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Table of Contents

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

 

(Mark One)

 

 

 

 

 

þ

 

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

 

 

 

For the quarterly period ended March 31, 2010

OR

 

o

 

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

 

 

 

For the transition period from          to

 

Commission File Number: 001-33138

 

KBW, INC.

(Exact name of registrant as specified in its charter)

 

Delaware

 (State or Other Jurisdiction of Incorporation or Organization)

 

13-4055775

 (I.R.S. Employer Identification No.)

 

787 Seventh Avenue, New York, New York 10019

 (Address of principal executive offices)

Registrant’s telephone number: (212) 887-7777

 

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 definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer    þ     Accelerated filer     o     Non-accelerated filer     o     Smaller reporting company     o

(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

 

The number of shares of the Registrant’s common stock, par value $0.01 per share, outstanding as April 30, 2010 was 35,471,666, which number includes 4,037,079 shares representing unvested restricted stock awards and excludes 1,046,448 shares underlying vested restricted stock units.

 



Table of Contents

 

TABLE OF CONTENTS

 

 

Page

 

Number

 

 

AVAILABLE INFORMATION

1

 

 

PART I–FINANCIAL INFORMATION

2

 

 

Item 1. Financial Statements

2

 

 

Consolidated Statements of Financial Condition–March 31, 2010 (Unaudited) and December 31, 2009

2

 

 

Consolidated Statements of Operations–Three Months ended March 31, 2010 and 2009 (Unaudited)

3

 

 

Consolidated Statement of Changes in Stockholders' Equity–Three Months ended March 31, 2010 (Unaudited)

4

 

 

Consolidated Statements of Cash Flows–Three Months ended March 31, 2010 and 2009 (Unaudited)

5

 

 

Notes to Consolidated Financial Statements

6

 

 

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

21

 

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

32

 

 

Item 4. Controls and Procedures

33

 

 

PART II–OTHER INFORMATION

34

 

 

Item 1. Legal Proceedings

34

 

 

Item 1A. Risk Factors

35

 

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

35

 

 

Item 3. Defaults Upon Senior Securities

35

 

 

Item 4. Other Information

35

 

 

Item 5. Exhibits

35

 

 

SIGNATURES

36

 

 

EXHIBIT INDEX

37

 

 

EX-31.1: CERTIFICATION

 

 

 

EX-31.2: CERTIFICATION

 

 

 

EX-32.1: CERTIFICATION

 

 

 

EX-32.2: CERTIFICATION

 

 



Table of Contents

 

AVAILABLE INFORMATION

 

KBW, Inc. is required to file current, annual and quarterly reports, proxy statements and other information required by the Securities Exchange Act of 1934, as amended (the “Exchange Act”), with the Securities and Exchange Commission (the “SEC”). You may read and copy any document we file with the SEC at the SEC’s Public Reference Room located at 100 F Street, N.E., Washington, DC 20549. Information on the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. In addition, the SEC maintains an internet website at http://www.sec.gov, from which interested persons can electronically access our SEC filings.

 

We will make available free of charge through our website http://www.kbw.com, our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, proxy statements, Forms 3, 4 and 5 filed by or on behalf of directors, executive officers and certain large stockholders, and any amendments to those documents filed or furnished pursuant to the Exchange Act. These filings will become available as soon as reasonably practicable after such material is electronically filed with or furnished to the SEC.

 

We also make available, on the Investor Relations page of our website, our (i) Corporate Governance Guidelines, (ii) Code of Business Conduct and Ethics, (iii) Supplement to Code of Business Conduct and Ethics for CEO and Senior Financial Officers, and (iv) charters of each of the Audit, Compensation, and Corporate Governance and Nominations Committees of our Board of Directors. You will need to have Adobe Acrobat Reader software installed on your computer to view these documents, which are in the PDF format. These documents are also available in print free of charge to any person who requests them by writing or telephoning: KBW, Inc., Office of the Corporate Secretary, 787 Seventh Avenue, New York, New York, 10019, U.S.A., telephone number (212) 887-7777. These documents, as well as the information on our website, are not a part of this report.

 

1



Table of Contents

 

PART I-FINANCIAL INFORMATION

 

Item 1.    Financial Statements.

 

KBW, INC. AND SUBSIDIARIES

Consolidated Statements of Financial Condition

(Dollars in thousands)

 

 

 

March 31,

 

 

 

 

2010

 

December 31,

 

 

(unaudited)

 

2009

ASSETS

 

 

 

 

 

 

Cash and cash equivalents

$

 

177,220

 

$

 

203,180

 

Financial instruments owned, at fair value:

 

 

 

 

 

 

Equities

 

81,812

 

 

56,720

 

Corporate and other debt

 

73,911

 

 

75,754

 

Mortgage-backed securities

 

33,656

 

 

-    

 

Other investments

 

45,092

 

 

41,917

 

 

 

234,471

 

 

174,391

 

Receivables from clearing brokers

 

82,803

 

 

161,811

 

Accounts receivable

 

39,659

 

 

28,703

 

Income taxes receivable

 

831

 

 

1,129

 

Furniture, equipment and leasehold improvements, at cost, less accumulated depreciation and amortization of $26,835 in 2010 and $25,636 in 2009

 

18,636

 

 

18,800

 

Other assets

 

43,143

 

 

43,354

 

Total assets

$

 

596,763

 

$

 

631,368

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

 

Liabilities:

 

 

 

 

 

 

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

 

 

 

 

 

 

Equities

$

 

49,509

 

$

 

31,288

 

Corporate debt

 

2,408

 

 

4,723

 

U.S. Government and agency securities

 

4,302

 

 

962

 

 

 

56,219

 

 

36,973

 

Accounts payable, accrued expenses, and other liabilities

 

63,056

 

 

134,658

 

Income taxes payable

 

14,144

 

 

10,668

 

Total liabilities

 

133,419

 

 

182,299

 

 

 

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

 

Preferred stock

 

-    

 

 

-    

 

Common stock

 

314

 

 

307

 

Paid-in capital

 

165,542

 

 

161,168

 

Retained earnings

 

310,247

 

 

298,626

 

Notes receivable from stockholders

 

(120

)

 

(609

)

Accumulated other comprehensive loss

 

(12,639

)

 

(10,423

)

Total stockholders’ equity

 

463,344

 

 

449,069

 

Total liabilities and stockholders’ equity

$

 

596,763

 

$

 

631,368

 

 

See accompanying notes to consolidated financial statements.

 

2



Table of Contents

 

KBW INC. AND SUBSIDIARIES

Consolidated Statements of Operations

(unaudited)

(Dollars in thousands, except per share information)

 

 

 

Three Months Ended

 

 

March 31,

 

 

2010

 

2009

Revenues:

 

 

 

 

 

 

Investment banking

$

 

69,962

 

$

 

26,860

 

Commissions

 

35,404

 

 

36,019

 

Principal transactions, net

 

19,047

 

 

4,116

 

Interest and dividend income

 

2,884

 

 

1,738

 

Investment advisory fees

 

294

 

 

313

 

Other

 

5,719

 

 

3,230

 

Total revenues

 

133,310

 

 

72,276

 

Expenses:

 

 

 

 

 

 

Compensation and benefits

 

81,878

 

 

45,667

 

Occupancy and equipment

 

5,612

 

 

5,159

 

Communications and data processing

 

7,656

 

 

6,660

 

Brokerage and clearance

 

5,086

 

 

3,882

 

Business development

 

3,460

 

 

3,032

 

Interest

 

258

 

 

169

 

Other

 

9,050

 

 

5,777

 

Total expenses

 

113,000

 

 

70,346

 

Income before income taxes

 

20,310

 

 

1,930

 

Income tax expense

 

8,689

 

 

1,200

 

Net income

$

 

11,621

 

$

 

730

 

 

 

 

 

 

 

 

Earnings per common share:

 

 

 

 

 

 

Basic

$

 

0.32

 

$

 

0.02

 

Diluted

$

 

0.32

 

$

 

0.02

 

 

 

 

 

 

 

 

Weighted average number of common shares outstanding:

 

 

 

 

 

 

Basic

 

32,240,838

 

 

31,354,507

 

Diluted

 

32,240,838

 

 

31,354,507

 

 

See accompanying notes to consolidated financial statements.

 

3



Table of Contents

 

KBW, INC. AND SUBSIDIARIES

Consolidated Statement of Changes in Stockholders’ Equity and Comprehensive Income

(unaudited)

(Dollars in thousands, except per share information)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Notes

 

Accumulated

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Receivable

 

Other

 

Total

 

 

Preferred

 

Common

 

Paid-in

 

Retained

 

from

 

Comprehensive

 

Stockholders’

 

 

Stock

 

Stock

 

Capital

 

Earnings

 

Stockholders

 

Loss

 

Equity

Balance at December 31, 2009

$

-

$

307

$

161,168

 

$

298,626

$

(609

)

$

(10,423

)

$

449,069

 

Net income

 

-

 

-    

 

-       

 

 

11,621

 

-       

 

-       

 

11,621

 

Other comprehensive loss, currency translation adjustment

 

-

 

-    

 

-       

 

 

-       

 

-       

 

(2,216

)

(2,216

)

Total comprehensive income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

9,405

 

Amortization of stock-based compensation

 

-

 

-    

 

14,294

 

 

-       

 

-       

 

-       

 

14,294

 

Cancellation of 433,879 shares of restricted stock in satisfaction of withholding tax requirements

 

-

 

(4

)

(11,580

)

 

-       

 

-       

 

-       

 

(11,584

)

Issuance of 1,114,502 shares of common stock

 

-

 

11

 

25,856

 

 

-       

 

-       

 

-       

 

25,867

 

Stock-based awards vested

 

-

 

-    

 

(25,808

)

 

-       

 

-       

 

-       

 

(25,808

)

Tax benefit related to stock-based awards

 

-

 

-    

 

1,612

 

 

-       

 

-       

 

-       

 

1,612

 

Repayment of notes receivable from stockholders

 

-

 

-    

 

 

-       

 

 

-       

 

 

489

 

 

-       

 

 

489

 

Balance at March 31, 2010

$

-

$

314

 

$

165,542

 

$

310,247

 

$

(120

)

$

(12,639

)

$

463,344

 

 

Description of preferred stock and details:

 

 

 

 

 

Number of Shares

 

 

 

Par Value

 

Authorized

 

Issued

 

Outstanding

 

 

 

 

 

 

 

 

 

 

 

March 31, 2010

 

$    0.01

 

10,000,000

 

-

 

-

 

December 31, 2009

 

$    0.01

 

10,000,000

 

-

 

-

 

 

Description of common stock and details:

 

 

 

 

 

Number of Shares

 

 

 

Par Value

 

Authorized

 

Issued(*)

 

Outstanding(*)

 

 

 

 

 

 

 

 

 

 

 

March 31, 2010

 

$    0.01

 

140,000,000

 

31,430,320

 

31,430,320

 

December 31, 2009

 

$    0.01

 

140,000,000

 

30,749,697

 

30,749,697

 

 

(*)These share amounts exclude legally vested restricted stock units.

 

See accompanying notes to consolidated financial statements.

 

4



Table of Contents

 

KBW, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

(unaudited)

(Dollars in thousands)

 

 

 

Three Months Ended March 31,

 

 

2010

 

2009

 

 

 

 

 

 

 

Cash flows from operating activities:

 

 

 

 

 

 

Net income

$

 

11,621

 

$

 

730

 

Adjustments to reconcile net income to net cash used in operating activities:

 

 

 

 

 

 

Amortization of stock-based compensation

 

14,294

 

 

12,025

 

Depreciation and amortization

 

1,269

 

 

1,192

 

Deferred income tax expense

 

3,064

 

 

393

 

 

 

 

 

 

 

 

(Increase) decrease in operating assets:

 

 

 

 

 

 

Financial instruments owned, at fair value

 

(60,700

)

 

11,440

 

Securities purchased under resale agreements

 

-    

 

 

(8,058

)

Receivables from clearing brokers

 

78,641

 

 

4,314

 

Accounts receivable

 

(11,066

)

 

(200

)

Income taxes receivable

 

252

 

 

2,216

 

Other assets

 

(2,985

)

 

(1,309

)

Increase (decrease) in operating liabilities:

 

 

 

 

 

 

Financial instruments sold, not yet purchased, at fair value

 

19,396

 

 

18,231

 

Securities sold under repurchase agreements

 

-    

 

 

8,613

 

Accounts payable, accrued expenses and other liabilities

 

(71,160

)

 

(92,354

)

Income taxes payable

 

3,477

 

 

149

 

Net cash used in operating activities

 

(13,897

)

 

(42,618

)

Cash flows from investing activities:

 

 

 

 

 

 

Purchase of furniture, equipment and leasehold improvements

 

(1,115

)

 

(1,016

)

Net cash used in investing activities

 

(1,115

)

 

(1,016

)

Cash flows from financing activities:

 

 

 

 

 

 

Issuance of shares of common stock

 

59

 

 

53

 

Cancellation of restricted stock in satisfaction of withholding tax requirements

 

(11,584

)

 

(4,463

)

Excess (shortfall) net tax benefit related to stock-based awards

 

1,612

 

 

(1,334

)

Repayment of notes receivable from stockholders

 

489

 

 

1,516

 

Net cash used in financing activities

 

(9,424

)

 

(4,228

)

Currency adjustment:

 

 

 

 

 

 

Effect of exchange rate changes on cash

 

(1,524

)

 

(994

)

Net decrease in cash and cash equivalents

 

(25,960

)

 

(48,856

)

Cash and cash equivalents at the beginning of the period

 

203,180

 

 

194,981

 

Cash and cash equivalents at the end of the period

$

 

177,220

 

$

 

146,125

 

 

 

 

 

 

 

 

Supplemental disclosures of cash flow information:

 

 

 

 

 

 

Cash paid during the period for:

 

 

 

 

 

 

Income taxes

$

 

906

 

$

 

103

 

Interest

$

 

224

 

$

 

260

 

 

See accompanying notes to consolidated financial statements.

 

5



Table of Contents

 

KBW, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(unaudited)

(Dollars in thousands, except per share information)

 

(1)              Organization and Basis of Presentation

 

The consolidated financial statements include the accounts of KBW, Inc., and its wholly owned subsidiaries (the “Company”), Keefe, Bruyette & Woods, Inc. (“Keefe”), Keefe, Bruyette & Woods Limited (“KBWL”), Keefe, Bruyette & Woods Asia Limited (“KBWAL”), KBW Asset Management, Inc. and KBW Ventures, Inc. Keefe is a regulatory member of the Financial Industry Regulatory Authority (“FINRA”) and is principally a broker-dealer in securities and a market-maker in certain financial services stocks and bonds in the United States. KBWL is authorized and regulated by the U.K. Financial Services Authority (“FSA”) and a member of the London Stock Exchange, Euronext, SWX Europe and Deutsche Boerse.  KBWAL is a securities firm licensed and regulated by the Securities and Futures Commission in Hong Kong.   Keefe’s, KBWL’s and KBWAL’s customers are predominantly institutional investors including other brokers and dealers, commercial banks, asset managers and other financial institutions. Keefe has a clearing arrangement with Pershing LLC on a fully disclosed basis. KBWL has a clearing arrangement with Pershing Securities Limited on a fully disclosed basis and is responsible for clearance and settlement for both KWBL and KBWAL.

 

These consolidated financial statements and these notes are unaudited and exclude some of the disclosures required in annual financial statements. These consolidated financial statements should be read in conjunction with the Company’s consolidated financial statements and notes thereto for the year ended December 31, 2009 included in its Annual Report on Form 10-K filed with the SEC. These consolidated financial statements reflect all adjustments (consisting of normal recurring adjustments) that are, in the opinion of management, necessary for the fair statement of the results for the interim periods. The results of operations for interim periods are not necessarily indicative of results for the entire year.

 

(2)              Summary of Significant Accounting Policies

 

(a)               Financial Accounting Standards Board (“FASB”) Accounting Standards Codification

 

In September 2009, the Company adopted FASB Statement of Financial Accounting Standards (“SFAS”) No. 168, The “FASB Accounting Standards Codification™” and the Hierarchy of Generally Accepted Accounting Principles (FASB Accounting Standards Codification 105)SFAS 168 establishes the FASB Accounting Standards Codification™ (“Codification” or “ASC”) as the single source of authoritative U.S. generally accepted accounting principles (“GAAP”) recognized by the FASB to be applied by nongovernmental entities.  Rules and interpretive releases of the SEC under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants.  The Codification supersedes all existing non-SEC accounting and reporting standards.  All other nongrandfathered, non-SEC accounting literature not included in the Codification is nonauthoritative.

 

Following the Codification, the Board 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, which will serve to update the Codification, provide background information about the guidance and provide the basis for conclusions on the changes to the Codification.

 

Reference to GAAP requirements, where provided in these financial statements are to the ASC.

 

(b)               Principles of Consolidation

 

The consolidated financial statements have been prepared in accordance with GAAP and include the accounts of the Company and its consolidated subsidiaries. All intercompany transactions and balances have been eliminated.

 

The Company consolidates entities for which it has a controlling financial interest as defined in ASC 810, Consolidation.  The usual condition for a controlling financial interest is ownership of a majority voting interest.  As a result, the Company generally consolidates entities when they have ownership, directly or indirectly, of over 50 percent of the outstanding voting shares of another entity.  Since a controlling financial interest may be achieved through arrangements that do not involve voting interest, the Company also evaluates entities for consolidation under the “variable interest model” in accordance with ASC 810.  The Company consolidates variable interest entities when its interests in the entity are expected to absorb a majority the entity’s expected losses, or expected residual returns, or both.  The Company had no variable interest entities that required consolidation at March 31, 2010.

 

In addition, the Company evaluates its investments in limited partnerships under ASC 810.  Under ASC 810, the general partners in limited partnerships are presumed to have control unless the limited partners have either a substantial ability to dissolve the

 

6



Table of Contents

 

KBW, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)

(unaudited)

(Dollars in thousands, except per share information)

 

limited partnership or otherwise can remove the general partner without cause or have substantial participating rights. There were no limited partnership interests that required consolidation at March 31, 2010.

 

(c)                Use of Estimates

 

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the Company’s financial statements and these footnotes including securities valuations, compensation accruals and other matters. Management believes that the estimates used in preparing the Company’s consolidated financial statements are reasonable. Actual results may differ from these estimates.

 

(d)               Cash and Cash Equivalents

 

Cash equivalents include investments with an original maturity of three months or less. Due to the short-term nature of these instruments, carrying value approximates their fair value.

 

(e)                Fair Value of Financial Instruments

 

The Company accounts for financial instruments that are being measured and reported on a fair value basis in accordance with ASC 820, Fair Value Measurements and Disclosures.  ASC 820 defines fair value, establishes a framework for measuring fair value and requires enhanced disclosures about fair value measurements.  ASC 820 defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an ordinary transaction between current market participants at the measurement date”.

 

Fair value is generally based on quoted market prices. If quoted market prices are not available, fair value is determined based on other relevant factors, including dealer price quotations, price activity for equivalent instruments and valuation pricing methods. Among the factors considered by the Company in determining the fair value of financial instruments for which there are no current quoted market prices are credit spreads, the terms and liquidity of the instrument, the financial condition, operating results and credit ratings of the issuer or underlying company, the quoted market price of publicly traded securities with similar duration and yield, assessing the underlying investments, market-based information, such as comparable company transactions, performance multiples and changes in market outlook as well as other measurements.  Financial instruments owned and financial instruments sold, not yet purchased are stated at fair value, with related changes in unrealized appreciation or depreciation reflected in principal transactions, net in the accompanying consolidated statements of operations. Financial assets and financial liabilities carried at contract amounts may include receivables from clearing brokers, securities purchased under resale agreements, short-term borrowings and securities sold under repurchase agreements. See Note 3 of the Notes to Consolidated Financial Statements for additional discussion of ASC 820.

 

ASC 825, Financial Instruments, provides entities the option to measure certain financial assets and financial liabilities at fair value with changes in fair value recognized in earnings each period.  ASC 825 permits the fair value option election, on an instrument-by-instrument basis, either at initial recognition of an asset or liability or upon an event that gives rise to a new basis of accounting for that instrument.  Such election must be applied to the entire instrument and not only a portion of the instrument.  The Company applied the fair value option for certain eligible instruments, including all private equity securities and limited partnership interests, as these financial instruments had been accounted for at fair value by the Company prior to the fair value option election in accordance with the ASC 940, Financial Services — Broker and Dealers. Generally, the fair values of these financial instruments have been determined based on company performance and, in those instances where market values are readily ascertainable, by reference to recent significant events occurring in the marketplace or quoted market prices. During the fourth quarter of 2009, the Company elected to adopt the measurement amendments included in Accounting Standards Update (“ASU”) No. 2009-12, Investments in Certain Entities That Calculate Net Asset Value per Share (or Its Equivalent) (ASC 820).  ASU No. 2009-12 permits, as a practical expedient, the use of the net asset value per share, or its equivalent, of an entity to estimate its fair value. The Company’s partnership interests are recorded at fair value, determined by using net asset values or capital statements provided by the general partner, updated for capital contributions and distributions and changes in market conditions up to the reporting date.

 

(f)                  Securities Purchased Under Resale Agreements and Securities Sold Under Repurchase Agreements

 

Securities purchased under resale agreements and securities sold under repurchase agreements are accounted for as collateralized financing transactions. The assets and liabilities that result from these agreements are recorded in the consolidated

 

7



Table of Contents

 

KBW, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)

(unaudited)

(Dollars in thousands, except per share information)

 

statements of financial condition at the amounts at which the securities were sold or purchased (contract value), respectively. It is the policy of the Company to obtain possession of collateral or deliver collateral, as the case may be, with a market value equal to or in excess of the principal amount of the transactions.  Collateral is valued daily, and the Company may require counterparties to deposit additional collateral or return collateral pledged when appropriate. Interest on securities purchased under resale agreements and securities sold under repurchase agreements is recognized in interest and dividend income and interest expense, respectively, in the consolidated statements of operations over the life of the transaction.

 

There were no resale or repurchase agreements outstanding as of March 31, 2010.

 

(g)               Receivables From Clearing Brokers

 

Receivables from clearing brokers include proceeds from securities sold, including financial instruments sold not yet purchased, commissions related to securities transactions, margin loans and related interest and deposits with clearing brokers. Proceeds related to financial instruments sold, not yet purchased may be restricted until the securities are purchased.  Balances are provided net when the right of set-off exists.

 

(h)               Furniture, Equipment and Leasehold Improvements

 

Furniture and equipment are carried at cost and depreciated on a straight-line basis using estimated useful lives of the related assets, generally two to five years. Leasehold improvements are amortized on a straight-line basis over the lesser of the economic useful life of the improvement or the term of the respective leases.

 

(i)                  Revenue Recognition

 

Investment Banking

 

The Company earns fees for providing strategic advisory services in mergers and acquisitions (“M&A”) and other transactions which are predominantly composed of fees based on a successful completion of a transaction, and from capital markets, which is comprised of underwriting securities’ offerings and arranging private placements, including securitized debt offerings.

 

Strategic advisory revenues are recorded when earned, the fees are determinable and collection is reasonably assured. Non-refundable upfront fees are generally deferred and recognized as revenue ratably over the expected period in which the related services are rendered.  Upon successful completion of a transaction or termination of an engagement, the recognition of revenue would be accelerated.

 

Capital markets revenue consists of:

 

·      Underwriting revenues, which are recognized on trade date, net of related syndicate expenses, at the time the underwriting is completed. In syndicated underwritten transactions, management estimates the Company’s share of transaction-related expenses incurred by the syndicate, and the Company recognizes revenue net of such expense. On final settlement, the Company adjusts these amounts to reflect the actual transaction-related expenses and resulting underwriting fee.

 

·      Private placement revenues, which are recorded when the services related to the underlying transaction are completed under the terms of the engagement.  This is generally the closing date of the transaction.

 

Since the Company’s investment banking revenues are generally recognized at the time of completion of each transaction or when the services are performed, these revenues typically vary between periods and may be considerably affected by the timing of the closing of significant transactions.

 

8



Table of Contents

 

KBW, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)

(unaudited)

(Dollars in thousands, except per share information)

 

Commissions

 

The Company’s sales and trading business generates revenue from equity securities’ trading commissions paid by institutional investor customers.  Commissions are recognized on a trade date basis.

 

Principal transactions

 

Financial instruments owned, at fair value and financial instruments sold, not yet purchased, at fair value are recorded on a trade-date basis with realized and unrealized gains and losses reflected in principal transactions, net in the consolidated statements of operations.

 

Interest and dividend income

 

The Company recognizes contractual interest on financial instruments owned at fair value on an accrual basis as a component of interest and dividend income.  Dividend income is recognized on the ex-dividend date.

 

Investment advisory fees

 

The Company recognizes management fees from managed funds over the period that the related service is provided based upon a percentage of account balances, capital invested, capital commitments or some combination thereof.  The Company also may be entitled to receive incentive fees based on a percentage of a fund’s return or when the return on assets under management exceeds certain performance targets. Some incentive fees are based on investment performance over a 12-month period and are subject to adjustment prior to the end of the measurement period. Accordingly, these incentive fees are recognized in the consolidated statements of operations when the measurement period ends.

 

(j)      Stock-Based Compensation

 

Stock-based compensation is measured at fair value on the date of grant and amortized to compensation expense over the requisite service period, net of estimated forfeitures. Stock-based awards that do not require future service (i.e., vested awards and awards granted to retirement eligible employees) are expensed immediately on the date of grant.  Withholding tax obligations may be satisfied by the repurchase of shares by the Company.  Such shares are cancelled upon repurchase.

 

(k)               Income Taxes

 

Deferred tax assets and liabilities are recognized for the future tax effect of differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.  Deferred tax assets and liabilities are measured using enacted tax rates.  The effect on deferred tax assets and liabilities of a change in tax rates is recognized in earnings in the period that includes the enactment date.  In the event it is more likely than not that a deferred tax asset will not be realized, a valuation allowance is recorded.

 

The Company applies ASC 740, Income Taxes, which prescribes a single, comprehensive model for how a company should recognize, measure, present and disclose in its financial statements uncertain tax positions that the company has taken or expects to take on its tax returns.  Income tax expense is based on pre-tax accounting income, including adjustments made for the recognition or derecognition related to uncertain tax positions.

 

(l)                  Earnings Per Common Share (“EPS”)

 

Basic EPS is computed by dividing net income applicable to common shareholders, which represents net income reduced by the allocation of earnings to participating securities, by the weighted average number of common shares.  Losses are not allocated to participating securities.  The weighted average number of common shares outstanding include restricted stock units for which no future service is required as a condition to the delivery of the underlying common stock.  Diluted EPS includes the determinants of basic EPS and, in addition, give effect to potentially dilutive common shares related to Company stock compensation plans.

 

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Table of Contents

 

KBW, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)

(unaudited)

(Dollars in thousands, except per share information)

 

ASC 260, Earnings Per Share, addresses whether instruments granted in share-based payment transactions are participating securities prior to vesting and therefore need to be included in the earnings allocation in calculating EPS under the two-class method. Accordingly, the Company treats unvested share-based payment awards that have non-forfeitable rights to dividend or dividend equivalents as a separate class of securities in calculating EPS.

 

(m)            Foreign Currency Translation

 

The Company translates the statements of financial condition of the Company’s foreign subsidiaries at the exchange rates in effect as of the end of each reporting period.  The consolidated statements of operations are translated at the average rates of exchange during the period. The resulting translation adjustments of the Company’s foreign subsidiaries are recorded directly to accumulated other comprehensive income (loss) in the consolidated statements of changes in stockholders’ equity.

 

(3)         Financial Instruments

 

The Company accounts for financial instruments that are being measured and reported on a fair value basis in accordance with ASC 820.  This includes those items currently reported in financial instruments owned, at fair value and financial instruments sold, not yet purchased, at fair value on the consolidated statements of financial condition.

 

As defined in ASC 820, fair value is 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 methods, primarily market and income approaches. Based on these approaches, the Company utilizes assumptions that market participants would use in pricing the asset or liability, including assumptions about risk and/or the risks inherent in the inputs to the valuation technique. These inputs can be readily observable, market corroborated, or generally unobservable firm inputs. The Company utilizes valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs. Based on the observability of the inputs used in the valuation techniques, the Company is required to provide the information set forth below according to the fair value hierarchy. The fair value hierarchy ranks the quality and reliability of the information used to determine fair values.   Financial instrument assets and liabilities carried at fair value have been classified and disclosed in one of the following three categories:

 

Level  1

 

Quoted market prices in active markets for identical assets or liabilities.

Level  2

 

Observable market based inputs or unobservable inputs that are corroborated by market data.

Level  3

 

Unobservable inputs that are not corroborated by market data.

 

Level 1 primarily consists of listed financial instruments whose value is based on quoted market prices, such as listed equities, options, warrants, and convertible preferred stock.  This category also may include U.S. Government and agency securities for which the Company typically receives independent external valuation information.  There were no transfers in or out of Level 1 during the three months ended March 31, 2010.

 

Level 2 includes those financial instruments that are valued using multiple valuation techniques, primarily the market approach.   The valuation methodologies utilized are calibrated to observable market inputs.  The Company considers recently executed transactions, market price quotations and various assumptions, including credit spreads, the terms and liquidity of the instrument, the financial condition, operating results and credit ratings of the issuer or underlying company, the quoted market price of publicly traded securities with similar duration and yield, time value, yield curve, as well as other measurements. In order to be classified as Level 2, substantially all of these assumptions would need to be observable in the marketplace or can be derived from observable data or supported by observable levels at which transactions are executed in the marketplace. Financial instruments in this category include certain corporate debt, collateralized debt obligations (“CDOs”) primarily collateralized by banking and insurance company trust preferred and capital securities, certain preferred stock, convertible debt and residential mortgage-backed securities.  There were no transfers in or out of Level 2 during the three months ended March 31, 2010.

 

Fair value of corporate debt, preferred stock, convertible debt and residential mortgage-backed securities classified as Level 2 was determined by using quoted market prices, broker or dealer quotes, or alternate pricing sources with reasonable levels of price transparency.  Fair value of CDOs primarily collateralized by banking and insurance company trust preferred and capital securities was determined primarily by considering recently executed transactions of similar securities and certain assumptions, including the

 

10



Table of Contents

 

KBW, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)

(unaudited)

(Dollars in thousands, except per share information)

 

financial condition, operating results and credit ratings of the issuer or underlying companies.

 

Level 3 is comprised of financial instruments whose fair value is estimated based on multiple valuation techniques, primarily market and income approaches. The valuation methodologies utilized may include significant inputs that are unobservable from objective sources. The Company considers various market inputs and assumptions, such as recently executed transactions, market price quotations, discount margins, market spreads applied, the terms and liquidity of the instrument, the financial condition, operating results and credit ratings of the issuer or underlying company, the quoted market price of publicly traded securities with similar duration and yield, time value, yield curve, default rates, as well as other measurements.  Included in this category are certain corporate and other debt, including banking and insurance company trust preferred, private equity securities and other investments including limited and general partnership interests.

 

Fair value of banking and insurance company trust preferred and capital securities classified as Level 3 was determined by primarily utilizing a market spread method for each of the individual trust preferred and capital securities utilizing credit spreads for secondary market trades for trust preferred and capital securities for issues which were substantially similar to such positions based on certain assumptions. The key market inputs in this method are the discount margins, market spreads applied, the yield expectations for similar instruments and the financial condition, operating results and credit ratings of the issuer or underlying company.

 

Fair value of private equity securities classified as Level 3 was determined by assessing market-based information, such as performance multiples, comparable company transactions and changes in market outlook. Fair value of limited and general partnership interests classified as Level 3 was determined by using net asset values or capital statements provided by the general partner, updated for capital contributions and distributions and changes in market conditions up to the reporting date.  Private equity securities and limited and general partnership interests generally trade infrequently.

 

The following table provides information related to financial instruments where a practical expedient was used as the basis to measure the fair value of certain entities that calculate a net asset value per share (or equivalent) as of March 31, 2010:

 

Type of Investment

 

Fair Value

 

Unfunded
Commitments

 

Redemption Frequency

 

Redemption Notice Period

 

Long/short hedge funds (a)

$

12,948

 

$

 

 

Monthly

 

30 Days

 

Public/private equity funds (b)

 

32,144

 

 

21,307

 

 

n/a

 

n/a

 

 

$

45,092

 

$

21,307

 

 

 

 

 

 

 

(a)          This category includes investments in hedge funds that invest primarily in domestic long/short positions in equity securities and various derivatives, including options on securities and stock index options with respect to companies in the financial services sector. Management of these funds also has the ability to invest in foreign equities and fixed income securities. The fair values of investments in this category have been estimated using the net asset value per share, or equivalent, of the investments.  Investments in this category can be redeemed monthly; however, the general partner may impose a “gate” for any withdrawal over 20% of the total fund net asset value.

 

(b)         This category includes several funds that invest primarily in domestic public and private companies operating in the financial services sector. Management of these funds also have the ability to invest in foreign public and private equities, debt financial instruments, warrants, hybrid securities and membership interests in the financial services sector. The fair values of investments in this category have been estimated using asset values based on capital statements provided by the general partner, updated, as necessary, for capital contributions and distributions and changes in market conditions up to the reporting date. These investments generally cannot be redeemed, unless approved by the general partners.  Upon liquidation of the underlying investments prior to the life expectancy / maturity of the funds, management of the funds can elect to make distributions to the limited partners. The time horizon for such distributions is at the discretion of the general partners but should not exceed the time horizon of the fund’s life expectancy. It is estimated that these investments would be liquidated approximately ten years following the initial investment date, some with options to extend for up to a two year period, ranging from 2010 — 2020.  Additional expenses, such as legal and administrative associated with the final liquidation can be incurred. Therefore, it is possible that upon final liquidation of the investments, the final funds distributed could be different from the estimated value of the investment.  However, these differences are not expected to be material.

 

11



Table of Contents

 

KBW, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)

(unaudited)

(Dollars in thousands, except per share information)

 

In determining the appropriate levels, the Company performed a detailed analysis of the assets and liabilities that are subject to ASC 820. At each reporting period, all assets and liabilities for which the fair value measurement is based on significant unobservable inputs are classified as Level 3.

 

Assets at Fair Value as of March 31, 2010

 

 

 

Level 1

 

Level 2

 

Level 3

 

Total

Financial instruments owned, at fair value:

 

 

 

 

 

 

 

 

 

 

 

 

Equities

$

45,305

 

$

18

 

$

23,265

 

$

68,588

 

Corporate and other debt:

 

 

 

 

 

 

 

 

 

 

 

 

Corporate debt

 

-    

 

 

46,883

 

 

9,651

 

 

56,534

 

CDOs

 

-    

 

 

5,481

 

 

1

 

 

5,482

 

Other debt obligations(1)

 

-    

 

 

-    

 

 

11,895

 

 

11,895

 

Total corporate and other debt

 

-    

 

 

52,364

 

 

21,547

 

 

73,911

 

Mortgage-backed securities - residential

 

-    

 

 

33,656

 

 

-    

 

 

33,656

 

Other investments(2)

 

-    

 

 

-    

 

 

45,092

 

 

45,092

 

Total non-derivative trading assets

 

45,305

 

 

86,038

 

 

89,904

 

 

221,247

 

Equity options/warrants

 

13,224

 

 

-    

 

 

-    

 

 

13,224

 

Total financial instruments owned

$

58,529

 

$

86,038

 

$

89,904

 

$

234,471

 

 

(1) Consists of bank and insurance company trust preferred and capital securities.

(2) Consists of limited and general partnership interests.

 

Liabilities at Fair Value as of March 31, 2010

 

 

 

Level 1

 

Level 2

 

Level 3

 

Total

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

 

 

 

 

 

 

 

 

 

 

 

 

Equities

$

45,071

 

$

-    

 

$

-    

 

$

45,071

 

Corporate debt

 

-    

 

 

2,408

 

 

-    

 

 

2,408

 

U.S. Government and agency securities

 

4,302

 

 

-    

 

 

-    

 

 

4,302

 

Total non-derivative trading liabilities

 

49,373

 

 

2,408

 

 

-    

 

 

51,781

 

Equity options/warrants

 

4,438

 

 

-    

 

 

-    

 

 

4,438

 

Total financial instruments sold, not yet purchased

$

53,811

 

$

2,408

 

$

-    

 

$

56,219

 

 

12



Table of Contents

 

KBW, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)

(unaudited)

(Dollars in thousands, except per share information)

 

Assets at Fair Value as of December 31, 2009

 

 

 

Level 1

 

Level 2

 

Level 3

 

Total

Financial instruments owned, at fair value:

 

 

 

 

 

 

 

 

 

 

 

 

Equities

$

40,197

 

$

22

 

$

15,873

 

$

56,092

 

Corporate and other debt:

 

 

 

 

 

 

 

 

 

 

 

 

Corporate debt

 

9,354

 

 

38,604

 

 

10,000

 

 

57,958

 

CDOs

 

-    

 

 

5,448

 

 

1

 

 

5,449

 

Other debt obligations(1)

 

-    

 

 

-    

 

 

12,347

 

 

12,347

 

Total corporate and other debt

 

9,354

 

 

44,052

 

 

22,348

 

 

75,754

 

Other investments(2)

 

-    

 

 

-    

 

 

41,917

 

 

41,917

 

Total non-derivative trading assets

 

49,551

 

 

44,074

 

 

80,138

 

 

173,763

 

Derivative financial instruments

 

628

 

 

-    

 

 

-    

 

 

628

 

Total financial instruments owned

$

50,179

 

$

44,074

 

$

80,138

 

$

174,391

 

 

(1) Consists of bank and insurance company trust preferred and capital securities.

(2) Consists of limited and general partnership interests.

 

Liabilities at Fair Value as of December 31, 2009

 

 

 

Level 1

 

Level 2

 

Level 3

 

Total

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

 

 

 

 

 

 

 

 

 

 

 

 

Equities

$

31,191

 

$

-    

 

$

-    

 

$

31,191

 

Corporate debt

 

-    

 

 

4,723

 

 

-    

 

 

4,723

 

U.S. Government and agency securities

 

962

 

 

-    

 

 

-    

 

 

962

 

Total non-derivative trading liabilities

 

32,153

 

 

4,723

 

 

-    

 

 

36,876

 

Derivative financial instruments

 

97

 

 

-    

 

 

-    

 

 

97

 

Total financial instruments sold, not yet purchased

$

32,250

 

$

4,723

 

$

-    

 

$

36,973

 

 

The non-derivative trading assets/liabilities categories were reported in financial instruments owned, at fair value and financial instruments sold, not yet purchased, at fair value on the Company’s consolidated statements of financial condition.

 

The derivative financial instruments were reported on a gross basis by level. The Company’s derivative activities included in financial instruments owned and financial instruments sold, not yet purchased consist of writing and purchasing listed equity options and warrants.

 

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Table of Contents

 

KBW, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)

(unaudited)

(Dollars in thousands, except per share information)

 

The following table provides a reconciliation of the beginning and ending balances for the non-derivative trading assets measured at fair value using significant unobservable inputs (Level 3) for the three months ended March 31, 2010 and 2009:

 

Level 3 Financial Assets

 

 

 

Balance as of
December 31, 2009

 

Total gains
and (losses)
(realized and
unrealized)

 

Purchases/
(sales), net

 

Transfers in (out)
of Level 3

 

Balance as of
March 31, 2010

 

Changes in
unrealized gains and
(losses) included in
earnings related to
assets still held at
reporting date

Equities

 

$15,873

 

$27

 

$7,365

 

$-

 

$23,265

 

$27

Corporate and other debt:

 

 

 

 

 

 

 

 

 

 

 

 

Corporate debt

 

10,000

 

(349)

 

-

 

-

 

9,651

 

(349)

CDOs

 

1

 

-

 

-

 

-

 

1

 

-

Other debt obligations

 

12,347

 

(452)

 

-

 

-

 

11,895

 

(452)

Total corporate and other debt

 

22,348

 

(801)

 

-

 

-

 

21,547

 

(801)

Other investments

 

41,917

 

1,828

 

1,347

 

-

 

45,092

 

1,828

Total Level 3 financial assets

 

$80,138

 

$1,054

 

$8,712

 

$-

 

$89,904

 

$1,054

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance as of
December 31, 2008

 

Total gains
and (losses)
(realized and
unrealized)

 

Purchases/
(sales), net

 

Transfers in (out)
of Level 3

 

Balance as of
March 31, 2009

 

Changes in
unrealized gains and
(losses) included in
earnings related to
assets still held at
reporting date

 

 

 

 

 

 

 

 

 

 

 

 

 

Non-derivative trading assets

 

$82,303

 

($5,030)

 

$1,139

 

$764

 

$79,176

 

($5,232)

 

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Table of Contents

 

KBW, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)

(unaudited)

(Dollars in thousands, except per share information)

 

Total gains and losses represent the total gains and/or losses (realized and unrealized) recorded for the Level 3 assets and were reported in principal transactions, net in the accompanying consolidated statements of operations. Additionally, the change in the unrealized gains and losses may be offset by realized gains and losses during the period.

 

Purchases/sales represent the net amount of Level 3 assets that were either purchased or sold during the period. The amounts were recorded at their end of period fair values.

 

Transfers in/out of Level 3 represent existing financial assets that were previously categorized at a lower level.  Transfers in or out of Level 3 result from changes in the observability of inputs used in determining fair values for different types of financial assets.  Transfers were reported at their fair value as of the actual date in which such changes in the fair value inputs occurs.

 

The amount of unrealized gains and losses included in earnings attributable to the change in unrealized gains and losses relating to Level 3 assets still held at the end of the period were reported in principal transactions, net in the accompanying consolidated statements of operations.  The change in unrealized gains and losses may be offset by realized gains and losses during the period.

 

(4)         Short-Term Borrowings

 

From time to time, the Company obtains secured short-term borrowings primarily through bank loans.  At March 31, 2010 and December 31, 2009, there were no short-term borrowing obligations outstanding.

 

(5)         Commitments and Contingencies

 

(a)               Leases

 

As of March 31, 2010, there were no significant changes in the Company’s lease agreements since December 31, 2009.

 

(b)               Litigation

 

In the ordinary course of business, the Company may be a defendant or codefendant in legal proceedings.  At March 31, 2010, the Company believes, based on currently available information, that the results of such proceedings, in the aggregate, will not have a material adverse effect on the Company’s financial condition. The results of such proceedings could be material to the Company’s operating results for any particular period, depending, in part, upon additional developments affecting such matters and the operating results for such period. Legal reserves have been established in accordance with ASC 450, Contingencies. Once established, reserves are adjusted when there is more information available or when an event occurs requiring a change.

 

Sentinel Management Group Litigation

 

On January 12, 2009, Frederick J. Grede, as Liquidation Trustee and Representative of the Estate of Sentinel Management Group, Inc. (“Sentinel”), filed a lawsuit in the United States District Court for the Northern District of Illinois against Keefe and against Delores E. Rodriguez; Barry C. Mohr, Jr.; and Jacques De Saint Phalle (all former employees of Keefe) and Cohen & Company Securities, LLC.  Ms. Rodriguez and Mr. Mohr were employed by Cohen & Company subsequent to being employed by Keefe and the complaint relates to activities by them at both Keefe and their subsequent employer.

 

The complaint alleges that Keefe recommended and sold to Sentinel Management Group structured finance products that were unsuitable for purchase.  The complaint alleges the following causes of action against Keefe, aiding and abetting breach of fiduciary duty by an officer and director of Sentinel; commercial bribery; violations of federal and state securities laws; violation of the Illinois Consumer Fraud Act; negligence; unjust enrichment; and avoidance and recovery of fraudulent transfers.  The complaint specifies that Sentinel sustained a loss associated with the sale of securities sold by Keefe of $4,920, and interrogatory responses from the Trustee in discovery now contend that Sentinel lost $5,629; however various causes of action in the complaint seek to recover amounts substantially in excess of that amount up to an amount in excess of $130,000, representing amounts paid for all securities purchased from Keefe regardless of suitability or whether there were losses on these securities.  Keefe believes the claims are without merit and will defend these claims vigorously. On April 1, 2009, Keefe filed a Motion to Dismiss the Complaint.  On July 29, 2009, the court denied most of the relief sought in Keefe’s Motion to Dismiss, though it dismissed the Illinois Consumer Fraud Act claim

 

15



Table of Contents

 

KBW, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)

(unaudited)

(Dollars in thousands, except per share information)

 

and granted Keefe’s motion to sever the Trustee’s case against Keefe from the case against Cohen.  On August 26, 2009, Keefe filed a Third-Party Complaint against Eric A. Bloom, the former President and CEO of Sentinel, and Charles K. Mosley, the former Senior Vice President and head trader of Sentinel, alleging fraud and seeking contribution for any damages for which Keefe is held liable to the Trustee.  The court stayed and severed this Third-Party Complaint on October, 7, 2009.

 

On May 21, 2009 the Trustee filed an additional complaint in the same court and against the same parties (the “Second Complaint”).  The Trustee claimed to be acting in the Second Complaint in his capacity as liquidation trustee and as an assignee of claims of Sentinel’s customers.  The Second Complaint makes substantially the same allegations as the complaint described above.  Keefe believes the claims in the Second Complaint are also without merit and will defend these claims vigorously.  On July 28, 2009, in Grede v. Bank of New York Mellon et al filed in the same court, in which the Trustee alleged similar customer claims as an assignee, the court dismissed the Trustee’s claims due to lack of standing.  The Trustee has appealed the court’s dismissal of Grede v. Bank of New York Mellon and, on August 19, 2009, the court stayed the Second Complaint while the Trustee’s appeal in Grede v. Bank of New York Mellon is pending.   On March 18, 2010, the Seventh Circuit reversed the district court, holding that the Trustee had standing to pursue the assigned customer claims against Bank of New York Mellon.  Currently, the Second Complaint remains stayed, pending the possibility of further appellate review in Grede v. Bank of New York Mellon, including en banc review by the Seventh Circuit and/or review by the Supreme Court.

 

MidFirst Bank Litigation

 

On December 6, 2007, MidFirst Bank (“MidFirst”) filed a lawsuit against Keefe in the Federal District Court for the Western District of Oklahoma, in an action captioned MidFirst Bank v. Keefe, Bruyette & Woods, Inc., Case No. 07-CV-1384-R (W.D. Oklahoma.).  The complaint arises out of MidFirst’s investment in subordinated trust certificates, which Keefe solicited MidFirst to acquire in early 2007.  MidFirst acquired the securities for approximately $5,000.  During the fall of 2007, in connection with the failure of the global markets, MidFirst’s investment declined in value.  MidFirst sued Keefe, claiming that Keefe misrepresented the terms of the securities.  MidFirst initially alleged that Keefe violated Section 10(b) of the Exchange Act, the Oklahoma Uniform Securities Act, committed common law fraud and negligent misrepresentation.   Keefe moved to dismiss and the Court granted the motion to dismiss the Section 10(b) claim which was not repleaded.  Based on its state law claims, MidFirst is seeking a rescission of approximately $5,100 in compensatory damages and an unspecified sum for punitive damages and attorney’s fees or in the alternative damages of approximately $2,400.

 

Keefe answered the complaint and brought a third-party complaint against Wachovia Capital Markets LLC (“Wachovia”), which solicited Keefe to sell these securities and which knew Keefe was purchasing them for resale to a customer.  Keefe’s claims against Wachovia are for contribution and indemnity, common law fraud and negligent misrepresentation.  Wachovia has answered the third-party complaint, denying all material allegations.

 

The parties are in the discovery process of this litigation and the case is currently scheduled for trial commencing in August 2010. Keefe has been and is continuing to defend against the MidFirst suit and prosecuting Keefe’s claims against Wachovia vigorously.

 

(c)                Investment Commitments

 

As of March 31, 2010, the Company had approximately $21,307, including $9,588 to an affiliated fund, in outstanding commitments for additional funding to limited partnership investments.

 

(6)         Financial Instruments with Off-Balance-Sheet Risk

 

In the normal course of its principal trading activities, the Company enters into transactions in financial instruments with off-balance-sheet risk. These financial instruments, such as options, warrants, futures and mortgage-backed to-be-announced (“TBA”) securities, contain off-balance-sheet risk inasmuch as ultimate settlement of these transactions may have market and/or credit risk in excess of amounts which are recognized in the consolidated financial statements. Transactions in listed options and warrants are conducted through regulated exchanges, which clear and guarantee performance of counterparties.

 

Also, in connection with its principal trading activities, 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 this obligation in the financial

 

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KBW, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)

(unaudited)

(Dollars in thousands, except per share information)

 

statements at market values of the related securities and will record a trading loss if the market value of the securities increases subsequent to the consolidated financial statements date.

 

(a)               Broker-Dealer Activities

 

The Company clears securities transactions on behalf of customers through its clearing brokers. In connection with these activities, customers’ unsettled trades may expose the Company to off-balance-sheet credit risk in the event customers are unable to fulfill their contracted obligations. The Company seeks to control the risk associated with its customer activities by monitoring the creditworthiness of its customers.

 

(b)               Derivative Financial Instruments

 

The Company’s derivative activities consist of writing and purchasing listed equity options and/or warrants and, from time to time, futures on interest rate, currency and equity products and mortgage-backed TBA securities for trading for our own account.  Options and warrants are included in financial instruments owned, at fair value and financial instruments sold, not yet purchased, at fair value in the accompanying consolidated statements of financial condition. See also Note 3 of the Notes to Consolidated Financial Statements for additional details. As a writer of options, the Company receives a cash premium at the beginning of the contract period and bears the risk of unfavorable changes in the fair value of the financial instruments underlying the options. Options written do not expose the Company to credit risk since they obligate the Company (not its counterparty) to perform.

 

In order to measure derivative activity, notional or contract amounts are frequently utilized. Notional contract amounts, which are not included on the consolidated statements of financial condition, are used as a basis to calculate contractual cash flows to be exchanged and generally are not actually paid or received.

 

A summary of the Company’s listed options, warrants, futures contracts and TBA securities is as follows:

 

 

 

Current

 

Average

 

End of

 

 

Notional

 

Fair

 

Period

 

 

Value

 

Value

 

Fair Value

March 31, 2010:

 

 

 

 

 

 

Purchased options/warrants

 

$

35,916

 

$

6,492

 

$

13,224

Written options

 

$

22,415

 

$

2,118

 

$

4,438

Short futures contracts

 

$

5,792

 

$

-

 

$

-

Agency mortgage-backed TBA securities

 

$

20,300

 

$

14

 

$

44

 

 

 

 

 

 

 

December 31, 2009:

 

 

 

 

 

 

Purchased options/warrants

 

$

8,285

 

$

380

 

$

628

Written options

 

$

630

 

$

511

 

$

97

Short futures contracts

 

$

6,136

 

$

-

 

$

-

 

The following table summarizes the net gains from trading activities included in principal transactions, net with respect to the consolidated statements of operations for the period ended March 31, 2010:

 

Type of Instrument

 

Principal
Transactions, Net

Equities

$

5,051

Corporate and other debt

 

8,831

Mortgage-backed securities

 

3,337

Other investments

 

1,828

Total

$

19,047

 

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KBW, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)

(unaudited)

(Dollars in thousands, except per share information)

 

The revenue related to the equities and mortgage-backed securities categories included realized and unrealized gains and losses on both derivative instruments and non-derivative instruments. Corporate and other debt and other investments included realized and unrealized gains and losses on non-derivative instruments.

 

(7)         Concentrations of Credit Risk

 

The Company is engaged in various securities trading and brokerage activities servicing primarily domestic and foreign institutional investors. Nearly all of the Company’s transactions are executed with and on behalf of institutional investors, including other brokers and dealers, commercial banks, mutual funds, and other financial institutions. The Company’s exposure to credit risk associated with the non-performance of these customers in fulfilling their contractual obligations pursuant to securities transactions can be directly impacted by volatile securities markets.

 

A substantial portion of the Company’s marketable securities are common stock and debt of financial institutions. The credit and/or market risk associated with these holdings can be directly impacted by factors that affect this industry such as volatile equity and credit markets and actions of regulatory authorities.

 

(8)         Notes Receivable from Stockholders

 

Notes receivable from stockholders represent full recourse notes issued to employees for their purchases of stock acquired pursuant to the Company’s book value stock purchase plan. Loans are payable in annual installments and bear interest of 5.0% per annum.

 

(9)         Stock-Based and Other Incentive Compensation

 

Stock-Based Compensation

 

At March 31, 2010, the Company had one effective stock-based compensation arrangement under the 2009 Incentive Compensation Plan (the “Plan”).  As part of the 2009 year-end performance award process (“2009 Bonus Awards”), the Company granted 1,344,042 restricted stock awards (“RSAs”) under the Plan to certain employees in February 2010. The aggregate fair value of the RSAs granted in connection with the 2009 Bonus Awards in February 2010 was $35,321.  This value was based upon the grant date share price of $26.28. RSAs are actual shares of common stock issued to the participant that are restricted.   The stock granted in connection with the 2009 Bonus Awards generally vests over a three year period. Vesting would accelerate on a change in control, death or permanent disability. Unvested RSAs are subject to forfeiture upon termination of employment and in certain circumstances failing to meet performance criteria.

 

For 2009 Bonus Awards that were granted to retirement-eligible employees, the Company recognized the grant date fair value as compensation expense for such awards on the date of grant instead of over the service period specified in the award terms. For employees who will be retirement-eligible prior to vesting of the 2009 Bonus Awards, the Company recognizes compensation expense ratably from the grant date to the retirement eligibility date. The Company recorded accelerated non-cash incremental compensation expense of $4,824 in the first quarter of 2010 related to 2009 Bonus Awards granted to retirement-eligible employees (including employees who will be retirement-eligible prior to vesting).

 

Long Term Incentive Program

 

In February 2010, the Company adopted a Long Term Incentive Program (the “LTIP”) under the Plan.  The LTIP allows the Company to make awards under the Plan to selected employees, which awards will provide for payments of such amounts pursuant to such terms and conditions as the Company shall determine.  The LTIP provides that amounts specified or calculated pursuant to awards may be earned during a performance cycle established for such an award upon the achievement of specified performance goals.

 

During the first quarter of 2010, the Company approved awards under the Plan to three employees.  The LTIP awards have established performance cycles and amounts payable based on achieving specific performance criteria during the performance cycle.

 

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KBW, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)

(unaudited)

(Dollars in thousands, except per share information)

 

(10)  Earnings Per Share

 

The computations of basic and diluted earnings per share are set forth below:

 

 

 

Three Months Ended

 

 

March 31,

 

 

2010

 

2009

 

 

 

 

 

 

 

 

 

 

Net income

$

 

11,621

$

 

730

Less:  Allocation of earnings to participating securities

 

1,258

 

85

Net income applicable to common shareholders

$

 

10,363

$

 

645

 

 

 

 

 

Weighted average number of common share outstanding (1)(2):

 

 

 

 

Basic

 

32,240,838

 

31,354,507

Effect of dilutive securities - restricted stock

 

-    

 

-    

Diluted

 

32,240,838

 

31,354,507

 

 

 

 

 

Earnings per common share(1)(2):

 

 

 

 

Basic

$

 

0.32

$

 

0.02

Diluted

$

 

0.32

$

 

0.02

 

(1) Participating securities in the form of unvested share based payment awards amounted to weighted average shares of 3,914,573 and 4,108,919 for the three months ended March 31, 2010 and 2009, respectively.

 

(2) Basic and diluted common shares outstanding were equal for the periods presented under the two-class method.

 

(11)  Income Taxes

 

The Company applies the provisions of ASC 740, which prescribes the recognition and measurement criteria related to tax positions taken or expected to be taken in a tax return.  For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities.  In addition, the following information required by ASC 740 is provided:

 

·                  The Company’s gross unrecognized tax benefits, excluding interest, have not changed significantly since December 31, 2009.

 

·                  The Company classifies interest and penalties, if any, related to tax uncertainties as income tax expenses.   As of March 31, 2010, this amount had not changed significantly since December 31, 2009.

 

·                  The Company and its subsidiaries file federal consolidated and various state, local and foreign tax returns.  The federal income tax returns have been audited through 2005.  Various state, local and foreign returns are subject to audits by tax authorities beginning with the 2002 tax year.  The settlement of certain state and local audits within the next 12 months, if any, is not anticipated to have a significant impact on the Company’s results or financial position.

 

(12)  Industry Segment Data

 

The Company follows the provisions of ASC 280, Segment Reporting, in disclosing its business segments. Pursuant to that statement, an entity is required to determine its business segments based on the way management organizes the segments within the enterprise for making operating decisions and assessing performance. Based upon these criteria, the Company has determined that its entire business should be considered a single segment.

 

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KBW, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Continued)

(unaudited)

(Dollars in thousands, except per share information)

 

(13)  Net Capital Requirement

 

Keefe is a registered U.S. broker-dealer that is subject to the Uniform Net Capital Rule (SEC Rule 15c3-1 or the Net Capital Rule) administered by the SEC and FINRA, which requires the maintenance of minimum net capital. Keefe has elected to use the basic method to compute net capital as permitted by the Net Capital Rule, which requires Keefe to maintain minimum net capital, as defined, of $3,411 as of March 31, 2010. These rules also require Keefe to notify and sometimes obtain approval from FINRA for significant withdrawals of capital.

 

 

 

March 31, 2010

Net Capital

 

$

107,265

Excess

 

$

103,854

 

KBWL is an investment firm authorized and regulated by the FSA in the United Kingdom and is subject to the capital requirements of the FSA. As of March 31, 2010, KBWL was in compliance with its local capital adequacy requirements.  At March 31, 2010, KBWL’s capital resources of approximately $34,222 exceeded the capital resources requirement by approximately $24,436.

 

(14)  Recent Accounting Developments

 

In January 2010, FASB issued ASU No. 2010-06, Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements.  ASU No. 2010-06 requires additional fair value measurement disclosure requirements and clarifies certain existing disclosure requirements. The additional disclosures include significant transfers in and out of Level 1 and Level 2 fair value measurements, and reasons for the transfers, and activity in Level 3 fair value measurements.  ASU No. 2010-06 is effective for interim and annual periods beginning after December 15, 2009, except for the disclosures on the activity in Level 3 fair value measurements, which is effective for interim and annual periods beginning after December 15, 2010. In January 2010, the Company adopted ASU No. 2010-06, except for the disclosure requirements related to the activity in Level 3 fair value measurements.

 

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Table of Contents

 

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

 

The following discussion should be read in conjunction with our unaudited consolidated financial statements and the related notes included elsewhere in this report.

 

Cautionary Statement Regarding Forward Looking Statements

 

We have made statements in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and in other sections of this report that are forward-looking statements. In some cases, you can identify these statements by forward-looking words such as “may,” “might,” “will,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential” or “continue,” the negative of these terms and other comparable terminology. These forward-looking statements, which are based on various underlying assumptions and expectations and are subject to risks, uncertainties and other unknown factors, may include projections of our future financial performance based on our growth strategies and anticipated trends in our business. These statements are only predictions based on our current expectations and projections about future events. There are or may be important factors that could cause our actual results, level of activity, performance or achievements to differ materially from the historical or future results, level of activity, performance or achievements expressed or implied by such forward-looking statements. These factors include, but are not limited to, those discussed in the section entitled “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2009.

 

Although we believe the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, level of activity, performance or achievements. Moreover, neither we nor any other person assumes responsibility for the accuracy or completeness of any of these forward-looking statements. You should not rely upon forward-looking statements as predictions of future events. We are under no duty to update any of these forward-looking statements after the date of filing of this report to conform such statements to actual results or revised expectations.

 

Overview

 

We are a full service investment bank specializing in the financial services industry. Our principal activities are:  (i) investment banking, including mergers and acquisitions (“M&A”) and other strategic advisory services, equity and fixed income securities offerings, and mutual thrift conversions, (ii) equity and fixed income sales and trading, (iii) research that provides fundamental, objective analysis that identifies investment opportunities and helps our investor customers make better investment decisions, and (iv) asset management, including investment management and other advisory services to institutional clients and private high net worth clients and various investment vehicles.

 

Within our full service business model, our focus includes bank and thrift holding companies, banking companies, thrift institutions, insurance companies, broker-dealers, mortgage banks, asset management companies, mortgage and equity real estate investment trusts, consumer and specialty finance firms, financial processing companies and securities exchanges.  We emphasize serving investment banking clients in the small and mid cap segments of the financial services industry although our clients also include many large-cap companies.  Our sales customers are primarily institutional investors.

 

Most revenues with respect to our services provided are primarily determined as a result of active competition in the marketplace. Our revenues are primarily generated through advisory, underwriting and private placement fees earned through our investment banking activities, commissions earned on equity sales and trading activities, interest and dividends earned on our securities’ inventories and profit and losses from trading activities related to the securities’ inventories.

 

Our largest expense is compensation and benefits.  Our performance is dependant on our ability to attract, develop and retain highly skilled employees who are motivated to provide quality service and guidance to our clients.

 

Many external factors affect our revenues and profitability. Such factors include equity and fixed income trading prices and volumes, the volatility of these markets, the level and shape of the yield curve, political events and regulatory developments, and competition. These factors influence our investment banking operations in that such factors affect the number and timing of equity and fixed income securities issuances and M&A activity within the financial services industry. These same factors also affect our sales and trading business by impacting equity and fixed income trading prices and volumes and valuations in secondary financial markets. Commission rates, market volatility and other factors also affect our sales and trading revenues. These market forces may cause our revenues and earnings to fluctuate significantly from period to period and the results of any one period should not be considered indicative of future results.  See “—Business Environment.”

 

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A significant portion of our expense base is variable, including employee compensation and benefits, brokerage and clearance, communication and data processing and business development expenses. Our remaining costs generally do not directly relate to the service revenues earned.

 

Certain data processing systems that support equity and fixed income trading, research, payroll, human resources and employee benefits are service bureau based and are operated in the vendors’ data centers. We believe that this stabilizes our fixed costs associated with data processing. We also license vendor information databases to support investment banking, sales and trading and research. Vendors may, at the end of contractual terms, terminate our rights or modify or significantly alter product and service offerings or related fees, which may affect our ongoing business activities or related costs.

 

Business Environment

 

Our business activities focus on the financial services sector, the landscape of which, in the U.S. and globally, has continued to evolve since the global financial crisis began in 2007.  In the U.S. there has been some return of market confidence in this sector and very strong activity in capital markets’ transactions, as selected companies have recapitalized following the completion by U.S. bank regulators of the Supervisory Capital Assessment Program, which provided markets with a uniform approach for estimating loan losses in valuing U.S. bank stocks.  Since the first quarter of 2009, the equity value of the U.S. financial sector has increased dramatically, which trend accelerated since the beginning of 2010.   Many institutions have positioned themselves to take advantage of acquisition opportunities that may develop, in some cases with government assistance.  We continued to be very active in capital markets transactions, participating in 24 equity capital raises for the first quarter in 2010.  However, the sector remains under stress and the market stability and continuation of current trends is not certain.  The valuation of certain classes of assets remains uncertain and there are continuing concerns in the credit quality of multiple asset classes, especially commercial real estate.  Securitization markets have not broadly reopened.  U.S. unemployment remains high and lenders continue to lend only to the most credit worthy borrowers, making credit tight across the broad economy.

 

In the U.S., the financial services sector remains highly fragmented.  There are approximately 1,020 publicly traded banks and thrifts and approximately 7,930 different banking entities in the U.S.  Because of our focus, we are particularly impacted by economic and market conditions affecting this sector.  Although many larger financial institutions have succeeded in recapitalizing and have repaid government assistance, bank failures among smaller institutions have continued.  In the first quarter of 2010,  there were 41 failed U.S. banks with assets totaling $19.7 billion compared to 21 failed banks in the U.S. with assets totaling $5.5 billion in the first quarter of 2009.  Trends in the global economy and domestic and international financial markets have a significant impact on the outlook for financial services, including the market prices for our stock and the securities of other companies in the sector.

 

Globally, there continues to be some stress in Europe with a bailout of sovereign debt for Greece posing challenges for the economies of other European countries putting stress on European financial markets.

 

It is difficult to predict how long these conditions will continue or whether additional deteriorations in asset quality, further credit market dislocations or sustained market downturns may exacerbate the impact of these factors on our overall revenues.   Even with increasing market stabilization in recent quarters, there has not been a significant return of M&A activity.  During 2009 and in the first quarter of 2010, many financial institutions have reported operating profitability, although others reported significant losses, in particular resulting from increases to loan loss reserves.  There are proposals in Congress to substantially change the regulation of the banking sector, including proposals to impose limitations on certain activities by banking entities.  Even if enacted, these laws will require substantial rulemaking prior to implementation, and the impact on our industry and on many of our clients and customers cannot currently be predicted.  We believe that we are well capitalized and remain well positioned to assist in capital markets and M&A transactions for the financial services industry in both the U.S. and Europe.

 

Results of Operations

 

Three Months Ended March  31, 2010 Compared with Three Months Ended March 31, 2009

 

Overview

 

Total revenues increased $61.0 million, or 84.4%, to $133.3 million for the three months ended March 31, 2010, compared with $72.3 million for the three months ended March 31, 2009. This increase was primarily due to record investment banking revenues of $70.0 million for the three months ended March 31, 2010, an increase of $43.1 million compared with the three months ended March 31, 2009.  In addition, principal transactions, net increased $14.9 million compared with the three months ended March 

 

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31, 2009.

 

Total expenses were $113.0 for the three months ended March 31, 2010 compared with $70.3 for the three months ended March 31, 2009.  The increase was due to a $36.2 million increase in compensation and benefits expense, reflecting higher revenues, and a $6.4 million increase in non-compensation expenses.

 

We recorded net income of $11.6 million, or $0.32 per diluted share, for the three months ended March 31, 2010, compared with $0.7 million, or $0.02 per diluted share, for the same period in 2009. After adjusting for the 2006 one-time restricted stock awards granted to employees in connection with our initial public offering (“IPO”), our non-GAAP operating net income was $13.1 million, or $0.36 per diluted share for the three months ended March 31, 2010, compared with $1.6 million, or $0.05 per diluted share for the same period in 2009. See “-Non-GAAP Financial Measures” for a reconciliation of our non-GAAP measures to their corresponding GAAP amounts.

 

The following table provides a comparison of our revenues and expenses for the periods presented (dollars in thousands):

 

 

 

Three Months Ended

 

 

 

 

 

 

 

 

 

March 31,

 

Period to Period

 

 

 

2010

 

2009

 

$ Change

 

% Change

 

 

 

(unaudited)

 

Revenues:

 

 

 

 

 

 

 

 

 

 

 

 

 

Investment banking

$

 

69,962

 

$

 

26,860

 

$

 

43,102

 

 

160.5

 

%

Commissions

 

35,404

 

 

36,019

 

 

(615

)

 

(1.7

)

 

Principal transactions, net

 

19,047

 

 

4,116

 

 

14,931

 

 

362.8

 

 

Interest and dividend income

 

2,884

 

 

1,738

 

 

1,146

 

 

65.9

 

 

Investment advisory fees

 

294

 

 

313

 

 

(19

)

 

(6.1

)

 

Other

 

5,719

 

 

3,230

 

 

2,489

 

 

77.1

 

 

Total revenues

 

133,310

 

 

72,276

 

 

61,034

 

 

84.4

 

 

Expenses:

 

 

 

 

 

 

 

 

 

 

 

 

 

Compensation and benefits

 

81,878

 

 

45,667

 

 

36,211

 

 

79.3

 

 

Occupancy and equipment

 

5,612

 

 

5,159

 

 

453

 

 

8.8

 

 

Communications and data processing

 

7,656

 

 

6,660

 

 

996

 

 

15.0

 

 

Brokerage and clearance

 

5,086

 

 

3,882

 

 

1,204

 

 

31.0

 

 

Business development

 

3,460

 

 

3,032

 

 

428

 

 

14.1

 

 

Interest

 

258

 

 

169

 

 

89

 

 

52.7

 

 

Other

 

9,050

 

 

5,777

 

 

3,273

 

 

56.7

 

 

Non-compensation expenses

 

31,122

 

 

24,679

 

 

6,443

 

 

26.1

 

 

Total expenses

 

113,000

 

 

70,346

 

 

42,654

 

 

60.6

 

 

Income before income taxes

 

20,310

 

 

1,930

 

 

18,380

 

 

952.3

 

 

Income tax expense

 

8,689

 

 

1,200

 

 

7,489

 

 

624.1

 

 

Net income

$

 

11,621

 

$

 

730

 

$

 

10,891

 

 

1,491.9

 

%

 

Non-GAAP Financial Measures

 

Compensation cost for stock-based awards are measured at fair value on the date of grant and recognized as compensation expense over the requisite service period, net of estimated forfeitures.

 

We reported our compensation and benefits expense, income before income taxes, income tax expense, net income, compensation ratio and basic and diluted earnings per share on a non-GAAP basis for the three months ended March 31, 2010 in our April 29, 2010 press release. The non-GAAP amounts exclude compensation expense related to the amortization of IPO restricted stock awards granted in November 2006.

 

Our management has utilized such non-GAAP calculations as an additional device to aid in understanding and analyzing our financial results for the periods ended March 31, 2010 and 2009. Specifically, our management believes that these non-GAAP

 

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measures provide useful information by excluding certain items that may not be indicative of our core operating results and business outlook. Our management believes that these non-GAAP measures will allow for a better evaluation of the operating performance of our business and facilitate meaningful comparison of our results in the current period to those in prior and future periods. Such periods did not and likely will not include substantial grants of restricted stock awards to employees such as the Company-wide IPO restricted stock awards. Our reference to these non-GAAP measures should not be considered as a substitute for results that are presented in a manner consistent with GAAP. These non-GAAP measures are provided to enhance investors’ overall understanding of our current financial performance.

 

A limitation of utilizing these non-GAAP measures is that the determination of these amounts in accordance with GAAP reflects the underlying financial results of our business.  These effects should not be ignored in evaluating and analyzing our financial results. Therefore, management believes that, with respect to the items set forth in the table below, both our GAAP and respective non-GAAP measures should be considered together.

 

The following table provides details with respect to reconciling compensation and benefits expense, income before income taxes, income tax expense, net income, compensation ratio and basic and diluted earnings per share on a non-GAAP basis for the three months ended March 31, 2010 and 2009.

 

 

 

 

 

Reconciliation

 

 

 

 

GAAP

 

Amount

 

Non-GAAP

 

 

(dollars in thousands, except per share information)

Quarter Ended March 31, 2010

 

 

 

 

 

 

 

 

 

 

Compensation and benefits expense

$

 

81,878

 

$

 

(2,558

)

(a)

$

 

79,320

 

Income before income taxes

$

 

20,310

 

$

 

2,558

 

(a)

$

 

22,868

 

Income tax expense

$

 

8,689

 

$

 

1,094

 

(b)

$

 

9,783

 

Net income

$

 

11,621

 

$

 

1,464

 

(c)

$

 

13,085

 

Compensation ratio (d):

 

61.4

%

 

 

 

 

 

59.5

%

 

 

 

 

 

 

 

 

 

 

 

Earnings per share (e):

 

 

 

 

 

 

 

 

 

 

Basic

$

 

0.32

 

$

 

0.04

 

 

$

 

0.36

 

Diluted

$

 

0.32

 

$

 

0.04

 

 

$

 

0.36

 

 

 

 

 

 

 

 

 

 

 

 

Weighted average number of common shares outstanding (e):

 

 

 

 

 

 

 

 

 

 

Basic

 

32,240,838

 

 

-    

 

(f)

 

32,240,838

 

Diluted

 

32,240,838

 

 

-    

 

(f)

 

32,240,838

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Quarter Ended March 31, 2009

 

 

 

 

 

 

 

 

 

 

Compensation and benefits expense

$

 

45,667

 

$

 

(2,302

)

(a)

$

 

43,365

 

Income before income taxes

$

 

1,930

 

 

2,302

 

(a)

$

 

4,232

 

Income tax expense

$

 

1,200

 

$

 

1,431

 

(b)

$

 

2,631

 

Net income

$

 

730

 

$

 

871

 

(c)

$

 

1,601

 

Compensation ratio (d):

 

63.2

%

 

 

 

 

 

60.0

%

 

 

 

 

 

 

 

 

 

 

 

Earnings per share (e):

 

 

 

 

 

 

 

 

 

 

Basic

$

 

0.02

 

$

 

0.03

 

 

$

 

0.05

 

Diluted

$

 

0.02

 

$

 

0.03

 

 

$

 

0.05

 

 

 

 

 

 

 

 

 

 

 

 

Weighted average number of common shares outstanding (e):

 

 

 

 

 

 

 

 

 

 

Basic

 

31,354,507

 

 

-    

 

(f)

 

31,354,507

 

Diluted

 

31,354,507

 

 

-    

 

(f)

 

31,354,507

 

 

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Table of Contents

 

(a)          The non-GAAP adjustment represents the pre-tax expense with respect to the amortization of the IPO restricted stock awards granted to employees on November 2006.

 

(b)         The non-GAAP adjustment with respect to income tax expense represents the elimination of the tax benefit resulting from the amortization of the IPO restricted stock awards in the period.

 

(c)          The non-GAAP adjustment with respect to net income was the after-tax amortization of the IPO restricted stock awards in the period.

 

(d)         The first quarter 2010 and first quarter 2009 compensation ratios were calculated by dividing compensation and benefits expense by total revenues of $133,310 and $72,276, respectively.

 

(e)          Basic and diluted common shares outstanding were equal for each respective period under the two-class method.

 

(f)            Both the basic and diluted weighted average number of common shares outstanding were not adjusted.

 

Our management utilizes these non-GAAP calculations in understanding and analyzing our financial results.  Our management believes that the non-GAAP measures provide useful information by excluding certain items that may not be indicative of our core operating results and business outlook. Our management believes that these GAAP measures will allow for a better evaluation of the operating performance of our business and facilitate meaningful comparison of our results in the current period to those in prior periods and future periods. Our reference to these non-GAAP measures should not be considered as a substitute for results that are presented in a manner consistent with GAAP. These non-GAAP measures are provided to enhance investors’ overall understanding of our current financial performance.

 

A limitation of utilizing these non-GAAP measures is that the GAAP accounting effects of these events do in fact reflect the underlying financial results of our business and these effects should not be ignored in evaluating and analyzing our financial results. Therefore, management believes that our GAAP measures of compensation and benefits expense, income before income taxes, income tax expense, net income, and basic and diluted earnings per share and the same respective non-GAAP measures of our financial performance should be considered together.

 

We expect to grant restricted stock awards and other share-based compensation in the future. We do not expect to make any such substantial grants to employees outside of our regular compensation and hiring process, as we did when we granted IPO restricted stock awards.

 

Revenues

 

Investment Banking

 

Investment banking revenue was $70.0 million for the three months ended March 31, 2010 compared with $26.9 million for the same period in 2009, an increase of $43.1 million, or 160.5%. Capital markets revenue increased $36.1 million, or 206.3%, to a quarterly record of $53.6 million for the three months ended March 31, 2010 compared with $17.5 million for the same period in 2009. The increase reflects the completion of a significantly higher number of equity capital market transactions in 2010 compared with the same period in 2009.  The majority of such transactions related to raising common equity capital for U.S. banking companies continuing the trend that began in the second quarter of 2009 following the completion by federal bank regulators of the Supervisory Capital Assessment Program which provided the market with an approach to estimating loan losses in valuing U.S. bank stocks.  M&A and advisory revenue was $16.4 million for the three months ended March 31, 2010 compared with $9.4 million for the same period in 2009, an increase of $7.0 million.  This increase was primarily due to an above average advisory fee earned from a transaction that closed in 2010.

 

Commissions

 

Commissions revenue was $35.4 million for the three months ended March 31, 2010 compared with $36.0 million for the same period in 2009, a decrease of $0.6 million, or 1.7%. European equity commissions were $10.4 million for the three months ended March 31, 2010 compared with $8.6 million for the same period in 2009, an increase of $1.8 million, or 20.9%, reflecting higher trading volume and the recovery of the market valuation of most European financial services stocks on which our European commissions are based. U.S. equity commissions were $25.0 million for the three months ended March 31, 2010 compared with $27.5 million for the same 2009 period, a decrease of $2.5 million, or 9.1%, reflecting lower trading volume.

 

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Table of Contents

 

Principal Transactions, Net

 

Principal transactions, net resulted in revenue of $19.0 million for the three months ended March 31, 2010 compared with $4.1 million for the same period in 2009.  Our fixed income revenue was $12.9 million for the three months ended March 31, 2010 compared to $10.2 million for the same period in 2009. Our equity market making activity resulted in a loss of $0.9 million for three months ended March 31, 2010 compared to a loss of $1.5 million for the same period in 2009. Trading for our own account, including firm investments, resulted in a net gain of $7.4 million for 2010 compared to a net loss of $1.0 million for the same period in 2009, reflecting an improved trading environment. The realized gain/loss and change in the fair value of our trust preferred backed collateralized debt obligations and related securities owned resulted in a loss of $0.4 million for 2010 compared to a loss of $3.5 million for the same period in 2009.

 

Interest and Dividend Income

 

Interest and dividend income increased $1.1 million, or 65.9%, to $2.9 million for the three months ended March 31, 2010 compared with $1.7 million for the same period in 2009.  The increase was primarily due to higher average holdings of interest bearing assets in 2010 relative to 2009.

 

Other

 

Other revenues increased $2.5 million, or 77.1%, to $5.7 million for the three months ended March 31, 2010 compared with $3.2 million for the same period in 2009. The increase was primarily due to higher loan portfolio sales fees compared with the same period in 2009.

 

Expenses

 

Compensation and Benefits

 

Compensation and benefits expense was $81.9 million, an increase of $36.2 million, or 79.3% for the three months ended March 31, 2010 compared with $45.7 million for the same period in 2009, reflecting higher revenues.  Compensation and benefits as a percentage of total revenue, after adjusting for expenses associated with the IPO restricted stock awards, was 59.5% for the first quarter of 2010 compared to 60.0% for the same period in 2009. See “-Non-GAAP Financial Measures” for a reconciliation of our non-GAAP measures to their corresponding GAAP amounts.

 

Brokerage and Clearance

 

Brokerage and clearance expense was $5.1 million for the three months ended March 31, 2010 compared with $3.9 million for the same period in 2009, an increase of $1.2 million, or 31.0%.  The increase was primarily a result of higher clearance charges on European equities.

 

Business Development

 

Business development expense increased $0.4 million, or 14.1%, to $3.5 million for the three months ended March 31, 2010 compared with $3.0 million for the same period in 2009.  The increase was primarily due to higher travel and entertainment expenses in 2010 relative to 2009.

 

Other

 

Other expenses were $9.1 million for the three months ended March 31, 2010 compared with $5.8 million for the same period in 2009, an increase of $3.3 million, or 56.7%.  The increase was primarily due to higher legal costs in 2010 relative to 2009.

 

Income Tax Expense

 

Income tax expense was $8.7 million for the three months ended March 31, 2010, which resulted in an effective tax rate of 42.8%, compared to $1.2 million for the same period in 2009, which resulted in an effective tax rate of 62.2%.  The change in the effective tax rate was primarily due to the impact of permanent differences relative to increased pre-tax income.

 

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Table of Contents

 

Critical Accounting Policies and Estimates

 

The preparation of our consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and of revenues and expenses during the reporting periods. We base our estimates and assumptions on historical experience and on various other factors that we believe are reasonable under the circumstances. The use of different estimates and assumptions could produce materially different results. For example, if factors such as those described in Item 1A under “Risk Factors” cause actual events to differ from the assumptions we used in applying the accounting policies, our results of operations, financial condition and liquidity could be materially adversely affected.

 

Our significant accounting policies are summarized in Note 2 of the Notes to Consolidated Financial Statements. On an ongoing basis, we evaluate our estimates and assumptions, particularly as they relate to accounting policies that we believe are most important to the presentation of our financial condition and results of operations. We regard an accounting estimate or assumption to be most important to the presentation of our financial condition and results of operations where the nature of the estimate or assumption is material due to the level of subjectivity and judgment necessary to account for highly uncertain matters or the susceptibility of such matters to change, as well as the impact of the estimate or assumption on our financial condition or operating performance is material.

 

Based on these criteria, we believe the following to be our critical accounting policies:

 

Fair Value of Financial Instruments

 

We account for financial instruments that are being measured and reported on a fair value basis in accordance with FASB Accounting Standards Codification™ (“ASC”) 820, Fair Value Measurements and Disclosures. ASC 820 defines fair value, establishes a framework for measuring fair value and requires enhanced disclosures about fair value measurements. ASC 820 defines fair value as “the price that would be received to sell an asset and paid to transfer a liability in an ordinary transaction between current market participants at the measurement date.”  See Note 3 of the Notes to Consolidated Financial Statements for a more detailed discussion of fair value of financial instruments.

 

ASC 825, Financial Instruments, provides entities the option to measure certain financial assets and financial liabilities at fair value with changes in fair value recognized in earnings each period.  ASC 825 permits the fair value option election, on an instrument-by-instrument basis, either at initial recognition of an asset or liability or upon an event that gives rise to a new basis of accounting for that instrument.  Such election must be applied to the entire instrument and not only a portion of the instrument. We applied the fair value option for certain eligible instruments, including all private equity securities and limited partnership interests, as these financial instruments had been accounted for at fair value prior to the fair value option election in accordance with the AICPA Audit and Accounting Guide — Brokers And Dealers In Securities (ASC 940).

 

Financial instruments are valued at quoted market prices, if available. For financial instruments that do not have readily determinable fair values through quoted market prices, the determination of fair value is based upon consideration of available information, including types of financial instruments, current financial information, restrictions on dispositions, fair values of underlying financial instruments and quotations for similar instruments.

 

The valuation process for financial instruments may include the use of valuation models and other techniques. Adjustments to valuations derived from valuations models may be made when, in management’s judgment, either the size of the position in the financial instrument in a nonactive market or other features of the financial instrument such as its complexity, or the market in which the financial instrument is traded (such as counterparty, credit, concentration or liquidity) require that an adjustment be made to the value derived from the models. An adjustment may be made if a financial instrument is subject to sales restrictions that would result in a price less than the quoted market price. Adjustments from the price derived from a valuation model reflects management’s judgment that other participants in the market for the financial instrument being measured at fair value would also consider in valuing that same financial instrument and are adjusted fo