10-K 1 y84689e10vk.txt INSTINET GROUP INCORPORATED -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2002 COMMISSION FILE NUMBER 000-32717 INSTINET GROUP INCORPORATED (Exact Name of Registrant as Specified in Its Charter)
DELAWARE 13-4134098 (State or Other Jurisdiction of (IRS Employer Incorporation or Organization) Identification No.) 3 TIMES SQUARE, NEW YORK, NY 10036 (Address of Principal Executive Offices) (Zip Code)
212-310-9500 (Registrant's Telephone Number, Including Area Code) SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
TITLE OF EACH CLASS NAME OF EXCHANGE ON WHICH REGISTERED ------------------- ------------------------------------ Common Stock $0.01 par value per share Nasdaq National Market
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. [X] Yes [ ] No Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment of this Form 10-K. [ ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). [X] Yes [ ] No As of June 30, 2002, the aggregate market value of voting and non-voting common equity held by non-affiliates of the registrant was approximately $259,002,123, based upon the Nasdaq National Market closing price for such shares on that date. For purposes of this calculation, the Registrant has assumed that its directors and executive officers are affiliates. Portions of the Instinet Group Incorporated Proxy Statement for the 2003 Annual Meeting of Stockholders are incorporated by reference in Part III hereof. The number of shares of Common Stock outstanding as of March 20, 2003 was 330,716,108 shares. -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- INSTINET GROUP INCORPORATED ANNUAL REPORT ON FORM 10-K FOR THE FISCAL YEAR ENDED DECEMBER 31, 2002 TABLE OF CONTENTS
PAGE ---- PART I Item 1. Business.................................................... 2 Certain Factors that May Affect Our Business................ Item 2. Properties.................................................. 48 Item 3. Legal Proceedings........................................... 48 Item 4. Submission of Matters to a Vote of Security Holders......... 49 PART II Item 5. Market for the Company's Common Equity and Related Stockholder Matters......................................... 50 Item 6. Selected Financial Data..................................... 52 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations................................... 54 Item 7A Quantitative and Qualitative Disclosures about Market Risk........................................................ 79 Item 8. Financial Statements and Supplementary Data................. 82 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.................................... 116 PART III Item 10. Directors and Executive Officers of the Company............. 116 Item 11. Executive Compensation...................................... 116 Item 12. Security Ownership of Certain Beneficial Owners and Management.................................................. 116 Item 13. Certain Relationships and Related Transactions.............. 116 Item 14. Controls and Procedures..................................... 116 PART IV Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K......................................................... 117 Signatures............................................................ II-1 Certifications........................................................ II-3 Exhibit Index.........................................................
Unless otherwise indicated or the context otherwise requires, references to the "company," "we," "us," and "our" mean Instinet Group Incorporated and its subsidiaries. We have made forward-looking statements in this Annual Report on Form 10-K for 2002, including in the sections entitled Business, Certain Factors that May Affect Our Business, Management's Discussion and Analysis of Financial Condition and Results of Operations and Quantitative and Qualitative Disclosures about Market Risk, that are based on our management's beliefs and assumptions and on information currently available to our management. Forward-looking statements include information concerning our possible or assumed future results of operations, business strategies, financing plans, competitive position, potential growth opportunities and the effects of competition and regulation. Forward-looking statements include all statements that are not historical facts. You can identify these statements by the use of forward-looking terminology, such as the words believes, expects, anticipates, intends, plans, estimates, may or might or other similar expressions. Forward-looking statements involve significant risks, uncertainties and assumptions. Although we believe that the expectations reflected in the forward-looking statements are reasonable, actual results may differ materially from those expressed in these forward-looking statements. You should not put undue reliance on any forward-looking statements. You should understand that many important factors, in addition to those discussed in the section entitled Certain Factors that May Affect Our Business and elsewhere in this annual report, could cause our results to differ materially from those expressed or suggested in forward-looking statements. 1 PART I ITEM 1. BUSINESS INTRODUCTION We are the largest global electronic agency securities broker and have been providing investors with electronic trading solutions for more than 30 years. Our services enable buyers and sellers worldwide to trade securities directly and anonymously with each other, gain price improvement for their trades, manage their orders and lower their overall trading costs. Through our electronic platforms, our customers also can access over 40 securities markets throughout the world, including Nasdaq, the NYSE, and stock exchanges in Frankfurt, Hong Kong, London, Paris, Sydney, Tokyo, Toronto and Zurich. Our customers primarily consist of institutional investors, such as mutual funds, pension funds, insurance companies and hedge funds, as well as market professionals, including broker-dealers. We have been operating in an increasingly challenging business, economic and regulatory environment. During the past three years, the major U.S. market indices have experienced a severe decline and significant volatility. The weak and uncertain economic climate, increased unemployment rates, reduced capital raising, decreased market capitalization,ongoing geopolitical and global conflicts, coupled with the current corporate governance and accounting issues, have contributed to a decreased pace of global economic growth. This has resulted in significantly lower equity prices, decreased corporate activity, increased market volatility, decreased trading volumes and a generally more difficult business environment. In addition, intense price competition from other liquidity providers and trading venues, together with recent SEC regulations and interpretive initiatives, have prompted us to reduce our prices significantly, which has resulted in decreased revenues and losses from operations. As a result, our revenues decreased from $1.4 billion in 2001 to $1.1 billion. We had a net loss of $735.2 million in 2002, primarily due to a $552.0 million charge for goodwill impairment, a restructuring charge and a writedown in our investments. In the past, we have implemented various cost reduction plans and in December 2002, we began implementing a cost reduction plan that targets a further reduction in operating costs of $100 million, on an annualized basis, by the end of 2003. During the first two months of 2003, the U.S. markets continued to weaken and trading volumes continued to decline. The average daily trading volumes in Nasdaq-quoted and U.S. exchange-listed stocks decreased 8% from 3.6 billion shares in the fourth quarter of 2002 to 3.3 billion shares during the first two months of 2003. Our average daily trading volumes have also decreased. Our average daily trading volumes in Nasdaq-quoted and U.S. exchange-listed stocks have decreased 13% from 575 million shares in the fourth quarter of 2002 to 504 million shares during the first two months of 2003. This decrease in trading volumes has had a negative effect on our transaction fee revenue. In addition, in March 2003 we announced a reduction of 12% in our global staffing levels resulting from attrition and the elimination of positions. We expect that these staff reductions will result in an estimated $20 million reduction in our operating costs, on an annualized basis, by the end of 2003. This staff reduction is part of our continued focus on cost reduction and is in addition to the $100 million cost reduction target previously announced. On September 20, 2002, we completed our acquisition of Island Holding Company, Inc., the parent company of The Island ECN, Inc., a leading electronic securities marketplace. We now operate two of the largest alternative trading systems (ATSs) trading Nasdaq-quoted stocks. In 2002, the Instinet ATS alone accounted for approximately 15% of the total trading volume in the Nasdaq market. Following the merger, in the fourth quarter of 2002, our two ATSs accounted for approximately 30% of the total trading volume in Nasdaq-quoted stocks. Like our Instinet ATS, the Island ATS has assembled a large liquidity pool of orders to buy and sell securities, which orders are published in its marketplace. Island's proprietary technology enables it to offer low cost, rapid and reliable order display and matching services to its customers. Our global electronic agency securities brokerage business centers almost exclusively on serving the needs of institutional investors and market professionals, including broker-dealers, in the global markets for equity securities. As of December 31, 2002, we had over 1,300 institutional investor customers and approximately 1,290 broker-dealer customers in the United States. Our Instinet ATS, which also has operations outside the United States, had approximately 890 customers in Europe and Asia as of December 31, 2002 and continues 2 to maintain a global presence. During 2002, our customers used our two ATSs to execute a combined volume of 156.0 million transactions globally (including Island volumes after September 20, 2002), of which 148.4 million transactions were in U.S. equity securities. Those U.S. transactions represented approximately 81.9 billion shares of Nasdaq-quoted stocks and 15.7 billion shares of U.S. exchange-listed stocks. More than 80% of our customers' transactions in U.S. equity securities using the electronic trading systems of our two ATSs are generally executed within our internal liquidity pools. We also offer our customers, through our Instinet ATS, technology (known as smart order-routing technology) that directs their equity securities transactions to access either our Instinet liquidity pool or one of the various markets to which we are connected to obtain better execution. In addition to our core execution services, we offer our customers services that enhance their ability to achieve their trading objectives, including extended hours trading, crossing services, block trading and portfolio trading, as well as global clearing and settlement of trades. We are one of the largest independent providers of research and other brokerage services through soft-dollar or other similar arrangements. We are also one of the largest providers of commission recapture services, which enable pension plan and other fund sponsors to recapture a portion of the gross transaction fees that the fund managers pay us. In addition, we provide correspondent clearing services to several securities brokers in the United States. We were founded in 1969 and, although continuously headquartered in New York since then, were a wholly owned subsidiary of Reuters Group PLC from May 1987 until our initial public offering in May 2001. Reuters currently owns approximately 62.6% of our outstanding common stock. We recently opened an office in Jersey City, New Jersey and also currently have offices in London, Frankfurt, Hong Kong, Paris, Tokyo, Toronto and Zurich. CORE VALUES We have built our business on a model that incorporates the following four core values: - Independence and Neutrality -- As an agency broker, we do not trade securities for our own account or maintain inventories of securities for sale. As a result, unlike exchange specialists, market makers and other market participants that trade for their own account, we have no direct interest in, or in maintaining, the trading spread (the difference between the price offered by a buyer and that asked by a seller) in the Nasdaq market or on an exchange. We avoid conflicts with our customers that interfere with their obtaining better pricing for their trades. - Anonymity -- Our systems do not require the identity of the ultimate buyer or seller to be disclosed to the counterparty or other market participants at any point in the trading process. We believe that anonymous trading can reduce the potential market impact of large transactions and transactions by certain investors whose trading activity, if known, may be more likely to influence other market activity, and may contribute to improved pricing for our customers. - Equal and Direct Access -- We provide our customers, without regard to their size or volume of trading, with equal and direct access to markets. Direct market access can increase the speed at which trades are executed and level the playing field among market participants. This enhanced market access also allows our customers to have available real-time information on the demand for and supply of one or more securities, a concept commonly referred to as transparency. - Customer Empowerment -- We use and develop, and may acquire, technology to empower our customers to achieve their trading objectives. Our trading services and tools give our customers flexibility in choosing their level of direct participation in carrying out their trades. As a result of these core values, we believe that we provide our customers with valuable benefits that help them achieve their trading objectives at reduced costs and with greater speed and efficiency. ACQUISITIONS AND DIVESTITURES In an effort to expand the scope of our business and complement our existing services, in recent years, we have acquired a number of companies. In addition to our acquisition of Island in September 2002, we acquired 3 Harborview LLC, a NYSE floor brokerage firm, in January 2003. In October 2001, we acquired ProTrader, a provider of advanced trading technologies and electronic brokerage services, and in February 2000, we acquired Lynch, Jones & Ryan, a leading provider of specialized brokerage, research and commission recapture services to pension plan sponsors and managers. On May 3, 2002, we closed our fixed income business, which we began developing in 1998 and started trading in the spring of 2000, and also closed Montag Popper & Partner GmbH, a German fixed income broker-dealer, that we acquired in October 1999 as part of the development of our global fixed income business. Against the background of a global economic slowdown and the uneven pace of acceptance of electronic fixed income trading platforms, however, our fixed income business was unable to reach a critical mass. We believe our acquisition of Island will result in better execution opportunities for our customers, a stronger technology and trading platform, an alternative to other offerings, cost savings and a stronger management team, which will ultimately bring together our complementary capabilities in the global equity markets and create a company better able to serve our customers' needs. We continue to develop and have begun to implement a plan to maximize our current operational and organizational functions by integrating Island into our business, increasing efficiencies and reducing costs. Our current target is to achieve savings of approximately $100 million of operating costs, on an annualized basis, by the end of 2003 through our integration efforts. We expect these savings to result from, among other things, the consolidation of our clearing operations, headcount reductions, consolidation of office space and maximizing infrastructure efficiencies. We will also focus on integrating our personnel, facilities, and key technologies. In the fourth quarter of 2002, we reduced our workforce by approximately 250 employees both in the U.S. and our international operations and consolidated our office space within the New York City area. In January 2003, we also completed the conversion of Island's trading activity from I-Clearing Corp. to Instinet Clearing Services, Inc. We continue to develop our plan and evaluate our integration goals and the time parameters necessary to achieve these goals. INDUSTRY BACKGROUND EQUITY TRADING VOLUME Over the past five years, the major U.S. market indices have experienced substantial growth followed by a severe decline and significant volatility. For example, the Dow Jones Industrial Average increased from 7,965 in January 1998, reached a peak of 11,723 in January 2000, dropped to a low of 7,286 in October 2002 and increased to 8,342 by the end of December 2002. The Nasdaq Composite experienced similar volatility increasing from 1,574 in January 1998 to a peak of 5,133 in March 2000, then experienced a severe decline to 1,336 by the end of December 2002. This trend comes after a period of tremendous growth in the global equity markets. This historical growth resulted from a number of factors, including strong economic conditions and increased issuances of equity securities and record high returns, particularly in the U.S. equity markets. A trend towards more self-directed individual investing and public interest in investing in equity securities also contributed to this growth. In addition, technological innovation, including increased reliance on the Internet and electronic brokers, reduced transaction costs and further stimulated trading activity. In non-U.S. markets, increased availability of market information, a growing trend toward public (rather than governmental) ownership of companies in Europe and Asia, greater access to equity investing and advances in trading technology contributed to increased trading volumes. Since 2002, the trend of growth in some U.S. markets has slowed, while other markets have experienced no growth or downward trends. In 2002, Nasdaq market volumes decreased slightly but had significant declines during the first quarter of 2003. However, since 2002, the U.S. exchanges have maintained moderate growth. For example, the average daily trading volume in the Nasdaq market increased from 1.8 billion shares to 1.9 billion shares from 2000 to 2001 but decreased to 1.8 billion shares in 2002. As of the end of February 2003, the average daily trading volume in the Nasdaq market decreased further to 1.3 billion shares. On U.S. exchanges, there was continued modest growth over this period with average daily trading volumes of 4 1.2 billion shares, 1.5 billion shares and 1.8 billion shares for 2000, 2001 and 2002, respectively. As of the end of February 2003, the average daily trading volume on U.S. exchanges remained at 1.8 billion shares. A number of factors have produced these recent trends, including a weakened and uncertain economic climate; increased unemployment rates; reduced capital-raising activities; decreased market capitalization; ongoing geopolitical and global conflicts; and current corporate governance and accounting issues, which have generally resulted in a decline in public confidence in the securities markets. Similar to the U.S. markets, non-U.S. markets have also experienced considerable volatility and a significant decline in stock prices since 2001. However, during this period, non-U.S. markets have maintained moderate growth in volumes. A number of factors have contributed to these trends, including a weakened and uncertain economic climate, reduced capital raising activities and an uncertain global political climate. U.S. MARKET STRUCTURE Until 1969, when Instinet was founded, stock markets operated primarily in a physical environment -- on a trading floor -- through an auction conducted by open outcry. The NYSE continues to operate an auction system on a physical trading floor, with orders for each listed stock being routed on the floor of the exchange, either electronically or physically, to a designated dealer, known as a specialist. In 1971, the Nasdaq system, a new electronic marketplace without a physical trading floor, was introduced as an outgrowth of the traditional and inefficient telephone-based over-the-counter market. Nasdaq dealers, known as market makers, are linked together via a screen-based electronic communications system, known as the Nasdaq quote montage. While both of these trading markets have accommodated historical trading patterns and volumes, they have substantial shortcomings, the most significant of which is limited access. Neither market enables buyers and sellers to deal directly with each other. Instead, trading is conducted indirectly through intermediaries -- the specialists, in the case of the NYSE, and the market makers, in the case of Nasdaq. Access to these intermediaries is further restricted. For example, in the case of the NYSE, only a member owning a "seat" on the exchange (or a brokerage firm to which that member has granted the use of this seat) may trade with or through a specialist. Until 1997, when the SEC order handling rules became effective, only market makers had access to the Nasdaq quote montage. In some cases, investors access a NYSE member firm or Nasdaq market maker through the intervention of yet another securities brokerage firm. Indirect access reduces the speed with which a desired trade is executed. In some cases, this delay may prevent an investor from trading at the last published price of which the investor had knowledge when placing an order for the trade. In addition, an investor with indirect access often has more limited pricing information than others with direct access (such as market makers or specialists). Other shortcomings are also apparent. Paper or telephone-based trading, which continues to be used where access to electronic systems is limited, also reduces the speed of execution and increases potential for errors and disputes. These factors lead to increased costs and market and execution risk for both broker-dealers and traders. Sophisticated trading strategies, such as those involving the execution of trades in more than one security or using multiple types of financial instruments, are particularly difficult to accomplish without rapid, direct and anonymous electronic market access. Regulatory and technological developments over the past five years have led to gradual increases in competition for trading shares that are listed on an exchange or quoted on Nasdaq. To fulfill its statutory mandate to foster this competition while integrating the trading of stocks on different venues into the National Market System (referred to as the NMS), the SEC has required the national securities exchanges and associations (referred to as self-regulatory organizations, or SROs) trading those stocks to jointly operate and participate in NMS systems for the consolidation, dissemination and sale of market data in U.S. exchange-listed stocks (the Consolidated Tape Association and Consolidated Quotation System) and Nasdaq-quoted stocks (the Nasdaq -- UTP Plan), as well as an intermarket order routing system for U.S. exchange-listed securities (the Intermarket Trading System, or ITS). For exchange-listed stocks, the so-called third market -- the trading of exchange-listed stocks by non-exchange members without recourse to the exchange trading floor-has emerged. In addition, regional exchanges, such as the Cincinnati Stock Exchange and Pacific Exchange have grown in relative importance. 5 For Nasdaq-quoted stocks, in 1997, the SEC's order handling rules for market makers and exchange specialists took effect. These rules provided a specified role for ECNs, or electronic systems that widely disseminate orders entered into them by a market maker or specialist to third parties and permit execution of those orders against each other. The order handling rules deal specifically with the processing of limit orders, which are orders with an associated limit price above which a buyer, or below which a seller, will not trade. In particular, the rules prohibit a market maker or exchange specialist from displaying its own limit order for a security through an ECN at a more favorable price than its published quote unless the ECN publishes its best- priced market maker and exchange specialist orders in that security and permits execution against those orders through the facilities, or pursuant to the rules, of a self-regulatory organization. Similarly, a market maker that receives a limit order better than its own published quote must generally either execute the order, incorporate the limit order price into its published quote or pass the order on to an ECN for public display and execution access. The emergence of electronic communications networks (ECNs) and, later, alternative trading systems (ATSs) -- a term that refers generally to systems, including ECNs, other than traditional exchanges or Nasdaq, that bring together the orders of buyers and sellers of securities through automated means -- has provided efficient means of access to market centers and has resulted in a shift in liquidity, or trading activity, away from the major established market centers towards the ATSs. Following the adoption of the order handling rules, in 1998 the SEC adopted Regulation ATS, which regulates the operation of ATSs registered as broker-dealers. Under Regulation ATS, an ATS may seek to register with the SEC as a national securities exchange. To date, The Island ATS has submitted a draft application for registration as a national securities exchange, and another ATS has already been approved to serve as a facility of an exchange. With exchange status, an ATS gains direct access to ITS, enabling an ATS to access publicly displayed orders in all ITS participant markets trading U.S. exchange-listed stocks and make its own orders available for execution through ITS. It also becomes a participant in other NMS systems, affording it a role in their governance, a share of the revenues generated by the sale of consolidated market data to vendors and market participants, and direct connectivity to those systems. As an exchange, an ATS also becomes an SRO or SRO facility, no longer subject to regulation by the NASD or another SRO. Recently, the NASD has implemented a number of rule changes for the Nasdaq market that move Nasdaq from a quote-driven display system to an order-driven execution system that directly competes with ECNs. The most significant of these rule changes resulted in the creation of SuperMontage, a new trading platform for the Nasdaq market. The SEC approved SuperMontage on January 10, 2001, and Nasdaq completed its implementation on December 2, 2002. Any ECN or market maker using Nasdaq facilities to display quotations in Nasdaq-quoted stocks or to access quotations on Nasdaq is now required to use SuperMontage. SuperMontage significantly altered the way the Nasdaq market operates. The new structure combines a computer display containing more bid and offer information about trading interest in individual Nasdaq-quoted stocks than was previously displayed and new rules establishing the execution priority of quotes and orders submitted to Nasdaq. Unlike its predecessor, SuperSoes, SuperMontage also includes functionality that facilitates participation by ECNs on the platform. On January 31, 2003, the SEC approved a 90-day pilot program to enable broker-dealers not registered as market makers to enter non-marketable limit orders directly on SuperMontage for execution. This pilot program allows Nasdaq for the first time to compete with the Instinet and Island ATSs and other market centers in attracting orders that provide liquidity from non-market maker broker-dealers. We are unable to predict the extent to which Nasdaq will be successful in attracting liquidity-providing orders from these broker-dealers, but to the extent it is, this pilot program may result in our receiving fewer orders that provide liquidity in Nasdaq-quoted stocks and therefore executing fewer orders in our liquidity pools in these stocks. In addition, Nasdaq is in the process of becoming a for-profit exchange, independent from the NASD. On March 15, 2001, Nasdaq submitted its application for registration as a national securities exchange to the SEC. By operating as an exchange with SuperMontage as its trading platform, Nasdaq would be continuing to evolve as a direct competitor of ATSs. If Nasdaq is registered as an exchange, we are unable to predict what changes to its operations it might propose or eventually implement. We are also unable to predict what impact Nasdaq's registration as an exchange may have on our business. 6 Even if Nasdaq gains status as an exchange, the NASD will continue to have an obligation to collect quotations and transaction reports from NASD member firms seeking to trade U.S. exchange-listed stocks -- which would then include Nasdaq stocks -- other than on an exchange. This was a factor in the SEC's decision to condition its approval of SuperMontage on the NASD establishing an alternative facility to SuperMontage that market makers and ECNs could use to meet their quotation display, order access and trade reporting obligations. On July 27, 2002, the SEC approved the NASD's proposal for the Alternative Display Facility (ADF) as a nine-month pilot program restricted to Nasdaq-quoted stocks. The ADF pilot displays quotes and collects trade reports, but keeps the NASD's obligations to operate a market to a minimum. The ADF pilot does not provide for order execution or routing services. As a result, ADF pilot participants themselves are required to provide NASD member broker-dealers with electronic access to their quotations. The NASD's pending proposal for ADF trading of U.S. exchange-listed stocks would provide ADF participants the choice of meeting their order access obligations through ITS or by providing other market participants with electronic access to their quotes themselves. Another pending change to the Nasdaq market structure, in recognition of Nasdaq's growing role as a competitor, is the expected replacement in 2004 of Nasdaq as exclusive collector and distributor of consolidated data (known as an exclusive securities information processor, or exclusive SIP), regarding quotations and trades in Nasdaq-quoted stocks. This role has given Nasdaq financial and other competitive advantages. The replacement is also expected to be an exclusive SIP but may not compete directly with us. The introduction of decimalization in April 2001 -- the quoting of stock prices in dollars and cents rather than in dollars and fractions of a dollar (such as 1/8 or 1/16) -- has also had an impact on the U.S. securities markets and increased competition for ATSs. Decimalization may assist investors in obtaining price improvement because improvement in smaller increments is possible. Because decimalization narrows average trading spreads, it has had a significant negative impact on the profitability of traditional broker-dealers. As a result, some market makers are moving from a business model in which they trade as principal for their own account to an agency business model. The SEC's recently expanded interpretation of Section 28(e) of the Exchange Act allowing institutional investors to obtain soft dollar credits from certain transactions executed through broker-dealers on a "riskless" principal basis, rather than only on an agency basis, may further encourage this trend. We believe decimalization has led to traditional broker-dealers executing a higher percentage of their customers' orders internally (a practice known as "internalization") instead of routing them to external market centers for execution, because the additional price risk they incur to fill orders internally has decreased to as little as a penny a share. The securities markets and the brokerage industry in which we operate are highly regulated. Many of the regulations applicable to us may have the effect of limiting our activities, including activities that might be profitable, or causing us to modify our business model in ways that may adversely affect our revenues. Accordingly, new regulations or interpretations may be adopted that could constrain our ability and our customers' ability to transact business through us and could have a material adverse effect on our business, financial condition and operating results. In addition, the SEC regularly considers a variety of regulations or interpretative initiatives with respect to the structure of the equity securities markets, including initiatives intended to reduce fragmentation, integrate ECNs and ATSs into the national market systems and create a national consolidated limit order book. Future SEC rulemakings or interpretations in this area could adversely affect our business, financial condition and operating results. We are unable to predict the outcome of the various deliberations and discussions on the evolution of the U.S. equities market structure and regulatory framework, although these issues or other issues of market structure may have a significant impact on our equities business. See "Certain Factors that May Affect Our Business -- Risks Related to Our Industry." IMPACT OF TECHNOLOGICAL DEVELOPMENTS Innovations in technology, particularly the growth of the Internet, have increased the speed of communications and the availability of information, facilitated the globalization of commerce, and simultaneously decreased the cost of electronic commerce. New methods have developed to enable institutional 7 investors to access and participate in the equity securities markets more easily and less expensively. Electronic markets have substantially reduced the need for intermediation, such as by NYSE members and NYSE specialists or Nasdaq market makers, because direct access is effectively unlimited and technology enhances the ability to determine the best price at which a trade can be executed. These developments, combined with the regulatory changes discussed above that allowed for the emergence of ATSs, have led to dramatic growth in electronic trading and provide a challenging competitive environment. Technological developments have also affected investing by individuals. Technological advances have created new and inexpensive means for individual investors to access markets directly on-line. As technology continues to improve and regulatory and customer scrutiny of execution and trading services intensifies, we believe that individual investors will increasingly demand institutional-quality services. INTERNATIONAL SECURITIES MARKETS Until the early 1990s, equity markets outside the United States were generally less developed than those in the United States, with relatively low trading volumes and less advanced trading systems. Thereafter, technological and regulatory changes, other competitive pressures, and increased globalization contributed to increasing trading activity and major structural changes in the established European exchanges, which generally moved to an electronic model. In this model, an electronic system receives and matches orders that are routed through the system. Intermediaries provide execution services to their customers primarily by providing connectivity to the exchange system. In addition, in Europe there has been an increasing trend towards consolidation of exchanges, encouraged by technology and the adoption of the euro. Recent economic and financial difficulties and disruptions in Asia have made trends in Asian securities markets less predictable. However, we believe that, except for the trend in Europe towards the consolidation of exchanges, similar competitive, demographic and technological developments will lead over time to an evolution in Asian markets generally comparable to that in Europe over the last decade. OUR COMPETITIVE STRENGTHS WE ARE A MARKET LEADER WITH STRONG BRAND AWARENESS We pioneered an electronic screen-based trading system and have been providing investors with electronic trading solutions for more than 30 years. We have been a market leader in the trading of Nasdaq-quoted stocks for many years and accounted for 18.6% of the total trading volume in that market in 2002. Our trading volumes include Island volumes subsequent to the merger, which was completed on September 20, 2002. Following the merger, in the fourth quarter of 2002, our two ATSs accounted for approximately 30% of the total trading volume in Nasdaq-quoted stocks. For an explanation of how we calculate our trading volumes, see "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Key Statistical Information -- Nasdaq Volume Calculations." Our substantial share trading volume, particularly in Nasdaq-quoted stocks, attracts significant customer attention and order flow. CNBC broadcast live daily from our sales trading centers in the pre-and post-market hours. As a result, we have strong name and brand recognition among institutional investors and market professionals. WE DELIVER COMPELLING BENEFITS TO OUR CUSTOMERS We believe that our core values of independence and neutrality, anonymity, equal and direct access and customer empowerment enable our customers to obtain superior execution of their trades, through reduced fees for taking liquidity and rebates for providing liquidity and reduced transaction costs than are generally achievable using traditional trading channels. For example, we believe that one of the biggest concerns of institutional investors in securities trading today is the market impact of the disclosure of their identity and trading intentions. Customers, therefore, often seek to break up orders to hide their overall intentions, but if the market becomes aware of a large investor seeking to sell securities, the price of those securities may drop before the investor's position can be fully liquidated. Similarly, market awareness of a large investor seeking to buy a large amount of securities may result in an increase in the price of the securities before the order can be fully executed. By allowing our customers to trade directly but anonymously, we reduce the potential for this 8 market impact, which we believe can result in better pricing for the customer. In addition, we believe that our services enable our customers to manage their orders more effectively as well as provide efficient access to multiple liquidity pools other than our liquidity pools. We believe that we provide our customers with the opportunity for price improvement and reduced transaction costs in executing their trades. In a report published in January 2003 based on data for the 12 months ended September 30, 2002, Plexus Group, an independent market research group, ranked Instinet first in execution quality in Nasdaq-listed stocks as well as U.S. exchange-listed stocks when compared to a universe of the 12 most-active full-service brokers for which Plexus has data. WE OFFER A BROAD RANGE OF SERVICES As an electronic agency broker, in addition to trade execution, we offer our customers a wide variety of other services. Companies acting solely as ECNs are generally limited to small order electronic execution and order routing. Our broader business model extends beyond these functions, and we provide service offerings tailored to our customers' diverse trading needs. These service offerings include a variety of trading services, and clearing and settlement, all of which add value for our customers. For example, we provide services such as: - simultaneous execution of multiple orders of securities (known as portfolio trading); - trading of large orders (referred to as block trading); - automatic matching of orders at specified levels (known as crossing); - extended hours trading; - directing orders to either our own liquidity pools or one of the various markets to which we are connected (known as smart order-routing); - technical assistance to customers in inputting orders; and - management of the execution of orders for customers over time (often referred to as working orders). We also are one of the largest global independent providers of research and other brokerage services through soft dollars or other similar arrangements and one of the largest providers of commission recapture services to pension plan sponsors and managers. WE OPERATE GLOBALLY Our customers use our Instinet ATS to trade securities in approximately 30 non-U.S. securities markets, and we are a member of 11 non-U.S. exchanges. As of December 31, 2002, approximately 735 customers in Europe and approximately 150 customers in Asia had access to the INSTINET(R) trading system. The number of transactions in non-U.S. equity securities executed through Instinet's systems has grown from approximately 1.5 million transactions in 2000 to 7.6 million transactions in 2002. In addition, outside the United States, we are an independent provider of research and other brokerage services through soft dollar and similar arrangements and a significant provider of commission recapture services to pension plan sponsors and managers. WE HAVE A PROVEN ABILITY TO INNOVATE AND ADAPT Throughout our more than 30-year history, we have been an innovator in using technology to enhance securities trading, have seized market opportunities and have adapted to numerous changes in our operating and regulatory environment while continuing to grow. Some of our most significant developments include the following: - At a time when most investors were paying fixed commissions to trade in NYSE-listed stocks, we pioneered an electronic screen-based trading system that allowed customers to trade without paying fixed commissions. 9 - After the abolition of fixed commissions in 1975 placed significant price pressure on our business, we established the first service to display real-time information showing NYSE and regional exchange quotes together on an electronic screen and provided our customers direct access to trade NYSE-listed or regional exchange-listed stocks through the regional exchanges. - In 1984, we created an electronic marketplace in which market makers and institutional investors could trade directly among themselves and obtain automated execution of trades inside the publicly quoted spreads for those stocks. In 1989, we enhanced this service by enabling our customers to interact and trade anonymously on our system. - In the late 1990s, we adapted to cost and pricing pressures in our equities business, to the introduction of the SEC's order handling rules, which substantially changed activity for Nasdaq participants, and to the SEC's adoption of Regulation ATS, which imposed new requirements on our activities. We enhanced and modified our services, lowered our prices and changed our cost structure to adjust to these changes in our operating environment. - In response to the increasing volumes in cross-border trading and the fragmentation of securities markets, we offered our customers ways to access multiple liquidity pools. We introduced the first integrated electronic trading platform to permit direct electronic access to equities markets across Europe, together with facilities to negotiate and trade directly and anonymously with other customers. - We introduced one of the first order management tools that allowed customers to manage, deliver and execute baskets of securities in the Nasdaq market. We also introduced tools that allow customers to use our technology to enter alternative pricing for trades (commonly referred to as discretionary pricing) or for alternative trade sizes (commonly referred to as reserve book features), which had in the past required a high degree of manual intervention. - We have been an innovator in developing extended hours trading and crossing capabilities starting in 1995 and 1986, respectively. These new services responded to globalization and continuous availability of information about markets and issuers, and the resulting demand by investors to trade equity securities after traditional exchanges and markets are closed. - In 2002, we introduced NEWPORT(TM), a unique, patent pending execution management system for portfolio trading that allows customers to organize and manipulate database components supporting the system's interface, in addition to permitting the customization of the display features. WE HAVE AN ESTABLISHED TECHNOLOGY INFRASTRUCTURE We developed one of the earliest electronic businesses in any field of commerce and introduced the first screen-based system through which institutional investors could trade Nasdaq-quoted stocks directly with each other. Our technology enables all of our customers to access the liquidity pools within our own electronic trading systems in order to trade these securities with one another or to access one of the various markets to which we are connected. We continue to develop and enhance our technology to provide our customers efficient access to our two ATS systems and to most other liquidity pools, resulting in enhanced order execution capabilities. In addition, we continue to provide our customers with enhanced technology to improve our customers' order management and execution capabilities. We believe that our ability to use technology effectively to improve our services has been a key component in the development of our business. OUR STRATEGY We are focused on delivering services that empower our customers to reduce their total transaction costs, gain price improvement on their trades, manage their orders and better achieve their trading objectives. Our objective is to take advantage of growth opportunities that may arise in the securities industry as a result of changing technology, regulation, competition and increased trading activity through electronic trading systems in global equity markets. We believe that our strong global competitive position, breadth and scale of operations, unique business model, and proven ability to innovate and use technology give us an advantage in this pursuit. 10 The principal elements of our strategy include: Maintain and Expand Our Liquidity. We continue to seek ways to maintain and expand our trading volumes in the global equity markets, particularly in the U.S. markets for Nasdaq-quoted and U.S. exchange-listed stocks. Over the past two years, volatility, declines in trading volumes and intense competition, particularly for U.S. broker-dealer customers, have resulted in a difficult operating environment. We remain focused, in this challenging climate, on maintaining and strengthening our liquidity by enhanced pricing and service offerings for these broker-dealer customers, and by leveraging our technological capabilities. We believe that this focus on liquidity and technology results in better executions for all of our customers. For our Instinet ATS, following our pricing initiatives in late 2001 and the first quarter of 2002, in March 2002, we introduced a new service initiative for U.S. broker-dealer customers that includes faster response times, enhanced functionality, reduced fees for taking liquidity and new rebates for providing liquidity. We also continue to assess our pricing for all of our customers. As part of our continued effort to operate as a low-cost provider to increase our efficiency, we have implemented a cost reduction plan to reduce our fixed cost base and continue to evaluate further cost reduction initiatives. We continued our efforts to maintain and expand our liquidity with our acquisition of Island in September 2002, which, among other things, resulted in an increase in our consolidated market share in both Nasdaq-quoted stocks and U.S. exchange-listed stocks. Our two ATSs, Instinet and The Island ECN, currently operate independently. As we evaluate the potential integration of the two trading platforms, we continue to develop our technology to enhance the ability of customers of each of our ATSs to access the liquidity in the other ATS. For example, in November 2002, we introduced technology that offers Instinet customers the option, for certain orders, to send automatically parts of orders that cannot be filled on the Instinet system to the Island system at no additional cost to the customer. In addition, we are developing technology that will enable customers of the Island ATS to connect directly to our smart order-routing technology through Inlet, Island's proprietary market data and order handling platform. We anticipate deploying this new technology to our customers during the second quarter of this year. Extend Our Global Brokerage and Technology Offering. We intend to continue to develop our global institutional agency brokerage business by enhancing our pricing and service options, as well as continuing to innovate and use technology to reduce our customers' transaction costs and provide better pricing for their trades. Specifically, we intend to continue to enhance our technology and improve our customer service and professional sales and trading assistance efforts. We also seek to increase customer awareness of the value of the benefits we provide as a result of our core values of independence and neutrality, anonymity, equal and direct access and customer empowerment. Both in the U.S. and internationally, we will continue to align our existing resources and focus our initiatives on developing products and services tailored to our various customer categories, based upon our customers' specific needs and their diverse business models, with the aim of improving our customers' execution performance. These services include portfolio trading, block trading, crossing, trading software, soft dollar and plan sponsor services, and professional sales and trading assistance. We believe that these efforts will also contribute to maintaining and expanding our trading volumes in the global equity markets. We have recently introduced a number of new products and services to enhance our customers' order management and trade execution. Our new Direct-FIX technology, introduced in February 2002, is an upgrade of our basic connectivity which combines faster connectivity with improved trading functionality. In October 2002, we introduced a new block trading functionality that we believe will improve our customers' performance and efficiency when executing large, complex orders. In the first half of 2002, we deployed two new customer interface products, INSTINET TRADING PORTAL (SM) and NEWPORT(TM). Instinet Trading Portal is aimed primarily at active fund managers and hedge funds and enhances our customer interface with smart order-routing technology and sophisticated order functionality, while Newport is an execution management application for portfolio trading that is designed to improve our customers' ability to execute program trades and implement trade strategies on a global basis while reducing their transaction costs. We plan to continue to roll these products out to new customers. 11 In pursuit of our strategy, we periodically engage in discussions regarding various types of transactions, including possible acquisitions or investments, some of which could be material to us. We may agree to pay the consideration in connection with a transaction in cash, our securities or some combination of the two. Some acquisition transactions that involve our securities could have a dilutive effect on our earnings per share. It is also possible that the number of shares of our common stock that may be issued in connection with a transaction could constitute a material portion of our then outstanding common stock not held by Reuters, even if not material compared to the total amount of common stock outstanding. At present, we have no agreements or understandings for any material acquisitions or investments. OUR BUSINESS OUR GLOBAL INSTITUTIONAL EQUITIES BUSINESS We offer our customers a broad range of trade, execution, order management and ancillary services, enabling them to trade equity securities directly with each other through our platforms, as well as with other investors in over 40 securities markets throughout the world. The size, nature and geographic distribution of our customers have generated distinct pools of liquidity on our two electronic platforms. We also offer our customers smart order-routing technology that directs their equity transactions among the various markets to which we are connected to obtain better execution. On a worldwide basis, in 2002, our customers used our two platforms to complete a total of 156.0 million transactions, representing an average of approximately 619,000 transactions each trading day. With our acquisition of Island in September 2002, we operate two of the largest ATSs trading Nasdaq-quoted stocks. Our two ATSs accounted for 18.6% of the total trading volume in Nasdaq-quoted stocks during 2002 (although that figure fluctuated significantly during the year). This trading volume includes all of Instinet's trading volume for 2002 and only Island's trading volume subsequent to the merger, which was completed on September 20, 2002. Following the merger, in the fourth quarter of 2002, our two ATSs accounted for approximately 30% of the total trading volume in Nasdaq-quoted stocks. Our average daily trading volume in Nasdaq-quoted stocks increased 22.4% from 265.7 million shares in 2001 to a combined volume of 325.2 million shares in 2002,with almost all of that increase resulting from the addition of Island's volumes. Including Island's trading volumes subsequent to September 20, 2002, our two ATSs together accounted for 3.4% of the total trading volume in U.S. exchange-listed stocks during 2002. Our average daily trading volume in U.S. exchange-listed stocks increased 40.1% from 44.4 million shares in 2001 to a combined volume of 62.2 million shares in 2002, with approximately half of that increase resulting from the addition of Island's volumes. Instinet's transaction volume in non-U.S. stocks was approximately 7.6 million transactions in 2002. For an explanation of how we calculate our trading volumes, see "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Key Statistical Information -- Nasdaq Volume Calculations" and "Calculation of Instinet ATS and Island ATS Combined Volumes." Customers Institutional investors (including mutual funds, hedge funds, pension funds, banks, insurance companies and investment portfolio managers) and market professionals (broker-dealers, including Nasdaq market makers) are the core of our customer base. As of December 31, 2002, our Instinet ATS provided equities trading services to approximately 2,865 customers, of which approximately 735 were in Europe and 150 in Asia. In the United States, our Instinet customers included approximately 1,250 institutional investors and 730 broker-dealers as of December 31, 2002. In the United States, Island provided equities trading services to approximately 620 customers, most of which were broker-dealers, as of December 31, 2002. 12 Our customers fall into the following broad categories: INSTITUTIONAL INVESTORS: - ACTIVE INSTITUTIONS, which generally include mutual funds and asset managers that make stock specific equity investment decisions based on fundamental company research; - PASSIVE AND QUANTITATIVE INSTITUTIONS, which include mutual funds and asset managers with a passive or quantitative approach to investing; - PLAN SPONSORS, which generally include pension fund managers; and - HEDGE FUNDS. MARKET PROFESSIONALS: - TRADITIONAL BROKER-DEALERS, which include market makers, agency traders and broker-dealers serving institutional and retail customers; - DIRECT ACCESS BROKERS-DEALERS, who provide smaller institutions, retail customers and individual professional traders electronic access to the markets; and - PROGRAM DRIVEN TRADERS, which include customers who execute a variety of arbitrage strategies and use automated computer processes to trade. - INDIVIDUAL PROFESSIONAL TRADERS, who seek to manage their own trading activity by accessing the markets directly instead of through market intermediaries or institutional investors. We have developed and are continuing to develop product and service offerings tailored to these customer categories, based upon their specific needs. Due to the diverse business models of our customers, some of our customers may fall into several of these categories. In this case, we provide our tailored services to each aspect of the customer's business model, rather than assigning the customer to one particular category. We believe that by offering our customers a tailored package of value-added services and order management and execution functionality, together with anonymous trading, access to our liquidity pool and efficient connections to other trading platforms, we can enhance our customers' ability to achieve their trading objectives. Services We offer our customers a broad range of trade execution, order management and other services through our two ATSs, Instinet and Island, including the following: Core Execution Services. Each of our two ATSs provides the automated matching of buy and sell orders for both Nasdaq-quoted securities and U.S. exchange-listed securities. Through each of our Instinet and Island electronic trading platforms, we enable our customers to enter orders and execute trades directly with one another. Direct trading between our customers over each of our platforms creates a deep liquidity pool, in particular for Nasdaq-quoted stocks and exchange-traded funds (an index fund representing a basket of stocks that trades on an exchange, with pricing throughout the day). Using the Instinet trading platform, customers are able to trade with other investors in over 40 securities markets worldwide and access market makers or other ECNs using our smart order-routing technology. For customers who trade in Nasdaq-quoted stocks, the Instinet trading platform provides an automated market interaction system, which automatically routes our customers' transactions in Nasdaq-quoted stocks to either our own liquidity pool or one of the various markets to which we are connected to obtain better execution. For customers who trade in NYSE-listed stocks or stocks listed on any other exchange, the Instinet platform primarily provides connections to the exchange and, in the case of the NYSE, the specialist for each listed stock, although our customers can trade directly with each other over the Instinet platform. We anticipate extending our automated market interaction system to include U.S. exchange-listed stocks by the end of the second quarter of this year. 13 For non-U.S. securities that are not traded in U.S. markets, Instinet primarily provides direct connections to the principal non-U.S. exchanges on which those securities are listed, although customers can also trade directly with each other over the Instinet platform. Instinet is a member of 11 non-U.S. exchanges and provides customers with direct access to those exchanges to execute their trades. For more than 20 additional non-U.S. markets, Instinet provides access through local exchange members. We are currently in the process of developing a plan to potentially integrate the core technologies of the matching engines of our two ATSs and to identify operating efficiencies so that our customers who trade through both of our trading platforms will be able to benefit from all of our value-added services. As part of our integration efforts, we have deployed technology that offers Instinet customers the option, for certain orders, to send automatically parts of orders that cannot be filled on the Instinet system to the Island system at no additional cost. If the order is not executed there, the order will be posted on the Instinet trading platform or routed to another market center for execution, based upon the customers' instructions. This enhanced functionality is only available to customers using our INSTINET TRADING PORTAL (SM) and NEWPORT(TM) trading applications and only to customers who access the Instinet trading platform through Direct-FIX. In addition, we are developing technology that will enable Island customers to connect directly to our smart order-routing technology through Inlet, Island's proprietary market data and order handling platform. We anticipate deploying this new technology to our customers during the second quarter of this year. Negotiating Orders. Our Instinet trading platform utilizes technology that allows our customers to communicate anonymously both with all customers and with specific customers who have placed an order. As a result, customers can determine whether there is interest by another customer in a potential transaction and negotiate the volume and price of that transaction, all directly and anonymously through our system, without requiring any intermediation from anyone or displaying any of the communications or negotiations to other customers. This capability facilitates the execution of large orders and also allows customers to manage the delivery and execution of their orders by themselves to minimize the market impact of a large order and obtain price improvement. Instinet also offers trading functionality that is designed to improve our customers' performance and efficiency when executing these large, complex orders. Instinet recently deployed a new order management application that allows our customers to manage the delivery and execution of their block orders by identifying potential counterparties for the order, and negotiating directly with them, without diminishing their ability to expose the order anonymously to the market as a whole. This new trading application enables our customers to minimize the market impact of a large order and reduce their transaction costs while continuing to use our existing infrastructure. We believe this enhanced functionality will help our customers to manage their order flow in a more efficient manner. Sales Trading Assistance. Each of our two ATSs has a dedicated group of sales and trading professionals who provide our customers with various types of sales and trading assistance and provide technical assistance in the use of our screen-based trading systems. Customers using the Instinet trading platform can also place orders by telephone with our sales and trading professionals, who enter the orders into our system on behalf of a customer, and in some cases will work those orders in an attempt to reduce their market impact and achieve price improvement. For example, they may divide a large order into a series of smaller orders that are entered over a period of time, possibly at different prices. In addition, Instinet has a dedicated team of sales and trading professionals available to assist its customers with their portfolio trading and perform execution quality analysis to assist Instinet's customers in their review of transaction costs. Also, Instinet's Technical Analysis Group produces packaged and customized technical analysis, as well as daily market commentary to enable customers using the Instinet trading platform to design efficient portfolio and trading strategies. As of December 31, 2002, our two ATSs together had 285 sales and trading professionals, of which 157 were located in North America, 92 in Europe and 36 in Asia. In Europe, Instinet sales traders in London are responsible for providing brokerage services to all of its customers and coverage of all of the markets where our Instinet trading platform operates. Recently, Instinet streamlined its local presence coverage in Europe, centralizing most of its European brokerage services in London. London also has a 14 specialized desk to service European portfolio traders. In Asia, Instinet provides coverage for its Japanese customers and the Japanese market through its Tokyo office, with the remainder of Asia and Australia serviced through our Hong Kong office. Instinet also has coverage in each of its offices in the United States, Canada, Europe and Asia to assist customers who wish to place orders through the Instinet trading platform in a different region (for example, a European institutional investor seeking to trade a U.S. or Japanese equity security). These cross-region trades are also covered by Instinet's sales and trading professionals for that market, thereby affording our customers in other regions access to local market expertise. Because Instinet has offices worldwide, we also are able to provide sales and trading assistance to our Instinet customers 24 hours a day without requiring additional sales and trading professionals to be staffed in any one office on a continuous basis throughout the day. Extended Hours Trading. Each of our Instinet and Island trading platforms allows customers to input orders for a security and execute the trade with other customers in our liquidity pool before, during and after normal market hours. This permits Instinet to make the liquidity pool generated by its customers available on a 24-hour basis, while Island customers have access to its liquidity pool until 8:00 p.m., New York City time. This service has also allowed our Instinet trading platform to expand globally to include customers and markets in Europe and Asia, whose trading hours do not coincide with those in the United States. Extended hours trading has been a particularly important innovation for our customers when material information about a market or company is released or reported after that market or the principal market for that company's securities is closed. When a pre- or post-market price-moving event occurs, market participants can interact directly at their election to discover a price, which could be significantly different from the closing price, at which they can trade following dissemination of news regarding the event. For example, after Microsoft Corp. announced that it would be issuing its first dividend in the company's history on January 17th, 2003, 12.5 million Microsoft shares traded through our two ATSs between the close on January 16, 2003 and the open on January 17, 2003. This represented approximately 31% of average daily trading volume of Microsoft Corp. during the prior 90-day period. Crossing. Through our INSTINET CROSSING(R) provided to customers using the Instinet trading platform, we enable customers to enter buy or sell orders in U.S. traded securities for execution in a "crossing session." In a crossing session, we electronically aggregate all orders to buy or sell at a pre-specified time; match (or "cross") them with other orders to sell or buy, respectively, and automatically execute them at a pre- determined benchmark price. A crossing trade will be executed only if there is a counterparty for that order (or portion of an order). Our crossing service provides an electronic platform with enhanced liquidity for block trades and better pricing outside regular trading hours than traditional brokerage or other intermediaries might provide, together with the reduced trading risk of a pre-determined benchmark price. Our Instinet trading platform has two crossing sessions each trading day, both of which occur outside of regular trading hours, the more significant of which is in the evening. Following the close of the market each day, we have one crossing session for orders priced at that day's closing price. On average in 2002, during each evening crossing session, our Instinet trading platform received buy and sell orders from 290 customers for approximately 101 million shares, of which trades were executed for approximately 10 million shares. Before the market opens, we have another crossing session using the volume-weighted average price for that trading day. In addition, we offer Instinet customers access to a crossing system for Japanese equity securities through JapanCross Securities Co., Ltd., our 50-50 joint venture with Nikko Salomon Smith Barney Ltd. JapanCross enables customers worldwide to enter orders to buy or sell Japanese equity securities in a pre-market crossing session at the volume-weighted average price for that trading day. We also offer our Instinet customers access to a crossing system for foreign currencies through The INSTINET FX CROSS(SM), our strategic alliance with Citibank, N.A. The Instinet FX Cross, which began operating in December 2002 for our North American clients, enables clients to execute large currency transactions anonymously at a transparent market price. The Instinet FX Cross currently offers two crossing sessions per day in 12 currencies, to be executed at the CitiFX Benchmark rate, against Citibank, N.A. the counterparty. Portfolio Trading. The trading services of our Instinet ATS also include portfolio trading, which allows a customer using our Instinet trading platform to execute multiple orders in a number of different 15 securities simultaneously, including both orders to buy and sell shares of stock as well as securities that are based on an index or basket of stocks. This portfolio trading capability, combined with Instinet's global access, also enables Instinet customers to manage and execute portfolios of securities denominated in a number of different currencies. Instinet's Trading Research Group performs transaction cost analysis to assist portfolio managers and traders in their effort to track and evaluate trading costs. In addition, in April 2002, Instinet deployed a technology to enhance its customers' ability to execute portfolio trade transactions and implement their trade strategies on a global basis. This patent pending execution management application, NEWPORT(TM), was developed in conjunction with passive and quantitative fund managers in the United States and Europe and uses Instinet's existing execution, smart order-routing and clearing capabilities, as well as Reuters market data infrastructure. In addition, this system facilitates collaboration between multiple traders at one customer site, the automation of trading using algorithms created by the customer, customization of the interface by the customer and integration with other systems commonly used by these customers. We believe these features help Instinet customers to manage their orders in a more efficient manner and reduce their operational and transaction costs. As of December 31, 2002, we deployed Newport(TM) to 50 Instinet customers in the United States and Europe and $29 billion in value (meaning the number of shares traded multiplied by the price of the shares) was transacted through the Newport platform since its introduction. Enhanced Customer Interface (INSTINET TRADING PORTAL(SM)). Based upon the technology we acquired through our acquisition of ProTrader, our Instinet ATS developed a trading application primarily for its active asset managers and hedge funds that enables these customers to enhance its customer interface and smart order-routing technology when using the Instinet trading platform. This new trading application uses Instinet's existing infrastructure while giving customers a broader view and broader access to multiple markets. With Instinet Trading Portal, Instinet customers now have the ability to view information for a single stock in multiple markets, increasing their ability to execute their orders in multiple markets for better execution. We believe this enhanced functionality helps these customers to manage their orders in a more efficient manner. In addition, as an Internet-based product, Instinet Trading Portal is designed to substantially reduce communication and field service costs associated with our traditional customer display screens. By the end of the fourth quarter of 2002, Instinet Trading Portal was deployed at over 600 Instinet customer sites,and over 1.4 billion shares were traded through Instinet Trading Portal in 2002. Inlet. Inlet is Island's proprietary Java-based, Internet-based market data and order handling platform that permits its customers to place orders in Island's marketplace. Currently, Inlet can only send orders to the Island ATS. As part of our integration efforts, we are developing technology that will allow Inlet to connect directly to the smart order-routing technology of our Instinet trading platform. Soft Dollar Program. Institutional investors often allocate a portion of their gross brokerage transaction fees for the purchase of independent third-party research products, as well as other brokerage services. The amounts allocated for those purposes are commonly referred to as soft dollar revenues. Our Instinet ATS is one of the largest independent providers of research and other brokerage services through soft dollar or other similar arrangements, and has offered soft dollar programs for over 15 years. Instinet offers soft dollar programs in order to increase the amount of business institutional customers conduct through the Instinet trading platform, thereby increasing its transaction volumes and the depth of its liquidity pool. We continue to focus on these programs, as part of our efforts to enhance our global brokerage offering and maintain and expand our liquidity pool. In particular, Instinet is continuing to develop tailored packages of independent third-party research products for its various customer categories. We also offer customers using the Instinet trading platform proprietary research tools and services. These services include Redbook, which publishes fundamental research on retail and related sectors and whose REDBOOK RETAIL SALES AVERAGE is recognized as a leading indicator of economic activity, and THE GREAT LAKES REVIEW, which focuses on uncovering stock opportunities among lesser-known companies in the Midwest, which is offered by our subsidiary, Lynch, Jones & Ryan. In addition, Instinet continues to make available soft-dollar payment options to its customers in connection with their use of the Research 16 and Analytics (R&A) product, an integrated equity workstation that provides users with real-time quotes and news as well as advanced analytics which is owned by Reuters. In 2002, more than one-third of Instinet's U.S. customers obtained third-party research services from us on a soft dollar basis. The portion of our transaction fee revenue representing soft dollar revenues is offset dollar-for-dollar by expenses we incur in paying for research from independent third parties. Instinet made $129.2 million in soft dollar payments to independent research providers on behalf of all customers using the Instinet trading platform in 2002. Plan Sponsor Services. As part of the transactional services our Instinet ATS provides to pension plans and other funds through their sponsors, such as corporations, unions, state and local governments, endowments and foundations, Instinet enables pension plan and other fund sponsors to recapture a portion of the gross transaction fees that their fund managers pay us. As of December 31, 2002, Instinet provided these services to approximately 1,350 pension plans and other funds. In addition, Instinet provides its plan sponsor customers with services that assist them when they transfer from one money manager to another. For example, Instinet's crossing, portfolio trading and trading research services can help these customers manage this transition. ProTrader. Through our ProTrader subsidiary, we provide advanced trading technologies and electronic brokerage services primarily to professional non-institutional traders, active fund managers, direct access brokers and hedge funds who use the Instinet trading platform. As of December 31, 2002, Protrader provided these services to approximately 950 customers. OUR CORRESPONDENT CLEARING BUSINESS We provide correspondent clearing services to a few securities brokers in the United States. We offer transaction processing, clearing and settlement of trades, recordkeeping and financing to our correspondent customers, as well as various products and services oriented toward the institutional investor community. CLEARING AND SETTLEMENT OPERATIONS We provide clearing and settlement services in nearly all of the markets in which we execute trades for customers. Our clearing and settlement operations are similar in design and function to other clearing brokers. We self-clear through our subsidiary, Instinet Clearing Services (ICS), which uses our proprietary CLEARING INFORMATION SYSTEM(TM) (CIS) to handle customer ticketing, processing of allocations and communications with industry clearing agents, depositories and books and records processing providers. In February 2003, we replaced portions of CIS with a new system for the processing of trades for our U.S. broker-dealer customers. This new system will improve the efficiency of CIS by providing increased capacity to process significantly higher volumes of trades for these customers. For processing of books and records, ICS uses Automated Data Processing, Inc. (ADP) in the United States, Nomura Institute's I-Star system in Japan and ACT Fiscal for all other non-U.S. business. We are currently evaluating our relationship with ADP and continuing to explore relationships with other established processing vendors. As part of our cost saving initiatives and integration efforts in connection with our acquisition of Island, on January 10, 2003, we completed the conversion of Island's trading activity from I-Clearing Corp. to Instinet Clearing Services, Inc. We also clear and settle for broker-dealer customers who have a contract with ICS. With respect to these trades, we are responsible for a variety of activities that take place after a securities trade has been executed, including confirming trades before settlement, submitting executed transaction information to industry clearing and settlement utilities, managing failed trades, communicating trade and settlement data including allocations to customers, managing corporate actions and updating and maintaining Instinet's books and records. 17 BUSINESS INVESTMENTS We have made a number of investments in companies with operations or technology to enhance our core service offerings in our global electronic agency securities business. We have beneficial ownership interests in the following companies: - 7.0% of WR HAMBRECHT + CO., INC., a U.S.-based investment banking firm that enables issuers to conduct auction-based securities offerings via the Internet through its OPENIPO(R). In addition, we have an option to buy additional shares in the event WR Hambrecht becomes a publicly-traded company. WR Hambrecht has also issued warrants that, if fully exercised, would dilute our ownership interest to 6.36%. - 4.8% of the voting interest of ARCHIPELAGO SECURITIES, LLC, the parent company of an ECN that has received approval to operate as a facility of a U.S. stock exchange. In March 2002, Archipelago, LLC merged with REDIBook ECN LLC, another ECN. - 47.9% of TRADEWARE S.A., a European-based provider of integrated order routing solutions to broker-dealers in Europe. We also have warrants that, if fully exercised, would increase our beneficial ownership to 57.3%. - 12.8% of STARMINE INC., a U.S.-based provider of independent ratings of Wall Street equity analysts. - 50% of JAPANCROSS SECURITIES CO., LTD., a 50-50 joint venture with Nikko Salomon Smith Barney Ltd. established to provide a crossing service for Japanese equity securities. - 9.8% of e-XCHANGE ADVANTAGE CORPORATION, a partnership with The Nasdaq Stock Market, formed to develop securities electronic trading systems and tools. - 1.7% of THE NASDAQ STOCK MARKET, INC., a company that operates an electronic stock market in the U.S. We also owned 13.8% of TP GROUP LDC, a consortium that owned 38.9% of virt-x, an electronic order-driven equities market for pan-European securities. On February 3, 2003, SWX Holding AG, a subsidiary of SWX Swiss Exchange, the Swiss market body, acquired 92% of virt-x. TP Group LDC received L13.6 million in connection with the sale and was subsequently liquidated. We expect to receive approximately $3.0 million as part of the liquidation in April 2003. 18 EXCHANGE MEMBERSHIPS Overall, through our Instinet and Island subsidiaries, we are a member of 21 exchanges in North America, Europe and Asia, and we continue to develop our direct connections to non-U.S. exchanges. Our Island subsidiaries are members of the Cincinnati Stock Exchange and the Philadelphia Stock Exchange. The following chart shows Instinet's various exchange memberships, which are through our Instinet subsidiaries only, unless otherwise indicated: EXCHANGE MEMBERSHIPS NORTH AMERICA American Stock Exchange Archipelago Exchange Bermuda Stock Exchange Boston Stock Exchange Chicago Board Options Exchange Chicago Stock Exchange Cincinnati Stock Exchange* New York Stock Exchange Philadelphia Stock Exchange* Toronto Stock Exchange EUROPE Euronext(1) Frankfurt Stock Exchange London Stock Exchange Helsinki Stock Exchange Milan Stock Exchange OFEX plc Stockholm Stock Exchange Swiss Stock Exchange virt-x ASIA-PACIFIC REGION Hong Kong Stock Exchange Tokyo Stock Exchange --------------- * Indicates membership of both Instinet and Island (1) The Paris, Amsterdam and Brussels Stock Exchanges merged on September 22, 2000 to form Euronext N.V. On February 6, 2002, Lisbon Stock Exchange also joined Euronext. We currently provide customers with access to Euronext for trades in French and Dutch stocks. MARKETING AND COMMUNICATIONS Our marketing and communications strategy is focused on three goals: - Creating positive awareness of our key products and services, including our sales and trading expertise, liquidity pools and our sophisticated trading tools. - Attracting new customers. - Retaining our existing customers and cross selling value-added services to them. We pursue these goals through a combination of marketing communications strategies. These include media (for example, offering a daily broadcast to CNBC of market activity information), print and broadcast advertising, interactive marketing on our own websites and other online channels, sponsorships of customer events, direct one-to-one marketing, traditional public relations and a variety of alliances and co-marketing programs and the production of clients newsletters, premiums and promotional items. Through our website, prospective customers can get detailed information on our services, as well as news about us and our market environment. OUR TECHNOLOGY AND INTELLECTUAL PROPERTY TECHNOLOGY Our sophisticated and proprietary technology connects us to our customers, automates traditionally labor-intensive securities transactions, provides us with a platform to support our operations, and is an important part of our compliance activities. We believe that our ability to use technology effectively to expand and enhance our services has been a key component in the development of our business. 19 Our systems provide customers with efficient service and have a proven track record of adaptability as usage has increased and service and product offerings have expanded. Our systems are designed to be interoperable and flexible. For example, our core matching systems use an architecture that allows us to independently develop and evolve the functionality of the systems in different areas as business needs and opportunities demand. We have four core data centers that enhance the capacity and reliability of our Instinet and Island trading platforms. Our two core data centers for Instinet are located in Jersey City, New Jersey and Bedford, Massachusetts. These two data centers support client connectivity, as well as trading and execution systems, clearing and settlement operations and customer interfaces. They also provide redundancy for Instinet's critical applications, systems and services, allowing Instinet to continue to operate from either site should the other site fail. Island is supported by two data centers located in Secaucus, New Jersey and New York, New York. These two data centers support client connectivity, trading and execution systems, as well as customer interfaces. If one of our four data centers were to be damaged, disabled or otherwise fail or experience difficulties, it might be more difficult for us to continue operating without disruption to our services. In order to mitigate this risk, we have installed additional power, telecommunications and hardware at the two core data centers that support the Instinet trading platform. In addition, we are reconfiguring our network infrastructure in order to be able to support both Instinet and Island client connectivity and critical systems and services from any of these four facilities, with each one being able to provide independent support. We anticipate that this reconfiguration will be completed by the third quarter of 2003. We also have two subsidiary data centers and distribution points in London serving Instinet's clients in Europe. Our Instinet ATS uses a range of sophisticated technologies, including Linux, Tibco's Rendezvous, Oracle, Java and Enterprise Java Beans (EJB), for the various components of its systems, including its central order matching engines for its institutional equities trading platform, as well as its crossing services and order management functions. Our Island ATS also uses a number of technologies including Linux, Windows, Java, Microsoft SQL for the various components of its trading system. Currently, our customers can access Instinet's trading platform through INSTINET(TM) display screens, direct links to our systems from those of our customers using the Financial Information Exchange (FIX) protocol, or other protocols, or our proprietary software. Recent products that Instinet has developed to access its marketplace include: - Instinet Trading Portal (SM), our new trading application primarily for our active asset managers and hedge funds. Instinet Trading Portal's Internet-based deployment strategy is designed to substantially reduce communication and field service costs associated with our traditional customer display screens. - Newport(TM), a patent pending program-trading solution aimed primarily at passive and quantitative fund managers. Newport allows for interaction between multiple traders at one customer site, the automation of trading using algorithms created by the customer, customization of the interface by the customer and integration with other systems commonly used by these customers, which improves our customers' ability to execute program trades in global markets. - Direct-FIX technology, an upgrade that offers enhanced trade reporting functionality, access to our smart order-routing technology and access to our market data. This upgrade combines faster connectivity with richer trading functionality than its predecessor and is more cost-effective for us. Most of the methods of connecting to Instinet's trading platform are by means of dedicated networks provided by Radianz, a joint venture between by Reuters and Equant Finance B.V. However, we also provide Internet-based connectivity to those customers who choose not to use Radianz. We are continuing to replace our proprietary communications and connectivity systems with various other methods of connectivity, including Internet-based systems and technology provided by third party vendors, that will shift communications and connectivity requirements to our customers. The availability of alternative methods of connectivity will also provide Instinet customers with multiple options for access to Instinet's trading platform. Customers can access Island's trading platform either directly, through the use of Island's proprietary technology, or through third-party trading platforms for which Island has developed various products to allow 20 those trading platforms to access its trading platform. Products that Island has developed to access its trading platform include: - Inlet(R), a proprietary Java-based, Internet-based, market data and order handling platform that permits subscriber customers to place orders in Island's trading platform. - OUCH(R), a proprietary protocol that provides subscriber customers with a fast, efficient means of entering orders in Island's trading platform. OUCH(R) allows investors to access the Island trading platform, either directly or through a third-party trading platform, to place orders and monitor order and trade information. All orders, whether entered by direct OUCH(R) users or users of Island's other connectivity products, are entered into Island's trading platform through the OUCH(R) protocol. - FIX Connectivity, a product that allows subscriber customers and vendors that have adopted the FIX protocol to connect to Island's trading platform quickly without incurring significant additional technology costs. IslandNet(R) is a managed network service that provides simplified connectivity to Island's trading platform and fully-redundant access over a private network to its full range of products, including OUCH(R), FIX products and Inlet(R). Island has also partnered with other leading providers of front-end trading platforms, network services and trade and order management systems to expand access to Island's matching services and data information. These third-party systems generally connect to Island's trading platform through OUCH(R) or FIX and then redistribute this connectivity to their customers. In the future, we expect to continue to make significant investments in systems technology to upgrade services for the development of our business. We are considering the potential integration of the core technologies of the matching engines of our two ATSs and continue to identify operating efficiencies so that our customers who trade through both of our trading platforms will be able to benefit from all of our value-added services. As part of our integration efforts, we have deployed technology that offers Instinet customers the option, for certain orders, to automatically send parts of orders that cannot be filled on the Instinet system to the Island system at no additional cost. If the order is not executed there, the order will be posted on the Instinet trading platform or routed to another market center for execution, based upon the customers' instructions. This enhanced functionality is only available to customers using our INSTINET TRADING PORTAL (SM) and NEWPORT(TM) trading applications and only to customers who access the Instinet trading platform through Direct-FIX. In addition, we are developing technology that will enable Island customers to connect directly to our smart order-routing technology through Inlet(R), Island's proprietary market data and order handling platform. We anticipate deploying this new technology to our customers during the second quarter of this year. In order to deal with increasing demands on our execution and clearing capacity in our equity securities trading system due to greater service levels and external circumstances such as decimalization, we have a team of employees dedicated to managing our capacity. We believe that it will be important not only to add capacity in the future, but to make this capacity more flexible to handle the complexity of changing circumstances. We have a test network to simulate complex system trading scenarios and to carry out various performance tests on our capacity. In addition, we have other ongoing capacity projects relating to clearing and other areas. INTELLECTUAL PROPERTY To protect our proprietary technology and intellectual property rights, we rely primarily on patent, copyright, trade secret and trademark law. We principally use material, software and technology that we have developed and that are protected by our own intellectual property rights. However, we also use software, as well as other material and technology, that is protected primarily by intellectual property rights belonging to third parties. We have taken measures to register and protect our trade name, logos, trademarks and service marks both in the United States and in various countries throughout the world. Notwithstanding the precautions we take to protect our intellectual property rights, it is possible that third parties may copy or otherwise obtain and use our proprietary technology without authorization or otherwise infringe on our proprietary rights. 21 COMPETITION The financial services industry generally, and in particular, the securities brokerage business in which we engage is very competitive, and we expect competition to remain intense in the future. We expect to face competition from a number of different sources varying in size, business objectives and strategy. In our various businesses, we compete with the following entities and types of entities, among others: - market makers, exchange specialists, and other traditional broker-dealers (including many of our own customers) acting as agent or principal; - traditional and electronic trading methods in use on U.S. and international exchanges, including NYSE specialists and the electronic matching systems of international exchanges; - Nasdaq's SuperMontage and Primex systems, which enable NASD members to trade electronically in Nasdaq-quoted stocks; - the NYSE's INSTITUTIONAL XPRESS(TM), NYSE OPENBOOK(TM) and NYSE DIRECT(TM) products; - ECNs, ATSs, electronic brokers and other electronic trading systems, including but not limited to Bloomberg Tradebook, and Archipelago (in March 2002, Archipelago merged with REDIBook); - automated trade execution services developed by third party vendors for commercialization in a wide range of financial products markets; - commercial banks and other financial institutions; and - trading system software companies. In our institutional equity securities business, both Instinet and Island compete on the basis of a number of factors, including: - total transaction cost; - amount and frequency of price improvement; - the depth and breadth of our liquidity pool; - our speed and quality of connectivity to other trading markets; - anonymity, attributable to customer orders; - functionality and ease of use of our trading platforms; and - reputation. Instinet also competes based upon the quality and availability of our value-added brokerage and research services. We have experienced intense price competition in our equity securities business in recent years that may continue as a result of the following factors: - continuing advances in technology; - price competition; - increased customer awareness and regulatory scrutiny of execution costs; and - continuing unbundling of financial services. Some of our competitors may have more modern technology and a broader range of services and, therefore, may be able to offer brokerage services to customers at lower prices than we can. To maintain our customer base and attempt to counter this pressure, we have aggressively reduced pricing for our U.S. broker- dealer customers and introduced reduced fees for taking liquidity and rebates for providing liquidity. In addition, we seek to continue to innovate and use technology on a global basis to reduce transaction costs; increase customer awareness of the value of price improvement and the benefits we provide as a result of our 22 core values of independence and neutrality, anonymity, equal and direct access and customer empowerment; maintain and expand our Nasdaq liquidity pool and the related benefits; and provide value-added brokerage and other services, tailored for our various types of customers. In our correspondent clearing business, we face competition from traditional clearing firms. Our main competitive factors are price competition and quality of execution. Many of the financial service providers with which we compete are substantially larger than we are and have substantially greater financial, technical, marketing and other resources. Outside the United States, in addition to our U.S. competitors with international capabilities, we compete with banks and other financial institutions that are well-capitalized and larger than we are and may have long-standing, well-established and, in some cases, dominant positions in their trading markets. Competition may remain intense for the following principal reasons: - As the profitability of broker-dealers has come under significant pressure due to the general economic downturn, as well as the impact of decimalization, they have increasingly focused on price in their selection of trading services. If this trend continues, the price competition we have experienced in recent years, and in particular in the fourth quarter of 2001 and in 2002, may persist. - Nasdaq is a for-profit entity and has applied to become a national securities exchange. In addition, Nasdaq and the NYSE have announced plans to introduce services in order to attract additional order flow and trading volume. Implementation of these plans would put them in direct competition with us for order flow, liquidity and trading commissions. - Competitors who apply for and receive status as securities exchanges or facilities of an exchange will be able to benefit from their exclusive participation in the various NMS systems. As a result, these competitors may have an advantage over us in attracting business in, and generating revenues from, their activity in U.S. exchange-listed and Nasdaq-quoted stocks. In addition, there may be other potential competitive advantages associated with securities exchange status, including a role in the governance of NMS systems, a share of the revenues generated by the sale of consolidated market data to vendors and market participants, and direct connectivity to NMS systems, including ITS, which enables an ATS to access publicly displayed orders in all ITS participant markets trading U.S. exchange-listed stocks and make its own orders available for execution through ITS. In addition, as exchanges, these competitors would become SROs or SRO facilities, no longer subject to regulation by the NASD or another SRO. One competitor, Archipelago, has already been approved and is operating as a facility of a U.S. stock exchange. - Multi-service competitors are able to cross-subsidize their agency brokerage and market making activities, with which we directly compete, with their revenues and profits from their other activities in which we do not engage, such as principal trading and investment banking. - Regulatory changes, such as NASD and Nasdaq rule changes, have altered, and may continue to alter, the competitive landscape in which we operate. Sometimes these changes give our competitors competitive advantages over us. See "-- Industry Background" and "-- Regulation." - New competitors have emerged, including companies who provide use of order routers or similar technology, that may not need to have any securities industry experience or be subject to securities industry regulations and potentially may compete against us effectively with lower overhead costs. Some of these competitors may also be better positioned than we are to exploit recent developments in Internet-related technology and to build more attractive or flexible competing products that could capture some of our business. - A variety of existing companies may seek to expand their own businesses to compete against us because of the size of the securities markets, the relationships between information and trading, and the importance of technology in creating efficient trading systems. These potential competitors could include companies that provide trading services for products and services other than securities, software 23 companies, information and media companies, and other companies that are not currently in the securities business. - Commercial banks and other financial institutions have expanded their product offerings to include many of the financial services traditionally provided by broker-dealers. We expect competition from commercial banks to increase as a result of regulatory initiatives in the United States to remove or relax restrictions on combining commercial banks and other types of financial service providers. - Consolidations and alliances among broker-dealers and ECNs and between commercial banks and broker-dealers have resulted, and we believe will continue to result, in increasingly large and well-capitalized financial service providers. Consolidation has occurred between multi-service financial institutions and market makers (including exchange specialists) that could result in better capitalized market makers that compete directly with us and our agency brokerage model. - As a result of decimalization and other factors, some market makers continue to move from a business model in which they trade as principal for their own account to an agency business model in which they charge commissions rather than profit from the "bid-ask" spread. The SEC's interpretation of Section 28(e) of the Exchange Act allowing institutional investors to obtain soft dollar credits from certain transactions executed through broker-dealers on a "riskless" principal basis, rather than only on an agency basis, may further encourage this trend. These developments may increase our competition, particularly in the provision of soft dollar programs. We compete with Nasdaq as a trading venue for Nasdaq-quoted stocks. We own an equity interest of less than 2% in Nasdaq. The NASD operates the ADF, through which Instinet meets its quotation display and order access requirements in Nasdaq-quoted stocks, regulates and polices the Nasdaq market, and regulates the activities of our U.S. broker-dealer subsidiaries through its own subsidiary, NASDR. The NASD also holds a controlling stake in Nasdaq. The NASD is thus able to propose, and often obtain, SEC approval of rule changes that we believe can be to Nasdaq's competitive benefit as a securities marketplace and our competitive disadvantage. In addition, we are required to allow the ADF to provide quotation and trade data to Nasdaq in its current role as exclusive SIP. NASD and Nasdaq (through NASD and as exclusive SIP) receive a share of the fees Nasdaq collects from market participants to whom it disseminates these data. This role has given Nasdaq certain financial and other competitive advantages. In recognition of Nasdaq's growing role as a competitor, however, it is expected to be replaced as the exclusive SIP in 2004. See "-- Industry Background" and "-- Regulation." For a further discussion of the risks relating to our competitive environment, see "Risk Factors -- We Face Substantial Competition That Could Reduce Our Market Share and Harm Our Financial Performance." REGULATION As a securities broker, an operator of two systems considered ATSs and ECNs under SEC regulations and an operator of a clearing business for our own customers and third parties, we are subject to extensive regulation in the United States and in certain other jurisdictions in which we operate. This regulatory framework generally applies directly to our subsidiaries that are registered or licensed in the various jurisdictions. Instinet Corporation, The Island ECN, Inc., Island Execution Services, Inc., The Island Futures Exchange, Instinet Clearing Services, Inc., Lynch, Jones & Ryan, Inc., ProTrader Securities Limited Partnership and Harborview LLC are each registered as U.S. broker-dealers with, and are subject to regulation by, the SEC and other entities, as described below. The purpose of these regulations is to generally safeguard the integrity of the markets and to protect the interests of investors participating in those markets, rather than the interests of securities firms or their creditors or stockholders. As a result, these regulations cannot be expected to protect or further the interests of our company and may have the effect of limiting or curtailing our activities, including activities that might be profitable. Furthermore, additional rulemaking or the initiation of proceedings could adversely affect our business, financial results and condition, prospects and reputation. 24 Regulation covers all aspects of our brokerage business, including: - registration of offices and personnel; - conduct of personnel; - access to our ATSs; - acceptance, execution, clearing and settlement of customer orders; - trading practices; - record keeping; - capital structure; - capacity, integrity and security standards for our trading systems; - sales practices and advertising; and - handling of customer funds and securities and supervision of accounts in connection with our wholesale business. In addition, our business may be significantly affected by regulation that extends to the structure of the markets for equities securities. The various governmental authorities and industry SROs that supervise and regulate us generally have broad enforcement powers. If we fail to remain in regulatory compliance, we could be censored or fined. Alternatively, regulators could issue cease-and-desist orders against us, prohibit us from engaging in some of our businesses, or suspend or expel us or any of our officers or employees from the securities industry. We face the risk of significant intervention by regulatory authorities, including extensive examination and surveillance activity. In the case of non-compliance or alleged non-compliance with regulations, we could be subject to investigations and judicial or administrative proceedings that may result in substantial penalties. In the case of non-compliance, we could also, in some situations, be subject to civil lawsuits by customers, in some cases for substantial damages. Our ability to comply with all applicable laws and rules is largely dependent on our establishment and maintenance of compliance, audit and reporting systems, as well as our ability to attract and retain qualified compliance and other personnel. Our U.S. Activities The securities industry in the United States is subject to extensive regulation under both federal and state laws. The SEC is the federal agency responsible for the administration of the federal securities laws. Our U.S. brokerage and clearing subsidiaries are registered with the SEC as broker-dealers, and our brokerage subsidiary, Instinet Corporation, is also registered with the SEC as an investment advisor. The SEC has delegated much of the regulation of broker-dealers to SROs, including the NASD, which has been designated by the SEC as our principal regulator. The NASD adopts rules (subject to approval by the SEC) that regulate the broker-dealer industry and govern the market structure of Nasdaq and the ADF. These rules regulate the conduct of our U.S. broker-dealer subsidiaries and their activities in Nasdaq-quoted and U.S. exchange-listed stocks. The NASD, through its subsidiary, NASDR, also conducts periodic examinations of the operations of those subsidiaries. Our U.S. broker-dealer and clearing subsidiaries also are registered as broker-dealers in a number of states and are subject to regulation by state securities administrators in states in which they conduct business. Instinet Corporation, Instinet Clearing Services, Inc., The Island ECN, Inc., Island Execution Services, Inc., Lynch, Jones & Ryan, Inc., ProTrader Securities Limited Partnership and Harborview LLC are also subject to regulation by the exchanges of which they are members. In addition, our U.S. broker-dealer subsidiaries are members of the Securities Investor Protection Corporation (SIPC). SIPC provides certain protection for customers' accounts in the event of the liquidation of a broker-dealer. SIPC is funded through assessments on registered broker-dealers, including us. 25 This regulatory environment is also subject to change. Our business, financial condition and operating results may be adversely affected as a result of new or revised regulations or rules imposed by the SEC, other U.S. regulatory authorities or self-regulatory organizations, such as the NASD. Our business, financial condition and operating results also may be adversely affected by changes in the interpretation or enforcement of existing laws and rules by the SEC, other regulatory authorities and SROs. Over the last five years, the SEC and the NASD have proposed a number of regulatory changes in an effort to shape or respond to developments in the securities markets and market structure that have resulted from advances in technology and the growth of electronic trading. Because a substantial part of our business involves electronic trading and relies heavily on technological advances, these proposals may have a direct and substantial impact on us. The Order Handling Rules Starting in 1994, the SEC and the U.S. Department of Justice conducted anti-trust investigations of the NASD and the Nasdaq market, including the market makers, addressing concerns of fraud, price fixing and collusion. In December 1997, 30 major brokerage firms and the Department of Justice entered into a settlement of these anti-trust proceedings. In a report discussing deficiencies in the NASD's oversight of the Nasdaq market and the NASD's failure to enforce broker-dealer compliance with NASD rules and the requirements of the federal securities laws, the SEC specifically noted that we were not a subject of the Department of Justice investigation or the SEC report. In response to the findings of these investigations, the SEC adopted the order handling rules for market makers and exchange specialists in 1996. These rules took effect with respect to Nasdaq-quoted stocks in 1997. The order handling rules prohibit a market maker or exchange specialist from displaying its own limit order for a security through an ECN at a more favorable price than its published quote unless the ECN publishes its best-priced market maker and exchange specialist orders in that security and permits execution against those orders through the facilities, or pursuant to the rules, of a SROs. Similarly, a market maker that receives a limit order better than its own published quote must generally either execute the order, incorporate the limit order price into its published quote or pass the order on to an ECN for public display and execution access. Regulation ATS, discussed below, requires display of institutional orders that represent the best price on a quote montage operated by a SROs. When the order handling rules were introduced, Instinet was the first and only existing ECN, and the best bids and offers from the Instinet trading system were directly displayed for the first time in the Nasdaq quote montage. The order handling rules, however, facilitated the proliferation of ECNs by providing a role for ECNs in the display and execution of orders. As additional ECNs came into existence, their quotes were also displayed in the Nasdaq quote montage, which has produced greater price transparency for investors in the market for Nasdaq-quoted stocks and resulted in greater competition for us. Since the introduction of the order handling rules, the SEC's Division of Market Regulation has issued a series of "no-action" letters to our Instinet ATS and the Island ATS over a number of years verifying and extending the Instinet ATS's and the Island ATS's status as ECNs in compliance with these rules. The most recent "no-action" letters for each of the Instinet ATS and the Island ATS are valid until July 6, 2003. The Division continues to condition its "no-action" positions upon, among other things, specified limitations on the fees we charge brokers who are not subscribers to our systems for executing orders on our systems displayed on an SRO through the SRO's facilities or according to the SRO's rules (fees commonly known as "access fees"). The Division also conditions its positions upon our representation that the trade execution and communication systems of each of our ATSs is able to handle anticipated present and future peak trading volumes. In connection with its annual examination of the capacity of market participants, the Division has in the past raised issues regarding the adequacy of our capacity, our testing of capacity limits and our plans for increasing capacity, which we believe we have addressed. The Division also has in the past raised issues regarding our access fees. We expect that the Division will continue to extend its "no-action" positions, but we cannot assure you that it will do so or that its applicable rules or the enforcement of those rules will not change. 26 Regulation ATS In December 1998, following the issuance of the order handling rules, the SEC promulgated new rules relating to the regulation of certain ATSs. The SEC expanded its interpretation of the definition of "exchange" under the U.S. securities laws to encompass a range of electronic brokerage activities, including those conducted by us. At the same time, Regulation ATS permits systems to register as broker-dealers, rather than as national securities exchanges with the SEC, if they comply with the regulation. The requirements of Regulation ATS applicable to us include: - mandatory public display of the best-priced buy and sell orders displayed within our systems to subscribers through an SRO and providing broker-dealers with access to these orders via an SRO's facilities or according to an SRO's rules; - limitations on the fees charged to broker-dealers for accessing system orders displayed through an SRO, and compliance with SRO rules relating to these fees; - the establishment of written standards for granting access to trading on our systems, and not unreasonably prohibiting or limiting access to the services offered by our systems by applying these access standards in an unfair or discriminatory manner; - the establishment of and application of capacity, integrity and security standards; and - additional notice, recordkeeping, reporting, confidential treatment and other requirements. We have modified and enhanced our trading systems to comply with Regulation ATS and continue to review and monitor our systems and procedures for compliance. Exchange Registration and the Island Exchange Application As a consequence of their compliance with the requirements of Regulation ATS, neither the Instinet ATS nor the Island ATS is currently required to register as a national securities exchange under applicable U.S. securities laws. However, if the Island ATS and the Instinet ATS are integrated over time, it is possible that our combined future share of the average daily trading volume in specified securities or classes of securities could result in an SEC determination that exchange registration is necessary. In addition, Island submitted an application in draft with the SEC staff for registration as a national securities exchange on June 28, 1999. If the SEC were to require either or both of our two ATSs to register as a national securities exchange, or if any of our subsidiaries were to voluntarily register as a national securities exchange, we could become subject to substantial additional regulation. Among other consequences, we might also be required to comply with fair representation or ownership requirements. Under our amended and restated corporate agreement with Reuters, in the event the SEC seeks to require either or both of our ATSs to register as a national securities exchange, we have agreed to take all commercially reasonable actions to mitigate the effect of such actions on Reuters rights, including the implementation of appropriate changes in our corporate structure and operations, although we would not be required to take any action that would have a material adverse effect on any material part of our business or its consolidated financial condition or results of operations. In addition, neither of our ATSs nor any of our subsidiaries may voluntarily register as a national securities exchange without the prior written consent of Reuters if such registration would materially affect Reuters ability to exercise its voting and other rights related to its ownership of our common shares. Quote Display and Order Execution Access in Exchange-Listed Stocks; Intermarket Trading System Under Regulation ATS, an ATS meeting certain trading volume thresholds during four calendar months in any six calendar month period in securities for which it displays quotation data must provide to an SRO its best bid and offer data for those securities and must provide other broker-dealers execution access to such quotes. Both of our ATSs currently provide all of their quotation data for Nasdaq-quoted stocks to various SROs in order to comply with Regulation ATS. Until recently, neither of our ATSs had met the trading 27 volume thresholds for any U.S. exchange-listed stocks. In Fall 2002, however, both our Instinet ATS and our Island ATS reached the trading volume thresholds in four of the prior six calendar months in exchange-traded funds reflecting the Dow Jones Industrial Average Index (known as Diamonds), the Standard & Poor's 500 Index (or SPYs) and the Nasdaq-100 Index (known as QQQs). The NASD provides its ATS members the ability to meet their Regulation ATS quote display and order access requirements for U.S. exchange-listed stocks through its Nasdaq Intermarket system, also commonly referred to as CAES/ITS. On November 4, 2002, Instinet began providing its quotation data for SPYs and QQQs through CAES/ITS and on December 2, 2002, began providing its quotation data for Diamonds through CAES/ITS. Instead of providing its quotation data for U.S. exchange-listed stocks to an SRO, however, Island discontinued the display of order information for these stocks, although it still permits subscribers to trade these stocks on a non-displayed basis, in accordance with Regulation ATS. Under current SRO regulations, ATSs that provide quotation data for U.S. exchange-listed stocks to an SRO, including our Instinet ATS, are subject to the rules of the ITS Plan. The ITS Plan imposes limitations and provides remedies with respect to transactions by members of ITS participant markets that involve a "trade-through" of bids and offers. A trade-through occurs when a market participant trades at a price that is inferior to a price displayed in another participating market. The ITS Plan also imposes certain requirements when market participants "lock" the market -- display bids and offers at prices that equal offers and bids from other market participants -- or "cross" the market -- display bids that exceed offers or display offers that are less than bids of another market participant -- for a particular security. Quotations in U.S. exchange-listed stocks displayed on our Instinet ATS and Island ATS frequently "lock" or "cross" other markets. On September 23, 2002, an SEC order became effective that granted a temporary de minimis exemption from the ITS trade-through rule for the trading of SPYs, QQQs and Diamonds. This temporary de minimis exemption, which ends on June 4, 2003, enables ATSs and other market participants to effect trade-throughs up to three cents away from the current best bid and offer in these three stocks. This temporary de minimis exemption has facilitated the ability of our Instinet ATS to continue to display quotations in and maintain its market share and liquidity pool in SPYs, QQQs, and Diamonds. Without the de minimis exception, our Instinet ATS would be required either to discontinue the display of order information in SPYs, QQQs, and Diamonds or to continue its participation in CAES/ITS or another SRO's, market with restrictions on its ability to execute trades that would result in trade-through and to display aggressively priced orders. Either alternative could have a significant adverse effect on Instinet's ability to attract orders to its liquidity pool and maintain and grow its market share and liquidity pool in the affected stocks. Because of its concerns regarding the ITS Plan restrictions, notwithstanding the temporary de minimis exemption from the trade-through rules, effective September 23, 2002, Island discontinued the display of order information for QQQs, Diamonds and SPYs, although it still permits subscribers to trade those stocks on a non-displayed basis. This has resulted in a decline in Island's market share in these stocks, which may have a negative impact on our financial results or our business. Island is currently exploring alternatives to enable it to provide quotation data for U.S. exchange-listed stocks in compliance with the requirements of Regulation ATS, including limited participation in CAES/ITS or another SRO's market. We have been engaged in discussions with the SEC regarding issues relating to the ITS Plan rules and their application to our two ATSs, but we are unable to predict the outcome of these discussions. SuperMontage On January 10, 2001, the SEC approved the NASD's rule changes creating SuperMontage, a new trading platform for the Nasdaq market. Nasdaq completed its implementation of SuperMontage on December 2, 2002. Any ECN or market maker using Nasdaq facilities to display quotations in Nasdaq-quoted stocks or to access quotations on Nasdaq is now required to use SuperMontage. SuperMontage significantly altered the way the Nasdaq market operates. SuperMontage combines a computer display containing more bid and offer information about trading interest in individual Nasdaq-quoted stocks than was previously displayed and new rules establishing the execution priority of quotes and orders submitted to Nasdaq. Unlike its predecessor, SuperSoes, SuperMontage also includes functionality that facilitates participation by ECNs on the platform. 28 Neither of our two ATSs currently displays its quotations in Nasdaq-quoted stocks on SuperMontage. The Instinet ATS does provide its subscribers with the ability to route orders for execution on SuperMontage. Our Instinet ATS currently displays its quotations on the NASD's Alternative Display Facility, while our Island ATS displays its quotations on the Cincinnati Stock Exchange. If either of our ATSs were to display quotations on SuperMontage, the system's execution priority rules contain provisions that could disadvantage us by comparison to market makers and any ATS that does not charge fees to broker-dealers for accessing orders in its trading system through Nasdaq. In addition, on January 31, 2003, the SEC approved a 90-day pilot program to enable broker-dealers not registered as market makers to enter non-marketable limit orders directly on SuperMontage for execution. This pilot program allows Nasdaq for the first time to compete with the Instinet and Island ATSs and other market centers in attracting orders that provide liquidity from non-market maker broker-dealers. Nasdaq Exchange Application Nasdaq is in the process of becoming a for-profit exchange, independent from the NASD. On March 15, 2001, Nasdaq submitted its application for registration as a national securities exchange to the SEC. By operating as an exchange with SuperMontage as its trading platform, Nasdaq is continuing to evolve as a direct competitor of ATSs. If Nasdaq is approved as an exchange, we are unable to predict what changes to its operations it might propose or eventually implement. We are also unable to predict what impact Nasdaq's registration as an exchange may have on our business. Alternative Display Facility and Securities Information Processor Even if Nasdaq gains status as a securities exchange, the NASD will continue to have an obligation to collect quotations and trade reports from NASD member firms seeking to trade U.S. exchange-listed stocks -- which would then include Nasdaq-listed stocks -- other than on an exchange. This was a factor in the SEC's decision to condition its approval of SuperMontage on the NASD establishing an alternative facility to SuperMontage that market makers and ECNs could use to meet their quotation display, order access and trade reporting obligations. On July 27, 2002, the SEC approved the NASD's proposal for the ADF as a nine-month pilot program restricted to Nasdaq-quoted stocks. The ADF pilot displays quotes and collects trade reports, but keeps the NASD's obligations to operate a market to a minimum. The ADF pilot does not provide for order execution or routing services. As a result, ADF market participants themselves are required to provide NASD member broker-dealers with electronic access to their quotations. The NASD's pending proposal for ADF trading of U.S. exchange-listed stocks would provide ADF participants the choice of meeting their order access obligations through ITS or by providing other market participants with electronic access to their quotes themselves. On October 14, 2002, Instinet began utilizing the ADF pilot to meet its quotation display and order access requirements under SEC rules, and since December 2, 2002, when SuperMontage became fully implemented, has met these requirements for all Nasdaq-quoted stocks through the ADF pilot. In February 2003, Instinet also began to use the ADF pilot to meet its trade reporting obligations. We continue to review and consider the implications of our participation in the ADF for our business. Island currently uses the Cincinnati Stock Exchange, not the ADF, to meet its quotation display, order access and trade reporting obligations in Nasdaq-quoted stocks. Another pending change to the Nasdaq market structure, in recognition of Nasdaq's growing role as a competitor, is the anticipated replacement in 2004 of Nasdaq as the exclusive SIP. This role has given Nasdaq financial and other competitive advantages. The replacement is also expected to be an exclusive SIP but may not compete directly with us. Market Data Revenues In the past, the Island ATS has earned market data revenues by participating in market data revenue-sharing programs and other revenue-sharing programs provided by Nasdaq and the CSE. Market data revenues consist of a portion of the fees that the SROs and Nasdaq receive for selling quotation and transaction data to independent market data providers and market participants such as broker-dealers. On 29 July 2, 2002, the SEC announced that it had abrogated proposals that were submitted by several markets, including Nasdaq and the CSE, to continue certain of their market data revenue-sharing programs. As a result, the Nasdaq and the CSE revenue-sharing programs from which Island has earned most of its market data revenues were suspended, and Island suspended its market data revenue-sharing program. The Nasdaq market data revenue-sharing program for U.S. exchange-listed stocks, which had represented a substantial portion of Island's market data revenues, was subsequently reinstated. The CSE has submitted a proposal to share a reduced proportion of the market data revenues it receives (50% instead of 75%) in Nasdaq-quoted stocks. The SEC, however, has not taken any action on this or any other market data revenue-sharing programs for Nasdaq-quoted stocks, and we cannot assure you that the SEC will approve any of them. In addition, we cannot assure you that the market data revenue-sharing programs for U.S. exchange-listed stocks will continue or remain in their current form. NASD Fees The NASD has also partially implemented proposed changes in its fee structure, including the introduction of a fee based on all NASD members' transactions in U.S. exchange-listed and Nasdaq-quoted stocks regardless of where those transactions occur. The NASD's new trading activity fee requires NASD member clearing firms to report and remit payment to the NASD on a monthly basis based on the trading activity cleared and settled by the firm on behalf of itself and other NASD members. We are unable to predict what impact these fee changes and required reporting will have on our business, financial condition or operating results. However, the NASD has established an exemption from the trading activity fee for NASD members that act as agent on behalf of another NASD member. As a result of the exemption, both of our ATSs have experienced a reduction in their transaction- based NASD regulatory fees. Because the NASD's proposed fee structure is still subject to review by the SEC, we are unable to predict what impact the final provisions of the fee structure will have. Decimalization The introduction of decimalization in April 2001 has also had an impact on the U.S. securities markets and increased competition for ATSs. Decimalization may assist investors in obtaining price improvement because improvement in smaller increments is possible. Because decimalization narrows average trading spreads, it has also had a significant negative impact on the profitability of traditional broker-dealers. As a result, we have received, and may continue to receive, fewer orders from our broker-dealer customers. We believe that decimalization has led to traditional broker-dealers executing a higher percentage of their customers' orders internally (a practice known as internalization) instead of routing them to external market centers, for execution, because the additional price risk they incur to fill orders internally has decreased to as little as a penny a share. Increased internalization by traditional broker-dealers has also reduced, and could continue to reduce, our order flow. In addition, the decline in broker-dealer profitability has resulted in some market makers moving from a business model in which they trade as principal for their own account to an agency business model. The SEC's interpretation of Section 28(e) of the Exchange Act, discussed below, may further encourage this trend, which may increase our competition. Section 28(e) Section 28(e) of the Exchange Act creates a limited safe harbor that allows investment advisers to cause their client accounts to pay more than the lowest available commission rate, as long as the adviser determines in good faith that the commission is reasonable in relation to the value of the research and brokerage services the broker provides to the adviser. In December, 2001, the SEC issued an expanded interpretation of Section 28(e) allowing institutional investors to obtain soft dollar credits from certain transactions executed through broker-dealers on a "riskless" principal basis, rather than only on an agency basis (which is how Instinet executes transactions). Coupled with the move of some market makers from a business model in which they trade as principal for their own account to an agency business model as a result of decimalization, this SEC interpretation may create greater competition for our soft dollar business. 30 Order Routing and Execution Disclosure Rules On January 30, 2001, SEC rules became effective (and were fully implemented by the end of November 2001) that require many market participants, including us, to make detailed public disclosure in electronic form of certain statistical measures of execution quality for orders in equity securities. Market centers must disclose information, categorized by security, size and type of order about the time frames in which orders are executed and on the prices offered by participants relative to each other and the marketplace. The rules also require securities brokers, including us, to provide detailed disclosure in electronic form regarding their order routing practices. In September 2001, the SEC issued an interpretation that provides an exemption from this order routing disclosure as long as the average number of customer non-directed orders routed by the security broker during the calendar quarter is 500 or less. To date, Instinet Clearing Services, Inc. has satisfied the requirements of the exemption. We cannot predict what impact these rules and the consequent disclosures will have on the number and size of orders we receive from customers. Nasdaq Market Data-Related Rule Changes Instead of using consolidated market data for Nasdaq-quoted stocks for closing price calculations and meeting certain market data-related regulatory requirements, Nasdaq has undertaken to obtain, and in some cases already obtained, SEC approval to establish Nasdaq-specific market data for these purposes. For example, Nasdaq has sought to obtain SEC approval of a rule change seeking to establish a Nasdaq official closing price and is actively marketing its use instead of the consolidated closing price for market participants' closing price-related activities. In addition, Nasdaq has received approval to require market participants using Nasdaq facilities to execute or report trades to use the Nasdaq best bid instead of the consolidated best bid in meeting their short sale regulatory requirements. Regulation of Clearing Activities We are a self-clearing broker in the United States through our subsidiary Instinet Clearing Services, Inc. We also have a correspondent clearing business in which we provide clearing services in the United States for broker-dealers that are not affiliated with us. Brokers that clear their own trades or clear trades for other broker-dealers are subject to substantially more regulatory requirements than brokers that rely on others to perform those functions. Errors in performing clearing functions, including clerical, technological and other errors related to the handling of funds and securities held by us on behalf of customers and broker-dealers, could lead to civil penalties imposed by applicable regulatory authorities as well as losses and liability in related lawsuits and proceedings brought by our customers, the customers of our wholesale customers and others. Any liability that arises as a result of our clearing operations could have a material adverse effect on our business, financial condition and operating results. In addition, securities industry regulators in the United States continues to review the extent to which clearing firms should be held accountable for the improper activities of the broker-dealers for which they provide clearing services. We cannot assure you that our procedures will be sufficient to protect us from liability for the acts of broker-dealers that use our correspondent clearing services under current laws and regulations. We can also not assure you that securities industry regulators will not enact more restrictive laws or regulations or change their interpretations of current laws and regulations in a manner that would increase our potential liability. Net Capital Requirements The SEC and the NASD, as well as other regulatory agencies and securities exchanges within and outside the United States, have stringent rules with respect to the maintenance of specific levels of net capital by regulated broker-dealers. These rules include the SEC's net capital rule, to which our U.S. broker-dealer subsidiaries are subject. The failure by one of these subsidiaries to maintain its required net capital may lead to suspension or revocation of its registration by the SEC and its suspension or expulsion by the NASD and other U.S. or international regulatory bodies, and ultimately could require its liquidation. In addition, a change in 31 the net capital rules, the imposition of new rules or any unusually large charge against the net capital of one of our broker-dealer subsidiaries could limit its operation, particularly those, such as correspondent clearing, that are capital intensive. A large charge to the net capital of one of these subsidiaries could result from an error or other operational failure or a failure of a customer to complete one or more transactions, including as a result of that customer's insolvency or other credit difficulties, and we cannot assure you that we would be able to furnish the affected subsidiary with the requisite additional capital to offset that charge. The net capital rules could also restrict our ability to withdraw capital from our broker-dealer subsidiaries, which could limit our ability to pay cash dividends, repay debt or repurchase shares of our outstanding stock. A significant operating loss or any unusually large charge against net capital could adversely affect our ability to maintain our present levels of business, or to expand, which could have a material adverse effect on our business, financial condition and operating results. Other U.S. Regulation The SEC and NASD are currently considering, and we are periodically in discussions with them regarding, other regulatory issues. These currently include: - data dissemination requirements; - the capacity, scalability and back-up of our trading systems; and - rules affecting market interaction and sharing of regulatory costs in the trading of Nasdaq-quoted securities. We are unable to predict the outcome of the various deliberations and discussions on the evolution of the U.S. equities market structure and regulatory framework, although these issues or other issues of market structure may have a significant impact on our equities business. In this regard, we may consider it desirable to modify the regulatory position for either or both of our two ECNs to advance our business strategy. Potential steps could include the creation of new subsidiaries regulated in the United States or abroad, the establishment of linkages that would enable us to act as a facility of a registered national securities exchange, the display of some or all of our orders in Nasdaq-quoted stocks on another exchange, the reporting of additional trades to the ADF or to another exchange, or efforts to register as an exchange to conduct some or all of our business. Our business, especially our communications with and connectivity to customers, increasingly relies on the Internet and other electronic communications gateways. We are in the process of expanding use of these gateways. Although to date the use of the Internet has been relatively free from regulatory restraints, the SEC, certain SROs and certain states are beginning to address the regulatory issues that may arise in connection with the use of the Internet for securities and financial services transactions. Accordingly, new regulations or interpretations may be adopted that could constrain our ability and our customers' ability to transact business through the Internet or other electronic communications gateways and could have a material adverse effect on our business, financial condition and operating results. Regulation of the Non-U.S. Securities Industries and Investment Service Providers The financial services industry, including the securities brokerage business, is heavily regulated outside of the United States. We are required to comply with regulatory controls of each specific country in which we or our subsidiaries conduct business, as well as the regulations of each exchange of which we or our subsidiaries are members. As we expand our international operations, we may be required to comply with requirements that are inconsistent with our existing international activities. As a result, the varying compliance requirements of these different regulatory jurisdictions and other factors may affect our business or limit our ability to expand our international operations. In many countries, the laws and regulations applicable to the securities and financial services industries are uncertain and evolving. In these countries, it may be difficult for us to determine the exact requirements of local laws and regulations in every market, particularly because legal and regulatory developments generally trail technological advances. Our inability to remain in compliance with regulatory requirements in a 32 particular jurisdiction could have a materially adverse effect on our operations in that market and on our reputation generally. The securities industry in the member states of the European Union (EU) is regulated by a number of agencies in each member state. European Union legislation, however, allows investment firms like us to obtain single authorization, or "passport", which is generally valid throughout the European Union and which in particular allows for remote membership of regulated markets or exchanges. Because our largest international operations are in the United Kingdom, our principal European regulator is the Financial Services Authority and we currently "passport" out of the UK into most EU member states. European legislation governing investment services (Investment Services Directive) is currently being amended and the European Commission has proposed new rules for investment firms operating ATSs. These new rules are likely to be based on the ATS standards already agreed upon and published by the Committee of European Securities Regulators (CESR) in July 2002. The seven main CESR standards require investment firms to notify regulators that they are operating an ATS; to ensure that users are treated fairly; to provide price transparency; to monitor user compliance with the rules of the system; to assist regulators in preventing market manipulation; to have adequate systems capacity; and to explain their arrangements for clearing and settlement. The Investment Services Directive is expected to be adopted in 2004 and to take effect in either 2005 or 2006. However, it is anticipated that the UK FSA will implement the CESR standards prior to the implementation of the Investment Services Directive, probably in 2004. We are unable at this time to predict how these proposed changes will affect our business. The provision of investment services is also regulated by other agencies in other jurisdictions outside of the European Union in which we operate, such as the Swiss Federal Banking Commission, the Securities and Futures Commission in Hong Kong and the Financial Supervisory Authority in Japan. Any of these non-U.S. regulatory agencies, as well as many non-U.S. exchanges of which we are a member, may conduct administrative proceedings against us which could result in censure, fine, the prevention of activities or our suspension or expulsion from their country or exchange as an investment services provider. The applicable regulations cover minimum financial resource requirements and conduct of business rules for all authorized investment businesses. New regulations, changes in existing regulations or changes in the interpretation or enforcement of existing regulations outside the United States may adversely affect or limit our business or operations and adversely affect our financial condition and operating results. CERTAIN FACTORS THAT MAY AFFECT OUR BUSINESS You should carefully consider the risks described below before making a decision to invest in our company. There may be additional risks that we do not currently know of or that we currently deem immaterial based on the information available to us. All of these risks may impair our business operations. RISKS RELATED TO OUR INDUSTRY ECONOMIC, POLITICAL AND MARKET FACTORS BEYOND OUR CONTROL COULD REDUCE DEMAND FOR OUR SERVICES AND HARM OUR BUSINESS We earn revenues primarily from securities brokerage and related services and expect to continue to do so. The demand for these services is directly affected by domestic and international factors that are beyond our control, including economic, political and market conditions; unforeseen market closures or other disruptions in trading; the availability of short-term and long-term funding and capital; the level and volatility of interest rates; currency exchange rates; and inflation. Any one or more of these factors may contribute to reduced activity and prices in the securities markets generally. The continuing weak and uncertain economic climate, increased unemployment rates, reduced capital raising activities, decreased market capitalization, ongoing geopolitical and global conflicts and the current corporate governance and accounting issues have led to decreasing trading volumes and intensified price competition and generally a more difficult business 33 environment for us. These conditions may continue or worsen, which could have a material adverse effect on our business, financial condition and operating results. DECREASES IN TRADING VOLUMES OR PRICES COULD HARM OUR BUSINESS AND PROFITABILITY Declines in the volume of securities trading and in market liquidity generally result in lower revenues from our trade execution, brokerage, and related activities. In addition, our revenues from trading outside the United States are determined on the basis of the value of transactions (rather than the number of shares traded), which are adversely affected by price declines. Our profitability would be adversely affected by a decline in our revenues because a significant portion of our costs is fixed. The continuing decline in trading volumes has had, and may continue to have, a significant adverse effect on our business, financial condition and operating results. Our competitors with more diversified business lines might withstand these declines better than we could. WE FACE SUBSTANTIAL COMPETITION THAT COULD REDUCE OUR MARKET SHARE AND HARM OUR FINANCIAL PERFORMANCE The financial services industry generally, and the securities brokerage business in which we engage in particular, is very competitive, and we expect competition to intensify in the future. Many of the financial service providers with which we compete are well-capitalized and substantially larger than we are and have substantially greater financial, technical, marketing and other resources. Many of them offer a wider range of services, have broader name recognition and have larger customer bases than we do. Some of them may be able to respond more quickly to new or evolving opportunities, technologies and customer requirements than we can and may be able to undertake more extensive promotional activities. Consolidation and alliances within the industry have resulted, and may continue to result, in increasingly intense competition. Outside the United States, in addition to our U.S. competitors with international capabilities, we compete with non-U.S. banks and other financial institutions that may also have long-standing, well-established and, in some cases, dominant positions in their trading markets. If we are not able to compete successfully in the future, our business, financial condition and operating results could be adversely affected. We compete with Nasdaq as a trading venue for Nasdaq-quoted stocks. The NASD regulates the activities of our U.S. broker-dealer subsidiaries, has a significant ownership interest in Nasdaq, operates the ADF, and regulates and polices the Nasdaq market. The NASD, either directly or through its subsidiaries, is thus able to propose, and often obtain, SEC approval of rule changes that we believe can be to Nasdaq's competitive benefit as a securities marketplace and our competitive disadvantage. Nasdaq has applied to register as a national securities exchange, and another of our competitors has been approved to serve as a facility of an existing exchange. Competitors that receive status as a national securities exchange or operate as a facility of an exchange will be able to gain certain benefits from their exclusive participation in the various NMS systems. These benefits may give these competitors an advantage over us in attracting business in, and generating revenues from, their activity in U.S. exchange-listed and Nasdaq-quoted stocks. In addition, by operating as an exchange independent from the NASD with SuperMontage as its trading platform, Nasdaq is continuing to evolve as a direct competitor of ATSs, including Instinet and Island, which could negatively impact our business, financial condition and operating results. We have experienced intense price competition in our equity securities business in recent years. Some of our competitors may have more modern technology and a broader range of services and, therefore, may be able to offer brokerage services to customers at lower prices than we can. As a result, we have aggressively reduced pricing for our U.S. broker-dealer customers and introduced reduced fees for taking liquidity and rebates for providing liquidity. These pricing changes have caused the transaction fee revenue we receive from this customer group to decline significantly and could cause the transaction fee revenue Instinet receives from this customer group to continue to decline, even if their volumes increase. As a result of our reduced pricing for our U.S. broker-dealer customers, we have experienced a decline in revenue and volatility in our market share. As a result of these pricing changes, we have taken, and will continue to take, actions to reduce costs, 34 which may include reducing our staff levels, consolidating our facilities, and reducing operational and transaction-related expenses, among other alternatives. In part, as a result of these pricing changes, we reported a net loss of $735.2 million, or $2.71 per share, for 2002. We expect intense competition to continue, and if it does so or intensifies, we could lose further market share and revenue. WE OPERATE IN A HIGHLY REGULATED INDUSTRY, WHICH MAY LIMIT OUR ACTIVITIES General The securities markets and the brokerage industry in which we operate are highly regulated. In our case, the impact of regulation extends beyond "traditional" areas of securities regulation, such as disclosure and prohibitions on fraud and manipulation by market participants, to the regulation of the structure of markets. We are subject to regulation as a securities broker, as an ATS and an ECN, and as an operator of a clearing business for our own customers and third parties. Many of the regulations applicable to us may have the effect of limiting our activities, including activities that might be profitable, or causing us to modify our business model in ways that may adversely affect our revenues. ATS Status and Exchange Registration As a result of our compliance with the requirements of Regulation ATS, neither of our two ATSs currently is required to register as a national securities exchange. It is possible that in the future the SEC could make a determination that exchange registration is necessary. Our Island ATS filed an application in draft form for registration as a national securities exchange with the SEC. If the SEC were to require either or both of our two ATSs to register as a national securities exchange, or if any of our subsidiaries were to voluntarily register as a national securities exchange, we could become subject to substantial additional regulation, which might reduce our operational flexibility in ways that could have a material adverse effect on our business. Among other consequences, we might also be required to comply with fair representation or ownership requirements. These requirements could adversely affect our operations and could also result in material limitations or restrictions on Reuters equity interest in us or Reuters ability to exercise its voting and other governance rights in the manner contemplated by our amended and restated corporate agreement with Reuters. In addition, we cannot assure you that Reuters would not withhold its consent to the voluntary registration of our ATSs or any of our subsidiaries as a national securities exchange, even if our management determines that exchange registration would be beneficial to us or one of our subsidiaries. Quote Display and Order Execution Access in Exchange-Listed Stocks; Intermarket Trading System The requirements of Regulation ATS requiring ATSs to display quotation data and provide order execution access for securities for which certain trading volume thresholds have been met, as well as the rules of the ITS Plan for ATSs that provide quotation data for U.S. exchange-listed stocks to an SRO, could have a significant adverse effect on our business, financial condition and operating results, including the following: - Our Instinet ATS's provision of quotes in SPYs, QQQs and Diamonds through CAES/ITS could have a significant negative impact on our trading volumes in those stocks. - We cannot assure you that the SEC will extend the temporary de minimis exemption from the trade-through rules of the ITS Plan beyond June 4, 2003 or extend it to any other U.S. exchange-listed stocks in which we may cross the Regulation ATS trading volume thresholds. Without the de minimis exception, our Instinet ATS would be required either to discontinue the display of order information in SPYs, QQQs, and Diamonds or to continue its participation in CAES/ITS or another SRO's market with restrictions on its ability to execute trades that would result in trade-through and to display aggressively priced orders. Either alternative could have a significant adverse effect on the ability of our Instinet ATS to attract orders to its liquidity pool and maintain and grow its market share and liquidity pool in the affected stocks. - Our Island ATS's discontinuation of the display of order information in SPYs, QQQs and Diamonds has resulted in a decline in Island's market share in these stocks. Island is currently exploring 35 alternatives to enable it to provide quotation data for U.S. exchange-listed stocks in compliance with the requirements of Regulation ATS, including limited participation in CAES/ITS or another SRO's market. However, we cannot assure you that it will find a viable mechanism to participate in an SRO market in these stocks or that it will do so in a manner that will avoid an adverse effect on our business, financial condition and operating results. - We cannot assure you that either of our two ATSs will not reach the ATS trading volume thresholds in other U.S. exchange-listed stocks, requiring us either to provide quotes and comply with ITS Plan rules or discontinue the display of order information. We have been engaged in discussions with the SEC regarding issues relating to the ITS Plan rules and their application to our two ATSs but have been unable to reach a satisfactory resolution of the relevant commercial and regulatory issues. We intend to continue to work on solutions to these issues and to discuss them with the SEC; however, we are unable to predict the outcome of these discussions. STRUCTURAL DEVELOPMENTS IN THE MARKETS IN WHICH WE OPERATE MAY PLACE US AT A COMPETITIVE DISADVANTAGE The structure of the Nasdaq stock market is currently undergoing a fundamental change, which may place us at a competitive disadvantage, adversely affecting our business, financial condition and operating results. Nasdaq has moved from a quote-driven display system to an order-driven execution system that directly competes with ECNs and ATSs. SuperMontage, Nasdaq's new trading platform which Nasdaq completed implementing on December 2, 2002, incorporates enhanced functionality, including the display of more quotation information than was previously displayed. We are unable to predict how successful SuperMontage will be as a direct competitor to our ATSs, but it could cause us to receive fewer orders and execute fewer orders in our liquidity pools for Nasdaq-quoted stocks, leading to a reduction in our liquidity pools. In addition, Nasdaq's current pilot program to enable broker-dealers not registered as market makers to enter non-marketable limit orders directly on SuperMontage for execution allows Nasdaq for the first time to compete with the Instinet and Island ATSs and other market centers in attracting orders that provide liquidity from non-market maker broker-dealers. We are unable to predict the extent to which Nasdaq will be successful in attracting liquidity-providing orders from these broker-dealers, but to the extent it is, this pilot program may result in our receiving fewer orders that provide liquidity in Nasdaq-quoted stocks and therefore executing fewer orders in our liquidity pools in these stocks. Since the full implementation of SuperMontage on December 2, 2002, our Instinet ATS has met its quotation display and order access requirements for all Nasdaq-quoted stocks through the NASD's ADF. In February 2003, Instinet also began to use the ADF to meet its trade reporting obligations. The ADF has only been approved as a pilot program for nine months and the approval is limited to Nasdaq-quoted stocks only. As the ADF is a relatively new system, we cannot assure you that the ADF will continue to provide a fully operational alternative to SuperMontage or that the ADF will prove to be a commercially viable facility. We also cannot assure you that its functionality will prove acceptable to our customers. In addition, the rules, fees and functionality of the ADF could place us at a commercial disadvantage to our competitors. For example, the ADF does not provide for order execution or routing services. As a result, ADF market participants themselves are required to provide NASD member broker-dealers with electronic access, either directly or indirectly, to their quotations, which could create additional costs for those participants, including our Instinet ATS. The current ADF fee structure also contains certain features that could cause fees to fall disproportionately on ECNs that do not meet certain trade reporting thresholds, further increasing costs for some participants (including our Instinet ATS). We are unable to predict accurately at this time the impact the ADF or our Instinet ATS's participation in it will have on our business. The ADF's rules, fees and functionality remain subject to change and further approval by the SEC, and we cannot predict the final features of the ADF. We cannot assure you that the decision of our Instinet ATS to use SuperMontage only for order routing, and the decision of our Island ATS not to use SuperMontage at all, will not have a significant negative impact 36 on the order flow of our two ATSs or their other business related to Nasdaq-quoted stocks. In addition, if at any time our Instinet ATS were to be unable to use the ADF or our Island ATS were unable to use the Cincinnati Stock Exchange to meet their regulatory requirements, we would be required to consider possible alternatives, including participation in SuperMontage. We cannot assure you that any of these alternatives would not have a significant material adverse effect on our business. In particular, if either of our ATSs were to display quotations on SuperMontage, the system's execution priority rules contain provisions that could disadvantage us by comparison to market makers and any ECN that does not charge fees to broker-dealers for accessing orders in its trading system through Nasdaq. OUR BUSINESS MAY BE AFFECTED BY SEC ACTIONS RELATING TO ECNS General The SEC regularly considers a variety of regulations or interpretative initiatives with respect to the structure of the equity securities markets, including initiatives intended to reduce fragmentation, integrate ECNs and ATSs into the NMS and create a national consolidated limit order book. Future SEC rulemakings or interpretations in this area could adversely affect our business, financial condition and operating results. Access Fees The SEC is currently considering, and we are periodically in discussions with it regarding, other important issues, such as the fees (including subscriber and non-subscriber access fees) ECNs charge, the levels of those fees, the circumstances in which access fees may be charged and the criteria for customers' access to an ECN's system and the requirements of Regulation ATS. For example, the SEC has, at times, approved rules or issued interpretations that directly govern how we determine prices for different types of customers and services. We are currently in a dispute with certain of our customers regarding the application of these rules or interpretations to our past pricing policies. We are unable to predict the outcome of this dispute. See also "Legal Proceedings." Future SEC rules or interpretations regarding any of these issues could have a significant and material adverse impact on our equity securities business. We are currently discussing the application of those rules and interpretations with the SEC, and we are unable to predict the outcome of these discussions. We also continue to evaluate our services and the fees we charge for them. The Instinet ATS implemented a new pricing policy that took effect on August 1, 2002, and the Island ATS implemented a new pricing policy that took effect on September 5, 2002. A further change in pricing became effective on October 21, 2002. The Island ECN has received a subpoena from the SEC for information regarding Island's access policies, including pricing, in connection with an investigation by the SEC of possible non-compliance with certain provisions of Regulation ATS by certain ECNs. The Island ECN has submitted its complete response to the subpoena. We currently do not know the intended scope or primary objectives of this investigation and cannot predict its outcome, but it could have a significant adverse effect on our equity securities business. Market Data Revenue In July 2002, the SEC abrogated certain market data revenue sharing programs. Market data revenues represented approximately 5% and 14% of Island's total revenues for 2001 and the first three months of 2002, respectively. For the first three months of 2002, these revenues were offset in part by market data rebates that Island paid to some of its customers. Since then, the SEC has not taken any action on SRO proposals to reinstate market data revenue sharing programs in Nasdaq-quoted stocks. In addition, we cannot assure you that the market data revenue sharing programs for U.S. exchange-listed stocks will continue or remain in their current form. As a result, we cannot assure you that our Island ATS will continue to earn market data revenues or, if it does, what the level of those revenues will be in the future. If our Island ATS is unable to resume earning market data revenue for Nasdaq-quoted stocks or continue earning market data revenue for U.S. exchange-listed stocks, this could adversely affect our business, financial condition and operating results. We also cannot predict the impact of the suspension of Island market data revenue rebates sharing on our business, financial condition and operating results. 37 In addition, the Island ECN received a subpoena from the SEC for information regarding trading and market rebate practices with respect to some of Island's market data revenue rebate programs, in connection with an investigation by the SEC of customer trading practices in some exchange-traded funds. The Island ECN has submitted its complete response to the subpoena. We currently do not know the intended scope or primary objectives of this investigation and cannot predict its outcome, but it could have a significant adverse effect on our equity securities business. REGULATORY CHANGES COULD ADVERSELY AFFECT OUR BUSINESS The securities industry generally has been and is subject to continuous regulatory changes, including changes in the rules of the SEC and of self-regulatory organizations such as the NYSE and the NASD. In the future, the industry may become subject to new regulations or changes in the interpretation or enforcement of existing regulations. We cannot predict the extent to which any future regulatory changes may adversely affect our business. Although regulatory changes can affect all aspects of our business, the markets for equity securities have been subject to the most significant regulatory changes. Our activities as an agency broker in equity securities are the principal source of our revenues and profits. Recent and proposed regulatory changes that have had or could have a significant effect on our equity securities business include the following: - The SEC has implemented rules requiring many market participants, including us, to make detailed public disclosure regarding orders in equity securities and order routing practices. We cannot predict what impact these rules will have on the number and size of orders we receive from customers. - The NASD has also partially implemented proposed changes in its fee structure, including the introduction of a new trading activity fee and related reporting requirements for transactions in U.S. exchange-listed and Nasdaq-quoted stocks regardless of where those transactions occur. We are unable to predict what impact these fee changes and required reporting will have on our business, financial condition or operating results. Although an exemption from the trading activity fee was established for NASD members that act as agent on behalf of another NASD member, which has reduced the fees of our two ATSs, we can not assure you that this exemption will continue to be available. Because the NASD's proposed fee structure is still subject to review by the SEC, we are unable to predict what impact the final provisions of the fee structure will have. - The SEC's Division of Market Regulation has issued a series of "no-action" letters to our Instinet ATS and our Island ATS over a number of years verifying and extending the status our two ATSs as ECNs. The most recent "no-action" letters for each of our two ATSs are valid until July 6, 2003. The Division's "no-action" positions are subject to our continuing to satisfy certain conditions, including those regarding our systems capacity, fair access for participants and a limitation on our maximum access fees. See "Risks Related to Our Business -- Insufficient Systems Capacity or Systems Failures Could Harm Our Business." Our recent acquisition of The Island ECN may also affect the Division's view of both businesses. We are in discussions with the Division from time to time regarding these issues, and we cannot assure you that the Division will continue to extend its "no-action" positions. An adverse change in any of the Division's positions could interfere with the ability of the Instinet ATS and the Island ATS to act as an ECN or participate in the ADF, CAES/ITS, CSE, or other markets and thereby have a material adverse effect on our business, financial condition and operating results. Nasdaq has sought to obtain, and in some cases already obtained, SEC approval of several rule changes that would have the result of establishing Nasdaq-specific market data for use in closing price calculations and for meeting certain regulatory requirements in Nasdaq-quoted stocks. We are unable to predict the impact of the approval and implementation of these proposals, including whether they will result in market participants directing a greater percentage of order flow to Nasdaq as opposed to either of our two ATSs. 38 INTERNATIONAL REGULATION COULD ADVERSELY AFFECT OUR BUSINESS The financial services industry, including the securities brokerage business, is heavily regulated in many jurisdictions outside the United States. We are required to comply with the regulatory regime of each country in which we conduct business, as well as the regulations of each exchange of which we are a member. The varying requirements of these jurisdictions may adversely affect our business or limit our ability to expand our international operations. We may not be able to obtain the necessary regulatory approvals for planned expansion; if approvals are obtained, they may impose restrictions on our business; or we may not be able to continue to comply with the terms of the approvals or applicable regulations. In addition, in many countries, the regulations applicable to the securities and financial services industries are uncertain and evolving, and it may be difficult for us to determine the exact regulatory requirements. Our inability to remain in compliance with regulatory requirements in a particular jurisdiction could have a materially adverse effect on our operations in that market and on our reputation generally. Changes in regulations or changes in the interpretation or enforcement of existing regulation outside the United States may adversely affect our business, financial condition and operating results. OUR INABILITY TO MANAGE THE RISKS OF INTERNATIONAL OPERATIONS EFFECTIVELY COULD ADVERSELY AFFECT OUR BUSINESS We have operations in Europe and Asia, and there are a number of risks inherent in doing business in international markets, including the following: - less developed technological infrastructures and generally higher costs, which could result in lower customer acceptance of our services or customers having difficulty accessing our electronic marketplace; - less automation in clearing and settlement systems, resulting in higher expenses and increased operational difficulties (including an increased risk of transactional errors and failure to complete customers' transactions); - difficulties in recruiting and retaining personnel, and managing international operations; - reduced protection for intellectual property rights; - seasonal reductions in business activity during the summer months; and - potentially adverse tax consequences. Our inability to manage these risks effectively could adversely affect our business, financial condition and operating results. Our international operations also expose us to the risk of fluctuations in currency exchange rates. If our risk management strategies relating to exchange rates prove ineffective, we could suffer losses that would adversely affect our business, financial condition and operating results. REGULATORY NET CAPITAL REQUIREMENTS COULD ADVERSELY AFFECT OUR ABILITY TO CONTINUE TO CONDUCT OR EXPAND OUR BUSINESS OPERATIONS OR TO PAY DIVIDENDS Our broker-dealer subsidiaries are subject to stringent rules with respect to the maintenance of specific levels of net capital by regulated broker-dealers, including the SEC's net capital rule. The failure by one of these subsidiaries to maintain its required net capital may lead to suspension or revocation of its registration by the SEC and its suspension or expulsion by the NASD or other U.S. or international regulatory bodies, and ultimately could require its liquidation. In addition, changes in net capital regulation or a significant operating loss or any unusually large charge against the net capital of one of our broker-dealer subsidiaries could limit its operations, particularly those, such as correspondent clearing, that are capital intensive. A large charge to the net capital of one of these subsidiaries could result from an error or other operational failure or a failure of a customer to complete one or more transactions, including as a result of that customer's insolvency or other credit difficulties. Our inability to maintain our present levels of business or to expand as a result of the net 39 capital rules could have a material adverse effect on our business, financial condition and operating results. The net capital rules also could restrict our ability to withdraw capital from our broker-dealer subsidiaries, which could limit our ability to pay cash dividends, repay debt or repurchase shares of our outstanding stock. RISKS RELATED TO OUR BUSINESS OUR INABILITY TO ADJUST OUR COST STRUCTURE IF REVENUES DECLINE SUDDENLY COULD ADVERSELY AFFECT OUR RESULTS Our expense structure is based on historical expense levels and historical and expected levels of demand for our services. If demand for our services and our resulting revenues should decline suddenly (as has occurred in the past), we may be unable to adjust our fixed cost base on a timely basis, which could have a material adverse effect on our operating results and financial condition. SHIFTS IN OUR BUSINESS MIX MAY DECREASE OUR PROFITABILITY AND NET INCOME Changes in the mix of customers we serve (large institutional investors, portfolio managers, hedge funds and broker-dealers) and in the use of our trading system by our customers can materially affect our profitability and net income. A substantial portion of our trading volume is derived from our broker-dealer customers. A shift in our customer mix toward fewer broker-dealers or a further decline in the use of our trading system by broker-dealers could reduce the depth and breadth of our liquidity pool, which could reduce its attractiveness to our customers and adversely affect our trading volumes, operating results and financial condition. WE MAY HAVE DIFFICULTY MANAGING OUR ACQUISITION OF ISLAND AND OUR OTHER ACQUISITIONS SUCCESSFULLY To achieve our strategic objectives, we have acquired or invested in, and in the future may seek to acquire or invest in, other companies or businesses. We cannot assure you that we will realize, when anticipated or at all, the benefits we expect as a result of our acquisitions, including our acquisition of Island. Achieving the benefits of our acquisitions will depend on many factors, including the successful and timely integration and, in some cases, the consolidation of products, technology, operations and administrative functions, of two companies that have previously operated separately. Considering the highly technical and complex nature of our and Island's products, these integration efforts may be difficult and time consuming. In addition, we may choose not to integrate some portions of Instinet's and Island's business, which may result in lower cost savings. - Acquisitions entail numerous other risks, including the following: - difficulties in the assimilation of acquired operations and products; - diversion of management's attention from other business concerns; - failure of our combined management to oversee and manage newly acquired companies effectively; - assumption of unknown material liabilities; - failure to integrate successfully any operations, personnel, services or products that we acquire; - failure to achieve financial or operating objectives; - failure to implement adequate compliance and risk management methods for new operations; - impairment of certain acquired intangible assets, which would reduce future reported earnings; and - potential loss of customers or key employees of acquired companies. Failure to manage our acquisitions to avoid these risks could have a material adverse effect on our business, financial condition and operating results. 40 IF WE FAIL TO INTRODUCE NEW SERVICES AND SERVICE ENHANCEMENTS AND ADAPT OUR TECHNOLOGY IN A TIMELY MANNER, WE MAY BE UNABLE TO COMPETE EFFECTIVELY Our business environment is characterized by rapid technological change, changing and increasingly sophisticated customer demands and evolving industry standards. If we are unable to anticipate and respond to the demand for new services, products and technologies on a timely and cost-effective basis and to adapt to technological advancements and changing standards, we will be less competitive, which could have a material adverse effect on our business, financial condition and operating results. In addition, new services that we may develop and introduce may not achieve market acceptance. DECREASES IN OUR AVERAGE TRANSACTION SIZE HAVE REDUCED, AND MAY CONTINUE TO REDUCE, OUR PROFITABILITY ON A PER TRANSACTION BASIS In recent years, although the number of customer transactions in U.S. equity securities that have been executed through our systems has increased, the average size of those transactions has declined, decreasing from 1,264 shares per transaction in 1998 to 658 shares per transaction in 2002 (including Island shares per transaction subsequent to September 20, 2002). This decline has caused our average revenue per transaction to decrease. As a result, our profitability and margins on a per transaction basis have decreased. There can be no assurance that this trend will not continue. COSTS RELATED TO OUR INVESTMENTS IN TECHNOLOGY MAY CONTINUE TO ADVERSELY AFFECT OUR PROFITABILITY AND NET INCOME We have incurred significant costs associated with our efforts to strengthen, expand and diversify our business and enhance our technology since 1998. Any technological innovations may require significant expenditures over long periods of time, so that our operating margins and profitability could be adversely affected. WE DEPEND ON OUR EXECUTIVE OFFICERS AND KEY PERSONNEL Our future success depends, in significant part, upon the continued service of our executive officers, as well as various key sales, trading and technical personnel. The loss of these key people could have a material adverse effect on our business, financial condition and operating results. We also cannot assure you that our recent management changes and headcount reductions will not have a material adverse effect on our business, financial condition and operating results. Our future success also will depend in significant part on our ability to recruit and retain highly skilled and often specialized individuals as employees, particularly in light of the rapid pace of technological advances. The level of competition in our industry for people with these skills is intense, and from time to time we have experienced losses of key employees. Significant losses of key personnel, particularly to other firms with which we compete, could have a material adverse effect on our business, financial condition and operating results. INSUFFICIENT SYSTEMS CAPACITY OR SYSTEMS FAILURES COULD HARM OUR BUSINESS We are heavily dependent on the capacity and reliability of the our proprietary software, computer and communications systems supporting our operations. Heavy use of our computer systems during peak trading times or at times of unusual market volatility could cause our systems to operate slowly or even to fail for periods of time. We also cannot assure you that our recent headcount reductions as part of our cost-cutting initiatives will not impact our ability to respond to system problems. Each of Instinet's and Island's status as a SEC-recognized ATS requires that our trade execution and communications systems be able to handle anticipated present and future peak trading volumes. In addition, the status of our subsidiaries as SEC-registered broker-dealers and NASD members is conditioned in part on their ability to process and settle trades. If any of our systems do not operate properly or are disabled, that ability could be compromised and we could suffer financial loss, liability to clients, regulatory intervention or reputational damage. 41 To accommodate potential increases in order message volume and trading volume, including as a result of our acquisition of Island, the trading practices of new and existing clients, the development of new and enhanced trading system functionalities, sub-penny pricing, and regulatory changes, we have made and will continue to make significant investments in additional hardware and software. We cannot assure you that our estimates of future trading volumes and order messages will be accurate or that our systems will always be able to accommodate actual trading volumes and order messages without failure or degradation of performance. System failure or degradation could result in regulatory inquiries or proceedings, and could also lead our customers to file formal complaints with industry regulatory organizations, file lawsuits against us, trade less frequently through us or cease doing business with us altogether. In connection with its annual examination of the capacity of market participants, the SEC's Division of Market Regulation has in the past raised issues regarding the adequacy of our capacity, our testing of capacity limits and our plans for increasing capacity. The inability of our systems to accommodate an increasing volume of transactions and order messages could also constrain our ability to expand our businesses. From time to time, we experience periods of extremely high trading volume in the equity securities markets. On a few occasions during these periods, the volume order messages and trading activity has caused a slowing of our order execution, trade allocation and related systems. Sustained periods of high trading volumes in the past have enabled us to identify specific areas of vulnerability in our transaction processing systems. These or similar events could interfere with our customers' ability to execute orders, and settle trades through us or prevent us from satisfying our responsibilities to clearing and settlement organizations and could result in financial exposure or regulatory action. We have been addressing each of these areas and upgrading our systems as necessary, but we cannot assure you that a similar slowing of our order message and trade allocation systems will not occur again in the future. We use new technologies to upgrade our established systems, and the development of these new technologies entails technical, financial and business risks. We cannot assure you that we will successfully implement new technologies or adapt our existing technology and transaction processing systems to customer requirements or emerging industry standards. Our core data centers support our trading and execution systems, clearing and settlement operations and customer interfaces. If one of our data centers were to be damaged, disabled or otherwise fail or experience difficulties, it may be more difficult for us to continue operating without disruption to our services. Our electronic systems could be adversely affected by general power or telecommunications failures, computer viruses or natural or other disasters (including terrorist attacks). They are also vulnerable to damage or failure due to human error and sabotage (both external and internal). The loss of support services from third parties could also have a material adverse effect on our electronic systems. FINANCIAL OR OTHER PROBLEMS EXPERIENCED BY THIRD PARTIES, INCLUDING CUSTOMERS, TRADING COUNTERPARTIES, CLEARING AGENTS AND EXCHANGES, COULD HAVE AN ADVERSE EFFECT ON OUR BUSINESS We are exposed to credit risk from third parties that owe us money, securities or other obligations. These parties include our customers, trading counterparties, clearing agents, exchanges and other financial intermediaries. These parties may default on their obligations to us due to bankruptcy, lack of liquidity, operational failure or other reasons. Although we believe we have no obligation to do so, we generally settle trades with a counterparty even if our customer fails to meet its obligations to us. We are exposed to substantial credit risk from both parties to a securities transaction during the period between the transaction date and the settlement date. This period is three business days in the U.S. equities markets and can be as much as 30 days in some international markets. In addition, we have credit exposure that extends beyond the settlement date in the case of a party that does not settle in a timely manner by failing either to make payment or to deliver securities. Adverse movements in the prices of securities that are the subject of these open transactions can increase our credit risk. Credit difficulties or insolvency or the perceived possibility of credit difficulties or insolvency of one or more large or visible market participants could also result in market-wide credit difficulties or other market disruptions whereby a large number of market participants may not settle transactions or otherwise perform their obligations. Credit losses could adversely affect our financial condition and operating results. 42 WE MAY HAVE DIFFICULTY MANAGING OUR JOINT VENTURES AND ALLIANCES SUCCESSFULLY From time to time we consider forming joint ventures or alliances with various strategic partners throughout the world. Entering into joint ventures and alliances entails risks, including: - difficulties in developing and expanding the business of newly formed joint ventures; - exercising influence over the activities of joint ventures in which we do not have a controlling interest; and - potential conflicts with our joint venture or alliance partners. Unsuccessful joint ventures or alliances could have a material adverse effect on our business, financial condition and operating results. OUR COMPLIANCE SYSTEMS MIGHT NOT BE FULLY EFFECTIVE Our ability to comply with all applicable laws and rules is largely dependent on our establishment and maintenance of compliance, audit and reporting systems and procedures, as well as our ability to attract and retain qualified compliance, audit and risk management personnel. We cannot assure you that these systems and procedures are fully effective. We also cannot assure you that our recent headcount reductions as part of our cost-cutting initiatives will not reduce the effectiveness of these systems and procedures. We face the risk of significant intervention by regulatory authorities, including extensive examination and surveillance activity. In the case of actual or alleged non-compliance with regulations, we could be subject to investigations and judicial or administrative proceedings that may result in substantial penalties or civil lawsuits, including by customers, for damages, which can be substantial. Any of these could adversely affect our business, reputation, financial condition and operating results and, in extreme cases, our ability to conduct our business or portions thereof. OUR RISK MANAGEMENT METHODS MIGHT NOT BE FULLY EFFECTIVE Our policies and procedures to identify, monitor and manage our risks may not be fully effective and may vary among our various businesses and subsidiaries worldwide. Some of our risk management methods depend upon evaluation of information regarding markets, customers or other matters that are publicly available or otherwise accessible by us. That information may not in all cases be accurate, complete, up-to-date or properly evaluated. The new business initiatives that we have recently launched or acquired, such as our correspondent clearing operations and the activities of our ProTrader and Island subsidiaries, may require different oversight procedures than those we have employed in the past. We cannot assure you that our recent headcount reductions as part of our cost-cutting initiatives will not reduce the effectiveness of our risk management policies and procedures. If our policies and procedures are not fully effective or we are not always successful in monitoring or evaluating the risks to which we are or may be exposed, our business, reputation, financial condition and operating results could be materially adversely affected. In addition, although we maintain insurance policies consistent with those maintained by others in the securities industry, we cannot assure you that our insurance policies will provide adequate coverage. WE MAY NOT BE ABLE TO OBTAIN ADDITIONAL FINANCING IF WE NEED IT Our business is dependent upon the availability of adequate funding and regulatory capital under applicable regulatory requirements. Historically, we have satisfied these needs from internally generated funds and from lines of credit made available to us by commercial banking institutions. Prior to our initial public offering, Reuters had issued non-binding, short-term letters to certain of these institutions confirming its ownership of us and indicating that if we were to default under the relevant facility, Reuters would consider, without any obligation, requests by these institutions for compensation. Reuters has withdrawn these letters and advised us that it will not issue any additional letters in the future, and we will thus not have the benefits of these letters. 43 Based on management's experience and current industry trends, we anticipate that our available cash resources will be sufficient to meet our presently anticipated working capital and capital expenditure requirements for at least the next 12 months. However, if for any reason we need to raise additional funds, we may not be able to obtain additional financing when needed on terms favorable to us. In addition, so long as Reuters owns a majority of our common stock, we will need Reuters consent to incur net indebtedness (indebtedness for borrowed money less cash on hand) in excess of an aggregate of $400 million, excluding any indebtedness incurred by us in the ordinary course of our brokerage or similar business or in connection with our clearing of securities trades or our obligations to securities exchanges or clearing systems. We cannot assure you that we will receive Reuters consent to incur indebtedness above this amount in the future if we need to do so for any reason. WE DEPEND ON THIRD PARTY SUPPLIERS FOR KEY SERVICES We rely on a number of third parties to supply elements of our trading, clearing and other systems, as well as computers and other equipment, and related support and maintenance. We cannot assure you that any of these providers will be able to continue to provide these services in an efficient, cost-effective manner or that they will be able to adequately expand their services to meet our needs. If we are unable to make alternative arrangements for the supply of critical services in the event of an interruption in or the cessation of service by an existing service provider, our business, financial condition and operating results could be materially adversely affected. In particular, we depend largely on the services of Radianz for the telecommunications network that connects us with our customers. Radianz, a joint venture between Reuters and Equant Finance B.V. that is 51% owned by Reuters, provides these services to us pursuant to an agreement it has entered into with Reuters. We are not a party to this agreement. Therefore, although we have rights under this agreement, we must rely on Reuters to enforce this agreement in the event of any breach by Radianz, but Reuters has no legal obligation to do so. Disruptions in Radianz' network services to us, including as a result of the termination of the agreement between Reuters and Radianz, or its inability to continue to support our business, would have a material adverse effect on our business, financial condition and operating results. OUR CLEARING OPERATIONS COULD EXPOSE US TO POTENTIAL LIABILITY Errors in performing clearing functions, including clerical, technological and other errors related to the handling of funds and securities held by us on behalf of customers and broker-dealers, could lead to civil penalties imposed by applicable regulatory authorities, as well as losses and liability in related lawsuits brought by customers and others. Any liability that arises as a result of our clearing operations could have a material adverse effect on our business, financial condition and operating results. Securities industry regulators in the United States are currently reviewing the extent to which clearing firms will be held accountable for the improper activities of broker-dealers for which they provide clearing services. In our correspondent clearing activities, our procedures may not be sufficient to protect us from liability for the acts of broker-dealers or other wholesale customers that use our correspondent clearing services under current laws and regulations. Securities industry regulators may also enact more restrictive laws or regulations or change their interpretations of current laws and regulations. EMPLOYEE MISCONDUCT OR ERRORS COULD HARM US AND ARE DIFFICULT TO DETECT AND DETER Employee misconduct could subject us to financial losses or regulatory sanctions and seriously harm our reputation. It is not always possible to deter employee misconduct, and the precautions we take to prevent and detect this activity may not be effective in all cases. Misconduct by our employees could include hiding unauthorized activities from us, improper or unauthorized activities on behalf of customers or improper use of confidential information. Employee errors in recording or executing transactions for customers can cause us to enter into transactions that customers may disavow and refuse to settle. These transactions expose us to risk of loss, which can be material, until we detect the errors in question and unwind or reverse the transactions. As with 44 any unsettled transaction, adverse movements in the prices of the securities involved in these transactions before we unwind or reverse them can increase this risk. OUR QUARTERLY RESULTS MAY FLUCTUATE SIGNIFICANTLY We have experienced, and may continue to experience, significant seasonality in our business. This seasonal trend may continue for the foreseeable future and similar trends may affect our business, financial condition and operating results in the future. As a result of this and the other factors and risks discussed in this section and under "Management's Discussion and Analysis of Financial Condition and Results of Operations", period-to-period comparisons of revenues and operating results are not necessarily meaningful, and the results of any quarter are not necessarily indicative of results for any future period. WE MAY NOT BE ABLE TO PROTECT OUR INTELLECTUAL PROPERTY RIGHTS We rely primarily on trade secret, copyright, trademark and patent law to protect our proprietary technology. However, it is possible that third parties may copy or otherwise obtain and use our proprietary technology without authorization or otherwise infringe on our rights. We may also face claims of infringement that could interfere with our ability to use technology that is material to our business operations. In addition, in the future, we may have to rely on litigation to enforce our intellectual property rights, protect our trade secrets, determine the validity and scope of the proprietary rights of others or defend against claims of infringement or invalidity. Any such litigation, whether successful or unsuccessful, could result in substantial costs to us and diversions of our resources, either of which could negatively affect our business. USE OF THE INTERNET TO ACCESS OUR SERVICES COULD EXPOSE US TO RISKS OF FAILURE OF INTERNET PERFORMANCE AND ADVERSE CUSTOMER REACTION Our business has traditionally been conducted with our customers through the use of proprietary networks for the execution of trades and the communication of information. To achieve better economies of distribution or to improve the delivery of our services to our customers, we have moved a portion of our business from our proprietary networks to non-proprietary networks and the Internet. Existing and prospective customers may react unfavorably to these changes due to their concerns regarding the security, reliability, cost, ease of use, accessibility and quality of service of the Internet or other systems. THE SERVICES WE PROVIDE TO PROFESSIONAL NON-INSTITUTIONAL TRADERS MAY INCREASE OUR EXPOSURE TO PRIVATE SECURITIES LITIGATION Many aspects of the securities brokerage business, including on-line trading services, involve substantial risk of liability. In recent years, there has been an increasing incidence of litigation involving the securities brokerage industry, including class action suits that generally seek substantial damages, including in some cases punitive damages. The services we provide to professional non-institutional traders through our ProTrader subsidiary may subject us to a greater risk of customer complaints, litigation and potential liability, including with respect to suitability and delays or errors in execution or settlement. Any litigation brought in the future could have a material adverse effect on our business, financial condition and operating results. RISKS RELATING TO OUR RELATIONSHIP WITH RELATED PARTIES REUTERS HAS SIGNIFICANT CONTROL OVER US AND MAY NOT ALWAYS EXERCISE ITS CONTROL IN A WAY THAT BENEFITS OUR PUBLIC STOCKHOLDERS Reuters beneficially owns approximately 62.6% of our common stock. Under our amended and restated certificate of incorporation, for as long as it continues to beneficially own more than 50% of our common stock, Reuters will control many matters that require a stockholder vote. These matters include the election of directors and the removal of directors without cause, mergers, acquisitions and other business combinations. In addition, Reuters exercises a significant amount of influence over corporate matters, such as payment of dividends and stock issuances, and over our management, business activities and operations. Currently, five of 45 our directors are also officers, former officers or directors of Reuters. In addition, if we are deemed to supply news services at a time when Reuters beneficially owns more than 50% of our common stock, we will be required to adhere to certain principles relating to integrity, independence, reliability and freedom from bias which apply to Reuters generally. If applicable, these principles may influence how we conduct our business. In addition, to the extent that these principles apply, they may affect Reuters ability to enter into a transaction that would effect a change of control of our company. Our amended and restated certificate of incorporation and our amended and restated corporate agreement with Reuters also include provisions that provide Reuters with rights, including when it beneficially owns less than a majority of our voting stock, that may be less favorable to you and us than the corporate law governing these matters would be in the absence of these provisions. These provisions include the right, when Reuters beneficially owns between 35% and 50% of our voting stock, to block some issuances of equity securities and some dispositions and acquisitions of assets or businesses exceeding specified thresholds. We have agreed not to take any action voluntarily that would reduce Reuters ownership of our then-outstanding voting stock to less than 51% of our capital stock or then-outstanding voting stock without Reuters consent. In addition, we have agreed with Reuters not to take any action that would violate a stock exchange rule or similar requirement applicable to Reuters, or that would result in adverse tax consequences for Reuters as a result of its relationship with us. Reuters substantial ownership position could also limit our ability to enter into a transaction that involves a change of control, which might adversely affect the market price of our common stock. CERTAIN OTHER OF OUR STOCKHOLDERS HAVE SIGNIFICANT CONTRACTUAL RIGHTS AND MAY EXERCISE THOSE RIGHTS IN A MANNER THAT MAY NOT BENEFIT OUR PUBLIC STOCKHOLDERS Some former Island stockholders associated with TA Associates, Bain Capital and Silver Lake Partners will have the right to nominate a total of three members to our board of directors as long as they each own 8,000,000 shares of our common stock that they received as consideration in our acquisition of Island. If the size of our board of directors is increased beyond its current size, then in most instances these stockholders would have the right to appoint additional directors. The right of these stockholders to nominate directors is based on the number of shares of our common stock issued to them as a result of the acquisition that they continue to own in the future and not the percentage of our outstanding common stock represented by those shares. If we issue a significant number of additional shares in the future, then these Island stockholders may retain the right to nominate directors to our board in a manner disproportionate to their overall ownership of our outstanding common stock. REUTERS AND CERTAIN OTHER STOCKHOLDERS MAY HAVE INTERESTS THAT CONFLICT WITH THE INTERESTS OF OUR OTHER STOCKHOLDERS AND US AND MAY CAUSE US TO FOREGO OPPORTUNITIES Various conflicts of interest between Reuters or some former Island stockholders and us may arise in the future in a number of areas relating to our business and relationships, including the following: - potential competitive business activities; - potential acquisitions of businesses or properties; - incurrence of indebtedness; - tax matters; - financial commitments; - marketing functions; - indemnity arrangements; - service arrangements; and - the exercise by Reuters or those stockholders of control over our management and affairs. 46 Individuals who are officers or directors of us and either Reuters, one of its other subsidiaries or one of the former stockholders of Island may have fiduciary duties to both companies. Our amended and restated certificate of incorporation includes provisions confirming the right of Reuters and some of the former Island stockholders -- those with the right to nominate directors to our board -- to engage in activities that compete with us and relating to the allocation of business opportunities between Reuters or the Island stockholders and us. The resulting situation may be more advantageous to Reuters or the Island stockholders than the corporate law governing those opportunities would be in the absence of those provisions. Reuters and the Island stockholders are not prohibited from engaging in our lines of business, including brokerage and research, and may directly or indirectly compete with us in the future. Bridge Trading, a Reuters subsidiary, is a broker-dealer that competes with us, primarily in the area of NYSE-listed stocks and in the soft-dollar business. SOME OF OUR AGREEMENTS WITH REUTERS MAY NOT BE THE RESULT OF ARMS-LENGTH NEGOTIATIONS BETWEEN INDEPENDENT PARTIES We have entered into a number of commercial agreements with Reuters. Some of these agreements were negotiated in the context of a parent-subsidiary relationship and therefore are not the result of arm's-length negotiations between independent parties. Accordingly, we cannot assure you that the terms of those agreements, including pricing and other material terms, are as advantageous to us as the terms we could have negotiated with unaffiliated third parties. RISKS ASSOCIATED WITH PURCHASING OUR COMMON STOCK CERTAIN PROVISIONS OF OUR CERTIFICATE OF INCORPORATION, BYLAWS AND DELAWARE CORPORATE LAW COULD MAKE A TAKE-OVER MORE DIFFICULT, COULD ADVERSELY AFFECT THE MARKET PRICE OF OUR COMMON STOCK OR DEPRIVE YOU OF A PREMIUM OVER OUR MARKET PRICE Our amended and restated certificate of incorporation and amended and restated bylaws and the laws of Delaware (the state in which we are organized) contain provisions that might make it more difficult for someone to acquire control of us in a transaction not approved by our board of directors. These provisions could also discourage proxy contests and make it more difficult for you and other stockholders to elect directors other than the candidates nominated by our board. For example, our certificate of incorporation authorizes our board of directors to determine the rights, preferences, privileges and restrictions of unissued series of preferred stock, without any vote or action by our stockholders. Thus, the board can authorize and issue shares of preferred stock with voting or conversion rights that could adversely affect the voting or other rights of holders of our common stock. In addition, the issuance of preferred stock may have the effect of delaying, deferring, or preventing a change of control of our company, because the terms of the preferred stock that might be issued could potentially prohibit our consummation of any merger, reorganization, sale of substantially all of our assets, liquidation or other extraordinary corporate transaction without the approval of our stockholders. The existence of these provisions could adversely affect the market price of our common stock. Although these provisions do not have a substantial practical significance to investors while Reuters controls us, these provisions could have the effect of depriving stockholders of an opportunity to sell their shares at a premium over prevailing market prices should Reuters voting power decrease to less than 50%. See the information incorporated in this annual report by reference from the "Certain Business Relationships" section of the Proxy Statement. FUTURE SALES OF OUR SHARES COULD ADVERSELY AFFECT THE MARKET PRICE OF OUR COMMON STOCK As of December 31, 2002, there were 330,714,705 shares of our common stock outstanding. Of this amount, 206,900,000 shares are owned beneficially by our parent, Reuters. Reuters will be able to sell its shares in the public markets from time to time, subject to certain limitations on the timing, amount, and method of such sales imposed by SEC regulations. We have also granted Reuters (and its transferees) rights 47 to demand registration of their shares and to include their shares in future registration statements. If Reuters were to sell a large number of its shares, the market price of our stock could decline significantly. In addition, the perception in the public markets that sales by Reuters might occur could also adversely affect the market price of our common stock. In connection with our acquisition of ProTrader Group, L.P. in October of 2001, we issued 5,017,058 common shares to former ProTrader stockholders. All of these shares may now be sold without restriction. On September 23, 2002, we filed a registration statement on Form S-8 under the Securities Act with respect to up to 1,553,151 shares of our common stock that are reserved for issuance pursuant to our stock option plan. As a result, shares received by employees upon exercise of their options will be eligible for resale by the holders in the public markets, subject to certain lock-up agreements and Rule 144 limitations applicable to affiliates. We may increase the size of its option plan and include additional shares in the Form S-8 under the Securities Act. We may file a registration statement permitting resale of these shares by affiliates. In connection with our acquisition of Island, we issued 80,658,829 common shares to former Island stockholders along with warrants and options to purchase an additional 5,793,455 of our common shares. Many of these shares may now be sold without restriction. In addition, we have agreed to provide some Island securityholders with registration rights that would facilitate their future sales of our common shares received as a result of the acquisition of Island. In the future, we may issue our securities in connection with acquisitions or investments. The amount of our common stock issued in connection with an acquisition or investment could constitute a material portion of our then outstanding common stock not held by Reuters. Sales of substantial amounts of our common shares in the public market could adversely affect the market price of those shares. A decline in the market price of our common shares could adversely affect its access to the equity capital markets. In addition, any issuance of shares by us could dilute our earnings per share. WEBSITE ACCESS We make our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports available, free of charge, on the "Investor Relations" section of our Internet website at http://www.Instinet.com as soon as reasonably practicable after we electronically file this material with, or furnish this material to, the Securities and Exchange Commission. ITEM 2. PROPERTIES We lease all of our office space, most of which is located in New York City and Jersey City, New Jersey. Our principal offices are located at 3 Times Square, New York, New York. We sublease the space for our principal offices from an affiliate of Reuters. For further information about this lease, see "Certain Relationships and Related Transactions." We also lease office space at Harborside Plaza 10, Jersey City, New Jersey, where our clearing, technology operations, disaster recovery and certain support functions, including finance, business services, human resources, are currently located. We may relocate additional employees to our New Jersey offices in 2003. In addition we have lease agreements for office space outside the United States in Frankfurt, Hong Kong, London, Paris, Tokyo and Zurich. For further information about our leased properties, see "Notes to Consolidated Financial Statements." ITEM 3. LEGAL PROCEEDINGS From time to time, we are involved in various legal proceedings (including those described below) arising in the ordinary course of business. We are also subject to periodic regulatory audits and inspections. While any litigation contains an element of uncertainty, it is the opinion of management after consultation with counsel, that the outcomes of such proceedings or claims are unlikely to have a material adverse effect on the business, financial condition or operating results of the company. 48 THE ISLAND ECN, INC. V. ARCHIPELAGO L.L.C.; B-TRADE SERVICES LLC; REDIBOOK ECN L.L.C. On September 20, 2002, Island commenced an arbitration proceeding against respondents Archipelago L.L.C. ("Archipelago"); B-Trade Services LLC ("B-Trade"); and REDIBook ECN L.L.C. ("REDIBook") before the NASD. Island alleges that each respondent entered into a subscriber agreement with Island which prescribed certain fees and, despite Island's demand that each respondent abide by the terms of its contract, each respondent has refused to pay such fees. Island asserts breach of contract, quantum meruit, unjust enrichment and account stated causes of action against respondents and seeks total damages in the amount of at least approximately $11,100,000 of which approximately $1,900,000 is due from B-Trade, $5,100,000 from Archipelago and $4,000,000 from REDIBook. Archipelago and REDIBook have served an answer and counterclaims upon Island in which they deny the substantive allegations of Island's statement of claim, assert certain affirmative defenses and allege counterclaims against Island alleging that Island engaged in unfair, discriminatory pricing practices against these respondents and asserting claims involving breach of contract, breach of obligation of good faith, and attempted monopolization and conspiracy to restrain trade under the Sherman Act. These counterclaims allege damages of no less than $30 million before trebling, for a total of no less than $90 million treble damages pursuant to the federal antitrust laws. Archipelago is also seeking attorney's fees. Respondent B-Trade separately also answered Island's statement of claim by denying each of Island's substantive allegations, asserting affirmative defenses, and alleging a breach of contract counterclaim against Island. B-Trade's counterclaim seeks at least $2.75 million in damages. Island intends to pursue vigorously its claims and oppose respondents' counterclaims. ARCHIPELAGO SECURITIES, L.L.C. V. INSTINET GROUP INCORPORATED On February 19, 2003, Archipelago Securities, L.L.C. commenced a separate action against Instinet before the NASD, in which it alleged that Instinet also engaged in unfair, discriminatory pricing practices against it and asserted claims involving a breach of contract, a breach of obligation of good faith, and attempted monopolization and conspiracy to restrain trade under the Sherman Act. Archipelago in its claim seeks no less than $41 million before trebling for a total of no less than $123 million trebled damages. Instinet intends to defend vigorously this proceeding by opposing Archipelago's claims and asserting certain affirmative defenses and its own counterclaims against Archipelago Securities L.L.C. NEXTRADE HOLDINGS, INC. V. PROTRADER GROUP, LP, PROTRADER SECURITIES CORP., PROTRADER TECHNOLOGIES LP, PROTRADER TRADING LLC, AND PROTRADER.COM LP On February 4, 2003, NexTrade Holdings, Inc. commenced an action against certain ProTrader subsidiaries in the United States District Court, Middle District of Florida, Tampa Division. The complaint alleges that these subsidiaries adopted and used the mark "ProTrader" to identify themselves and their goods and services in the securities industry and, in so doing, these subsidiaries have infringed plaintiff's exclusive rights in its federally registered trademark "Pro-Trade(R)" in violation of sec.32(1) of the Lanham Act. The complaint further alleges that these subsidiaries' use of the ProTrader mark is likely to cause confusion, mistake or deception among purchasers of software, services and goods bearing the name "ProTrader," which allegedly constitutes false designation of origin and unfair competition in violation of sec.43(a) of the Lanham Act. The complaint also alleges that these subsidiaries' use constitutes trademark infringement in violation of Florida state statutes and its common law, and unfair competition based on trademark infringement in violation of the common law of Florida. Finally, the complaint alleges fraud in the inducement based on defendants' alleged deceitful negotiations to resolve the dispute. Plaintiff seeks to recover all of these subsidiaries' profits, gains and advantages resulting from the unauthorized use of the "ProTrader" mark, damages sustained by the plaintiff of no less than $15 million before trebling and that such damages be trebled, and exemplary and punitive damages of not less than $90 million. Defendants intend to vigorously contest plaintiff's claims. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY SHAREHOLDERS No matters were submitted to security holders for a vote during the fourth quarter ended December 31, 2002. 49 PART II ITEM 5. MARKET FOR THE COMPANY'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Our common stock commenced trading on the Nasdaq National Market on May 18, 2001 under the symbol "INET." Prior to that date, there was no public market for our common stock. The following table sets forth, for the periods indicated, the high and low closing prices per share for our common stock as reported on the Nasdaq National Market and the dividend declared per share of our common stock:
DIVIDEND DECLARED PERIOD HIGH LOW PER SHARE ------ ------ ------ --------- Second quarter 2001 (from May 18, 2001 to June 30, 2001)................................................... $20.86 $16.30 $ 0 Third quarter 2001........................................ $17.92 $ 9.44 $ 0 Fourth quarter 2001....................................... $11.36 $ 7.56 $ 0 First quarter 2002........................................ $10.30 $ 6.41 $ 0 Second quarter 2002....................................... $ 7.95 $ 6.30 $ 0 Third quarter 2002........................................ $ 7.09 $ 2.93* $1.00 Fourth quarter 2002....................................... $ 4.23 $ 2.45 $ 0
--------------- * adjusted for cash dividend On March 20, 2003, the last reported sales price for our common stock on the Nasdaq National Market was $3.54. As of March 20, 2003, there were approximately 8,500 holders of record of our common stock. The equity compensation plan information required to be furnished pursuant to this item is incorporated by reference from the Equity Compensation Plan Information section of the Proxy Statement. DIVIDENDS Prior to our reorganization in 2000, most of our international operations and some of our other activities were conducted by other companies within the Reuters Group. In order to fund these operations, we paid dividends to Reuters, which then made capital contributions to those companies. As a result of our reorganization, all of our international operations are now conducted by our own subsidiaries. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Our Reorganization and Initial Public Offering." In connection with our acquisition of Island, we paid a $1.00 per common share cash dividend to our stockholders of record as of September 19, 2002, which represented a distribution of $248.7 million, of which $206.9 million was paid to Reuters. We paid this dividend on October 3, 2002. We intend to retain our future earnings for use in our business and do not anticipate paying any cash dividends in the foreseeable future. Any decision to declare and pay dividends in the future will be made at the discretion of our board of directors, after taking into account our financial results, capital requirements and other factors they may deem relevant. So long as Reuters continues to beneficially own more than 50% of our outstanding common stock, it will be able to exercise control over our payment of dividends. RECENT SALES OF UNREGISTERED SECURITIES The following information relates to securities issued or sold by the Registrant since June 27, 2000, the date of the Registrant's inception. During that time, the Registrant has issued unregistered securities in the transactions described below. Securities issued in such transactions were offered and sold in reliance upon the exemption from registration under Section 4(2) of the Securities Act, relating to offers of securities by an issuer not involving any public offering, or in reliance upon the exemption from registration under Regulation S under the Securities Act, relating to offers of securities outside the United States to persons who are not citizens or residents of the United States. The offers and sales of securities described below were made 50 without an underwriter and the certificates representing the securities bear a restrictive legend permitting the transfer of the securities only upon their registration under, or pursuant to an exemption from the registration requirements of, the Securities Act. (1) On July 25, 2000, Instinet Group LLC and Instinet Corporation executed a Contribution Agreement pursuant to which Instinet Corporation contributed 100 shares of common stock of Instinet Global Holdings, Inc. to Instinet Group LLC in exchange for 32,486 limited liability company interests of Instinet Group LLC. (2) On July 31, 2000, Instinet Group LLC and Reuters Holdings Switzerland SA executed a Subscription Agreement pursuant to which Reuters Holdings Switzerland SA contributed $167,300,000 to Instinet Group LLC in exchange for 10,064,564 limited liability company interests in Instinet Group LLC. (3) On July 31, 2000, Instinet Group LLC and Instinet Corporation executed an Asset Contribution Agreement pursuant to which Instinet Corporation contributed substantially all of its assets and liabilities to Instinet Group LLC in exchange for 169,236,283 limited liability company interests in Instinet Group LLC. (4) On September 29, 2000, Instinet Group LLC and Reuters C Corp. (formerly known as Instinet Corporation) executed a Contribution Agreement pursuant to which Reuters C Corp. contributed to Instinet Group LLC (a) all of its rights and interest in 100 shares of common stock of Instinet Fixed Income Inc. and all of its liabilities related to Instinet Fixed Income Inc. in exchange for 1,348,371 limited liability company interests in Instinet Group LLC and (b) all of its rights and interest in three Class A shares of Hambrecht Instinet Ltd. in exchange for a payment of $3.00. (5) On September 29, 2000, Instinet Group LLC and Reuters Holdings Switzerland SA executed a Contribution Agreement pursuant to which Reuters Holdings Switzerland SA contributed 12,000 shares of common stock of Instinet Investments (Bermuda) Ltd. to Instinet Group LLC in exchange for 1,679,335 limited liability company interests in Instinet Group LLC. (6) On September 29, 2000, Instinet Group LLC and Reuters Holdings Switzerland SA executed a Contribution Agreement pursuant to which Reuters Holdings Switzerland SA contributed 100,057,300 shares of common stock of Instinet Holdings Limited to Instinet Group LLC in exchange for 28,315,789 limited liability company interests in of Instinet Group LLC. (7) On October 1, 2001, we acquired ProTrader Group, LP pursuant to an Interest Purchase Agreement dated as of July 23, 2001, as amended as of October 1, 2001 (the "Purchase Agreement"), between us and David G. Jamail, David R. Burch, Overunder, LLC, John A. McEntire IV, John Bunda, Laura Horne, Currin Van Eman and Shayne Young (together, the "ProTrader Sellers"). Pursuant to the Purchase Agreement, we paid the ProTrader Sellers a purchase price of $100 million in cash and an aggregate of 5,017,058 shares of our common stock, valued at $50 million. We sold 4,629,427 shares to the ProTrader Sellers on October 1, 2001 in a private placement pursuant to Regulation D of the Securities Act. We sold the remaining 387,631 shares to one of the ProTrader Sellers on January 3, 2002 in a private placement pursuant to Regulation D of the Securities Act. (8) In connection with our merger with Island on September 20, 2002, we assumed two hedge option agreements with Ameritrade Holding Corporation. These hedge option agreements were originally entered into between Island and Datek Online Holdings Corp. (which Ameritrade acquired on September 9, 2002) and hedged Ameritrade's obligations under a stock appreciation rights (SARs) plan. The SARs were granted to various directors, officers and employees of Datek and, upon exercise, entitled the holders to receive cash in an amount equal to the excess of the market value of our common shares over the exercise price of the SAR. In connection with our merger with Island, Ameritrade accelerated the SARs, in accordance with the terms of the SAR plan. Pursuant to an option exercise agreement dated as of October 18, 2002 we entered into with Ameritrade and Datek, we sold 1,651,238 shares of our common stock to Ameritrade for an exercise price of $0.91 per share in a series of private placements pursuant to Regulation D of the Securities Act in November and December 2002. 51 ITEM 6. SELECTED FINANCIAL DATA (In thousands, except volume, share and per share data and growth rates) The following selected consolidated financial data should be read together with our financial statements and the related notes included elsewhere in this annual report and the discussion under "Management's Discussion and Analysis of Financial Condition and Results of Operations." The information as of and for the years ended December 31, 2002, 2001 and 2000 set forth below was derived from our audited consolidated financial statements and related notes included elsewhere in this annual report. The information as of and for the years ended December 31, 1999 and 1998 set forth below was derived from our audited consolidated financial statements that are not included in this annual report. The historical financial information may not be indicative of our future performance and does not reflect what our financial position and results of operation would have been had we operated as a separate, stand-alone entity during 2000, 1999 and 1998.
YEAR ENDED DECEMBER 31, -------------------------------------------------------------- 2002 2001 2000 1999 1998 ---------- ---------- ---------- ---------- ---------- REVENUE Transaction fees................ $1,078,172 $1,424,343 $1,381,405 $ 935,550 $ 821,757 Interest........................ 40,137 49,296 38,015 23,916 21,587 Investments..................... (59,109) 17,388 9,059 8,570 (1,175) ---------- ---------- ---------- ---------- ---------- Total revenues............. 1,059,200 1,491,027 1,428,479 968,036 842,169 EXPENSES Compensation and benefits....... 281,761 406,348 379,320 239,607 200,022 Communications and equipment.... 125,720 156,002 143,194 89,234 69,614 Soft dollar and commission recapture..................... 217,314 220,050 180,035 89,469 80,339 Brokerage, clearing and exchange fees.......................... 149,521 146,223 136,163 78,966 67,766 Depreciation and amortization... 78,424 80,754 74,158 70,710 64,502 Professional fees............... 24,594 39,990 90,208 56,648 22,027 Occupancy....................... 55,528 49,918 35,946 27,096 22,935 Marketing and business development................... 17,094 22,143 32,145 22,340 9,234 Broker Dealer Rebates........... 124,399 -- -- -- -- Other........................... 58,984 54,534 37,065 24,283 20,123 Impairment of goodwill.......... 551,991 -- -- -- -- Restructuring................... 120,800 24,378 -- -- -- Loss of fixed assets and World Trade Center.................. -- 20,346 -- -- -- Recovery of fixed assets lost... -- (21,000) -- -- -- ---------- ---------- ---------- ---------- ---------- Total expenses............. 1,806,130 1,199,686 1,108,234 698,353 556,562 Income/(loss) from continuing operations before income taxes and cumulative effect of change in accounting principle..................... (746,930) 291,341 320,245 269,683 285,607 Income tax provision/(benefit)........... (53,088) 122,210 135,993 110,614 117,714 ---------- ---------- ---------- ---------- ---------- Income/(loss) from continuing operations before cumulative change in accounting principle....... (693,842) 169,131 184,252 159,069 167,893
52
YEAR ENDED DECEMBER 31, -------------------------------------------------------------- 2002 2001 2000 1999 1998 ---------- ---------- ---------- ---------- ---------- Discontinued operations: Loss from operations of fixed income business............ (33,768) (39,133) (55,635) (35,310) (12,301) Income tax benefit............ 11,022 14,769 (19,565) (12,359) (4,305) ---------- ---------- ---------- ---------- ---------- Income before cumulative effect of change in accounting principle..................... (716,588) 144,767 148,182 136,118 159,897 Cumulative effect of change in accounting principle, net of tax........................... (18,642) -- -- -- -- ---------- ---------- ---------- ---------- ---------- Net income/(loss).......... $ (735,230) $ 144,767 $ 148,182 $ 136,118 $ 159,897 ========== ========== ========== ========== ========== Earnings/(loss) per share -- basic and diluted.... $ (2.71) $ 0.63 $ 0.72(1) $ 0.66(1) $ 0.77(1) Shares outstanding -- basic..... 271,542 230,561 206,900(1) 206,900(1) 206,900(1) Shares outstanding -- diluted... 272,135 230,564 206,900(1) 206,900(1) 206,900(1)
--------------- (1) Calculated based on the number of common shares that would have been held by Reuters after giving effect to a return of capital payment of $150 million to Reuters and our conversion from a limited liability company to a corporation, which is pushed back for EPS calculation purposes.
2002/2001 2001/2000 2000/1999 1999/1998 --------- --------- --------- --------- Year-to-year growth rates: Total revenue..................................... 29.7% 4.4% 47.6% 14.9% Total expenses.................................... 50.6 8.3 58.7 25.5 Net income/(loss)................................. (607.9) (2.3) 8.9 (14.9)
DECEMBER 31, -------------------------------------------------------------- 2002 2001 2000 1999 1998 ---------- ---------- ---------- ---------- ---------- Statement of Financial Condition Data: Cash and cash equivalents...... $ 275,837 $ 703,678 $ 415,199 $ 349,522 $ 339,281 Securities owned, at market value....................... 348,051 236,007 185,121 214,625 190,393 Receivable from broker-dealers.............. 159,695 421,196 660,319 434,995 139,838 Receivable from customers...... 56,257 68,280 149,080 110,006 37,555 Total assets................ 2,282,895 2,994,841 2,440,424 1,747,470 1,155,576 Stockholders' equity........... 1,023,534 1,462,509 927,336 778,842 703,022
YEAR ENDED DECEMBER 31,(1)(2)(3)(4) -------------------------------------------- 2002 2001 2000 1999 1998 ------- ------- ------ ------ ------ Our total U.S. market share volume (millions)... 97,623 76,909 66,711 41,146 33,731 Our Nasdaq share volume (millions).............. 81,942 65,893 57,390 35,211 28,653 Our U.S. exchange-listed share volume (millions).................................... 15,681 11,016 9,321 5,935 5,078 Our U.S. equity transaction volume (thousands)................................... 148,415 98,346 82,437 44,902 26,800 Our international equity transaction volume (thousands)................................... 7,618 7,685 5,181 2,827 1,334 ------- ------- ------ ------ ------ Our total equity transaction volume (thousands)................................... 156,033 106,031 87,618 47,729 28,134 Our average equity transactions per day (thousands)................................... 619 428 348 189 112
53
2002/2001 2001/2000 2000/1999 1999/1998 --------- --------- --------- --------- YEAR-TO-YEAR GROWTH RATES: Our Nasdaq share volume........................... 24.4% 14.8% 63.0% 22.9% Our U.S. exchange-listed share volume............. 42.3 18.2 57.1 16.9 Our total U.S. share volume....................... 26.9 15.3 62.1 22.0 Our U.S. equity transaction volume................ 50.9 19.3 83.6 67.5 Our international equity transaction volume....... (0.9) 48.3 83.3 111.9 Our total equity transaction volume............... 47.2 21.0 83.6 69.7
--------------- (1) U.S. shares consist of shares of U.S. exchange-listed and Nasdaq-quoted stocks. (2) Historical amounts may be restated due to updates of volume information from Nasdaq. (3) For a description of how we calculate our Nasdaq share volumes, see -- "Nasdaq Volume Calculations" and "Calculation of Instinet ATS and Island ATS Volume Combined Volumes' (4) Island's results, subsequent to September 20, 2002, are consolidated with our results for the periods described. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This annual report contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in forward-looking statements for many reasons, including the risks described in "Certain Factors that May Affect Our Business" and elsewhere in this annual report. You should read the following discussion with "Selected Financial Data" and our financial statements and related notes included elsewhere in this annual report. OVERVIEW We have been operating in an increasingly challenging business, economic and regulatory environment. During the past three years, the major U.S. market indices have experienced a severe decline and significant volatility. The weak and uncertain economic climate, increased unemployment rates, reduced capital raising, decreased market capitalization, ongoing geopolitical and global conflicts, coupled with the current corporate governance and accounting concerns, have contributed to a decreased pace of global economic growth. This has resulted in significantly lower equity prices, decreased corporate activity, increased market volatility, decreased trading volumes, and a generally more difficult business environment. In addition, intense competition from other liquidity providers and trading venues, together with recent SEC regulations and interpretive initiatives, have prompted us to reduce our prices significantly, which has resulted in decreased revenues and losses from operations. Our transaction fee revenues have declined from a record $1.4 billion in 2001 to $1.1 billion in 2002 and our net income decreased from $144.8 million to a loss of $735.2 million, primarily due to a $552.0 million charge for goodwill impairment, a restructuring charge and a write down in our investments. In the past, we have implemented various cost reduction plans and in December 2002, we began implementing a cost reduction plan that targets a further reduction in operating costs of $100 million, on an annualized basis, by the end of 2003. Our transaction fees earned from our customers trading equity securities have represented a substantial part of our revenues and accounted for approximately 99% of our transaction fee revenues in 2002 and 2001. During the first two months of 2003, the U.S. markets continued to weaken and trading volumes continued to decline. The average daily trading volumes in Nasdaq-quoted and U.S. exchange-listed stocks decreased 8% from 3.6 billion shares in the fourth quarter of 2002 to 3.3 billion shares during the first two months of 2003. Our average daily trading volumes have also decreased. Our average daily trading volumes in Nasdaq-quoted and U.S. exchange listed stocks have decreased 13% from 575 million shares in the fourth quarter of 2002 to 504 million shares during the first two months of 2003. This decrease in trading volumes has had a negative effect on our transaction fee revenue. In addition, in March 2003, we announced a reduction of 12% of our global staffing levels, approximately 175 positions, resulting from attrition and the eliminations of 54 positions. We expect that these staff reductions will result in an estimated $20 million reduction in our operating costs, on an annualized basis, by the end of 2003. This staff reduction is part of our continued focus on cost reduction and is in addition to the $100 million cost reduction target previously announced. ACQUISITION OF ISLAND AND SPECIAL DIVIDEND On September 20, 2002, we completed our acquisition of Island. We now operate two of the largest alternative trading systems (ATSs) trading Nasdaq-quoted stocks. We believe this transaction brings together complementary capabilities in the global equity markets, creating a company better able to serve customer needs. We expect the merger to deliver synergies as a result of expanded liquidity and cost savings in technology, clearing, facilities and compensation. Under the terms of the acquisition agreement, we issued 80,658,886 shares of our common stock to Island stockholders and converted options, warrants and stock appreciation rights to holders of Island options, warrants and stock appreciation rights outstanding at September 20, 2002. Subsequent to the acquisition, we incurred various non-cash charges related to the amortization of identified intangible assets and the conversion of existing Island equity options. In addition, we incurred charges to enable us to achieve on-going cost synergies. In connection with our acquisition of Island, we paid a $1.00 per common share cash dividend to our stockholders of record as of September 19, 2002, which represented a distribution of $248.7 million, of which $206.9 million was paid to Reuters. We paid this dividend on October 3, 2002. BUSINESS ENVIRONMENT Over the past five years, the major U.S. market indices experienced substantial growth followed by a severe decline and significant volatility. For example, the Dow Jones Industrial Average increased from 7,965 in January 1998, reached a peak of 11,723 in January 2000, dropped to a low of 7,286 in October 2002 and increased to 8,342 by the end of December 2002. The Nasdaq composite experienced similar volatility, increasing from 1,574 in January 1998 to a peak of 5,133 in March 2000, then experienced a severe decline to 1,336 by the end of December 2002. This trend comes at the end of a period of tremendous growth in the global equity markets. Our transaction fee revenues grew at a compound annual growth rate of 20% from $821.8 million in 1998 to $1.4 billion in 2001. This growth in revenues was primarily driven by increases in share volumes in the equity securities markets and by our expanded international business. For example, the total number of shares of U.S. exchange-listed and Nasdaq-quoted stocks traded increased at a compound annual rate of 27% from 403.7 billion in 1998 to 832.3 billion in 2001. However, beginning in the second half of 2001 through 2002, the growth rate of the volume of trading in the U.S. markets began to slow, and in 2002, Nasdaq market volumes declined, although the U.S. exchanges still maintained moderate growth. We believe the slowdown in trading volumes and the downward pressure on share prices, has been caused in part by an overall decline in the global economy, particularly in the U.S. The growth rate in the total number of shares of U.S. exchange-listed and Nasdaq-quoted stocks traded decreased to 9% from 2001 to 2002. As a result of these market and competitive pressures, we significantly reduced our prices in 2002 which contributed to a decrease in our transaction fee revenues to $1.1 billion in 2002 (For the year-to-year growth rates, see "Selected Financial Data."). The international equity markets have experienced similar volatility and downward share prices as the U.S. markets. Our international equity transaction volume increased at a compound annual rate of 55%, from 1.3 million transactions in 1998 to 7.6 million transactions in 2002 (For the year-to-year growth rates, see "Selected Financial Data."). Our transaction fee revenue earned from non-U.S. equities has grown over the past five years from $139.2 million to a peak of $267.5 million in 2000. However, these fees declined to $212.4 million in 2002 primarily due to price declines in non-U.S. securities. Our net transaction fee revenue earned from non-U.S. equities (a non-GAAP financial measurement), which excludes revenues directly related to soft dollar and commission recapture, has grown over the past five years from $107.9 million in 1998 55 to a peak of $207.7 million in 2000. However, these fees began to decline in 2001, and in 2002, declined to $154.3 million, primarily due to price reductions in non-U.S. securities. Our revenues from international transactions are determined on the basis of the value of transactions, rather than the number of shares traded. In addition, we continue to operate in an increasingly challenging business environment due to recent significant regulatory changes. The securities markets and the brokerage industry in which we operate are highly regulated. Many of the regulations applicable to us may have the effect of limiting our activities, including activities that might be profitable, or causing us to modify our business model in ways that may adversely affect our revenues. OUR MARKET SHARE Our share trading volume in U.S. exchange-listed and Nasdaq-quoted stocks has increased at a compound annual rate of 23% from 33.7 billion in 1998 to 76.9 billion in 2001. Our share trading volume grew 27% to 97.6 billion in 2002, which included 16.9 billion from Island. (See -- "Calculation of Instinet ATS and Island ATS Combined Volumes."(For the year-to-year growth rates, see "Selected Financial Data.") Our share of the total trading volume in U.S. exchange-listed and Nasdaq-quoted stocks, while fluctuating over the period, increased from 8.4% in 1998 to 10.8% in 2002. Our Instinet ATS alone accounted for approximately 15% of the total trading volume in the Nasdaq quoted stock in 2002. Following our acquisition of Island, our two ATSs accounted for approximately 30% of the total trading volume in Nasdaq-quoted stocks for the three months ended December 31, 2002. We experienced a decline in our Nasdaq market share beginning in the second half of 2001. This was primarily attributable to lower volumes from our broker-dealer customers, increased price competition and the introduction of Nasdaq's SuperSoes system in the third quarter of 2001. The following graph depicts our share volume and our transaction fee revenues, on a quarterly basis, from 1998 to 2002: [GRAPH] 56 PRICING CHANGES To respond to the intense price competition and our declining market share, particularly for Nasdaq-quoted trading, in September 2001, we reduced our pricing, implementing a new pricing schedule for our U.S. broker-dealer customers and adjusted certain pre-set volume levels at which we offer those customers lower per share transaction fees. In March 2002, we implemented a new pricing plan to offer further pricing incentives to our U.S. broker-dealer customers, reducing prices paid by broker-dealers trading Nasdaq-quoted stocks by approximately 60% and simplifying the pricing schedule by further adjusting certain pre-set volume levels. We will continue to monitor future price competition and evaluate our pricing structure as part of our ongoing efforts to maintain and expand the liquidity pools of our two ATSs. These price changes have significantly affected our average U.S. equity transaction fee revenue per share, which decreased 40.8% from $0.0076 in 2001 to $0.0045 2002. Our average U.S. net equity transaction fee revenue per share (a non-GAAP financial measurement) decreased 53.8% from $0.0065 in 2001 to $0.0030 in 2002. BUSINESS EXPANSION, COST REDUCTION INITIATIVES & BUSINESS REALIGNMENT Our expenses grew significantly from 1998 to 2001, primarily due to increased transactions by our customers, as well as increased expenses related to our efforts to expand and diversify our activities, which has caused reductions in our margins. In 1998, we began developing a fixed income securities platform, which we launched in the spring of 2000 in the United States and Europe. In October 2000, we began providing correspondent clearing services to a few brokers in the United States. With the emergence of Internet-based retail brokerage as a significant and growing portion of the equity marketplace, we initially planned to develop our own Internet-based retail brokerage operation and, starting in 1998, designed and developed a platform for this business. These internal development efforts resulted in significant costs, which we expensed as incurred. In response to the various regulatory and competitive changes in our business and in the marketplace, in 2000, 2001 and 2002, we engaged in various cost reduction plans and re-aligned our core business focus, resulting in restructuring charges: - In December 2000, we announced that based upon a review of market conditions and an evaluation of possible alternate strategies, we decided to terminate our retail brokerage efforts. As a result, we recorded a charge of $7.5 million in 2000 and $4.0 million in 2001. Between 1998 and 2001, we incurred total expenses of $76.9 million related to our retail brokerage initiative, including these restructuring charges. - In July 2001, in order to address the declines in our margins, we announced a review of spending initiatives with the aim of reducing our underlying operating cost structure by approximately $70 million annually compared to our total expenses in the first half of 2001. This program was completed in 2001 at a charge of $24.4 million. Employee headcount levels were reduced by 226. The departments primarily affected were various operational areas in technology support, sales and trading, administrative functions and clearing operations in our U.S. and international offices. We closed our office in Sydney, Australia, consolidated our European trading and clearing operations, significantly reducing the size of our Zurich office, and in the U.S., closed the Greenwich, Detroit and Seattle trading offices of our ProTrader subsidiary. We also aggressively managed discretionary spending in areas such as marketing costs, professional fees and travel costs. - In March 2002, in order to offset the impact of reduced revenues due to our price reductions to U.S. broker-dealer customers, we announced that we would reduce our annualized fixed operating costs by approximately $120 million compared to our annualized fixed cost run rate in the fourth quarter of 2001. This program was substantially completed by the end of the first half of 2002 at a cost of $58.4 million. It included reducing staff levels by 489. The departments primarily affected were various operational areas in technology support functions, clearing operations, sales and trading, and administrative functions in our U.S. and international offices. We closed the Houston, Los Angeles and San Jose trading offices of our ProTrader subsidiary, consolidated our European trading and clearing 57 operations, significantly reduced the size of our offices in Switzerland, U.K. and France, and consolidated our office space in the U.S. - In May 2002, we closed our fixed income trading platform. Against the background of a global economic slowdown and the uneven pace of acceptance of electronic fixed income trading platforms, the business had been unable to reach a critical mass. As part of this shutdown, we recorded a discontinued operations charge, net of tax, of $22.7 million in 2002. Between 1998 and 2002, we incurred a charge of $168.7 million related to our fixed income business, including this restructuring charge. - In December 2002, we announced that we had commenced a cost-reduction plan to reduce operating costs by $100 million on an annualized basis (compared to the level in the third quarter of 2002, as if Island was included for the full quarter) by the end of 2003 in order to achieve cost synergies in connection with our acquisition of Island. As part of this plan, we reduced our workforce by 300, or approximately 17% of our global full-time employees, consolidated office space within the New York City area and closed most of the remaining offices of our ProTrader subsidiary. A charge of $62.4 million was recorded in 2002 in connection with these measures. We continue to evaluate further cost initiatives, which may result in future charges. FIXED AND VARIABLE COST BASE As a result of the initiatives described above, we have begun to achieve a reduction in our expenses. Our total expenses, which included the charges for cost reduction initiatives, were $1.8 billion in 2002, $1.2 billion in 2001 and $1.1 billion in 2000; however, our fixed-cost base (a non-GAAP financial measure) decreased to $642.1 million in 2002, from $809.7 million in 2001 and $792.0 million in 2000. Island contributed $16.9 million to our fixed expenses in 2002. Our fixed-cost base excludes non-operating expenses (goodwill impairment and restructuring costs) and variable costs (soft dollar and commission recapture, broker-dealer rebates and brokerage, clearing and exchange fees). Our variable expenses are generally related to transaction volumes as well as share volumes. Our average number of shares per transaction has declined primarily due to a change in our customer mix and increased trades, particularly from our broker-dealer clients. GOODWILL IMPAIRMENT During the third quarter of 2002, we experienced a decline in our market capitalization, particularly towards the end of the quarter. Due to this significant decrease, Instinet's book value exceeded its fair market value. We believe that this significant decline in market value reflected the ongoing challenging business environment, declining business fundamentals, the commoditization of some of our services, the launch of significant competitive products and a difficult regulatory environment. These events prompted us to perform a goodwill impairment test. In accordance with SFAS No. 142, "Goodwill and Other Intangible Assets" ("SFAS 142"), based on the results of a valuation analysis prepared by an independent specialist, we determined that our existing goodwill had been completely impaired and as a result, we recorded a pre-tax goodwill impairment loss of $552.0 million, the remaining carrying value of our goodwill, as of September 30, 2002. This was a non-cash charge and resulted in no reduction in tangible book value. We recorded a related tax benefit of approximately $26.0 million related to this charge. OTHER BUSINESS ACQUISITIONS In February 2000, we acquired Lynch, Jones & Ryan, a leading provider of specialized brokerage, research and commission recapture services to pension plan sponsors and managers, for $50.0 million, in order to expand our services to certain customer groups. 58 In October 2001, we acquired ProTrader, a provider of advanced trading technologies and electronic brokerage services. This acquisition was intended to enhance our customer interface and order routing technology. The acquisition excluded ProTrader's proprietary trading business. The $150 million purchase price consisted of $100 million in cash and 5,017,058 shares of our common stock valued at $50 million. The shares issued in this transaction are eligible for resale subject to applicable limitations under the Securities Act of 1933. We granted registration rights with respect to these shares. On January 7, 2003, pursuant to an existing option purchase agreement, we purchased Harborview LLC, a NYSE floor brokerage firm for $594,000. We believe that this acquisition will reduce our execution costs and enhance our execution capabilities. OUR REORGANIZATION AND INITIAL PUBLIC OFFERING Effective September 30, 2000, we, together with Reuters, reorganized our operations to combine all of our operations under one holding company structure. Prior to the reorganization, while most of our U.S. business was conducted by our own direct or indirect subsidiaries, most of our international operations and some of our other activities were conducted by other companies affiliated with us within the Reuters Group. In order to fund these international operations, we paid dividends to Reuters, which then made corresponding capital contributions to the appropriate companies. In the reorganization, Reuters transferred various assets, liabilities and ownership interests in those companies to us. On May 9, 2001, we converted our company from a Delaware limited liability company into a Delaware corporation, based on a conversion ratio of 1.033209 shares per membership interest. In May 2001, we completed an initial public offering of 36.8 million shares at an offering price of $14.50 per share. We received net proceeds of approximately $487 million in the offering after deducting our offering expenses. MANAGEMENT CHANGES We have had several executive management changes beginning in 2002: In April 2002, Douglas M. Atkin, President and Chief Executive Officer, resigned from Instinet. Mark Nienstedt, then Chief Financial Officer, was appointed to serve as Instinet's acting President and Chief Executive Officer. Kenneth K. Marshall, then Chief Operating Officer, also announced his retirement and Jean-Marc Bouhelier was appointed Chief Operating Officer. Subsequent to the acquisition of Island in September 2002, Edward J. Nicoll, then Chairman of Island, was appointed Chief Executive Officer and Director of Instinet. In November 2002, John F. Fay was appointed Chief Financial Officer of Instinet. Mark Nienstedt continued as Instinet's President until his resignation on February 10, 2002; however, Mr. Nienstedt continues to serve as director and officer of Instinet. Effective January 2003, Andre Villeneuve retired as Instinet's Executive Chairman of the Board of Directors and Ian Strachan was appointed to succeed him as non-executive Chairman of the Board. SEASONALITY We have experienced, and may continue to experience, significant seasonality in our business. As a result of this and other factors described above, period-to-period comparisons of our revenues and operating results are not necessarily meaningful, and the results for any quarter are not necessarily indicative of results for any future period. NON-GAAP FINANCIAL MEASUREMENT In evaluating our financial performance and results of operations, management reviews certain financial measures that are not in accordance with generally accepted accounting standards in the United States ("non-GAAP"). Non-GAAP measurements do not have any standardized meaning and are therefore unlikely to be comparable to similar measures presented by other companies. Management uses non-GAAP financials 59 measures in evaluating our operating performance. In light of the use by management of these non-GAAP measurements to assess our operational performance, we believe it is useful to provide information with respect to these non-GAAP measurements so as to share this perspective of management. These non-GAAP financials measures should be considered in the context with our GAAP results. A reconciliation of our non-GAAP measurements are provided below: - Our transaction fees earned from our customers trading equity securities have represented, and continue to represent, a substantial part of our revenues. GAAP requires us to add our soft dollar and commission recapture expenses and broker-dealer rebates, dollar-for-dollar, to related equity transaction fee revenues, which has a dilutive effect on our operating margins. Therefore, when evaluating our revenues from equity transactions, management reviews our net equity transaction fee revenue, based on U.S. securities and non-U.S. securities. Our net equity transaction fee revenues are calculated by subtracting the soft dollar and commission recapture expenses as well as broker-dealer rebates from the related equity transaction fees, as well as non-equity related revenues, and is calculated as follows:
YEAR ENDED DECEMBER 31, ------------------------------------ 2002 2001 2000 ---------- ---------- ---------- (IN THOUSANDS) TOTAL Transaction fee revenue, as reported............... $1,078,172 $1,424,343 $1,381,405 Less non equity related transaction fee revenue.... 11,517 10,766 2,512 Less soft dollar revenues and commission recapture expenses......................................... 217,314 220,050 180,035 Less broker-dealer rebates......................... 124,399 -- -- ---------- ---------- ---------- Net equity transaction fee revenue................. $ 724,942 $1,193,527 $1,198,858 ========== ========== ========== U.S Transaction fee revenue from U.S. equities......... $ 865,777 $1,167,155 $1,113,919 Less non equity related transaction fee revenue.... 11,517 10,766 2,512 Less soft dollar revenues and commission recapture expenses from U.S. equities...................... 159,207 161,624 120,210 Less broker-dealer rebates......................... 124,399 -- -- ---------- ---------- ---------- Net equity transaction fee revenue from U.S. equities......................................... $ 570,653 $ 994,765 $ 991,197 ========== ========== ========== U.S. REVENUE PER SHARE Average U.S. equity transaction fee revenue (per share, per side)................................. $ 0.0045 $ 0.0076 $ 0.0083 Less non equity related transaction fee revenue.... 0.0001 0.0001 -- Less soft dollar revenues and commission recapture expenses from U.S. equities...................... 0.0008 0.0011 0.0009 Less broker-dealer rebates......................... 0.0006 -- -- ---------- ---------- ---------- Average U.S. equity net transaction fee revenue (per share, per side)............................ $ 0.0030 $ 0.0065 $ 0.0074 NON-U.S Transaction fee revenue from non-U.S. equities..... $ 212,395 $ 257,188 $ 267,486 Less non equity related transaction fee revenue.... -- -- -- Less soft dollar revenues and commission recapture expenses from non-U.S equities................... 58,106 58,426 59,825 ---------- ---------- ---------- Net equity transaction fee revenue from non-U.S. equities......................................... $ 154,289 $ 198,762 $ 207,661 ========== ========== ==========
- Our expense structure includes a certain level of fixed costs, as well as a variable cost base that fluctuates with customer transaction volumes as well as share volumes. If demand for our brokerage 60 services declines and we are unable to respond by adjusting our fixed cost base, our operating results could be materially adversely affected. Therefore, we have undertaken cost reduction initiatives to reduce our fixed cost base. We estimate our fixed cost base by subtracting line items that we have determined to be predominantly variable in nature. Some of these variable line items may contain a fixed component. Similarly, some of our fixed expense line items may contain a variable component. Management does not adjust for the variable or fixed component within each line item when analyzing our fixed cost base. Our fixed cost base is calculated as follows:
YEAR ENDED DECEMBER 31, ---------------------------------------- 2002 2001 2000 ---------- -------------- ---------- (IN THOUSANDS) Total expenses, as reported...................... $1,806,130 $1,199,686 $1,108,234 Less brokerage, clearing and exchange fees....... 149,521 146,223 136,163 Less soft dollar and commission recapture expenses....................................... 217,314 220,050 180,035 Less broker-dealer rebates....................... 124,399 -- -- Less restructuring............................... 120,800 24,378 -- Less goodwill impairment......................... 551,991 -- -- Less loss of fixed assets at the World Trade Center......................................... -- 20,346 -- Less recovery of fixed assets lost............... -- (21,000) -- ---------- ---------- ---------- Total fixed costs................................ $ 642,105 $ 809,689 $ 792,036 ========== ========== ==========
REVENUES Our revenues consist of transaction fees, interest and investment income. Transaction fees accounted for the significant portion of our revenues in 2002. These fees are commission and other revenues earned on our customers' use of our various brokerage and related services, and fluctuate based upon share volumes and pricing changes. These services include ECN transaction revenues, service bureau transaction fees, market data, communication, clearing and other brokerage services. Transaction fees also include soft dollar revenues and revenues that are subject to commission recapture which offset dollar-for-dollar the expenses we incur in paying for research from independent third parties and for commission recapture payments to pension plan and other fund sponsors. ECN transaction fee revenues include commissions charged to broker-dealers who consume liquidity from our ECNs. The commissions we charge to liquidity consumers more than offset the amount we pay broker-dealers who liquidity to our ECNs. For transactions in U.S. equity securities, we generally base our fees on a per share basis. Our broker-dealer customers are subject to a fee schedule that provides for a per share amount that declines based upon pre-set volume levels. Our institutional customers pay a per share amount based upon the customer's level of usage of our services. For transactions in non-U.S. equity securities, we generally base our fees on the transaction value per trade as is customary in the international markets in which we operate, and also take into account the customer's level of trading activity. As described above under "-- Overview," we have aggressively reduced pricing for our U.S. broker-dealer customers. Clearing fees are earned on a per ticket basis. A ticket refers to one or more customer transactions grouped together for clearing purposes. In some cases, a single transaction is cleared using more than one ticket. Interest income is interest earned on the cash provided as collateral on stock borrowing transactions related to our clearing business, our interest earning assets, which primarily consist of fixed income securities, and on our cash balances. Investment income consists of realized and unrealized gains and losses, dividends and other income earned on a series of strategic alliances and long-term investments we have made in other companies, as well as realized and unrealized gains and losses from our marketable securities. 61 OPERATING EXPENSES Employee compensation and benefits expense includes salaries, incentive compensation and related employee benefits and taxes. Salaries and benefits account for just over half of our employee compensation and benefits expense. Many employees receive annual incentive compensation based on our overall operating results as well as their individual performance. As a result, a portion of this expense fluctuates based on our operating results. Some employees, such as sales employees, receive periodic incentive compensation based on new customer acquisitions and revenues. As part of our cost reduction initiatives, we have been reducing our headcount, which we expect will result in lower compensation expense in the future. Soft dollar and commission recapture expense consists primarily of expenses we incur to purchase research products from third parties for our customers in connection with our soft dollar research business, as well as commission recapture payments to pension plan and other fund sponsors. Our soft dollar and commission recapture expense fluctuates based upon the level of our customers' demand for these services and overall market transaction volumes. Broker-dealer rebates represents were commission rebates to broker-dealers who provide liquidity to our ECNs as part of our pricing incentives for broker-dealers. We charge commissions to broker-dealers who consume liquidity, which is recorded as transaction fee revenue. The commissions we charge to liquidity consumers more than offset the amount we pay to broker-dealers who provide liquidity to our ECNs. Brokerage, clearing and exchange fees include fees paid to clearing entities for clearing and settlement services, fees paid to floor brokers and exchanges for trade execution, and fees paid to third-party vendors for data processing services. These costs generally fluctuate based on transaction volumes. Communications and equipment expense consists primarily of costs for our network connections with our customers; costs for maintenance of our core network and other systems development efforts; costs for software, computers and other equipment; and fees for access to stock market data. Communications and equipment expense generally fluctuates based upon long-term trends in our business activity. Certain elements of this expense, which we incur in anticipation of certain transaction volume levels, have both a fixed and variable nature. Once we incur these expenses initially, we may not incur them going forward on a recurring, annual basis. As a result of the importance of our systems to the viability of our business, we continue to invest heavily in areas such as system capacity and reliability, increased functionality and performance, and security. We also must modify our systems from time to time to comply with various regulatory requirements, such as the SEC order handling rules, Regulation ATS and the introduction of decimalization. The expenses we incur for these modifications may vary substantially from period to period. We expect our communications and equipment expense to decrease slightly in 2003 as we leverage our improved network and systems efficiencies, as well as reduced costs from Radianz, which provides us with network communications services. See "Certain Relationships and Related Transactions." Depreciation and amortization expense results primarily from the depreciation of the fixed assets we purchase, as well as the amortization of goodwill resulting from our acquisitions. Goodwill amortization was recorded until January 1, 2002, when we adopted new accounting rules, which require that goodwill no longer be amortized to earnings. In 2002, we wrote off all of our goodwill. Occupancy expense includes the costs of leasing, furnishing and maintaining our office and operations space, primarily in the New York metropolitan area. Occupancy expense is primarily affected by increases or decreases in the number of employees and expansion or contraction of our services and related support functions. We expect these costs to decrease in 2003 as we have consolidated our office space in the New York City area. Professional fees include fees paid to consultants as well as legal and accounting fees. Marketing and business development expense consists primarily of media, print and other advertising expenses incurred to create brand awareness, promote our services and introduce new products. It also includes travel and client entertainment expenses. 62 Other expenses consist primarily of interest costs related to securities lending activities by our clearing operations, administrative expenses, provision for bad debt, interest expense related to the use of our credit facilities and borrowings from Reuters, if any, as well as other general office costs. Provision for income taxes includes taxes related to our income in each country or jurisdiction in which we operate. The difference between our effective tax rate and the U.S. statutory tax rate may differ period to period, but primarily results from state and local taxes in the U.S., foreign income taxes, valuation allowances against losses that may not be realized and the effect of certain non-deductible expenses. CRITICAL ACCOUNTING POLICIES Our accounting policies related to our strategic alliances and long term investments ("investments") and goodwill are the most critical accounting policies that requires us to make estimates and use judgments that could affect our results. INVESTMENTS Our investments are stated at estimated fair value as determined in good faith by management. Generally, we will initially value investments at cost as a proxy for fair value, and require that changes in value be established by meaningful third-party transactions or a significant impairment in the financial condition or operating performance of the issuer, unless meaningful developments occur that otherwise warrant a change in the valuation of an investment. Factors considered in valuing individual investments include, without limitation, available market prices, type of security, purchase price, purchases of the same or similar securities by other investors, marketability, restrictions on disposition, current financial position and operating results, and other pertinent information. We use our best judgment in estimating the fair value of these investments. There are inherent limitations to any estimation technique. The fair value estimates presented herein are not necessarily indicative of an amount that we could realize in a current transaction. Because of the inherent uncertainty of valuation, these estimated fair values do not necessarily represent amounts that might be ultimately realized, since such amounts depend on future circumstances, and the differences could be material. In 2002, we wrote down our investments in WR Hambrecht + Co., Archipelago Holding LLC, The Nasdaq Stock Market, Inc. and Knight Roundtable Europe Ltd., by $45.2 million, based upon management's best judgment of each investment's fair market value. GOODWILL SFAS 142 requires that management perform a detailed review of the carrying value of the Company's tangible and intangible assets. In this process, management is required to make estimates and assumptions in order to determine the fair value of the Company's assets and liabilities and projected future earnings using various valuation techniques. Management uses its best judgment and information available to it at the time to perform this review, as well as the services of an expert valuation specialist. Because management's assumptions and estimates are used in the valuation, actual results may differ. In accordance with SFAS 142, based on the results of a valuation analysis prepared by an independent specialist, we determined that our existing goodwill had been completely impaired and as a result, we recorded a pre-tax goodwill impairment loss of $552.0 million in 2002. In addition, based upon a review of the discounted cash flows of our ProTrader subsidiary, we incurred a goodwill impairment charge of $15.7 million upon our adoption of SFAS 142. See Note 2 to the consolidated financial statements for a summary of our significant accounting policies. 63 KEY STATISTICAL INFORMATION The following table presents key transaction volume information, as well as certain other operating information.
YEAR ENDED DECEMBER 31, ---------------------------------------------------------- 2002(5) 2001 2000 1999 1998 ---------- ---------- ---------- -------- -------- Total U.S. market share volume (millions)(1)(2).............................. 905,350 832,340 754,193 514,851 403,725 Our total U.S. market share volume (millions)(1)(2).............................. 97,623 76,909 66,711 41,146 33,731 Our percentage of total U.S. market share volume(1)(2).................................. 10.8% 9.2% 8.9% 8.0% 8.4% ---------- ---------- ---------- -------- -------- Nasdaq share volume (millions)(2)............... 441,586 471,216 442,752 270,108 202,040 Our Nasdaq share volume (millions)(2)........... 81,942 65,893 57,390 35,211 28,653 Our percentage of Nasdaq share volume(2)........ 18.6% 14.0% 13.0% 13.0% 14.2% ---------- ---------- ---------- -------- -------- U.S. exchange-listed share volume (millions).... 463,764 361,123 311,441 244,743 201,685 Our U.S. exchange-listed share volume (millions)(2)................................. 15,681 11,016 9,321 5,935 5,078 Our percentage of U.S. exchange-listed share volume(2)..................................... 3.4% 3.1% 3.0% 2.4% 2.5% ---------- ---------- ---------- -------- -------- Our U.S. equity transaction volume (thousands)................................... 148,415 98,346 82,437 44,902 26,800 Our international equity transaction volume (thousands)................................... 7,618 7,685 5,181 2,827 1,334 ---------- ---------- ---------- -------- -------- Our total equity transaction volume (thousands)................................... 156,033 106,031 87,618 47,729 28,134 ---------- ---------- ---------- -------- -------- Our average U.S. equity transaction size (shares per transaction).............................. 658 782 809 916 1,264 Our average equity transactions per day (thousands)................................... 619 428 348 189 112 Our average U.S. equity transaction fee revenue (per share, per side)......................... $ 0.0045 $ 0.0076 $ 0.0083 $ 0.0091 $ 0.0101 Our average U.S. net equity transaction fee revenue (per share, per side)(non-GAAP financial measure)(4)(6)...................... $ .0030 $ .0065 $ .0074 $ .0085 $ .0094 ---------- ---------- ---------- -------- -------- Our transaction fees from U.S. equities (thousands)(3)................................ $ 865,777 $1,167,155 $1,113,919 $752,613 $682,738 Our transaction fees from non-U.S. equities (thousands)(3)................................ 212,395 257,188 267,486 182,937 139,219 ---------- ---------- ---------- -------- -------- Our total equity transaction fees (thousands)(3)................................ $1,078,172 $1,424,343 $1,381,405 $935,550 $821,757 Our net transaction fees from U.S. equities (thousands)(non-GAAP financial measure)(3).... $ 570,653 $ 994,765 $ 991,197 $701,474 $633,709 Our net transaction fees from non-U.S. equities (thousands)(non-GAAP financial measure)(3).... 154,289 198,762 207,661 144,658 107,940 ---------- ---------- ---------- -------- -------- Our total net equity transaction fees (thousands)(non-GAAP financial measure)(3).... $ 724,942 $1,193,527 $1,198,858 $846,132 $741,649
--------------- (1) U.S. shares consist of shares of U.S exchange-listed and Nasdaq-quoted stocks. (2) For a description of how we calculate our Nasdaq share volumes, see -- "Nasdaq Volume Calculations" and "Calculation of Instinet ATS and Island ATS Volume Combined Volumes" (3) Our net equity transaction fee revenues are calculated by subtracting the soft dollar and commission recapture expenses and broker-dealer rebates from the related equity transaction fees. GAAP requires us to add our soft dollar and commission recapture expenses and broker-dealer rebates, dollar-for-dollar, to related equity transaction fee revenues. (4) Our average U.S. net equity transaction fee revenue is calculated by dividing our net U.S. equity transaction fee revenue for the buy and sell side of each transaction by our total U.S. share volume. (5) Island's results, subsequent to September 20, 2002, are consolidated with our results for the periods described. 64 (6) In 2002, our average U.S. net equity transaction fee revenue has fluctuated significantly as was $0.0018, $0.0025, $0.0036 and $0.0055 for the three months ended December 31, 2002, September 30, 2002, June 30, 2002 and March 31, 2002, respectively. NASDAQ VOLUME CALCULATIONS For purposes of calculating our published share volumes, we count the number of shares that are traded through us as broker once. We do not count both sides of the transaction, although we usually receive transaction fees from parties on both sides of the transaction. As a result, we treat a transaction of 10,000 shares on our system as a single 10,000 share transaction for purposes of calculating our share volumes. We use the Nasdaq share volumes published by Nasdaq as resulting from the NASD's transaction reporting rules for our calculations, including our percentage of Nasdaq share volume, where Nasdaq share volume is the denominator. Historical amounts may be restated due to updates of volume information from Nasdaq. Because of the structure of the Nasdaq market, the sale of shares by one investor and purchase of those shares by another investor can require a series of transactions, most often through one or more market makers, all of which are reported to Nasdaq and included by Nasdaq in total transaction volume. For example, in a 10,000-share purchase and sale involving two market makers, the 10,000-share sale by Investor 1 to Market Maker 1 would be reported to Nasdaq as a 10,000 share transaction by Market Maker 1. The sale in turn by Market Maker 1 of the same 10,000 shares to Market Maker 2 would also be reported to Nasdaq by Market Maker 1 as a 10, 000-share transaction. Finally, the purchase in turn of the same 10,000 shares by Customer 2 from Market Maker 2 would be reported to Nasdaq by Market Maker 2 as a third 10,000-share transaction. Total Nasdaq trading volume would thus be 30,000 shares. We could act as agency broker in any one or more of these three transactions and would count any transaction in which we acted once in our published trading volume. If, for example, we acted as broker in the transaction between Market Maker 1 and Market Maker 2, we would act as broker for both parties, but our trading volume would be a total of 10,000 shares. As another example, in a 10,000 share purchase and sale involving a single market maker, the 10,000 share sale by Investor 1 to Market Maker would be reported by Market Maker to Nasdaq as a 10,000 share transaction, and the purchase in turn by Investor 2 from Market Maker would be reported by Market Maker to Nasdaq as a second 10,000 share transaction. Total Nasdaq trading volume would thus be 20,000 shares. We could again act as agency broker in either or both of these two transactions and would count any transaction in which we acted once in our published trading volume. If, for example, we acted as broker in the transaction between Investor 1 and Market Maker, we would report our trading volume as 10,000 shares. As a final example, we (or another broker) could act as agency broker for two investors in the purchase and sale by them of 10,000 shares of a Nasdaq-quoted stock. In this case, we act as agency broker for both parties but would report a single 10,000 share transaction to Nasdaq, total Nasdaq trading volume would be 10,000 shares, and our published trading volume would be 10,000 shares. CALCULATION OF INSTINET ATS AND ISLAND ATS COMBINED VOLUMES Our two ATSs, Instinet and The Island ECN, currently operate independently; however, we disclose the volumes from our two ATSs on a combined basis. Currently, Instinet customers have the option, for certain orders, to automatically send parts of orders that cannot be filled on the Instinet system to the Island system. In calculating our combined volumes, we eliminate one side of these routed orders. 65 RESULTS OF OPERATIONS The following table sets forth our consolidated statements of income data for the periods presented as a percentage of total revenue:
YEAR ENDED DECEMBER 31, ------------------------- 2002 2001 2000 ------- ------ ------ REVENUE Transaction fees............................................ 101.8% 95.5% 96.7% Interest.................................................... 3.8% 3.3% 2.7% Investments................................................. -5.6% 1.2% 0.6% ------ ----- ----- Total revenues......................................... 100.0% 100.0% 100.0% EXPENSES Compensation and benefits................................... 26.6% 27.3% 26.6% Soft dollar and commission recapture........................ 20.5% 14.8% 12.6% Broker dealer rebates....................................... 11.7% 0.0% 0.0% Brokerage, clearing and exchange fees....................... 14.1% 9.8% 9.5% Communications and equipment................................ 11.9% 10.5% 10.0% Depreciation and amortization............................... 7.4% 5.4% 5.2% Occupancy................................................... 5.2% 3.3% 2.5% Professional fees........................................... 2.3% 2.7% 6.3% Marketing and business development.......................... 1.6% 1.5% 2.3% Other....................................................... 5.6% 3.7% 2.6% Goodwill impairment......................................... 52.1% 0.0% 0.0% Restructuring............................................... 11.4% 1.6% 0.0% Loss of fixed assets and World Trade Center................. 0.0% 1.4% 0.0% Recovery of fixed assets lost............................... 0.0% -1.4% 0.0% ------ ----- ----- Total expenses......................................... 170.5% 80.5% 77.6% Income/(loss) from continuing operations before income taxes, and cumulative effect of change in accounting principle................................................. -70.5% 19.5% 22.4% Income tax provision/(benefit).............................. -5.0% 8.2% 9.5% ------ ----- ----- Income/(loss) from continuing operations before cumulative change in accounting principle......................... -65.5% 11.3% 12.9% Discontinued operations: Loss from operations of fixed income business............. -3.2% -2.6% 3.9% Income tax benefit........................................ 1.0% 1.0% -1.4% ------ ----- ----- Income before cumulative effect of change in accounting principle................................................. -67.7% 9.7% 10.4% Cumulative effect of change in accounting principle, net of tax....................................................... -1.8% 0.0% 0.0% ------ ----- ----- NET INCOME/(LOSS)...................................... -69.4% 9.7% 10.4% ====== ===== =====
DECEMBER 31, 2002 VERSUS DECEMBER 31, 2001 Overview Net income decreased from $144.8 million for 2001 to a net loss of $735.2 million for 2002 primarily due to a $552.0 million charge for goodwill impairment, a restructuring charge and a write down in our investments. 66 Our revenues decreased 29.0% from $1.5 billion for 2001 to $1.1 billion for the comparable period in 2002, primarily as a result of lower average pricing, which more than offset revenues related to our increased share volumes and acquisition of Island. Expenses increased 50.6% from $1.2 billion for 2001 to $1.8 billion for 2002. Our expenses for 2002 included a goodwill impairment charge of $552.0 million and restructuring charges of $120.8 million. Our expenses for 2001 included a restructuring charge of $24.4 million. Excluding these charges (a non-GAAP financial measurement), our expenses decreased 3.6% from $1.2 billion in 2001 to $1.1 billion for 2002. In addition, Island contributed $60.3 million of expenses in 2002. Revenues Transaction fee revenue decreased 24.3% from $1.4 billion in 2001 to $1.1 billion in 2002. Transaction fee revenue excluding revenues directly related to soft dollar and commission recapture as well as broker-dealer rebates, declined 39.3% from $1.2 billion in 2001 to $724.9 million in 2002. These decreases were primarily due to a decline in average pricing as a result of our pricing changes. Our average transaction fee revenue per U.S. share, decreased 40.8% from $0.0076 in 2001 to $0.0045 in 2002. Our average net transaction fee revenue per U.S. share (a non-GAAP financial measure), which excludes revenues directly related to soft dollar and commission recapture as well as broker-dealer rebates, decreased 53.8% from $0.0065 in 2001 to $0.0030 in 2002. On a quarterly basis, our average net U.S. equity transaction fee revenue has fluctuated significantly and was $0.0018, $0.0025, $0.0036 and $0.0055 for the three months ended December 31, 2002, September 30, 2002, June 30, 2002 and March 31, 2002, respectively. Primarily due to the acquisition of Island in September 2002, our various pricing changes, and the introduction of our broker-dealer rebates, we increased our trading volumes and market share in Nasdaq quoted and U.S. exchange-listed stocks between 2001 and 2002, however, the decrease in our average pricing more than offset the effect of the increases in our trading volumes. Our trading volumes in Nasdaq-quoted stocks increased 24.4% and our trading volumes in U.S exchange-listed stocks increased 42.3% in 2002, compared to 2001. Island contributed 90.8% or 14.6 billion shares, of the increase in Nasdaq-quoted stocks and 50.3% or 2.3 billion shares, of the increase in U.S. exchange-listed stocks. Our share of volume in Nasdaq-quoted stocks, while fluctuating during the period, increased from 14.0% in 2001 to 18.6% in 2002, and our share of volume in U.S. exchange-listed stocks increased from 3.1% in 2001 to 3.4% in 2002. Our Instinet ATS alone accounted for 15.3% of the total trading volume in the Nasdaq quoted stocks for 2002. Following our acquisition of Island, our two ATSs accounted for 29.7% of the total trading volume in Nasdaq-quoted stocks for the three months ended December 31, 2002. Our average number of transactions per day in Nasdaq-quoted and U.S. exchange-listed stocks decreased 15.9% from 782,025 in 2001 to 657,771 in 2002. Our soft dollar revenues and our revenues that are subject to commission recapture, which are offset dollar-for-dollar by our soft dollar research payments and commission recapture expenses, decreased 1.2% from $220.1 million in 2001 to $217.3 million in 2002, primarily due to a decrease in our soft dollar revenues due to reduced use of this service partly offset by increased use of the commission recapture services provided by our Lynch, Jones and Ryan subsidiary. Our transaction fee revenue earned from U.S. equity transactions decreased 25.8% from $1.2 billion in 2001 to $865.8 million in 2002. Our transaction fee revenue earned from non-U.S. equities declined 17.4% from $257.2 million in 2001 to $212.4 million in 2002. This amount represented 18.1% of our total equity transaction fee revenue in 2001, and 19.7% in 2002. Our net transaction fee revenue earned from U.S. equity transactions (a non-GAAP financial measurement), which excludes revenues directly related to soft dollar and commission recapture and broker-dealer rebates, decreased 42.6% from $994.8 million in 2001 to $570.7 million in 2002 due to the decrease in our average pricing resulting from lower rates for U.S. broker-dealer customers following the price reductions we initiated for this group in March 2002. Our net transaction fee revenue earned from non-U.S. equities (a non-GAAP financial measurement), which excludes revenues directly related to soft dollar and commission recapture and broker-dealer rebates, declined 22.4% from $198.8 million in 2001 to $154.3 million in 2002. This amount represented 16.7% of our total net equity transaction fee revenue in 2001, and 21.3% in 2002. This increase was primarily due to a greater decrease in 67 our U.S. net equity transaction fees as a result of our price changes versus our non-U.S. net equity transaction fees. Interest revenue decreased 18.6% from $49.3 million in 2001 to $40.1 million in 2002. This decrease was primarily due to a decrease in interest rates, which affects the revenue generated by our stock borrowing activities related to our clearing services, as well as a decrease in our interest bearing cash and cash equivalents. Investments revenue decreased from a gain of $17.4 million in 2001 to a loss of $59.1 million in 2002. The loss was primarily due to write downs of $45.2 million where management made a determination that the fair value of investments was impaired and $12.1 million for investments accounted for under the equity method, offset by gains on our securities owned, including $2.7 million on our sale of shares in the Toronto Stock Exchange upon its demutualization and initial public offering in November 2002. Expenses Compensation and benefits expense decreased 30.7% from $406.3 million in 2001 to $281.8 million in 2002. This decrease was primarily due to a decrease in our worldwide headcount, particularly in our U.S. offices, the closure of our fixed income business as part of our cost reduction initiatives, as well as a decline in incentive compensation due to our lower revenues. Our average headcount was 2,083 in 2001 and 1,672 in 2002. Our total headcount decreased from 2,132 employees as of December 31, 2001 to 1,474 employees (including 133 employees from Island) as of December 31, 2002. In addition, employees have also been given incentives through the issuance of stock options. The Company's policy is not to reflect an expense for stock options granted to employees. Soft dollar and commission recapture expense decreased 1.2% from $220.1 million in 2001 to $217.3 million in 2002. This expense is offset dollar-for-dollar by soft dollar revenues and revenues that are subject to commission recapture. This decrease was primarily due to a decrease in our soft dollar costs due to lower volumes partly offset by expanded use of our commission recapture services offered by our Lynch Jones & Ryan subsidiary. Broker-dealer rebates were $124.4 million in 2002. As noted above, as part of our pricing incentives for broker-dealers, we now offer commission rebates to broker-dealers who provide liquidity, which is recorded as an expense, and charge commissions to broker-dealers who consume liquidity, which is recorded as transaction fee revenue. The commissions we charge to liquidity consumers more than offset the amount we pay to broker-dealers who provide liquidity to our ECNs. Brokerage, clearing and exchange fees increased 2.3% from $146.2 million in 2001 to $149.5 million in 2002. This increase was due to higher brokerage and exchange fees as a result of our new order routing technology (which allows us to route trades to other ECNs, which in turn, charge us fees for this service), our acquisition of Island and fees charged to our ProTrader subsidiary. Partly offsetting these increases were a reduction in our regulatory fees and lower U.S. clearing costs as a result of implementing certain technology efficiencies, such as trade compression. Communications and equipment expense decreased 19.4% from $156.0 million in 2001 to $125.7 million in 2002. This decrease was due in large part to lower core communications costs, which decreased 23.1% from $77.9 million in 2001 to $62.8 million in 2002, reflecting the benefit of improved network and systems efficiencies. Our equipment and software costs for upgrading our existing systems and other enhancements decreased 21.2% from $38.0 million in 2001 to $30.0 million in 2002 primarily due to decreased spending in this area. Our exchange data access charges also decreased 19.7% from $19.8 million in 2001 to $15.9 million, primarily due to the sale of our Research and Analytics product to Reuters in September 2001. Depreciation and amortization expense decreased 2.9% from $80.8 million in 2001 to $78.4 million in 2002. This decrease was primarily due a reduction in depreciation of our capitalizable assets, which decreased as part of our cost reduction initiatives, offsetting a slight increase due to our acquisition of Island. In addition, we ceased amortizing goodwill as a result of our adoption of SFAS 142 on January 1, 2002. Offsetting this 68 decrease in goodwill amortization was amortization related to our intangible assets, which we acquired in connection with our acquisition of Island and ProTrader. Occupancy expense increased 11.2% from $49.9 million in 2001 to $55.5 million in 2002, primarily due to increased property insurance, maintenance and one time costs associated with our move to new corporate headquarters in New York and our acquisition of Island. Partly offsetting these increases was a decrease in rent expense due to consolidation of our office space in the New York metropolitan area. Professional fees decreased 38.5% from $40.0 million in 2001 to $24.6 million in 2002. This decrease was primarily due to reduced use of technical and management consultants, partly offset by an increase in our legal expenses and our acquisition of Island. Marketing and business development decreased 22.8% from $22.1 million in 2001 to $17.1 million in 2002. This decrease was due to a scaling back of our branding campaign as a result of our cost reduction initiatives. Other expenses increased 8.2% from $54.5 million in 2001 to $59.0 million in 2002. This increase was primarily due to an increase in our provision for bad debts due to loans we made, payments to Reuters in connection with the sale of our R&A product in order to allow our customers to receive this service and support from Reuters instead of us, and interest costs related to our securities lending and other clearing activities. Partly offsetting these increases were decreases in our travel expenses as part of our cost reduction initiatives, a one-time refund of value added tax previously paid to certain non-U.S. tax authorities and interest expense related to a loan Reuters provided to us to fund our acquisition of Lynch Jones & Ryan in February 2000. This loan was repaid in June 2001. Provision for Income Taxes Our tax provision on income/(loss) from continuing operations decreased from a charge of $122.2 million in 2001 to a benefit of $53.1 million in 2002 as a result of our loss from continuing operations before income taxes and cumulative effect of change in accounting principle. Our effective income tax rate decreased from 41.9% in 2001 to 7.11% in 2002. This decrease resulted from the permanent impairment of goodwill that was not deductible for tax purposes, restructuring charges, write-down in our investments, operating losses in tax jurisdictions where utilization of tax losses is doubtful and other valuation allowances. Cumulative Effect of Change in Accounting Principle The cumulative effect of a change in accounting principle related to goodwill, net of tax, was $18.6 million in 2002. We adopted SFAS 142 on January 1, 2002. SFAS 142 requires that goodwill no longer be amortized to earnings, but instead be reviewed for impairment. Impairment is deemed to exist when the carrying value of goodwill exceeds its implied fair value. This methodology differs from our previous policy, as permitted under accounting standards existing before SFAS 142, of using undiscounted cash flows of the businesses acquired over its estimated life. Upon adoption of SFAS 142, we incurred goodwill impairment before tax of $15.7 million related to our acquisition of ProTrader and $3.3 million related to our acquisition of Montag Popper & Partner GmbH, a fixed income broker-dealer in Germany. Decreased customer transaction volumes led to operating losses, closure of several trading offices and restructuring of our ProTrader subsidiary. In addition, after a review of market conditions we determined our fixed income operations could not reach critical mass and therefore the carrying value of goodwill related to our acquisition of Montag was impaired and written off. DECEMBER 31, 2001 VERSUS DECEMBER 31, 2000 Overview Net income decreased 2.3% from $148.2 million in 2000 to $144.8 million in 2001. Our revenues grew 4.4% from $1.4 billion in 2000 to $1.5 billion in 2001 primarily as a result of increased U.S. trading volumes in the first half of 2001, notwithstanding the effects of the market closures from the events of September 11. This growth offset a 4.3% decline in our net transaction fee revenue earned from our customers trading non-U.S. 69 equities primarily as a result of declines in share prices in non-U.S. securities markets despite our increased volumes in those markets. Our revenues from trading outside the United States are determined on the basis of the value of transactions, rather than the number of shares traded. This revenue growth was offset by the 8.3% increase in expenses from $1.1 billion in 2000 to $1.2 billion in 2001. This increase in expenses was primarily due to increased expenses related to our soft dollar and commission recapture businesses as a result of increased customer demand for this service, higher compensation and benefits expense and a restructuring charge related to our cost reduction initiatives, offset by a reduction in our professional fees and marketing and business development expenses. Expenses increased despite a decrease in our business development costs in connection with our efforts to expand and diversify our activities. Our expenses related to the creation of a retail brokerage capability decreased from $56.6 million in 2000 to $4.7 million in 2001. Included in the 2000 and 2001 amounts are restructuring charges of $7.5 million and $4.0 million, respectively. All charges related to our change in strategy related to our retail brokerage capability were incurred as of March 31, 2001. Our loss from the discontinued operations of our fixed income business decreased from $55.6 million in 2000 to 39.1 million in 2001. Revenues Transaction fee revenue increased 3.1% from $1.38 billion in 2000 to $1.42 billion in 2001. This increase was due to higher trading volumes primarily in the first half of 2001 both domestically and internationally, reflecting growth in trading volumes in the global securities markets. Our soft dollar revenues and our revenues that are subject to commission recapture, which are offset dollar-for-dollar by our soft dollar research payments and commission recapture expenses, increased 22.2% from $180.0 million in 2000 to $220.1 million in 2001 primarily a result of increased customer demand for our soft dollar services as well as our purchase of Lynch, Jones & Ryan in February 2000. Our transaction fee revenue earned from non-U.S. equities declined 3.8% from $267.5 million in 2000 to $257.2 million in 2001. This amount represented 19.4% of our total equity transaction fee revenue in 2000, and 18.1% in 2001. Our net transaction fee revenue earned from non-U.S. equities (a non-GAAP financial measurement), which excludes revenues directly related to soft dollar and commission recapture, declined 4.3% from $207.7 million in 2000 to $198.8 million in 2001. This amount represented 17.3% of our total net equity transaction fee revenue in 2000, and 16.7% in 2001. This decrease was primarily due to declines in share prices in non-U.S. securities markets despite our increased transaction volumes in those markets. Our revenues from trading outside the United States are determined on the basis of the value of transactions, rather than the number of shares traded. Our trading volumes in Nasdaq-quoted and U.S. exchange-listed stocks increased 14.8% and 18.2%, respectively, primarily in the first half of 2001. Our share of volume in Nasdaq-quoted stocks increased from 13.0% in 2000 to 14.0% in 2001, and our share of volume in U.S. exchange-listed stocks increased from 3.0% in 2000 to 3.1% in 2001. Our average number of transactions in Nasdaq-quoted and U.S. exchange-listed stocks per day increased 23.0% from 347,690 in 2000 to 427,544 in 2001. Interest revenue increased 29.7% from $38.0 million in 2000 to $49.3 million in 2001. This increase was primarily due to revenue generated by our clearing services, as well as interest from our fixed income investments and higher cash balances as a result of our initial public offering in May 2001. Investment income increased 91.9% from $9.1 million in 2000 to $17.4 million in 2001. This increase was primarily due to mark-to-market gains of $18.6 million in shares we own in the Euronext, London and Hong Kong stock exchanges as a result of their demutualizations, as well as unrealized gains of $0.9 million on our fixed income investments. Partly offsetting these gains was a net write-down of $1.6 million related to our strategic alliances and long-term investments. We wrote-up our investment in Archipelago by a net amount of $16.9 million due to the November 2001 merger announcement between Archipelago and REDIBook and based on valuations of independent third parties involved in this transaction. Offsetting this gain was a net write-down of $17.7 million of our strategic alliances and long-term investments in businesses which are in the 70 area of capital raising, in particular WR Hambrecht + Co. and Vencast. In accordance with our accounting policy, we initially value investments at cost as a proxy for fair value and require that changes in value be established by meaningful third-party transactions or a significant impairment in the issuer. Expenses Compensation and benefits expense increased 7.1% from $379.3 million in 2000 to $406.3 million in 2001. This increase was primarily due to higher salary costs partly offset by a decrease in our incentive compensation. Our headcount increased in 2001 as compared to the comparable period in 2000, reaching 2,123 employees as of March 31, 2001, but then declining as of December 31, 2001 to 1,852 employees as part of our cost reduction initiatives, excluding the effect of our ProTrader acquisition in October 2001 and our discontinued fixed income business. As of December 31, 2001, after giving effect to the ProTrader acquisition, our employee headcount was 2,132. Our acquisition of ProTrader contributed to the increase in our compensation and benefits expense as a percentage of revenues from 26.6% in 2000 to 27.3% in 2001. Soft dollar and commission recapture expense increased 22.2% from $180.0 million in 2000 to $220.1 million in 2001. This expense is offset dollar-for-dollar by soft dollar revenues and revenues that are subject to commission recapture. This increase was primarily due to our acquisition of Lynch, Jones & Ryan in February 2000, as well as an increase in the overall use of our soft dollar services by our customers and increased market transaction volumes. Primarily as a result of our purchase of Lynch, Jones & Ryan, this expense increased as a percentage of our revenues from 12.6% in 2000 to 14.8% in 2001. Brokerage, clearing and exchange fees increased 7.4% from $136.2 million in 2000 to $146.2 million in 2001. This increase resulted from higher domestic and international brokerage and exchange fees as well as higher domestic clearing fees primarily due to an increase in the number of transactions. Partly offsetting this increase was a decrease in our international clearing fees due to lower rates charged by our clearing banks. Primarily as a result of higher brokerage and exchange fees, as a percent of revenue brokerage, clearing and exchange fees increased from 9.5% in 2000 to 9.8% in 2001. Communications and equipment expense increased 8.9% from $143.2 million in 2000 to $156.0 million in 2001. This increase was due in large part to higher costs related to our core communications, which increased 40.3% from $58.2 million in 2000 to $81.6 million in 2001. Of this amount, $58.7 million related to network communications services that Radianz began providing to us in June 2000. We outsourced these services and transferred employees to Radianz at that time. In addition, our office communication expense increased 35.4% from $10.9 million in 2000 to $14.8 million in 2001 primarily due to the move to our new corporate headquarters. Partly offsetting these increases was a decrease in our equipment, hardware and software costs for upgrading our existing systems. These costs decreased 13.9% from $44.2 million in 2000 to $38.0 million in 2001, reflecting the benefit of improved network and systems efficiencies. Our exchange data access charges also decreased primarily due to the sale of R&A to Reuters in the fourth quarter of 2001. Primarily as a result of increased core communications costs, communications and equipment expense increased as a percentage of our revenues from 10.0% in 2000 to 10.5% in 2001. Depreciation and amortization expense increased 8.9% from $74.2 million in 2000 to $80.8 million in 2001. This increase was primarily due to an increase in depreciation as a result of our additional purchases of fixed assets and amortization of leasehold improvements, in connection with our move to our new corporate headquarters in New York. As a percentage of our revenues, depreciation and amortization expense increased from 5.2% in 2000 to 5.4% in 2001. Occupancy expense increased 38.9% from $35.9 million in 2000 to $49.9 million in 2001. This increase was primarily due to higher lease payments and related expenses for our new corporate headquarters in New York. Professional fees decreased 55.7% from $90.2 million in 2000 to $40.0 million in 2001. This decrease was primarily due to reduced use of technical and management consultants as a result of our cost reduction initiatives, as well as reduced legal expenses. These fees were higher in 2000 as we were preparing for our reorganization and initial public offering. A total of $20.4 million of the decrease in professional fees was 71 attributable to reduced use of consultants for the creation of a retail brokerage capability and for our fixed income business. Professional fees decreased as a percentage of our revenues from 6.3% in 2000 to 2.7% in 2001. Marketing and business development expense decreased 31.1% from $32.1 million in 2000 to $22.1 million in 2001. This decrease was due primarily to a decreased level of advertising as a result of our cost reduction initiatives as well as the change in strategy related to our retail brokerage capability. Other expenses increased 47.1% from $37.1 million in 2000 to $54.5 million in 2001. This increase was primarily due to our interest costs related to our securities lending activities, allowance for doubtful accounts, payments to Reuters in connection with our sale of our R&A product in order to allow customers to continue to receive this service and support from Reuters instead of us, and our charitable donations and other costs associated with the events of September 11. Partly offsetting this increase was a decrease in our travel costs as a result of our cost reduction initiatives. Loss of fixed assets at World Trade Center and recovery of fixed assets lost relates to losses of $20.4 million we incurred in our offices at the World Trade Center as a result of the events of September 11. We recovered $21.0 million from our insurance carrier. Provision for Income Taxes Our tax provision decreased 10.1% from $136.0 million in 2000 to $122.2 million in 2001. Our effective income tax rate decreased from 42.5% in 2000 to 41.9% in 2001. The reduction in the rate for 2001 is primarily due to lower state and local income taxes. QUARTERLY RESULTS The following tables set forth certain unaudited consolidated quarterly statement of income data, both in dollar amounts and as a percentage of total revenues, and certain unaudited consolidated quarterly operating data for the eight quarters ended December 31, 2001. In our opinion, this unaudited information has been prepared on substantially the same basis as the consolidated financial statements appearing elsewhere in this annual report and includes all adjustments (consisting of normal recurring adjustments) necessary for a fair statement of the unaudited consolidated quarterly data. The unaudited consolidated quarterly data should be read together with the consolidated financial statements and related notes included elsewhere in this annual report. The results for any quarter are not necessarily indicative of results for any future period.
QUARTER ENDED ---------------------------------------------------------------------------------------- DEC. 31, SEPT. 30, JUNE 30, MAR. 30, DEC. 31, SEPT. 30, JUNE 30, MAR. 30, 2002 2002 2002 2002 2001 2001 2001 2001 --------- --------- -------- -------- -------- --------- -------- -------- REVENUE Transaction fees........ $ 278,441 $ 263,917 $269,933 $265,881 $319,219 $311,737 $378,891 $414,496 Interest................ 8,546 10,699 11,958 8,934 11,562 14,254 11,199 12,281 Investments............. (19,878) (20,336) (13,181) (5,714) 17,817 (6,330) 3,689 2,212 --------- --------- -------- -------- -------- -------- -------- -------- Total revenues...... 267,109 254,280 268,710 269,101 348,598 319,661 393,779 428,989 EXPENSES Compensation and benefits.............. 60,745 63,809 70,989 86,218 83,996 84,820 112,735 124,797 Soft dollar and commission recapture............. 50,161 51,824 61,738 53,591 58,174 51,595 54,228 56,053 Broker-dealer rebates... 56,601 39,004 25,503 3,291 -- -- -- -- Brokerage, clearing and exchange fees......... 36,994 42,079 33,767 36,681 40,364 33,284 36,185 36,390 Communications and equipment............. 36,604 26,620 29,187 33,309 32,872 36,939 42,560 43,631
72
QUARTER ENDED ---------------------------------------------------------------------------------------- DEC. 31, SEPT. 30, JUNE 30, MAR. 30, DEC. 31, SEPT. 30, JUNE 30, MAR. 30, 2002 2002 2002 2002 2001 2001 2001 2001 --------- --------- -------- -------- -------- --------- -------- -------- Depreciation and amortization.......... 24,659 16,712 17,930 19,123 21,269 21,206 19,669 18,610 Occupancy............... 16,158 12,223 13,595 13,552 11,587 14,424 13,796 10,111 Professional fees....... 7,820 5,110 6,646 5,018 7,880 8,085 9,012 15,013 Marketing and business development........... 3,756 2,451 7,480 3,407 2,739 843 8,477 10,084 Other................... 16,559 9,899 16,852 15,674 13,742 14,312 13,545 12,935 Restructuring........... 62,405 955 42,410 15,030 1,557 22,821 -- -- Goodwill impairment..... -- 551,991 -- -- -- -- -- -- Loss of fixed assets at the World Trade Center................ -- -- -- -- 818 19,528 -- -- Insurance recovery of fixed assets lost..... -- -- -- -- (1,472) (19,528) -- -- --------- --------- -------- -------- -------- -------- -------- -------- Total expenses...... 372,462 822,677 326,097 284,894 273,526 288,329 310,207 327,624 Income/(loss) from continuing operations before income taxes and cumulative effect of change in accounting principle............. (105,353) (568,397) (57,387) (15,793) 75,072 31,332 83,572 101,365 Income tax provision/(benefit)... 6,690 (39,958) (14,117) (5,703) 26,662 15,685 36,198 43,665 --------- --------- -------- -------- -------- -------- -------- -------- Income/(loss) from continuing operations before cumulative effect of change in accounting principle............. (112,043) (528,439) (43,270) (10,090) 48,410 15,647 47,374 57,700 Discontinued operations: Loss from operations of fixed income business............ (412) -- (23,581) (9,775) (4,535) (11,871) (10,841) (11,886) Income tax benefit.... 252 -- 6,946 3,824 1,844 4,434 4,197 4,294 --------- --------- -------- -------- -------- -------- -------- -------- Income before cumulative effect of change in accounting principle............. (112,203) (528,439) (59,905) (16,041) 45,719 8,210 40,730 50,108 Cumulative effect of change in accounting principle, net of tax................... -- -- -- (18,642) -- -- -- -- --------- --------- -------- -------- -------- -------- -------- -------- NET INCOME/(LOSS)... $(112,203) $(528,439) $(59,905) $(34,683) $ 45,719 $ 8,210 $ 40,730 $ 50,108 ========= ========= ======== ======== ======== ======== ======== ======== OPERATING DATA: Total U.S. market share volume (millions)..... 228,692 239,100 225,445 212,113 220,876 180,711 208,587 222,389 Our total U.S. market share volume (millions)............ 36,771 26,471 19,221 15,160 17,229 15,550 21,389 22,742 Our percentage of total U.S. market share volume................ 16.1% 11.1% 8.5% 7.1% 7.8% 8.6% 10.3% 10.2%
73 The following data sets forth as a percentage of revenue certain unaudited consolidated quarterly income data.
QUARTER ENDED --------------------------------------------------------------------------------------- DEC. 31, SEPT. 30, JUNE 30, MAR. 30, DEC. 31, SEPT. 30, JUNE 30, MAR. 30, 2002 2002 2002 2002 2001 2001 2001 2001 -------- --------- -------- -------- -------- --------- -------- -------- REVENUE Transaction fees........................ 104.2% 103.8% 100.5% 98.8% 91.6% 97.5% 96.2% 96.6% Interest................................ 3.2% 4.2% 4.5% 3.3% 3.3% 4.5% 2.8% 2.9% Investments............................. -7.4% -8.0% -4.9% -2.1% 5.1% -2.0% 0.9% 0.5% ----- ------ ----- ----- ----- ----- ----- ----- Total revenues...................... 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% EXPENSES Compensation and benefits............... 22.7% 25.1% 26.4% 32.0% 24.1% 26.5% 28.6% 29.1% Soft dollar and commission recapture.... 18.8% 20.4% 23.0% 19.9% 16.7% 16.1% 13.8% 13.1% Broker-dealer rebates................... 21.2% 15.3% 9.5% 1.2% 0.0% 0.0% 0.0% 0.0% Brokerage, clearing and exchange fees... 13.8% 16.5% 12.6% 13.6% 11.6% 10.4% 9.2% 8.5% Communications and equipment............ 13.7% 10.5% 10.9% 12.4% 9.4% 11.6% 10.8% 10.2% Depreciation and amortization........... 9.2% 6.6% 6.7% 7.1% 6.1% 6.6% 5.0% 4.3% Occupancy............................... 6.0% 4.8% 5.1% 5.0% 3.3% 4.5% 3.5% 2.4% Professional fees....................... 2.9% 2.0% 2.5% 1.9% 2.3% 2.5% 2.3% 3.5% Marketing and business development...... 1.4% 1.0% 2.8% 1.3% 0.8% 0.3% 2.2% 2.4% Other................................... 6.2% 3.9% 6.3% 5.8% 3.9% 4.5% 3.4% 3.0% Restructuring........................... 23.4% 0.4% 15.8% 5.6% 0.4% 7.1% 0.0% 0.0% Goodwill impairment..................... 0.0% 217.1% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% Loss of fixed assets at WTC............. 0.0% 0.0% 0.0% 0.0% 0.2% 6.1% 0.0% 0.0% Insurance recovery of fixed assets at WTC................................... 0.0% 0.0% 0.0% 0.0% -0.4% -6.1% 0.0% 0.0% ----- ------ ----- ----- ----- ----- ----- ----- Total expenses...................... 139.4% 323.5% 121.4% 105.9% 78.5% 90.2% 78.8% 76.4% Income/(Loss) from continuing operations before income taxes and cumulative effect of change in accounting principle............................. -39.4% -223.5% -21.4% -5.9% 21.5% 9.8% 21.2% 23.6% Income tax provision/(benefit).......... 2.5% -15.7% -5.3% -2.1% 7.6% 4.9% 9.2% 10.2% ----- ------ ----- ----- ----- ----- ----- ----- Income/(loss) from continuing operations before cumulative effect of change in accounting principle... -41.9% -207.8% -16.1% -3.7% 13.9% 4.9% 12.0% 13.5% Discontinued operations: Loss from operations of fixed income business............................ -0.2% 0.0% -8.8% -3.6% -1.3% -3.7% -2.8% -2.8% Income tax benefit.................... 0.1% 0.0% 2.6% 1.4% 0.5% 1.4% 1.1% 1.0% ----- ------ ----- ----- ----- ----- ----- ----- Income before cumulative effect of change in accounting principle........ -42.0% -207.8% -22.3% -6.0% 13.1% 2.6% 10.3% 11.7% Cumulative effect of change in accounting principle, net of tax...... 0.0% 0.0% 0.0% -6.9% 0.0% 0.0% 0.0% 0.0% ----- ------ ----- ----- ----- ----- ----- ----- NET INCOME/(LOSS)................... -42.0% -207.8% -22.3% -12.9% 13.1% 2.6% 10.3% 11.7% ===== ====== ===== ===== ===== ===== ===== =====
We have experienced, and expect to continue to experience, significant fluctuations in quarterly operating results as a result of a variety of factors, including: - trading volumes; - impact of competition; 74 - changes in pricing; - changes in interest rates; - changes in foreign currency rates; - changes in regulations; - our ability to manage personnel and process trading activity; - the amount and timing of capital expenditures; - the incurrence of costs associated with acquisitions; - general economic conditions; and - seasonality. Our expense structure includes a certain level of fixed costs, as well as a variable cost base that fluctuates with customer transaction volumes. In addition, we incur certain costs in anticipation of certain transaction volume levels. If demand for our brokerage services should decline suddenly (as has occurred in the past) and we may be unable to adjust our fixed cost base on a timely basis, which could have a material adverse effect on our operating results and financial condition. In addition, we may continue to make significant expenditures related to technological innovations over long periods of time, so that our operating margins and profitability could be adversely affected. Due to all of the foregoing factors, period-to-period comparisons of our revenues and operating results are not necessarily meaningful, and these comparisons cannot be relied upon as indicators of future performance. In addition, we cannot assure you that we will be able to achieve the rates of revenue growth that we have experienced in the past, that we will be able to improve our operating results or that we will be able to achieve profitability on a quarterly basis. See "Certain Factors that May Affect Our Business." LIQUIDITY AND CAPITAL RESOURCES We finance our business primarily through cash generated by our operating activities. In addition, we have access to a number of credit facilities, although our borrowings under these facilities have been traditionally low. Our financial liquidity is primarily determined by the performance of our business and partly by the return on our investments. We maintain a highly liquid balance sheet that can fluctuate significantly between financial statement dates. Our cash equivalents and securities owned are primarily comprised of highly liquid investments that can be sold in the secondary market, if necessary. We currently anticipate that our existing cash resources and credit facilities, will be more than sufficient to meet our anticipated working capital, capital expenditures and regulatory capital requirements, operating losses, restructuring charges as well as other anticipated requirements for at least the next twelve months. To the extent that overall market volumes and our trading volumes decrease beyond certain levels, we may be required to obtain additional financing from third parties or Reuters. We received net proceeds of $486.9 million during our initial public offering in 2001. We used $150.0 million of these proceeds to repay our indebtedness to Reuters, $100.0 million in connection with our acquisition of ProTrader in October 2001 and used the remaining proceeds to pay a portion of a special dividend of $248.7 million in connection with our acquisition of Island in September 2002. Cash and cash equivalents, together with assets readily convertible into cash, accounted for 67.7%, 65.8% and 66.2% of our assets as of December 31, 2000, 2001 and 2002, respectively. Cash and cash equivalents decreased to $275.8 million as of December 31, 2002 from $703.7 million as of December 31, 2001, primarily due to our dividend payment of $248.7 million in connection with our acquisition of Island, decreases in our securities owned and purchases of fixed assets and leasehold improvements. Decreases in our payables to broker-dealers and payables to customers and increases in securities borrowed were partly offset by a decrease in our receivables from broker-dealers. Cash and cash equivalents increased to $703.7 million as of December 31, 2001 from $415.2 million as of December 31, 2000 primarily due to the $486.9 million of net 75 proceeds we received from our initial public offering in May 2001, as well as increases in our securities loaned. This increase was offset in part by an increase in our securities segregated under federal regulations and securities borrowed. The increase in our securities borrowed and loaned, as well as securities segregated under federal regulations relates to our clearing business. Assets readily convertible into cash consist primarily of the following components as set forth on our Statement of Financial Condition: - Receivables from broker-dealers principally represent amounts due on securities transactions that have not been completed as of the settlement date. The settlement date generally occurs within three business days of the trade date for U.S. securities transactions, but can take as long as 30 days for non-U.S. equity transactions. - Receivables from customers principally represent customer debit balances and amounts due on securities transactions that have not been completed as of the settlement date. - Commissions receivable represent commissions (transaction fees) principally from broker-dealers. - Securities owned consist principally of U.S. government and agency securities, municipal bonds and corporate bonds in which we invest our excess cash. For the purpose of this calculation, we have excluded the shares we own in various stock exchanges. - Securities borrowed represent the amount of collateral deposited with brokers securing marketable equity securities borrowed by us in connection with covering customer securities transactions in our clearing business. Changes in our total assets and liabilities, in particular, receivable from broker-dealers and customers, securities borrowed, and commissions receivable and payable to broker-dealers and customers, generally lead to large fluctuations in our cash flows from operating activities from period to period and within periods. Capital expenditures in 2000, 2001 and 2002 related to the purchase of data processing and communications equipment, leasehold improvements and purchases of furniture for our additional office facilities. We incurred losses of approximately $20.3 million in 2001 related to fixed assets at our offices in the World Trade Center, as a result of the events of September 11. We recovered $21.0 million in 2001 from our insurance carrier. Capital expenditures and investments in new technology were financed primarily through income from operations. Additionally, we made cash payments or acquired cash in excess of net assets of $26.0 in 2002 in connection with our acquisition of Island and ProTrader, $71.2 million in October 2001 and $5.3 million in January 2002 in connection with our acquisition of ProTrader and $48.5 million in February 2000 in connection with our acquisition of Lynch, Jones & Ryan. Historically, acquisitions of new businesses had generally been funded through subordinated borrowings from Reuters. Since our initial public offering, acquisitions have generally been funded from the proceeds from our initial public offering, cash generated by our operations or through issuance of our common stock. We also repurchased $1.5 million of our common stock in 2002 to satisfy future conversions of restricted stock units into common stock under our Restricted Stock Unit plan. We received $1.4 million related to the issuance of our common stock to satisfy options exercised during 2002. Lastly, we paid a $248.7 million special dividend in 2002 in connection with our acquisition of Island. 76 Our future cash payments associated with contractual obligations, which are primarily leases for office space and equipment under non-cancelable operating leases with third parties and Reuters, are summarized as follows:
Year ending December 31, 2003............................... $ 36.3 million Year ending December 31, 2004............................... $ 30.5 million Year ending December 31, 2005............................... $ 26.7 million Year ending December 31, 2006............................... $ 24.9 million Year ending December 31, 2007............................... $ 24.1 million Thereafter.................................................. $110.5 million
Our aggregate minimum lease commitments after 2007 relate to our 20-year lease for our headquarters in New York. We anticipate that we will meet our 2002 capital expenditure needs out of operating cash flows. Cash provided by/(used in) financing activities totaled $(248.9) million, $286.8 million and $50.4 million in 2002, 2001 and 2000, respectively. As noted above, we made a $248.7 million dividend payment. In May 2001, we made a return of capital of $150.0 million to Reuters. We funded that return of capital through an intercompany advance from Reuters. We repaid that advance in May 2001 out of the net proceeds we received from our initial public offering. In addition, Reuters loaned us $49.0 million to fund our acquisition of Lynch, Jones & Ryan in February 2000. This loan bore interest at an annual rate based on six-month LIBOR plus 1.25% and was repaid in June 2001. As of December 31, 2002, we had access to $201.0 million of uncommitted credit lines from commercial banking institutions to meet the funding needs of our U.S. operations. These credit lines are collateralized by a combination of customer securities and our marketable securities. As of December 31, 2002, there were no borrowings outstanding under these credit lines. We currently pay no annual fees to maintain these facilities. In addition, as of December 31, 2002, we had access to $599.4 million of uncommitted credit lines from commercial banking institutions to meet the funding needs of our European and Asian subsidiaries. These credit lines are uncollateralized, and we currently pay no annual fees to maintain these facilities. As of December 31, 2002, there was $27.3 million outstanding under these credit lines. Prior to our initial public offering, Reuters had issued non-binding, short-term letters to certain of these institutions confirming its ownership of us and indicating that if we were to default under the relevant facility, Reuters would consider, without any obligation, requests by these institutions for compensation. Reuters has withdrawn these letters and advised us that it will not issue any additional letters. Our broker-dealer subsidiaries are subject to regulatory requirements intended to ensure their respective general financial soundness and liquidity, which require that they comply with certain minimum capital requirements. These regulations, which differ in each country, generally prohibit a broker-dealer subsidiary from repaying borrowings from us or our affiliates, paying cash dividends, making loans to us or our affiliates or otherwise entering into transactions that would result in a significant reduction in its regulatory net capital position without prior notification or approval of its principal regulator. Our capital structure is designed to provide each of our subsidiaries with capital and liquidity consistent with its business and regulatory requirements. As of December 31, 2002, our U.S. registered broker-dealer subsidiary Instinet Clearing Services, Inc., which is the counterparty to each of our customer transactions in U.S. securities executed through our subsidiary Instinet Corporation (but not The Island ECN, which cleared its securities transactions through another broker-dealer until January 10, 2003, after which point it began clearing its transactions through ICS), had net capital of $168.1 million, which was $160.2 million in excess of its required net capital of $2.9 million. We have an active securities borrowing and lending business, where we borrow securities from one party and lend them to another, as well as to facilitate the settlement process to meet our customers' needs. Under these transactions, we either receive or provide collateral, generally cash. When we borrow securities, we provide cash to the lenders as collateral and earn interest on the cash. Similarly, when we loan securities, we receive cash as collateral and pay interest to the borrower. The initial collateral advanced or received approximates, or is greater than, fair value of the securities borrowed or loaned. In the event the counterparty 77 is unable to meet its contractual obligations to return the pledged collateral, we may be exposed to the market risk of acquiring the collateral at prevailing market prices. We provided $608.5 million and $455.9 million as collateral for securities borrowed as of December 31, 2002 and 2001, respectively. We also received $453.3 million and $257.0 million as collateral for securities loaned as of December 31, 2002 and 2001, respectively. Included in commissions and other receivables is approximately $30 million from Archipelago L.L.C., B-Trade Services LLC and REDIBook ECN L.L.C of which we have commenced arbitration proceedings before the NASD for approximately $11 million. We have established an appropriate reserve against the disputed amount based upon a review of the facts and circumstances surrounding the dispute. In connection with our correspondent clearing business, we are required to maintain segregated funds in a special reserve bank account for the exclusive benefit of our customers. As of December 31, 2002, these funds amounted to $251.8 million. In addition, so long as Reuters owns a majority of our common stock, we will need Reuters consent to incur net indebtedness (indebtedness for borrowed money less cash on hand) in excess of an aggregate of $400.0 million and any indebtedness incurred by us in the ordinary course of our brokerage or similar business or in connection with the clearance of securities or obligations to securities exchanges or clearing systems. We cannot assure you that we will receive Reuters consent to incur indebtedness above this amount in the future if we need to do so for any reason. RECENTLY ISSUED ACCOUNTING STANDARDS SFAS No. 143, "Accounting for Asset Retirement Obligations," was issued in August 2001 and is effective for fiscal years beginning after June 15, 2002. SFAS No. 143 provides accounting and reporting standards for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. Management does not believe adoption of this statement will have a material impact upon our financial condition and results of operations. SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities," was issued in June 2002 and is effective for fiscal years beginning after December 31, 2002. SFAS No. 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)." SFAS No 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. Under Issue 94-3, a liability for an exit cost as defined in Issue 94-3 was recognized at the date of an entity's commitment to an exit plan. Management does not believe adoption of this statement will have a material impact upon our financial condition and results of operations. SFAS No. 148, "Accounting for Stock-Based Compensation -- Transition and Disclosure -- an amendment of FASB Statement No. 123," was issued in December 2002 and amends FASB Statement No. 123, "Accounting for Stock-Based Compensation," to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this Statement amends the disclosure requirements of Statement 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company's policy is not to expense stock options; therefore, management does not believe adoption of this statement will have a material impact on our financial condition and results of operations. FIN No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Guarantees of Indebtedness of Others" was issued in November 2002. FIN No. 45 elaborates disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The initial recognition and initial measurement provisions of FIN 45 are applicable on a prospective basis to guarantees issued or 78 modified after December 31, 2002. The disclosure requirements are effective for periods ending after December 15, 2002. Management is reviewing the potential impact of adoption of this statement on its financial condition and results of operations. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Market risk generally represents the risk of changes in value of a financial instrument that might result from fluctuations in interest rates, foreign exchange rates and equity prices. We have established policies, procedures and internal processes governing our management of market risks in the normal course of our business operations. INTEREST RATE RISK We invest a portion of our available cash in marketable securities, classified as securities owned in our consolidated statements of financial condition, to maximize yields while continuing to meet our cash and liquidity needs and the net capital requirements of our regulated subsidiaries. We maintain a short-term investment portfolio of securities consisting of the following:
DECEMBER 31, --------------- 2002 2001 ------ ------ U.S. government and federal agency obligations.............. $ 10.9 $ 42.4 Municipal bonds............................................. 157.7 73.6 Corporate bonds............................................. 91.9 72.4 Foreign sovereign obligations............................... 58.1 18.3 ------ ------ Total..................................................... $318.6 $206.7 ====== ======
These securities are subject to interest rate risk and will fall in value if interest rates increase. If interest rates had increased immediately and uniformly by 100 basis points, or 65 basis points in the case of municipal bonds, as of December 31, 2002 and 2001, the fair value of the portfolio would have declined by $1.5 million and $2.1 million, respectively. We generally hold these securities until maturity and therefore would not expect our financial condition, operating results or cash flows to be affected to any significant degree by a sudden change in interest rates. In addition, as a part of our brokerage business, we invest portions of our excess cash in short-term interest earning assets (mainly cash and money market instruments), which totaled $275.8 and $703.7 million as of December 31, 2002 and 2001, respectively. We also had short-term borrowings of $27.3 and $69.3 million as of December 31, 2002 and 2001, respectively, on which we are generally charged rates that approximate the U.S. Federal Funds rate or the local equivalent rate. As a result, we do not anticipate that changes in interest rates will have a material impact on our financial condition, operating results or cash flows. EXCHANGE RATE RISK A portion of our operations consists of brokerage services provided outside of the United States. Therefore, our results of operations could be adversely affected by factors such as changes in foreign currency exchange rates or economic conditions in the foreign markets in which we have operations. We are primarily exposed to changes in exchange rates on the British pound and the Euro. When the U.S. dollar strengthens against these currencies, the U.S. dollar value of non-U.S. dollar-based revenues decreases. When the U.S. dollar weakens against these currencies, the U.S. dollar value of non-U.S. dollar-based revenues increases. Correspondingly, the U.S. dollar value of non-U.S. dollar-based costs increases when the U.S. dollar weakens and decreases when the U.S. dollar strengthens. Accordingly, changes in exchange rates may affect our results. However, we do not believe that our exchange rate exposure will have a material adverse effect on our financial condition, results of operations or cash flows; therefore, we have not hedged this exposure. In the future, we may enter into derivative financial instruments as a means of hedging this risk. 79 We manage currency exposure related to our brokerage business on a geographic basis. We generally match each of the non-U.S. subsidiary's liabilities with assets denominated in the same local currency and manage each subsidiary's balance sheet in local currency. This generally results in the net equity of the subsidiary being reported in its functional currency and subject to the effect of changes in currency exchange rates when translated into the U.S. dollar, our reporting currency. We currently do not seek to mitigate this exchange rate exposure, but we may in the future. We may enter into forward foreign currency contracts to facilitate our customers' settling transactions in various currencies, primarily the U.S. dollar, British pound or Euro. These forward foreign currency contracts are with third parties and with terms generally identical to our customers' transactions. Because our customers' transactions are matched to the forward foreign exchange contract, our exposure to exchange rate risk is not material. The following is a breakdown of the currency denominations of our securities owned (in millions):
DECEMBER 31, ------------- CURRENCY 2002 2001 -------- ----- ----- British pound............................................... $52.7 $12.1 Euros....................................................... 18.1 20.9 Japanese yen................................................ 8.4 7.6 Canadian dollar............................................. 7.2 5.7 Hong Kong dollar............................................ 1.0 1.2 ----- ----- Total.................................................. $87.4 $47.5 ===== =====
Our resulting exposure to exchange rate risk is estimated as the potential loss in fair value resulting from a hypothetical 10% adverse change in foreign exchange rates due to functional versus reporting currency exposure and was $7.9 million and $4.3 million as of December 31, 2002 and 2001, respectively. A portion of our revenues and expenses are denominated in non-U.S. dollar currencies. Approximately 20.4% of our revenues and 10.1% of our expenses as of December 31, 2002 and 24.3% of our revenues and 22.0% of our expenses as of December 31, 2001 were so denominated. Our profits are therefore exposed to foreign currency risk -- not a loss of funds but rather a loss for financial reporting purposes. We estimate this risk as the potential loss in revenue resulting from a hypothetical 10% adverse change in foreign exchange rates on the mix in our profits between our functional currency and the respective reporting currencies of our subsidiaries. On this basis, the estimated risk was approximately $3.3 million and $4.3 million as of December 31, 2002 and 2001, respectively. We do not hedge this exposure as it is for financial reporting purposes. EQUITY PRICE RISK As an agency broker, we do not trade securities for our own account or maintain inventories of securities for sale. However, we own marketable securities of the London, Hong Kong and Euronext stock exchanges as a result of their demutualizations, which exposes us to market price risk. This risk is estimated as the potential loss in fair value resulting from a hypothetical 10% adverse change in quoted market prices and amounted to approximately $2.9 million and $5.6 million as of December 31, 2002 and 2001, respectively. CREDIT RISKS We are exposed to substantial credit risk from both parties to a securities transaction during the period between the transaction date and the settlement date. This period is three business days in the U.S. equities markets and can be as much as 30 days in some international markets. In addition, we have credit exposure that extends beyond the settlement date in the case of a party that does not settle in a timely manner by failing either to make payment or to deliver securities. We hold the securities that are the subject of the transaction as collateral for our customer receivables. Adverse movements in the prices of these securities can increase our 80 credit risk. Over the last three years, our loss from transactions in which a party refused or was unable to settle and other credit losses have been immaterial. We are also exposed to credit risks from third parties that owe us money, securities or other obligations. These parties include our customers, trading counterparties clearing agents, exchanges and other financial institutions. These parties may default on their obligations due to bankruptcy, lack of liquidity, operational failure or other reasons. Over the last three years, our loss from a counterparty refusing to pay or was unable to settle with us have been immaterial. We are exposed to the credit worthiness of agencies with which we invest a portion of our available cash, primarily U.S and non-U.S. government and agency obligations, as well as corporate and municipal bonds. For investments maturing within six months, our credit policy is that all investments have at least an A1/P1 credit rating from Standard & Poors and Moody's Investors Service. We also maintain counterparty concentration limits that specify the amount that we can invest with any one counterparty. 81 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INSTINET GROUP INCORPORATED INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
PAGE ---- Report of Independent Accountants........................... 83 Consolidated Statements of Financial Condition as of December 31, 2002 and 2001................................ 84 Consolidated Statements of Operations for the years ended December 31, 2002, 2001 and 2000.......................... 85 Consolidated Statements of Changes in Stockholders' Equity for the years ended December 31, 2002, 2001 and 2000...... 86 Consolidated Statements of Cash Flows for the years ended December 31, 2002, 2001 and 2000.......................... 87 Notes to Consolidated Financial Statements.................. 88
82 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors of Instinet Group Incorporated In our opinion, the accompanying consolidated financial statements present fairly, in all material respects, the financial position of Instinet Group Incorporated and its subsidiaries at December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As discussed in Note 2 and 5 to the financial statements, on January 1, 2002 the Company has adopted the goodwill provisions of Statement of Financial Accounting Standard No. 142, "Goodwill and Other Intangible Assets." PricewaterhouseCoopers LLP New York, New York January 27, 2003 83 INSTINET GROUP INCORPORATED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
DECEMBER 31, ------------------------- 2002 2001 ----------- ----------- (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) ASSETS Cash and cash equivalents................................... $ 275,837 $ 703,678 Securities segregated under federal regulations............. 251,775 310,692 Securities owned, at market value........................... 348,051 236,007 Securities borrowed......................................... 608,475 455,922 Receivable from broker-dealers.............................. 159,695 421,196 Receivable from customers................................... 56,257 68,280 Commissions and other receivables, net...................... 85,296 116,027 Receivable from affiliates, net............................. 3,216 -- Investments................................................. 41,837 91,899 Fixed assets and leasehold improvements, net................ 176,775 205,136 Deferred tax assets, net.................................... 70,223 52,165 Goodwill, net............................................... -- 145,066 Other intangible assets, net................................ 127,993 63,664 Other assets................................................ 77,465 125,109 ---------- ---------- Total assets................................................ $2,282,895 $2,994,841 ========== ========== LIABILITIES AND STOCKHOLDERS' EQUITY LIABILITIES Short-term borrowings....................................... $ 27,279 $ 69,299 Securities loaned........................................... 453,251 257,000 Payable to broker-dealers................................... 115,565 369,817 Payable to customers........................................ 278,569 389,803 Taxes payable............................................... 19,943 30,229 Payable to Reuters.......................................... 1,616 2,254 Payable to affiliates, net.................................. -- 12,707 Accrued compensation........................................ 90,279 128,175 Accounts payable, accrued expenses and other liabilities.... 272,859 273,048 ---------- ---------- Total liabilities........................................... 1,259,361 1,532,332 ---------- ---------- Commitments and contingencies (Note 19) STOCKHOLDERS' EQUITY Common stock, $0.01 par value (950,000 shares authorized, 330,920 and 248,351 issued as of December 31, 2002 and 2001, respectively)....................................... 3,309 2,483 Additional paid-in capital.................................. 1,661,118 1,396,551 Retained earnings/(accumulated deficit)..................... (661,114) 74,116 Treasury stock, at cost (206 shares as of December 31, 2002)..................................................... (1,270) -- Accumulated other comprehensive income/(loss)............... 23,235 (726) Unearned compensation....................................... (1,744) (9,915) ---------- ---------- Total stockholders' equity.................................. 1,023,534 1,462,509 ---------- ---------- Total liabilities and stockholders' equity.................. $2,282,895 $2,994,841 ========== ==========
The accompanying notes are an integral part of these consolidated financial statements. 84 INSTINET GROUP INCORPORATED CONSOLIDATED STATEMENTS OF OPERATIONS
YEAR ENDED DECEMBER 31, ------------------------------------------ 2002 2001 2000 ------------ ------------ ------------ (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) REVENUES Transaction fees......................................... $1,078,172 $1,424,343 $1,381,405 Interest................................................. 40,137 49,296 38,015 Investments.............................................. (59,109) 17,388 9,059 ---------- ---------- ---------- Total revenues...................................... 1,059,200 1,491,027 1,428,479 EXPENSES Compensation and benefits................................ 281,761 406,348 379,320 Soft dollar and commission recapture..................... 217,314 220,050 180,035 Broker-dealer rebates.................................... 124,399 -- -- Brokerage, clearing and exchange fees.................... 149,521 146,223 136,163 Communications and equipment............................. 125,720 156,002 143,194 Depreciation and amortization............................ 78,424 80,754 74,158 Occupancy................................................ 55,528 49,918 35,946 Professional fees........................................ 24,594 39,990 90,208 Marketing and business development....................... 17,094 22,143 32,145 Other.................................................... 58,984 54,534 37,065 Goodwill impairment...................................... 551,991 -- -- Restructuring............................................ 120,800 24,378 -- Loss of fixed assets at World Trade Center............... -- 20,346 -- Insurance recovery of fixed assets lost.................. -- (21,000) -- ---------- ---------- ---------- Total expenses...................................... 1,806,130 1,199,686 1,108,234 Income/(loss) from continuing operations before income taxes and cumulative effect of change in accounting principle.............................................. (746,930) 291,341 320,245 Provision for/(benefit from) income taxes................ (53,088) 122,210 135,993 ---------- ---------- ---------- Income/(loss) from continuing operations before cumulative effect of change in accounting principle.... (693,842) 169,131 184,252 Discontinued operations: Loss from operations of fixed income business, net of tax................................................. (22,746) (24,364) (36,070) ---------- ---------- ---------- Income/(loss) before cumulative effect of change in accounting principle, net of tax....................... (716,588) 144,767 148,182 Cumulative effect of change in accounting principle...... (18,642) -- -- ---------- ---------- ---------- Net income/(loss)................................... $ (735,230) $ 144,767 $ 148,182 ========== ========== ========== Basic and diluted earnings/(loss) per share: Income/(loss) from continuing operations before cumulative effect of change in accounting principle........................................... $ (2.56) $ 0.73 0.89 Discontinued operations: Loss from operations of fixed income business, net of tax................................................. (0.08) (0.10) (0.17) ---------- ---------- ---------- Income/(loss) before cumulative effect of change in accounting principle, net of tax....................... (2.64) 0.63 0.72 Cumulative effect of change in accounting principle...... (0.07) -- -- ---------- ---------- ---------- Net income/(loss)................................... $ (2.71) $ 0.63 $ 0.72 ========== ========== ========== Shares used in basic earnings/(loss) per share calculation............................................ 271,542 230,561 206,900 Shares used in dilutive earnings/(loss) per share calculation............................................ 271,542 230,564 206,900
The accompanying notes are an integral part of these consolidated financial statements. 85 INSTINET GROUP INCORPORATED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
ACCUMULATED ADDITIONAL OTHER HISTORICAL COMMON PAID IN RETAINED TREASURY COMPREHENSIVE SHARES EQUITY STOCK CAPITAL EARNINGS STOCK INCOME ------- ---------- ------ ---------- --------- -------- ------------- (IN THOUSANDS) As of December 31, 1999.................. -- $ 783,415 -- -- -- -- $(4,573) Net income.............. -- 148,182 -- -- -- -- -- Currency translation adjustment............ -- (4,573) -- -- -- -- 2,544 Stock options granted... -- 23,271 -- -- -- -- -- Stock options forfeited............. -- (1,932) -- -- -- -- -- Amortization of stock based plans........... -- -- -- -- -- -- -- ------- --------- ------ ---------- --------- ------- ------- As of December 31, 2000.................. -- 948,363 -- -- -- -- (2,029) Net income January 1, 2001 to May 17, 2001.................. -- 70,651 -- -- -- -- -- Return of capital....... -- (150,000) -- -- -- -- -- Conversion from limited liability company to a corporation........... 206,900 (869,014) $2,437 $ 866,577 -- -- -- Net proceeds from initial public offering.............. 36,800 -- -- 486,916 -- -- -- Net income May 17, 2001 to December 31, 2001.................. -- -- -- -- $ 74,116 -- -- Stock options exercised............. 19 -- -- 279 -- -- -- Tax benefit for options exercised............. -- -- -- 28 -- -- -- Stock options forfeited............. -- -- -- (3,365) -- -- -- Amortization of stock based plans........... -- -- -- -- -- -- -- Currency translation adjustment............ -- -- -- -- -- -- 1,303 Issuance of shares for acquisition........... 4,629 -- 46 46,091 -- -- -- Issuance of shares to Board................. 3 -- -- 25 -- -- -- ------- --------- ------ ---------- --------- ------- ------- As of December 31, 2001.................. 248,351 -- $2,483 $1,396,551 $ 74,116 -- $ (726) Net loss................ -- -- -- -- (735,230) -- -- Issuance of shares for acquisition........... 81,046 -- 811 495,878 -- -- -- Conversion of stock based plans........... -- -- -- 21,583 -- -- -- Stock options granted... -- -- -- 20 -- -- -- Stock options exercised............. 1,523 -- 15 1,372 -- -- -- Tax benefit for options exercised............. -- -- -- 69 -- -- -- Stock options forfeited............. -- -- -- (5,616) -- -- -- Amortization of stock based plans........... -- -- -- -- -- -- -- Purchase of treasury stock................. (245) -- -- -- -- $(1,532) -- Treasury stock re-issued............. 39 -- -- 262 -- Dividend................ -- -- -- (248,739) -- -- -- Currency translation adjustment............ -- -- -- -- -- -- 23,961 ------- --------- ------ ---------- --------- ------- ------- As of December 31, 2002.................. 330,714 -- $3,309 $1,661,118 $(661,114) $(1,270) $23,235 ======= ========= ====== ========== ========= ======= ======= TOTAL UNEARNED STOCKHOLDERS' COMPENSATION EQUITY ------------ ------------- (IN THOUSANDS) As of December 31, 1999.................. -- $ 778,842 Net income.............. -- 148,182 Currency translation adjustment............ -- (2,029) Stock options granted... $(23,271) -- Stock options forfeited............. 1,932 -- Amortization of stock based plans........... 2,341 2,341 -------- ---------- As of December 31, 2000.................. (18,998) 927,336 Net income January 1, 2001 to May 17, 2001.................. -- 70,651 Return of capital....... -- (150,000) Conversion from limited liability company to a corporation........... -- -- Net proceeds from initial public offering.............. -- 486,916 Net income May 17, 2001 to December 31, 2001.................. -- 74,116 Stock options exercised............. -- 279 Tax benefit for options exercised............. -- 28 Stock options forfeited............. 3,365 -- Amortization of stock based plans........... 5,718 5,718 Currency translation adjustment............ -- 1,303 Issuance of shares for acquisition........... -- 46,137 Issuance of shares to Board................. -- 25 -------- ---------- As of December 31, 2001.................. $ (9,915) 1,462,509 Net loss................ -- (735,230) Issuance of shares for acquisition........... -- 496,689 Conversion of stock based plans........... (1,442) 20,141 Stock options granted... (20) -- Stock options exercised............. -- 1,387 Tax benefit for options exercised............. -- 69 Stock options forfeited............. 5,616 -- Amortization of stock based plans........... 4,017 4,017 Purchase of treasury stock................. -- (1,532) Treasury stock re-issued............. -- 262 Dividend................ -- (248,739) Currency translation adjustment............ -- 23,961 -------- ---------- As of December 31, 2002.................. $ (1,744) $1,023,534 ======== ==========
The accompanying notes are an integral part of these consolidated financial statements. 86 INSTINET GROUP INCORPORATED CONSOLIDATED STATEMENTS OF CASH FLOWS
YEAR ENDED DECEMBER 31, ------------------------------------- 2002 2001 2000 --------- --------- --------- (IN THOUSANDS) CASH FLOWS FROM OPERATING ACTIVITIES: Net income/(loss)........................................... $(735,230) $ 144,767 $ 148,182 Adjustments to reconcile net income to cash provided by operating activities: Unrealized loss on investments............................ 59,707 1,628 -- Depreciation and amortization............................. 78,424 84,088 77,721 Deferred tax assets, net.................................. (49,203) 24,752 (35,898) Stock based compensation, net............................. 4,086 9,055 2,341 Write off of fixed assets and leasehold improvements...... 21,869 -- -- Goodwill impairment....................................... 571,037 (Increases)/decreases in operating assets: Securities segregated under federal regulations......... 58,917 (240,692) (70,000) Securities borrowed..................................... (152,553) (210,089) (105,715) Receivable from broker-dealers.......................... 261,501 239,123 (225,324) Receivable from customers............................... 12,023 80,800 (39,074) Commissions and other receivables, net.................. 57,306 7,582 (33,817) Receivable from affiliates, net......................... (3,216) 14,267 (14,267) Other assets............................................ 58,005 13,703 (51,185) Increases/(decreases) in operating liabilities: Short-term borrowings................................... (42,020) (47,773) (77,938) Securities loaned....................................... 196,251 257,000 -- Payable to broker-dealers............................... (254,252) (172,914) 194,707 Payable to customers.................................... (111,234) 42,937 221,077 Taxes payable........................................... (10,998) (20,287) 22,417 Payable to Reuters...................................... (638) (20,234) 10,104 Payable to affiliates, net.............................. (12,707) 12,707 (2,372) Accrued compensation.................................... (37,896) (74,592) 56,025 Accounts payable, accrued expenses and other liabilities........................................... (32,763) 92,817 70,023 --------- --------- --------- Cash (used in)/provided by operating activities....... (63,584) 238,645 147,007 --------- --------- --------- CASH FLOWS FROM INVESTING ACTIVITIES: Securities owned, at market value......................... (112,044) (50,886) 29,504 Investments............................................... (9,645) (9,726) (35,434) Proceeds from sale of fixed assets to affiliate........... -- 7,867 17,300 Purchase of fixed assets and leasehold improvements....... (43,597) (113,691) (92,645) Acquisitions of businesses, net of assets acquired and liabilities assumed..................................... 25,952 (71,157) (48,500) Loss of fixed assets at World Trade Center................ -- 20,346 -- Insurance recovery of fixed assets lost................... -- (21,000) -- --------- --------- --------- Cash used in investing activities..................... (139,334) (238,247) (129,775) --------- --------- --------- CASH FLOWS FROM FINANCING ACTIVITIES: Subordinated debt to affiliate............................ -- -- 50,417 Repayment of subordinated debt to affiliate............... -- (50,417) -- Loan from Parent.......................................... -- 150,000 -- Capital distribution to Parent............................ -- (150,000) -- Net proceeds from initial public offering................. -- 486,916 -- Repayment of loan from Parent............................. -- (150,000) -- Proceeds from issuance of common stock.................... 1,387 279 -- Dividend.................................................. (248,739) -- -- Purchase of treasury stock................................ (1,532) -- -- --------- --------- --------- Cash provided by/(used in) financing activities....... (248,884) 286,778 50,417 --------- --------- --------- Effect of exchange rate changes............................. 23,961 1,303 (1,972) --------- --------- --------- Increase/(decrease) in cash and cash equivalents............ (427,841) 288,479 65,677 Cash and cash equivalents, beginning of year................ 703,678 415,199 349,522 --------- --------- --------- Cash and cash equivalents, end of year...................... $ 275,837 $ 703,678 $ 415,199 ========= ========= ========= SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Cash paid for interest.................................... $ 12,743 $ 7,042 $ 337 Cash paid for taxes....................................... $ 9,044 $ 139,403 $ 95,828 NON-CASH ACTIVITIES: The value of common stock issued in connection with business combinations was $512,967 and $50,000 for the years ended December 31, 2002 and 2001. The value of common stock issued to a Board member was $25 for the year ended December 31, 2001. The Company exchanged its members' units for common stock as of December 31, 2001. The Company issued $262 of treasury stock in connection with its restricted stock plan.
The accompanying notes are an integral part of these consolidated financial statements. 87 INSTINET GROUP INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. ORGANIZATION AND DESCRIPTION OF BUSINESS Instinet Group Incorporated (the "Company" or "Instinet") is a Delaware holding company which, through its operating subsidiaries, provides agency and other brokerage services to broker-dealers, institutional customers, hedge funds and professional traders. The Company is approximately 63% owned by a subsidiary of Reuters Group PLC ("Reuters" or "Parent"). The Company's primary operating subsidiaries are: - Instinet Corp. ("ICorp."), a U.S. registered broker-dealer which provides agency brokerage services to broker-dealers and institutional customers primarily through its automated real-time trading system. - The Island ECN, Inc. ("Island"), a U.S. registered broker-dealer which provides agency brokerage services primarily to broker-dealers, through its automated real-time trading system. - Instinet Clearing Services, Inc. ("ICS"), a U.S. registered broker-dealer which provides execution and clearing services to affiliates and unaffiliated broker-dealers in the United States. - Lynch, Jones & Ryan, Inc. ("LJR"), a U.S. registered broker-dealer offering specialized brokerage, research and commission recapture services to pension plan sponsors and managers. - Instinet International Corp., a Delaware holding company which, through its locally registered broker-dealer subsidiaries, provides agency and other brokerage services to broker-dealers and institutional customers in Europe, Asia and Canada. - ProTrader Securities LP. ("ProTrader"), a U.S. registered broker-dealer which provides direct access execution and advanced trading technology primarily to professional and non-institutional traders, active fund managers and hedge funds. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION The accompanying consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant transactions and balances between and among the Company and its subsidiaries have been eliminated in consolidation. USE OF ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates. TRANSACTION FEES Transaction fees and related expenses arising from securities brokerage transactions are recorded on a trade date basis. SOFT DOLLAR AND COMMISSION RECAPTURE Soft dollar and commission recapture expenses primarily relate to the purchase of third party research products as well as payments made as part of the Company's commission recapture services. The Company reports its transaction fee revenue from these businesses separately from its soft dollar and commission recapture expenses. Soft dollar revenues and revenues subject to commission recapture are offset dollar-for-dollar by soft dollar research payments and commission recapture expenses. 88 INSTINET GROUP INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) INVESTMENTS Investments are stated at estimated fair value as determined in good faith by management. Generally, management will initially value investments at cost and require that changes in value be established by meaningful third-party transactions or a significant impairment in the financial condition or operating performance of the issuer, unless meaningful developments occur that otherwise warrant a change in the valuation of an investment. Factors considered in valuing individual investments include, without limitation, available market prices, type of security, purchase price, purchases of the same or similar securities by other investors, marketability, restrictions on disposition, current financial position and operating results, and other pertinent information. Management uses its best judgment in estimating the fair value of these investments. There are inherent limitations in any estimation technique. The fair value estimates presented herein are not necessarily indicative of an amount which the Company could realize in a current transaction. Because of the inherent uncertainty of valuation, these estimated fair values do not necessarily represent amounts that might be ultimately realized, since such amounts depend on future circumstances, and the differences could be material. Investments are accounted for under the equity method if the Company has the ability to exercise significant influence, but not control over the investee. Significant influence is deemed to exist if the Company has ownership of between 20% and 50%. Realized and unrealized gains and losses from investments are included in investment income on the Consolidated Statements of Operations. DEPRECIATION AND AMORTIZATION OF FIXED ASSETS ($ IN THOUSANDS) Depreciation of capitalized furniture and equipment is provided on a straight-line basis using estimated useful lives of three to ten years. Leasehold improvements are amortized on a straight-line basis over the lesser of the lease term or the estimated useful life. Fixed assets are stated at cost, net of accumulated amortization of $295,098 and $373,689 as of December 31, 2002 and 2001, respectively. ACQUISITIONS AND GOODWILL All business acquisitions have been accounted for under the purchase method and, accordingly, the excess of the purchase price over the fair value of the net assets acquired has been recorded as goodwill on the Consolidated Statements of Financial Condition. The carrying value of goodwill is reviewed on a periodic basis for impairment based upon estimated fair value of the Company's reporting units. The Company estimates fair value by using a discounted cash flow model or by using the services of an external valuation specialist. Should the review indicate that goodwill is impaired, the Company's carrying value of goodwill would be reduced by the estimated shortfall of the discounted cash flows. In accordance with SFAS No. 142, "Goodwill and other Intangible Assets" ("SFAS 142"), goodwill existing as of June 30, 2001 was amortized until December 31, 2001. For goodwill arising from acquisitions after June 30, 2001, the Company did not amortize goodwill but reviewed it for impairment in accordance with the Company's impairment policy noted above. Pursuant to the purchase method, the results of operations, changes in stockholders' equity and cash flows of acquired companies and businesses are included in consolidated operations only for those periods following the date of their acquisition. 89 INSTINET GROUP INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The Company's subsidiary, ProTrader Group, L.P. ("ProTrader"), has entered into agreements whereby additional consideration would be paid to former owners of trading offices it had purchased. The additional consideration is generally based on actual trading volumes of the respective trading office and is generally effective for a period of two years from the date of acquisition. In accordance with EITF 95-8: "Accounting for Contingent Consideration Paid to Shareholders of an Acquired Enterprise in a Purchase Business Combination", the Company records these contingent payments as additional goodwill. MARKETING AND BUSINESS DEVELOPMENT Advertising costs are expensed when incurred. SOFTWARE COSTS Costs for internal use software, whether developed or obtained, are assessed to determine whether they should be capitalized or expensed in accordance with American Institute of Certified Public Accountants' Statement ("SOP") 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use." Capitalized software costs, which are reflected as fixed assets on the statements of financial condition, were $1,126 and $6,001 at December 31, 2002 and 2001. Amortization expense was $3,373, $5,136 and $4,431 for the years ended December 31, 2002, 2001 and 2000, respectively. INCOME TAXES The Company files a consolidated income tax return in the U.S. and combined U.S. state and local income tax returns, where applicable. The Company records deferred tax assets and liabilities for the difference between the tax basis of assets and liabilities and the amounts recorded for financial reporting purposes, using current tax rates. Deferred tax expenses and benefits are recognized in the Consolidated Statements of Operations for changes in deferred tax assets and liabilities. STOCK-BASED COMPENSATION The Company accounts for its stock-based compensation plans in accordance with APB Opinion No. 25, Accounting for Stock Issued to Employees ("APB No. 25"), SFAS No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"), and related accounting interpretations. The Company has chosen to account for stock options granted to employees using the intrinsic value method prescribed in APB No. 25 and accordingly compensation expense is measured as the excess, if any, of the estimated fair value of the Company at the date of grant over the option exercise price and is recorded over the vesting period. For options granted to non-employees, the Company uses the fair value method prescribed in SFAS 123 and accordingly, records compensation expense over the vesting period. 90 INSTINET GROUP INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Had the Company determined compensation cost based on the estimated fair value at the grant dates for its stock based plans under SFAS 123, the Company's net income for the years ended December 31, 2002, 2001 and 2000 would have been as follows:
YEAR ENDED DECEMBER 31, ------------------------------- 2002 2001 2000 --------- -------- -------- Net income/(loss), as reported...................... $(735,230) $144,767 $148,182 Add: Stock based employee compensation expense, net of related tax benefits, included in reported net income/(loss)..................................... 2,723 3,432 1,094 Deduct: Stock based employee compensation, net of related tax effects, determined under fair value based methods for all awards...................... (36,361) (57,022) (8,624) --------- -------- -------- Pro forma net income/(loss)......................... $ 768,868 91,177 140,652 Earnings/(loss) per share, as reported -- basic and diluted........................................... $ (2.71) $ 0.63 $ 0.72 Pro Forma earnings/(loss) per share -- basic and diluted........................................... $ (2.83) 0.40 0.68
CASH AND CASH EQUIVALENTS The Company considers all highly liquid investments with original maturities of three months or less to be cash equivalents. SECURITIES OWNED ($ IN THOUSANDS) Securities owned are recorded on a trade date basis and are carried at their market value with unrealized gains and losses reported in investment income on the Consolidated Statements of Operations. Securities owned, with the exception of shares in stock exchanges, have maturities of less than 3 years and consisted of the following:
DECEMBER 31, ------------------- 2002 2001 -------- -------- U.S. government and federal agency obligations.............. $ 10,867 $ 42,446 Municipal bonds............................................. 157,683 73,637 Corporate bonds............................................. 91,909 72,408 Foreign sovereign obligations............................... 58,146 18,317 Shares of stock exchanges................................... 29,246 29,199 Other....................................................... 200 -- -------- -------- Total.................................................. $348,051 $236,007 ======== ========
SECURITIES BORROWED AND LOANED Securities borrowed and loaned are recorded at the amount of cash collateral advanced or received. Securities borrowed require the Company to deposit cash with the lender. For securities loaned, the Company receives collateral in the form of cash in an amount generally in excess of the market value of the securities loaned. The Company monitors the market value of the securities borrowed and loaned on a daily basis, with additional collateral obtained or refunded, as necessary. 91 INSTINET GROUP INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) RECEIVABLE FROM AND PAYABLE TO BROKER-DEALERS Receivable from broker-dealers are primarily comprised of fails to deliver. Fails to deliver arise when the Company does not deliver securities on settlement date. The Company records the selling price as a receivable due from the purchasing broker-dealer. The receivable is collected upon delivery of the securities. Payable to broker-dealers are primarily comprised of fails to receive. Fails to receive arise when the Company does not receive securities on settlement date. The Company records the amount of the purchase price as a payable due to the selling broker-dealer. The liability is paid upon receipt of the securities. RECEIVABLE FROM AND PAYABLE TO CUSTOMERS Receivable from customers primarily represent customer debit balances and payable to customers represent free credit balances in customer accounts. COMMISSIONS AND OTHER RECEIVABLES, NET ($ IN THOUSANDS) Commissions and other receivables are reported net of a provision for doubtful accounts of $22,002 and $7,472 as of December 31, 2002 and 2001, respectively. Included in commissions and other receivables is approximately $30 million from Archipelago L.L.C.., B-Trade Services LLC and REDIBook ECN L.L.C of which approximately $11 million is under dispute. The Company has commenced arbitration proceedings before the NASD and has established a reserve against the disputed amount based upon a review of the facts and circumstances surrounding the dispute. (Note 19) SECURITIES PURCHASED UNDER AGREEMENTS TO RESELL AND SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE Transactions involving purchases of securities under agreements to resell and securities sold under agreements to repurchase are treated as collateralized financing transactions and are recorded at their contracted resale amounts plus accrued interest. It is the Company's policy to take possession of securities with a market value in excess of the principal amount loaned plus the accrued interest thereon, in order to collateralize reverse repurchase agreements. Similarly, the Company is required to provide securities to counterparties in order to collateralize repurchase agreements. The Company's agreements with counterparties generally contain contractual provisions allowing for additional collateral to be obtained, or excess collateral returned, when necessary. It is the Company's policy to value collateral daily and to obtain additional collateral, or to retrieve excess collateral from counter-parties, when deemed appropriate. FOREIGN CURRENCY TRANSLATION Assets and liabilities of subsidiaries whose functional currency is not the U.S. dollar are translated based on the end of period exchange rates from local currency to U.S. dollars. Results of operations are translated at the average exchange rates in effect during the period. The resulting gains or losses are reported as comprehensive income. DERIVATIVES The Company may enter into forward foreign currency contracts to facilitate customers' settling transactions in various currencies, primarily the U.S. dollar, British pound or Euro. These forward foreign currency contracts are entered into with third parties and with terms generally identical to its customers' transactions, thereby mitigating exposure to currency risk. Forward foreign currency contracts generally do not extend beyond 14 days and realized and unrealized gains and losses resulting from these transactions are recognized in the Consolidated Statements of Operations as transaction fees in the period during which they are incurred. These activities have not resulted in a material impact to the Company's operations to date. 92 INSTINET GROUP INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) TREASURY STOCK The Company's purchases of shares of its own common stock are recorded as treasury stock under the cost method and are shown as a reduction to stockholders' equity on the statement of financial condition. RESTRUCTURING The Company accounts for its cost reduction initiatives and resulting restructuring charges in accordance with EITF 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)," SFAS No. 112, "Employer's Accounting for Post Retirement Benefits," and SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." 3. REORGANIZATION AND INITIAL PUBLIC OFFERING Prior to September 30, 2000, Reuters ownership of the Company's global agency brokerage operations was structured such that its U.S. operations were owned through a U.S.-based holding company, and its European and Asian operations were owned through European-based holding companies. Effective September 30, 2000, Instinet reorganized its worldwide operations to combine all of Instinet's operations under one holding company structure. The reorganization was accounted for at historical cost in a manner similar to a pooling of interests. On May 23, 2001, the Company completed its initial public offering. In that offering, the Company sold 36,800,000 shares of common stock and received net proceeds of approximately $487 million after deducting offering expenses and an advance to the Company of $150 million by Reuters. In connection with the Company's initial public offering, the Company converted from a limited liability company to a corporation in the state of Delaware. 4. ACQUISITIONS ($ IN THOUSANDS) ISLAND On September 20, 2002, the Company acquired 100% of the outstanding common stock of Island Holding Company, Inc., the parent company of The Island ECN, Inc. (collectively, "Island"). Island's results of operations, since that date, have been included in the Company's consolidated financial statements. Island is a leading electronic securities marketplace, with a large liquidity pool of orders to buy and sell securities that are published in its marketplace. Island's proprietary technology enables it to offer low cost, rapid and reliable order display and matching services to its customers. The Company believes this acquisition will result in better execution opportunities for its customers, a stronger technology and trading platform, an alternative to other offerings, cost savings, and a stronger management team. The aggregate purchase price was $555,349, consisting of $492,826 representing 80,658,886 shares of the Company's common stock, $20,141 representing additional common shares for the conversion of options, warrants and stock appreciation rights, deferred tax liability of $32,560 related to intangible assets and $9,822 representing direct costs of the acquisition. The value of the common shares issued was determined based on the average closing market price of the Company's common shares over the 2-day period before and after June 10, 2002, the date the terms of the acquisition were agreed to and announced. The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the date of acquisition. The allocation of the excess purchase price over the estimated fair values of Island's 93 INSTINET GROUP INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) assets and liabilities was performed by an independent valuation specialist and were as follows as of September 20, 2002:
Assets: Cash...................................................... $ 41,100 Receivables, net.......................................... 26,575 Fixed assets, net......................................... 14,103 Other assets.............................................. 11,776 Intangible assets......................................... 74,000 Goodwill.................................................. 421,081 -------- Total assets acquired.................................. 588,635 Less liabilities assumed.................................... (33,286) -------- Net assets acquired......................................... $555,349 ========
PROTRADER In October 2001, the Company acquired ProTrader, a U.S. registered broker-dealer which provides direct access execution and advanced trading technology primarily to professional and non-institutional traders, active fund managers and hedge funds. The Company believed this acquisition would enhance its customer interface and order routing technology. The Company agreed to acquire ProTrader for $100 million in cash and 5.02 million shares of Instinet common stock valued in aggregate at $50 million, based on the average share price of Instinet stock for the seven trading days prior to closing. Direct capitalizable costs associated with this transaction were $2,806. On October 1, 2001, the Company acquired approximately 92% and acquired the remaining 8% on January 3, 2002. The following table summarizes the estimated fair values of the assets acquired and liabilities assumed: Assets: Current and long term assets.............................. $ 19,062 Intangible asset.......................................... 71,777 Goodwill.................................................. 70,583 -------- Total assets acquired.................................. 161,422 Less liabilities assumed.................................... (8,616) -------- Net assets acquired......................................... $152,806 ========
Of the consideration paid, approximately 50% of the excess purchase price over net assets acquired was assigned to an intangible asset, consisting of intellectual property and the related technology of ProTrader. The amount of goodwill expected to be deductible for tax purposes is $16,804. A description of the Company's significant acquisitions prior to December 31, 2001, including the date acquired, purchase price (including acquisition costs) and goodwill recognized, is as follows: - Montag Popper & Partner GmbH ("Montag"), a German fixed income broker-dealer, was acquired in October 1999 for $5,989. The $3,881 excess of the purchase price over the fair value of the net assets acquired was recorded as goodwill. - LJR was acquired in February 2000 for $49,500. The $48,500 excess of the purchase price over the fair value of the net assets acquired was recorded as goodwill. 94 INSTINET GROUP INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The following unaudited supplemental pro forma information has been prepared to give effect to acquisition of Island as of the beginning of the year preceding the year in which the acquisition occurred. Pro forma consolidated results after giving effect to the acquisition as of the beginning of the year preceding the year in which the acquisition occurred would not have been materially different from the reported amounts for the Company's acquisition of LJR and ProTrader.
YEAR ENDED DECEMBER 31, ----------------------- 2001 2000 ---------- ---------- Pro forma revenues.......................................... $1,656,457 $1,594,405 Pro forma net income........................................ 167,885 170,737
5. GOODWILL ($ IN THOUSANDS) The following table sets forth the changes in the carrying amount of goodwill:
YEAR ENDED DECEMBER 31, ------------------------ 2002 2001 ----------- ---------- Balance, beginning of period................................ $ 145,066 $ 81,830 Goodwill acquired during the period......................... 425,971 63,236 Goodwill impairment......................................... (571,037) -- --------- -------- Balance, end of period...................................... $ -- $145,066 ========= ========
Instinet Corporation was acquired by Reuters in 1987. For purposes of preparing the consolidated financial statements of the Company, the $96,893 excess over the fair value of the net assets acquired by Reuters was recorded by the Company as goodwill. Goodwill arising from acquisitions of businesses, as well as the acquisition of Instinet Corporation by Reuters, was amortized on a straight-line basis over periods of 15 to 20 years until December 31, 2001. Goodwill is stated at cost, net of accumulated amortization of $76,608, as of December 31, 2001. Goodwill amortization was $8,110 and $7,505 for the years ending December 31, 2001 and 2000, respectively. The Company acquired approximately 92% of ProTrader in 2001, thereby increasing goodwill by $70,583, and acquired the remaining 8% in 2002, increasing its goodwill by $4,606. In addition, the Company recorded additional goodwill of $23 related to contingency consideration paid to former owners of trading offices purchased by its subsidiary ProTrader. The Company completed its merger with Island on September 20, 2002, thereby increasing its goodwill by $421,081. In addition, Island had existing goodwill of $261. In the first quarter of 2002, during the Company's adoption of SFAS 142 and its transitional review test of goodwill, the Company identified indicators of possible impairment of its recorded goodwill related to its ProTrader acquisition. Such indicators were an overall decrease in customer transaction volumes during the first quarter, which led to operating losses. As a result, the Company closed several trading offices and restructured its operations in the first quarter of 2002. In accordance with SFAS 142, based on the results of a discounted cash flow analysis, the Company calculated a pre-tax level of goodwill impairment of $15,750, which was represented by the shortfall of the discounted cash flows versus the carrying amount of goodwill. In May 2002, the Company closed its fixed income trading platform. Due to a global economic slowdown and the uneven pace of acceptance of electronic fixed income trading platforms, the business had been unable to reach a critical mass. As a result, the Company's goodwill related to its acquisition Montag was impaired. Therefore, the Company recorded a pre-tax impairment loss of $3,296, the remaining carrying value of its goodwill for that business in May 2002. 95 INSTINET GROUP INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) During the third quarter of 2002, the Company experienced a decline in its market capitalization, particularly towards the end of the quarter. Due to this significant decrease, the Company's book value exceeded its fair market value. The Company believes that the significant decline in market value reflects the ongoing challenging business environment, declining business fundamentals, the commoditization of its services, the launch of significant competitive products and a difficult regulatory environment. These events prompted the Company to perform a goodwill impairment test. In accordance with SFAS 142, based on the results of a valuation analysis prepared by an independent specialist, the Company has determined that its existing goodwill had been completely impaired and as a result the Company recorded a pre-tax goodwill impairment loss of approximately $552 million, the remaining carrying value of its goodwill, as of September 30, 2002. For comparative purposes, the following table reflects the Company's results for the years ended December 31, 2001 and 2000, adjusted as though the Company had adopted SFAS 142 on January 1, 2000:
DECEMBER 31, ------------------- 2001 2000 -------- -------- Net income, as reported..................................... $144,767 $148,182 Goodwill amortization....................................... 8,044 7,505 Tax effect.................................................. (1,422) (1,185) -------- -------- Net income, as adjusted..................................... $151,389 $154,502 ======== ======== Basic and diluted earnings per share, as reported........... $ 0.63 $ 0.72 Basic and diluted earnings per share, as adjusted........... $ 0.66 $ 0.75
6. INTANGIBLE ASSETS ($ IN THOUSANDS) Information regarding the Company's identifiable intangible assets are as follows:
ESTIMATED LIFE IDENTIFIABLE INTANGIBLE ASSETS (YEARS) VALUE ----------------- --------- ------------ Technology.................................................. 7.0 $122,984 Customer relationships...................................... 5.0 15,500 Trade name.................................................. 1.5 4,800 Non-compete agreements...................................... 1.0 1,300
DECEMBER 31, ------------------ 2002 2001 -------- ------- Gross carrying amount....................................... $144,584 $66,022 Accumulated amortization.................................... (16,591) (2,358) -------- ------- Net carrying amount......................................... $127,993 $63,664 ======== =======
Intangible assets arose in connection with the Company's acquisitions of ProTrader in October 2001 and Island in September 2002. The intangible assets are amortized on a straight-line basis over their respective 96 INSTINET GROUP INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) estimated useful lives as shown above. Amortization expense for the year ended December 31, 2002 and 2001 was $14,232 and $2,358, respectively. Estimated amortization expense for each of the next 5 years is:
YEAR EXPENSE ---- ------- 2003........................................................ $24,813 2004........................................................ 21,390 2005........................................................ 20,670 2006........................................................ 20,670 2007........................................................ 19,817
7. INVESTMENTS ($ IN THOUSANDS) From time to time, the Company makes strategic alliances and long-term investments in other companies. The changes in the carrying values at the end of each period result from additional investments, sales, and unrealized and realized gains and losses, as well as fluctuations in exchange rates for investments made in non-U.S. dollars. A description of the Company's more significant investments is as follows: - WR Hambrecht + Co ("Hambrecht")-- In 1999 and 2000, the Company made strategic investments totaling $27,500, now representing a 7.0% interest, in Hambrecht. Hambrecht underwrites initial public offerings through its auction-based securities offering via the Internet, performs research and analysis, places and invests in private equity transactions, and offers mergers and acquisition advisory services. As of December 31, 2001, the Company carried its investment at estimated fair value of $16,450. In December 2002, the Company wrote off its remaining value in Hambrecht due to a significant decrease in the valuation of its shares as a result of a recent round of financing, as well as the dramatic slowdown in investment banking activity. In addition, as of December 31, 2002, the Company has recorded a loan receivable from Hambrecht in the amount of $2,031. This loan accrues interest at prevailing market rates and matures in February 2007 and June 2007. - TP Group LDC -- Beginning in 1999, the Company made strategic investments, and also sold certain portions of its investment, in TP Group LDC, now representing a 13.8% interest. TP Group LDC is a consortium led by the Company that owns 38.9% of virt-x, an electronic order driven equities market for pan-European securities. In November 2000, the Company made an additional investment and, as of December 31, 2002 and 2001, the Company carried its investment at estimated fair value of $2,695 and $8,816, respectively. - Archipelago Holdings LLC ("Archipelago") -- In 1999, the Company made an investment of 15,528 GBP, now representing approximately 4.8% interest, in Archipelago. Archipelago, through its subsidiary, provides order entry and execution capabilities using proprietary systems while providing customers access to liquidity, including access to other electronic communication networks. In March 2002, Archipelago merged with REDIBook ECN LLC, another ECN. As of December 31, 2002 and 2001, the Company carried its investment at estimated fair value of $15,000 and $40,000, respectively. - The Nasdaq Stock Market, Inc ("Nasdaq") -- In 2000, the Company made an investment of $15,475 in Nasdaq, and its subsidiaries, ProTrader and Island, carried investments in Nasdaq totaling $2,817, together now representing 1.7% interest. As of December 31, 2002 and 2001, the Company carried its investment at estimated fair value of $14,792 and $15,736. - Tradeware S.A. ("Tradeware") -- In 2000, the Company made strategic investments of 4,000 euros, and in 2001, 66,925 Belgian francs and 1,500 euros, now representing a 47.9% interest, in Tradeware. Tradeware is a European based provider of integrated order routing solutions to broker-dealers in Europe. As of December 31, 2002 and 2001, the Company carried its investment at $3,254 and $4,492, respectively, as determined under the equity method. In addition, as of December 31, 2002, the 97 INSTINET GROUP INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Company recorded a loan receivable from Tradeware in the amount of $2,045. This loan accrues interest at prevailing market rates and matures on December 31, 2004. - JapanCross Securities Co. Ltd. ("Japan Cross") -- In 2001, the Company made a series of strategic investments totaling $3,782, now representing a 50% interest in Japan Cross, a joint venture which was established to provide a crossing service for Japanese equity securities. As of December 31, 2002 and 2001, the Company carried its investment at $2,096 and $3,782, respectively as determined under the equity method. - Starmine Corporation ("Starmine") -- In February 2002, the Company made an investment of $2,000 representing a 12.8% interest in Starmine. Starmine provides independent ratings of Wall Street equity analysts. As of December 31, 2002, the Company carried its investment at estimated fair value of $2,000. - e-Xchange Advantage Corporation ("e-Xchange") -- In July 2002, the Company made an investment of $2,000 representing a 9.8% interest in e-Xchange. e-Xchange formed a partnership with Nasdaq to develop securities electronic trading systems and tools. As of December 31, 2002, the Company carried its investment at estimated fair value of $2,000. - Vencast, Inc. ("Vencast") -- In 2000 and 2001, the Company made investments of 5,031 GBP and $1,500, respectively, in Vencast. Vencast provided solutions by using the Internet to facilitate the process of raising capital and investing for the private equity industry. As of December 31, 2001, the Company carried its investment at $2,373, as determined under the equity method. In March 2002, Vencast ceased operations and the Company wrote off its carrying value. In addition, as of December 31, 2001, the Company had recorded a loan receivable from Vencast in the amount of $3,000, which was subsequently written off. - Knight Roundtable Europe Ltd. ("Roundtable") -- In 2001, the Company made an investment of $1,000 in Roundtable. Roundtable is a pan-European broker consortium designed to compete for order flow from small investors in the region. At December 31, 2001, the Company carried its investment at estimated fair value of $250. In June 2002, the Company wrote off its investment in Roundtable. 8. RESTRUCTURING ($ IN THOUSANDS) The Company has initiated several cost reduction programs, which have resulted in restructuring charges. Information regarding the Company's restructuring charges follows: In 1998, the Company began to design and develop a web-based retail brokerage operation. In December 2000, based upon a review of market conditions and an evaluation of possible alternate strategies, the Company decided to re-direct its retail brokerage efforts. As part of this redeployment, the Company recorded a charge of $4,000 and $7,500 for the years ended December 31, 2001 and 2000. All of the liability related to this restructuring charge had been paid as of December 31, 2001. In July 2001, the Company announced a review of spending initiatives with the aim of reducing its underlying operating cost structure. This restructuring was completed in 2001 at a cost of $24,400 in the year ended December 31, 2001 and included: - Workforce Reduction -- the Company reduced its employee headcount by 226. The departments primarily affected were various operational areas in technology support functions, sales and trading, administrative functions and clearing operations in its U.S. and international offices. The Company recorded a pre-tax charge of approximately $21,000 related to its workforce reduction during the second half of 2001. 98 INSTINET GROUP INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) - Office Closures/Consolidation -- the Company closed its office in Sydney, Australia and consolidated its European trading and clearing operations, significantly reducing the size of its Zurich office. In the U.S., the Company closed the Greenwich, Detroit and Seattle trading offices of its ProTrader subsidiary. The Company recorded a pre-tax charge of approximately $3,000 related to its office closures during the second half of 2001. As of December 31, 2002, the Company carried a liability of $3,273 associated with this restructuring on its Consolidated Statements of Financial Condition, which is reflected as follows:
BALANCE BALANCE DECEMBER 31, DECEMBER 31, 2001 PAYMENTS 2002 ------------ -------- ------------ Workforce reduction............................... $5,694 $2,896 $2,798 Office closures/consolidation..................... 1,085 610 475 ------ ------ ------ Total............................................. $6,779 $3,506 $3,273 ====== ====== ======
The Company expects to pay the remaining liability by December 31, 2003. In March 2002, the Company announced that it would reduce its annualized fixed operating costs in order to offset the impact of reduced revenues due to its price reductions to U.S. broker-dealer customers. This restructuring included reducing staff levels and related occupancy costs, improving system and network efficiencies, and restructuring non-core businesses. During the year ended December 31, 2002, the Company incurred a charge of $58,395, which included: - Workforce Reduction -- the Company reduced its employee headcount by 489. The departments primarily affected were various operational areas in technology support functions, clearing operations, sales and trading, and administrative functions in its U.S. and international offices. The Company recorded a pre-tax charge of $39,989 for the year ended December 31, 2002, related to its workforce reduction. - Office Closures/Consolidation -- the Company closed the Houston, Los Angeles and San Jose trading offices of its ProTrader subsidiary, consolidated its European trading and clearing operations, significantly reduced the size of its offices in Switzerland, U.K. and France, and consolidated its office space in the U.S. given its lower headcount. The Company recorded a pre-tax charge of $18,406 for the year ended December 31, 2002, related to its office closures. As of December 31, 2002, the Company carried a liability of $29,543 associated with this restructuring on its Consolidated Statements of Financial Condition, which is reflected as follows:
BALANCE ORIGINAL DECEMBER 31, ACCRUAL PAYMENTS 2002 -------- -------- ------------ Workforce reduction.................................. $48,264 25,119 $14,870 Office closures/consolidation........................ 18,406 3,773 14,673 ------- ------- ------- Total................................................ $66,670 $28,852 $29,543 ======= ======= =======
The Company expects to pay approximately $22 million of the remaining liability by December 31, 2003. In December 2002, the Company announced that it had commenced a cost-reduction plan to reduce operating costs in order to achieve cost synergies in connection with its acquisition of Island. This restructuring 99 INSTINET GROUP INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) included reducing staff levels and related occupancy costs. During the year ended December 31, 2002, the Company incurred a charge of $62,405, which included: - Workforce Reduction -- the Company reduced its employee headcount by 300. The departments primarily affected were various operational areas in technology support functions, clearing operations, sales and trading, and administrative functions in its U.S. and international offices. The Company recorded a pre-tax charge of $26,356 related to its workforce reduction. - Office Closures/Consolidation -- the Company closed the Tampa, Dallas and Chicago offices and consolidated the remaining office space at its ProTrader subsidiary, and consolidated its office space in the New York City area, given its lower headcount. The Company recorded a pre-tax charge of $36,049 related to its office closures. As of December 31, 2002, the Company carried a liability of $50,709 associated with this restructuring on its Consolidated Statements of Financial Condition, which is reflected as follows:
BALANCE ORIGINAL DECEMBER 31, ACCRUAL PAYMENTS 2002 -------- -------- ------------ Workforce reduction.................................. $26,356 $ 6,860 $19,496 Office closures/consolidation........................ 36,049 4,836 31,213 ------- ------- ------- Total................................................ $62,405 $11,696 $50,709 ======= ======= =======
The Company expects to pay approximately $13 million to $15 million of the remaining liability by December 31, 2003. 9. DISCONTINUED OPERATIONS ($ IN THOUSANDS) On May 3, 2002, the Company closed its fixed income trading platform. The Company began developing its fixed income business in 1998 and started trading in the spring of 2000. Against the background of a global economic slowdown and the uneven pace of acceptance of electronic fixed income trading platforms, the business had been unable to reach a critical mass. As a result of the closure, the Company incurred the following charges:
YEAR ENDED DECEMBER 31, ------------------------------ 2002 2001 2000 -------- -------- -------- Loss from discontinued operations: Loss from operation of fixed income business....... $ 33,768 $ 39,133 $ 55,635 Income tax benefit................................. (11,022) (14,769) (19,565) -------- -------- -------- Net loss from discontinued operations........... $ 22,746 $ 24,364 $ 36,070 ======== ======== ======== Loss per share -- basic and diluted: Loss from operation of fixed income business....... $ 0.12 $ 0.17 $ 0.27 Income tax benefit................................. (0.04) (0.06) (0.10) -------- -------- -------- Net loss from discontinued operations........... $ 0.08 $ 0.11 $ 0.17 ======== ======== ========
A restructuring charge of $22,514 related to the closure of the Company's fixed income platform is reflected for the year ended December 31, 2002. As of December 31, 2002, the Company carried a liability of $221 associated with this restructuring on its consolidated statements of financial condition, which is expected to be substantially paid by June 30, 2003. 100 INSTINET GROUP INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 10. STOCK-BASED PLANS ($ IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) RESTRICTED STOCK UNITS In 2002, the Company granted Restricted Stock Units ("RSU") to certain members of senior management in lieu of cash for a portion of each member's calendar year 2001 bonus, including a Board member and the newly appointed Chief Executive Officer. The RSUs are convertible into an equal number of shares of the Company's common stock and generally vest either one or two years from the date of grant. As of December 31, 2002, the Company has granted 208,807 RSUs. WARRANTS Under the terms of the merger agreement with Island, the Company converted and issued 2,851,327 warrants to holders of Island warrants as substitutions for Island warrants outstanding at September 20, 2002. The warrants have an exercise price of $1.04 and expire in January 2011. STOCK APPRECIATION RIGHTS ("SARS") Under the terms of the merger agreement with Island, the Company converted and issued 19,006 SARs as substitutions for SARs to holders of Island SARs outstanding at September 20, 2002. The SARs have an exercise price of $0.91, vest over 3 or 4 years and have a term of 7 years. OPTIONS Instinet Plan Substantially all employees and certain directors of the Company and certain employees of Radianz who were previously employees of the Company (Note 20) participate in the Company's stock option plan ("Instinet Plan"), which was adopted in February 2000. Under the Instinet Plan, options on the Company's common shares are issued for terms of 7 years and generally vest over 4 years. Subject to vesting and expiration provisions, participant exercise rights occur upon an initial public offering or six and one-half years from the original grant date. The options are exercisable at the estimated fair market value of the shares on the date the options were issued. The terms for options granted to employees and non-employees are the same. The Company has authorized the issuance of a maximum of 34,118 shares of common stock under the Instinet Plan. Options expire on dates ranging from March 2003 to December 2011. Under the terms of the merger agreement with Island, the Company converted and issued 2,942,128 options to holders of Island options as substitutions for Island options outstanding at September 20, 2002. These converted options are subject to the provisions of the Island Stock Option plan, which vest over 3 or 4 years, have a terms of 5 to 10 years and carry exercise prices ranging from $0.91 to $9.23. 101 INSTINET GROUP INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) A summary of the Instinet Plan stock option activity is as follows:
WEIGHTED WEIGHTED AVERAGE AVERAGE WEIGHTED EXERCISE EXERCISE AVERAGE PRICE PER PRICE PER REMAINING OPTIONS EXERCISABLE OPTIONS OPTION LIFE (YEARS) EXERCISABLE OPTION ---------- --------- ------------ ----------- ----------- Outstanding, December 31, 2000........................ 7,003,969 14.86 5.8 -- -- Granted....................... 17,056,356 16.51 Forfeited..................... (2,936,849) 17.16 Exercised..................... (19,280) 14.52 ---------- Outstanding, December 31, 2001........................ 21,104,196 16.03 6.1 2,548,784 $14.82 Granted (including conversion of Island options).......... 11,585,267 5.07 Forfeited..................... (7,259,932) 13.88 Exercised..................... (1,522,656) 0.91 ---------- Outstanding, December 31, 2002........................ 23,906,187 $11.48 5.6 8,303,974 $15.40 ==========
Additional information on options outstanding as of December 31, 2002 is as follows:
WEIGHTED WEIGHTED AVERAGE AVERAGE OPTIONS EXERCISE REMAINING EXERCISE PRICES OUTSTANDING PRICE LIFE (YEARS) --------------- ----------- -------- ------------ $0.91 to $1.22...................................... 424,283 $ 1.03 7.8 $3.29 to $3.48...................................... 1,150,000 3.39 6.8 $6.00 to $6.53...................................... 6,992,301 6.02 6.3 $8.48 to $9.97...................................... 1,199,592 8.85 7.7 $13.42 to $14.80.................................... 8,159,600 13.59 5.0 $17.77 to $18.70.................................... 5,980,411 17.79 5.2
In September 2000, the board of directors of the Company approved a modification to the Instinet Plan changing the exercise terms. Accordingly, the Company recorded as unearned compensation, the difference between the exercise price of the option and estimated fair market value of the Company as of the date of modification for options granted to employees. For options granted to non-employees, the Company recorded the estimated fair value of the option on the date of modification as unearned compensation. The Company recorded unearned compensation of $22,553 and $718 for employees and non-employees, respectively, as unearned compensation on the modification date as a separate component of stockholders' equity. In May 2001, the Company adjusted the shares and exercise price of its existing options as a result of its conversion from a limited liability company to a corporation in connection with its initial public offering, at a conversion rate of 1.033209. There was no change in the economic value per each option granted. In October 2002, the Company approved an adjustment to the exercise prices of all outstanding options issued prior to September 19, 2002 to adjust for the dividend to the Company's stockholders, in accordance with FIN 44, "Accounting for Certain Transactions involving Stock Compensation an Interpretation of APB No. 25." The exercise prices of these options were decreased by $0.98 per option. The $0.98 adjustment reflects the change in the price of Company's common stock between the close of business on Friday, September 20, 2002, the last date on which the common stock price included the dividend, and the open of business on Monday, September 23, 2002, the first date on which the common stock began trading without the right to the dividend. 102 INSTINET GROUP INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Reuters Plans Certain employees of the Company participate in the following Reuters stock option plans (collectively, the "Reuters Plans"). - Save As You Earn Plan ("SAYE Plan") -- Reuters introduces a new SAYE plan each year. For U.S.-based employees, options are issued on Reuters American Depository Shares ("ADS"). SAYE options are issued for terms of 4 or 6 years, vest over a 3 or 5 year period, respectively, and are exercisable at the market price of the ADS on the date of grant. The Company will contribute 20% of the exercise price of the option to U.S.-based employees when exercised. For non-U.S.-based employees, options are issued on Reuters ordinary shares. Options are issued for terms similar to the U.S.-based employees; however, they have an exercise price 20% less than the market price of the ordinary shares on the date of grant. Accordingly, the Company recorded as deferred compensation the intrinsic value of the stock options awarded which is recognized over the vesting period. The following table summarizes Reuters ADS and ordinary share options issued under the Reuters SAYE Plan as of December 31, 2002 and 2001:
WEIGHTED AVERAGE WEIGHTED AVERAGE OPTIONS EXERCISE PRICE REMAINING CONTRACTUAL OUTSTANDING ($/OPTIONS) LIFE (YEARS) --------------- ---------------- ---------------------- DECEMBER 31, DECEMBER 31, DECEMBER 31, --------------- ---------------- ---------------------- PLAN 2002 2001 2002 2001 2002 2001 ---- ------ ------ ------ ------- ------ ------ ADS: 1998 SAYE.......... -- 9,826 -- $58.88 -- 1.8 1999 SAYE.......... 3,641 9,843 82.06 82.06 1.8 1.6 Ordinary Shares: 1996 SAYE.......... 7,411 10,209 9.39 8.60 0.3 0.3 1997 SAYE.......... 22,364 23,051 7.82 7.16 0.3 0.8 1998 SAYE.......... 24,818 21,790 7.46 6.84 0.8 1.8 1999 SAYE.......... 21,088 65,242 10.41 9.54 1.1 1.4 2000 SAYE.......... 50,659 80,512 15.48 14.19 1.6 2.7 2001 SAYE.......... -- 38,759 -- 14.58 -- 3.3
- Plan 2000 -- Reuters introduced the Plan 2000 option plan in 1998, under which employees may be entitled to a single option award to acquire 2000 shares of Reuters ordinary shares. Options are issued for terms of 4 years, vest after a 3-year period and are exercisable at the market price of the ordinary share on the date of grant. The following table summarizes Reuters ordinary share options issued under the Reuters Plan 2000 as of December 31, 2002 and 2001:
WEIGHTED AVERAGE WEIGHTED AVERAGE EXERCISE PRICE REMAINING CONTRACTUAL OPTIONS OUTSTANDING ($/OPTIONS) LIFE (YEARS) ------------------- ---------------- ---------------------- DECEMBER 31, DECEMBER 31, DECEMBER 31, ------------------- ---------------- ---------------------- PLAN 2002 2001 2002 2001 2002 2001 ---- ------- --------- ------ ------- ------ ------ 1998 Plan 2000....... 284,000 1,360,000 8.58 $ 7.87 2.8 3.8 1999 Plan 2000....... 28,000 334,000 12.70 11.64 3.3 4.3
103 INSTINET GROUP INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Reuters ADS option activity under the Reuters SAYE Plan is as follows:
WEIGHTED WEIGHTED WEIGHTED AVERAGE AVERAGE AVERAGE DEC. 31, EXERCISE DEC. 31, EXERCISE DEC. 31, EXERCISE 2002 PRICE 2001 PRICE 2000 PRICE -------- -------- -------- -------- -------- -------- Outstanding, beginning of period.................... 19,669 $70.48 33,508 $65.89 33,711 $65.65 Granted..................... -- -- -- -- -- Exercised................... -- (516) 58.88 -- -- Forfeited................... (16,058) 63.76 (13,323) 58.88 (203) 58.88 ------- ------- ------ Outstanding, end of period.................... 3,641 $82.06 19,669 $70.48 33,508 $65.89 ======= ======= ====== Exercisable, end of period.................... -- -- -- -- -- --
Reuters ordinary shares option activity is as follows:
WEIGHTED WEIGHTED WEIGHTED AVERAGE AVERAGE AVERAGE DEC. 31, EXERCISE DEC. 31, EXERCISE DEC. 31, EXERCISE 2002 PRICE 2001 PRICE 2000 PRICE ---------- -------- --------- -------- --------- -------- Outstanding, beginning of period........... 1,933,563 $8.95 1,956,598 $ 9.54 1,975,452 $ 9.55 Granted............... -- -- 38,759 14.19 (82,507) 15.38 Exercised............. (8,000) 8.58 (44,981) 7.55 (98,977) 6.34 Forfeited............. (1,487,223) 9.54 (16,813) 7.62 (2,384) 14.13 ---------- --------- --------- Outstanding, end of period.............. 438,340 $9.64 1,933,563 $ 8.95 1,956,598 $ 9.54 ========== ========= ========= Exercisable, end of period.............. -- -- -- -- -- --
OPTION EXPENSE The Company applies APB Opinion No. 25, "Accounting for Stock Issued to Employees", SFAS 123, and related accounting interpretations for all of its stock-based plans referred to above. As a result, the Company has recorded as compensation expense $4,254, $5,979 and $2,674 as of December 31 2002, 2001 and 2000, respectively. OTHER The weighted average estimated fair value of the Instinet Plan options granted during the years ended December 31, 2002 and 2001 was $4.42 and $5.80 per option, respectively. The weighted average estimated fair value of the Reuters Plan's ordinary share options granted during the years ended December 31, 2001 was 104 INSTINET GROUP INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) $8.58 per option. The fair value of each option granted is estimated, as of its respective grant dates, using a Black-Scholes option-pricing model with the following weighted average assumptions:
EXPECTED DIVIDEND EXPECTED RISK FREE LIFE, IN PLAN YIELD VOLATILITY INTEREST RATE YEARS ---- -------- ---------- ------------- -------- Instinet Plan (for the year ended December 31, 2000).................................. 0% 69.50% 4.38% 7 Instinet Plan (for the year ended December 31, 2001).................................. 0 68.48 6.54 7 Instinet Plan (for the year ended December 31, 2002).................................. 0 87.39 3.20 7 1996 SAYE.................................... 1.47 23.79 7.00 3 or 5 1997 SAYE.................................... 1.47 23.79 7.00 3 or 5 1998 SAYE.................................... 1.50 21.64 6.78 3 or 5 1999 SAYE.................................... 1.70 23.69 5.24 3 or 5 2000 SAYE.................................... 1.30 47.90 6.76 3 or 5 2001 SAYE.................................... 1.33 48.84 6.77 3 or 5 1998 Plan 2000............................... 1.70 34.30 6.00 3 1999 Plan 2000............................... 1.70 34.30 5.23 3
11. EARNINGS PER SHARE ($ AND SHARES IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) Basic earnings per share ("EPS") excludes dilution and is computed by dividing net income by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential reduction in EPS that could occur if securities or other contracts to issue common stock were exercised or converted into common stock. Options and warrants to purchase 4,426 shares of common stock were not included in the computation of diluted EPS for the year ended December 31, 2002 as the Company incurred losses during the period. Accordingly, the diluted EPS computation does not include the anti-dilutive effect of these options and warrants. Options to purchase 20,373 shares of common stock were not included in the computation of diluted EPS for the year ended December 31, 2001 as the exercise price for these options exceeded the average market price of the Company's common stock for each of the respective periods. Accordingly, the diluted EPS computation does not include the anti-dilutive effect of these options. The number of common shares outstanding, both basic and diluted, for the year ended December 31, 2000 reflects the number of shares that would have been held by Reuters after giving effect to the return of capital payment of $150,000 to Reuters and conversion of the Company from a limited liability company to a corporation, which is pushed back for EPS calculation purposes. 105 INSTINET GROUP INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Earnings per share under the basic and diluted computations are as follows:
DECEMBER 31, ------------------------------- 2002 2001 2000 --------- -------- -------- Net income/(loss)................................... $(735,230) $144,767 $148,182 Weighted average number of common shares outstanding -- basic.............................. 271,542 230,561 206,900 Common stock equivalent shares related to stock incentive plans................................... -- 3 -- --------- -------- -------- Weighted average number of common shares outstanding -- diluted............................ 271,542 230,564 206,900 Basic earnings/(loss) per share..................... $ (2.71) $ 0.63 $ 0.72 Diluted earnings/(loss) per share................... $ (2.71) $ 0.63 $ 0.72
12. SHORT-TERM BORROWINGS ($ IN THOUSANDS) Short-term borrowings represent amounts borrowed on uncommitted bank lines of credit, which provide for borrowings for operational and general corporate purposes which generally bear interest rates that approximate the Federal Funds rate in the United States and euro or pound sterling LIBOR rates in Europe. The following is a summary of short-term borrowings information:
YEAR ENDED DECEMBER 31, -------------------------------- 2002 2001 2000 -------- -------- ---------- Average amount outstanding during each period: U.S. dollar denominated........................... $ 2,259 $ 15,390 $ 5,970 Non-U.S. dollar denominated....................... 37,700 65,055 153,136 -------- -------- ---------- Total.......................................... 39,959 80,445 159,106 ======== ======== ========== Maximum amount outstanding during each period: U.S. dollar denominated........................... 40,002 90,714 114,000 Non-U.S. dollar denominated....................... 134,362 145,614 913,279 -------- -------- ---------- Total.......................................... $174,364 $236,328 $1,027,279 ======== ======== ==========
Weighted average interest rates for U.S. dollar and non-U.S. dollar denominated obligations are as follows:
YEAR ENDED DECEMBER 31, ------------------ 2002 2001 2000 ---- ---- ---- U.S. dollar denominated: Weighted average interest rate during each period......... 2.66% 5.34% 6.67% Weighted average interest rate at each period end......... 2.50 5.02 7.06 Non-U.S. dollar denominated: Weighted average interest rate during each period......... 3.64 3.75 5.86 Weighted average interest rate at each period end......... 4.29 4.65 6.21
106 INSTINET GROUP INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 13. EMPLOYEE BENEFIT PLANS ($ IN THOUSANDS) The Company participates in various Reuters pension plans around the world. The U.S. employees are eligible to participate in the Reuters 401(k) plan. The majority of non-U.S. employees who join the Company prior to April 1999 are eligible to participate in Reuters Pension Fund ("RP Fund"). The majority of non-U.S. employees who joined after April 1999 are eligible to participate in the Reuters Retirement Plan ("RR Plan"). Each of these plans is supplemented by non-qualified plans that allow for contributions above limits imposed by local taxing authorities. Funding is provided by voluntary contributions from members of the plans and contributions from the Company. U.S. employees can contribute up to 13% of their annual base salary to the 401(k) plan and the Company contributes 8.125% of the employees' annual base salary. For the RR Plan, non-U.S. employees can contribute up to 4% of their annual base salary and the Company contributes 7% of their annual base salary. For the RP Fund, non-U.S. employees can contribute up to 6% of their annual base salary and the Company contributes 10.025% of their annual base salary. All plans are administered by third parties. Certain employees of the Company also participate in a long-term performance-based incentive compensation plan ("long term plan"). Under the long term plan, a portion of the operating earnings of the Company exceeding certain predetermined targets aggregated over a four-year period (a "Performance Period") are distributed to participants. A new Performance Period is started each January and as of December 31, 2001 and 2000, there were 1 and 2 long term plans in effect, respectively. Substantially all employees of the Company are eligible to participate in Reuters employee stock purchase plan ("ESP Plan") where employees can contribute up to a predetermined limit of their salary towards the purchase of Reuters common shares for non-U.S. employees or ADS for U.S. employees. The Company may contribute 20% of the employees' contribution to the plan. Reuters also provides certain employees of the Company with post retirement benefits such as healthcare and life insurance. Eligible employees are those who retire from the Company at normal retirement age. In 2002, Reuters modified its post retirement benefits and a majority of accrued costs related to the post retirement plans will be reversed over the next 19 years in accordance with generally accepted accounting principles. The Company's expenses related to the employee benefit plans referred to above are as follows:
YEAR ENDED DECEMBER 31, ------------------------- PLAN 2002 2001 2000 ---- ------ ------- ------ Pension plans............................................. $9,513 $12,937 $6,981 Long term plan............................................ 47 9,405 9,918 ESP plan.................................................. -- 206 191 Post retirement benefits.................................. 733 1,358 986
In addition, certain employees of the Company are eligible to participate in the Instinet Management Deferral Plan (the "Deferral Plan"). Under the Deferral Plan, employees can voluntarily defer a portion of their compensation for a period of five years by investing in certain employer provided investment options administered by ICS. The participating employees bear the entire risk of each investment election. Deferred compensation as of December 31, 2001 and 2000 was $15,750 and $42,577, respectively. The Company ceased the deferral plan at the end of 2002. Employees of Island are eligible to participate in Island's defined contribution 401(k) plan upon meeting certain eligibility requirements. The Company makes discretionary contributions based upon its results of operations. In January 2003, the Company terminated the Island plan and transferred the Island employees to the Instinet Plans. 107 INSTINET GROUP INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 14. INCOME TAXES ($ IN THOUSANDS) The provision for income tax consisted of the following:
YEAR ENDED DECEMBER 31, ------------------------------ 2002 2001 2000 -------- -------- -------- Current: Federal............................................ $(30,911) $ 61,751 $102,869 State.............................................. 6,456 19,463 40,097 Foreign............................................ 5,292 1,187 9,029 -------- -------- -------- Total current................................... (19,163) 82,401 151,995 Deferred: Federal............................................ (28,323) 14,113 (27,352) State.............................................. (6,629) 3,726 (9,037) State operating loss carryforward.................. (11,982) -- -- Foreign............................................ 1,583 7,201 822 -------- -------- -------- Total deferred.................................. (45,351) 25,040 (35,567) -------- -------- -------- Total provision for income taxes................ $(64,591) $107,441 $116,428 ======== ======== ========
The temporary differences which have created deferred tax assets and liabilities are detailed below:
DECEMBER 31, ------------------- 2002 2001 -------- -------- Deferred tax assets: Depreciation and amortization............................. $ 6,838 $ 12,104 Deferred compensation..................................... 13,516 25,246 Foreign tax credits....................................... 1,322 -- Net operating losses...................................... 29,815 5,170 Accruals and allowances................................... 59,582 24,449 Goodwill.................................................. 23,997 -- Unrealized gains and losses on securities owned........... 21,749 3,190 -------- -------- Total deferred tax assets.............................. 156,819 70,159 Deferred tax liabilities: Depreciation and amortization............................. (22,015) -- Unrealized gains on securities owned...................... (9,572) (12,835) -------- -------- Total deferred tax liabilities......................... (31,587) (12,835) -------- -------- Valuation allowance......................................... (55,009) (5,159) -------- -------- Deferred tax assets, net.................................... $ 70,223 $ 52,165 ======== ========
Management believes that it is more likely than not the tax assets, net of the valuation allowance, will be realized. The valuation allowance relates to operating losses in certain non-U.S. subsidiaries and unrealized losses on securities owned that may not be realized in the future. The following is a reconciliation of the provision for income taxes and the amount computed by applying the U.S. Federal statutory rate to income before income taxes. 108 INSTINET GROUP INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
YEAR ENDED DECEMBER 31, -------------------- 2002 2001 2000 ----- ---- ----- U.S. federal income tax rate................................ 35.0% 35.0% 35.0% State and local income tax, net of Federal income tax benefit................................................... 0.8 5.2 8.5 Foreign income taxes........................................ (2.4) 1.8 0.5 Permanent differences....................................... (22.2) 1.3 (0.1) Valuation allowance......................................... (2.9) -- -- Miscellaneous............................................... (0.2) (0.7) 0.1 ----- ---- ----- 8.1% 42.6% 44.0% ===== ==== =====
15. COMPREHENSIVE INCOME ($ IN THOUSANDS) Comprehensive income includes net income and changes in stockholders' equity except those resulting from investments by, or distributions to, stockholders. Comprehensive income is as follows:
DECEMBER 31, ------------------------------- 2002 2001 2000 --------- -------- -------- Net income/(loss)................................... $(735,230) $144,767 $148,182 Changes in other comprehensive income/(loss): Foreign currency translation adjustment........... 23,961 1,303 (2,029) --------- -------- -------- Total comprehensive income/(loss), net of tax....... $(711,269) $146,070 $146,153 ========= ======== ========
16. ALLOWANCE FOR DOUBTFUL ACCOUNTS ($ IN THOUSANDS) The following table summarizes the activity in the Company's allowance for doubtful accounts:
BALANCE AT ADDITIONS BALANCE AT BEGINNING OF CHARGED TO AMOUNTS OTHER END OF PERIOD EXPENSE WRITTEN OFF ADDITIONS PERIOD ------------ ---------- ----------- --------- ---------- For the year ended December 31, 2002... $7,472 $19,739 $(15,087) $10,238 $22,002 For the year ended December 31, 2001... 3,186 6,313 (2,027) -- 7,472 For the year ended December 31, 2000... 1,941 1,850 (605) -- 3,186
Other additions were acquired in connection with the Company's acquisition of Island. 17. SEGMENT/GEOGRAPHIC DATA ($ IN THOUSANDS) The Company's activities as a provider of agency brokerage services constitute a single business segment pursuant to SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information. The accompanying table summarizes select data about the Company's domestic and international operations. Because of the highly integrated nature of the financial markets in which the Company competes and the integration of the Company's worldwide business activities, the Company believes that results by geographic region are not necessarily meaningful in understanding its business. 109 INSTINET GROUP INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
YEAR ENDED DECEMBER 31, ------------------------------------ 2002 2001 2000 ---------- ---------- ---------- Total revenues: Domestic....................................... $ 843,384 $1,130,940 $1,093,687 International.................................. 215,816 360,087 334,792 ---------- ---------- ---------- Total....................................... 1,059,200 1,491,027 1,428,479 ========== ========== ========== Income/(loss) before income taxes: Domestic....................................... (779,844) 180,437 248,725 International.................................. 32,914 110,904 71,520 ---------- ---------- ---------- Total....................................... $ (746,930) $ 291,341 $ 320,245 ========== ========== ==========
DECEMBER 31, ----------------------- 2002 2001 ---------- ---------- Identifiable assets: Domestic.................................................. $1,905,418 $2,102,145 International............................................. 377,477 892,696 ---------- ---------- Total.................................................. $2,282,895 $2,994,841 ========== ==========
18. NET CAPITAL REQUIREMENTS ($ IN THOUSANDS) The Company's U.S. broker-dealer subsidiaries are subject to the SEC's Uniform Net Capital Rule, which requires the maintenance of minimum net capital. The subsidiaries have elected to use the alternative method, which requires that they maintain minimum net capital equal to the greater of $250 or 2% of aggregate debit items arising from customer transactions. As of December 31, 2002 and 2001, ICS, which is the counterparty to each of the customer transactions in U.S. securities executed through ICorp (but not Island, which clears its securities transactions through another broker-dealer), had net capital of $163,084 and $259,990, which was $160,179 and $256,443 in excess of its required net capital of $2,905 and $3,547, respectively. Certain other U.S. broker-dealer subsidiaries of the Company are also subject to capital adequacy requirements and were in compliance with their respective requirements. The Company's international broker-dealer subsidiaries are subject to capital adequacy requirements promulgated by authorities of the countries in which they operate. As of December 31, 2002 and 2001, these subsidiaries had met their local capital adequacy requirements. 19. COMMITMENTS AND CONTINGENCIES ($ IN THOUSANDS) LITIGATION From time to time, the Company is involved in various legal proceedings arising in the ordinary course of business. The Company is also subject to periodic regulatory audits and inspections. While any litigation contains an element of uncertainty, it is the opinion of management after consultation with counsel, that the outcomes of such proceedings or claims are unlikely to have a material adverse effect on the business, financial condition or operating results of the Company. 110 INSTINET GROUP INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) LEASES The Company leases office space and equipment under non-cancellable operating leases with third parties and Reuters extending for periods in excess of one year. Certain leases contain renewal options and escalation clauses. Future minimum rental commitments under the Company's leases are as follows:
Year ending December 31, 2003............................... $ 36,281 Year ending December 31, 2004............................... 30,502 Year ending December 31, 2005............................... 26,736 Year ending December 31, 2006............................... 24,870 Year ending December 31, 2007............................... 24,115 Thereafter.................................................. 110,499
Rental expense amounted to $26,818, $32,299 and $23,238 for the years ended December 31, 2002, 2001 and 2000, respectively. OTHER COMMITMENTS AND CONTINGENCIES The Company has received letter of credit agreements totaling $99,813, $174,800 and $343,313 for the years ended December 31, 2002, 2001 and 2000 as guarantees to various non-U.S. securities clearing and regulatory agencies, as well as other corporate services and obligations. The Company pays an annual fee of one half of one percent of the value of the letter of credit. 20. RELATED PARTY TRANSACTIONS ($ IN THOUSANDS) The Company transacts business and has extensive relationships with Reuters and its related parties. Due to these relationships, it is possible that the terms of these transactions are not the same as those that would result from transactions among unrelated parties. All receivables and payables with affiliates and the Parent are generally settled on a quarterly basis. A description of these transactions and relationships is set forth below: The Company receives Reuters data consisting of news and information which is used by the Company as well as distributed to its customers. For the years ended December 31, 2002, 2001 and 2000, the Company recorded as expense $11,814, $13,849 and $12,321, respectively, related to these services. Reuters provides certain operational and administrative support and other general corporate services to the Company. For the years ended December 31, 2002, 2001 and 2000, the Company recorded as expense $28,864, $31,228 and $41,239, respectively, related to these services. In 2002, the Company entered into agreements with Bridge Trading, a wholly owned subsidiary of Reuters, under which the Company pays fees for accounts or orders introduced by Bridge Trading to the Company. Payments under these agreements amounted to $415 for the year ended December 31, 2002. In 2001, the Company leased office space for its corporate headquarters in New York City from 3 Times Square Associates LLC, a joint venture between Reuters and an independent third party. The lease expires in 2021 with a one-time right to cancel the lease after 10 years. Payment related to this lease agreement was $14,569 and $8,563 for the years ended December 31, 2002 and 2001. Effective September 2001, the Company sold at book value its Research and Analytical Product ("R&A") to Reuters in order to allow Instinet R&A users to leverage Reuters investment in Bridge by allowing them to participate in a much broader service, while still benefiting from the information currently available through R&A. Under the agreement, the Company sold to Reuters all the assets, rights, claims, contracts, licenses, trade secrets and confidential and proprietary business information, and substantially all of 111 INSTINET GROUP INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) the R&A employees used by it in the R&A product platform. In turn, Reuters agreed to assume certain liabilities and obligations of the R&A business. The net book value of the assets sold, which consisted of computer hardware, machinery and equipment, was $7,868. The Company entered into a mutual services agreement with Reuters under which the Company will continue to assist Reuters in supporting the R&A business for up to 18 months. In addition, the Company and Reuters have agreed to allow customers of the Company who have been using the R&A product to continue to receive service and support from Reuters. For the years ended December 31, 2002 and 2001, the Company has recorded $5,582 and $1,757, respectively, as expense to Reuters for continuing to provide this service. In June 2000, the Company sold at book value all of its equipment related to its telecommunications network and transferred certain employees to Radianz, a joint venture between Reuters and Equant Finance B.V., which was created to provide internet protocol networks to the financial services industry. Equant Finance B.V. is a provider of voice, data and internet services. Since June 2000, Radianz provides services related to the Company's core communications network that prior to the sale would have been provided by the Company. The Company, by the nature of a master agreement between Reuters and Radianz, is subject to fee arrangements negotiated by Reuters. For the years ended December 31, 2002 and 2001, and the period from July 2000 to December 31, 2000, the Company incurred expenses of $30,042, $58,686 and $30,959, respectively, related to the Radianz agreement. In February 2000, Reuters provided a subordinated loan to the Company of $49,000 to fund the Company's purchase of LJR. This subordinated loan bore an interest rate based on six-month LIBOR plus 1.25% and was repaid in June 2001. For the years ended December 31, 2001 and 2000, the Company recorded interest expense related to this loan of $1,640 and 3,250, respectively. The Company performs for Reuters certain technology enhancement related services and provides trading information and use of the Company's technology platform related to its fixed income trading systems at no cost to Reuters. 21. DIVIDEND ($ IN THOUSANDS) In connection with the acquisition of Island, the Company paid a $1.00 per common share cash dividend to its stockholders of record as of September 19, 2002, which represented a distribution of $248,739, of which $206,900 was distributed to the Company's Parent. The Company paid this dividend on October 3, 2002. 22. TREASURY STOCK ($ IN THOUSANDS) During 2002, the Company purchased 244,960 shares of its own common stock at a cost of $1,532 in connection with its RSU plan (Note 10) and reissued 39,153 shares as RSUs became vested. 23. COLLATERAL ARRANGEMENTS ($ IN THOUSANDS) As of December 31, 2002 and 2001, the fair value of collateral held by the Company that can be sold or repledged totaled $777,286 and $607,069, respectively. Such collateral is generally obtained under resale and securities borrowing agreements. Of this collateral, $699,037 and $548,487 had been sold or repledged generally to cover short sales or effect deliveries of securities as of December 31, 2002 and 2001, respectively. In addition, securities in customer accounts with a fair value of $47,549 and $76,462 could be sold or repledged by the Company as of December 31, 2002 and 2001, respectively. 24. FAIR VALUE OF FINANCIAL INSTRUMENTS Statement of Financial Accounting Standards No. 107, "Disclosure about Fair Value of Financial Instruments," requires the disclosure of the fair value of financial instruments, including assets and liabilities recognized on the consolidated statements of financial condition. Management estimates that the aggregate 112 INSTINET GROUP INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) net fair value of all financial instruments recognized on the consolidated statements of financial condition approximates their carrying value, as such financial instruments are short term in nature and bear interest at current market rates. 25. CONCENTRATIONS OF CREDIT, MARKET AND OTHER RISKS The Company is exposed to substantial credit risk from both parties to a securities transaction during the period between the transaction date and the settlement date. This period is three business days in the U.S. equities markets and can be as much as 30 days in some international markets. In addition, the Company may have credit exposure that extends beyond the settlement date in the case of a party that does not settle in a timely manner by failing either to make payment or to deliver securities. We hold the securities that are the subject of the transaction as collateral for our customer receivables. Adverse movements in the prices of these securities can increase our credit risk. The majority of the Company's transactions and, consequently, the concentration of its credit exposure are with broker-dealers and other financial institutions, primarily located in the United States and the U.K. The Company seeks to control its credit risk through a variety of reporting and control procedures, including establishing credit limits and enforcing credit standards based upon a review of the counter-parties' financial condition and credit ratings. The Company monitors trading activity and collateral levels on a daily basis for compliance with regulatory and internal guidelines and obtains additional collateral, if appropriate. For the years ended December 31, 2002, 2001 and 2000, losses from transactions in which a party refused or was unable to settle have been immaterial. The Company uses securities borrowed and loaned transactions to facilitate the settlement process to meet its customers' needs. Under these transactions, the Company either receives or provides collateral, generally cash or securities. In the event the counterparty is unable to meet its contractual obligations to return the pledged collateral, the Company may be exposed to the market risk of acquiring the collateral at prevailing market prices. The Company is subject to operational, technological and settlement risks. These include the risk of potential financial loss attributable to operational factors such as untimely or inaccurate trade execution, clearance or settlement or the inability to process large volumes or transactions. The Company is also subject to risk of loss attributable to technological limitations or computer failures that may constrain the Company's ability to gather, process and communicate information efficiently, securely and without interruption. 26. SUBSEQUENT EVENTS Effective January 1, 2003, the Company terminated its participation in the Reuters 401(k) plan and formed the Instinet 401(k) plan. On January 7, 2003, pursuant to an existing option purchase agreement, the Company purchased Harborview LLC, a NYSE floor brokerage firm for $594,000. 113 INSTINET GROUP INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 27. QUARTERLY RESULTS (UNAUDITED) The following tables set forth certain unaudited consolidated quarterly statement of income data. The unaudited consolidated quarterly data should be read together with the consolidated financial statements and related notes included elsewhere in this annual report. The results for any quarter are not necessarily indicative of results for any future period.
QUARTER ENDED ---------------------------------------------------------------------------------------- DEC. 31, SEPT. 30, JUNE 30, MAR. 31, DEC. 31, SEPT. 30, JUNE 30, MAR. 31, 2002 2002 2002 2002 2001 2001 2001 2001 --------- --------- -------- -------- -------- --------- -------- -------- REVENUE Transaction fees........ $ 278,441 $ 263,917 $269,933 $265,881 $319,219 $311,737 $378,891 $414,496 Interest................ 8,546 10,699 11,958 8,934 11,562 14,254 11,199 12,281 Investments............. (19,878) (20,336) (13,181) (5,714) 17,817 (6,330) 3,689 2,212 --------- --------- -------- -------- -------- -------- -------- -------- Total revenues...... 267,109 254,280 268,710 269,101 348,598 319,661 393,779 428,989 EXPENSES Compensation and benefits.............. 60,745 63,809 70,989 86,218 83,996 84,820 112,735 124,797 Soft dollar and commission recapture............. 50,161 51,824 61,738 53,591 58,174 51,595 54,228 56,053 Broker-dealer rebates... 56,601 39,004 25,503 3,291 -- -- -- -- Brokerage, clearing and exchange fees......... 36,994 42,079 33,767 36,681 40,364 33,284 36,185 36,390 Communications and equipment............. 36,604 26,620 29,187 33,309 32,872 36,939 42,560 43,631 Depreciation and amortization.......... 24,659 16,712 17,930 19,123 21,269 21,206 19,669 18,610 Occupancy............... 16,158 12,223 13,595 13,552 11,587 14,424 13,796 10,111 Professional fees....... 7,820 5,110 6,646 5,018 7,880 8,085 9,012 15,013 Marketing and business development........... 3,756 2,451 7,480 3,407 2,739 843 8,477 10,084 Other................... 16,559 9,899 16,852 15,674 13,742 14,312 13,545 12,935 Restructuring........... 62,405 955 42,410 15,030 1,557 22,821 -- -- Goodwill impairment..... -- 551,991 -- -- -- -- -- -- Loss of fixed assets at World Trade Center.... -- -- -- -- 818 19,528 -- -- Insurance recovery of fixed assets lost..... -- -- -- -- (1,472) (19,528) -- -- --------- --------- -------- -------- -------- -------- -------- -------- Total expenses...... 372,462 822,677 326,097 284,894 273,526 288,329 310,207 327,624 Income/(loss) from continuing operations before income taxes, cumulative effect of change in accounting principle............. (105,353) (568,397) (57,387) (15,793) 75,072 31,332 83,572 101,365 Income tax provision/(benefit)... 6,690 (39,958) (14,117) (5,703) 26,662 15,685 36,198 43,665 Income/(loss) from continuing operations before cumulative change in accounting principle........... (112,043) (528,439) (43,270) (10,090) 48,410 15,647 47,374 57,700 Discontinued operations: Loss from operations of fixed income business............ (412) -- (23,581) (9,775) (4,535) (11,871) (10,841) (11,886) Income tax benefit.... 252 -- 6,946 3,824 1,844 4,434 4,197 4,294 --------- --------- -------- -------- -------- -------- -------- --------
114 INSTINET GROUP INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
QUARTER ENDED ---------------------------------------------------------------------------------------- DEC. 31, SEPT. 30, JUNE 30, MAR. 31, DEC. 31, SEPT. 30, JUNE 30, MAR. 31, 2002 2002 2002 2002 2001 2001 2001 2001 --------- --------- -------- -------- -------- --------- -------- -------- Income before cumulative effect of change in accounting principle............. (112,203) (528,439) (59,905) (16,041) 45,719 8,210 40,730 50,108 Cumulative effect of change in accounting principle, net of tax................... -- -- -- (18,642) -- -- -- -- --------- --------- -------- -------- -------- -------- -------- -------- NET INCOME/(LOSS)... $(112,203) $(528,439) $(59,905) $(34,683) $ 45,719 $ 8,210 $ 40,730 $ 50,108 Basic and diluted: Earnings/(loss) per share............... $ (0.34) $ (2.05) $ (0.24) $ (0.14) $ 0.18 $ 0.03 $ 0.18 $ 0.24
115 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY The information about Directors and Executive Officers required to be furnished pursuant to this item is incorporated by reference from the "General Information Concerning the Board of Directors," "Compensation of Directors," and "Compensation of Executive Officers" sections of our definitive proxy statement for our 2003 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission pursuant to Regulation 14A within 120 days after December 31, 2002 (the "Proxy Statement"). ITEM 11. EXECUTIVE COMPENSATION The information required to be furnished pursuant to this item is incorporated by reference from the "Compensation of Executive Officers" section of the Proxy Statement. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required to be furnished pursuant to this item is incorporated by reference from the "Security Ownership of Directors, Nominees and Executive Officers" section of the Proxy Statement. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required to be furnished pursuant to this item is incorporated by reference from the "Certain Business Relationships" section of the Proxy Statement. ITEM 14. CONTROLS AND PROCEDURES EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES Within the 90 days prior to the date of this report, we carried out an evaluation under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based upon and as of the date of that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the disclosure controls and procedures are effective in all material respects to ensure that information required to be disclosed in the reports we file and submit under the Exchange Act are recorded, processed, summarized and reported as and when required. CHANGES IN INTERNAL CONTROLS There have been no significant changes in our internal controls or other factors that could significantly affect our internal controls subsequent to the date of their evaluation. There were no significant deficiencies or material weaknesses identified in the evaluation and therefore no corrective actions were taken. 116 PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) Exhibit List
EXHIBIT NUMBER DESCRIPTION ------- ----------- 2.1 Contribution Agreement between Instinet Corporation and Instinet Group LLC, dated July 25, 2000 (Incorporated by reference to Exhibit 2.1 to the Registrant's Form S-1 (Registration No. 333-55190). 2.2 Asset Contribution Agreement between Instinet Corporation and Instinet Group LLC, dated July 31, 2000 (Incorporated by reference to Exhibit 2.2 to the Registrant's Form S-1 (Registration No. 333-55190). 2.3 Subscription Agreement between Reuters Holdings Switzerland SA and Instinet Group LLC, dated July 31, 2000 (Incorporated by reference to Exhibit 2.3 to the Registrant's Form S-1 (Registration No. 333-55190). 2.4 Contribution Agreement between Reuters C Corporation and Instinet Group LLC, dated September 29, 2000 (Incorporated by reference to Exhibit 2.4 to the Registrant's Form S-1 (Registration No. 333-55190). 2.5 Contribution Agreement between Reuters Holdings Switzerland SA and Instinet Group LLC, dated September 29, 2000 (Incorporated by reference to Exhibit 2.5 to the Registrant's Form S-1 (Registration No. 333-55190)). 2.6 Contribution Agreement between Reuters Holdings Switzerland SA and Instinet Group LLC, dated September 29, 2000 (Incorporated by reference to Exhibit 2.6 to the Registrant's Form S-1 (Registration No. 333-55190)). 2.7 Agreement and Plan of Merger, dated as of June 9, 2002, (as amended as of August 7, 2002) among Instinet Group Incorporated, Instinet Merger Corporation and Island Holding Company, Inc. (Incorporated by reference to Exhibit 2.1 to the Registrant's Form S-4 (Registration No. 333-97071)). 3.1 Amended and Restated Certificate of Incorporation of Instinet Group Incorporated (Incorporated by reference to Exhibit 3.1 to the Registrant's Current Report on Form 8-K as filed with the Commission on September 23, 2002). 3.2 Amended and Restated By-Laws of Instinet Group Incorporated (Incorporated by reference to Exhibit 3.2 to the Registrant's Current Report on Form 8-K as filed with the Commission on September 23, 2002). 4.1 Form of Common Stock Certificate (Incorporated by reference to Exhibit 4.1 to the Registrant's Form S-1 (Registration No. 333-55190)). 4.2 Rights Agreement between Instinet Group Incorporated and Mellon Investor Services LLC (Incorporated by reference to Exhibit 4.3 to the Registrant's Quarterly Report filed on Form 10-Q (Commission file No. 000-32717) for the quarterly period ended June 30, 2001). 4.3 Amendment No. 1 to the Rights Agreement between Instinet Group Incorporated and Mellon Investor Services LLC dated as of September 3, 2002 (Incorporated by reference to Exhibit 99.1 to the Registrant's Current Report on Form 8-K as filed with the Commission on September 13, 2002). 10.1 Exchange Agent Agreement, dated as of August 27, 2002, between Instinet Group Incorporated, and Mellon Investor Services LLC 2002 (Incorporated herein by reference to Exhibit 10.1 to Registrant's Quarterly Report on Form 10-Q (Commission File No. 000-32717) for the period ended September 30, 2002). 10.2 Ameritrade Option Exercise Agreement between Instinet Group Incorporated, Datek Online Holdings Corporation and Ameritrade Holding Corporation dated as of October 18, 2002 (Incorporated by reference to Exhibit 10.1 to the Registrant's Form S-3 (Registration No. 333-100670)).
117
EXHIBIT NUMBER DESCRIPTION ------- ----------- 10.3+ Employment Agreement between Instinet Group Incorporated and Andre-Francois Helier Villeneuve, dated September 16, 2002 (Incorporated herein by reference to Exhibit 10.4 to Registrant's Quarterly Report on Form 10-Q (Commission File No. 000-32717) for the period ended September 30, 2002). 10.4+ Employment Agreement between Instinet Group Incorporated and Edward J. Nicoll, dated September 20, 2002 (Incorporated herein by reference to Exhibit 10.5 to Registrant's Quarterly Report on Form 10-Q (Commission file No. 000-32717) for the period ended September 30, 2002). 10.5+ Agreement between Instinet Group Incorporated and Peter Fenichel, dated October 7, 2002 (Incorporated herein by reference to Exhibit 10.6 to Registrant's Quarterly Report on Form 10-Q (Commission file No. 000-32717) for the period ended September 30, 2002). 10.6*+ Non-Executive Chairman Compensation Letter between Instinet Group Incorporated and Ian Strachan, dated January 1, 2003. 10.7+ Employment Agreement between Instinet Group LLC and Douglas M. Atkin, dated April 2, 2001 (Incorporated by reference to Exhibit 10.1 to the Registrant's Form S-1 (Registration No. 333-55190)). 10.8*+ Employment Agreement between Instinet Group Incorporated and Mark Nienstedt, dated January 1, 2003. 10.9+ Employment Agreement between Instinet Group LLC and Mark Nienstedt, dated April 2, 2001 (Incorporated by reference to Exhibit 10.2 to the Registrant's Form S-1 (Registration No. 333-55190)). 10.10+ Employment Agreement between Instinet Group LLC and Kenneth K. Marshall, dated April 2, 2001 (Incorporated by reference to Exhibit 10.3 to the Registrant's Form S-1 (Registration No. 333-55190)). 10.11+ Employment Agreement between Instinet Group LLC and Andre-Francois Helier Villeneuve, dated April 30, 2001 (Incorporated by reference to Exhibit 10.27 to the Registrant's Form S-1 (Registration No. 333-55190)). 10.12+ Employment Agreement between Instinet Group LLC and Jean-Marc Bouhelier, dated April 2, 2001 (Incorporated by reference to Exhibit 10.5 to the Registrant's Annual Report on Form 10-K (Commission File No. 000-32717) for the fiscal year ended December 31, 2001). 10.13+ Employment Agreement between Instinet Corporation and John A. McEntire, IV dated October 1, 2001(Incorporated by reference to Exhibit 10.6 to the Registrant's Form S-1 (Incorporated by reference to Exhibit 10.6 to the Registrant's Annual Report on Form 10-K (Commission File No. 000-32717) for the fiscal year ended December 31, 2001). 10.14*+ Employment Agreement between Instinet Group LLC and Paul A. Merolla, dated April 30, 2001. 10.15*+ Termination Agreement between Instinet Group Incorporated and Mark Nienstedt, dated December 31, 2002. 10.16*+ Settlement, Release, Covenant Not To Sue, Waiver and Non-Disclosure Agreement between Instinet Group Incorporated and Andre-Francois Helier Villeneuve, dated December 10, 2002. 10.17*+ Settlement, Release, Covenant Not To Sue, Waiver and Non-Disclosure Agreement between Instinet Corporation and Douglas M. Atkin, dated April 30, 2002. 10.18*+ Settlement, Release, Covenant Not To Sue, Waiver and Non-Disclosure Agreement between Instinet Corporation and Michael J. Clancy, dated December 15, 2002. 10.19+ Settlement, Release, Covenant Not To Sue, Waiver and Non-Disclosure Agreement between Instinet Corporation and Michael Galano dated January 9, 2002 (Incorporated by reference to Exhibit 10.7 to the Registrant's Annual Report on Form 10-K (Commission File No. 000-32717) for the fiscal year ended December 31, 2001). 10.20+ Instinet Group Annual Bonus Plan (Incorporated by reference to Exhibit 10.5 to the Registrant's Form S-1 (Registration No. 333-55190)).
118
EXHIBIT NUMBER DESCRIPTION ------- ----------- 10.21+ Instinet Earnings Participation Unit Plan effective January 1, 1993; form of 1998 Performance Award; Instinet 1999 Equity Super Plan Summary and Amendment; 1999 Super(EPU) Plan for Fixed Income Group (Incorporated by reference to Exhibit 10.6 to the Registrant's Form S-1 (Registration No. 333-55190)). 10.22+ Instinet 2000 Stock Option Plan (Incorporated by reference to Exhibit 10.7 to the Registrant's Form S-1 (Registration No. 333-55190)). 10.23*+ Instinet 2000 Stock Option Plan, as amended and restated, April 30, 2002. 10.24* Transaction System Agreement, effective as of September 19, 2002, between Instinet Corporation and Bridge Trading Company. 10.25* Global Solutions Agreement, dated as of March 14, 2003, between Instinet Group Incorporated and Reuters Limited. 10.26 Commission Sharing Agreement, dated as of April 23, 2002, between Instinet Corporation and Bridge Trading Company (Incorporated herein by reference to Exhibit 10.8 to Registrant's Quarterly Report on Form 10-Q for the period ended June 30, 2002). 10.27 Non-Exclusive Limited Patent License Agreement, effective as of August 2, 2002, between Instinet Group Incorporated and Reuters Limited (Incorporated herein by reference to Ex- hibit 10.9 to Registrant's Quarterly Report on Form 10-Q for the period ended June 30, 2002). 10.28 Institutional Order Entry Enhancements Agreement, dated as of September 19, 2002, between Instinet Group Incorporated and Reuters SA. (Incorporated by reference to Exhibit 10.1 to the Registrant's Current Report on Form 8-K as filed with the Commission on October 16, 2002). 10.29 Newport Content Services Agreement, dated as of September 19, 2002, between Instinet Group Incorporated and Reuters Limited. (Incorporated by reference to Exhibit 10.2 to the Registrant's Current Report on Form 8-K as filed with the Commission on October 16, 2002). 10.30 Preferred Soft Dollar Agreement, dated as of September 19, 2002, between Instinet Group Incorporated and Reuters Limited. (Incorporated by reference to Exhibit 10.3 to the Registrant's Current Report on Form 8-K as filed with the Commission on October 16, 2002). 10.31 Fixed Income Data Agreement between Reuters Limited and Instinet Corporation, dated October 1, 1999 (Incorporated by reference to Exhibit 10.8 to the Registrant's Form S-1 (Registration No. 333-55190)). 10.32 Letter agreement between Reuters Limited and Instinet Corporation, dated August 1, 2000, amending the Fixed Income Data Agreement (Incorporated by reference to Exhibit 10.10 to the Registrant's Form S-1 (Registration No. 333-55190)). 10.33 Global Reuters Services Contract between Reuters Limited and Instinet Global Holdings, Inc., dated December 21, 2000 (Incorporated by reference to Exhibit 10.9 to the Registrant's Form S-1 (Registration No. 333-55190)). 10.34 Redistribution Addendum to Reuters Global Agreement between Reuters Limited and Instinet Global Holding, Inc., dated December 21, 2000, amending the Global Reuters Services Contract (Incorporated by reference to Exhibit 10.11 to the Registrant's Form S-1 (Registration No. 333-55190)). 10.35 Lease between Kenvic Associates and Instinet Corporation, dated November 1992 (Incorporated by reference to Exhibit 10.12 to the Registrant's Form S-1 (Registration No. 333-55190)). 10.36 Lease Modification Agreement between Kenvic Associates and Instinet Corporation, dated July 9, 1993 (Incorporated by reference to Exhibit 10.13 to the Registrant's Form S-1 (Registration No. 333-55190)). 10.37 Second Lease Modification Agreement between Kenvic Associates and Instinet Corporation, dated June 7, 1994 (Incorporated by reference to Exhibit 10.14 to the Registrant's Form S-1 (Registration No. 333-55190)). 10.38 Third Lease Modification Agreement between Kenvic Associates and Instinet Corporation, dated October 21, 1994 (Incorporated by reference to Exhibit 10.15 to the Registrant's Form S-1 (Registration No. 333-55190)).
119
EXHIBIT NUMBER DESCRIPTION ------- ----------- 10.39 Fourth Lease Modification Agreement between Kenvic Associates and Instinet Corporation, dated February 14, 1996 (Incorporated by reference to Exhibit 10.16 to the Registrant's Form S-1 (Registration No. 333-55190)). 10.40 Fifth Lease Modification Agreement between Kenvic Associates and Instinet Corporation, dated June 14, 1996 (Incorporated by reference to Exhibit 10.17 to the Registrant's Form S-1 (Registration No. 333-55190)). 10.41 Sixth Lease Modification Agreement between Kenvic Associates and Instinet Corporation, dated July 24, 1997 (Incorporated by reference to Exhibit 10.18 to the Registrant's Form S-1 (Registration No. 333-55190)). 10.42 Sublease between Charles Schwab & Co., Inc. and Instinet Group Incorporated dated December 18, 2001 (Incorporated by reference to Exhibit 10.36 to the Registrant's Annual Report on Form 10-K (Commission File No. 000-32717) for the fiscal year ended December 31, 2001). 10.43* First Amendment to Sublease between Charles Schwab & Co., Inc. and Instinet Group Incorporated dated June 5, 2002. 10.44* Second Amendment to Sublease between Charles Schwab & Co., Inc. and Instinet Group Incorporated dated November 7, 2002. 10.45 Sublease between Reuters C Corp. and Instinet Global Holdings, Inc. (Incorporated by reference to Exhibit 10.17 to the Registrant's Quarterly Report filed on Form 10-Q (Commission file No. 000-32717) for the quarterly period ended June 30, 2001). 10.46 Data Distribution Agreement between Instinet Global Holdings, Inc. and Reuters America, Inc. (Incorporated by reference to Exhibit 10.13 to the Registrant's Quarterly Report filed on Form 10-Q (Commission file No. 000-32717) for the quarterly period ended June 30, 2001). 10.47 U.S. Tax Sharing Agreement by and among Reuters America Holdings, Inc., Instinet Group Incorporated and Instinet Global Holdings, Inc. (Incorporated by reference to Exhibit 10.15 to the Registrant's Quarterly Report filed on Form 10-Q (Commission file No. 000-32717) for the quarterly period ended June 30, 2001). 10.48 U.K. Tax Sharing Agreement between Reuters Group PLC, Instinet Group Incorporated and Instinet Holdings Limited (Incorporated by reference to Exhibit 10.16 to the Registrant's Quarterly Report filed on Form 10-Q (Commission file No. 000-32717) for the quarterly period ended June 30, 2001). 10.49 Corporate Services Agreement between Reuters Limited and Instinet Group Incorporated (Incorporated by reference to Exhibit 10.19 to the Registrant's Quarterly Report on Form 10-Q (Commission file No. 000-32717 for the quarterly period ended June 30, 2001)). 10.50 License Agreement between Instinet Global Services Limited and Reuters Limited dated May 17, 2001 (Incorporated by reference to Exhibit 10.14 to the Registrant's Quarterly Report on Form 10-Q (Commission file No. 000-32717 for the quarterly period ended June 30, 2001)). 10.51 Corporate Agreement between Instinet Group Incorporated and Reuters Limited, dated May 17, 2001 (Incorporated herein by reference to Exhibit 4.2 to the Registrant's Quarterly Report on Form 10-Q (Commission File No. 000-32717) for the period ended 10.52 Amended and Restated Corporate Agreement between Instinet Group Incorporated and Reuters Limited, dated June 9, 2002 (Incorporated herein by reference to Exhibit 10.1 to the Registrant's Form S-4 (Registration No. 333-97071)). 10.53 Registration Rights Agreement, dated as of September 20, 2002, by and among Instinet Group Incorporated, Reuters Limited, Reuters C Corp., Reuters Holdings Switzerland SA, the other entities listed on Exhibit A as the Bain Entities, the Silver Lake Entities, the TA Entities, the Finanzas Entities, the Advent Entities, Ameritrade Holding Corporation and Edward J. Nicoll (Incorporated herein by reference to Exhibit 10.2 to Registrant's Quarterly Report on Form 10-Q (Commission File No. 000-32717)for the period ended September 30, 2002).
120
EXHIBIT NUMBER DESCRIPTION ------- ----------- 10.54 Interest Purchase Agreement between Instinet Group Incorporated and David G. Jamail, David R. Burch, Overunder, LLC, John A. McEntire, IV, John Bunda, Laura Horne, Currin Van Eman and Shayne Young dated July 23, 2001 (Incorporated by reference to Exhibit 10.29 to the Registrant's Annual Report on Form 10-K (Commission File No. 000-32717) for the fiscal year ended December 31, 2001). 10.55 Amendment No. 1, dated as of October 1, 2001, to the Interest Purchase Agreement between Instinet Group Incorporated and David G. Jamail, David R. Burch, Overunder, LLC, John A. McEntire, IV, John Bunda, Laura Horne, Currin Van Eman and Shayne Young dated July 23, 2001 (Incorporated by reference to Exhibit 10.30 to the Registrant's Annual Report on Form 10-K (Commission File No. 000-32717) for the fiscal year ended December 31, 2001). 10.56 Registration Rights Agreement between Instinet Group Incorporated and David G. Jamail, David R. Burch, Overunder, LLC, John A. McEntire, IV, John Bunda, Laura Horne, Currin Van Eman and Shayne Young, dated October 1, 2001 (Incorporated by reference to Exhibit 10.39 to the Registrant's Annual Report on Form 10-K (Commission File No. 000-32717) for the fiscal year ended December 31, 2001). 10.57 Execution Services Agreement between Instinet Group Incorporated and ProTrader Securities Corporation, Zone Trading Partners, LLC, Zone Equity Partners, LP, David G. Jamail, David R. Burch and Andrew Kershner dated October 1, 2001, as amended (Incorporated by reference to Exhibit 10.31 to the Registrant's Annual Report on Form 10-K (Commission File No. 000-32717) for the fiscal year ended December 31, 2001). 10.58 Research and Analytics Asset Purchase Agreement between Instinet Group Incorporated and Reuters Group PLC effective as of September 28, 2001 (Incorporated by reference to Ex- hibit 10.32 to the Registrant's Annual Report on Form 10-K (Commission File No. 000-32717) for the fiscal year ended December 31, 2001). 10.59 Mutual Services Agreement between Instinet Group Incorporated and Reuters America Inc. dated December 18, 2001 (Incorporated by reference to Exhibit 10.33 to the Registrant's Annual Report on Form 10-K (Commission File No. 000-32717) for the fiscal year ended December 31, 2001). 10.60 Software License Agreement, as amended, between TIBCO Finance Technology, Inc. and Instinet Corporation, effective September 25, 1998 (Incorporated by reference to Exhibit 10.34 to the Registrant's Annual Report on Form 10-K (Commission File No. 000-32717) for the fiscal year ended December 31, 2001). 10.61 Software Maintenance Agreement between TIBCO Finance Technology, Inc. and Instinet Corporation, effective September 25, 1998 (Incorporated by reference to Exhibit 10.35 to the Registrant's Annual Report on Form 10-K (Commission File No. 000-32717) for the fiscal year ended December 31, 2001). 10.62 Testing and Certification Agreement between Instinet UK Limited (now called Instinet Europe Limited) and Effix SA dated November 7, 2000 (Incorporated by reference to Exhibit 10.37 to the Registrant's Annual Report on Form 10-K (Commission File No. 000-32717) for the fiscal year ended December 31, 2001). 10.63 Vendor Interface Agreement between Instinet UK Limited (now called Instinet Europe Limited) and Reuters AG dated July 17, 2001 (Incorporated by reference to Exhibit 10.38 to the Registrant's Annual Report on Form 10-K (Commission File No. 000-32717) for the fiscal year ended December 31, 2001). 10.64 Registration Rights Agreement between Instinet Group Incorporated and David G. Jamail, David R. Burch, Overunder, LLC, John A. McEntire, IV, John Bunda, Laura Horne, Currin Van Eman and Shayne Young, dated October 1, 2001 (Incorporated by reference to Exhibit 10.39 to the Registrant's Annual Report on Form 10-K (Commission File No. 000-32717) for the fiscal year ended December 31, 2001).
121
EXHIBIT NUMBER DESCRIPTION ------- ----------- 10.65 Facilities Management Service Agreement among Canon Business Services, Reuters America Inc. and Instinet Corporation dated July 1, 2001 (Incorporated by reference to Exhibit 10.40 to the Registrant's Annual Report on Form 10-K (Commission File No. 000-32717) for the fiscal year ended December 31, 2001). 10.66 Datek Stockholders Agreement, dated as of June 9, 2002, by and among Instinet Group Incorporated, Reuters Limited and Datek Online Holdings Corp. (Incorporated herein by reference to Exhibit 10.2 to the Registrant's Form S-4 (Registration No. 333-97071)). 10.67 Stockholders Agreement, dated as of June 9, 2002, by and among Instinet Group Incorporated, Reuters Limited, Reuters C Corp., Reuters Holdings Switzerland SA, the other entities listed on Exhibit B thereto and Edward J. Nicoll (Incorporated herein by reference to Exhibit 10.3 to the Registrant's Form S-4 (Registration No. 333-97071)). 10.68 Company Voting Agreement, dated as of June 9, 2002, by and among Island Holding Company, Inc., the stockholders of Island Holding Company, Inc., and Instinet Group Incorporated (Incorporated herein by reference to Exhibit 10.4 to the Registrant's Form S-4 (Registration No. 333-97071)). 10.69 Parent Voting Agreement, dated as of June 9, 2002, by and among Reuters Limited, Reuters C Corp and Reuters Holdings Switzerland SA, Island Holding Company, Inc., and Instinet Group Incorporated (Incorporated herein by reference to Exhibit 10.5 to the Registrant's Form S-4 (Registration No. 333-97071)). 10.70 Datek Voting Agreement, dated as of June 9, 2002, by and between Datek Online Holdings Corp. and Instinet Group Incorporated (Incorporated herein by reference to Exhibit 10.6 to the Registrant's Form S-4 (Registration No. 333-97071)). 10.71 Amendment No. 1 to Company Voting Agreement, dated as of August 7, 2002, by and among Island Holding Company, Inc., the stockholders of Island Holding Company, Inc. and Instinet Group Incorporated (Incorporated herein by reference to Exhibit 10.10 to the Registrant's Form S-4 (Registration No. 333-97071)). 10.72 Amendment No. 1 to Parent Voting Agreement, dated as of August 7, 2002, by and among Reuters Limited, Reuters C Corp and Reuters Holding Switzerland SA, Island Holding Company, Inc., and Instinet Group Incorporated (Incorporated herein by reference to Exhibit 10.11 to the Registrant's Form S-4 (Registration No. 333-97071)). 10.73 Amendment No. 1 to Datek Voting Agreement, dated as of August 7, 2002, by and Datek Online Holdings Corp. and Instinet Group Incorporated (Incorporated herein by reference to Exhibit 10.12 to the Registrant's Form S-4 (Registration No. 333-97071)). 21.1* List of Subsidiaries 24.1* Power of Attorney
--------------- * Filed herewith + Management Compensation Arrangement 122 (b) The following reports on Form 8-K were filed for the last quarter covered by this report, and subsequently through March 28, 2003:
FINANCIAL STATEMENTS DATE OF REPORT ITEM NUMBER REQUIRED TO BE FILED -------------- ----------- -------------------- October 3, 2002 Items 5 & 7 No October 16, 2002 Items 5 & 7 No October 22, 2002 Items 5 & 7 No November 1, 2002 Items 5 & 7 No November 4, 2002 Items 5 & 7 No November 14, 2002 Items 7 & 9 Yes December 3, 2002 Items 5 & 7 No December 9, 2002 Items 7 & 9 No February 12, 2003 Items 5 & 7 No February 12, 2003 Items 7 & 9 Yes March 28, 2003 Items 7 & 9 No March 28, 2003 Items 5 & 7 No
123 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. INSTINET GROUP INCORPORATED By: /s/ PAUL A. MEROLLA ------------------------------------ Paul A. Merolla Date: March 28, 2003. Pursuant to the requirements of the Securities Act of 1934, this report has been signed by the following persons in the capacities and on the dates indicated.
SIGNATURE TITLES DATE --------- ------ ---- * Chief Executive Officer and -------------------------------------- Director Name: Edward J. Nicoll * Officer and Director -------------------------------------- Name: Mark Nienstedt * Executive Vice President and -------------------------------------- Chief Financial Officer Name: John F. Fay * Director and Chairman of the Board -------------------------------------- Name: Ian Strachan * Senior Director -------------------------------------- Name: Thomas H. Glocer * Director -------------------------------------- Name: John C. Bogle * Director -------------------------------------- Name: David Grigson * Director -------------------------------------- Name: Glenn Hutchins * Director -------------------------------------- Name: Peter J. Job * Director -------------------------------------- Name: John Kasich * Director -------------------------------------- Name: Kay Koplovitz
II-1
SIGNATURE TITLES DATE --------- ------ ---- * Director -------------------------------------- Name: Kevin Landry * Director -------------------------------------- Name: Stephen Pagliuca * Director -------------------------------------- Name: Devin Wenig *By: /s/ PAUL A. MEROLLA ------------------------------ Paul A. Merolla, Attorney-In-Fact
II-2 CERTIFICATIONS I, Edward J. Nicoll, certify that: 1. I have reviewed this annual report on Form 10-K of Instinet Group Incorporated; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): (a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: March 28, 2003 By: /s/ EDWARD J. NICOLL ------------------------------------ Name: Edward J. Nicoll Title: Chief Executive Officer II-3 I, John F. Fay, certify that: 1. I have reviewed this annual report on Form 10-K of Instinet Group Incorporated; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: d) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; e) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and f) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): (c) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and (d) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: March 28, 2003 By: /s/ JOHN FAY ------------------------------------ Name: John Fay Title: Chief Financial Officer II-4 EXHIBIT INDEX
EXHIBIT NUMBER DESCRIPTION ------- ----------- 2.1 Contribution Agreement between Instinet Corporation and Instinet Group LLC, dated July 25, 2000 (Incorporated by reference to Exhibit 2.1 to the Registrant's Form S-1 (Registration No. 333-55190). 2.2 Asset Contribution Agreement between Instinet Corporation and Instinet Group LLC, dated July 31, 2000 (Incorporated by reference to Exhibit 2.2 to the Registrant's Form S-1 (Registration No. 333-55190). 2.3 Subscription Agreement between Reuters Holdings Switzerland SA and Instinet Group LLC, dated July 31, 2000 (Incorporated by reference to Exhibit 2.3 to the Registrant's Form S-1 (Registration No. 333-55190). 2.4 Contribution Agreement between Reuters C Corporation and Instinet Group LLC, dated September 29, 2000 (Incorporated by reference to Exhibit 2.4 to the Registrant's Form S-1 (Registration No. 333-55190). 2.5 Contribution Agreement between Reuters Holdings Switzerland SA and Instinet Group LLC, dated September 29, 2000 (Incorporated by reference to Exhibit 2.5 to the Registrant's Form S-1 (Registration No. 333-55190)). 2.6 Contribution Agreement between Reuters Holdings Switzerland SA and Instinet Group LLC, dated September 29, 2000 (Incorporated by reference to Exhibit 2.6 to the Registrant's Form S-1 (Registration No. 333-55190)). 2.7 Agreement and Plan of Merger, dated as of June 9, 2002, (as amended as of August 7, 2002) among Instinet Group Incorporated, Instinet Merger Corporation and Island Holding Company, Inc. (Incorporated by reference to Exhibit 2.1 to the Registrant's Form S-4 (Registration No. 333-97071)). 3.1 Amended and Restated Certificate of Incorporation of Instinet Group Incorporated (Incorporated by reference to Exhibit 3.1 to the Registrant's Current Report on Form 8-K as filed with the Commission on September 23, 2002). 3.2 Amended and Restated By-Laws of Instinet Group Incorporated (Incorporated by reference to Exhibit 3.2 to the Registrant's Current Report on Form 8-K as filed with the Commission on September 23, 2002). 4.1 Form of Common Stock Certificate (Incorporated by reference to Exhibit 4.1 to the Registrant's Form S-1 (Registration No. 333-55190)). 4.2 Rights Agreement between Instinet Group Incorporated and Mellon Investor Services LLC (Incorporated by reference to Exhibit 4.3 to the Registrant's Quarterly Report filed on Form 10-Q (Commission file No. 000-32717) for the quarterly period ended June 30, 2001). 4.3 Amendment No. 1 to the Rights Agreement between Instinet Group Incorporated and Mellon Investor Services LLC dated as of September 3, 2002 (Incorporated by reference to Exhibit 99.1 to the Registrant's Current Report on Form 8-K as filed with the Commission on September 13, 2002). 10.1 Exchange Agent Agreement, dated as of August 27, 2002, between Instinet Group Incorporated, and Mellon Investor Services LLC 2002 (Incorporated herein by reference to Exhibit 10.1 to Registrant's Quarterly Report on Form 10-Q (Commission File No. 000-32717) for the period ended September 30, 2002). 10.2 Ameritrade Option Exercise Agreement between Instinet Group Incorporated, Datek Online Holdings Corporation and Ameritrade Holding Corporation dated as of October 18, 2002 (Incorporated by reference to Exhibit 10.1 to the Registrant's Form S-3 (Registration No. 333-100670)). 10.3+ Employment Agreement between Instinet Group Incorporated and Andre-Francois Helier Villeneuve, dated September 16, 2002 (Incorporated herein by reference to Exhibit 10.4 to Registrant's Quarterly Report on Form 10-Q (Commission File No. 000-32717) for the period ended September 30, 2002).
EXHIBIT NUMBER DESCRIPTION ------- ----------- 10.4+ Employment Agreement between Instinet Group Incorporated and Edward J. Nicoll, dated September 20, 2002 (Incorporated herein by reference to Exhibit 10.5 to Registrant's Quarterly Report on Form 10-Q (Commission file No. 000-32717) for the period ended September 30, 2002). 10.5+ Agreement between Instinet Group Incorporated and Peter Fenichel, dated October 7, 2002 (Incorporated herein by reference to Exhibit 10.6 to Registrant's Quarterly Report on Form 10-Q (Commission file No. 000-32717) for the period ended September 30, 2002). 10.6*+ Non-Executive Chairman Compensation Letter between Instinet Group Incorporated and Ian Strachan, dated January 1, 2003. 10.7+ Employment Agreement between Instinet Group LLC and Douglas M. Atkin, dated April 2, 2001 (Incorporated by reference to Exhibit 10.1 to the Registrant's Form S-1 (Registration No. 333-55190)). 10.8*+ Employment Agreement between Instinet Group Incorporated and Mark Nienstedt, dated January 1, 2003. 10.9+ Employment Agreement between Instinet Group LLC and Mark Nienstedt, dated April 2, 2001 (Incorporated by reference to Exhibit 10.2 to the Registrant's Form S-1 (Registration No. 333-55190)). 10.10+ Employment Agreement between Instinet Group LLC and Kenneth K. Marshall, dated April 2, 2001 (Incorporated by reference to Exhibit 10.3 to the Registrant's Form S-1 (Registration No. 333-55190)). 10.11+ Employment Agreement between Instinet Group LLC and Andre-Francois Helier Villeneuve, dated April 30, 2001 (Incorporated by reference to Exhibit 10.27 to the Registrant's Form S-1 (Registration No. 333-55190)). 10.12+ Employment Agreement between Instinet Group LLC and Jean-Marc Bouhelier, dated April 2, 2001 (Incorporated by reference to Exhibit 10.5 to the Registrant's Annual Report on Form 10-K (Commission File No. 000-32717) for the fiscal year ended December 31, 2001). 10.13+ Employment Agreement between Instinet Corporation and John A. McEntire, IV dated October 1, 2001(Incorporated by reference to Exhibit 10.6 to the Registrant's Form S-1 (Incorporated by reference to Exhibit 10.6 to the Registrant's Annual Report on Form 10-K (Commission File No. 000-32717) for the fiscal year ended December 31, 2001). 10.14*+ Employment Agreement between Instinet Group LLC and Paul A. Merolla, dated April 30, 2001. 10.15*+ Termination Agreement between Instinet Group Incorporated and Mark Nienstedt, dated December 31, 2002. 10.16*+ Settlement, Release, Covenant Not To Sue, Waiver and Non-Disclosure Agreement between Instinet Group Incorporated and Andre-Francois Helier Villeneuve, dated December 10, 2002. 10.17*+ Settlement, Release, Covenant Not To Sue, Waiver and Non-Disclosure Agreement between Instinet Corporation and Douglas M. Atkin, dated April 30, 2002. 10.18*+ Settlement, Release, Covenant Not To Sue, Waiver and Non-Disclosure Agreement between Instinet Corporation and Michael J. Clancy, dated December 15, 2002. 10.19+ Settlement, Release, Covenant Not To Sue, Waiver and Non-Disclosure Agreement between Instinet Corporation and Michael Galano dated January 9, 2002 (Incorporated by reference to Exhibit 10.7 to the Registrant's Annual Report on Form 10-K (Commission File No. 000-32717) for the fiscal year ended December 31, 2001). 10.20+ Instinet Group Annual Bonus Plan (Incorporated by reference to Exhibit 10.5 to the Registrant's Form S-1 (Registration No. 333-55190)). 10.21+ Instinet Earnings Participation Unit Plan effective January 1, 1993; form of 1998 Performance Award; Instinet 1999 Equity Super Plan Summary and Amendment; 1999 Super(EPU) Plan for Fixed Income Group (Incorporated by reference to Exhibit 10.6 to the Registrant's Form S-1 (Registration No. 333-55190)). 10.22+ Instinet 2000 Stock Option Plan (Incorporated by reference to Exhibit 10.7 to the Registrant's Form S-1 (Registration No. 333-55190)). 10.23*+ Instinet 2000 Stock Option Plan, as amended and restated, April 30, 2002.
EXHIBIT NUMBER DESCRIPTION ------- ----------- 10.24* Transaction System Agreement, effective as of September 19, 2002, between Instinet Corporation and Bridge Trading Company. 10.25* Global Solutions Agreement, dated as of March 14, 2003, between Instinet Group Incorporated and Reuters Limited. 10.26 Commission Sharing Agreement, dated as of April 23, 2002, between Instinet Corporation and Bridge Trading Company (Incorporated herein by reference to Exhibit 10.8 to Registrant's Quarterly Report on Form 10-Q for the period ended June 30, 2002). 10.27 Non-Exclusive Limited Patent License Agreement, effective as of August 2, 2002, between Instinet Group Incorporated and Reuters Limited (Incorporated herein by reference to Exhibit 10.9 to Registrant's Quarterly Report on Form 10-Q for the period ended June 30, 2002). 10.28 Institutional Order Entry Enhancements Agreement, dated as of September 19, 2002, between Instinet Group Incorporated and Reuters SA. (Incorporated by reference to Exhibit 10.1 to the Registrant's Current Report on Form 8-K as filed with the Commission on October 16, 2002). 10.29 Newport Content Services Agreement, dated as of September 19, 2002, between Instinet Group Incorporated and Reuters Limited. (Incorporated by reference to Exhibit 10.2 to the Registrant's Current Report on Form 8-K as filed with the Commission on October 16, 2002). 10.30 Preferred Soft Dollar Agreement, dated as of September 19, 2002, between Instinet Group Incorporated and Reuters Limited. (Incorporated by reference to Exhibit 10.3 to the Registrant's Current Report on Form 8-K as filed with the Commission on October 16, 2002). 10.31 Fixed Income Data Agreement between Reuters Limited and Instinet Corporation, dated October 1, 1999 (Incorporated by reference to Exhibit 10.8 to the Registrant's Form S-1 (Registration No. 333-55190)). 10.32 Letter agreement between Reuters Limited and Instinet Corporation, dated August 1, 2000, amending the Fixed Income Data Agreement (Incorporated by reference to Exhibit 10.10 to the Registrant's Form S-1 (Registration No. 333-55190)). 10.33 Global Reuters Services Contract between Reuters Limited and Instinet Global Holdings, Inc., dated December 21, 2000 (Incorporated by reference to Exhibit 10.9 to the Registrant's Form S-1 (Registration No. 333-55190)). 10.34 Redistribution Addendum to Reuters Global Agreement between Reuters Limited and Instinet Global Holding, Inc., dated December 21, 2000, amending the Global Reuters Services Contract (Incorporated by reference to Exhibit 10.11 to the Registrant's Form S-1 (Registration No. 333-55190)). 10.35 Lease between Kenvic Associates and Instinet Corporation, dated November 1992 (Incorporated by reference to Exhibit 10.12 to the Registrant's Form S-1 (Registration No. 333-55190)). 10.36 Lease Modification Agreement between Kenvic Associates and Instinet Corporation, dated July 9, 1993 (Incorporated by reference to Exhibit 10.13 to the Registrant's Form S-1 (Registration No. 333-55190)). 10.37 Second Lease Modification Agreement between Kenvic Associates and Instinet Corporation, dated June 7, 1994 (Incorporated by reference to Exhibit 10.14 to the Registrant's Form S-1 (Registration No. 333-55190)). 10.38 Third Lease Modification Agreement between Kenvic Associates and Instinet Corporation, dated October 21, 1994 (Incorporated by reference to Exhibit 10.15 to the Registrant's Form S-1 (Registration No. 333-55190)). 10.39 Fourth Lease Modification Agreement between Kenvic Associates and Instinet Corporation, dated February 14, 1996 (Incorporated by reference to Exhibit 10.16 to the Registrant's Form S-1 (Registration No. 333-55190)). 10.40 Fifth Lease Modification Agreement between Kenvic Associates and Instinet Corporation, dated June 14, 1996 (Incorporated by reference to Exhibit 10.17 to the Registrant's Form S-1 (Registration No. 333-55190)). 10.41 Sixth Lease Modification Agreement between Kenvic Associates and Instinet Corporation, dated July 24, 1997 (Incorporated by reference to Exhibit 10.18 to the Registrant's Form S-1 (Registration No. 333-55190)).
EXHIBIT NUMBER DESCRIPTION ------- ----------- 10.42 Sublease between Charles Schwab & Co., Inc. and Instinet Group Incorporated dated December 18, 2001 (Incorporated by reference to Exhibit 10.36 to the Registrant's Annual Report on Form 10-K (Commission File No. 000-32717) for the fiscal year ended December 31, 2001). 10.43* First Amendment to Sublease between Charles Schwab & Co., Inc. and Instinet Group Incorporated dated June 5, 2002. 10.44* Second Amendment to Sublease between Charles Schwab & Co., Inc. and Instinet Group Incorporated dated November 7, 2002. 10.45 Sublease between Reuters C Corp. and Instinet Global Holdings, Inc. (Incorporated by reference to Exhibit 10.17 to the Registrant's Quarterly Report filed on Form 10-Q (Commission file No. 000-32717) for the quarterly period ended June 30, 2001). 10.46 Data Distribution Agreement between Instinet Global Holdings, Inc. and Reuters America, Inc. (Incorporated by reference to Exhibit 10.13 to the Registrant's Quarterly Report filed on Form 10-Q (Commission file No. 000-32717) for the quarterly period ended June 30, 2001). 10.47 U.S. Tax Sharing Agreement by and among Reuters America Holdings, Inc., Instinet Group Incorporated and Instinet Global Holdings, Inc. (Incorporated by reference to Exhibit 10.15 to the Registrant's Quarterly Report filed on Form 10-Q (Commission file No. 000-32717) for the quarterly period ended June 30, 2001). 10.48 U.K. Tax Sharing Agreement between Reuters Group PLC, Instinet Group Incorporated and Instinet Holdings Limited (Incorporated by reference to Exhibit 10.16 to the Registrant's Quarterly Report filed on Form 10-Q (Commission file No. 000-32717) for the quarterly period ended June 30, 2001). 10.49 Corporate Services Agreement between Reuters Limited and Instinet Group Incorporated (Incorporated by reference to Exhibit 10.19 to the Registrant's Quarterly Report on Form 10-Q (Commission file No. 000-32717 for the quarterly period ended June 30, 2001)). 10.50 License Agreement between Instinet Global Services Limited and Reuters Limited dated May 17, 2001 (Incorporated by reference to Exhibit 10.14 to the Registrant's Quarterly Report on Form 10-Q (Commission file No. 000-32717 for the quarterly period ended June 30, 2001)). 10.51 Corporate Agreement between Instinet Group Incorporated and Reuters Limited, dated May 17, 2001 (Incorporated herein by reference to Exhibit 4.2 to the Registrant's Quarterly Report on Form 10-Q (Commission File No. 000-32717) for the period ended June 30, 2001). 10.52 Amended and Restated Corporate Agreement between Instinet Group Incorporated and Reuters Limited, dated June 9, 2002 (Incorporated herein by reference to Exhibit 10.1 to the Registrant's Form S-4 (Registration No. 333-97071)). 10.53 Registration Rights Agreement, dated as of September 20, 2002, by and among Instinet Group Incorporated, Reuters Limited, Reuters C Corp., Reuters Holdings Switzerland SA, the other entities listed on Exhibit A as the Bain Entities, the Silver Lake Entities, the TA Entities, the Finanzas Entities, the Advent Entities, Ameritrade Holding Corporation and Edward J. Nicoll (Incorporated herein by reference to Exhibit 10.2 to Registant's Quarterly Report on Form 10-Q (Commission File No. 000-32717)for the period ended September 30, 2002). 10.54 Interest Purchase Agreement between Instinet Group Incorporated and David G. Jamail, David R. Burch, Overunder, LLC, John A. McEntire, IV, John Bunda, Laura Horne, Currin Van Eman and Shayne Young dated July 23, 2001 (Incorporated by reference to Exhibit 10.29 to the Registrant's Annual Report on Form 10-K (Commission File No. 000-32717) for the fiscal year ended December 31, 2001). 10.55 Amendment No. 1, dated as of October 1, 2001, to the Interest Purchase Agreement between Instinet Group Incorporated and David G. Jamail, David R. Burch, Overunder, LLC, John A. McEntire, IV, John Bunda, Laura Horne, Currin Van Eman and Shayne Young dated July 23, 2001 (Incorporated by reference to Exhibit 10.30 to the Registrant's Annual Report on Form 10-K (Commission File No. 000-32717) for the fiscal year ended December 31, 2001).
EXHIBIT NUMBER DESCRIPTION ------- ----------- 10.56 Registration Rights Agreement between Instinet Group Incorporated and David G. Jamail, David R. Burch, Overunder, LLC, John A. McEntire, IV, John Bunda, Laura Horne, Currin Van Eman and Shayne Young, dated October 1, 2001 (Incorporated by reference to Exhibit 10.39 to the Registrant's Annual Report on Form 10-K (Commission File No. 000-32717) for the fiscal year ended December 31, 2001). 10.57 Execution Services Agreement between Instinet Group Incorporated and ProTrader Securities Corporation, Zone Trading Partners, LLC, Zone Equity Partners, LP, David G. Jamail, David R. Burch and Andrew Kershner dated October 1, 2001, as amended (Incorporated by reference to Exhibit 10.31 to the Registrant's Annual Report on Form 10-K (Commission File No. 000-32717) for the fiscal year ended December 31, 2001). 10.58 Research and Analytics Asset Purchase Agreement between Instinet Group Incorporated and Reuters Group PLC effective as of September 28, 2001 (Incorporated by reference to Exhibit 10.32 to the Registrant's Annual Report on Form 10-K (Commission File No. 000-32717) for the fiscal year ended December 31, 2001). 10.59 Mutual Services Agreement between Instinet Group Incorporated and Reuters America Inc. dated December 18, 2001 (Incorporated by reference to Exhibit 10.33 to the Registrant's Annual Report on Form 10-K (Commission File No. 000-32717) for the fiscal year ended December 31, 2001). 10.60 Software License Agreement, as amended, between TIBCO Finance Technology, Inc. and Instinet Corporation, effective September 25, 1998 (Incorporated by reference to Exhibit 10.34 to the Registrant's Annual Report on Form 10-K (Commission File No. 000-32717) for the fiscal year ended December 31, 2001). 10.61 Software Maintenance Agreement between TIBCO Finance Technology, Inc. and Instinet Corporation, effective September 25, 1998 (Incorporated by reference to Exhibit 10.35 to the Registrant's Annual Report on Form 10-K (Commission File No. 000-32717) for the fiscal year ended December 31, 2001). 10.62 Testing and Certification Agreement between Instinet UK Limited (now called Instinet Europe Limited) and Effix SA dated November 7, 2000 (Incorporated by reference to Exhibit 10.37 to the Registrant's Annual Report on Form 10-K (Commission File No. 000-32717) for the fiscal year ended December 31, 2001). 10.63 Vendor Interface Agreement between Instinet UK Limited (now called Instinet Europe Limited) and Reuters AG dated July 17, 2001 (Incorporated by reference to Exhibit 10.38 to the Registrant's Annual Report on Form 10-K (Commission File No. 000-32717) for the fiscal year ended December 31, 2001). 10.64 Registration Rights Agreement between Instinet Group Incorporated and David G. Jamail, David R. Burch, Overunder, LLC, John A. McEntire, IV, John Bunda, Laura Horne, Currin Van Eman and Shayne Young, dated October 1, 2001 (Incorporated by reference to Exhibit 10.39 to the Registrant's Annual Report on Form 10-K (Commission File No. 000-32717) for the fiscal year ended December 31, 2001). 10.65 Facilities Management Service Agreement among Canon Business Services, Reuters America Inc. and Instinet Corporation dated July 1, 2001 (Incorporated by reference to Exhibit 10.40 to the Registrant's Annual Report on Form 10-K (Commission File No. 000-32717) for the fiscal year ended December 31, 2001). 10.66 Datek Stockholders Agreement, dated as of June 9, 2002, by and among Instinet Group Incorporated, Reuters Limited and Datek Online Holdings Corp. (Incorporated herein by reference to Exhibit 10.2 to the Registrant's Form S-4 (Registration No. 333-97071)). 10.67 Stockholders Agreement, dated as of June 9, 2002, by and among Instinet Group Incorporated, Reuters Limited, Reuters C Corp., Reuters Holdings Switzerland SA, the other entities listed on Exhibit B thereto and Edward J. Nicoll (Incorporated herein by reference to Exhibit 10.3 to the Registrant's Form S-4 (Registration No. 333-97071)). 10.68 Company Voting Agreement, dated as of June 9, 2002, by and among Island Holding Company, Inc., the stockholders of Island Holding Company, Inc., and Instinet Group Incorporated (Incorporated herein by reference to Exhibit 10.4 to the Registrant's Form S-4 (Registration No. 333-97071)).
EXHIBIT NUMBER DESCRIPTION ------- ----------- 10.69 Parent Voting Agreement, dated as of June 9, 2002, by and among Reuters Limited, Reuters C Corp and Reuters Holdings Switzerland SA, Island Holding Company, Inc., and Instinet Group Incorporated (Incorporated herein by reference to Exhibit 10.5 to the Registrant's Form S-4 (Registration No. 333-97071)). 10.70 Datek Voting Agreement, dated as of June 9, 2002, by and between Datek Online Holdings Corp. and Instinet Group Incorporated (Incorporated herein by reference to Exhibit 10.6 to the Registrant's Form S-4 (Registration No. 333-97071)). 10.71 Amendment No. 1 to Company Voting Agreement, dated as of August 7, 2002, by and among Island Holding Company, Inc., the stockholders of Island Holding Company , Inc. and Instinet Group Incorporated Incorporated (Incorporated herein by reference to Exhibit 10.10 to the Registrant's Form S-4 (Registration No. 333-97071)). 10.72 Amendment No. 1 to Parent Voting Agreement, dated as of August 7, 2002, by and among Reuters Limited, Reuters C Corp and Reuters Holding Switzerland SA, Island Holding Company, Inc., and Instinet Group Incorporated (Incorporated herein by reference to Exhibit 10.11 to the Registrant's Form S-4 (Registration No. 333-97071)). 10.73 Amendment No. 1 to Datek Voting Agreement, dated as of August 7, 2002, by and Datek Online Holdings Corp. and Instinet Group Incorporated (Incorporated herein by reference to Exhibit 10.12 to the Registrant's Form S-4 (Registration No. 333-97071)). 21.1* List of Subsidiaries 24.1* Power of Attorney
--------------- * Filed herewith + Management Compensation Arrangement