XPAR:KCG Quarterly Report 10-Q Filing - 6/30/2012

Effective Date 6/30/2012

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Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

For the quarterly period ended June 30, 2012
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2012

OR

 

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

001-14223

Commission File Number

 

 

KNIGHT CAPITAL GROUP, INC.

(Exact name of registrant as specified in its charter)

DELAWARE

(State or other jurisdiction of incorporation or organization)

22-3689303

(I.R.S. Employer Identification Number)

545 Washington Boulevard, Jersey City, NJ 07310

(Address of principal executive offices and zip code)

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

 

 

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

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

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

Large accelerated filer  x        Accelerated filer  ¨

Non-accelerated filer (Do not check if a smaller reporting company)  ¨        Smaller reporting company  ¨

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

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

As of August 6, 2012 the number of shares outstanding of the Registrant’s Class A Common Stock was 97,814,427 and there were no shares outstanding of the Registrant’s Class B Common Stock.

As of August 6, 2012, the number of shares outstanding of the Registrant’s Series A-1 Cumulative Perpetual Convertible Preferred Stock was 79,600 and Series A-2 Non-Voting Cumulative Perpetual Convertible Preferred Stock was 320,400.

 

 

 


Table of Contents

KNIGHT CAPITAL GROUP, INC.

FORM 10-Q QUARTERLY REPORT

For the Quarter Ended June 30, 2012

TABLE OF CONTENTS

 

PART I

   FINANCIAL INFORMATION:   

Item 1.

  

Financial Statements (Unaudited)

     3   
  

Consolidated Statements of Operations

     3   
  

Consolidated Statements of Comprehensive Income

     4   
  

Consolidated Statements of Financial Condition

     5   
  

Consolidated Statements of Cash Flows

     6   
   Notes to Consolidated Financial Statements      7   

Item 2.

   Management’s Discussion and Analysis of Financial Condition and Results of Operations      42   

Item 3.

  

Quantitative and Qualitative Disclosures About Market Risk

     65   

Item 4.

  

Controls and Procedures

     68   

PART II

   OTHER INFORMATION:      69   

Item 1.

  

Legal Proceedings

     69   

Item 1A.

  

Risk Factors

     69   

Item 2.

  

Unregistered Sales of Equity Securities and Use of Proceeds

     77   

Item 3.

  

Defaults Upon Senior Securities

     77   

Item 4.

  

Mine Safety Disclosures

     77   

Item 5.

  

Other Information

     78   

Item 6.

  

Exhibits

     78   

Signatures

     79   

 

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PART I. FINANCIAL INFORMATION

 

Item 1. Financial Statements.

KNIGHT CAPITAL GROUP, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

 

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

Revenues

          

Commissions and fees

   $ 175,123       $ 195,514      $ 357,703       $ 378,072   

Net trading revenue

     96,675         125,808        253,222         277,596   

Interest, net

     5,924         2,306        13,062         5,406   

Investment income and other, net

     11,532         2,354        14,292         4,684   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total revenues

     289,254         325,982        638,279         665,758   
  

 

 

    

 

 

   

 

 

    

 

 

 

Expenses

          

Employee compensation and benefits

     130,878         140,126        278,132         289,090   

Execution and clearance fees

     53,193         58,737        106,448         112,186   

Communications and data processing

     24,427         21,691        46,757         42,414   

Payments for order flow

     20,155         22,337        41,843         43,046   

Interest

     13,981         9,540        27,439         19,420   

Depreciation and amortization

     13,476         13,524        26,789         26,733   

Occupancy and equipment rentals

     6,361         7,146        12,880         14,500   

Business development

     5,898         7,250        11,057         10,961   

Professional fees

     5,132         5,514        10,867         9,868   

Writedown of assets and lease loss accrual

     -           -          -           945   

Other

     10,397         10,663        16,711         17,057   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total expenses

     283,898         296,528        578,923         586,220   
  

 

 

    

 

 

   

 

 

    

 

 

 

Income from continuing operations before income taxes

     5,356         29,454        59,356         79,538   

Income tax expense

     2,065         11,704        22,959         31,155   
  

 

 

    

 

 

   

 

 

    

 

 

 

Income from continuing operations, net of tax

     3,291         17,750        36,397         48,383   

Loss from discontinued operations, net of tax

     -           (178     -           (319
  

 

 

    

 

 

   

 

 

    

 

 

 

Net income

   $ 3,291       $ 17,572      $ 36,397       $ 48,064   
  

 

 

    

 

 

   

 

 

    

 

 

 
          

Basic earnings per share from continuing operations

   $ 0.04       $ 0.19      $ 0.41       $ 0.52   
  

 

 

    

 

 

   

 

 

    

 

 

 

Diluted earnings per share from continuing operations

   $ 0.04       $ 0.19      $ 0.39       $ 0.51   
  

 

 

    

 

 

   

 

 

    

 

 

 

Basic earnings per share

   $ 0.04       $ 0.19      $ 0.41       $ 0.52   
  

 

 

    

 

 

   

 

 

    

 

 

 

Diluted earnings per share

   $ 0.04       $ 0.19      $ 0.39       $ 0.51   
  

 

 

    

 

 

   

 

 

    

 

 

 

Shares used in computation of basic earnings per share

     89,624         92,493        89,685         92,184   
  

 

 

    

 

 

   

 

 

    

 

 

 

Shares used in computation of diluted earnings per share

     92,682         94,682        93,167         94,884   
  

 

 

    

 

 

   

 

 

    

 

 

 

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

 

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Table of Contents

KNIGHT CAPITAL GROUP, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited)

 

     For the three months
ended June 30,
     For the six months
ended June 30,
 
         2012             2011          2012      2011  
     (In thousands)      (In thousands)  

Net Income

   $ 3,291      $ 17,572       $ 36,397       $ 48,064   

Other comprehensive income:

          

Cumulative translation adjustment

     (237     81         88         (214
  

 

 

   

 

 

    

 

 

    

 

 

 

Comprehensive income

   $ 3,054      $ 17,653       $ 36,485       $ 47,850   
  

 

 

   

 

 

    

 

 

    

 

 

 

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

 

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Table of Contents

KNIGHT CAPITAL GROUP, INC.

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(Unaudited)

 

     June 30,
2012
    December 31,
2011
 

ASSETS

    

Cash and cash equivalents

   $ 364,798      $ 467,633   

Cash and securities segregated under federal and other regulations

     190,391        11,010   

Financial instruments owned, at fair value, including securities pledged of $4,269,725 at June 30, 2012 and $2,672,709 at December 31, 2011:

    

Equities

     1,641,451        1,416,090   

Debt securities

     262,598        134,631   

Listed equity options

     191,157        280,384   

Loan inventory

     183,900        206,572   

Other financial instruments

     11,927        21,483   

Securitized HECM loan inventory

     2,738,917        1,722,631   
  

 

 

   

 

 

 

Total financial instruments owned, at fair value

     5,029,950        3,781,791   

Collateralized agreements:

    

Securities borrowed

     1,907,781        1,494,647   

Receivable from brokers, dealers and clearing organizations

     880,080        623,897   

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

     107,787        111,464   

Investments

     101,427        83,231   

Goodwill

     344,460        337,843   

Intangible assets, less accumulated amortization

     88,539        92,889   

Other assets

     179,749        148,546   
  

 

 

   

 

 

 

Total assets

   $     9,194,962      $     7,152,951   
  

 

 

   

 

 

 

LIABILITIES & EQUITY

    

Liabilities

    

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

    

Equities

   $ 1,256,365      $ 1,369,750   

Debt securities

     237,163        63,073   

Listed equity options

     178,990        254,506   

Other financial instruments

     8,000        34,563   
  

 

 

   

 

 

 

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

     1,680,518        1,721,892   

Collateralized financings:

    

Securities loaned

     1,239,168        697,998   

Financial instruments sold under agreements to repurchase

     550,185        420,320   

Other secured financings

     96,439        59,405   

Liability to GNMA trusts, at fair value

     2,717,323        1,710,627   
  

 

 

   

 

 

 

Total collateralized financings

     4,603,115        2,888,350   

Payable to brokers, dealers and clearing organizations

     289,810        322,660   

Payable to customers

     431,838        23,664   

Accrued compensation expense

     111,883        188,939   

Accrued expenses and other liabilities

     174,407        121,083   

Long-term debt

     406,425        424,338   
  

 

 

   

 

 

 

Total liabilities

     7,697,996        5,690,926   
  

 

 

   

 

 

 

Equity

    

Class A common stock

    

Shares authorized: 500,000 at June 30, 2012 and at December 31, 2011; Shares issued: 170,088 at June 30, 2012 and 166,361 at December 31, 2011;

    

Shares outstanding: 97,909 at June 30, 2012 and 96,645 at December 31, 2011

     1,701        1,664   

Additional paid-in capital

     881,331        850,837   

Retained earnings

     1,469,717        1,433,320   

Treasury stock, at cost; 72,179 at June 30, 2012 and 69,717 shares at December 31, 2011

     (855,099     (823,023

Accumulated other comprehensive loss

     (684     (773
  

 

 

   

 

 

 

Total equity

     1,496,966        1,462,025   
  

 

 

   

 

 

 

Total liabilities and equity

   $ 9,194,962      $ 7,152,951   
  

 

 

   

 

 

 

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

 

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Table of Contents

KNIGHT CAPITAL GROUP, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 

     For the six months
ended June 30,
 
     2012     2011  
     (In thousands)  

Cash flows from operating activities

    

Net income

   $ 36,397      $ 48,064   

Loss from discontinued operations, net of tax

     -          (319
  

 

 

   

 

 

 

Income from continuing operations, net of tax

     36,397        48,383   

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

    

Stock-based compensation

     28,206        28,204   

Depreciation and amortization

     26,789        26,733   

Debt discount accretion and other debt related expenses

     8,646        7,379   

Writedown of assets and lease loss accrual

     -          945   

Deferred rent

     (277     148   

Unrealized gain on investments

     (10,006     (1,833

Operating activities from discontinued operations

     -          (394

(Increase) decrease in operating assets

    

Cash and securities segregated under federal and other regulations

     (78,836     (3,496

Financial instruments owned, at fair value

     (1,257,690     (1,150,716

Securities borrowed

     (413,134     (270,430

Receivable from brokers, dealers and clearing organizations

     104,311        (206,981

Other assets

     (9,910     (37,336

(Decrease) increase in operating liabilities

    

Financial instruments sold, not yet purchased, at fair value

     (31,842     607,536   

Securities loaned

     541,170        94,991   

Financial instruments sold under agreements to repurchase

     129,865        281,075   

Other secured financings

     37,035        16,399   

Liability to GNMA trusts, at fair value

     1,006,696        557,711   

Payable to brokers and dealers and clearing organizations

     (32,850     74,871   

Payable to customers

     (64,023     4,695   

Accrued compensation expense

     (74,005     (57,268

Accrued expenses and other liabilities

     6,084        29,432   
  

 

 

   

 

 

 

Net cash (used in) provided by operating activities

     (47,374     50,048   
  

 

 

   

 

 

 

Cash flows from investing activities

    

Distributions from investments

     3,309        3,689   

Purchases of investments

     (9,747     (21,596

Purchases of fixed assets and leasehold improvements

     (15,211     (22,096

Purchase of intangible asset

     (50     -     

Purchases of business, net of cash acquired

     (3,072     -     
  

 

 

   

 

 

 

Net cash used in investing activities

     (24,771     (40,003
  

 

 

   

 

 

 

Cash flows from financing activities

    

Proceeds from credit facility

     -          97,838   

Stock options exercised

     1,076        644   

Income tax benefit related to stock-based compensation

     170        64   

Cost of common stock repurchased

     (32,024     (13,392
  

 

 

   

 

 

 

Net cash (used in) provided by financing activities

     (30,778     85,154   
  

 

 

   

 

 

 

Effect of exchange rate changes on cash and cash equivalents

     88        (214
  

 

 

   

 

 

 

(Decrease) increase in cash and cash equivalents

     (102,835     94,985   

Cash and cash equivalents at beginning of period

     467,633        375,569   
  

 

 

   

 

 

 

Cash and cash equivalents at end of period

   $ 364,798      $ 470,554   
  

 

 

   

 

 

 

Supplemental disclosure of cash flow information:

    

Cash paid for interest

   $ 32,318      $ 22,887   
  

 

 

   

 

 

 

Cash paid for income taxes

   $ 44,166      $ 12,283   
  

 

 

   

 

 

 

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

 

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Table of Contents

KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1.    Organization and Description of the Business

Knight Capital Group, Inc. (collectively with its subsidiaries, “Knight” or the “Company”) is a global financial services firm that provides access to the capital markets across multiple asset classes to a broad network of clients, including broker-dealers, institutions and corporations. The Company seeks to continually apply its expertise and innovation to the market making and trading process to build lasting client relationships through consistent performance and superior client service. The Company has four operating segments: (i) Market Making; (ii) Institutional Sales and Trading; (iii) Electronic Execution Services; and (iv) Corporate and Other.

Market Making

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

Institutional Sales and Trading

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

Electronic Execution Services

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

 

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Table of Contents

KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

Corporate and Other

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

Discontinued Operations

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

2.    Significant Accounting Policies

Basis of consolidation and form of presentation

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

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

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

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

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

Cash and cash equivalents

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

Cash and securities segregated under federal and other regulations

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

Market making, sales, trading and execution activities

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

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

The Company’s third party clearing agreements call for payment or receipt of interest income, net of transaction-related interest charged by clearing brokers, for facilitating the settlement and financing of securities transactions. The Company also nets interest income on its securitized HECM loan inventory against interest expense on its liability to Government National Mortgage Association (“GNMA”) trusts. Interest income and interest expense which have been netted on the Consolidated Statements of Operations are as follows (in thousands):

 

     For the three months
ended June 30,
    For the six months
ended June 30,
 
     2012     2011     2012     2011  

Interest Income

   $ 33,083      $ 6,165      $ 64,001      $ 12,767   

Interest Expense

     (27,159     (3,859     (50,939     (7,361
  

 

 

   

 

 

   

 

 

   

 

 

 

Interest, net

   $       5,924      $       2,306      $       13,062      $       5,406   
  

 

 

   

 

 

   

 

 

   

 

 

 

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

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

 

     For the three months
ended June 30,
    For the six months
ended June 30,
 
           2012                 2011           2012     2011  

Dividend Income

   $ 7,311      $ 5,982      $ 14,271      $ 10,589   
  

 

 

   

 

 

   

 

 

   

 

 

 

Dividend Expense

   $     (7,143   $     (5,505   $     (12,170   $     (10,259
  

 

 

   

 

 

   

 

 

   

 

 

 

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

Fair value of financial instruments

The Company values its financial instruments using a hierarchy of fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs when measuring fair value.

The fair value hierarchy can be summarized as follows:

 

   

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

 

   

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

 

   

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

Changes in fair value are recognized in earnings each period for financial instruments that are carried at fair value. See Footnote 4 “Fair Value of Financial Instruments” for a description of valuation methodologies applied to the classes of financial instruments at fair value.

Securitization activities

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

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

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

Collateralized agreements and financings

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

 

   

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

 

   

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

 

   

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

 

   

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

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

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

Investments

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

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

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

 

Goodwill and intangible assets

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

Payable to customers

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

Treasury stock

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

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

Foreign currency translation and foreign currency forward contracts

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

Assets and liabilities of foreign subsidiaries having non-U.S. dollar functional currencies are translated at exchange rates at the end of a period. Revenues and expenses are translated at average exchange rates during the period. Gains and losses resulting from translating foreign currency financial statements into U.S. dollars are included in Accumulated other comprehensive loss on the Consolidated Statements of Financial Condition and Cumulative translation adjustment on the Consolidated Statements of Comprehensive Income. Gains or losses resulting from foreign currency transactions are included in Investment income and other, net on the Company’s Consolidated Statements of Operations. For the three months ended June 30, 2012 and 2011, a gain of $0.9 million and a loss of $0.8 million, respectively, were recorded in Investment income and other, net on the Company’s Consolidated Statements of Operations and a gain of $1.1 million and a loss of $1.0 million were recorded for the six months ended June 30, 2012 and 2011, respectively.

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

Soft dollar expense

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

Depreciation, amortization and occupancy

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

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

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

Lease loss accrual

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

Income taxes

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

Stock-based compensation

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

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

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

Variable interest entities

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

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

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

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

 

   

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

 

   

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

Nonconsolidated VIEs

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

 

   

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

 

   

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

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

 

   

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

 

   

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

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

 

     June 30, 2012  
     Securitized
HECM loan
inventory
     MBS  

Carrying value of the VIEs

     

Assets

   $ -         $ 169,406   

Liabilities

     618         -     

Maximum exposure to loss in nonconsolidated VIEs

     

Commitments

     19,015         -     

Purchased interests

     -           169,406   

 

     December 31, 2011  
     Securitized
HECM loan
inventory
     MBS  

Carrying value of the VIEs

     

Assets

   $ -         $ 16,399   

Liabilities

     2,299         -     

Maximum exposure to loss in nonconsolidated VIEs

     

Commitments

     12,874         -     

Purchased interests

     -           16,399   

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

Use of estimates

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

Accounting Standards Updates

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

3.    Segregated Cash and Securities

Cash and Securities segregated under federal and other regulations primarily relates to the Company’s recently acquired FCM business (see Footnote 16 “Acquisition” for further discussion) consists of the following (in thousands):

 

     June 30,
2012
     December 31,
2011
 

Segregated cash

   $ 188,091       $ 11,010   

Segregated securities

     2,300         -     
  

 

 

    

 

 

 

Total Segregated Cash and Securities

   $ 190,391       $ 11,010   
  

 

 

    

 

 

 

Segregated securities consist of U.S. government obligations.

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

4.    Fair Value of Financial Instruments

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

 

    Assets and Liabilities Measured at
Fair Value on a Recurring Basis
 

June 30, 2012

  Level 1     Level 2     Level 3     Total  

Assets

       

Financial instruments owned, at fair value:

       

Equities(1)

  $ 1,641,451      $ -        $ -        $ 1,641,451   

Listed equity options

    191,157        -          -          191,157   

U.S. government obligations

    9,734        -          -          9,734   

Corporate debt(2)

    83,458        -          -          83,458   

Mortgage-backed securities

    112,159        57,247        -          169,406   

Loan inventory

    -          183,900        -          183,900   

Purchased call options

    -          8,001        -          8,001   

Foreign currency forward contracts

    -          3,926        -          3,926   

Securitized HECM loan inventory(3)

    -          2,738,917        -          2,738,917   
 

 

 

   

 

 

   

 

 

   

 

 

 

Total Financial instruments owned, at fair value

    2,037,959        2,991,991        -          5,029,950   

Securities segregated under federal and other regulations(4)

    2,300        -          -          2,300   

Securities on deposit with clearing organizations(4)

    183,556        -          -          183,556   

Deferred compensation investments(5)

    -          20,859        -          20,859   

Investment in Deephaven Funds(5)

    -          2,154        -          2,154   
 

 

 

   

 

 

   

 

 

   

 

 

 

Total fair value of financial instrument assets

  $ 2,223,815      $ 3,015,004      $ -        $ 5,238,819   
 

 

 

   

 

 

   

 

 

   

 

 

 

Liabilities

       

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

       

Equities(1)

  $ 1,256,365      $ -        $ -        $ 1,256,365   

Listed equity options

    178,990        -          -          178,990   

U.S. government obligations

    148,880        -          -          148,880   

Corporate debt(2)

    88,282        -          -          88,282   

Embedded conversion derivative

    -          8,001        -          8,001   
 

 

 

   

 

 

   

 

 

   

 

 

 

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

    1,672,517        8,001        -          1,680,518   

Liability to GNMA trusts, at fair value(3)

    -          2,717,323        -          2,717,323   
 

 

 

   

 

 

   

 

 

   

 

 

 

Total fair value of financial instrument liabilities

  $ 1,672,517      $ 2,725,324      $ -        $ 4,397,841   
 

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) Equities of $713.3 million have been netted by their respective long and short positions by CUSIP number.
(2) Corporate debt of $0.6 million has been netted by respective long and short positions by CUSIP number.

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

(3) Represents HECMs that have been securitized into HECM Mortgage Backed Securities (“HMBS”) where the securitization is not accounted for as a sale of the underlying HECMs. See Securitized HECM loan inventory below for full description.
(4) Securities segregated under federal and other regulations and Securities on deposit with clearing organizations consist of U.S. government obligations.
(5) Deferred compensation investments and investment in the Deephaven Funds are included within Investments on the Consolidated Statements of Financial Condition.

 

    Assets and Liabilities Measured at
Fair Value on a Recurring Basis
 

December 31, 2011

  Level 1     Level 2     Level 3     Total  

Assets

       

Financial instruments owned, at fair value:

       

Equities(1)

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

Listed equity options

    280,384        -          -          280,384   

U.S. government obligations

    44,316        -          -          44,316   

Corporate debt(2)

    73,916        -          -          73,916   

Mortgage-backed securities

    16,399        -          -          16,399   

Loan inventory

    -          206,572        -          206,572   

Purchased call options

    -          17,532        -          17,532   

Foreign currency forward contracts

    -          3,951        -          3,951   

Securitized HECM loan inventory(3)

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

 

 

   

 

 

   

 

 

   

 

 

 

Total Financial instruments owned, at fair value

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

Deferred compensation investments(4)

    -          20,414        -          20,414   

Investment in Deephaven Funds(4)

    -          1,319        -          1,319   
 

 

 

   

 

 

   

 

 

   

 

 

 

Total fair value of financial instrument assets

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

 

 

   

 

 

   

 

 

   

 

 

 

Liabilities

       

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

       

Equities(1)

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

Listed equity options

    254,506        -          -          254,506   

U.S. government obligations

    10,644        -          -          10,644   

Corporate debt(2)

    52,429        -          -          52,429   

Embedded conversion derivative

    -          17,532        -          17,532   

Total return swap

    -          17,031        -          17,031   
 

 

 

   

 

 

   

 

 

   

 

 

 

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

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

Liability to GNMA trusts, at fair value(3)

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

 

 

   

 

 

   

 

 

   

 

 

 

Total fair value of financial instrument liabilities

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

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) Equities of $400.6 million have been netted by their respective long and short positions by CUSIP number.
(2) Corporate debt of $0.4 million has been netted by respective long and short positions by CUSIP number.

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

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

The Company’s equities, listed equity options, U.S. government obligations, rated corporate debt, and actively traded mortgage-backed securities will generally be classified within Level 1 of the fair value hierarchy because they are valued using quoted market prices or broker or dealer quotations with reasonable levels of price transparency.

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

Certain instruments are classified within Level 3 of the fair value hierarchy because they trade infrequently and therefore have little or no price transparency. For those instruments that are not traded in active markets or are subject to transfer restrictions, valuations are adjusted to reflect illiquidity and/or non-transferability, and such adjustments are generally based on available market evidence. In the absence of such evidence, management’s best estimate is used. As of June 30, 2012 and December 31, 2011, the Company did not hold any financial instruments that met the definition of Level 3.

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

As of June 30, 2012 and December 31, 2011, the Company’s loan inventory, foreign currency forward contracts, certain mortgage-backed securities, purchased call options and embedded conversion derivative related to its long-term debt (see Footnote 9 “Long-Term Debt”), deferred compensation investments and its remaining investment in the Deephaven Funds are classified within Level 2 of the fair value hierarchy.

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

Loan inventory

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

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

Securitized HECM loan inventory

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

Foreign currency forward contracts

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

Mortgage-backed securities

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

Purchased call options and embedded conversion derivative

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

Deferred compensation investments

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

Investment in the Deephaven Funds

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

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

Fair value of derivative instruments

The Company enters into derivative transactions, primarily with respect to making markets in listed domestic options. In addition, the Company enters into derivatives to manage foreign currency exposure and related to its long-term debt (see Footnote 9 “Long-Term Debt”). Cash flows associated with such derivative activities are included in cash flows from operating activities on the Consolidated Statements of Cash Flows, when applicable.

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

 

Asset Derivatives

  

Statements of Financial

Condition Location

   Fair Value as of  
      June 30,
2012
     December 31,
2011
 

Derivative instruments not designated as hedging instruments:

  

Financial instruments owned,

at fair value

     

Purchased call options

      $ 8,001       $ 17,532   

Listed equity options(1)

        191,157         280,384   

Foreign currency forward contracts

        234         477   
     

 

 

    

 

 

 
      $     199,392       $     298,393   
     

 

 

    

 

 

 

Derivative instruments designated as hedging instruments:

  

Financial instruments owned,

at fair value

     

Foreign currency forward contracts

      $ 3,692       $ 3,474   
     

 

 

    

 

 

 

Liability Derivatives

                  

Derivative instruments not designated as hedging instruments:

   Financial instruments sold, not yet purchased, at fair value      

Embedded conversion derivative

      $ 8,001       $ 17,532   

Listed equity options(1)

        178,990         254,506   

Total return swap(2)

        -           17,031   
     

 

 

    

 

 

 
      $ 186,991       $ 289,069   
     

 

 

    

 

 

 

 

(1) At June 30, 2012, the Company held 1.0 million long and 1.0 million short listed equity option contracts. At December 31, 2011, the Company held 1.3 million long and 1.5 million short listed equity option contracts. These contracts are not subject to collateral requirements and are not netted.
(2) At December 31, 2011, the total return swap liability was offset by an asset of equal value that was included in Financial Instruments owned, at fair value on the Company’s Consolidated Statements of Financial Condition. This total return swap was liquidated during the first quarter of 2012.

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

 

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

Financial Statements Location

           2012                     2011          

Derivative instruments not designated as hedging instruments:

       

Purchased call options

   Investment income and other, net    $ (4,315   $ (14,133

Listed equity options(1)

   Net trading revenue      9,784        8,682   

Embedded conversion derivative

   Investment income and other, net      4,315        14,133   

Total return swap(2)

   Investment income and other, net      -          (5,825

Foreign currency forward contracts

   Investment income and other, net      400        -     
     

 

 

   

 

 

 
      $ 10,184      $ 2,857   
     

 

 

   

 

 

 

Derivative instruments designated as hedging instruments:

       

Foreign currency forward
contracts

   Accumulated other comprehensive income (loss)    $ 2,208      $ (125
     

 

 

   

 

 

 

 

          Gain (Loss) Recognized
For the six months ended
June 30,
 
    

Financial Statements Location

           2012                     2011          

Derivative instruments not designated as hedging instruments:

       

Purchased call options

   Investment income and other, net    $ (9,531   $ (22,226

Listed equity options(1)

   Net trading revenue      (5,802     8,731   

Embedded conversion derivative

   Investment income and other, net      9,531        22,226   

Total return swap(2)

   Investment income and other, net      -          (6,770

Foreign currency forward contracts

   Investment income and other, net      197        -     
     

 

 

   

 

 

 
      $ (5,605   $ 1,961   
     

 

 

   

 

 

 

Derivative instruments designated as hedging instruments:

       

Foreign currency forward
contracts

   Accumulated other comprehensive loss    $ (1,120   $ (3,686
     

 

 

   

 

 

 

 

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

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

5.    Collateralized Transactions

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

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

 

     June 30,
2012
     December 31,
2011
 

Collateral permitted to be delivered or repledged

   $ 1,884,877       $ 1,450,281   

Collateral that was delivered or repledged

     1,479,916         1,383,298   

Collateral permitted to be further repledged by the receiving counterparty

     352,432         275,912   

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

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

 

     June 30,
2012
     December 31,
2011
 

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

   $         3,623,697       $         2,121,783   

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

     646,028         550,926   

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

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

 

     June 30,
2012
     December 31,
2011
 

Receivable:

     

Clearing organizations and other

   $         755,243       $         553,960   

Securities failed to deliver

     124,837         69,937   
  

 

 

    

 

 

 
   $ 880,080       $ 623,897   
  

 

 

    

 

 

 

Payable:

     

Clearing organizations and other

   $ 215,092       $ 306,728   

Securities failed to receive

     74,718         15,932   
  

 

 

    

 

 

 
   $ 289,810       $ 322,660   
  

 

 

    

 

 

 

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

7.    Investments

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

 

     June 30,
2012
     December 31,
2011
 

Strategic investments:

     

Investments accounted for under the equity method

   $ 76,626       $ 59,711   

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

     1,788         1,787   
  

 

 

    

 

 

 

Total Strategic investments

     78,414         61,498   

Deferred compensation investments

     20,859         20,414   

Investment in Deephaven Funds

     2,154         1,319   
  

 

 

    

 

 

 

Total Investments

   $         101,427       $         83,231   
  

 

 

    

 

 

 

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

8.    Goodwill and Intangible Assets

Goodwill and intangible assets with an indefinite useful life are tested for impairment annually or when events indicate that the amounts may not be recoverable. As part of the test for impairment, the Company considers the profitability of the respective segment or reporting unit, an assessment of the fair value of the respective segment or reporting unit as well as the overall market value of the Company compared to its net book value. In June 2012 and 2011, the Company tested for the impairment of goodwill as part of its annual assessment and concluded that there was no impairment at that time. As a result of the event described in Footnote 18 “Subsequent Event”, which occurred after June 30, 2012 and therefore does not impact the carrying value of goodwill and intangible assets as of June 30, 2012. The Company will assess the impact of the subsequent event on goodwill and intangible assets in the quarter ending September 30, 2012.

As a result of a corporate restructuring the Company wrote off goodwill of $1.0 million in the Corporate and Other segment during the third quarter of 2011. No other events occurred in 2012 or 2011 that would indicate that the carrying amounts of the Company’s goodwill may not be recoverable.

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

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

 

     June 30, 2012      December 31,
2011
 

Market Making

   $ 24,727       $ 24,727   

Institutional Sales and Trading

     147,736         147,736   

Electronic Execution Services

     165,380         165,380   

Corporate and Other(1)

     6,617         -     
  

 

 

    

 

 

 

Consolidated Total

   $         344,460       $         337,843   
  

 

 

    

 

 

 

 

(1) During the second quarter of 2012, the Company recorded goodwill of $6.6 million as a result of the acquisition of certain assets and liabilities of the former futures division of Penson.

Intangible assets primarily represent client relationships and are amortized over their estimated remaining useful lives, the majority of which have been determined to range from two to 20 years. The weighted average remaining life of the Company’s intangible assets at both June 30, 2012 and December 31, 2011 is approximately 11 years.

Amortizable intangibles are tested for recoverability whenever events indicate that the carrying amounts may not be recoverable. No events occurred during the three and six months ended June 30, 2012 or 2011 that would indicate that the carrying amounts of the Company’s intangible assets may not be recoverable.

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

 

     June 30, 2012      December 31,
2011
 

Market Making

     

Trading rights

   $ 24,182       $ 25,283   

Other

     46         -     
  

 

 

    

 

 

 

Total

     24,228         25,283   
  

 

 

    

 

 

 

Institutional Sales and Trading

     

Customer and broker relationships

     21,142         24,165   

Trade names

     1,300         1,350   

Other

     3,152         3,905   
  

 

 

    

 

 

 

Total

     25,594         29,420   
  

 

 

    

 

 

 

Electronic Execution Services

     

Customer and broker relationships

     24,834         26,730   

Trade names

     5,980         6,207   

Other

     4,403         5,249   
  

 

 

    

 

 

 

Total

     35,217         38,186   
  

 

 

    

 

 

 

Corporate and Other

     

Customer and broker relationships(1)

     3,500         -     
  

 

 

    

 

 

 

Total

     3,500         -     
  

 

 

    

 

 

 

Consolidated Total

   $         88,539       $         92,889   
  

 

 

    

 

 

 

 

25


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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

 

(1) During the second quarter of 2012, the Company recorded intangible assets of $3.5 million as a result of the acquisition of certain assets and liabilities of the former futures division of Penson.

 

          June 30,
2012
    December 31,
2011
 

Customer and broker relationships(1)

   Gross carrying amount    $ 97,100      $ 93,600   
  

Accumulated amortization

     (47,624     (42,705
     

 

 

   

 

 

 
   Net carrying amount      49,476        50,895   
     

 

 

   

 

 

 

Trading Rights(2)

   Gross carrying amount      28,520        28,520   
  

Accumulated amortization

     (4,338     (3,237
     

 

 

   

 

 

 
   Net carrying amount      24,182        25,283   
     

 

 

   

 

 

 

Trade names(3)

   Gross carrying amount      9,800        9,800   
  

Accumulated amortization

     (2,520     (2,243
     

 

 

   

 

 

 
   Net carrying amount      7,280        7,557   
     

 

 

   

 

 

 

Other(4)

   Gross carrying amount      18,761        18,761   
  

Accumulated amortization

     (11,160     (9,607
     

 

 

   

 

 

 
   Net carrying amount      7,601        9,154   
     

 

 

   

 

 

 

Total

   Gross carrying amount      154,181        150,681   
  

Accumulated amortization

     (65,642     (57,792
     

 

 

   

 

 

 
   Net carrying amount    $         88,539      $         92,889   
     

 

 

   

 

 

 

 

(1) Customer and broker relationships primarily relate to the Donaldson, Direct Trading, Hotspot, EdgeTrade, Libertas, Urban and Astor acquisitions. The weighted average remaining life is approximately 11 years as of June 30, 2012 and 10 years as of December 31, 2011. Lives may be reduced depending upon actual retention rates.
(2) Trading rights weighted average remaining life is approximately 13 years as of June 30, 2012 and 14 years as of December 31, 2011.
(3) Trade names weighted average remaining life is approximately 14 years as of both June 30, 2012 and December 31, 2011.
(4) Other primarily includes technology and non-compete agreements acquired weighted average remaining life is approximately two years as of both June 30, 2012 and December 31, 2011.

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

 

     For the three months ended
June 30,
     For the six months ended
June 30,
 
             2012                      2011                      2012                      2011          

Amortization expense

   $         3,952       $         3,950       $         7,900       $         7,900   

 

26


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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

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

 

     Amortization
expense
 

Six months ended December 31, 2012

   $          7,864   

For the year ended December 31, 2013

     13,074   

For the year ended December 31, 2014

     10,450   

For the year ended December 31, 2015

     8,295   

For the year ended December 31, 2016

     5,536   

9.    Long-Term Debt

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

 

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

Term Credit Agreement

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

Convertible Notes

     331,425         316,894         324,338         287,505   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

     431,425         416,894         424,338         387,505   

Less: Current portion recorded in

           

Accrued expenses and other liabilities

     25,000         25,000         -           -     
  

 

 

    

 

 

    

 

 

    

 

 

 

Total Long-Term Debt

   $         406,425       $         391,894       $         424,338       $         387,505   
  

 

 

    

 

 

    

 

 

    

 

 

 

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

Credit Agreements

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

 

27


Table of Contents

KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

Term Credit Agreement

The proceeds of the Term Credit Agreement are being used for general corporate purposes. As of June 30, 2012, the Company has borrowed all the funds under the Term Credit Agreement. Borrowings under the Term Credit Agreement bear interest at variable rates as determined at the Company’s election, at LIBOR or a base rate, in each case, plus an applicable margin of (a) for each LIBOR loan, 2.50% or 3.00% per annum or (b) for each base rate loan, 1.50% or 2.00% per annum (in each case, depending on the Company’s leverage ratio). As of June 30, 2012, the interest rate was 2.75% per annum, which is based on the one month LIBOR rate plus 2.50%. Interest is paid monthly. The Term Credit Agreement is repayable in three installments as follows: $25.0 million on June 28, 2013, $25.0 million on December 27, 2013 and $50.0 million on June 27, 2014.

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

Revolving Credit Agreement

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

Borrowings under the Revolving Credit Agreement bear interest at a rate equal to the greater of the federal funds rate or the one month LIBOR rate plus (a) for each Borrowing Base A Loan, a margin of 1.50% per annum and (b) for Borrowing Base B Loans, a margin of 2.00% per annum. Interest is payable quarterly. As of June 30, 2012 and December 31, 2011, there were no outstanding borrowings under the Revolving Credit Agreement.

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

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

 

28


Table of Contents

KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

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

Cash Convertible Senior Subordinated Notes

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

The Notes bear interest at a rate of 3.50% per year, payable semi-annually in arrears, on March 15 and September 15 of each year, commencing on September 15, 2010 and will mature on March 15, 2015, subject to earlier repurchase or conversion. In connection with the issuance of the Notes, the Company recognized an original issue discount of $73.8 million which is being accreted to interest expense over the term of the Notes, resulting in an effective annual interest rate of the Notes of approximately 7.90%. The Notes, net of unamortized original issue discount are reported as Long-term debt in the Company’s Consolidated Statements of Financial Condition.

Prior to December 15, 2014, the Notes will be convertible into cash only upon specified events which are based upon the price of the Company’s common shares and of the Notes or upon the occurrence of specified corporate events. On or after December 15, 2014, the Notes will be convertible at any time, based on an initial conversion rate of 47.9185 shares of the Company’s Class A common stock per $1,000 principal amount of Notes, which is equivalent to an initial conversion price of approximately $20.87 or a conversion premium of approximately 32.5% over the closing sale price of $15.75 per share of the Company’s Class A common stock on the Nasdaq Global Select Market on March 15, 2010. The conversion rate and conversion price will be subject to adjustment in certain events, such as distributions of dividends or stock splits. Upon cash conversion, the Company will deliver an amount of cash calculated over the applicable observation period. The Company will not deliver its common stock (or any other securities) upon conversion under any circumstances. In addition, following certain corporate events that occur prior to the maturity date, the Company will pay a cash make-whole premium by increasing the conversion rate for a holder who elects to convert its Notes in connection with such a corporate event in certain circumstances. Subject to certain exceptions, holders may require the Company to repurchase, for cash, all or part of the Notes upon a “fundamental change” at a price equal to 100% of the principal amount of the Notes being repurchased plus any accrued and unpaid interest.

Concurrent with the sale of the Notes, the Company paid $73.7 million to enter into privately negotiated cash convertible note hedge transactions (the “purchased call options”) with affiliates of the initial purchasers of the Notes and another financial institution (the “option counterparties”) that are expected generally to reduce the Company’s exposure to potential cash payments in excess of the principal amount of the Notes that may be required to be made by the Company upon the cash conversion of the Notes under certain conditions. The purchased call options cover, subject to adjustments, approximately 18 million shares of the Company’s Class A common stock at a strike price of $20.87 and are expected to reduce the Company’s economic exposure to potential cash payments in the event that the market price per share of the Company’s Class A common stock is greater than

 

29


Table of Contents

KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

the conversion price of the Notes. The purchased call options were recorded as an asset within Financial instruments owned, at fair value on the Consolidated Statements of Financial Condition and is accounted for as derivative instruments under GAAP. As of June 30, 2012, the fair value of the purchased call options was $8.0 million.

In connection with the sale of the Notes, the Company also entered into separate warrant transactions with the option counterparties whereby the Company sold to the option counterparties, for $15.0 million, warrants (the “warrants”) to purchase shares of the Company’s Class A common stock, subject to adjustments, at a strike price of $31.50 per share, which represents a premium of approximately 100% over the closing price of the Company’s Class A common stock on March 15, 2010. The warrants are net share settled, meaning that the Company will issue a number of shares per warrant having a value equal to the difference between the share price at each warrant expiration date and the strike price; however, at the discretion of the Company, the Company may elect to settle the warrants in cash. If the market price per share of the Company’s Class A common stock exceeds the strike price of the warrants over the warrants’ exercise period and the Company elects net share settlement, the warrants would have a dilutive effect on the Company’s Class A common stock. The warrants may not be exercised prior to the maturity of the Notes. The warrants have been recorded as Additional paid-in capital in the Consolidated Statements of Financial Condition. The warrants also meet the criteria of derivative instruments under GAAP; however, because the warrants are indexed to the Company’s Class A common stock and are recorded within Equity in the Consolidated Statements of Financial Condition, the warrants are exempt from the scope and fair value provisions of GAAP related to accounting for derivative instruments.

The requirement that the Company settle conversions of the Notes entirely in cash gives rise to a bifurcatable derivative instrument under GAAP (the “embedded conversion derivative”). The initial valuation of the embedded conversion derivative was $73.8 million, and was recorded as a liability within Financial instruments sold, not yet purchased, at fair value on the Consolidated Statements of Financial Condition. As of June 30, 2012, the fair value of the embedded conversion derivative was $8.0 million.

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

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

 

30


Table of Contents

KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

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

 

     For the three months ended
June 30,
     For the six months ended
June 30,
 
           2012                  2011                2012              2011      

Interest expense

   $ 7,647       $ 6,656       $ 15,045       $ 13,070   

Amortization of debt issuance cost(1)

     781         425         1,559         850   

Commitment fee(1)

     150         -           276         -     
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $         8,578       $         7,081       $         16,880       $         13,920   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

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

10.    Stock-Based Compensation

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

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

Restricted Shares and Restricted Stock Units

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

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

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

 

     For the three months ended
June 30,
     For the six months ended
June 30,
 
     2012      2011      2012      2011  

Stock award compensation expense

   $         14,287       $         12,754       $         27,712       $         27,459   
  

 

 

    

 

 

    

 

 

    

 

 

 

Income tax benefit

   $ 5,601       $ 5,000       $ 10,863       $ 10,764   
  

 

 

    

 

 

    

 

 

    

 

 

 

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

 

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

Outstanding at January 1, 2012

     307      $ 16.20         7,716      $ 14.33   

Granted

     21        13.09         3,816        13.01   

Vested

     (219     16.34         (2,004     15.28   

Forfeited

     (6     15.66         (226     13.11   
  

 

 

      

 

 

   

Outstanding at June 30, 2012

               104      $         15.31                   9,302      $         13.74   
  

 

 

      

 

 

   

There is $73.5 million of unamortized compensation related to unvested restricted awards outstanding at June 30, 2012. The cost of these unvested restricted awards is expected to be recognized over a weighted average life of 1.8 years.

Stock Options

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

The fair value of each option granted is estimated as of its respective grant date using the Black-Scholes option-pricing model. Stock options granted have exercise prices equal to the market value of the Company’s common stock at the date of grant as defined by the Stock Plans. The principal assumptions utilized in valuing options and the methodology for estimating such model inputs include: (1) risk-free interest rate – estimate is based on the yield of U.S. zero coupon securities with a maturity equal to the expected life of the option; (2) expected volatility – estimate is based on several factors including implied volatility of market-traded options on the Company’s common stock on the grant date

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

and the volatility of the Company’s common stock; and (3) expected option life – estimate is based on internal studies of historical experience and projected exercise behavior based on different employee groups and specific option characteristics, including the effect of employee terminations. The Company did not grant any options during the six months ended June 30, 2012 or 2011.

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

 

     For the three months
ended June 30,
     For the six months ended
June 30,
 
           2012                  2011                2012              2011      

Stock option compensation expense

   $           201       $           190       $           494       $           744   
  

 

 

    

 

 

    

 

 

    

 

 

 

Income tax benefit

   $ 79       $ 75       $ 193       $ 292   
  

 

 

    

 

 

    

 

 

    

 

 

 

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

 

Stock Option Activity (in thousands)

   Number of
Stock Options
    Weighted-
Average
Exercise
Price
 

Outstanding at January 1, 2012

     2,829      $ 13.48   

Granted at market value

     -          -     

Exercised

     (116     9.27   

Forfeited or expired

     (39     16.48   
  

 

 

   

Outstanding at June 30, 2012

     2,674      $ 13.62   
  

 

 

   

Exercisable at June 30, 2012

     2,404      $     13.36   
  

 

 

   

Available for future grants at June 30, 2012*

             6,844     
  

 

 

   

 

* Represents both options and awards available for grant

There is $0.7 million of unrecognized compensation related to unvested stock options outstanding at June 30, 2012. The cost of these unvested awards is expected to be recognized over a weighted average life of 0.6 years.

11.    Income taxes

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

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

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

 

     For the three months
ended June 30,
    For the six months
ended June 30,
 
         2012             2011             2012             2011      

U.S. federal statutory income tax rate

     35.0     35.0     35.0     35.0

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

     3.6     4.3     3.6     4.0

Nondeductible charges and other, net

     0.0     0.4     0.1     0.2
  

 

 

   

 

 

   

 

 

   

 

 

 

Actual income tax rate

                 38.6                 39.7                 38.7                 39.2
  

 

 

   

 

 

   

 

 

   

 

 

 

At June 30, 2012, the Company had $2.9 million of unrecognized tax benefits, all of which would affect the Company’s effective tax rate if recognized.

As of June 30, 2012, the Company is subject to U.S. Federal income tax examinations for the tax years 2006 through 2010, and to non-U.S. income tax examinations for the tax years 2007 through 2010. In addition, the Company is subject to state and local income tax examinations in various jurisdictions for the tax years 2003 through 2010. The final outcome of these examinations is not yet determinable. However, the Company anticipates that adjustments to the unrecognized tax benefits, if any, will not result in a material change to the results of operations or financial condition.

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

12.    Earnings Per Share

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

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

 

     For the three months ended June 30,  
     2012      2011  
     Numerator /
net income
     Denominator /
shares
     Numerator /
net income
     Denominator /
shares
 

Income and shares used in basic calculations

   $ 3,291         89,624       $ 17,572         92,493   

Effect of dilutive stock based awards

     -           3,058         -           2,189   
  

 

 

    

 

 

    

 

 

    

 

 

 

Income and shares used in diluted calculations

   $ 3,291         92,682       $ 17,572         94,682   
  

 

 

    

 

 

    

 

 

    

 

 

 

Basic earnings per share

      $ 0.04          $ 0.19   
     

 

 

       

 

 

 

Diluted earnings per share

      $ 0.04          $ 0.19   
     

 

 

       

 

 

 

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

     For the six months ended June 30,  
     2012      2011  
     Numerator /
net income
     Denominator /
shares
     Numerator /
net income
     Denominator /
shares
 

Income and shares used in basic calculations

   $ 36,397         89,685       $ 48,064         92,184   

Effect of dilutive stock based awards

     -           3,482         -           2,700   
  

 

 

    

 

 

    

 

 

    

 

 

 

Income and shares used in diluted calculations

   $ 36,397         93,167       $ 48,064         94,884   
  

 

 

    

 

 

    

 

 

    

 

 

 

Basic earnings per share

      $ 0.41          $ 0.52   
     

 

 

       

 

 

 

Diluted earnings per share

      $ 0.39          $ 0.51   
     

 

 

       

 

 

 

The above calculations exclude options that could potentially dilute EPS in the future but were antidilutive for the periods presented. The number of such options excluded was approximately 1.7 million and 1.9 million for the three months ended June 30, 2012 and 2011, respectively, and 1.7 million and 2.0 million for the six months ended June 30, 2012 and 2011, respectively.

13.    Significant Clients

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

14.    Commitments and Contingencies

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

On July 18, 2012, the Company announced pre-tax trading losses of $35.4 million related to the Facebook IPO. On July 21, 2012, NASDAQ announced that it would file a proposed voluntary accommodation program (the “Accommodation Program”) with the SEC which, among other things, creates a fund for voluntary accommodations for qualifying NASDAQ members disadvantaged by problems that arose during the Facebook IPO. The Accommodation Program, which was published in the Federal Register by the SEC on August 1, 2012, will be subject to a 21 day public comment period and thereafter approval by the SEC. Under the proposed Accommodation Program, the Company

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

would be entitled to submit claims, within seven days of formal approval by the SEC, in accordance with the parameters set forth in the Accommodation Plan. The claims would be processed and evaluated by the Financial Industry Regulatory Authority (“FINRA”) applying the accommodation standards set forth in the Accommodation Program. Under the Accommodation Program as proposed by NASDAQ, the Company would recover a portion of its pre-tax trading losses. The Company is evaluating the Accommodation Program as well as its other options, and plans to submit a comment letter to the SEC. There can be no assurance that the Accommodation Program will be approved by the SEC or that the terms of the Accommodation Program will not change from those proposed. As previously disclosed, there are no assurances that the Company will be able to recover its pre-tax trading losses relating to the Facebook IPO.

The Company leases office space under noncancelable operating leases. Certain office leases contain fixed dollar-based escalation clauses. Rental expense under the office leases was $3.9 million and $4.8 million for the three months ended June 30, 2012 and 2011, respectively, and is included in Occupancy and equipment rentals on the Consolidated Statements of Operations. For the six months ended June 30, 2012 and 2011, rental expense under the office leases was $8.1 million and $9.8 million, respectively.

During the first quarter of 2011, the Company recorded a lease loss accrual of $0.9 million related to excess office space in New York City.

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

Lease & Contract Obligations

 

     Gross Lease
Obligations
     Sublease
Income
     Net Lease
Obligations
     Other
Obligations
 

Six months ending December 31, 2012

   $ 12.4       $ 1.0       $ 11.4       $ -     

Year ending December 31, 2013

     23.3         2.2         21.1         5.5   

Year ending December 31, 2014

     22.4         2.0         20.4         -     

Year ending December 31, 2015

     21.6         1.8         19.8         -     

Year ending December 31, 2016

     21.2         1.9         19.3         -     

Thereafter through August 31, 2023

     99.7         2.8         96.9         -     
  

 

 

    

 

 

    

 

 

    

 

 

 
   $         200.6       $         11.7       $         188.8       $         5.5   
  

 

 

    

 

 

    

 

 

    

 

 

 

During the normal course of business, the Company collateralizes certain leases or other contractual obligations through letters of credit or segregated funds held in escrow accounts. As of June 30, 2012, the Company has provided a letter of credit for $1.0 million, collateralized by U.S. Treasury Bills, as a guarantee for one of the Company’s lease obligations. In the ordinary course of business, Knight Capital Group, Inc. also has provided, and may provide in the future, unsecured guarantees with respect to the payment obligations of certain of its subsidiaries under trading, repurchase, financing and stock loan arrangements, as well as under certain leases.

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

The Company has issued floating rate HECMs for which the borrowers have additional borrowing capacity of approximately $301.6 million as of June 30, 2012. This additional borrowing capacity is primarily in the form of undrawn lines of credit, with the balance available on a scheduled payments basis. As the issuer of these HECMs, the Company is under the obligation to fund this capacity upon the borrowers requesting such funds or such scheduled payments coming due, as applicable.

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

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

 

         Fair Value of asset or (liability) as of  

Futures Contracts

 

Consolidated Statements of

Financial Condition Location

       June 30,    
2012
        December 31,    
2011
 

Notional Value

  Not Applicable    $ (31,228   $ (20,769
    

 

 

   

 

 

 

Fair Value

  (Payable) Receivable to brokers, dealers and clearing organizations    $ (3,550   $ 895   
    

 

 

   

 

 

 

 

Futures Contracts

  

Consolidated Statements of
Operations Location

   Gain Recognized
For the three months ended June 30,
 
              2012                      2011          

Unrealized Gain

   Net trading revenue    $ 13,194       $ 18,462   
     

 

 

    

 

 

 

 

Futures Contracts

  

Consolidated Statements of
Operations Location

   Gain (Loss) Recognized
For the six months ended June 30,
 
              2012                      2011          

Unrealized Gain (Loss)

   Net trading revenue    $ 6,097       $ (38,965
     

 

 

    

 

 

 

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

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

Upon the acquisition of the futures business of Penson in June 2012, the Company began providing execution, clearing and custody services in futures contracts and options on futures contracts to facilitate customer transactions on major U.S. and European futures and options exchanges.

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

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

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

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

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

16.    Acquisition

Penson Futures

On June 1, 2012, the Company completed the acquisition of certain assets and liabilities of Penson Futures, the futures division of Penson for $5.0 million in cash and a potential earn-out based on future performance valued at $7.9 million. Goodwill and intangible assets recognized upon the closing transaction amounted to $10.1 million. All of the goodwill from this transaction is expected to be deductible for income tax purposes. The following table summarizes the estimated fair values of the assets acquired and liabilities assumed (in thousands):

 

Cash

   $ 5,000   

Fair value of earn-out

     7,900   
  

 

 

 

Recorded purchase price

   $         12,900   
  

 

 

 

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

Cash

   $ 1,928   

Segregated cash and securities

     100,545   

Receivable from brokers, dealers and clearing organizations

     360,494   

Goodwill

     6,617   

Intangible assets

     3,500   

Other assets

     24,604   

Payable to customers

     (472,197

Accrued expenses and other liabilities

     (12,591
  

 

 

 

Purchase of business

   $         12,900   
  

 

 

 

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

17.    Business Segments

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

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

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

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

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

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

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

 

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

For the three months ended June 30, 2012:

         

Revenues(1)

  $ 113,491      $ 109,698      $ 43,260      $ 22,805      $ 289,254   

Pre-tax earnings

    5,934        (7,488     11,349        (4,439     5,356   

Total assets

    1,773,261        4,336,929        297,205        2,787,567        9,194,962   

For the three months ended June 30, 2011:(3)

         

Revenues

  $ 145,038      $ 134,885      $ 41,926      $ 4,133      $ 325,982   

Pre-tax earnings

    39,173        (3,968     11,812        (17,562     29,454   

Total assets(2)

    2,093,892        2,162,993        261,226        1,906,517        6,424,628   

For the six months ended June 30, 2012:

         

Revenues(1)

  $ 265,655      $ 251,936      $ 87,508      $ 33,180      $ 638,279   

Pre-tax earnings

    51,064        7,168        23,615        (22,491     59,356   

Total assets

    1,773,261        4,336,929        297,205        2,787,567        9,194,962   

For the six months ended June 30, 2011:(3)

         

Revenues

  $ 312,227      $ 262,257      $ 82,259      $ 9,015      $ 665,758   

Pre-tax earnings

    102,541        (11,659     23,170        (34,514     79,538   

Total assets(2)

        2,093,892            2,162,993            261,226            1,906,517            6,424,628   

 

(1) Included in revenues for the three and six months ended June 30, 2012 is a Facebook IPO trading loss of $35.4 million which includes $26.0 million for Market Making and $9.4 million for Institutional Sales and Trading.
(2) Total assets do not include assets within discontinued operations of $2.6 million at June 30, 2011.
(3) Prior period amounts have been recast to conform with current period presentation. Such recast had no effect on previously reported Consolidated Pre-tax earnings.

 

Subsequent Event

18.    Subsequent Event

The Company experienced a technology issue at the open of trading at the NYSE on August 1, 2012. This issue was related to the installation that day of trading software and resulted in the Company sending numerous erroneous orders in NYSE-listed and NYSE Arca securities into the market. Although this software was subsequently removed from the Company’s systems and clients were not negatively affected by the erroneous orders, it resulted in the Company realizing a pre-tax loss of approximately $440.0 million. This event severely impacted the Company’s capital base and business operations, and the Company experienced reduced order flow, liquidity pressures and harm to customer and counterparty confidence. As a result, there was substantial doubt about the Company’s ability to continue as a going concern. Following the event of August 1, 2012, the Company has begun an internal review into such event and associated controls.

 

 

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KNIGHT CAPITAL GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued

(Unaudited)

 

In light of this event, on August 6, 2012 the Company, after evaluating and pursuing various strategic alternatives, sold 400,000 shares of convertible preferred stock in private placements to investors in exchange for aggregate cash consideration of $400.0 million. The preferred stock consisted of 79,600 shares of Series A-1 preferred stock and 320,400 shares of Series A-2 preferred stock. The Series A-1 preferred stock and Series A-2 preferred stock are convertible into approximately 266.7 million shares of Class A common stock, or approximately 73% of the total number of shares of Class A common stock outstanding as of August 3, 2012, assuming the conversion in full of the preferred stock into Class A common stock.

Although the Company’s capital base was severely impacted as a result of the event, the Company’s regulated broker-dealer subsidiaries remained in full compliance with their net capital requirements at all times. In addition, the Company remains in good standing with The Depository Trust & Clearing Corporation’s depository and clearing subsidiaries as well as the OCC. As of the close of business on August 6, 2012, Knight Capital Americas LLC, the Company’s domestic broker-dealer subsidiary, had excess net capital greater than $300.0 million.

 

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

The following discussion of our results of operations should be read in conjunction with our Consolidated Financial Statements and notes included in Current Report on Form 8-K dated August 6, 2012 as filed with the U.S. Securities and Exchange Commission (“SEC”). This discussion contains forward-looking statements that involve risks and uncertainties, including those discussed in our Form 10-K for the year ended December 31, 2011 and herein. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of certain factors, including, but not limited to, those set forth elsewhere in this document and in our Form 10-K.

Certain statements contained in this Quarterly Report on Form 10-Q, including, without limitation, those under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” herein (“MD&A”), “Quantitative and Qualitative Disclosures About Market Risk” in Part I, Item 3, “Legal Proceedings” and “Risk Factors” in Part II and the documents incorporated by reference, may constitute forward-looking statements. These forward-looking statements are not historical facts and are based on current expectations, estimates and projections about the Company’s industry, management’s beliefs and certain assumptions made by management, many of which, by their nature, are inherently uncertain and beyond our control. Accordingly, readers are cautioned that any such forward-looking statements are not guarantees of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict including, without limitation, risks associated with the August 1, 2012 technology issue that resulted in the Company sending numerous erroneous orders in NYSE-listed and NYSE Arca securities into the market and the impact to the Company’s capital structure and business as well as actions taken in response thereto and consequences thereof, risks associated with the Company’s ability to recover all or a portion of the damages that are attributable to the manner in which NASDAQ OMX handled the Facebook IPO, risks associated with changes in market structure, legislative, regulatory or financial reporting rules, risks associated with the Company’s changes to its organizational structure and management and the costs, integration, performance and operation of businesses previously acquired or developed organically, or that may be acquired or developed organically in the future. Readers should carefully review the risks and uncertainties disclosed in the Company’s reports with the SEC including, without limitation, those detailed under “Certain Factors Affecting Results of Operations” within MD&A herein and under “Risk Factors” herein and in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011 and in other reports or documents the Company files with, or furnishes to, the SEC from time to time. This information should also be read in conjunction with the Company’s Consolidated Financial Statements and the Notes thereto contained in this Form 10-Q, and in other reports or documents the Company files with, or furnishes to, the SEC from time to time.

Executive Overview

We are a global financial services firm that provides access to the capital markets across multiple asset classes to a broad network of clients, including broker-dealers, institutions and corporations. We seek to continually apply our expertise and innovation to the market making and trading process to build lasting client relationships through consistent performance and superior client service. We also provide capital markets services to corporate issuers and private companies. We have four operating segments: (i) Market Making; (ii) Institutional Sales and Trading; (iii) Electronic Execution Services; and (iv) Corporate and Other.

 

   

Market Making – Our Market Making segment principally consists of market making in global equities and listed domestic options. As a market maker, we commit capital for trade executions by offering to buy securities from, or sell securities to, institutions and broker-dealers. Our Market Making segment primarily includes client, and to a lesser extent, non-client electronic market making activities in which we operate as a market maker in equity

 

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securities quoted and traded on the Nasdaq Stock Market, the over-the-counter (“OTC”) market for New York Stock Exchange (“NYSE”), NYSE Amex Equities (“NYSE Amex”), NYSE Arca listed securities and several European exchanges. As a complement to electronic market making, our cash trading business handles specialized orders and also transacts on the OTC Bulletin Board, the OTC Pink Markets, and the Alternative Investment Market (“AIM”) of the London Stock Exchange. We provide trade executions as an equities Designated Market Maker (“DMM”) on the NYSE and NYSE Amex. Market Making also includes our option market making business which trades on substantially all domestic electronic exchanges.

 

   

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

 

   

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

 

   

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

 

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

 

     For the three months ended
June 30,
    For the six months ended
June 30,
 
         2012             2011(1)              2012             2011(1)       

Market Making

        

Revenues

   $         113.5      $         145.0      $         265.7      $         312.2   

Expenses

     107.6        105.9        214.6        209.7   
  

 

 

   

 

 

   

 

 

   

 

 

 

Pre-tax earnings

     5.9        39.2        51.1        102.5   
  

 

 

   

 

 

   

 

 

   

 

 

 

Institutional Sales and Trading

        

Revenues

     109.7        134.9        251.9        262.3   

Expenses

     117.2        138.9        244.8        273.9   
  

 

 

   

 

 

   

 

 

   

 

 

 

Pre-tax (loss) earnings

     (7.5     (4.0     7.2        (11.7
  

 

 

   

 

 

   

 

 

   

 

 

 

Electronic Execution Services

        

Revenues

     43.3        41.9        87.5        82.3   

Expenses

     31.9        30.1        63.9        59.1   
  

 

 

   

 

 

   

 

 

   

 

 

 

Pre-tax earnings

     11.3        11.8        23.6        23.2   
  

 

 

   

 

 

   

 

 

   

 

 

 

Corporate and Other

        

Revenues

     22.8        4.1        33.2        9.0   

Expenses

     27.2        21.7        55.7        43.5   
  

 

 

   

 

 

   

 

 

   

 

 

 

Pre-tax (loss)

     (4.4     (17.6     (22.5     (34.5
  

 

 

   

 

 

   

 

 

   

 

 

 

Consolidated

        

Revenues

     289.3        326.0        638.3        665.8   

Expenses

     283.9        296.5        578.9        586.2   
  

 

 

   

 

 

   

 

 

   

 

 

 

Pre-tax earnings

   $ 5.4      $ 29.5      $ 59.4      $ 79.5   
  

 

 

   

 

 

   

 

 

   

 

 

 

 

* Totals may not add due to rounding.
(1) – Prior period amounts have been recast to conform to current period segment presentation. Such recast had no effect on previously reported consolidated pre-tax earnings.

Consolidated revenues for the three months ended June 30, 2012 decreased $36.7 million, or 11.3%, from the same period a year ago, while consolidated expenses decreased $12.6 million, or 4.3%. Consolidated pre-tax earnings for the three months ended June 30, 2012 decreased $24.1 million, or 81.8%, from the same period a year ago.

Consolidated revenues for the six months ended June 30, 2012 decreased $27.5 million, or 4.1%, from the same period a year ago, while consolidated expenses decreased $7.3 million, or 1.2%. Consolidated pre-tax earnings for the six months ended June 30, 2012 decreased $20.2 million, or 25.4%, from the same period a year ago.

Consolidated revenues for the three and six months ended June 30, 2012 include an aggregate $35.4 million trading loss related to the Facebook IPO, which primarily impacted our Market Making and Institutional Sales and Trading segments.

On July 18, 2012, we announced pre-tax trading losses of $35.4 million related to the Facebook IPO. On July 21, 2012, NASDAQ announced that it would file a proposed voluntary accommodation program (the “Accommodation Program”) with the SEC which, among other things, creates a fund for voluntary accommodations for qualifying NASDAQ members disadvantaged by problems that arose

 

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during the Facebook IPO. The Accommodation Program, which was published in the Federal Register by the SEC on August 1, 2012, will be subject to a 21 day public comment period and thereafter approval by the SEC. Under the proposed Accommodation Program, we would be entitled to submit claims, within seven days of formal approval by the SEC, in accordance with the parameters set forth in the Accommodation Plan. The claims would be processed and evaluated by the Financial Industry Regulatory Authority (“FINRA”) applying the accommodation standards set forth in the Accommodation Program. Under the Accommodation Program as proposed by NASDAQ, we would recover a portion of our pre-tax trading losses. We are evaluating the Accommodation Program as well as our other options, and plan to submit a comment letter to the SEC. There can be no assurance that the Accommodation Program will be approved by the SEC or that the terms of the Accommodation Program will not change from those proposed. As previously disclosed, there are no assurances that we will be able to recover our pre-tax trading losses relating to the Facebook IPO.

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

 

   

Market Making – Our pre-tax earnings from Market Making for the three months ended June 30, 2012 decreased by $33.2 million, or 84.9%, from the comparable period in 2011. Our pre-tax earnings from Market Making for the six months ended June 30, 2012 decreased by $51.5 million, or 50.2%, from the comparable period in 2011. The quarter over quarter and year over year decrease is primarily due to a $26.0 million trading loss related to the Facebook IPO and a decrease in volumes resulting in lower revenues from both our client and non-client quantitative trading models, offset, in part, by higher average revenue capture per U.S. equity Market Making dollar value traded, excluding the impact of Facebook IPO.

 

   

Institutional Sales and Trading – Our pre-tax loss from Institutional Sales and Trading for the three months ended June 30, 2012 increased by $3.5 million from the comparable period in 2011. The quarter over quarter increased loss is primarily due to a $9.4 million trading loss related to the Facebook IPO and lower revenues and pre-tax results from our capital markets and reverse mortgage businesses offset, in part, by a decrease in guaranteed compensation in our fixed income business and improved results from our listed derivatives business. Our pre-tax earnings from Institutional Sales and Trading for the six months ended June 30, 2012 increased by $18.8 million, from a loss in the comparable period in 2011. The year over year increase is primarily due to increased earnings from our fixed income business, including our reverse mortgage business and listed derivatives business, offset, in part, by a trading loss related to the Facebook IPO and lower revenues from our capital markets business.

 

   

Electronic Execution Services – Our pre-tax earnings from Electronic Execution Services for the three months ended June 30, 2012 decreased by $0.5 million, or 3.9%, from the comparable period in 2011. The quarter over quarter decrease is primarily due to higher compensation expense, offset, in part, by higher earnings from increased volumes in our Knight Direct business. Our pre-tax earnings from Electronic Execution Services for the six months ended June 30, 2012 increased by $0.4 million, or 1.9%, from the comparable period in 2011. The year over year increase is primarily due to higher earnings from increased volumes in our Knight Direct business offset, in part, by decreased volumes in our Knight Hotspot FX business.

 

   

Corporate and Other – Our pre-tax loss from our Corporate and Other segment for the three months ended June 30, 2012 decreased by $13.1 million from the comparable period in 2011 and our pre-tax loss for the six months ended June 30, 2012 decreased by $12.0 million from the comparable period in 2011. The decrease in loss for both periods is primarily due to a $10.0 million gain related to a change in the tax status of a strategic investment accounted for

 

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under the equity method of accounting, offset, in part, by higher interest expense related to our long-term debt and securities lending activity for the three and six months ended June 30, 2012.

Subsequent Event

We experienced a technology issue at the open of trading at the NYSE on August 1, 2012. This issue was related to the installation that day of trading software and resulted in us sending numerous erroneous orders in NYSE-listed and NYSE Arca securities into the market. Although this software was subsequently removed from our systems and clients were not negatively affected by the erroneous orders, it resulted in us realizing a pre-tax loss of approximately $440.0 million. This event severely impacted our capital base and business operations, and we experienced reduced order flow, liquidity pressures and harm to customer and counterparty confidence. As a result, there was substantial doubt about our ability to continue as a going concern. Following the event of August 1, 2012, we have begun an internal review into such event and associated controls.

In light of this event, on August 6, 2012, after evaluating and pursuing various strategic alternatives, we sold 400,000 shares of convertible preferred stock in private placements to investors in exchange for aggregate cash consideration of $400.0 million. The preferred stock consisted of 79,600 shares of Series A-1 preferred stock and 320,400 shares of Series A-2 preferred stock. The Series A-1 preferred stock and Series A-2 preferred stock are convertible into approximately 266.7 million shares of Class A common stock, or approximately 73% of the total number of shares of Class A common stock outstanding as of August 3, 2012, assuming the conversion in full of the preferred stock into Class A common stock.

Although our capital base was severely impacted as a result of the event, our regulated broker-dealer subsidiaries remained in full compliance with their net capital requirements at all times. In addition, we remain in good standing with The Depository Trust & Clearing Corporation’s depository and clearing subsidiaries as well as the OCC. As of the close of business on August 6, 2012, Knight Capital Americas LLC, our domestic broker-dealer subsidiary, had excess net capital greater than $300.0 million.

Certain Factors Affecting Results of Operations

We may experience significant variation in our future results of operations. These fluctuations may result from numerous factors, including, among other things, market conditions and the resulting volatility, credit and counterparty risks that may result; introductions of, or enhancements to, trade execution services by us or our competitors; the value of our securities positions and other financial instruments and our ability to manage the risks attendant thereto; the volume of our trade execution activities; the dollar value of securities and other instruments traded; the composition and profile of our order flow; our market share with institutional and broker-dealer clients; the performance and size of, and volatility in, our client market making and program trading portfolios; the performance of our non-client principal trading activities; movements of credit spreads; home equity conversion mortgages (“HECMs”) origination and HECM Mortgage Backed Securities (“HMBS”) securitization volumes; the overall size of our balance sheet and capital usage; the potential impairment of goodwill and/or intangible assets; the performance of our global operations, trading technology and trading infrastructure; costs associated with overall business growth; the effectiveness of our self-clearing and futures platforms and our ability to manage risk related thereto; the availability of credit and liquidity in the marketplace; erroneous trade orders submitted by us on account of technology or other issues (such as occurred on August 1, 2012) and consequences thereof; the performance, operation and connectivity to various market centers; our ability to manage personnel, compensation, overhead and other expenses; the strength of our client relationships; changes in payments for order flow; changes to execution quality and changes in clearing, execution and regulatory transaction costs; interest rate

 

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

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

Trends

Global Economic Trends

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

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

Trends Affecting Our Company

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

 

   

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

 

   

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

 

   

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

 

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venues which compete within the OTC and listed trading venues. For example, on July 3, 2012, the SEC approved proposed rules submitted by the NYSE and NYSE Amex to establish a Retail Liquidity Program (“RLP”) on a pilot basis for one year. The RLP seeks to attract retail flow to the NYSE and NYSE Amex. This new program (as well as any similar program established by other national stock exchanges) could draw market share away from Knight, and thus negatively impact our business. In addition, there are many new entrants into the market, including ATS, Multilateral Trading Facilities, systematic internalizers, dark liquidity pools, high frequency trading firms, and market making firms competing for retail and institutional order flow. Further, many broker-dealers are offering their own internal crossing networks. These factors continue to create further fragmentation and competition in the marketplace.

 

   

Over the past few years, market structure changes, competition, market conditions and a steady increase in electronic trading have resulted in a reduction in institutional commission rates and volumes which may continue in the future. Additionally, many institutional clients allocate commissions to broker-dealers based not only on the quality of executions, but also in exchange for research, or participation in soft dollar and commission recapture programs.

 

   

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

 

   

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

 

   

There has been continued scrutiny of the capital markets industry by the regulatory and legislative authorities, both in the U.S. and abroad. New legislation or new or modified regulations and rules could occur in the future. Members of the U.S. Congress have asked the SEC and other regulators to take a close look at the regulatory structure and make the changes necessary to insure the rule framework governing the U.S. financial markets is comprehensive and complete. The SEC and other regulators have stated that they will propose and adopt rules where necessary, on a variety of marketplace issues – including, but not limited to: high frequency trading, indications of interest, off-exchange trading, dark liquidity pools, internalization, post-trade attribution, co-location, sponsored access, short sales, consolidated audit trails and market volatility rules (including, circuit breakers and limit-up, limit-down rules).

 

   

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

 

   

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

 

   

Reverse mortgages can be a cost-effective way to help seniors (age 62 and older) meet their financial needs in retirement, by enabling them to tap the equity in their home. Reverse mortgages have been popular with seniors who have equity in their homes and want to supplement their income and enhance their liquidity. This popularity may continue as the Baby Boomer generation enters retirement age. However, there is no guarantee that current volumes or the referenced popularity will continue.

 

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

 

   

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

Income Statement Items

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

Revenues

Our revenues consist principally of Commissions and fees and Net trading revenue from all of our business segments.

Revenues on transactions for which we charge explicit commissions or commission equivalents, which include the majority of our institutional client orders, commissions on futures transactions, as well as the mark-to-market of securitized HECM loan inventory, are included within Commissions and fees. Commissions and fees are primarily affected by changes in our equity, fixed income, futures and foreign exchange transaction volumes with institutional clients, changes in commission rates, level of volume based fees from providing liquidity to other trading venues, loan origination and securitization volume and spreads, assets under management and the level of our soft dollar and commission recapture activity.

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

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

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

 

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Expenses

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

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

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

Payments for order flow primarily represent payments to broker-dealer clients, in the normal course of business, for directing to us their order flow in U.S. equities and options. Payments for order flow also include fees paid to third party brokers with respect to reverse mortgage wholesale loan production and fluctuate as we modify our rates and as our percentage of clients whose policy is not to accept payments for order flow varies. Payments for order flow also fluctuate based on U.S. equity share and option volumes, reverse mortgage loan production and channel mix, our profitability and the mix of market orders, limit orders, and customer mix.

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

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

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

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

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

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

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

 

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Three Months Ended June 30, 2012 and 2011

Revenues

Market Making

 

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

Commissions and fees (millions)

   $ 23.0      $ 27.5       $ (4.5     -16.2

Net trading revenue (millions)

     91.9        115.7         (23.8     -20.5

Interest, net (millions)

     (1.5     1.9         (3.3     N/M   
  

 

 

   

 

 

    

 

 

   

Total Revenues from Market Making (millions)

   $ 113.5      $ 145.0       $ (31.5     -21.8
  

 

 

   

 

 

    

 

 

   

U.S. equity Market Making statistics:

         

Average daily dollar value traded ($ billions)*

     20.9        23.4         (2.4     -10.3

Average daily trades (thousands)*

     3,303.1        3,253.8         49.3        1.5

Nasdaq and Listed shares traded (billions)*

     45.7        48.4         (2.7     -5.7

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

     166.9        261.8         (94.9     -36.3

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

     0.80        0.93         (0.13     -13.5

Average revenue capture per U.S. equity dollar value traded, excluding impact of Facebook IPO (bps)**

     1.00        0.93         0.07        7.5

 

* Represents new presentation for U.S. equity Market Making for all periods presented as described more fully in text below.
** Statistic excludes $26.0 million in trading losses related to the Facebook IPO.

Totals may not add due to rounding.

N/M – Not meaningful

Total revenues from the Market Making segment, which primarily comprises Net trading revenue from our domestic businesses, decreased 21.8% to $113.5 million for the three months ended June 30, 2012, from $145.0 million for the comparable period in 2011. Revenues for the three months ended June 30, 2012 were negatively impacted by $26.0 million of trading losses related to the Facebook IPO and lower volumes, which resulted in a decrease in revenues from both our client and non-client quantitative trading models offset, in part, by slightly higher average revenue capture per U.S. equity dollar value traded, excluding the impact of Facebook IPO.

In the first quarter of 2012, we modified our quarterly revenue capture and monthly equity volume statistics in order to provide data specific to the U.S. equity market making activity within the Market Making segment. Our revenue capture and volume statistics previously also included U.S. institutional sales activity. Average revenue capture per U.S. equity dollar value traded was 0.80 basis points (“bps”) for the second quarter of 2012, down 13.5% from the second quarter of 2011. Excluding the impact of the Facebook IPO, average revenue capture per U.S. equity dollar value traded was 1.0 bps for the second quarter of 2012, up 7.5% from the second quarter of 2011. Excluding the impact of the Facebook IPO, the primary driver for the slight increase in revenue capture was due in part to growth and enhancements to our trading models and infrastructure. Average revenue capture per U.S. equity market making dollar value traded is calculated as the total of net domestic market making trading revenues plus volume based fees from providing liquidity to other trading venues (included in Commissions and fees), less certain transaction-related regulatory fees (included in Execution and clearance fees) (collectively “Domestic U.S. Equity Market Making Revenues”), divided by the total

 

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dollar value of the related equity transactions. Domestic U.S. Equity Market Making Revenues were $106.1 million, $132.1 million excluding the impact of Facebook IPO, and $136.8 million for the three months ended June 30, 2012 and 2011, respectively.

Institutional Sales and Trading

 

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

Commissions and fees (millions)

   $ 105.9      $ 125.7      $ (19.9     -15.8

Net trading revenue (millions)

     4.9        10.4        (5.4     -52.4

Interest, net (millions)

     (1.3     (2.8     1.5        53.0

Investment income and other, net (millions)

     0.2        1.6        (1.4     -85.5
  

 

 

   

 

 

   

 

 

   

Total Revenues from Institutional Sales and Trading (millions)

   $ 109.7      $ 134.9      $ (25.2     -18.7
  

 

 

   

 

 

   

 

 

   

 

Totals may not add due to rounding.

Total revenues from the Institutional Sales and Trading segment, which primarily comprises Commissions and fees from institutional equities, ETFs, fixed income sales and reverse mortgage originations, decreased 18.7% to $109.7 million for the three months ended June 30, 2012, from $134.9 million for the comparable period in 2011. Revenues were negatively impacted by $9.4 million of trading losses related to the Facebook IPO and lower revenues from our capital markets and reverse mortgage businesses offset, in part, by higher revenues from our listed derivatives business.

Electronic Execution Services

 

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

Commissions and fees (millions)

   $ 43.2       $ 42.3      $ 0.9        2.1

Investment income and other, net (millions)

     0.0         (0.4     0.4        N/M   
  

 

 

    

 

 

   

 

 

   

Total Revenues from Electronic Execution Services (millions)

   $ 43.3       $ 41.9      $ 1.3        3.2
  

 

 

    

 

 

   

 

 

   

Average daily Knight Direct equity shares (millions)

     218.8         162.2        56.6        34.9

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

     28.1         31.5        (3.3     -10.6

 

* In the second quarter of 2012, we modified the reporting of Knight Hotspot FX notional dollar value traded volume to count one side of the transaction. We previously counted total client volume to include both sides of the transaction.

Totals may not add due to rounding.

N/M – Not meaningful

Total revenues from the Electronic Execution Services segment, which primarily comprises Commissions and fees from agency execution activity, increased 3.2% to $43.3 million for the three months ended June 30, 2012, from $41.9 million for the comparable period in 2011. Revenues were positively impacted by higher volumes from our Knight Direct and Knight BondPoint businesses.

 

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Corporate and Other

 

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

Total Revenues from Corporate and Other (millions)

   $ 22.8       $ 4.1       $ 18.7         451.8

Total revenues from the Corporate and Other segment, which primarily represent interest income from our securities borrowing activity, gains or losses on strategic investments, and deferred compensation investments related to certain employees and directors, increased to $22.8 million for the three months ended June 30, 2012, from $4.1 million for the comparable period in 2011. The primary drivers for the increase in revenues were a $10.0 million gain from a strategic investment that we account for under the equity method of accounting, offset, in part, by higher interest expense related to our long-term debt and securities lending activity. This investment gain was due to an income tax benefit recognized by the investee that arose from a change in its tax status during 2010, but which was reported and disclosed to us in the second quarter of 2012. The $10.0 million gain that we recorded in the second quarter of 2012 represents our share of the investee’s net income which we recorded under the equity method of accounting.

Expenses

Employee compensation and benefits expense decreased to $130.9 million for the three months ended June 30, 2012 from $140.1 million for the comparable period in 2011. As a percentage of total revenue, Employee compensation and benefits increased to 45.2% for the three months ended June 30, 2012, from 43.0% for the comparable period in 2011. The decrease on a dollar basis was primarily due to an overall decrease and change in the mix of our revenues across businesses and a decrease in guaranteed compensation from our Institutional Sales and Trading segment. The increase as a percentage of revenues was primarily due to the $35.4 million of trading losses as a result of the Facebook IPO. As a percentage of total revenue, excluding the effects of the Facebook IPO and the one-time $10.0 million investment gain from a strategic investment, Employee compensation and benefits decreased to 41.6% for the three months ended June 30, 2012, from 43.0% for the comparable period in 2011.

The number of full time employees increased to 1,535 at June 30, 2012, from 1,465 at June 30, 2011, primarily due to the acquisition of our futures business and the expansion of our market making and reverse mortgage businesses, offset by the reduction in force in connection with our restructuring in third quarter 2011. Employee compensation and benefits expense fluctuates, for the most part, based on changes in our business mix, revenues, profitability, and the number of employees.

Execution and clearance fees decreased to $53.2 million for the three months ended June 30, 2012, from $58.7 million for the comparable period in 2011. As a percentage of total revenue, Execution and clearance fees increased slightly to 18.4% for the three months ended June 30, 2012, from 18.0% for the comparable period in 2011. Execution and clearance fees fluctuate based on changes in transaction volumes, shift in business mix, regulatory fees and operational efficiencies and scale.

Payments for order flow decreased 9.8% to $20.2 million for the three months ended June 30, 2012, from $22.3 million for the comparable period in 2011. As a percentage of total revenue, Payments for order flow increased slightly to 7.0% for the three months ended June 30, 2012, from 6.9% for the comparable period in 2011. Payments for order flow fluctuate as a percentage of revenue due to changes in volume, reverse mortgage loan production, client and product mix, profitability, and competition.

 

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All other expenses increased by 5.8%, or $4.3 million, to $79.7 million for the three months ended June 30, 2012 from $75.3 million for the comparable period in 2011. Interest expense increased primarily due to our increased securities lending activity and long-term debt. Communications and data processing expense increased primarily due to higher market data and connectivity expenses as a result of our overall growth. Business development expense decreased due to fewer client related events. Occupancy and equipment rentals expense decreased primarily due to the reduction in lease costs. Professional fees decreased slightly due to lower consulting expenses. Other expenses decreased slightly due to lower reserves associated with our GNMA issuances, offset, by higher administrative expenses.

Our effective tax rate from continuing operations of 38.6% and 39.7% for the three months ended June 30, 2012 and 2011, respectively, differed from the federal statutory rate of 35% primarily due to state and local income taxes and non-deductible charges.

Six Months Ended June 30, 2012 and 2011

Revenues

Market Making

 

    For the six months
ended June 30,
             
            2012                     2011             Change     % of Change  

Commissions and fees (millions)

  $ 45.4      $ 56.3      $ (10.9     -19.4

Net trading revenue (millions)

    219.0        251.3        (32.3     -12.9

Interest, net (millions)

    1.2        4.6        (3.4     N/M   
 

 

 

   

 

 

   

 

 

   

Total Revenues from Market Making (millions)

  $ 265.7      $ 312.2      $ (46.6     -14.9
 

 

 

   

 

 

   

 

 

   

U.S. equity Market Making statistics:

       

Average daily dollar value traded
($ billions)
*

    21.5        24.4        (2.9     -11.9

Average daily trades (thousands)*

    3,324.3        3,347.7        (23.3     -0.7

Nasdaq and Listed shares traded (billions)*

    93.0        104.9        (11.9     -11.3

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

    338.1        582.6        (244.5     -42.0

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

    0.92        0.97        (0.05     -5.4

Average revenue capture per U.S. equity dollar value traded, excluding impact of Facebook IPO (bps)**

    1.01        0.97        0.04        4.1

 

* Represents new presentation for U.S. equity Market Making for all periods presented as described more fully in text below.
** Statistic excludes $26.0 million in trading losses related to the Facebook IPO.

Totals may not add due to rounding.

N/M – Not meaningful

Total revenues from the Market Making segment, which primarily comprises Net trading revenue from our domestic businesses, decreased 14.9% to $265.7 million for the six months ended June 30, 2012, from $312.2 million for the comparable period in 2011. Revenues for the six months ended June 30, 2012 were negatively impacted by $26.0 million of trading losses related to the Facebook IPO

 

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and lower volumes, which resulted in a decrease in revenues from both our client and non-client quantitative trading models offset, in part, by slightly higher average revenue capture per U.S. equity dollar value traded, excluding the impact of Facebook IPO.

Average revenue capture per U.S. equity dollar value traded was 0.92 basis points (“bps”) for the first half of 2012, down 5.4% from the first half of 2011. Excluding the impact of the Facebook IPO, average revenue capture per U.S. equity dollar value traded was 1.01 bps for the first half of 2012, up 4.1% from the first half of 2011. Excluding the impact of the Facebook IPO, the primary driver for the increase in revenue capture was due in part to growth and enhancements to our trading models and infrastructure. Domestic U.S. Equity Market Making Revenues were $246.2 million, $272.2 excluding the impact of Facebook IPO, and $295.2 million for the six months ended June 30, 2012 and 2011, respectively.

Institutional Sales and Trading

 

     For the six months
ended June 30,
             
             2012                     2011             Change     % of Change  

Commissions and fees (millions)

   $ 221.3      $ 239.4      $ (18.1     -7.6

Net trading revenue (millions)

     34.6        25.9        8.7        33.6

Interest, net (millions)

     (4.3     (5.2     1.0        18.8

Investment income and other, net (millions)

     0.3        2.2        (1.9     -86.1
  

 

 

   

 

 

   

 

 

   

Total Revenues from Institutional Sales and Trading (millions)

   $ 251.9      $ 262.3      $ (10.3     -3.9
  

 

 

   

 

 

   

 

 

   

 

Totals may not add due to rounding.

Total revenues from the Institutional Sales and Trading segment, which primarily comprises Commissions and fees from institutional equities, ETFs, fixed income sales and reverse mortgage originations, decreased 3.9% to $251.9 million for the six months ended June 30, 2012, from $262.3 million for the comparable period in 2011. Revenues were negatively impacted by $9.4 million of trading losses related to the Facebook IPO and lower revenues from our capital markets and equity sales businesses offset, in part, by higher revenues from our listed derivatives, fixed income, and reverse mortgage businesses.

Electronic Execution Services

 

     For the six months
ended June 30,
             
             2012                     2011             Change     % of Change  

Commissions and fees (millions)

   $ 87.7      $ 82.8      $ 4.9        6.0

Investment income and other, net (millions)

     (0.2     (0.5     0.3        N/M   
  

 

 

   

 

 

   

 

 

   

Total Revenues from Electronic Execution Services (millions)

   $ 87.5      $ 82.3      $ 5.2        6.4
  

 

 

   

 

 

   

 

 

   

Average daily Knight Direct equity shares (millions)

     217.3        163.7        53.6        32.7

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

     28.0        29.5        (1.5     -5.2

 

* In the second quarter of 2012, we modified the reporting of Knight Hotspot FX notional dollar value traded volume to count one side of the transaction. We previously counted total client volume to include both sides of the transaction.

Totals may not add due to rounding.

N/M – Not meaningful

 

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Total revenues from the Electronic Execution Services segment, which primarily comprises Commissions and fees from agency execution activity, increased 6.4% to $87.5 million for the six months ended June 30, 2012, from $82.3 million for the comparable period in 2011. Revenues were positively impacted by higher volumes from our Knight Direct and Knight BondPoint businesses.

Corporate and Other

 

     For the six months
ended June 30,
               
             2012                      2011              Change      % of Change  

Total Revenues from Corporate and Other (millions)

   $ 33.2       $ 9.0       $ 24.2         269.3

Total revenues from the Corporate and Other segment, which primarily represent interest income from our securities borrowing activity, gains or losses on strategic investments, and deferred compensation investments related to certain employees and directors, increased to $33.2 million for the six months ended June 30, 2012, from $9.0 million for the comparable period in 2011. The primary drivers for the increase in revenues were a $10.0 million gain from a strategic investment that we account for under the equity method of accounting, offset, in part, by higher interest expense related to our long-term debt and securities lending activity. This investment gain was due to an income tax benefit recognized by the investee that arose from a change in its tax status during 2010, but which was reported and disclosed to us in the second quarter of 2012. The $10.0 million gain that we recorded in the second quarter of 2012 represents our share of the investee’s net income which we recorded under the equity method of accounting.

Expenses

Employee compensation and benefits expense decreased to $278.1 million for the six months ended June 30, 2012 from $289.1 million for the comparable period in 2011. As a percentage of total revenue, Employee compensation and benefits increased slightly to 43.6% for the six months ended June 30, 2012, from 43.4% for the comparable period in 2011. The decrease on a dollar basis was primarily due to an overall decrease and change in the mix of our revenues across businesses as well as by a decrease in guaranteed compensation from our Institutional Sales and Trading segment. As a percentage of total revenue, excluding the effects of the Facebook IPO and the one-time $10.0 million investment gain from a strategic investment, Employee compensation and benefits decreased to 41.9% for the six months ended June 30, 2012, from 43.4% for the comparable period in 2011.

Execution and clearance fees decreased to $106.4 million for the six months ended June 30, 2012, from $112.2 million for the comparable period in 2011. As a percentage of total revenue, Execution and clearance fees decreased slightly to 16.7% for the six months ended June 30, 2012, from 16.9% for the comparable period in 2011. Execution and clearance fees fluctuate based on changes in transaction volumes, shift in business mix, regulatory fees and operational efficiencies and scale.

Payments for order flow decreased 2.8% to $41.8 million for the six months ended June 30, 2012, from $43.0 million for the comparable period in 2011. As a percentage of total revenue, Payments for order flow increased slightly to 6.6% for the six months ended June 30, 2012, from 6.5% for the comparable period in 2011. Payments for order flow fluctuate as a percentage of revenue due to changes in volume, reverse mortgage loan production, client and product mix, profitability, and competition.

There was no writedown of assets and lease loss accrual for the six months ended June 30, 2012. Writedown of assets and lease loss accrual of $0.9 million for the six months ended June 30, 2011 relate to excess real estate capacity.

 

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All other expenses increased by 8.2%, or $11.5 million, to $152.5 million for the six months ended June 30, 2012 from $141.0 million for the comparable period in 2011. Interest expense increased primarily due to our increased securities lending activity and long-term debt. Communications and data processing expense increased primarily due to higher market data and connectivity expenses as a result of our overall growth. Business development expense decreased due to fewer client related events. Occupancy and equipment rentals expense decreased primarily due to the reduction in lease costs. Professional fees decreased slightly due to lower consulting expenses. Other expenses decreased slightly due to lower reserves associated with our GNMA issuances, offset, by higher administrative expenses.

Our effective tax rate from continuing operations of 38.7% and 39.2% for the six months ended June 30, 2012 and 2011, respectively, differed from the federal statutory rate of 35% primarily due to state and local income taxes and non-deductible charges.

Financial Condition, Liquidity and Capital Resources

Refer to the “Subsequent Event” section herein for a discussion of the impact on our liquidity and capital resources as a result of the event that occurred on August 1, 2012.

Financial Condition

We have historically maintained a highly liquid balance sheet, with a substantial portion of our total assets consisting of cash, highly liquid marketable securities and short term receivables. As of June 30, 2012 and December 31, 2011, we had $9.19 billion and $7.15 billion, respectively, in assets, a portion of which consisted of cash or assets readily convertible into cash as follows (in millions):

 

     June 30,
2012
     December 31,
2011
 

Cash and cash equivalents

   $ 364.8       $ 467.6   

Financial instruments owned, at fair value:

     

Equities

     1,641.5         1,416.1   

Listed equity options

     191.2         280.4   

U.S. government obligations

     9.7         44.3   

Corporate debt

     83.5         73.9   

Mortgage-backed securities

     112.2         16.4   

Collateralized agreements:

     

Securities borrowed

     1,907.8         1,494.6   

Receivable from brokers, dealers and clearing organizations

     880.1         623.9   
  

 

 

    

 

 

 

Total cash and assets readily convertible to cash

   $     5,190.8       $     4,417.3   
  

 

 

    

 

 

 

Substantially all of the amounts disclosed in the table above can be liquidated to cash within five business days under normal market conditions, however, the liquidated values may be subjected to haircuts during distressed market conditions.

Financial instruments owned principally consist of equities and listed equity options that trade on the NYSE, NYSE Amex and NYSE Arca markets, Nasdaq and on the OTC Bulletin Board as well as securitized HECM loan inventories.

Securities borrowed represent the value of cash or other collateral deposited with securities lenders to facilitate our trade settlement process.

Receivables from brokers, dealers and clearing organizations include interest bearing cash balances held with third party clearing brokers, including, or net of, amounts related to securities transactions that have not yet reached their contracted settlement date, which is generally within three business days of the trade date.

 

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As of June 30, 2012 and December 31, 2011, $1.37 billion and $798.2 million, respectively, of equities have been pledged as collateral to third-parties under financing arrangements.

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

Total assets increased $2.0 billion, or 28.5%, from $7.15 billion at December 31, 2011 to $9.19 billion at June 30, 2012. The majority of the increase in assets relates to the growth of our financial instruments owned. Financial instruments owned increased by $1.25 billion, or 33.0%, from $3.78 billion at December 31, 2011, to $5.03 billion at June 30, 2012, primarily due to the $1.02 billion increase in securitized HECM loan inventory, which represents HECM loans that have been securitized into GNMA securities which have been sold to third parties but where the securitization is not accounted for as a sale under current accounting standards. Also contributing to the increase in financial instruments owned are the increases in the size of the securities inventory utilized in our ETF and fixed income activities resulting from expansion of our strategies, offset, in part, by a decrease in financial instruments within our market making strategies. Our securities inventory fluctuates based on trading volumes, market conditions, trading strategies utilized and our pre-determined risk limits. Receivable from brokers, dealers and clearing organizations increased by $256.2 million, from $623.9 million at December 31, 2011 to $880.1 million at June 30, 2012, due to increased deposits at third party clearing organizations including customer balances related to our futures business as well as timing relating to trade date versus settlement date differences. Securities borrowed increased by $413.1 million, from $1.49 billion at December 31, 2011 to $1.91 billion at June 30, 2012. The growth of our securities borrowed is a by-product of our self-clearing activities. Cash and securities segregated under federal and other regulations increased $179.4 million from $11.0 million at December 31, 2011 to $190.4 million at June 30, 2012, primarily due to the acquisition of our futures business.

Total liabilities increased $2.01 billion, or 35.3%, from $5.69 billion at December 31, 2011 to $7.70 billion at June 30, 2012. The majority of the increase in liabilities relates to increases in Collateralized financings and Financial instruments sold, not yet purchased. Collateralized financings increased by $1.71 billion, or 59.4%, from $2.89 billion at December 31, 2011, to $4.60 billion at June 30, 2012 primarily due to the increased Liability to GNMA trusts, at fair value associated with the securitization of HECM loans into GNMA securities, where such securitization is not accounted for as a sale, as well as the increased lending activity to facilitate transaction settlements relating to self-clearing and loan origination. Financial instruments sold, not yet purchased decreased by $41.4 million, or 2.4%, from $1.72 billion at December 31, 2011, to $1.68 billion at June 30, 2012, primarily due to a decrease in the size of the securities inventory utilized in our equity market making and ETF activities and for trade execution services. Our securities inventory fluctuates based on trading volumes, market conditions, trading strategies utilized and our pre-determined risk limits and is consistent with the decrease in our long securities position within our market making business. Payable to brokers, dealers and clearing organizations decreased by $32.9 million, from $322.7 million at December 31, 2011 to $289.8 million at June 30, 2012, due to timing relating to trade date versus settlement date differences. Payable to customers increased by $408.2 million at December 31, 2011 to $431.8 million at June 30, 2012, primarily due to the acquisition of our futures business. Accrued compensation expense decreased from $188.9 million at December 31, 2011 to $111.9 million at June 30, 2012 primarily as a result of the payment of 2011 incentive compensation offset, in part, by the accrual of current period incentive compensation.

Stockholders’ equity increased by $34.9 million, from $1.46 billion at December 31, 2011 to $1.50 billion at June 30, 2012. The increase in stockholders’ equity from December 31, 2011 was primarily a result of earnings and stock-based compensation activity during the six months ended June 30, 2012, offset by our stock repurchase activity.

 

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Liquidity and Capital Resources

We have financed our business primarily through cash generated by operations, our long-term debt and other borrowings. At June 30, 2012, we had net current assets, which consist of net assets readily convertible into cash less current liabilities, of $1.07 billion.

We have acquired several businesses over the last few years. In July 2010, we completed the acquisition of Urban Financial Group, Inc. (“Urban”) for $28.4 million, comprising $19.4 million in cash, approximately 350,000 shares of unregistered Knight common stock valued at $5.0 million and a potential earn-out based on future performance valued at $4.7 million. Urban achieved its first year performance target as of July 31, 2011. Therefore, the seller received $1.3 million split evenly between cash and unregistered shares of Knight common stock. In June 2012, we completed the acquisition of certain assets and liabilities of Penson Futures, the division of Penson Financial Services, Inc. for $5.0 million in cash and a potential earn-out based on future performance with an estimated fair value of $7.9 million. We expect to fund the purchase price of any future acquisitions with our current cash position or, in some cases, through the issuance of our stock or debt.

Net income was $3.3 million and $17.6 million for the three months ended June 30, 2012 and 2011, respectively. Included in these amounts were a non-cash investment gain of $10.0 million related to a strategic investment accounted for under the equity method of accounting and certain non-cash expenses such as stock-based compensation, depreciation and amortization. Stock-based compensation was $14.5 million and $12.9 million for the three months ended June 30, 2012 and 2011, respectively. Depreciation and amortization expense was $13.5 million for each of the three months ended June 30, 2012 and 2011, respectively. There were no non-cash writedowns for each of the three months ended June 30, 2012 or 2011.

Capital expenditures were $7.0 million and $9.7 million during the three months ended June 30, 2012 and 2011, respectively. Purchases of investments were $0.2 million and $6.9 million and distributions from investments were $1.9 million and $1.5 million for the three months ended June 30, 2012 and 2011, respectively. The purchase of our futures business, net of cash acquired, was $3.1 million, for the three months ended June 30, 2012. There were no payments relating to acquisitions of businesses, trading rights and other items for the three months ended June 30, 2011.

In March 2010, we issued Cash Convertible Senior Subordinated Notes (“Notes”) with a face amount of $375.0 million in a private offering. Net proceeds from the offering were $167.5 million, which included $15.0 million from the sale of warrants, less $140.5 million for the termination and required repayment of the borrowings under our previous $140.0 million credit agreement including accrued interest, $73.7 million for the purchase of call options and $8.5 million of offering expenses. The Notes bear interest at a rate of 3.50% per year, payable semi-annually in arrears, on March 15 and September 15 of each year, commencing on September 15, 2010 and will mature on March 15, 2015, subject to earlier repurchase or conversion. For the three months ended June 30, 2012 and 2011, we recognized interest expense related to the Notes of $6.9 million and $6.7 million, respectively.

In June 2011, we entered into a $100.0 million three-year Term Loan Credit Agreement (the “Term Credit Agreement”) with the same consortium of banks. As of June 30, 2012, the Company has borrowed all the funds under the Term Credit Agreement and the interest rate was 2.75% per annum, which is based on the one month LIBOR rate plus 2.50%. Interest is paid monthly. The Term Credit Agreement is repayable in three installments as follows: $25.0 million on June 28, 2013, $25.0 million on December 27, 2013 and $50.0 million on June 27, 2014. For the three months ended June 30, 2012, we recognized interest expense related to the Term Credit Agreement of $0.7 million.

 

 

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In June 2011, we also entered into a $200.0 million one-year Revolving Credit Agreement (the “Revolving Credit Agreement”) with Knight Execution & Clearing Services LLC and Knight Capital Americas, L.P., as borrowers, with a consortium of banks. Borrowings under the Revolving Credit Agreement bear interest at a rate equal to the greater of the federal funds rate or the one month LIBOR rate plus a margin ranging from 1.50% – 2.00% per annum. Interest is payable quarterly. In June 2012, we renewed our Revolving Credit Agreement with substantially the same consortium of banks on substantially the same terms and conditions as the Revolving Credit Agreement. As of June 30, 2012, and December 31, 2011 there were no borrowings under the Revolving Credit Agreement. We are charged an annual commitment fee of 0.25% on the average daily amount of the unused portion of the Revolving Credit Agreement. For the three months ended June 30, 2012, we recorded $0.1 million in commitment fees.

See Footnote 9 “Long-Term Debt,” included in Part I, Item 1 “Financial Statements” of this Form 10-Q for further information regarding the Notes, Term Credit Agreement and Revolving Credit Agreement.

We have an authorized stock repurchase program of $1.00 billion. We repurchase 0.9 million shares for $11.1 million under the stock repurchase program during the second quarter of 2012. Through June 30, 2012, we had repurchased 76.7 million shares for $879.1 million under this program. We may repurchase shares from time to time in open market transactions, accelerated stock buyback programs, tender offers, privately negotiated transactions or by other means. Repurchases may also be made under Rule 10b5-1 plans. The timing and amount of repurchase transactions will be determined by our management based on its evaluation of market conditions, share price, legal requirements and other factors. The program may be suspended, modified or discontinued at any time without prior notice. We caution that there are no assurances that any further repurchases will actually occur. We had 97.9 million shares of Class A Common Stock outstanding as of June 30, 2012.

Our U.S. registered broker-dealers are subject to regulatory requirements intended to ensure the general financial soundness and liquidity of broker-dealers and futures commission merchants (“FCM”) and require the maintenance of minimum levels of net capital, as defined in SEC Rule 15c3-1 as well as other capital requirements from several commodity organizations including the Commodities Futures Trading Commission (“CFTC”) and the National Futures Association (“NFA”). These regulations also prohibit a broker-dealer from repaying subordinated borrowings, paying cash dividends, making loans to its parent, affiliates or employees, or otherwise entering into transactions which would result in a reduction of its total net capital to less than 120% of its required minimum capital. Moreover, broker-dealers are required to notify the SEC, CFTC and other regulators prior to repaying subordinated borrowings, paying dividends and making loans to its parent, affiliates or employees, or otherwise entering into transactions, which, if executed, would result in a reduction of 30% or more of its excess net capital (net capital less minimum requirement). The SEC and the CFTC have the ability to prohibit or restrict such transactions if the result is detrimental to the financial integrity of the broker-dealer. As of June 30, 2012, all of our broker-dealers were in compliance with the applicable regulatory net capital rules.

The following table sets forth the net capital levels and requirements for the following significant regulated U.S. broker-dealer subsidiaries at June 30, 2012, as reported in their respective regulatory filings (in millions):

 

Entity

   Net Capital      Net Capital
Requirement
     Excess Net
Capital
 

Knight Capital Americas, L.P.

   $         198.1       $         1.0       $         197.1   

Knight Execution & Clearing Services LLC

     93.7         20.7         73.0   

 

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Effective as of the close of business on June 30, 2012, we merged our broker-dealer subsidiary Knight Capital Americas, L.P. into Knight Execution & Clearing Services LLC (“KECS”) with KECS as the surviving entity and only U.S. broker-dealer. KECS was then immediately renamed Knight Capital Americas LLC and remains an indirect, wholly-owned subsidiary of Knight Capital Group, Inc.

Our foreign registered broker-dealers are subject to certain financial resource requirements of either the Financial Services Authority (“FSA”) or the Securities and Futures Commission (“SFC”). The following table sets forth the financial resource requirement for the following significant foreign regulated broker-dealer at June 30, 2012 (in millions):

 

Entity

   Financial
Resources
     Resource
Requirement
     Excess Financial
Resources
 

Knight Capital Europe Limited

   $         130.8       $         46.6       $         84.2   

Off-Balance Sheet Arrangements

As of June 30, 2012, we did not have any off-balance sheet arrangements, as defined in Item 303(a) (4) (ii) of SEC Regulation S-K.

Effects of Inflation

Because the majority of our assets are liquid in nature, they are not significantly affected by inflation. However, the rate of inflation may affect our expenses, such as employee compensation, office leasing costs and communications expenses, which may not be readily recoverable in the prices of the services offered by us. To the extent inflation results in rising interest rates and has other adverse effects on the securities markets, it may adversely affect our financial position and results of operations.

Critical Accounting Policies

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

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

The fair value hierarchy can be summarized as follows:

 

   

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

 

 

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

 

   

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

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

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

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

As discussed in Footnote 9 “Long-Term Debt,” included in Part I, Item 1 “Financial Statements” of this Form 10-Q, we entered into purchased call options and recorded an embedded conversion derivative concurrent with our issuance of the Notes. The fair value of these options and derivative are determined using an option pricing model based on observable inputs such as implied volatility of our common stock, risk-free interest rate, and other factors and, as such, are classified within Level 2 of the fair value hierarchy.

Our loan inventory including securitized HECM loan inventory, foreign currency forward contracts, investment in the Deephaven Funds, deferred compensation investments and certain mortgage-backed securities are also classified within Level 2.

Certain instruments are classified within Level 3 of the fair value hierarchy because they trade infrequently and therefore have little or no price transparency. For those instruments that are not traded in active markets or are subject to transfer restrictions, valuations are adjusted to reflect illiquidity and/or non-transferability, and such adjustments are generally based on available market evidence. In the absence of such evidence, management’s best estimate is used. As of June 30, 2012 and December 31, 2011, we did not hold any financial instruments that met the definition of Level 3.

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

Securitization activities – We securitize HECMs under our GNMA issuance authority. Securitization and transfer of financial assets are generally accounted for as sales when an issuer has relinquished control over the transferred assets. Based upon the current structure of the GNMA securitization program, we believe that we have not met the GAAP criteria for relinquishing control over the transferred assets and therefore our securitizations fail to meet the GAAP criteria for sale accounting. As such, we continue to recognize the HECMs in Financial instruments owned, at fair value, and we recognize a corresponding liability in Liability to GNMA trusts, at fair value on the Consolidated Statements of Financial Condition.

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

 

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Goodwill

Goodwill of $344.5 million at June 30, 2012 primarily relates to our Institutional Sales and Trading and Electronic Execution Services segments. We test the goodwill in each of our reporting units for impairment at least annually by comparing the estimated fair value of each reporting unit with its estimated net book value. We derive the fair value of each of our reporting units based on valuation techniques we believe market participants would use for each segment (observable price-to-book multiples and discounted cash flow analyses) and we derive the net book value of our reporting units by estimating the amount of shareholders’ equity required to support the activities of each reporting unit. As part of our test for impairment, we also consider the profitability of the applicable reporting unit as well as our overall market value, compared to our book value. We performed our annual test for impairment of goodwill in the second quarter of 2012 and determined that goodwill was not impaired at that time.

Intangible Assets

Intangible assets, less accumulated amortization, of $88.5 million at June 30, 2012 are primarily attributable to our Institutional Sales and Trading and Electronic Execution Services segments. We amortize these assets, which primarily consist of customer relationships on a straight-line basis over their useful lives, the majority of which have been determined to range from two to 20 years. We test amortizable intangibles for recoverability whenever events indicate that the carrying amounts may not be recoverable.

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

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

We maintain a deferred compensation plan related to certain employees and directors. This plan provides a return to the participants based upon the performance of various investments. In order to hedge our liability under this plan, we generally acquire the underlying investments and hold such investments until the deferred compensation liabilities are satisfied. We record changes in the values of such investments in Investment income and other, net, with a corresponding charge or credit to Employee compensation and benefits on the Consolidated Statements of Operations.

Market Making, Sales, Trading and Execution Activities – Financial instruments owned and Financial instruments sold, not yet purchased, which relate to market making and trading activities, include listed and OTC equity securities, listed equity options and fixed income securities which are recorded on a trade date basis and carried at fair value. Net trading revenue (trading gains, net of trading losses) and commissions (which includes commission equivalents earned on institutional client orders, futures transactions, and HECM loan originations and securitization activities) and related expenses are also recorded on a trade date basis. Our third party clearing agreements call for payment or receipt of interest income, net of transaction-related interest charged by clearing brokers for

 

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facilitating the settlement and financing of securities transactions. The Company also nets interest income on its securitized HECM loan inventory against interest expense on its liability to GNMA trusts.

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

Lease Loss Accrual – It is our policy to identify excess real estate capacity and where applicable, accrue for related future costs, net of estimated sublease income.

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

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

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

We estimate and accrue for potential losses that may arise out of litigation and regulatory proceedings to the extent that such losses are probable and can be estimated. Significant judgment is required in making these estimates and our final liabilities may ultimately be materially different. Our total liability accrued with respect to litigation and regulatory proceedings is determined on a case-by-case basis and represents an estimate of probable losses based on, among other factors, the progress of each case, our experience and industry experience with similar cases and the opinions and views of internal and external legal counsel. Giv