Back to GetFilings.com

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2004

001-14223

Commission File Number

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

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2)    Yes  x    No  ¨

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

At November 5, 2004 the number of shares outstanding of the Registrant’s Class A Common Stock was 113,814,886 and there were no shares outstanding of the Registrant’s Class B Common Stock as of such date.

KNIGHT TRADING GROUP, INC.

FORM 10-Q QUARTERLY REPORT

For the Quarter Ended September 30, 2004

TABLE OF CONTENTS

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

KNIGHT TRADING GROUP, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

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

3

KNIGHT TRADING GROUP, INC.

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(Unaudited)

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

4

KNIGHT TRADING GROUP, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

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

5

KNIGHT TRADING GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2004

(Unaudited)

1. Organization and Description of the Business

Knight Trading Group, Inc. and its subsidiaries (the “Company”) currently operate in Equity Markets, Asset Management and Derivative Markets segments. The Company’s business segments are comprised of the following operating subsidiaries:

Equity Markets

Asset Management

Derivative Markets

6

2. Significant Accounting Policies

Basis of consolidation and form of presentation

The accompanying unaudited consolidated financial statements include the accounts of the Company and its subsidiaries and, in the opinion of management, reflect all adjustments, consisting only of normal recurring adjustments, necessary for a fair statement of the results for the interim period. All significant intercompany transactions and balances within continuing operations have been eliminated. Certain footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to SEC rules and regulations, although the Company believes that the disclosures are adequate to make the information presented not misleading. The nature of the Company’s business is such that the results of an interim period are not necessarily indicative of the results for the full year. These unaudited consolidated financial statements should be read in conjunction with the financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003 as filed with the SEC.

Certain prior period amounts have been reclassified to conform to the current period presentation.

Cash and cash equivalents

Cash and cash equivalents include 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.

Market making and sales activities

Securities owned and securities sold, not yet purchased, which primarily consist of listed and OTC equities 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 (which includes commission equivalents earned on institutional client orders) and related expenses are also recorded on a trade date basis. In the first quarter of 2004, we changed the classification of revenues from transactions that generate commission equivalents from inclusion in Net trading revenues to inclusion in Commissions and fees as commission equivalents are similar in nature to commissions on agency transactions. Commission equivalents for the three and nine months ended September 30, 2004 were $27.4 million and $103.7 million, respectively. Commission equivalents for the three and nine months ended September 30, 2003 were $32.2 million and $81.4 million, respectively.

Payments for order flow represent payments to broker-dealer clients for directing their order executions to the Company. Soft dollar and commission recapture expense represents payments to institutions in connection with soft dollar and commission recapture programs. The Company’s clearing agreements call for payment or receipt of interest income, net of interest expense, for facilitating the settlement and financing of securities transactions.

Asset management fees

The Company earns asset management fees for sponsoring and managing the Deephaven Funds. Such fees are recorded monthly as earned and are calculated as a percentage of the Deephaven Funds’ monthly net assets, plus a percentage of a new high net asset value (the “Incentive Allocation Fee”), 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 Deephaven Funds exceeds the greater of either the highest previous net asset value in the Deephaven Funds, or the net asset value at the time each investor made a purchase. The Incentive Allocation Fee may increase or decrease during the year based on the performance of the Deephaven Funds. If Deephaven’s Market Neutral Fund, which contains the majority of assets under management, recognizes a loss in the second half of a calendar year, the Incentive Allocation Fee is recalculated on an annual rather than a semi-annual basis. As such, the Incentive Allocation Fee may be negative for certain periods, but not lower than zero on a year-to-date basis.

Estimated fair value of financial instruments

The Company’s securities owned and securities sold, not yet purchased are carried at market value, which is estimated using market quotations available from major securities exchanges, clearing brokers 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.

7

Accounting for derivatives

The Company’s derivative financial instruments, primarily comprised of listed options and futures, are all held for trading purposes and are carried at market value.

Goodwill and intangible assets

The Company applies the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 142 Goodwill and Other Intangible Assets, which requires that goodwill and intangible assets with an indefinite useful life no longer be amortized, but instead, be tested for impairment annually or when an event occurs or circumstances change that signify the existence of impairment. Other intangible assets are amortized over their useful lives.

Strategic investments

Strategic investments include equity ownership interests of less than 20% in financial services-related businesses and are accounted for under the equity method or at fair value. The equity method of accounting is used for investments in limited partnerships and limited liability corporations. The fair value of investments for which a quoted market or dealer price is not available for the size of our investment, is based on management’s estimate. Among the factors considered by management in determining the fair value of investments are the cost of the investment, terms and liquidity, developments since the acquisition of the investment, the sales price of recently issued securities, the financial condition and operating results of the issuer, earnings trends and consistency of operating cash flows, the long-term business potential of the issuer, the quoted market price of securities with similar quality and yield that are publicly traded, and other factors generally pertinent to the valuation of investments. The fair value of these investments is subject to a high degree of volatility and may be susceptible to significant fluctuations in the near term. The valuations of strategic investments, which include our investments in Nasdaq and the ISE, are reviewed by management on an ongoing basis.

Treasury stock

The Company records its purchases of treasury stock at cost as a separate component of Stockholders’ equity. The Company obtains treasury stock through purchases in the open market or through privately negotiated transactions.

Foreign currencies

The functional currency of the Company’s consolidated foreign subsidiaries is the U.S. dollar. 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. Prior to its liquidation, KSJ’s functional currency was the Japanese yen. The foreign exchange gains and losses resulting from the translation of the financial statements of KSJ were included within a separate component of Stockholders’ equity until KSJ’s liquidation. As discussed in Footnote 9 “Discontinued Operations,” in the second quarter of 2003, KSJ ceased its operations, and its results, including the effects of translation, are included in Income from discontinued operations, net of taxes on the Consolidated Statements of Operations.

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 shorter of the life of the related office lease or the expected useful life of the assets. The Company records rent expense on a straight-line basis over the lives of the leases. The Company capitalizes certain costs associated with the acquisition or development of internal-use software and amortizes the software over its estimated useful life of three years, commencing at the time the software is placed in service.

Writedown of fixed assets

Writedowns of fixed assets are recognized when it is determined that the fixed assets are no longer actively used and are determined to be impaired. The amount of the impairment writedown is determined by the difference between the carrying amount and the fair value of the fixed asset. In determining the impairment, an estimated fair value is obtained through research and inquiry of the market. Fixed assets are reviewed for impairment on a quarterly basis.

8

Lease loss accrual

It is the Company’s policy to identify excess real estate capacity and where applicable, accrue for such future costs. In determining the accrual, a nominal cash flow analysis is performed for lease losses initiated prior to December 31, 2002, the effective date of SFAS No. 146 Accounting for Costs Associated with Exit or Disposal Activities (which requires the accrual of future costs to be made using a discounted cash flow analysis for lease losses initiated after such date), and costs related to the excess capacity are accrued.

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. Deferred tax assets and liabilities are included in Other assets and Accrued expenses and other liabilities, respectively.

Discontinued Operations

In accordance with SFAS No. 144, Accounting for the Disposal of Long-Lived Assets, all of the assets and liabilities within a separate business segment or reporting unit that has been disposed of through closure or sale, or is classified as held for sale, are disclosed separately as Assets or Liabilities within discontinued operations on the Statements of Financial Condition for all periods presented. The assets and liabilities are deemed to be held for sale upon management’s approval and commitment to a plan to dispose of or sell the business segment or reporting unit. Also, the revenues and expenses associated with these business segments or reporting units are included within Income from discontinued operations, net of taxes, on the Statements of Operations for all periods presented. Additionally, in accordance with the provisions of SFAS 144, the Company ceases amortizing long-lived assets while they are classified as held for sale.

Stock-based compensation

The Company applies Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”) and related interpretations in accounting for its stock-based compensation plans. As options are granted at the then market value, 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 SFAS No. 123, Accounting for Stock-Based Compensation, the Company’s net (loss) income and earnings per share amounts for the three and nine months ended September 30, 2004 and 2003, respectively, would have been as follows (in millions, except per share data):

9

The Company records the fair market value of restricted stock awards on the date of grant as unamortized stock-based compensation in Stockholders’ equity and amortizes the balance to compensation expense ratably over the vesting period.

Other

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

3. Securities Owned and Securities Sold, Not Yet Purchased

Securities owned and securities sold, not yet purchased from continuing operations are carried at market value and consist of the following (in millions):

4. Receivable from and Payable to Brokers and Dealers

Amounts receivable from and payable to brokers and dealers from continuing operations consist of the following (in millions):

5. Goodwill and Intangible Assets

The Company adopted the provisions of SFAS No. 142 Goodwill and Other Intangible Assets as of January 1, 2002. This statement established new standards for accounting for goodwill and intangible assets acquired outside of, and subsequent to, a business combination. Under the new standards, goodwill and intangible assets with indefinite useful lives are no longer being amortized, but are tested for impairment annually or when an event occurs or circumstances change that signify the existence of

10

impairment. As part of our annual test for impairment, we consider the profitability of the respective segment or reporting unit, an assessment of the fair value of the respective segment or reporting unit as well as the overall market value of the Company compared to its net book value.

In June 2004, the Company tested for the impairment of goodwill and intangible assets and concluded that there was no impairment. The goodwill balance from continuing operations of $19.2 million at September 30, 2004, related to the Equity Markets segment. Goodwill from continuing operations is net of accumulated amortization of $21.9 million recorded through December 31, 2001, the effective date the Company adopted SFAS No. 142. In the first half of 2004, the Company acquired all of the ownership interests of the minority owners of Knight Roundtable Europe Limited (“KREL”) (which is the Company’s subsidiary that owns KEMIL) for $2.5 million, which was recorded as goodwill and is attributable to the Equity Markets business segment.

At September 30, 2004, the Company had intangible assets, net of accumulated amortization, of $11.7 million from continuing operations, all included within the Equity Markets business segment. Intangible assets, net of accumulated amortization, of $11.5 million resulted from the purchase of the business of Donaldson and primarily represent the value of client relationships. The carrying value of these intangible assets is being amortized over the remaining useful lives, which have been determined to range from five to thirty years.

In the third quarter of 2004, the Company recorded amortization expense from continuing operations, related to its intangible assets within its Equity Markets business segment of $155,000. The estimated amortization expense from continuing operations relating to the intangible assets for each of the next five years approximates $155,000 for the remainder of 2004 and $620,000 per year in the subsequent four years.

The chart below summarizes the activity of the Company’s Goodwill and Intangible assets, net of accumulated amortization, from continuing operations, for the nine months ended September 30, 2003 and 2004 (in millions), respectively:

6. Investment in Deephaven Sponsored Funds and Strategic Investments

The Company’s subsidiary, Deephaven, is the investment manager and sponsor of the Deephaven Funds, which engage in various trading strategies involving equities, debt instruments and derivatives. The underlying investments in the Deephaven Funds are carried at market value. Of the $3.5 billion of assets under management in the Deephaven Funds as of September 30, 2004, the Company had a corporate investment of $206.3 million. Additionally, Other assets on the Consolidated Statements of Financial Condition at September 30, 2004 and December 31, 2003 included $19.8 million and $3.5 million, respectively, of investments in the Deephaven Funds related to employee deferred compensation plans. In addition, certain officers, directors and employees of the Company had direct investments of approximately $13.0 million in the Deephaven Funds, in the aggregate, as of September 30, 2004.

11

Strategic investments, which primarily include the Company’s investments in Nasdaq and the ISE, are reviewed on an ongoing basis to ensure that the fair values of the investment have not been impaired. In accordance with this policy, the Company wrote down its investment in Nasdaq, to fair value, resulting in an impairment charge of $6.8 million in the first quarter of 2003.

7. Significant Clients

The Company considers significant clients to be clients, from its continuing operations, who account for 10% or more of the total U.S. equity dollar value traded by the Company during the period. One customer accounted for approximately 11.5% and 12.0% of the Company’s U.S. equity dollar value traded during the three and nine months ended September 30, 2004, respectively. Payments for order flow to this firm for U.S. equity order flow for the three and nine months ended September 30, 2004 amounted to $2.8 million and $15.2 million, respectively.

The Company’s corporate investment in the Deephaven Funds of $206.3 million accounted for 5.8% of total assets under management as of September 30, 2004. One institutional investor accounted for more than 10% of the Deephaven Funds’ assets under management, with 13.1% as of September 30, 2004.

8. Writedown of Assets and Lease Loss Accrual

The Writedown of assets and lease loss accrual from continuing operations for the three months ended September 30, 2004 of $874,000 is related to the writedown of fixed assets that are no longer actively used. The Writedown of assets and lease loss accrual from continuing operations for the nine months ended September 30, 2004 was $3.5 million, which includes $2.6 million of costs associated with excess real estate capacity in Jersey City, NJ.

The Writedown of assets and lease loss accrual from continuing operations for the nine months ended September 30, 2003 was $16.7 million. The writedown primarily consists of $9.8 million related to costs associated with excess real estate capacity in Jersey City, NJ and $6.8 million related to the writedown of the investment in Nasdaq to fair value.

9. Discontinued Operations

Derivative Markets

On August 8, 2004, the Company entered into a definitive agreement with Citigroup under which Citigroup will acquire substantially all of the assets and assume certain of the liabilities (the “adjusted book value”) that comprise the Derivatives Markets business operated by KFP and KEP for approximately $225 million in cash, subject to an adjustment based on the adjusted book value of the Derivative Markets business at the time the deal closes. The decision to sell the Derivative Markets business was based on a review of the overall options industry, the capital and risk required to maintain this business successfully and the business’ role in the Company’s long-term strategy. The transaction is expected to close in the fourth quarter of 2004 and is subject to customary closing conditions, including antitrust and regulatory approvals.

In accordance with SFAS No. 144, Accounting for the Disposal of Long-Lived Assets, all of the assets and liabilities within Derivative Markets that have been designated as “held for sale” are disclosed separately as Assets or Liabilities within discontinued operations on the Statements of Financial Condition for all periods presented. Additionally, the revenues and expenses associated with these businesses have been included within Income from discontinued operations, net of taxes on the Statements of Operations for all periods presented.

Equity Markets – Knight Securities Japan

On March 31, 2003, the Company and its joint venture partner, Nikko Cordial Group, announced that KSJ would cease its operations. KSJ’s business plan was significantly impaired due to changes in market structure, the withdrawal of Nasdaq Japan, poor market conditions and limited market-making opportunities in Japan. As a result, trading operations ceased at KSJ on May 2, 2003. After the cessation of trading, the parties liquidated KSJ, and all charges related to this liquidation were incurred during the second quarter of 2003.

12

The revenues and results of operations of the discontinued operations for the three and nine month periods ended September 30, 2003 and 2004 are summarized as follows (in millions):

The Consolidated Statements of Financial Condition include Assets within discontinued operations and Liabilities within discontinued operations. The net balance of these items represents the adjusted book value of the discontinued operations in accordance with the agreement to sell the Derivative Markets business. The major asset and liability classes included within these categories at September 30, 2004 and December 31, 2003, respectively, are as follows (in millions):

Included within Other assets in the table above is $4.4 million of Goodwill related to the Derivative Markets business segment. This amount is net of accumulated amortization of $556,000 recorded through December 31, 2001. Also included within Other assets in the table above are intangible assets related to the Derivative Markets business segment. The balance, net of accumulated amortization, of $1.6 million, primarily resulted from the purchase of various options related specialist posts. These intangible assets were being amortized over the remaining useful lives, which had been determined to range between ten and fourteen years.

13

In accordance with the provisions of SFAS 144 Accounting for the Disposal of Long-Lived Assets, the Company ceased amortizing long-lived assets held by the Derivative Markets segment upon the formal decision to sell the Derivative Markets business.

10. Commitments and Contingent Liabilities

In the ordinary course of business, the nature of the Company’s business subjects it to claims, lawsuits, regulatory examinations and other proceedings. The results of these matters cannot be predicted with certainty. There can be no assurance that these matters will not have a material adverse effect on the Company’s results of operations in any future period and a material judgment could have a material adverse impact on the Company’s financial condition and results of operations. However, it is the opinion of management, after consultation with legal counsel that, based on information currently available, the ultimate outcome of these matters will not have a material adverse impact on the business, financial condition or operating results of the Company.

The Company leases office space under noncancelable 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, from continuing operations, under the office leases was $2.6 million and $2.3 million for the three months ended September 30, 2004 and 2003, respectively. For both of the nine month periods ended September 30, 2004 and 2003, rental expense, from continuing operations, was $7.2 million.

The Company leases certain computer and other equipment under noncancelable operating leases. In addition, the Company has entered into guaranteed employment contracts with certain of its employees. As of September 30, 2004, future minimum rental commitments under all noncancelable office, computer and equipment leases (“Operating Leases”), and obligations on clearing contracts and guaranteed employment contracts longer than one year (“Other Obligations”) were as follows:

During the normal course of business, the Company collateralizes certain leases, employment agreements or other contractual obligations through letters of credit or segregated funds held in escrow accounts. As of September 30, 2004, the Company has provided a $10.0 million letter of credit, collateralized by U.S. Treasury Bills, as a guarantee for one of the Company’s lease obligations.

On October 22, 2003, the Company announced that it had entered into new long-term employment contracts with the senior management team of Deephaven (the “Deephaven managers”). These employment agreements, which became effective on January 1, 2004, are for three-year terms and include an option for renewal by the Deephaven managers through 2009 under certain circumstances. In addition, the agreements provide that, in the event of a change of control of the Company during the initial three- year term, the Deephaven managers would have the option to obtain a 51% interest in Deephaven in exchange for the termination of their employment contracts and associated profit-sharing bonuses, which in the aggregate range from 42% to 50% of the pre-tax, pre-profit sharing profits of Deephaven during the term of the agreements. If a change of control of the Company were to occur, and if the Deephaven managers exercised this option, the Company would retain a 49% interest in Deephaven.

11. Regulatory Charges and Related Matters

As disclosed in our Annual Report on Form 10-K for the year ended December 31, 2003, in March 2004, Knight Securities L.P., (“KSLP,” now known as KEM) received Wells Notices from the staffs of the SEC’s Division of Enforcement and from NASD’s Department of Market Regulation.

14

On July 7, 2004, the Company announced that KSLP had reached an agreement in principle with the staffs of the SEC and NASD to settle investigations in connection with specific institutional trade activity, conduct and supervision that occurred in 1999 through 2001; and books and records, document production and record-keeping deficiencies. The agreement in principle is subject to the drafting of settlement papers and final approval by the SEC and NASD.

Under the terms of the agreement in principle, KSLP would disgorge $41.2 million in institutional trading profits, and pay $13 million in interest and $25 million in penalties, for a total of $79.2 million. The SEC and NASD would then determine how the funds would be distributed. KSLP expects the proposed settlement to take the form of an administrative order, in which KSLP would neither admit nor deny the findings. During the second quarter of 2004, the Company recorded a pre-tax charge of $79.2 million, which is recorded as Regulatory charges and related matters on the Consolidated Statements of Operations, and reflected within Accrued expenses and other liabilities on the Consolidated Statements of Financial Condition. Based on the information currently available, the Company has not recorded a tax benefit for the $25.0 million penalty.

The findings concerning KSLP will include violations of the antifraud provisions of Section 15(c)(1) of the Securities Exchange Act of 1934 (“Exchange Act”) and associated rules. The findings will also include violations of the SEC books and records rules (Rules 17a-3 and 17a-4 under the Exchange Act) in connection with the retention of e-mails and order tickets and the use of trade modifiers; violations of NASD rules concerning the production of books and records (NASD Rule 8210), including just and equitable principles of trade (NASD 2110); failures to supervise under Exchange Act Section 15(b)(4)(E) and NASD Rules 3010 and 2110; and violations of NASD rules in connection with the use of trade modifiers (NASD Rules 4632 and 4642) and the filing of NASD Form U5 notices for certain former employees (NASD Rule 2110).

The proposed settlement would resolve the matters for which KSLP received Wells Notices from the staffs of the Division of Enforcement of the SEC and NASD’s Department of Market Regulation. The agreement in principle does not address the Wells Notices received by four former employees of KSLP.

The agreement in principle also does not address the private arbitration claim against KSLP made by a former KSLP employee relating to his employment and termination, as the Company originally disclosed in its Form 10-Q for the quarter ending June 30, 2002, and as updated in subsequent securities filings. As disclosed in the Company’s Form 8-K filing on September 23, 2004, KSLP was notified on September 22, 2004 by NASD Dispute Resolution, Inc. of a favorable decision with respect to this private employee arbitration. All claims and counterclaims in the private arbitration were dismissed, except that the arbitration panel awarded the former employee the amount of $19,101 (without interest) relating to the calculation of his override bonus payment for the year 2000.

For additional information related to legal proceedings and regulatory matters, please see “Legal Proceedings” in Part II, Item 1 of this document.

12. Earnings per Share

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

15

The following is a reconciliation of the numerators and denominators of the basic and diluted earnings per share computations for the three and nine month periods ended September 30, 2004 and 2003 (in millions, except for share and per share data):

For the three and nine months ended September 30, 2004, 3,897,143 and 5,629,848 shares of common stock equivalents, respectively, were not included in the calculation of weighted average shares for diluted EPS because the Company incurred losses during these periods, and the effect of their inclusion would be anti-dilutive.

13. Stock-Based Compensation

The Company has established the Knight Trading Group, Inc. 1998 Long Term Incentive Plan, the Knight Trading Group, Inc. 1998 Nonemployee Director Stock Option Plan and the Knight Trading Group, Inc. 2003 Equity Incentive Plan (collectively, the “Plans”). The purpose of the Plans is to provide long-term incentive compensation to employees and directors of the Company. 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 (collectively, the “awards”), as defined by the Plans. In addition, the Plans limit the number of awards that may be granted overall and to any individual.

The Company’s policy is 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 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. Restricted stock generally vests over three years. The Company has the right to fully vest employees in their awards upon retirement and in certain other circumstances.

The Company granted 15,000 restricted shares under the Plans during the third quarter of 2004 as stock-based compensation. At September 30, 2004 the Company had 2,777,512 restricted shares outstanding, in aggregate, both under and outside of the Plans. The Company recognizes compensation expense for the fair values of the restricted shares of Class A Common Stock granted to employees over the vesting period. For the three months ended September 30, 2004 and 2003, the Company recorded compensation expense, related to its continuing operations, for the fair values of the restricted shares of Class A Common Stock granted to employees of $2.4 million and $751,000, respectively, and $6.8 million and $1.7 million for the nine months ended September 30, 2004 and 2003, respectively, all of which has been included in Employee compensation and benefits in the Consolidated Statements of Operations.

16

14. Income Taxes

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

The following table reconciles the provision to the U.S. federal statutory income tax (benefit) rate:

15. Business Segments for Continuing Operations

The Company has two reportable business segments from continuing operations: Equity Markets and Asset Management. Equity Markets primarily represents market-making in U.S. equities. The Asset Management segment consists of investment management and sponsorship of the Deephaven Funds and the Company’s corporate investment in the Deephaven Funds.

During the third quarter of 2004, the Company agreed to sell its third business segment, Derivative Markets. In accordance with SFAS No. 144, Accounting for the Disposal of Long-Lived Assets, all of the assets and liabilities within Derivative Markets that have been designated as “held for sale” are disclosed separately as Assets or Liabilities within discontinued operations on the Statements of Financial Condition for all periods presented. Additionally, the revenues and expenses associated with these businesses have been included within Income from discontinued operations, net of taxes on the Statements of Operations for all periods presented. For a discussion of discontinued operations as well as a breakout of discontinued operations by business segment, please see Footnote 9, “Discontinued Operations.”

The Company’s revenues, (loss) income from continuing operations before income taxes and total assets by segment are summarized below (amounts in millions). Other revenues and expenses that are not directly attributable to a particular segment and relate to the Company’s general corporate functions are allocated to the segments based upon the Company’s allocation methodologies, which are generally based on each segment’s respective resource usage or other appropriate measures. In accordance with SFAS 144, the Company did not allocate any of these expenses to its discontinued operations. Historical amounts allocated to the segments with discontinued operations have been removed and re-allocated to continuing operations. The expenses that would have been allocated to the Derivative Markets segment had it not been classified as a discontinued operation were $1.6 million and $1.5 million for the three months ended September 30, 2004 and 2003, respectively and $4.7 million and $4.5 million for the nine months ended September 30, 2004 and 2003, respectively.

17