The unaudited consolidated financial statements of Heritage Commerce Corp (the “Company” or “HCC”) 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 that were included in the Company’s Form 10-K for the year ended December 31, 2019.

HBC is a commercial bank serving customers primarily located in Alameda, Contra Costa, Marin, San Benito, San Francisco, San Mateo, and Santa Clara counties of California. CSNK Working Capital Finance Corp. a California corporation, dba Bay View Funding (“Bay View Funding”) is a wholly owned subsidiary of HBC, and provides business-essential working capital factoring financing to various industries throughout the United States. No customer accounts for more than 10% of revenue for HBC or the Company. The Company reports its results for two segments: banking and factoring. The Company’s management uses segment results in its operating and strategic planning.

In management’s opinion, all adjustments necessary for a fair presentation of these consolidated financial statements have been included and are of a normal and recurring nature. All intercompany transactions and balances have been eliminated.

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ significantly from these estimates. Material estimates that are particularly susceptible to significant change include the determination of the allowance for credit losses and any impairment of goodwill or intangible assets. It is reasonably possible the Company’s estimate of the allowance for credit losses and evaluation of impairment of goodwill or intangible assets could change as a result of the continued impact of the COVID-19 pandemic on the economy. The resulting change in these estimates could be material to the Company’s consolidated financial statements.

The results for the three and nine months ended September 30, 2020 are not necessarily indicative of the results expected for any subsequent period or for the entire year ending December 31, 2020.

London Inter-Bank Offered Rate (“LIBOR”) Transition and Phase-Out

We have loans and borrowings that are tied to LIBOR benchmark interest rates. It is anticipated that the LIBOR index will be phased-out by the end of 2021 and the Federal Reserve Bank of New York has established the Secured Overnight Financing Rate (“SOFR”) as its recommended alternative to LIBOR. We have created a sub-committee of our Asset Liability Management Committee to address LIBOR transition and phase-out issues. We are currently reviewing loan documentation, technology systems and procedures we will need to implement for the transition.

Asset Valuation

Asset Valuation

While certain valuation assumptions and judgments will change to account for pandemic-related circumstances such as widening credit spreads, the Company does not anticipate significant changes in methodology used to determine the fair value of assets measured in accordance with GAAP.

The extent to which the COVID-19 pandemic will impact our business, results of operations and financial condition will depend on future developments, which are highly uncertain and difficult to predict. Those developments and factors include the duration and spread of the pandemic, its severity, the actions to contain the pandemic or address its impact, and how quickly and to what extent normal economic and operating conditions can resume. We do not yet know the full extent of the impact. However, the effects could have a material adverse impact on our business, asset valuations, financial condition and results of operations. Material adverse impacts may include all or a combination of valuation impairments on our intangible assets, investments, loans, or deferred tax assets.

Adoption of New Accounting Standards

In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. The amendments in this update replace the incurred loss impairment methodology in prior GAAP with a methodology that reflects expected life-of-instrument credit losses and requires consideration of a broader range of reasonable and supportable information to estimate future credit loss estimates. As Current Expected Credit Losses (“CECL”) encompasses all financial assets carried at amortized cost, the requirement that reserves be established based on an organization’s reasonable and supportable estimate of expected credit losses extends to held-to-maturity debt securities. The Company adopted CECL on January 1, 2020, using the modified retrospective method for all financial assets measured at amortized cost and off-balance sheet credit exposures. Results for the reporting periods after January 1, 2020, are presented under Topic 326, while prior period amounts continue to be reported in accordance with previously applicable GAAP.

The following table shows the impact of adopting CECL on January 1, 2020:


		As Reported		Pre-		Impact of
		Under		Topic 326		Topic 326
		Topic 326		Adoption		Adoption

		(Dollars in thousands)
Assets:
Allowance for credit losses on debt securities
Held-to-maturity municipal securities	$	58	$	-	$	58
Loans
Commercial		6,790		10,453		(3,663)
CRE - owner occupied		6,994		3,825		3,169
CRE - non-owner occupied		11,672		3,760		7,912
Land and construction		1,458		2,621		(1,163)
Home equity		1,321		2,244		(923)
Multifamily		1,253		57		1,196
Residential mortgage		678		243		435
Consumer and other		1,689		82		1,607
Allowance for credit losses on loans	$	31,855	$	23,285	$	8,570

Liabilities:
Allowance for credit losses on off-balance sheet
credit exposures	$	679	$	886	$	(207)

For CECL modeling purposes, the Company uses forecast data for the state of California including Gross Domestic Product (“GDP”) and unemployment projections provided by the California Economic Forecast (“CEF”, www.CaliforniaForecast.com). At January 1, 2020, the forecast for California GDP for 2020 was an annual increase in the low single digits and the forecasted California unemployment rate for 2020 was in the mid single digits.

As of the implementation date of January 1, 2020, the Company recognized an increase of $8,570,000 to its allowance for credit losses for loans. The majority of this increase is related to loan portfolios acquired in our recent acquisitions that under the previous methodology had no recognized allowance for loan losses until the estimated allowance exceeded the unaccreted discount.

As of the implementation date, there was a $58,000 allowance for losses recorded on the Company’s held-to-maturity municipal investment securities portfolio. The allowance for losses on held-to-maturity securities is based on historic loss rates of municipal securities by bond ratings and change in bond ratings of the municipal securities held by the Company will impact the reserve. Any significant ratings downgrades on these securities will impact the allowance for losses on these securities.

In the normal course of business, the Company makes commitments to extend credit to its customers as long as there are no violations of any conditions established in contractual arrangements. These commitments are obligations that represent a potential credit risk to the Company, yet are not reflected in any form within the Company’s consolidated balance sheets. As of the implementation date, there was a reduction of $207,000 to the allowance for losses recorded for the Company’s off-balance sheet credit exposures. The reduction in reserves for off-balance sheet credit exposures at implementation was primarily driven by applying a lower estimated CECL loss factor for unfunded commercial loan and construction loan commitments.

The cumulative-effect adjustment as a result of the adoption of this guidance was recorded, net of tax of $2,359,000, as a $6,062,000 reduction to retained earnings effective January 1, 2020.

In January 2017, the FASB issued ASU No. 2017-04, Simplifying the Test for Goodwill Impairment. The provisions of the update eliminate the existing second step of the goodwill impairment test which provides for the allocation of reporting unit fair value among existing assets and liabilities, with the net remaining amount representing the implied fair value of goodwill. In replacement of the existing goodwill impairment rule, the update will provide that impairment should be recognized as the excess of any of the reporting unit’s goodwill over the fair value of the reporting unit. Under the provisions of this update, the amount of the impairment is limited to the carrying value of the reporting unit’s goodwill. The amendments of the update became effective for the Company on January 1, 2020.