10-K 1 d10k.htm FORM 10-K Form 10-K
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

FORM 10-K

 

x   ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2010

 

OR

 

¨   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

001-14223

Commission File Number

 

 

 

KNIGHT CAPITAL GROUP, INC.

(Exact name of registrant as specified in its charter)

 

DELAWARE

(State or other jurisdiction of incorporation or organization)

 

22-3689303

(I.R.S. Employer Identification Number)

 

545 Washington Boulevard, Jersey City, NJ 07310

(Address of principal executive offices and zip code)

 

Registrant’s telephone number, including area code: (201) 222-9400

 

 

 

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

 

Title of each class

 

Name of each exchange on which registered

Class A Common Stock, $0.01 par value   New York Stock Exchange

 

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

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  x    No  ¨

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ¨    No  x

 

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 such 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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    Yes  x    No  ¨

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.  Large accelerated filer   x   Accelerated filer ¨   Non-accelerated filer ¨  Smaller reporting company ¨

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

 

The aggregate market value of the Class A Common Stock held by nonaffiliates of the Registrant was approximately $1.05 billion at June 30, 2010 based upon the closing price for shares of the Registrant’s Class A Common Stock as reported by the New York Stock Exchange. For purposes of this calculation, affiliates are considered to be officers, directors and holders of 10% or more of the outstanding common stock of the Registrant.

 

At February 24, 2011 the number of shares outstanding of the Registrant’s Class A Common Stock was 101,321,910 and there were no shares outstanding of the Registrant’s Class B Common Stock as of such date.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Definitive Proxy Statement relating to the Company’s 2011 Annual Meeting of Stockholders to be filed hereafter (incorporated, in part, into Part III hereof).

 

 

 


Table of Contents

KNIGHT CAPITAL GROUP, INC.

 

FORM 10-K ANNUAL REPORT

 

For the Year Ended December 31, 2010

 

TABLE OF CONTENTS

 

          Page  

PART I

  

Item 1.

  

Business

     4   

Item 1A.

  

Risk Factors

     15   

Item 1B.

  

Unresolved Staff Comments

     24   

Item 2.

  

Properties

     24   

Item 3.

  

Legal Proceedings

     24   

Item 4.

  

[Omitted and Reserved]

  

PART II

  

Item 5.

  

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

     25   

Item 6.

  

Selected Financial Data

     29   

Item 7.

  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

     31   

Item 7A.

  

Quantitative and Qualitative Disclosures About Market Risk

     51   

Item 8.

  

Financial Statements and Supplementary Data

     54   

Item 9.

  

Changes in and Disagreements With Accountants on Accounting and Financial Disclosures

     101   

Item 9A.

  

Controls and Procedures

     101   

Item 9B.

  

Other Information

     101   

PART III

  

Item 10.

  

Directors, Executive Officers and Corporate Governance

     101   

Item 11.

  

Executive Compensation

     101   

Item 12.

  

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

     101   

Item 13.

  

Certain Relationships and Related Transactions, and Director Independence

     101   

Item 14.

  

Principal Accountant Fees and Services

     101   

PART IV

  

Item 15.

  

Exhibits and Financial Statement Schedules

     102   

Signatures

     107   

Certifications

  

Exhibit Index

  

 

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FORWARD LOOKING STATEMENTS

 

Certain statements contained in this Annual Report on Form 10-K, including without limitation, those under “Legal Proceedings” in Part I, Item 3, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 (“MD&A”), and “Quantitative and Qualitative Disclosures About Market Risk” in Part II, Item 7A, and the documents incorporated by reference herein may constitute forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. These forward-looking statements are not historical facts and are based on current expectations, estimates and projections about the Company’s industry, management’s beliefs and certain assumptions made by management, many of which, by their nature, are inherently uncertain and beyond our control. Accordingly, readers are cautioned that any such forward-looking statements are not guarantees of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict including, without limitation, risks associated with changes in market structure, legislative or regulatory rule changes, risks related to the performance of the Company’s Electronic Trading Group and the Company’s ability to hire qualified management personnel and the costs, integration, performance and operation of businesses recently acquired or developed organically, or that may be acquired in the future. Since such statements involve risks and uncertainties, the actual results and performance of the Company may turn out to be materially different from the results expressed or implied by such forward-looking statements. Given these uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements. Unless otherwise required by law, the Company also disclaims any obligation to update its view of any such risks or uncertainties or to announce publicly the result of any revisions to the forward-looking statements made herein. Readers should carefully review the risks and uncertainties disclosed in the Company’s reports with the U.S. Securities and Exchange Commission (“SEC”), including those detailed under “Certain Factors Affecting Results of Operations” in MD&A and in “Risk Factors” in Part I, Item 1A herein, and in other reports or documents the Company files with, or furnishes to, the SEC from time to time. This information should be read in conjunction with the Company’s Consolidated Financial Statements and the Notes thereto contained in this Form 10-K, and in other reports or documents the Company files with, or furnishes to, the SEC from time to time.

 

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PART I

 

Item 1. Business

 

Overview

 

Knight Capital Group, Inc., a Delaware corporation (collectively with its subsidiaries, “Knight” or the “Company”), is a global financial services firm that provides access to the capital markets across multiple asset classes to a broad network of clients, including buy- and sell-side firms and corporations.

 

The Company was organized in January 2000 as the successor to the business of Knight/Trimark Group, Inc. (the “Predecessor”). The Predecessor was organized in April 1998 as the successor to the business of Roundtable Partners, LLC, which was formed in March 1995. In May 2000, the Company changed its name from Knight/Trimark Group, Inc. to Knight Trading Group, Inc., and in May 2005 the Company further changed its name to Knight Capital Group, Inc. Our corporate headquarters are located at 545 Washington Boulevard, Jersey City, New Jersey 07310. Our telephone number is (201) 222-9400.

 

Financial information concerning our business segments for each of 2010, 2009 and 2008, respectively, is set forth in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 (“MD&A”) and the Consolidated Financial Statements and Notes thereto located in Part II, Item 8 entitled “Financial Statements and Supplementary Data.”

 

Available Information

 

Our Internet address is www.knight.com. We make available free of charge, on or through the “Investor Relations” section of our corporate website under “SEC Filings”, annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, Forms 3, 4 and 5 filed on behalf of directors and executive officers, and any amendments to those reports filed or furnished pursuant to the Securities Exchange Act of 1934, and our proxy statement as soon as reasonably practicable after such materials are electronically filed with, or furnished to, the SEC. Also posted on our corporate website is our Code of Business Conduct and Ethics (the “Code”) governing our directors, officers and employees. Within the time period required by the SEC, we will post on our corporate website any amendments and waivers to such Code applicable to our executive officers and directors, as defined in the Code.

 

Our Board of Directors (the “Board”) has standing Finance and Audit, Compensation and Nominating and Corporate Governance committees. Each of these Board committees has a written charter approved by the Board. Our Board has also adopted a set of Corporate Governance Guidelines. Each committee charter, along with the Corporate Governance Guidelines, is posted on the Company’s website. None of the information on our corporate website is incorporated by reference into this report.

 

All of the above materials are also available in print, without charge, to any person who requests them by writing or telephoning:

 

Knight Capital Group, Inc.

Communications, Marketing and Investor Relations

545 Washington Boulevard, 3rd Floor

Jersey City, NJ 07310

(201) 222-9400

 

Unless otherwise indicated, references to the “Company,” “Knight,” “We,” “Us,” or “Our” shall mean Knight Capital Group, Inc. and its subsidiaries.

 

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Operating Segments

 

Effective the fourth quarter of 2009, we separated our former Global Markets segment into two operating segments: i) Equities and ii) Fixed Income, Currencies and Commodities (“FICC”). This breakout is consistent with the organizational structure of our businesses. As a result of this change in segment reporting, we have three operating segments within our continuing operations, Equities, FICC and Corporate.

 

   

Equities—Our Equities segment includes market-making and institutional sales and trading in global equities, exchange traded funds (“ETFs”), options and futures. In the course of market-making and trading, we provide capital facilitation and a range of complementary services, including research and commission management. Within our Equities segment, we also provide equity capital markets and asset management services.

 

   

FICC—Our FICC segment includes research, sales and trading in global fixed income, as well as electronic trading in fixed income and foreign exchange. Fixed income research publishes reports across several sectors in the Americas and emerging markets, evaluating corporate credit risk, interest rate risk and individual issuers. Within our FICC segment, we also provide debt capital markets services and originate home equity conversion mortgages, commonly referred to as reverse mortgages.

 

   

Corporate—Our Corporate segment invests in strategic financial services-oriented opportunities, allocates, deploys and monitors all capital, and maintains all corporate overhead expenses and all other expenses that are not attributable to the Equities and FICC segments.

 

The following table sets forth: (i) Revenues, (ii) Expenses, (iii) Other income and (iv) Pre-tax earnings (loss) from continuing operations of our segments and on a consolidated basis (in millions):

 

     For the years ended December 31,  
     2010     2009     2008  

Equities

      

Revenues

   $ 902.5      $ 891.0      $ 851.5   

Expenses

     673.4        663.7        505.0   
                        

Pre-tax earnings

     229.1        227.3        346.4   
                        

FICC

      

Revenues

     249.1        266.7        79.3   

Expenses

     255.3        218.8        67.0   
                        

Pre-tax (loss) earnings

     (6.2     47.8        12.3   
                        

Corporate

      

Revenues

     (2.5     4.7        8.1   

Expenses

     70.4        47.1        49.1   

Other income

     —          —          15.9   
                        

Pre-tax (loss)

     (72.9     (42.3     (25.1
                        

Consolidated

      

Revenues

     1,149.1        1,162.4        938.9   

Expenses

     999.1        929.6        621.2   

Other income

     —          —          15.9   
                        

Pre-tax earnings

   $ 150.0      $ 232.8      $ 333.6   
                        

 

Totals may not add due to rounding.

 

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Equities Segment

 

Business Segment Overview

 

We provide market-making and trading, primarily in global equities as well as ETFs, options and futures. Our approach to trading combines deep liquidity with sophisticated trading technology and capital facilitation to deliver high quality trade executions consistent with client-defined measures. We feature both advanced electronic trading and traditional sales and trading which allows buy- and sell-side clients to interact with the market based on their specific needs and preferences. As a result, we are able to attract a significant base of clients with diverse investment styles and strategies, while at the same time, capture a greater share of client order flow. To do so, our model requires that we manage risk and deploy capital effectively as well as maintain efficient and reliable trading technology and infrastructure. We are connected to a large number of external market centers including electronic communication networks (“ECN”), alternative trading systems (“ATS”), dark liquidity pools, alternative display facilities (“ADF”), multilateral trading facilities (“MTF”), exchanges and other broker-dealers.

 

The majority of our Equities revenue is derived from market-making and trade executions in U.S. equities. Generally, market makers display the prices at which they are willing to bid, meaning buy, or offer, meaning sell, securities and adjust their bid and offer prices in response to the forces of supply and demand for each security. As a market maker operating in Nasdaq, the over-the-counter (“OTC”) market for New York Stock Exchange (“NYSE”), NYSE Amex Equities and NYSE Arca listed securities, the OTC Bulletin Board, and the Pink Sheets, we provide trade executions by offering to buy securities from, or sell securities to, institutions and broker-dealers. Effective January 2011, we now provide trade executions as an equities Designated Market Maker (“DMM”) and ETF Lead Market Maker (“LMM”) on the NYSE, NYSE Amex and NYSE Arca. When acting as principal, we commit our own capital and derive revenues from the difference between the price paid when securities are bought and the price received when securities are sold. We conduct the vast majority of client market-making activity as principal through the use of automated quantitative models. Our traders offer execution services for complex trades and a variety of order types. We also provide trade executions for institutions on an agency or riskless principal basis, generating commissions or commission equivalents, respectively. Another component of our trading strategy employs the use of non-client principal trading models which interact with street flow. These non-client principal models buy and sell equities and other financial instruments with high frequency and for very short holding periods and are generally designed to benefit from pricing and arbitrage opportunities within the marketplace, while leveraging our sophisticated trading technology and infrastructure.

 

Effective January 1, 2011, we completed a consolidation of certain wholly-owned subsidiaries. As a result of streamlining our corporate structure, our domestic Equities activities will be primarily operated out of Knight Capital Americas, L.P. (“KCA”) and Knight Execution & Clearing Services LLC (“KECS”). KCA and KECS are registered with the SEC and are members of the Financial Industry Regulatory Authority (“FINRA”).

 

Our international Equities activities are primarily operated through Knight Capital Europe Limited (“KCEL”), a U.K. registered broker-dealer authorized and regulated by the U.K. Financial Services Authority (“FSA”). KCEL provides execution services for institutional and broker-dealer clients in global equities. Knight Capital Asia Limited (“KCAL”) offers trade execution services in Asian, U.S. and European equities to institutional clients worldwide. KCAL is a broker-dealer registered as an exchange participant with the Hong Kong Stock Exchange and is regulated by the Hong Kong Securities and Futures Commission (“SFC”).

 

In addition to our organic initiatives to expand and diversify our products and services within our Equities segment, over the past five years, we have completed the following stock or asset acquisitions

 

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(and subsequent sales of equity interests) of complementary businesses to strengthen our Equities business segment and expand and diversify our products and services:

 

   

In June 2005, we acquired the business of Direct Trading Institutional, Inc. now operating as Knight Direct. The acquired business was a privately held firm specializing in providing institutions with direct market access (“DMA”) through a third party execution platform. Since the acquisition, we have developed our own execution management system, Knight DirectTM, which handles all of Knight’s DMA activity.

 

In January 2008, we acquired EdgeTrade Inc. (“EdgeTrade”), an agency-only trade execution and algorithmic software firm that allowed buy- and sell-side clients to more effectively source liquidity and manage the trading process as well as maintain anonymity, reduce market impact and lower transaction costs. EdgeTrade’s execution algorithms are offered through the Knight Direct platform and on a standalone basis.

 

Since the acquisitions of Direct Trading Institutional, Inc. and EdgeTrade, we have made significant enhancements to our DMA product offerings, functionality, EdgeTrade algorithms and the Knight Direct platform.

 

   

In October 2005, we acquired the business of the ATTAIN ECN (now operating as Direct Edge ECN LLC), an ATS that operated an ECN. Direct Edge ECN LLC (“Direct Edge”) provides a liquidity destination with the ability to match and route trades in Nasdaq, NYSE, NYSE Amex Equities and NYSE Arca listed securities.

 

In 2007 and 2008, we sold portions of our equity interest in Direct Edge Holdings, the parent company of Direct Edge. As a result of these sales we now own a 19.9% interest in Direct Edge Holdings. During 2010, Direct Edge obtained exchange status.

 

   

In October 2010, we acquired Astor Asset Management, L.L.C. (“Astor”), a fee-based money management firm employing a portfolio management approach to investing involving modeling economic data and utilizing low cost ETFs to capitalize on cyclical changes.

 

   

In December 2010, we acquired the DMM and LMM business units of Kellogg Capital Markets LLC (“Kellogg”). As of January 1, 2011, we have assumed responsibility for making markets in approximately 765 NYSE- and NYSE Amex-listed securities as well as approximately 400 ETFs and structured products on NYSE Arca.

 

Clients and Products

 

Clients

 

Within Equities, we offer products and provide services via electronic and voice access points primarily to two main client groups: sell-side (also referred to as broker-dealers) and buy-side (also referred to as institutions). Our sell-side clients include global, national, regional and on-line broker-dealers, private wealth managers and traditional investment banks in North America and Europe. We provide sell-side clients with deep liquidity, high fulfillment rates and high-quality trade executions according to client-defined and regulatory measures. Our buy-side clients include mutual funds, pension plans, plan sponsors, hedge funds, trusts and endowments across North America, Europe and the Asia-Pacific region. We provide buy-side clients with deep liquidity, actionable market insights, anonymity and trade executions with minimal market impact.

 

In 2010, our Equities business did not have any client that accounted for more than 10% of our U.S. equity dollar value traded.

 

We provide capital markets services to small- and mid-cap corporate issuers as well as private companies in the U.S., including capital structure advisory services, transition services and distribution

 

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across the equity and debt capital markets. As a result of the acquisition of Astor in October 2010, we also provide asset management services, primarily to retail investors.

 

Products and Services

 

Our strategy for our Equities segment is to differentiate ourselves from competitors by providing high quality and competitive trade execution services combined with superior client service. Over the past several years we have worked to expand our products and services.

 

For our buy-side clients, we offer comprehensive trade execution services covering the depth and breadth of the market. We handle large complex trades, accessing liquidity from our order flow, as well as other sources. When liquidity is not naturally present in the equities market, we may offer capital facilitation to complete our clients’ trades. Our institutional products include access to our global sales and trading team, as well as our electronic trading products. Our institutional equity products and services include global equities, ETFs, options and futures trade execution solutions, block trading, program trading, special situations/risk arbitrage, research, soft dollar and commission recapture programs, corporate access services, direct market access through Knight DirectTM, EdgeTrade algorithms and internal crossing through our Knight Match product. The majority of our revenues from institutional clients are commissions on agency transactions or commission-equivalents on riskless principal transactions.

 

We seek to provide sell-side clients with high quality and competitive trade executions that enable them to satisfy their fiduciary obligations to their customers to seek to obtain the best execution reasonably available in the marketplace. Most of our equity order flow is executed as principal and handled electronically using sophisticated algorithms to optimize the execution of client order flow, including order flow through Knight Link, an electronic access point into Knight’s off-exchange liquidity. We maintain a team of cash traders to handle oversized or difficult-to-handle orders. The majority of the revenues we earn from broker-dealer clients are net trading revenues, generated from the difference between the price paid when we buy securities and the price received when we sell securities. We also have expanded our non-client principal trading activity, which primarily covers equities, but also includes such products as ETFs, options, futures, and foreign exchange. For these activities, we interact directly with street flow. In addition, we made significant progress in electronic options market-making during 2010. We now operate on three electronic exchanges and make markets in approximately 750 names.

 

During 2009, we commenced self-clearing certain of our equities trades using a proprietary platform and enhanced our related operational processes and infrastructure. We now self-clear substantially all of our domestic equities businesses and intend to expand internationally and across product offerings and asset classes in the future.

 

Equities Competition

 

Our client offerings, including our trade execution services, compete primarily with similar products offered by domestic and international broker-dealers, exchanges, ATSs, crossing networks, ECNs and dark liquidity pools. We also compete with various market participants who utilize highly automated, electronic trading models. Another source of competition is broker-dealers who execute portions of their client flow through internal market-making desks rather than sending the client flow to third party execution destinations, such as Knight.

 

We compete primarily on the basis of our execution standards (including price, liquidity, speed and other client-defined measures), client relationships, client service, payments for order flow and technology. Over the past several years, regulatory changes, competition and the continued focus by

 

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regulators and investors on execution quality and overall transaction costs have resulted in a market environment characterized by narrowed spreads and reduced revenue capture metrics. Consequently, maintaining profitability has become extremely difficult for many firms. Generally, improvements in execution quality, such as faster execution speed and greater price improvement, negatively impact the ability to derive revenues from executing client order flow. For example, we have made, and continue to make, changes to our execution protocols and quantitative models, which have had, or could have, a significant impact on our profitability. To remain profitable, some competitors have limited or ceased activity in illiquid or marginally profitable securities or, conversely, have sought to execute a greater volume of trades at a lower cost by increasing the automation and efficiency of their operations.

 

Competition for order flow in the U.S. equity markets continues to be intense and is evolving rapidly as reflected in publicly disclosed execution metrics, i.e., SEC Rules 605 and 606. These rules, applicable to broker-dealers, add greater disclosure to execution quality and order-routing practices. Rule 605 requires market centers that trade national market system securities to make available to the public monthly electronic reports that include uniform statistical measures of execution quality on a security-by-security basis. Rule 606 requires broker-dealers that route equity and option orders on behalf of their customers to make publicly available quarterly reports that describe their order routing practices and disclose the venues to which customer orders are routed for execution. These statistics on execution quality vary by order sender based on their mix of business. This rule also requires the disclosure of payment for order flow arrangements and internalization practices. The intent of this rule is to encourage routing of order flow to destinations based primarily on the demonstrable quality of executions at those destinations, supported by the order entry firms’ fiduciary obligations to seek to obtain best execution for their customers’ orders.

 

We believe the trend toward increased competition and the growth of alternative trading venues will continue. We may experience competitive pressures in these and other areas in the future as some of our competitors seek to obtain greater market share by reducing prices. Competition for business with institutional clients is based on a variety of factors, including execution quality, research, soft dollar, commission sharing and recapture services, technology, market access (including direct market access and execution algorithms), client relationships, client service, cost, capital facilitation and reputation.

 

In the equity capital markets space, we compete against traditional investment banks and smaller boutique-sized firms.

 

FICC Segment

 

Business Segment Overview

 

We provide research, sales and trading in global fixed income, as well as electronic trading in fixed income and foreign exchange. Our approach to trading involves traditional sales and trading on behalf of our clients as well as operating neutral platforms with sophisticated trading technology that electronically matches buyers and sellers.

 

We engage in sales and trading for buy-side clients primarily on a riskless principal basis in a variety of fixed income products. We also operate a fixed income ECN that allows sell-side clients to engage in electronic trading of municipals, corporates, agencies, treasuries and certificates of deposit and a foreign exchange ECN that allows buy-side clients to engage in electronic trading in various currencies as well as precious metals.

 

Our specialized products and services allow us to deepen relationships with existing clients, build liquidity across asset classes and establish relationships with new clients.

 

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Effective January 1, 2011, we completed a consolidation of certain wholly-owned subsidiaries. As a result of streamlining our corporate structure, our FICC activities will be primarily operated out of KCA and KECS, as well as Hotspot FX Holdings, Inc. and its subsidiaries (collectively, “Hotspot”) and Urban Financial Group, Inc. (“Urban”). KCA and KECS are registered with the SEC and the Municipal Securities Rulemaking Board (“MSRB”) and are members of FINRA.

 

Our international FICC activities are primarily operated through KCEL and KCAL.

 

Over the past five years, we have built up our FICC segment primarily through acquisitions of complementary businesses in an effort to expand and diversify our products and services:

 

   

In April 2006, we acquired Hotspot which provides access to electronic foreign exchange spot trade executions through an advanced ECN-based platform.

 

   

In October 2006, we acquired Knight BondPoint, Inc. (“Knight BondPoint”) which provides electronic access and trade execution services for the retail fixed income market.

 

   

In July 2008, we acquired Knight Libertas Holdings LLC and its affiliates (collectively, “Knight Fixed Income”), a business specializing in a variety of global fixed income products and services.

 

   

In July 2010, we acquired Urban. Urban is principally an originator of home equity conversion mortgages (“HECMs”), commonly referred to as reverse mortgages, insured by the Federal Housing Administration (“FHA”).

 

Since these acquisitions, we have expanded these products, enhanced the various platforms utilized and grown these businesses.

 

Clients and Products

 

Clients

 

Within our FICC segment, we serve a broad range of buy-side and sell-side firms across fixed income, foreign exchange and precious metals.

 

In 2010, our FICC segment did not have any client that accounted for more than 10% of our fixed income notional value traded.

 

In fixed income, our buy-side clients include mutual funds, insurance companies, pension funds, hedge funds and banks across North America, Europe and the Asia-Pacific region. Knight Fixed Income provides buy-side clients with access to investment research, a broad range of securities and products, trading expertise and an extensive client network to match buyers and sellers. Knight BondPoint’s sell-side clients include broker-dealers, financial advisors and private wealth managers in the U.S. Knight BondPoint provides sell-side clients with centralized liquidity, connectivity, price discovery and trading efficiencies. Urban’s clients primarily represent homeowners throughout the U.S. and Puerto Rico that are eligible for reverse mortgages.

 

In foreign exchange and precious metals, Hotspot’s buy-side clients include mutual funds, pension funds, hedge funds, banks and commodity trade advisors across North America, Europe and the Asia-Pacific region. Hotspot provides buy-side clients with access to liquidity and fast anonymous trade executions.

 

In FICC, we provide debt capital markets services to small- and mid-cap corporate issuers as well as private companies in the U.S and Europe. We offer corporate issuers and private companies capital structure advisory services and access to our large debt distribution network.

 

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Products and Services

 

The FICC business segment includes research, sales and trading in global fixed income, as well as capital markets services. This segment also includes electronic fixed income, foreign exchange trading and mortgage origination. We also engage in limited collateralized lending activity within our FICC segment.

 

Knight Fixed Income provides buy-side firms with research, sales and trading across a broad range of fixed income securities, including high-yield and high-grade corporate bonds, distressed debt, asset- and mortgage-backed securities, federal agency securities, hybrid securities, syndicated bank loans and emerging markets. Fixed income research publishes reports across several sectors in the Americas and emerging markets, evaluating corporate risk, interest rate risk and individual issuers.

 

Urban originates direct and brokered HECMs, commonly referred to as reverse mortgages, insured by the FHA. In February 2011, Urban received Government National Mortgage Association (“GNMA”) issuance authority for the securitization of HECMs.

 

Knight BondPoint provides electronic fixed income trading solutions to sell-side firms. Knight BondPoint operates a fixed income ECN that serves as an electronic inter-dealer system and allows clients to access live and executable offerings. Knight BondPoint also provides a front-end application for brokers and advisors as well as a trading application for traders.

 

Hotspot provides electronic foreign exchange trading solutions to buy-side firms through a foreign exchange ECN that provides clients with access to live, executable prices for 53 currency pairs as well as spot gold and silver streamed by market maker banks and other clients. Hotspot offers clients several access options including direct high-speed connectivity and a traditional front-end application.

 

FICC Competition

 

Our institutional fixed income offering, including sales, trading and independent research, competes with traditional investment banks and boutique firms. During 2010, there was heightened competition in the fixed income industry as spreads tightened and competitive pressure increased on a global basis. Traditional investment banks re-emerged as major competitors, offering increased balance sheet utilization and increasing competition for experienced talent.

 

The tightening of spreads in the fixed income market has put pressure on firms to expand their global presence and to expand into other asset classes. We have continued to expand our offering to include emerging markets, syndicated bank loans and additional ABS/MBS products, including reverse mortgages, and have broadened the geographical reach of our European sales and trading team.

 

Independent research remains one of our competitive advantages as many other firms have stopped delivering this type of research to their clients. Our offering of fundamental research across an issuer’s capital structure including bank debt, corporate bonds, convertible bonds, preferred shares and common stock, helps our clients make informed decisions.

 

Urban’s competition includes mortgage origination units within large financial institutions, as well as several independent mortgage originators. In 2010, the securitization market for reverse mortgages experienced increased price competition in the wholesale market as a result of strong demand.

 

In the debt capital markets space, we compete against traditional investment banks and boutique firms.

 

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There is increasing pressure in the retail bond space to deliver best execution similar to the equity markets. By delivering centralized liquidity and an electronic inter-dealer system, we offer clients greater price discovery.

 

Hotspot competes with other electronic trading platforms for orders from institutional firms and, to a lesser extent, with foreign exchange sales and trading teams at larger firms. Hotspot provides clients with anonymity, speed, market data and an array of order types. Hotspot competes on the basis of full market transparency, centralized price discovery and full depth-of-book display.

 

Corporate Segment

 

Our Corporate segment invests in strategic financial service-oriented opportunities, allocates, deploys and monitors all capital, and maintains all corporate overhead expenses and all other expenses that are not attributable to the Equities and FICC segments. The Corporate segment includes investment results from strategic investments and has historically included investment results from our corporate investment in the Deephaven Funds. Corporate overhead expenses primarily consist of compensation for certain senior executives and other individuals employed at the corporate holding company, interest on our long-term debt, legal and other professional expenses related to corporate matters, directors’ fees, investor and public relations expenses and directors’ and officers’ insurance.

 

Discontinued Operations

 

Deephaven Capital Management LLC and its subsidiaries (collectively, “Deephaven”) was the former registered investment adviser to, and sponsor of, the Deephaven investment funds (the “Deephaven Funds”). During the first quarter of 2009, Deephaven completed the sale of substantially all of its assets to Stark & Roth, Inc. (together with its affiliates, “Stark”) with Stark agreeing to assume certain limited liabilities of Deephaven. At that time, Deephaven was replaced by Stark as the investment manager, managing member and general partner for the Deephaven Funds and the Company exited the Deephaven business. As a result of this sale, Deephaven was classified as a discontinued operation.

 

Infrastructure

 

We have invested significant resources to expand our execution capacity, upgrade our trading systems and infrastructure and plan to make additional investments in technology and infrastructure in the future. Our ability to identify and deploy emerging technologies that facilitate the execution of trades, including developing and enhancing our quantitative client market-making models, is key to the successful execution of our business model. Technology has enhanced our capacity and ability to handle order flow faster and also has been an important component of our strategy to comply with government and industry regulations, achieve competitive execution standards, increase trading automation and provide superior client service. We continually enhance our use of technology and quantitative models to further refine our execution services and continue to develop and enhance our non-client principal trading models.

 

We use our proprietary technology and technology licensed from third parties to execute trades, monitor the performance of our traders, assess our inventory positions, manage risk and provide ongoing information to our clients. We are electronically linked to institutions and broker-dealers to provide immediate access to our trading operations and to facilitate the handling of client orders. Our business-to-business portal, and our Knight Link, Knight Match, Knight BondPoint, Hotspot and Knight Direct™ platforms and EdgeTrade algorithms, provide our clients with an array of tools to interact with our trading systems, multiple marketplaces throughout the globe, and most U.S. equity, ETF, options and futures market centers.

 

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In connection with our self-clearing initiative for equities, we developed a proprietary clearing platform and have deployed a dedicated team of technology, operations, finance, legal and compliance professionals to support these efforts. We now self-clear substantially all of our domestic equities businesses and intend to expand internationally and across product offerings and asset classes in the future.

 

Alternative trading and data center facilities are in place for our primary domestic Equities and FICC operations. These facilities have been designed to allow us to continue a substantial portion of our operations if we are prevented from accessing or utilizing our primary office locations for an extended period of time. While we have taken significant steps to develop, implement and maintain reasonable business continuity plans, we cannot guarantee that our alternative systems and facilities will provide full continuity of operations should a significant business disruption occur.

 

Intellectual Property and Other Proprietary Rights

 

Our success and ability to compete are dependent to a significant degree on our intellectual property, which includes our execution technology, quantitative client market-making and non-client principal trading models, trade secrets and client base. We rely primarily on trade secret, trademark, domain name, patent and contract law to protect our intellectual property. It is our policy to enter into confidentiality, intellectual property invention assignment and/or non-competition and non-solicitation agreements or restrictions with our employees, independent contractors and business partners, and to control access to and distribution of our intellectual property.

 

Government Regulation and Market Structure

 

Most aspects of the Company’s business are subject to extensive regulation under federal, state and international laws. The SEC, Commodity Futures Trading Commission (“CFTC”), FSA, SFC, FINRA, NYSE, MSRB, National Futures Association (“NFA”), FHA, the Department of Housing and Urban Development (“HUD”), other self-regulatory organizations (“SRO”), and other regulatory bodies, such as state securities commissions and foreign regulators, promulgate numerous rules and regulations that may impact our business. As a matter of public policy, regulatory bodies are charged with safeguarding the integrity of the securities and other financial markets and with protecting the interests of investors in those markets. Regulated entities are subject to regulations concerning all aspects of their business, including trade practices, best execution practices, capital structure, record retention and the conduct of officers, supervisors and registered employees. Failure to comply with any of these laws, rules or regulations could result in administrative or court proceedings, censures, fines, the issuance of cease-and-desist orders or injunctions, or the suspension or disqualification of the entity and/or its officers, supervisors or registered employees. We, and certain of our past and present officers, directors and employees, have been subject to claims alleging the violation of such laws, rules and regulations. Certain aspects of the Company’s public disclosure, corporate governance, internal control environment and the roles of auditors and counsel are subject to the Sarbanes-Oxley Act of 2002 and related regulations and rules of the SEC and NYSE.

 

Rule-making by these and other regulators (foreign and domestic), and the resulting market structure changes, has had an impact on the Company’s regulated subsidiaries by directly affecting our method of operation and, at times, our profitability. Legislation can impose, and has imposed, significant obligations on broker-dealers, including our regulated subsidiaries. These increased obligations require the implementation and maintenance of internal practices, procedures and controls which have increased our costs and may subject us to regulatory inquiries, claims or penalties.

 

The regulatory environment in which we operate our Equities and FICC businesses is subject to constant change. Our business, financial condition and operating results may be adversely affected as

 

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a result of new or revised legislation or regulations imposed by the U.S. Congress, SEC, CFTC, FSA, SFC, FINRA, NYSE, MSRB, NFA, FHA, HUD, other SROs, other United States or foreign governmental regulatory authorities, applicable state agencies and administrative departments and other regulatory bodies. Additional regulations, changes in existing laws and rules, or changes in interpretations or enforcement of existing laws and rules often directly affect the method of operation and profitability of regulated broker-dealers. We cannot predict what effect, if any, such changes might have. However, there were, and could be, significant technological, operational and compliance costs associated with the obligations which derive from compliance with such regulations.

 

On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) was enacted in the United States. Implementation of the Dodd-Frank Act will be accomplished through extensive rulemaking by the SEC and other governmental agencies. The Dodd-Frank Act also mandates the preparation of studies on a wide range of issues. These studies could lead to additional regulatory changes. At this time, it is difficult to assess the impact that the Dodd-Frank Act will have on us and on the financial services industry.

 

We have foreign based subsidiaries and plan to continue to expand our international presence. The brokerage industry in many foreign countries is heavily regulated, much like the U.S. The varying compliance requirements of these different regulatory jurisdictions and other factors may limit our ability to conduct business or expand internationally. For example, the Markets in Financial Instruments Directive (“MiFID”), which was implemented in November 2007, is now under further review by the European Commission. MiFID represented one of the more significant changes to take place in the operation of European capital markets. On December 8, 2010, the European Commission released its MiFID II public consultation documents. Some broader trends of the revision address increased transparency and oversight of financial firms, with a focus on high frequency trading, broker dark pools, crossing networks and multilateral trading facilities. There were significant technological and compliance costs associated with the obligations which derived from compliance with MiFID and further costs are likely on completion of revision of the MiFID II public consultation process.

 

Net Capital Requirements

 

Certain of our subsidiaries are subject to the SEC’s Uniform Net Capital Rule and capital adequacy requirements by foreign regulators. These rules, which specify minimum net capital requirements for registered broker-dealers, are designed to measure the general financial integrity and liquidity of a broker-dealer and require that at least a minimum part of its assets be kept in relatively liquid form. In general, net capital is defined as net worth (assets minus liabilities), plus qualifying subordinated borrowings and certain discretionary liabilities, less certain mandatory deductions that result from excluding assets that are not readily convertible into cash and from valuing conservatively certain other assets. Among these deductions are adjustments, commonly called haircuts, which reflect the possibility of a decline in the market value of an asset before disposition, and non-allowable assets.

 

Failure to maintain the required net capital may subject a firm to suspension or revocation of registration by the SEC or FSA and suspension or expulsion by FINRA and other regulatory bodies, and ultimately could require the relevant entity’s liquidation. The Uniform Net Capital Rule prohibits payments of dividends, redemption of stock, the prepayment of subordinated indebtedness and the making of any unsecured advance or loan to a stockholder, employee or affiliate, if such payment would reduce the firm’s net capital below required levels.

 

A change in the Uniform Net Capital Rule, the imposition of new rules or any unusually large charges against net capital could limit those operations that require the intensive use of capital and also could restrict our ability to withdraw capital from our broker-dealer subsidiaries. A significant operating loss or any unusually large charge against net capital could adversely affect our ability to expand or even maintain our present levels of business.

 

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For additional discussion related to net capital, see Footnote 18 “Net Capital Requirements” included in Part II, Item 8 “Financial Statements and Supplementary Data” of this document.

 

Employees

 

At December 31, 2010, our headcount from continuing operations was 1,326 full-time employees, compared to 1,126 full-time employees at December 31, 2009. The increase in headcount is primarily related to personnel additions related to acquisitions, the development and launch of new products and geographic expansion throughout the year. Of our 1,326 full-time employees at December 31, 2010, 1,156 were employed in the U.S. and 170 outside the U.S., primarily in London. As a result of the acquisition of the market-making units of Kellogg, headcount at January 1, 2011 increased by 38 full-time employees. None of our employees is subject to a collective bargaining agreement. We believe that our relations with our employees are good.

 

Item 1A.    Risks Factors

 

We face a number of risks that may adversely affect our business, financial condition and operating results. The risks described below are not the only risks facing our Company. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may adversely affect our business, financial condition and/or operating results in a material manner. In addition, we may also be affected by general risks not directly related to our business, including but not limited to, acts of war, terrorism and natural disasters.

 

 

Conditions in the financial services industry and the securities markets may adversely affect our trading volumes and market liquidity

 

Our Equities and FICC operating segments are primarily transaction-based, and declines in trading volumes, volatility, prices and market liquidity would adversely affect our business and profitability. Declines in the volume of equities and fixed income transactions and in volatility and market liquidity generally result in lower revenues from transaction execution activities. Lower price levels of securities and other instruments and tightening spreads may also result in reduced revenue capture, and thereby reduced revenues from trade executions. Declines in market values of securities or other instruments can result in illiquid markets, losses on securities or other instruments held in inventory, the failure of buyers and sellers to fulfill their obligations and settle their trades, and increases in claims and litigation. Accordingly, any reduction in trading volumes, market liquidity or volatility could adversely affect our business and financial results in a material fashion.

 

 

Our future operating results may fluctuate significantly as a result of numerous factors

 

We may experience significant variation in our future results of operations. These fluctuations may result from numerous factors. These factors include, among other things, market conditions and the resulting volatility and credit and counterparty risks that may result; introductions of, or enhancements to, trade execution services by us or our competitors; the value of our securities positions and other financial instruments and our ability to manage the risks attendant thereto; the volume of our trade execution activities; the dollar value of securities and other financial instruments traded; the composition and profile of our order flow; our market share with institutional and broker-dealer clients; the performance and size of, and volatility in, our client market-making and program trading portfolios; the performance of our non-client principal trading models; movements of credit spreads; the performance of our global operations; costs associated with global expansion and domestic growth; the effectiveness of our self-clearing platform; our ability to manage personnel, compensation, overhead and other expenses, including our occupancy expenses under our office leases and expenses and charges relating to legal and regulatory proceedings; the strength of our client relationships; changes in payments for order flow, changes to execution quality and changes in clearing, execution and

 

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regulatory transaction costs; interest rate movements; the addition or loss of executive management, sales, electronic and voice trading and technology professionals; legislative, legal and regulatory changes; legal and regulatory matters or proceedings; geopolitical risk; the amount and timing of capital expenditures, acquisitions and divestitures; the integration, performance and operation of acquired businesses; the incurrence of costs associated with acquisitions and dispositions; investor sentiment; technological changes and events; seasonality; competition; and general market, business, and economic conditions.

 

Such factors may also have an impact on our ability to achieve our strategic objectives, including, without limitation, increases in our market share, growth and profitability in our Equities and FICC segments. If demand for our services declines in our Equities or FICC business segments due to any of the above factors, and we are unable to adjust our cost structure on a timely basis, our operating results could be materially and adversely affected. As a result of the foregoing factors, period-to-period comparisons of our revenues and operating results are not necessarily meaningful and such comparisons cannot be relied upon as indicators of future performance. There also can be no assurance that we will be able to continue the rates of revenue growth that we have experienced in the past or that we will be able to improve our operating results.

 

 

Our trading activities expose us to the risk of significant losses

 

We conduct our trading activities predominantly as principal, which subjects our capital to significant risks. These activities involve the purchase, sale or short sale of securities and other financial instruments for our own account and, accordingly, involve risks of price fluctuations and illiquidity, or rapid changes in the liquidity of markets that may limit or restrict our ability to either resell securities or other financial instruments we purchase or to repurchase securities or other financial instruments we sell in such transactions. From time to time, we may have large position concentrations in securities or other financial instruments of a single issuer or issuers engaged in a specific industry, which might result in higher trading losses than would occur if our positions and activities were less concentrated. The success of our trading activities primarily depends upon our ability to attract order flow, the performance and size of, and volatility in, our client market-making and program trading portfolios, the performance of our non-client principal trading models, market interaction, the skill of our trading personnel, general market conditions, effective hedging strategies and risk management processes, the price volatility of specific securities or other financial instruments, and the availability and allocation of capital. To attract order flow, we must be competitive on price, size of securities positions and other financial instruments traded, liquidity offerings, order execution speed, technology, reputation, and client relationships and service. In our role as a market maker, we attempt to derive a profit from the difference between the prices at which we buy and sell securities. However, competitive forces often require us to match, or improve upon, the quotes other market makers display and to hold varying amounts of securities in inventory. By having to maintain inventory positions, we are subject to a high degree of risk. There can be no assurance that we will be able to manage such risk successfully or that we will not experience significant losses from such activities. All of the above factors could have a material adverse effect on our business, financial condition and operating results.

 

 

Regulatory and legal uncertainties could harm our business

 

The capital markets industry in the United States and other jurisdictions where we conduct our business is subject to extensive oversight under federal, state and applicable foreign laws, rules and regulations, as well as SRO rules. Broker-dealers, investment advisors and financial services firms are subject to regulations concerning all aspects of their business, including trade practices, best execution practices, capital structure, record-keeping, anti-money laundering and the conduct of their officers, supervisors and registered employees. Our operations and profitability may be directly affected by, among other things, additional legislation or regulation, such as those related to the Dodd-Frank Act, changes in rules promulgated by the SEC, CFTC, FSA, SFC, FINRA, NYSE, MSRB, NFA and other

 

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regulatory bodies (domestic or foreign) or SROs; changes in laws passed by the U.S. Congress or foreign governments or agencies; and changes in the interpretation or enforcement of existing laws, regulations and rules (including those related to the Foreign Corrupt Practices Act). Failure to comply with these laws, rules or regulations could result in, among other things, administrative or court proceedings, censure, fines, the issuance of cease-and-desist orders or injunctions, loss of membership, or the suspension or disqualification of the market participant or broker-dealer, and/or their officers, supervisors or registered employees. Our ability to comply with applicable laws, regulations and rules is largely dependent on our internal systems to ensure compliance, as well as our ability to attract and retain qualified compliance personnel. We are currently the subject of regulatory reviews and investigations that may result in disciplinary actions in the future due to alleged noncompliance.

 

The SEC, CFTC, FSA, SFC, FINRA, NYSE, MSRB, NFA and other regulatory bodies (domestic and foreign) and SROs are constantly proposing, or enacting, new regulations for the marketplace. For example, the SEC adopted in 2010 a number of new regulations relating to the trading of securities, including: short sale restrictions, sponsored access requirements, market maker obligations, as well as OTC marketplace rules (i.e., OTCBB and Pink Sheet securities). In addition, the SEC has proposed a number of new regulations which have not yet been adopted, including: elimination of flash orders, limitations on the use of indications of interest, and consolidated audit trail rules. Further, in January 2010, the SEC issued a Concept Release seeking public comment on certain market structure issues such as high frequency trading, co-location, internalization, and markets that do not publicly display priced quotations including dark liquidity pools. In January 2011, the SEC submitted to Congress a study recommending a uniform fiduciary standard of conduct for broker-dealers and investment advisers when those financial professionals provide personalized investment advice about securities to retail investors. Additionally, the SEC could raise its Section 31 fees substantially in the future in order to meet its budgetary needs. Any of these adopted or proposed laws, rules or regulations, as well as any regulatory or legal actions or proceedings, changes in legislation or regulation, and changes in market customs and practices could have a material adverse effect on the Company’s business, financial condition and operating results.

 

 

Our business is subject to substantial risk from litigation, regulatory investigations and potential liability under federal, state and international laws, rules and regulations

 

Many aspects of our business involve substantial risks of liability. We are exposed to liability under federal and state securities laws, other federal and state laws and court decisions, as well as rules and regulations promulgated by the SEC, CFTC, FSA, SFC, FINRA, NYSE, MSRB, NFA, FHA, HUD, Department of Labor and other U.S. and non-U.S. regulatory bodies and SROs. We are also subject to the risk of litigation. From time to time, we, and certain of our past and present officers, directors and employees, have been named as parties in legal actions, regulatory investigations and proceedings, arbitrations and administrative claims and have been subject to claims alleging the violation of such laws, rules and regulations, some of which have resulted in the payment of fines, awards, judgments and settlements. Moreover, we may be required to indemnify past and present officers, directors and employees in regards to these matters. We are subject to such matters as further described in “Legal Proceedings” in Part I, Item 3 herein. Certain corporate events, such as a reduction in our workforce or employee separations, could also result in additional litigation or arbitration.

 

As we intend to defend vigorously any such litigation or proceeding, we could incur significant legal expenses. An adverse resolution of any current or future lawsuits, legal or regulatory proceedings or claims against us could have a material adverse effect on the Company’s business and reputation, financial condition and operating results.

 

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Substantial competition could reduce our market share and harm our financial performance

 

All aspects of our business are intensely competitive. We face competition in our Equities business primarily from global, national and regional broker-dealers, exchanges, ATSs, crossing networks, ECNs and dark liquidity pools. Equities competition is based on a number of factors, including our execution standards (e.g., price, liquidity, speed and other client-defined measures), client relationships and service, reputation, market structure, product and service offerings, and technology. In our FICC business, we face competition from global, national and regional broker-dealers who provide fixed income trade execution services, fixed income research firms, spot foreign exchange execution firms and capital market service firms. Competition in our fixed income business is primarily on the basis of the quality of trade execution services, quality of research, market intelligence, quality of professional personnel, price execution, consistency of performance, ability to make markets in a variety of securities, balance sheet utilization and reputation. A number of competitors of our Equities and FICC businesses have greater financial, technical, marketing and other resources than we do. Some of our competitors offer a wider range of services and financial products than we do and have greater name recognition and a more extensive client base. These competitors may be able to respond more quickly than we do to new or evolving opportunities and technologies, market changes, and client requirements and may be able to undertake more extensive promotional activities and offer more attractive terms to clients. Moreover, current and potential competitors have established or may establish cooperative relationships among themselves or with third parties or may consolidate to enhance their services and products. It is possible that new competitors, or alliances among competitors, may also emerge and they may acquire significant market share. The trend toward increased competition in our businesses is expected to continue and it is possible that our competitors may acquire increased market share.

 

As a result of the above, there can be no assurance that we will be able to compete effectively with current or future competitors, which could have a material adverse effect on our business, financial condition and operating results.

 

 

We could lose significant sources of revenues if we lose any of our larger clients

 

At times, a limited number of clients have accounted for a significant portion of our order flow, revenues and profitability, and we expect a large portion of the future demand for, and profitability from, our trade execution services to remain concentrated within a limited number of clients. None of our clients is contractually obligated to utilize us for trade execution services and, accordingly, these clients may direct their trade execution activities to other execution providers or market centers at any time. Some of these clients have acquired market makers and specialist firms to internalize order flow or have entered into strategic relationships with competitors. There can be no assurance that we will be able to retain these major clients or that such clients will maintain or increase their demand for our trade execution services. The loss, or a significant reduction, of demand for our services from any of these clients could have a material adverse effect on our business, financial condition and operating results.

 

 

Exposure to credit risk and the increased risk of defaults by counterparties may adversely affect our results of operations

 

We are at risk if issuers whose securities or other instruments we hold, customers, trading counterparties, counterparties under derivative contracts or financing agreements, clearing agents, exchanges, clearing houses or other financial intermediaries or guarantors default on their obligations to us due to bankruptcy, insolvency, lack of liquidity, adverse economic conditions, operational failure, fraud or other reasons. Such defaults could have a material adverse effect on our results of operations, financial condition and cash flows.

 

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We conduct the majority of our trade executions as principal or riskless-principal with broker-dealers, financial services firms and institutional counterparties. We clear a minority of our trade executions through unaffiliated clearing brokers. Under the terms of the agreements between us and our clearing brokers, the clearing brokers have the right to charge us for losses that result from a counterparty’s failure to fulfill its contractual obligations. No assurance can be given that any such counterparty will not default on its obligations, which default could have a material adverse effect on our business, financial condition and operating results.

 

 

Self-clearing exposes us to significant operational, financial, and liquidity risks

 

In 2009, we undertook an initiative to self-clear our securities transactions using an internally-developed platform. We currently self-clear substantially all of our domestic equities businesses and intend to expand internationally and across product offerings and asset classes in the future. Self-clearing exposes our business to operational risks, including business disruption, operational inefficiencies, liquidity and financing risks and potentially increased expenses and lost revenue opportunities. While our clearing platform, operational processes, enhanced infrastructure, and current and future financing arrangements, have been carefully designed, we may nevertheless encounter difficulties that may lead to operating inefficiencies, including delays in implementation, dissatisfaction amongst our client base, disruption in the infrastructure that supports the business, inadequate liquidity and financial loss. Any such delay, disruption or failure could adversely affect our ability to effect transactions and manage our exposure to risk. Moreover, any of these events could have a material adverse effect on our business, financial condition and operating results.

 

 

We may not be able to keep up with rapid technological and other changes or adequately protect our intellectual property

 

The markets in which we compete are characterized by rapidly changing technology, evolving industry standards, frequent new product and service announcements, introductions and enhancements, and changing client demands. If we are not able to keep up with these rapid changes on a timely and cost-effective basis, we may be at a competitive disadvantage. The widespread adoption of new internet, networking or telecommunications technologies or other technological changes could require us to incur substantial expenditures to modify or adapt our services or infrastructure. Any failure by us to anticipate or respond adequately to technological advancements, client requirements or changing industry standards or to adequately protect our intellectual property, or any delays in the development, introduction or availability of new services, products or enhancements, could have a material adverse effect on our business, financial condition and operating results.

 

 

Capacity constraints, systems failures and delays could harm our business

 

Our business activities are heavily dependent on the integrity and performance of the computer and communications systems supporting them and the services of certain third parties. Our systems and operations are vulnerable to damage or interruption from human error, natural disasters, power loss, computer viruses, intentional acts of vandalism, terrorism and other similar events. Extraordinary trading volumes or other events could cause our computer systems to operate at an unacceptably low speed or even fail. While we have invested significant amounts of capital to upgrade the capacity, reliability and scalability of our systems, there can be no assurance that our systems will be sufficient to handle such extraordinary trading volumes. Many of our systems are, and much of our infrastructure is, designed to accommodate additional growth without redesign or replacement; however, we may need to make significant investments in additional hardware and software to accommodate growth. Failure to make necessary expansions and upgrades to our systems and infrastructure could lead to failures and delays. Such failures and delays could cause substantial losses for our clients and could subject us to claims from our clients for losses, including litigation claiming, among other matters, fraud or negligence. In the past, high trading volume has caused significant delays in executing some trading

 

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orders, resulting in some clients’ orders being executed at prices they did not anticipate. From time to time, we have reimbursed our clients for losses incurred in connection with systems failures and delays.

 

Capacity constraints, systems failures and delays may occur again in the future and could cause, among other things, unanticipated disruptions in service to our clients, slower system response times resulting in transactions not being processed as quickly as our clients desire, decreased levels of client service and client satisfaction, and harm to our reputation. If any of these events were to occur, we could suffer a loss of clients, including our largest clients, or a reduction in the growth of our client base, increased operating expenses, financial losses, litigation or other client claims, and regulatory sanctions or additional regulatory burdens.

 

We have developed business continuity capabilities that can be utilized in the event of a disaster or disruption. Since the timing and impact of disasters and disruptions are unpredictable, we have to be flexible in responding to actual events as they occur. Significant business disruptions can vary in their scope. A disruption might only affect the Company, a building housing the Company, a business district in which the Company is located, a city in which the Company is located or an entire region. Within each of these areas, the severity of the disruption can also vary from minimal to severe. Our business continuity facilities are designed to allow us to substantially continue operations if we are prevented from accessing or utilizing our primary offices for an extended period of time. Although we have employed significant effort to develop, implement and maintain reasonable business continuity plans, the Company cannot guarantee our systems will fully recover after a significant business disruption in a timely fashion. If we are prevented from using any of our current trading operations or any third party services, or if our business continuity operations do not work effectively, we may not have complete business continuity. This could have a material adverse effect on our business, financial condition and operating results.

 

 

We are highly dependent on key personnel

 

We are highly dependent on a limited number of key personnel. Except for Thomas Joyce, our Chairman of the Board and Chief Executive Officer, who has an employment contract through December 2012, no other key executive has an employment contract with the Company. Our success will be dependent to a large degree on our ability to retain the services of our existing key executives and to attract and retain additional qualified personnel in the future. Competition for such personnel is intense. The loss of the services of any of our key executives or the inability to identify, hire and retain necessary highly qualified executive management in the future could have a material adverse effect on our business, financial condition and operating results.

 

Our success also depends, in part, on the highly skilled, and often specialized, individuals we employ. Our ability to attract and retain management, market-making, sales, electronic and voice trading and technology professionals is important to our business strategy. The Company strives to provide high quality services that will allow it to establish and maintain long-term relationships with its clients. The Company’s ability to do so depends, in large part, upon the individual employees who represent the Company in its dealings with such clients. There can be no assurance that the Company will not lose such professionals due to increased competition or other factors in the future. The loss of sales, trading or technology professionals, particularly senior professionals with broad industry or technical expertise, could have a material adverse effect on the Company’s business, financial condition and operating results.

 

 

Urban’s business is subject to substantial risks

 

Urban originates, funds, buys and sells reverse mortgage loans, and buys and sells forward mortgage loans. Urban is subject to approval of, and is heavily regulated by, federal and state

 

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regulatory agencies as a mortgage lender, GNMA issuer, broker and servicer. The reverse mortgage business is subject to substantial risks, including market, credit, interest rate, operational and legal risks. For example, values of mortgage assets or revenues can be adversely affected by changes in market conditions or interest rates; the secondary market for the FHA insured HECM loans is not assured; to the extent the program requires Congressional appropriations in future years, which are not forthcoming, the program could be jeopardized; and/or, consumer demand could be reduced if FHA actions result in a reduction of initial principal limit available to borrowers. Reverse mortgages are also subject to cross-over risk that the total outstanding loan balance will exceed the value of the home securing the loan. Urban can be requested to repurchase loans under various conditions, or required to indemnify HUD with respect to mortgage insurance claims. In addition, Urban faces greater responsibility and has potential administrative liability in connection with the selection and supervision of its third party originator business partners. Urban has recently been approved by GNMA as an issuer of HECM Mortgage Backed Securities (“HMBS”). As a GNMA issuer, Urban will have additional risks and liabilities associated with the funding of advances and repurchasing of loans. Urban may be required to purchase loans under certain conditions, and repurchased loans that have become due and payable may not be assigned to HUD and must be serviced to termination. Urban will also be responsible for funding any payments due to borrowers in a timely manner, remitting to investors interest accrued, and paying for interest shortfalls. Urban is also subject to market risk on un-pooled HECM balances to be securitized in subsequent HMBS participations. All of the above factors could have a material adverse effect on our business, financial condition and operating results.

 

 

Acquisitions, strategic investments and strategic relationships involve certain risks

 

Over the last several years, we have undertaken several strategic acquisitions, including the completed acquisitions of EdgeTrade, Knight Fixed Income, Urban, Astor and the DMM and LMM business units of Kellogg. We may continue to pursue opportunistic strategic acquisitions of, or investments in, businesses and technologies. Acquisitions may entail numerous risks, including difficulties in assessing values for acquired businesses, intangible assets and technologies, difficulties in the assimilation of acquired operations and products, diversion of management’s attention from other business concerns, assumption of unknown material liabilities of acquired companies, amortization of acquired intangible assets and the potential writedown of goodwill due to impairment, which could reduce future reported earnings, or result in potential loss of clients or key employees of acquired companies. We may not be able to integrate successfully any operations, personnel, services or products that we have acquired or may acquire in the future. Strategic investments may also entail some of the risks described above. If these investments are unsuccessful, we may need to incur charges against earnings. We have also established a number of strategic relationships. These relationships and others we may enter into in the future may be important to our business and growth prospects. We may not be able to maintain these relationships or develop new strategic alliances.

 

 

International expansion involves certain risks

 

We have expanded our international presence which may expose us to cultural, regulatory and governmental risks. The financial services industry in many foreign countries is heavily regulated, much like the U.S. The varying compliance requirements of these different regulatory jurisdictions and other factors may limit our ability to successfully conduct or expand our business internationally. It also may increase our costs of investment. Additionally, the expansion into international locations involves substantial operational and execution risk. We may not be able to manage these cost or risks effectively.

 

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The market price of our common stock could fluctuate significantly

 

Our Class A Common Stock, and the U.S. securities markets in general, have experienced significant price fluctuations in recent years. The price of our Class A Common Stock could decrease substantially. Since the market price of our Class A Common Stock tends to fluctuate significantly, we may become the subject of securities class action litigation which may result in substantial costs and a diversion of management’s attention and resources. Our future quarterly operating results may not consistently meet the expectations of securities analysts or investors, which could have a material adverse effect on the market price of our Class A Common Stock.

 

 

Fluctuations in currency exchange rates could adversely affect our earnings

 

A significant portion of our international business is conducted in currencies other than the U.S. dollar, and changes in foreign exchange rates relative to the U.S. dollar can therefore affect the value of non-U.S. dollar net assets, revenues and expenses. Potential exposures as a result of these fluctuations in currencies are closely monitored, and, where cost-justified, strategies are adopted that are designed to reduce the impact of these fluctuations on the Company’s financial performance. These strategies may include the financing of non-U.S. dollar assets with borrowings in the same currency and the use of various hedging transactions related to net assets, revenues, expenses or cash flows. Any material fluctuations in currencies could have a material effect on our operating results.

 

 

Servicing our debt requires a significant amount of cash, and we may not have sufficient cash flow from our business to pay our substantial debt

 

Our ability to make scheduled payments of the principal of, to pay interest on or to refinance our indebtedness, including the Cash Convertible Senior Subordinated Notes (“Notes”) issued in March 2010, depends on our future performance, which is subject to economic, financial, competitive and other factors beyond our control. Our business may not continue to generate cash flow from operations in the future sufficient to service our debt and make necessary capital expenditures. If we are unable to generate such cash flow, we may be required to adopt one or more alternatives, such as selling assets, restructuring debt, undertaking additional borrowings or issuing additional debt or obtaining additional equity capital on terms that may be onerous or highly dilutive. Our ability to refinance all or a portion of our indebtedness will depend on the capital markets and our financial condition at such time. We may not be able to engage in any of these activities or engage in these activities on desirable terms, which could result in a default on our debt obligations.

 

 

Despite our current debt levels, we may still incur substantially more debt or take other actions that could increase our aggregate borrowings and adversely impact our ability to service our debt obligations and/or operate or grow our businesses

 

We are not restricted under the terms of the indenture governing the Notes (filed as Exhibit No. 4.1 to the Company’s Form 8-K filed with the SEC on March 19, 2010) (the “Indenture”) or otherwise currently restricted from incurring additional debt, securing existing or future debt, recapitalizing our debt or taking any number of other actions that could increase our aggregate borrowings and adversely impact our ability to service our debt obligations and/or operate or grow our businesses. In particular, although we repaid all amounts outstanding under and terminated our prior credit facility in connection with the issuance of the Notes, we anticipate (though we can give no assurances) that we will enter into new senior secured term loans and/or revolving credit facilities to meet working capital needs. Any new credit facilities or other future borrowings may (1) contain covenants that limit the discretion of our management with respect to certain business matters, (2) require us to meet certain financial ratios and financial conditions tests, and (3) be secured by certain of our assets. Such new credit facilities or borrowings could:

 

   

make it difficult for us to satisfy our obligations with respect to the Notes or other then-outstanding debt obligations;

 

   

increase our vulnerability to general adverse economic and industry conditions;

 

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require us to dedicate a portion of our cash flow from operations to payments on our indebtedness, thereby reducing the availability of cash flow to fund working capital, capital expenditures, acquisitions and investments and other general corporate purposes;

 

   

make it difficult for us to optimally capitalize and manage the cash flow for our businesses;

 

   

limit our flexibility in planning for, or reacting to, changes in our businesses and the markets in which we operate;

 

   

place us at a competitive disadvantage compared to our competitors that have less debt; and

 

   

limit our ability to borrow additional funds.

 

In addition, it is possible that we may need to incur additional indebtedness in the future in the ordinary course of business or otherwise. Furthermore, if future debt financing is not available to us when required or is not available on acceptable terms, we may be unable to grow our business, take advantage of business opportunities, respond to competitive pressures or refinance maturing debt, any of which could have a material and adverse effect on our operating results and financial condition.

 

 

We may not have the ability to raise the funds necessary to pay the cash due upon conversions of the Notes or to repurchase the Notes upon a fundamental change, and our future debt may contain limitations on our ability to pay cash upon conversion or repurchase of the Notes

 

Holders of the Notes have the right to require us to repurchase the Notes upon the occurrence of a fundamental change at 100% of their principal amount, plus accrued and unpaid interest, if any, and upon conversion of any Notes, we will be required to pay to the holder of a Note a cash payment based on the applicable conversion rate as described in the Indenture. However, we may not have enough available cash or be able to obtain financing at the time we are required to repurchase Notes surrendered or settle conversions of the Notes. In addition, our ability to repurchase the Notes or to pay cash upon conversions of the Notes may be limited by law or by agreements governing our future indebtedness. Our failure to repurchase Notes at a time when the repurchase is required by the Indenture or to pay cash upon future conversions of the Notes as required by the Indenture would constitute a default under the Indenture. A default under the Indenture or the fundamental change itself could also lead to a default under agreements governing our future indebtedness. If the repayment of the related indebtedness were to be accelerated after any applicable notice or grace periods, we may not have sufficient funds to repay the indebtedness and repurchase the Notes or make cash payments upon conversions thereof.

 

 

The conditional conversion features of the Notes, if triggered, may adversely affect our financial condition and operating results

 

In the event the conditional conversion features of the Notes are triggered, holders of Notes will be entitled to convert the Notes at any time during specified periods at their option as described in the Indenture. If one or more holders elect to convert their Notes, we would be required to pay cash to such holder to settle any such conversion, which could adversely affect our liquidity. In addition, even if holders do not elect to convert their Notes, we could be required under applicable accounting rules to recharacterize all or a portion of the outstanding principal of the Notes as a short-term rather than long-term liability, which would result in a material reduction of our net working capital.

 

 

The accounting for the Notes will result in our having to recognize interest expense significantly greater than the stated interest rate of the Notes and may result in volatility to our Consolidated Statements of Operations

 

As described in the Indenture, we will settle conversions of the Notes entirely in cash. Accordingly, the conversion option that is part of the Notes is accounted for as a derivative pursuant to accounting standards relating to derivative instruments and hedging activities. In general, this resulted in an initial valuation of the conversion option, which was bifurcated from the debt component of the Notes,

 

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resulting in an original issue discount. The original issue discount will be accreted to interest expense over the term of the Notes, which will result in an effective interest rate reported in our Consolidated Statements of Operations significantly in excess of the stated coupon rate of the Notes. This will reduce our earnings and could adversely affect the price at which our Class A common stock trades, but will have no effect on the amount of cash interest paid to holders or on our cash flows.

 

For each financial statement period after issuance of the Notes, a gain (or loss) will be reported in our Consolidated Statements of Operations to the extent the valuation of the conversion option changes from the previous period. The cash convertible note hedge transaction is described in Exhibits No. 10.1(a) and 10.1(b) of Form 8-K, filed on March 19, 2010, will also be accounted for as a derivative, offsetting the gain (or loss) associated with changes to the valuation of the conversion option. Although we do not expect there to be any net impact to our Consolidated Statements of Operations as a result of our issuing the Notes and entering into the cash convertible note hedge transaction, we cannot assure that these transactions will be completely offset, which may result in volatility in our Consolidated Statements of Operations.

 

Item 1B.    Unresolved Staff Comments

 

None.

 

Item 2.    Properties

 

Our corporate headquarters are located in Jersey City, New Jersey. We lease approximately 266,000 square feet at 545 Washington Boulevard under a lease that expires in October 2021. We also collectively lease approximately 250,000 square feet for our other office locations in the U.S., Europe and Asia.

 

Item 3.    Legal Proceedings

 

From time to time, we and certain of our past and present officers, directors and employees have been named as parties to legal actions, arbitrations, administrative claims and regulatory reviews and investigations arising in connection with the conduct of our businesses. We are subject to such matters at the present time. Certain of these legal actions include claims for substantial compensatory and/or punitive damages or claims for indeterminate amounts of damages. In view of the inherent difficulty of predicting the outcome of such matters, particularly in cases in which claimants seek substantial or indeterminate damages, we cannot predict the eventual loss, or range of loss, or the range of potential recovery, related to such matters. We are contesting liability and/or the amount of damages in each pending matter. Although there can be no assurances, at this time we believe, based on information currently available, that the outcome of each of the matters will not have a material adverse effect on the consolidated financial condition of the Company, although they might be material to operating results for any particular period, depending, in part, upon operating results for that period.

 

We own subsidiaries including regulated entities that are subject to extensive oversight under federal, state and applicable international laws as well as SRO rules. Changes in market structure and the need to remain competitive require constant changes to our systems and order handling procedures. We make these changes while continuously endeavoring to comply with many complex laws and rules. Compliance, surveillance and trading issues common in the securities industry are monitored by, reported to, and/or reviewed in the ordinary course of business by our primary regulators, the SEC, CFTC, FSA, SFC, FINRA, NYSE, MSRB, NFA, FHA and HUD. As a major order flow execution destination, we are named from time to time in, or are asked to respond to a number of regulatory matters brought by U.S. regulators, foreign regulators and SROs that arise from our trading activity. We are currently the subject of various regulatory reviews and investigations. In some instances, these matters may rise to a SEC, CFTC, FSA, SFC, FINRA, NYSE, MSRB, NFA, FHA, HUD, other SRO disciplinary action and/or civil or administrative action.

 

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PART II

 

Item 5.    Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

On May 25, 2010, the Company commenced trading under the ticker symbol “KCG” on the New York Stock Exchange (“NYSE”) as well as the Professional Segment of the Paris market of NYSE Euronext. Previously, our Class A Common Stock was listed on the Nasdaq Global Select Market under the symbol “NITE”. Public trading of our Class A Common Stock commenced on July 8, 1998. The following table sets forth, for the past two years, the high and low quarterly closing sales price per share of the Class A Common Stock as reported by the NYSE or Nasdaq Global Select Market during the relevant periods.

 

2010

   High      Low  

First Quarter

   $ 16.70       $ 14.89   

Second Quarter

     15.78         13.79   

Third Quarter

     14.90         11.88   

Fourth Quarter

     14.03         12.36   

2009

             

First Quarter

     19.87         13.54   

Second Quarter

     18.63         14.39   

Third Quarter

     22.40         16.55   

Fourth Quarter

     22.98         14.12   

 

The closing sale price of our Class A Common Stock as reported by the NYSE on February 18, 2011, was $14.57 per share. As of that date there were approximately 360 holders of record of our Class A Common Stock based on information provided by our transfer agent. The number of stockholders does not reflect the actual number of individual or institutional stockholders that hold our stock because certain stock is held in the name of nominees. Based on information made available to us by our transfer agent, there are approximately 25,000 beneficial holders of our Class A Common Stock. Restricted stock awards are included in the calculation of holders of record while restricted stock unit awards are not included.

 

We have never declared or paid a cash dividend on our Class A Common Stock. The payment of cash dividends is within the discretion of our Board of Directors and will depend on many other factors, including, but not limited to, our results of operations, financial condition, capital requirements, restrictions imposed by financing arrangements, general business conditions and legal requirements.

 

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Comparative Stock Performance Graph

 

The graph below compares the total cumulative return of the Knight Class A Common Stock from December 31, 2005 through December 31, 2010, to the Standard & Poor’s 500 Index and the SNL Broker/Dealer Index. The graph assumes that dividends were reinvested and is based on an investment of $100 on December 31, 2005.

 

LOGO

 

     Period Ending  

Index

   12/31/05      12/31/06      12/31/07      12/31/08      12/31/09      12/31/10  

Knight Capital Group, Inc.

     100.00         193.83         145.60         163.30         155.71         139.43   

SNL Broker/Dealer Index

     100.00         141.39         126.97         42.60         67.32         67.20   

S&P 500 Index

     100.00         115.79         122.16         76.96         97.33         111.99   

 

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The following table contains information about our purchases of Knight Class A Common Stock during the fourth quarter of 2010 (in thousands, except average price paid per share):

 

Period

   Total Number
of Shares
Purchased
     Average
Price Paid
per Share
     Total Number of
Shares
Purchased as
Part of Publicly
Announced
Plans or
Programs(1)
     Approximate
Dollar Value of
Shares That May
Yet Be Purchased
Under the

Plans or Programs
 

October 1, 2010 - October 31, 2010

           

Common stock repurchases

     300            300       $ 192,198   

Employee transactions(2)

     9            —        
                       

Total

     309       $ 12.68         300      
                       

November 1, 2010 - November 30, 2010

           

Common stock repurchases

     300            300       $ 188,106   

Employee transactions(2)

     7            —        
                       

Total

     307       $ 13.64         300      
                       

December 1, 2010 - December 31, 2010

           

Common stock repurchases

     400            400       $ 182,635   

Employee transactions(2)

     69            —        
                       

Total

     469       $ 13.69         400      
                       

Total

           

Common stock repurchases

     1,000            1,000      

Employee transactions(2)

     86            —        
                       

Total

     1,086       $ 13.39         1,000      
                       

 

Totals may not add due to rounding.

 

(1)   On April 4, 2002, the Company’s Board of Directors announced the authorization of a stock repurchase program, which allowed for the purchase of Class A Common Stock up to a total amount of $35 million. This repurchase program was increased by an aggregate of $965 million to a total of $1 billion by resolutions of the Company’s Board of Directors adopted on July 16, 2002, May 12, 2003, April 20, 2004, August 8, 2004, April 19, 2005, October 18, 2005, April 18, 2006 and July 17, 2007. The Company may repurchase shares from time to time in the open market, accelerated stock buyback programs, tender offers, privately negotiated transactions or by other means. Repurchases may also be made under a Rule 10b5-1 plan. The timing and amount of repurchase transactions will be determined by the Company’s management based on its evaluation of current and future financing needs, market conditions, share price, legal requirements and other factors. The program may be suspended, modified or discontinued at any time without prior notice. The Company cautions that there are no assurances that any further repurchases will actually occur. The repurchase program has no set expiration or termination date.
(2)   Represents shares of common stock withheld in satisfaction of tax withholding obligations upon vesting of restricted stock.

 

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Equity Compensation Plan Information

 

The following table sets forth certain information as of December 31, 2010, regarding the Company’s equity compensation plans for stock-based awards.

 

Plan Category

   Number of securities
to be issued upon
exercise of
outstanding options,
warrants and rights(1)
     Weighted-average
exercise

price of  outstanding
options, warrants
and rights
     Number of securities
remaining available for
future issuance under
equity compensation
plans (excluding securities
reflected in column (a)(2)(3)
 
     (In thousands, except weighted-average exercise price)  
     (a)      (b)      (c)  

Equity compensation plans approved by security holders

     3,740       $ 14.06         9,946   

Equity compensation plans not approved by security holders

     —           —           964   
                          

Total

     3,740       $ 14.06         10,910   
                          

 

(1)   Outstanding stock-based awards have been issued under the following shareholder-approved equity compensation plans: Knight Capital Group 1998 Long Term Incentive Plan, Knight Capital Group, Inc. 2003 Equity Incentive Plan, and the Knight Capital Group, Inc. 2006 Equity Incentive Plan (collectively, the “Prior Stock Plans”), and the Knight Capital Group, Inc. 2010 Equity Incentive Plan (the “2010 Plan”).
(2)   All securities remaining available for future issuance under equity compensation plans approved by security holders are pursuant to the 2010 Plan. As a result of the establishment of the 2010 Plan in May 2010 after stockholder approval, the 2010 Plan replaced the Prior Stock Plans for future equity grants and no additional grants will be made under the Prior Stock Plans (but the terms and conditions of any outstanding equity grants under the Prior Stock Plans were not affected). Shares remaining available for grant under the Prior Stock Plans as of the approval date of the 2010 Plan were transferred to, and made available for grant under the 2010 Plan. In addition, any shares which would have become available again under the Prior Stock Plans due to cancellation or expiration of existing grants under the Existing Stock Plans will become available for grant under the 2010 Plan.
(3)   Securities remaining available for future issuance under equity compensation plans not approved by security holders comprise 1.0 million shares under the Knight Capital Group, Inc. Amended and Restated 2009 Inducement Award Plan.

 

These plans are discussed further in Footnote 10, “Stock-Based Compensation” to the Company’s Consolidated Financial Statements included in Part II, Item 8 “Financial Statements and Supplementary Data.”

 

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Item  6.    Selected Financial Data

 

The following should be read in conjunction with the Consolidated Financial Statements and the discussion under “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this document. The Consolidated Statements of Operations Data for 2010, 2009 and 2008 and the Consolidated Statements of Financial Condition Data at December 31, 2010 and 2009 have been derived from our audited Consolidated Financial Statements included elsewhere in this document. The Consolidated Statements of Operations Data for 2007 and 2006 and the Consolidated Statements of Financial Condition Data at December 31, 2008, 2007 and 2006 are derived from Consolidated Financial Statements not included in this document.

 

     For the years ended December 31,  
     2010     2009     2008     2007     2006  
     (In thousands, except per share amounts)  

Consolidated Statements of Operations Data:

  

Revenues

          

Commissions and fees

   $ 660,527      $ 670,406      $ 478,126      $ 386,128      $ 339,857   

Net trading revenue

     489,394        486,684        446,707        286,199        243,761   

Interest, net

     2,092        (1,712     7,644        16,133        15,662   

Investment (loss) income and other, net

     (2,957     7,053        6,380        28,699        71,910   
                                        

Total revenues

     1,149,056        1,162,431        938,857        717,159        671,190   
                                        

Expenses

          

Employee compensation and benefits

     546,748        527,327        331,311        257,486        226,258   

Execution and clearance fees

     176,116        169,805        107,402        120,261        106,908   

Communications and data processing

     69,597        61,071        45,359        35,363        31,765   

Depreciation and amortization

     42,773        34,368        26,535        21,567        20,059   

Payments for order flow and ECN Rebates

     37,700        71,629        43,639        54,564        42,191   

Occupancy and equipment rentals

     26,632        23,177        19,642        13,194        12,644   

Interest

     25,896        4,777        5,052        182        299   

Business development

     19,493        18,807        17,279        14,611        13,173   

Professional fees

     17,463        13,043        14,749        14,491        16,961   

Writedown of assets and lease loss accrual (benefit), net

     1,032        (9,704     1,236        (2,470     8,480   

Restructuring

     16,731        —          —          —          —     

Other

     18,909        15,326        8,969        11,951        10,772   
                                        

Total expenses

     999,090        929,626        621,173        541,200        489,510   
                                        

Other Income

          

Non-operating gain from subsidiary stock issuance

     —          —          15,947        8,757        —     
                                        

Income from continuing operations before income taxes

     149,966        232,805        333,631        184,716        181,680   

Income tax expense

     57,969        81,189        139,921        70,155        69,423   
                                        

Income from continuing operations, net of tax

     91,997        151,616        193,710        114,561        112,257   

(Loss) income from discontinued operations, net of tax

     (359     (34,514     (15,799     7,679        46,089   
                                        

Net Income

   $ 91,638      $ 117,102      $ 177,911      $ 122,240      $ 158,346   
                                        

Basic earnings per share from continuing operations

   $ 1.02      $ 1.70      $ 2.19      $ 1.18      $ 1.11   
                                        

Diluted earnings per share from continuing operations

   $ 0.97      $ 1.60      $ 2.11      $ 1.14      $ 1.06   
                                        

Basic earnings per share from discontinued operations

   $ (0.00   $ (0.39   $ (0.18   $ 0.08      $ 0.45   
                                        

Diluted earnings per share from discontinued operations

   $ (0.00   $ (0.37   $ (0.17   $ 0.08      $ 0.43   
                                        

Basic earnings per share

   $ 1.02      $ 1.31      $ 2.01      $ 1.26      $ 1.56   
                                        

Diluted earnings per share

   $ 0.97      $ 1.24      $ 1.94      $ 1.21      $ 1.49   
                                        

Shares used in computation of basic earnings per share

     90,167        89,095        88,407        97,050        101,420   
                                        

Shares used in computation of diluted earnings per share

     94,447        94,504        91,760        100,796        106,243   
                                        

 

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     December 31,  
     2010      2009      2008      2007      2006  

Consolidated Statements of Financial Condition Data:

              

Cash and cash equivalents

   $ 375,569       $ 427,106       $ 416,957       $ 190,924       $ 170,958   

Financial instruments owned, at fair value

     1,603,139         926,589         476,111         412,565         711,775   

Total assets

     4,670,211         3,014,024         2,025,426         1,782,944         2,074,761   

Financial instruments sold, not yet purchased, at fair value

     1,311,324         639,259         385,003         335,280         693,071   

Long-term debt

     311,060         —           —           —           —     

Credit facility

     —           140,000         140,000         70,000         —     

Total Knight Capital Group, Inc. stockholders’ equity

     1,360,237         1,213,502         1,027,358         885,378         962,487   

 

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  Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Executive Overview

 

We are a global financial services firm that provides access to the capital markets across multiple asset classes to a broad network of clients, including buy- and sell-side firms and corporations. We seek to continually apply our expertise and innovation to the trade execution process to build lasting client relationships through consistent performance and superior client service. We also provide capital markets services to corporate issuers and private companies. We have three operating segments within our continuing operations, Equities, Fixed Income, Currencies and Commodities (“FICC”) and Corporate.

 

   

Equities—Our Equities segment includes market-making and trading in global equities, ETFs, options and futures. In the course of market-making and trading, we provide capital facilitation and a range of complementary services, including research and commission management. Within our Equities segment, we also provide equity capital markets and asset management services.

 

   

FICC—Our FICC segment includes research, sales and trading in global fixed income, as well as electronic trading in fixed income and foreign exchange. Fixed income research publishes reports across several sectors in the U.S. and emerging markets evaluating corporate risk, interest rate risk and individual issuers. Within our FICC segment, we also provide debt capital markets services and originate home equity conversion mortgages, commonly referred to as reverse mortgages.

 

   

Corporate—Our Corporate segment invests in strategic financial services-oriented opportunities, allocates, deploys and monitors all capital, and maintains all corporate overhead expenses and all other expenses that are not attributable to the Equities and FICC segments. Corporate overhead expenses consist of compensation for senior executives and other employees of the corporate holding company, interest on our long-term debt, legal and other professional expenses related to corporate matters, directors’ fees, investor and public relations expenses and directors’ and officers’ insurance. Results of our Corporate segment includes income from investments in funds formerly managed by Deephaven Capital Management (“Deephaven Funds”).

 

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The following table sets forth: (i) Revenues, (ii) Expenses, (iii) Other income and (iv) Pre-tax earnings (loss) from continuing operations of our segments and on a consolidated basis (in millions):

 

     For the years ended December 31,  
     2010     2009     2008  

Equities

      

Revenues

   $ 902.5      $ 891.0      $ 851.5   

Expenses(1)

     673.4        663.7        505.0   
                        

Pre-tax earnings

     229.1        227.3        346.4   
                        

FICC

      

Revenues

     249.1        266.7        79.3   

Expenses(1)

     255.3        218.8        67.0   
                        

Pre-tax (loss) earnings

     (6.2     47.8        12.3   
                        

Corporate

      

Revenues

     (2.5     4.7        8.1   

Expenses(1)

     70.4        47.1        49.1   

Other income

     —          —          15.9   
                        

Pre-tax (loss)

     (72.9     (42.3     (25.1
                        

Consolidated

      

Revenues

     1,149.1        1,162.4        938.9   

Expenses(1)

     999.1        929.6        621.2   

Other income

     —          —          15.9   
                        

Pre-tax earnings

   $ 150.0      $ 232.8      $ 333.6   
                        

 

Totals   may not add due to rounding.

 

(1)  -  Included in Expenses for the year ended December 31, 2010 is a Restructuring charge of $16.7 millon which comprises $3.1 million for Equities, $12.9 million for FICC and $0.7 million for Corporate.

 

Consolidated Revenues in 2010 decreased $13.4 million, or 1.2% from 2009, while consolidated Expenses increased $69.5 million or 7.5% from 2009. Consolidated Pre-tax earnings from continuing operations in 2010 decreased $82.8 million, or 35.6% from 2009.

 

The changes in our Pre-tax earnings (loss) from continuing operations by segment from 2009 to 2010 are summarized as follows:

 

   

Equities—Our Pre-tax earnings from Equities increased in 2010 by $1.8 million, or 0.8%, from 2009. The increase is primarily due to higher equity dollar value traded and strong performance in our market-making and agency based electronic trading offset, in part, by higher expenses including: our investments in businesses and infrastructure, both domestically and internationally; additional compensation costs associated with changes in our business mix and additional headcount; and increased volume-based transaction fees.

 

   

FICC—Our Pre-tax results from FICC decreased in 2010 by $54.0 million, or 113.0%, from 2009. The decrease is primarily due to increased competition, tighter spreads, higher compensation costs associated with employee retention, a slowdown in volumes in our institutional fixed income business, and a $12.9 million restructuring charge that was incurred in the third quarter of 2010 offset, in part, by higher volumes and earnings from our Hotspot and Knight BondPoint businesses.

 

   

Corporate—Our Pre-tax loss from our Corporate segment increased in 2010 by $30.6 million from 2009, primarily due to higher interest expense related to our Notes which were issued in

 

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March 2010, a net loss of $9.8 million from our strategic investments in 2010, the elimination of $2.9 million of revenue within FICC related to the Notes offering, a $13.1 million reversal of a lease loss accrual in 2009 and higher legal and consulting fees relating to new business initiatives offset, in part, by lower compensation costs and an increase in the returns from our corporate investment in the Deephaven Funds.

 

Certain Factors Affecting Results of Operations

 

We may experience significant variation in our future results of operations. These fluctuations may result from numerous factors. These factors include, among other things, market conditions and the resulting volatility and credit and counterparty risks that may result; introductions of, or enhancements to, trade execution services by us or our competitors; the value of our securities positions and other financial instruments and our ability to manage the risks attendant thereto; the volume of our trade execution activities; the dollar value of securities and other instruments traded; the composition and profile of our order flow; our market share with institutional and broker-dealer clients; the performance and size of, and volatility in, our market-making and program trading portfolios; the performance of our non-client principal trading models; movements of credit spreads; the performance of our global operations; costs associated with our global expansion and domestic growth; the effectiveness of our self-clearing platform; our ability to manage personnel, compensation, overhead and other expenses, including our occupancy expenses under our office leases and expenses and charges relating to legal and regulatory proceedings; the strength of our client relationships; changes in payments for order flow, changes to execution quality and changes in clearing, execution and regulatory transaction costs; interest rate movements; the addition or loss of executive management, sales, electronic and voice trading and technology professionals; legislative, legal and regulatory changes; legal and regulatory matters or proceedings; geopolitical risk; the amount, timing and cost of capital expenditures, acquisitions and divestitures; the integration, performance and operation of acquired businesses; the incurrence of costs associated with acquisitions and dispositions; investor sentiment; technological changes and events; seasonality; competition; and market and economic conditions.

 

Such factors may also have an impact on our ability to achieve our strategic objectives, including, without limitation, increases in our market share, growth and profitability in our Equities and FICC segments. If demand for our services declines due to any of the above factors, and we are unable to adjust our cost structure on a timely basis, our operating results could be materially and adversely affected. As a result of the foregoing factors, period-to-period comparisons of our revenues and operating results are not necessarily meaningful and such comparisons cannot be relied upon as indicators of future performance. There also can be no assurance that we will be able to continue the rates of revenue growth that we have experienced in the past or that we will be able to improve our operating results.

 

Trends

 

Global Economic Trends

 

Our businesses are affected by many factors in the global financial markets and worldwide economic conditions. These factors include the growth level of gross domestic product in the U.S., Europe and Asia, and the existence of transparent, efficient and liquid equity and debt markets and level of trading volumes.

 

Global economic activity improved broadly during 2010 and volatility across equity markets generally declined. Credit spreads contracted in the U.S., although spreads in Europe were relatively more volatile as European sovereign spreads in certain countries widened. The improvement in economic conditions was tempered by increases in U.S. interest rates, inflation concerns, and rising commodity prices.

 

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Trends Affecting Our Company

 

We believe that our businesses are affected by the aforementioned global economic trends as well as more specific trends. Some of the specific trends that impact our operations, financial condition and results of operations are:

 

   

Broker-dealer clients continue to focus on statistics measuring the quality of equity executions (including speed of execution and price improvement). In an effort to improve the quality of their executions as well as increase efficiencies, market makers have increased the level of automation within their operations and the extent of price improvement. The greater focus on execution quality has resulted in greater competition in the marketplace, which, along with market structure changes and market conditions, has negatively impacted the revenue capture metrics of the Company and other market-making firms.

 

   

Equities and FICC transaction volumes executed by broker-dealers have fluctuated over the past few years due to retail and institutional investor sentiment, market conditions and a variety of other factors, resulting in a shift of product mix. Equities and FICC transaction volumes may not be sustainable and are not predictable.

 

   

In recent years several exchanges have entered into joint ventures with broker-dealers to create their own ATSs and ECNs and compete within the OTC and listed trading venues. In addition, there are many new entrants into the market, including ATS, Multilateral Trading Facilities, systematic internalizers, dark liquidity pools, high frequency trading firms, and market-making firms competing for retail and institutional order flow. Further, many broker-dealers are offering their own internal crossing networks. These factors continue to create further fragmentation and competition in the marketplace.

 

   

Market structure changes, competition and market conditions have triggered an industry shift toward market makers charging explicit commissions or commission equivalents to institutional clients for executions in OTC securities. For the majority of our institutional client orders, we charge explicit fees in the form of commissions or commission equivalents. Institutional commission rates have fallen in the past few years due to competitive forces and increased electronic trading, and may continue to fall in the future.

 

   

Market structure changes, competition and technology advancements have also led to a dramatic increase in electronic message traffic. These increases in message traffic place heavy strains on the technology resources, bandwidth and capacities of market participants.

 

   

Many institutional clients allocate commissions to broker-dealers based on the quality of executions, as well as in exchange for research, or soft dollar and commission recapture programs.

 

   

There has been continued scrutiny of the capital markets industry by the regulatory and legislative authorities, both in the U.S. and abroad. New legislation or new or modified regulations and rules could occur in the future. Members of the U.S. Congress have raised various concerns about the regulatory structure of the U.S. capital markets and have asked the SEC to take a close look at the regulatory structure and make the changes necessary to insure the rule framework governing the U.S. capital markets is comprehensive and complete. The SEC has stated that it will carefully review, and propose rules where necessary, on a variety of marketplace trading issues—including, but not limited to: high frequency trading, indications of interest, various forms of off-exchange trading, dark liquidity pools, internalization, post-trade attribution, co-location, and sponsored access. In addition, the SEC has proposed rules dealing with flash orders, indications of interest, ATS thresholds, and other market-related rules (some of which have been finalized).

 

   

On July 21, 2010, the Dodd-Frank Act was enacted into law marking a significant change to the regulation of the financial services industry. This legislation will affect nearly all financial

 

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institutions that operate in the U.S. As a result, financial institutions must now begin to deal with the historic shift in U.S. banking, securities, derivatives, executive compensation, consumer protection and corporate governance that will grow out of the general framework established by the Dodd-Frank Act. While the weight of the Dodd-Frank Act falls more heavily on large, complex financial institutions, smaller institutions will also face a more complicated and expensive regulatory framework.

 

   

There continues to be growth in equity electronic trading, as evidenced by increased volumes over the past few years in direct market access platforms, algorithmic and program trading, high frequency trading and ECNs and dark liquidity pools. In addition, electronic trading continues to expand to other asset classes, including options, currencies and fixed income. The expansion of electronic trading may result in the growth of innovative electronic products and competition for order flow.

 

   

The macro-economic environment and market conditions have had an adverse impact on the profitability of the institutional customer base, resulting in volatile earnings and decreased volumes.

 

Income Statement Items

 

The following section briefly describes the key components of, and drivers to, our significant revenues and expenses.

 

Revenues

 

Our revenues consist principally of Commissions and fees and Net trading revenue from our Equities and FICC segments.

 

Revenues on transactions for which we charge explicit commissions or commission equivalents, which include the majority of our institutional client orders, are included within Commissions and fees. Commissions and fees are primarily affected by changes in our equity, fixed income and foreign exchange transaction volumes with institutional clients, changes in commission rates, assets under management and the level of our soft dollar and commission recapture activity.

 

Trading profits and losses on principal transactions primarily relate to our market-making activities and are included within Net trading revenue. These revenues are primarily affected by changes in the amount and mix of U.S. equity trade and share volumes, our revenue capture, dollar value of equities traded, our ability to derive trading gains by taking proprietary positions, changes in our execution standards, development of, and enhancement to, our market-making models, performance of our non-client principal trading models that interact with street flow, volatility in the marketplace, our mix of sell- and buy-side clients, regulatory changes and evolving industry customs and practices.

 

Interest income, net is earned from our cash held at banks, and cash held in trading accounts at third party clearing brokers and from collateralized financing arrangements, such as stock borrowing. The Company’s third party clearing agreements call for payment or receipt of interest income, net of transaction-related interest charged by clearing brokers for facilitating the settlement and financing of securities transactions. Net interest is primarily affected by interest rates, the level of cash balances held at banks and third party clearing brokers, our level of securities positions in which we are long compared to our securities positions in which we are short, and the extent of our collateralized financing arrangements.

 

Investment (loss) income and other, net primarily represents returns on our strategic investments, returns on deferred compensation investments and return on our corporate investment in the Deephaven Funds. Such income or loss is primarily affected by the performance and activity of our strategic investments and changes in value of certain deferred compensation investments.

 

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Expenses

 

Employee compensation and benefits expense, our largest expense, primarily consists of salaries and wages paid to all employees and profitability-based compensation, which includes compensation paid to sales personnel, incentive compensation paid to all other employees based on our profitability and changes in value of certain deferred compensation investments. Employee compensation and benefits expense fluctuates, for the most part, based on changes in our revenues and business mix, profitability and the number of employees. Compensation for employees engaged in sales activities is determined primarily based on a percentage of their gross revenues net of certain transaction-based expenses.

 

Execution and clearance fees primarily represent fees paid to third party clearing brokers for clearing equities transactions, transaction fees paid to Nasdaq and other exchanges and regulatory bodies, and execution fees paid to third parties, primarily for executing trades on the NYSE and other exchanges, and for executing orders through ECNs. Execution and clearance fees primarily fluctuate based on changes in equity trade and share volume, changes in execution strategies, rate of clearance fees charged by clearing brokers and rate of fees paid to ECNs, exchanges and certain regulatory bodies.

 

Communications and data processing expense primarily consists of costs for obtaining market data, telecommunications services and systems maintenance.

 

Depreciation and amortization expense results from the depreciation of fixed assets, which consist of computer hardware, furniture and fixtures, and the amortization of purchased software, capitalized software development costs, acquired intangible assets and leasehold improvements. We depreciate our fixed assets and amortize our purchased software, capitalized software development costs and acquired intangible assets on a straight-line basis over their expected useful lives. We amortize leasehold improvements on a straight-line basis over the lesser of the life of the improvement or the remaining term of the lease.

 

Payments for order flow primarily represent payments to broker-dealer clients, in the normal course of business, for directing to us their order flow in U.S. equities and options. Payments for order flow fluctuate as we modify our rates and as our percentage of clients whose policy is not to accept payments for order flow varies. Payments for order flow also fluctuate based on U.S. equity share and option volumes, our profitability, the mix of market orders and limit orders, and customer mix.

 

Occupancy and equipment rentals consist primarily of rent and utilities related to leased premises and office equipment.

 

Interest expense consists primarily of costs associated with our Notes, our former credit facility and for collateralized financing arrangements such as stock lending and sale of financial instruments under our agreements to repurchase.

 

Business development consists primarily of costs related to sales and marketing, conferences and relationship management.

 

Professional fees consist primarily of legal, accounting and consulting fees.

 

Restructuring charge consists of severance and related costs.

 

Other income

 

Other income consists of non-operating gains from subsidiary stock issuances relating to the partial sales of our ownership of Direct Edge.

 

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Results of Operations

 

The following table sets forth the consolidated statements of operations data as a percentage of total revenues:

 

     For the years ended
December 31,
 
     2010     2009     2008  

Revenues

      

Commissions and fees

     57.5     57.7     50.9

Net trading revenue

     42.6     41.9     47.6

Interest, net

     0.2     -0.1     0.8

Investment (loss) income and other, net

     -0.3     0.6     0.7
                        

Total revenues

     100.0     100.0     100.0
                        

Expenses

      

Employee compensation and benefits

     47.6     45.4     35.3

Execution and clearance fees

     15.3     14.6     11.4

Communications and data processing

     6.1     5.3     4.8

Depreciation and amortization

     3.7     3.0     2.8

Payments for order flow

     3.3     6.2     4.6

Occupancy and equipment rentals

     2.3     2.0     2.1

Interest

     2.3     0.4     0.5

Business development

     1.7     1.6     1.8

Professional fees

     1.5     1.1     1.6

Writedown of assets and lease loss accrual (benefit), net

     0.1     -0.8     0.1

Restructuring

     1.5     0.0     0.0

Other

     1.6     1.3     1.0
                        

Total expenses

     86.9     80.0     66.2
                        

Other Income

      

Non-operating gain from subsidiary stock issuance

     0.0     0.0     1.7
                        

Income from continuing operations before income taxes

     13.1     20.0     35.5

Income tax expense

     5.0     7.0     14.9
                        

Income from continuing operations, net of tax

     8.0     13.0     20.6

Loss from discontinued operations, net of tax

     0.0     -3.0     -1.7
                        

Net income

     8.0     10.1     18.9
                        

 

Percentages may not add due to rounding.

 

Years Ended December 31, 2010 and 2009

 

Revenues

 

The results of Urban and Astor are consolidated and included within revenues from FICC and Equities, respectively, from their acquisition dates of July 2010 and October 2010, respectively.

 

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Equities

 

    For the years ended December 31,              
            2010                     2009             Change     % of Change  

Commissions and fees (millions)

  $ 417.8      $ 405.2      $ 12.6        3.1

Net trading revenue (millions)

    485.8        485.8        (0.0     0.0

Interest, net (millions)

    (1.6     (3.2     1.6        50.2

Investment income and other, net (millions)

    0.5        3.2        (2.7     -85.1
                         

Total Revenues from Equities (millions)

  $ 902.5      $ 891.0      $ 11.5        1.3
                         

Average daily U.S. equity dollar value traded ($ billions)

    26.6        23.0        3.6        15.5

Average daily U.S. equity trades (thousands)

    3,730.4        3,904.5        (174.1     -4.5

Nasdaq and Listed equity shares traded (billions)

    275.3        343.1        (67.7     -19.7

OTC Bulletin Board and Pink Sheet shares traded (billions)

    1,988.9        2,170.7        (181.8     -8.4

Average revenue capture per U.S. equity dollar value traded (bps)

    1.1        1.3        (0.2     -15.6

Average daily Knight Direct equity shares (millions)

    148.8        69.1        79.7        115.3

 

Total revenues from the Equities segment, which primarily comprises Commissions and fees and Net trading revenue from our domestic businesses, increased 1.3% to $902.5 million in 2010, from $891.0 million in 2009. Revenues in 2010 were positively impacted by increased revenues from higher volumes at Knight Direct, growth of recently launched products and international expansion efforts, market conditions, improved results from our market-making and non-client principal trading models and higher equity dollar volumes offset, in part, by lower average revenue capture per U.S. equity dollar value traded.

 

Average revenue capture per U.S. equity dollar value traded was 1.1 basis points (“bps”) in 2010, down 15.6% from 1.3 bps in 2009. The primary drivers for the decrease in revenue capture were heightened competition, ongoing investments in price improvement and execution quality, lower volatility and the change in profile and mix of our order flow. Average revenue capture per U.S. equity dollar value traded is calculated as the total of net domestic trading revenues plus U.S. institutional commissions and commission equivalents (included in Commissions and fees), less certain transaction-related regulatory fees (included in Execution and clearance fees), (collectively “Domestic Equity Trading Revenues”) divided by the total dollar value of the related equity transactions. Domestic Equity Trading Revenues were $738.5 million and $756.5 million in 2010 and 2009, respectively. Domestic Equity Trading Revenues do not include revenues from our international and Knight Direct businesses.

 

FICC

 

     For the years ended December 31,              
             2010                      2009             Change     % of Change  

Commissions and fees (millions)

   $ 244.3       $ 265.0      $ (20.7     -7.8

Net trading revenue (millions)

     3.6         0.9        2.7        295.8

Interest, net (millions)

     0.5         (0.7     1.2        N/M   

Investment income and other, net (millions)

     0.7         1.5        (0.8     -53.9
                           

Total Revenues from FICC (millions)

   $ 249.1       $ 266.7      $ (17.6     -6.6
                           

Average daily Hotspot FX notional dollar value traded ($ billions)

     36.9         22.8        14.1        62.0

 

N/M—Not meaningful

 

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Total revenues from the FICC segment, which primarily comprises Commissions and fees, decreased 6.6% to $249.1 million in 2010, from $266.7 million in 2009. Revenues were negatively impacted by a slowdown in volumes and tightening of credit spreads in our Knight Fixed Income business and intensified competition as a result of the re-emergence of large banks, offset by higher volumes from our Hotspot and Knight BondPoint businesses, revenues from Urban and a $2.9 million intercompany fee relating to the placement of the Notes offering during the first quarter of 2010. Excluding the intercompany fee received from our Notes offering, total revenues decreased 7.7% to $246.1 million in 2010.

 

Corporate

 

     For the years ended December 31,               
     2010     2009      Change     % of Change  

Total Revenues from Corporate (millions)

   $ (2.5   $ 4.7       $ (7.2     -153.1

 

Total revenues from the Corporate segment, which primarily represent gains or losses on strategic investments, deferred compensation investments related to certain employees and directors, and from our corporate investment as a limited partner or non-managing member in the Deephaven Funds, decreased to net negative revenues of $2.5 million in 2010, from net positive revenues of $4.7 million in 2009. During the first quarter of 2010, Corporate paid a $2.9 million fee to the FICC segment with respect to the offering of our Notes. This fee was eliminated in consolidation. Our strategic investments had a net loss of $9.8 million in 2010 as compared to a net gain of $1.8 million in 2009.

 

Expenses

 

Employee compensation and benefits expense increased to $546.7 million in 2010 from $527.3 million in 2009. As a percentage of total revenue, Employee compensation and benefits increased to 47.6% in 2010, from 45.4% in 2009. The increase on a dollar basis was primarily due to higher compensation accruals due to improved results from our Equities segment, increased headcount due to the growth and investments in both our domestic and international businesses, and increased compensation expense at Knight Fixed Income due to hiring and retention costs.

 

The number of full time employees increased to 1,326 at December 31, 2010, from 1,126 at December 31, 2009, primarily due to staff additions relating to our move to self clearing, the growth and expansion in our international business and expanded domestic product offerings, including our acquisitions, offset, in part, by a headcount reduction related to our restructuring plan in the third quarter of 2010. Employee compensation and benefits expense fluctuates, for the most part, based on changes in our business mix, revenues, profitability and the number of employees.

 

Execution and clearance fees increased 3.7% to $176.1 million in 2010, from $169.8 million in 2009, primarily due to greater volumes. As a percentage of total revenue, Execution and clearance fees increased to 15.3% in 2010, from 14.6% in 2009. Execution and clearance fees fluctuate based on changes in transaction volumes, regulatory fees and operational efficiencies and scale.

 

Payments for order flow decreased to $37.7 million in 2010, from $71.6 million in 2009. As a percentage of total revenue, Payments for order flow decreased to 3.3% in 2010, from 6.2% in 2009. This expense decreased primarily due to changes in rebate arrangements with clients, competition, volumes and customer mix.

 

Writedown of assets and lease loss accrual (benefit), net was $1.0 million in 2010 comprising $0.3 million for the discontinued use of the Libertas trade name and a lease loss accrual of $0.7 million relating to excess real estate capacity. Writedown of assets and lease loss accrual (benefit), net was a

 

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benefit of $9.7 million in 2009, primarily due to a $13.1 million lease loss reversal recognized with respect to our office space in Jersey City, N.J. Also included in Writedown of assets and lease loss accrual (benefit), net is a charge of $2.4 million in 2009, relating to our decision to discontinue the use of the Donaldson trade name, a writedown of $0.7 million relating to capitalized software resulting from the sale of Hotspot’s retail customer accounts and a charge of $0.3 million due to a lease loss with respect to excess office space in New York City.

 

The restructuring charge of $16.7 million in 2010 comprises severance and related costs in connection with a reduction of headcount in order to rationalize expenses.

 

All other expenses increased by $50.2 million to $220.8 million in 2010 from $170.6 million in 2009. Interest expense increased from $4.8 million to $25.9 million primarily due to our Notes offering and our increased stock lending activity. Communications and data processing expense increased primarily due to higher market data and connectivity expenses related to the growth within our Equities and FICC segments. Depreciation and amortization expense increased primarily due to fixed asset purchases and greater capitalized software development costs. Occupancy and equipment rentals expense increased primarily due to the costs associated with new office space leases. Professional fees increased due to higher consulting and legal expenses related to our acquisitions and our new business initiatives. Other expenses increased due to higher employment fees and administrative expenses.

 

Our effective tax rate for 2010 from continuing operations of 38.7% differed from the federal statutory rate of 35% primarily due to state and local income taxes and non-deductible charges.

 

Years Ended December 31, 2009 and 2008

 

Revenues

 

The results of Knight Fixed Income is consolidated and included in FICC from the acquisition date of July 2008.

 

Equities

 

    For the years ended December 31,              
            2009                     2008             Change     % of Change  

Commissions and fees (millions)

  $ 405.2      $ 392.5      $ 12.7        3.2

Net trading revenue (millions)

    485.8        446.9        38.9        8.7

Interest, net (millions)

    (3.2     3.6        (6.7     -188.7

Investment income and other, net (millions)

    3.2        8.6        (5.4     -62.6
                         

Total Revenues from Equities (millions)

  $ 891.0      $ 851.5      $ 39.5        4.6
                         

Average daily U.S. equity dollar value traded
($ billions)

    23.0        19.2        3.9        20.1

Average daily U.S. equity trades (thousands)

    3,904.5        2,548.0        1,356.5        53.2

Nasdaq and Listed equity shares traded (billions)

    343.1        195.7        147.4        75.3

OTC Bulletin Board and Pink Sheet shares traded (billions)

    2,170.7        802.7        1,367.9        170.4

Average revenue capture per U.S. equity dollar value traded (bps)

    1.3        1.5        (0.2     -12.5

Average daily Knight Direct equity shares (millions)

    69.1        50.6        18.5        36.7

 

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Total revenues from the Equities segment, which primarily comprises Commissions and fees and Net trading revenue from our domestic businesses, increased 4.6% to $891.0 million in 2009, from $851.5 million in 2008. Revenues in 2009 were positively impacted by higher volumes and improved results from additional trading strategies deployed through our quantitative market-making and non-client principal trading offset, in part, by lower average revenue capture per U.S. equity dollar value traded.

 

Average revenue capture per U.S. equity dollar value traded was 1.3 bps in 2009, down 12.5% from 1.5 bps in 2008. The primary drivers for the decrease in revenue capture were the profile of our order flow which included a greater percentage of volumes derived from low-priced Nasdaq and Listed stocks, heightened competition, ongoing investments in price improvement and execution quality, and lower volatility. Domestic Equity Trading Revenues were $756.5 million and $721.6 million in 2009 and 2008, respectively. Domestic Equity Trading Revenues do not include revenues from our international and Knight Direct businesses.

 

FICC

 

     For the years ended December 31,              
             2009                     2008             Change     % of Change  

Commissions and fees (millions)

   $ 265.0      $ 78.6      $ 186.4        237.0

Net trading revenue (millions)

     0.9        (0.1     1.0        N/M   

Interest, net (millions)

     (0.7     0.2        (0.9     N/M   

Investment income and other, net (millions)

     1.5        0.6        0.9        153.1
                          

Total Revenues from FICC (millions)

   $ 266.7      $ 79.3      $ 187.4        236.3
                          

Average daily Hotspot FX notional dollar value traded ($ billions)

     22.8        18.4        4.4        23.9

 

N/M—Not meaningful

 

Total revenues from the FICC segment, which primarily comprises Commissions and fees, increased 236.3% to $266.7 million in 2009, from $79.3 million in 2008, primarily due to the inclusion of a full year of revenues from Knight Fixed Income in 2009 compared to a partial year in 2008, due to the closing of the transaction in July of that year as well as increased volumes from Hotspot and Knight BondPoint.

 

Corporate

 

     For the years ended December 31,               
             2009                      2008              Change     % of Change  

Total Revenues from Corporate (millions)

   $ 4.7       $ 8.1       $ (3.4     -41.6

Total Other income from Corporate (millions)

     —           15.9         (15.9     N/M   

 

N/M—Not meaningful

 

Total revenues from the Corporate segment, which primarily represents income from our corporate investments as a limited partner or non-managing member in the Deephaven Funds and other strategic investments, decreased 41.6% to $4.7 million, from $8.1 million in 2008. Losses from our corporate investments in the Deephaven Funds were $2.2 million in 2009 and $28.3 million in 2008. These losses were primarily due to the performance of the Deephaven Funds and lower investment balances in such funds. Our strategic investments had a net gain of $1.8 million in 2009 as compared to a net gain of $45.4 million in 2008, which includes $15.9 million of Non-operating gain from subsidiary stock issuance.

 

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During 2008 we recognized a pre-tax gain of $51.6 million from the partial sale of our investment in Direct Edge. Of the $51.6 million pre-tax gain in 2008, $15.9 million is reported as Non-operating gain from subsidiary stock issuance, and $35.7 million is included in Investment (loss) income and other, net on the Consolidated Statements of Operations.

 

Expenses

 

Employee compensation and benefits expense increased to $527.3 million in 2009 from $331.3 million in 2008. As a percentage of total revenue, Employee compensation and benefits increased to 45.4% in 2009, from 35.3% in 2008. The increase on a dollar basis and as a percentage of total revenues was primarily due to increased headcount and a shift in the mix of our business, with a greater contribution from our voice-related businesses, including Knight Fixed Income, which generally have higher compensation ratios. The number of full time employees from continuing operations increased to 1,126 at December 31, 2009, from 910 at December 31, 2008, primarily due to the growth and expansion in our domestic and international Equities and FICC businesses and infrastructure, including our self-clearing initiative. Employee compensation and benefits expense fluctuates, for the most part, based on changes in our business mix, revenues, profitability and the number of employees.

 

Execution and clearance fees increased 58.1% to $169.8 million in 2009, from $107.4 million in 2008, primarily due to greater trade and share volumes along with higher regulatory fees resulting from higher rates enacted in the second quarter of 2009. As a percentage of total revenue, Execution and clearance fees increased to 14.6% in 2009, from 11.4% in 2008. Execution and clearance fees fluctuate based on changes in transaction volumes, regulatory fees and operational efficiencies and scale.

 

Payments for order flow increased to $71.6 million in 2009, from $43.6 million in 2008. As a percentage of total revenue, Payments for order flow increased to 6.2% in 2009, from 4.6% in 2008. This expense increased primarily due to the increase in shares traded, specifically in low-priced Nasdaq and Listed shares, increased profitability-based rebates paid to broker-dealer clients and heightened competition.

 

Writedown of assets and lease loss accrual (benefit), net was a benefit of $9.7 million in 2009, primarily due to a $13.1 million lease loss reversal recognized with respect to office space at our 545 Washington Boulevard property in Jersey City, N.J. (the “J.C. lease”). We previously considered a portion of these premises to be excess real estate and had therefore recorded a lease loss accrual for such excess office space. Based on expected growth and future needs we decided to build out and occupy the excess office space and we therefore recorded a benefit related to the reversal of such previously recorded lease loss. Also included in Writedown of assets and lease loss accrual (benefit), net is a charge of $2.4 million related to our decision to discontinue the use of the Donaldson trade name, a charge of $0.3 million due to a lease loss with respect to excess office space in New York City and the writedown of $0.7 million of capitalized software resulting from the sale of Hotspot’s retail customer accounts.

 

All other expenses increased by $33.0 million to $170.6 million in 2009 from $137.6 million in 2008. Communications and data processing expense increased primarily due to higher market data and connectivity expenses as a result of our overall growth. Depreciation and amortization expense increased primarily due to fixed asset purchases, greater capitalized software development costs and acquired intangible assets. Occupancy and equipment rentals expense increased primarily due to the costs associated with our international expansion efforts. Professional fees, which have fluctuated based on the activity relating to our various legal proceedings, decreased due to lower legal and consulting expenses. Other expenses increased due to higher employment fees and other administrative expenses.

 

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Our effective tax rate for 2009 from continuing operations of 34.9% differed from the federal statutory rate of 35% primarily due to non-recurring tax benefits relating to the recognition of state net operating losses and the recognition of purchased net operating losses from certain acquisitions that demonstrated a track record of profitability during 2009, offset, by state income taxes and non-deductible charges.

 

Financial Condition, Liquidity and Capital Resources

 

Financial Condition

 

We have historically maintained a highly liquid balance sheet, with a substantial portion of our total assets consisting of cash, highly liquid marketable securities and short term receivables. As of December 31, 2010, we had $4.67 billion in assets, 80.6% of which consisted of cash or assets readily convertible into cash, principally receivables from brokers, dealers and clearing organizations, financial instruments owned and securities borrowed. Receivables from brokers, dealers and clearing organizations include interest bearing cash balances held with third party clearing brokers, including, or net of, amounts related to securities transactions that have not yet reached their contracted settlement date, which is generally within three business days of the trade date. Financial instruments owned principally consist of equity securities that trade on the NYSE, NYSE Amex Equities and NYSE Arca markets, Nasdaq and on the OTC Bulletin Board. Securities borrowed represents the value of cash or other collateral deposited with stock lenders to facilitate the trade settlement process.

 

Other assets primarily represent net deferred tax assets, deposits and other miscellaneous receivables.

 

Total assets increased $1.66 billion, or 54.9%, from $3.01 billion at December 31, 2009 to $4.67 billion at December 31, 2010. The majority of the increase in assets relates to the growth of our trading book and stock borrow and loan activity relating to self-clearing. Securities borrowed increased by $966.6 million, from $394.4 million at December 31, 2009 to $1.36 billion at December 31, 2010, due to increased internal financing as we migrate towards self-clearing and an increase in the matched-book activity within our self-clearing entity. Financial instruments owned increased by $676.6 million, or 73.0%, from $926.6 million at December 31, 2009, to $1.60 billion at December 31, 2010, due to an increase in the size of the securities inventory utilized in our market-making, non-client principal trading activities and trade execution services, loan inventory, and the purchased call options relating to our Notes offering. Our securities inventory fluctuates based on trading volumes, market conditions, trading strategies utilized and our pre-determined risk limits.

 

Total liabilities increased $1.51 billion, or 83.9%, from $1.80 billion at December 31, 2009 to $3.31 billion at December 31, 2010. The majority of the increase in liabilities relates to increases in Financial instruments sold, not yet purchased, Collateralized financings, Payable to brokers, dealers and clearing organizations and Long-term debt offset, in part, by the repayment of our credit facility. Financial instruments sold, not yet purchased increased by $672.1 million, or 105.1%, from $639.3 million at December 31, 2009, to $1.31 billion at December 31, 2010, due to an increase in the size of the securities inventory utilized in our market-making and non-client principal trading activities and for trade execution services as well as the embedded conversion derivative associated with our Notes offering. Our securities inventory fluctuates based on trading volumes, market conditions, trading strategies utilized and our pre-determined risk limits and is consistent with the increase in our long securities position. Collateralized financings increased by $498.5 million, or 90.6%, from $550.2 million at December 31, 2009, to $1.05 billion at December 31, 2010 due to increased lending activity to facilitate transaction settlements and an increase in the matched-book activity within our self-clearing entity. Long-term debt increased to $311.1 million at December 31, 2010 due to the offering of our Notes in March 2010. A portion of the proceeds of the Notes were used to repay our $140.0 million credit facility.

 

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Stockholders’ equity, excluding Noncontrolling interests, increased by $146.7 million, from $1.21 billion at December 31, 2009 to $1.36 billion at December 31, 2010. The increase in stockholders’ equity from December 31, 2009 was primarily a result of earnings, issuance of shares related to business purchases and stock-based compensation activity.

 

Liquidity and Capital Resources

 

We have financed our business primarily through cash generated by operations, the proceeds from our stock issuances and our 2010 Notes offering with a face amount of $375.0 million. At December 31, 2010, we had net current assets, which consist of net assets readily convertible into cash less current liabilities, of approximately $767.6 million.

 

We have acquired several businesses over the last few years. In January 2008, we completed the acquisition of EdgeTrade for $58.2 million comprising $28.2 million in cash and approximately 2.3 million shares of unregistered Knight common stock valued at $30.0 million. In July 2008, we completed the acquisition of Knight Fixed Income’s business for $75.3 million, comprising $50.3 million in cash and approximately 1.5 million shares of unregistered Knight common stock valued at $25.0 million. The terms of the transaction include a potential earn-out of up to $75.0 million of unregistered Knight common stock based on the future performance of Knight Fixed Income during the three-year period following the closing of the transaction. Knight Fixed Income has achieved both its first year and second year performance targets which entitled the sellers to receive a total of approximately $66.6 million of the aforementioned earn-out in the form of unregistered shares of Knight common stock. In July 2010, we completed the acquisition of Urban for $28.4 million, comprising $19.4 million in cash, approximately 350,000 shares of unregistered Knight common stock valued at $5.0 million and a potential earn-out based on future performance valued at $4.0 million. In October, 2010 we completed the acquisition of Astor for $18.0 million, comprising $10.8 million in cash and approximately 579,000 shares of unregistered Knight common stock valued at $7.2 million. In December, 2010 we completed the acquisition of the DMM and LMM business units of Kellogg for $22.5 million in cash. We expect to fund the purchase price of any future acquisitions with our current cash position or, in some cases, through the issuance of our stock or debt.

 

Income from continuing operations before income taxes was $150.0 million, $232.8 million and $333.6 million for 2010, 2009 and 2008, respectively. Included in these amounts were certain non-cash expenses such as stock-based compensation, depreciation, amortization and certain non-cash writedowns. Stock-based compensation was $51.8 million, $48.2 million and $28.1 million during 2010, 2009 and 2008, respectively. Depreciation expense was $13.4 million, $10.8 million, and $7.5 million during 2010, 2009 and 2008, respectively. Amortization expense, which related to software, software development costs, intangible assets and leasehold improvements, was $29.4 million, $23.6 million and $19.0 million during 2010, 2009 and 2008, respectively. Non-cash gains were $15.9 million during 2008, representing non-operating gains from subsidiary stock issuances. Non-cash writedown of assets and lease loss accrual in 2010 was $1.0 million comprising $0.3 million related to our decision to discontinue the use of the Libertas trade name and $0.7 million relating to excess real estate capacity. A net non-cash benefit of $9.7 million in 2009 represents a $13.1 million benefit for the adjustment of a previously recognized lease loss with respect to our Jersey City, N.J. office offset, in part, by a $0.3 million lease loss charge related to a Knight Direct lease, a charge of $2.4 million for the discontinued use of the Donaldson trade name and a writedown of $0.7 million of capitalized software resulting from the sale of Hotspot’s retail customer accounts. Non-cash writedown of $2.5 million in 2008 represents the writedown of the Direct Trading Institutional trade name.

 

Capital expenditures were $48.9 million, $42.2 million and $37.5 million during 2010, 2009 and 2008, respectively. Purchases of investments were $8.0 million, $7.8 million and $13.4 million and distributions from investments were $37.6 million, $64.3 million and $142.2 million during 2010, 2009

 

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and 2008, respectively. During 2008, we received proceeds of $47.5 million relating to the sales of a portion of our interest in Direct Edge. Payments relating to acquisitions of businesses, trading rights and other items, net of cash received were $53.4 million and $77.3 million during 2010 and 2008, respectively. There were no cash payments relating to acquisitions of businesses in 2009.

 

In March 2010, we issued Notes with a face amount of $375.0 million in a private offering. Net proceeds from the offering were $167.5 million, which included $15.0 million from the sale of warrants, less $140.5 million for the termination and required repayment of the borrowings under our Credit Agreement (defined below) including accrued interest, $73.7 million for the purchase of call options and $8.5 million of offering expenses. The Notes bear interest at a rate of 3.5% per year, payable semi-annually in arrears, on March 15 and September 15 of each year, commencing on September 15, 2010 and will mature on March 15, 2015, subject to earlier repurchase or conversion. In 2010, we recognized interest expense related to the Notes of $20.1 million. See Footnote 9 “Long-Term Debt and Credit Facility,” included in Part II, Item 8 “Financial Statements and Supplementary Data” of this Form 10-K for further information.

 

In October 2007, we entered into a three-year $140.0 million credit agreement (“Credit Agreement”) with a consortium of banks. The Credit Agreement included a three-year delayed-draw senior secured term loan facility of $70.0 million and a three-year senior secured revolving facility of $70.0 million for which we had borrowed the full $140.0 million. The proceeds of the borrowings under the Credit Agreement were used to finance share repurchases, finance selective acquisitions and for general corporate purposes. The Credit Agreement was paid off and terminated with the proceeds of the Notes offering in March 2010.

 

We have an authorized stock repurchase program of $1 billion. We repurchased 3.4 million shares for $47.0 million under the stock repurchase program during 2010. Through December 31, 2010, we had repurchased 71.7 million shares for $817.4 million under this program. We may repurchase shares from time to time in open market transactions, accelerated stock buyback programs, tender offers, privately negotiated transactions or by other means. Repurchases may also be made under Rule 10b5-1 plans. The timing and amount of repurchase transactions will be determined by our management based on its evaluation of market conditions, share price, legal requirements and other factors. The program may be suspended, modified or discontinued at any time without prior notice. We caution that there are no assurances that any further repurchases will actually occur. We had 97.7 million shares of Class A Common Stock outstanding as of December 31, 2010.

 

Our U.S. registered broker-dealers are subject to regulatory requirements intended to ensure the general financial soundness and liquidity of broker-dealers and require the maintenance of minimum levels of net capital, as defined in SEC Rule 15c3-1. These regulations also prohibit a broker-dealer from repaying subordinated borrowings, paying cash dividends, making loans to its parent, affiliates or employees, or otherwise entering into transactions which would result in a reduction of its total net capital to less than 120% of its required minimum capital. Moreover, broker-dealers are required to notify the SEC and other regulators prior to repaying subordinated borrowings, paying dividends and making loans to its parent, affiliates or employees, or otherwise entering into transactions, which, if executed, would result in a reduction of 30% or more of its excess net capital (net capital less minimum requirement). The SEC has the ability to prohibit or restrict such transactions if the result is detrimental to the financial integrity of the broker-dealer.

 

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The following table sets forth the net capital levels and requirements for the following significant domestic regulated broker-dealer subsidiaries at December 31, 2010, as reported in their respective regulatory filings (in millions):

 

Entity

   Net
Capital
     Net Capital
Requirement
     Excess Net Capital  

KCS

   $ 84.2       $ 1.0       $ 83.2   

KEM

     70.2         1.0         69.2   

KCM

     62.2         1.0         61.2   

Knight Direct

     22.8         0.3         22.5   

Knight Libertas

     11.5         3.4         8.1   

 

Our foreign registered broker-dealers are subject to certain financial resource requirements of either the FSA or the SFC. The following table sets forth the financial resource requirement for the following significant foreign regulated broker-dealer at December 31, 2010 (in millions):

 

Entity

   Financial
Resources
     Resource
Requirement
     Excess
Financial
Resources
 

KCEL

   $ 131.0       $ 32.7       $ 98.3   

 

Contractual Obligations

 

In connection with our operating activities, we enter into certain contractual obligations. Our future cash payments associated with our contractual obligations pursuant to operating leases, net of sublease obligations and guaranteed employment contracts longer than one year as of December 31, 2010 are summarized below (in millions):

 

     Payments due in:  
     2011      2012-2013      2014-2015      Thereafter through
August 31, 2023
     Total  

Operating lease obligations1

   $ 20.2       $ 40.9       $ 36.5       $ 112.8       $ 210.5   

Other obligations1

     62.5         19.5         —           —           82.0   
                                            

Total

   $ 82.7       $ 60.4       $ 36.5       $ 112.8       $ 292.5   
                                            

 

1  -  See Footnote 17, “Commitments and Contingent Liabilities” to the Consolidated Financial Statements

Totals   may not add due to rounding.

 

Knight Capital Group, Inc. also has provided, and may in the future provide, in the ordinary course of business, unsecured guarantees to guarantee the payment obligations of certain of its subsidiaries under trading, repurchase, financing and stock loan arrangements, as well as under certain leases.

 

Off-Balance Sheet Arrangements

 

As of December 31, 2010, we did not have any off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of SEC Regulation S-K.

 

Effects of Inflation

 

Because the majority of our assets are liquid in nature, they are not significantly affected by inflation. However, the rate of inflation may affect our expenses, such as employee compensation,

 

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office leasing costs and communications expenses, which may not be readily recoverable in the prices of the services offered by us. To the extent inflation results in rising interest rates and has other adverse effects on the securities markets, it may adversely affect our financial position and results of operations.

 

Discontinued Operations

 

Deephaven Capital Management LLC and its subsidiaries (collectively, “Deephaven”) was formerly the registered investment adviser to, and sponsor of, the Deephaven investment funds (the “Deephaven Funds”). Prior to February 1, 2008, Deephaven was a wholly-owned subsidiary. On February, 1, 2008, we contributed our interest in Deephaven to Deephaven Capital Management Holdings LLC (“Deephaven Holdings”) in exchange for a 51% interest in Deephaven Holdings. Certain Deephaven managers (“Deephaven Managers”) acquired a 49% interest in Deephaven Holdings in exchange for the termination of their employment agreements and associated profit sharing bonuses and an equity contribution.

 

On January 27, 2009, Deephaven entered into an Asset Purchase Agreement along with Deephaven Managing Partners, LLC, the Company, and each of the Deephaven Managers to sell substantially all of Deephaven’s assets to Stark & Roth, Inc. (together with its affiliates, “Stark”) with Stark agreeing to assume certain limited liabilities of Deephaven.

 

On March 31, 2009, Deephaven completed the sale of substantially all of its assets to Stark. As of that date, Deephaven was replaced by Stark as the investment manager, managing member and general partner for the Deephaven Funds. As a result of this sale, Deephaven was classified as a discontinued operation.

 

Critical Accounting Estimates

 

Our Consolidated Financial Statements are based on the application of GAAP which requires us to make estimates and assumptions about future events that affect the amounts reported in our financial statements and the accompanying notes. Future events and their effects cannot be determined with certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results could differ from those estimates and any such differences may be material to our Consolidated Financial Statements. We believe that the estimates set forth below may involve a higher degree of judgment and complexity in their application than our other accounting estimates and represent the critical accounting estimates used in the preparation of our consolidated financial statements. We believe our judgments related to these accounting estimates are appropriate. However, if different assumptions or conditions were to prevail, the results could be materially different from the amounts recorded.

 

Financial Instruments and Fair Value—We value our financial instruments using a hierarchy of fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs when measuring fair value.

 

The fair value hierarchy can be summarized as follows:

 

   

Level 1—Valuations based on quoted prices in active markets for identical assets or liabilities that we have the ability to access. Since valuations are based on quoted prices that are readily and regularly available in an active market, valuation of these products does not entail a significant degree of judgment.

 

   

Level 2—Valuations based on quoted prices in markets that are not active or for which all significant inputs are observable, either directly or indirectly.

 

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Level 3—Valuations based on inputs that are unobservable and significant to the overall fair value measurement.

 

Changes in fair value are recognized in earnings each period for financial instruments that are carried at fair value.

 

The majority of our financial instruments owned and financial instruments sold, not yet purchased are classified within Level 1 of the fair value hierarchy because they are valued using quoted market prices or broker or dealer quotations with reasonable levels of price transparency.

 

The types of instruments that trade in markets that are not considered to be active, but are valued based on observable inputs such as quoted market prices or alternative pricing sources with reasonable levels of price transparency, are generally classified within Level 2 of the fair value hierarchy.

 

As discussed in Footnote 9 “Long-Term Debt and Credit Facility,” we entered into purchased call options and recorded an embedded conversion derivative concurrent with our issuance of long-term debt. The fair value of these options and derivative are determined using an option pricing model based on observable inputs such as implied volatility of our common stock, risk-free interest rate, and other factors and, as such, are classified within Level 2 of the fair value hierarchy.

 

As of December 31, 2010, our loans inventory, foreign currency forward contracts, investment in the Deephaven Funds, deferred compensation investments and certain mortgage-backed securities are also classified within Level 2.

 

Certain instruments are classified within Level 3 of the fair value hierarchy because they trade infrequently and therefore have little or no price transparency. For those instruments that are not traded in active markets or are subject to transfer restrictions, valuations are adjusted to reflect illiquidity and/or non-transferability, and such adjustments are generally based on available market evidence. In the absence of such evidence, management’s best estimate is used. As of December 31, 2010, we did not hold any financial instruments that met the definition of Level 3.

 

We have elected to account for our loan inventory associated with the Urban business at fair value, as these assets are generally not held to maturity and we believe that fair value better reflects the economics of these loan transactions.

 

Goodwill and Intangible Assets—As a result of our various acquisitions, we have acquired goodwill and identifiable intangible assets. We determine the values and useful lives of intangible assets upon acquisition. Goodwill is the cost of acquired companies in excess of the fair value of net assets, including identifiable intangible assets, at the acquisition date. We test goodwill and the useful lives of intangible assets for impairment at least annually or when an event occurs or circumstances change that signifies the existence of impairment.

 

Goodwill

 

Goodwill of $338.7 million at December 31, 2010 primarily relates to our Equities and FICC segments. Goodwill primarily represents purchases of the businesses now operating as Knight Direct in our Equities segment and Hotspot, Knight BondPoint, Knight Fixed Income and Urban in our FICC segment. We test the goodwill in each of our operating segments for impairment at least annually by comparing the estimated fair value of each segment with its estimated net book value. We derive the

 

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fair value of each of our operating segments based on valuation techniques we believe market participants would use for each segment (observable price-to-book multiples and discounted cash flow analyses) and we derive the net book value of our operating segments by estimating the amount of shareholders’ equity required to support the activities of each operating segment. As part of our test for impairment, we also consider the profitability of the applicable reporting unit as well as the overall market value of the Company, compared to the Company’s book value. We performed our annual test for impairment of goodwill in the second quarter of 2010 and determined that goodwill was not impaired at that time. We believe there was no impairment of our goodwill at December 31, 2010.

 

Intangible Assets

 

Intangible assets with definite lives are amortized over their respective lives. Intangible assets, less accumulated amortization, of $109.8 million at December 31, 2010 are primarily attributable to our Equities and FICC segments. Substantially all intangible assets resulted from the purchases of the businesses now operating as Knight Direct, Hotspot, Knight BondPoint, Knight Fixed Income and Urban. We amortize these assets, which primarily consist of customer relationships on a straight-line basis over their useful lives, the majority of which have been determined to range from four to 24 years. We performed our annual test for impairment of intangible assets with definitive lives in the second quarter of 2010. We test amortizable intangibles for recoverability whenever events indicate that the carrying amounts may not be recoverable. During the second quarters of 2010 and 2009, we discontinued the use of the Libertas and Donaldson trade names, respectively. No other events occurred in 2010 or 2009 that would indicate that the carrying amounts of our amortizable intangible assets may not be recoverable, and we do not believe that our intangible assets were impaired at December 31, 2010.

 

Investments—Investments comprise strategic investments, deferred compensation investments and investment in the Deephaven Funds. Strategic investments include noncontrolling equity ownership interests and debt instruments held by us within our non-broker-dealer subsidiaries, primarily in financial services-related businesses. Strategic investments are accounted for under the equity method, at cost or at fair value. We used the equity method of accounting where we are considered to exert significant influence on the investee. We hold strategic investments at cost, less impairment if any, when we are not considered to exert significant influence on operating and financial policies of the investee. We account for our deferred compensation investments in mutual funds and the investment in the Deephaven Funds at fair value.

 

We review investments on an ongoing basis to ensure that the carrying values of the investments have not been impaired. If we assess that an impairment loss on a strategic investment has occurred due to a decline in fair value or other market conditions, we write the investment down to its estimated impaired value.

 

We have several deferred compensation plan investments related to certain employees and directors. These plans provide a return to the participants based upon the performance of various investments. In order to hedge our liability under these plans, we generally acquire the underlying investments and hold such investments until the deferred compensation liabilities are satisfied. We record changes in value of such investments in Investment (loss) income and other, net, with a corresponding charge or credit to Employee compensation and benefits on the Consolidated Statements of Operations.

 

Market-Making, Trading and Sales Activities—Financial instruments owned and Financial instruments sold, not yet purchased, which primarily consist of listed and OTC equities, are carried at fair value and are recorded on a trade date basis. Net trading revenue (trading gains, net of trading

 

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losses) and commissions (which includes commission equivalents earned on institutional client orders) and related expenses are also recorded on a trade date basis. Our third party clearing agreements call for payment or receipt of interest income, net of transaction-related interest charged by clearing brokers for facilitating the settlement and financing of securities transactions.

 

Dividend income relating to securities owned and dividend expense relating to securities sold, not yet purchased, derived from our market-making activities are included as a component of Net trading revenue on our Consolidated Statements of Operations.

 

Lease Loss Accrual—It is our policy to identify excess real estate capacity and where applicable, accrue for related future costs, net of estimated sublease income. In determining the accrual, we perform a nominal cash flow analysis for lease losses initiated prior to December 31, 2002 and we accrue costs related to the excess capacity. For lease losses initiated after December 31, 2002, our policy is to accrue future costs related to excess capacity using a discounted cash flow analysis.

 

Other Estimates—The preparation of financial statements in conformity with GAAP requires management to make certain estimates and assumptions. In addition to the estimates that we make in connection with accounting for the items noted above, the use of estimates is also important in determining provisions for potential losses that may arise from litigation, regulatory proceedings and tax audits.

 

When determining stock-based employee compensation expense, we make certain estimates and assumptions relating to volatility and forfeiture rates. We estimate volatility based on several factors including implied volatility of market-traded options on our common stock on the grant date and the historical volatility of our common stock. We estimate forfeiture rates based on historical rates of forfeiture of employee stock awards.

 

A portion of our Employee compensation and benefits expense on the Consolidated Statements of Operations represents discretionary bonuses, which are accrued for throughout the year and paid after the end of the year. Among many factors, discretionary bonus accruals are generally influenced by our overall performance and competitive industry compensation levels.

 

We estimate and accrue for potential losses that may arise out of litigation and regulatory proceedings to the extent that such losses are probable and can be estimated. Significant judgment is required in making these estimates and our final liabilities may ultimately be materially different. Our total liability accrued with respect to litigation and regulatory proceedings is determined on a case-by-case basis and represents an estimate of probable losses based on, among other factors, the progress of each case, our experience and industry experience with similar cases and the opinions and views of internal and external legal counsel. Given the inherent difficulty of predicting the outcome of our litigation and regulatory matters, particularly in cases or proceedings in which substantial or indeterminate damages or fines are sought, or where cases or proceedings are in the early stages, we cannot estimate losses or ranges of losses for cases or proceedings where there is only a reasonable possibility that a loss may be incurred. For more information on our legal and regulatory matters, see “Legal Proceedings” in Part I, Item 3 included in this document.

 

Accounting Standards Updates

 

In July, 2009, the Financial Accounting Standards Board (“FASB”) issued The FASB Accounting Standards Codification (the “Codification”). The Codification became the source of authoritative U.S. GAAP recognized by the FASB for nongovernmental entities. Rules and interpretive releases of the SEC under authority of federal securities laws are also sources of authoritative GAAP to the Company. The FASB will no longer issue new standards in the form of Statements, FASB Staff Positions or

 

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Emerging Issues Task Force Abstracts; instead the FASB will issue Accounting Standards Updates (“ASU”). The issuance of the Codification did not change GAAP and was effective for reporting periods ending after September 15, 2009. The implementation of the Codification did not have any impact on our Consolidated Financial Statements.

 

Effective January 1, 2010, we adopted two ASUs, which were issued by the FASB. The first ASU requires a reporting entity to disclose separately the amounts of transfers in and out of Level 1 and Level 2 fair value measurements and describe the reasons for the transfers. This ASU also clarifies existing disclosure requirements related to how assets and liabilities should be grouped by class and valuation techniques used for recurring and nonrecurring fair value measurements. Certain disclosure requirements of this ASU were effective for us beginning in the first quarter of 2010, while other disclosure requirements of this ASU are effective for financial statements issued for reporting periods beginning after December 15, 2010. Since these amended principles require only additional disclosures concerning fair value measurements, adoption did not and will not affect our Consolidated Financial Statements.

 

The second ASU relates to the accounting for a variable interest entity (“VIE”). This ASU significantly changed the criteria by which an enterprise determines whether or not it must consolidate a VIE. Under the new guidance, consolidation of a VIE requires both the power to direct the activities that most significantly impact the VIE’s economic performance and the obligation to absorb losses of the VIE that could potentially be significant to the VIE or the right to receive benefits of the VIE that could potentially be significant to the VIE. The adoption of this ASU had no impact on our Consolidated Financial Statements.

 

Item 7A.    Quantitative and Qualitative Disclosures About Market Risk

 

For a further discussion of these and other important factors that could affect our business, see Part I, Item 1A, “Risk Factors” of this Annual Report on Form 10-K.

 

Market Risk

 

Our market-making and trading activities expose our capital to significant risks. These risks include, but are not limited to, absolute and relative price movements, price volatility and changes in liquidity, over which we have virtually no control.

 

For working capital purposes, we invest in money market funds and government securities or maintain interest-bearing balances at banks and in our trading accounts with clearing brokers, which are classified as Cash and cash equivalents and Receivable from brokers, dealers and clearing organizations, respectively, on the Consolidated Statements of Financial Condition. These financial instruments do not have maturity dates or present a material market risk, as the balances are short-term in nature and subject to daily repricing. Our cash and cash equivalents held in foreign currencies are subject to the exposure of foreign currency fluctuations. These balances are monitored daily and are not material to our overall cash position.

 

We employ proprietary position management and trading systems that provide real-time, on-line position management and inventory control. We monitor our risks by reviewing trading positions and their appropriate risk measures. We have established a system whereby transactions are monitored by senior management and an independent risk control function on a real-time basis as are individual and aggregate dollar and inventory position totals, capital allocations, and real-time profits and losses. Our management of trading positions is enhanced by our review of mark-to-market valuations and position summaries on a daily basis.

 

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In the normal course of business, we maintain inventories of exchange-listed and OTC equity securities, and to a significantly lesser extent, loans, listed equity options and fixed income products. The fair value of these financial instruments at December 31, 2010 and 2009 was $1.53 billion and $923.1 million, respectively, in long positions and $1.27 billion and $639.3 million, respectively, in short positions. The potential change in fair value, using a hypothetical 10% decline in prices, is estimated to be a loss of $26.1 million and $28.4 million as of December 31, 2010 and 2009, respectively, due to the offset of gains in short positions with the losses in long positions. The following table illustrates, for the period indicated, our average, highest and lowest month-end inventory at market value (based on both the aggregate and the net of the long and short positions of financial instruments (in millions):

 

    2010     2009     2008  
    Aggregate of
Long and Short
Positions
    Net of
Long  and
Short
Positions
    Aggregate of
Long  and

Short
Positions
    Net of
Long  and
Short
Positions
    Aggregate of
Long  and

Short
Positions
    Net of
Long  and
Short
Positions
 

Average month-end

  $ 2,258.9      $ 143.1      $ 1,514.0      $ 232.9      $ 899.1      $ 107.6   

Highest month-end

    2,793.1        311.7        1,727.6        283.8        1,015.3        198.8   

Lowest month-end

    1,725.7        29.1        1,185.4        207.7        775.4        14.2   

 

Operational Risk

 

Operational risk can arise from many factors ranging from routine processing errors to potentially costly incidents arising, for example, from major systems failures. We incur operational risk across all of our business activities, including revenue generating activities as well as support functions. Legal and compliance risk is included in the scope of operational risk and is discussed below under “Legal Risk.”

 

Primary responsibility for the management of operational risk lies with our operating segments and supporting functions. Our operating segments maintain controls designed to manage and mitigate operational risk for existing activities. As new products and business activities are developed, we identify operational risks and design controls to mitigate the identified risks.

 

Disaster recovery plans are in place for critical facilities related to our primary operations and resources and redundancies are built into the systems as deemed appropriate. We have also established policies, procedures and technologies to protect our systems and other assets from unauthorized access.

 

Legal Risk

 

Legal risk includes the risk of non-compliance with applicable legal and regulatory requirements and standards. Legal risk also includes contractual and commercial risk such as the risk that counterparty’s performance obligations will be unenforceable. We are generally subject to extensive regulation in the different jurisdictions in which we conduct our business (see “Government Regulation and Market Structure” in Part I, Item 1). We have established procedures based on legal and regulatory requirements that are designed to foster compliance with applicable statutory and regulatory requirements. We have also established procedures that are designed to require that our policies relating to conduct, ethics and business practices are followed.

 

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Consolidated Quarterly Results

 

The following table sets forth certain unaudited consolidated quarterly statement of operations data for 2010 and 2009. In the opinion of management, this unaudited information has been prepared on substantially the same basis as the Consolidated Financial Statements appearing elsewhere in this document and includes all adjustments (consisting of normal recurring adjustments) necessary for a fair statement of the unaudited consolidated quarterly data. The unaudited consolidated quarterly data should be read in conjunction with the audited Consolidated Financial Statements and notes thereto appearing elsewhere in this document. The results of any quarter are not necessarily indicative of results for any future period.

 

    Quarter Ended*  
    Dec. 31,
2010
    Sept. 30,
2010
    Jun. 30,
2010
    Mar. 31,
2010
    Dec. 31,
2009
    Sept. 30,
2009
    Jun. 30,
2009
    Mar. 31,
2009
 
    (in thousands, except per share amounts)  

Revenues

               

Commissions and fees

  $ 165,901      $ 157,121      $ 177,992      $ 159,513      $ 166,874      $ 177,025      $ 175,797      $ 150,710   

Net trading revenue

    96,619        79,847        187,964        124,964        132,225        119,595        135,405        99,460   

Interest, net

    1,240        92        137        624        975        (1,050     (1,041     (597

Investment (loss) income and other, net

    (4,727     2,449        181        (862     3,206        4,360        3,706        (4,219
                                                               

Total revenues

    259,033        239,509        366,274        284,239        303,280        299,930        313,867        245,354   
                                                               

Expenses

               

Employee compensation and benefits

    133,972        115,730        158,695        138,350        143,192        139,334        135,614        109,187   

Execution and clearance fees

    41,966        44,167        47,521        42,462        47,852        50,430        42,432        29,091   

Communications and data processing

    19,287        17,180        17,071        16,058        17,221        15,781        14,281        13,788   

Depreciation and amortization

    12,435        11,269        9,834        9,235        9,145        8,777        8,260        8,187   

Payments for order flow

    8,987        6,598        11,089        11,025        13,816        17,737        23,047        17,027   

Interest

    8,785        7,501        7,137        2,474        2,108        713        974        981   

Occupancy and equipment rentals

    7,300        6,630        6,361        6,341        5,997        5,930        5,890        5,361   

Professional fees

    4,701        3,976        4,033        4,753        3,633        3,410        3,098        2,902   

Business development

    4,502        4,451        6,312        4,228        5,310        4,058        5,093        4,346   

Restructuring

    —          16,731        —          —          —          —          —          —     

Writedown of assets and lease loss accrual (benefit), net

    —          —          1,032        —          292        —          (10,695     699   

Other

    4,331        5,163        6,061        3,355        3,587        4,003        4,981        2,756   
                                                               

Total expenses

    246,266        239,396        275,146        238,281        252,153        250,173        232,975        194,325   
                                                               

Income from continuing operations before income taxes

    12,767        113        91,128        45,958        51,127        49,757        80,892        51,029   

Income tax expense

    3,391        45        36,693        17,840        7,829        19,278        32,934        21,148   
                                                               

Income from continuing operations, net of tax

    9,376        68        54,435        28,118        43,298        30,479        47,958        29,881   

(Loss) income from discontinued operations, net of tax

    (144     135        (44     (306     (286     (1,253     (12,460     (20,514
                                                               

Net income

  $ 9,232      $ 203      $ 54,391      $ 27,812      $ 43,012      $ 29,226      $ 35,498      $ 9,367   
                                                               

Diluted earnings per share from continuing operations

  $ 0.10      $ —        $ 0.58      $ 0.30      $ 0.46      $ 0.32      $ 0.52      $ 0.33   
                                                               

Diluted earnings per share from discontinued operations

  $ —        $ —        $ —        $ —        $ —        $ (0.01   $ (0.13   $ (0.23
                                                               

Diluted earnings per share

  $ 0.10      $ —        $ 0.58      $ 0.30      $ 0.46      $ 0.31      $ 0.39      $ 0.10   
                                                               

 

*   Quarterly totals may not add to full year due to rounding.

 

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Item 8.    Financial Statements and Supplementary Data

 

KNIGHT CAPITAL GROUP, INC.

 

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

 

     Page  

Management’s Report on Internal Control over Financial Reporting

     55   

Report of Independent Registered Public Accounting Firm

     56   

Consolidated Statements of Financial Condition as of December 31, 2010 and 2009

     57   

Consolidated Statements of Operations for the years ended December 31, 2010, 2009 and 2008

     58   

Consolidated Statements of Changes in Equity for the years ended December 31, 2010, 2009 and 2008

     59   

Consolidated Statements of Comprehensive Income for the years ended December 31, 2010, 2009 and 2008

     60   

Consolidated Statements of Cash Flows for the years ended December 31, 2010, 2009 and 2008

     61   

Notes to Consolidated Financial Statements

     62   

 

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MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

 

Knight Capital Group, Inc.’s (“Knight”) management is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is defined in Rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended, as a process designed by, or under the supervision of, the Company’s principal executive and principal financial officers and effected by the Company’s board of directors, management and other personnel 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 and includes those policies and procedures that:

 

   

pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of Knight;

 

   

provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of Knight; and

 

   

provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risks that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

Management assessed the effectiveness of Knight’s internal control over financial reporting as of December 31, 2010. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control—Integrated Framework.

 

Based on our assessment, Knight’s management has concluded that, as of December 31, 2010, internal control over financial reporting is effective.

 

The effectiveness of Knight’s internal control over financial reporting as of December 31, 2010 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report which appears herein.

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Board of Directors and the Shareholders of

Knight Capital Group, Inc.:

 

In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Knight Capital Group, Inc. and its subsidiaries (the “Company”) at December 31, 2010 and December 31, 2009, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2010 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements and maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Report on Internal Control over Financial Reporting appearing on page 55. Our responsibility is to express opinions on these financial statements and on the Company’s internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

 

A company’s internal control over financial reporting is a process designed 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. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

PRICEWATERHOUSECOOPERS LLP

 

New York, New York

March 1, 2011

 

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KNIGHT CAPITAL GROUP, INC.

 

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

 

     December 31,  
     2010     2009  
     (In thousands)  
Assets     

Cash and cash equivalents

   $ 375,569      $ 427,106   

Financial instruments owned, at fair value, including securities pledged of $812,379 in 2010 and $212,425 in 2009

     1,603,139        926,589   

Collateralized agreements:

    

Securities borrowed

     1,361,010        394,417   

Receivable from brokers, dealers and clearing organizations

     476,159        500,143   

Fixed assets and leasehold improvements, at cost, less accumulated depreciation and amortization of $118,552 in 2010 and $128,045 in 2009

     117,601        98,696   

Investments

     81,331        118,619   

Goodwill

     338,743        265,530   

Intangible assets, less accumulated amortization of $51,141 in 2010 and $38,018 in 2009

     109,784        93,332   

Other assets

     206,875        189,592   
                

Total assets

   $ 4,670,211      $ 3,014,024   
                
Liabilities & Equity     

Liabilities

    

Financial instruments sold, not yet purchased, at fair value

   $ 1,311,324      $ 639,259   

Collateralized financings:

    

Securities loaned

     527,945        550,226   

Financial instruments sold under agreement to repurchase

     485,184        —     

Other secured financings

     35,583        —     

Payable to brokers, dealers and clearing organizations

     337,430        155,148   

Accrued compensation expense

     186,451        205,282   

Accrued expenses and other liabilities

     114,376        109,987   

Credit facility

     —          140,000   

Long-term debt

     311,060        —     
                

Total liabilities

     3,309,353        1,799,902   
                

Commitments and contingent liabilities (Note 17)

    

Equity

    

Knight Capital Group, Inc. stockholders’ equity

    

Class A common stock

    

Shares authorized: 500,000 at December 31, 2010 and at December 31, 2009; Shares issued: 162,818 at December 31, 2010 and 158,641 at December 31, 2009; Shares outstanding: 97,736 at December 31, 2010 and 92,791 at December 31, 2009

     1,628        1,586   

Additional paid-in capital

     807,287        746,778   

Retained earnings

     1,317,462        1,229,112   

Treasury stock, at cost; 65,082 at December 31, 2010 and 65,850 shares at December 31, 2009

     (765,875     (763,974

Accumulated other comprehensive loss

     (265     —     
                

Total Knight Capital Group, Inc. stockholders’ equity

     1,360,237        1,213,502   

Noncontrolling interests

     621        620   
                

Total equity

     1,360,858        1,214,122   
                

Total liabilities and equity

   $ 4,670,211      $ 3,014,024   
                

 

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

 

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KNIGHT CAPITAL GROUP, INC.

 

CONSOLIDATED STATEMENTS OF OPERATIONS

 

     For the years ended December 31,  
     2010     2009     2008  
    

(In thousands, except per share

amounts)

 

Revenues

      

Commissions and fees

   $ 660,527      $ 670,406      $ 478,126   

Net trading revenue

     489,394        486,684        446,707   

Interest, net

     2,092        (1,712     7,644   

Investment (loss) income and other, net

     (2,957     7,053        6,380   
                        

Total revenues

     1,149,056        1,162,431        938,857   
                        

Expenses

      

Employee compensation and benefits

     546,748        527,327        331,311   

Execution and clearance fees

     176,116        169,805        107,402   

Communications and data processing

     69,597        61,071        45,359   

Depreciation and amortization

     42,773        34,368        26,535   

Payments for order flow

     37,700        71,629        43,639   

Occupancy and equipment rentals

     26,632        23,177        19,642   

Interest

     25,896        4,777        5,052   

Business development

     19,493        18,807        17,279   

Professional fees

     17,463        13,043        14,749   

Writedown of assets and lease loss accrual (benefit), net

     1,032        (9,704     1,236   

Restructuring

     16,731        —          —     

Other

     18,909        15,326        8,969   
                        

Total expenses

     999,090        929,626        621,173   
                        

Other Income

      

Non-operating gain from subsidiary stock issuance

     —          —          15,947   
                        

Income from continuing operations before income taxes

     149,966        232,805        333,631   

Income tax expense

     57,969        81,189        139,921   
                        

Income from continuing operations, net of tax

     91,997        151,616        193,710   

Loss from discontinued operations, net of tax

     (359     (34,514     (15,799
                        

Net income

   $ 91,638      $ 117,102      $ 177,911   
                        

Basic earnings per share from continuing operations

   $ 1.02      $ 1.70      $ 2.19   
                        

Diluted earnings per share from continuing operations

   $ 0.97      $ 1.60      $ 2.11   
                        

Basic earnings per share from discontinued operations

   $ (0.00   $ (0.39   $ (0.18
                        

Diluted earnings per share from discontinued operations

   $ (0.00   $ (0.37   $ (0.17
                        

Basic earnings per share

   $ 1.02      $ 1.31      $ 2.01   
                        

Diluted earnings per share

   $ 0.97      $ 1.24      $ 1.94   
                        

Shares used in computation of basic earnings per share

     90,167        89,095        88,407   
                        

Shares used in computation of diluted earnings per share

     94,447        94,504        91,760   
                        

 

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

 

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KNIGHT CAPITAL GROUP, INC.

 

CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY

 

For the Years Ended December 31, 2008, 2009 and 2010

(In thousands)

 

    Knight Capital Group, Inc. Stockholders’ Equity     Non-
controlling
Interests
    Total
Equity
 
    Class A
Common Stock
    Additional
Paid-In
Capital
    Retained
Earnings
    Treasury Stock     Accumulated
Other
Comprehensive
Loss
    Total      
    Shares     Amount         Shares     Amount          

Balance, January 1, 2008

    150,801      $ 1,509      $ 587,025      $ 934,099        (59,265   $ (637,255     —        $ 885,378      $ —        $ 885,378   

Capital contribution from noncontrolling interests

    —          —          —          —          —          —          —          —          1,000        1,000   

Net income

    —          —          —          177,911        —          —          —          177,911        —          177,911   

Net income attributable to noncontrolling interests related to discontinued operations

    —          —          —          —          —          —          —          —          6,178        6,178   

Common stock repurchased

    —          —          —          —          (8,756     (138,229     —          (138,229     —          (138,229

Reissuance of treasury shares

    —          —          14,428        —          3,738        40,572        —          55,000        —          55,000   

Stock options exercised

    1,187        11        10,349        —          —          —          —          10,360        —          10,360   

Income tax benefit—stock based compensation

    —          —          6,117        —          —          —          —          6,117        —          6,117   

Stock-based compensation

    2,416        24        30,797        —          —          —          —          30,821        —          30,821   
                                                                               

Balance, December 31, 2008

    154,404      $ 1,544      $ 648,716      $ 1,112,010        (64,283   $ (734,912   $ —        $ 1,027,358      $ 7,178      $ 1,034,536   
                                                                               

Net income

    —          —          —          117,102        —          —          —          117,102        —          117,102   

Net loss attributable to noncontrolling interests related to discontinued operations

    —          —          —          —          —          —          —          —          (380     (380

Distribution to noncontrolling interests

    —          —          —          —          —          —          —          —          (6,178     (6,178

Common stock repurchased

    —          —          —          —          (1,946     (33,412     —          (33,412     —          (33,412

Reissuance of treasury shares

    —          —          2,201        —          378        4,350        —          6,551        —          6,551   

Stock options exercised

    1,083        11        11,010        —          —          —          —          11,021        —          11,021   

Income tax benefit—stock based compensation

    —          —          4,374        —          —          —          —          4,374        —          4,374   

Stock-based compensation

    3,154        31        80,477        —          —          —          —          80,508        —          80,508   
                                                                               

Balance, December 31, 2009

    158,641      $ 1,586      $ 746,778      $ 1,229,112        (65,850   $ (763,974   $ —        $ 1,213,502      $ 620      $ 1,214,122   
                                                                               

Net income

    —          —          —          91,638        —          —          —          91,638        —          91,638   

Net income attributable to noncontrolling interests related to discontinued operations

    —          —          —          —          —          —          —          —          1        1   

Common stock repurchased

    —          —          —          —          (4,254     (60,090     —          (60,090     —          (60,090

Warrants issued

    —          —          15,000        —          —          —          —          15,000        —          15,000   

Reissuance of treasury shares

    —          —          23,778        —          5,022        58,189        —          81,967        —          81,967   

Stock options exercised

    590        6        5,778        —          —          —          —          5,784        —          5,784   

Income tax provision—stock based compensation

    —          —          (2,760     —          —          —          —          (2,760     —          (2,760

Cummulative translation adjustment

    —          —          —          (3,288     —          —          (265     (3,553     —          (3,553

Stock-based compensation

    3,587        36        18,713        —          —          —          —          18,749        —          18,749   
                                                                               

Balance, December 31, 2010

    162,818      $ 1,628      $ 807,287      $ 1,317,462        (65,082   $ (765,875   $ (265   $ 1,360,237      $ 621      $ 1,360,858   
                                                                               

 

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

 

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KNIGHT CAPITAL GROUP, INC.

 

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

 

     For the years ended December 31,  
     2010     2009      2008  
           (In thousands)         

Net Income

   $ 91,638      $ 117,102       $ 177,911   

Other comprehensive loss:

       

Cumulative translation adjustment

     (265     —           —     
                         

Comprehensive income

   $ 91,373      $ 117,102       $ 177,911   
                         

 

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

 

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KNIGHT CAPITAL GROUP, INC.

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

     For the years ended
December 31,
 
     2010     2009     2008  
     (In thousands)  

Cash flows from operating activities

      

Net income

   $ 91,638      $ 117,102      $ 177,911   

Loss from discontinued operations, net of tax

     (359     (34,514     (15,799
                        

Income from continuing operations, net of tax

     91,997        151,616        193,710   

Adjustments to reconcile income from continuing operations, net of tax to net cash (used in) provided by operating activities

      

Stock-based compensation

     51,773        48,237        28,098   

Depreciation and amortization

     42,773        34,368        26,535   

Debt discount accretion and other debt related expenses

     11,453        —          —     

Deferred income taxes

     (8,400     (5,332     6,773   

Deferred rent

     4,761        1,242        1,222   

Writedown of assets and lease loss accrual (benefit), net

     1,032        (9,704     1,236   

Unrealized loss (gain) on investments

     7,720        (2,650     37,357   

Realized gain from sale of investments

     —          —          (35,635

Non-operating gain from subsidiary stock issuance

     —          —          (15,947

Operating activities from discontinued operations

     (1,326     (6,063     7,860   

(Increase) decrease in operating assets

      

Financial instruments owned, at fair value

     (642,649     (450,478     (63,500

Securities borrowed

     (966,592     (382,569     29,335   

Receivable from brokers, dealers and clearing organizations

     23,985        (170,641     17,675   

Other assets

     (5,901     (56,013     (65,431

Increase (decrease) in operating liabilities

      

Financial instruments sold, not yet purchased, at fair value

     638,162        254,256        49,723   

Securities loaned

     (22,281     550,226        —     

Financial instruments sold under agreements to repurchase

     485,184        —          —     

Other secured financings

     35,583        —          —     

Payable to brokers and dealers

     182,282        57,011        (18,863

Accrued compensation expense

     (17,673     32,732        58,522   

Accrued expenses and other liabilities

     1,580        (26,180     4,983   
                        

Net cash (used in) provided by operating activities

     (86,537     20,058        263,653   
                        

Cash flows from investing activities

      

Distributions from investments

     37,558        64,303        142,190   

Purchases of investments

     (7,997     (7,787     (13,442

Purchases of fixed assets and leasehold improvements

     (48,880     (42,230     (37,491

Purchases of businesses, net of cash acquired

     (48,133     —          (77,308

Purchase of referral rights

     (3,275     —          —     

Purchase of customer list

     (1,000     —          —     

Purchase of noncontrolling interest

     (1,000     —          —     

Investing activities from discontinued operations

     —          —          (817
                        

Net cash (used in) provided by investing activities

     (72,727     14,286        13,132   
                        

Cash flows from financing activities

      

Repayment of credit facility

     (140,000     —          —     

Proceeds from credit facility

     —          —          70,000   

Proceeds from issuance of cash convertible notes

     363,808        —          —     

Purchase of call options

     (73,750     —          —     

Proceeds from issuance of warrants

     15,000        —          —     

Stock options exercised

     5,784        11,021        10,360   

Income tax (provision) benefit related to stock-based compensation

     (2,760     4,374        6,117   

Cost of common stock repurchased

     (60,090     (33,412     (138,229

Financing activities from discontinued operations

     —          (6,178     1,000   
                        

Net cash provided by (used in) financing activities

     107,992        (24,195     (50,752
                        

Effect of exchange rate changes on cash and cash equivalents

     (265     —          —     
                        

(Decrease) increase in cash and cash equivalents

     (51,537     10,149        226,033   

Cash and cash equivalents at beginning of period

     427,106        416,957        190,924   
                        

Cash and cash equivalents at end of period

   $ 375,569      $ 427,106      $ 416,957   
                        

Supplemental disclosure of cash flow information:

      

Cash paid for interest

   $ 22,068      $ 4,777      $ 5,014   
                        

Cash paid for income taxes

   $ 59,384      $ 87,463      $ 114,618   
                        

 

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

 

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KNIGHT CAPITAL GROUP, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

1.    Organization and Description of the Business

 

Knight Capital Group, Inc. (collectively with its subsidiaries, the “Company”) is a global financial services firm that provides access to the capital markets across multiple asset classes to a broad network of clients, including buy- and sell-side firms, and corporations. The Company seeks to continually apply its expertise and innovation to the market-making and trading process to build lasting client relationships through consistent performance and superior client service. The Company also provides capital markets services to corporate issuers and private companies. The Company has three operating segments, Equities, Fixed Income, Currencies and Commodities (“FICC”) and Corporate. As of December 31, 2010, the Company’s operations comprised the following:

 

   

Knight Equity Markets, L.P. (“KEM”) primarily operates as a market maker in equity securities quoted and traded on the Nasdaq Stock Market and quoted on the OTC Bulletin Board and Pink OTC Markets. KEM also operates the Company’s primary domestic institutional equity sales business. As of the close of business on December 31, 2010, KEM acquired the equities Designated Market Maker (“DMM”) and exchange traded fund (“ETF”) Lead Market Maker (“LMM”) business units of Kellogg Capital Markets LLC (“Kellogg”).

 

   

Knight Capital Markets LLC (“KCM”) primarily operates as a market maker in the over-the-counter market for NYSE, NYSE Amex Equities and NYSE Arca listed securities. KCM also provides equity capital markets services to corporate issuers and private companies.

 

   

Knight Capital Europe Limited (“KCEL”) is a U.K. registered broker-dealer that provides trade execution services for institutional and broker-dealer clients in U.S., European and Asian equities. KCEL also provides trade execution services for institutional clients in U.S., European and Asian fixed income and foreign exchange products.

 

   

Knight Capital Asia Limited (“KCAL”) provides trade execution services in Asian, U.S. and European equities and fixed income to institutional clients worldwide.

 

   

Knight Direct LLC (“Knight Direct”) provides institutions with direct market access trading through Knight DirectTM, an advanced electronic trading platform. Knight Direct offers a suite of algorithms that allow buy- and sell-side clients to more effectively source liquidity, manage the trading process, and enhance performance, as well as maintain anonymity, reduce market impact and lower transaction costs. Knight Direct’s European business is operated through KCEL.

 

   

Knight Clearing Services LLC (“KCS”) operates as a self-clearing broker-dealer that provides equity settlement and clearance services for the Company’s domestic broker-dealer subsidiaries.

 

   

Astor Asset Management, L.L.C. (“Astor”), acquired on October 1, 2010, is a fee-based money management firm employing a portfolio management approach to investing involving modeling economic data and utilizing low cost ETFs to capitalize on cyclical changes.

 

   

Knight Libertas Holdings LLC and its affiliates (collectively, “Knight Fixed Income”) provide research, sales and trading across a broad range of fixed income securities, including high-yield and high-grade corporate bonds, distressed debt, asset- and mortgage-backed securities, federal agency securities, hybrid securities, syndicated bank loans and emerging markets. Knight Fixed Income also provides capital markets services to corporate issuers and private companies. Knight Fixed Income’s European business is operated through KCEL.

 

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KNIGHT CAPITAL GROUP, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—Continued