10-Q 1 d400391d10q.htm FORM 10-Q Form 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2012

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

 

 

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 (§232.405 of this chapter) 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 whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See 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 (Do not check if a smaller reporting company)  ¨        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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

As of November 5, 2012 the number of shares outstanding of the Registrant’s Class A Common Stock was 181,892,665 and there were no shares outstanding of the Registrant’s Class B Common Stock.

As of November 5, 2012, the number of shares outstanding of the Registrant’s Series A-1 Cumulative Perpetual Convertible Preferred Stock was 266,350 and Series A-2 Non-Voting Cumulative Perpetual Convertible Preferred Stock was 7,865.

 

 

 


Table of Contents

KNIGHT CAPITAL GROUP, INC.

FORM 10-Q QUARTERLY REPORT

For the Quarter Ended September 30, 2012

TABLE OF CONTENTS

 

PART I

   FINANCIAL INFORMATION:   

Item 1.

  

Financial Statements (Unaudited)

     3   
  

Consolidated Statements of Operations

     3   
  

Consolidated Statements of Comprehensive Income

     4   
  

Consolidated Statements of Financial Condition

     5   
  

Consolidated Statements of Changes in Convertible Preferred Stock and Equity

     6   
  

Consolidated Statements of Cash Flows

     7   
   Notes to Consolidated Financial Statements      8   

Item 2.

   Management’s Discussion and Analysis of Financial Condition and Results of Operations      51   

Item 3.

  

Quantitative and Qualitative Disclosures About Market Risk

     77   

Item 4.

  

Controls and Procedures

     80   

PART II

   OTHER INFORMATION:      81   

Item 1.

  

Legal Proceedings

     81   

Item 1A.

  

Risk Factors

     82   

Item 2.

  

Unregistered Sales of Equity Securities and Use of Proceeds

     83   

Item 3.

  

Defaults Upon Senior Securities

     83   

Item 4.

  

Mine Safety Disclosures

     84   

Item 5.

  

Other Information

     84   

Item 6.

  

Exhibits

     84   

Signatures

     85   

 

2


Table of Contents

PART I. FINANCIAL INFORMATION

 

Item 1. Financial Statements.

KNIGHT CAPITAL GROUP, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

 

     For the three months
ended September 30,
    For the nine months
ended September 30,
 
     2012     2011     2012     2011  
     (In thousands, except per share amounts)  

Revenues

        

Commissions and fees

   $ 144,217      $ 207,252      $ 501,920      $ 585,324   

Net trading revenue

     (343,618     185,981        (90,396     463,578   

Interest, net

     4,812        (1,201     17,874        4,205   

Investment income and other, net

     4,751        5,410        19,043        10,093   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total revenues

     (189,838     397,442        448,441        1,063,200   
  

 

 

   

 

 

   

 

 

   

 

 

 

Expenses

        

Employee compensation and benefits

     124,638        157,201        402,770        446,290   

Execution and clearance fees

     46,731        63,589        153,179        175,775   

Communications and data processing

     25,788        23,137        72,545        65,552   

Payments for order flow

     20,099        22,985        61,942        66,031   

Interest

     12,330        10,822        39,769        30,242   

Depreciation and amortization

     11,924        13,747        38,713        40,480   

Professional fees

     8,066        5,530        18,933        15,398   

Occupancy and equipment rentals

     7,127        7,026        20,007        21,526   

Business development

     4,983        5,909        16,040        16,870   

Writedown of assets and lease loss accrual

     143,034        1,333        143,034        2,278   

Restructuring

     -          28,624        -          28,624   

Other

     8,302        13,095        25,014        30,152   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total expenses

     413,022        352,998        991,946        939,218   
  

 

 

   

 

 

   

 

 

   

 

 

 

(Loss) income from continuing operations before income taxes

     (602,860     44,444        (543,505     123,982   

Income tax (benefit) expense

     (212,939     17,449        (189,980     48,605   
  

 

 

   

 

 

   

 

 

   

 

 

 

(Loss) income from continuing operations, net of tax

     (389,921     26,995        (353,525     75,377   

Loss from discontinued operations, net of tax

     -          (59     -          (378
  

 

 

   

 

 

   

 

 

   

 

 

 

Net (loss) income

   $ (389,921   $ 26,936      $ (353,525   $ 74,999   
        

Dividend on convertible preferred shares

     (1,051     -          (1,051     -     

Deemed dividend related to beneficial conversion feature of convertible preferred shares

     (373,364     -          (373,364     -     
  

 

 

   

 

 

   

 

 

   

 

 

 

Net (loss) income attributable to common stockholders

   $ (764,336   $ 26,936        (727,940   $ 74,999   
  

 

 

   

 

 

   

 

 

   

 

 

 

Basic (loss) earnings per share from continuing operations

   $ (6.30   $ 0.29      $ (7.20   $ 0.82   
  

 

 

   

 

 

   

 

 

   

 

 

 

Diluted (loss) earnings per share from continuing operations

   $ (6.30   $ 0.29      $ (7.20   $ 0.80   
  

 

 

   

 

 

   

 

 

   

 

 

 

Basic (loss) earnings per share

   $ (6.30   $ 0.29      $ (7.20   $ 0.82   
  

 

 

   

 

 

   

 

 

   

 

 

 

Diluted (loss) earnings per share

   $ (6.30   $ 0.29      $ (7.20   $ 0.79   
  

 

 

   

 

 

   

 

 

   

 

 

 

Shares used in computation of basic earnings per share

     121,246        91,564        101,044        91,877   
  

 

 

   

 

 

   

 

 

   

 

 

 

Shares used in computation of diluted earnings per share

     121,246        93,840        101,044        94,803   
  

 

 

   

 

 

   

 

 

   

 

 

 

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

 

3


Table of Contents

KNIGHT CAPITAL GROUP, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited)

 

     For the three months
ended September 30,
     For the nine months
ended September 30,
 
     2012     2011      2012     2011  
     (In thousands)      (In thousands)  

Net (loss) income

   $ (389,921   $ 26,936       $ (353,525   $ 74,999   

Other comprehensive income:

         

Cumulative translation adjustment

     1,056        448         1,145        234   
  

 

 

   

 

 

    

 

 

   

 

 

 

Comprehensive (loss) income

   $ (388,865   $ 27,384       $ (352,380   $ 75,233   
  

 

 

   

 

 

    

 

 

   

 

 

 

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

 

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Table of Contents

KNIGHT CAPITAL GROUP, INC.

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(Unaudited)

 

     September 30,
2012
    December 31,
2011
 
     (In thousands)  

ASSETS

    

Cash and cash equivalents

   $ 420,808      $ 467,633   

Cash and securities segregated under federal and other regulations

     137,794        11,010   

Financial instruments owned, at fair value, including securities pledged of $4,338,136 at September 30, 2012 and $2,672,709 at December 31, 2011:

    

Equities

     1,170,813        1,416,090   

Debt securities

     248,916        134,631   

Loan inventory

     151,772        206,572   

Listed equity options

     132,379        280,384   

Other financial instruments

     109        21,483   

Securitized HECM loan inventory

     3,410,607        1,722,631   
  

 

 

   

 

 

 

Total financial instruments owned, at fair value

     5,114,596        3,781,791   

Collateralized agreements:

    

Securities borrowed

     1,060,049        1,494,647   

Receivable from brokers, dealers and clearing organizations

     944,239        623,897   

Fixed assets and leasehold improvements, at cost, less accumulated depreciation and amortization

     107,947        111,464   

Investments

     97,620        83,231   

Goodwill

     218,600        337,843   

Intangible assets, less accumulated amortization

     68,170        92,889   

Income taxes receivable

     173,638        9,788   

Other assets

     242,393        138,758   
  

 

 

   

 

 

 

Total assets

   $     8,585,854      $     7,152,951   
  

 

 

   

 

 

 

LIABILITIES, CONVERTIBLE PREFERRED STOCK & EQUITY

    

Liabilities

    

Financial instruments sold, not yet purchased, at fair value:

    

Equities

   $ 1,080,339      $ 1,369,750   

Listed equity options

     111,691        254,506   

Debt securities

     99,679        63,073   

Other financial instruments

     4,431        34,563   
  

 

 

   

 

 

 

Total financial instruments sold, not yet purchased, at fair value

     1,296,140        1,721,892   

Collateralized financings:

    

Financial instruments sold under agreements to repurchase

     471,349        420,320   

Securities loaned

     353,953        697,998   

Other secured financings

     115,311        59,405   

Liability to GNMA trusts, at fair value

     3,383,240        1,710,627   
  

 

 

   

 

 

 

Total collateralized financings

     4,323,853        2,888,350   

Payable to brokers, dealers and clearing organizations

     303,277        322,660   

Payable to customers

     460,826        23,664   

Accrued compensation expense

     131,970        188,939   

Accrued expenses and other liabilities

     183,611        121,083   

Long-term debt

     410,089        424,338   
  

 

 

   

 

 

 

Total liabilities

     7,109,766        5,690,926   
  

 

 

   

 

 

 

Convertible Preferred Stock

    

Series A convertible preferred stock

    

Shares issued: 400 at September 30, 2012,

    

Shares outstanding: 274 at September 30, 2012

     259,278        -     
  

 

 

   

 

 

 

Equity

    

Class A common stock

    

Shares authorized: 500,000 at September 30, 2012 and at December 31, 2011; Shares issued: 254,171 at September 30, 2012 and 166,361 at December 31, 2011; Shares outstanding: 181,505 at September 30, 2012 and 96,645 at December 31, 2011

     2,542        1,664   

Additional paid-in capital

     1,367,625        850,837   

Retained earnings

     705,380        1,433,320   

Treasury stock, at cost; 72,666 at September 30, 2012 and 69,717 shares at December 31, 2011

     (859,109     (823,023

Accumulated other comprehensive income (loss)

     372        (773
  

 

 

   

 

 

 

Total equity

     1,216,810        1,462,025   
  

 

 

   

 

 

 

Total liabilities, convertible preferred stock and equity

   $ 8,585,854      $ 7,152,951   
  

 

 

   

 

 

 

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

 

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Table of Contents

KNIGHT CAPITAL GROUP, INC.

CONSOLIDATED STATEMENTS OF CHANGES IN CONVERTIBLE PREFERRED STOCK AND EQUITY

For the Year Ended December 31, 2011 and Nine Months Ended September 30, 2012

(Unaudited)

 

                           Knight Capital Group, Inc. Stockholders’ Equity              
                           (in thousands)              
          Series A
Convertible
Preferred Stock
         Class A
Common Stock
                Treasury Stock                          
    Series
A-1
Shares
    Series
A-2
Shares
    Amount          Shares     Amount     Additional
Paid-In
Capital
    Retained
Earnings
    Shares     Amount     Accumulated
other
comprehensive
income (loss)
    Total     Non-
controlling
Interests
    Total
Equity
 

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   
 

 

 

   

 

 

   

 

 

   

 

 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income

    -          -          -              -          -          -          115,237        -          -          -          115,237        -          115,237   

Net loss attributable to noncontrolling interests related to discontinued operations

    -          -          -              -          -          -          621        -          -          -          621        (621     -     

Common stock repurchased

    -          -          -              -          -          -          -          (4,754     (58,553     -          (58,553     -          (58,553

Reissuance of treasury shares

    -          -          -              -          -          (27     -          119        1,405        -          1,378        -          1,378   

Stock options exercised

    -          -          -              91        1        999        -          -          -          -          1,000        -          1,000   

Income tax provision – stock based compensation

    -          -          -              -          -          (6,449     -          -          -          -          (6,449     -          (6,449

Cumulative translation adjustment

    -          -          -              -          -          -            -          -          (508     (508     -          (508

Stock-based compensation

    -          -          -              3,452        35        49,027        -          -          -          -          49,062        -          49,062   
 

 

 

   

 

 

   

 

 

   

 

 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance, December 31, 2011

    -          -        $ -              166,361      $ 1,664      $ 850,837      $ 1,433,320        (69,717   $ (823,023   $ (773   $ 1,462,025      $ -        $ 1,462,025   
 

 

 

   

 

 

   

 

 

   

 

 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net loss

    -          -          -              -          -          -          (353,525     -          -          -          (353,525     -          (353,525

Issuance of Series A convertible preferred stock, net of issuance costs of $40,519

    80        320        359,481            -          -          -          -          -          -          -          -          -          -     

Beneficial Conversion Feature

    -          -          -              -          -          373,364        (373,364     -          -          -          -          -          -     

Series A-2 converted to Series A-1 convertible preferred stock

    312        (312     -              -          -          -          -          -          -          -          -          -          -     

Series A-1 convertible preferred stock converted into Class A common stock

    (126     -          (100,203         83,857        839        99,364        -          -          -          -          100,203        -          100,203   

Dividend on convertible preferred shares

    -          -          -              -          -          -          (1,051     -          -          -          (1,051     -          (1,051

Common stock repurchased

    -          -          -              -          -          -          -          (2,949     (36,086     -          (36,086     -          (36,086

Stock options exercised

    -          -          -              130        1        1,139        -          -          -          -          1,140        -          1,140   

Income tax provision – stock based compensation

    -          -          -              -          -          195        -          -          -          -          195        -          195   

Reclassification of Urban earnout to liabilities

    -          -          -              -          -          (2,000     -          -          -          -          (2,000     -          (2,000

Cumulative translation adjustment

    -          -          -              -          -          -          -          -          -          1,145        1,145        -          1,145   

Stock-based compensation

    -          -          -              3,823        38        44,726        -          -          -          -          44,764        -          44,764   
 

 

 

   

 

 

   

 

 

       

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance, September 30, 2012

    266        8      $ 259,278            254,171      $ 2,542      $ 1,367,625      $ 705,380        (72,666   $ (859,109   $ 372      $ 1,216,810      $ -        $ 1,216,810   
 

 

 

   

 

 

   

 

 

       

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

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

 

6


Table of Contents

KNIGHT CAPITAL GROUP, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 

     For the nine months
ended September 30,
 
     2012     2011  
     (In thousands)  

Cash flows from operating activities

    

Net (loss) income

   $ (353,525   $ 74,999   

Loss from discontinued operations, net of tax

     -          (378
  

 

 

   

 

 

 

(Loss) income from continuing operations, net of tax

     (353,525     75,377   

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

    

Writedown of assets and lease loss accrual

     143,034        2,278   

Stock-based compensation

     42,393        38,887   

Depreciation and amortization

     38,713        40,480   

Debt discount accretion and other debt related expenses

     13,053        11,534   

Restructuring charges

     -          11,454   

Deferred rent

     (925     245   

Unrealized (gain) loss on investments

     (11,014     888   

Operating activities from discontinued operations

     -          (1,195

(Increase) decrease in operating assets

    

Cash and securities segregated under federal and other regulations

     (26,239     47,503   

Financial instruments owned, at fair value

     (1,350,227     (1,961,226

Securities borrowed

     434,598        (113,474

Receivable from brokers, dealers and clearing organizations

     40,152        (180,600

Income taxes receivable

     (163,850     (15,501

Other assets

     (246,935     (107,170

(Decrease) increase in operating liabilities

    

Financial instruments sold, not yet purchased, at fair value

     (408,330     569,534   

Financial instruments sold under agreements to repurchase

     51,029        111,567   

Securities loaned

     (344,045     157,027   

Other secured financings

     55,906        36,780   

Liability to GNMA trusts, at fair value

     1,672,613        1,210,680   

Payable to brokers and dealers and clearing organizations

     (19,382     72,890   

Payable to customers

     (35,035     44,995   

Accrued compensation expense

     (54,680     (17,976

Accrued expenses and other liabilities

     178,289        26,175   
  

 

 

   

 

 

 

Net cash (used in) provided by operating activities

     (344,407     61,152   
  

 

 

   

 

 

 

Cash flows from investing activities

    

Distributions from investments

     4,220        4,078   

Purchases of investments

     (5,842     (24,952

Purchases of fixed assets and leasehold improvements

     (23,600     (32,009

Purchase of intangible asset

     (50     -     

Purchases of business, net of cash acquired

     (3,072     (625
  

 

 

   

 

 

 

Net cash used in investing activities

     (28,344     (53,508
  

 

 

   

 

 

 

Cash flows from financing activities

    

Proceeds of convertible preferred stock offering, net of issuance costs of $40,519

     359,480        -     

Proceeds from credit facility

     -          97,838   

Proceeds from revolving credit agreement

     200,000        -     

Repayment of revolving credit agreement

     (200,000     -     

Stock options exercised

     1,140        758   

Income tax benefit related to stock-based compensation

     195        67   

Cost of common stock repurchased

     (36,034     (32,337
  

 

 

   

 

 

 

Net cash provided by financing activities

     324,781        66,326   
  

 

 

   

 

 

 

Effect of exchange rate changes on cash and cash equivalents

     1,145        234   
  

 

 

   

 

 

 

(Decrease) increase in cash and cash equivalents

     (46,825     74,204   

Cash and cash equivalents at beginning of period

     467,633        375,569   
  

 

 

   

 

 

 

Cash and cash equivalents at end of period

   $ 420,808      $ 449,773   
  

 

 

   

 

 

 

Supplemental disclosure of cash flow information:

    

Cash paid for interest

   $ 45,533      $ 20,522   
  

 

 

   

 

 

 

Cash paid for income taxes

   $ 44,910      $ 39,859   
  

 

 

   

 

 

 

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

 

7


Table of Contents

KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1.    Organization and Description of the Business

Knight Capital Group, Inc. (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 broker-dealers, institutions 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 has four operating segments: (i) Market Making; (ii) Institutional Sales and Trading; (iii) Electronic Execution Services; and (iv) Corporate and Other.

Market Making

The Market Making segment principally consists of market making in global equities and listed domestic options. As a market maker, the Company commits capital for trade executions by offering to buy securities from, or sell securities to, institutions and broker-dealers. The Market Making segment primarily includes client, and to a lesser extent, non-client market making activities in which the Company operates as a market maker in equity securities quoted and traded on the Nasdaq Stock Market; the over-the-counter (“OTC”) market for New York Stock Exchange (“NYSE”), NYSE Amex Equities (“NYSE Amex”), NYSE Arca listed securities; and several European exchanges. As a complement to electronic market making, the Company’s cash trading business handles specialized orders and also transacts on the OTC Bulletin Board, the OTC Pink Markets and the Alternative Investment Market (“AIM”) of the London Stock Exchange. The segment provides trade executions as an equities Designated Market Maker (“DMM”) on the NYSE and NYSE Amex. The Market Making segment also includes the Company’s option market making business which trades on substantially all domestic electronic exchanges.

Institutional Sales and Trading

The Institutional Sales and Trading segment includes global equity, exchange traded fund (“ETF”), and fixed income sales; reverse mortgage origination and securitization; capital markets; and asset management activities. The primary business of the Institutional Sales and Trading segment is to execute and facilitate equities, ETFs and fixed income transactions as an agent on behalf of institutional clients, and commit capital on behalf of clients when needed. This is predominantly a full-service execution business, in which much of the interaction is based on the Company’s client relationships. This segment also facilitates client orders through program and block trades and riskless principal trades and provides capital markets services, including equity and debt offerings as well as private placements.

Electronic Execution Services

The Electronic Execution Services segment offers access via its electronic agency-based platforms to markets and self-directed trading in equities, options, fixed income, foreign exchange and futures. In contrast to Market Making, the businesses within this segment generally do not act as a principal to transactions that are executed and generally earn commissions for acting as an agent between the principals to the trade.

 

8


Table of Contents

KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

Corporate and Other

The Corporate and Other segment invests in strategic financial services-oriented opportunities, allocates, deploys and monitors all capital, and maintains corporate overhead expenses and all other income and expenses that are not attributable to the other segments. The Corporate and Other segment houses functions that support the Company’s other segments such as self-clearing services, including securities lending activities. Beginning in the second quarter of 2012, the Corporate and Other segment includes the Company’s Futures Commission Merchant (“FCM”) which comprises certain assets and liabilities that were acquired or assumed from the futures division of Penson Financial Services, Inc. (“Penson”) on June 1, 2012. This business primarily provides futures execution, clearing and custody services to facilitate transactions among brokers, institutions and non-clearing FCMs on major U.S. and European futures and options exchanges.

Discontinued Operations

Discontinued operations comprise costs associated with shutting down the Company’s former Deephaven Capital Management business which was discontinued in 2009.

2.    Significant Accounting Policies

Basis of consolidation and form of presentation

The accompanying unaudited Consolidated Financial Statements, prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”), should be read in conjunction with the audited Consolidated Financial Statements for the year ended December 31, 2011 included in the Company’s Current Report on Form 8-K dated August 6, 2012 which was filed in relation to the Company’s raising of $400.0 million in equity financing. These unaudited Consolidated Financial Statements reflect all adjustments that are, in the opinion of management, necessary for a fair statement of the results for the interim periods presented. All such adjustments are of a normal recurring nature. Certain footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to U.S. Securities and Exchange Commission (“SEC”) rules and regulations, although the Company believes that the disclosures herein are adequate to make the information presented not misleading. All significant intercompany transactions and balances have been eliminated. Interim period operating results may not be indicative of the operating results for a full year.

Certain reclassifications have been made to the prior periods’ Consolidated Financial Statements in order to conform to the current year presentation. Such reclassifications had no effect on previously reported net income.

The Company consolidates all of its wholly-owned subsidiaries as well as any investment in which it is considered to be the primary beneficiary of a variable interest entity (“VIE”). The Company performs a qualitative assessment to determine if a VIE should be consolidated. As described in more detail in this footnote, the primary attributes the Company assesses include the entity’s capital structure and power. The Company will consolidate a VIE if it has both (i) the power to direct the activities of a VIE that most significantly impact the entity’s economic performance and (ii) the

 

9


Table of Contents

KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

obligation to absorb losses of the entity that could potentially be significant to the VIE or the right to receive benefits from the entity that could potentially be significant to the VIE. As of September 30, 2012 and December 31, 2011, the Company was not considered to be a primary beneficiary of any VIE.

Cash and cash equivalents

Cash and cash equivalents include money market accounts, which are payable on demand, and short-term investments with an original maturity of less than 90 days. The carrying amount of such cash equivalents approximates their fair value due to the short-term nature of these instruments.

Cash and securities segregated under federal and other regulations

The Company maintains custody of customer funds and, as a result, it is subject to various regulatory rules and regulations. As a result of these customer holdings, the Company is obligated by the SEC and the Commodities Futures Trading Commission (“CFTC”) to segregate or set aside cash and/or qualified securities to satisfy these regulations, which have been promulgated to protect customer assets. The amounts recognized as Cash and securities segregated under federal and other regulations approximate fair value.

Market making, sales, trading and execution activities

Financial instruments owned and Financial instruments sold, not yet purchased, which relate to market making and trading activities, include listed and OTC equity securities, listed equity options and fixed income securities which are recorded on a trade date basis and carried at fair value. Net trading revenue (trading gains, net of trading losses) are also recorded on a trade date basis.

Commissions (which includes commission equivalents earned on institutional client orders, commissions on futures transactions and home equity conversion mortgage (“HECM”) loan origination and securitization activities) and related expenses are also recorded on a trade date basis. Commissions earned by the Company’s FCM are recorded net of any commissions paid to independent brokers and are recognized on a half-turn basis.

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. The Company also nets interest income on its securitized HECM loan inventory against interest expense on its liability to Government National Mortgage Association (“GNMA”) trusts. Interest income and interest expense which have been netted on the Consolidated Statements of Operations are as follows (in thousands):

 

     For the three months
ended September 30,
    For the nine months
ended September 30,
 
     2012     2011     2012     2011  

Interest Income

   $ 36,409      $       12,330      $       100,410      $       28,872   

Interest Expense

     (31,597     (13,531     (82,536     (24,667
  

 

 

   

 

 

   

 

 

   

 

 

 

Interest, net

   $       4,812      $ (1,201   $ 17,874      $ 4,205   
  

 

 

   

 

 

   

 

 

   

 

 

 

 

10


Table of Contents

KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

Dividend income relating to securities owned and dividend expense relating to securities sold, not yet purchased, derived primarily from the Company’s market making activities are included as a component of Net trading revenue on the Consolidated Statements of Operations. Net trading revenue includes dividend income and expense as follows (in thousands):

 

     For the three months
ended September 30,
    For the nine months
ended September 30,
 
     2012     2011     2012     2011  

Dividend Income

   $ 7,730      $ 4,547      $ 22,001      $ 15,136   
  

 

 

   

 

 

   

 

 

   

 

 

 

Dividend Expense

   $     (6,778   $     (5,167   $     (18,947   $     (15,426
  

 

 

   

 

 

   

 

 

   

 

 

 

Payments for order flow represent payments to broker-dealer clients, in the normal course of business, for directing their order flow in U.S. equities and options to the Company. Payments for order flow also include fees paid to third party brokers with respect to wholesale loan production at the Company’s reverse mortgage business.

Fair value of financial instruments

The Company values its 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 the Company has 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.

 

   

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. See Footnote 6 “Fair Value of Financial Instruments” for a description of valuation methodologies applied to the classes of financial instruments at fair value.

Securitization activities

The Company securitizes HECMs under its GNMA issuance authority. Securitization and transfer of financial assets to a third party are generally accounted for as sales when an issuer has relinquished control over the transferred assets. Based upon the current structure of the GNMA securitization program, the Company believes that it has not met the GAAP criteria for relinquishing control over the transferred assets and therefore its securitizations fail to meet the GAAP criteria for sale accounting. As such, the Company continues to recognize the HECMs in Financial instruments owned, at fair value, and the Company recognizes a corresponding liability in Liability to GNMA trusts, at fair value on

 

11


Table of Contents

KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

the Consolidated Statements of Financial Condition. The associated change in fair value of the securitized HECM loan inventory is recorded in Commissions and fees on the Consolidated Statements of Operations.

Collateralized agreements and financings

Collateralized agreements consist of securities borrowed and collateralized financings include securities loaned, financial instruments sold under agreements to repurchase, other secured financings and liability to GNMA trusts, at fair value.

 

   

Securities borrowed and securities loaned transactions are recorded at the amount of cash collateral advanced or received. Securities borrowed transactions facilitate the securities settlement process and require the Company to deposit cash or other collateral with the lender. Securities loaned transactions help finance the Company’s securities inventory whereby the Company lends stock to counterparties in exchange for the receipt of cash or other collateral from the borrower. In these transactions, the Company receives or lends cash or other collateral in an amount generally in excess of the market value of the applicable securities borrowed or loaned. The Company monitors the market value of securities borrowed or loaned on a daily basis, with additional collateral obtained or refunded as necessary.

 

   

Financial instruments sold under agreements to repurchase are used to finance inventories of securities and other financial instruments and are recorded at their contractual amount. The Company has entered into bilateral and tri-party term and overnight repurchase agreements which bear interest at negotiated rates. The Company receives cash and makes delivery of financial instruments to a custodian who monitors the market value of these instruments on a daily basis. The market value of the instruments delivered must be equal to or in excess of the principal amount loaned under the repurchase agreements plus the agreed upon margin requirement. The custodian may request additional collateral, if appropriate.

 

   

Other secured financings represent contractual agreements used to finance financial instruments and are recorded at their contractual amount. These agreements are short-term in nature with durations of typically less than one month and bear interest at negotiated rates. The Company receives cash and pledges financial instruments to banks and other financial institutions as collateral for these secured financing arrangements. The market value of the collateral delivered must be in excess of the principal amount loaned plus the agreed upon margin requirement under the secured financings. The banks and other financial institutions may request additional collateral, if appropriate.

 

   

Liability to GNMA trusts, at fair value, represents the liability associated with the Company’s securitization of HECMs where the securitization does not meet the GAAP criteria for sale treatment.

The Company’s securities borrowed, securities loaned, financial instruments sold under agreements to repurchase and other secured financings are recorded at amounts that approximate fair value. These items are recorded based upon their contractual terms and are not materially sensitive to shifts in interest rates because they are short-term in nature and are fully collateralized. These items would be categorized as Level 2 in the fair value hierarchy if they were required to be recorded at fair value.

 

12


Table of Contents

KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

Investments

Investments primarily comprise strategic investments and deferred compensation investments. Strategic investments include noncontrolling equity ownership interests and debt instruments held by the Company within its 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. The equity method of accounting is used where the Company is considered to exert significant influence on the investee. Strategic investments are held at cost, less impairment if any, when the Company is not considered to exert significant influence on operating and financial policies of the investee. Deferred compensation investments primarily consist of mutual funds, which are accounted for at fair value.

Strategic investments are reviewed on an ongoing basis to ensure that the carrying values of the investments have not been impaired. If the Company determines that an impairment loss on a strategic investment has occurred due to a decline in fair value or other market conditions, the investment is written down to its estimated fair value.

The Company maintains a non-qualified deferred compensation plan related to certain employees and directors. This plan provides a return to the participants based upon the performance of various investments. In order to hedge its liability under this plan, the Company generally acquires the underlying investments and holds such investments until the deferred compensation liabilities are satisfied. Changes in value of such investments are recorded in Investment income and other, net, with a corresponding charge or credit to Employee compensation and benefits on the Consolidated Statements of Operations.

Goodwill and intangible assets

The Company tests goodwill and intangible assets with an indefinite useful life for impairment annually or when an event occurs or circumstances change that signifies the existence of an impairment. The Company amortizes other intangible assets on a straight line basis over their estimated useful lives and tests for recoverability whenever events indicate that the carrying amounts may not be recoverable.

Payable to customers

Payable to customers arise primarily from futures transactions and include amounts due on cash and margin transactions. Due to their short-term nature, such amounts approximate fair value.

Treasury stock

The Company records its purchases of treasury stock at cost as a separate component of stockholders’ equity. The Company obtains treasury stock through purchases in the open market or through privately negotiated transactions. The Company may re-issue treasury stock, at average cost, for the acquisition of new businesses or, in certain instances, as inducement grants to new hires or grants to consultants.

 

13


Table of Contents

KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

Foreign currency translation and foreign currency forward contracts

The Company’s European subsidiary utilizes the Pound Sterling as its functional currency while the Company’s Hong Kong subsidiary utilizes the Hong Kong dollar as its functional currency. For all other entities, the Company’s functional currency is the U.S. dollar.

Assets and liabilities of foreign subsidiaries having non-U.S. dollar functional currencies are translated at exchange rates at the end of a period. Revenues and expenses are translated at average exchange rates during the period. Gains and losses resulting from translating foreign currency financial statements into U.S. dollars are included in Accumulated other comprehensive income (loss) on the Consolidated Statements of Financial Condition and Cumulative translation adjustment on the Consolidated Statements of Comprehensive Income. Gains or losses resulting from foreign currency transactions are included in Investment income and other, net on the Company’s Consolidated Statements of Operations. For the three months ended September 30, 2012 and 2011, losses of $2.0 million and $0.1 million, respectively, were recorded in Investment income and other, net and losses of $0.9 million and a $1.0 million, respectively, were recorded for the nine months ended September 30, 2012 and 2011, respectively.

The Company seeks to reduce the impact of fluctuations in foreign exchange rates on its net investment in certain non-U.S. operations through the use of foreign currency forward contracts. For foreign currency forward contracts designated as hedges, the Company assesses its risk management objectives and strategy, including identification of the hedging instrument, the hedged item and the risk exposure and how effectiveness is to be assessed prospectively and retrospectively. The ineffectiveness of the hedge is assessed based on the overall changes in the fair value of the forward contracts. For qualifying net investment hedges, any gains or losses, to the extent effective, are included in Accumulated other comprehensive income (loss) on the Consolidated Statements of Financial Condition and the Consolidated Statements of Comprehensive Income. The ineffective portion, if any, is recorded in Investment income and other, net on the Consolidated Statements of Operations.

Soft dollar expense

Under a commission management program, the Company allows institutional clients to allocate a portion of their gross commissions to pay for research and other services provided by third parties. As the Company acts as an agent in these transactions, it records such expenses on a net basis within Commissions and fees on the Consolidated Statements of Operations.

Depreciation, amortization and occupancy

Fixed assets are depreciated on a straight-line basis over their estimated useful lives of three to seven years. Leasehold improvements are being amortized on a straight-line basis over the shorter of the term of the related office lease or the expected useful life of the assets. The Company capitalizes certain costs associated with the acquisition or development of internal-use software and amortizes the software over its estimated useful life of three years, commencing at the time the software is placed in service. The Company reviews fixed assets and leasehold improvements for impairment whenever events or changes in circumstances indicate that the related carrying amounts may not be recoverable.

 

14


Table of Contents

KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

The Company recognizes rent expense under operating leases with fixed rent escalations, lease incentives and free rent periods on a straight-line basis over the lease term beginning on the date the Company takes possession of or controls the use of the space, including during free rent periods.

Lease loss accrual

The Company’s policy is to identify excess real estate capacity and where applicable, accrue for related future costs, net of estimated sub-lease income. In the event the Company is able to sub-lease the excess real estate after recording a lease loss, such accrual is adjusted to the extent the actual terms of sub-leased property differ from the assumptions used in the calculation of the accrual. In the event that the Company concludes that previously determined excess real estate is needed for the Company’s use, such lease loss accrual is adjusted accordingly.

Income taxes

The Company records deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities and measures them using the enacted tax rates and laws that will be in effect when such differences are expected to reverse. The Company evaluates the recoverability of future tax deductions by assessing the adequacy of future expected taxable income from all sources, including reversal of temporary differences and forecasted operating earnings. Net deferred tax assets and liabilities are included in Other assets and Accrued expenses and other liabilities, respectively, on the Consolidated Statements of Financial Condition.

Stock-based compensation

Stock-based compensation is measured based on the grant date fair value of the awards. These costs are amortized over the requisite service period, which is typically the vesting period.

Expected forfeitures are considered in determining stock-based employee compensation expense. For all periods presented, the Company recorded a benefit for expected forfeitures on all outstanding stock-based awards. The benefit recorded did not have a material impact on the results of operations in any of the periods presented.

The Company applies a non-substantive vesting period approach for stock-based awards whereby the expense is accelerated for those employees and directors that receive options and restricted stock units (“RSUs”) and are eligible to retire prior to the options or RSUs vesting.

Variable interest entities

A VIE is an entity that lacks one or more of the following characteristics (i) the total equity investment at risk is sufficient to enable the entity to finance its activities independently and (ii) the equity holders have the power to direct the activities of the entity that most significantly impact its economic performance, the obligation to absorb the losses of the entity and the right to receive the residual returns of the entity. The Company has a controlling financial interest and will consolidate a VIE if it has both (i) the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance and (ii) the obligation to absorb losses of the VIE or the right to receive benefits from the VIE that could potentially be significant to the VIE.

 

15


Table of Contents

KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

VIEs generally finance the purchase of assets by issuing debt and equity securities that are either collateralized by or indexed to the assets held by the VIE. The debt and equity securities issued by a VIE may include tranches of varying levels of subordination. The Company’s involvement with VIEs includes purchased interests and commitments to VIEs.

The Company is principally involved with VIEs through the following business activities:

 

   

Mortgage-backed securities (“MBS”) – The Company purchases and sells beneficial interests issued by mortgage-backed VIEs in connection with its trading activities

 

   

Securitized HECM loan inventory – The Company sells HECM loans to GNMA trusts which have the characteristics of a VIE and retains certain commitments and obligations to these trusts

Nonconsolidated VIEs

The Company’s exposure to the obligations of VIEs is generally limited to its interests in these entities. Nonconsolidated VIEs are aggregated based on principal business activity.

 

   

For MBS, the maximum exposure to loss is the carrying value of these interests

 

   

For Securitized HECM loan inventory, the maximum exposure to loss is the value of the obligations as issuer and servicer to the GNMA trust

The carrying values of the Company’s variable interests in nonconsolidated VIEs are included in the Consolidated Statements of Financial Condition as follows:

 

   

MBS are included as Debt securities within Financial instruments owned, at fair value

 

   

Securitized HECM loan inventory VIEs are captured in the valuation of the Securitized HECM loan inventory and the Liability to GNMA trusts, at fair value

The following table presents the Company’s nonconsolidated VIEs at September 30, 2012 and December 31, 2011 (in thousands):

 

     September 30, 2012  
     Securitized
HECM loan
inventory
     MBS  

Carrying value of the VIEs

     

Assets

   $ -         $ 114,636   

Liabilities

     794         -     

Maximum exposure to loss in nonconsolidated VIEs

     

Commitments

     24,217         -     

Purchased interests

     -           114,636   

 

16


Table of Contents

KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

     December 31, 2011  
     Securitized
HECM loan
inventory
     MBS  

Carrying value of the VIEs

     

Assets

   $ -         $ 16,399   

Liabilities

     2,299         -     

Maximum exposure to loss in nonconsolidated VIEs

     

Commitments

     12,874         -     

Purchased interests

     -           16,399   

Use of estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results may differ from those estimates.

Accounting Standards Updates

In December 2011, the Financial Accounting Standards Board (“FASB”) issued an Accounting Standard Update (“ASU”) that requires additional disclosures about financial assets and liabilities that are subject to netting arrangements. Under the ASU, financial assets and liabilities must be disclosed at their respective gross asset and liability amounts, the amounts offset on the balance sheet and a description of the respective netting arrangements. The new disclosures are required for annual reporting periods beginning on or after January 1, 2013, and are to be applied retrospectively. Other than the change in disclosures, the Company has determined that the adoption of this ASU will not have an impact on its Consolidated Financial Statements.

In July 2012, the FASB issued an ASU which allows a company to first assess qualitative factors to determine whether it is necessary to perform a quantitative impairment test of an indefinite-lived intangible asset. This ASU simplifies the guidance for impairment testing of indefinite-lived intangible assets other than goodwill and gives companies the option to assess qualitative factors to determine whether it is necessary to perform a quantitative impairment test. Companies electing to perform a qualitative assessment are no longer required to calculate the fair value of an indefinite-lived intangible asset unless the company determines, based on a qualitative assessment, that it is “more likely than not” that the asset is impaired. This update is effective for annual impairment tests, or more frequently if deemed appropriate, performed in fiscal years beginning after September 15, 2012; however, early adoption is permitted. The Company is currently evaluating the impact, if any that this ASU will have on its Consolidated Financial Statements.

3.    August 1, 2012 Technology Issue

The Company experienced a technology issue at the open of trading at the NYSE on August 1, 2012. This issue was related to the installation of trading software and resulted in the Company’s broker-dealer subsidiary, Knight Capital Americas LLC, sending numerous erroneous orders in NYSE-listed and NYSE Arca securities into the market. Although this software was subsequently removed from the Company’s systems, the Company’s results for the three and nine months ended

 

17


Table of Contents

KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

September 30, 2012 includes a $457.6 million trading loss which is included in Net trading revenues, and $3.5 million in incremental professional fees which are included in Professional fees as a result of the technology issue.

4.    Series A Convertible Preferred Stock

As a result of the financial losses incurred due to the August 1, 2012 technology issue, the Company, on August 6, 2012, raised $400.0 million in equity financing through a convertible preferred share offering with several investors. Under the terms, the Company sold 400,000 shares of Series A Convertible Preferred Stock, par value $0.01 per share. The Series A Convertible Preferred Stock consisted of 79,600 shares of Series A-1 Cumulative Perpetual Convertible Preferred Stock (the “Series A-1 Shares”) and 320,400 shares of Series A-2 Non-Voting Cumulative Perpetual Convertible Preferred Stock (the “Series A-2 Shares”) (collectively the “Series A Shares”). The Series A-1 and Series A-2 preferred shares are convertible into approximately 266.7 million shares of Class A common stock, or approximately 73% of the total number of shares of Class A common stock outstanding at August 6, 2012 assuming the conversion in full of the Series A Shares into Class A common stock.

The Series A-1 Shares and Series A-2 Shares rank on parity with each other, and rank senior to the Class A common stock as to dividend and liquidation rights. Dividends on the Series A Shares accrue daily and are payable on a cumulative basis, as and if declared by the Board of Directors, in cash at a rate per annum equal to 2% of (i) the liquidation preference of $1,000 per share and (ii) the amount of any accrued but unpaid dividends in respect of such shares. Declared dividends on the Series A Shares are payable quarterly, in arrears, on each January 15, April 15, July 15 and October 15, with the first dividend paid on October 15, 2012. The Company is prohibited from paying any dividend with respect to shares of Class A common stock or repurchasing or redeeming any shares of Class A common stock in any quarter unless full dividends are paid on the Series A Shares in such quarter. The Series A Shares participate in any dividends paid on the Class A common stock.

Holders of Series A-1 Shares are entitled to vote with holders of Class A common stock, on an as-converted into Class A common stock basis on all matters submitted to a vote. The Series A-2 Shares do not have voting rights. Each Series A-2 Share is convertible, at the option of the holder, into one Series A-1 Share with all associated rights. Each Series A-1 Share is convertible, at the option of the holder, into 666.667 shares of Class A common stock (the “Conversion Rate”), subject to customary anti-dilution adjustments. The Conversion Rate also will be adjusted upon the occurrence of certain merger or acquisition transactions and fundamental changes. The “Conversion Price” is equal to $1,000 divided by the Conversion Rate in effect at such time, for an initial Conversion Price of $1.50 per share of Class A common stock.

The outstanding Series A Shares will mandatorily convert into Class A common stock on the third trading day following the date on which the closing price of the Class A common stock exceeds 200% of the then-applicable Conversion Price (as defined below) for 60 consecutive trading days.

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

Neither the Series A-1 Shares nor the Series A-2 Shares are redeemable by the Company or by the holders other than in connection with certain fundamental corporate changes, which include but are not limited to a change in control, a merger or consolidation, or a delisting of the Company’s Class A common stock. Upon a fundamental change, a holder of Series A Shares may elect to require the Company to redeem such holder’s shares of Series A for consideration payable (at the option of the Company) in cash or securities listed on a national securities exchange with a fair market value equal to the greater of (1) the fair market value of such Series A Shares or (2) $1,000 per share plus the accrued but unpaid dividends thereon.

The Company incurred approximately $40.5 million of fees and costs related to the issuance of the Series A Shares which have been recorded as a reduction of the initial $400.0 million in proceeds, resulting in an initial balance of $359.5 million which is classified as temporary equity as described below.

The $359.5 million initial temporary equity balance has been reduced on a pro-rata basis as the 400,000 Series A Shares are converted into Class A common stock. During the third quarter of 2012, 125,785 or approximately 30% of the original Series A Shares were converted to Class A common stock (resulting in 274,215 Series A Shares outstanding at September 30, 2012 comprising 266,350 Series A-1 Shares and 7,865 Series A-2 Shares). These conversions resulted in a $100.2 million reduction in the temporary equity balance to $259.3 million at September 30, 2012, which was offset by a $0.8 million increase in Class A common stock and a $99.4 million increase in Additional paid-in capital.

Temporary equity classification

Pursuant to GAAP, an equity instrument with redemption features that are not solely within the control of the issuer is required to be classified outside of permanent equity as “temporary equity”, which is presented on the Consolidated Statement of Financial Condition above permanent equity.

Since the Series A Shares become redeemable at the option of the holder upon a fundamental change, and such a fundamental change could come about under circumstances that are not solely within the control of the Company, Series A Shares are classified as temporary equity on the Company’s Consolidated Statements of Financial Condition.

Beneficial conversion feature

Pursuant to GAAP, a beneficial conversion feature (“BCF”) exists to the extent that a convertible security is issued at a price that is less than the fair value of the security into which it is convertible. This guidance applies to the Series A Shares as these shares were issued at $1,000 per share which, based on the Conversion Rate computes to a common share equivalent price of $1.50 per share, which was less than the share price of the Company’s Class A common stock at the time of issuance of $2.81 per share. The difference between these two prices, as well as costs paid to investors with respect to the issuance, created a BCF. The BCF is treated as a deemed dividend to the Series A Shares shareholders since the conversion feature is immediately exercisable for the Series A Shares. The BCF is recorded as a decrease to Retained earnings and an increase to Additional paid-in capital. The deemed dividend also affects the Company’s earnings per share calculations by increasing the

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

loss attributable to Class A common stockholders to the extent that it is not anti-dilutive. As a result of the BCF, the Company recorded a $373.4 million non-cash deemed dividend for the period ended September 30, 2012.

Dividend

On September 24, 2012, the Company’s Board of Directors declared the first quarterly dividend with respect to the Series A Shares, and that dividend was paid on October 15, 2012. Such dividend totaled $1.1 million based upon 274,215 Series A Shares outstanding as of the record date covering the period from August 6, 2012 through October 14, 2012. As this dividend was declared prior to September 30, 2012, it was reflected in the Consolidated Financial Statements for the period ended September 30, 2012 as a reduction in Retained earnings and in the earnings per share calculation as an increase in the loss attributable to the common stockholders.

5.    Segregated Cash and Securities

Cash and securities segregated under federal and other regulations primarily relates to the Company’s recently acquired FCM business (see Footnote 20 “Acquisition” for further discussion) and consists of the following (in thousands):

 

     September 30,
2012
     December 31,
2011
 

Segregated cash

   $ 137,519       $ 11,010   

Segregated securities

     275         -     
  

 

 

    

 

 

 

Total Segregated cash and securities

   $         137,794       $         11,010   
  

 

 

    

 

 

 

Segregated securities consist of U.S. government obligations.

 

20


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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

6.    Fair Value of Financial Instruments

The Company’s financial instruments recorded at fair value have been categorized based upon a fair value hierarchy, as described more fully in Footnote 2 “Significant Accounting Policies.” The following fair value hierarchy table presents information about the Company’s financial assets and liabilities measured at fair value on a recurring basis (in thousands):

 

     Assets and Liabilities Measured at
Fair Value on a Recurring Basis
 

September 30, 2012

   Level 1      Level 2      Level 3      Total  

Assets

           

Financial instruments owned, at fair value:

           

Equities(1)

   $ 1,170,813       $ -         $ -         $ 1,170,813   

U.S. government and Non-U.S. government obligations

     57,762         -           -           57,762   

Corporate debt(2)

     76,518         -           -           76,518   

Mortgage-backed securities

     -           114,636         -           114,636   

Loan inventory

     -           151,772         -           151,772   

Listed equity options

     132,379         -           -           132,379   

Purchased call options

     -           109         -           109   

Securitized HECM loan inventory(3)

     -           3,410,607         -           3,410,607   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total Financial instruments owned, at fair value

     1,437,472         3,677,124         -           5,114,596   

Securities segregated under federal and other regulations(4)

     275         -           -           275   

Securities on deposit with clearing organizations(4)

     201,619         -           -           201,619   

Deferred compensation investments(5)

     -           21,711         -           21,711   

Investment in Deephaven Funds(5)

     -           1,406         -           1,406   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total fair value of financial instrument assets

   $         1,639,366       $         3,700,242       $         -         $         5,339,608   
  

 

 

    

 

 

    

 

 

    

 

 

 

Liabilities

           

Financial instruments sold, not yet purchased, at fair value:

           

Equities(1)

   $ 1,080,339       $ -         $ -         $ 1,080,339   

Listed equity options

     111,691         -           -           111,691   

U.S. government obligations

     18,626         -           -           18,626   

Corporate debt(2)

     81,053         -           -           81,053   

Embedded conversion derivative

     -           109         -           109   

Foreign currency forward contracts

     -           4,322         -           4,322   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total Financial instruments sold, not yet purchased, at fair value

     1,291,709         4,431         -           1,296,140   

Liability to GNMA trusts, at fair value(3)

     -           3,383,240         -           3,383,240   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total fair value of financial instrument liabilities

   $ 1,291,709       $ 3,387,671       $ -         $ 4,679,380   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

21


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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

 

(1) Equities of $560.2 million have been netted by their respective long and short positions by CUSIP number.
(2) Corporate debt of $8.1 million has been netted by respective long and short positions by CUSIP number.
(3) Represents HECMs that have been securitized into HECM Mortgage Backed Securities (“HMBS”) where the securitization is not accounted for as a sale of the underlying HECMs. See Securitized HECM loan inventory below for full description.
(4) Securities segregated under federal and other regulations and Securities on deposit with clearing organizations consist of U.S. government obligations.
(5) Deferred compensation investments and investment in the Deephaven Funds are included within Investments on the Consolidated Statements of Financial Condition.

 

    Assets and Liabilities Measured at
Fair Value on a Recurring Basis
 

December 31, 2011

  Level 1     Level 2     Level 3     Total  

Assets

       

Financial instruments owned, at fair value:

       

Equities(1)

  $ 1,416,090      $ -        $ -        $ 1,416,090   

U.S. government obligations

    44,316        -          -          44,316   

Corporate debt(2)

    73,916        -          -          73,916   

Mortgage-backed securities

    16,399        -          -          16,399   

Loan inventory

    -          206,572        -          206,572   

Listed equity options

    280,384        -          -          280,384   

Purchased call options

    -          17,532        -          17,532   

Foreign currency forward contracts

    -          3,951        -          3,951   

Securitized HECM loan inventory(3)

    -          1,722,631        -          1,722,631   
 

 

 

   

 

 

   

 

 

   

 

 

 

Total Financial instruments owned, at fair value

    1,831,105        1,950,686        -          3,781,791   

Deferred compensation investments(4)

    -          20,414        -          20,414   

Investment in Deephaven Funds(4)

    -          1,319        -          1,319   
 

 

 

   

 

 

   

 

 

   

 

 

 

Total fair value of financial instrument assets

  $         1,831,105      $         1,972,419      $         -        $         3,803,524   
 

 

 

   

 

 

   

 

 

   

 

 

 

Liabilities

       

Financial instruments sold, not yet purchased, at fair value:

       

Equities(1)

  $ 1,369,750      $ -        $ -        $ 1,369,750   

U.S. government obligations

    10,644        -          -          10,644   

Corporate debt(2)

    52,429        -          -          52,429   

Listed equity options

    254,506        -          -          254,506   

Embedded conversion derivative

    -          17,532        -          17,532   

Total return swap

    -          17,031        -          17,031   
 

 

 

   

 

 

   

 

 

   

 

 

 

Total Financial instruments sold, not yet purchased, at fair value

    1,687,329        34,563        -          1,721,892   

Liability to GNMA trusts, at fair value(3)

    -          1,710,627        -          1,710,627   
 

 

 

   

 

 

   

 

 

   

 

 

 

Total fair value of financial instrument liabilities

  $ 1,687,329      $ 1,745,190      $ -        $ 3,432,519   
 

 

 

   

 

 

   

 

 

   

 

 

 

 

22


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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

 

(1) Equities of $400.6 million have been netted by their respective long and short positions by CUSIP number.
(2) Corporate debt of $0.4 million has been netted by respective long and short positions by CUSIP number.
(3) Represents HECMs that have been securitized into HMBS where the securitization is not accounted for as a sale of the underlying HECMs. See Securitized HECM loan inventory below for full description.
(4) Deferred compensation investments and investment in the Deephaven Funds are included within Investments on the Consolidated Statements of Financial Condition. Excluded from deferred compensation investments is $1.1 million of Level 2 assets which relate to discontinued operations and are included within Other assets on the Consolidated Statements of Financial Condition.

The Company’s equities, listed equity options, U.S. government and Non-U.S. government obligations, rated corporate debt, and actively traded mortgage-backed securities will generally be 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.

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 September 30, 2012 and December 31, 2011, the Company did not hold any financial instruments that met the definition of Level 3.

The Company’s assets measured at fair value on a nonrecurring basis solely relates to goodwill and intangible assets arising from various acquisitions which would be classified as Level 3 within the fair value hierarchy. See Footnote 10 “Goodwill and Intangible Assets” for additional information.

There were no transfers of financial instruments between levels of the fair value hierarchy for any periods presented.

As of September 30, 2012 and December 31, 2011, the Company’s loan inventory, foreign currency forward contracts, certain mortgage-backed securities, purchased call options and embedded conversion derivative related to its long-term debt (see Footnote 11 “Long-Term Debt”), deferred compensation investments and its remaining investment in the Deephaven Funds are classified within Level 2 of the fair value hierarchy.

 

23


Table of Contents

KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

The following is a description of the valuation basis, techniques and significant inputs used by the Company in valuing its Level 2 assets:

Loan inventory

The Company’s loan inventory primarily comprises newly issued HECMs that it has originated or purchased and for which the Company has elected to account for at fair value. Significant inputs that are used in determining fair value include LIBOR and U.S. treasury interest rates, weighted average coupon and pricing of actively-traded HMBS and dealer quotations for HECMs.

Securitized HECM loan inventory

Securitized HECM loan inventory comprises HECMs that the Company has securitized into HMBS. The Company has recorded the securitized loans in Financial instruments owned, at fair value and a corresponding liability recorded as Liability to GNMA trusts, at fair value, on its Consolidated Statements of Financial Condition. As of September 30, 2012 and December 31, 2011 all of the HMBS created by the Company has been sold to third parties. Significant inputs that are used in determining fair value include LIBOR and U.S. treasury interest rates, weighted average coupon and pricing of actively-traded HMBS and dealer quotations for HECMs.

Foreign currency forward contracts

At September 30, 2012 and December 31, 2011, the Company had a foreign currency forward contract with a notional value of 75.0 million British pounds which is used to hedge the Company’s investment in its European subsidiary. As of September 30, 2012 and December 31, 2011, the Company had a foreign currency forward contract with a notional value of 10.3 million Euros and 6.0 million Euros, respectively, which is used as an economic hedge against a strategic investment that is denominated in Euros. The fair value of these contracts was determined based upon spot foreign exchange rates, LIBOR interest rates and dealer quotations.

Mortgage-backed securities

The Company’s mortgage-backed securities that are not actively traded are priced based upon dealer quotations, prices observed from recently executed transactions and cash flow models that incorporate LIBOR forward interest rates, weighted average coupon, weighted average loan age, loan to value and other observable inputs.

Purchased call options and embedded conversion derivative

The fair value of the purchased call options and embedded conversion derivative are determined using an option pricing model based on observable inputs such as implied volatility of the Company’s Class A common stock, risk-free interest rate, and other factors.

Deferred compensation investments

Deferred compensation investments comprise investments in liquid mutual funds that the Company acquires to hedge its obligations to employees and directors under certain non-qualified deferred compensation arrangements. These mutual fund investments can generally be redeemed at any time and are valued based upon quoted market prices.

 

24


Table of Contents

KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

Investment in the Deephaven Funds

Investment in the Deephaven Funds represents our residual investment in certain funds that were formerly managed by Deephaven Capital Management. These investments are in the process of liquidation and are valued based upon the fair value of the underlying investments within such funds.

Fair value of derivative instruments

The Company enters into derivative transactions, primarily with respect to making markets in listed domestic options. In addition, the Company enters into derivatives to manage foreign currency exposure and related to its long-term debt (see Footnote 11 “Long-Term Debt”). Cash flows associated with such derivative activities are included in cash flows from operating activities on the Consolidated Statements of Cash Flows, when applicable.

The following tables summarize the fair value of derivative instruments in the Consolidated Statements of Financial Condition and the gains and losses included in the Consolidated Statements of Operations (in thousands):

 

    

Statements of Financial

Condition Location

   Fair Value as of  

Asset Derivatives

      September 30,
2012
     December 31,
2011
 

Derivative instruments not designated as hedging instruments:

   Financial instruments owned, at fair value      

Purchased call options

      $ 109       $ 17,532   

Listed equity options(1)

        132,379         280,384   

Foreign currency forward contracts

        -           477   
     

 

 

    

 

 

 
      $         132,488       $ 298,393   
     

 

 

    

 

 

 

Derivative instruments designated as hedging instruments:

   Financial instruments owned, at fair value      

Foreign currency forward contracts

      $ -         $ 3,474   
     

 

 

    

 

 

 

Liability Derivatives

                  

Derivative instruments not designated as hedging instruments:

   Financial instruments sold, not yet purchased, at fair value      

Embedded conversion derivative

      $ 109       $ 17,532   

Listed equity options(1)

        111,691         254,506   

Total return swap(2)

        -           17,031   

Foreign currency forward contracts

        472         -     
     

 

 

    

 

 

 
      $ 112,272       $ 289,069   
     

 

 

    

 

 

 

 

25


Table of Contents

KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

    

Statements of Financial

Condition Location

   Fair Value as of  

Asset Derivatives

      September 30,
2012
     December 31,
2011
 

Liability Derivatives

                  

Derivative instruments designated as hedging instruments:

   Financial instruments sold, not yet purchased, at fair value      

Foreign currency forward contracts

      $ 3,850       $ -     
     

 

 

    

 

 

 

 

(1) At September 30, 2012, the Company held 0.6 million long and 0.6 million short listed equity option contracts. At December 31, 2011, the Company held 1.3 million long and 1.5 million short listed equity option contracts. These contracts are not subject to collateral requirements and are not netted.
(2) At December 31, 2011, the total return swap liability was offset by an asset of equal value that was included in Financial instruments owned, at fair value on the Company’s Consolidated Statements of Financial Condition. This total return swap was liquidated during the first quarter of 2012.

 

    

Financial Statements

Location

   Gain (Loss) Recognized
For the three months ended

September 30,
 
                2012                     2011          

Derivative instruments not designated as hedging instruments:

       

Purchased call options

   Investment income and other, net    $ (7,891   $ 7,577   

Listed equity options(1)

   Net trading revenue      (3,382     (10,703

Embedded conversion derivative

   Investment income and other, net              7,891        (7,577

Total return swap(2)

   Investment income and other, net      -                  1,035   

Foreign currency forward contracts

   Investment income and other, net      (1,696     600   
     

 

 

   

 

 

 
      $ (5,078)      $ (9,068)   
     

 

 

   

 

 

 

Derivative instruments designated as hedging instruments:

       

Foreign currency forward contracts

   Accumulated other comprehensive income (loss)    $ (2,164)      $ 3,500   
     

 

 

   

 

 

 

 

26


Table of Contents

KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

    

Financial Statements

Location

  Gain (Loss) Recognized
For the nine months ended

September 30,
 
       2012     2011  

Derivative instruments not designated as hedging instruments:

      

Purchased call options

   Investment income and other, net   $ (17,422   $ (14,649

Listed equity options(1)

   Net trading revenue     (9,185     (2,072

Embedded conversion derivative

   Investment income and other, net           17,422              14,649   

Total return swap(2)

   Investment income and other, net     -          (5,735

Foreign currency forward contracts

   Investment income and other, net     (1,498     600   
    

 

 

   

 

 

 
     $ (10,683   $ (7,207
    

 

 

   

 

 

 

Derivative instruments designated as hedging instruments:

      

Foreign currency forward contracts

   Accumulated other comprehensive income (loss)   $ (3,284   $ (118
    

 

 

   

 

 

 

 

(1) Realized gains and losses on listed equity options relate to the Company’s market making activities in such options. Such market making activities also comprise trading in the underlying equity securities, with gains and losses on such securities generally offsetting the gains and losses reported in this table. Gains and losses on such equity securities are also included in Net trading revenue on the Company’s Consolidated Statements of Operations.
(2) Loss on the total return swap is offset by an equal gain on the underlying position which is recorded in Investment income and other, net on the Company’s Consolidated Statements of Operations.

7.    Collateralized Transactions

The Company receives financial instruments as collateral in connection with securities borrowed. Such financial instruments generally consist of equity and convertible securities but may include obligations of the U.S. government, federal agencies, Non-U.S. government and corporations. In most cases, the Company is permitted to deliver or repledge these financial instruments in connection with securities lending and other secured financings and meeting settlement requirements.

The table below presents financial instruments at fair value received as collateral that were permitted to be delivered or repledged and that were delivered or repledged by the Company and in some instances could be further repledged by the receiving counterparty (in thousands):

 

     September 30,
2012
     December 31,
2011
 

Collateral permitted to be delivered or repledged

   $ 1,018,017       $ 1,450,281   

Collateral that was delivered or repledged

     951,027         1,383,298   

Collateral permitted to be further repledged by the receiving counterparty

     47,600         275,912   

 

27


Table of Contents

KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

In order to finance securities positions and loan inventory, the Company also pledges financial instruments that it owns to counterparties who, in turn, are permitted to deliver or repledge them. Under these transactions, the Company pledges certain financial instruments owned to collateralize repurchase agreements and other secured financings. Repurchase agreements and other secured financings are short-term and mature within one year. Financial instruments owned and pledged to counterparties that do not have the right to sell or repledge such financial instruments consist of equity securities and loans.

The table below presents information about assets pledged by the Company (in thousands):

 

     September 30,
2012
     December 31,
2011
 

Financial instruments owned, at fair value, pledged to counterparties that had the right to deliver or repledge

   $         3,699,610       $         2,121,783   

Financial instruments owned, at fair value, pledged to counterparties that do not have the right to deliver or repledge

   $ 638,526       $ 550,926   

8.    Receivable from and Payable to brokers, dealers, and clearing organizations

Amounts receivable from and payable to brokers, dealers, and clearing organizations consist of the following (in thousands):

 

     September 30,
2012
     December 31,
2011
 

Receivable:

     

Clearing organizations and other

   $ 772,888       $ 553,960   

Securities failed to deliver

     171,351         69,937   
  

 

 

    

 

 

 
   $ 944,239       $ 623,897   
  

 

 

    

 

 

 

Payable:

     

Clearing organizations and other

   $ 226,201       $ 306,728   

Securities failed to receive

     77,077         15,932   
  

 

 

    

 

 

 
   $         303,277       $         322,660   
  

 

 

    

 

 

 

9.    Investments

Investments include strategic investments, deferred compensation investments related to employee and director deferred compensation plans and investment in Deephaven Funds. Investments consist of the following (in thousands):

 

     September 30,
2012
     December 31,
2011
 

Strategic investments:

     

Investments accounted for under the equity method

   $ 72,714       $ 59,711   

Common stock of companies representing less than 20% equity ownership held at adjusted cost

     1,789         1,787   
  

 

 

    

 

 

 

Total Strategic investments

     74,502         61,498   

Deferred compensation investments

     21,711         20,414   

Investment in Deephaven Funds

     1,406         1,319   
  

 

 

    

 

 

 

Total Investments

   $         97,620       $         83,231   
  

 

 

    

 

 

 

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

During the second quarter of 2012, the Company became aware that a strategic investee that is accounted for under the equity method of accounting had identified errors in its accounting for income taxes. Specifically, the investee had not correctly accounted for an income tax benefit that resulted from a change in its tax status during 2010. The correction of this error by the investee resulted in an increase in the Company’s equity method investment of $10.0 million. The Company evaluated the impact of recording this investment gain in the relevant prior periods and concluded that such amounts would not have been material, qualitatively or quantitatively, to its previously issued consolidated financial statements for any prior period. The Company also concluded that recording the investment gain in 2012 would not be material to its forecasted results for the year. Accordingly the Company recorded a $10.0 million gain in the second quarter of 2012.

10.    Goodwill and Intangible Assets

Goodwill is assessed for impairment annually or when events indicate that the amounts may not be recoverable. The Company assesses goodwill for impairment at the reporting unit level. The Company’s reporting units are the components of its business segments for which discrete financial information is available and is regularly reviewed by the Company’s management. As part of the assessment for impairment, the Company considers the cash flows of the respective reporting unit and assesses the fair value of the respective reporting unit as well as the overall market value of the Company compared to its net book value. The assessment of fair value of the reporting units is principally performed using a discounted cash flow methodology with a risk-adjusted weighted average cost of capital which the Company believes to be the most reliable indicator of the fair values of its respective reporting units. The Company also assess the fair value of each reporting unit based upon its estimated market value and assesses the Company’s overall market value based upon the market price of its Class A common shares. In June 2012 and 2011, the Company assessed the impairment of goodwill as part of its annual assessment and concluded that there was no impairment at that time.

Intangible assets are assessed for recoverability when events or changes in circumstances indicate that the carrying amount of the asset or asset group may not be recoverable. The Company assesses intangible assets for impairment at the “asset group” level which is the lowest level for which identifiable cash flows are largely independent of the cash flows of other groups of assets and liabilities. As part of the assessment for impairment, the Company considers the cash flows of the respective asset group and assesses the fair value of the respective asset group. Step 1 of the impairment assessment for intangibles is performed using undiscounted cash flow models, which indicates whether the future cash flows of the asset group are sufficient to recover the book value of such asset group. When an asset is not considered to be recoverable, step 2 of the impairment assessment is performed using a discounted cash flow methodology with a risk-adjusted weighted average cost of capital to determine the fair value of the intangible asset group. In cases where amortizable intangible assets and goodwill are assessed for impairment at the same time, the amortizable intangibles are assessed for impairment prior to goodwill being assessed.

The events surrounding the August 1, 2012 technology issue resulted in a substantial decrease in the Company’s market capitalization and decreases in trading volumes and commission revenues as many customers reduced their trading activity. This was determined by management to be a triggering event for certain of the Company’s businesses and resulted in the Company being required to assess the carrying amount and recoverability of the goodwill related to those businesses. Certain reporting

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

units did not have a triggering event as they were relatively unaffected by the August 1, 2012 events. These events also indicated that certain of the Company’s amortizable intangible assets may not be recoverable.

The intangible asset impairment assessment performed in the third quarter of 2012 indicated that the intangible assets in the Company’s DMM, asset management and reverse mortgage businesses were impaired, and that the fair value of such intangible assets was less than the book value. As a result, the Company recorded an impairment charge of $15.3 million during the third quarter of 2012 comprising $11.9 million of trading rights related to the Company’s DMM business and $3.4 million of customer relationships related to the Company’s asset management business. During the third quarter of 2012 the Company also recorded a charge of $1.4 million related to the abandonment of intangible assets related to the Company’s reverse mortgage business.

The goodwill impairment assessment performed as a result of the August 1, 2012 triggering event, indicated that the fair value of goodwill within the institutional fixed income and asset management reporting units was less than their book values and as a result the Company recorded an impairment charge of $126.4 million during the third quarter of 2012 comprising goodwill of $114.3 million and $12.1 million related to the institutional fixed income and asset management reporting units, respectively.

As a result of a corporate restructuring the Company wrote off goodwill of $1.0 million in the Corporate and Other segment during the third quarter of 2011.

No other events occurred in 2012 or 2011 that would indicate that the carrying amounts of the Company’s goodwill or intangible assets may not be recoverable.

The following table summarizes the Company’s Goodwill as of September 30, 2012 and December 31, 2011 by segment (in thousands):

 

     September 30,
2012
     December 31,
2011
 

Market Making

   $ 24,727       $ 24,727   

Institutional Sales and Trading

     21,376         147,736   

Electronic Execution Services

     165,380         165,380   

Corporate and Other

     7,117         -     
  

 

 

    

 

 

 

Total

   $         218,600       $         337,843   
  

 

 

    

 

 

 

 

In 2012, the Company recorded goodwill of $7.1 million as a result of the acquisition of certain assets and assumption of certain liabilities of the former futures division of Penson.

Intangible assets primarily represent client relationships and are amortized over their estimated remaining useful lives, the majority of which have been determined to range from one to 18 years. The weighted average remaining life of the Company’s intangible assets at September 30, 2012 and December 31, 2011 is approximately 10 and 11 years, respectively.

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

The following tables summarize the Company’s Intangible assets, net of accumulated amortization as of September 30, 2012 and December 31, 2011 by segment and type (in thousands):

 

     September 30,
2012
     December 31,
2011
 

Market Making

     

Trading rights

   $ 11,769       $ 25,283   

Other

     43         -     
  

 

 

    

 

 

 

Total

     11,812         25,283   
  

 

 

    

 

 

 

Institutional Sales and Trading

     

Customer and broker relationships

     17,591         24,165   

Trade names

     1,275         1,350   

Other

     325         3,905   
  

 

 

    

 

 

 

Total

     19,191         29,420   
  

 

 

    

 

 

 

Electronic Execution Services

     

Customer and broker relationships

     23,886         26,730   

Trade names

     5,867         6,207   

Other

     3,979         5,249   
  

 

 

    

 

 

 

Total

     33,732         38,186   
  

 

 

    

 

 

 

Corporate and Other

     

Customer and broker relationships

     3,435         -     
  

 

 

    

 

 

 

Total

     3,435         -     
  

 

 

    

 

 

 

Consolidated Total

   $         68,170       $         92,889   
  

 

 

    

 

 

 

 

In 2012, the Company recorded intangible assets of $3.5 million as a result of the acquisition of certain assets and assumption of certain liabilities of the former futures division of Penson.

 

          September 30,
2012
    December 31,
2011
 

Customer and broker relationships(1)

   Gross carrying amount    $ 94,200      $ 93,600   
  

Accumulated amortization

     (49,288     (42,705
     

 

 

   

 

 

 
   Net carrying amount      44,912        50,895   
     

 

 

   

 

 

 

Trading rights(2)

   Gross carrying amount      15,520        28,520   
  

Accumulated amortization

     (3,751     (3,237
     

 

 

   

 

 

 
   Net carrying amount      11,769        25,283   
     

 

 

   

 

 

 

Trade names(3)

   Gross carrying amount      9,800        9,800   
  

Accumulated amortization

     (2,658     (2,243
     

 

 

   

 

 

 
   Net carrying amount      7,142        7,557   
     

 

 

   

 

 

 

Other(4)

   Gross carrying amount      13,960        18,761   
  

Accumulated amortization

     (9,613     (9,607
     

 

 

   

 

 

 
   Net carrying amount      4,347        9,154   
     

 

 

   

 

 

 

Total

   Gross carrying amount      133,480        150,681   
  

Accumulated amortization

     (65,310     (57,792
     

 

 

   

 

 

 
   Net carrying amount    $         68,170      $         92,889   
     

 

 

   

 

 

 

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

 

(1) Customer and broker relationships primarily relate to the Donaldson, Direct Trading, Hotspot, EdgeTrade, Libertas, Urban, Astor and Penson Futures acquisitions. The weighted average remaining life is approximately 11 years as of September 30, 2012 and 10 years as of December 31, 2011. Lives may be reduced depending upon actual retention rates.
(2) Trading rights provide the Company with the rights to trade on certain exchanges. The gross and net carrying amounts were reduced in the third quarter of 2012 by $13.0 million and $11.9 million, respectively as a result of the impairment assessment described above. The weighted average remaining life is approximately 8 years as of September 30, 2012 and 14 years as of December 31, 2011.
(3) Trade names relate to the acquisitions of Hotspot, EdgeTrade and Urban. The weighted average remaining life is approximately 14 years as of both September 30, 2012 and December 31, 2011.
(4) Other primarily includes technology and non-compete agreements acquired by the Company. The gross and net carrying amounts were reduced in the third quarter of 2012 by $7.8 million and $4.8 million, respectively as a result of the impairment assessment described above. The weighted average remaining life is approximately three years as of September 30, 2012 and two years as of December 31, 2011.

The following table summarizes the Company’s amortization expense relating to Intangible assets (in thousands):

 

     For the three months ended
September 30,
     For the nine months ended
September 30,
 
             2012                      2011                      2012                      2011          

Amortization expense

   $         3,695       $         3,965       $         11,595       $         11,866   

As of September 30, 2012, the following table summarizes the Company’s estimated amortization expense for the following future periods (in thousands):

 

     Amortization
expense
 

Three months ended December 31, 2012

   $         3,338   

For the year ended December 31, 2013

     11,539   

For the year ended December 31, 2014

     9,720   

For the year ended December 31, 2015

     7,565   

For the year ended December 31, 2016

     4,718   

11.    Long-Term Debt

The Company’s Long-term debt is recorded at amortized cost. The carrying value and fair value of such Long-term debt as of September 30, 2012 and December 31, 2011 is as follows (in thousands):

 

     September 30, 2012      December 31, 2011  
     Carrying Amount      Fair Value      Carrying Amount      Fair Value  
           

Term Credit Agreement

   $ 100,000       $ 100,000       $ 100,000       $ 100,000   

Convertible Notes

     335,089         309,589         324,338         287,505   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

     435,089         409,589         424,338         387,505   

Less: Current portion recorded in Accrued expenses and other liabilities

     25,000         25,000         -           -     
  

 

 

    

 

 

    

 

 

    

 

 

 

Total Long-term debt

   $ 410,089       $ 384,589       $ 424,338       $ 387,505   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

The carrying value of the Term Credit Agreement approximates fair value as it is not materially sensitive to shifts in interest rates due to its floating interest rate, which also considers changes in the Company’s credit risks and financial condition. The fair value of the Convertible Notes is based upon the value of such debt in the secondary market. The Term Credit Agreement and the Convertible Notes would both be categorized as Level 2 in the fair value hierarchy if they were required to be recorded at fair value.

Credit Agreements

On June 29, 2011, the Company, as borrower, entered into a $100.0 million three-year Term Loan Credit Agreement (the “Term Credit Agreement”) with a consortium of banks. The Company, as guarantor, also entered into a $200.0 million one-year Revolving Credit Agreement (the “Revolving Credit Agreement” and together with the Term Credit Agreement, the “Credit Agreements”) with the same consortium of banks with Knight Execution & Clearing Services LLC (“KECS”) and Knight Capital Americas, L.P., wholly-owned subsidiaries of the Company, as borrowers. The Revolving Credit Agreement was renewed with substantially the same consortium of banks on substantially the same terms and conditions on June 27, 2012 and will expire on June 26, 2013. As a result of the consolidation of Knight Capital Americas, L.P. into KECS as of June 30, 2012, and the subsequent renaming of KECS to Knight Capital Americas LLC (“KCA”), KCA is now the sole borrower under the Revolving Credit Agreement.

Term Credit Agreement

The proceeds of the Term Credit Agreement are being used for general corporate purposes. As of September 30, 2012, the Company has borrowed all the funds under the Term Credit Agreement. Borrowings under the Term Credit Agreement bear interest at variable rates as determined at the Company’s election, at LIBOR or a base rate, in each case, plus an applicable margin of (a) for each LIBOR loan, 2.50% or 3.00% per annum or (b) for each base rate loan, 1.50% or 2.00% per annum (in each case, depending on the Company’s leverage ratio). As of September 30, 2012, the interest rate was 2.72% per annum, which is based on the one month LIBOR rate plus 2.50%. Interest is paid monthly. The Term Credit Agreement is repayable in three installments as follows: $25.0 million on June 28, 2013, $25.0 million on December 27, 2013 and $50.0 million on June 27, 2014.

Under the Term Credit Agreement, substantially all of the Company’s material subsidiaries (the “Guarantors”), other than its foreign subsidiaries, excluded regulated subsidiaries (which include registered broker-dealer subsidiaries) and subsidiaries thereof, guarantee the repayment of loans made pursuant to the Term Credit Agreement. The Term Credit Agreement is secured by substantially all of the assets of the Company and the Guarantors unless and until the Company obtains an investment grade rating.

Revolving Credit Agreement

The Revolving Credit Agreement comprises two classes of loans: Borrowing Base A and Borrowing Base B. The proceeds of the Borrowing Base A Loans are available to KCA and may be used to meet the short-term liquidity needs of KCA arising in the ordinary course of clearing and settlement activity. The proceeds of the Borrowing Base B Loans can only be used to fund National Securities Clearing Corporation (“NSCC”) margin deposits.

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

Borrowings under the Revolving Credit Agreement bear interest at a rate equal to the greater of the federal funds rate or the one month LIBOR rate plus (a) for each Borrowing Base A Loan, a margin of 1.50% per annum and (b) for each Borrowing Base B Loan a margin of 2.00% per annum. Interest is payable quarterly. On August 6, 2012, the Company drew down $200.0 million under the Revolving Credit Agreement for both a Borrowing Base A and Borrowing Base B Loan and repaid the full amount of each loan on August 7, 2012. As of September 30, 2012 and December 31, 2011, there were no outstanding borrowings under the Revolving Credit Agreement.

The Company is charged an annual commitment fee of 0.25% on the average daily amount of the unused portion of the Revolving Credit Agreement. Depending on each borrowing base, availability under the Revolving Credit Agreement is limited to either (i) a percentage of the market value of temporary positions pledged as collateral in the case of Borrowing Base A Loans, or (ii) a percentage of the margin deposit required by the NSCC in the case of Borrowing Base B Loans.

Among other restrictions, the Credit Agreements include customary representations, warranties, affirmative and negative covenants related to (a) liens, (b) financial covenant requirements for maintaining a consolidated leverage ratio and a liquidity ratio, as well as requirements for maintaining minimum levels of tangible net worth and regulatory capital, and (c) restrictions on investments, dispositions and other restrictions and events of default customary for financings of these types. As of September 30, 2012, the Company was in compliance with all covenants under the Credit Agreements.

In connection with the Credit Agreements, the Company incurred issuance costs of $2.2 million. The issuance costs are recorded within Other assets on the Consolidated Statements of Financial Condition and are being amortized over the term of the Credit Agreements.

Cash Convertible Senior Subordinated Notes

In March 2010, the Company issued $375.0 million of Cash Convertible Senior Subordinated Notes (the “Notes”) due on March 15, 2015 in a private offering exempt from registration under the Securities Act of 1933, as amended. At the same time, the Company entered into hedge transactions effected through the purchase of options and sale of warrants designed to limit shareholder dilution up to a price of $31.50 per share.

The Notes bear interest at a rate of 3.50% 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 connection with the issuance of the Notes, the Company recognized an original issue discount of $73.8 million which is being accreted to interest expense over the term of the Notes, resulting in an effective annual interest rate of the Notes of approximately 7.90%. The Notes, net of unamortized original issue discount are reported as Long-term debt in the Company’s Consolidated Statements of Financial Condition.

Prior to December 15, 2014, the Notes will be convertible into cash only upon specified events which are based upon the price of the Company’s common shares and of the Notes or upon the occurrence of specified corporate events. On or after December 15, 2014, the Notes will be convertible at any time, based on an initial conversion rate of 47.9185 shares of the Company’s Class A common stock per $1,000 principal amount of Notes, which is equivalent to an initial conversion price of approximately $20.87 or a conversion premium of approximately 32.5% over the closing sale price of $15.75 per share of the Company’s Class A common stock on the Nasdaq Global Select Market on March 15, 2010. The conversion rate and conversion price will be subject to adjustment in certain

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

events, such as distributions of dividends or stock splits. Upon cash conversion, the Company will deliver an amount of cash calculated over the applicable observation period. The Company will not deliver its common stock (or any other securities) upon conversion under any circumstances. In addition, following certain corporate events that occur prior to the maturity date, the Company will pay a cash make-whole premium by increasing the conversion rate for a holder who elects to convert its Notes in connection with such a corporate event in certain circumstances. Subject to certain exceptions, holders may require the Company to repurchase, for cash, all or part of the Notes upon a “fundamental change” at a price equal to 100% of the principal amount of the Notes being repurchased plus any accrued and unpaid interest.

Concurrent with the sale of the Notes, the Company paid $73.7 million to enter into privately negotiated cash convertible note hedge transactions (the “purchased call options”) with affiliates of the initial purchasers of the Notes and another financial institution (the “option counterparties”) that are expected generally to reduce the Company’s exposure to potential cash payments in excess of the principal amount of the Notes that may be required to be made by the Company upon the cash conversion of the Notes under certain conditions. The purchased call options cover, subject to adjustments, approximately 18 million shares of the Company’s Class A common stock at a strike price of $20.87 and are expected to reduce the Company’s economic exposure to potential cash payments in the event that the market price per share of the Company’s Class A common stock is greater than the conversion price of the Notes. The purchased call options were recorded as an asset within Financial instruments owned, at fair value on the Consolidated Statements of Financial Condition and is accounted for as derivative instruments under GAAP. As of September 30, 2012, the fair value of the purchased call options was $0.1 million.

In connection with the sale of the Notes, the Company also entered into separate warrant transactions with the option counterparties whereby the Company sold to the option counterparties, for $15.0 million, warrants (the “warrants”) to purchase shares of the Company’s Class A common stock, subject to adjustments, at a strike price of $24.10 per share, which represents a premium of approximately 100% over the closing price of the Company’s Class A common stock on March 15, 2010. The warrants are net share settled, meaning that the Company will issue a number of shares per warrant having a value equal to the difference between the share price at each warrant expiration date and the strike price; however, at the discretion of the Company, the Company may elect to settle the warrants in cash. If the market price per share of the Company’s Class A common stock exceeds the strike price of the warrants over the warrants’ exercise period and the Company elects net share settlement, the warrants would have a dilutive effect on the Company’s Class A common stock. The warrants may not be exercised prior to the maturity of the Notes. The warrants have been recorded as Additional paid-in capital in the Consolidated Statements of Financial Condition. The warrants also meet the criteria of derivative instruments under GAAP; however, because the warrants are indexed to the Company’s Class A common stock and are recorded within Equity in the Consolidated Statements of Financial Condition, the warrants are exempt from the scope and fair value provisions of GAAP related to accounting for derivative instruments.

The requirement that the Company settle conversions of the Notes entirely in cash gives rise to a bifurcatable derivative instrument under GAAP (the “embedded conversion derivative”). The initial valuation of the embedded conversion derivative was $73.8 million, and was recorded as a liability within Financial instruments sold, not yet purchased, at fair value on the Consolidated Statements of Financial Condition. As of September 30, 2012, the fair value of the embedded conversion derivative was $0.1 million.

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

Both the purchased call options and the embedded conversion derivative are derivative instruments and as such are marked to fair value each reporting period with any change recognized on the Consolidated Statements of Operations as Investment income and other, net. The Company expects the gain or loss associated with changes to the valuation of the purchased call options to substantially offset the gain or loss associated with changes to the valuation of the embedded conversion derivative.

In connection with the issuance of the Notes, the Company incurred issuance costs of $8.5 million. The issuance costs are being recorded within Other assets on the Consolidated Statements of Financial Condition and are amortized over the term of the Notes.

The Company recorded expenses with respect to the Long-term debt as follows (in thousands):

 

     For the three months ended
September 30,
     For the nine months ended
September 30,
 
           2012                  2011                  2012                  2011        

Interest expense

   $ 7,640       $ 7,380       $ 22,685       $ 20,450   

Amortization of debt issuance cost(1)

     743         780         2,301         1,630   

Commitment fee(1)

     125         128         401         128   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $         8,508       $         8,288       $         25,387       $         22,208   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) Included in Other expense on the Consolidated Statements of Operations.

12.    Related Parties

As a result of the August 6, 2012 recapitalization, as of September 30, 2012, three investors held more than 10% of the Class A common stock plus Series A Shares on a fully converted basis and therefore are considered related parties.

The Company interacts with these three investors as part of its normal day-to-day operations. It earns revenues, incurs expenses and maintains balances with these related parties or their affiliates on a regular basis. As of the date and period indicated below, the Company had the following balances and transactions with the related parties or their affiliates as follows (in thousands):

 

Statement of Operations

   For the period
August 6, 2012 to
September 30,
2012
 

Revenues

  

Commissions and fees

   $ 77   

Net trading revenue

     406   

Interest, net

     16   
  

 

 

 

Total revenues with related parties

   $         499   
  

 

 

 

Expenses

  

Execution and clearance fees

   $ 12   

Interest expense

     133   
  

 

 

 

Total expenses with related parties

   $ 145   
  

 

 

 

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

Statement of Financial Condition

   As of September 30,
2012
 

Assets

  

Securities borrowed

   $         47,269   

Other assets

   $ 4,425   

Liabilities

  

Securities loaned

   $ 37,023   

Payable to brokers, dealers and clearing organizations

   $ 56   

Accrued expenses and other liabilities

   $ 5,936   

The Company paid a total of $22.6 million in fees to related parties in connection with the August 6, 2012 recapitalization which was recorded as a reduction of the proceeds from the $400.0 million convertible preferred share offering. In the ordinary course of business, the Company enters into foreign exchange contracts with related parties.

13.    Stock-Based Compensation

The Knight Capital Group, Inc. 2010 Equity Incentive Plan (“2010 Plan”) was established to provide long-term incentive compensation to employees and directors of the Company. The 2010 Plan is administered by the Compensation Committee of the Company’s Board of Directors, and allows for the grant of options, stock appreciation rights, restricted stock and restricted stock units (collectively, the “awards”), as defined by the 2010 Plan. In addition to overall limitations on the aggregate number of awards that may be granted, the 2010 Plan also limits the number of awards that may be granted to a single individual. The 2010 Plan replaced prior stockholder-approved equity plans for future equity grants and no additional grants will be made under those historical stock plans. However, the terms and conditions of any outstanding equity grants under the historical stock plans were not affected. As of September 30, 2012, the Company has not issued any stock appreciation rights. In addition, the Company established the Knight Capital Group, Inc. 2009 Inducement Award Plan (the “Inducement Plan”) (along with the 2010 Plan, the “Stock Plans”) which is used under limited circumstances for equity grants to new hires. The Company did not issue any awards pursuant to the Inducement Plan in 2012 or 2011.

Unvested awards granted before September 1, 2010 are generally canceled if employment is terminated for any reason before the end of the relevant vesting period. For annual incentive awards granted after September 1, 2010 and up to September 30, 2011, full vesting is given where an employee has been terminated without cause by the Company. For all other awards granted after September 1, 2010 and up to September 30, 2011 unvested awards are generally canceled if employment is terminated for any reason before the end of the relevant vesting period. Effective October 1, 2011, for all awards granted after such date, unless otherwise provided for in the applicable award agreement, full vesting will be given where an employee has been terminated without cause by the Company.

Under the terms of our prior stockholder-approved equity plans (excluding the 2010 Plan), accelerated vesting of unvested equity awards is triggered upon a change-in-control which is generally defined, amongst other things, as the acquisition by any one person of 20% or more of the Company’s voting stock. Subsequent to the Company’s issuance of Series A Shares on August 6, 2012, one of the investors exceeded the 20% ownership threshold on an as-converted basis, which resulted in the accelerated vesting

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

of unvested grants held by employees under these historical plans. The affected equity awards were generally granted from December 2009 through March 2010, and generally would have vested between December 2012 and March 2013. The accelerated vesting resulted in additional stock-based compensation of $1.6 million in the third quarter of 2012. Each of our Named Executive Officers and Section 16 reporting persons previously executed letters waiving the acceleration of vesting triggered by this change-in-control for any unvested awards held by them under the prior historical plans as of such date.

Restricted Shares and Restricted Stock Units

Eligible employees and directors may receive restricted shares and/or restricted stock units (collectively “restricted awards”) as a portion of their total compensation. The majority of restricted awards vest ratably over three years. The Company has also issued restricted awards that vest based upon the market price of Knight’s Class A common stock reaching a certain price for a specified period of time, however no such awards were granted in 2012 or 2011. The Company has the right to fully vest employees and directors in their restricted stock units upon retirement and in certain other circumstances.

The Company measures compensation cost related to restricted awards based on the fair value of the Company’s Class A common stock at the date of grant. Compensation expense relating to restricted awards, primarily recorded in Employee compensation and benefits, and the corresponding income tax benefit, which was recorded in Income tax (benefit) expense on the Consolidated Statements of Operations are presented in the following table (in thousands):

 

     For the three months ended
September 30,
     For the nine months ended
September 30,
 
           2012                  2011                  2012                  2011        

Stock award compensation expense

   $         13,615       $         13,480       $         41,327       $         40,939   
  

 

 

    

 

 

    

 

 

    

 

 

 

Income tax benefit

   $ 4,765       $ 5,284       $ 14,464       $ 16,048   
  

 

 

    

 

 

    

 

 

    

 

 

 

The following table summarizes restricted awards activity during the nine months ended September 30, 2012 (shares and units in thousands):

 

     Restricted Shares      Restricted Stock Units  
     Number
of Shares
    Weighted-
Average
Grant date
Fair Value
     Number of
Units
    Weighted-
Average
Grant date
Fair Value
 

Outstanding at January 1, 2012

     307      $ 16.20         7,716      $ 14.33   

Granted

     21        13.09         4,268        12.45   

Vested

     (234     16.32         (3,072     15.00   

Forfeited

     (11     15.74         (460     13.17   
  

 

 

      

 

 

   

Outstanding at September 30, 2012

               83      $         15.12                   8,452                13.34   
  

 

 

      

 

 

   

There is $60.8 million of unamortized compensation related to unvested restricted awards outstanding at September 30, 2012. The cost of these unvested restricted awards is expected to be recognized over a weighted average life of 1.8 years.

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

Stock Options

The Company’s policy is to grant options for the purchase of shares of Class A common stock at not less than market value. Options generally vest ratably over a three or four-year period and expire on the fifth or tenth anniversary of the grant date, pursuant to the terms of the applicable option award agreement. The Company has the right to fully vest employees in their options upon retirement and in certain other circumstances. Options are otherwise canceled if employment is terminated before the end of the relevant vesting period. The Company’s policy is to issue new shares upon share option exercises by its employees and directors.

The fair value of each option granted is estimated as of its respective grant date using the Black-Scholes option-pricing model. Stock options granted have exercise prices equal to the market value of the Company’s Class A common stock at the date of grant as defined by the Stock Plans. The principal assumptions utilized in valuing options and the methodology for estimating such model inputs include: (1) risk-free interest rate – estimate is based on the yield of U.S. zero coupon securities with a maturity equal to the expected life of the option; (2) expected volatility – estimate is based on several factors including implied volatility of market-traded options on the Company’s Class A common stock on the grant date and the volatility of the Company’s Class A common stock; and (3) expected option life – estimate is based on internal studies of historical experience and projected exercise behavior based on different employee groups and specific option characteristics, including the effect of employee terminations. The Company did not grant any options in 2012 or 2011.

Compensation expense relating to stock options, which was recorded in Employee compensation and benefits, and the corresponding income tax benefit, which was recorded in Income tax (benefit) expense on the Consolidated Statements of Operations are as follows (in thousands):

 

     For the three months ended
September 30,
     For the nine months ended
September 30,
 
           2012                  2011                  2012                  2011        

Stock option compensation expense

   $ 572       $ 294       $           1,066       $           1,038   
  

 

 

    

 

 

    

 

 

    

 

 

 

Income tax benefit

   $           200       $           115       $ 373       $ 407   
  

 

 

    

 

 

    

 

 

    

 

 

 

The following table summarizes stock option activity during the nine months ended September 30, 2012 (shares and units in thousands):

 

     Number of
Stock Options
    Weighted-
Average
Exercise
Price
 

Outstanding at January 1, 2012

     2,829      $     13.48   

Granted at market value

     -          -     

Exercised

     (130     8.77   

Forfeited or expired

     (94     16.11   
  

 

 

   

Outstanding at September 30, 2012

     2,605        13.62   
  

 

 

   

Exercisable at September 30, 2012

     2,569        13.59   
  

 

 

   

Available for future grants at September 30, 2012*

             7,173     
  

 

 

   

 

* Represents both options and awards available for grant

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

There is $0.1 million of unrecognized compensation related to unvested stock options outstanding at September 30, 2012. The cost of these unvested awards is expected to be recognized over a weighted average life of 0.3 years.

14.    Income taxes

The Company and its subsidiaries file a consolidated federal income tax return as well as combined state income tax returns in certain jurisdictions. In other jurisdictions, the Company and its subsidiaries file separate company state and local income tax returns.

The following table reconciles the U.S. federal statutory income tax rate to the Company’s actual income tax rate:

 

     For the three months ended
September 30,
    For the nine months ended
September 30,
 
         2012             2011             2012             2011      

U.S. federal statutory income tax rate

     35.0     35.0     35.0     35.0

U.S. state and local income taxes, net of U.S. federal income tax effect

     0.8     4.0     0.5     4.0

Nondeductible charges and other, net

     -0.5     0.3     -0.5     0.2
  

 

 

   

 

 

   

 

 

   

 

 

 

Actual income tax rate

                 35.3                 39.3                 35.0                 39.2
  

 

 

   

 

 

   

 

 

   

 

 

 

At September 30, 2012, the Company had $1.0 million of unrecognized tax benefits, all of which would affect the Company’s effective tax rate if recognized.

As of September 30, 2012, the Company is subject to U.S. Federal income tax examinations for the tax years 2008 through 2011, and to non-U.S. income tax examinations for the tax years 2007 through 2011. In addition, the Company is subject to state and local income tax examinations in various jurisdictions for the tax years 2003 through 2011. The final outcome of these examinations is not yet determinable. However, the Company anticipates that adjustments to the unrecognized tax benefits, if any, will not result in a material change to the results of operations or financial condition.

The Company’s policy for recording interest and penalties associated with audits is to record such items as a component of income or loss from continuing operations before income taxes. Penalties, if any, are recorded in Other expenses and interest paid or received is recorded in Interest expense and Interest, net, on the Consolidated Statements of Operations.

Deferred income taxes reflect the net tax effects of temporary differences between the financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when such differences are expected to reverse. Valuation allowances recorded on the balance sheet dates are necessary in cases where management believes that it is more likely than not that some portion or all of the deferred tax assets will not be realized.

At September 30, 2012 and December 31, 2011, the Company had federal and state deferred tax assets related to temporary differences and tax loss carryforwards of $86.8 million and $26.2 million, respectively. Due to the losses generated in the third quarter of 2012, the Company currently is in a

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

three year cumulative loss position. The Company has a long standing history of sustainable profitability, and based on its forecasts it is expecting to return to profitability. A significant portion of the customer base has remained unchanged and the business has generally demonstrated a return to normality following the technology related losses of August 1, 2012, and the Company does not expect the loss to recur in the future. The goodwill and intangible asset impairment that the Company recorded in the third quarter of 2012 are related to businesses that have not performed well and are not reflective of any weakness in the Company’s electronic market making business, which has historically been its most profitable business. Based on the weight of the positive and negative evidences considered, management believes that it is more likely than not that it will be able to realize its deferred tax assets in the future and therefore has not established a valuation allowance against its net deferred tax assets for the period ended September 30, 2012.

As a result of the losses generated in the third quarter of 2012, it is likely that the Company will generate federal, state and local net operating losses for the year ending December 31, 2012.

A significant portion of our anticipated 2012 U.S. federal net operating loss will be eligible to be carried back against taxable income earned by the Company in 2010 and 2011, which will result in a refund of U. S. federal taxes that the Company previously paid in such years. Since the Company uses a calendar year for tax reporting purposes, it cannot calculate its taxable loss for the year ending December 31, 2012 until after the close of that period. For the nine months ended September 30, 2012, however, the Company estimates its taxable loss to be approximately $400.0 million.

The Company generated taxable income for 2010 and 2011 of approximately $338.0 million and paid U.S. federal income tax of approximately $118.0 million for these years. Based upon the estimated $400.0 million U.S. federal taxable loss for the nine months ended September 30, 2012, the Company would be able to carry $338.0 million of such loss back to 2010 and 2011 and the Company would be able to obtain a $118.0 million refund of U.S. federal income taxes. This $118.0 million benefit has been recorded within Income taxes receivable on the Company’s Consolidated Statements of Financial Condition as of September 30, 2012. The balance of the $173.6 million Income taxes receivable on the Company’s Consolidated Statements of Financial Condition as of September 30, 2012 also includes $55.6 million of refunds due the Company with respect to estimated taxes paid for the year ending December 31, 2012 and refunds due the Company with respect to earlier periods.

The portion of the $400.0 million loss that could not be carried back, approximately $70.0 million, would generate a U.S. federal net operating loss carryforward related to the nine months ended September 30, 2012. Including this estimated $70.0 million tax loss carryforward the Company had U.S. federal net operating loss carryforwards of approximately $100.0 million and $31.3 million at September 30, 2012 and December 31, 2011, respectively, of which $31.3 million resulted from acquisitions. The Company recorded related deferred income tax assets related to these net operating loss carryforwards of $35.1 million and $11.0 million as of September 30, 2012 and December 31, 2011, respectively. As of both periods, the Company recorded an offsetting valuation allowance of $7.0 million which represents the portion of these net operating loss carryforwards that are considered more likely than not to expire unutilized.

In accordance with Section 382 of the Internal Revenue Code of 1986, as amended, a change in equity ownership of greater than 50% of the Company within a three-year period results in an annual limitation on the Company’s ability to utilize its net operating losses (“NOL”) carryforwards that were

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

created during tax periods prior to the change in ownership. As a result of the Series A convertible preferred stock equity issuance, on August 6, 2012, the Company experienced an ownership change under Section 382 and therefore the rate of utilization of a portion of the Company’s NOL carryforwards will be limited. The Company does not believe this limitation will have a significant effect on the Company’s ability to utilize its anticipated federal NOL carryforward. The Company’s U.S. federal NOL carryforwards will begin to expire in 2019.

Net operating losses generally cannot be carried back for state income tax purposes, and as a result the Company had significant state and local net operating loss carryforwards as of September 30, 2012. The Company recorded a valuation allowance for substantially all of its anticipated state and local tax loss carryforwards as it is more likely than not that due to limitations on utilization in the particular jurisdictions in which the Company operates that the benefit of such items will not be realized.

At September 30, 2012, the Company had non-U.S. net operating loss carryforwards of $66.9 million as compared to $63.7 at December 31, 2011. The Company recorded foreign deferred tax assets of $17.4 million and $17.8 million related to these loss carryforwards as of September 30, 2012 and December 31, 2011, respectively, along with offsetting U.S. federal deferred tax liabilities of $17.4 million and $17.8 million for the expected future reduction in U.S. foreign tax credits associated with the use of the non-U.S. loss carryforwards. These non-U.S. net operating losses may be carried forward indefinitely.

15.    Restructuring, Writedown of Assets and Lease Loss Accrual

As discussed in footnote 10 “Goodwill and Intangible Assets”, in the third quarter of 2012 the Company recorded a non-cash impairment charge of $143.0 million, representing $126.4 of goodwill related to the institutional fixed income and asset management businesses and $16.7 million of intangible assets related to the Company’s DMM, asset management and reverse mortgage businesses.

In the third quarter of 2011, the Company undertook a corporate restructuring designed to lower operating expenses and improve financial performance. This restructuring comprised a reduction in workforce, a significant downsizing of its Hong Kong presence and discontinuing certain other initiatives. For the three and nine months ended September 30, 2011, the Company recorded a Restructuring charge of $28.6 million which affected all segments and comprised the following:

 

   

Employee severance and other employee benefit costs of $17.7 million;

 

   

Hong Kong asset writedown, lease and contract termination costs of $2.7 million; and

 

   

Capitalized software, intangible asset and goodwill writedown of $8.3 million.

Writedown of assets and lease loss accrual was $1.3 million and $2.3 million for the three and nine months ended September 30, 2011, respectively, related to excess real estate capacity.

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

16.    Earnings Per Share

Basic loss or earnings per common share (“EPS”) have been calculated by dividing net loss income by the weighted average shares of Class A common stock outstanding during each respective period. Diluted EPS reflects the potential reduction in EPS using the treasury stock method to reflect the impact of common stock equivalents if stock options were exercised, restricted awards were to vest and preferred stock were to convert to Class A common stock.

The Series A Shares are participating securities and as a result the Company is required to calculate EPS under two class method whereby earnings are allocated to Class A common stock and Series A Shares as if all of the earnings for the period had been distributed. Since the Company recorded a net loss for the period ended September 30, 2012 the impact of the two class method would be antidilutive. The calculation of diluted EPS excludes the conversion of Series A Shares into Class A common stock and excludes options, restricted awards and Series A Shares that could potentially dilute EPS in the future but were antidilutive for the periods presented. The number of such options excluded was approximately 2.6 million and 1.8 million for the three months ended September 30, 2012 and 2011, respectively, and 1.8 million and 2.0 million for the nine months ended September 30, 2012 and 2011, respectively. The number of such restricted awards excluded was approximately 1.1 million for the three months ended September 30, 2012 and 2.8 million for the nine months ended September 30, 2012. The number of such Series A Shares excluded was approximately 129.1 million for the three months ended September 30, 2012 and 43.3 million for the nine months ended September 30, 2012. The computation of diluted shares can vary among periods due in part to the change in the average price of the Company’s Class A common stock.

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

The following is a reconciliation of the numerators and denominators of the basic and diluted (loss) earnings per share computations for the three and nine months ended September 30, 2012 and 2011 (in thousands):

 

     For the three months ended September 30,  
     2012     2011  
     Numerator /
(net loss)
    Denominator /
shares
    Numerator /
net income
     Denominator /
shares
 

Net (loss) income

   $ (389,921     $ 26,936      

Dividend on convertible preferred shares

     (1,051       -        

Deemed dividend related to beneficial conversion feature of convertible preferred shares

     (373,364       -        
  

 

 

     

 

 

    

Net (loss) income attributable to common stockholders and shares used in basic calculations

   $ (764,336     121,246      $ 26,936         91,564   

Effect of dilutive stock based awards

       -             2,276   
  

 

 

   

 

 

   

 

 

    

 

 

 

(Loss) Income and shares used in diluted calculations

   $ (764,336     121,246      $ 26,936         93,840   
  

 

 

   

 

 

   

 

 

    

 

 

 

Basic (loss) earnings per share

     $ (6.30      $ 0.29   
    

 

 

      

 

 

 

Diluted (loss) earnings per share

     $ (6.30      $ 0.29   
    

 

 

      

 

 

 

 

     For the nine months ended September 30,  
     2012     2011  
     Numerator /
(net loss)
    Denominator /
shares
    Numerator /
net income
     Denominator /
shares
 

Net (loss) income

   $ (353,525     $ 74,999      

Dividend on convertible preferred shares

     (1,051       -        

Deemed dividend related to beneficial conversion feature of convertible preferred shares

     (373,364       -        
  

 

 

     

 

 

    

(Loss) Income attributable to common stockholders and shares used in basic calculations

   $ (727,940     101,044      $ 74,999         91,877   

Effect of dilutive stock based awards

       -             2,926   
  

 

 

   

 

 

   

 

 

    

 

 

 

(Loss) Income and shares used in diluted calculations

   $ (727,940     101,044      $ 74,999         94,803   
  

 

 

   

 

 

   

 

 

    

 

 

 

Basic (loss) earnings per share

     $ (7.20      $ 0.82   
    

 

 

      

 

 

 

Diluted (loss) earnings per share

     $ (7.20      $ 0.79   
    

 

 

      

 

 

 

17.    Significant Clients

The Company considers significant clients to be those clients who account for 10% or more of the total U.S. equity dollar value traded or fixed income notional value traded by the Company. No clients accounted for more than 10% of the Company’s U.S. equity dollar value traded or fixed income notional value traded during the three and nine months ended September 30, 2012 or 2011.

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

18.    Commitments and Contingencies

In the ordinary course of business, the nature of the Company’s business subjects it to claims, lawsuits, regulatory examinations and other proceedings. The Company is subject to several of these matters at the present time. Given the inherent difficulty of predicting the outcome of the 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, the Company cannot estimate losses or ranges of losses for cases or proceedings where there is only a reasonable possibility that a loss may be incurred. There can be no assurance that these matters will not have a material adverse effect on the Company’s results of operations in any future period and a material judgment could have a material adverse impact on the Company’s financial condition and results of operations. However, it is the opinion of management, after consultation with legal counsel that, based on information currently available, the ultimate outcome of these matters will not have a material adverse impact on the business, financial condition or operating results of the Company although they might be material to the operating results for any particular period, depending, in part, upon operating results for that period.

As previously mentioned, the Company experienced a technology issue at the open of trading at the NYSE on August 1, 2012. This issue was related to the installation of trading software and resulted in the Company’s broker-dealer subsidiary, KCA, sending numerous erroneous orders in NYSE-listed and NYSE Arca securities into the market. The Company has since been named in two putative class actions and has received several derivative demand letters and/or requests for the inspection or production of certain books and records pursuant to Delaware law related to the technology issue and the August 6, 2012 recapitalization. In addition, the Company and/or KCA are the subject of regulatory investigations. While the Company is unable to predict the outcome of any possible litigation or investigation related to the technology issue or the August 6, 2012 recapitalization, an unfavorable outcome in one or more of these matters could have a material adverse effect on the Company’s financial condition or ongoing operations. In addition, the Company expects to incur additional expenses in defending against litigation and in connection with investigations.

In the second quarter of 2012, the Company recorded pre-tax trading losses of $35.4 million related to the Facebook IPO. On August 1, 2012 Nasdaq’s proposed voluntary accommodation program (the “Accommodation Program”) was published in the Federal Register by the SEC. The Accommodation Program creates a fund for voluntary accommodations for qualifying Nasdaq members disadvantaged by problems that arose during the Facebook IPO. Under the Accommodation Program as proposed by Nasdaq, the Company would recover a portion of its pre-tax trading losses. The Accommodation Program, however, remains subject to SEC approval and there can be no assurance will be approved by the SEC or that the terms will not change from those proposed. As previously disclosed, there are no assurances that the Company will be able to recover its pre-tax trading losses relating to the Facebook IPO.

The Company leases office space under noncancelable operating leases. Certain office leases contain fixed dollar-based escalation clauses. Rental expense under the office leases was $4.9 million and $5.3 million for the three months ended September 30, 2012 and 2011, respectively, and is included in Occupancy and equipment rentals on the Consolidated Statements of Operations. For the nine months ended September 30, 2012 and 2011, rental expense under the office leases was $12.9 million and $15.1 million, respectively.

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

The Company leases certain computer and other equipment under noncancelable operating leases and has entered into guaranteed employment contracts with certain employees. As of September 30, 2012, future minimum rental commitments under all noncancelable office, computer and equipment leases (“Gross Lease Obligations”), Sublease Income and guaranteed employment contracts longer than one year (“Other Obligations”) were as follows (in thousands):

Lease & Contract Obligations

 

     Gross Lease
Obligations
     Sublease
Income
     Net Lease
Obligations
     Other
Obligations
 

three months ending December 31 , 2012

   $ 6,043       $ 527       $ 5,516       $ -     

Year ending December 31, 2013

     23,444         2,170         21,274         8,941   

Year ending December 31, 2014

     22,480         1,987         20,493         -     

Year ending December 31, 2015

     21,696         1,813         19,883         -     

Year ending December 31, 2016

     21,309         1,856         19,453         -     

Thereafter through August 31, 2023

     100,061         2,816         97,245         -     
  

 

 

    

 

 

    

 

 

    

 

 

 
   $     195,033       $     11,169       $     183,864       $     8,941   
  

 

 

    

 

 

    

 

 

    

 

 

 

During the normal course of business, the Company collateralizes certain leases or other contractual obligations through letters of credit or segregated funds held in escrow accounts. In the ordinary course of business, Knight Capital Group, Inc. has provided, and may provide in the future, unsecured guarantees with respect to the payment obligations of certain of its subsidiaries under trading, repurchase, financing and stock loan arrangements, as well as under certain leases.

The Company has issued floating rate HECMs for which the borrowers have additional borrowing capacity of approximately $382.9 million as of September 30, 2012. This additional borrowing capacity is primarily in the form of undrawn lines of credit, with the balance available on a scheduled payments basis. As the issuer of these HECMs, the Company is under the obligation to fund this capacity upon the borrowers requesting such funds or such scheduled payments coming due, as applicable.

During the normal course of business, our Market Making and Institutional Sales and Trading segments may enter into futures contracts. These financial instruments are subject to varying degrees of risks whereby the fair value of the securities underlying the financial instruments, may be in excess of, or less than, the contract amount. The Company is obligated to post collateral against certain futures contracts.

The following tables summarize the Company’s futures contract activity (in thousands):

 

         Fair Value of asset or (liability) as of  

Futures Contracts

 

Consolidated Statements of

Financial Condition Location

       September 30,    
2012
        December 31,    
2011
 

Notional Value

  Not Applicable    $ (175,284   $ (20,769
    

 

 

   

 

 

 

Fair Value

  (Payable to) Receivable from brokers, dealers and clearing organizations    $ (399   $ 895   
    

 

 

   

 

 

 

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

    

Consolidated Statements of
Operations Location

   Gain (Loss) Recognized
For the three months ended September  30,
 

Futures Contracts

              2012                      2011          

Unrealized Gain (Loss)

   Net trading revenue    $ 4,609       $ (23,587
     

 

 

    

 

 

 

 

    

Consolidated Statements of
Operations Location

   Gain (Loss) Recognized
For the nine months ended September  30,
 

Futures Contracts

              2012                      2011          

Unrealized Gain (Loss)

   Net trading revenue    $ 10,706       $ (62,543
     

 

 

    

 

 

 

19.    Financial Instruments with Off-Balance Sheet Risk and Concentrations of Credit Risk

As a market maker of equities and options, the majority of the Company’s securities transactions are conducted as principal or riskless principal with broker-dealers and institutional counterparties primarily located in the United States. The Company self-clears substantially all of its U.S. equity and option securities transactions. The Company clears a portion of its securities transactions through third party clearing brokers. Foreign transactions are settled pursuant to global custody and clearing agreements with major U.S. banks. Substantially all of the Company’s credit exposures are concentrated with its clearing brokers, broker-dealer and institutional counterparties. The Company’s policy is to monitor the credit standing of counterparties with which it conducts business.

Upon the acquisition of the futures business of Penson in June 2012 (see Footnote 20 “Acquisition”), the Company began providing execution, clearing and custody services in futures contracts and options on futures contracts to facilitate customer transactions on major U.S. and European futures and options exchanges. Customer activities may expose the Company to off-balance sheet risk in the event the customer is unable to fulfill its contracted obligation as the Company guarantees the performance of its customers to the respective clearing houses or other brokers. In accordance with regulatory requirements and market practice, the Company requires its customers to meet, at a minimum, the margin requirements established by each of the exchanges at which contracts are traded. Margin is a good faith deposit from the customer that reduces risk to the Company of failure by the customer to fulfill obligations under these contracts. The Company establishes customer credit limits and monitors required margin levels on a daily basis and, pursuant to such guidelines, require customers to deposit additional collateral, or to reduce positions, when necessary. Further, the Company seeks to reduce credit risk by entering into netting agreements with customers, which permit receivables and payables with such customers to be offset in the event of a customer default. Management believes that the margin deposits and collateral held at September 30, 2012 were adequate to minimize the risk of material loss that could be created by positions held at that time.

In the normal course of its operations, the Company enters into contracts that contain a variety of representations and warranties which provide general indemnifications. The Company’s maximum exposure under these arrangements is unknown, as this would involve future claims that may be made against the Company that have not yet occurred. However, based on experience, the Company believes the risk of significant loss is minimal.

Financial instruments sold, not yet purchased, at fair value represent obligations to purchase such securities (or underlying securities) at a future date. The Company may incur a loss if the market value of the securities subsequently increases.

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

The Company currently has no loans outstanding to any former or current executive officer or director.

20.    Acquisition

Penson Futures

On June 1, 2012, the Company completed the acquisition of certain assets and assumption of certain liabilities of Penson Futures, the futures division of Penson for $5.0 million in cash and a potential earn-out based on future performance valued at $8.4 million. Goodwill and intangible assets recognized upon the closing of the transaction amounted to $10.6 million. All of the goodwill from this transaction is expected to be deductible for income tax purposes. The following table summarizes the estimated fair values of the assets acquired and liabilities assumed (in thousands):

 

Cash

   $ 5,000   

Fair value of earn-out

     8,400   
  

 

 

 

Recorded purchase price

   $         13,400   
  

 

 

 

 

Cash

   $ 1,928   

Segregated cash and securities

     100,545   

Receivable from brokers, dealers and clearing organizations

     360,494   

Goodwill

     7,117   

Intangible assets

     3,500   

Other assets

     24,604   

Payable to customers

     (472,197

Accrued expenses and other liabilities

     (12,591
  

 

 

 

Purchase of business

   $         13,400   
  

 

 

 

Assuming this transaction had been made at the beginning of any period presented, the consolidated pro forma results would not be materially different from reported results.

21.    Business Segments

The Company has four operating segments: (i) Market Making; (ii) Institutional Sales and Trading; (iii) Electronic Execution Services; and (iv) Corporate and Other.

The Market Making segment principally consists of market making in global equities and listed domestic options. Market Making primarily includes client, and to a lesser extent, non-client electronic market making and cash trading activities in which the Company operates as a market maker in equity securities. Market Making also includes the Company’s option market making business which trades on substantially all domestic electronic exchanges.

The Institutional Sales and Trading segment includes global equity, ETFs, and fixed income sales; reverse mortgage origination and securitization; capital markets; and asset management activities. The primary business of the Institutional Sales and Trading segment is to execute and facilitate transactions predominantly as agent on behalf of institutional clients for equities and fixed income

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

offerings, and the Company commits its capital on behalf of its clients when needed. This is predominantly a full-service business, in which much of the interaction is based on the Company’s client relationships. This segment also facilitates client orders through program and block trades and riskless principal trades, and provides capital markets services, including equity and debt offerings as well as private placements.

The Electronic Execution Services segment offers access via its electronic agency-based platforms to markets and self-directed trading in equities, options, fixed income, foreign exchange and futures.

The Corporate and Other segment invests in strategic financial services-oriented opportunities, allocates, deploys and monitors all capital, and maintains corporate overhead expenses and other expenses that are not attributable to the other segments. The Corporate and Other segment houses functions that support Knight’s other segments such as self-clearing services, including securities lending, and other support and overhead. This segment also provides futures execution, clearing and custody services to facilitate transactions among brokers, institutions and non-clearing FCMs.

The Company’s revenues, income (loss) from continuing operations before income taxes (“Pre-tax earnings”) and total assets by segment are summarized in the following table (in thousands):

 

    Market Making     Institutional
Sales and
Trading
    Electronic
Execution
Services
    Corporate
and Other
    Consolidated
Total
 

For the three months ended September 30, 2012:

         

Revenues

  $ (341,154   $ 101,719      $ 34,778      $ 14,819      $ (189,838

Pre-tax earnings

    (451,964     (140,807     6,267        (16,356     (602,860

Total assets

    1,363,992        4,467,878        379,350        2,374,634        8,585,854   

For the three months ended September 30, 2011:

         

Revenues

  $ 204,879      $ 145,440      $ 45,088      $ 2,034      $ 397,442   

Pre-tax earnings

    69,188        (15,552     13,838        (23,030     44,444   

Total assets

    2,130,021        2,655,021        271,948        2,003,485        7,060,475   

For the nine months ended September 30, 2012:

         

Revenues

  $ (75,499   $ 353,654      $ 122,287      $ 47,999      $ 448,441   

Pre-tax earnings

    (400,901     (133,639     29,882        (38,847     (543,505

Total assets

    1,363,992        4,467,878        379,350        2,374,634        8,585,854   

For the nine months ended September 30, 2011:

         

Revenues

  $ 517,105      $ 407,697      $ 127,347      $ 11,051      $ 1,063,200   

Pre-tax earnings

    171,729        (27,211     37,007        (57,544     123,982   

Total assets

        2,130,021            2,655,021            271,948            2,003,485            7,060,475   

Included in Market Making revenues for the three and nine months ended September 30, 2012 is a trading loss of $457.6 million related to the August 1st technology issue.

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

Included in Pre-tax earnings for the three and nine months ended September 30, 2012 is a writedown of assets of $143.0 million which includes $11.9 million for Market Making and $131.1 million for Institutional Sales and Trading. Additionally, the Corporate and Other segment includes $3.5 million in professional fees related to the August 1st technology issue.

Included in revenues for the nine months ended September 30, 2012 is a Facebook IPO trading loss of $35.4 million which includes $26.0 million for Market Making and $9.4 million for Institutional Sales and Trading.

Included in revenues for the nine months ended September 30, 2012 in the Corporate and Other segment is a gain on a strategic investment of $10.0 million.

Included in expenses for the three and nine months ended September 30, 2011 is a Restructuring charge of $28.6 million which includes $0.5 million for Market Making, $23.9 million for Institutional Sales and Trading, $0.4 million for Electronic Execution Services, and $3.8 million for Corporate and Other.

Total assets do not include assets within discontinued operations of $2.4 million at September 30, 2011.

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion of our results of operations should be read in conjunction with our audited Consolidated Financial Statements and notes for the year ended December 31, 2011 included in our Current Report on Form 8-K dated August 6, 2012 as filed with the U.S. Securities and Exchange Commission (“SEC”). On August 6, 2012, we entered into a securities purchase agreement where we raised $400.0 million in equity financing through a convertible preferred share offering with several investors. The Form 8-K filed on this date updated the historical consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2011 by revising the order of presentation of the Company’s Consolidated Statement of Comprehensive Income and Consolidated Statements of Changes in Equity. This discussion contains forward-looking statements that involve risks and uncertainties, including those discussed in our Form 10-K for the year ended December 31, 2011, our Quarterly Report on Form 10-Q for the period ended June 30, 2012 and herein. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of certain factors, including, but not limited to, those set forth elsewhere in this document, in our Form 10-K for the year ended December 31, 2011 and in our Quarterly Report on Form 10-Q for the period ended June 30, 2012.

Certain statements contained in this Quarterly Report on Form 10-Q, including, without limitation, those under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” herein (“MD&A”), “Quantitative and Qualitative Disclosures About Market Risk” in Part I, Item 3, “Legal Proceedings” and “Risk Factors” in Part II and the documents incorporated by reference, may constitute forward-looking statements. 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 the August 1, 2012 technology issue that resulted in the Company’s broker-dealer subsidiary, Knight Capital Americas LLC (“KCA”), sending numerous erroneous orders in NYSE-listed and NYSE Arca securities into the market and the impact to the Company’s capital structure and business as well as actions taken in response thereto and consequences thereof, risks associated with the Company’s ability to recover all or a portion of the damages that are attributable to the manner in which NASDAQ OMX handled the Facebook IPO, risks associated with changes in market structure, legislative, regulatory or financial reporting rules, risks associated with the Company’s changes to its organizational structure and management and the costs, integration, performance and operation of businesses previously acquired or developed organically, or that may be acquired or developed organically in the future. Readers should carefully review the risks and uncertainties disclosed in the Company’s reports with the SEC including, without limitation, those detailed under “Certain Factors Affecting Results of Operations” within MD&A herein and under “Risk Factors” herein and in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011 and in other reports or documents the Company files with, or furnishes to, the SEC from time to time. This information should also be read in conjunction with the Company’s Consolidated Financial Statements and the Notes thereto contained in this Form 10-Q, and in other reports or documents the Company files with, or furnishes to, the SEC from time to time.

 

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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 broker-dealers, institutions and corporations. We seek to continually apply our expertise and innovation to the market making and trading 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 four operating segments: (i) Market Making; (ii) Institutional Sales and Trading; (iii) Electronic Execution Services; and (iv) Corporate and Other.

 

   

Market Making – Our Market Making segment principally consists of market making in global equities and listed domestic options. As a market maker, we commit capital for trade executions by offering to buy securities from, or sell securities to, institutions and broker-dealers. Our Market Making segment primarily includes client, and to a lesser extent, non-client electronic market making activities in which we operate as a market maker in equity securities quoted and traded on the Nasdaq Stock Market, the over-the-counter (“OTC”) market for New York Stock Exchange (“NYSE”), NYSE Amex Equities (“NYSE Amex”), NYSE Arca listed securities and several European exchanges. As a complement to electronic market making, our cash trading business handles specialized orders and also transacts on the OTC Bulletin Board, the OTC Pink Markets, and the Alternative Investment Market (“AIM”) of the London Stock Exchange. We provide trade executions as an equities Designated Market Maker (“DMM”) on the NYSE and NYSE Amex. Market Making also includes our option market making business which trades on substantially all domestic electronic exchanges.

 

   

Institutional Sales and Trading – Our Institutional Sales and Trading segment includes global equity, exchange traded fund (“ETF”) and fixed income sales; reverse mortgage origination and securitization; capital markets; and asset management activities. The primary business of the Institutional Sales and Trading segment is to execute and facilitate equities, ETFs, and fixed income transactions as agent on behalf of institutional clients, and we commit capital on behalf of our clients when needed. This is predominantly a full-service execution business, in which much of the interaction is based on the Company’s client relationships. This segment also facilitates client orders through program and block trades and riskless principal trades and provides capital markets services, including equity and debt private placement.

 

   

Electronic Execution Services – Our Electronic Execution Services segment offers access via our electronic agency-based platforms to markets and self-directed trading in equities, options, fixed income, foreign exchange and futures. In contrast to Market Making, we generally do not act as a principal to transactions that are executed within this segment and generally earn commissions for acting as agent between the principals to the trade.

 

   

Corporate and Other – Our Corporate and Other segment invests in strategic financial services-oriented opportunities, allocates, deploys and monitors all capital, and maintains corporate overhead expenses and all other income and expenses that are not attributable to the other segments. The Corporate and Other segment houses functions that support our other segments such as self-clearing services, including securities lending activities. Beginning in the second quarter of 2012, our Corporate and Other segment includes our futures commission merchant (“FCM”) which comprises certain assets and liabilities which we acquired or assumed from the futures division of Penson Financial Services, Inc. on June 1, 2012. This business primarily provides futures execution, clearing and custody services to facilitate transactions among brokers, institutions and non-clearing FCMs on major U.S. and European futures and options exchanges.

 

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The following table sets forth: (i) Revenues; (ii) Expenses; and (iii) Pre-tax earnings or loss from our segments and on a consolidated basis (in millions):

 

     For the three months ended
September 30,
    For the nine months ended
September 30,
 
         2012             2011               2012                 2011        

Market Making

        

Revenues(1)(3)

   $ (341.2   $         204.9      $ (75.5   $         517.1   

Expenses(2)(5)

     110.8        135.7        325.4        345.4   
  

 

 

   

 

 

   

 

 

   

 

 

 

Pre-tax (loss) earnings

     (452.0     69.2        (400.9     171.7   
  

 

 

   

 

 

   

 

 

   

 

 

 

Institutional Sales and Trading

        

Revenues(3)

     101.7        145.4        353.7        407.7   

Expenses(2)(5)

     242.5        161.0        487.3        434.9   
  

 

 

   

 

 

   

 

 

   

 

 

 

Pre-tax loss

     (140.8     (15.6     (133.6     (27.2
  

 

 

   

 

 

   

 

 

   

 

 

 

Electronic Execution Services

        

Revenues

     34.8        45.1        122.3        127.3   

Expenses(5)

     28.5        31.3        92.4        90.3   
  

 

 

   

 

 

   

 

 

   

 

 

 

Pre-tax earnings

     6.3        13.8        29.9        37.0   
  

 

 

   

 

 

   

 

 

   

 

 

 

Corporate and Other

        

Revenues(4)

     14.8        2.0        48.0        11.0   

Expenses(2)(5)

     31.2        25.1        86.8        68.6   
  

 

 

   

 

 

   

 

 

   

 

 

 

Pre-tax loss

     (16.4     (23.0     (38.8     (57.5
  

 

 

   

 

 

   

 

 

   

 

 

 

Consolidated

        

Revenues

     (189.8     397.4                448.4        1,063.2   

Expenses

             413.0        353.0        991.9        939.2   
  

 

 

   

 

 

   

 

 

   

 

 

 

Pre-tax (loss) earnings

   $ (602.9   $ 44.4      $ (543.5   $ 124.0   
  

 

 

   

 

 

   

 

 

   

 

 

 

 

* Totals may not add due to rounding.
(1) – Included in revenues for the three and nine months ended September 30, 2012 is a trading loss of $457.6 million related to the August 1st technology issue.
(2) – Included in expenses for the three and nine months ended September 30, 2012 is a writedown of assets of $143.0 million which includes $11.9 million for Market Making and $131.1 million for Institutional Sales and Trading. Additionally, the Corporate and Other segment includes $3.5 million in professional fees related to the August 1st technology issue.
(3) – Included in revenues for the nine months ended September 30, 2012 is a Facebook IPO trading loss of $35.4 million which includes $26.0 million for Market Making and $9.4 million for Institutional Sales and Trading.
(4) – Included in revenues for the nine months ended September 30, 2012 is a gain on a strategic investment of $10.0 million.
(5) – Included in expenses for the three and nine months ended September 30, 2011 is a Restructuring charge of $28.6 million which includes $0.5 million for Market Making, $23.9 million for Institutional Sales and Trading, $0.4 million for Electronic Execution Services, and $3.8 million for Corporate and Other.

Consolidated revenues for the three months ended September 30, 2012 decreased $587.3 million from the same period a year ago, while consolidated expenses increased $60.0 million. Consolidated pre-tax loss for the three months ended September 30, 2012 was $602.9 million as compared to consolidated pre-tax earnings of $44.4 million for the same period a year ago.

 

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Consolidated revenues for the nine months ended September 30, 2012 decreased $614.8 million from the same period a year ago, while consolidated expenses increased $52.7 million. Consolidated pre-tax loss for the nine months ended September 30, 2012 was $543.5 million as compared to consolidated pre-tax earnings of $124.0 million for the same period a year ago.

On August 1, 2012, we experienced a technology issue at the open of trading at the NYSE. This issue was related to the installation of trading software and resulted in KCA sending numerous erroneous orders in NYSE-listed and NYSE Arca securities into the market. Although this software was subsequently removed from our systems, it resulted in trading losses and subsequent related costs of $461.1 million (“August 1, 2012 Loss”). This event was deemed a triggering event requiring us to assess the carrying amount and recoverability of our goodwill and intangible assets. As a result of this assessment, we recorded a non-cash impairment charge of $143.0 million, representing $126.4 million of goodwill related to our acquisitions of Libertas and Astor, and $16.7 million of intangible assets primarily related to our acquisitions of Astor, Kellogg and Urban.

On August 6, 2012 we raised $400.0 million in equity financing through a convertible preferred share offering with several investors. We incurred approximately $40.5 million in fees and costs related to the offering, resulting in net proceeds of $359.5 million. As a result of our ability to obtain these capital resources we no longer believe there is a substantial doubt in our ability to continue as a going concern.

In the second quarter of 2012, we recorded pre-tax trading losses of $35.4 million related to the Facebook IPO. On August 1, 2012 Nasdaq’s proposed voluntary accommodation program (the “Accommodation Program”) was published in the Federal Register by the SEC. The Accommodation Program creates a fund for voluntary accommodations for qualifying Nasdaq members disadvantaged by problems that arose during the Facebook IPO. Under the Accommodation Program as proposed by Nasdaq, we would recover a portion of our pre-tax trading losses. The Accommodation Program, however, remains subject to SEC approval and there can be no assurance will be approved by the SEC or that the terms will not change from those proposed. As previously disclosed, there are no assurances that we will be able to recover our pre-tax trading losses relating to the Facebook IPO.

The changes in our pre-tax earnings (loss) by segment from the three and nine months ended September 30, 2011 are summarized as follows:

 

   

Market Making – Our pre-tax losses from Market Making for the three and nine months ended September 30, 2012 were $452.0 million and $400.9 million, respectively, compared to pre-tax earnings of $69.2 million and $171.7 million, respectively, during the comparable periods in 2011. Excluding the $457.6 million effects of the August 1, 2012 Loss, which resulted in trading losses of $457.6 million, and subsequent review of our intangible assets that resulted in an $11.9 million writedown to intangible assets, and the second quarter 2012 $26.0 million trading loss related to the Facebook IPO, our pre-tax results from Market Making for the three and nine months ended September 30, 2012 decreased $51.7 million and $77.2 million, respectively, to pre-tax earnings of $17.5 million and $94.6 million, respectively. The reason for the decrease in results, excluding the noted items, was primarily a decrease in volumes, which were impacted by the August 1, 2012 technology issue as well as lower overall market volumes. The lower volumes had a negative impact on both our client and non-client quantitative trading models.

 

   

Institutional Sales and Trading – Our pre-tax losses from Institutional Sales and Trading for the three and nine months ended September 30, 2012 increased by $125.3 million and $106.4 million, respectively, from the comparable periods in 2011. Excluding the effects of the third quarter 2012 asset impairment assessment that resulted in a writedown of $131.1 million

 

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related to goodwill and intangible assets primarily within our institutional fixed income and asset management businesses and as well as the second quarter 2012 $9.4 million trading loss related to the Facebook IPO, our pre-tax results from Institutional Sales and Trading for the three and nine months ended September 30, 2012 improved by $5.9 million and $34.1 million, respectively, to a pre-tax loss of $9.7 million and pre-tax earnings of $6.9 million, respectively. The improvement in segment results, excluding the noted items, was primarily attributable to improved results from our reverse mortgage business, a decrease in guaranteed compensation in our fixed income business and the absence of restructuring costs offset, in part, by a decrease in client volumes as a result of the events surrounding the August 1 technology issue.

 

   

Electronic Execution Services – Our pre-tax earnings from Electronic Execution Services for the three and nine months ended September 30, 2012 decreased by $7.6 million and $7.1 million, respectively, from the comparable periods in 2011. The quarter over quarter and year over year decrease is primarily due to temporary lower volumes as a result of the August 1, 2012 Loss. By the end of the third quarter of 2012, volumes were substantially back to pre-August 1 levels.

 

   

Corporate and Other – Our pre-tax results from our Corporate and Other segment for the three months ended September 30, 2012 improved by $6.7 million from the comparable period in 2011. The improved results quarter over quarter is primarily due to a $5.3 million grant received in August 2012 from the State of New Jersey related to the Business Employment Incentive Program (“BEIP”) offset, in part, by higher professional fees related to the August 1, 2012 technology issue. Our pre-tax results from our Corporate and Other segment for the nine months ended September 30, 2012 improved by $18.7 million from the comparable period in 2011. The improved results year over year is primarily due to a $10.0 million gain related to a change in the tax status of a strategic investment accounted for under the equity method of accounting and a $5.3 million BEIP grant received in August 2012 offset, in part, by higher interest expense related to our long-term debt and securities lending activity and higher professional fees related to the August 1, 2012 technology issue.

Certain Factors Affecting Results of Operations

We may experience significant variation in our future results of operations. These fluctuations may result from numerous factors, including, among other things, market conditions and the resulting volatility, 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 client market making and program trading portfolios; the performance of our non-client principal trading activities; movements of credit spreads; home equity conversion mortgages (“HECMs”) origination and HECM Mortgage Backed Securities (“HMBS”) securitization volumes; the overall size of our balance sheet and capital usage; further impairment of goodwill and/or intangible assets; the performance of our global operations, trading technology and trading infrastructure; costs associated with overall business growth; the effectiveness of our self-clearing and futures platforms and our ability to manage risk related thereto; the availability of credit and liquidity in the marketplace; erroneous trade orders submitted by us on account of technology or other issues (such as occurred on August 1, 2012) and consequences thereof; the performance, operation and connectivity to various market centers; our ability to manage personnel, compensation, overhead and other expenses; 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

 

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addition or loss of executive management, sales, trading and technology professionals; legislative, legal, regulatory and financial reporting changes; legal, 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 other economic conditions.

Such factors may also have an impact on our ability to achieve our strategic objectives, including, without limitation, increases in market share, growth and profitability in our four operating segments. If demand for our services declines or our performance deteriorates significantly 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 the level of trading volumes and volatility in such markets.

During the quarter ended September 30, 2012, volatility levels across equity markets decreased as compared to the previous quarter, while in the debt markets, credit spreads narrowed. Secondary trading volumes in the equity and fixed income markets were down significantly from prior periods. Overall, there are still concerns about global stability and growth, inflation and declining asset values.

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:

 

   

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 sophistication and 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 and margin metrics of the Company and other market making firms.

 

   

Market Making, Institutional Sales and Trading and Electronic Execution Services transaction volumes executed by clients have fluctuated over the past few years due to retail and institutional investor sentiment, market conditions and a variety of other factors. Market Making, Institutional Sales and Trading and Electronic Execution Services transaction volumes may not be sustainable and are not predictable.

 

   

Over the past several years exchanges have become far more competitive, and market participants have created alternative trading systems (“ATS”), ECN and other execution

 

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venues which compete within the OTC and listed trading venues. For example, on July 3, 2012, the SEC approved proposed rules submitted by the NYSE and NYSE Amex to establish a Retail Liquidity Program (“RLP”) on a pilot basis for one year. The RLP seeks to attract retail flow to the NYSE and NYSE Amex. This new program (as well as any similar program established by other national stock exchanges) could draw market share away from Knight, and thus negatively impact our business. 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, market conditions and a steady increase in electronic trading have resulted in a reduction in institutional commission rates and volumes which may continue in the future. Additionally, many institutional clients allocate commissions to broker-dealers based not only on the quality of executions, but also in exchange for research, or participation in soft dollar and commission recapture programs.

 

   

There continues to be growth in electronic trading, as evidenced by increased volumes 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 and may further reduce demand for traditional institutional voice services.

 

   

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.

 

   

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 asked the SEC and other regulators to take a close look at the regulatory structure and make the changes necessary to insure the rule framework governing the U.S. financial markets is comprehensive and complete. The SEC and other regulators have stated that they will propose and adopt rules where necessary, on a variety of marketplace issues – including, but not limited to: high frequency trading, indications of interest, off-exchange trading, dark liquidity pools, internalization, post-trade attribution, co-location, market access, short sales, consolidated audit trails and market volatility rules (including, circuit breakers and limit-up, limit-down rules).

 

   

We expect increases, possibly substantial, in Section 31 fees and fees imposed by other regulators. In addition, DTCC and NSCC are considering proposals which could require substantial increases in clearing margin and collateral requirements.

 

   

The Dodd-Frank Act affects nearly all financial institutions that operate in the U.S. While the weight of the Dodd-Frank Act falls more heavily on large, complex financial institutions, smaller institutions will continue to face a more complicated and expensive regulatory framework.

 

   

Reverse mortgages can be a cost-effective way to help seniors (age 62 and older) meet their financial needs in retirement, by enabling them to tap the equity in their home. Reverse mortgages have been popular with seniors who have equity in their homes and want to

 

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supplement their income and enhance their liquidity. This popularity may continue as the Baby Boomer generation enters retirement age. However, there is no guarantee that current volumes or the referenced popularity will continue.

 

   

In 2011, two of the largest reverse mortgage originators exited the reverse mortgage business. Declining home values and the inability to assess borrowers’ financial health were cited as factors contributing to their respective decisions. In 2012, the largest reverse mortgage lender also exited the reverse mortgage business citing its focus on other business lines.

 

   

In January 2011, the U.S. Department of Housing and Urban Development (“HUD”) provided loss mitigation guidance for the resolution of HECMs that are delinquent due to, among other things, unpaid property charges (including taxes and homeowners insurance). HUD also discussed what steps lenders could take to get mortgagors back on track (e.g., establishing a repayment plan). HUD noted that foreclosure is and must remain a method of last resort for the resolution of unpaid property charges. It has also been reported that HUD is developing procedures that would allow lenders to assess a prospective borrower’s income and expenses, and possibly require homeowners to set aside money to pay for taxes and homeowners insurance. However, no formal guidelines have yet been published.

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 all of our business segments.

Revenues on transactions for which we charge explicit commissions or commission equivalents, which include the majority of our institutional client orders, commissions on futures transactions, as well as the mark-to-market of securitized HECM loan inventory, are included within Commissions and fees. Commissions and fees are primarily affected by changes in our equity, fixed income, futures and foreign exchange transaction volumes with institutional clients, changes in commission rates, level of volume based fees from providing liquidity to other trading venues, loan origination and securitization volume and spreads, 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 global market making activities and are included within Net trading revenue. These revenues are primarily affected by changes in the amount and mix of 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 trading models, volatility in the marketplace, our mix of broker-dealer and institutional clients, regulatory changes and evolving industry customs and practices.

Interest income, net is earned from our cash held at banks, cash held in trading accounts at third party clearing brokers and from collateralized financing arrangements, such as securities borrowing, carry interest on loans and bonds held, and interest income net of interest expense on securitized HECM loan inventory. 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

 

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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 including those held for customers, the level of our securities borrowing activity, our level of securities positions in which we are long compared to our securities positions in which we are short, the extent of our collateralized financing arrangements and the level of securitized HECM loan inventory.

Investment income and other, net primarily represents returns on our strategic and deferred compensation investments. 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.

Expenses

Employee compensation and benefits expense, our largest expense, primarily consists of salaries and wages paid to all employees, profitability-based compensation, which includes compensation paid to sales personnel and incentive compensation paid to all other employees based on our profitability, employee benefits, and changes in value of certain deferred compensation liabilities. 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, options and fixed income transactions; transaction fees paid to Nasdaq and other exchanges, clearing organizations and regulatory bodies; execution fees paid to third parties, primarily for executing trades on the NYSE, other exchanges and ECNs; and loan processing fees. Execution and clearance fees primarily fluctuate based on changes in trade and share volume, execution strategies, rate of clearance fees charged by clearing brokers and rate of fees paid to ECNs, exchanges and certain regulatory bodies and loan origination volume.

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

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 also include fees paid to third party brokers with respect to reverse mortgage wholesale loan production and 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, reverse mortgage loan production and channel mix, our profitability and the mix of market orders, limit orders, and customer mix.

Interest expense consists primarily of costs associated with our long-term debt and for collateralized financing arrangements such as securities lending and sale of financial instruments under our agreements to repurchase.

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.

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

 

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

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

Restructuring charges consist of employee severance and other benefit costs, writedown of assets, inclusive of capitalized software, intangible assets and goodwill, and lease and contract terminations in connection with restructuring plans set in place in order to lower operating expenses.

Writedown of assets and lease loss accrual consist primarily of costs associated with the writedown of assets, primarily goodwill and intangible assets, and lease losses related to excess office space.

Other expenses include regulatory fees, corporate insurance, employment fees, partial month interest reserves associated with our Government National Mortgage Association (“GNMA”) issuances, and general office expense.

Three Months Ended September 30, 2012 and 2011

Revenues

Market Making

 

    For the three months
ended September 30,
    Change     % of Change  
            2012                     2011              

Commissions and fees (millions)

  $ 15.5      $ 41.2      $ (25.8     -62.4

Net trading revenue (millions)

    (353.5     161.9        (515.4     -318.3

Interest, net (millions)

    (3.2     1.7        (4.9     N/M   
 

 

 

   

 

 

   

 

 

   

Total Revenues from Market Making (millions)

  $ (341.2   $ 204.9      $ (546.0     -266.5
 

 

 

   

 

 

   

 

 

   

U.S. equity Market Making statistics:

       

Average daily dollar value traded ($ billions)*

    16.7        29.3        (12.6     -42.8

Average daily trades (thousands)*

    2,507.5        4,189.6        (1,682.1     -40.1

Nasdaq and Listed shares traded (billions)*

    37.9        60.6        (22.8     -37.5

FINRA OTC Bulletin Board and Other shares traded (billions)*

    151.2        174.6        (23.4     -13.4

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

    (3.29     1.04        (4.34     -415.5

Average revenue capture per U.S. equity dollar value traded, excluding impact of August 1st technology issue (bps)**

    1.04        1.04        (0.00