UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

 

 

 

Form 10-Q

 

 

Commission file number. 001-32878

 

 

 

 

Penson Worldwide, Inc.

(Exact name of registrant as specified in its charter)

 

 

(214) 765-1100

(Registrant’s telephone number, including area code)

 

 

 

 

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 þ     No o

 

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

 

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

 

(Do not check if a smaller reporting company)

 

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

 

As of November 5, 2009, there were 25,457,258 shares of the registrant’s $.01 par value common stock outstanding.

 

 

Penson Worldwide, Inc.

 

INDEX TO FORM 10-Q

 

 

 

Penson Worldwide, Inc.
Condensed Consolidated Statements of Financial Condition

 

 

 

See accompanying notes to condensed consolidated financial statements.

Penson Worldwide, Inc.
Condensed Consolidated Statements of Income
(In thousands, except per share data)

 

 

See accompanying notes to condensed consolidated financial statements.

Penson Worldwide, Inc.

Condensed Consolidated Statement of Stockholders’ Equity

 

 

See accompanying notes to condensed consolidated financial statements.

Penson Worldwide, Inc.

Condensed Consolidated Statements of Cash Flows

 

 

See accompanying notes to condensed consolidated financial statements.

Penson Worldwide, Inc.

Notes to the Unaudited Condensed Consolidated Financial Statements
(in thousands, except per share data or where noted)

 

 

Organization and Business — Penson Worldwide, Inc. (“PWI” or the “Company”) is a holding company incorporated in Delaware. The Company conducts business through its wholly owned subsidiary SAI Holdings, Inc. (“SAI”). SAI conducts business through its principal direct and indirect operating subsidiaries, Penson Financial Services, Inc. (“PFSI”), Penson Financial Services Canada Inc. (“PFSC”), Penson Financial Services Ltd. (“PFSL”), Nexa Technologies, Inc. (“Nexa”), Penson GHCO (“Penson GHCO”), Penson Asia Limited (“Penson Asia”) and Penson Financial Services Australia Pty Ltd (“Penson Australia”). Through these operating subsidiaries, the Company provides securities and futures clearing services including integrated trade execution, clearing and custody services, trade settlement, technology services, risk management services, customer account processing and customized data processing services. The Company also participates in margin lending and securities lending and borrowing transactions, primarily to facilitate clearing and financing activities.

 

PFSI is a broker-dealer registered with the Securities and Exchange Commission (“SEC”), a member of the New York Stock Exchange and a member of the Financial Industry Regulatory Authority (“FINRA”), and is licensed to do business in all fifty states of the United States of America. PFSC is an investment dealer and is subject to the rules and regulations of the Investment Industry Regulatory Organization of Canada. PFSL provides settlement services to the London financial community and is regulated by the Financial Services Authority (“FSA”) and is a member of the London Stock Exchange. Penson GHCO is a registered Futures Commission Merchant (“FCM”) with the Commodity Futures Trading Commission (“CFTC”) and is a member of the National Futures Association (“NFA”), various futures exchanges and is regulated in the United Kingdom by the FSA. Penson Australia holds an Australian Financial Services License and is a market participant of the Australian Securities Exchange and a clearing participant of the Australian Clearing House.

 

The accompanying unaudited interim condensed consolidated financial statements include the accounts of PWI and its wholly-owned subsidiary SAI. SAI’s subsidiaries include among others, PFSI, Nexa, Penson Execution Services, Inc., GHP1, Inc. (“GHP1”), which includes its direct and indirect subsidiaries GHP2, LLC (“GHP2”), First Capitol Group, LLC (“FCG”) and Penson GHCO and Penson Holdings, Inc. (“PHI”), which includes its subsidiaries PFSC, PFSL, Penson Asia and Penson Australia. All significant intercompany transactions and balances have been eliminated in consolidation.

 

The unaudited interim condensed consolidated financial statements as of and for the three and nine months ended September 30, 2009 and 2008 contained in this Quarterly Report (collectively, the “unaudited interim condensed consolidated financial statements”) were prepared in accordance with accounting principles generally accepted in the United States (“U.S. GAAP”) for all periods presented.

 

In the opinion of management, the unaudited accompanying condensed consolidated statements of financial condition and related interim statements of income, cash flows, and stockholders’ equity include all adjustments, consisting only of normal recurring items, necessary for their fair presentation in conformity with U.S. GAAP. Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. GAAP have been condensed or omitted in accordance with rules and regulations of the SEC. These unaudited interim condensed consolidated financial statements should be read in conjunction with the Penson Worldwide, Inc. consolidated financial statements as of and for the year ended December 31, 2008, as filed with the SEC on Form 10-K. Operating results for the three and nine months ended September 30, 2009 are not necessarily indicative of the results to be expected for the entire year.

 

In connection with the delivery of products and services to its clients and customers, the Company manages its revenues and related expenses in the aggregate. As such, the Company evaluates the performance of its business activities and evaluates clearing and commission, technology, and interest income along with the associated interest expense as one integrated activity.

 

Penson Worldwide, Inc.

 

Notes to the Unaudited Condensed Consolidated Financial Statements (Continued)

 

The Company’s cost infrastructure supporting its business activities varies by activity. In some instances, these costs are directly attributable to one business activity and sometimes to multiple activities. As such, in assessing the performance of its business activities, the Company does not consider these costs separately, but instead, evaluates performance in the aggregate along with the related revenues. Therefore, the Company’s pricing considers both the direct and indirect costs associated with transactions related to each business activity, the client relationship and the demand for the particular product or service in the marketplace. As a result, the Company does not manage or capture the costs associated with the products or services sold, or its general and administrative costs by revenue line.

 

Management’s Estimates and Assumptions — The preparation of financial statements in conformity with U.S. 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 period. Actual results could differ from those estimates. The Company reviews all significant estimates affecting the financial statements on a recurring basis and records the effect of any necessary adjustments prior to their issuance.

 

Recent Accounting Pronouncements

 

In June 2009, the Financial Accounting Standards Board (“FASB”) issued the FASB Accounting Standards Codification (the “Codification”), the single source of accounting principles and the framework for selecting the principles used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles (“GAAP”) in the United States. All guidance contained in the Codification carries an equal level of authority. The Codification supersedes all existing non-SEC accounting and reporting standards and was effective for the Company beginning July 1, 2009. The FASB will not issue new standards in the form of Statements, FASB Staff Positions, or Emerging Issues Task Force Abstracts; instead, it will issue Accounting Standards Updates. The FASB will not consider Accounting Standards Updates as authoritative in their own right; these updates will serve only to update the Codification, provide background information about the guidance, and provide the bases for conclusions on the changes in the Codification.

 

In May 2008, the FASB issued authoritative guidance for convertible debt instruments. This guidance requires that entities with convertible debt instruments that may be settled entirely or partially in cash upon conversion should separately account for the liability and equity components of the instrument in a manner that reflects the issuer’s economic interest cost. The effect of the proposed new rules for the Company’s convertible debentures is that the equity component would be included in the paid-in-capital section of shareholders’ equity on an entity’s consolidated balance sheet and the value of the equity component would be treated as original issue discount for purposes of accounting for the debt component of convertible debt. The Company adopted this guidance on January 1, 2009. See Note 9 for the impact on our consolidated condensed financial statements.

 

In April 2009, the FASB issued authoritative disclosure guidance for financial instruments. The guidance requires an entity to provide interim disclosures about the fair value of financial instruments and to include disclosures related to the methods and significant assumptions used in estimating those instruments. The Company adopted this guidance during the quarter ended June 30, 2009. The adoption of this guidance did not have a material impact on the Company’s consolidated condensed financial statements.

 

In April 2009, the FASB issued additional guidance on estimating fair value when the volume and level of transaction activity for an asset or liability have significantly decreased in relation to normal market activity for the asset or liability. Additionally, this guidance requires additional disclosures regarding fair value in interim and annual reports. The Company adopted this guidance during the quarter ended June 30, 2009. The adoption did not have a material impact on the Company’s consolidated condensed financial statements.

 

In May 2009, the FASB issued authoritative guidance for subsequent events, which establishes standards on events that occur after the balance sheet date but prior to the issuance of the financial statements. This guidance

 

Penson Worldwide, Inc.

 

Notes to the Unaudited Condensed Consolidated Financial Statements (Continued)

 

distinguishes events requiring recognition in the financial statements and those that may require disclosure in the financial statements. Furthermore, it requires disclosure of the date through which subsequent events were evaluated. The Company adopted this guidance during the quarter ended June 30, 2009. The Company has evaluated subsequent events for potential recognition and/or disclosure through November 6, 2009, the date the consolidated condensed financial statements included in this Quarterly Report on Form 10-Q were issued.

 

 

First Capitol Group, LLC

 

In November 2007, our subsidiary Penson GHCO acquired all of the assets of FCG, an FCM and a leading provider of technology products and services to futures traders, and assigned the purchased membership interest to GHP1 effective immediately thereafter. We closed the transaction in November, 2007 and paid approximately $9.4 million in cash, subject to a reconciliation to reported actual net income for the period ended November 30, 2008, as defined in the purchase agreement and approximately 150 shares of common stock valued at $2.2 million to the previous owners of FCG. In addition, the Company agreed to pay an annual earnout in cash for the two year period following the actual net income reconciliation, based on average net income, subject to certain adjustments including cost of capital, for the acquired business. The Company paid approximately $8.7 million related to the first year of the earnout period. The Company finalized the acquisition valuation during the third quarter of 2008 and recorded goodwill of approximately $4.0 million and intangibles of approximately $7.6 million. The financial results of FCG have been included in the Company’s consolidated financial statements since the November 30, 2007 acquisition date. On May 31, 2008, Penson GHCO acquired substantially all of the assets of FCG as part of an internal reorganization and consolidation of assets. FCG currently conducts business as a division of Penson GHCO.

 

Goldenberg Hehmeyer and Co.

 

In November 2006, the Company entered into a definitive agreement to acquire the partnership interests of Chicago-based GHCO, a leading international futures clearing and execution firm. The Company closed the transaction on February 16, 2007 and paid $27.9 million, including cash and approximately 139 shares of common stock valued at $3.9 million to the previous owners of GHCO. In addition, the Company agreed to pay additional consideration in the form of an earnout over the next three years, in an amount equal to 25% of Penson GHCO’s pre-tax earnings, as defined in the purchase agreement executed with the previous owners of GHCO. The Company did not make an earnout payment related to the first and second years of the integrated Penson GHCO business. Goodwill of approximately $2.8 million and intangibles of approximately $1.0 million were recorded in connection with the acquisition. The assets and liabilities acquired as well as the financial results of Penson GHCO have been included in the Company’s consolidated financial statements since the February 16, 2007 acquisition date.

 

Acquisition of the clearing business of Schonfeld Securities, LLC

 

In November 2006, the Company acquired the clearing business of Schonfeld Securities LLC (“Schonfeld”), a New York based securities firm. The Company closed the transaction in November 2006 and in January 2007, the Company issued approximately 1.1 million shares of common stock valued at $28.3 million to the previous owners of Schonfeld as partial consideration for the assets acquired of which approximately $14.8 million was recorded as goodwill and $13.5 million as intangibles. In addition, the Company agreed to pay an annual earnout of stock and cash over a four year period that commenced on June 1, 2007, based on net income, as defined in the asset purchase agreement, for the acquired business. The Company successfully completed the conversion of the seven Schonfeld correspondents in the second quarter of 2007. A payment of approximately $26.6 million was paid in connection with the first year earnout that ended May 31, 2008 and approximately $14.9 million has been paid in connection with the second year of the year earnout that ended May 31, 2009. At September 30, 2009, a liability of approximately $15.5 million was accrued as a result of the second year of the earnout ended May 31, 2009

 

Penson Worldwide, Inc.

 

Notes to the Unaudited Condensed Consolidated Financial Statements (Continued)

 

($10.5 million) and four months of the year three earnout ending May 31, 2010 ($5.0 million). This balance is included in other liabilities in the condensed consolidated statement of financial condition. The offset of this liability, goodwill, is included in other assets.

 

 

The following is a reconciliation of the numerators and denominators of the basic and diluted net income per share computation. Common stock equivalents related to stock options are excluded from the diluted earnings per share calculation if their effect would be anti-dilutive to earnings per share.

 

 

At September 30, 2009 and 2008, stock options and restricted stock units totaling 1,043 and 1,093 were excluded from the computation of diluted earnings per share as their effect would have been anti-dilutive.

 

 

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. In determining fair value, the Company uses various valuation approaches, including market, income and/or cost approaches. The fair value model establishes a hierarchy which prioritizes the inputs to valuation techniques used to measure fair value. This hierarchy increases the consistency and comparability of fair value measurements and related disclosures by maximizing the use of observable inputs and minimizing the use of unobservable inputs by requiring that observable inputs be used when available. Observable inputs reflect the assumptions market participants would use in pricing the assets or liabilities based on market data obtained from sources independent of the Company. Unobservable inputs reflect the Company’s own assumptions about the assumptions market participants would use in pricing the asset or liability developed based on the best information available in the circumstances. The hierarchy prioritizes the inputs into three broad levels based on the reliability of the inputs as follows:

 

 

Penson Worldwide, Inc.

 

Notes to the Unaudited Condensed Consolidated Financial Statements (Continued)

 

 

 

The following is a description of the valuation techniques applied to the Company’s major categories of assets and liabilities measured at fair value on a recurring basis:

 

U.S. government and agency securities

 

U.S. government securities are valued using quoted market prices in active markets. Accordingly, U.S. government securities are categorized in Level 1 of the fair value hierarchy.

 

U.S. agency securities consist of agency issued debt and are valued using quoted market prices. As such these securities are categorized in Level 1 of the fair value hierarchy.

 

Canadian government obligations

 

Canadian government securities include both Canadian federal obligations and Canadian provincial obligations. These securities are valued using quoted market prices. These bonds are generally categorized in Level 2 of the fair value hierarchy as the price quotations are not always from active markets.

 

Corporate debt

 

Corporate bonds are generally valued using quoted market prices. Corporate bonds are generally classified in Level 2 of the fair value hierarchy as prices are not always from active markets.

 

Corporate equity

 

Corporate equity securities represent exchange-traded securities are generally valued based on quoted prices in active markets. These securities are categorized in Level 1 of the fair value hierarchy.

 

Certificates of deposit and term deposits

 

The fair value of certificates of deposits and term deposits is estimated using third-party quotations. These deposits are categorized in Level 2 of the fair value hierarchy.

 

Money market

 

Money market funds are generally valued based on quoted prices in active markets. These securities are categorized in Level 1 of the fair value hierarchy.

 

Penson Worldwide, Inc.

 

Notes to the Unaudited Condensed Consolidated Financial Statements (Continued)

 

The following table summarizes by level within the fair value hierarchy “Receivable from broker-dealers and clearing organizations”, “Securities owned, at fair value”, “Deposits with clearing organizations” and “Securities sold, not yet purchased, at fair value” as of September 30, 2009.

 

 

 

Cash and securities segregated under U.S. federal and other regulations totaled $3,345,945 at September 30, 2009. Cash and securities segregated under federal and other regulations by PFSI totaled $2,981,193 at September 30, 2009. Of this amount, $2,948,488 was segregated for the benefit of customers under Rule 15c3-3 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), against a requirement as of September 30, 2009 of $2,969,794. An additional deposit of $60,000 was made on October 2, 2009 as allowed by Rule 15c3-3. The remaining balance of $32,705 at the end of the period relates to the Company’s election to compute a reserve requirement for Proprietary Accounts of Introducing Broker-Dealers (“PAIB”) calculation, as defined, against a requirement as of September 30, 2009 of $14,243. The PAIB calculation is completed in order for each correspondent firm that uses the Company as its clearing broker-dealer to classify its assets held by the Company as allowable assets in the correspondent’s net capital calculation. In addition, $370,603, including cash of $134,144 was segregated for the benefit of customers by Penson GHCO pursuant to CFTC Rule 1.20 at September 30, 2009. Finally, $86,976 and $143,632 was segregated under similar Canadian and United Kingdom regulations, respectively. At December 31, 2008, $2,383,948 was segregated for the benefit of customers under Rule 15c3-3 of the Exchange Act and PAIB, and similar Canadian and United Kingdom regulations.

 

Penson Worldwide, Inc.

 

Notes to the Unaudited Condensed Consolidated Financial Statements (Continued)

 

 

 

Amounts receivable from and payable to broker-dealers and clearing organizations consists of the following:

 

 

Receivables from broker-dealers and clearing organizations include amounts receivable for securities failed to deliver, amounts receivable from clearing organizations relating to open transactions, good-faith and margin deposits, and floor-brokerage receivables. Payables to broker-dealers and clearing organizations include amounts payable for securities failed to receive, amounts payable to clearing organizations on open transactions, and floor-brokerage payables. In addition, the net receivable or payable arising from unsettled trades are reflected in these categories.

 

 

Securities owned and securities sold, not yet purchased consist of trading and investment securities at quoted market if available, or fair values as follows:

 

 

 

At September 30, 2009 and December 31, 2008, the Company had $363,406 and $130,846, respectively in short-term bank loans outstanding under seven uncommitted lines of credit with seven financial institutions. Five of

 

Penson Worldwide, Inc.

 

Notes to the Unaudited Condensed Consolidated Financial Statements (Continued)

 

these lines of credit permitted the Company to borrow up to an aggregate of approximately $308,522 while two lines do not have specified borrowing limits. The fair value of short-term bank loans approximates their carrying values.

 

The Company also has the ability to borrow under stock loan arrangements. At September 30, 2009 and December 31, 2008, the Company had $234,369 and $319,801, respectively in borrowings and no specific limitations on additional borrowing capacities. Borrowings under these arrangements bear interest at variable rates, are secured primarily by our firm inventory and customers’ margin account securities, and are repayable on demand. The fair value of these borrowings approximates their carrying values. The remaining balance in securities loaned relates to the Company’s conduit stock loan business.

 

 

Revolving Credit Facility

 

On May 1, 2009 the Company signed a new secured revolving credit facility (the “Credit Facility”) with a syndicate of financial institutions. The Credit Facility was subsequently amended on May 27, 2009 and September 22, 2009. The Credit Facility allows the Company to borrow up to a maximum $100,000 at a variable rate of interest (6.75% at September 30, 2009) with a term of 364 days. The Company’s obligations under the Credit Facility are secured by a guaranty from SAI and PHI, and a pledge by the Company, SAI and PHI of the equity interests of certain of the Company’s subsidiaries. The Credit Facility contains various positive and negative covenants, including certain financial covenants such as maintenance of minimum consolidated tangible net worth, a minimum fixed charge coverage ratio, a maximum consolidated leverage ratio, a minimum capital requirement, a minimum liquidity requirement and maximum capital expenditures. As of September 30, 2009 $70,000 was outstanding. The fair value of the Credit Facility approximates its carrying value. Subsequent to September 30, 2009, the Company amended the Credit Facility that among other things, resulted in modified financial covenants. See Note 18.

 

Senior Convertible Notes

 

On June 3, 2009, the Company issued $60,000 aggregate principal amount of 8.00% Senior Convertible Notes due 2014 (the “Convertible Notes”). The $60,000 aggregate principal amount of Convertible Notes includes $10,000 issued in connection with the exercise in full by the initial purchasers of their over-allotment option. The net proceeds from the sale of the convertible notes were approximately $56,200 after initial purchaser discounts and other expenses.

 

The Convertible Notes bear interest at a rate of 8.0% per year. Interest on the Convertible Notes is payable semi-annually in arrears on June 1 and December 1 of each year, beginning December 1, 2009. The Convertible Notes will mature on June 1, 2014, subject to earlier repurchase or conversion.

 

Holders may convert their Convertible Notes at their option at any time prior to the close of business on the business day immediately preceding the maturity date for such Convertible Notes under the following circumstances: (1) during any fiscal quarter after the fiscal quarter ending September 30, 2009 (and only during such fiscal quarter), if the last reported sale price of the Company’s common stock for at least 20 trading days in the period of 30 consecutive trading days ending on the last trading day of the immediately preceding fiscal quarter is equal to or more than 120% of the conversion price of the Convertible Notes on the last day of such preceding fiscal quarter; (2) during the five business-day period after any five consecutive trading-day period in which the trading price per $1,000 (in whole dollars) principal amount of the Convertible Notes for each day of that period was less than 98% of the product of the last reported sale price of the Company’s common stock and the conversion rate of the Convertible Notes on each such day; (3) upon the occurrence of specified corporate transactions, including upon certain distributions to holders of the Company’s common stock and certain fundamental changes, including changes of control and dispositions of substantially all of the Company’s assets; and (4) at any time beginning on March 1, 2014. Upon conversion, the Company will pay or deliver, at the Company’s option, cash, shares of the

 

Penson Worldwide, Inc.

 

Notes to the Unaudited Condensed Consolidated Financial Statements (Continued)

 

Company’s common stock or a combination thereof. The initial conversion rate for the Convertible Notes will be 101.9420 shares of the Company’s common stock per $1,000 (in whole dollars) principal amount of Convertible Notes (6,117 shares), equivalent to an initial conversion price of approximately $9.81 per share of common stock. Such conversion rate will be subject to adjustment in certain events, but will not be adjusted for accrued or additional interest. In addition, the Indenture provides that, in no event will the Company issue shares upon conversion of Convertible Notes that exceed 19.99% of its common stock outstanding as of June 3, 2009, unless it has obtained stockholder approval in accordance with NASDAQ listing standards.

 

Following certain corporate transactions, the Company will increase the applicable conversion rate for a holder who elects to convert its Convertible Notes in connection with such corporate transactions by a number of additional shares of common stock. The Company may not redeem the Convertible Notes prior to their stated maturity date. If the Company undergoes a fundamental change, holders may require the Company to repurchase all or a portion of the holders’ Convertible Notes for cash at a price equal to 100% of the principal amount of the Convertible Notes to be purchased, plus any accrued and unpaid interest, including any additional interest, to, but excluding, the fundamental change purchase date.

 

The Convertible Notes are unsecured obligations of the Company and contain customary covenants, such as reporting of annual and quarterly financial results, and restrictions on certain mergers, consolidations and changes of control. The Convertible Notes also contain customary events of default, including failure to pay principal or interest, breach of covenants, cross-acceleration to other debt in excess of $20,000, unsatisfied judgments of $20,000 or more and bankruptcy events. The Convertible Notes contain no financial covenants.

 

The Company is required to separately account for the liability and equity components of the Convertible Notes in a manner that reflects the Company’s nonconvertible debt borrowing rate at the date of issuance when interest cost is recognized in subsequent periods. The Company allocated approximately $8,822, net of tax of $5,593, of the $60,000 principal amount of the Convertible Notes to the equity component, which represents a discount to the debt and will be amortized into interest expense using the effective interest method through June 1, 2014. Accordingly, the Company’s effective interest rate on the Convertible Notes will be 15.0%. The Company will recognize interest expense during the twelve months ended May 2010 on the Convertible Notes in an amount that approximates 15.0% of $45,585, the liability component of the Convertible Notes at the date of issuance. The Convertible Notes were further discounted by approximately $2,850 for the costs associated with the initial purchasers. These costs and other debt issuance costs will be amortized into interest expense over the life of the Convertible Notes. The interest expense recognized for the Convertible Notes in the twelve months ended May 2011 and subsequent periods will be greater as the discount is amortized and the effective interest method is applied. For the three and nine month periods ended September 30, 2009, the Company recognized interest expense of $1,200 and $1,573, respectively, related to the coupon and $509 and $679, respectively, related to the conversion feature.

 

The estimated fair value of the Convertible Notes was estimated using a discounted cash flow analysis based on our current borrowing rate for an instrument with similar terms. At September 30, 2009 the fair value of the Convertible Notes approximated the carrying value of $46,265.

 

 

In the normal course of business, the Company purchases and sells securities as both principal and agent. If another party to the transaction fails to fulfill its contractual obligation, the Company may incur a loss if the market value of the security is different from the contract amount of the transaction.

 

The Company deposits customers’ margin account securities with lending institutions as collateral for borrowings. If a lending institution does not return a security, the Company may be obligated to purchase the security in order to return it to the customer. In such circumstances, the Company may incur a loss equal to the amount by which the market value of the security on the date of nonperformance exceeds the value of the loan from the institution.

 

Penson Worldwide, Inc.

 

Notes to the Unaudited Condensed Consolidated Financial Statements (Continued)

 

In the event a customer fails to satisfy its obligations, the Company may be required to purchase or sell financial instruments at prevailing market prices to fulfill the customer’s obligations. The Company seeks to control the risks associated with its customer activities by requiring customers to maintain margin collateral in compliance with various regulatory and internal guidelines. The Company monitors required margin levels daily and, pursuant to such guidelines, requires customers to deposit additional collateral or to reduce positions when necessary.

 

Securities purchased under agreements to resell are collateralized by U.S. Government or U.S. Government-guaranteed securities. Such transactions may expose the Company to off-balance-sheet risk in the event such borrowers do not repay the loans and the value of collateral held is less than that of the underlying contract amount. A similar risk exists on Canadian Government securities purchased under agreements to resell that are a part of other assets. These agreements provide the Company with the right to maintain the relationship between market value of the collateral and the contract amount of the receivable.

 

The Company’s policy is to regularly monitor its market exposure and counterparty risk. The Company does not anticipate nonperformance by counterparties and maintains a policy of reviewing the credit standing of all parties, including customers, with which it conducts business.

 

For customers introduced on a fully-disclosed basis by other broker-dealers, the Company has the contractual right of recovery from such introducing broker-dealers in the event of nonperformance by the customer.

 

In addition, the Company has sold securities that it does not currently own and will therefore be obligated to purchase such securities at a future date. The Company has recorded these obligations in the financial statements at September 30, 2009, at fair values of the related securities and may incur a loss if the fair value of the securities increases subsequent to September 30, 2009.

 

 

The Company makes awards of stock options and restricted stock units (“RSUs”) under the Amended and Restated 2000 Stock Incentive Plan, as amended in May 2009 (the “2000 Stock Incentive Plan”), under which 4,466 shares of common stock have been authorized for issuance. Of this amount, options and RSUs to purchase 2,564 shares of common stock, net of forfeitures have been granted and 1,902 shares remain available for future grants at September 30, 2009. The Company also provides an employee stock purchase plan (“ESPP”).

 

The 2000 Stock Incentive Plan includes three separate programs: (1) the discretionary option grant program under which eligible individuals in the Company’s employ or service (including officers, non-employee board members and consultants) may be granted options to purchase shares of common stock of the Company; (2) the stock issuance program under which such individuals may be issued shares of common stock directly or stock awards that vest over time, through the purchase of such shares or as a bonus tied to the performance of services; and (3) the automatic grant program under which grants will automatically be made at periodic intervals to eligible non-employee board members. The Company’s Board of Directors or its Compensation Committee may amend or modify the 2000 Stock Incentive Plan at any time, subject to any required stockholder approval.

 

Stock options

 

During the three and nine months ended September 30, 2009 and 2008, the Company did not grant any stock options to employees.

 

The Company recorded compensation expense relating to options of approximately $301 and $337, respectively, for the three months ended September 30, 2009 and 2008, and $926 and $1,174, respectively, for the nine months ended September 30, 2009 and 2008.

 

Penson Worldwide, Inc.

 

Notes to the Unaudited Condensed Consolidated Financial Statements (Continued)

 

A summary of the Company’s stock option activity is as follows:

 

 

There were no options exercised during the three and nine month periods ended September 30, 2009. At September 30, 2009, the Company had approximately $724 of total unrecognized compensation expense, net of estimated forfeitures, related to stock option plans that will be recognized over the weighted average period of .97 years.

 

Restricted Stock Units

 

A summary of the Company’s Restricted Stock Unit activity is as follows:

 

 

The Company recorded compensation expense relating to restricted stock units of approximately $710 and $626 during the three month periods ended September 30, 2009 and 2008, respectively, and $2,750 and $1,893 for the nine months ended September 30, 2009 and 2008, respectively.

 

As of September 30, 2009, there is approximately $5,937 of unamortized compensation expense, net of estimated forfeitures, related to unvested restricted stock units outstanding that will be recognized over the weighted average period of 2.42 years.

 

Employee stock purchase plan

 

In July 2005, the Company’s Board of Directors adopted the ESPP, designed to allow eligible employees of the Company to purchase shares of common stock, at semiannual intervals, through periodic payroll deductions. A total of 313 shares of common stock were initially reserved under the ESPP. The share reserve will automatically increase on the first trading day of January each calendar year, beginning in calendar year 2007, by an amount equal to 1% of the total number of outstanding shares of common stock on the last trading day in December in the prior calendar year. Under the current plan, no such annual increase may exceed 63 shares.

 

Penson Worldwide, Inc.

 

Notes to the Unaudited Condensed Consolidated Financial Statements (Continued)

 

The ESPP may have a series of offering periods, each with a maximum duration of 24 months. Offering periods will begin at semi-annual intervals as determined by the plan administrator. Individuals regularly expected to work more than 20 hours per week for more than five calendar months per year may join an offering period on the start date of that period. However, employees may participate in only one offering period at a time. Participants may contribute 1% to 15% of their annual compensation through payroll deductions, and the accumulated deductions will be applied to the purchase of shares on each semi-annual purchase date. The purchase price per share shall be determined by the plan administrator at the start of each offering period and shall not be less than 85% of the lower of the fair market value per share on the start date of the offering period in which the participant is enrolled or the fair market value per share on the semi-annual purchase date. The plan administrator shall have the discretionary authority to establish the maximum number of shares of common stock purchasable per participant and in total by all participants in that particular offering period. The Company’s Board of Directors or its Compensation Committee may amend, suspend or terminate the ESPP at any time, and the ESPP will terminate no later than the last business day of June 2015. As of September 30, 2009, 500 shares of common stock had been reserved and 354 shares of common stock had been purchased by employees pursuant to the ESPP plan. The Company recognized expense of $45 and $36 for the three months ended September 30, 2009 and 2008, and $131 and $144 for the nine months ended September 30, 2009 and 2008, respectively.

 

 

From time to time, we are involved in legal proceedings arising in the ordinary course of business relating to matters including, but not limited to, our role as clearing broker for our correspondents. In some instances, but not all, where we are named in arbitration proceedings solely in our role as the clearing broker for our correspondents, we are able to pass through expenses related to the arbitration to the correspondent involved in the arbitration.

 

Under its bylaws, the Company has agreed to indemnify its officers and directors for certain events or occurrences arising as a result of the officer or director serving in such capacity. The Company has entered into indemnification agreements with each of its directors that require us to indemnify our directors to the extent permitted under our bylaws and applicable law. Although management is not aware of any claims, the maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited. However, the Company has a directors and officer liability insurance policy that limits its exposure and enables it to recover a portion of any future amounts paid. As a result of its insurance policy coverage, the Company believes the estimated fair value of these indemnification agreements is minimal and has no liabilities recorded for these agreements as of September 30, 2009 or December 31, 2008.

 

 

The differences in income tax provided and the amounts determined by applying the statutory rate to income before income taxes results from the following:

 

 

Penson Worldwide, Inc.

 

Notes to the Unaudited Condensed Consolidated Financial Statements (Continued)

 

 

 

The Company is organized into operating segments based on geographic regions. These operating segments have been aggregated into three reportable segments; United States, Canada and Other. The Company evaluates the performance of its operating segments based upon operating income before unusual and non-recurring items. The following table summarizes selected financial information.

 

 

 

 

 

Penson Worldwide, Inc.

 

Notes to the Unaudited Condensed Consolidated Financial Statements (Continued)

 

 

 

PFSI is subject to the SEC Uniform Net Capital Rule (SEC Rule 15c3-1), which requires the maintenance of minimum net capital. PFSI elected to use the alternative method, permitted by Rule 15c3-1, which requires that PFSI maintain minimum net capital, as defined, equal to the greater of $250 or 2% of aggregate debit balances, as defined in the SEC’s Reserve Requirement Rule (Rule 15c3-3). At September 30, 2009, PFSI had net capital of $97,047, and was $74,432 in excess of its required net capital of $22,615. At December 31, 2008, PFSI had net capital of $85,535, and was $66,558 in excess of its required net capital of $18,977.

 

Our Penson GHCO, PFSL, PFSC and Penson Australia subsidiaries are also subject to minimum financial and capital requirements. All subsidiaries were in compliance with their minimum financial and capital requirements as of September 30, 2009.

 

 

In re Sentinel Management Group, Inc. is a Chapter 11 bankruptcy case filed on August 17, 2007 in the U.S. Bankruptcy Court for the Northern District of Illinois by Sentinel Management Group, Inc., a registered futures commission merchant (“Sentinel”). Prior to the filing of this action, Penson GHCO and Penson Financial Futures, Inc. (“PFFI”) held customer segregated accounts with Sentinel totaling approximately $36 million. Sentinel subsequently sold certain securities to Citadel Equity Fund, Ltd. and Citadel Limited Partnership. On August 20, 2007, the Bankruptcy Court authorized distributions of 95 percent of the proceeds Sentinel received from the sale of those securities to certain FCM clients of Sentinel, including Penson GHCO. This distribution to the Penson GHCO and PFFI customer segregated accounts along with a distribution received immediately prior to the bankruptcy filing totaled approximately $25.4 million.

 

On May 12, 2008, a committee of Sentinel creditors, consisting of a majority of non-FCM creditors, together with the trustee appointed to manage the affairs and liquidation of Sentinel (the “Sentinel Trustee”), filed with the Court their proposed Plan of Liquidation (the “Committee Plan”) and on May 13, 2008 filed a Disclosure Statement related thereto. The Committee Plan allows the Sentinel Trustee to seek the return from FCMs, including Penson GHCO and PFFI, of a portion of the funds previously distributed to their customer segregated accounts. On June 19, 2008, the Court entered an order approving the Disclosure Statement over objections by Penson GHCO and others. On September 16, 2008, the Sentinel Trustee filed suit against Penson GHCO and PFFI along with several other FCMs that received distributions to their customer segregated accounts from Sentinel. The suit against Penson GHCO and PFFI seeks the return of approximately $23.6 million of post-bankruptcy petition transfers and $14.4 million of pre-bankruptcy petition transfers. The suit also seeks to declare that the funds distributed to the customer segregated accounts of Penson GHCO and PFFI by Sentinel are the property of the Sentinel bankruptcy estate rather than the property of customers of Penson GHCO and PFFI.

 

Penson Worldwide, Inc.

 

Notes to the Unaudited Condensed Consolidated Financial Statements (Continued)

 

On December 15, 2008, over the objections of Penson GHCO and PFFI, the court entered an order confirming the Committee Plan, and the Committee Plan became effective on December 17, 2008. On January 7, 2009, Penson GHCO and PFFI filed their answer and affirmative defenses to the suit brought by the Sentinel Trustee. Also, on January 7, 2009, Penson GHCO, PFFI and a number of other FCMs that had placed customer funds with Sentinel filed motions to withdraw the reference with the federal district court for the Northern District of Illinois, effectively asking the federal district court to remove the Sentinel suits against the FCMs from the bankruptcy court and consolidate them with other Sentinel related actions pending in the federal district court. On April 8, 2009, the Sentinel Trustee filed an amended complaint, which added a claim for unjust enrichment. Penson GHCO and PFFI’s response seeking to dismiss this claim was filed on May 8, 2009. On June 30, 2009, the Court denied the motion to dismiss without prejudice. The Court also held a preliminary pretrial hearing on June 30, 2009, and ordered that the first trial of the Sentinel Trustee’s claims against one FCM would commence on July 6, 2010, and the thirteen remaining trials would be scheduled at one month intervals thereafter. The trial of the Sentinel Trustee’s claims against Penson GHCO and PFFI is scheduled to proceed from September 20-23, 2010.

 

On July 31, 2009, Penson GHCO and PFFI filed their motion for reconsideration of the Court’s order denying their motion to dismiss the unjust enrichment claim. On September 1, 2009, the Court denied the motion for reconsideration without prejudice. On September 11, 2009, Penson GHCO and PFFI filed their amended answer and amended affirmative defenses to the Sentinel Trustee’s amended complaint. On October 28, 2009, the federal district court for the Northern District of Illinois granted Penson GHCO, PFFI, and certain other FCM’s motions requesting removal of the matters referenced above from the bankruptcy court, thereby removing these matters to the federal district court. While the trial schedule referenced above is still pending, it may change given the granting of the motions removing these matters to the federal district court.

 

The Company believes that the Court was correct in ordering the prior distributions and Penson GHCO and PFFI intend to continue to vigorously defend their position. However, there can be no assurance that any actions by Penson GHCO or PFFI will result in a limitation or avoidance of potential repayment liabilities. In the event that Penson GHCO and PFFI are obligated to return all previously distributed funds to the Sentinel Estate, any losses the Company might suffer would most likely be partially mitigated as it is likely that Penson GHCO and PFFI would share in the funds ultimately disbursed by the Sentinel Estate.

 

 

On July 3, 2007, the Company’s Board of Directors authorized the Company to purchase up to $25.0 million of its common stock in open market purchases and privately negotiated transactions. The repurchase program was completed in October 2007. On December 6, 2007, the Company’s Board of Directors authorized the Company to purchase an additional $12.5 million of its common stock. No shares were repurchased during the nine months ended September 30, 2009. The Company has approximately $4.7 million available under the current repurchase program as of September 30, 2009.

 

 

On November 2, 2009, PWI, together with PFSI, entered into an asset purchase agreement (the “Asset Purchase Agreement”) with Broadridge Financial Solutions, Inc. (“Broadridge”) and its wholly owned subsidiary Ridge Clearing & Outsourcing Solutions, Inc. (“Ridge”) to acquire substantially all of Ridge’s contracts with its securities clearing clients.

 

Under the terms of the Asset Purchase Agreement, PWI will pay between $60 million and $70 million in total consideration (the “Purchase Price”) to Broadridge consisting of (a) a five-year subordinated note (the “Seller Note”) payable by PWI bearing interest at an annual rate equal to 90-day LIBOR plus 5.5%, and (b) shares of PWI’s common stock (“PWI Common Stock”) equal to the lesser of (i) the number of shares of PWI Common Stock equal to the quotient of one third of the Purchase Price divided by the volume weighted-average selling price of PWI Common Stock over the 10 trading day period immediately prior to the closing, (ii) the number of shares of PWI Common Stock

 

Penson Worldwide, Inc.

 

Notes to the Unaudited Condensed Consolidated Financial Statements (Continued)

 

equal to 9.9% of the issued and outstanding shares of PWI (the “Common Stock”) as of the close of business on the business day immediately prior to the closing, or (iii) 2,517,451 shares of PWI Common Stock. The specific amount of such consideration will be determined immediately prior to closing pursuant to an agreed formula based upon the revenues attributable to the contracts being purchased by PFSI. The allocation of the consideration between the Seller Note and the PWI Common Stock will also be determined prior to the closing of the transaction. The Purchase Price will be subject to certain adjustments post-closing upon the occurrence of agreed upon events.

 

Concurrent with entering into the Asset Purchase Agreement, PWI and Broadridge entered into a ten-year master services agreement (the “Outsourcing Agreement”). Under the Outsourcing Agreement, Ridge will provide certain securities processing and back-office services to PFSI. This agreement will include selective processing services for PFSI’s existing securities processing operations and back-office functions, as well as selective processing services related to the clearing client contracts acquired by PFSI from Ridge. The provision of services under the Outsourcing Agreement is conditioned upon finalization of certain service level agreements, receipt of regulatory approvals and the closing of the transaction under the Asset Purchase Agreement.

 

Concurrent with the closing of the transaction, the parties will enter into a number of ancillary agreements, including a Joint Selling Agreement and a Stockholder’s and Registration Rights Agreement.

 

The Joint Selling Agreement will be entered into by Broadridge, Ridge, PWI and PFSI and will have a term concurrent with the term of the Outsourcing Agreement. Under the Joint Selling Agreement, the parties will engage in activities to offer, in the case of PFSI, Ridge’s self-clearing and securities processing solutions, and in the case of Ridge, PFSI and its affiliates’ correspondent clearing solutions, and will mutually agree to fee arrangements with respect to activities contemplated by the Joint Selling Agreement.

 

The Stockholder’s and Registration Rights Agreement will restrict the transfer of the PWI Common Stock to be received as a portion of the consideration for a period of one year from the closing of the transaction. Thereafter, Broadridge will be entitled to one demand registration right and piggy back registration rights, subject to customary terms and conditions. In addition, following expiration of the one-year restricted period, Broadridge will be entitled to sell the PWI Common Stock as permitted under SEC Rule 144. In the event PWI redeems or repurchases any of its Common Stock, if necessary, it will repurchase the PWI Common Stock on a pro rata basis on the same terms and conditions so that Broadridge’s beneficial ownership of PWI Common Stock will not exceed 9.9% of PWI’s issued and outstanding Common Stock following any such repurchases or redemptions.

 

In addition, the Asset Purchase Agreement contemplates PWI raising $50 million in additional regulatory capital with respect to its operations pertaining to the correspondent clearing contracts to be acquired. At PWI’s option, Broadridge has agreed to lend, under certain circumstances, this amount to PWI pursuant to an eighteen-month subordinated note (the “Backstop Note”) payable by PWI and bearing interest at an annual rate equal to 90-day LIBOR plus 14%.

 

The Seller Note and, if utilized, the Backstop Note, will be subordinated to PWI bank debt and be subject to customary subordination provisions. Therefore, among other things, in the event there is a payment default, or other event of default that would permit acceleration of PWI bank debt, payment on the Seller Note and, if utilized, the Backstop Note, will be blocked for up to 270 days in any twelve-month period.

 

On November 2, 2009 PWI entered into the Third Amendment (the “Third Amendment”) to its Amended and Restated Credit Agreement, dated as of May 1, 2009, with Regions Bank, as Administrative Agent, Swing Line Lender and Letter of Credit Issuer, the lenders party thereto and other parties thereto, as amended by the First Amendment on May 27, 2009 and Second Amendment dated September 22, 2009 (the “Credit Agreement”). The Third Amendment, among other things, makes changes to a number of covenants in the Credit Agreement, including the financial covenants, in order to permit the acquisition of the clearing contracts of Ridge and the issuance of the Common Stock portion of the Purchase Price, the Seller Note and the Backstop Note. In addition, the Third Amendment authorizes PWI to raise additional capital. In the event that the Backstop Note has been issued at the time of such capital raising, the Third Amendment requires that the proceeds will be used to repay the Backstop Note.

 

The following discussion and analysis should be read in conjunction with the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section and the consolidated financial statements and related notes thereto included in our December 31, 2008 Annual Report on Form 10-K (File No. 001-32878), filed with the SEC and with the unaudited interim condensed consolidated financial statements and related notes thereto presented in this Quarterly Report on Form 10-Q.

 

Overview

 

We are a leading provider of a broad range of critical securities and futures processing infrastructure products and services to the global financial services industry. Our products and services include securities and futures clearing and execution, financing and cash management technology and other related offerings, and we provide tools and services to support trading in multiple markets, asset classes and currencies.

 

Since starting our business in 1995 with three correspondents, we have grown to serve approximately 244 active securities clearing correspondents and 43 futures clearing correspondents as of September 30, 2009. Our net revenues were $72.2 million and $79.3 million for the three months ended September 30, 2009 and 2008, respectively, while our net revenues were $215.5 million and $224.1 million for the nine months ended September 30, 2009 and 2008, respectively. Our revenues consist primarily of transaction processing fees earned from our clearing operations and net interest income earned from our margin lending activities, from investing customers’ cash and from stock lending activities. Our clearing and commission fees are based principally on the number of trades we clear. We receive interest income from financing the securities purchased on margin by the customers of our clients. We also earn licensing and development revenues from fees we charge to our clients for their use of our technology solutions.

 

Fiscal 2009 Highlights

 

 

Financial overview

 

Net revenues

 

Revenues

 

We generate revenues from most clients in several different categories. Clients generating revenues for us from clearing transactions almost always also generate significant interest income from related balances. Revenues from clearing transactions are driven largely by the volume of trading activities of the customers of our correspondents and proprietary trading by our correspondents. Our average clearing revenue per trade is a function of numerous pricing elements that vary based on individual correspondent volumes, customer mix, and the level of margin debit balances and credit balances. Our clearing revenue fluctuates as a result of these factors as well as changes in trading volume. We focus on maintaining the profitability of our overall correspondent relationships, including the clearing revenue from trades and net interest from related customer margin balances, and by reducing associated variable costs. We collect the fees for our services directly from customer accounts when trades are processed. We only remit

commissions charged by our correspondents to them after deducting our charges. For this reason, we have no significant receivables to collect.

 

We often refer to our interest income as “Interest, gross” to distinguish this category of revenue from “Interest, net” that is generally used in our industry. Interest, gross is generated by charges to customers or correspondents on margin balances and interest earned by investing customers’ cash, and therefore these revenues fluctuate based on the volume of our total margin loans outstanding, the volume of the cash balances we hold for our correspondents’ customers, the rates of interest we can competitively charge on margin loans and the rates at which we can invest such balances. We also earn interest from our stock borrowing and lending activities.

 

Technology revenues consist of transactional, development and licensing revenues generated by Nexa. A significant portion of these revenues are collected directly from clearing customers along with other charges for clearing services as described above. Most development revenues and some transaction revenues are collected directly from clients and are reflected as receivables until they are collected.

 

Other revenues include charges assessed directly to customers for certain transactions or types of accounts, trade aggregation and profits from proprietary trading activities, including foreign exchange transactions and fees charged to our correspondents’ customers. Subject to certain exceptions, our clearing brokers in the U.S., Canada and the U.K. each generate these types of transactions.

 

Interest expense from securities operations

 

Interest expense is incurred in our daily operations in connection with interest we pay on credit balances we hold and on short-term borrowings we make to fund activities of our correspondents and their customers. We have two primary sources of borrowing: commercial banks and stock lending institutions. Regulations differ by country as to how operational needs can be funded, but we often find that stock loans that are secured with customer or correspondent securities as collateral can be obtained at a lower rate of interest than loans from commercial banks. Operationally, we review cash requirements each day and borrow the requirements from the most cost effective source.

 

Revenues from clearing and commission fees represented 51% of our total net revenues for the three months ended at each of September 30, 2009 and 2008, and 51% of our total net revenues for each of the nine months ended September 30, 2009 and 2008, respectively. Net interest income represented 23% and 27% of our total net revenues for the three months ended September 30, 2009 and 2008, respectively, and 24% and 27% for the nine months ended September 30, 2009 and 2008, respectively.

 

Expenses

 

Employee compensation and benefits

 

Our largest category of expense is the compensation and benefits that we pay to our employees, which includes salaries, bonuses, group insurance, contributions to benefit programs, stock compensation and other related employee costs. These costs vary by country according to the local prevailing wage standards. We utilize technology whenever practical to limit the number of employees and thus keep costs competitive. In the U.S., most of our employees are located in cities where employee costs are lower than where our largest competitors primarily operate. A portion of total employee compensation is paid in the form of bonuses and performance-based compensation. As a result, depending on the performance of particular business units and the overall Company performance, total employee compensation and benefits could vary materially from period to period.

 

Other operating expenses

 

Expenses incurred to process trades include floor brokerage and exchange and clearance fees, and those expenses tend to vary significantly with the level of trading activity. The related data processing and communication costs vary less with the level of trading activity. Occupancy and equipment expenses include lease expenses for office space, computers and other equipment that we require to operate our businesses. Other expenses include legal, regulatory, professional consulting, accounting, travel and miscellaneous expenses.

In addition, as a public company, we incur additional costs for external advisers such as legal, accounting, auditing and investor relations services, as well as additional costs for compliance with the Sarbanes-Oxley Act of 2002.

 

Profitability of services provided

 

Management records revenue for the clearing operations and technology business separately. We record expenses in the aggregate as many of these expenses are attributable to multiple business activities. As such, net profitability before tax is determined in the aggregate. We also separately record interest income and interest expense to determine the overall profitability of this activity.

 

Comparison of the three months ended September 30, 2009 and September 30, 2008

 

Overview

 

Results of operations declined for the three months ended September 30, 2009 compared to the three months ended September 30, 2008 primarily due to lower clearing and commission fees and lower net interest earned, partially offset by higher other revenues. Clearing and commission fees decreased due to lower equity and futures volumes, which was partially offset by higher options volumes. The decline in net interest earned is a result of higher customer average paying balances, lower average balances in our conduit business and lower interest spreads in the September 30, 2009 quarter as compared to the year ago quarter. Other revenues increased due to higher execution services revenues. Operating results decreased $5.9 million during the third quarter of 2009 as compared to the third quarter of 2008, for our U.S., Canadian and London businesses.

 

Our U.S. operating subsidiaries experienced a decrease in operating profits of approximately $3.8 million due to lower net interest income and technology revenues and higher communications and data processing costs resulting from a move to SunGard’s latest generation system consisting of equipment dedicated to our U.S. clearing business. Our Canadian business experienced an operating profit of $2.8 million for the September 30, 2009 quarter compared to an operating profit of $3.2 million in the September 30, 2008 quarter due primarily to decreases in net interest income. London incurred an operating loss of $1.4 million in the current quarter compared to an operating loss of $1.0 million in the year ago quarter due primarily to lower net interest income.

 

While we have continued to see profitability in our stock loan conduit business, we have seen decreased demand resulting from certain regulatory changes. The business consists of a “matched book” where we borrow stock from an independent party in the securities business and then loan the exact same shares to a third party who needs the shares. We pay interest expense on the borrowings and earn interest income on the loans, earning an average net spread of 50 to 75 basis points on the transactions. Due to regulatory and marketplace changes regarding short-selling of certain securities, clearing brokers that violate certain short-selling rules, including the failure to timely deliver securities, are now subject to significantly more stringent penalties. These changes as well as potential future regulatory changes have had and may continue to have a negative impact on the earnings we have historically seen in our conduit business.

 

The above factors resulted in lower operating results for the three months ended September 30, 2009 compared to the three months ended September 30, 2008.

The following is a summary of the increases (decreases) in the categories of revenues and expenses for the three months ended September 30, 2009 compared to the three months ended September 30, 2008.

 

 

Net Revenues

 

Net revenues decreased $7.1 million, or 8.9%, to $72.2 million from the quarter ended September 30, 2008 to the quarter ended September 30, 2009. The decrease is primarily attributed to the following:

 

Clearing and commission fees decreased $3.3 million, or 8.2%, to $36.9 million during this same period primarily due to a lower volume of equity and futures transactions, offset in part by higher option volumes.

 

Technology revenue increased $.1 million, or 1.2%, to $6.3 million due to higher recurring revenue offset by lower development revenue.

 

Interest, gross decreased $22.2 million or 46.9%, to $25.1 million during the quarter over quarter period. Interest revenues from customer balances decreased $11.8 million or 38.9% to $18.5 million as our average daily interest rate decreased 93 basis points (during this same period the average federal funds rate decreased 175 basis points) or 40.3% to 1.38% offset by an increase in our average daily interest earning assets of $441.9 million, or 8.9% to $5.4 billion. Interest from our stock conduit borrows operations decreased $10.4 million or 61.3% to $6.6 million, as a result of a decrease in our average daily assets of $1.5 billion or 68.0% to $697.7 million, offset by

an increase in our average daily interest rate of approximately 66 basis points, or 21.3% to 3.76%. (See page 22 for a description of our conduit business.)

 

Other revenue increased $1.3 million, or 11.4%, to $12.6 million due to increased execution services revenues of $1.3 million and increased fees revenues, partially offset by decreases in equity and foreign exchange trading.

 

Interest expense from securities operations decreased $17.0 million, or 66.4%, to $8.6 million from the quarter ended September 30, 2008 to the quarter ended September 30, 2009. Interest expense from clearing operations decreased approximately $8.5 million, or 71.6%, to $3.4 million due to an 87 basis point or 75.7% decrease in our average daily interest rate to .28% offset by an increase in our average daily balances on our short-term obligations of $649.7 million, or 15.8%, to $4.8 billion. Interest from our stock conduit loans decreased $8.5 million, or 62.0% to $5.2 million due to a $1.5 billion, or 68.0% decrease in our average daily balances to $695.6 million, offset by a 48 basis point increase, or 19.0% in our average daily interest rate to 3.01%.

 

Interest, net decreased from $21.6 million for the quarter ended September 30, 2008 to $16.5 million for the quarter ended September 30, 2009. This decrease was due to a higher ratio of customer interest paying balances to interest earning balances combined with significantly lower conduit balances, and a lower interest rate spread of 6 basis points on customer balances, offset slightly by a higher interest rate spread of 18 basis points on conduit balances.

 

Employee compensation and benefits

 

Total employee costs decreased $1.0 million, or 3.5%, to $27.2 million from the quarter ended September 30, 2008 to the quarter ended September 30, 2009, primarily due to lower incentive-based compensation expense. Employee count remained fairly constant, increasing by 1.3% to 1,020 as of September 30, 2009.

 

Floor brokerage, exchange and clearance fees

 

Floor brokerage, exchange and clearance fees decreased less than $.1 million, or .3%, to $8.5 million for the quarter ended September 30, 2009 from the quarter ended September 30, 2008, due to lower equity and futures volumes offset in part by higher options volumes.

 

Communication and data processing

 

Total expenses for our communication and data processing requirements increased $1.5 million, or 14.3%, to $11.7 million from the quarter ended September 30, 2008 to the quarter ended September 30, 2009. This increase reflects costs associated with additional data processing capacity resulting from a move to SunGard’s latest generation system consisting of equipment dedicated to our U.S. clearing business.

 

Occupancy and equipment

 

Total expenses for occupancy and equipment decreased $.4 million, or 5.0%, to $7.4 million from the quarter ended September 30, 2008 to the quarter ended September 30, 2009. This decrease is primarily due to costs associated with our occupancy leases.

 

Other expenses

 

Other expenses decreased $3.9 million, or 33.5%, to $7.7 million from the quarter ended September 30, 2008 to the quarter ended September 30, 2009, due to a $2.4 million litigation reserve recorded in the quarter ended September 30, 2008 and decreased travel expenses and professional fees, offset in part by increased legal fees.

 

Interest expense on long-term debt

 

Interest expense on long-term debt increased 293.2% from $.9 million for the quarter ended September 30, 2008 to $3.5 million for the quarter ended September 30, 2009 as a result of higher interest rates on our revolving credit facility, combined with additional interest expense of approximately $1.9 million associated with our senior convertible notes issued on June 3, 2009.

Provision for income taxes

 

Income tax expense, based on an effective income tax rate of approximately 37.4%, was $2.3 million for the quarter ended September 30, 2009 as compared to an effective tax rate of 38.0% and income tax expense of $4.6 million for the quarter ended September 30, 2008. This decrease is primarily attributed to lower operating profit in the current quarter. The lower effective rate is attributable to lower pretax income in the United States.

 

Net income

 

As a result of the foregoing, net income decreased to $3.9 million for the quarter ended September 30, 2009 from $7.5 million for the quarter ended September 30, 2008.

 

Comparison of the nine months ended September 30, 2009 and September 30, 2008

 

Overview

 

Results of operations declined for the nine months ended September 30, 2009 compared to the nine months ended September 30, 2008 primarily due to lower clearing and commission fees, lower net interest revenue, higher floor brokerage, exchange and clearance fees due to the timing of rebates received in the prior year and higher communications and data processing fees resulting from a move to SunGard’s latest generation system consisting of equipment dedicated to our U.S. clearing business, partially offset by higher technology and other revenues. Technology increased due to licensing revenue for the current nine month period that did not begin until the third quarter of 2008. The decline in net interest earned is a result of higher customer average paying balances, lower average balances in our conduit business and lower interest spreads on our customer balances in the current period as compared to the year ago period, offset slightly by higher interest rate spreads on our conduit business and higher customer balances. Operating results declined $15.6 million during the first nine months of 2009 as compared to the first nine months of 2008, for our U.S., Canadian and London businesses.

 

Our U.S. operating subsidiaries experienced a decrease in operating profits of approximately $2.5 million due to lower net interest income and higher communications and data processing costs, offset in part by higher technology revenue. Our Canadian business experienced an operating profit of $6.3 million for the September 30, 2009 period compared to an operating profit of $12.1 million in the September 30, 2008 period due primarily to lower net interest income. London incurred an operating loss of $4.0 million in the current period compared to an operating loss of $1.6 million in the year ago period, due primarily to the loss of the contracts for difference business and lower net interest income.

 

While we have continued to see profitability in our stock loan conduit business, we have seen decreased demand resulting from regulatory changes. The business consists of a “matched book” where we borrow stock from an independent party in the securities business and then loan the exact same shares to a third party who needs the shares. We pay interest expense on the borrowings and earn interest income on the loans, earning an average net spread of 50 to 75 basis points on the transactions. Due to regulatory and marketplace changes regarding short-selling of certain securities, clearing brokers that violate certain short-selling rules, including the failure to timely deliver securities, are now subject to significantly more stringent penalties. These changes and potential future regulatory changes have had and may continue to have a negative impact on the earnings we have historically seen in our conduit business.

 

The above factors resulted in lower operating results for the nine months ended September 30, 2009 compared to the nine months ended September 30, 2008.

The following is a summary of the increases (decreases) in the categories of revenues and expenses for the nine months ended September 30, 2009 compared to the nine months ended September 30, 2008.

 

 

Net Revenues

 

Net revenues decreased $8.6 million, or 3.9%, to $215.5 million from the nine months ended September 30, 2008 to the nine months ended September 30, 2009. The decrease is primarily attributed to the following:

 

Clearing and commission fees decreased $3.9 million, or 3.4%, to $110.2 million during this same period primarily due to a lower volume of equity and futures transactions, offset by an increase in options contracts and a change in our mix of correspondents.

 

Technology revenue increased $2.3 million, or 14.3%, to $18.4 million primarily due to approximately $1.9 million in licensing revenue and higher recurring revenue, offset by lower development revenue.

 

Interest, gross decreased $62.7 million or 44.6%, to $78.0 million during the first nine months of 2009 compared to the 2008 period. Interest revenues from customer balances decreased $40.3 million or 41.4% to $57.1 million as our average daily interest rate decreased 114 basis points (during this same period the average federal funds rate decreased 218 basis points) or 43.2% to 1.50% offset by an increase in our average daily interest earning assets of $223.5 million, or 4.8% to $4.9 billion. Interest from our stock conduit borrows operations decreased $22.3 million or 51.8% to $20.8 million, due to decrease in our average daily assets of $1.0 billion or

61.4% to $657.1 million, offset by an increase in our average daily interest rate of approximately 84 basis points, or 24.8% to 4.23% (see page 25 for a description of our conduit business).

 

Other revenue increased $3.5 million, or 10.8%, to $35.8 million due to increased revenues of $1.3 million from our trade aggregation business in the U.S and increased execution services revenues of $3.2 million, offset by decreases in equity and foreign exchange trading.

 

Interest expense from securities operations decreased $52.1 million, or 65.9%, to $27.0 million from the nine months ended September 30, 2008 to the nine month period ended September 30, 2009. Interest expense from clearing operations decreased approximately $33.5 million, or 75.0%, to $11.2 million due to a 118 basis point or 77.6% decrease in our average daily interest rate to .34%, offset by an increase in our average daily balances of our short-term obligations of $466.1 million, or 11.9%, to $4.4 billion. Interest from our stock conduit loans decreased $18.6 million, or 54.1% to $15.8 million due to a $1.0 billion, or 61.3% decrease in our average daily balances to $655.1 million, offset by a 50 basis point increase, or 18.5% in our average daily interest rate to 3.21%.

 

Interest, net decreased from $61.6 million for the nine months ended September 30, 2008 to $51.0 million for the nine months ended September 30, 2009. This decrease was due to a higher ratio of customer interest paying balances to interest earning balances combined with significantly lower conduit balances, offset slightly by a higher interest rate spread of 4 basis points on customer balances and 34 basis points on conduit balances.

 

Employee compensation and benefits

 

Total employee costs decreased $1.2 million, or 1.4%, to $85.3 million from the nine months ended September 30, 2008 to the nine months ended September 30, 2009, primarily due to lower incentive-based compensation expense, offset by $.8 million of severance costs in the first quarter. Employee count remained fairly constant, increasing 1.3% to 1,020 as of September 30, 2009.

 

Floor brokerage, exchange and clearance fees

 

Floor brokerage, exchange and clearance fees increased $3.7 million, or 17.4% to $24.7 million for the nine months ended September 30, 2009 from the nine months ended September 30, 2008, primarily due to industry rebates received in the prior year period that were not received in the current period due to changes in the timing in which rebates are received. These expenses also reflected increased fees due to higher options volumes, offset in part by lower equity and futures volumes.

 

Communication and data processing

 

Total expenses for our communication and data processing requirements increased $4.8 million, or 16.6%, to $33.9 million from the nine months ended September 30, 2008 to the nine months ended September 30, 2009. This increase reflects costs associated with additional data processing capacity resulting from a move to SunGard’s latest generation system consisting of equipment dedicated to our U.S. clearing business.

 

Occupancy and equipment

 

Total expenses for occupancy and equipment decreased $.1 million, or .4%, to $22.0 million from the nine months ended September 30, 2008 to the nine months ended September 30, 2009. This decrease is primarily due to costs associated with our occupancy leases.

 

Other expenses

 

Other expenses decreased $3.3 million, or 11.7%, to $24.5 million from the nine months ended September 30, 2008 to the nine months ended September 30, 2009. The decrease relates to a $2.4 million litigation reserve recorded in the quarter ended September 30, 2008 and lower travel expenses, offset in part by increases in legal and consulting fees.

Interest expense on long-term debt

 

Interest expense on long-term debt increased from $3.0 million for the nine months ended September 30, 2008 to $6.0 million for the nine months ended September 30, 2009 as a result of additional interest expense of approximately $2.5 million associated with our senior convertible notes issued on June 3, 2009 and higher interest expense on our revolving credit facility due to higher interest rates.

 

Provision for income taxes

 

Income tax expense, based on an effective income tax rate of approximately 38.4%, was $7.3 million for the nine months ended September 30, 2009 as compared to an effective tax rate of 37.9% and income tax expense of $13.1 million for the nine months ended September 30, 2008. This decrease is primarily attributed to decreased operating profit in the current period offset by a higher effective tax rate. The higher effective rate is primarily attributable to permanent differences encompassing a higher percentage of pretax income in the current period as compared to the prior period due to lower pretax earnings.

 

Net income

 

As a result of the foregoing, net income decreased to $11.7 million for the nine months ended September 30, 2009 from $21.5 million for the nine months ended September 30, 2008.

 

Liquidity and capital resources

 

Operating Liquidity — Our clearing broker-dealer subsidiaries typically finance their operating liquidity needs through secured bank lines of credit and through secured borrowings from stock lending counterparties in the securities business, which we refer to as “stock loans.” Most of our borrowings are driven by the activities of our clients or correspondents, primarily the purchase of securities on margin by those parties. As of September 30, 2009, we had seven uncommitted lines of credit with seven financial institutions for the purpose of facilitating our clearing business as well as the activities of our customers and correspondents. Five of these lines of credit permitted us to borrow up to an aggregate of approximately $308.5 million while two lines had no stated limit. As of September 30, 2009, we had approximately $363.4 million in short-term bank loans outstanding, which left approximately $154.8 million available under our lines of credit with stated limitations.

 

As noted above, our businesses that are clearing brokers also have the ability to borrow through stock loan arrangements. There are no specific limitations on our borrowing capacities pursuant to our stock loan arrangements. Borrowings under these arrangements bear interest at variable rates, are secured primarily by our firm inventory or customers’ margin account securities, and are repayable on demand. At September 30, 2009, we had approximately $234.4 million in borrowings under stock loan arrangements.

 

As a result of our customers’ and correspondents’ aforementioned activities, our operating cash flows may vary from year to year.

 

Capital Resources — PWI provides capital to all of our subsidiaries. PWI has the ability to obtain capital through equipment leases and through a $100.0 million line of credit under a secured credit facility. Equipment purchased under capital leases is typically secured by the equipment itself. As of September 30, 2009, the Company had $70.0 million outstanding on this line of credit that expires in April 2010. On June 3, 2009, the Company issued $60 million aggregate principal amount of 8.00% Senior Convertible Notes due 2014. The net proceeds from the sale of the convertible notes were approximately $56.2 after initial purchaser discounts and other expenses.

 

As a holding company, we access the earnings of our operating subsidiaries through the receipt of dividends from these subsidiaries. Some of our subsidiaries are subject to the requirements of securities regulators in their respective countries relating to liquidity and capital standards, which may serve to limit funds available for the payment of dividends to the holding company.

 

Our principal U.S. broker-dealer subsidiary, PFSI, is subject to the SEC Uniform Net Capital Rule (“Rule 15c3-1”), which requires the maintenance of a minimum net capital. PFSI elected to use the alternative method, permitted by Rule 15c3-1, which requires PFSI to maintain minimum net capital, as defined, equal to the

greater of $250,000 or 2% of aggregate debit balances, as defined in the SEC’s Reserve Requirement Rule (“Rule 15c3-3”). At September 30, 2009, PFSI had net capital of $97.0 million, which was $74.4 million in excess of its required net capital of $22.6 million.

 

Our Penson GHCO, PFSL, PFSC and Penson Australia subsidiaries are also subject to minimum financial and capital requirements. These requirements are not material either individually or collectively to the unaudited interim condensed consolidated financial statements as of September 30, 2009. All subsidiaries were in compliance with their minimum financial and capital requirements as of September 30, 2009.

 

Contractual obligations and commitments

 

We have contractual obligations to make future payments under long-term debt and long-term non-cancelable lease agreements and have contingent commitments under a variety of commercial arrangements. See Note 12 to our unaudited interim condensed consolidated financial statements for further information regarding our commitments and contingencies.

 

Off-balance sheet arrangements