XNYS:JEF Quarterly Report 10-Q Filing - 8/31/2012

Effective Date 8/31/2012

Table of Contents

 

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-Q

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

For the quarterly period ended August 31, 2012

OR

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

For the transition period from                     to                     

Commission file number 1-14947

JEFFERIES GROUP, INC.

(Exact name of registrant as specified in its charter)

 

Delaware   95-4719745

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

520 Madison Avenue,

New York, New York

  10022
(Address of principal executive offices)   (Zip Code)

Registrant’s telephone number, including area code:

(212) 284-2550

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).     Yes   x       No  ¨

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

 

Large accelerated filer   x   Accelerated filer   ¨    Non-accelerated filer   ¨   Smaller reporting company   ¨

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date. 203,124,613 shares as of the close of business on September 19, 2012.

 

 

 

 


Table of Contents

JEFFERIES GROUP, INC.

INDEX TO QUARTERLY REPORT ON FORM 10-Q

August 31, 2012

 

   PART I. FINANCIAL INFORMATION   

Item 1.

   Financial Statements:   
   Consolidated Statements of Financial Condition (Unaudited) - August 31, 2012 and November 30, 2011    2
   Consolidated Statements of Earnings (Unaudited) - Three and Nine Months Ended August 31, 2012 and August 31, 2011    5
   Consolidated Statements of Comprehensive Income (Unaudited) - Three and Nine Months Ended August 31, 2012 and August 31, 2011    6
   Consolidated Statements of Changes in Stockholders’ Equity (Unaudited) - Nine Months Ended August 31, 2012 and Twleve Months Ended November 30, 2011    7
   Consolidated Statements of Cash Flows (Unaudited) - Nine Months Ended August 31, 2012 and August 31, 2011    8
   Notes to Consolidated Financial Statements (Unaudited)    10

Item 2.

   Management’s Discussion and Analysis of Financial Condition and Results of Operations.    70

Item 3.

   Quantitative and Qualitative Disclosures About Market Risk.    112

Item 4.

   Controls and Procedures    112
   PART II. OTHER INFORMATION   

Item 1.

   Legal Proceedings    112

Item 1A.

   Risk Factors    112

Item 2.

   Unregistered Sales of Equity Securities and Use of Proceeds    112

Item 6.

   Exhibits    113

 

1


Table of Contents

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

JEFFERIES GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (UNAUDITED)

(In thousands)

 

     August 31,      November 30,  
     2012      2011  

ASSETS

     

Cash and cash equivalents

   $ 2,844,513       $ 2,393,797   

Cash and securities segregated and on deposit for regulatory purposes or deposited with clearing and depository organizations

     3,752,782         3,344,960   

Financial instruments owned, at fair value, including securities pledged of $12,720,617 and $12,452,970 at August 31, 2012 and November 30, 2011, respectively:

     

Corporate equity securities

     1,632,178         1,235,079   

Corporate debt securities

     2,531,046         2,868,304   

Government, federal agency and other sovereign obligations

     4,335,015         7,471,563   

Mortgage- and asset-backed securities

     4,232,036         3,923,303   

Loans and other receivables

     524,009         376,146   

Derivatives

     358,823         525,893   

Investments, at fair value

     144,888         105,585   

Physical commodities

     159,011         172,668   
  

 

 

    

 

 

 

Total financial instruments owned, at fair value

     13,917,006         16,678,541   

Investments in managed funds

     60,121         70,740   

Loans to and investments in related parties

     703,923         594,538   

Securities borrowed

     5,218,205         5,169,689   

Securities purchased under agreements to resell

     3,942,915         2,893,043   

Securities received as collateral

     484         21,862   

Receivables:

     

Brokers, dealers and clearing organizations

     1,636,335         1,235,393   

Customers

     892,051         1,116,982   

Fees, interest and other

     191,968         163,092   

Premises and equipment

     175,880         175,139   

Goodwill

     365,456         365,574   

Other assets

     705,719         748,072   
  

 

 

    

 

 

 

Total assets

   $ 34,407,358       $ 34,971,422   
  

 

 

    

 

 

 

Continued on next page.

 

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Table of Contents

JEFFERIES GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION — CONTINUED (UNAUDITED)

(In thousands)

     August 31,
2012
    November 30,
2011
 

LIABILITIES AND STOCKHOLDERS’ EQUITY

    

Short-term borrowing

   $ 250,000      $ 52,721   

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

    

Corporate equity securities

     1,541,892        1,330,096   

Corporate debt securities

     1,793,417        1,614,493   

Government, federal agency and other sovereign obligations

     4,386,204        3,209,713   

Mortgage- and asset-backed securities

     217,172        50,517   

Loans

     136,060        151,117   

Derivatives

     233,716        249,037   

Physical commodities

     45,508          
  

 

 

   

 

 

 

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

     8,353,969        6,604,973   

Securities loaned

     2,061,548        1,706,308   

Securities sold under agreements to repurchase

     8,216,852        9,620,663   

Obligation to return securities received as collateral

     484        21,862   

Payables:

    

Brokers, dealers and clearing organizations

     611,155        2,816,877   

Customers

     5,004,324        4,763,364   

Accrued expenses and other liabilities

     876,741        803,219   

Long-term debt

     4,860,917        4,608,926   

Mandatorily redeemable convertible preferred stock

     125,000        125,000   

Mandatorily redeemable preferred interests of consolidated subsidiaries

     339,825        310,534   
  

 

 

   

 

 

 

Total liabilities

     30,700,815        31,434,447   
  

 

 

   

 

 

 

STOCKHOLDERS’ EQUITY

    

Common stock, $.0001 par value. Authorized 500,000,000 shares; issued 203,202,305 shares at August 31, 2012 and 197,197,848 shares at November 30, 2011

     20        20   

Additional paid-in capital

     2,194,142        2,207,410   

Retained earnings

     1,227,357        1,067,858   

Treasury stock, at cost, 131,952 shares at August 31, 2012 and 37,842 shares at November 30, 2011

     (1,845     (486

Accumulated other comprehensive loss:

    

Currency translation adjustments

     (39,727     (39,520

Additional minimum pension liability

     (10,970     (10,970
  

 

 

   

 

 

 

Total accumulated other comprehensive loss

     (50,697     (50,490
  

 

 

   

 

 

 

Total common stockholders’ equity

     3,368,977        3,224,312   

Noncontrolling interests

     337,566        312,663   
  

 

 

   

 

 

 

Total stockholders’ equity

     3,706,543        3,536,975   
  

 

 

   

 

 

 

Total liabilities and stockholders’ equity

   $ 34,407,358      $ 34,971,422   
  

 

 

   

 

 

 

Continued on next page.

 

3


Table of Contents

JEFFERIES GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION — CONTINUED (UNAUDITED)

(In thousands)

 

The table below presents the carrying amount and classification of assets of consolidated variable interest entities (“VIEs”) that can be used only to settle obligations of the consolidated VIEs and the liabilities of consolidated VIEs for which creditors (or beneficial interest holders) do not have recourse to our general credit. The assets and liabilities of these consolidated VIEs are included in the Consolidated Statements of Financial Condition and are presented net of intercompany eliminations.

 

     August 31,
2012
     November 30,
2011
 

Assets

     

Cash and cash equivalents

   $ 445,860       $ 345,959   

Financial instruments owned, at fair value

     

Corporate equity securities

     106,855         61,670   

Corporate debt securities

     337,046         326,549   

Mortgage- and asset-backed securities

     44,052         41,004   

Loans and other receivables

     304,214         281,416   

Derivatives

     506         569   

Investments, at fair value

     5,296         1,570   
  

 

 

    

 

 

 

Total financial instruments owned, at fair value

     797,969         712,778   

Receivables:

     

Brokers, dealers and clearing organizations

     137,645         150,592   

Fees, interest and other

     7,720         7,396   

Other assets

     463         385   
  

 

 

    

 

 

 

Total assets

     1,389,657         1,217,110   
  

 

 

    

 

 

 

Liabilities

     

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

     

Corporate equity securities

     10,587         7,122   

Corporate debt securities

     330,516         200,223   

Loans

     125,175         117,958   

Derivatives

     310         935   
  

 

 

    

 

 

 

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

     466,588         326,238   

Payables:

     

Brokers, dealers and clearing organizations

     110,925         105,165   

Accrued expenses and other liabilities

     12,677         9,740   

Mandatorily redeemable preferred interests of consolidated subsidiaries

     339,825         310,534   
  

 

 

    

 

 

 

Total liabilities

   $ 930,015       $ 751,677   
  

 

 

    

 

 

 

See accompanying unaudited notes to consolidated financial statements.

 

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Table of Contents

JEFFERIES GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF EARNINGS (UNAUDITED)

(In thousands, except per share amounts)

 

     Three Months Ended     Nine Months Ended  
     August 31,
2012
     August 31,
2011
    August 31,
2012
     August 31,
2011
 

Revenues:

          

Commissions

   $ 119,200       $ 154,896      $ 358,495       $ 404,108   

Principal transactions

     297,037         (74,003     793,834         391,464   

Investment banking

     260,163         293,750        842,921         861,230   

Asset management fees and investment income from managed funds

     3,116         3,086        10,648         37,501   

Interest

     242,625         353,006        788,935         930,647   

Other

     22,911         63,369        103,102         105,948   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total revenues

     945,052         794,104        2,897,935         2,730,898   

Interest expense

     206,114         284,822        668,000         736,068   
  

 

 

    

 

 

   

 

 

    

 

 

 

Net revenues

     738,938         509,282        2,229,935         1,994,830   

Interest on mandatorily redeemable preferred interests of consolidated subsidiaries

     8,304         (14,671     34,604         6,183   
  

 

 

    

 

 

   

 

 

    

 

 

 

Net revenues, less mandatorily redeemable preferred interests

     730,634         523,953        2,195,331         1,988,647   
  

 

 

    

 

 

   

 

 

    

 

 

 

Non-interest expenses:

          

Compensation and benefits

     440,391         299,640        1,310,394         1,174,468   

Non-compensation expenses:

          

Floor brokerage and clearing fees

     30,280         32,959        91,039         92,475   

Technology and communications

     58,681         60,039        180,460         153,563   

Occupancy and equipment rental

     24,077         22,581        71,582         60,997   

Business development

     27,736         21,853        72,362         64,248   

Professional services

     14,667         19,061        45,656         48,437   

Other

     12,433         12,582        46,018         45,805   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total non-compensation expenses

     167,874         169,075        507,117         465,525   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total non-interest expenses

     608,265         468,715        1,817,511         1,639,993   
  

 

 

    

 

 

   

 

 

    

 

 

 

Earnings before income taxes

     122,369         55,238        377,820         348,654   

Income tax expense

     44,048         1,228        134,403         107,899   
  

 

 

    

 

 

   

 

 

    

 

 

 

Net earnings

     78,321         54,010        243,417         240,755   

Net earnings (loss) to noncontrolling interests

     8,150         (14,265     32,612         4,523   
  

 

 

    

 

 

   

 

 

    

 

 

 

Net earnings to common shareholders

   $ 70,171       $ 68,275      $ 210,805       $ 236,232   
  

 

 

    

 

 

   

 

 

    

 

 

 

Earnings per common share:

          

Basic

   $ 0.31       $ 0.30      $ 0.92       $ 1.07   

Diluted

   $ 0.31       $ 0.30      $ 0.91       $ 1.07   

Dividends declared per common share

   $ 0.075       $ 0.075      $ 0.225       $ 0.225   

Weighted average common shares:

          

Basic

     214,756         218,426        216,509         209,544   

Diluted

     218,867         222,541        220,621         213,661   

See accompanying unaudited notes to consolidated financial statements.

 

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Table of Contents

JEFFERIES GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)

(In thousands)

 

     Three Months
Ended
    Nine Months
Ended
 
     August 31,
2012
     August 31,
2011
    August 31,
2012
    August 31,
2011
 

Net earnings

   $ 78,321       $ 54,010      $ 243,417      $ 240,755   
  

 

 

    

 

 

   

 

 

   

 

 

 

Other comprehensive income, net of tax:

         

Currency translation adjustments

     6,519         (6,266     (207     17,231   
  

 

 

    

 

 

   

 

 

   

 

 

 

Total other comprehensive income (loss), net of tax(1)

     6,519         (6,266     (207     17,231   
  

 

 

    

 

 

   

 

 

   

 

 

 

Comprehensive income

     84,840         47,744        243,210        257,986   

Net earnings (loss) attributable to noncontrolling interests

     8,150         (14,265     32,612        4,523   
  

 

 

    

 

 

   

 

 

   

 

 

 

Comprehensive income to common shareholders

   $ 76,690       $ 62,009      $ 210,598      $ 253,463   
  

 

 

    

 

 

   

 

 

   

 

 

 

 

(1) Total other comprehensive income, net of tax, is attributable to common shareholders. No other comprehensive income is attributable to noncontrolling interests.

See accompanying unaudited notes to consolidated financial statements.

 

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Table of Contents

JEFFERIES GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (UNAUDITED)

(In thousands, except per share amounts)

 

     Nine Months
Ended
August 31,
2012
    Twelve Months
Ended
November 30,
2011
 

Common stock, par value $0.0001 per share

    

Balance, beginning of period

   $ 20      $ 20   

Issued

     1        2   

Retired

     (1     (2
  

 

 

   

 

 

 

Balance, end of period

     20        20   
  

 

 

   

 

 

 

Additional paid-in capital

    

Balance, beginning of period

     2,207,410        2,218,123   

Benefit plan share activity(1)

     9,984        31,176   

Share-based expense, net of forfeitures and clawbacks

     61,923        134,076   

Proceeds from exercise of stock options

     104        95   

Acquisitions and contingent consideration

            419   

Tax benefit for issuance of share-based awards

     19,433        32,200   

Equity component of convertible debt, net of tax

     (427     (217

Dividend equivalents on share-based plans

     5,008        8,883   

Issuance of treasury stock

            97,770   

Retirement of treasury stock

     (109,293     (315,115
  

 

 

   

 

 

 

Balance, end of period

     2,194,142        2,207,410   
  

 

 

   

 

 

 

Retained earnings

    

Balance, beginning of period

     1,067,858        850,654   

Net earnings to common shareholders

     210,805        284,618   

Dividends

     (51,306     (67,414
  

 

 

   

 

 

 

Balance, end of period

     1,227,357        1,067,858   
  

 

 

   

 

 

 

Treasury stock, at cost

    

Balance, beginning of period

     (486     (539,530

Purchases

     (104,202     (152,827

Returns / forfeitures

     (6,451     (20,368

Issued

            397,122   

Retirement of treasury stock

     109,294        315,117   
  

 

 

   

 

 

 

Balance, end of period

     (1,845     (486
  

 

 

   

 

 

 

Accumulated other comprehensive loss

    

Balance, beginning of period

     (50,490     (51,278

Currency adjustment

     (207     3,339   

Pension adjustment, net of tax

            (2,551
  

 

 

   

 

 

 

Balance, end of period

     (50,697     (50,490
  

 

 

   

 

 

 

Total common stockholders’ equity

     3,368,977        3,224,312   
  

 

 

   

 

 

 

Noncontrolling interests

    

Balance, beginning of period

     312,663        332,976   

Net earnings to noncontrolling interests

     32,612        1,750   

Contributions

            1,713   

Distributions

     (7,709     (22,056

Deconsolidation of asset management entity

            (1,720
  

 

 

   

 

 

 

Balance, end of period

     337,566        312,663   
  

 

 

   

 

 

 

Total stockholders’ equity

   $ 3,706,543      $ 3,536,975   
  

 

 

   

 

 

 

 

(1) Includes grants related to the Incentive Plan, Deferred Compensation Plan, and Directors’ Plan.

See accompanying unaudited notes to consolidated financial statements.

 

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Table of Contents

JEFFERIES GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

(In thousands)

 

     Nine Months
Ended
 
     August 31,
2012
    August 31,
2011
 

Cash flows from operating activities:

    

Net earnings

   $ 243,417      $ 240,755   
  

 

 

   

 

 

 

Adjustments to reconcile net earnings to net cash provided by (used in) operating activities:

    

Depreciation and amortization

     54,836        53,786   

Bargain purchase gain

     (3,368     (52,509

Gain on repurchase of long-term debt

     (9,898       

Fees related to assigned management agreements

     (2,780     (2,728

Interest on mandatorily redeemable preferred interests of consolidated subsidiaries

     34,604        6,183   

Accruals related to various benefit plans and stock issuances, net of forfeitures

     65,457        56,601   

Increase in cash and securities segregated and on deposit for regulatory purposes or deposited with clearing and depository organizations

     (408,445     (555,008

(Increase) decrease in receivables:

    

Brokers, dealers and clearing organizations

     (401,758     (840,670

Customers

     224,761        185,110   

Fees, interest and other

     (28,921     (56,909

(Increase) decrease in securities borrowed

     (48,893     375,677   

Decrease (increase) in financial instruments owned

     2,758,173        (1,124,290

Increase in loans to and investments in related parties

     (109,997     (353,053

Decrease in investments in managed funds

     10,619        57,685   

Increase in securities purchased under agreements to resell

     (1,050,263     (1,229,802

Decrease (increase) in other assets

     26,957        (153,776

(Decrease) increase in payables:

    

Brokers, dealers and clearing organizations

     (2,204,936     810,130   

Customers

     241,725        610,233   

Increase in securities loaned

     355,679        197,357   

Increase in financial instruments sold, not yet purchased

     1,750,709        797,320   

(Decrease) increase in securities sold under agreements to repurchase

     (1,402,558     219,933   

Increase (decrease) in accrued expenses and other liabilities

     74,927        (251,027
  

 

 

   

 

 

 

Net cash provided by (used in) operating activities

     170,047        (1,009,002
  

 

 

   

 

 

 

Cash flows from investing activities:

    

Net payments on premises and equipment

     (39,848     (60,275

Cash received (paid) in connection with acquisition during the period, net of cash acquired

     2,257        (318,196

Cash received from contingent consideration

     2,774        2,733   

Cash paid from contingent consideration

     (1,172     (754
  

 

 

   

 

 

 

Net cash used in investing activities

     (35,989     (376,492
  

 

 

   

 

 

 

Continued on next page.

 

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Table of Contents

JEFFERIES GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS — CONTINUED (UNAUDITED)

(In thousands)

 

 

     Nine Months
Ended
 
     August 31,
2012
    August 31,
2011
 

Cash flows from financing activities:

    

Excess tax benefits from the issuance of share-based awards

   $ 30,576      $ 33,311   

Proceeds from short-term borrowings

     9,563,063        2,881,000   

Payments on short-term borrowings

     (9,370,557     (2,829,027

Proceeds from secured credit facility

     680,000          

Payments on secured credit facility

     (370,000       

Repayment of long-term debt

     (253,232       

Payments on repurchase of long-term debt

     (1,435       

Payments on mandatorily redeemable preferred interest of consolidated subsidiaries

     (5,313     (8,973

Payments on repurchase of common stock

     (104,202     (96,929

Payments on dividends

     (46,298     (43,417

Proceeds from exercise of stock options, not including tax benefits

     104        95   

Net proceeds from (payments on):

    

Issuance of common shares

            494,895   

Issuance of senior notes, net of issuance costs

     201,010        794,587   

Noncontrolling interest

     (7,709     (20,343
  

 

 

   

 

 

 

Net cash provided by financing activities

     316,007        1,205,199   
  

 

 

   

 

 

 

Effect of foreign currency translation on cash and cash equivalents

     651        6,247   
  

 

 

   

 

 

 

Net increase (decrease) in cash and cash equivalents

     450,716        (174,048

Cash and cash equivalents at beginning of period

     2,393,797        2,188,998   
  

 

 

   

 

 

 

Cash and cash equivalents at end of period

   $ 2,844,513      $ 2,014,950   
  

 

 

   

 

 

 

Supplemental disclosures of cash flow information:

    

Cash paid during the period for:

    

Interest

   $ 648,394      $ 667,376   

Income taxes, net of refunds

     12,816        143,058   

See accompanying unaudited notes to consolidated financial statements.

 

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Index

 

Note

       Page  

Note 1.

 

Organization and Basis of Presentation

     11   

Note 2.

 

Summary of Significant Accounting Policies

     12   

Note 3.

 

Acquisitions

     20   

Note 4.

 

Cash, Cash Equivalents and Short-Term Investments

     21   

Note 5.

 

Fair Value Disclosures

     22   

Note 6.

 

Derivative Financial Instruments

     38   

Note 7.

 

Collateralized Transactions

     42   

Note 8.

 

Securitization Activities

     43   

Note 9.

 

Variable Interest Entities

     44   

Note 10.

 

Investments

     49   

Note 11.

 

Goodwill and Other Intangible Assets

     52   

Note 12.

 

Short-Term Borrowings

     55   

Note 13.

 

Long-Term Debt

     56   

Note 14.

 

Mandatorily Redeemable Convertible Preferred Stock

     57   

Note 15.

 

Noncontrolling Interest and Mandatorily Redeemable Preferred Interests of Consolidated Subsidiaries

     57   

Note 16.

 

Benefit Plans

     58   

Note 17.

 

Compensation Plans

     59   

Note 18.

 

Earnings per Share

     62   

Note 19.

 

Income Taxes

     64   

Note 20.

 

Commitments, Contingencies and Guarantees

     64   

Note 21.

 

Net Capital Requirements

     67   

Note 22.

 

Segment Reporting

     68   

Note 23.

 

Related Party Transactions

     69   

 

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Note 1. Organization and Basis of Presentation

Organization

The accompanying unaudited Consolidated Financial Statements include the accounts of Jefferies Group, Inc. and all our subsidiaries (together, “we” or “us”), including Jefferies & Company, Inc. (“Jefferies”), Jefferies Execution Services, Inc., (“Jefferies Execution”), Jefferies Bache, LLC, Jefferies International Limited, Jefferies Bache, Limited, Jefferies Hong Kong Limited, CoreCommodity Management, LLC (formerly Jefferies Asset Management, LLC), Jefferies Bache Financial Services, Inc. and all other entities in which we have a controlling financial interest or are the primary beneficiary, including Jefferies High Yield Holdings, LLC (“JHYH”), Jefferies Special Opportunities Partners, LLC (“JSOP”) and Jefferies Employees Special Opportunities Partners, LLC (“JESOP”).

We operate in two business segments, Capital Markets and Asset Management. Capital Markets includes our securities, commodities, futures and foreign exchange trading (including the results of our indirectly partially owned subsidiary, Jefferies High Yield Trading, LLC) and investment banking activities, which provides the research, sales, trading and origination effort for various equity, fixed income and advisory products and services. Asset Management provides investment management services to various private investment funds, separate accounts and mutual funds.

On July 1, 2011, we acquired Prudential Bache’s Global Commodities Group (“Global Commodities Group” or “Jefferies Bache”) from Prudential Financial Inc. (“Prudential”). The Global Commodities Group provides execution and clearing services (including sales and trading activities) covering a wide variety of commodity, financial and foreign exchange futures, swaps and forward contracts to an institutional client base. On February 1, 2012, we acquired the corporate broking business of Hoare Govett from The Royal Bank of Scotland Group plc (“RBS”). The acquired business represents the corporate broking business carried on under the name RBS Hoare Govett in the United Kingdom and comprises corporate broking advice and services. See Note 3, Acquisitions for further details.

Basis of Presentation

The accompanying unaudited Consolidated Financial Statements have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements and should be read in conjunction with our Annual Report on Form 10-K for the year ended November 30, 2011.

We have made a number of estimates and assumptions relating to the reporting of assets and liabilities and the disclosure of contingent assets and liabilities to prepare these financial statements in conformity with U.S. GAAP. The most important of these estimates and assumptions relate to fair value measurements, compensation and benefits, goodwill, the ability to realize deferred tax assets and the recognition and measurement of uncertain tax positions. Although these and other estimates and assumptions are based on the best available information, actual results could be materially different from these estimates.

Consolidation

Our policy is to consolidate all entities in which we own more than 50% of the outstanding voting stock and have control. In addition, we consolidate entities which meet the definition of a variable interest entity for which we are the primary beneficiary. The primary beneficiary is the party who has the power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance and who has an obligation to absorb losses of the entity or a right to receive benefits from the entity that could potentially be significant to the entity. For consolidated entities that are less than wholly owned, the third-party’s holding of equity interest is presented as Noncontrolling interests in the Consolidated Statements of Financial Condition and Consolidated Statements of Changes in Stockholders’ Equity. The portion of net earnings attributable to the noncontrolling interests are presented as Net earnings to noncontrolling interests in the Consolidated Statements of Earnings.

 

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In situations where we have significant influence, but not control, of an entity that does not qualify as a variable interest entity, we apply either the equity method of accounting or fair value accounting pursuant to the fair value option election under U.S. GAAP, with our portion of net earnings or gains and losses recorded within Other Revenues. We also have formed nonconsolidated investment vehicles with third-party investors that are typically organized as partnerships or limited liability companies and are carried at fair value. We act as general partner or managing member for these investment vehicles and have generally provided the third-party investors with termination or “kick-out” rights.

Intercompany accounts and transactions are eliminated in consolidation.

 

Note 2. Summary of Significant Accounting Policies

Revenue Recognition Policies

Commissions.    All customer securities transactions are reported on the Consolidated Statements of Financial Condition on a settlement date basis with related income reported on a trade-date basis. We permit institutional customers to allocate a portion of their gross commissions to pay for research products and other services provided by third parties. The amounts allocated for those purposes are commonly referred to as soft dollar arrangements. Soft dollar expenses amounted to $7.1 million and $22.9 million for the three and nine months ended August 31, 2012, respectively and $14.1 million and $36.4 million for the three and nine months ended August 31, 2011, respectively. These arrangements are accounted for on an accrual basis and, as we are not the primary obligor for these arrangements, expenses relating to soft dollars are netted against commission revenues. The commissions and related expenses on client transactions executed by Jefferies Bache, LLC, a futures commission merchant, are recorded on a half-turn basis.

Principal Transactions.    Financial instruments owned and Financial instruments sold, but not yet purchased (all of which are recorded on a trade-date basis) are carried at fair value with gains and losses reflected in Principal transactions in the Consolidated Statements of Earnings on a trade date basis. Fees received on loans carried at fair value are also recorded within Principal transactions.

Investment Banking.    Underwriting revenues and fees from mergers and acquisitions, restructuring and other investment banking advisory assignments or engagements are recorded when the services related to the underlying transactions are completed under the terms of the assignment or engagement. Expenses associated with such assignments are deferred until reimbursed by the client, the related revenue is recognized or the engagement is otherwise concluded. Out-of-pocket expenses are recorded net of client reimbursements. Revenues are presented net of related out-of-pocket unreimbursed expenses. Unreimbursed out-of-pocket expenses with no related revenues are included in Business development and Professional services expenses in the Consolidated Statements of Earnings.

Asset Management Fees and Investment Income From Managed Funds.    Asset management fees and investment income from managed funds include revenues we earn from management, administrative and performance fees from funds managed by us, revenues from management and performance fees we earn from related-party managed funds and investment income from our investments in these funds. We earn fees in connection with management and investment advisory services performed for various funds and managed accounts. These fees are based on assets under management or an agreed upon notional amount and may include performance fees based upon the performance of the funds. Management and administrative fees are generally recognized over the period that the related service is provided. Generally, performance fees are earned when the return on assets under management exceeds certain benchmark returns, “high-water marks” or other performance targets. Performance fees are accrued (or reversed) on a monthly basis based on measuring performance to date versus any relevant benchmark return hurdles stated in the investment management agreement. Performance fees are not subject to adjustment once the measurement period ends (generally annual periods) and the performance fees have been realized.

 

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Interest Revenue and Expense.    We recognize contractual interest on Financial instruments owned and Financial instruments sold, but not yet purchased, on an accrual basis as a component of interest revenue and expense. Interest flows on derivative trading transactions and dividends are included as part of the fair valuation of these contracts and recognized in Principal transactions in the Consolidated Statements of Earnings rather than as a component of interest revenue or expense. We account for our short-term borrowings, long-term borrowings and our mandatorily redeemable convertible preferred stock on an accrual basis with related interest recorded as Interest expense. In addition, we recognize interest revenue related to our securities borrowed and securities purchased under agreements to resell activities and interest expense related to our securities loaned and securities sold under agreements to repurchase activities on an accrual basis.

Cash Equivalents

Cash equivalents include highly liquid investments, including money market funds, not held for resale with original maturities of three months or less.

Cash and Securities Segregated and on Deposit for Regulatory Purposes or Deposited With Clearing and Depository Organizations

In accordance with Rule 15c3-3 of the Securities Exchange Act of 1934, Jefferies as a broker-dealer carrying client accounts, is subject to requirements related to maintaining cash or qualified securities in a segregated reserve account for the exclusive benefit of its clients. In addition, certain financial instruments used for initial and variation margin purposes with clearing and depository organizations are recorded in this caption. Jefferies Bache, LLC, as a futures commission merchant, is obligated by rules mandated by the Commodities Futures Trading Commission under the Commodities Exchange Act, to segregate or set aside cash or qualified securities to satisfy such regulations, which regulations have been promulgated to protect customer assets. Certain other entities are also obligated by rules mandated by their primary regulators to segregate or set aside cash or equivalent securities to satisfy regulations, promulgated to protect customer assets.

Financial Instruments

Financial instruments owned and Financial instruments sold, not yet purchased are recorded at fair value, either as required by accounting pronouncements or through the fair value option election. These instruments primarily represent our trading activities and include both cash and derivative products. Gains and losses are recognized in Principal transactions in our Consolidated Statements of Earnings. The fair value of a financial instrument is the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (the exit price).

Fair Value Hierarchy

In determining fair value, we maximize the use of observable inputs and minimize the use of unobservable inputs by requiring that observable inputs be used when available. Observable inputs are inputs that market participants would use in pricing the asset or liability based on market data obtained from independent sources. Unobservable inputs reflect our assumptions that market participants would use in pricing the asset or liability developed based on the best information available in the circumstances. We apply a hierarchy to categorize our fair value measurements broken down into three levels based on the transparency of inputs as follows:

Level 1:    Quoted prices are available in active markets for identical assets or liabilities as of the reported date.

Level 2:    Pricing inputs are other than quoted prices in active markets, which are either directly or indirectly observable as of the reported date. The nature of these financial instruments include cash instruments for which quoted prices are available but traded less frequently, derivative instruments whose fair value have been derived using a model where inputs to the model are directly observable in the market, or can be derived principally from or corroborated by observable market data, and instruments that are fair valued using other financial instruments, the parameters of which can be directly observed.

 

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Level 3:    Instruments that have little to no pricing observability as of the reported date. These financial instruments are measured using management’s best estimate of fair value, where the inputs into the determination of fair value require significant management judgment or estimation.

Financial instruments are valued at quoted market prices, if available. Certain financial instruments have bid and ask prices that can be observed in the marketplace. For financial instruments whose inputs are based on bid-ask prices, the financial instrument is valued at the point within the bid-ask range that meets our best estimate of fair value. We use prices and inputs that are current as of the measurement date. For financial instruments that do not have readily determinable fair values using quoted market prices, the determination of fair value is based upon consideration of available information, including types of financial instruments, current financial information, restrictions on dispositions, fair values of underlying financial instruments and quotations for similar instruments.

The valuation of financial instruments may include the use of valuation models and other techniques. Adjustments to valuations derived from valuation models may be made when, in management’s judgment, features of the financial instrument such as its complexity, the market in which the financial instrument is traded and risk uncertainties about market conditions require that an adjustment be made to the value derived from the models. Adjustments from the price derived from a valuation model reflect management’s judgment that other participants in the market for the financial instrument being measured at fair value would also consider in valuing that same financial instrument. To the extent that valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires more judgment.

The availability of observable inputs can vary and is affected by a wide variety of factors, including, for example, the type of financial instrument and market conditions. As the observability of prices and inputs may change for a financial instrument from period to period, this condition may cause a transfer of an instrument among the fair value hierarchy levels. Transfers among the levels are recognized at the beginning of each period. The degree of judgment exercised in determining fair value is greatest for instruments categorized in Level 3.

Valuation Process for Financial Instruments

The Independent Price Verification (“IPV”) Group, which is part of Finance, in partnership with Market Risk Management, is responsible for establishing our valuation policies and procedures. The IPV Group and Market Risk Management, which are independent of our business functions, play an important role and serve as a control function in determining that our financial instruments are appropriately valued and that fair value measurements are reliable. This is particularly important where prices or valuations that require inputs are less observable. In the event that observable inputs are not available, the control processes are designed to assure that the valuation approach utilized is appropriate and consistently applied and that the assumptions are reasonable. The IPV Group reports to the Global Controller and is subject to the oversight of the IPV Committee, which is comprised of the Chief Financial Officer, Global Controller, Global Head of Product Control, Chief Risk Officer and the Principal Accounting Officer, among other personnel. Our independent price verification policies and procedures are reviewed, at a minimum, annually and changes to the policies require the approval of the IPV Committee.

Price Testing Process.    The business units are responsible for determining the fair value of our financial instruments using approved valuation models and methodologies. In order to ensure that the business unit valuations represent a fair value exit price, the IPV Group tests and validates the fair value of our financial instruments inventory. In the testing process, the IPV Group obtains prices and valuation inputs from sources independent of Jefferies, consistently adheres to established procedures set forth in our valuation policies for sourcing prices and valuation inputs and utilizing valuation methodologies. Sources used to validate fair value prices and inputs include, but are not limited to, exchange data, recently executed transactions, pricing data obtained from third party vendors, pricing and valuation services, broker quotes and observed comparable transactions.

 

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To the extent discrepancies between the business unit valuations and the pricing or valuations resulting from the price testing process are identified, such discrepancies are investigated by the IPV Group and fair values are adjusted, as appropriate. The IPV Group maintains documentation of its testing, results, rationale and recommendations and prepares a monthly summary of its valuation results. This process also forms the basis for our classification of fair values within the fair value hierarchy (i.e., Level 1, Level 2 or Level 3). The IPV Group utilizes the additional expertise of Market Risk Management personnel in valuing more complex financial instruments and financial instruments with less or limited pricing observability. The results of the valuation testing are reported to the IPV Committee on a monthly basis, which discusses the results and is charged with the final conclusions as to the financial instrument fair values in the consolidated financial statements. This process specifically assists the Chief Financial Officer in asserting as to the fair presentation of our financial condition and results of operations as included within our Quarterly Reports on Form 10-Q and Annual Report on Form 10-K. At each quarter end, the overall valuation results, as concluded upon by the IPV Committee, are presented to the Audit Committee.

Judgment exercised in determining Level 3 fair value measurements is supplemented by daily analysis of profit and loss performed by the Product Control functions. Gains and losses, which result from changes in fair value, are evaluated and corroborated daily based on an understanding of each of the trading desks’ overall risk positions and developments in a particular market on the given day. Valuation techniques generally rely on recent transactions of suitably comparable financial instruments and use the observable inputs from those comparable transactions as a validation basis for Level 3 inputs. Level 3 fair value measurements are further validated through subsequent sales testing and market comparable sales, if such information is available. Level 3 fair value measurements require documentation of the valuation rationale applied, which is reviewed for consistency in application from period to period; and the documentation includes benchmarking the assumptions underlying the valuation rationale against relevant analytic data.

Third Party Pricing Information.    Pricing information obtained from external data providers and pricing services may incorporate a range of market quotes from dealers, recent market transactions and benchmarking model derived prices to quoted market prices and trade data for comparable securities. External pricing data is subject to evaluation for reasonableness using a variety of means including comparisons of prices to those of similar product types, quality and maturities, consideration of the narrowness or wideness of the range of prices obtained, knowledge of recent market transactions and an assessment of the similarity in prices to comparable dealer offerings in a recent time period. We have a process whereby we challenge the appropriateness of pricing information obtained from data providers and pricing services in order to validate the data for consistency with the definition of a fair value exit price. Our process includes understanding and evaluating the service providers’ valuation methodologies. For corporate, U.S. government and agency, and municipal debt securities (excluding auction rate securities), and loans, to the extent pricing services or broker quotes are utilized in our valuation process, the vendor services are collecting and aggregating observable market information as to recent trade activity and active bid-ask submissions. The composite pricing information received from the independent pricing service is not based on unobservable inputs or proprietary models. For mortgage- and other asset-backed securities and collateralized debt obligations, our independent pricing service uses a matrix evaluation approach incorporating both observable yield curves and market yields on comparable securities as well as implied inputs from observed trades for comparable securities in order to determine prepayment speeds, cumulative default rates and loss severity. Further, we consider pricing data from multiple service providers as available as well as compare pricing data to prices we have observed for recent transactions, if any, in order to corroborate our valuation inputs.

Model Review Process.    Where a pricing model is to be used to determine fair value, the pricing model is reviewed for theoretical soundness and appropriateness by Market Risk Management, independent from the trading desks, and then approved to be used in the valuation process. Review and approval of a model for use includes benchmarking the model against relevant third party valuations, testing sample trades in the model, backtesting the results of the model against actual trades and stress-testing the sensitivity of the valuation model using varying inputs and assumptions. In addition, recently executed comparable transactions and other observable market data are considered for purposes of validating assumptions underlying the model. Models are independently reviewed and validated annually or more frequently if market conditions or use of the valuation model changes.

 

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Investments in Managed Funds

Investments in managed funds include our investments in funds managed by us and our investments in related-party managed funds in which we are entitled to a portion of the management and/or performance fees. Investments in nonconsolidated managed funds are accounted for at fair value with gains or losses included in Asset management fees and investment income from managed funds in the Consolidated Statements of Earnings.

Loans to and Investments in Related Parties

Loans to and investments in related parties include investments in private equity and other operating entities made in connection with our capital markets activities in which we exercise significant influence over operating and capital decisions and loans issued in connection with such activities. Loans to and investments in related parties are accounted for using the equity method or at cost, as appropriate. Revenues on Loans to and investments in related parties are included in Other income in the Consolidated Statements of Earnings. See Note 10, Investments, for additional information regarding certain of these investments.

Receivable from and Payable to Customers

Receivable from and payable to customers includes amounts receivable and payable on cash and margin transactions. Securities owned by customers and held as collateral for these receivables are not reflected in the accompanying consolidated financial statements. Receivable from officers and directors included within this financial statement line item represents balances arising from their individual security transactions. These transactions are subject to the same regulations as customer transactions and are provided on substantially the same terms.

Securities Borrowed and Securities Loaned

Securities borrowed and securities loaned are carried at the amounts of cash collateral advanced and received in connection with the transactions and accounted for as collateralized financing transactions. In connection with both trading and brokerage activities, we borrow securities to cover short sales and to complete transactions in which customers have failed to deliver securities by the required settlement date, and lend securities to other brokers and dealers for similar purposes. We have an active securities borrowed and lending matched book business in which we borrow securities from one party and lend them to another party. When we borrow securities, we generally provide cash to the lender as collateral, which is reflected in our Consolidated Statements of Financial Condition as Securities borrowed. We earn interest revenues on this cash collateral. Similarly, when we lend securities to another party, that party provides cash to us as collateral, which is reflected in our Consolidated Statements of Financial Condition as Securities loaned. We pay interest expense on the cash collateral received from the party borrowing the securities. The initial collateral advanced or received approximates or is greater than the fair value of the securities borrowed or loaned. We monitor the fair value of the securities borrowed and loaned on a daily basis and request additional collateral or return excess collateral, as appropriate.

Securities Purchased Under Agreements to Resell and Securities Sold Under Agreements to Repurchase

Securities purchased under agreements to resell and Securities sold under agreements to repurchase (collectively “repos”) are accounted for as collateralized financing transactions and are recorded at their contracted resale or repurchase amount plus accrued interest. We earn and incur interest over the term of the repo, which is reflected in Interest income and Interest expense on our Consolidated Statements of Earnings on an accrual basis. Repos are presented in the Consolidated Statements of Financial Condition on a net-basis-by counterparty, where permitted by generally accepted accounting principles. We monitor the fair value of the underlying securities daily versus the related receivable or payable balances. Should the fair value of the underlying securities decline or increase, additional collateral is requested or excess collateral is returned, as appropriate.

 

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Premises and Equipment

Premises and equipment are depreciated using the straight-line method over the estimated useful lives of the related assets (generally three to ten years). Leasehold improvements are amortized using the straight-line method over the term of the related leases or the estimated useful lives of the assets, whichever is shorter.

Goodwill and Intangible Assets

Goodwill.    At least annually, and more frequently if warranted, we assess whether goodwill has been impaired by comparing the estimated fair value of each reporting unit with its carrying value. If the estimated fair value exceeds the carrying value, goodwill at the reporting unit level is not impaired. If the estimated fair value is less than carrying value, further analysis is necessary to determine the amount of impairment, if any. The methodologies we utilize in estimating the fair value of reporting units include market capitalization, price-to-book multiples of comparable exchange traded companies and multiples of merger and acquisitions of similar businesses. Periodically estimating the fair value of a reporting unit requires significant judgment and often involves the use of estimates and assumptions that could have a significant effect on whether or not an impairment charge is recorded and the magnitude of such a charge. Our annual goodwill impairment testing date is June 1. Refer to Note 11, Goodwill and Other Intangible Assets for further details on our assessment of goodwill.

Intangible Assets.    Intangible assets deemed to have finite lives are amortized on a straight line basis over their estimated useful lives, where the useful life is the period over which the asset is expected to contribute directly, or indirectly, to our future cash flows. Intangible assets are reviewed for impairment on an interim basis when certain events or circumstances exist. For amortizable intangible assets, impairment exists when the carrying amount of the intangible asset exceeds its fair value. At least annually, the remaining useful life is evaluated.

An intangible asset with an indefinite useful life is not amortized but assessed annually, or more frequently when certain events or circumstances exist, for impairment. Impairment exists when the carrying amount exceeds its fair value. To the extent an impairment loss is recognized, the loss establishes the new cost basis of the asset that is amortized over the remaining useful life of that asset. Subsequent reversal of impairment losses is not permitted. Our annual indefinite-lived intangible asset impairment testing date is June 1.

Income Taxes

We file a consolidated U.S. federal income tax return, which includes all of our qualifying subsidiaries. We also are subject to income tax in various states and municipalities and those foreign jurisdictions in which we operate. Amounts provided for income taxes are based on income reported for financial statement purposes and do not necessarily represent amounts currently payable. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and for tax loss carry-forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period that includes the enactment date. Deferred income taxes are provided for temporary differences in reporting certain items, principally share-based compensation, deferred compensation, unrealized gains and losses on investments and tax amortization of intangible assets. The realization of deferred tax assets is assessed and a valuation allowance is recorded to the extent that it is more likely than not that any portion of the deferred tax asset will not be realized.

The tax benefit related to dividends and dividend equivalents paid on nonvested share based payment awards and outstanding equity options is recognized as an increase to Additional paid-in capital. These amounts are included in tax benefits for issuance of share-based awards on the Consolidated Statements of Changes in Stockholders’ Equity.

Legal Reserves

In the normal course of business, we have been named, from time to time, as a defendant in legal and regulatory proceedings. We are also involved, from time to time, in other exams, investigations and similar reviews (both formal and informal) by governmental and self-regulatory agencies regarding our businesses, certain of which may result in judgments, settlements, fines, penalties or other injunctions.

 

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We recognize a liability for a contingency in Accrued expenses and other liabilities when it is probable that a liability has been incurred and the amount of loss can be reasonably estimated. If the reasonable estimate of a probable loss is a range, we accrue the most likely amount of such loss, and if such amount is not determinable, then we accrue the minimum in the range as the loss accrual. The determination of the outcome and loss estimates requires significant judgment on the part of management.

In many instances, it is not possible to determine whether any loss is probable or even possible or to estimate the amount of any loss or the size of any range of loss. We believe that, in the aggregate, the pending legal actions or regulatory proceedings and any other exams, investigations or similar reviews (both formal and informal) should not have a material adverse effect on our consolidated results of operations, cash flows or financial condition. In addition, we believe that any amount that could be reasonably estimated of potential loss or range of potential loss in excess of what has been provided in the consolidated financial statements is not material.

Share-based Compensation

Share-based awards are measured based on the grant-date fair value of the award and recognized over the period from the service inception date through the date the employee is no longer required to provide service to earn the award. Expected forfeitures are included in determining share-based compensation expense.

Foreign Currency Translation

Assets and liabilities of foreign subsidiaries having non-U.S. dollar functional currencies are translated at exchange rates at the end of a period. Revenues and expenses are translated at average exchange rates during the period. The gains or losses resulting from translating foreign currency financial statements into U.S. dollars, net of hedging gains or losses and taxes, if any, are included in Other comprehensive income. Gains or losses resulting from foreign currency transactions are included in Principal transactions in the Consolidated Statements of Earnings.

Earnings per Common Share

Basic earnings per share (“EPS”) is computed by dividing net earnings available to common shareholders by the weighted average number of common shares outstanding and certain other shares committed to be, but not yet issued. Net earnings available to common shareholders represent net earnings to common shareholders reduced by the allocation of earnings to participating securities. Losses are not allocated to participating securities. Common shares outstanding and certain other shares committed to be, but not yet issued, include restricted stock and restricted stock units (“RSUs”) for which no future service is required. Diluted EPS is computed by dividing net earnings available to common shareholders plus dividends on dilutive mandatorily redeemable convertible preferred stock by the weighted average number of common shares outstanding and certain other shares committed to be, but not yet issued, plus all dilutive common stock equivalents outstanding during the period.

Unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and, therefore, are included in the earnings allocation in computing earnings per share under the two-class method of earning per share. We grant restricted stock and RSUs as part of our share-based compensation that contain nonforfeitable rights to dividends and dividend equivalents, respectively, and therefore, prior to the requisite service being rendered for the right to retain the award, restricted stock and RSUs meet the definition of a participating security. As such, we calculate Basic and Diluted earnings per share under the two-class method.

 

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(Unaudited)

 

Securitization Activities

We engage in securitization activities related to commercial mortgage loans and mortgage-backed and other asset-backed securities. Such transfers of financial assets are accounted for as sales when we have relinquished control over the transferred assets. The gain or loss on sale of such financial assets depends, in part, on the previous carrying amount of the assets involved in the transfer allocated between the assets sold and the retained interests, if any, based upon their respective fair values at the date of sale. We may retain interests in the securitized financial assets as one or more tranches of the securitization. These retained interests are included within Financial instruments owned in the Consolidated Statements of Financial Condition at fair value. Any changes in the fair value of such retained interests are recognized within Principal transactions revenues in the Consolidated Statements of Earnings.

When a transfer of assets does not meet the criteria of a sale, that transfer is treated as a secured borrowing. We continue to recognize the assets of a secured borrowing in Financial instruments owned and recognize the associated financing in Other liabilities in the Consolidated Statements of Financial Condition.

Accounting Developments

Accounting Standards to be Adopted in Future Periods

Indefinite-Lived Intangible Asset Impairment.    In July 2012, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2012-02, Testing Indefinite-Lived Intangible Assets for Impairment. The guidance permits an entity to first assess qualitative factors to determine whether it is more likely than not that an indefinite-lived intangible asset, other than goodwill, is impaired as a basis for determining whether it is necessary to perform the quantitative impairment test. The update does not revise the requirement to test indefinite-lived intangible assets annually for impairment, or more frequently if deemed appropriate. The new guidance is effective for annual and interim tests performed for fiscal years beginning after September 15, 2012, with early adoption permitted (fiscal year ended November 30, 2013). The adoption of this guidance will not affect our financial condition, results of operations or cash flows as it does not affect how impairment is calculated.

Balance Sheet Offsetting Disclosures.    In December 2011, the FASB issued ASU No. 2011-11, Disclosures about Offsetting Assets and Liabilities. The update requires new disclosures regarding balance sheet offsetting and related arrangements. For derivatives and financial assets and liabilities, the amendments require disclosure of gross asset and liability amounts, amounts offset on the balance sheet, and amounts subject to the offsetting requirements but not offset on the balance sheet. The guidance is effective for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods (fiscal year ended November 30, 2014), and is to be applied retrospectively. This guidance does not amend the existing guidance on when it is appropriate to offset; as a result, this guidance will not affect our financial condition, results of operation or cash flows.

Goodwill Testing.    In September 2011, the FASB issued ASU No. 2011-08, Testing Goodwill for Impairment. The update outlines amendments to the two step goodwill impairment test permitting an entity to first assess qualitative factors in determining whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step quantitative goodwill impairment test. The update is effective for annual and interim goodwill tests performed for fiscal years beginning after December 15, 2011, with early adoption permitted (fiscal year ended November 2013). The adoption of this guidance will not affect our financial condition, results of operation or cash flows as it does not change how goodwill is calculated nor assigned to reporting units.

Adopted Accounting Standards

Comprehensive Income.    In June 2011, the FASB issued ASU No. 2011-05, Presentation of Comprehensive Income. The update requires entities to report comprehensive income either (1) in a single continuous statement of comprehensive income or (2) in two separate but consecutive statements. We adopted the guidance on March 1, 2012, and elected the two separate but consecutive statements approach. Accordingly, we now present our Consolidated Statements of Comprehensive Income immediately following our Consolidated Statements of Earnings within our consolidated financial statements.

 

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Fair Value Measurements and Disclosures.     In May 2011, the FASB issued ASU No. 2011-04 Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS. The amendments prohibit the use of blockage factors at all levels of the fair value hierarchy and provide guidance on measuring financial instruments that are managed on a net portfolio basis. Additional disclosure requirements include transfers between Levels 1 and 2; and for Level 3 fair value measurements, a description of our valuation processes and additional information about unobservable inputs impacting Level 3 measurements. We adopted this guidance on March 1, 2012 and have reflected the new disclosures in our consolidated financial statements. The adoption of this guidance did not have an impact on our financial condition, results of operations or cash flows.

Reconsideration of Effective Control for Repurchase Agreements.     In April 2011, the FASB issued ASU No. 2011-03, Reconsideration of Effective Control for Repurchase Agreements. In assessing whether to account for repurchase and other agreements that both entitle and obligate the transferor to repurchase or redeem financial assets before their maturity as sales or as secured financing, this guidance removes from the assessment of effective control 1) the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms and 2) the collateral maintenance implementation guidance related to that criterion. The guidance is effective prospectively for transactions beginning on or after January 1, 2012. The adoption of this guidance did not have an impact on our financial condition, results of operations or cash flows.

 

Note 3. Acquisitions

Global Commodities Group

On July 1, 2011, we acquired Prudential Bache’s Global Commodities Group from Prudential. Total cash payments made as consideration for the acquisition were $422.0 million. The acquisition included 100% of the equity interests in Prudential Bache Commodities LLC, a US-based full-service futures commission merchant; Prudential Bache Securities LLC, a US-based registered broker-dealer, which has since merged with Jefferies; Bache Commodities Limited, a UK-based global commodities and financial derivatives broker; Prudential Bache Asset Management, Inc., a US-based registered investment advisor and commodity trading advisor, Prudential Bache Financial Services, Inc., a global over-the-counter commodities dealer; and Bache Commodities (Hong Kong) Ltd., a Hong Kong-based licensed futures dealer. In addition, we acquired related information technology assets and contracts used by the Global Commodities Group. We refer to this business collectively as “Jefferies Bache.”

We accounted for the acquisition under the acquisition method of accounting. Accordingly, the assets acquired, including identifiable intangible assets, and liabilities assumed were recorded at their respective fair values as of the date of acquisition. The fair values of the net assets acquired, including identifiable intangible assets, was approximately $474.5 million, which exceeded the purchase price of $422.0 million, resulting in a bargain purchase gain of approximately $52.5 million recognized in July 2011. The business of Jefferies Bache is included within the Capital Markets business segment.

For further information on the acquisition, see Note 3, Acquisition of the Global Commodities Group to the consolidated financial statements for the year ended November 30, 2011 included in our Annual Report on Form 10-K.

Hoare Govett

On February 1, 2012, we acquired the corporate broking business of Hoare Govett from RBS. Total cash consideration paid by us to RBS for the acquisition was £1. In addition, under the terms of the purchase agreement RBS agreed to pay us approximately £1.9 million towards retention payments made to certain employees, which constituted a reduction of the final purchase price. The business acquired represents the corporate broking business carried on under the name RBS Hoare Govett in the United Kingdom and comprises corporate broking advice and services, as well as certain equity sales and trading activities. The acquisition included the Hoare Govett trade name, domain name, client

 

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agreements and the exclusive right to carry on the business in succession to RBS. The acquisition of Hoare Govett provides us with the opportunity to continue our growth in corporate broking and significantly expand the capabilities and reach of our established European Investment Banking and Equities businesses.

We accounted for the acquisition under the acquisition method of accounting. Accordingly, the assets acquired, including identifiable intangible assets, and liabilities assumed were recorded at their respective fair values as of the date of acquisition. The fair values of the net assets acquired, including identifiable intangible assets, was approximately $0.3 million, which exceeded the negative purchase price of $3.1 million (cash consideration paid of £1 less remittance from RBS of £1.9 million), resulting in a bargain purchase gain of approximately $3.4 million. The bargain purchase gain is included within Other Revenues in the Consolidated Statement of Earnings and is presented within the Capital Markets business segment. Approximately $0.4 million was recognized at the date of acquisition as the fair value of the Hoare Govett trade name. See Note 11, Goodwill and Other Intangible Assets for further details. The fair value of the intangible asset is amortized on a straight line basis over a useful life of 5 years. Additionally, on February 1, 2012, we recognized a deferred tax liability of approximately $0.1 million, recorded within Accrued expenses and other liabilities on the Consolidated Statement of Financial Condition.

Our results of operations for the nine months ended August 31, 2012 include the results of operations of Hoare Govett for the period from February 1, 2012 to August 31, 2012. The acquisition closed on February 29, 2012.

 

Note 4. Cash, Cash Equivalents and Short-Term Investments

We generally invest our excess cash in money market funds and in other short-term instruments. Cash equivalents include highly liquid investments not held for resale and with original maturities of three months or less. The following are financial instruments, classified as cash and cash equivalents, that are deemed by us to be generally readily convertible into cash as of August 31, 2012 and November 30, 2011 (in thousands):

 

      August 31,
2012
     November 30,
2011
 

Cash and cash equivalents:

     

Cash in banks

   $ 567,030       $ 846,990   

Money market investments

     2,277,483         1,546,807   
  

 

 

    

 

 

 

Total cash and cash equivalents

   $ 2,844,513       $ 2,393,797   
  

 

 

    

 

 

 

Cash and securities segregated(1)

   $ 3,752,782       $ 3,344,960   
  

 

 

    

 

 

 

 

(1) Consists of deposits at exchanges and clearing organizations, as well as deposits in accordance with Rule 15c3-3 of the Securities Exchange Act of 1934, which subjects Jefferies as a broker-dealer carrying client accounts to requirements related to maintaining cash or qualified securities in a segregated reserve account for the exclusive benefit of its clients, and Jefferies Bache, LLC which, as a futures commission merchant, is subject to the segregation requirements pursuant to the Commodity Exchange Act.

 

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Note 5. Fair Value Disclosures

The following is a summary of our financial assets and liabilities that are accounted for at fair value on a recurring basis as of August 31, 2012 and November 30, 2011 by level within the fair value hierarchy (in thousands):

 

     August 31, 2012  
      Level 1(1)      Level 2(1)      Level 3     Counterparty
and Cash
Collateral
Netting(2)
    Total  

Assets:

            

Financial instruments owned:

            

Corporate equity securities

   $ 1,289,905       $ 322,490       $ 19,783      $      $ 1,632,178   

Corporate debt securities

             2,523,488         7,558               2,531,046   

Collateralized debt obligations

             67,778         81,598               149,376   

U.S. government and federal agency securities

     999,618         100,006                       1,099,624   

Municipal securities

             435,009         83               435,092   

Sovereign obligations

     1,846,487         953,812                       2,800,299   

Residential mortgage-backed securities

             3,399,387         144,988               3,544,375   

Commercial mortgage-backed securities

             461,359         31,513               492,872   

Other asset-backed securities

             45,205         208               45,413   

Loans and other receivables

             415,220         108,789               524,009   

Derivatives

     416,652         1,769,428         340        (1,827,597     358,823   

Investments at fair value

             52,909         91,979               144,888   

Physical commodities

             159,011                       159,011   
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

Total financial instruments owned

   $ 4,552,662       $ 10,705,102       $ 486,839      $ (1,827,597   $ 13,917,006   
  

 

 

    

 

 

      

 

 

   

 

 

 

Level 3 financial instruments for which the firm does not bear economic exposure(3)

           (50,799    
        

 

 

     

Level 3 financial instruments for which the firm bears economic exposure

         $ 436,040       
        

 

 

     

Cash and cash equivalents

   $ 2,844,513       $       $      $      $ 2,844,513   

Investments in managed funds

   $       $       $ 60,121      $      $ 60,121   

Cash and securities segregated and on deposit for regulatory purposes(4)

   $ 3,752,782       $       $      $      $ 3,752,782   

Securities received as collateral

   $ 484       $       $      $      $ 484   
        

 

 

     

Total Level 3 assets for which the firm bears economic exposure

         $ 496,161       
        

 

 

     

Liabilities:

            

Financial instruments sold, not yet purchased:

            

Corporate equity securities

   $ 1,440,045       $ 101,809       $ 38      $      $ 1,541,892   

Corporate debt securities

             1,793,417                       1,793,417   

U.S. government and federal agency securities

     1,674,682                               1,674,682   

Sovereign obligations

     1,858,650         852,872                       2,711,522   

Residential mortgage-backed securities

             216,939                       216,939   

Commercial mortgage-backed securities

             233                       233   

Loans

             131,775         4,285               136,060   

Derivatives

     363,860         1,853,769         12,087        (1,996,000     233,716   

Physical commodities

             45,508                       45,508   
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

Total financial instruments sold, not yet purchased

   $ 5,337,237       $ 4,996,322       $ 16,410      $ (1,996,000   $ 8,353,969   
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

 

Obligation to return securities received as collateral

   $ 484       $       $      $      $ 484   

 

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(1) There were no transfers between Level 1 and Level 2 for the nine months ended August 31, 2012.

 

(2) Represents counterparty and cash collateral netting across the levels of the fair value hierarchy for positions with the same counterparty.

 

(3) Consists of Level 3 assets attributable to third party or employee noncontrolling interests in certain consolidated entities.

 

(4) Includes U.S. government securities segregated for regulatory purposes with a fair value of $299.3 million.

 

    As of November 30, 2011  
    Level 1(1)     Level 2(1)     Level 3     Counterparty
and Cash
Collateral

Netting(2)
    Total  

Assets:

         

Financial instruments owned:

         

Corporate equity securities

  $ 1,088,358      $ 133,232      $ 13,489      $      $ 1,235,079   

Corporate debt securities

    1,521        2,818,643        48,140               2,868,304   

Collateralized debt obligations

           102,209        47,988               150,197   

U.S. government and federal agency securities

    5,443,721        266,460                      5,710,181   

Municipal securities

           582,497        6,904               589,401   

Sovereign obligations

    737,082        434,759        140               1,171,981   

Residential mortgage-backed securities

           2,961,682        149,965               3,111,647   

Commercial mortgage-backed securities

           582,974        52,407               635,381   

Other asset-backed securities

           22,794        3,284               26,078   

Loans and other receivables

           278,855        97,291               376,146   

Derivatives

    632,148        2,344,625        124        (2,451,004     525,893   

Investments at fair value

           27,259        78,326               105,585   

Physical commodities

           172,668                      172,668   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total financial instruments owned

  $ 7,902,830      $ 10,728,657      $ 498,058      $ (2,451,004   $ 16,678,541   
 

 

 

   

 

 

     

 

 

   

 

 

 

Level 3 financial instruments for which the firm does not bear economic exposure(3)

      $ (45,901    
     

 

 

     

Level 3 financial instruments for which the firm bears economic exposure

      $ 452,157       
     

 

 

     

Cash and cash equivalents

  $ 2,393,797      $      $      $      $ 2,393,797   

Investments in managed funds

  $      $      $ 70,740      $      $ 70,740   

Cash and securities segregated and on deposit for regulatory purposes(4)

  $ 3,344,960      $      $      $      $ 3,344,960   

Securities received as collateral

  $ 21,862      $      $      $      $ 21,862   
     

 

 

     

Total Level 3 assets for which the firm bears economic exposure

      $ 522,897       
     

 

 

     

Liabilities:

         

Financial instruments sold, not yet purchased:

         

Corporate equity securities

  $ 1,266,096      $ 64,000      $      $      $ 1,330,096   

Corporate debt securities

           1,614,419        74               1,614,493   

U.S. government and federal agency securities

    2,032,091        9,685                      2,041,776   

Municipal securities

           90                      90   

Sovereign obligations

    790,568        377,279                      1,167,847   

Residential mortgage-backed securities

           50,517                      50,517   

Loans

           140,960        10,157               151,117   

Derivatives

    535,503        2,289,759        9,409        (2,585,634     249,037   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total financial instruments sold, not yet purchased

  $ 4,624,258      $ 4,546,709      $ 19,640      $ (2,585,634   $ 6,604,973   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Obligation to return securities received as collateral

  $ 21,862      $      $      $      $ 21,862   

 

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(1) There were no transfers between Level 1 and Level 2 for the twelve months ended November 30, 2011.

 

(2) Represents counterparty and cash collateral netting across the levels of the fair value hierarchy for positions with the same counterparty.

 

(3) Consists of Level 3 assets attributable to third party or employee noncontrolling interests in certain consolidated entities.

 

(4) Includes U.S. government securities segregated for regulatory purposes with a fair value of $115.0 million.

The following is a description of the valuation basis, including valuation techniques and inputs, used in measuring our financial assets and liabilities that are accounted for at fair value on a recurring basis:

Corporate Equity Securities

 

   

Exchange Traded Equity Securities:     Exchange-traded equity securities are measured based on quoted exchange prices, which are generally obtained from external pricing services, and are categorized within Level 1 of the fair value hierarchy.

 

   

Non-exchange Traded Equity Securities:     Non-exchange traded equity securities are measured primarily using broker quotations, pricing data from external pricing services and prices observed for recently executed market transactions and are categorized within Level 2 of the fair value hierarchy. Where such information is not available, non-exchange traded equity securities are categorized within Level 3 of the fair value hierarchy and measured using valuation techniques involving quoted prices of or market data for comparable companies, similar company ratios and multiples (e.g., price/EBITDA, price/book value), discounted cash flow analyses and transaction prices observed for subsequent financing or capital issuance by the company. When using pricing data of comparable companies, judgment must be applied to adjust the pricing data to account for differences between the measured security and the comparable security (e.g., issuer market capitalization, yield, dividend rate, geographical concentration).

 

   

Equity warrants:     Non-exchange traded equity warrants are generally categorized within Level 3 of the fair value hierarchy and are measured using the Black-Scholes model with key inputs impacting the valuation including the underlying security price, implied volatility, dividend yield, interest rate curve, strike price and maturity date.

Corporate Debt Securities

 

   

Corporate Bonds:    Corporate bonds are measured primarily using pricing data from external pricing services and broker quotations, where available, prices observed for recently executed market transactions of comparable size, and bond spreads or credit default swap spreads of the issuer adjusted for basis differences between the swap curve and the bond curve. Corporate bonds measured using these valuation methods are categorized within Level 2 of the fair value hierarchy. If broker quotes, pricing data or spread data is not available, alternative valuation techniques are used including cash flow models incorporating interest rate curves, single name or index credit default swap curves for comparable issuers and recovery rate assumptions. Corporate bonds measured using alternative valuation techniques are categorized within Level 3 of the fair value hierarchy and comprise a limited portion of our corporate bonds.

 

   

High Yield Corporate and Convertible Bonds:    A significant portion of our high yield corporate and convertible bonds are categorized within Level 2 of the fair value hierarchy and are measured primarily using broker quotations and pricing data from external pricing services, where available, and prices observed for recently executed market transactions of comparable size. Where pricing data is less observable, valuations are categorized within Level 3 and are based on pending transactions involving the issuer or comparable issuers, prices implied from an issuer’s subsequent financings or recapitalizations, models incorporating financial ratios and projected cash flows of the issuer and market prices for comparable issuers.

Collateralized Debt Obligations

Collateralized debt obligations are measured based on prices observed for recently executed market transactions or based on valuations received from third party brokers and are categorized within Level 2 or Level 3 of the fair value hierarchy depending on the observability of the pricing inputs.

 

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U.S. Government and Federal Agency Securities

 

   

U.S. Treasury Securities:     U.S. Treasury securities are measured based on quoted market prices and categorized within Level 1 of the fair value hierarchy.

 

   

U.S. Agency Issued Debt Securities:     Callable and non-callable U.S. agency issued debt securities are measured primarily based on quoted market prices obtained from external pricing services. Non-callable U.S. agency securities are generally categorized within Level 1 and callable U.S. agency securities are categorized within Level 2 of the fair value hierarchy.

Municipal Securities

Municipal securities are measured based on quoted prices obtained from external pricing services and are generally categorized within Level 2 of the fair value hierarchy.

Sovereign Obligations

Foreign sovereign government obligations are measured based on quoted market prices obtained from external pricing services, where available, or recently executed independent transactions of comparable size. To the extent external price quotations are not available or recent transactions have not been observed, valuation techniques incorporating interest rate yield curves and country spreads for bonds of similar issuers, seniority and maturity are used to determine fair value of sovereign bonds or obligations. Foreign sovereign government obligations are classified in Level 1, 2 or Level 3 of the fair value hierarchy, primarily based on the country of issuance.

Residential Mortgage-Backed Securities

 

   

Agency Residential Mortgage-Backed Securities:     Agency residential mortgage-backed securities include mortgage pass-through securities (fixed and adjustable rate), collateralized mortgage obligations, interest-only and principal-only securities and to-be-announced securities and are generally measured using market price quotations from external pricing services and categorized within Level 2 of the fair value hierarchy.

 

   

Agency Residential Inverse Interest-Only Securities (“Agency Inverse IOs”):     The fair value of agency inverse IOs is estimated using expected future cash flow techniques that incorporate prepayment models and other prepayment assumptions to amortize the underlying mortgage loan collateral. We use prices observed for recently executed transactions to develop market-clearing spread and yield curve assumptions. Valuation inputs with regard to the underlying collateral incorporate weighted average coupon, loan-to-value, credit scores, geographic location, maximum and average loan size, originator, servicer, and weighted average loan age. Agency inverse IOs are categorized within Level 2 of the fair value hierarchy. We also use vendor data in developing assumptions, as appropriate.

 

   

Non-Agency Residential Mortgage-Backed Securities:     Fair values are determined primarily using discounted cash flow methodologies and securities are categorized within Level 2 or Level 3 of the fair value hierarchy based on the observability of the pricing inputs used. Performance attributes of the underlying mortgage loans are evaluated to estimate pricing inputs, such as prepayment rates, default rates and the severity of credit losses. Attributes of the underlying mortgage loans that affect the pricing inputs include, but are not limited to, weighted average coupon; average and maximum loan size; loan-to-value; credit scores; documentation type; geographic location; weighted average loan age; originator; servicer; historical prepayment, default and loss severity experience of the mortgage loan pool; and delinquency rate. Yield curves used in the discounted cash flow models are based on observed market prices for comparable securities and published interest rate data to estimate market yields.

 

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Commercial Mortgage-Backed Securities

 

   

Agency Commercial Mortgage-Backed Securities:     GNMA project loan bonds and FNMA Delegated Underwriting and Servicing (“DUS”) mortgage-backed securities are generally measured by using prices observed for recently executed market transactions to estimate market-clearing spread levels for purposes of estimating fair value. GNMA project loan bonds and FNMA DUS mortgage-backed securities are categorized within Level 2 of the fair value hierarchy.

 

   

Non-Agency Commercial Mortgage-Backed Securities:     Non-agency commercial mortgage-backed securities are measured using pricing data obtained from external pricing services and prices observed for recently executed market transactions and are categorized within Level 2 and Level 3 of the fair value hierarchy.

Other Asset-Backed Securities

Other asset-backed securities include, but are not limited to, securities backed by auto loans, credit card receivables and student loans and are categorized within Level 2 and Level 3 of the fair value hierarchy. Valuations are determined using pricing data obtained from external pricing services and prices observed for recently executed market transactions.

Loans and Other Receivables

 

   

Corporate Loans:     Corporate loans categorized within Level 2 of the fair value hierarchy are measured based on market price quotations from external pricing services where sufficient observability exists as to the extent of market transaction data supporting the pricing data. Corporate loans categorized within Level 3 of the fair value hierarchy, are measured based on market price quotations that are considered to be less transparent, market prices for debt securities of the same creditor, and estimates of future cash flow incorporating assumptions regarding creditor default and recovery rates and consideration of the issuer’s capital structure.

 

   

Participation Certificates in GNMA Project and Construction Loans:     Valuations of participation certificates in GNMA project and construction loans are based on observed market prices of recently executed purchases of similar loans which are then used to derive a market implied spread, which in turn is used as the primary input in estimating the fair value of loans at the measurement date. The loan participation certificates are categorized within Level 2 of the fair value hierarchy given the observability and volume of recently executed transactions.

 

   

Project Loans:     Valuation of project loans are based on benchmarks of prices for recently executed transactions of related realized collateralized securities and are categorized within Level 2 of the fair value hierarchy.

 

   

Escrow and Trade Claim Receivables:     Escrow and trade claim receivables are categorized within Level 3 of the fair value hierarchy where fair value is estimated based on reference to market prices and implied yields of debt securities of the same or similar issuers. Escrow and trade claim receivables are categorized within Level 2 of the fair value hierarchy where fair value is based on recent trade activity in the same security.

Derivatives

 

   

Listed Derivative Contracts:     Listed derivative contracts are measured based on quoted exchange prices, which are generally obtained from external pricing services, are categorized within Level 1 of the fair value hierarchy. Listed derivatives for which there is limited trading activity are measured based on incorporating the closing auction price of the underlying equity security and are categorized within Level 2 of the fair value hierarchy.

 

   

OTC Derivative Contracts:     OTC derivative contracts are generally valued using models, whose inputs reflect assumptions that we believe market participants would use in valuing the derivative in a current period transaction. Inputs to valuation models are appropriately calibrated to market data. For many OTC derivative contracts, the valuation models do not involve material subjectivity as the methodologies do not entail significant judgment and the inputs to valuation models do not involve a high degree of subjectivity as the valuation model inputs are readily observable or can be derived from actively quoted markets. OTC derivative contracts are primarily categorized within Level 2 of the fair value hierarchy given the observability of the inputs to the valuation models. Where significant inputs to the valuation are unobservable derivative instruments are categorized within Level 3 of the fair value hierarchy.

 

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OTC options include OTC equity, foreign exchange and commodity options measured using Black-Scholes models with key inputs impacting the valuation including the underlying security, foreign exchange spot rate or commodity price, implied volatility, dividend yield, interest rate curve, strike price and maturity date. Discounted cash flow models are utilized to measure certain OTC derivative contracts including the valuations of our interest rate swaps, which incorporate observable inputs related to interest rate curves, valuations of our foreign exchange forwards and swaps, which incorporate observable inputs related to foreign currency spot rates and forward curves and valuations of our commodity swaps, which incorporate observable inputs related to commodity spot prices and forward curves. Credit defaults swaps include both index and single-name credit default swaps. External prices are available as inputs in measuring index credit default swaps and single-name credit default swaps. For commodity and equity total return swaps, market prices are observable for the underlying asset and used as the basis for measuring the fair value of the derivative contracts. Total return swaps executed on other underlyings are measured based on valuations received from external pricing services.

Physical Commodities

Physical commodities include base and precious metals and are measured using observable inputs including spot prices and published indices. Physical commodities are categorized within Level 2 of the fair value hierarchy.

Investments at Fair Value and Investments in Managed Funds

Investments at fair value and Investments in managed funds include investments in hedge funds, fund of funds, private equity funds, convertible bond funds and commodity funds, which are measured at fair value based on the net asset value of the funds provided by the fund managers and are categorized within Level 2 or Level 3 of the fair value hierarchy. Investments at fair value also include direct equity investments in private companies, which are measured at fair value using valuation techniques involving quoted prices of or market data for comparable companies, similar company ratios and multiples (e.g., price/EBITDA, price/book value), discounted cash flow analyses and transaction prices observed for subsequent financing or capital issuance by the company. Direct equity investments in private companies are categorized within Level 3 of the fair value hierarchy. Additionally, investments at fair value include investments in insurance contracts relating to our defined benefit plan in Germany and shares in non-US exchanges and clearing houses. Fair value for the insurance contracts is determined using a third party and are categorized within Level 3 of the fair value hierarchy. Fair value for the shares in non-US exchanges and clearing houses is determined based on recent transactions or third party model valuations and are categorized within Level 2 or Level 3 of the fair value hierarchy. The following tables present information about our investments in entities that have the characteristics of an investment company at August 31, 2012 and November 30, 2011 (in thousands):

 

     August 31, 2012
     Fair Value
(7)
     Unfunded
Commitments
     Redemption
Frequency
(if currently eligible)

Equity Long/Short Hedge Funds(1)

   $ 28,793       $       Monthly, Quarterly

High Yield Hedge Funds(2)

     767               —  

Fund of Funds(3)

     722         106       —  

Equity Funds(4)

     75,367         59,272       —  

Convertible Bond Funds(5)

     2,970               At Will

Other Investments(6)

     19               Bi-Monthly
  

 

 

    

 

 

    

Total(8)

   $ 108,638       $ 59,378      
  

 

 

    

 

 

    

 

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     November 30, 2011
     Fair Value
(7)
     Unfunded
Commitments
     Redemption
Frequency
(if currently eligible)

Equity Long/Short Hedge Funds(1)

   $ 27,604       $       Monthly, Quarterly

High Yield Hedge Funds(2)

     938              

Fund of Funds(3)

     772         126      

Equity Funds(4)

     88,294         74,283      

Convertible Bond Funds(5)

     2,827               At Will

Other Investments(6)

     19               Bi-Monthly
  

 

 

    

 

 

    

Total(8)

   $ 120,454       $ 74,409      
  

 

 

    

 

 

    

 

(1) This category includes investments in hedge funds that invest, long and short, in equity securities in domestic and international markets in both the public and private sectors. At August 31, 2012 and November 30, 2011, investments representing approximately 99% and 98%, respectively, of the fair value of investments in this category are redeemable with 30 — 65 days prior written notice, and includes investments in private asset management funds managed by us with an aggregate fair value of $10.7 million and $10.7 million, respectively. The remaining investments in this category cannot be redeemed as they are in liquidation and distributions will be received through the liquidation of the underlying assets of the funds. We are unable to estimate when the underlying assets will be liquidated.

 

(2) Includes investments in three funds that invest in domestic and international public high yield debt, private high yield investments, senior bank loans, public leveraged equities, distressed debt, and private equity investments. There are no redemption provisions. The underlying assets of the funds are being liquidated and we are unable to estimate when the underlying assets will be fully liquidated.

 

(3) Includes investments in fund of funds that invest in various private equity funds. At August 31, 2012 and November 30, 2011, approximately 95% of the fair value of investments in this category is managed by us and has no redemption provisions, instead distributions are received through the liquidation of the underlying assets of the fund of funds, which are estimated to be liquidated in one to two years. As of August 31, 2012 and November 30, 2011, we have requested redemption for investments representing approximately 5% of the fair value of investments in this category; however, we are unable to estimate when these funds will be returned.

 

(4) At August 31, 2012 and November 30, 2011, investments representing approximately 94% and 96% of the fair value of investments in this category include investments in equity funds that invest in the equity of various U.S. and foreign private companies in the energy, technology, internet service and telecommunication service industries. At August 31, 2012 and November 30, 2011, a fund that invests in Croatian companies represents approximately 4% of the total investment in equity funds. These investments cannot be redeemed instead distributions are received through the liquidation of the underlying assets of the funds which are expected to liquidate in one to eight years. At August 31, 2012, investments representing approximately 3% of the fair value of investments in equity funds are in liquidation and we are unable to estimate when the underlying assets will be fully liquidated. At August 31, 2012 and November 30, 2011, this category includes investments in equity funds managed by us with a fair value of $58.2 million and $69.1 million and unfunded commitments of $56.9 million and $70.7 million, respectively.

 

(5) Investment in the Jefferies Umbrella Fund, an open-ended investment company managed by us that invests primarily in convertible bonds. This investment is redeemable with 5 days prior written notice.

 

(6) Other investments at August 31, 2012 and November 30, 2011 included investments in funds that invest in commodity futures and options contracts.

 

(7) Fair value has been estimated using the net asset value derived from each of the funds’ capital statements.

 

(8) Investments at fair value in the Consolidated Statements of Financial Condition at August 31, 2012 and November 30, 2011 include $96.4 million and $55.9 million, respectively, of direct investments which are not investment companies and therefore not included within this table.

 

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Pricing information

At August 31, 2012 and November 30, 2011, our Financial instruments owned and Financial instruments sold, not yet purchased are measured using different valuation bases as follows:

 

     August 31, 2012     November 30, 2011  
     Financial
Instruments
Owned
    Financial
Instruments  Sold,
Not Yet
Purchased
    Financial
Instruments
Owned
    Financial
Instruments  Sold,
Not Yet

Purchased
 

Exchange closing prices

     11     19     7     19

Recently observed transaction prices

     3     1     2     1

External pricing services

     70     77     77     75

Broker quotes

     2     0     1     0

Valuation techniques

     14     3     13     5
  

 

 

   

 

 

   

 

 

   

 

 

 
     100     100     100     100
  

 

 

   

 

 

   

 

 

   

 

 

 

The following is a summary of changes in fair value of our financial assets and liabilities that have been categorized within Level 3 of the fair value hierarchy for the three months ended August 31, 2012 (in thousands):

 

     Three Months Ended August 31, 2012  
     Balance,
May 31,
2012
     Total gains/
losses  (realized

and unrealized)
(1)
    Purchases     Sales     Settlements     Net
transfers
into/
(out of)
Level 3
    Balance,
August 31,
2012
     Change in
unrealized  gains/
(losses) relating  to
instruments
still held  at
August 31,
2012
 

Assets:

                  

Financial instruments owned:

                  

Corporate equity securities

   $ 25,789       $ 260      $ 2,991      $ (15,418   $      $ 6,161      $ 19,783       $ (907

Corporate debt securities

     7,972         (101     521        (1,118            284        7,558         (136

Collateralized debt obligations

     84,006         6,710               (11,008            1,890        81,598         5,836   

Municipal securities

     465         5               (387                   83         5   

Residential mortgage-backed securities

     123,555         2,542        27,401        (65,422     (5,216     62,128        144,988         359   

Commercial mortgage-backed securities

     40,594         (1,327     2,092        (1,307     (450     (8,089     31,513         (1,310

Other asset-backed securities

     1,273                              (291     (774     208           

Loans and other receivables

     108,674         (528     57,790        (30,632     (56,404     29,889        108,789         (237

Investments, at fair value

     91,836         (202     1,120               (775            91,979         (466

Investments in managed funds

     68,314         (5,389     2,173               (4,987     10        60,121         (5,382

Liabilities:

                  

Financial instruments sold, not yet purchased:

                  

Corporate equity securities

   $ 12,039       $ (410   $ (11,782   $ 191      $      $      $ 38       $   

Corporate debt securities

     74         (15     (59                                    

Net derivatives(2)

     4,395         7,342                             10        11,747         6,209   

Loans

                           4,285                      4,285           

 

(1) Realized and unrealized gains/losses are reported in Principal transactions in the Consolidated Statements of Earnings.

 

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(2) Net derivatives represent Financial instruments owned – Derivatives and Financial instruments sold, not yet purchased – Derivatives.

Analysis of Level 3 Assets and Liabilities for the Three Months Ended August 31, 2012

During the three months ended August 31, 2012, transfers of assets of $156.5 million from Level 2 to Level 3 are primarily attributed to:

 

   

Non-agency residential mortgage-backed securities of $74.5 million and Commercial mortgage-backed securities of $9.0 million for which no recent trade activity was observed for purposes of determining observable inputs;

 

   

Loans and other receivables of $53.0 million due to a lack of observable market transactions or vendor quotes during the period to support classification within Level 2 as less market interest likely existed for the specific loans during the period;

 

   

Collateralized debt obligations of $9.3 million which have no recent trade activity; and

 

   

Corporate equity securities of $6.3 million and Corporate debt securities of $4.4 million due to lack of observable market transactions.

During the three months ended August 31, 2012, transfers of assets of $65.0 million from Level 3 to Level 2 are primarily attributed to:

 

   

Loans and other receivables of $23.1 million due to a greater number of contributors for certain vendor quotes supporting classification into Level 2 as greater market interest likely existed for the specific loans during the quarter;

 

   

Commercial mortgage-backed securities of $17.1 million, Non-agency residential mortgage-backed securities of $12.4 million and Other asset-backed securities of $0.8 million for which market trades were observed in the period for either identical or similar securities or for which vendor prices were corroborated to actual market transactions;

 

   

Collateralized debt obligations of $7.4 million due to a greater number of contributors for certain vendor quotes supporting classification into Level 2 during the period; and

 

   

Corporate equity securities of $0.1 million and Corporate debt securities of $4.1 million due to an increase in observable broker levels and recent trade activity in certain bonds and private equity positions.

During the three months ended August 31, 2012 there were no transfers of liabilities from Level 2 to Level 3 and transfers of $0.01 million from Level 3 to Level 2.

Net gains on Level 3 assets were $2.0 million and net losses on Level 3 liabilities were $6.9 million for the three months ended August 31, 2012. Net gains on Level 3 assets were primarily due to increased valuations of certain collateralized debt obligations and residential mortgage backed securities. These gains were partially offset by decreased valuations of investments in managed funds, commercial mortgage backed securities and loans and other receivables. Net losses on Level 3 liabilities were primarily due to decreased valuations of certain derivative instruments.

The following is a summary of changes in fair value of our financial assets and liabilities that have been categorized within Level 3 of the fair value hierarchy for the three months ended August 31, 2011 (in thousands):

 

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     Three Months Ended August 31, 2011  
     Balance,
May 31,
2011
     Total gains/
losses (realized
and unrealized)
(1)
    Purchases,
sales,
settlements,
and
issuances
    Transfers
into
Level 3
     Transfers
out of
Level 3
    Balance,
August 31,
2011
     Change in
unrealized gains/
(losses) relating to
instruments

still held at
August 31,

2011
 

Assets:

                 

Financial instruments owned:

                 

Corporate equity securities

   $ 18,230       $ 1,720      $ 2,631      $ 861       $ (12,030   $ 11,412       $ (154

Corporate debt securities

     39,688         (4,069     6,230        14,425         (1,044     55,230         (7,349

Collateralized debt obligations

     84,046         (3,417     9,325        19,029         (12,319     96,664         (5,413

Municipal securities

     858         11        (183                    686         1   

Sovereign obligations

                    128                       128           

Residential mortgage-backed securities

     206,721         (12,527     15,276        41,510         (79,461     171,519         (12,917

Commercial mortgage-backed securities

     33,516         (3,652     (292     17,364         (6,741     40,195         (3,690

Other asset-backed securities

     9,352         (329     2,773        99         (8,417     3,478         (329

Loans and other receivables

     261,056         710        (92,362     27,077         (32,318     164,163         (116

Investments at fair value

     71,008         2,397        19,045        11         (33     92,428         (938

Investments in managed funds

     125,303         (83     (51,320                    73,900         62   

Liabilities:

                 

Financial instruments sold, not yet purchased:

                 

Corporate equity securities

   $ 38       $ 21      $      $       $      $ 59       $ 20   

Net derivatives(2)

     2,739         696                       11        3,446         687   

Loans

     6,398         (230     5,290                       11,458         (230

 

(1) Realized and unrealized gains/losses are reported in Principal transactions in the Consolidated Statements of Earnings.

 

(2) Net derivatives represent Financial instruments owned – Derivatives and Financial instruments sold, not yet purchased – Derivatives.

Analysis of Level 3 Assets and Liabilities for the Three Months Ended August 31, 2011

During the three months ended August 31, 2011, transfers of assets of $120.4 million from Level 2 to Level 3 are primarily attributed to:

 

   

Non-agency residential mortgage-backed securities, collateralized debt obligations, and commercial mortgage backed securities due to less observable trading activity and vendor quotes that were not corroborated to market transactions;

 

   

Loans and other receivables due to lower number of contributors comprising vendor quotes to support classification in Level 2; and

 

   

Corporate debt securities due to lack of observable market transactions.

During the three months ended August 31, 2011, transfers of assets of $152.4 million from Level 3 to Level 2 are primarily attributed to:

 

   

Non-agency residential mortgage-backed securities, collateralized debt obligations, other asset-backed securities, and commercial mortgage backed securities for which market trades were observed in the period for either identical or similar securities or for which vendor prices were corroborated to actual market transactions;

 

   

Loans and other receivables due to greater number of contributors comprising vendor quotes supporting classification into Level 2; and

 

   

Corporate equity securities due to announced market transactions or more observable market data on comparable securities used as a benchmark.

 

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During the three months ended August 31, 2011 there were no transfers of liabilities from Level 2 to Level 3 and $.01 million transfers of liabilities from Level 3 to Level 2.

Net losses on Level 3 assets were $19.2 million and net losses on Level 3 liabilities were $0.5 million for the three months ended August 31, 2011. Net losses on Level 3 assets were primarily due to decreased valuations of various residential mortgage-backed securities, corporate debt, collateralized debt obligations, and commercial mortgage-backed securities, offset by sales of certain investments at fair value, corporate debt, and collateralized debt obligations.

The following is a summary of changes in fair value of our financial assets and liabilities that have been categorized within Level 3 of the fair value hierarchy for the nine months ended August 31, 2012 (in thousands):

 

     Nine Months Ended August 31, 2012  
     Balance,
November 30,
2011
     Total gains/
losses (realized
and unrealized)
(1)
    Purchases     Sales     Settlements     Net
transfers
into/

(out  of)
Level 3
    Balance,
August 31,
2012
     Change in
unrealized gains/
(losses) relating to
instruments

still held at
August  31,

2012
(1)
 

Assets:

                  

Financial instruments owned:

                  

Corporate equity securities

   $ 13,489       $ (2,580   $ 20,676      $ (13,437   $      $ 1,635      $ 19,783       $ (4,636

Corporate debt securities

     48,140         85        7,228        (39,367     (1,276     (7,252     7,558         (656

Collateralized debt obligations

     47,988         4,278        8,479        (18,699     (3,892     43,444        81,598         3,515   

Municipal securities

     6,904         (74            (1,366            (5,381     83         5   

Sovereign obligations

     140                                     (140               

Residential mortgage-backed securities

     149,965         (17,833     59,477        (101,039     (8,489     62,907        144,988         (8,884

Commercial mortgage-backed securities

     52,407         (2,221     5,090        (5,441     (115     (18,207     31,513         (2,769

Other asset-backed securities

     3,284         141        19,397        (20,351     (51     (2,212     208         3   

Loans and other receivables

     97,291         (2,674     158,305        (60,111     (104,476     20,454        108,789         (4,109

Investments, at fair value

     78,326         15,076        1,909        (6     (3,326            91,979         14,412   

Investments in managed funds

     70,740         (17,765     12,683               (5,537            60,121         (17,765

Liabilities:

                  

Financial instruments sold, not yet purchased:

                  

Corporate equity securities

   $       $ 38      $      $      $      $      $ 38       $ 38   

Corporate debt securities

     74         (15     (59                                    

Net derivatives(2)

     9,285         5,064        (389                   (2,213     11,747         6,087   

Loans

     10,157                (10,157     4,285                      4,285           

 

(1) Realized and unrealized gains/losses are reported in Principal transactions in the Consolidated Statements of Earnings.

 

(2) Net derivatives represent Financial instruments owned – Derivatives and Financial instruments sold, not yet purchased – Derivatives.

Analysis of Level 3 Assets and Liabilities for the Nine Months Ended August 31, 2012

During the nine months ended August 31, 2012, transfers of assets of $184.2 million from Level 2 to Level 3 of the fair value hierarchy are attributed to:

 

   

Non-agency residential mortgage-backed securities of $67.5 million, Commercial mortgage-backed securities of $11.7 million for which no recent trade activity was observed for purposes of determining observable inputs;

 

   

Loans and other receivables of $55.2 million due to a lower number of contributors comprising vendor quotes to support classification within Level 2 as less market interest likely existed for the specific loans during the period;

 

   

Collateralized debt obligations of $47.3 million which have little to no transparency in trade activity; and

 

   

Corporate equity securities of $1.7 million and Corporate debt securities of $0.6 million due to lack of observable market transactions.

 

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During the nine months ended August 31, 2012, transfers of assets of $88.9 million from Level 3 to Level 2 are attributed to:

 

   

Loans and other receivables of $34.8 million and Collateralized debt obligations of $3.9 million due to a greater number of contributors for certain vendor quotes supporting classification into Level 2;

 

   

Commercial mortgage-backed securities of $29.9 million, Non-agency residential mortgage-backed securities of $4.5 million and $2.4 million of Other asset-backed securities for which market trades were observed in the period for either identical or similar securities or for which vendor prices were corroborated to actual market transactions; and

 

   

Corporate debt securities of $7.9 million and Municipal securities of $5.4 million due to increased observability of trades in certain debt and municipal securities.

During the nine months ended August 31, 2012, there were no transfers of liabilities from Level 2 to Level 3 and there were $2.2 million transfers of net derivative liabilities from Level 3 to Level 2 due to an increase in observable significant inputs used in valuing the derivative contracts.

Net losses on Level 3 assets were $23.6 million and net losses on Level 3 liabilities were $5.1 million for the nine months ended August 31, 2012. Net losses on Level 3 assets were primarily due to decreased valuations of certain residential mortgage-backed securities, investments in managed funds, loans and other receivables, commercial mortgage backed securities and corporate equity securities, offset by an increase in valuation of certain investments at fair value and collateralized debt obligations. Net losses on Level 3 liabilities were primarily due to decreased valuations of certain derivative instruments.

The following is a summary of changes in fair value of our financial assets and liabilities that have been categorized within Level 3 of the fair value hierarchy for the nine months ended August 31, 2011 (in thousands):

 

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     Nine Months Ended August 31, 2011  
      Balance,
November 30,
2010
     Total gains/
losses (realized
and unrealized)
(1)
    Purchases,
sales,
settlements,
and

issuances
    Transfers
into
Level 3
     Transfers
out of
Level 3
    Balance,
August 31,
2011
     Change
in unrealized gains/
(losses) relating to
instruments

still held at
August 31,
2011
 

Assets:

                 

Financial instruments owned:

                 

Corporate equity securities

   $ 22,619       $ 2,905      $ (3,040   $ 816       $ (11,888   $ 11,412       $ (422

Corporate debt securities

     73,408         (487     (22,533     6,304         (1,462     55,230         (5,906

Collateralized debt obligations

     31,121         10,423        54,351        779         (10     96,664         9,632   

Municipal securities

     472         89        125                       686         78   

Sovereign obligations

                    128                       128           

Residential mortgage-backed securities

     132,359         (8,354     64,906        29,901         (47,293     171,519         (25,284

Commercial mortgage-backed securities

     6,004         1,625        25,574        6,992                40,195         112   

Other asset-backed securities

     567         (604     3,156        926         (567     3,478         (604

Loans and other receivables

     227,596         2,476        (57,473     9,006         (17,442     164,163         (1,452

Investments at fair value

     77,784         9,326        8,421                (3,103     92,428         6,495   

Investments in managed funds

     131,585         15,159        (72,844                    73,900         14,575   

Liabilities:

                 

Financial instruments sold, not yet purchased:

                 

Corporate equity securities

   $ 38       $ 21      $      $       $      $ 59       $ 20   

Net derivatives(2)

     2,346         1,100                              3,446         1,200   

Loans

     47,228         (230     (35,540                    11,458         (230

 

(1) Realized and unrealized gains/losses are reported in Principal transactions in the Consolidated Statements of Earnings.

 

(2) Net derivatives represent Financial instruments owned – Derivatives and Financial instruments sold, not yet purchased – Derivatives.

Analysis of Level 3 Assets and Liabilities for the Nine Months Ended August 31, 2011

During the nine months ended August 31, 2011, transfers of assets of $54.7 million from Level 2 to Level 3 are primarily attributed to:

 

   

Non-agency residential mortgage-backed securities and commercial asset backed securities due to a tightening in the historical trading period used for corroborating market data and a greater scrutiny of vendor prices;

 

   

Loans and other receivables due to lower number of contributors comprising vendor quotes to support classification in Level 2; and

 

   

Corporate debt securities due to lack of observable market transactions.

During the nine months ended August 31, 2011, transfers of assets of $81.8 million from Level 3 to Level 2 are primarily attributed to:

 

   

Non-agency residential mortgage-backed securities for which market trades were observed in the period for either identical or similar securities or for which vendor prices were corroborated to actual market transactions;

 

   

Loans and other receivables due to greater number of contributors comprising vendor quotes supporting classification into Level 2; and

 

   

Corporate equity securities due to announced market transactions or more observable market data on comparable securities used as a benchmark.

 

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During the nine months ended August 31, 2011 there were no transfers of liabilities from Level 2 to Level 3 or from Level 3 to Level 2.

Net gains on Level 3 assets were $32.6 million and net losses on Level 3 liabilities were $0.9 million for the nine months ended August 31, 2011. Net gains on Level 3 assets were primarily due to sales or settlements of various residential mortgage-backed securities, corporate debt securities, loans and other receivables, investments at fair value, and corporate equity securities, increased valuations of certain collateralized debt obligations and investments at fair value, offset by decreased valuations of certain residential mortgage-backed securities and corporate debt securities.

Components or portions of interest rate and credit risk related to mortgage-backed securities categorized within Level 3 of the fair value hierarchy are frequently economically hedged with U.S. Treasury and Eurodollar futures and short U.S. Treasury securities, which are categorized within Level 1 liabilities, and with interest rate swaps and, to a lesser extent, index credit default swaps categorized within Level 2 assets or liabilities. Accordingly, a portion of the gains and losses on mortgage-backed securities reported in Level 3 are offset by gains and losses from the economic hedges attributed to instruments categorized within Level 1 and Level 2. Economic hedging is often executed on a macro-basis for a given asset class rather than an instrument-specific basis. Valuation inputs and prices for hedging instruments categorized within Level 1 and Level 2 provide a level of observability used in valuing Level 3 mortgage-backed securities; however, other inputs, such as prepayment, default rates and other credit specific factors are significant to the valuation and are not derived from the prices of the hedging instruments. Basis risk differences may also arise between the Level 3 mortgage-backed securities and the Level 1 and Level 2 hedging instruments due to the underlying interest rates and the underlying credits comprising the referenced credit index. Hedge effectiveness is limited by factors that include idiosyncratic collateral performance and basis risk as well as the sizing of the macro-hedge.

Quantitative Information about Significant Unobservable Inputs used in Level 3 Fair Value Measurements at August 31, 2012

The tables below present information on the valuation techniques, significant unobservable inputs and their ranges for our financial assets and liabilities, subject to threshold levels related to the market value of the positions held, measured at fair value on a recurring basis with a significant Level 3 balance. The range of unobservable inputs could differ significantly across different firms given the range of products across different firms in the financial services sector. The inputs are not representative of the inputs that could have been used in the valuation of any one financial instruments; i.e., the input used for valuing one financial instrument within a particular class of financial instruments may not be appropriate for valuing other financial instruments within that given class. Additionally, the ranges of inputs presented below should not be construed to represent uncertainty regarding the fair values of our financial instruments.

 

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Financial Instruments Owned

   Market Value
(in thousands)
   

Valuation Technique

  

Significant Unobservable Input(s)

   Range

Corporate debt securities

   $ 7,558           
     Comparable pricing    Comparable bond price    $0 to $83.50
     Discounted cash flows    Constant prepayment rate    0%
        Constant default rate    2%
        Loss severity    58%
        Yield    18%

Corporate equity securities

   $ 19,783           

Non-exchange traded securities

     Market approach    EBITDA (a) multiple    5.0 to 16.8
     Scenario analysis    Estimated recovery percentage    40%

Warrants

     Option model    Volatility    39.12

Investments at fair value

   $ 35,588           

Private equity securities

     Market approach    EBITDA (a) multiple    5.9 to 7.8
     Market approach    Price per acre    $40,000.00
     Comparable pricing    Comparable share price    $328.00

Loans and other receivables

   $ 105,689           
     Comparable pricing    Comparable bond or loan price            $85.71 to $101.25
     Discounted cash flows            Yield    18%
        Cumulative loss rate    0%
     Market approach    Yield    5% to 13%
     Scenario analysis    Estimated recovery percentage    15%

Collateralized debt obligations

   $ 71,427           
     Discounted cash flows    Constant prepayment rate    0% to 5%
        Constant default rate    0% to 10%
        Loss severity    0% to 85%
        Yield    10% to 84%
     Liquidation value    Comparable loan price    $68.33 to $110.38

Commercial mortgage-backed securities

   $ 31,513           
     Discounted cash flows    Yield    20% to 36%
        Cumulative loss rate    3% to 20%

Residential mortgage-backed securities

   $ 144,988           
     Discounted cash flows    Constant prepayment rate    0% to 30%
        Constant default rate    0% to 14%
        Loss severity    0% to 70%
        Yield    1% to 46%

Financial Instruments Sold, Not Yet

Purchased

   Market Value
(in  thousands)
   

Valuation Technique

  

Significant Unobservable Input(s)

   Range

Derivatives

          

Equity options

   $ (12,087   Option model    Volatility    40.25

Loan commitments

     Comparable pricing    Comparable bond or loan price    $100.88

 

(a) Earnings before interest, taxes, depreciation and amortization (“EBITDA”).

 

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The fair values of certain Level 3 assets that were determined based on third-party pricing information, unadjusted past transaction prices, reported net asset value or a percentage of the reported enterprise fair value are excluded from the above table. At August 31, 2012, the exclusions consisted of $65.9 million primarily comprised of investments in private equity and hedge funds, investments in reinsurance contracts, certain collateralized debt obligations and corporate loans. The provisions of ASU No. 2011-04 were adopted on a prospective basis during the second quarter of fiscal 2012 and accordingly, disclosures for prior periods are not presented.

Sensitivity of Fair Values to Changes in Significant Unobservable Inputs

For recurring fair value measurements categorized within Level 3 of the fair value hierarchy, the sensitivity of the fair value measurement to changes in significant unobservable inputs and interrelationships between those unobservable inputs (if any) are described below:

 

   

Corporate bonds, private equity securities, loans and other receivables and collateralized debt obligations using comparable pricing valuation techniques. A significant increase (decrease) in the comparable bond or loan price in isolation would result in a significant higher (lower) fair value measurement.

 

   

Non-exchange traded securities, private equity securities and loans and other receivables using a market approach valuation technique. A significant increase (decrease) in the EBITDA or other multiples in isolation would result in a significantly higher (lower) fair value measurement.

 

   

Non-exchange traded securities and loans and other receivables using scenario analysis. A significant increase (decrease) in the possible recovery rates of the cash flow outcomes underlying the investment would result in a significantly higher (lower) fair value measurement for the financial instrument.

 

   

Corporate bonds, collateralized debt obligations, residential and commercial mortgage-backed securities using a discounted cash flow valuation technique. A significant increase (decrease) in isolation in the constant default rate, loss severities or cumulative loss rate and discount rate would result in a significantly lower (higher) fair value measurement. The impact of changes in the constant prepayment rate would have differing impacts depending on the capital structure of the security. A significant increase (decrease) in the bond yield would result in a significant lower (higher) fair value measurement.

 

   

Short derivative equity options using an option model. A significant increase (decrease) in volatility would result in a significant lower (higher) fair value measurement.

 

   

Collateralized debt obligations using a liquidation valuation technique. A significant increase (decrease) in the comparable loan prices in would result in a significant higher (lower) fair value measurement.

Fair Value Option Election

We have elected the fair value option for all loans and loan commitments made by our capital markets businesses. These loans and loan commitments include loans entered into by our investment banking division in connection with client bridge financing and loan syndications, loans purchased by our leveraged credit trading desk as part of its bank loan trading activities and mortgage loan commitments and fundings in connection with mortgage-backed securitization activities. Loans and loan commitments originated or purchased by our leveraged credit and mortgage-backed businesses are managed on a fair value basis. Loans are included in Financial instruments owned and loan commitments are included in Financial instruments owned-derivatives and Financial instruments sold, not yet purchased — derivatives on the Consolidated Statements of Financial Condition. The fair value option election is not applied to loans made to affiliate entities as such loans are entered into as part of ongoing, strategic business ventures. Loans to affiliate entities are included within Loans to and investments in related parties on the Consolidated Statements of Financial Condition and are accounted for on an amortized cost basis. We have elected the fair value option for our investment in Knight Capital Group, Inc., which is included in Financial Instruments owned — Corporate equity securities on the Consolidated Statement of Financial Condition. See Note 10, Investments for further details regarding our investment in Knight Capital Group, Inc. We also have elected the fair value option for certain financial instruments held by subsidiaries that are not registered broker-dealers as the investments are risk managed by us on a fair value basis. The fair value option has also been elected for secured financings that arise in

 

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connection with our securitization activities. Receivables — Brokers, dealers and clearing organizations, Receivables — Customers, Receivables — Fees, interest and other, Payables — Brokers, dealers and clearing organizations and Payables — Customers, are not accounted for at fair value; however, the recorded amounts approximate fair value due to their liquid or short-term nature.

The following is a summary of gains and (losses) due to changes in instrument specific credit risk on loans and other receivables and loan commitments measured at fair value under the fair value option (in thousands):

 

                                     
     Three Months Ended
August 31, 2012
    Nine Months Ended
August 31, 2012
 

Financial Instruments Owned:

    

Loans and other receivables

   $ 5,012      $ 9,664   

Financial Instruments Sold:

    

Loans

   $ (320   $ (466

Loan commitments

     (5.213     (7,088

The following is a summary of the amount by which contractual principal exceeds fair value for loans and other receivables measured at fair value under the fair value option (in thousands):

 

                                             
     August 31,      November 30,  
     2012      2011  

Financial Instruments Owned:

     

Loans and other receivables(2)

   $ 269,801       $ 277,336   

Loans greater than 90 days past due(1)(2)

   $ 5,699       $ 2,253   

 

(1) The aggregate fair value of loans that were 90 or more days past due was $20.2 million and $5.5 million at August 31, 2012 and November 30, 2011.

 

(2) Interest income is recognized separately from other changes in fair value and is included within Interest revenues on the Consolidated Statements of Earnings.

There were no loans or other receivables on nonaccrual status at August 31, 2012 and November 30, 2011.

 

Note 6. Derivative Financial Instruments

Off-Balance Sheet Risk

We have contractual commitments arising in the ordinary course of business for securities loaned or purchased under agreements to resell, repurchase agreements, future purchases and sales of foreign currencies, securities transactions on a when-issued basis and underwriting. Each of these financial instruments and activities contains varying degrees of off-balance sheet risk whereby the fair values of the securities underlying the financial instruments may be in excess of, or less than, the contract amount. The settlement of these transactions is not expected to have a material effect upon our consolidated financial statements.

Derivative Financial Instruments

Our derivative activities are recorded at fair value in the Consolidated Statements of Financial Condition in Financial instruments owned — derivatives and Financial instruments sold, not yet purchased — derivatives net of cash paid or received under credit support agreements and on a net counterparty basis when a legal right to offset exists under a master netting agreement. Net realized and unrealized gains and losses are recognized in Principal transactions in the Consolidated Statements of Earnings on a trade date basis and as a component of cash flows from operating activities in the Consolidated Statements of Cash Flows. Acting in a trading capacity, we may enter into derivative transactions to satisfy the needs of our clients and to manage our own exposure to market and credit risks resulting from our trading activities. (See Note 5, Fair Value Disclosures and Note 20, Commitments, Contingencies and Guarantees for additional disclosures about derivative instruments.)

 

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Derivatives are subject to various risks similar to other financial instruments, including market, credit and operational risk. The risks of derivatives should not be viewed in isolation, but rather should be considered on an aggregate basis along with our other trading-related activities. We manage the risks associated with derivatives on an aggregate basis along with the risks associated with proprietary trading as part of our firm wide risk management policies. In connection with our derivative activities, we may enter into master netting agreements and collateral arrangements with counterparties. These agreements provide us with the ability to offset a counterparty’s rights and obligations, request additional collateral when necessary or liquidate the collateral in the event of counterparty default.

The following table presents the fair value and related number of derivative contracts at August 31, 2012 and November 30, 2011 categorized by predominant risk exposure. The fair value of assets/liabilities related to derivative contracts represents our receivable/payable for derivative financial instruments, gross of counterparty netting and cash collateral received and pledged (in thousands, except contract amounts):

 

     August 31, 2012  
     Assets      Liabilities  
     Fair Value     Number of
Contracts
     Fair Value     Number of
Contracts
 

Interest rate contracts

   $     917,424        86,810       $ 1,050,973        106,403   

Foreign exchange contracts

     526,363        101,140         468,695        100,721   

Equity contracts

     368,222        1,376,634         315,503        1,280,589   

Commodity contracts

     359,206        644,588         378,706        638,297   

Credit contracts

     15,205        21         15,839        27   
  

 

 

   

 

 

    

 

 

   

 

 

 

Total

     2,186,420        2,209,193         2,229,716        2,126,037   
    

 

 

      

 

 

 

Counterparty/cash-collateral netting

     (1,827,597        (1,996,000  
  

 

 

      

 

 

   

Total per Consolidated Statement of Financial Condition

   $     358,823         $ 233,716     
  

 

 

      

 

 

   
     November 30, 2011  
     Assets      Liabilities  
     Fair Value     Number of
Contracts
     Fair Value     Number of
Contracts
 

Interest rate contracts

   $ 542,221        63,751       $     636,692        66,027   

Foreign exchange contracts

         1,009,765        102,578         1,015,900        119,780   

Equity contracts

     638,228        2,364,390         548,195        2,119,165   

Commodity contracts

     725,927        434,428         598,166        421,330   

Credit contracts

     60,756        59         35,718        39   
  

 

 

   

 

 

    

 

 

   

 

 

 

Total

     2,976,897        2,965,206         2,834,671        2,726,341   
    

 

 

      

 

 

 

Counterparty/cash-collateral netting

     (2,451,004        (2,585,634  
  

 

 

      

 

 

   

Total per Consolidated Statement of Financial Condition

   $ 525,893         $     249,037     
  

 

 

      

 

 

   

 

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The following table presents unrealized and realized gains and (losses) on derivative contracts for the three and nine months ended August 31, 2012 and 2011 (in thousands):

 

     Three Months Ended     Nine Months Ended  
     August 31, 2012
Gains (Losses)
    August 31, 2011
Gains (Losses)
    August 31, 2012
Gains (Losses)
    August 31, 2011
Gains (Losses)
 

Interest rate contracts

   $ 38,067      $ (103,572   $ (39,667   $ (190,800

Foreign exchange contracts

     (4,616     2,200        4,193        (5,981

Equity contracts

     (46,930     (74,564     (72,691     (178,433

Commodity contracts

     11,074        8,512        57,586        41,102   

Credit contracts

     (5,887     11,383        (15,274     17,123   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total

   $ (8,292   $ (156,041   $ (65,853   $ (316,989
  

 

 

   

 

 

   

 

 

   

 

 

 

OTC Derivatives. The following tables set forth the remaining contract maturity of the fair value of OTC derivative assets and liabilities as of August 31, 2012 (in thousands):

 

     OTC derivative assets(1)(2)(4)  
     0-12 Months      1-5 Years      Greater Than
5 Years
     Cross-Maturity
Netting(3)
    Total  

Commodity swaps, options and forwards

   $ 108,376       $ 784       $       $ (701   $ 108,459   

Credit default swaps

             8,914         5,140         (478     13,576   

Equity swaps and options

     696                                696   

Total return swaps

     218                                218   

Foreign currency forwards, swaps and options

     122,956         30,747                 (38     153,665   

Fixed income forwards

     1,249                                1,249   

Interest rate swaps and options

     13,047         47,941         207,828         (78,316     190,500   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Total

   $ 246,542       $ 88,386       $ 212,968       $ (79,533     468,363   
  

 

 

    

 

 

    

 

 

    

 

 

   

Cross product counterparty netting

                (17,224
             

 

 

 

Total OTC derivative assets included in Financial instruments owned

              $ 451,139   
             

 

 

 

 

(1) At August 31, 2012, we held exchange traded derivative assets and other credit enhancements with a fair value of $80.8 million, which are not included in this table.

 

(2) OTC derivative assets in the table above are gross of collateral received. OTC derivative assets are recorded net of collateral received on the Consolidated Statements of Financial Condition. At August 31, 2012, cash collateral received was $173.1 million.

 

(3) Amounts represent the netting of receivable balances with payable balances for the same counterparty within product category across maturity categories.

 

(4) Derivative fair values include counterparty netting within product category.

 

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     OTC derivative liabilities(1)(2)(4)  
     0-12 Months      1-5 Years      Greater Than
5 Years
     Cross-Maturity
Netting(3)
    Total  

Commodity swaps, options and forwards

   $ 119,708       $ 80       $       $ (701   $ 119,087   

Credit default swaps

     397         445         6,322         (478     6,686   

Equity swaps and options

     7,739         4,376                        12,115   

Total return swaps

     534                                534   

Foreign currency forwards, swaps and options

     71,988         27,440                 (38     99,390   

Interest rate swaps and options

     10,484         125,569