%		9,166		306		4.46	%
Notes payable to subsidiary grantor trusts		23,702		1,581		8.92	%		23,702		1,455		8.20	%
Securities sold under agreement to repurchase		43,460		729		2.24	%		41,510		627		2.02	%
Total interest bearing liabilities		746,163	$	11,134		2.00	%		674,594	$	6,971		1.38	%
Demand, noninterest bearing		260,389							268,749
Other liabilities		20,852							14,870
Total liabilities		1,027,404							958,213
Shareholders' equity		103,716							92,410
Total liabilities and shareholders' equity	$	1,131,120						$	1,050,623
Net interest income / margin			$	35,178		4.52	%			$	29,946		4.18	%

Note: Yields and amounts earned on loans include loan fees of $1,191,000 and $1,243,000 for the nine month periods ended September 30, 2005 and 2004, respectively. Interest income is reflected on an actual basis, not a fully taxable equivalent basis. Nonaccrual loans are included in the average balance calculation above.

Net interest income for the three and nine months ended September 30, 2005 increased 15% and 17%, respectively, over the same period in 2004. For the three and nine months ended September 30, 2005, average interest earning assets increased by $52,641,000 and $83,744,000, respectively, or 5% and 9%, over the prior period in 2004. For the three and nine months ended September 30, 2005, the average yield on interest earning assets was 6.22% and 5.95%, respectively, an increase of 99 and 80 basis points from 5.23% and 5.15% for the same period in 2004. The rates paid on interest bearing liabilities increased 83 and 62 basis points to 2.24% and 2.00% for the three and nine months ended September 30, 2005 compared to 1.41% and 1.38% for the same period in 2004. As a result, the net interest margin increased 36 and 34 basis points to 4.61% and 4.52% for the three and nine months ended September 30, 2005, from 4.25% and 4.18% for the same period in 2004. The increase in net interest income was attributable to increases in the volume of average earning assets and increases in key market interest rates in 2005. The changes in volume contributed $212,000 for the three months ended September 30, 2005 and $1,937,000 for the nine months ended September 30, 2005, respectively, to net interest income. The effect of the changes in rates contributed $1,351,000 and $3,295,000, respectively, for the three and nine months ended September 30, 2005. These changes resulted in an overall increase of $1,563,000 and $5,232,000, respectively, for the three and nine months ended September 30, 2005 from 2004.

The following table sets forth an analysis of the changes in interest income resulting from changes in the average volume of interest earning assets and liabilities and changes in the average rates earned and paid. The total change is shown in the column designated “Net Change” and is allocated in the columns to the left, for the portions attributable to volume changes and rate changes that occurred during the period indicated. Changes due to both volume and rate have been allocated to the change in volume.

	Three Months Ended September 30,
	2005 vs. 2004
	Increase (Decrease) Due to Change In:
	Average			Average			Net
(Dollars in thousands)	Volume			Rate			Change
Interest earning assets
Loans, gross	$	276		$	2,593		$	2,869
Securities		(69	)		-			(69	)
Interest bearing deposits in other financial institutions		19			5			24
Federal funds sold		407			117			524
Total interest earnings assets	$	633		$	2,715		$	3,348
Interest bearing liabilities
Demand, interest bearing	$	50		$	257		$	307
Savings and money market		32			684			716
Time deposits, under $100		(5	)		111			106
Time deposits, $100 and over		124			257			381
Brokered time deposits, $100 and over		302			(10	)		292
Notes payable to subsidiary grantor trusts		1			50			51
Securities sold under agreement to repurchase		(83	)		15			(68	)
Total interest bearing liabilities	$	421		$	1,364		$	1,785
Net interest income	$	212		$	1,351		$	1,563

	Nine Months Ended September 30,
	2005 vs. 2004
	Increase (Decrease) Due to Change In:
	Average			Average			Net
(Dollars in thousands)	Volume			Rate			Change
Interest earning assets
Loans, gross	$	2,307		$	5,625		$	7,932
Investment securities		462			85			547
Interest bearing deposits in other financial institutions		33			18			51
Federal funds sold		408			457			865
Total interest earnings assets	$	3,210		$	6,185		$	9,395
Interest bearing liabilities
Demand, interest bearing	$	164		$	595		$	759
Savings and money market		62			1,266			1,328
Time deposits, under $100		(22	)		257			235
Time deposits, $100 and over		319			631			950
Brokered time deposits, $100 and over		719			(56	)		663
Notes payable to subsidiary grantor trusts		(2	)		128			126
Securities sold under agreement to repurchase		33			69			102
Total interest bearing liabilities		1,273			2,890			4,163
Net interest income	$	1,937		$	3,295		$	5,232

Provision for Loan Losses

The provision for loan losses represents the current period expense associated with maintaining an appropriate allowance for credit losses. The loan loss provision and level of allowance for each period is dependent upon many factors, including loan growth, net charge-offs, changes in the composition of the loan portfolio, delinquencies, management’s assessment of the quality of the loan portfolio, the valuation of problem loans and the general economic conditions in the Company’s market area. Periodic fluctuations in the provision for loan losses result from management’s assessment of the adequacy of the allowance for loan and lease losses; however, actual loan losses may vary from current estimates. The Company reduced the allowance for loan and lease losses by $494,000 during the third quarter of 2005. This reduction reflects sound credit quality as demonstrated by net recoveries of $130,000 for the third quarter of 2005 and a decrease in nonperforming loans to $2,715,000 at September 30, 2005 from $5,561,000 at the prior quarter end. The Company’s provision for loan losses was $313,000 for the nine months ended September 30, 2005. The Company’s provision for loan losses were $254,000 and $1,392,000, respectively, for the three and nine months ended September 30, 2004. See additional discussion under the caption "Allowance for loan and lease losses.”

Noninterest Income

The following table sets forth the various components of the Company’s noninterest income for the periods indicated:

	Three Months Ended				Increase (decrease)
	September 30,				2005 versus 2004
(Dollars in thousands)	2005		2004		Amount			Percent
Gain on sale of loans	$	702	$	920	$	(218	)		-24	%
Loan servicing income		510		426		84			20	%
Service charges and other fees on deposit accounts		332		415		(83	)		-20	%
Increase in cash surrender value of life insurance		331		236		95			40	%
Gain on sale of leased equipment		-		-		-			N/	A
Equipment leasing		-		245		(245	)		-100	%
Gain on sales securities available-for-sale		-		-		-			N/	A
Mortgage brokerage fees		-		19		(19	)		-100	%
Other		306		375		(69	)		-18	%
Total	$	2,181	$	2,636	$	(455	)		-17	%

	Nine Months Ended				Increase (decrease)
	September 30,				2005 versus 2004
(Dollars in thousands)	2005		2004		Amount			Percent
Gain on sale of loans	$	2,160	$	2,285	$	(125	)		-5	%
Loan servicing income		1,368		1,105		263			24	%
Service charges and other fees on deposits accounts		1,120		1,385		(265	)		-19	%
Increase in cash surrender value of life insurance		887		798		89			11	%
Gain on sale of leased equipment		299		-		299			N/	A
Equipment leasing		131		735		(604	)		-82	%
Gain on sales securities available-for-sale		-		476		(476	)		-100	%
Mortgage brokerage fees		-		168		(168	)		-100	%
Other		1,112		1,054		58			6	%
Total	$	7,077	$	8,006	$	(929	)		-12	%

Noninterest income for the three and nine months ended September 30, 2005 was $2,181,000 and $7,077,000, respectively, a decrease of 17% and 12%, respectively, from $2,636,000 and $8,006,000 for the same period in 2004.

In the three and nine months ended September 30, 2005, gain on sale of Small Business Administration (SBA) loans and other guaranteed business loans decreased 24% and 5% to $702,000 and $2,160,000, respectively, however, loan servicing income increased 20% and 24% to $510,000 and $1,368,000, respectively, compared to the same period in 2004. The Company has an ongoing program of originating SBA and other guaranteed business loans and selling the government guaranteed portion in the secondary market, while retaining the servicing of the whole loans. The decrease in noninterest income was attributable to the decrease in lease income of $245,000 and $604,000, respectively, for the three months and nine months ended September 30, 2005 due to the sale of all leased equipment during the second quarter, and the absence of gain on securities sales recognized in the three and nine months ended September 30, 2005, compared to zero and $476,000 in securities gains in the three and nine months ended September 30, 2004.

Deposit related activity charges decreased $83,000 and $265,000 from the three and nine months ended September 30, 2004 compared to the three and nine months ended September 30, 2005 primarily because higher interest rates applied to collected balances created a waiver of (or credit against) service charges for many business customers.

Noninterest Expense

The following table sets forth the various components of the Company’s noninterest expense for the periods indicated:

	Three Months				Increase (decrease)
	September 30,				2005 versus 2004
(Dollars in thousands)	2005		2004		Amount			Percent
Salaries and employee benefits	$	4,375	$	4,301	$	74			2	%
Occupancy		779		875		(96	)		-11	%
Professional fees		511		670		(159	)		-24	%
Retirement plan expense		416		358		58			16	%
Client services		300		228		72			32	%
Amortization of low income housing projects		260		279		(19	)		-7	%
Advertising and promotion		290		364		(74	)		-20	%
Furniture and equipment		181		206		(25	)		-12	%
Data processing expense		167		170		(3	)		-2	%
Amortization of leased equpiment		-		250		(250	)		-100	%
Other		1,199		1,059		140			13	%
Total	$	8,478	$	8,760	$	(282	)		-3	%

	Nine Months Ended				Increase (decrease)
	September 30,				2005 versus 2004
(Dollars in thousands)	2005		2004		Amount			Percent
Salaries and employee benefits	$	14,040	$	14,477	$	(437	)		-3	%
Occupancy		2,471		2,789		(318	)		-11	%
Professional fees		1,232		1,986		(754	)		-38	%
Retirement plan expense		1,154		1,576		(422	)		-27	%
Client services		1,051		644		407			63	%
Amortization of low income housing projects		806		640		166			26	%
Advertising and promotion		802		862		(60	)		-7	%
Furniture and equipment		584		698		(114	)		-16	%
Data processing expense		508		492		16			3	%
Amortization of leased equpiment		334		766		(432	)		-56	%
Other		3,684		3,289		395			12	%
Total	$	26,666	$	28,219	$	(1,553	)		-6	%

The following table indicates the percentage of noninterest expense in each category:

	For The Three Months Ended September 30,
			Percent					Percent
(Dollars in thousands)	2005		of Total			2004		of Total
Salaries and employee benefits	$	4,375		52	%	$	4,301		49	%
Occupancy		779		9	%		875		10	%
Professional fees		511		6	%		670		8	%
Retirement plan expense		416		5	%		358		4	%
Client services		300		4	%		228		3	%
Amortization of low income housing projects		260		3	%		279		3	%
Advertising and promotion		290		3	%		364		4	%
Furniture and equipment		181		2	%		206		2	%
Data processing expense		167		2	%		170		2	%
Amortization of leased equpiment		-		0	%		250		3	%
Other		1,199		14	%		1,059		12	%
Total	$	8,478		100	%	$	8,760		100	%

	For The Nine Months Ended September 30,
			Percent					Percent
(Dollars in thousands)	2005		of Total			2004		of Total
Salaries and employee benefits	$	14,040		53	%	$	14,477		51	%
Occupancy		2,471		9	%		2,789		10	%
Professional fees		1,232		5	%		1,986		7	%
Retirement plan expense		1,154		4	%		1,576		6	%
Client services		1,051		4	%		644		2	%
Amortization of low income housing projects		806		3	%		640		2	%
Advertising and promotion		802		3	%		862		3	%
Furniture and equipment		584		2	%		698		2	%
Data processing expense		508		2	%		492		2	%
Amortization of leased equpiment		334		1	%		766		3	%
Other		3,684		14	%		3,289		12	%
Total	$	26,666		100	%	$	28,219		100	%

Noninterest expense for the three and nine months ended September 30, 2005 was $8,478,000 and $26,666,000, respectively, down $282,000 and $1,553,000, or 3% and 6%, from $8,760,000 and $28,219,000 for the same period in the prior year.

For the three and nine month period ended September 30, 2005 compared to the three and nine month period ended September 30, 2004:

·   Salaries and employee benefits increased $74,000, or 2%, for quarter ended September 30, 2005 but decreased $437,000, or 3%, for the nine months ended September 30, 2005, compared to the same period in 2004. The decrease for the nine months ended September 30, 2005 from 2004 was primarily due to expense related to the severance expense in 2004. Salaries and employee benefits as a percentage of total noninterest expense increased to 52% and 53%, respectively, from 49% and 51%, over the comparative three and nine month period.

·   Occupancy decreased by $96,000 and $318,000, respectively, or 11% and 11%, compared to the same period in 2004. The decrease was primarily as a result of lower depreciation on leasehold improvements in 2005. During the third quarter of 2005, the Company amended two of its existing lease contracts to reduce monthly rent by extending the term of the lease. Occupancy costs as a percentage of total noninterest expense decreased to 9% from 10% over the comparative three month and nine month period.

·   Professional fees decreased $159,000 and $754,000, respectively, or 24% and 38%, compared to the same period in 2004. The comparable periods in 2004 included significant legal fees associated with a proxy contest and other corporate governance matters. Professional fees as a percentage of total noninterest expense decreased to 6% and 5%, respectively, from 8% and 7% over the comparative three and nine month period.

·   Supplemental retirement plan increased $58,000, or 16%, for the quarter ended September 30, 2005 but decreased $422,000, or 27%, for the nine months ended September 30, 2005, compared to the same period in 2004. Retirement plan expense as a percentage of total noninterest expense increased to 5% from 4% over the comparative three month period but decreased to 4% from 6% over the comparative nine month period.

·   Client services increased $72,000 and $407,000, respectively, or 32% and 63%, compared to the same period in 2004. The increase from 2004 was primarily due to the increase in service fees charged to the Company from third party vendors. Client services as a percentage of total noninterest expense increased to 4% from 3% and 2% over the comparative three and nine month period.

·   Amortization of low income housing projects increased $166,000, or 26%, for the nine months ended September 30, 2005, compared to the same period in 2004. The increase compared to last year was primarily due to an additional investment in a low income housing project in June 2004 and the increased losses from three fully active funds in 2005.

·   Furniture and equipment expense decreased by $25,000 and $114,000, respectively, or 12% and 16%, compared to the same period in 2004. The decrease was primarily due to fewer equipment repairs, and lower depreciation on furniture and equipment in 2005. Furniture and equipment, as a percentage of total noninterest expense remains at 2% over the comparative three and nine month period.

·   Amortization of leased equipment decreased $250,000 and $432,000, respectively, or 100% and 56%, compared to the same period in 2004. All of the leased equipment was sold in the second quarter of 2005.

Income Taxes

Income tax expense for the three and nine months ended September 30, 2005 was $2,245,000 and $5,087,000, respectively, as compared to $1,210,000 and $2,509,000 for the same periods in the prior year. The following table shows the effective income tax rate for each period indicated.

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2005			2004			2005			2004
Effective income tax rate		34.86	%		28.13	%		33.30	%		30.08	%

The difference in the effective tax rate compared to the combined federal and state statutory tax rate of 42% is primarily the result of the Company’s investment in life insurance policies whose earnings are not subject to taxes, tax credits related to investments in low income housing and investments in tax-free municipal securities. The effective tax rate in 2005 is higher compared to 2004 because pre-tax income increased more than the savings from tax advantaged investments.

FINANCIAL CONDITION

As of September 30, 2005, total assets were $1,160,591,000, an increase of $52,418,000, or 5%, from $1,108,173,000 at December 31, 2004, and an increase of $72,553,000, or 7%, from the same period in 2004. Securities available-for-sale decreased $23,394,000, or 10%, and $19,068,000, or 8%, at September 30, 2005 from December 31, 2004 and September 30, 2004. Total loans increased $12,449,000, or 2%, at September 30, 2005 from December 31, 2004, and increased $13,767,000, or 2%, from September 30, 2004. Total deposits increased $56,659,000, or 6%, to $975,194,000 at September 30, 2005 from $918,535,000 at December 31, 2004, and increased $72,538,000, or 8%, from $902,656,000 at September 30, 2004.

Securities Portfolio

A major component of the Company's earning assets is its securities portfolio. The following table sets forth the estimated fair value of securities at the dates indicated:

	September 30,				December 31,
(Dollars in thousands)	2005		2004		2004
Securities available-for-sale (at fair value)
U.S. Treasury	$	11,918	$	5,964	$	5,942
U.S. Government Agencies		84,367		91,041		90,308
Mortgage-Backed Securities		90,098		102,511		107,735
Municipals - Tax Exempt		8,596		9,250		9,206
Collateralized Mortgage Obligations		14,436		19,717		19,618
Total	$	209,415	$	228,483	$	232,809

The following table summarizes the composition of the Company’s securities available-for-sale and the weighted average yields at September 30, 2005:

	September 30, 2005
	Maturity
						After One and					After Five and
	Within One Year					Within Five Years					Within TenYears					After Ten Years					Total
(Dollars in thousands)	Amount		Yield			Amount		Yield			Amount		Yield			Amount		Yield			Amount		Yield
Securities available-for-sale (at fair value):
U.S. Treasury	$	5,984		1.67	%	$	5,934		3.50	%	$	-		-		$	-		-		$	11,918		2.58	%
U.S. Government Agencies		69,640		2.19	%		14,727		3.27	%		-		-			-		-			84,367		2.38	%
Mortgage Backed Securities		-		-			2,606		3.07	%		6,944		4.09	%		80,548		4.01	%		90,098		3.99	%
Municipals - non-taxable		402		6.78	%		8,194		2.95	%		-		-			-		-			8,596		3.13	%
Collateralized Mortgage Obligations		-		-			-		-			-		-			14,436		2.59	%		14,436		2.59	%
Total	$	76,026		2.17	%		31,461		3.21	%	$	6,944		4.09	%	$	94,984		3.79	%	$	209,415		3.13	%

Securities that are classified as available for sale are carried at their fair value. This means that the carrying amount will increase or decrease based on changes in interest rates or, very rarely, changes in credit rating.

As of September 30, 2005, the only securities held by the Company where the aggregate carrying value of the Company's investment in securities of a single issuer exceeded 10% of the Company's shareholders' equity were direct obligations of the U.S. government or U.S. government agencies.

The securities portfolio of the Company is also used as collateral to meet requirements imposed as a condition of deposit by some depositors such as political subdivisions (public funds) or bankruptcy trustees and other contractual obligations such as repurchase agreements. Securities with amortized cost of $68,057,000 and $90,843,000 as of September, 2005 and 2004 were pledged to secure public and certain other deposits as required by law or contract and other contractual obligations. A portion of these deposits can only be secured by U.S. Treasury securities. The Company has not used interest rate swaps or other derivative instruments to hedge fixed rate loans or to otherwise mitigate interest rate risk.

Loans

Loans increased $12,449,000, or 2%, to $737,979,000 at September 30, 2005 from $725,530,000 at December 31, 2004, and increased $13,767,000, or 2%, from $724,212,000 at September 30, 2004.

For the three and nine months ended September 30, 2005, $25,574,000 and $60,727,000, respectively, in guaranteed loans were generated and held for sale, and $11,840,000 and $34,530,000, respectively, of guaranteed loans held for sale were sold into the secondary market.

At September 30, 2005 and December 31, 2004, the Company serviced SBA and other business loans, which it had sold into the secondary market, of approximately $178,417,000 and $166,813,000, respectively. At September 30, 2005 and December 31, 2004, the carrying amount of the servicing assets was $2,180,000 and $2,213,000, respectively. There was no valuation allowance as of September 30, 2005 or December 31, 2004. The balance of Interest-Only (I/O) strip receivables at September 30, 2005 and December 31, 2004 was $4,770,000, net of unrealized gain of $1,963,000, and $3,954,000, net of unrealized gain of $1,536,000, respectively. These assets represent the servicing spread generated from the sold guaranteed portions of SBA and other business loans.

Servicing income from these loans was $510,000 and $1,368,000, respectively, for the three and nine months ended September 30, 2005, compared to $426,000 and $1,105,000 for the same period in 2004. Amortization of the related assets was $518,000 and $1,684,000, respectively, for the three and nine months ended September 30, 2005, compared to $393,000 and $1,138,000 for the same period in 2004. Heritage Bank of Commerce is a preferred lender with the U.S. Small Business Administration, which allows the Company to grant certain U.S. Small Business Administration loans without the prior approval of the SBA.

The following table summarizes the composition of the Company’s loan portfolio at the dates indicated:

	September 30, 2005						September 30, 2004						December 31, 2004
(Dollars in thousands)	2005			% to Total			2004			% to Total			2004			% to Total
Commercial	$	298,900			41	%	$	314,142			43	%	$	300,452			41	%
Real estate - mortgage		287,618			39	%		301,249			42	%		303,154			42	%
Real estate - land and construction		148,650			20	%		106,303			15	%		118,290			16	%
Consumer		1,776			0	%		2,051			0	%		2,908			1	%
Total loans		736,944			100	%		723,745			100	%		724,804			100	%
Deferred loan costs		1,035						467						726
Allowance for loan losses		(11,112	)					(12,973	)					(12,497	)
Loans, net	$	726,867					$	711,239					$	713,033

The loan portfolio is primarily composed of commercial loans to companies principally engaged in manufacturing, wholesale, and service businesses and real estate lending. The real estate mortgage loan portfolio decreased in the third quarter of 2005 from the third quarter of 2004 was mainly attributable to loan refinancing and pay downs during 2005 with the attractive mortgage rate environment. The construction loan portfolio increase in the third quarter of 2005 from the third quarter of 2004 was attributable to increased demand on construction projects.

The following table sets forth the maturity distribution of the Company’s loan portfolio at September 30, 2005:

			Over One
	Due in		Year But
	One Year		Less than		Over
(Dollars in thousands)	or Less		Five Years		Five Years		Total
Commercial	$	271,693	$	22,237	$	4,970	$	298,900
Real estate - mortgage		182,383		56,825		48,409		287,617
Real estate - land and construction		148,651		-		-		148,651
Consumer		1,666		110		-		1,776
Total loans	$	604,393	$	79,172	$	53,379	$	736,944
Loans with variable interest rates	$	582,974	$	34,064	$	183	$	617,221
Loans with fixed interest rates		21,419		45,108		53,196		119,723
Total loans	$	604,393	$	79,172	$	53,379	$	736,944

The table above also shows the distribution of loans between those with predetermined (fixed) interest rates and those with variable (floating) interest rates. Floating rates generally fluctuate with changes in the prime rate as reflected in the western edition of The Wall Street Journal. At September 30, 2005, approximately 84% of the Company’s loan portfolio consisted of floating interest rate loans.

Nonperforming assets

Nonperforming assets consist of nonaccrual loans and leases, loans and leases past due 90 days and still accruing, troubled debt restructurings and other real estate owned. Management generally places loans on nonaccrual status when they become 90 days past due, unless they are well secured and in the process of collection. When a loan is placed on nonaccrual status, any interest previously accrued but not collected is generally reversed from income. Loans are charged off when management determines that collection has become unlikely. Restructured loans are those where the Company has granted a concession on the interest paid or original repayment terms due to financial difficulties of the borrower. Other real estate owned (“OREO”) consists of real property acquired through foreclosure on the related underlying defaulted loans. The following table shows nonperforming assets at the dates indicated:

	September 30,						December 31,
(Dollars in thousands)	2005			2004			2004
Nonaccrual loans	$	2,715		$	1,926		$	1,028
Loans 90 days past due and still accruing		-			711			302
Restructured loans		-			-			-
Total nonperforming loans		2,715			2,637			1,330
Other real estate owned		-			-			-
Total nonperforming assets	$	2,715		$	2,637		$	1,330
Nonperforming assets as a percentage of
loans plus other real estate owned		0.37	%		0.36	%		0.18	%

As of September 30, 2005, the Company had $2,715,000 loans on nonaccrual status, which were considered impaired loans, compared to $1,028,000 as of December 31, 2004 and $1,926,000 as of September 30, 2004.

Allowance for loan and lease losses

The Company assigns a risk grade consistent with the system recommended by regulatory agencies to all of its loans. Grades range from "Pass" to "Loss" depending on credit quality, with "Pass" representing loans that involve an acceptable degree of risk. Management conducts an evaluation of the "Pass" loan portfolio at least annually. Among other things, this evaluation takes into consideration loan payment history, covenant compliance and economic conditions then in existence. For loans where a higher degree of risk has been identified, the evaluation includes periodic loan by loan review for certain loans to evaluate the level of impairment as well as detailed reviews of other loans (either individually or in pools) based on an assessment of the following factors: past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower's ability to repay, collateral value, loan volumes and concentrations, size and complexity of the loans, recent loss experience in particular segments of the portfolio, bank regulatory examination results, and current economic conditions in the Company's marketplace, in particular the state of the technology industry and the real estate market.

This process attempts to assess the risk of loss inherent in the entire portfolio by segregating loans into six components for purposes of determining an appropriate level of the allowance: “pass,” "watch," "special mention," "substandard," "doubtful,” and “loss.” Additionally, the Company maintains a program for regularly scheduled reviews of certain new and renewed loans by an outside loan review consultant. Any loans identified during an external review process that expose the Company to increased risk are appropriately downgraded. Further, the Company is examined periodically by the FDIC, FRB, and the California Department of Financial Institutions at which time a further review of loan quality is conducted.

Loans that demonstrate a weakness, for which there is a possibility of loss if the weakness is not corrected, are categorized as "classified." Classified loans include all loans graded substandard, doubtful and loss and may result from problems specific to a borrower's business or from economic downturns that affect the borrower's ability to repay or that cause a decline in the value of the underlying collateral (particularly real estate).

It is the policy of management to maintain the allowance for loan and lease losses at a level adequate for risks inherent in the loan portfolio. Based on information currently available to analyze loan loss risk and a history of actual charge-offs, management believes that the loan loss allowance is adequate. However, the loan portfolio could be adversely affected if the California economy or real estate values in the Company’s market area were to weaken. Also, any weakness of a prolonged nature in the technology industry would have a negative impact on the local market. The effect of such events, although uncertain at this time, could result in an increase in the level of nonperforming loans and increased loan losses, which could adversely affect the Company's future growth and profitability. No assurance of the ultimate level of credit losses can be given with any certainty. Loans are charged against the allowance when management believes that the collectibility of the principal is unlikely.

The following table summarizes the Company’s loan loss experience as well as provisions, charge-offs and recoveries to the allowance for loan and lease losses and certain pertinent ratios for the periods indicated:

	Nine Months Ended						For the Year Ended
	September 30,						December 31,
(Dollars in thousands)	2005			2004			2004
Balance, beginning of period / year	$	12,497		$	13,451		$	13,451
Net charge-offs		(1,738	)		(1,870	)		(1,339)
Provision for loan losses		313			1,392			666
Reclassification to other liabilities		40			-			(281)	(1)
Balance, end of period/ year	$	11,112		$	12,973		$	12,497

(1) The Company reclassified the allowance for loan and lease losses on unused commitments of $281,000 to other liabilities as of December 31, 2004. As of September 30, 2005, this allowance was $183,000.

Charge-off reflects the realization of losses in the portfolio that were recognized previously though provisions for loan losses. The year-to-date net charge-offs as of September 30, 2005 were $1,738,000, compared to $1,870,000 as of September 30, 2004. Historical net charge-offs are not necessarily indicative of the amount of net charge-offs that the Company will realize in the future.

The decrease in the overall level of the allowance and in the allowance as a percentage of total loans since December 31, 2004 is primarily the result of net charge-offs in 2005. Other than the loans already classified, the Company has not identified any additional potential problem loans at September 30, 2005.

Loans are charged against the allowance when management believes that the collectibility of the principal is doubtful. The Company's methodology for assessing the appropriateness of the allowance consists of several key elements, which include specific allowances, the formula allowance and the unallocated allowance.

The current business, economic, and real estate markets along with the seasoning of the portfolio and the nature and duration of the current business cycle will affect the amount of estimated losses. There can be no assurance that the adverse impact of any of these above conditions on the Bank will not be in excess of the current level of estimated losses.

In an effort to improve its analysis of risk factors associated with its loan portfolio, the Company continues to monitor and to make appropriate changes to its internal loan policies. These efforts better enable the Company to assess risk factors prior to granting new loans and to assess the sufficiency of the allowance for loan and lease losses.

Management believes that it has adequately provided an allowance for estimated probable losses in the credit portfolio. Significant deterioration in Northern California real property values or economic downturns could impact future operating results, liquidity or capital resources and require additional provisions to the allowance or cause losses in excess of the allowance.

Deposits

Total deposits were $975,194,000 at September 30, 2005, an increase of 6% and 8%, respectively,compared to deposits at December 31, 2004 and at September 30, 2004. At September 30, 2005, compared to December 31, 2004, noninterest bearing demand deposits decreased $18,987,000, or 7%; interest bearing demand deposits increased $9,437,000, or 8%; savings and money market deposits decreased $39,752,000, or 11%; time deposits increased $8,280,000, or 6%; and brokered deposits increased $18,177,000, or 92%.

The following table summarizes the distribution of average deposits and the average rates paid for the periods indicated:

	Nine Months Ended					Nine Months Ended					Year Ended
	September 30, 2005					September 30, 2004					December 31, 2004
			Average					Average					Average
	Average		Rate			Average		Rate			Average		Rate
(Dollars in thousands)	Balance		Paid			Balance		Paid			Balance		Paid
Demand, noninterest bearing	$	260,389		--	%	$	268,749		--	%	$	275,192		--	%
Demand, interest bearing		130,424		1.16	%		110,909		0.44	%		112,439		0.48	%
Savings and money market		359,175		1.51	%		352,402		1.03	%		350,922		1.04	%
Time deposits, under $100		37,634		2.32	%		38,943		1.44	%		38,717		1.49	%
Time deposits, $100 and over		116,290		2.33	%		97,962		1.47	%		100,309		1.55	%
Brokered deposits, $100 and over		35,478		3.65	%		9,166		4.46	%		11,460		4.13	%
Total average deposits	$	939,390		1.26	%	$	878,131		0.74	%	$	889,039		0.76	%

As of September 30, 2005, the Company had a deposit mix of 41% in savings and money market accounts, 19% in time deposits, 13% in interest bearing demand accounts, and 27% in noninterest bearing demand deposits. As of September 30, 2005, approximately $2,400,000, or less than 1%, of deposits were from public sources, and approximately $74,584,000, or 8%, of deposits were from title and escrow companies. As of September 30, 2004, the Company had a deposit mix of 39% in savings and money market accounts, 16% in time deposits, 13% in interest bearing demand accounts, and 32% in noninterest bearing demand deposits. As of September 30, 2004, approximately $6,610,000, or less than 1%, of deposits were from public sources, and approximately $91,546,000, or 10%, of deposits were from title and escrow companies.

The Company obtains deposits from a cross-section of the communities it serves. The Company's business is not seasonal in nature. The Company had brokered deposits totaling $38,039,000 and $3,964,000 at September 30, 2005 and 2004, respectively. These brokered deposits generally mature within one to three years. The Company is not dependent upon funds from sources outside the United States.

The following table indicates the maturity schedule of the Company’s time deposits of $100,000 or more as of September 30, 2005.

Time Deposits of $100,000 and Over
(Dollars in thousands)	Balance		% of Total
Three months or less	$	58,257		38	%
Over three months through twelve months		49,299		33	%
Over twelve months		44,092		29	%
Total	$	151,648		100	%

The Company focuses primarily on providing and servicing business deposit accounts that are frequently over $100,000 in average balance per account. As a result certain types of business clients whom the Company serves typically carry average deposits in excess of $100,000. The account activity for some account types and client types necessitates appropriate liquidity management practices by the Company to ensure its ability to fund deposit withdrawals.

Return on Equity and Assets

The following table indicates the ratios on the annualized return on average assets and average equity and average equity to average assets for each indicated period.

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2005			2004			2005			2004
Return on average assets		1.45	%		1.12	%		1.20	%		0.74	%
Return on average equity		15.64	%		13.10	%		13.13	%		8.43	%
Average equity to average assets ratio		9.27	%		8.53	%		9.17	%		8.80	%

Interest Rate Sensitivity

The planning of asset and liability maturities is an integral part of the management of an institution’s net yield. To the extent maturities of assets and liabilities do not match in a changing interest rate environment, net yields may change over time. Even with perfectly matched repricing of assets and liabilities, risks remain in the form of prepayment of loans or investments or in the form of delays in the adjustment of rates of interest applying to either earning assets with floating rates or to interest bearing liabilities. The Company has generally been able to control its exposure to changing interest rates by maintaining primarily floating interest rate loans and a majority of its time certificates with relatively short maturities.

The following table sets forth the interest rate sensitivity of the Company’s interest-earning assets and interest-bearing liabilities at September 30, 2005, using the rate sensitivity gap ratio. For purposes of the following table, an asset or liability is considered rate-sensitive within a specified period when it can be repriced or when it is scheduled to mature within the specified time frame:

				Due in			Due After
	Within			Three to			One to			Due After			Not Rate
(Dollars in thousands)	Three Months			Twelve Months			Five Years			Five Years			Sensitive			Total
Interest earning assets:
Federal funds sold	$	63,700		$	-		$	-		$	-		$	-		$	63,700
Interest bearing deposits in other financial institutions		3,869			-			-			-			-			3,869
Securities		16,718			59,309			31,461			101,927			-			209,415
Total loans, including loans held for sale		552,532			92,560			79,172			53,379			-			777,643
Total interest earning assets		636,819			151,869			110,633			155,306						1,054,627
Cash and dues from banks														40,192			40,192
Other assets					33,016									32,756			65,772
Total assets	$	636,819		$	184,885		$	110,633		$	155,306		$	72,948		$	1,160,591
Interest bearing liabilities:
Demand, interest bearing	$	130,327		$	-		$	-		$	-		$	-		$	130,327
Savings and money market		397,070			-			-			-			-			397,070
Time deposits		71,856			69,350			48,127			-			-			189,333
Securities sold under agreement to repurchase		-			10,900			21,800			-			-			32,700
Notes payable to subsidiary grantor trusts		9,279			-			-			14,423			-			23,702
Total interest bearing liabilities		608,532			80,250			69,927			14,423			-			773,132
Noninterest demand deposits		42,990			-			-			-			215,474			258,464
Accrual interest payable and other liabilities		-			-			-			-			21,938			21,938
Shareholders' equity		-			-			-			-			107,057			107,057
Total liabilities and shareholder's equity	$	651,522		$	80,250		$	69,927		$	14,423		$	344,469		$	1,160,591
Interest rate sensitivity GAP	$	(14,703	)	$	104,635		$	40,706		$	140,883		$	(271,521	)	$	-
Cumulative interest rate sensitivity GAP	$	(14,703	)	$	89,932		$	130,638		$	271,521		$	-		$	-
Cumulative interest rate sensitivity GAP ratio		-1	%		8	%		11	%		23	%		0	%		0	%

Interest rate changes do not affect all categories of assets and liabilities equally or at the same time. Varying interest rate environments can create unexpected changes in prepayment levels of assets and liabilities, which may have a significant effect on the net interest margin and are not reflected in the interest sensitivity analysis table. Because of these factors, an interest sensitivity gap report may not provide a complete assessment of the exposure to changes in interest rates. To supplement traditional GAP analysis, the Company performs simulation modeling to estimate the potential effects of changing interest rate environments but there is no significant difference as of September 30, 2005, compared to December 31, 2004. The process allows the Company to explore the complex relationships within the GAP over time and various interest rate environments.

Liquidity risk represents the potential for loss as a result of limitations on the Company's ability to adjust for future cash flows, to meet the needs of depositors and borrowers, and to fund operations on a timely and cost-effective basis. The liquidity policy approved annually by the board of directors requires monthly review of the Company's liquidity by the asset/liability committee, which is composed of senior executives, and the finance and investment committee of the board of directors.

The Company's internal Asset/Liability Committee and the Finance and Investment Committee of the Board of Directors each meet monthly to monitor the Company's investments, liquidity needs and to oversee its asset/liability management. The Company evaluates the rates offered on its deposit products on a regular basis.

Liquidity and Asset/Liability Management

To meet liquidity needs, the Company maintains a portion of its funds in cash deposits in other banks, in Federal funds sold, and in securities. At September 30, 2005, the Company’s primary liquidity ratio was 21.20%, comprised of $107,487,000 in securities available-for-sale with maturities (or probable calls) of up to five years,less $10,819,000 of securities that were pledged to secure public and certain other deposits as required by law and contract;Federal funds sold of $63,700,000, and $44,061,000 in cash and due from banks, as a percentage of total unsecured deposits of $964,375,000. At December 31, 2004 and September 30, 2004, the Company's primary liquidity ratio was 16.35% and 16.06%, respectively.

The following table summarizes the Company's borrowings under its Federal funds purchased, security repurchase arrangements and lines of credit for the periods indicated:

	September 30,
(Dollars in thousands)	2005			2004
YTD average balance	$	43,460		$	41,538
YTD average interest rate		2.24	%		2.02	%
Maximum month-end balance	$	57,800		$	48,600
Average rate at September 30,		4.01	%		2.22	%

The Company has Federal funds purchase and lines of credit arrangements totaling $57,000,000 from correspondent banks. As of September 30, 2005, the Company had borrowing capacity of approximately $99,000,000 under a borrowing arrangement with the Federal Home Loan Bank secured by certain loans and securities.

Capital Resources

The following table summarizes risk-based capital, risk-weighted assets, and risk-based capital ratios of the Company:

	September 30,						December 31,
(Dollars in thousands)	2005			2004			2004
Capital components:
Tier 1 Capital	$	129,018		$	117,461		$	121,096
Tier 2 Capital		11,295			11,337			11,623
Total risk-based capital	$	140,313		$	128,798		$	132,719
Risk-weighted assets	$	962,090		$	905,300		$	929,241
Average assets	$	1,149,088		$	1,102,171		$	1,112,526
										Minimum
										Regulatory
Capital ratios										Requirements
Total risk-based capital		14.58	%		14.23	%		14.30	%	8.00	%
Tier 1 risk-based capital		13.41	%		12.97	%		13.00	%	4.00	%
Leverage (1)		11.23	%		10.66	%		10.90	%	4.00	%

(1)     Tier 1 capital divided by average assets (excluding goodwill).

At September 30, 2005 and 2004, and December 31, 2004, the Company’s capital met all minimum regulatory requirements. As of September 30, 2005, management believes that HBC was considered “Well Capitalized” under the Prompt Corrective Action Provisions.

To enhance regulatory capital and to provide liquidity the Company, through unconsolidated subsidiary grantor trusts, issued the following mandatorily redeemable cumulative trust preferred securities of subsidiary grantor trusts: In the first quarter of 2000, the Company issued $7,000,000 aggregate principal amount of 10.875% subordinated debentures due on March 8, 2030 to a subsidiary trust, which in turn issued a similar amount of trust preferred securities. In the third quarter of 2000, the Company issued $7,000,000 aggregate principal amount of 10.60% subordinated debentures due on September 7, 2030 to a subsidiary trust, which in turn issued a similar amount of trust preferred securities. In the third quarter of 2001, the Company issued $5,000,000 aggregate principal amount of Floating Rate Junior Subordinated Deferrable Interest Debentures due on July 31, 2031 to a subsidiary trust, which in turn issued a similar amount of trust preferred securities. In the third quarter of 2002, the Company issued $4,000,000 aggregate principal amount of Floating Rate Junior Subordinated Deferrable Interest Debentures due on September 26, 2032 to a subsidiary trust, which in turn issued a similar amount of trust preferred securities. Under applicable regulatory guidelines, the Trust Preferred securities currently qualify as Tier I capital. The subsidiary trusts are not consolidated in the Company’s consolidated financial statements and the subordinated debt payable to the subsidiary grantor trusts is recorded as debt of the Company to the related trusts.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

No material changes have occurred during the quarter to the Company’s market risk profile or information. For further information refer to the Company’s Form 10-K.

ITEM 4. CONTROLS AND PROCEDURES

Disclosure Control and Procedures

The Company carried out an evaluation, under the supervision and with the participation of the Company's management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures as of September 30, 2005. As defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), disclosure controls and procedures are controls and procedures designed to ensure that information required to be disclosed in reports filed or submitted under the Exchange Act are recorded, processed, summarized and reported on a timely basis. Based upon that evaluation and as result of the material weakness described below, the Chief Executive Officer and Chief Financial Officer have concluded that the Company's disclosure controls and procedures were effective as of September 30, 2005.

Changes in Internal Control over Financial Reporting

As mentioned in the March 31, 2005 Form 10Q, the Company had a material weakness according to which the Company did not design and implement controls over the selection and application of accounting policies for complex, non-routine transactions which was identified during the December 31, 2004 audit. During the nine months of 2005, the Company created a formal process related to the design and implementation of control over the selection and application of complex, non-routine transactions. This process includes the early identification of complex, non-routine transactions. These transactions are initially documented by the Company’s internal accounting staff. There are regular meetings with accounting staff and executive level officers who are involved and familiar with these types of accounting issues, and who review the initial documentation of complex, non-routine transactions. Outside legal and accounting advice has been obtained when needed to review the complex, non-routine accounting transactions. In addition, the Company has hired additional employees with more banking and accounting experience to assist in reviewing the non-routine and complex accounting transactions.

Based on the Company’s new procedures, new additions to the staff and continuing expert consultation, the Company has had sufficient remediation for the material weakness found. The new procedures and in house expertise will properly address the review of the related policies and procedures for complex, non-routine accounting transactions. The internal controls over financial reporting were operating effectively as of September 30, 2005. Therefore, management has determined that there is no material weakness in the Company’s internal control over financial reporting as of September 30, 2005. However, the effectiveness of any system of internal controls is subject to inherent limitations and there can be no assurance that the Company’s internal control over financial reporting will prevent or detect all errors. The Company intends to continue to evaluate and strengthen its system of internal control over financial reporting.

During the nine months ended September 30, 2005, except as noted above there were no changes in our internal controls over financial reporting that materially affected, or are reasonably likely to affect, our internal controls over financial reporting.

Part II — OTHER INFORMATION

ITEM 2 - Unregistered Sales of Equity Securities and Use of Proceeds

In June 2004, the Company’s Board of Director authorized the purchase of up to $10 million of its common stock, which represents approximately 700,000 shares, or 6%, of its outstanding shares at current market price. The share repurchase authorization is valid through December 31, 2005. The repurchase program was completed at the end of third quarter 2005.

The Company has financed the stock repurchases by using its available cash. Shares may be repurchased by the Company in open market purchases or in privately negotiated transactions as permitted under applicable rules and regulations. The repurchase program may be modified, suspended or terminated by the Board of Directors at any time without notice. The extent to which the Company repurchases its shares and the timing of such repurchases will depend upon market conditions and other corporate considerations.

As of September 30, 2005, repurchases of equity securities are presented in the table below.

							Approximate
					Total Number of		Dollar of Shares That
					Shares Purchased		May Yet Be
	Total Number of		Price Paid		as Part of Publicly		Purchased
Settlement Date	Shares Purchased		Per Share		Announced Plans		Under the Plan
August 18, 2005		8,700	$	19.84		8,700	$	1,739,510.73
August 19, 2005		8,700	$	19.95		8,700	$	1,565,935.29
August 22, 2005		8,700	$	19.55		8,700	$	1,395,850.29
August 23, 2005		8,700	$	19.51		8,700	$	1,226,140.26
August 24, 2005		8,700	$	20.01		8,700	$	1,052,086.32
August 25, 2005		10,690	$	20.04		10,690	$	837,873.69
August 26, 2005		10,690	$	20.23		10,690	$	621,647.06
August 29, 2005		6,690	$	20.44		6,690	$	484,905.46
August 30, 2005		10,690	$	20.39		10,690	$	266,952.40
August 31, 2005		10,500	$	20.24		10,500	$	54,432.40
		92,760				92,760

ITEM 6. EXHIBITS

ExhibitDescription

31.1Certification of Registrant’s Chief Executive Officer Pursuant To

Section 302 of the Sarbanes-Oxley Act of 2003

31.2   Certification of Registrant’s Chief Financial Officer Pursuant To

   Section 302 of the Sarbanes-Oxley Act of 2003

32.1Certification of Registrant’s Chief Executive Officer Pursuant To 

 18 U.S.C. Section 1350

32.2Certification of Registrant’s Chief Financial Officer Pursuant To

18 U.S.C. Section 1350

SIGNATURES

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

	Heritage Commerce Corp
November 8, 2005	(Registrant) /s/ Walter T. Kaczmarek
Date November 8, 2005	Walter T. Kaczmarek Chief Executive Officer /s/ Lawrence D. McGovern
Date	Lawrence D. McGovern Chief Financial Officer

EX-31.1

Exhibit 31.1

CERTIFICATION UNDER SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002

REGARIDNG THE QUARTERLY REPORT ON FORM 10-Q

I, Walter T. Kaczmarek, certify that:

1.   I have reviewed this Quarterly Report on Form 10-Q for the Quarter Ended September 30, 2005 of Heritage Commerce Corp;

2.   Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3.   Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4.   The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

(a)   Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b)   Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

(c)   Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(d)   Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and

5.   The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions):

(a)   All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and

(b)   Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting.

Date: November 8, 2005

/s/ Walter T. Kaczmarek

Walter T. Kaczmarek

 Chief Executive Officer

EX-31.2

Exhibit 31.2

CERTIFICATION UNDER SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002

REGARIDNG THE QUARTERLY REPORT ON FORM 10-Q

I, Lawrence D. McGovern, certify that:

1.   I have reviewed this Quarterly Report on Form 10-Q for the Quarter Ended September 30, 2005 of Heritage Commerce Corp;

2.   Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3.   Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4.   The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

(a)   Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b)   Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

(c)   Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(d)   Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and

5.   The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions):

(a)   All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and

(b)   Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting.

Date: November 8, 2005

/s/ Lawrence D. McGovern

Lawrence D. McGovern

Chief Financial Officer

EX-32.1

Exhibit 32.1

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Quarterly Report of Heritage Commerce Corp (the "Company") on Form 10-Q for the period ending September 30, 2005 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Walter T. Kaczmarek, Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that:

(1) The Report fully complies with the requirements of Section 13(a) or

15(d) of the Securities Exchange Act of 1934; and

(2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

November 8, 2005

/s/ Walter T. Kaczmarek

Walter T. Kaczmarek

Chief Executive Officer

EX-32.2

Exhibit 32.2

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Quarterly Report of Heritage Commerce Corp (the "Company") on Form 10-Q for the period ending September 30, 2005 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Lawrence D. McGovern, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that:

(1) The Report fully complies with the requirements of Section 13(a) or

15(d) of the Securities Exchange Act of 1934; and

(2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

November 8, 2005

/s/ Lawrence D. McGovern

Lawrence D. McGovern

Chief Financial Officer