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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2001
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
001-14223
Commission File Number
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KNIGHT TRADING 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)
525 Washington Boulevard, Jersey City, NJ 07310
(Address of principal executive offices and zip code)
Registrant's telephone number, including area code: (201) 222-9400
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Securities registered pursuant to Section 12(b) of the Act:
None.
Securities registered pursuant to Section 12(g) of the Act:
Class A Common Stock, $0.01 par value
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 if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to
this Form 10-K. [_]
The aggregate market value of the Class A Common Stock held by nonaffiliates
of the Registrant was approximately $716,565,769 at March 25, 2002 based upon
the closing price for shares of the Registrant's Class A Common Stock as
reported by the National Market System of the Nasdaq Stock Market on that date.
For purposes of this calculation, affiliates are considered to be officers,
directors and holders of 10% or more of the outstanding common stock of the
Registrant.
At March 25, 2002 the number of shares outstanding of the Registrant's Class
A Common Stock was 124,214,113 and there were no shares outstanding of the
Registrant's Class B Common Stock as of such date.
DOCUMENTS INCORPORATED BY REFERENCE
Definitive Proxy Statement relating to the Company's 2002 Annual Meeting to be
filed hereafter (incorporated into Part III hereof).
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KNIGHT TRADING GROUP, INC.
FORM 10-K ANNUAL REPORT
For the Fiscal Year Ended December 31, 2001
TABLE OF CONTENTS
PART I
Item 1. Business............................................................................. 3
Item 2. Properties........................................................................... 15
Item 3. Legal Proceedings.................................................................... 15
Item 4. Submission of Matters to a Vote of Security Holders.................................. 16
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters................ 16
Item 6. Selected Financial Data.............................................................. 17
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 18
Item 7A. Quantitative and Qualitative Disclosures About Market Risk........................... 37
Item 8. Financial Statements and Supplementary Data.......................................... 40
Item 9. Changes in and Disagreements With Accountants on Accounting and
Financial Disclosures................................................................ 61
PART III
Item 10. Directors............................................................................ 61
Item 11. Executive Compensation............................................................... 61
Item 12. Security Ownership of Certain Beneficial Owners and Management....................... 61
Item 13. Certain Relationships and Related Transactions....................................... 61
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K...................... 61
Exhibit Index................................................................................. 61
Signatures.................................................................................... 62
2
UNLESS THE CONTEXT OTHERWISE REQUIRES, THE "COMPANY," "KNIGHT", "WE", OR "OUR"
SHALL MEAN KNIGHT TRADING GROUP, INC. AND ITS WHOLLY-OWNED SUBSIDIARIES.
CERTAIN STATEMENTS CONTAINED IN THIS ANNUAL REPORT ON FORM 10-K AND THE
DOCUMENTS INCORPORATED BY REFERENCE, INCLUDING WITHOUT LIMITATION, STATEMENTS
CONTAINING THE WORDS "BELIEVES", "INTENDS", "EXPECTS", "ANTICIPATES" AND WORDS
OF SIMILAR IMPORT, CONSTITUTE "FORWARD-LOOKING STATEMENTS" WITHIN THE MEANING
OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995. THESE FORWARD-LOOKING
STATEMENTS ARE BASED ON CURRENT EXPECTATIONS, ESTIMATES AND PROJECTIONS ABOUT
THE COMPANY'S INDUSTRY, MANAGEMENT'S BELIEFS AND CERTAIN ASSUMPTIONS MADE BY
MANAGEMENT. 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. SINCE SUCH
STATEMENTS INVOLVE RISKS AND UNCERTAINTIES, THE ACTUAL RESULTS AND PERFORMANCE
OF THE COMPANY MAY TURN OUT TO BE MATERIALLY DIFFERENT FROM THE RESULTS
EXPRESSED OR IMPLIED BY SUCH FORWARD-LOOKING STATEMENTS. GIVEN THESE
UNCERTAINTIES, READERS ARE CAUTIONED NOT TO PLACE UNDUE RELIANCE ON SUCH
FORWARD-LOOKING STATEMENTS. UNLESS OTHERWISE REQUIRED BY LAW, THE COMPANY ALSO
DISCLAIMS ANY OBLIGATION TO UPDATE ITS VIEW OF ANY SUCH RISKS OR UNCERTAINTIES
OR TO ANNOUNCE PUBLICLY THE RESULT OF ANY REVISIONS TO THE FORWARD-LOOKING
STATEMENTS MADE IN THIS REPORT; HOWEVER, READERS SHOULD CAREFULLY REVIEW THE
RISK FACTORS SET FORTH HEREIN, IN OTHER REPORTS OR DOCUMENTS THE COMPANY FILES
FROM TIME TO TIME WITH THE SECURITIES AND EXCHANGE COMMISSION. THIS DISCUSSION
SHOULD BE READ IN CONJUNCTION WITH THE COMPANY'S CONSOLIDATED FINANCIAL
STATEMENTS AND THE NOTES THERETO CONTAINED IN THIS REPORT.
PART I
Item 1. Business
Overview
Knight Trading Group, Inc., a Delaware corporation, and its subsidiaries
(collectively "Knight" or the "Company") operate in two business segments:
wholesale securities market-making and asset management. We are the leading
wholesale equities market maker in The Nasdaq Stock Market ("Nasdaq") and the
Nasdaq Intermarket in the U.S., and, during the past two years, we have
established majority-owned wholesale equity market-making operations in Europe
and Japan. The Company also operates a leading listed options market-making
business and a professional options execution business in the U.S. Through our
Deephaven Capital Management LLC ("Deephaven") subsidiary, we also operate an
asset management business for institutions and high net worth individuals.
In the midst of changes in the securities industry in the early-1990's, our
founders developed a vision of the next-generation business model for
market-making. The business model required a focus on client service,
technology and operating efficiencies resulting from high trading volumes. In
1995, our founders' vision materialized with the establishment of Knight
Securities, L.P. ("KS"), and the acquisition of Knight Capital Markets LLC
("KCM"). Through KS, we make markets in equity securities in Nasdaq and on the
OTC Bulletin Board of the National Association of Securities Dealers, Inc.
("NASD"). Through KCM, we make markets in the Nasdaq Intermarket, which is the
over-the-counter market in exchange-listed equity securities, primarily those
listed on the New York Stock Exchange ("NYSE") and the American Stock Exchange
("AMEX"). Since our inception, we have experienced significant growth in market
share for our equity market-making services. Our dedication to providing
quality executions allowed us to expand quickly our client base during the
rapid increase of on-line investing that occurred during this time. Although
retail on-line investing has decreased since mid-2000, we have maintained our
industry-leading market share in the equity markets in which we participate.
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In 2000, we entered the options market-making and asset management
businesses by acquiring Arbitrade Holdings LLC ("Arbitrade"). We subsequently
renamed the options market-making business Knight Financial Products LLC
("KFP") and retained the Deephaven name for our asset management business. KFP
is a leading equity options market maker in the U.S. and Deephaven sponsors a
private investment fund with over $1.2 billion in assets under management as of
December 31, 2001. We also entered international markets in 2000 and 2001 by
establishing majority-owned wholesale equities market-making operations in
Japan and Europe, respectively.
For the year ended December 31, 2001, we had revenues of $684.7 million, a
46% decrease from 2000 revenues of $1,257.3 million. Our pre-tax income
decreased to $54.3 million in 2001, an 87% decrease over 2000 pre-tax income of
$418.5 million. In 2001, we executed 117.3 million U.S. equity trades and
traded 135.0 billion U.S. equity shares, down from 142.7 million trades and up
from 112.1 billion shares in the prior year.
Wholesale Market-Making
Equity Industry Background
Over the last five years, the U.S. market for equity securities has
experienced strong growth in trading volumes. The increase in trading volumes
resulted from a number of factors, including increased cash flows into
equity-based mutual funds, historic high returns in U.S. equity markets, the
emergence and rapid growth of on-line discount brokers and retail investor
participation, technological innovations, like the emergence of the Internet,
and reduced transaction costs.
Market makers provide trade executions by offering to buy securities from,
or sell securities to, broker-dealers and institutions. Market-making firms
that have elected to make a market in securities, display the prices at which
they are willing to bid, meaning buy, or ask, meaning sell, these securities
and adjust their bid and ask prices in response to the forces of supply and
demand for each security. Traditionally, market makers were either internal
departments within larger, diversified securities firms focused on a limited
range of securities to support their investment banking and research
departments, or independent businesses. Many discount brokers and on-line
brokers did not have internal market-making functions and, accordingly, relied
entirely on third-party market makers for order execution. This trend has
changed over time as discount brokers, large diversified securities firms and
on-line brokers have either acquired market-making firms or expanded the number
of stocks in which they make markets.
A market maker acts as principal and derives revenues from the difference
between the price paid when securities are bought and the price received when
those securities are sold. In the past, market makers relied on the spreads
between bid and ask prices to ensure profitability and built cost structures
based on these spreads. However, recent changes in regulations governing the
securities industry and the recent adoption of decimalization and the resulting
one-penny minimum price variant ("MPV") have reduced average spreads. Trading
in decimal prices became fully implemented in NYSE and AMEX listed securities
in January 2001 and in Nasdaq markets in April 2001. A June 11, 2001 study
conducted by Nasdaq Economic Research demonstrated that effective spreads
contracted by 46% in the first month of decimalization, greater than the
original projections of a 10% contraction.
In this narrow spread environment, maintaining profitability has become
extremely difficult for many market makers. To remain profitable, market makers
must execute a larger volume of trades and maintain increased inventory
positions. Large volumes of trading provide an opportunity to spread fixed
costs over a larger number of trades. However, increases in trading volumes are
only a benefit for the market maker if its cost per trade is lower than its
revenue per trade and if the market maker is able to manage the risks
associated with larger inventory positions. As net profit per trade in the
industry has significantly declined with the advent of decimalization and the
one-penny MPV, market makers have had to rely on inventory management expertise
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versus spread trading, a practice made more challenging in the current market
environment given the lack of directionality in the markets.
Over the course of the last year, competition for order flow in the U.S.
equity markets has intensified due to the implementation of the Securities and
Exchange Commission ("SEC") Rules 11Ac1-5 and 11Ac1-6. These rules add greater
disclosure to execution quality and order-routing practices. Rule 11Ac1-5
requires market centers that trade national market system securities to make
available to the public monthly electronic reports that include uniform
statistical measures of execution quality on a security-by-security basis. Rule
11Ac1-6 requires broker-dealers that route equity and option orders on behalf
of their customers to make publicly available quarterly reports that describe
their order routing practices and disclose the venues to which customer orders
are routed for execution. These statistics on execution quality vary by order
sender based on their mix of business. This rule also requires the disclosure
of payment for order flow arrangements as well as internalization practices.
Given an order entry firm's fiduciary requirement to seek to obtain best
execution for their clients' orders, competition for order flow is now based
more on the demonstrable quality of executions and less on personal
relationships with other firms. To compete effectively today for order flow, we
and our competitors are focusing more than ever on these statistical
measurements of quality of order execution, which encompasses the price, speed
and size of executions.
Options Industry Background
Before 1999, most actively traded U.S. equity options classes were listed on
only one options exchange, giving brokers no choice of routing destinations for
their options orders. Since mid-1999, the U.S. equity options markets have
undergone significant change.
In August 1999, the options exchanges began to aggressively compete with
each other by listing options that had previously traded exclusively on only
one exchange, giving brokers a choice of where to send their customers' orders.
Accordingly, exchanges and their members began competing intensely for those
orders. This competition has taken many forms, including faster and more
reliable executions, lower transaction costs, and increased liquidity at the
displayed quotes. Competition also has been heightened by the entry in year
2000 of the first new options exchange in 27 years, the International
Securities Exchange. Competition has produced a variety of results, including
the narrowing of spreads.
With increased competition for options order flow, options market liquidity
providers, like KFP and participants in the equities markets, have offered
direct and indirect economic inducements to brokers in return for brokers
agreeing to route their customers' order flow to them. These economic
inducements have generally taken the form of payment for order flow and
reciprocal order routing agreements. Economic inducements to attract order flow
have made it more expensive to transact business in the options markets. Other
factors have also contributed to increased competition in the options markets,
such as "internalization" of retail options orders, i.e., firms trading as
counterparties with their customer orders, or firms routing to affiliated
specialists.
In addition, over the past year the options industry has seen significant
consolidation. Today, fewer options market liquidity providers exist. However,
the largest options market liquidity providers have increased their percentage
share of the options market. KFP is one of these liquidity providers in the
options markets.
The Knight Trading Group Market-Making Strategy
Since inception, Knight's market-making business model has been focused on
providing competitive best execution services, managing risk profitably,
maintaining efficient and reliable trading technology, and providing
high-quality client services. This model has enabled Knight to achieve
economies of scale and operating efficiencies.
5
The main elements of our strategy include:
. Competitive Best Execution Services
We have implemented a variety of best execution practices that provide our
clients with timely and competitive executions. These practices include, but
are not limited to, price improvement, continuous liquidity, speed of
executions for market orders and high fulfillment rate plus rapidity of
executions for limit orders. As required by SEC Rule 11Ac1-5, we post our
aggregated execution quality statistics for our domestic equities business on
our website on a monthly basis. These statistics indicate that our execution
quality is highly competitive in the marketplace.
. Maintaining Efficient and Reliable Trading Technology
We rely heavily on technology to facilitate our market-making activities.
KS, KSIL (defined herein) and KSJ (defined herein) use the BRASS(R) trading
system under license from SunGard Trading Systems (formerly known as Automated
Securities Clearance). BRASS(R) is used by approximately 250 market makers. KS
and KSIL are one of a small number of BRASS(R) users to run BRASS(R) on their
own computers with their own personnel, while other market makers, and our KSJ
subsidiary, use SunGard Trading Systems as a service bureau. KCM employs a
TCAM/Appletree trading system. KFP has developed its own proprietary trading
and risk management systems.
We have made significant investments in our technology platform and
infrastructure since our inception. Our equity market-making trading systems
are augmented by software applications that enable the processing of a large
volume of order flow efficiently, without diminishing speed of execution. Our
equity market-making systems are designed to process up to 1.5 million trades
per day. This capacity assumes an even distribution of trading activity
throughout the day; however, our systems may experience processing delays
during peak volume periods that result from heavy trading activity. We continue
to invest in technology to further enhance our processing capability, as we
believe that the market-making business will continue to be driven by firms
that recognize the importance of scale. Our ability to process large volumes of
trades at a decreasing cost will be crucial to generating profits.
. Managing Risk Profitably
Our net trading revenues are dependent on our ability to evaluate and act
rapidly on market trends and to manage risk profitably. Our methodology focuses
on the dynamic, real-time analysis of market activity and price movements,
which enables us to manage risk better. Throughout the business day, we
continually analyze our trading positions in individual securities and monitor
our short and long positions and our aggregate profits and losses. Management
uses this information to assess market trends and adjust its trading strategy
on a real-time basis in an effort to maximize its trading profits.
. Commitment to High Quality Client Service
We are committed to providing high quality client service. We believe that
our highly skilled, experienced and entrepreneurial workforce can effectively
address the needs of our clients. Our client service group is dedicated to
handling orders greater than the automated execution size and ensuring
consistent quality of execution. We are also actively expanding our product
offerings to institutions.
Market-Making Subsidiaries
The majority of our revenues come from our wholesale market-making
operations in the U.S. Our international market-making businesses are in
developmental stages, and have not been profitable to date.
6
Domestic Market-Making
Knight Securities, L.P.
KS is the largest wholesale market maker operating in Nasdaq. KS is a
broker-dealer registered with the Securities and Exchange Commission ("SEC")
and is also a member of the NASD. KS is the largest of the Company's
subsidiaries and provides the majority of our revenues. The majority of KS
revenues come from net trading revenues, which is derived from executing retail
and institutional order flow on a principal basis.
Based on rankings published by The AutEx Group, a widely recognized industry
reporting service that publishes daily trading volume and market share
statistics reported by market makers, KS achieved a #1 market share ranking of
volume in Nasdaq/OTC securities for the first time in February 1998. KS has
continued to maintain this #1 ranking. While our trading volumes have declined
from their peak highs in late 1999 and early 2000 as retail trading levels have
fallen, our share volumes have increased due to lower prices for securities as
a result of the overall decline in the equities markets. For 2001, KS share
volume in U.S. equity shares was 110.9 billion or 82% of our total U.S. equity
share volume.
Over the last 18 months, KS's profitability has been negatively impacted by
the downturn in the U.S. economy and market structure changes. The downturn in
the U.S. economy in 2000 and 2001 affected retail investor participation in the
equity markets. As a result, a higher percentage of KS orders came from
professional traders and investors, which traditionally have a lower revenue
capture per equity share than retail investor order flow. Our profitability has
also been negatively impacted by lower share prices as a result of the overall
decline in the equities markets. In addition, in 2001 a significant market
structure change was introduced into the marketplace. The U.S. equity markets
began trading in decimals, instead of the traditional fractions. The
introduction of decimal pricing led to the narrowing of bid/offer spreads to a
one-penny MPV creating less profit opportunity.
As a result of these two factors, we have focused on adapting our trading
methodologies to reflect these market structure changes and increasing our
revenues from institutional trading. Historically, institutional order flow has
had a higher revenue capture per share than retail order flow. In the future,
KS intends to continue to expand its institutional sales force to increase its
penetration into the leading U.S. institutions and to expand the variety of
products and services that we offer clients.
Knight Capital Markets LLC
KCM, formerly Trimark Securities, Inc., is the largest Nasdaq Intermarket
trading firm. KCM is a broker-dealer registered with the SEC and is also a
member of the NASD.
According to the NASD, KCM has held the #1 market share ranking in the
trading of the over-the-counter market for NYSE-listed securities in the Nasdaq
Intermarket since 1998. According to the NASD, KCM has also held the #1 market
share ranking in the trading of the over-the-counter market for AMEX-listed
securities in the Nasdaq Intermarket since 1998. For 2001, KCM share volume in
U.S. equity shares was 24.1 billion or 18% of our total U.S. equity share
volume. In addition, based on information published by The AutEx Group for
December 2001, we had a 8.74% market share and were ranked #3 in listed block
volume. KCM's trade and share volumes increased in 2001 primarily due to the
overall lower prices of listed equity securities. KCM also faced the same
economic and market structure challenges that impacted KS in 2001, as described
above.
Knight Financial Products LLC
KFP is a leading U.S. equity options market maker, and has a strong presence
on all five of the U.S. options exchanges. KFP is also a founding member of the
International Securities Exchange, the first electronic options exchange in the
U.S. KFP makes markets in listed options on individual equities, equity indices
and fixed income futures instruments in the U.S. We are in the process of
closing our small options market-making operations in Europe and Australia as
they were not profitable and were non-core to our business strategy.
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Volume in KFP trading posts nearly doubled in 2001, rising from 5.3% of the
volume of domestic option contracts to 9.9% at year-end. This increase was
primarily due to KFP adding 193 option classes to its specialist posts in 2001
resulting from its specialist post acquisitions during the year. Since our
acquisition of KFP, KFP has acquired a total of 342 option classes and now
provides options market-making in approximately 570 options classes, which
cover more than half of all equity option order flow on all five U.S. options
exchanges. We expect further consolidation to occur in the options industry in
2002, as evidenced already by the recent acquisitions by TD Bank Financial
Group of LETCO and Stafford. As a result of these acquisitions, KFP is now the
fourth largest U.S. equity options market maker (at the end of 2001, KFP was
the third largest U.S. equity options market maker).
KFP's trading volume in listed options grew by over 75% in 2001. KFP's
trading volume increased to 37.4 million U.S. option contracts in 2001 from
21.4 million U.S. option contracts in 2000. Due to lower underlying prices of
equities, and increased competition, revenue per option contract declined in
2001. We expect revenue per option contract to continue to decline as
consolidation continues. We will continue to evaluate our operations and cost
structure in light of this decline in revenue per option contract.
KFP is a broker-dealer registered with the SEC. KFP is also a member of the
Chicago Board Options Exchange, the American Stock Exchange, the Pacific
Exchange, the Philadelphia Stock Exchange, the International Stock Exchange,
the Chicago Board of Trade and the Chicago Mercantile Exchange.
Knight Execution Partners LLC
In 2000, we purchased the professional options execution services business
from Mesirow Financial, which we subsequently renamed Knight Execution Partners
LLC ("KEP"). KEP is a broker-dealer registered with the SEC and is also a
member on all five U.S. options exchanges.
Acting as a broker, KEP routes client options order flow to all five options
exchanges, including those options in which KFP acts as a specialist. KEP
provides its domestic and foreign broker-dealer clients and institutions with
best execution for their retail order flow, at the most appropriate venue for
each order. KEP's revenue streams have changed considerably over the past year.
When we purchased this business, KEP charged its clients for providing best
execution and order routing services. During late 2000 and early 2001,
competitive pressures in the U.S. options marketplace forced KEP to drastically
reduce the order routing fees it charges third parties. KEP's main revenue
source at the present time is to receive rebates from KFP and other execution
destinations for routing option order flow. While this entity was profitable
when we purchased it in 2000, these competitive changes have greatly reduced
the profit potential from operating this business, and we expect KEP to
continue to operate this business as an additional service to support KFP's
business.
International Market-Making
Knight Roundtable Europe Limited
In 2001, we established a European market-making venture, named Knight
Roundtable Europe Limited ("KREL"), with 21 pan-European and U.S. banks and
broker-dealers, who contributed a total of $29.6 million. We also contributed
$29.6 million in cash and our UK broker-dealer, Knight Securities International
Ltd. ("KSIL"), to the venture in exchange for an approximate 85% ownership
stake. KREL's sole business is to own and operate KSIL. KSIL provides wholesale
market-making services primarily in UK equity securities and routes U.S. equity
orders to KS for execution.
At the time we established KREL, we anticipated that the significant growth
in the U.S. equity markets and, specifically, on-line retail trading would
expand to the European equity markets. However, this growth did not materialize
as planned, and trading volumes were significantly lower than anticipated. As a
result, our initial infrastructure investment proved to be oversized for the
market conditions. As a result of lower volumes and difficult market
conditions, we incurred operating losses throughout the first half of 2001. We
responded in the
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second half of 2001 by scaling back our infrastructure and reducing our
European workforce by 43 percent to 110 people. In addition, we reduced the
number of European and UK stocks in which we make markets to approximately 650
from over 1,100 in mid-2001. Despite these expense reductions, we continued to
experience losses through the second half of 2001 and to the present time. We
will continue to reassess our investment in Europe based on market conditions
and our financial performance.
KSIL is regulated by the Financial Services Authority and is a member of the
London Stock Exchange, Deutsche Borse and Nasdaq Europe.
Knight Securities Japan Ltd.
In the third quarter of 2000, we established a joint venture operation with
Nikko Cordial Group ("Nikko") to provide wholesale market-making services in
Japanese equity securities. This entity, called Knight Securities Japan Ltd.
("KSJ"), is registered as a securities firm in accordance with Japanese
Securities and Exchange Law. KSJ combines our technology and trading expertise
with the regulatory and market expertise, cultural insight and management
experience of Nikko. We own 60% of this joint venture.
KSJ commenced trading Jasdaq equity securities in December 2000. Jasdaq is a
relatively small exchange which trades in both market-making and auction
markets. There are 336 Jasdaq stocks in which market-making occurs and 589
names in the auction market. Currently, we are a leading market maker on
Jasdaq. We recently announced that Matsui Securities Co., Ltd. ("Matsui") will
route to KSJ its orders for Jasdaq stocks that require market-making. Matsui is
the first non-affiliated securities firm that will electronically send to KSJ
its Jasdaq market-making orders via a host-to-host connection. We also intend
to develop a number of additional direct electronic links to other securities
firms in 2002. KSJ has also invested in Nasdaq Japan and plans to be a founding
market maker upon its launch. KSJ's current investment is carried at
approximately $3.7 million. The launch date for Nasdaq Japan has been delayed.
As a result of this delay, Nasdaq Japan's financial performance to date, and
uncertainty about the future prospects of Nasdaq Japan, KSJ may have to
writedown all, or a portion, of its investment. Ultimately, KSJ anticipates
that it will expand its market-making services to stocks traded on additional
Japanese equity markets, dependent upon changes to current Japanese market
regulations.
Since trading commenced, the market environment in Japan has been very
challenging. In addition, market structure changes (the movement towards
market-making and the introduction of best execution practices) have been slow
to occur. As a result, we have experienced losses at KSJ through the present
time. KSJ's future profitability will be largely dependent upon improved market
conditions and market structure changes, and until market conditions improve in
Japan, and market structure changes occur, we believe the profitability outlook
for KSJ is modest. We will continue to reassess our investment in Japan based
on market conditions and our financial performance.
Asset Management
Deephaven Capital Management LLC
Deephaven performs investment management and sponsors a private investment
fund. Managing a market neutral portfolio, it offers institutions,
fund-of-funds, pension plan sponsors, trusts, endowments and high net worth
individuals access to a variety of investment strategies focused on
sophisticated arbitrage trading (convertible, statistical and risk), volatility
trading and private placements. The managed portfolio has historically had a
low correlation to the equities markets but its returns are primarily dependent
upon equity trading volumes, equity volatility, mergers and acquisitions and
secondary offering activity in the capital markets.
In 2001, the managed fund generated a return to investors of 11.5% and ended
the year with approximately $1.2 billion in assets. The return for 2001
exceeded the benchmark for Deephaven's peer group, Zurich Market Neutral
Arbitrage Median, which returned 4.75% during the same period. These results
were earned despite low
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IPO and M&A activity that existed throughout 2001. The Company was an investor
in the fund throughout 2001. As of April 1, 2002, the Company's investments in
the fund will comprise approximately 11% of the total assets under management.
Clients
In the equities market-making industry, our clients include global,
national, and regional full-service broker-dealers, discount brokers,
institutions and electronic communication networks. Our goal is to provide
these clients with quality and competitive executions that enables them to
satisfy their fiduciary duties to their customers to seek and obtain the best
execution reasonably available in the marketplace. Consequently, our executions
typically occur at the national best bid or offer ("NBBO"), or better.
A key focus in our market-making business is institutional money managers,
who manage mutual funds, pension plans, trusts and endowments. Due to the size
of the orders involved, institutional orders generally are more profitable than
retail orders. As a result, we intend to continue growing our institutional
sales force to support our growing institutional client base.
In 2001, our largest client accounted for 10.9% of the Company's U.S. equity
order flow in 2001 as measured in U.S. equity share volume. No other client
accounted for over 10% of our equity order flow as measured in share volume.
In the asset management segment, our clients include institutions, fund of
funds, pension plan sponsors, trusts, endowments and high net worth
individuals. No one investor accounted for 10% or more of the fund assets.
However, as of April 1, 2002, we anticipate that our investment in the fund
will comprise approximately 11% of the assets under management.
Marketing
We seek to increase our market share through print advertising, advertising
on our Web site and a public relations program. Our marketing focuses on
advertising our execution services in publications targeted at the securities
industry. From time to time, we may choose to increase our advertising to
target specific groups of clients or to decrease advertising in response to
market conditions.
We also market aggressively through one-on-one meetings with clients and
potential clients, and continuous communications with existing clients. Our
marketing strategy on the market-making front is to continue to differentiate
Knight from competitors by enhancing its reputation and brand as the provider
of quality and competitive execution solutions and liquidity with high quality
client service. On the asset management side, we differentiate ourselves
through our proven track record of strong fund returns.
We also sponsor the Knight Senior Advisory Committee, which is a committee
of senior securities industry professionals who meet to discuss operational
procedures, strategic direction and their trading partnerships with us. During
these meetings, we attempt to enhance communications between firms and address
our clients' concerns, questions and ideas.
Clearing Arrangements
In October 1999, KS began clearing all of its trades through Broadcort
Clearing Corp., a subsidiary of Merrill Lynch & Co. The contract between the
parties will remain in effect until terminated by either party upon sixty days'
prior written notice or upon thirty days' written notice in certain limited
circumstances. KSIL clears through Merrill Lynch International, also a
subsidiary of Merrill Lynch & Co. The contract between the parties will remain
in effect until the earlier of July 2003 or until specified gross payments are
paid by KSIL to Merrill Lynch International. KCM clears all of its trades
through National Investor Services Corp., a subsidiary of
10
TD Waterhouse Group, Inc. The contract will remain in effect until terminated
by either party upon sixty days' prior written notice. KFP clears the majority
of its trades through First Options of Chicago, a subsidiary of Goldman Sachs
Group, Inc.
Technology
Our success is largely attributable to management's ability to identify and
deploy emerging technologies that facilitate the execution of trades. Not only
has technology enhanced our ability to handle order flow, it has also been an
important component of our strategy to comply with government regulations,
achieve competitive execution standards and provide high-quality client
service. We use our proprietary technology and technology licensed from third
parties to monitor the performance of our traders, to assess our inventory
positions and to provide ongoing information to our clients. We are
electronically linked to our broker-dealer and institutional clients through
dedicated circuits. Our trading volume is transacted over dedicated
communications networks, which provide immediate access to our trading
operations and facilitate the handling of client orders. We plan to continue to
make additional investments in technology and to further automate our execution
services.
Architectural Design and Industry Standards. Our systems are designed to be
open, interoperable, scalable, redundant and flexible. We utilize leading edge
technologies including Sun Microsystems, Inc.'s operating system and hardware,
C/C++ programming languages, Java, relational database management systems and
on-line analytical processing.
Electronic Commerce. Our electronic commerce architecture enables our
broker-dealer and institutional clients to send their orders through a variety
of electronic communications gateways, including the Internet and direct client
interfaces over our private network. Our clients can use their own order
management system, an institutional portfolio management system or can select
from a variety of electronic connection protocols.
Trading Systems. KS, KSIL and KSJ use versions of the BRASS(R) trading
system designed by SunGard. This system has a client/server architecture that
uses Sun Microsystems, Inc. workstations and servers. KS, KSIL and KSJ run a
local version of BRASS(R). KS, KSIL and KSJ also make extensive use of
application program interfaces, commonly known as APIs, to develop proprietary
analytics that integrate with our trading systems.
KCM uses the Appletree trading system designed by TCAM. This system runs on
Stratus Computer Inc.'s fault tolerant platform. KCM has also developed
software applications using APIs.
KFP uses an inhouse developed proprietary system to make markets in options
traded on all five options exchanges in the U.S. The system supports screen
based trading as well as floor trading.
Portal. Our business to business portal provides our clients with an array
of web-based tools to interact with our trading systems. Broker-dealers, both
foreign and domestic, use this portal to send us order flow, access reports and
use the other tools it offers to facilitate their business.
Institutional Sales Technology. Our integrated institutional sales
technology platform consists of an order management system for the entry,
management and routing of institutional orders, a system for the simultaneous
distribution of indications of interest and trade advertisements to various
sources, and a rules-based trade allocation matching engine to receive
allocation instructions from clients and automate post-trade processing.
Disaster Recovery Center. A disaster recovery facility is being designed at
KCM's current site in Purchase, New York to provide back-up and disaster
recovery capability. The Purchase site will initially be a "warm" site that has
limited real-time production capability. Ultimately, this facility will run a
"hot" real-time copy of all our trading data and provide back-up real-time
operations to support our trading floors in Jersey City. This site will also
have the ability to host a production system as well as facilities to support
up to 75 of our traders on-site. In addition, all required connectivity
(client, market data, clearing and market centers) will be available to ensure
business continuity in the event of a disaster or major system malfunction.
11
Originally, we had planned to construct a disaster recovery center in
Fairfield, New Jersey. However, we believe that the Purchase location is more
cost-effective and offers more advantages to the Company. As a result, we are
currently exploring subletting all or part of the Fairfield premises.
Competition
Through 2001, we derived substantially all of our revenues from
market-making and asset management activities. The market for these services is
rapidly evolving and intensely competitive. We have seen an increase in
competition during the past few years and we expect competition to continue and
intensify in the future. KS competes primarily with wholesale global, national,
and regional broker-dealers, as well as alternative trading venues, such as
electronic communications networks ("ECNs"). KCM competes with the NYSE, the
AMEX, regional exchanges, other broker-dealer competitors and ECNs. KFP
competes with other options specialists and market makers, while Deephaven
competes with other asset management companies. We compete primarily on the
basis of execution standards, our relationship with our clients, our reputation
and technology.
ECNs. Electronic communications networks, commonly referred to as ECNs, are
significant competitors. ECNs provide market participants with the ability to
trade securities anonymously, manage inventory and obtain immediate display of
their limit orders. However, ECNs merely provide a neutral forum in which third
parties can display and match their limit orders. ECNs accounted for
approximately 40% of Nasdaq volume in 2001 compared with the estimated 20% of
Nasdaq volume they provided in 1999. ECNs also account for a small, but rising,
portion of listed volume.
Employees
Our employee headcount decreased from 2000 levels. During 2001, we reduced
our headcount in both the U.S. and Europe. At December 31, 2001 we had a total
of 1,307 full-time employees, of which 47 were employed by Knight Trading
Group, Inc., 528 were employed at KS, 122 were employed at KCM, 300 were
employed at KFP, 107 were employed at Deephaven, 58 were employed at KEP, 110
were employed at KSIL and 35 were employed at KSJ. None of our employees are
subject to a collective bargaining agreement. We believe that our relations
with our employees are good.
We recruit and retain our employees by compensating them largely on a
performance basis, measuring performance primarily in terms of revenue
generation. We are committed to improving the skill levels of our employees
and, to that end, we have established Knight School, formal training sessions
in which trading staff learn new trading techniques and are informed of
regulatory developments. We continue to develop additional programs to improve
the skills and productivity of our work force.
Intellectual Property and Other Proprietary Rights
Our success and ability to compete are dependent to a degree on our
intellectual property, which includes our proprietary technology, trade secrets
and client base. We rely primarily on trade secret, trademark, domain name,
patent and contract law to protect our intellectual property. Notwithstanding
the precautions we take to protect our intellectual property rights, it is
possible that third parties may copy or otherwise obtain and use our
intellectual property without authorization or otherwise infringe upon our
proprietary rights. It is also possible that third parties may independently
develop technologies similar to ours. It may be difficult for us to police
unauthorized use of our intellectual property rights. In addition, litigation
may be necessary in the future to enforce our intellectual property rights, to
protect our trade secrets, to determine the validity and scope of the
proprietary rights of others, or to defend against claims of infringement or
invalidity. These litigations, whether successful or unsuccessful, could result
in substantial costs and diversions of resources either of which could have a
material adverse effect on our business, financial condition and operating
results. We may in the future receive notices of claims of infringement of
other parties' proprietary rights.
12
In addition, it is our policy to enter into confidentiality, intellectual
property ownership and/or non-competition agreements with our employees,
independent contractors and business partners, and to control access to and
distribution of our intellectual property.
Government Regulation
The securities industry in the United States is subject to extensive
regulation under both federal and state laws. In addition, the SEC, the NASD,
other self regulatory organizations, commonly known as SROs, such as the
various stock exchanges, and other regulatory bodies, such as state securities
commissions, require strict compliance with their rules and regulations. As a
matter of public policy, regulatory bodies are charged with safeguarding the
integrity of the securities and other financial markets and with protecting the
interests of clients participating in those markets, not protecting creditors
or stockholders of market makers. Market makers are subject to regulation
concerning certain aspects of their business, including trade practices,
capital structure, record retention and the conduct of directors, officers and
employees. Failure to comply with any of these laws, rules or regulations could
result in censure, fine, the issuance of cease-and-desist orders or the
suspension or disqualification of directors, officers or employees, and other
adverse consequences. We, and certain of our officers and other employees,
have, in the past, been subject to claims arising from the violation of such
laws, rules and regulations, which resulted in the payment of fines and
settlements.
Significant legislation and rule-making occurred in 2001 and early 2002.
First, decimalization was introduced. Decimalization and the effects of
decimalization are discussed in other sections of this document. Second,
Section 31(a) fees were reduced by Congress in late 2001. Section 31(a) fees
are assessed on the sales of certain securities and are meant to subsidize the
functioning of the SEC. Due in part to the increase in trading volumes over the
last few years, these fees had far exceeded the amount budgeted for the SEC. As
a result, Congress approved a reduction in these fees across the board for all
equities by 55 percent. However, on March 1, 2002, the SEC announced that due
to decreases in trading activity, the Section 31(a) revenue was lower than
expected and increased the Section 31(a) fees, albeit to a level lower than
that in 2001. This reversal will reduce the anticipated benefits of this
legislation in 2002.
The third and final rule-making item from 2001 and early 2002 was the
announcement by Nasdaq of its plans to launch SuperMontage, a Nasdaq routing
and execution system, in summer 2002. Participation in SuperMontage by market
makers and ECNs is voluntary and the launch date is dependent on both
technology development and the NASD's simultaneous launch of its Alternative
Display Facility. Upon implementation, Nasdaq will complete its transition from
a quote-driven market to a full-order driven market as quotes and orders will
be treated the same. The anticipated benefits of SuperMontage are that it
should simplify the marketplace by making trading easier and more
cost-effective and efficient. For example, under the current system only one
price level is shown. Under SuperMontage, market makers and ECNs will be able
to show trading interest at five different price levels. Investors will then be
able to see individual and aggregated interest across all market participants
at the NBBO and four additional layers above or below the NBBO, making trading
more efficient. Trading will also be simpler due to the elimination of
SuperSoes and SelectNet, two execution systems currently used. As SuperMontage
is voluntary, it may only be successful if all market participants participate.
The regulatory environment in which we operate is subject to change. Our
business, financial condition and operating results may be adversely affected
as a result of new or revised legislation or regulations imposed by the SEC,
other United States or foreign governmental regulatory authorities or the NASD.
Our business, financial condition and operating results also may be adversely
affected by changes in the interpretation or enforcement of existing laws and
rules by these governmental authorities and the NASD.
Additional regulation, changes in existing laws and rules, or changes in
interpretations or enforcement of existing laws and rules often directly affect
the method of operation and profitability of securities firms. We cannot
predict what effect any such changes might have. Both regulations directly
applicable to us and regulations of general application could have a material
adverse effect on our business, financial condition, and operating results. For
example, the volume of our market-making activities in a given period could be
affected
13
by, among other things, existing and proposed tax legislation, antitrust policy
and other governmental regulations and policies (including the interest rate
policies of the Federal Reserve Board) and changes in interpretation or
enforcement of existing laws and rules that affect the business and financial
communities. The level of trading and market-making activity can be affected
not only by such legislation or regulations of general applicability, but also
by industry-specific legislation or regulations.
In addition, we have established London and Japan-based subsidiaries. To
operate these international businesses successfully, and to further expand our
services internationally, we will have to comply with the regulatory controls
of each country in which we conduct business. The brokerage industry in many
foreign countries, like the U.S., is heavily regulated. The varying compliance
requirements of these different regulatory jurisdictions and other factors may
limit our ability to conduct business or expand internationally.
Our asset management subsidiary, Deephaven, is a private asset management
company and is subject to limited regulatory oversight. However, recent
regulatory initiatives of the federal government in money laundering and
privacy have imposed certain restrictions on who can be an investor and what
can be disclosed about such investors. Otherwise, the anti-fraud provisions of
the Investment Advisors of 1940 apply to Deephaven's business.
Net Capital Requirements
Certain of our subsidiaries are subject to the SEC's Net Capital Rule. This
rule, which specifies minimum net capital requirements for registered
broker-dealers, is designed to measure the general financial integrity and
liquidity of a broker-dealer and requires that at least a minimum part of its
assets be kept in relatively liquid form. In general, net capital is defined as
net worth (assets minus liabilities), plus qualifying subordinated borrowings
and certain discretionary liabilities, and less certain mandatory deductions
that result from excluding assets that are not readily convertible into cash
and from valuing conservatively certain other assets. Among these deductions
are adjustments, commonly called haircuts, and non-allowable assets, which
reflect the possibility of a decline in the market value of an asset before
disposition.
Failure to maintain the required net capital may subject a firm to
suspension or revocation of registration by the SEC and suspension or expulsion
by the NASD and other regulatory bodies and ultimately could require the firm's
liquidation. The Net Capital Rule prohibits payments of dividends, redemption
of stock, the prepayment of subordinated indebtedness and the making of any
unsecured advance or loan to a stockholder, employee or affiliate, if such
payment would reduce the firm's net capital below required levels.
The Net Capital Rule also provides that the SEC may restrict for up to 20
business days any withdrawal of equity capital, or unsecured loans or advances
to stockholders, employees or affiliates (capital withdrawal), if such capital
withdrawal, together with all other net capital withdrawals during a 30-day
period, exceeds 30% of excess net capital and the SEC concludes that the
capital withdrawal may be detrimental to the financial integrity of the
broker-dealer. In addition, the Net Capital Rule provides that the total
outstanding principal amount of a broker-dealer's indebtedness under certain
subordination agreements, the proceeds of which are included in its net
capital, may not exceed 70% of the sum of the outstanding principal amount of
all subordinated indebtedness included in net capital, par or stated value of
capital stock, paid in capital in excess of par, retained earnings and other
capital accounts for a period in excess of 90 days.
A change in the Net Capital Rule, the imposition of new rules or any
unusually large charges against net capital could limit those of our operations
that require the intensive use of capital and also could restrict our ability
to withdraw capital from our broker-dealer subsidiaries, which in turn could
limit our ability to pay dividends, repay debt and repurchase shares of our
outstanding stock. A significant operating loss or any unusually large charge
against net capital could adversely affect our ability to expand or even
maintain our present levels of business.
14
Additionally, our foreign subsidiaries in London and Japan are subject to
capital adequacy requirements of the Financial Services Authority in the United
Kingdom and the Financial Supervisory Agency in Japan, respectively.
Item 2. Properties
Our headquarters are located in Jersey City, New Jersey. We lease
approximately 106,633 square feet at 525 Washington Boulevard under a lease
that expires in March 2006, and we have an option to extend the lease term for
an additional five-year period. We also lease approximately 266,000 square feet
at 545 Washington Boulevard that expires in October 2021, which is currently
not occupied. We also lease approximately 218,273 square feet for our offices
in Purchase, NY; New York, NY; Minnetonka, MN; Chicago, IL; Santa Clara, CA;
San Francisco, CA; Boston, MA; Jericho, NY; White Plains, NY; Philadelphia, PA;
Fairfield, NJ; London, England and Tokyo, Japan.
We believe that our present facilities, together with our current options to
extend lease terms and occupy additional space, exceed our current needs. We
are actively reviewing our real estate needs and may in the future sublet,
assign or return some of our space.
Item 3. Legal Proceedings
From time to time, we and certain of our past and present officers,
directors and employees have been named as parties in lawsuits, securities
arbitrations and administrative claims. We and certain of our past and present
officers, directors and employees are currently the subject of proceedings that
are in their initial stages. In the opinion of management, based upon
consultation with legal counsel, we are not currently a party to any legal
proceedings, the adverse outcome of which, individually or in the aggregate, we
can predict with any reasonable certainty, could have a material adverse effect
on our business, financial condition or operating results.
In previous filings, we noted that the Company and certain current and
former officers and directors were named as defendants in two putative class
action lawsuits which sought damages based on alleged violations of the federal
securities laws. One, Prager v. Knight Trading Group, Inc. et al., alleged,
generally, that the Company improperly traded securities for its own account in
advance of trading securities for broker-dealer clients in the pre-market
period. Upon our motion, and pursuant to an Order of the United States District
Court, District of New Jersey, dated July 17, 2001, the action was dismissed
with prejudice. The plaintiff appealed the dismissal by filing a Notice of
Appeal in August 2001. To avoid the time and expense involved with the Appeal,
we reached a settlement for an amount, not material to us, and plaintiff has
dismissed the appeal with prejudice.
Further, the second action, Patricia Murray et al v. Knight Trading Group,
Inc. et al. (now known as In Re Knight Trading Group, Inc. Securities
Litigation), concerned statements allegedly made by Company employees with
respect to projected earnings during the third quarter of 2000. On March 5,
2002 upon the Company's motion, Judge Katherine Hayden of the United States
District Court, District of New Jersey, ordered the dismissal with prejudice of
this consolidated class action. We note that in accordance with the Federal
Rules of Appellate Procedure, the plaintiff has thirty days from the entry of
judgment to file a Notice of Appeal. As of the date of this disclosure, the
Company has not received notification that the plaintiff has filed a Notice of
Appeal.
Compliance and trading problems that are reported to NASD Regulation, Inc.
("NASDR") or the NASD by dissatisfied customers of our broker-dealer clients
may be investigated by the NASDR or the SEC and may rise to the level of
arbitration or disciplinary action. In addition, the securities industry is
subject to extensive regulation under federal, state and applicable
international laws. As a result, we are required to comply with many complex
laws and rules and our ability to so comply is dependent in large part upon the
establishment and maintenance of a qualified compliance system.
In January 2002, KS reached a comprehensive settlement with NASDR, without
admitting or denying the alleged violations. Pursuant to that settlement, KS
agreed to pay an administrative fine of $700,000, representing
15
a collection of smaller fines, and make adjustments in the collective sum of
$800,000 with interest to its clients concerning a limited number of trades in
one security on one day. The collection of fines, when viewed independently,
are completely consistent with prior actions taken by NASDR against other
firms. This comprehensive settlement, which covered outstanding issues over a
four year period, involved a miniscule portion of KS' overall trades that were
old and addressed issues since corrected by market structure changes and
improvements, advances in technology and self-initiated enhancements to the
firm's trading systems.
Item 4. Submission of Matters to a Vote of Security Holders
None.
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters
Our Class A Common Stock is traded on the Nasdaq National Market under the
symbol "NITE." Public trading of our Class A Common Stock commenced on July 8,
1998. Before that, no public market for our Class A Common Stock existed. The
following table sets forth, for the past two years, the high and low quarterly
sales price per share of the Class A Common Stock in the Nasdaq National Market:
2000 High Low
---- ------ ------
First Quarter. $60.06 $29.50
Second Quarter 53.00 24.31
Third Quarter. 39.75 25.00
Fourth Quarter 35.73 13.88
2001
----
First Quarter. 24.50 13.00
Second Quarter 19.99 8.39
Third Quarter. 12.30 7.25
Fourth Quarter 13.35 7.53
The closing sale price of our Class A Common Stock as reported on the Nasdaq
National Market as of March 25, 2002, was $7.42 per share. As of that date
there were approximately 476 holders of record of our Class A Common Stock
based on information provided by the transfer agent. The number of stockholders
does not reflect the actual number of individual or institutional stockholders
that hold our stock because certain stock is held in the name of nominees.
Based on information made available to us by the transfer agent, there are
approximately 80,000 beneficial holders of our Class A Common Stock.
We have never declared or paid a dividend on our Class A Common Stock. We
currently intend to retain all of our future earnings, if any, to finance the
development and expansion of our business and, therefore, do not anticipate
paying any cash dividends in the foreseeable future. The payment of cash
dividends is within the discretion of our Board of Directors and will depend on
many other factors, including, but not limited to, our results of operations,
financial condition, capital requirements, restrictions imposed by financing
arrangements, general business conditions and legal requirements.
16
Item 6. Selected Financial Data
The following selected consolidated financial data are qualified by the
Consolidated Financial Statements of Knight Trading Group, Inc. and the Notes
thereto included elsewhere in this document. You should read the following in
conjunction with the Consolidated Financial Statements and the discussion under
"Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations" included elsewhere in this document. The Consolidated
Statements of Income Data for the years ended December 31, 1999, 2000 and 2001
and the Consolidated Statements of Financial Condition Data at December 31,
2000 and 2001 have been derived from our audited Consolidated Financial
Statements included elsewhere in this document. The Consolidated Statements of
Income Data for the years ended December 31, 1997 and 1998 and the Consolidated
Statements of Financial Condition Data at December 31, 1997, 1998 and 1999 are
derived from Consolidated Financial Statements not included in this document.
For the years ended December 31,
------------------------------------------------------------------
2001 2000 1999 1998 1997
------------ ------------ ------------ ------------ -----------
Consolidated Statement of Income Data (1): (In thousands, except share and per share data)
Revenues
Net trading revenue.................................. $ 564,630 $ 1,157,516 $ 845,105 $ 395,417 $ 262,217
Commissions and fees................................. 47,943 32,548 16,439 3,983 705
Asset management fees................................ 36,757 41,884 19,921 6,134 7,389
Interest and dividends, net of interest expense...... 24,949 16,137 11,950 3,981 1,382
Investment income and other.......................... 10,433 9,225 3,160 1,520 477
------------ ------------ ------------ ------------ -----------
Total revenues.................................... 684,712 1,257,310 896,575 411,035 272,170
------------ ------------ ------------ ------------ -----------
Expenses
Employee compensation and benefits................... 249,971 421,170 269,224 123,023 70,977
Execution and clearance fees......................... 117,519 112,238 89,575 50,724 34,613
Payments for order flow.............................. 81,942 174,646 138,697 82,499 66,912
Communications and data processing................... 50,856 33,025 18,944 11,721 7,843
Depreciation and amortization........................ 42,759 25,336 11,396 7,271 4,630
Occupancy and equipment rentals...................... 20,540 18,742 10,706 6,139 2,916
Professional fees.................................... 15,052 21,527 7,889 4,513 2,363
Business development................................. 11,617 14,806 10,295 2,913 1,798
Merger related costs................................. -- -- 9,969 -- --
Interest on preferred units.......................... -- -- -- 715 1,942
Writedown of assets and lease loss accrual........... 20,539 -- -- -- --
Other................................................ 19,572 17,289 7,050 3,435 1,370
------------ ------------ ------------ ------------ -----------
Total expenses.................................... 630,367 838,779 573,745 292,953 195,364
------------ ------------ ------------ ------------ -----------
Income before income taxes and minority interest........ 54,345 418,531 322,830 118,082 76,806
Income tax expense...................................... 25,461 159,446 111,546 22,251 --
------------ ------------ ------------ ------------ -----------
Income before minority interest......................... 28,884 259,085 211,284 95,831 76,806
Minority interst in consolidated subsidiaries........... 9,642 837 -- -- --
------------ ------------ ------------ ------------ -----------
Net income.............................................. $ 38,526 $ 259,922 $ 211,284 $ 95,831 $ 76,806
============ ============ ============ ============ ===========
Basic earnings per share................................ $ 0.31 $ 2.12 $ 1.75 $ 0.93 0.82
============ ============ ============ ============ ===========
Diluted earnings per share.............................. $ 0.31 $ 2.05 $ 1.68 $ 0.93 0.82
============ ============ ============ ============ ===========
Pro forma adjustments
Income before income taxes and minority interest..... 418,531 $ 322,830 $ 118,082 $ 76,806
Adjustment for pro forma employee compensation and
benefits (2)........................................ (267) (7,580) (5,097) (4,647)
------------ ------------ ------------ -----------
Pro forma income before income taxes and minority
interest............................................ 418,264 315,250 112,985 72,159
Pro forma income tax expense (3)..................... 160,089 126,790 48,040 30,918
------------ ------------ ------------ -----------
Pro forma income before minority interest............ 258,175 188,460 64,945 41,241
Minority interest in consolidated subsidiaries....... 837 -- -- --
------------ ------------ ------------ -----------
Pro forma net income................................. $ 259,012 $ 188,460 $ 64,945 $ 41,241
============ ============ ============ ===========
Pro foma basic earnings per share.................... $ 2.11 $ 1.56 $ 0.63 $ 0.44
============ ============ ============ ===========
Pro forma diluted earnings per share................. $ 2.04 $ 1.50 $ 0.63 $ 0.44
============ ============ ============ ===========
Shares used in basic earnings per share calculations (4) 123,796,181 122,520,733 120,821,710 103,115,712 93,696,762
============ ============ ============ ============ ===========
Shares used in diluted earnings per share
calculations (4)....................................... 125,758,863 126,863,316 125,755,430 103,115,712 93,696,762
============ ============ ============ ============ ===========
17
December 31,
--------------------------------------------------
2001 2000 1999 1998 1997
---------- ---------- ---------- -------- --------
Consolidated Statement of Financial Condition Data:
Cash and cash equivalents.......................... $ 361,294 $ 364,058 $ 304,054 $117,705 $ 13,918
Securities owned, at market value.................. 1,754,483 1,799,967 910,233 411,288 180,957
Receivable from clearing brokers................... 820,103 114,047 215,423 107,537 35,747
Total assets....................................... 3,226,687 2,521,409 1,540,286 684,644 264,788
Securities sold, not yet purchased, at market value 2,039,356 1,427,214 720,919 328,171 125,827
Mandatorily Redeemable Preferred Units............. -- -- -- -- 27,484
Total stockholders' (members') equity.............. 834,256 774,186 499,231 205,873 61,804
- --------
(1) Certain prior year amounts have been reclassified to conform to current
year presentation.
(2) Before our merger with Arbitrade on January 12, 2000, Arbitrade was a
limited liability company and compensation and benefits to Arbitrade's
members were accounted for as distributions of members' equity. Pro forma
compensation expense was computed as 15% of the before-tax profits earned
by Arbitrade for the years ended December 31, 1997, 1998 and 1999 and for
the period ended January 12, 2000.
(3) Before our initial public offering in July 1998, we were a limited
liability company and were not subject to income taxes. Pro forma income
tax expense was computed based on an effective tax rate of 43% and 42.5%,
for the year ended December 31, 1997, and for the period through our
initial public offering in 1998, respectively. Additionally, before our
merger, Arbitrade was a limited liability company and was not subject to
taxes. Pro forma income tax expense was computed based on Arbitrade's
income at an effective tax rate of 42.5% for the years ended December 31,
1997, 1998 and 1999 and for the period ended January 12, 2000.
(4) Weighted average shares outstanding for all years presented have been
determined as if the merger and reorganization described in Notes 1 and 2
to the Consolidated Financial Statements included elsewhere in this
document occurred as of the earliest date presented. Shares issued in
connection with our initial public offering have been considered in
determining weighted average shares outstanding only from the date they
were issued.
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations
Overview
We are a leading market maker in equity securities and in options on
individual equities, equity indices and fixed income futures instruments.
Additionally, we maintain an asset management business for institutions and
high net worth individuals Our principal operating subsidiaries are:
. Knight Securities ("KS"): KS is the largest wholesale market maker
operating in Nasdaq. Based on rankings published by The AutEx Group, KS
was ranked first in Nasdaq/OTC securities volume in 2001. KS's U.S.
equity share volume totaled 110.9 billion, 90.8 billion and 64.0 billion,
or 82%, 81% and 79% of our total U.S. equity share volume, for the years
ended December 31, 2001, 2000 and 1999, respectively. Since commencing
operations in 1995, KS's business has grown rapidly and accounted for
87%, 86% and 86% of our total U.S. equity share volume growth during the
years ended December 31, 2001, 2000 and 1999, respectively.
. Knight Capital Markets ("KCM"): Through KCM we are the largest market
maker in the Nasdaq Intermarket, the over-the-counter market for all NYSE
and AMEX listed equity securities. KCM has also experienced increases in
U.S. equity share volume since 1995. In addition, KCM has held the #1
market share ranking in trading of securities in the over-the-counter
market for NYSE and AMEX listed securities since 1998 as reported by the
NASD. KCM's U.S. equity share volume totaled 24.1 billion, 21.2 billion
and 17.0 billion, or 18%, 19% and 21% of our total U.S. equity share
volume for the years ended December 31, 2001, 2000 and 1999, respectively.
. Knight Roundtable Europe, Ltd. ("KREL"): Through KREL, and its U.K.
broker-dealer, Knight Securities International Ltd. ("KSIL"), we provide
wholesale market-making services primarily in U.K. equity securities.
KSIL also routes U.S. equity orders to KS for execution. Our majority
interest in KREL is approximately 85%. The remaining 15% is owned by 21
pan-European and U.S. broker-dealers and banks.
. Knight Securities Japan ("KSJ"): Through KSJ we make markets in equity
securities in Japan. We own a majority interest of 60% of the business of
KSJ. The remaining 40% is owned by Nikko Cordial Group.
18
. Knight Financial Products ("KFP"): Through KFP we make markets in listed
options on individual equities, equity indices and fixed income futures
instruments in the U.S. KFP's U.S. option contract volume amounted to
37.4 million, 21.4 million and 10.6 million for the years ended December
31, 2001, 2000 and 1999, respectively.
. Knight Execution Partners ("KEP"): KEP operates a professional options
execution services business.
. Deephaven Capital Management ("Deephaven"): Through Deephaven, we perform
investment management services and sponsor a private investment fund for
institutions and high net worth individuals. Deephaven's total assets
under management totaled approximately $1.2 billion, $743.5 million and
$314.3 million at December 31, 2001, 2000 and 1999, respectively.
We have two reportable business segments: wholesale securities market-making
and asset management. Wholesale securities market-making primarily includes the
operations of KS, KCM, KFP, KSIL and KSJ and primarily includes market-making
in equity securities listed on Nasdaq, on the OTCBB of the NASD, in the
over-the-counter market for NYSE and AMEX listed securities and in options on
individual equities, equity indices and fixed income futures instruments in the
U.S. The asset management segment includes the operations of Deephaven and
consists of investment management and sponsorship of a private investment fund.
Revenues
Our revenues consist principally of net trading revenue from U.S. securities
market-making activities. Net trading revenue, which represents trading gains
net of trading losses, is primarily affected by changes in U.S. equity trade
and share volumes and U.S. option contract volumes, our revenue capture per
U.S. equity share and per U.S. option contract, dollar value of U.S. equities
and U.S. options traded, our ability to derive trading gains by taking
proprietary positions, changes in our execution standards, volatility in the
marketplace, our mix of broker-dealer and institutional clients and by
regulatory changes and evolving industry customs and practices.
OTC securities transactions with institutional clients are executed as
principal, and all related profits and losses are included within net trading
revenue. Listed securities transactions with institutional clients are
primarily executed on an agency basis through KS, for which we earn commissions
on a per share basis. We also receive fees for providing certain information to
market data providers and for directing trades to certain destinations for
execution. Commissions and fees are primarily affected by changes in our trade
and share volumes in listed securities as well as by changes in fees earned for
directing trades to certain destinations for execution.
Asset management fees represent fees earned for sponsoring and managing the
investments of a private investment fund. Asset management fees are primarily
affected by the rates of return earned on the fund we manage and changes in the
amount of assets under management.
We earn interest income from our cash held at banks and cash held in trading
accounts at clearing brokers, net of transaction-related interest charged by
clearing brokers for facilitating the settlement and financing of securities
transactions. Net interest is primarily affected by the changes in cash
balances held at banks and clearing brokers and the level of securities
positions in which we are long compared to our securities positions in which we
are short.
Expenses
Our operating expenses largely consist of employee compensation and
benefits, payments for order flow and execution and clearance fees. A
substantial portion of these expenses vary in proportion to our trading revenue
and volume. Employee compensation and benefits expense, which is predominantly
profitability based, fluctuates, for the most part, based on changes in net
trading revenue, our profitability and our number of
19
employees. Payments for order flow fluctuate based on U.S. equity share and
option volume, the mix of market orders and limit orders, the mix of orders
received from broker-dealers who accept payments for order flow and changes in
our payment for order flow policy. Execution and clearance fees primarily
fluctuate based on changes in equity trade and share volume, option volume, the
mix of trades of OTC securities compared to listed securities, clearance fees
charged by clearing brokers and fees to access electronic communications
networks, commonly referred to as ECNs.
Employee compensation and benefits expense primarily consists of salaries
and wages paid to all employees and profitability based compensation, which
includes compensation and benefits paid to market-making and sales personnel
based on their individual performance, and incentive compensation paid to all
other employees based on our overall profitability. Profitability-based
compensation represented 82%, 79% and 50% of total employee compensation and
benefits expense for the years ended December 31, 1999, 2000 and 2001,
respectively. We have grown from 803 full time employees at December 31, 1999
to 1,364 and 1,307 full time employees as of December 31, 2000 and 2001,
respectively, reaching a high of approximately 1,400 full time employees during
2001. At year-end, approximately 67% of our employees were directly involved in
market-making, sales or customer service activities. Compensation for employees
engaged in market-making and sales activities, the largest component of
employee compensation and benefits, is determined primarily based on a
percentage of gross trading profits net of expenses including payments for
order flow, execution and clearance costs and overhead allocations. Employee
compensation and benefits will, therefore, be affected by changes in payments
for order flow, execution and clearance costs and the overhead costs we
allocate to employees engaged in market-making and sales activities.
Execution and clearance fees primarily represent clearance fees paid to
clearing brokers for OTC and listed securities and option contracts,
transaction fees paid to exchanges, payments made to third parties for exchange
seat leases, execution fees paid to third parties, primarily for executing
trades in listed securities on the NYSE and AMEX and for executing orders
through ECNs and clearance fees for our international businesses. Due to our
equity share and trade volume, we have been able to negotiate favorable rates
and volume discounts from clearing brokers and providers of execution services.
Payments for order flow represent customary payments to broker-dealers, in
the normal course of business, for directing their order flow in U.S. equity
securities and U.S. option contracts to us. We only pay broker-dealers for
orders that provide us with a profit opportunity. For example, in our U.S.
equities market-making activities, we make payments on market orders and
marketable limit orders, but do not pay on non-marketable limit orders.
Payments for order flow change as we modify our payment formulas and as our
percentage of customers whose policy is not to accept payments for order flow
varies.
Communications and data processing expense primarily consists of costs for
obtaining market data, telecommunications services and systems maintenance.
Depreciation and amortization expense results from the depreciation of fixed
assets and leasehold improvements and the amortization of intangible assets and
goodwill, which includes the amortization of goodwill and intangible assets
related to our purchases of various options-related businesses as well as
contingent consideration resulting from the acquisitions of the listed
securities market-making businesses of KCM and Tradetech Securities, L.P.
("Tradetech"), and capitalized software.
Professional fees primarily consist of fees paid to computer programming and
systems consultants, as well as legal and other professional fees.
Occupancy and equipment rentals expense primarily consists of rental
payments on office and equipment leases.
Business development expense primarily consists of travel, promotional and
advertising costs.
20
Merger-related expenses primarily consist of investment banking, legal and
accounting costs incurred in connection with our merger with Arbitrade Holdings
LLC ("Arbitrade"). This transaction closed in January 2000.
The writedown of assets and lease loss accrual consists of losses related to
permanent impairments to outside investments, estimated loss on the disposal of
excess real estate and the writedown of fixed assets to estimated market value
and other capitalized costs associated with the design of leased property which
we do not believe we will fully occupy.
Other expenses primarily consist of administrative expenses and other
operating costs such as recruitment fees, regulatory fees and general office
expenses.
Income Tax
Before our merger with Arbitrade, Arbitrade (and its two subsidiaries, KFP
and Deephaven) was a limited liability company, which was treated as a
partnership for tax purposes and its U.S. federal and state income taxes were
borne by its individual partners. As such, Arbitrade's historical financial
statements only include a provision for non-U.S. income taxes. Subsequent to
the merger, Arbitrade's income is subject to federal income taxes and state
income taxes. This period is referred to as the post-merger period. Our
effective tax rate for the post-merger period and pro forma effective tax rate
for all periods before the post-merger period, differ from the federal
statutory rate of 35% due to state income taxes, non-deductible foreign losses
as well as nondeductible expenses, including the amortization of goodwill
resulting from the acquisition of KCM and a portion of business development
expenses and merger-related expenses.
Certain Factors Affecting Results of Operations
Our results of operations may be materially affected by market fluctuations,
regulatory changes and by economic factors. We have experienced, and expect to
continue to experience, significant fluctuations in operating results due to a
variety of factors, including, but not limited to, the value of our securities
positions and our ability to manage the risks attendant thereto, the volume of
our market-making activities, the dollar value of securities traded, volatility
in the securities markets, our ability to manage personnel and expenses, our
ability to manage our client base, the amount of revenue derived from limit
orders as a percentage of net trading revenues, changes in payments for order
flow and clearing costs, the addition or loss of sales and trading
professionals, legislative, legal and regulatory changes, the amount and timing
of capital expenditures, the incurrence of costs associated with acquisitions,
investor sentiment, competition, technological changes and events, seasonality
and general economic and market conditions. Such factors may also have an
impact on our ability to achieve our strategic objectives, including (without
limitation to) increased market share in our market-making activities and
growth in assets under management. If demand for our market-making services
declines and we are unable to adjust our cost structure on a timely basis, our
operating results and strategic objectives could be materially and adversely
affected.
As a result of all 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 return to the rates of revenue
growth that we have experienced in the past, that we will be able to improve
our operating results or that we will be able to regain our profitability
levels on an annual and/or quarterly basis.
Trends
We believe that our business is currently, or may be, impacted by several
trends that may affect our financial condition and results of operations.
First, the effects of decimalization and the one-penny minimum price variant
("MPV") have resulted in a significant decline in revenue per share in our
equities market-making business. This trend has also resulted in a change to
our order flow payment policies, resulting in a reduction in
21
payment for order flow. Second, decimalization is beginning to trigger a shift
to agency-based business (where capital is not committed) in the equities
markets, as declining spreads reduce profits for principal equity trading firms
and as firms become more risk-averse in their capital commitments. In 2001, we
instituted a commission charge on a very small percentage of institutional
equity transactions to more effectively price our capital commitment. Certain
competitors have also begun to charge commissions. Third, non-traditional
trading venues, such as electronic communications networks ("ECNs") and other
alternative trading systems now account for a significant amount of Nasdaq
trading volume. Also, direct access trading solutions and application service
providers are growing in popularity. Finally, the effects of decimalization and
market conditions have resulted in consolidation in the equities and options
market-making industries. We expect these trends to continue in 2002.
Market and Economic Conditions in 2001.
Market and economic conditions during 2001 were significantly less favorable
compared with those experienced during the prior year. For the year 2001, the
Nasdaq Composite Index was down 21%, the DJIA was down 7% and the S&P 500 was
down 13%. The level of economic activity declined throughout fiscal 2001, as
the world's major economies, including the U.S., Japan and Europe, all
experienced difficulties. These conditions contributed to sharp declines in the
global equity markets, as well as lower levels of investment banking activity
and retail investor participation in the financial markets. The terrorist
attacks of September 11, 2001 placed additional pressure on the U.S. economy
and financial markets in the fourth quarter of 2001. It currently is not clear
when these market and economic conditions will improve. These conditions
adversely affected our 2001 results of operations, as the net income of each of
our two business segments (wholesale securities market-making and asset
management) declined from the levels achieved in 2000. Our wholesale securities
market-making business recorded lower revenues from its institutional sales and
trading activities in 2001 as compared with 2000. The decline in revenues in
the asset management business reflected a decrease in performance fees related
to a lower investment return for the managed fund.
22
Results of Operations
The following table sets forth the consolidated statement of income data as
a percentage of total revenues:
For the years ended
December 31,
-------------------
2001 2000 1999
----- ----- -----
Revenues
Net trading revenue......................................... 82.5% 92.1% 94.3%
Commissions and fees........................................ 7.0% 2.6% 1.8%
Asset management fees....................................... 5.4% 3.3% 2.2%
Interest and dividends, net of interest expense............. 3.6% 1.3% 1.3%
Investment income and other................................. 1.5% 0.7% 0.4%
----- ----- -----
Total revenues.......................................... 100.0% 100.0% 100.0%
----- ----- -----
Expenses
Employee compensation and benefits.......................... 36.5% 33.5% 30.0%
Execution and clearance fees................................ 17.2% 8.9% 10.0%
Payments for order flow..................................... 12.0% 13.9% 15.5%
Communications and data processing.......................... 7.4% 2.6% 2.1%
Depreciation and amortization............................... 6.2% 2.0% 1.3%
Occupancy and equipment rentals............................. 3.0% 1.5% 1.2%
Professional fees........................................... 2.2% 1.7% 0.9%
Business development........................................ 1.7% 1.2% 1.1%
Merger related costs........................................ 0.0% 0.0% 1.1%
Writedown of assets and lease loss accrual.................. 3.0% 0.0% 0.0%
Other....................................................... 2.9% 1.4% 0.8%
----- ----- -----
Total expenses.......................................... 92.1% 66.7% 64.0%
----- ----- -----
Income before income taxes and minority interest............... 7.9% 33.3% 36.0%
Income tax expense............................................. 3.7% 12.7% 12.4%
----- ----- -----
Income before minority interest................................ 4.2% 20.6% 23.6%
Minority interest in consolidated subsidiaries................. 1.4% 0.1% 0.0%
----- ----- -----
Net income..................................................... 5.6% 20.7% 23.6%
===== ===== =====
Pro forma adjustments
Income before income taxes and minority interest............ 33.3% 36.0%
Adjustment for pro forma employee compensation and benefits. 0.0% -0.8%
----- -----
Pro forma income before income taxes and minority interest.. 33.3% 35.2%
Pro forma income tax expense................................ 12.7% 14.1%
----- -----
Pro forma income before minority interest................... 20.6% 21.1%
Minority interest in consolidated subsidiaries.............. 0.1% 0.0%
----- -----
Pro forma net income........................................ 20.7% 21.1%
===== =====
23
Years Ended December 31, 2001 and 2000
In 2001, we had gross revenues of $684.7 million, down from $1,257.3 million
in 2000. Our total expenses were $630.4 million, down from $838.8 million in
2000. Our 2001 net income was $38.5 million, resulting in earnings per share
("EPS") on a fully diluted basis of $0.31. This compares to net income of
$259.9 million and an EPS of $2.05 on a fully diluted basis in 2000. Our
international expansion efforts resulted in an approximate $0.30 charge to our
EPS in 2001. During the third quarter of 2001, we had our first ever quarterly
loss due to the effects of decimalization, international expansion,
seasonality, market conditions and the lost trading days due to the terrorist
attacks on September 11th.
Revenues
2001 2000 Change % of Change
------- -------- ------- ------------
Trading Revenues (millions).................................. $ 564.6 $1,157.5 $(592.9) -51.2%
U.S. Shares Traded (billions)................................ 135.0 112.1 23.0 20.5%
U.S. Options Contracts (millions)............................ 37.4 21.4 16.1 75.1%
Revenue Capture per U.S. Equity Share ($).................... 0.0032 0.0092 (0.006) -64.8%
Revenue Capture per U.S. Option Contract ($)................. 3.37 6.11 (2.74) -44.9%
% of Bulletin Board Equity Shares of Total U.S. Equity Shares 47.7% 37.4% 10.3% 27.5%
As a result of the market and economic conditions in 2001, our net trading
revenue from equity security market-making decreased 57.3% to $435.7 million in
2001, from $1,020.9 million in 2000. U.S. equity trading revenue represents the
majority of our equity market-making revenue. This decrease in equity trading
revenue was primarily due to decreased average revenue capture per U.S. equity
share and market conditions. Average revenue capture per U.S. equity share was
impacted by a reduction in spreads due to decimalization and the introduction
of a one-penny MPV, which allows for trading increments as small as one cent,
in the second quarter 2001. Average revenue capture per U.S. equity share
decreased to $0.0032 per share in 2001, from $0.0092 per share in 2000. The
decrease was offset, in part, due to an increase in U.S. equity share volume.
Total U.S. equity share volume increased 20.5% to 135.0 billion U.S. equity
shares in 2001, from 112.1 billion U.S. equity shares in 2000. The increase in
U.S. equity share volume only partially offset the reduction in net trading
revenues from lower revenue capture from equity security market-making, as the
majority of the increase resulted from share volume in low-priced Bulletin
Board and Pink Sheet stocks which have lower revenue capture opportunity. Net
trading revenue from options market-making decreased 5.6% to $128.9 million in
2001, from $136.6 million in 2000. The decrease is primarily due to lower
average revenue capture per U.S. option contract due to low volatility and
increased competition. Average revenue per U.S. option contract decreased to
$3.37 in 2001, from $6.11 in 2000. The decrease was partially offset by the
increase in U.S. option contracts executed. Total U.S. option contracts
executed increased 75.1% to 37.4 million contracts in 2001, from 21.4 million
contracts in 2000. Our U.S. option contract volume was positively impacted by
KFP's purchases of additional exchange posts during 2001, which increased our
overall options market-making coverage.
Our commissions and fees increased 47.3% to $47.9 million in 2001, from
$32.5 million in 2000. This increase is primarily due to payments received by
our professional option execution services business, KEP, for directing order
executions, as well as higher U.S. equity share volumes from institutional
customers in listed securities.
Asset management fees decreased 12.2% to $36.8 million in 2001 from $41.9
million in 2000. The decrease in fees was primarily due to a decrease in fund
returns from 33.61% in 2000 to 11.52% in 2001. The decrease was offset, in
part, by the increase in funds under management in the Deephaven Market Neutral
Master Fund from $743.5 million at December 31, 2000 to $1.2 billion at
December 31, 2001.
Our interest income, net of interest expense, increased 54.6% to $24.9
million in 2001, from $16.1 million in 2000. This increase was primarily due to
changes in our market-making positions from net long to net short.
24
Investment income and other income increased 13.1% to $10.4 million in 2001,
from $9.2 million in 2000. This increase was primarily due to an increase in
benefits received from a state employment incentive grant
Expenses
Our employee compensation and benefits expense decreased 40.7% to $250.0
million in 2001, from $421.4 million in 2000 (presented on a pro forma basis).
As a percentage of total revenue, employee compensation and benefits expense
increased to 36.5% in 2001 from 33.5% in 2000. The decrease on a dollar basis
was primarily due to decreases in gross trading profits and lower margins
offset, in part, by a growth in the number of our employees. The increase on a
percentage basis was primarily due to the significantly lower revenues and the
decrease in average revenue capture per U.S. equity share and per U.S. option
contract as well as an increase for most of the year in our number of employees
and severance costs. Due to unfavorable market and economic conditions,
employee headcount was reduced and severance costs were incurred. The number of
full-time employees increased to approximately 1,400 for much of 2001, from
1,364 as of December 31, 2000; however, as of December 31, 2001 total headcount
was 1,307. Severance costs related to the decrease in headcount amounted to
approximately $5.9 million. Due to decreased net trading revenue and
profitability, profitability-based compensation decreased 62.7% to $123.8
million in 2001, from $331.8 million on a pro forma basis in 2000.
Profitability-based compensation represented 49.5% and 78.7% of total
compensation and benefits for 2001 and on a pro forma basis in 2000,
respectively.
Execution and clearance fees increased 4.7% to $117.5 million in 2001, from
$112.2 million in 2000. As a percentage of total revenue, execution and
clearance fees increased to 17.2% in 2001 from 8.9% in 2000. The increase on a
dollar basis was primarily due to the 75.1% increase in U.S. option contracts
executed as well as additional fixed costs in relation to our purchases of
additional options trading posts. Execution and clearance fees also increased
as a result of our international expansion efforts in Europe and Japan. The
increase was partially offset by a 17.8% decrease in U.S. equity trades
executed to 117.3 million U.S. equity trades in 2001, from 142.7 million U.S.
equity trades in 2000. The increase in execution and clearance fees as a
percentage of total revenue was primarily due to the decrease in average
revenue capture per U.S. equity trade and per U.S. option contract.
Our payments for order flow decreased 53.1% to $81.9 million in 2001, from
$174.6 million in 2000. As a percentage of total revenue, payments for order
flow decreased to 12.0% in 2001 from 13.9% in 2000. The decrease in payments
for order flow on a dollar basis and as a percentage of total revenue was
primarily due to changes in our payment for order flow policy, resulting from
decimalization and the introduction of a one-penny MPV, initiated in the second
quarter 2001. The decrease was offset, in part, by the 20.5% increase in U.S.
equity shares traded in 2001 as well as the fact that payment for order flow in
the options marketplace was not introduced until the third quarter of 2000.
Communications and data processing expense increased 54.0% to $50.9 million
in 2001, from $33.0 million in 2000. This increase was generally attributable
to an increase in the number of employees for most of the year, investment in
technology and our international expansion in Europe and Japan. Additionally,
communications and data processing expense increased due to the growth in our
options trading business, which almost doubled the number of options that it
trades.
Our depreciation and amortization expense increased 68.8% to $42.8 million
in 2001, from $25.3 million in 2000. This increase was primarily due to the
purchase of approximately $50.6 million of additional fixed assets and
leasehold improvements during 2001 and the amortization of goodwill and
intangible assets primarily related to the acquisition of various options
related businesses.
Occupancy and equipment rentals expense increased 9.6% to $20.5 million in
2001, from $18.7 million in 2000. This increase was primarily attributable to
additional leased office space.
Our professional fees decreased 30.1% to $15.1 million in 2001, from $21.5
million in 2000. This decrease was primarily due to decreased consulting
expenses related to our investments in technology, our European and Asian
expansion efforts as well as decreased other professional fees.
Business development expense decreased 21.5% to $11.6 million in 2001, from
$14.8 million in 2000. This decrease was primarily the result of decreased
advertising and lower travel and entertainment costs.
25
For the year ended December 31, 2001, pre-tax non-operating charges of $20.5
million were incurred for the writedown of assets and a lease loss accrual. The
charges consist of a $10.7 million non-recurring charge relating to impaired
investments in non-public e-commerce companies, $6.8 million related to a
writedown of fixed assets and other capitalized costs related to purchases of
equipment and costs associated with the design of space for leased property
which we do not believe we will fully occupy, $1.4 million related to estimated
losses on the disposal of excess real estate and $1.6 million related to the
writedown of certain options exchange seats.
Other expenses increased 13.2% to $19.6 million in 2001, from $17.3 million
in 2000. This was primarily the result of increased administrative expenses and
other operating costs in connection with our options business growth as well as
our European and Asian expansion.
Income Tax
Our effective and pro forma effective income tax rates for 2001 and 2000,
respectively, differ from the federal statutory rate of 35% due to state income
taxes, non-deductible foreign losses as well as non-deductible expenses,
including the amortization of goodwill resulting from the acquisition of KCM
and a portion of business development expenses. Pro forma income tax rates for
2000 are used because, before our merger with Arbitrade on January 12, 2000,
Arbitrade (and its two subsidiaries, KFP and Deephaven) was a limited liability
company, which was treated as a partnership for tax purposes and its U.S.
federal and state income taxes were borne by its individual partners. Our
effective tax rate increased to 46.9% in 2001 from a pro forma effective tax
rate in 2000 of 38.3% primarily due to the non-deductible foreign losses
incurred in 2001.
Years Ended December 31, 2000 and 1999
In 2000, we had gross revenues of $1,257.3 million, up from $896.6 million
in 1999. Our total expenses were $838.8 million, up from $573.7 million in
1999. Our 2000 net income was $259.9 million, resulting in an EPS on a fully
diluted basis of $2.05. This compares to net income of $211.3 million and an
EPS of $1.68 on a fully diluted basis in 1999. Our international expansion
efforts resulted in a $0.05 charge to our EPS in 2000.
Revenues
2000 1999 Change % of Change
-------- ------- -------- ------------
Trading Revenues (millions).................................. $1,157.5 $ 845.1 $ 312.4 37.0%
U.S. Shares Traded (billions)................................ 112.1 81.0 31.0 38.3%
U.S. Options Contracts (millions)............................ 21.4 10.6 10.8 101.6%
Revenue Capture per U.S. Equity Share ($).................... 0.0092 0.0095 (0.0004) -3.9%
Revenue Capture per U.S. Option Contract ($)................. 6.11 7.02 (0.912) -13.0%
% of Bulletin Board Equity Shares of Total U.S. Equity Shares 37.4% 37.5% -0.1% -0.3%
Our net trading revenue from equity security market-making increased 32.3%
to $1,020.9 million in 2000, from $771.4 million in 1999. This increase was
primarily due to higher U.S. equity share volume, particularly in OTC
securities. U.S. equity trading revenue represents the majority of our equity
market-making revenue. Total U.S. equity share volume increased 38.3% to 112.1
billion shares in 2000, from 81.0 billion shares in 1999. The effect of this
increase was offset, slightly, by the decrease in average revenue capture per
U.S. equity share which decreased from $0.0095 per U.S. equity share in 1999 to
$0.0092 per U.S. equity share in 2000. Net trading revenue from options
market-making increased 85.4% to $136.6 million in 2000, from $73.7 million in
1999. The increase is due to higher U.S. option contract volume, offset by
lower average revenue capture per U.S. option contract. Total U.S. option
contract volume was positively impacted by KFP's purchases of additional
exchange posts during 2000, which increased our options market-making coverage.
Total U.S. option contract volume increased 101.6% to 21.4 million contracts in
2000, from 10.6 million contracts in 1999. The increase was partially offset by
the decrease in average revenue capture per U.S. option contract, which
decreased to $6.11 in 2000, from $7.02 in 1999.
26
Commissions and fees increased 98.0% to $32.5 million in 2000, from $16.4
million in 1999. This increase is primarily due to higher U.S. equity share
volumes from institutional customers in listed securities, higher fees for
providing certain information to market data providers and for directing trades
to certain destinations for execution.
Our asset management fees increased 110.2% to $41.9 million in 2000 from
$19.9 million in 1999. The increase in fees was primarily due to an increase in
fund returns from 21.08% in 1999 to 33.61% in 2000. Additionally, there was an
increase in funds under management from $314.3 million at December 31, 1999 to
$743.5 million at December 31, 2000.
Interest income, net of interest expense, increased 35.0% to $16.1 million
in 2000, from $11.9 million in 1999. This increase was primarily due to larger
cash balances held at banks and our clearing brokers.
Investment income and other income increased 191.9% to $9.2 million in 2000,
from $3.2 million in 1999. This increase was primarily due to an increase in
income from our investments, primarily our investments in the private
investment fund that we sponsor and manage.
Expenses
Pro forma employee compensation and benefits expense increased 52.3% to
$421.4 million in 2000, from $276.8 million in 1999. As a percentage of total
revenue, pro forma employee compensation and benefits expense increased to
33.5% in 2000 from 30.8% in 1999. The increase on a dollar basis was primarily
due to increases in gross trading revenue and growth in our number of
employees. The increase on a percentage basis is primarily due to an increase
in our number of employees and the decrease in average revenue capture per U.S.
equity share and U.S. option contract. Due to increased net trading revenue and
profitability, pro forma profitability-based compensation increased 46.4% to
$331.8 million in 2000, from $226.6 million in 1999. The number of employees
increased to 1,364 employees as of December 31, 2000, from 803 employees as of
December 31, 1999.
Execution and clearance fees increased 25.3% to $112.2 million in 2000, from
$89.6 million in 1999. As a percentage of total revenue, execution and
clearance fees decreased to 8.9% in 2000 from 10.0% in 1999. The increase on a
dollar basis was primarily due to a 57.4% increase in U.S. equity trades
executed to 142.7 million U.S. equity trades in 2000, from 90.7 million U.S.
equity trades in 1999 and the 101.6% growth in U.S. options contracts executed.
The increase on a dollar basis was offset, in part, by a decrease in clearance
rates charged by clearing brokers and volume discounts. The decrease in
execution and clearance fees as a percentage of total revenue was primarily due
to the decrease in clearance rates charged by clearing brokers, volume
discounts and growth in the volume of OTC securities transactions.
Payments for order flow increased 25.9% to $174.6 million in 2000, from
$138.7 million in 1999. As a percentage of total revenue, payments for order
flow decreased to 13.9% in 2000 from 15.5% in 1999. The increase in payments
for order flow on a dollar basis was primarily due to the 38.3% increase in
U.S. equity shares traded in 2000 and the introduction of payments for order
flow for options during the third quarter of 2000. The decrease in payments for
order flow as a percentage of total revenue was primarily due to increases in
our institutional, asset management and options revenues, respectively, which
have less payments for order flow associated with them.
Communications and data processing expense increased 74.3% to $33.0 million
in 2000, from $18.9 million in 1999. This increase was generally attributable
to higher trading volumes, a growth in our options business and an increase in
the number of employees.
Depreciation and amortization expense increased 122.3% to $25.3 million in
2000, from $11.4 million in 1999. This increase was primarily due to the
purchase of approximately $71.0 million of additional fixed assets and
leasehold improvements during 2000 and the amortization of goodwill and
intangible assets primarily related to the acquisition of the listed securities
market-making businesses of KCM and Tradetech and various options related
businesses.
Occupancy and equipment rentals expense increased 75.1% to $18.7 million in
2000, from $10.7 million in 1999. This increase was primarily attributable to
additional office space and increased computer equipment lease expense.
27
Professional fees increased 172.9% to $21.5 million in 2000, up from $7.9
million in 1999. This increase was primarily due to increased consulting
expenses related to our investments in technology, our European and Asian
expansion efforts as well as legal and other professional fees.
Business development expense increased 43.8% to $14.8 million in 2000, from
$10.3 million in 1999. This increase was primarily the result of increased
advertising and higher travel and entertainment costs consistent with the
growth in our business and our increased focus on the institutional sales
business.
Merger-related expenses primarily consist of investment banking, legal and
accounting costs incurred during 1999 in connection with our merger with
Arbitrade Holdings LLC. This transaction closed in January 2000.
Other expenses increased 145.2% to $17.3 million in 2000, from $7.1 million
in 1999. This was primarily the result of increased administrative expenses and
other operating costs in connection with our overall business growth.
Income Tax
Our effective and pro forma effective income tax rates for 2000 and 1999,
respectively, differ from the federal statutory rate of 35% due to state income
taxes, as well as nondeductible expenses, including the amortization of
goodwill resulting from the acquisition of KCM and a portion of business
development expenses. Our pro forma effective tax rate declined to 38.3% in
2000 from a pro forma effective tax rate of 40.2% in 1999 primarily due to
lower state and local income taxes.
Liquidity
Historically, we have financed our business primarily through cash generated
by operations, as well as the proceeds from our initial public and follow-on
stock offerings. As of December 31, 2001, we had $3.2 billion in assets, 91% of
which consisted of cash or assets readily convertible into cash, principally
receivables from clearing brokers and securities owned. Receivables from
clearing brokers include interest bearing cash balances held with 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. Securities owned principally
consist of equity securities that trade in Nasdaq and on the NYSE and AMEX
markets and listed options contracts that trade on national exchanges. In
addition to our cash and assets readily convertible into cash, at December 31,
2001, we had a $50.9 million investment in the private investment fund that we
sponsor and manage. This investment can be liquidated upon request with no
advance notice. At December 31, 2001 the Company had net liquid assets, which
consists of net assets readily convertible into cash, of approximately $594.4
million.
Net income plus depreciation and amortization was $81.3 million, $284.3
million and $199.9 million during 2001 and the years ended 2000 and 1999,
respectively (stated on a pro forma basis). Depreciation and amortization
expense, which related to fixed assets, goodwill and intangible assets, was
$42.8 million, $25.3 million and $11.4 million during 2001, 2000 and 1999,
respectively. Capital expenditures were $50.6 million in 2001, $71.0 million in
2000 and $19.4 million in 1999, or 7.4%, 5.6% and 2.2% of total revenues in
each year, respectively. Capital expenditures in 2001 primarily related to the
purchase of data processing and communications equipment, as well as leasehold
improvements and additional office facilities to support our growth. In
acquiring fixed assets, particularly technology equipment, we make a decision
about whether to lease such equipment or purchase it outright based on a number
of factors including its estimated useful life, obsolescence and cost.
Strategic investments and acquisition expenditures were $15.3 million, $58.9
million, and $17.3 million during 2001, 2000 and 1999, respectively. Strategic
investments and acquisition expenditures primarily relate to outside
investments and trading post acquisitions in support of the development and
growth our business. We also made investments in Deephaven's private investment
fund of $38.3 million and $19.4 million in 2001 and 1999, respectively. A
redemption of $13.8 million was made from the Deephaven private
28
investment fund in 2000. Our Deephaven investment can be liquidated upon
request with no advance notice. Additionally, we made cash payments of $6.3
million and $6.0 million in 2000 and 1999, respectively, in connection with our
acquisitions of the listed securities market-making businesses of KCM in 1995
and Tradetech in 1997. These arrangements ended during 2000. The aggregate
minimum rental commitments for 2002 are $22.4 million.
We have no debt at December 31, 2001 nor do we currently have any debt
commitments for 2002. We do not anticipate that we will need to incur debt to
meet our 2002 capital expenditure and operating needs.
As registered broker-dealers and market makers, KS, KCM, KFP and KEP are
subject to regulatory requirements intended to ensure the general financial
soundness and liquidity of broker-dealers and requiring the maintenance of
minimum levels of net capital, as defined in SEC Rule 15c3-1. These regulations
also prohibit a broker-dealer from repaying subordinated borrowings, paying
cash dividends, making loans to its parent, affiliates or employees, or
otherwise entering into transactions which would result in a reduction of its
total net capital to less than 120.0% of its required minimum capital.
Moreover, broker-dealers, including KS, KCM, KFP and KEP, are required to
notify the SEC 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 30.0% or more
of their excess net capital (net capital less minimum requirement). The SEC has
the ability to prohibit or restrict such transactions if the result is
detrimental to the financial integrity of the broker-dealer. At December 31,
2001, KS had net capital of $238.9 million, which was $236.2 million in excess
of its required net capital of $2.7 million, KCM had net capital of $56.1
million, which was $54.8 million in excess of its required net capital of $1.3
million, KFP had net capital of $38.3 million, which was $38.0 million in
excess of its required net capital of $250,000 and KEP had net capital of $2.1
million, which was $2.0 million in excess of its required net capital of
$141,531. Additionally, KSIL, KSJ and KFP are subject to capital adequacy
requirements of the Financial Services Authority in the United Kingdom and the
Financial Supervisory Agency in Japan, respectively. As of December 31, 2001,
we were in compliance with the capital adequacy requirements of all of our
foreign subsidiaries.
We currently anticipate that available cash resources and credit facilities
will be sufficient to meet our anticipated working capital and capital
expenditure requirements for at least the next 12 months.
Critical Accounting Policies
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions. We believe that, of our significant accounting policies, the
following policies involve higher degree of judgment.
Market-Making Activities--Securities owned and securities sold, not yet
purchased, which primarily consist of listed and OTC stocks and listed options
contracts, are carried at market value and are recorded on a trade date basis.
Market value is estimated daily using market quotations available from major
securities exchanges and dealers.
Goodwill and Intangible Assets--The useful lives of goodwill and intangible
assets are determined upon acquisition. Goodwill and intangible assets are
amortized over their respective lives. Impairment of the amounts recorded as
goodwill and intangible assets as well as their useful lives are tested, at a
minimum, on an annual basis.
Investments--Investments include strategic ownership interests of less than
20% in publicly and non-publicly traded companies which are accounted for under
the equity method or the cost basis of accounting. Additionally included is the
investment in the private investment fund for which the Company is the
investment manager and sponsor. The underlying investments in this private
investment fund are carried at market value. Investments are reviewed on an
ongoing basis to ensure that the valuation is reasonable.
29
Writedown of Fixed Assets--Writedowns for fixed assets are recognized when
it is determined that the carrying amount of the fixed asset is not recoverable
or has been impaired. The amount of the writedown is determined by the
difference between the carrying amount and the fair value of the fixed asset.
In determining recoverability and impairment, an estimated price is obtained
through research and inquiry of the market.
Lease Loss Accrual--It is the Company's policy to identify excess real
estate capacity and where applicable, accrue against such future costs. In
determining the accrual, a nominal cash flow analysis is performed, and costs
related to the excess capacity are accrued for.
Recently Issued Accounting Standards
In June 1998, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards (SFAS) No. 133, Accounting for
Derivative Instruments and Hedging Activities. This statement established
accounting and reporting standards for derivative instruments, including
certain derivative instruments imbedded in other contracts, and for hedging
activities. In June 1999, the FASB issued SFAS No. 137, Accounting for
Derivative Instruments and Hedging Activities--Deferral of the Effective Date
of FASB Statement No. 133--an amendment of FASB Statement No. 133. In June
2000, the FASB issued SFAS No. 138 Accounting for Certain Derivative
Instruments and Certain Hedging Activities, which is an amendment to SFAS No.
133 and is effective concurrently with SFAS No. 137. We adopted the provisions
of SFAS Nos. 133, 137 and 138 as of January 1, 2001. The adoption of these
statements did not have a material impact on our financial statements.
In September 2000, the FASB issued SFAS No. 140 Accounting for the Transfers
and Servicing of Financial Assets and Extinguishments of Liabilities--a
replacement of FASB Statement No. 125. This statement resets accounting
standards for differentiating between securitizations and other transfers of
financial assets that are sales from transfers that are secured borrowings. We
adopted certain provisions of SFAS No. 140 as of December 31, 2000, which did
not have a material impact on our financial statements. We adopted the
remaining provisions of SFAS No. 140 as of April 1, 2001, which did not have a
material impact on our financial statements.
In June 2001, the FASB issued SFAS No. 141, Business Combinations. This
statement requires that companies account for all business combinations
initiated after June 30, 2001 using the purchase method of accounting. Business
combinations completed before June 30, 2001 originally accounted for under the
pooling of interest method will continue to be accounted for under that method.
This statement also addresses the initial recognition and measurement of
goodwill and other intangible assets acquired in a business combination. We
adopted the provisions of SFAS No. 141 as of July 1, 2001. The adoption of this
statement did not have an impact on our financial statements.
In July 2001, the FASB issued SFAS No. 142, Goodwill and Other Intangible
Assets. This statement establishes new standards for accounting for goodwill
and intangible assets acquired outside of, and subsequent to a business
combination. Under the new standards, goodwill and certain intangible assets
with an indefinite useful life will no longer be amortized, but will be tested
for impairment at least annually. Other intangible assets will continue to be
amortized over their useful lives. The useful lives and any impairment of other
intangible assets will also be tested at least annually. We adopted the
provisions of SFAS No. 142 effective January 1, 2002. The Company is currently
evaluating the effects, if any, of impairment of goodwill. The Company expects
that the elimination of the amortization of goodwill and intangible assets with
indefinite lives will decrease operating expenses by approximately $6.4 million
in 2002.
In June 2001, the FASB issued SFAS No. 143, Accounting for Asset Retirement
Obligations. This statement establishes standards for financial accounting and
reporting for obligations associated with the retirement of tangible long-lived
assets and the associated asset retirement costs. We adopted the provisions of
SFAS No. 143 effective January 1, 2002 and do not believe that the adoption of
this statement will have a material impact on our financial statements.
30
In August 2001, the FASB issued SFAS No. 144 Accounting for the Impairment
or Disposal of Long-Lived Assets. This statement supersedes SFAS No. 121
Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
be Disposed Of. SFAS No. 144 establishes a single model for accounting for the
impairment or disposal of long-lived assets. We adopted the provisions of SFAS
No. 144 effective January 1, 2002 and do not believe that the adoption of this
statement will have a material impact on our financial statements.
Risk Factors
We face a number of risks that may adversely affect our business, financial
condition and results. These include, but are not limited to, the following:
. GENERAL RISKS ASSOCIATED WITH FLUCTUATIONS IN THE SECURITIES BUSINESS
The securities industry has undergone several fundamental changes over the
last five years as a result of new regulations at the federal and state level,
the emergence of electronic discount brokers, the increased prominence of
retail investors, consolidation among firms in the securities industry and the
increased use of technology. These changes have resulted in an increase in the
volume of equity securities traded in the U.S. equity markets and a decrease in
spreads between the bid and ask prices. The introduction of decimalization and
the one-penny MPV in 2001 has further significantly adversely affected spreads
with a resulting decrease in our profitability and revenue capture per trade.
There can be no assurance that the spreads market makers receive upon execution
of trades in equity securities will not continue to decrease in the future. Any
further decline in the spreads between the bid and ask prices could have a
material adverse effect on the Company's business, financial condition and
operating results.
. REGULATORY AND LEGAL UNCERTAINTIES COULD HARM OUR BUSINESS
The securities industry in the United States is subject to extensive
regulation under both federal and state laws. Market makers are subject to
regulations concerning certain aspects of their business, including trade
practices, best execution practices, capital structure, record retention and
the conduct of directors, officers and employees. Our operations and
profitability may be directly affected by, among other things, additional
legislation, changes in rules promulgated by the SEC, the NASD, the Federal
Reserve, the various stock exchanges and other self-regulatory organizations,
or changes in the interpretation or enforcement of existing laws and rules.
Failure to comply with any of these laws, rules or regulations could result in
censure, fines, the issuance of cease-and-desist orders or the suspension or
disqualification of a market makers' directors, officers or employees. Our
ability to comply with applicable laws and rules is largely dependent on our
internal system to ensure compliance, as well as our ability to attract and
retain qualified compliance personnel. We could be subject to disciplinary or
other actions in the future due to claimed noncompliance, which could have a
material adverse effect on our business, financial condition and results of
operations.
In addition, our business, both directly and indirectly, relies on the
Internet and other electronic communications gateways. The use of such gateways
may be expanded in the future. To date, the use of the Internet has been
relatively free from regulatory restraints. It is possible that additional laws
and regulations relating to the Internet may be adopted in the future,
including regulations regarding the taxation, pricing, content and quality of
products and services delivered over the Internet. Any such laws or regulations
might constrain our, and our customers', ability to transact business through
the Internet or other electronic communications gateways and/or increase the
cost of such use. As a result, the adoption of such laws and regulations could
have a material adverse effect on our business, financial condition and results
of operations.
The NASD has announced the pending launch of a new facility for order
collection and display in Nasdaq, called SuperMontage, in summer 2002. This new
initiative, along with other potential regulatory actions and improvements in
technology, could impact the manner in which business is currently conducted in
Nasdaq. These
31
new rules, regulatory actions, and changes in market customs and practices
could have a material adverse effect on the Company's business, financial
condition and operating results.
During the last two years, we have expanded our business internationally. As
a result, we need to comply with the relevant regulations of each country in
which we conduct business. Our international expansion may be limited by the
compliance requirements of these jurisdictions.
. WE ARE HIGHLY DEPENDENT ON KEY PERSONNEL
We are highly dependent on a limited number of key executive officers. We
have entered into an employment agreement with our interim Chief Executive
Officer, Anthony M. Sanfilippo, and maintain a "key person" life insurance
policy on him. Certain other officers at our subsidiaries also have employment
agreements but we do not maintain "key person" life insurance policies on any
of them. Our success will be dependent to a large degree on our ability to
retain the services of our existing key executive officers and to attract and
retain additional qualified personnel in the future. Competition for these
personnel is intense. Recently, we have experienced changeover in our executive
management team. The loss of the services of any of our key remaining executive
officers or the inability to identify, hire and retain other highly qualified
executive management in the future could have a material adverse effect on our
business, financial condition and results of operations.
Our success also depends, in part, on the highly skilled, and often
specialized, individuals we employ. Our ability to attract and retain
management, sales, trading and technical professionals is particularly
important to our business strategy. The Company strives to provide high quality
services that will allow it to establish and maintain long-term relationships
with its customers. The Company's ability to do so depends, in large part, upon
the individual employees who represent the Company in its dealings with such
customers. There can be no assurance that the Company will not lose such
professionals due to increased competition or other factors in the future. The
loss of a sales and trading professional, particularly a senior professional
with broad industry expertise, could have a material adverse effect on the
Company's business, financial condition and operating results.
. LITIGATION AND POTENTIAL SECURITIES LAWS LIABILITY
Many aspects of our business involve substantial risks of liability. A
market maker is exposed to liability under federal and state securities laws,
other federal and state laws and court decisions, as well as rules and
regulations promulgated by the SEC and the NASD. We are also subject to the
risk of litigation and claims that may be without merit. From time to time, we
and certain of our past and present officers,directors and employees have been
named as parties in lawsuits, securities arbitrations and administrative
claims. In addition, certain corporate events, such as a reduction in our
workforce, could also result in additional litigation or arbitration. As we
intend to defend vigorously any such litigation or proceeding, legal expenses
could be incurred. An adverse resolution of any current or future lawsuits,
proceedings or claims against us could have a material adverse effect on the
Company's business, financial condition and operating results.
. RISK OF LOSSES ASSOCIATED WITH OUR MARKET-MAKING AND TRADING
We conduct our market-making activities predominantly as a principal, which
subjects our capital to significant risks. These activities involve the
purchase, sale or short sale of securities for our own account and,
accordingly, involve risks of price fluctuations and illiquidity, or rapid
changes in the liquidity of markets that may limit or restrict our ability to
either resell securities we purchase or to repurchase securities we sell in
such transactions. From time to time, we may have large position concentrations
in securities of a single issuer or issuers engaged in a specific industry,
which might result in higher trading losses than would occur if our positions
and activities were less concentrated. The success of our market-making
activities depends upon our ability to attract order flow, the skill of our
personnel, general market conditions, the price volatility of specific
securities and the availability of capital. To attract order flow, we must be
competitive on price, size of securities positions traded, order execution,
technology, reputation and customer service. In our role as a market maker, we
32
attempt to derive a profit from the difference between the prices at which we
buy and sell securities. However, competitive forces often require us to match
the quotes other market makers display and to hold varying amounts of
securities in inventory. By having to maintain inventory positions, we are
subject to a high degree of risk. There can be no assurance that we will be
able to manage such risk successfully or that we will not experience
significant losses from such activities. All of the above factors could
materially adversely affect our business, financial condition and operating
results.
. OUR FUTURE OPERATING RESULTS MAY FLUCTUATE SIGNIFICANTLY
We may experience significant variation in our future quarterly results of
operations. These fluctuations may result from, among other things,
introductions of or enhancements to market-making services by us or our
competitors, the value of our securities positions and our ability to manage
the risks attendant thereto, the volume of our market-making activities,
volatility in the securities markets, performance of our early-stage
international businesses, our ability to manage personnel, overhead and other
expenses, the amount of revenue derived from limit orders as a percentage of
total revenues, changes in payments for order flow, clearing costs, the
addition or loss of sales and trading professionals, legislative and regulatory
changes, the amount and timing of capital expenditures, the incurrence of costs
associated with acquisitions, seasonality and general economic conditions. Our
expense structure is based on historical expense levels and the levels of
demand for our market-making services. Recently, with our expansion
internationally, our fixed costs have risen. If demand for our market-making
services declines due to any of the above factors, or others not listed, and we
are unable to adjust our cost structure on a timely basis, our operating
results could be materially and adversely affected. There also can be no
assurance that we will be able to sustain the rates of revenue growth that we
have experienced in the past, that we will be able to improve our operating
results or that we will be able to sustain our profitability on a quarterly
basis. In addition, our future quarterly operating results may not consistently
meet the expectations of securities analysts or investors, which could have a
material adverse effect on the market price of our Class A Common Stock.
. OUR BUSINESS COULD BE HARMED BY ADVERSE ECONOMIC, POLITICAL AND MARKET
CONDITIONS
The securities business generally is, by its nature, volatile. It is
directly affected by numerous national and international factors that are
beyond our control, including, among others, economic, political and market
conditions; the availability of short-term and long-term funding and capital;
the level and volatility of interest rates; legislative and regulatory changes;
currency values and inflation. Any one or more of these factors may contribute
to reduced levels of activity in the securities markets generally, or increased
market volatility, which could result in lower revenues from the Company's
market-making activities. For example, the terrorist attacks in the United
States on September 11, 2001 resulted in lost revenues due to the closing of
U.S. financial markets for four days. When the markets reopened, there was a
period of substantial market volatility. Any reduction in revenues or any loss
resulting from the above factors could have a material adverse effect on the
Company's business, financial condition and operating results.
. SUBSTANTIAL COMPETITION COULD REDUCE OUR MARKET SHARE AND HARM OUR FINANCIAL
PERFORMANCE
We derive substantially all of our revenues from market-making and asset
management activities. The market for these services is rapidly evolving and
intensely competitive. We expect the competitive environment to continue and
intensify in the future. We face direct competition in our equity market-making
business primarily from wholesale global national and regional broker-dealers,
and also alternative trading systems, including ECNs. In our options
market-making business we compete with other options specialists and
market-makers, while our asset management business competes with other asset
management companies. We compete in market-making primarily on the basis of
execution standards, our relationship with our customers, reputation and
technology. In asset management we compete primarily on our reputation and
returns on our managed fund. A number of our competitors have greater
financial, technical, marketing and other resources than we do. Some of our
competitors offer a wider range of services and financial products than we do
and have greater name
33
recognition and a more extensive client base than we do. These competitors may
be able to respond more quickly to new or evolving opportunities, technologies
and customer requirements than us and may be able to undertake more extensive
promotional activities and offer more attractive terms to clients. Moreover,
current and potential competitors have established or may establish cooperative
relationships among themselves or with third parties or may consolidate to
enhance their services and products. We believe that new competitors, or
alliances among competitors, may also emerge and they may acquire significant
market share. There can be no assurance that we will be able to compete
effectively with current or future competitors, which could have a material
adverse effect on our business, financial condition and results of operations.
. OUR DEPENDENCE ON MARKET-MAKING ACTIVITIES AND CREDIT RISKS ASSOCIATED WITH
OUR CLEARING BROKERS
The majority of our revenues are derived from market-making activities. We
expect this to continue for the foreseeable future. Any factor adversely
affecting market-making in general, or our market-making activities in
particular, could adversely affect our business, financial condition and
operating results. Our future success will depend on continued demand for our
market-making services and our ability to respond to regulatory and
technological changes, as well as customer demands. If demand for our
market-making services fails to grow, grows more slowly than we currently
anticipate, or declines, our business, financial condition and operating
results could be materially and adversely affected.
As a market maker of OTC and listed stocks, and as a specialist in listed
options, the majority of our securities transactions are conducted as principal
with broker-dealer and institutional counterparties located in the United
States. We clear our securities transactions through unaffiliated clearing
brokers. Under the terms of the agreements between us and our clearing brokers,
the clearing brokers have the right to charge us for losses that result from a
counterparty's failure to fulfill its contractual obligations. Our policy is to
monitor the credit standing of the counterparties with which we conduct
business. However, no assurance can be given that any such counterparty will
not default on their obligations, which default could have a material adverse
effect on our business, financial condition and operating results. In addition,
at any time, a substantial portion of our assets are held at one or more
clearing brokers and, accordingly, we are subject to credit risk with respect
to such clearing brokers. Consequently, we are reliant on the ability of our
clearing brokers to adequately discharge their obligations on a timely basis.
We are also dependent on the solvency of such clearing brokers. Any failure by
the clearing brokers to adequately discharge their obligations on a timely
basis, or failure by a clearing broker to remain solvent, or any event
adversely affecting the clearing brokers, could have a material adverse effect
on our business, financial condition and operating results.
. RISKS RELATED TO CUSTOMER CONCENTRATION
A small number of customers have historically accounted for a significant
portion of our equity order flow, and we expect a significant portion of the
future demand for our market-making services to remain concentrated within a
limited number of customers. None of our customers are contractually obligated
to utilize us as market maker and, accordingly, these customers may direct
their trading activities to other market makers at any time. Recently, some of
these customers have purchased market-makers and specialist firms to
internalize order flow. There can be no assurance that we will be able to
retain these major customers or that such customers will maintain or increase
their demand for our market-making activities. Our asset management business
also has a limited number of investors. The loss, or a significant reduction,
of demand for our services from any of these customers could have a material
adverse effect on our business, financial condition and operating results.
. THE MARKET PRICE OF OUR CLASS A COMMON STOCK COULD FLUCTUATE
Our Class A Common Stock has experienced price fluctuations in the last year
along with the stock market in general. In addition, certain former officers
and directors own shares of our Class A Common Stock, with limited restrictions
on their resale. As a result, the price of our Class A Common Stock could
continue to fluctuate. In addition, because the market price of our Class A
Common Stock tends to fluctuate we may become the object of securities class
action litigation. Securities class action litigation may result in substantial
costs and a diversion of management's attention and resources.
34
. RISKS ASSOCIATED WITH DECLINES IN MARKET VOLUME, PRICE OR LIQUIDITY
Our revenues may decrease in the event of a decline in market volume, prices
or liquidity. Declines in the volume of securities transactions and in market
liquidity generally result in lower revenues from market-making activities.
Lower price levels of securities may also result in decreased trading volume
and reduced revenue capture per share, and thereby reduced revenues from
market-making transactions, as well as result in losses from declines in the
market value of securities held in inventory. Sudden sharp declines in market
values of securities can result in illiquid markets, declines in the market
values of securities held in inventory, the failure of buyers and sellers of
securities to fulfill their obligations and settle their trades and increases
in claims and litigation. Any decline in market volume, price or liquidity or
any other of these factors could have a material adverse effect on our
business, financial condition and operating results.
. WE MAY NOT SUCCEED IN INTERNATIONAL MARKETS
We have limited experience in providing market-making services
internationally as we currently have operations only in London, England and
Tokyo, Japan. We may not succeed in marketing our services in international
markets. In addition, there are risks inherent in doing business in
international markets that may include in some markets, less developed
technological infrastructures, lower client acceptance of, or access to,
electronic channels, regulatory requirements, tariffs and other trade barriers,
reduced protection for intellectual property rights, difficulties in staffing
and managing foreign operations, less developed automation in exchanges,
depositories and clearing systems, fluctuations in currency exchange rates, and
potentially adverse tax consequences. We have experienced significant losses to
date in our international operations. We continue, and will continue in the
future, to reassess our investments in international markets based on the above
factors, market conditions and our financial performance. Should market
conditions and financial performance continue to decline we may elect to
discontinue part or all of our international market-making operations which
could have a material adverse impact on our business, financial condition and
operating results.
. WE EXPERIENCE SEASONALITY IN OUR BUSINESS
We have experienced, and may experience in the future, seasonality in our
business. We have historically experienced a decrease in revenues in the third
quarter of the year, due to lower volumes typically associated with the summer
months. We believe that this seasonal trend will continue for the foreseeable
future and that the Company's business, financial condition and operating
results may be adversely affected by such trends in the future. As a result,
period-to-period comparisons of the revenues and operating results of the
Company are not necessarily meaningful and such comparisons cannot be relied
upon as indicators of future performance.
. OUR ASSET MANAGEMENT BUSINESS COULD BE HARMED
Our asset management business is subject to a variety of risks. These risks
include the departure of key management, excessive redemptions by investors and
volatility of the fund's returns. If any of these events were to occur, it
could have a material adverse impact on our business, financial condition and
operating results.
. WE MUST PROTECT OUR INTELLECTUAL PROPERTY
Our success and ability to compete are dependent to a degree on fully
protecting our intellectual property, which includes our proprietary
technology, trade secrets and client base. We rely on numerous modes of
intellectual property protection to protect our intellectual property,
including copyright, trade secret, trademark, domain name, patent and contract
law. Notwithstanding the precautions taken by us to protect our intellectual
property, it is possible that third parties may misappropriate, obtain, copy or
use without authorization, or otherwise infringe upon, our intellectual
property. It is also possible that third parties may independently develop
intellectual property similar to ours. There can be no assurance that the steps
taken by us will prevent misappropriation of our intellectual property rights.
Such misappropriation could have a material adverse effect upon our business,
financial condition and operating results. In addition, the laws of foreign
countries may afford different, and possibly inadequate, protection of our
intellectual property.
35
We license software from third parties, including our trading systems, that
are integral to our business. The failure by us to maintain these
relationships, or to find a replacement for such technology in a timely and
cost-effective manner, could have a material adverse effect on our business,
financial condition and operating results. In addition, litigation may be
necessary in the future to enforce our intellectual property rights, to protect
our trade secrets, to determine the validity and scope of the proprietary
rights of others, or to defend against claims of infringement or invalidity.
Such litigation, whether successful or unsuccessful, could result in
substantial costs and diversions of resources either of which could have a
material adverse effect on our business, financial condition and operating
results.
. SYSTEMS FAILURES AND DELAYS COULD HARM OUR BUSINESS
Our market-making activities are heavily dependent on the integrity and
performance of the computer and communications systems supporting them. Our
systems and operations are vulnerable to damage or interruption from human
error, natural disasters, power loss, computer viruses, intentional acts of
vandalism and similar events. Extraordinary trading volumes or other events
could cause our computer systems to operate at an unacceptably low speed or
even fail. While we have invested significant amounts in the last few years to
upgrade the reliability and scalability of our systems, there can be no
assurance that our systems will be sufficient to handle such extraordinary
trading volumes or other events for our clients. Any significant degradation or
failure of our computer systems or any other systems in the trading process
could cause clients to suffer delays in trading. Such delays could cause
substantial losses for our clients and could subject us to claims from our
clients for losses, including litigation claiming fraud or negligence. In the
past, high trading volume has caused significant delays in executing some
trading orders, resulting in some clients' orders being executed at prices they
did not anticipate. From time to time, we have reimbursed our clients for
losses incurred in connection with systems failures and delays. Systems
failures and delays may occur again in the future and could cause, among other
things, unanticipated disruptions in service to our clients, slower system
response times resulting in transactions not being processed as quickly as our
clients desire, decreased levels of client service and client satisfaction, and
harm to our reputation. If any of these events were to occur, we could suffer a
loss of clients or a reduction in the growth of our client base, increased
operating expenses, financial losses, additional litigation or other client
claims, and regulatory sanctions or additional regulatory burdens. In addition,
we currently do not have a live disaster recovery center. If we are prevented
from using our current trading operations, we will not have business
continuity. This could have a material adverse effect on our business,
financial condition and operating results.
. CAPACITY CONSTRAINTS OF OUR SYSTEMS COULD HARM OUR BUSINESS
In the event our business significantly increases, we may need to expand and
upgrade our transaction processing systems, network infrastructure and other
aspects of our technology. Many of our systems are designed to accommodate
additional growth without redesign or replacement; however, we may need to
continue to make investments in additional hardware and software to accommodate
growth. We may not be able to project accurately the rate, timing or cost of
any increases in our business, or to expand and upgrade our systems and
infrastructure to accommodate any increases in a timely manner. Failure to make
necessary expansions and upgrades to our systems and infrastructure could lead
to failures and delays, which could have a material adverse effect on our
business, financial condition and results of operations.
. WE MAY NOT BE ABLE TO KEEP UP WITH RAPID TECHNOLOGICAL AND OTHER CHANGES
The markets in which we compete are characterized by rapidly changing
technology, evolving industry standards, frequent new product and service
announcements, introductions and enhancements and changing customer demands. If
we are not able to keep up with these rapid changes on a timely and
cost-effective basis, we may be at a competitive disadvantage. In addition, the
widespread adoption of new Internet, networking or telecommunications
technologies or other technological changes could require us to incur
substantial expenditures to modify or adapt our services or infrastructure. Any
failure by us to anticipate or respond adequately to technological
advancements, customer requirements or changing industry standards, or any
delays in the development, introduction or availability of new services,
products or enhancements could have a material adverse effect on our business,
financial condition and operating results.
36
. WE WILL NEED TO INTRODUCE NEW PRODUCTS AND SERVICES TO REMAIN COMPETITIVE
Our future success depends in part on our ability to develop and enhance our
products and services. There are numerous technical and financial risks in the
development of new or enhanced products and services, including the risk that
we will be unable to effectively use new technologies, adapt our services to
emerging industry standards, or develop, introduce and market new or enhanced
products and services. If we are unable to develop and introduce enhanced or
new products and services quickly enough to respond to market or client
requirements, or if our products and services fail to achieve market
acceptance, our business, financial condition and results of operations could
be materially adversely affected.
. ACQUISITIONS, EQUITY INVESTMENTS AND STRATEGIC RELATIONSHIPS INVOLVE CERTAIN
RISKS
We may in the future pursue strategic acquisitions of, or equity investments
in, businesses and technologies. Acquisitions may entail numerous risks,
including difficulties in assessing values for acquired businesses and
technologies, difficulties in the assimilation of acquired operations and
products, diversion of management's attention from other business concerns,
assumption of unknown material liabilities of acquired companies, amortization
of acquired intangible assets, which could reduce future reported earnings, and
potential loss of clients or key employees of acquired companies. We may not be
able to integrate successfully any operations, personnel, services or products
that we acquire in the future. Equity investments may also entail some of the
risks described above. We currently have a number of equity investments in the
financial services industry, totaling in the aggregate $40.4 million, including
investments in Nasdaq, Nasdaq Europe and Nasdaq Japan. If these investments are
unsuccessful, we may need to incur an impairment charge against earnings. We
have also established a number of strategic relationships. These relationships
and others we may enter into in the future may be important to our business and
growth prospects. We may not be able to maintain these relationships or develop
new strategic alliances.
. FAILURE TO COMPLY WITH NET CAPITAL REQUIREMENTS COULD ADVERSELY AFFECT OUR
BUSINESS
The SEC, the NASD and various other regulatory agencies have stringent rules
with respect to the maintenance of specific levels of net capital by securities
broker-dealers. Net capital is a SEC-defined measure of a broker-dealer's
readily available liquid assets, reduced by its total liabilities other than
approved subordinated debt. All of our broker-dealer subsidiaries are required
to comply with the net capital requirements. If we fail to maintain the
required net capital, the SEC could suspend or revoke our registration, or the
NASD and other regulatory bodies could suspend or expel us, which could
ultimately lead to our liquidation. If the net capital rules are changed or
expanded, or if there is an unusually large charge against net capital,
operations that require the intensive use of capital would be limited. A
significant operating loss or any unusually large charge against net capital
could adversely affect our ability to expand or even maintain our present
levels of business, which could have a material adverse effect on our business,
financial condition and results of operations.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Our market-making and trading activities expose our capital to significant
risks. These risks include, but are not limited to, absolute and relative price
movements, price volatility and changes in liquidity, over which we have
virtually no control.
We employ automated proprietary trading and risk management systems which
provide real-time risk management and inventory control. We monitor our risks
by a constant review of trading positions and their appropriate risk measures.
We have established a system whereby transactions are monitored by senior
management on a real-time basis as are individual and aggregate dollar and
inventory position totals, appropriate risk measures and real-time profits and
losses. The management of trading positions is enhanced by review of
mark-to-market valuations and position summaries on a daily basis.
37
In the normal course of our equities market-making business, we maintain
inventories of exchange-listed and OTC equity securities. The fair value of
these securities at December 31, 2001 and 2000 was $152.8 million and $256.4
million, respectively, in long positions and $153.6 million and $70.0 million,
respectively, in short positions. Additionally, at December 31, 2001, we have
$137.5 million in long positions and $70.5 million in short positions in
accounts managed by Deephaven. The potential change in fair value, using a
hypothetical 10.0% decline in prices, is estimated to be a $6.6 million loss
and a $18.6 million loss as of December 31, 2001 and 2000, respectively, due to
the offset of losses in long positions with gains in short positions. The
following table illustrates, for the period indicated, our average, highest and
lowest month-end inventory at market value (based on both the aggregate and the
net of the long and short positions of trading securities from our OTC and
exchange-listed market making business).
Year Ended December 31,
-------------------------------------------------------------------------------------
2001 2000 1999
--------------------------- --------------------------- ---------------------------
Aggregate of Net of Long Aggregate of Net of Long Aggregate of Net of Long
Long and Short and Short Long and Short and Short Long and Short and Short
Positions Positions Positions Positions Positions Positions
-------------- ------------ -------------- ------------ -------------- ------------
Average month-end $263,363,432 $ 15,983,285 $315,072,743 $ 62,933,087 $193,579,372 $ 22,266,851
Highest month-end 518,042,400 70,961,224 511,802,399 186,379,465 398,804,534 51,252,815
Lowest month-end. 200,780,312 (41,878,074) 217,495,778 (57,737,157) 147,263,084 (22,736,612)
In the normal course of our options market-making business, we maintain
inventories of options, futures and equities. Our main exposure is from equity
price and volatility risk. We manage these exposures by constantly monitoring
and diversifying our exposures and position sizes and establishing offsetting
hedges. Our market-making staff and trading room managers continuously manage
our positions and our risk exposures. Our systems incorporate trades and update
our risk profile using options pricing models on a real-time basis.
Our proprietary options risk management system allows us to stress test our
portfolio on a real-time basis. On a daily basis, risk reports are distributed
to senior management and the firm's risk managers who incorporate this
information in our daily market-making decisions. These reports identify
potential exposures in terms of options and futures on individual securities
and index contracts, organized in different ways such as industry sectors,
under extreme price and volatility movements. At December 31, 2001, 10%
movements in volatility and stock prices on our entire equity options and
equity index options portfolios, which contain the majority of our market risk,
would have resulted in approximately the following gains (losses) in our
options market making portfolio:
Change in Stock Prices
----------------------------------------
-10% None +10%
------------ ------------ -------------
Change in Volatility
+10%............. $5.6 million $1.4 million $12.3 million
None............. 5.2 million -- 10.2 million
-10%............. 5.0 million (1.3 million) 7.9 million
This stress analysis covers positions in options and futures, underlying
securities and related hedges. The 10% changes in stock prices and volatility
in the charts above make the assumption of a universal 10% movement in all of
our underlying positions. The analysis also includes a number of estimates that
we believe to be reasonable, but cannot assure that they produce an accurate
measure of future risk.
For working capital purposes, we invest in money market funds, commercial
paper, government securities or maintain interest-bearing balances in our
trading accounts with clearing brokers, which are classified as cash
equivalents and receivable from clearing brokers, respectively, in the
Consolidated Statements of Financial Condition. These other amounts do not have
maturity dates or present a material market risk, as the balances are
short-term in nature and subject to daily repricing. Our cash and cash
equivalents held in foreign currencies are subject to the exposure of foreign
currency fluctuations. These balances are monitored daily, and are not material
to the Company's overall cash position.
38
Consolidated Quarterly Results (unaudited)
The following table sets forth certain unaudited consolidated quarterly
statement of income data and certain unaudited consolidated quarterly operating
data for the years ended December 31, 2001 and 2000. In the opinion of our
management, this unaudited information has been prepared on substantially the
same basis as the consolidated financial statements appearing elsewhere in this
annual report and includes all adjustments (consisting of normal recurring
adjustments) necessary to present fairly the unaudited consolidated quarterly
data. The unaudited consolidated quarterly data should be read in conjunction
with the audited consolidated financial statements and notes thereto appearing
elsewhere in this annual report. The results of any quarter are not necessarily
indicative of results for any future period.
Quarter Ended
-----------------------------------------------------------------------------
Dec. 31, Sept. 30, June 30, Mar. 31, Dec. 31, Sept. 30, June 30, Mar. 31,
2001 2001 2001 2001 2000 2000 2000 2000
-------- --------- -------- -------- -------- --------- -------- --------
(in thousands)
Revenues
Net trading revenue.................. $139,106 $103,039 $135,030 $187,454 $223,116 $165,106 $282,515 $486,778
Commissions and fees................. 11,317 9,688 12,426 14,512 13,255 5,877 5,998 7,418
Asset management fees................ 4,978 10,471 8,588 12,720 10,857 10,013 11,241 9,774
Interest and dividends, net of
interest expense.................... 4,332 6,599 8,709 5,309 2,865 5,653 4,112 3,507
Investment income and other.......... 2,587 1,142 1,053 5,651 1,235 1,216 3,262 3,512
-------- -------- -------- -------- -------- -------- -------- --------
Total revenues...................... 162,320 130,939 165,806 225,646 251,328 187,865 307,128 510,989
-------- -------- -------- -------- -------- -------- -------- --------
Expenses
Employee compensation and
benefits/pro forma employee
compensation and benefits (1)....... 58,002 53,636 58,638 79,695 86,377 57,308 102,286 175,466
Execution and clearance fees......... 30,729 26,645 30,096 30,049 28,623 24,476 28,917 30,222
Payments for order flow.............. 17,610 14,413 20,200 29,718 39,738 37,270 38,319 59,318
Communications and data
processing.......................... 11,392 13,237 13,396 12,831 10,737 8,057 7,105 7,126
Depreciation and amortization........ 11,548 10,620 10,368 10,223 8,244 7,375 5,501 4,215
Occupancy and equipment rentals...... 6,799 4,144 4,586 5,011 5,930 5,405 4,314 3,093
Professional fees.................... 2,207 3,681 3,510 5,654 5,043 5,844 6,107 4,532
Business development................. 1,751 2,392 4,105 3,370 4,245 2,438 2,884 5,239
Writedown of assets and lease loss
accrual............................. 2,343 6,624 11,572 -- -- -- -- --
Other................................ 3,699 5,659 4,271 5,943 4,824 5,168 2,304 4,996
-------- -------- -------- -------- -------- -------- -------- --------
Total expenses...................... 146,080 141,051 160,742 182,494 193,761 153,341 197,737 294,207
-------- -------- -------- -------- -------- -------- -------- --------
Income before income taxes and
minority interest..................... 16,240 (10,112) 5,064 43,152 57,567 34,524 109,391 216,782
Income tax expense/pro forma income
tax expense (2)....................... 5,052 (1,129) 3,556 17,982 22,976 14,110 41,906 81,098
-------- -------- -------- -------- -------- -------- -------- --------
Income before minority interest........ 11,188 (8,983) 1,508 25,170 34,591 20,414 67,485 135,684
Minority interest in consolidated
subsidiaries.......................... (2,289) (3,311) (2,295) (1,747) (659) (178) -- --
-------- -------- -------- -------- -------- -------- -------- --------
Net income/pro forma net income........ $ 13,477 $ (5,672) $ 3,803 $ 26,917 $ 35,250 $ 20,592 $ 67,485 $135,684
======== ======== ======== ======== ======== ======== ======== ========
Other Operating Data
Total U.S. equity shares traded (in
millions)............................. 43,100 31,422 34,066 26,451 24,797 21,922 21,517 43,817
Total U.S. equity trades executed...... 30,900 24,414 31,804 30,177 33,957 31,419 33,285 44,069
Average daily U.S. equity trades....... 483 414 505 487 539 499 528 700
Average daily net U.S. equities trading
revenues.............................. $ 1,777 $ 1,162 $ 1,697 $ 2,342 $ 2,905 $ 2,269 $ 3,893 $ 7,209
Total U.S. option contracts executed... 9,827 8,677 10,486 8,450 8,250 5,131 4,473 3,527
- --------
Certain prior quarter amounts have been reclassified to conform to current
year presentation.
(1) Before our merger, Arbitrade was a limited liability company and
compensation and benefits to Arbitrade's members was accounted for as
distributions of members' equity. Pro forma compensation expense was
computed as 15% of the before-tax profits earned by Arbitrade for the
period ended January 12, 2000, the date of the Merger.
(2) Before our merger with Arbitrade, Arbitrade was a limited liability company
and was not subject to income taxes. Of the $81,098 in income taxes for the
quarter ended March 31, 2000, $643 represents pro forma income taxes for
the period from January 1, 2000 through January 12, 2000, and $80,455
represents actual income taxes for the period from January 13, 2000 through
March 31, 2000. The income tax amounts for subsequent quarters represent
actual income taxes. See Note 15 of the Notes to Consolidated Financial
Statements.
39
Item 8. Financial Statements and Supplementary Data
KNIGHT TRADING GROUP, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
----
Report of Independent Accountants................................................................ 41
Consolidated Statements of Financial Condition as of December 31, 2001 and 2000.................. 42
Consolidated Statements of Income for the years ended December 31, 2001, 2000 and 1999........... 43
Consolidated Statements of Changes in Stockholders' Equity for the years ended December 31, 1999,
2000 and 2001.................................................................................. 44
Consolidated Statements of Cash Flows for the years ended December 31, 2001, 2000 and 1999....... 45
Notes to Consolidated Financial Statements....................................................... 46
40
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of
Knight Trading Group, Inc.
In our opinion, the accompanying consolidated statements of financial
condition and the related consolidated statements of income, of changes in
stockholders' equity and of cash flows present fairly, in all material
respects, the financial position of Knight Trading Group, Inc. and its
subsidiaries at December 31, 2001 and 2000, and the results of their operations
and their cash flows for each of the three years in the period ended December
31, 2001, in conformity with accounting principles generally accepted in the
United States of America. These financial statements are the responsibility of
the Company's management; our responsibility is to express an opinion on these
financial statements based on our audits. We conducted our audits of these
statements in accordance with auditing standards generally accepted in the
United States of America, which require that we plan and perform the audits to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements, assessing
the accounting principles used and significant estimates made by management,
and evaluating the overall financial statement presentation. We believe that
our audits provide a reasonable basis for our opinion.
PRICEWATERHOUSECOOPERS LLP
New York, New York
January 16, 2002
41
KNIGHT TRADING GROUP, INC.
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
December 31, December 31,
2001 2000
-------------- --------------
Assets
Cash and cash equivalents............................................ $ 361,294,311 $ 364,057,534
Securities owned, held at clearing broker, at market value........... 1,754,482,505 1,799,966,679
Receivable from brokers and dealers.................................. 820,103,479 114,047,275
Fixed assets and leasehold improvements at cost, less accumulated
depreciation and amortization of $67,505,292 in 2001 and
$34,969,580 in 2000................................................ 90,125,704 79,014,393
Goodwill and intangible assets, less accumulated amortization of
$25,364,234 in 2001 and $16,871,280 in 2000........................ 51,899,985 45,239,177
Investments.......................................................... 92,665,597 64,917,975
Other assets......................................................... 56,115,374 54,166,139
-------------- --------------
Total assets.................................................. $3,226,686,955 $2,521,409,172
============== ==============
Liabilities and Stockholders' Equity
Liabilities
Securities sold, not yet purchased, at market value............... $2,039,355,967 $1,427,214,323
Payable to brokers and dealers.................................... 227,526,691 184,269,478
Accrued compensation expense...................................... 65,121,718 62,444,645
Accrued execution and clearance fees.............................. 10,271,164 6,092,754
Accrued payments for order flow................................... 5,594,935 12,117,998
Accounts payable, accrued expenses and other liabilities.......... 22,286,928 30,093,885
Income taxes payable.............................................. 1,624,319 4,813,771
-------------- --------------
Total liabilities............................................. 2,371,781,722 1,727,046,854
-------------- --------------
Minority interest in consolidated subsidiaries....................... 20,648,809 20,175,872
-------------- --------------
Commitments and contingent liabilities (Notes 12 and 17)
Stockholders' equity
Class A Common Stock, $0.01 par value, 500,000,000 shares
authorized; 124,158,570 shares issued and outstanding at
December 31, 2001 and 123,290,780 shares issued and outstanding
at December 31, 2000............................................ 1,241,586 1,232,908
Additional paid-in capital........................................ 335,796,119 309,611,248
Retained earnings................................................. 504,472,861 465,947,294
Unamortized stock-based compensation.............................. (672,763) --
Accumulated other comprehensive income (loss)--foreign currency
translation adjustments, net of tax............................. (6,581,379) (2,605,004)
-------------- --------------
Total stockholders' equity.................................... 834,256,424 774,186,446
-------------- --------------
Total liabilities and stockholders' equity.................... $3,226,686,955 $2,521,409,172
============== ==============
The accompanying notes are an integral part of these consolidated financial
statements.
42
KNIGHT TRADING GROUP, INC.
CONSOLIDATED STATEMENTS OF INCOME
For the years ended December 31,
----------------------------------------
2001 2000 1999
------------ -------------- ------------
Revenues
Net trading revenue................................. $564,630,212 $1,157,515,897 $845,105,365
Commissions and fees................................ 47,942,570 32,547,907 16,439,090
Asset management fees............................... 36,756,865 41,883,882 19,921,092
Interest and dividends, net of interest expense..... 24,949,310 16,137,298 11,949,821
Investment income and other......................... 10,433,418 9,224,764 3,160,075
------------ -------------- ------------
Total revenues.................................. 684,712,375 1,257,309,748 896,575,443
------------ -------------- ------------
Expenses
Employee compensation and benefits.................. 249,971,154 421,169,673 269,223,837
Execution and clearance fees........................ 117,518,622 112,238,423 89,575,394
Payments for order flow............................. 81,941,538 174,645,438 138,696,691
Communications and data processing.................. 50,856,148 33,025,036 18,944,361
Depreciation and amortization....................... 42,759,165 25,335,639 11,395,735
Occupancy and equipment rentals..................... 20,540,053 18,741,887 10,706,397
Professional fees................................... 15,052,273 21,526,495 7,889,198
Business development................................ 11,617,364 14,806,302 10,294,545
Merger related costs................................ -- -- 9,969,295
Writedown of assets and lease loss accrual.......... 20,538,652 -- --
Other............................................... 19,572,254 17,289,411 7,050,073
------------ -------------- ------------
Total expenses.................................. 630,367,223 838,778,304 573,745,526
------------ -------------- ------------
Income before income taxes and minority interest....... 54,345,152 418,531,444 322,829,917
Income tax expense..................................... 25,461,246 159,446,394 111,545,941
------------ -------------- ------------
Income before minority interest........................ 28,883,906 259,085,050 211,283,976
Minority interest in consolidated subsidiaries......... 9,641,661 836,952 --
------------ -------------- ------------
Net income............................................. $ 38,525,567 $ 259,922,002 $211,283,976
============ ============== ============
Basic earnings per share............................... $ 0.31 $ 2.12 $ 1.75
============ ============== ============
Diluted earnings per share............................. $ 0.31 $ 2.05 $ 1.68
============ ============== ============
Shares used in basic earnings per share (see Note 13).. 123,796,181 122,520,733 120,821,710
============ ============== ============
Shares used in diluted earnings per share (see Note 13) 125,758,863 126,863,316 125,755,430
============ ============== ============
The accompanying notes are an integral part of these consolidated financial
statements.
43
KNIGHT TRADING GROUP, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
For the Years Ended December 31, 1999, 2000 and 2001
Class A Common Stock Class B Common Stock
---------------------- --------------------
Additional
Paid-In Retained
Shares Amount Shares Amount Capital Earnings
----------- ---------- ---------- -------- ------------ ------------
Balance January 1, 1999...................... 108,629,369 $1,086,294 7,885,396 $ 78,854 $174,906,189 $ 29,810,681
----------- ---------- ---------- -------- ------------ ------------
Net Income................................... -- -- -- -- -- 211,283,976
Translation adjustment arising during period,
net of taxes................................ -- -- -- -- -- --
Total comprehensive income...................
Net proceeds from stock offering............. 4,849,440 48,494 -- -- 80,171,043 --
Conversion of Class B Common Stock into Class
A Common Stock.............................. 7,885,396 78,854 (7,885,396) (78,854) -- --
Capital contributions from members of
pooled entity............................... 21,100,568
Capital distributions to members of
pooled entity............................... -- (35,069,365)
Stock options exercised...................... 757,265 7,573 -- -- 5,477,629 --
Income tax benefit--stock options exercised.. -- -- -- -- 10,311,592 --
----------- ---------- ---------- -------- ------------ ------------
Balance, December 31, 1999................... 122,121,470 1,221,215 -- -- 291,967,021 206,025,292
----------- ---------- ---------- -------- ------------ ------------
Net Income................................... -- -- -- -- -- 259,922,002
Translation adjustment arising during period,
net of taxes................................ -- -- -- -- -- --
Total comprehensive income...................
Stock options exercised...................... 1,169,310 11,693 -- -- 8,645,304 --
Income tax benefit--stock options exercised.. -- -- -- -- 8,998,923 --
----------- ---------- ---------- -------- ------------ ------------
Balance, December 31, 2000................... 123,290,780 1,232,908 -- -- 309,611,248 465,947,294
----------- ---------- ---------- -------- ------------ ------------
Net Income................................... -- -- -- -- -- 38,525,567
Translation adjustment arising during period,
net of taxes................................ -- -- -- -- -- --
Total comprehensive income...................
Stock options exercised...................... 795,550 7,956 -- -- 5,639,442 --
Issuance of restricted stocks................ 72,240 722 -- -- 845,640 --
Income tax benefit--stock options exercised.. -- -- -- -- 2,612,132 --
Amortization of restricted stock............. -- -- -- -- --
Capital contributions from minority investors -- -- -- -- 17,087,657 --
----------- ---------- ---------- -------- ------------ ------------
Balance, December 31, 2001................... 124,158,570 $1,241,586 -- $ -- $335,796,119 $504,472,861
=========== ========== ========== ======== ============ ============
Unamortized Other
Stock-based Comprehensive
Compensation Income Total
------------ ------------- ------------
Balance January 1, 1999...................... $ -- $ -- $205,882,018
--------- ----------- ------------
Net Income................................... -- -- 211,283,976
Translation adjustment arising during period,
net of taxes................................ -- 17,574 17,574
------------
Total comprehensive income................... 211,301,550
Net proceeds from stock offering............. -- -- 80,219,537
Conversion of Class B Common Stock into Class
A Common Stock.............................. -- -- --
Capital contributions from members of
pooled entity............................... 21,100,568
Capital distributions to members of
pooled entity............................... (35,069,365)
Stock options exercised...................... -- 5,485,202
Income tax benefit--stock options exercised.. -- -- 10,311,592
--------- ----------- ------------
Balance, December 31, 1999................... -- 17,574 499,231,102
--------- ----------- ------------
Net Income................................... -- -- 259,922,002
Translation adjustment arising during period,
net of taxes................................ -- (2,622,578) (2,622,578)
------------
Total comprehensive income................... 257,299,424
Stock options exercised...................... -- -- 8,656,997
Income tax benefit--stock options exercised.. -- -- 8,998,923
--------- ----------- ------------
Balance, December 31, 2000................... -- (2,605,004) 774,186,446
--------- ----------- ------------
Net Income................................... -- -- 38,525,567
Translation adjustment arising during period,
net of taxes................................ -- (3,976,375) (3,976,375)
------------
Total comprehensive income................... 34,549,192
Stock options exercised...................... -- -- 5,647,398
Issuance of restricted stocks................ (845,640) -- 722
Income tax benefit--stock options exercised.. -- -- 2,612,132
Amortization of restricted stock............. 172,877 172,877
Capital contributions from minority investors -- -- 17,087,657
--------- ----------- ------------
Balance, December 31, 2001................... $(672,763) $(6,581,379) $834,256,424
========= =========== ============
The accompanying notes are an integral part of these consolidated financial
statements.
44
KNIGHT TRADING GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the year ended December 31,
-------------------------------------------
2001 2000 1999
------------- ------------- -------------
Cash flows from operating activities
Net income.................................................. $ 38,525,567 $ 259,922,002 $ 211,283,976
Adjustments to reconcile net income to net cash provided by
operating activities
Income tax credit from stock options exercised........... 2,612,132 8,998,923 10,311,592
Issuance of restricted stock to employees................ 722 -- --
Depreciation and amortization............................ 42,759,165 25,335,639 11,395,735
Amortization of stock based compensation................. 172,877 -- --
Minority interest in losses of consolidated subsidiary... (9,641,661) (836,952) --
Writedown of assets and lease loss accrual............... 20,538,652 -- --
(Increase) decrease in operating assets
Securities owned......................................... 45,484,174 (889,733,763) (498,944,733)
Receivable from brokers and dealers...................... (706,056,204) 101,375,933 (107,886,202)
Other assets............................................. (3,520,748) (35,718,592) (11,858,208)
Increase (decrease) in operating liabilities
Securities sold, not yet purchased....................... 612,141,644 706,295,310 392,748,376
Securities sold under agreements to repurchase........... -- (10,409,736) (781,264)
Payable to brokers and dealers........................... 43,257,213 24,326,460 100,162,267
Accrued compensation expense............................. 2,677,073 5,210,037 34,117,054
Accounts payable, accrued expenses and other liabilities. (14,759,748) (26,734,175) 26,594,351
Accrued execution and clearance fees..................... 4,178,410 (2,278,302) 1,472,961
Accrued payments for order flow.......................... (6,523,063) (1,860,856) 5,306,186
Income taxes payable..................................... (3,189,452) (11,179,166) 13,707,317
------------- ------------- -------------
Net cash provided by operating activities............ 68,656,753 152,712,762 187,629,408
------------- ------------- -------------
Cash flows from investing activities
Purchases of fixed assets and leasehold improvements........ (50,611,876) (71,031,773) (19,370,770)
(Investment in)/redemptions from Deephaven-sponsored private
investment fund........................................... (38,313,572) 13,788,223 (19,357,725)
Strategic investments and acquisitions...................... (15,344,181) (58,850,150) (17,317,951)
Payment of contingent consideration......................... -- (6,284,903) (5,953,219)
------------- ------------- -------------
Net cash used in investing activities................ (104,269,629) (122,378,603) (61,999,665)
------------- ------------- -------------
Cash flows from financing activities
Repayment of short term loan................................ -- -- (11,016,766)
Proceeds from issuance of common stock...................... -- -- 80,219,537
Stock options exercised..................................... 5,647,398 8,656,997 5,485,202
Minority interest in consolidated subsidiary................ 27,202,255 21,012,824 --
Capital distributions to members of KFP..................... -- -- (13,968,797)
------------- ------------- -------------
Net cash provided by financing activities............ 32,849,653 29,669,821 60,719,176
------------- ------------- -------------
(Decrease) Increase in cash and cash equivalents............ (2,763,223) 60,003,980 186,348,919
------------- ------------- -------------
Cash and cash equivalents at beginning of period............ 364,057,534 304,053,554 117,704,635
------------- ------------- -------------
Cash and cash equivalents at end of period.................. $ 361,294,311 $ 364,057,534 $ 304,053,554
============= ============= =============
Supplemental disclosure of cash flow information:
Cash paid for interest............................... $ 23,274,594 $ 40,643,281 $ 9,070,476
============= ============= =============
Cash paid for income taxes........................... $ 33,664,468 $ 175,180,680 $ 98,376,867
============= ============= =============
- --------
Supplemental information pertaining to noncash investing and financing
activities:
During 1999, all outstanding shares of Class B Common Stock were converted into
shares of Class A Common Stock.
The accompanying notes are an integral part of these consolidated financial
statements.
45
KNIGHT TRADING GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Organization and Description of the Business
Knight Trading Group, Inc. (the "Company") and its subsidiaries operate in
securities market-making and asset management business lines. Knight Securities
("KS") operates as a market maker in over-the-counter equity securities ("OTC
securities"), primarily those traded in the Nasdaq stock market and on the OTC
Bulletin Board. Knight Capital Markets ("KCM," formerly Trimark Securities)
operates as a market maker in the Nasdaq Intermarket, the over-the-counter
market for New York Stock Exchange (NYSE)- and American Stock Exchange (AMEX)-
listed securities. Additionally, the Company makes markets in equity securities
in Europe and Japan. Knight Financial Products ("KFP") makes markets in options
on individual equities, equity indices and fixed income futures instruments in
the U.S. The Company also operates a professional option execution services
business through Knight Execution Partners ("KEP"). KS, KCM, KFP and KEP are
registered as broker-dealers with the Securities and Exchange Commission ("SEC"
or the "Commission"). Additionally, KS and KCM are members of the National
Association of Securities Dealers, Inc. ("NASD"). KFP is a member of the
Chicago Board Options Exchange as well as the American Stock Exchange, the
Pacific Exchange, the Philadelphia Stock Exchange and the International Stock
Exchange. The Company also maintains an asset management business for
institutions and high net worth individuals through its Deephaven subsidiary.
In the first quarter of 2001, the Company began its Knight Roundtable Europe
venture. Currently, 21 broker-dealers and banks from Europe and the United
States own an approximate 15% minority interest in the venture. The venture
owns and operates Knight Securities International, Ltd. ("KSIL"), which
provides execution services for European investors in European and U.S.
equities. In the third quarter of 2000 the Company established a joint venture
operation of which it owns 60%, called Knight Securities Japan ("KSJ"), with
Nikko Cordial Group to provide wholesale market-making services in Japanese
equity securities.
The Company was organized in January 2000 as the successor to the business
of its predecessor, Knight/Trimark Group, Inc. (the "Predecessor"). The
Predecessor was organized in April 1998 as the successor to the business of
Roundtable Partners, L.L.C. ("Roundtable"). Roundtable was organized in March
1995 to own and operate the securities market-making businesses of the
predecessors to KS and KCM. In May 2000, the Company changed its name from
Knight/Trimark Group, Inc. to Knight Trading Group, Inc.
On January 12, 2000, the Company completed a merger (the "Merger") with
Arbitrade Holdings LLC ("Arbitrade"). The transaction resulted in the Company,
a newly formed parent holding company, issuing shares on a tax-free basis to
holders of the Predecessor's common stock and to the owners of Arbitrade.
Following the transaction, the Predecessor and Arbitrade became subsidiaries of
the Company, which assumed the name Knight/Trimark Group, Inc. and became the
publicly traded Nasdaq company under the same ticker symbol as the Predecessor
(NITE). Arbitrade's options market-making unit subsequently changed its name to
Knight Financial Products. The transaction was accounted for as a pooling of
interest and, as such, the historical financial statements have been restated
to account for the merger on a retroactive basis.
2. Reorganization, Public Stock Offerings and Stock Split
On February 25, 1999, the Company sold 20,700,000 shares of Class A Common
Stock at a price to the public of $17.50 per share. Of those shares, 4,849,440
were sold by Knight/Trimark, generating net offering proceeds, after deducting
underwriting discounts and commissions and offering expenses, of approximately
$80.2 million. An additional 15,850,560 shares were sold by selling
shareholders.
In April 1999, the Company's Board of Directors approved a two-for-one stock
split of the Company's Class A and Class B Common Stock. Shareholders of record
as of the close of business on April 30, 1999 received, in the form of a stock
dividend, one additional share for each share held by them. On May 14, 1999,
the transfer agent distributed the additional shares. All share and per share
amounts presented in this document have been adjusted to reflect the stock
split.
46
In connection with the Merger, the Company issued 10,505,001 shares of Class
A Common Stock to the former shareholders of Arbitrade.
3. Significant Accounting Policies
Basis of consolidation and form of presentation
The accompanying consolidated financial statements include the accounts of
the Company and its majority and wholly-owned subsidiaries. All significant
intercompany transactions and balances have been eliminated.
Certain prior year amounts have been reclassified to conform to the current
year presentation.
Cash and cash equivalents
Cash equivalents represent money market accounts, which are payable on
demand, or short-term investments with an original maturity of less than 30
days. The carrying amount of such cash equivalents approximates their fair
value due to the short-term nature of these instruments.
Investments
Investments on the Consolidated Statements of Financial Condition includes
strategic ownership interests of less than 20% in publicly and non-publicly
traded companies which are accounted for under the equity method or the cost
basis of accounting. The equity method of accounting is used for investments in
limited partnerships. Investments also include the Company's investments in the
private investment fund for which the Company is the investment manager and
sponsor. Investments are reviewed on an ongoing basis to ensure that the
valuations have not been impaired.
Market-making activities
Securities owned and securities sold, not yet purchased, which primarily
consist of listed and OTC stocks and listed options contracts are carried at
market value and are recorded on a trade date basis. Net trading revenue
(trading gains, net of trading losses) and commissions and related expenses,
including compensation and benefits, execution and clearance fees and payments
for order flow, are also recorded on a trade date basis. Payments for order
flow represent payments to other broker-dealers for directing their order
executions to the Company. The Company records interest income net of
transaction-related interest charged by clearing brokers for facilitating the
settlement and financing of securities transactions. Interest expense incurred
during 2001, 2000 and 1999 amounted to approximately $23.0 million, $40.9
million and $11.9 million, respectively.
Asset management fees
The Company earns asset management fees for sponsoring and managing the
investments of a private investment fund. Such fees are recorded monthly as
earned and are calculated as a percentage of the fund's monthly net assets,
plus a percentage of a new high net asset value, as defined, for any six-month
period ended June 30th or December 31st. A new high net asset value is
generally defined as the amount by which the net asset value of the fund
exceeds the greater of either the highest previous net asset value in the fund,
or the net asset value at the time each investor made his purchase.
Securities borrowed/loaned
Securities borrowed and securities loaned, which are included in receivable
from and payable to brokers and dealers, are recorded at the amount of cash or
other collateral advanced or received. Securities borrowed transactions require
the Company to deposit cash or similar collateral with the lender. With respect
to securities loaned, the Company receives collateral in the form of cash in an
amount generally in excess of the market value
47
of securities loaned. The Company monitors the market value of securities
borrowed and loaned on a daily basis. Substantially all of the Company's
securities borrowed and securities loaned transactions are conducted with banks
and other securities firms.
Foreign currencies
The functional currency of the Company's consolidated foreign subsidiaries
are the U.S. dollar, the British Pound and the Japanese Yen. Assets and
liabilities in foreign currencies are translated into U.S. dollars using
current exchange rates at the date of the Consolidated Statements of Financial
Condition. Revenues and expenses are translated at average rates during the
periods. The foreign exchange gains and losses resulting from translation of
financial statements of a subsidiary whose functional currency is not the U.S.
dollar are included as a separate component of stockholders' equity in the
Consolidated Statements of Financial Condition. Gains or losses resulting from
foreign currency transactions are included in Investment income and other in
the Consolidated Statements of Income.
Depreciation, amortization and occupancy
Fixed assets are being 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 life of the related office
lease. The Company records rent expense on a straight-line basis over the life
of the lease. The Company capitalizes certain costs associated with the
acquisition or development of internal-use software and amortizes software over
its estimated useful life of three years.
Lease loss accrual
It is the Company's policy to identify excess real estate capacity and where
applicable, accrue against such future costs. In determining the accrual, a
nominal cash flow analysis is performed, and costs related to the excess
capacity are accrued for.
Income taxes
Income tax expense in the Consolidated Statements of Income represents
income taxes incurred for the years ended December 31, 2001, 2000 and 1999.
Before the Merger, Arbitrade was a limited liability company which was treated
as a partnership for tax purposes and its federal and state income taxes were
borne by individual partners. As such, Arbitrade's historical financial
statements only include a provision for non-U.S. income taxes. Subsequent to
the Merger, Arbitrade's income is subject to federal and state 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 are measured using the
enacted tax rates and laws that will be in effect when such differences are
expected to reverse.
Estimated fair value of financial instruments
The Company's securities owned and securities sold, not yet purchased are
carried at market value. Fair value for securities owned and securities sold,
not yet purchased, is estimated using market quotations available from major
securities exchanges and dealers. Management estimates that the fair values of
other financial instruments recognized on the Consolidated Statements of
Financial Condition (including receivables, payables and accrued expenses)
approximate their carrying values, as such financial instruments are short-term
in nature, bear interest at current market rates or are subject to frequent
repricing.
Minority interest
Minority interest represents minority owners' share of net income or losses
and equity in two of the Company's consolidated subsidiaries, KSIL and KSJ.
48
Accounting for derivatives
In June 1998, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards (SFAS) No. 133, Accounting for
Derivative Instruments and Hedging Activities. This statement established
accounting and reporting standards for derivative instruments, including
certain derivative instruments imbedded in other contracts, and for hedging
activities. In June 1999, the FASB issued SFAS No. 137, Accounting for
Derivative Instruments and Hedging Activities--Deferral of the Effective Date
of FASB Statement No. 133--an amendment of FASB Statement No. 133. In June
2000, the FASB issued SFAS No. 138 Accounting for Certain Derivative
Instruments and Certain Hedging Activities, which is an amendment to SFAS No.
133 and is effective concurrently with SFAS No. 137. The Company adopted the
provisions of SFAS No. 133, 137 and 138 as of January 1, 2001. The Company's
derivative financial instruments are all held for trading purposes and
historically have been carried at fair value. As such, the adoption of these
statements did not have a material impact on the Company's financial statements.
Restricted stock
The Company records the fair market value of shares associated with
restricted stock awards as unamortized stock-based compensation in
stockholders' equity and amortizes the balance to compensation expense over the
vesting period.
Other
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
4. Securities Owned and Securities Sold, Not Yet Purchased
Securities owned and securities sold, not yet purchased are carried at
market value and consist of the following:
December 31, December 31,
2001 2000
-------------- --------------
Securities owned:
Equities........................ $ 734,638,954 $ 661,327,729
Options......................... 907,988,169 1,126,483,498
Convertible bonds............... 93,474,975 --
U.S. government obligations..... 18,380,407 12,155,452
-------------- --------------
$1,754,482,505 $1,799,966,679
============== ==============
Securities sold, not yet purchased:
Equities........................ $ 998,438,044 $ 170,167,713
Options......................... 1,019,052,935 1,257,046,610
Convertible bonds............... 21,864,988 --
-------------- --------------
$2,039,355,967 $1,427,214,323
============== ==============
49
5. Receivable from/Payable to Brokers and Dealers
At December 31, 2001, amounts receivable from and payable to brokers and
dealers consist of the following:
Receivable:
Clearing brokers............. $701,748,826
Securities failed to deliver. 6,007,502
Securities borrowed.......... 110,268,570
Other........................ 2,078,581
------------
$820,103,479
============
Payable:
Clearing brokers............. $133,253,448
Securities failed to receive. 12,947,759
Securities loaned............ 81,325,484
------------
$227,526,691
============
The Company had received and pledged collateral approximately equal to the
amount borrowed and loaned, respectively.
6. Investments
The Company's wholly-owned subsidiary, Deephaven, is the investment manager
and sponsor of a private investment fund that engages in various trading
strategies involving equities, debt instruments and derivatives. The Company
owns an interest in this private investment fund. The investment amounted to
approximately $50.9 million at December 31, 2001. Certain officers of the
Company also own interests in this private investment fund. Additionally, the
Company has made strategic investments in Nasdaq, Nasdaq Europe (formerly known
as Easdaq), Nasdaq Japan and other public and non-public companies.
7. Significant Customers
The Company considers affiliates to be holders of 10% or more of the
Company's outstanding common stock ("Affiliates"). During 2001 there were no
Affiliates of the Company.
One customer provided 10.9% of the Company's U.S. equity order flow for the
year ended December 31, 2001 as measured in U.S. equity share volume. Rebates
paid to this firm for U.S. equity share and U.S. options contract volume
amounted to $12.0 million during the same period.
8. Goodwill and Intangible Assets
The Company's acquisition of the business of Trimark Securities, L.P.
("Trimark") during 1995 was recorded under the purchase method and the carrying
values of the assets and liabilities acquired were adjusted to their fair
market values as of the acquisition date. The excess of the purchase price over
the fair value of the net assets acquired of $13,960,195 was recorded as
goodwill and is being amortized over a period of 10 years. In connection with
the acquisition, the Company entered into an agreement which entitled the
former owners to receive additional consideration during the five years
immediately subsequent to the acquisition, through March 2000, equal to 10% of
Trimark's pre-tax earnings, before amortization of goodwill and depreciation on
fixed assets initially purchased. All amounts paid under this arrangement have
been capitalized as additional purchase price (goodwill) and are being
amortized over the remainder of the original ten-year amortization period.
Pursuant to an agreement effective November 17, 1997, Trimark purchased the
business and the related fixed assets of Tradetech Securities, L.P.
("Tradetech"), an Illinois Limited Partnership, in exchange for $750,000 in
cash and contingent consideration. Tradetech operated as a market maker in
listed stocks and, after
50
the acquisition, its business and operations were integrated into Trimark's.
The acquisition was accounted for under the purchase method and the carrying
values of the assets acquired were adjusted to their fair market values as of
the acquisition date. The excess of the purchase price over the fair value of
the assets acquired of $400,000 was recorded as goodwill and is being amortized
over a period of five years.
In connection with the acquisition, Trimark entered into an agreement with
Tradetech which entitled Tradetech to additional consideration equal to 10% of
Trimark's pretax earnings during the period from the acquisition date through
December 31, 2000 (the "Earnout Period"). All amounts paid under this
arrangement have been capitalized as additional purchase price (goodwill) and
are being amortized over the remainder of the original five-year amortization
period.
The total contingent consideration paid and recorded as goodwill by the
Company was as follows:
Trimark Tradetech
Additional Additional
Consideration Consideration Total
------------- ------------- ----------
For the year ended December 31, 1999. $3,098,161 $2,855,058 $5,953,219
For the year ended December 31, 2000. 1,757,948 4,526,955 6,284,903
For the year ended December 31, 2001. -- -- --
Additionally, consistent with the growth of the Company's options
market-making business, KFP has acquired various options related businesses.
Goodwill, representing the total excess of the purchase prices over the fair
value of the assets acquired, and other intangible assets, in the aggregate
totaling $42,240,877 was recorded in connection with these acquisitions and is
being amortized over a period of 15 years.
The Company has adopted the provisions of Statement of Financial Accounting
Standards (SFAS) No. 142 Goodwill and Other Intangible Assets as of January 1,
2002. This statement establishes new standards for accounting for goodwill and
intangible assets acquired outside of, and subsequent to a business
combination. Under the new standards, goodwill and certain intangible assets
with an indefinite useful life will no longer be amortized, but will be tested
for impairment at least annually. Other intangible assets will continue to be
amortized over their useful lives. The Company expects that the adoption of
this statement will result in a decrease in amortization expense of
approximately $6.4 million in 2002. Annual amortization expense related to
goodwill in 2001 was $6.7 million.
As a result of the adoption of SFAS No. 142, the Company's goodwill and
intangible balances, net of accumulated amortization as of January 1, 2002
consist of the following:
Goodwill............................... $17,535,556
Intangible Assets, definite useful life 34,364,429
-----------
Total Goodwill and Intangible Assets... $51,899,985
===========
Intangible assets deemed to have definite lives will continue to be amortized
over their useful lives, which have been determined to be 15 years.
51
9. Fixed Assets and Leasehold Improvements
Fixed assets and leasehold improvements comprise the following:
December 31,
Depreciation -----------------------
Period 2001 2000
------------- ----------- -----------
Computer hardware and software................. 3 years 111,888,136 81,847,768
Leasehold improvements......................... Life of Lease 21,140,042 15,028,116
Telephone systems.............................. 5 years 7,531,763 6,944,133
Furniture and fixtures......................... 7 years 8,574,119 6,901,463
Trading systems................................ 5 years 4,267,131 1,613,082
Equipment...................................... 5 years 11,052,556 1,649,411
----------- -----------
164,453,747 113,983,973
Less--Accumulated depreciation and amortization 67,505,292 34,969,580
Less--Writedown of assets...................... 6,822,751 --
----------- -----------
90,125,704 79,014,393
----------- -----------
10. Writedown of Assets and Lease Loss Accrual
The writedown of assets on the Consolidated Statements of Income represents
$20.5 million in pre-tax non-operating charges. These charges consist of a loss
of $6.8 million related to a writedown of fixed assets and other capitalized
costs related to excess real-estate capacity, $1.4 million related to estimated
losses on the disposal of excess real-estate, a $10.7 million non-recurring
charge relating to impaired investments in non-public e-commerce companies and
$1.6 million related to a writedown of certain exchange seats.
11. Short-Term Financing
On June 19, 1998, the Company entered into an unsecured $30.0 million loan
agreement with an affiliate of one of its clearing brokers. Such loan paid
interest monthly based on the London Interbank Offered Rate and was to mature
on June 19, 1999. The loan agreement allowed for scheduled principal
pre-payments without penalty. During 1998, the Company made principal
pre-payments under the loan of $20.0 million. On January 19, 1999, the Company
repaid the final $10.0 million. Interest expense incurred on such loan for the
year ended December 31, 1999 amounted to $39,734.
Prior to the Company's merger with Arbitrade, at December 31, 1999,
Arbitrade had a $10,000,000 collateralized credit facility with a bank under
which it borrowed on a revolving basis. Interest was variable based on prime
plus one percent per annum and payable monthly. The Company paid one half
percent per annum commitment fee on the unused portion of the facility. The
unused portion of the facility and interest rate at December 31, 1999 were
$7,945,408 and 9.00%, respectively.
At December 31, 2001, KSJ, a joint venture operation of which the Company
owns 60%, has two daylight overdraft facilities with different Japanese
financial institutions totalling 5 billion yen. The intraday credit facilities
are used to facilitate the daily gross settlement of securities transactions
and bear market rates of interest in Japan.
Subsequent to December 31, 2001, KSJ entered into an additional 5 billion
yen daylight overdraft facility with an affiliate of Nikko Cordial Group, the
owner of the remaining 40% interest in the joint venture. Pursuant to the terms
of the loan contract, both the Company and Nikko are required to guarantee
liabilities arising from the overdraft facility in their respective percentages
of ownership. This overdraft facility bears a market rate of interest in Japan.
52
12. Commitments and Contingent Liabilities
The Company leases office space under noncancellable operating leases. The
office leases contain certain escalation clauses whereby the rental commitments
may be increased if certain conditions are satisfied and specify yearly
adjustments to the lease amounts based on annual adjustments to the Consumer
Price Index. Rental expense under the office leases was as follows:
For the year ended December 31, 1999 $ 2,989,873
For the year ended December 31, 2000 7,288,699
For the year ended December 31, 2001 11,306,884
Additionally, the Company leases computer and other equipment under
noncancellable operating leases. As of December 31, 2001, future minimum rental
commitments under all noncancellable operating leases were as follows:
Office Leases Other Leases Total
------------- ------------ ------------
Year ending December 31, 2002...... $ 16,753,228 $ 5,669,050 $ 22,422,278
Year ending December 31, 2003...... 15,922,286 3,794,881 19,717,167
Year ending December 31, 2004...... 13,520,911 2,664,202 16,185,113
Year ending December 31, 2005...... 12,294,645 8,009 12,302,654
Year ending December 31, 2006...... 9,701,377 -- 9,701,377
Thereafter through October 31, 2021 133,875,423 -- 133,875,423
------------ ----------- ------------
$202,067,870 $12,136,142 $214,204,012
============ =========== ============
The Company has provided a $11.0 million letter of credit as a guarantee to
one of the Company's lease obligations.
The Company has a guarantee with one of its foreign subsidiary's clearing
brokers, obligating the Company to generate and pay clearing fees of a minimum
of $9.0 million for each of the years ended June 30, 2002 and June 30, 2003. As
of December 31, 2001, the Company has generated $3.4 million against this
guarantee.
13. Earnings per Share
Basic earnings per common share ("EPS") have been calculated by dividing net
income by the sum of the weighted average shares of Class A Common Stock and
Class B 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 share equivalents if stock awards such as stock
options and restricted stock were exercised or converted into common stock.
Except for voting rights, the Class B Common Stock had identical rights and
rewards as the Class A Common Stock and was automatically converted to Class A
Common Stock in the event of a sale or a transfer by the owner. All outstanding
shares of Class B Common Stock were converted into shares of Class A Common
Stock during 1999.
53
Weighted-average shares outstanding for the years ended December 31, 1999
and 2000 have been determined as if the Merger described in Note 1 occurred as
of the earliest date presented. The following is a reconciliation of the
numerators and denominators of the basic and diluted earnings per share
computations for the years ended December 31, 2001, 2000 and 1999:
For the year ended December 31,
----------------------------------------------------------------------------
2001 2000 1999
------------------------ ------------------------- -------------------------
Numerator/ Denominator/ Numerator/ Denominator/ Numerator/ Denominator/
net income shares net income shares net income shares
----------- ------------ ------------ ------------ ------------ ------------
Income and shares used in basic
calculations.................... $38,525,567 123,796,181 $259,922,002 122,520,733 $211,283,976 120,821,710
Effect of dilutive stock awards.. -- 1,962,682 -- 4,342,583 -- 4,933,720
----------- ------------ ------------ ------------ ------------ ------------
Income and shares used in diluted
calculations.................... $38,525,567 125,758,863 $259,922,002 126,863,316 $211,283,976 125,755,430
=========== ============ ============ ============ ============ ============
Basic earnings per share......... $ 0.31 $ 2.12 $ 1.75
============ ============ ============
Diluted earnings per share....... $ 0.31 $ 2.05 $ 1.68
============ ============ ============
14. Employee Benefit Plan
The Company sponsors 401(k) profit sharing plans (the "Plans") in which
substantially all of its employees are eligible to participate. Under the terms
of the Plans, the Company is required to make annual contributions to the Plans
equal to 100% of the contributions made by its employees, up to certain
limitations. The total expense recognized with respect to the Plans was as
follows:
For the year ended December 31, 1999 $1,838,036
For the year ended December 31, 2000 2,856,197
For the year ended December 31, 2001 5,377,539
15. Income Taxes
The Company and its subsidiaries file a consolidated federal income tax
return. Before the Merger, Arbitrade was treated as a partnership for U.S. tax
purposes and its federal and state income taxes were borne by Arbitrade's
individual partners. As such Arbitrade's historical financial statements do not
include a provision for federal or state income taxes.
The provision for income taxes consists of:
2001 2000 1999
----------- ------------ ------------
Current:
U.S. federal........... $25,468,048 $145,441,308 $ 95,344,483
U.S. state and local... 5,006,968 18,560,206 18,498,299
----------- ------------ ------------
30,475,016 164,001,514 113,842,782
----------- ------------ ------------
Deferred:
U.S. federal........... (3,171,776) (4,119,805) (1,845,141)
U.S. state and local... (1,841,994) (435,315) (451,700)
----------- ------------ ------------
(5,013,770) (4,555,120) (2,296,841)
----------- ------------ ------------
Provision for income taxes $25,461,246 $159,446,394 $111,545,941
----------- ------------ ------------
54
The following table reconciles the provision to the U.S. federal statutory
income tax rate:
2001 2000 1999
---- ---- ----
U.S. federal statutory income tax rate.................................... 35.0% 35.0% 35.0%
U.S. state and local income taxes, net of U.S. federal income tax benefits 3.8 2.8 3.6
Non-U.S. operations....................................................... 6.6 -- --
Pre-merger Arbitrade income............................................... -- (0.1) (4.7)
Nondeductible charges..................................................... 2.7 0.4 0.6
Other, net................................................................ (1.2) -- 0.1
---- ---- ----
Effective income tax rate................................................. 46.9% 38.1% 34.6%
---- ---- ----
Deferred income taxes reflect the net tax effects of temporary differences
between the financial reporting and tax bases of assets and liabilities and are
measured using the enacted tax rates and laws that will be in effect when such
differences are expected to reverse. Significant components of the Company's
deferred tax assets and liabilities at December 31, 2001, 2000 and 1999 are as
follows:
2001 2000 1999
----------- ---------- ----------
Deferred tax assets:
Employee compensation and benefit plans... $ 7,918,251 $5,709,498 $1,964,276
Fixed assets and other amortizable assets. 2,317,210 1,720,333 332,567
Valuation and other reserves.............. 4,896,738 -- --
----------- ---------- ----------
Total deferred tax assets.................... 15,132,199 7,429,831 2,296,843
----------- ---------- ----------
Deferred tax liabilities:
Valuation of investments.................. 1,019,651 564,428 --
Deferred management fees.................. 2,246,815 13,440 --
----------- ---------- ----------
Total deferred tax liabilities............... 3,266,466 577,868 --
----------- ---------- ----------
Net deferred tax assets...................... $11,865,733 $6,851,963 $2,296,843
----------- ---------- ----------
16. Long-Term Incentive Plans
The Company established the Knight/Trimark Group, Inc. 1998 Long Term
Incentive Plan and the Knight/Trimark Group, Inc. 1998 Nonemployee Director
Stock Option Plan (together, the "Plans") to provide long-term incentive
compensation to selected employees and directors of Knight Trading Group and
its subsidiaries. The Plans are administered by the compensation committee of
the Company's Board of Directors, and allow for the grant of options,
restricted stock and restricted stock units, as defined by the Plans. Including
a stockholder-approved increase in the number of shares reserved under the
Plans by three million in May 2001, the maximum number of shares of Class A
Common Stock reserved for the grant of options under the Plans is 27,819,000,
subject to adjustment. The maximum number of restricted stock and restricted
stock units which may be issued under each of the Plans is 3,000,000, which
includes a two million share increase reserved under the Plans that was
approved by stockholders in May 2001. In addition, the Plans limit the number
of shares which may be granted to a single individual, and the Plans also limit
the number of shares of restricted stock that may be awarded.
It is the Company's policy to grant options for the purchase of shares of
Class A Common Stock at not less than market value, which the Plans define as
the average of the high and low sales prices on the date prior to the grant
date. Options and awards generally vest 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 agreements. The Company has the right to fully vest
55
employees in their option grants and awards upon retirement. The following is a
reconciliation of option activity for the Plans for the years ended December
31, 2001 and 2000, and a summary of options outstanding and exercisable at
December 31, 2001:
2001 2000
--------------------- ---------------------
Weighted- Weighted-
Average Average
Number of Exercise Number of Exercise
Options Price Options Price
---------- --------- ---------- ---------
Outstanding, January 1................................... 12,448,675 $19.60 10,445,235 $10.77
Granted at market value.................................. 4,461,576 16.17 4,290,500 37.40
Exercised................................................ (784,850) 7.24 (1,184,810) 7.31
Surrendered.............................................. (1,745,826) 23.35 (1,102,250) 18.37
---------- ------ ---------- ------
Outstanding at December 31............................... 14,379,575 $18.76 12,448,675 $19.60
========== ====== ========== ======
Exercisable at December 31............................... 5,786,992 $14.39 3,484,050 $ 9.81
========== ====== ========== ======
Available for future grants at December 31............... 10,712,000 10,427,750
========== ==========
Weighted average fair value of grants during the year (at
market value).......................................... $ 7.42 $19.80
====== ======
Options Outstanding Options Exercisable
----------------------- ---------------------
Weighted-
Average Weighted- Weighted-
Remaining Average Number Average
Outstanding Contractual Exercise Exercisable Exercise
at 12/31/01 Life Price at 12/31/01 Price
Range of Exercise Prices ----------- ----------- --------- ----------- ---------
$ 6.54............. 113,000 6.80 $ 6.54 78,000 $ 6.54
$ 7.25............. 6,229,825 6.50 7.25 4,433,575 7.25
$ 7.90--$17.75..... 3,220,750 4.38 15.30 32,917 12.70
$ 17.93--$39.75..... 1,943,500 6.56 26.78 390,875 30.78
$ 39.84--$39.84..... 2,342,000 8.04 39.84 585,500 39.84
$ 42.91--$73.22..... 530,500 7.33 55.01 266,125 55.71
The Company granted a total of 72,240 restricted shares of Class A Common
Stock to certain employees of the Company under the 1998 Long Term Incentive
Plan and recorded compensation expense of $173,599 during 2001 for the fair
value of the shares, which has been included in Compensation and Benefits in
the Consolidated Statements of Income. The unamortized portion of the
restricted shares is recognized as compensation expense over the vesting
period. The restricted stock requires future service as a condition of the
underlying shares of common stock.
The Company applies Accounting Principles Board Opinion No. 25, "Accounting
for Stock Issued to Employees" and related interpretations in accounting for
its stock option plans. Accordingly, no compensation expense has been
recognized for the fair values of the options granted to employees. Had
compensation expense for the Company's options been determined based on the
fair value at the grant dates in accordance with Statement of Financial
Accounting Standards No. 123, "Accounting for Stock-Based Compensation," the
Company's net income and earnings per share amounts for the years ended
December 31, 2001, 2000 and 1999 would have been as follows:
2001 2000 1999
---------- ------------ ------------
Net income, as reported................ 38,525,567 $259,922,002 $211,283,976
Pro forma net income................... 19,619,223 232,403,643 200,895,647
Basic earnings per share, as reported.. 0.31 2.12 1.75
Diluted earnings per share, as reported 0.31 2.05 1.68
Pro forma basic earnings per share..... 0.16 1.90 1.66
Pro forma diluted earnings per share... 0.16 1.83 1.60
56
The fair value of each option granted is estimated as of its respective
grant date using the Black-Scholes option-pricing model with the following
assumptions:
2001 2000 1999
---- ---- ----
Dividend yield.......... 0.0% 0.0% 0.0%
Expected volatility..... 65% 70% 70%
Risk-free interest rate. 4.5% 6.0% 6.0%
Expected life (in years) 4 5 5
17. Financial Instruments with Off-Balance Sheet Risk and Concentrations of
Credit Risk
As a market maker of OTC and listed stocks and listed options contracts, the
majority of the Company's securities transactions are conducted as principal
with broker-dealer and institutional counterparties primarily located in the
United States. The Company clears all of its securities transactions through
clearing brokers on a fully disclosed basis. Accordingly, substantially all of
the Company's credit exposures are concentrated with the clearing brokers. The
clearing brokers can rehypothecate the securities held. Additionally, pursuant
to the terms of the agreement between the Company and the clearing brokers, the
clearing brokers have the right to charge the Company for losses that result
from a counterparty's failure to fulfill its contractual obligations. The
Company's policy is to monitor the credit standing of the clearing brokers and
all counterparties with which it conducts business. Additionally, as of
December 31, 2001, the Company's credit exposures were concentrated with the
clearing brokers and amounted to $820.1 million. As of December 31, 2001, the
clearing brokers also held, as custodians, securities and options owned by the
Company with a market value of $1.8 billion.
Securities sold, not yet purchased represent obligations to purchase such
securities at a future date. The Company may incur a loss if the market value
of the securities subsequently increases.
Derivative contracts are financial instruments whose value is based upon
underlying asset, index, reference rate or a combination of these factors. The
Company uses derivative financial instruments as part of its options
market-making and trading business and its overall risk management process.
These financial instruments, which generally include exchange-traded options,
options on futures and futures contracts, expose the Company to varying degrees
of market and credit risk. The Company records its derivative-trading
activities at market value, and unrealized gains and losses are recognized
currently.
18. Net Capital Requirements
As registered broker-dealers, KS, KCM, KFP and KEP are subject to the SEC's
Uniform Net Capital Rule (the "Rule") which requires the maintenance of minimum
net capital. KS, KCM and KEP have elected to use the basic method, permitted by
the Rule, which requires that they each maintain net capital equal to the
greater of $1.0 million ($100,000 for KEP) or 6 2/3% of aggregate indebtedness,
as defined. KFP has elected to use the alternative method, permitted by the
Rule, which requires that it maintains net capital equal to the greater of
$250,000 or 2% of aggregate debit items, as defined.
At December 31, 2001, KS had net capital of $238,903,385, which was
$236,158,892 in excess of its required net capital of $2,744,493, KCM had net
capital of $56,154,602, which was $54,848,186 in excess of its required net
capital of $1,306,416, KFP had net capital of $38,329,302 which was $38,079,302
in excess of its required net capital of $250,000 and KEP had net capital of
$2,124,490 which was $1,982,959 in excess of its required net capital of
$141,531.
Additionally, KSIL, KSJ and KFP are subject to regulatory requirements in
the countries in which they operate, including the requirements of the
Financial Services Authority in the United Kingdom, and the Financial
Supervisory Agency in Japan. As of December 31, 2001, the Company was in
compliance with these capital adequacy requirements.
57
19. Business Segments
The Company has two reportable business segments: wholesale securities
market-making and asset management. Domestic securities market-making primarily
represents market-making in U.S. equity securities listed on Nasdaq, on the
OTCBB of the NASD, in the over-the-counter market for NYSE- and AMEX-listed
securities and in U.S. options on individual equities, equity indices, fixed
income futures instruments and certain commodities. International securities
market-making includes market-making in equities in Europe and Japan and in
options in Europe. The asset management segment consists of investment
management and sponsorship for a private investment fund.
The Company's net revenues, income before income taxes and minority interest
and assets by segment are summarized below:
Elimination
Domestic International of
Market Market Total Market Asset Intersegment Consolidated
Making* Making** Making Management*** Balances**** Total
------------- ------------- ------------- ------------- ------------ -------------
For the year ended
December 31, 2001:
Revenues........................ 633,756,770 14,262,199 648,018,969 42,699,070 (1,106,185) 689,611,854
Intra-segment revenues.......... (357,830) (4,541,649) (4,899,479) (4,899,479)
------------- ----------- ------------- ---------- ---------- -------------
Total Revenues.................. 633,398,940 9,720,550 643,119,490 42,699,070 (1,106,185) 684,712,375
Income/(loss) before income
taxes and minority interest.... 96,759,221 (68,866,270) 27,892,951 26,452,201 -- 54,345,152
Total Assets.................... 2,731,317,276 424,134,213 3,155,451,489 71,235,466 -- 3,226,686,955
For the year ended
December 31, 2000:
Revenues........................ 1,205,926,864 32,909,726 1,238,836,590 46,094,714 -- 1,284,931,304
Intra-segment revenues.......... -- (27,621,556) (27,621,556) -- -- (27,621,556)
------------- ----------- ------------- ---------- ---------- -------------
Total Revenues.................. 1,205,926,864 5,288,170 1,211,215,034 46,094,714 -- 1,257,309,748
Income before income taxes and
minority interest.............. 395,451,222 (11,618,251) 383,832,971 34,698,473 -- 418,531,444
Total Assets.................... 2,136,341,091 345,354,278 2,481,695,369 39,713,803 -- 2,521,409,172
For the year ended
December 31, 1999:
Revenues........................ 876,424,848 2,010,046 878,434,894 20,907,547 -- 899,342,441
Intra-segment revenues.......... -- (2,766,998) (2,766,998) -- -- (2,766,998)
------------- ----------- ------------- ---------- ---------- -------------
Total Revenues.................. 876,424,848 (756,952) 875,667,896 20,907,547 -- 896,575,443
Income before income taxes and
minority interest.............. 310,554,470 (3,912,183) 306,642,287 16,187,630 -- 322,829,917
Total Assets.................... 1,504,599,415 5,529,635 1,510,129,050 30,156,756 -- 1,540,285,806
- --------
* The year ended December 31, 2001 includes $20.5 million in pre-tax
non-operating charges, which consists of a loss of $6.8 million on the
writedown of fixed assets and other capital costs related to excess
real-estate capacity, $1.4 million related to estimated losses on the
disposal of excess real estate, a $10.7 million non-recurring charge
relating to impaired investments in non-public e-commerce companies and
$1.6 million related to a writedown of certain exchange seats.
** International market-making includes costs incurred in the U.S. that are
related to international market-making businesses. In 2000 and 1999, KSIL
was working under a business model that provided for revenues to be earned
from its domestic affiliate (i.e., intra-segment revenues) based on a
formula derived from costs incurred. In 2001, KSIL's business model was
modified, such that reported revenues were based on actual results.
*** The years ended December 31, 2001, 2000 and 1999, include $5.5 million,
$4.7 million and $2.3 million, respectively, which primarily consists of
revenues generated from the Company's investment in a private investment
fund for which Deephaven is the investment manager and sponsor.
**** Intersegment balances primarily represents asset management fees paid to
Deephaven by certain of the Company's domestic market-making subsidiaries
for management services.
58
20. Condensed Financial Statements of Knight Trading Group, Inc. (parent only)
Presented below are the Condensed Statements of Financial Condition, Income
and Cash Flows for the Company on an unconsolidated basis.
Statements of Financial Condition
Knight Trading Group, Inc. (parent only)
December 31, December 31,
2001 2000
------------ ------------
Assets
Cash and cash equivalents............................... $ 11,000,203 $ 25,874,092
Securities owned, at market value....................... 26,404,975 12,155,452
Investments in subsidiaries, equity method.............. 756,371,712 731,643,361
Receivable from subsidiaries............................ 31,978,297 5,883,085
Other assets............................................ 26,448,600 15,578,475
------------ ------------
Total assets......................................... $852,203,787 $791,134,465
============ ============
Liabilities and Stockholders' Equity
Liabilities
Accrued compensation expense............................ $ 12,767,462 $ 10,361,525
Accounts payable, accrued expenses and other liabilities 3,558,645 2,131,888
Income taxes payable.................................... 1,621,256 4,454,606
------------ ------------
Total liabilities.................................... 17,947,363 16,948,019
Total stockholders' equity........................... 834,256,424 774,186,446
------------ ------------
Total liabilities and stockholders' equity........... $852,203,787 $791,134,465
============ ============
Statements of Income
Knight Trading Group, Inc. (parent only)
For the years ended December 31,
--------------------------------------
2001 2000 1999
----------- ------------ ------------
Revenues
Equity in earnings of subsidiaries $49,564,400 $265,900,963 $217,486,596
Other............................. 7,810,210 2,580,130 3,857,671
----------- ------------ ------------
Total revenues................. 57,374,610 268,481,093 221,344,267
----------- ------------ ------------
Expenses
Compensation expense.............. 6,060,707 -- --
Professional fees................. 5,230,621 5,562,241 1,850,310
Business development.............. 2,019,224 3,193,359 4,779,582
Merger related costs.............. -- -- 5,189,295
Other............................. 3,645,758 1,064,815 1,161,569
----------- ------------ ------------
Total expenses................. 16,956,310 9,820,415 12,980,756
----------- ------------ ------------
Income before income taxes........ 40,418,300 258,660,678 208,363,511
Income tax expense (benefit)...... 1,892,733 (1,261,324) (2,920,465)
----------- ------------ ------------
Net income..................... $38,525,567 $259,922,002 $211,283,976
=========== ============ ============
59
Statements of Cash Flows
Knight Trading Group, Inc. (parent only)
For the year ended December 31,
------------------------------------------
2001 2000 1999
------------ ------------- -------------
Cash flows from operating activities
Net income..................................................... $ 38,525,567 $ 259,922,002 $ 211,283,976
Adjustments to reconcile net income to net cash (used in)
provided by operating activities
Equity earnings of subsidiaries............................. (49,564,400) (265,900,963) (217,486,596)
Issuance of restricted stock to employees................... 722 -- --
Amortization of stock based compensation.................... 172,877 -- --
Income tax credit from stock options exercised.............. 2,612,132 8,998,923 10,311,592
(Increase) decrease in operating assets
Securities owned............................................ (14,249,523) (12,155,452) 1,285,525
Receivable from subsidiaries................................ (26,095,212) 12,567,100 (15,834,339)
Other assets................................................ (10,870,125) (6,472,250) (8,570,753)
Increase (decrease) in operating liabilities
Accrued compensation expense................................ 2,405,937 4,502,579 5,858,946
Accounts payable, accrued expenses and other
liabilities............................................... 1,426,757 (13,062,080) 14,070,659
Income taxes payable........................................ (2,833,350) (13,101,481) 15,247,367
------------ ------------- -------------
Net cash (used in) provided by operating activities..... (58,468,618) (24,701,622) 16,166,377
------------ ------------- -------------
Cash flows from investing activities
Capital contributions to subsidiaries.......................... (32,496,862) (129,810,015) (20,230,922)
------------ ------------- -------------
Net cash (used in) investing activities................. (32,496,862) (129,810,015) (20,230,922)
------------ ------------- -------------
Cash flows from financing activities
Repayment of short term loan................................... -- -- (10,000,000)
Proceeds from issuance of common stock......................... -- -- 80,219,537
Stock options exercised........................................ 5,647,398 8,656,997 5,485,202
Dividends received from subsidiaries........................... 70,444,193 72,000,000 --
------------ ------------- -------------
Net cash provided by financing activities............... 76,091,591 80,656,997 75,704,739
------------ ------------- -------------
(Decrease) increase in cash and cash equivalents............... (14,873,889) (73,854,640) 71,640,194
Cash and cash equivalents at beginning of period............... 25,874,092 99,728,732 28,088,538
------------ ------------- -------------
Cash and cash equivalents at end of period..................... $ 11,000,203 $ 25,874,092 $ 99,728,732
============ ============= =============
Supplemental disclosure of cash flow information:
Cash paid for interest.................................. $ 37 $ 32,718 $ 168,638
============ ============= =============
Cash paid for income taxes.............................. $ 33,664,468 $ 175,180,680 $ 72,535,458
============ ============= =============
60
Item 9. Changes in and Disagreements With Accountants on Accounting and
Financial Disclosures
None.
PART III
Items 10, 11, 12 and 13
The Company's Proxy Statement for its 2002 Annual Meeting of Stockholders,
which, when filed pursuant to Regulation 14A under the Securities Exchange Act
of 1934, will be incorporated by reference in this Annual Report on Form 10-K
pursuant to General Instruction G(3) of Form 10-K, provides the information
required under Part III (Items 10, 11, 12 and 13).
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K
(a) The following documents are filed as part of this report:
Consolidated Financial Statements and Financial Statement Schedules. See
"Item 8, Financial Statements and Supplementary Data"
(b) Reports on Form 8-K:
On December 26, 2001, the Company filed a Current Report on Form 8-K to
report the retirement of Kenneth D. Pasternak as Chairman and Chief
Executive Officer, effective January 31, 2002.
On January 31, 2002, the Company filed a Current Report on Form 8-K to
report that Anthony M. Sanfilippo has been named Interim Chief Executive
Officer and that Peter S. Hajas, President and Chief Operating Officer, had
left the Company.
On March 12, 2002, the Company filed a Current Report on Form 8-K to
report on two class action lawsuits against the Company, one of which was
settled and the other of which was dismissed.
61
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized, in the City of
Jersey City, State of New Jersey, on this 28th day of March, 2002.
KNIGHT TRADING GROUP, INC.
By: /S/ ANTHONY M. SANFILIPPO
-----------------------------
Director and Interim Chief
Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this
Registration Statement has been signed by the following persons in the
capacities and on the date indicated.
Name Title Date
---- ----- ----
/S/ ANTHONY M. SANFILIPPO Director and Interim Chief March 28, 2002
- ----------------------------- Executive Officer
Anthony M. Sanfilippo
/S/ ROBERT I. TURNER Director, Executive Vice March 28, 2002
- ----------------------------- President, Treasurer and
Robert I. Turner Chief Financial Officer
(principal financial and
accounting officer)
/S/ WALTER F. RAQUET Director and Executive Vice March 28, 2002
- ----------------------------- President
Walter F. Raquet
/S/ CHARLES V. DOHERTY Chairman of the Board March 28, 2002
- -----------------------------
Charles V. Doherty
/S/ GARY R. GRIFFITH Director March 28, 2002
- -----------------------------
Gary R. Griffith
/S/ ROBERT GREIFELD Director March 28, 2002
- -----------------------------
Robert Greifeld
/S/ PETER S. HAJAS Director March 28, 2002
- -----------------------------
Peter S. Hajas
/S/ ROBERT M. LAZAROWITZ Director March 28, 2002
- -----------------------------
Robert M. Lazarowitz
/S/ BRUCE R. MCMAKEN Director March 28, 2002
- -----------------------------
Bruce R. McMaken
/S/ KENNETH D. PASTERNAK Director March 28, 2002
- -----------------------------
Kenneth D. Pasternak
/S/ RODGER O. RINEY Director March 28, 2002
- -----------------------------
Rodger O. Riney
/S/ V. ERIC ROACH Director March 28, 2002
- -----------------------------
V. Eric Roach
62