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

 

 

 

 

Form 10-K

 

 

001-32878

(Commission File Number)

 

 

 

 

PENSON WORLDWIDE, INC.

(Exact name of registrant as specified in its charter)

 

 

1700 Pacific Avenue, Suite 1400
Dallas, Texas 75201
(214) 765-1100
(Address, including zip code, and telephone number, including area code, of the registrant’s principal executive offices)

 

Securities registered pursuant to Section 12(b) of the Act

 

 

Securities registered pursuant to Section 12(g) of the Act
None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

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 (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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

 

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

 

(Do not check if a smaller reporting company)

 

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

 

The aggregate market value of the registrant’s common stock held by non-affiliates as of June 30, 2010 (the last business day of the registrants’ most recently completed second fiscal quarter) was $86,553,301.

 

The number of outstanding shares of the registrant’s Common Stock, $0.01 par value, as of March 1, 2011 was 28,492,249.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Certain portions of registrant’s Definitive Proxy Statement relating to its 2011 annual meeting of stockholders are incorporated by reference into Part III.

 

 

PENSON WORLDWIDE, INC.
Form 10-K
For the Fiscal Year Ended December 31, 2010

TABLE OF CONTENTS

 

 

“Penson” and the Penson logo are our trademarks. Other service marks, trademarks and trade names referred to in this annual report are the property of their respective owners.

 

In this Annual Report on Form 10-K, the term “Penson” refers to Penson Worldwide, Inc., a Delaware corporation and its subsidiaries on a consolidated basis. Unless otherwise indicated, all references in this report to the “Company,” “Penson,” “we,” “us” and “our” refer to Penson Worldwide, Inc. and our subsidiaries.

 

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

 

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

 

As of the date of this Annual Report, Penson has one class of common stock and one class of convertible preferred stock. The common stock is currently held by public shareholders and certain directors, officers and employees of the Company. None of the preferred stock is issued and outstanding. As used in this Annual Report, the term “common stock” means the common stock, and the term “preferred stock” means the convertible preferred stock, in each case unless otherwise specified.

 

This Annual Report and the information contained herein include forward-looking statements that involve both risk and uncertainty and that may not be based on current or historical fact. Although we believe our expectations to be accurate, forward-looking statements are subject to known and unknown risks and uncertainties that could cause actual results to differ materially from those expressed or implied by such statements. Factors that could cause or contribute to such differences include but are not limited to:

 

 

 

Forward-looking statements can be identified by the use of forward-looking words such as “believes,” “expects,” “hopes,” “may,” “will,” “plans,” “intends,” “estimates,” “could,” “should,” “would,” “continue,” “seeks,” “pro forma,” or “anticipates” or other similar words (including their use in the negative), or by discussions of future matters such as the development of new technology, integration of acquisitions, possible changes in our regulatory environment and other statements that are not historical. Additional important factors that may cause our actual results to differ from our projections are detailed later in this report under the section entitled “Risk Factors.” You should not place undue reliance on any forward-looking statements, which speak only as of the date hereof. Except as required by law, we undertake no obligation to publicly update or revise any forward-looking statement.

Glossary of selected terms

 

“Algorithmic traders” means firms or individuals that engage in “algorithmic trading,” defined below.

 

“Algorithmic trading” means the automatic generation of size and timing of orders based on preset parameters, occurs largely as a result of complex computational models and is often highly if not totally automated (i.e., trading does not necessarily require the intervention of a live trader but is generated by computers). Such trading is at times referred to as “black box” trading.

 

“ASP” refers to “Application Service Provider,” which means a licensor of software products that hosts such products on its own proprietary or leased hardware and offers customer service relating to such products to the licensee.

 

“Back-end trading software” means software programs that interface between the clearing firm, exchange or ECN, and the trader using front-end trading software.

 

“Clearing” means the verification of information between two counterparties (e.g. brokers) in a securities transaction and the subsequent settlement of that transaction, either as a book-entry transfer or through physical delivery of certificates, in exchange for payment. Clearing is the procedure by which an organization acts as an intermediary and assumes the role of buyer and seller for transactions in order to reconcile orders between transacting parties. Clearing enables the matching of buy and sell orders in a market and, typically, provides for more efficient markets as parties can make transfers to a clearing agent rather than to each individual party with whom they have transacted.

 

“Clearing firm” means the firm that provides clearing, custody, settlement and/or other services to correspondents and, at times, to customers. Clearing firms may or may not provide technology products and services such as front-end trading software and data.

 

“Client” means both correspondents and other customers who may not utilize our clearing, futures or securities products and services but which may, for example, use solely technology products and services.

 

“Correspondent” means entities (e.g., broker-dealers) that use our clearing firms’ respective regulated securities and/or futures record keeping, custody and/or settlement services as opposed to only using technology products and services. Our typical correspondent is a firm that introduces its customers to our clearing firms for clearing, custody and/or settlement services.

 

“Custody” means when a party has taken legal responsibility to hold another party’s assets such as physical securities. Custody services are the safe-keeping and managing of another party’s assets, as well as customer account maintenance and customized data processing services.

 

“Customers” means the customers of our Correspondents. Customers of our correspondents may be individuals or entities and may have an institutional or retail focus.

 

“Direct access” or “Direct market access” means when a front-end trading application permits the trader to select the market destination on which execution is desired and the order is transmitted completely electronically without human intervention.

 

“Electronic Communications Network” or “ECN” means an electronic system that matches buy and sell orders typically via computerized systems.

 

“Execution routing” means the sending of securities orders to exchanges and other market destinations such as market makers through the use of telecommunications infrastructure combined with proprietary or third party trading software.

 

“FCM” means futures commission merchant (which is similar to a broker-dealer but operates in the futures arena).

 

“Front-end trading software” means software programs used by traders to access trading information and execute trades, and that interface with back-end software systems that communicate with the clearing firm, exchange or ECN. Level II trading software (see definition below) is a form of front-end trading software.

“Level I market information” means the most basic information available about a stock consisting principally of the bid and ask price and last trade data.

 

“Level I trading software” means a front-end trading software system designed to provide access to Level I market information for use in online trading.

 

“Level II market information” means information from multiple exchanges and other markets for the same security type.

 

“Level II trading software” means a front-end trading software system designed to provide access to Level II market information for use in active online trading and which enables a trader to select a specific exchange or market across various markets.

 

“Online trading” means trading via electronic means (typically via the Internet). Direct access trading, for example, is often viewed as a subset or a type of online trading.

 

“Settlement” means the conclusion of a securities transaction in which a broker-dealer pays for securities bought for a customer or delivers securities sold and receives payment from the buyer’s broker-dealer.

 

 

Overview

 

We are a leading provider of a broad range of critical securities and futures processing infrastructure products and services to the global financial services industry. Our products and services include securities and futures clearing and execution, financing and cash management technology and other related offerings, and we provide tools and services to support trading in multiple markets, asset classes and currencies. Unlike most other major clearing providers, we are not affiliated with a large financial institution and we generally do not compete with our clients in other lines of business. We believe that our position as the leading independent provider in Canada, Australia and the United States is a significant differentiating factor relative to our competitors. We supply a flexible offering of infrastructure and related products and services to our clients, available both on an unbundled basis and as a fully-integrated platform encompassing all of our products and services. We believe our ability to integrate our technology offerings into our products and services is a key advantage in our effort to expand our sales and attract new clients.

 

Clearing is the verification of information between two parties in a securities or futures transaction and the subsequent settlement of that transaction, either as a book-entry transfer or through physical delivery of certificates, in exchange for payment. Custody services are the safe-keeping and managing of another party’s assets, such as physical securities, as well as customer account maintenance and customized data processing services. Clients for whom we provide securities clearing and custody services are generally referred to as our “correspondents.”

 

Since starting our business in 1995 with three correspondents, we have grown to be a leading provider of clearing services. Based on the number of correspondents as of December 31, 2010, we are the largest independent clearing broker in the U.S., and among the top two clearing brokers overall in the U.S., the largest independent clearing broker in Canada, the largest independent clearing broker in Australia and the second largest in the U.K. We have grown both organically and through acquisitions. As of December 31, 2010, we had 430 active correspondents worldwide, compared to 290 correspondents as of December 31, 2009. As of December 31, 2010, our pipeline of new correspondents under contract was 30, the majority of which we expect to begin clearing with us by June 30, 2011.

 

With operations based in the U.S., Canada, U.K., Asia and Australia, we have established a worldwide presence primarily focused on the global markets for equities, options, futures, fixed income and foreign exchange products. We believe that international markets offer an important target market as certain characteristics of the U.S. market, including significant increases in retail, self-directed and online trading, and increased trading volumes and executions, continue to expand globally. We are organized into operating segments based on geographic regions (See Note 22 to our consolidated financial statements).

 

Our non-interest revenues include: fees from our correspondents for transaction processing and clearing; fees for providing technology solutions; and fees for providing other non-trading activities and services, including execution services, trade aggregation, prime brokerage, foreign exchange and fixed income. Clearing and commission fees are based principally on the number of trades we process. We also earn licensing and development fees from clients for their use of our technology solutions.

 

Our interest revenues are generated from customer-related balances and from our stock borrowing transactions. Interest revenues from customers are generated from margin lending, securities lending and the reinvestment of customer funds. We also derive net interest revenue from our stock conduit borrowing activities, which consist of borrowing securities from one broker-dealer and lending the same securities to another broker-dealer on a matched book basis.

 

For the year ended December 31, 2010, we generated net revenues of $288.3 million. Clearing and commission fees, net interest income, technology revenues and other revenues comprised 53%, 24%, 7% and 16% of our net revenues, respectively. Approximately 40% of our securities correspondents generate both clearing and technology revenue. In addition, some of our customers generate revenue from both securities and futures trading, and trade in

multiple global markets. The following table represents the percentages of net revenues and total correspondents by correspondent type:

 

 

The Other category consists of broker-dealers trading on a proprietary basis, broker-dealers specializing in option trading, futures trading, hedge funds, algorithmic traders and financial technology firms. See also Part II, Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, for more information.

 

As an integral part of our securities clearing relationships, we maintain a significant margin lending business with our correspondents and their customers. Under these margin lending arrangements, we extend credit to our correspondents and their customers so that they may purchase securities on margin. As is typical in margin lending arrangements, we extend credit for a portion of the purchase price of the securities, which is collateralized by existing securities and cash in the accounts of our correspondents and their customers. We also earn interest income from both our securities and futures operations by investing customers’ cash and we engage in securities lending activities as a means of financing our business and generating additional interest income. Over the past year, our net interest revenues increased from $65.9 million in 2009 to $68.5 million in 2010, representing approximately 23% and 24% of our aggregate net revenues, respectively.

 

Clients

 

Currently, our principal clients are online, direct access, institutional and traditional retail brokers. We are increasingly adding large banks, institutional brokers, financial technology companies and securities exchanges as clients. Online broker-dealers principally enable investors to perform trades through the broker via the Internet through browser-based technology. Direct access broker-dealers principally provide investors with dedicated software which executes orders through direct exchange interfaces and provides real-time high speed Level II market information. Traditional retail brokers usually engage in agency trades for their customers, which may or may not be online. Institutional brokers and hedge funds typically engage in algorithmic trading or other proprietary trading strategies for their own account or, at times, agency trades for others. Our bank clients typically are non-U.S. entities making purchases for their brokerage operations. The type of financial technology client that would most likely use our products and services is a financial data content or trading software firm that purchases our data or combines its offerings with our trading software. Through our acquisitions of Goldenberg Hehmeyer and Co. (“GHCO”) and First Capitol Group LLC (“FCG”) in 2007,which both operate within Penson Futures, we added a number of futures related clients, including introducing brokers, non-clearing FCMs, commercial customers, customers who engage in hedging and risk management activities and other customers who trade futures and other instruments.

 

We have made significant investments in our U.S. and international data and execution infrastructure, as well as various types of multi-currency and multi-lingual trading software. We provide what we believe to be a flexible offering of infrastructure products and services to our clients, available both on an unbundled basis and as a fully-integrated solution. Our technology offerings are typically private-labeled to emphasize the client’s branding. We seek to put our clients’ interests first and we believe our position as the leading independent provider of U.S. securities clearing services is a significant differentiating factor. We believe we are well-positioned to take advantage of our significant investments in technology infrastructure to expand sales of our products and services to these and many other clients worldwide.

Industry trends

 

We believe that the market for securities and futures processing products and services is influenced by several significant industry trends creating continuing opportunities for us to expand our business, including:

 

Shift to outsourced solutions.  Broker-dealers and many FCMs are continuing to outsource their clearing functions. In addition, firms in the global securities and investment industry are expanding their use of third-party technology to manage their securities trading infrastructure.

 

Increase in trading in multiple markets.  Investors increasingly seek to trade in multiple markets, asset classes and currencies at once. The technological challenges associated with clearing, settlement, and custody in multiple geographies, currencies, and asset classes are prompting correspondents to seek the most comprehensive and sophisticated service providers. We have sought to capitalize on this trend by expanding our product offering into high growth areas such as the futures market, where we have significantly expanded since early 2007. Net revenues from our futures product offering comprised approximately 10% and 11% of total net revenues in 2010 and 2009.

 

Industry consolidation.  Although the significant effort and potential business disruption associated with conversion to a new clearing firm may discourage some correspondents from switching service providers, consolidation among clearing service providers has led to forced conversions. These conversions result in opportunities for correspondents to seek competing offers and, thus, for service providers to solicit new correspondents’ business without having to overcome the threshold issue of converting from an incumbent. We believe we have benefited from industry consolidation by attracting correspondents as a result of the acquisitions of major competitors by larger financial institutions and acquiring other firms.

 

Demand for increased reporting capabilities and integrated technology solutions.  Clients are increasingly demanding products that seamlessly integrate front, middle and back-office systems and allow for near real-time updating of account status and margin balances. Our ability to meet these demands makes us a preferred processing firm for correspondents in the growing algorithmic trading and hedge fund sectors.

 

Opportunities in the Canadian, European, Asian and Australian markets.  The securities and investments industries outside of the U.S., including those in Canada, Europe, Asia and Australia have followed many of the same trends as the U.S. market. Many industry participants are now requiring the same complex and sophisticated clearing and execution services that are common in the U.S. In addition, clearing firms in these markets are less likely to own trading applications, creating opportunities for the sale of Nexa’s products. We opened our first Asian office in Hong Kong in the first quarter of 2007 and an office in Tokyo during 2008 in order to expand our Asian operations. Our Asian operations are currently focused on marketing our technology products. We launched our Australian office in the second quarter of 2009, and began clearing operations there in December, 2009. We recently acquired execution contracts for 34 Australian correspondents and we currently have 48 Australian correspondents. We expect significant growth opportunities in Australian markets in 2011.

 

Our product offering

 

Clearing and related services

 

As a securities and futures processing infrastructure provider, Penson’s services include securities and futures clearing and settlement, execution, custody, account maintenance, data processing services, and technology services. Clearing is the verification of information and matching between two parties in a securities or futures transaction which is followed by the subsequent settlement of that transaction in exchange for payment or margin deposit. Custody services are the safe-keeping and managing of another party’s assets, such as securities, as well as customer account maintenance and customized data processing services. Clients for whom we provide securities clearing and custody services are generally referred to as our “correspondents” or “introducing brokers.” We also provide commodity risk management and other services to certain of our futures customers.

 

We have made substantial investments in the development of customized data processing systems that we use to provide these “back-office” services to our correspondents on an integrated, efficient and cost-effective basis,

allowing us to process a high volume of transactions without sacrificing stability and reliability. In 2010, we processed an average of 1.3 million equity transactions, 1.4 million equity options contracts and 492,000 futures contracts per day. Our products and services reduce the need for our correspondents to make significant capital investments in a clearing infrastructure and allow them to focus on their core business competencies. These systems also enable our correspondents to provide customized, timely transaction and account information to their customers, and to monitor the risk level of their customers on a real-time basis. We have found that our comprehensive suite of advanced technology solutions is often an important factor in winning new correspondents.

 

As an integral part of our securities clearing relationships, we maintain a significant margin lending business with most of our correspondents and their customers. Under these margin lending arrangements, we extend credit to our correspondents and their customers so that they may purchase securities on margin. As is typical in margin lending arrangements, we extend credit for a portion of the purchase price of the securities, which is collateralized by existing securities and cash in the accounts of our correspondents and their customers. We also earn interest income from both our securities and futures operations by investing customers’ cash and we engage in securities lending activities as a means of financing our business and generating additional interest income.

 

Technology and data products

 

An important component of our business strategy is to identify and deploy technologies relevant to our target markets. Our technology and data product offerings, which are principally developed and marketed through our Nexa subsidiary, include customizable front-end trading platforms, a comprehensive database of real-time and historical U.S. and international equities, options and futures trade data, and order-management services. This technology embedded in our securities and futures processing infrastructure has enhanced our capacity to handle an increasing volume of transactions without a corresponding increase in personnel. We use our proprietary technology and technology licensed from third parties to provide customized, detailed account information to our clients. Our technology is critical to our vision of providing a flexible and comprehensive offering of products and services to our clients. Our technology revenues generally include revenues from software development and customization of products and features, but our technology products are designed to generate substantial subscription-based revenues. The majority of our technology revenues is recurring in nature and is generated by correspondents under contracts that generally have initial terms of two years.

 

Our competitive strengths

 

Established market position as the largest independent provider of correspondent clearing services in our primary markets.

 

We have grown organically and through acquisitions to become the leading global independent provider of securities clearing services in our primary markets with 430 active correspondents in the U.S., Canadian, Asian, Australian and U.K. markets, which includes 59 futures correspondents as of December 31, 2010. As of December 31, 2010 (based on the number of correspondents), we were the largest independent clearing broker-dealer in the U.S., Canada and Australia, as well as the second largest clearing broker in the U.K. Furthermore, as of December 31, 2010 (based on the number of correspondents), we are also the second largest clearing broker in the U.S. overall. Unlike most other major clearing service providers, we are not affiliated with a large financial institution and we generally do not compete with our clients in other lines of business. We believe our position as the leading independent provider of securities clearing services in our primary markets is a significant differentiating factor.

 

Fully-integrated securities-processing and technology solutions.

 

We are a leading provider of infrastructure to financial intermediaries, offering integrated solutions with the ability to address all major securities-processing needs. Through the integration of our own technology across all of our products and services, we have been able to expand our client base and increase our revenue from existing clients. Our products and services facilitate trading in multiple markets, asset classes and currencies, with integrated execution, clearing and settlement solutions. It is our belief that, while some clients are willing to obtain these

products from multiple vendors, many will determine that it is easier to obtain solutions with lower integration costs and risks from one provider that can also address the regulatory requirements of their business.

 

Flexible services and infrastructure.

 

We provide a broad offering of infrastructure, technology and data products and services to our clients, available both on an unbundled basis and as a fully-integrated solution. We work closely with each of our clients to tailor the set of products and services appropriate for their individual needs.

 

Highly attractive and diversified client base.

 

Our client base comprises the following categories:  online, direct market access, institutional, retail and algorithmic, options, futures, foreign exchange and other. For the year ended December 31, 2010, no single category of correspondent represented more than 17% of total net revenues. In addition, no single correspondent represented more than 6.8% of net revenue, with our top ten correspondents constituting 26.1% of our net revenues. As previously announced, we will be losing a significant amount of the revenues generated from our largest correspondent during 2011; however, we believe we will be able to replace a substantial portion of that revenue from new correspondents we have signed. Additionally, we have diversified our client base internationally through our operations in Canada, the U.K., Australia and Asia, and by asset class through expanding our operations into the futures business and foreign exchange businesses, among others.

 

Scalable, recurring revenue model.

 

Our business benefits from a highly scalable platform that is capable of processing significant additional volume with limited incremental increases in our expenses. We receive a recurring stream of revenues based on the trading volumes of each of our correspondents with a low marginal cost to process transactions. We typically maintain two- to three-year exclusive contracts with our correspondents. Furthermore, there are typically high switching costs as the transition from one provider of clearing services to another is disruptive to a correspondent’s business. In addition, a significant portion of our technology revenues are based on ASP arrangements with clients, linked to transactions and users. Thus, we become even more indispensable to our clients by not only licensing them our software but by also providing them with hardware to run our products along with related support services.

 

Proven and highly motivated management team.

 

With an average of 31 years of industry experience and holding a substantial equity interest in Penson, our Executive Committee has the proven ability to manage our business through all stages of the business cycle. Roger J. Engemoen, Jr., and Philip A. Pendergraft, our Chairman and Chief Executive Officer, respectively, founded our business in 1995 and have built it to its current position. Daniel P. Son, co-founder of our company, resigned his position as President of the Company effective September 1, 2010, but continues to serve the Company as a non-executive vice chairman of the Board, and is expected to provide consulting services in 2011 pursuant to a contract entered into between PWI and Holland Consulting, LLC, a company controlled by Mr. Son.

 

Business strategies

 

Leverage existing platform to expand our product offerings and client base.

 

We believe our infrastructure provides a leading fully-integrated securities clearing and technology product package to our core market, and additional products can be offered and new clients can be added with minimal marginal cost. Using this infrastructure, we intend to expand our client base by:

 

 

 

Expanding our operations internationally.

 

We believe our ability to service clients internationally will become more important as investors increasingly trade on a global basis. In addition, we intend to expand our margin lending business internationally. Our presence in the non-U.S. markets gives us several opportunities to pursue additional revenues across our product and service offerings. It allows us to better serve our correspondents who are U.S.-based by helping facilitate their growth and providing them with greater access to international markets. It also gives us greater access to the potential customer base in those local markets. We opened our first Asian office in Hong Kong in the first quarter of 2007 and an office in Tokyo in 2008. We expanded our offering of technology products in Asian markets in 2009 and 2010 and intend to continue expansion into the Asian markets in 2011. We launched PFSA in the second quarter of 2009, and began clearing operations there in December 2009. We expect significant growth opportunities in the Australian markets in 2011.

 

Enhance revenue potential of each client relationship.

 

Our growth model includes selling additional products to our existing clients. Many of our correspondents currently only utilize our securities clearing services, but we maintain a broad product suite across geographies that provides us with a significant opportunity to cross-sell our execution, futures, foreign exchange and technology services to our current base of correspondents.

 

Capitalize on industry trends.

 

We are positioned to benefit from several broad industry trends, including internationalization of trading activity, consolidation among service providers, and increased demand for trading infrastructure that supports multiple products on the same computer terminal, including equities, options, futures and foreign exchange as well as increased outsourcing of securities-processing.

Pursue accretive acquisitions.

 

Through our past acquisitions, we have grown internationally, expanded our product base and added correspondents. As of December 31, 2010, we had successfully integrated our acquisition of the clearing contracts of Ridge Clearing & Outsourcing Solutions, Inc. (“Ridge”), our most significant acquisition to date. While we will continue to invest in developing and enhancing our existing business solutions, we also may pursue accretive acquisitions that will expand our technology product offerings, our clearing service capability and our client base.

 

Securities processing

 

Our securities and futures processing infrastructure products and services are principally marketed under the “Penson” brand name. Penson Worldwide, Inc. is the ultimate parent company for the businesses that provide these products and services in each geographic market we serve.

 

Clearing and related operations

 

United States

 

We generally provide securities clearing services to our correspondents in the U.S. on a fully-disclosed basis. In a fully-disclosed clearing transaction, the identity of the correspondent’s customer is known to us, and we are known to them, and we maintain the customer’s account and perform a variety of services as agent for the correspondent.

 

Our U.S. securities clearing broker is PFSI, which is registered with the SEC and is a member of the following: New York Stock Exchange, NYSE Alternext, Chicago Board Options Exchange, Chicago Stock Exchange, International Securities Exchange, NASDAQ, NYSE ARCA Equities Exchange, NYSE ARCA Options Exchange, Philadelphia Stock Exchange, OneChicago, DTC, Euroclear, ICMA, MSRB, FINRA, NSCC, Options Clearing Corp., and Securities Investor Protection Corporation (“SIPC”) and is a participant in the Boston Options Exchange (“BOX”).

 

With respect to futures transactions, Penson Futures provides our clearing and execution services for futures and FCG, which now operates as a division of Penson Futures, provides risk management and consultation services for some of our futures clients. Penson Futures is regulated by the CFTC, the NFA and the FSA and is a member of the Chicago Board of Trade, the Chicago Mercantile Exchange, the Kansas City Board of Trade, London International Financial Futures Exchange, the Minneapolis Grain Exchange, the Clearing Corporation, and the London Clearinghouse.

 

Canada

 

PFSC provides clearing services in accordance with the rules and regulations of Canada’s provincial and territorial securities regulators and IIROC. Canada has four types of approved clearing models and our Canadian operation is approved to act as a carrying broker for all of these. We concentrate primarily on providing services to Type 2 and Type 3 correspondent brokers. As a Type 2 or 3 carrying broker, our key responsibilities may include the trading of securities for customers’ accounts and for the correspondent’s principal business, making deliveries and settlements of cash and securities in connection with such trades, holding securities and/or cash of customers and of the correspondent and preparing and delivering directly to customers documents as required by applicable law and regulatory requirements with respect to the trades cleared by us, including confirmation of trades, monthly statements summarizing transactions for the preceding month and, for inactive accounts, quarterly statements of securities and money balances held by us for customers.

 

PFSC is our Canadian clearing broker and provides fully-disclosed and omnibus clearing services to the Canadian markets. In an omnibus relationship, the identity of the end customer is not always known to us. PFSC is a member participating organization or subscriber of the Toronto Stock Exchange, the Montreal Exchange, the TSX Venture Exchange and various other Canadian marketplaces including alternative trading systems. PFSC is a member of the Canadian Investor Protection Fund and is regulated by the IIROC and the securities regulatory authorities of each province and territory in Canada.

United Kingdom

 

In the U.K. we offer a broad range of securities clearing services through PFSL, our U.K. clearing broker, including: Model A and Model B clearing and settlement, Euroclear, global custody, customized data processing, regulatory reporting, execution, and portfolio management and modeling systems. In Model A clearing, we provide a purely administrative back-office service and act as agent for our correspondents’ customers, and supply these customers with the information needed to settle their transactions. Model B clearing provides the authority to process transactions under a fully-disclosed clearing model similar to the U.S. Under Model B clearing, we assume the positions and therefore full liability for the clearing and settlement of the trades. All of our correspondents in the U.K. are categorized as Professional Clients under FSA Rules. PFSL is a member of the London Stock Exchange and is authorized and regulated by the FSA.

 

Asia

 

We opened Penson Asia, our first Asian office, in Hong Kong in the first quarter of 2007 and an office in Tokyo in 2008. We entered into a number of technology services agreements with correspondents primarily related to North American and U.K. securities through our Penson Asia office in 2010, and expect to further expand our Asian business in 2011.

 

Australia

 

We launched PFSA, our clearing broker in Australia in the second quarter of 2009, and began clearing operations there in December, 2009. PFSA provides clearing and settlement services to, among others, broker dealers, Australian Securities Exchange members and Australian Financial Service License holders. Clearing arrangements are made on a fully disclosed basis, are generally three to five years in term and are typically exclusive. PFSA holds an Australian Financial Services License and is a market participant of the ASX and a clearing participant of the Australian Clearing House.

 

Internet account portfolio information services

 

We have created customized software solutions to enable our correspondents and their customers to review their account portfolio information through the Internet. Through the use of our internally developed technology, combined with technology licensed from third parties, we are able to update the account portfolios of our correspondents’ customers as securities transactions are executed and cleared. A customer is able to access detailed and personalized information about his account, including current buying power, trading history and account balances. Further, our solution allows a customer to download brokerage account information into Quicken, a personal financial management software program, and other financial and spreadsheet applications so that all financial data can be integrated.

 

Holding and safeguarding securities and cash deposits

 

We hold and safeguard securities and cash deposits of our correspondents’ customers, which require us to take legal responsibility for those assets. Many of our correspondents do not have the ability to hold securities and cash deposits due to regulatory requirements that require that the holder must comply with the net capital rules of the SEC and other regulators with respect to these activities.

 

Securities borrowing and lending

 

We lend securities that we hold for our correspondents and their customers to other broker-dealers as a means of financing our business and facilitating transactions. We also engage in conduit activities where we borrow securities from one broker-dealer and lend the same securities to another broker-dealer. This lending is permitted under and governed by SEC rules. See “Government regulation” and “Regulation of securities lending and borrowing.” All of our securities borrowing and lending activities are performed under a standard form of securities lending agreement, which governs each party’s rights to mark securities to market.

Proprietary trading

 

Certain of our subsidiaries engage in limited forms of proprietary trading. This trading includes computerized trading and non-automated trading strategies involving short-term proprietary positions in exchange traded equities and options, derivatives, foreign currencies, fixed income and other securities, In general, these strategies involve relatively short-term market exposure and are typically undertaken in conjunction with hedging strategies and the use of derivative contracts designed to mitigate the risk associated with these proprietary positions. These activities in the aggregate are insignificant to revenues and pretax income (loss).

 

Futures products

 

In addition to the futures clearing services provided by Penson Futures, the FCG division of Penson Futures provides retail, risk management and consultation services for certain of our futures clients.

 

Technology and data products

 

An important component of our business strategy is to identify and to deploy technologies relevant to our target markets. The technology embedded in our securities and futures processing infrastructure has enhanced our capacity to handle an increasing volume of transactions without a corresponding increase in personnel. We use our proprietary technology and technology licensed from third parties to provide customized, detailed account information to our clients. To increase our processing capacity, we moved our U.S. securities clearing operations to a dedicated processing platform provided by SunGard in the first quarter of 2009. We intend to move our Canadian and U.S. operations to Broadridge’s systems during 2011 and our UK operations during 2012. Our technology is critical to our vision of providing a flexible and comprehensive offering of products and services to our clients.

 

Our technology and data product offerings include customizable front-end trading platforms, a comprehensive database of historic U.S. and international equities, options and futures trade data, and order-management services. Our approach to the development and acquisition of technology has allowed us to create an evolving suite of products that provides specific solutions to meet our clients’ individual requirements. We also provide risk management and consultation services to our futures customers through the FCG division of our Penson Futures subsidiary.

 

Nexa provides our clients with innovative trading management technology with a global perspective. Nexa specializes in direct access trading technology and provides complete online brokerage solutions, including direct access trading applications, browser-based trading interfaces, back-office order management systems, market data feeds, historical data, and execution technology services, generally on a license-fee basis. Nexa’s FastPath product provides a full suite of Financial Information Exchange (“FIX”) gateway solutions for clients who require global connectivity, high throughput and reliability. FIX execution solutions allow clients to automatically transmit, receive or cancel advanced-order types, execution reports, order status, positions, liquidity flags and account balances. Clients can connect using their own front-end or back-office applications or utilize applications available from Nexa. We generally provide our solutions to our clients on a private-labeled basis to emphasize the client’s branding.

 

Nexa’s products, such as Omni Pro, Axis Pro, and Meridian, are designed to accommodate various market segments by providing different trading platforms and functionality to users. Most of our front-end products benefit from several important features such as the ability to trade equities, options and futures and to have unified risk management for trading across multiple asset classes.

 

Although there is a significant market for front-end trading platforms that is independent of the market for clearing services, we have found that our ability to integrate our technology-related products with our clearing services provides clients with another compelling reason to use Penson for their clearing needs. We believe this broader, integrated offering is a significant factor in our conversion of client prospects into actual clients.

 

Our technology revenues generally include revenues from software development, customization of products and features and licensing fees, but our technology products are designed to generate subscription-based revenue

over time. Our technology revenues decreased over the last year from $23.8 million in 2009 to $20.4 million in 2010.

 

Institutional and active retail front-end trading software

 

Nexa has developed and is continuing to expand various front-end trading software products. We offer several products that are oriented towards different market segments. Omni Pro is a Level II trading platform oriented to professional traders and provides broker-dealer administrative modules. Level II software enables the trader, among other things, to view prices for the same security across various markets and to select the desired market for order execution. Axis Pro is a multi-currency Level II trading platform focused on active retail traders. Meridian is a Level I trading platform for less intensive applications for the active retail trader. Both Axis Pro and Meridian are offered with broker-dealer administrative modules that allow broker-dealers to monitor customer buying power and other regulatory compliance tasks, and to provide a repository for customer information.

 

All of our front-end products benefit from a number of compelling features such as the ability to trade equities, options and futures and have unified risk management for trading across these products. Many of our clearing competitors do not have similar systems that effect trades in all such instruments with similar risk mitigation capabilities. There is a dynamic market for front-end trading platforms that is independent of the market for our clearing services. However, we have found that our ability to offer these products provides our clients with another compelling reason to use our clearing and other products and services and is at times important in our conversion of client prospects into actual clients.

 

Global execution infrastructure

 

Nexa has built significant proprietary software and licensed certain software and telecommunications services to enable our clients to use our technology infrastructure to send orders for securities to all major North American exchanges, ECNs and market destinations. Our clients can choose to use our execution infrastructure, independent of our other services, or to opt for a bundled solution combining technology products together with clearing and settlement. This allows us to access a differentiated market segment for clients that clear with another firm or are self-clearing, but which do not have a similar infrastructure capability. In particular, because our network has been designed to maximize speed of execution, our offerings are very attractive to algorithmic traders for whom speed is essential to successful implementation of their trading strategies. Our infrastructure required significant time and investment to build and very few of our clearing competitors offer anything that is directly comparable.

 

Global data products

 

We believe it is critical to provide our clients with global trade data solutions. Nexa provides research-quality, historical intraday time series data plus real-time data feeds for the commodity and equity markets. Our suite of data products was significantly enhanced by our acquisition of the Tick Data assets in January 2005. Its database of historical intraday equities, options and futures data from exchanges in North America, Europe and Asia is presented tick-by-tick and is delivered in a compressed, proprietary format. The database of historical cash index data contains the most widely followed equity indices. Nexa also offers TickStream, a fully customized, low latency, real-time market data feed. Data is delivered through a simple-to-use application program interface (“API”) and powered by advanced ticker plants that have multiple direct connections to global exchanges. While these products do not currently generate material revenues, we provide data to over 3,000 clients, which we believe provides significant opportunities for cross-selling our other products and services.

 

Nexa has also built its own data ticker plant to access data from most U.S. and many foreign exchanges and market centers. We have also licensed certain foreign data from other sources. The result is a very comprehensive offering of real-time, delayed and historical data that we can market to our clients. As with the international execution hub, our clients can use our data solutions together with, or independent of, our other products and services. This enables us to compete with major securities data providers to offer comprehensive data solutions. Furthermore, historical data offerings are not offered by most data services providers or clearing firm competitors and enable us to serve new client segments such as algorithmic traders and hedge funds to which we have had relatively less historical exposure through our clearing operations.

Key licensed technology and proprietary customization

 

We license a software program called Phase3 from SunGard. Phase3 is an online, real-time data processing system for securities transactions. Phase3 performs the core settlement functions with industry clearing and depository organizations. To increase our processing capacity, we moved our U.S. securities clearing operations to a dedicated processing platform provided by SunGard in the first quarter of 2009. We have built a significant amount of proprietary software around Phase3 which allows us to customize Phase3 to meet each of our client’s unique needs. This customization increases the reliability and efficiency of our data processing model and permits us to process trades more quickly than if we relied on Phase3 alone. This customization also offers our clients more flexible access to information regarding their accounts, including the ability to:

 

 

The above-noted products are principally used by our U.S. securities clearing subsidiary but, in many cases, enable our non-U.S. customers, both through our non-U.S. affiliates and directly, to access leading-edge products and services when trading in the U.S. markets. We offer third party software that we have licensed that we believe offers an increased variety of settlement and clearing applications, to certain of our Canadian correspondents who trade futures products. We currently process the trading activity of the correspondents we acquired from Ridge principally using Broadridge’s systems, and we intend to transition the remainder of our U.S. operations to Broadridge’s systems during 2011. We completed the conversion of our Canadian operations to Broadridge’s systems in February, 2011. We anticipate this transition will expand our product offering to include, among other things, the outsourcing of certain of our correspondents’ operations. We intend to transition our U.K. operations to Broadridge’s systems in 2012. See “Business — Strategic Acquisitions” for a description of the proposed Broadridge transaction.

 

Sales and marketing

 

We focus our sales and marketing efforts in the U.S. primarily on the direct access and online sectors, but also focus on the algorithmic trading and hedge fund sectors of the global securities and investment industry. We are aggressively marketing execution-only services to the global financial services market domestically and through our foreign subsidiaries. We have capitalized on this opportunity by implementing cross-border and multi-currency trade processing capabilities.

 

We participate in industry conferences and trade shows and seek to differentiate our company from our competitors based on our reputation as an independent provider of a technology-focused integrated execution, clearing and settlement solution and based on our ability to support trading in multiple markets, multiple investment products and multiple currencies.

 

We generally enter into standard clearing agreements with our securities correspondents for an initial term of two years, though many of our contracts are for much longer terms. During the contract period, we provide clearing services based on a schedule of fees determined by the nature of the financial instrument traded and the volume of the securities cleared. In some cases our standard contract will also include minimum monthly clearing charge requirements. Subsequent to the initial term, these contracts typically allow the correspondent to cancel our services upon providing us with 45 days written notice. Futures clearing contracts between us and our correspondents are generally terminable on 30 days notice. Futures clearing contracts directly between us and our customers are generally terminable at will.

 

As of December 31, 2010, we had 430 active correspondents worldwide, consisting of 371 active securities clearing correspondents and 59 active futures clearing correspondents. Of the 371 active securities clearing correspondents, 278 are located in the U.S., while our U.K., Canadian and Australian clearing operations provide services to 16, 29 and 48 correspondents, respectively. Before conducting business with a correspondent, we review a variety of factors relating to the prospective correspondent, including the correspondent’s experience in the

securities industry, its financial condition and the personal backgrounds of the key principals of the firm. We seek to establish relationships with correspondents whose management teams and operations we believe will be successful in the long-term, so that we may benefit from increased clearing volume and margin lending activity as the businesses of our correspondents grow.

 

Strategic acquisitions

 

We have engaged in a number of acquisitions that have facilitated our ability to expand our client base and provide leading-edge technology infrastructure as well as to open international markets, positioning us to pursue a strategy of combining our increasingly global securities offerings with enhanced technology offerings on a multi-instrument, multi-currency, international platform. To date, none of our acquisitions have exceeded the defined significant subsidiary thresholds pursuant to Section 1-02(w) of SEC Regulation S-X.

 

On November 2, 2009, the Company entered into an asset purchase agreement (“Ridge APA”) to acquire the clearing and execution business of Ridge Clearing & Outsourcing Solutions, Inc. (“Ridge”) from Ridge and Broadridge Financial Solutions, Inc. (“Broadridge”), Ridge’s parent company. The acquisition closed on June 25, 2010, and under the terms of the Ridge APA, as later amended, the Company paid $35.2 million. The acquisition date fair value of consideration transferred was $31.9 million, consisting of 2.5 million shares of PWI common stock with a fair value of $14.6 million (based on our closing share price of $5.95 on that date) and a $20.6 million five-year subordinated note (the “Ridge Seller Note”) with an estimated fair value of $17.3 million on that date (see Note 14 to our consolidated financial statements for a description of the Ridge Seller Note discount), payable by the Company bearing interest at an annual rate equal to 90-day LIBOR plus 5.5%.

 

The Company recorded a liability of $4.1 million attributable to the estimated fair value of contingent consideration to be paid 14 months and 19 months after closing (subject to extension in the event the dispute resolution procedures set forth in the Ridge APA are invoked). The amount of contingent consideration ultimately payable will be added to the Ridge Seller Note. The contingent consideration is primarily composed of two categories. The first category includes a group of correspondents that had not generated at least six months of revenue as of May 31, 2010 (“Stub Period Correspondents”). Twelve months after closing a calculation will be performed to adjust the estimated annualized revenues as of May 31, 2010 to the actual annualized revenues based on a six-month review period as defined in the Ridge APA (“Stub Period Revenues”). The Ridge Seller Note will be adjusted 14 months after closing based on .9 times the difference between the estimated and actual annualized revenues. As of December 31, 2010 all of the correspondents in this category had generated at least six months of revenues. The Company reduced its contingent consideration liability by $.3 million, which is included in other expenses in the consolidated statements of operations for the year ended December 31, 2010. The second category includes a group of correspondents that had not yet begun generating revenues (“Non-revenue Correspondents”) as of May 31, 2010. A calculation will be performed 15 months after closing to determine the annualized revenues, based on a six-month review period, for each such non revenue correspondent (“Non-revenue Correspondent Revenues”). The Ridge Seller Note will be adjusted 19 months after closing by an amount equal to .9 times the Non-revenue Correspondent Revenues. The estimated undiscounted range of outcomes for this category is $4.0 million to $5.0 million. There is no limit to the consideration to be paid.

 

The Company recorded goodwill of $15.9 million, intangibles of $20.1 million and a discount on the Ridge Seller Note of $3.3 million. The qualitative factors that make up the recorded goodwill include value associated with an assembled workforce, value attributable to enhanced revenues related to various products and services offered by the Company and synergies associated with cost reductions from the elimination of certain fixed costs as well as economies of scale resulting from the additional correspondents. The goodwill is included in the United States segment. A portion of the recorded goodwill associated with the contingent consideration may not be deductible for tax purposes if future payments are less than the $4.1 million initially recorded. The tax goodwill will be deductible for tax purposes over a period of 15 years. The Company has incurred acquisition related costs of approximately $5.3 million with $3.7 million and $1.6 million, respectively recognized in the years ended December 31, 2010 and 2009. Net revenues of $26.4 million and net income of approximately $1.5 million from Ridge were included in the consolidated statement of operations as of the date of the acquisition for the year ended December 31, 2010. The Company estimates that net revenues would have been $312.9 million for the year ended December 31, 2010, respectively compared to $337.2 million and $345.8 million, respectively for the years ended December 31, 2009

and 2008, and net income (loss) would have been $(19.0) million for the year ended December 31, 2010 compared to $17.3 million and $12.8 million, respectively for the years ended December 31, 2009 and 2008 had the acquisition occurred as of January 1, 2008.

 

In November 2007, our subsidiary Penson Futures acquired all of the assets of FCG, an FCM and a leading provider of technology products and services to futures traders, and assigned the purchased membership interest to GHP1 effective immediately thereafter. We closed the transaction in November, 2007 and paid approximately $9.4 million in cash and approximately 150,000 shares of common stock valued at approximately $2.2 million to the previous owners of FCG. In addition, the Company agreed to pay an annual earnout in cash for the following three-year period based on average net income, subject to certain adjustments including cost of capital, for the acquired business. The Company paid approximately $8.7 million related to the first year of the earnout period. The Company did not make an earnout payment related to the second or third year of the earnout period. The Company finalized the acquisition valuation during the third quarter of 2008 and recorded goodwill of approximately $4.0 million and intangibles of approximately $7.6 million. FCG currently conducts business as a division of Penson Futures.

 

In November 2006, the Company entered into a definitive agreement to acquire the partnership interests of Chicago-based GHCO, a leading international futures clearing and execution firm. The Company closed the transaction on February 16, 2007 and paid approximately $27.9 million, including cash and approximately 139,000 shares of common stock valued at approximately $3.9 million to the previous owners of GHCO. Goodwill of approximately $2.8 million and intangibles of approximately $1.0 million were recorded in connection with the acquisition. In addition, the Company agreed to pay additional consideration in the form of an earnout over the next three years, in an amount equal to 25% of Penson Futures’ pre-tax earnings, as defined in the purchase agreement executed with the previous owners of GHCO. The Company did not make an earnout payment related to the first or second years of the integrated Penson Futures business. The Company paid approximately $1.1 million related to the third year of the earnout in July 2010.

 

In November 2006, the Company acquired the clearing business of Schonfeld Securities LLC (“Schonfeld”), a New York-based securities firm. The Company closed the transaction in November 2006 and in January 2007, the Company issued approximately 1.1 million shares of common stock valued at approximately $28.3 million to the previous owners of Schonfeld as partial consideration for the assets acquired of which approximately $14.8 million was recorded as goodwill and approximately $13.5 million as intangibles. In addition, the Company agreed to pay an annual earnout of stock and cash over a four-year period that commenced on June 1, 2007, based on net income, as defined in the asset purchase agreement (“Schonfeld Asset Purchase Agreement”), for the acquired business. On April 22, 2010, SAI and PFSI entered into a letter agreement (the “Letter Agreement”) with Schonfeld Group Holdings LLC (“SGH”), Schonfeld, and Opus Trading Fund LLC (“Opus”) that amends and clarifies certain terms of the Schonfeld Asset Purchase Agreement. The Letter Agreement, among other things, for purpose of determining the total payment due to Schonfeld under the earnout provision of the Schonfeld Asset Purchase Agreement: (i) removes the payment cap; (ii) clarifies that PFSI has no obligation to compress tickets across subaccounts (unless PFSI does so for other of its correspondents at a later date); and (iii) reduces the SunGard synergy credit from $2.9 million to $1.5 million in 2010 and $1.0 million in 2011. The Letter Agreement also assigns all of Schonfeld’s responsibilities under the Schonfeld Asset Purchase Agreement to its parent company, SGH, and extends the initial term of Opus’s portfolio margining agreement with PFSI from April 30, 2017 to April 30, 2019.

 

A payment of approximately $26.6 million was paid in connection with the first year earnout that ended May 31, 2008 and approximately $25.5 million was paid in connection with the second year of the earnout that ended May 31, 2009. At December 31, 2010, a liability of approximately $20.5 million was accrued as result of the third year of the earnout ended May 31, 2010 ($15.2 million) and the first seven months of the year four earnout, which we do not expect to pay prior to the second half of 2011 ($5.3 million). This balance is included in other liabilities in the consolidated statement of financial condition. The offset of this liability, goodwill, is included in other assets. In January, 2011, the Company and SGH entered into a letter agreement setting the amount due for the third year earnout at $6.0 million due to the provisions in various agreements related to the Schonfeld transaction, including the termination/compensation agreement, which reduced the amount that we are required to pay under the Schonfeld Asset Purchase Agreement. This will result in a reduction in goodwill and other liabilities of $9.2 million in the first quarter of 2011. The letter agreement also stipulated that the third year earnout will be paid evenly over a 12 month period commencing on September 1, 2011.

Competition

 

The market for securities clearing and margin lending services is highly competitive. We expect competition to continue and intensify in the future. We encounter direct competition from firms that offer services to direct access and online brokers. Some of these competitors include Goldman Sachs Execution & Clearing, L.P.; Pershing LLC, a member of BNY Securities Group; National Financial Services LLC, a Fidelity Investments company; Merrill Lynch & Co., Inc., a subsidiary of Bank of America; MF Global Ltd. (formerly Man Financial) and RJ O’Brien & Associates LLC. We also encounter competition from other clearing firms that provide clearing and execution services to the securities industry. Most of our competitors are affiliated with large financial institutions.

 

We believe that the principal competitive factors affecting the market for our clearing and margin lending services are breadth of services, technology, financial strength, client service and price. Based on management’s experience, we believe that we presently compete effectively with respect to most of these factors.

 

Some of our competitors have significantly greater financial, technical, marketing and other resources than we have. Some of our competitors offer a wider range of services and products than we offer and have greater name recognition and more extensive client bases. These competitors may be able to respond more quickly to new or evolving opportunities, technologies and client requirements than we can and may be able to undertake more extensive promotional activities and offer more attractive terms to clients. Recent advancements in computing and communications technology are substantially changing the means by which securities transactions are effected and processed, including more access online to a wide variety of services and information, and have created a demand for more sophisticated levels of client service. The provision of these services may entail considerable cost without an offsetting increase in revenues. Moreover, current and potential competitors have established or may establish cooperative relationships among themselves or with third parties or may consolidate to enhance their services and products. New competitors or alliances among competitors may emerge and they may acquire significant market share. Additionally, large firms that currently perform their own clearing functions may decide to start marketing their clearing services to other firms.

 

In addition to companies that provide clearing services to our target markets, we are subject to the risk that one or more of our correspondents may elect to perform their clearing functions themselves. The option to convert to self-clearing operations may be attractive due to the fact that as the transaction volume of the correspondent increases, the cost of implementing the necessary infrastructure for self-clearing may eventually be offset by the elimination of per-transaction processing fees that would otherwise be paid to a clearing firm. Additionally, performing their own clearing services allows self-clearing firms to retain customer free credit balances and securities for use in margin lending activities. In order to make a clearing arrangement with us more attractive to these high-volume broker-dealers, we may offer such firms transaction volume discounts or other incentives.

 

We are also subject to the risk that one or more of our correspondents may be acquired by a firm which is already self clearing, or clears through another broker-dealer. Our largest correspondent, thinkorswim, was acquired by TD Ameritrade in 2009. We anticipate that approximately two-thirds of the business we currently clear for thinkorswim will be converted to TD Ameritrade in 2011.

 

Intellectual property and other proprietary rights

 

Despite the precautions we take to protect our intellectual property rights, it is possible that third parties may copy or otherwise obtain and use our proprietary technology without authorization or otherwise infringe upon our proprietary rights. It is also possible that third parties may independently develop technologies similar to ours. It may be difficult for us to police unauthorized use of our intellectual property. In addition, litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets, to determine the validity and scope of the proprietary rights of others, or to defend against claims of infringement or invalidity.

 

We have incurred litigation expenses related to the protection of our intellectual property in the past, and are continuing to do so with respect to the Realtime Data proceedings (See Legal Proceedings for a description of these proceedings). Intellectual property claims, with or without merit, are time consuming to defend, often result in costly litigation, can divert management’s attention and resources and may require us to enter into royalty or licensing agreements.

Government regulation

 

The securities and financial services industries generally are subject to extensive regulation in the U.S. and elsewhere. As a matter of public policy, regulatory bodies in the U.S. and the rest of the world are charged with, among other things, safeguarding the integrity of the securities and other financial markets and with protecting the interests of customers participating in those markets, not with protecting the interests of creditors or the shareholders of regulated entities (such as Penson).

 

In the U.S., the securities and futures industry is subject to regulation under both federal and state laws. At the federal level, the SEC regulates the securities industry, while the CFTC regulates the futures industry. These federal agencies along with NYSE, FINRA, NFA, the various stock and futures exchanges and other self regulatory organizations (“SROs”) require strict compliance with their rules and regulations. Companies that operate in these industries are subject to regulation concerning many aspects of their business, including trade practices, capital structure, record retention, money-laundering prevention, and the supervision of the conduct of directors, officers and employees. Failure to comply with any of these laws, rules or regulations could result in censure, fines, the issuance of cease-and-desist orders, the suspension or termination of the operations of the Company or the suspension or disqualification of our directors, officers or employees. In the ordinary course of our operations, we and some of our officers and other employees have been subject to claims arising from the violation of such laws, rules and regulations.

 

As a registered broker-dealer, PFSI is required by law to belong to the Securities Investor Protection Corporation (“SIPC”). In the event of a member’s insolvency, the SIPC Fund provides protection for customer accounts up to $500,000 per customer, with a limitation of $100,000 on claims for cash balances.

 

In addition, we have subsidiaries in the U.K., Australia and Canada that are involved in the securities and financial services industries and may expand our business into other countries in the future. To expand our services internationally, we will have to comply with the regulatory controls of each country in which we conduct business.

 

The securities and financial services industry in many foreign countries is heavily regulated. The varying compliance requirements of these different regulatory jurisdictions and other factors may limit our ability to expand internationally. Due to its focus on technology products, which are generally not subject to the regulatory regimes applicable to securities trading, Penson Asia is not subject to many of the same restrictions that apply to our U.K., Australia and Canada subsidiaries.

 

The regulatory environment in which we operate is subject to change. Additional regulation, changes in existing laws and rules, or changes in interpretations or enforcement of existing laws and rules often directly affect the method of operation and profitability of securities firms.

 

Dodd-Frank Wall Street Reform and Consumer Protection Act

 

Recent market and economic conditions have led to the enactment of new legislation and other proposals for changes in the regulation of the financial services industry. On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act, or the “Dodd-Frank Act,” into law. While certain provisions of the Dodd-Frank Act will be effective immediately, many other provisions will be effective only following extended transition periods of varying lengths. Therefore, it is impractical at present to forecast the comprehensive effects of the legislation. The Dodd-Frank Act also mandates the preparation of studies on a wide range of issues, which could lead to additional legislation or regulatory changes. This legislation makes extensive changes to the laws regulating financial services firms and requires significant rule-making. The legislation and regulation of financial institutions, both domestically and internationally, include calls to increase capital and liquidity requirements; limit the size and types of the activities permitted; and increase taxes on some institutions.

 

Regulation of clearing activities

 

We provide clearing services in the U.S., Canada, Australia and Europe through our subsidiaries. Broker-dealers and FCMs that clear their own trades are subject to substantially more regulatory requirements than brokers that rely on others to perform those functions. Errors in performing clearing functions, including clerical, technological and other errors related to the handling of funds and securities held by us on behalf of customers

and broker-dealers, could lead to censures, fines or other sanctions imposed by applicable regulatory authorities as well as losses and liability in related lawsuits and proceedings brought by our clients, the customers of our clients and others. Due to our provision of futures clearing services in addition to securities clearing services, we are also subject to additional regulatory requirements, including those of the CFTC, NFA and futures exchange regulations in various jurisdictions. As a result, we must comply with an increased amount of regulatory requirements and face additional liabilities if we are not able to comply with the regulatory environment. We also provide sponsored access to certain entities, which allows those entities to submit trades to certain exchanges through our market participant identification (MPID). Through the provision of sponsored access, we have been able to substantially increase our volumes on certain exchanges. The increased volume often allows us to achieve certain pricing discounts, which we generally share with our sponsored participants. We are responsible for any trades submitted by those entities that use our MPID. Recently, the SEC and certain domestic and foreign SROs have increased scrutiny of sponsored access programs. To the extent any additional regulations are enacted with respect to sponsored access in any jurisdiction where we provide sponsored access, we will be required to follow such regulations which may result in our limiting or eliminating the use of this service. Even if we are able to continue to offer this service, we may have to incur substantial costs related to implementation of risk controls with low latency to comply with new regulations.

 

Regulation of securities lending and borrowing

 

We engage in securities lending and borrowing services with other broker-dealers by lending the securities that we hold for our correspondents and their customers to other broker-dealers, by borrowing securities from other broker-dealers to facilitate our customer transaction activity, or by borrowing securities from one broker-dealer and lending the same securities to another broker-dealer. Within the U.S., these types of securities lending and borrowing arrangements are governed by the SEC and the rules of the Federal Reserve. The following is what we believe to be a descriptive summary of some important SEC and Federal Reserve rules that govern these types of activities, but it is not intended to be an exhaustive list of the regulations that govern these types of activities.

 

Our securities lending and borrowing activities are primarily, although not exclusively, transacted through our U.S. broker-dealer subsidiary, which is subject to the SEC’s net capital rule and customer protection rule. The net capital rule, which specifies minimum net capital requirements for registered broker-dealers, is designed to ensure that broker-dealers will have adequate resources, including a percentage of liquid assets, to fund expenses of a self or court supervised liquidation. See “Business — Government regulation” and “Regulatory capital requirements.” While the net capital rule is designed to ensure that the broker-dealer has adequate resources to pay liquidation expenses, the objective of the SEC’s customer protection rule is to ensure that investment property of the firm’s customers will be available to be distributed to customers in liquidation. The customer protection rule operates to protect both customer funds and customer securities. To protect customer securities, the customer protection rule requires that broker-dealers promptly obtain possession or control of customers’ fully-paid securities free of any lien. However, broker-dealers may lend or borrow customers’ securities purchased on margin or customers’ fully paid securities, if the broker-dealer provides collateral exceeding the market value of the securities it borrowed and makes certain other disclosures to the customer. With respect to customer funds, the customer protection rule requires broker-dealers to make deposits into an account held only for the benefit of customers (“reserve account”) based on its computation of the reserve formula. The reserve formula requires that broker-dealers compare the amount of funds it has received from customers or through the use of their securities (“credits”) to the amount of funds the firm has used to finance customer activities (“debits”). In this manner, the customer protection rule ensures that the broker-dealer’s securities lending and borrowing activities do not impact the amount of funds available to customers in the event of liquidation.

 

SEC Rules 8c-1 and 15c2-1 under the Exchange Act (the “hypothecation rules”) set forth requirements relating to the borrowing or lending of customers securities. The hypothecation rules prohibit us from borrowing or lending customers securities in situations where (1) the securities of one customer will be held together with securities of another customer, without first obtaining the written consent of each customer; (2) the securities of a customer will be held together with securities owned by a person or entity that is not a customer; or (3) the securities of a customer will be subject to a lien for an amount in excess of the aggregate indebtedness of all customers’ securities.

Regulation T was issued by the Federal Reserve pursuant to the Exchange Act in part to regulate the borrowing and lending of securities by broker-dealers, as well as to regulate the extension of credit by broker-dealers. With respect to securities borrowing and lending, Regulation T requires that a borrowing or lending of securities by a broker-dealer be for a “proper purpose,” i.e. for the purpose of making delivery of the securities in the case of short sales, failure to receive securities required to be delivered, or other similar situations. If a broker-dealer reasonably anticipates a short sale or fail transaction, a borrowing may be made by the broker-dealer up to one settlement cycle in advance of trade date.

 

Regulation T also regulates payment requirements for transactions in customer cash accounts and the level of credit extended in customer margin accounts. A broker-dealer may extend credit to a customer in a margin account only against collateral consisting of cash or margin-eligible securities, as defined in the Exchange Act or “margin securities,” as defined in Regulation T. Under Regulation T, the current required initial margin for a long position in a margin equity security is 50 percent of the current market value of the security. The required margin for a short position is 150 percent of the current market value of the security. Maintenance margin requirements are set in accordance with the rules of the SROs. However, we may require the deposit of a higher percentage of the value of equity securities purchased on margin. Securities borrowed transactions are extensions of credit in that the securities lender generally receives cash collateral that exceeds the market value of the securities that were lent. In the National Securities Markets Improvements Act of 1996, the U.S. Congress amended section 7(c) of the Exchange Act to exempt certain broker-dealers from the Federal Reserve’s credit regulations. Recently, the SEC and other SROs have approved new rules permitting portfolio margining that have the effect of permitting increased margin on securities and other assets held in portfolio margin accounts relative to non-portfolio accounts. We began offering portfolio margining to our clients in the second quarter of 2007 and had 881 portfolio margin accounts as of December 31, 2010.

 

With respect to such securities borrowing and lending, Regulation SHO issued under the Exchange Act generally prohibits, among other things, a broker-dealer from accepting a short sale order unless either the broker-dealer has already borrowed the security, has entered into a bona-fide arrangement to borrow the security or has “reasonable grounds” to believe that the security can be borrowed so that it can be delivered on the date delivery is due and has documented compliance with this requirement. Rule 204 under the Exchange Act requires broker-dealers and clients to make delivery on short sales effected in the U.S. no later than T+3. Under Rule 204, a clearing broker-dealer that does not purchase or borrow securities to cover any fail position as of the opening of trading on T+4 is subject to a borrowing penalty for each security that the clearing-broker fails to deliver (subject to the allocation provision noted below). The borrowing penalty will apply until the clearing broker-dealer purchases a sufficient amount of the security to make full delivery on the fail position and that purchase clears and settles. If a clearing broker-dealer becomes subject to the borrowing penalty, the penalty will prohibit the clearing broker-dealer from effecting short sales for its own account or for that of any correspondent broker-dealer or customer unless the clearing broker-dealer has borrowed the securities in question or has entered into a bona-fide arrangement to borrow the securities. Clearing broker-dealers are permitted to reasonably allocate the close-out requirement to a correspondent broker-dealer that is responsible for the fail position. Accordingly, if we have a fail position that we are unable to timely cover, or where the fail position was the responsibility of one of our correspondent broker-dealers and we cannot allocate the close-out responsibility to it, we would be subject to the borrowing penalty. We could remain subject to the borrowing penalty until such time as we have purchased a sufficient amount of the security to make full delivery on the fail position and that purchase has cleared and settled, which generally is three business days after the purchase. Due to the requirements of Rule 204, our costs associated with securities borrowings to facilitate customer short selling may continue to increase and the scope of our securities lending business may significantly decrease, which may adversely affect our operations and financial condition.

 

Failure to maintain the required net capital, accurately compute the reserve formula or comply with Regulation T, portfolio margining rules or Regulation SHO may subject us to suspension or revocation of registration by the SEC and suspension or expulsion by NYSE, FINRA and other regulatory bodies and, if not cured, could ultimately require our U.S. broker-dealer subsidiary’s liquidation. A change in the net capital rule, the customer protection rule, Regulation T or the portfolio margining rules or the imposition of new rules could adversely impact our ability to engage in securities lending and borrowing.

Regulation of internet activities

 

Our business, both directly and indirectly, relies extensively on the Internet and other electronic communications gateways. To date, the use of the Internet has been relatively free from regulatory restraints. However, the governmental agencies within the U.S. and elsewhere are beginning to address regulatory issues that may arise in connection with the use of the Internet. Accordingly, new regulations or interpretations may be adopted that change our own and our correspondents’ abilities to transact business through the Internet or other electronic communications gateways.

 

Regulatory capital requirements

 

As a registered broker-dealer and member of NYSE and FINRA, PFSI is subject to the SEC’s net capital rule. The net capital rule, which specifies minimum net capital requirements for registered broker-dealers, is designed to measure the general financial integrity and liquidity of a broker-dealer and requires that at least a minimum part of its assets be kept in relatively liquid form. Among deductions from net capital are adjustments that are commonly called “haircuts,” which reflect the possibility of a decline in the market value of firm inventory prior to disposition.

 

Failure to maintain the required net capital would require us to cease securities activities during any period where we did not meet minimum levels of net capital and may subject us to suspension or revocation of registration by the SEC and suspension or expulsion by NYSE, FINRA and other regulatory bodies and, if not cured, could ultimately require liquidation of our U.S. clearing operations. The net capital rule prohibits payments of dividends, redemption of stock, the prepayment of subordinated indebtedness and the making of any unsecured advance or loan to a stockholder, employee or affiliate, if such payment would reduce our net capital below required levels. Finally, NYSE and FINRA rules prevent a broker-dealer from expanding its business or permit NYSE or FINRA to require reductions in the broker-dealer’s business for broker-dealers experiencing financial or operational difficulties.

 

The net capital rule also requires notice to regulators with respect to certain capital withdrawals and provides that the SEC may restrict any capital withdrawal, including the withdrawal of equity capital, or unsecured loans or advances to stockholders, employees or affiliates, if such capital withdrawal, together with all other net capital withdrawals during a 30-day period, exceeds 30% of excess net capital and the SEC concludes that the capital withdrawal may be detrimental to the financial integrity of the broker-dealer. In addition, the net capital rule provides that the total outstanding principal amount of a broker-dealer’s indebtedness under specified subordination agreements, the proceeds of which are included in its net capital, may not exceed 70% of the sum of the outstanding principal amount of all subordinated indebtedness included in net capital, par or stated value of capital stock, paid in capital in excess of par, retained earnings and other capital accounts for a period in excess of 90 days.

 

A change in the net capital rule, the imposition of new rules or any unusually large charges against net capital could limit some of our operations that require the intensive use of capital and also could restrict our ability to withdraw capital from PFSI, which in turn could limit our ability to pay dividends, repay or repurchase debt, including the 8.00% Senior Convertible Notes due 2014, the 12.50% Senior Second Lien Notes due 2017, the Amended and Restated Credit Facility and the Ridge Seller Note, or repurchase shares of outstanding stock. A significant operating loss or any unusually large charge against net capital could adversely affect our ability to expand or even maintain our present levels of business.

 

Our U.K. subsidiary is subject to FSA rules that require it to maintain adequate financial resources (including both capital resources and liquidity resources) in order to meet its liabilities as they fall due. The current capital resources requirement for the subsidiary is approximately £3.8 million although the capital resources requirement will vary depending on the current expenditure, liabilities and risks incurred or assumed. Capital resources may be constituted by eligible share capital and eligible subordinated debt. The subsidiary must constantly monitor compliance with its financial resource requirements, regularly submit financial reports to the FSA (monthly) and report any breach of the financial resource requirements to the FSA. A breach of the financial resource requirements may result in disciplinary action against the subsidiary for which it may receive a financial penalty, or where the breach is serious, a suspension or cessation of the subsidiary’s business and a withdrawal of the subsidiary’s authorization to conduct investment business in whole or in part. The imposition of FSA disciplinary sanctions, the temporary suspension of business or the partial revocation of the subsidiary’s authorization to conduct investment

business may severely damage the reputation of the subsidiary and result in diminution of earnings. The revocation of the subsidiary’s authorization to conduct investment business in the U.K. may result in a discontinuation of our U.K. operations and the loss of its revenues.

 

PFSC is a member of IIROC, an approved participant with the Montreal Exchange, a participating organization of the Toronto Stock Exchange and a member of the TSX Venture Exchange and various Canadian alternative trading systems. PFSC is subject to rules, including those of IIROC, relating to the maintenance of capital. IIROC regulates the maintenance of capital by dealer members by requiring that investment dealers periodically calculate their risk adjusted capital (“RAC”) in accordance with a prescribed formula which is intended to ensure that members will be in a position to meet their liabilities as they become due.

 

A dealer member’s RAC is calculated by starting with its net allowable assets, which are assets that are conservatively valued with emphasis on liquidity, and excluding assets that cannot be disposed of in a short time frame or whose current realizable value is not readily known, net of all liabilities, and deducting the applicable minimum capital and margin requirements, adding tax recoveries, if any, and subtracting the member’s securities concentration charge.

 

Furthermore, IIROC rules provide for an early warning system which is designed to provide advance warning of a dealer member encountering financial difficulties. Various parameters based on prescribed calculations involving the dealer member’s RAC are designed to identify dealer members with capital adequacy problems. If any of the parameters are violated, several sanctions or restrictions are imposed on the dealer member. These sanctions, which may include the early filing of a monthly financial report, a written explanation to IIROC from the Chief Executive Officer and Chief Financial Officer, a description of the resolution, or an on-site visit by an examiner, are designed to reduce further financial deterioration and prevent a subsequent capital deficiency.

 

Failure of a member to maintain the required risk adjusted capital as calculated in accordance with applicable IIROC requirements can result in further sanctions such as monetary penalties, suspension or other sanctions, including expulsion of the dealer member.

 

PFSA holds an Australian Financial Services License and is a market participant of the ASX and is an ASX Clear participant . As such, PFSA is subject to, amongst other things, the rules established by the ASX and ASX Clear governing the minimum risk based capital requirements for participants in the ASX and ASX Clear. The ASX Clear capital requirements establish minimum core liquid capital requirements and minimum requirements for a participant’s liquid capital as compared to a number of different risk based metrics which make up the participant’s total risk requirement. The risk requirements vary depending on the operations undertaken by the participant. A participant’s core liquid capital is based principally on a participant’s equity and retained profits, while the liquid capital adjusts core liquid capital to take account of reserves and in certain cases subordinated debt and preferred stock. Currently, participants, including PFSA, are required to maintain a core liquid capital of at least AUD$10 million. The core liquid capital requirement for third party clearing participants such as PFSA will increase to AUD$20 million on January 1, 2012. ASX Clear participants are also required to maintain a ratio of their liquid capital to total risk requirements of greater than 1.2 and a ratio of total option risk margin to liquid capital of less than 2.0. In the event that this ratio is 2.0 or more the participant is required to deposit funds to reduce the ratio and such funds may then not be withdrawn until the ratio is below 1.8. PFSA is currently in compliance with the minimum capital requirements established by ASX Clear which are applicable to it and regularly calculates its core liquid capital, liquid capital, total risk requirements and other applicable metrics to monitor ongoing compliance with the minimum capital requirements established by ASX Clear.

 

Our futures clearing business is subject to the capital and segregation rules of the CFTC, NFA, and futures exchanges in the U.S. and the FSA and futures exchanges in the U.K. If we fail to maintain the required capital or violate the customer segregation rules, we may be subject to monetary fines and the suspension or revocation of our license to clear futures contracts and carry customer accounts. Any interruption in our ability to continue this business would impact our revenues and profitability.

 

The regulatory capital requirements that affect our regulated subsidiaries are stringent and subject to significant and uncontrollable change. Our inability to comply with any of the current requirements or any future changes to these requirements could cause us to suffer significant financial loss.

Margin risk management

 

Our margin lending activities expose our capital to significant risks. These risks include, but are not limited to, absolute and relative price movements, price volatility and changes in liquidity, over which we have virtually no control.

 

We attempt to minimize the risks inherent in our margin lending activities by retaining in our margin lending agreements the ability to adjust margin requirements as needed and by exercising a high degree of selectivity when accepting new correspondents. When determining whether to accept a new correspondent, we evaluate, among other factors, the correspondent’s experience in the industry, its financial condition and the background of the principals of the firm. In addition, we have multiple layers of protection, including the balances in customers’ accounts, correspondents’ commissions on deposit, clearing deposits and equity in correspondent firms, in the event that a correspondent or one of its customers does not deliver payment for our services. We also maintain a bad debt reserve.

 

Our customer agreements and fully-disclosed clearing agreements require industry arbitration in the event of a dispute. Arbitration is generally less expensive and more timely than dispute resolution through the court system. Although we attempt to minimize the risk associated with our margin lending activities, there is no assurance that the assumptions on which we base our decisions will be correct or that we are in a position to predict factors or events which will have an adverse impact on any individual customer or issuer, or the securities markets in general.

 

Local regulations

 

PFSI is a broker-dealer authorized to conduct business in all 50 states, the District of Columbia and Puerto Rico under applicable local securities regulations. PFSC is authorized to conduct business in all major provinces and territories in Canada.

 

Employees

 

As of December 31, 2010, we had 985 employees, of whom 416 were employed in clearing operations, 275 in technology support and development, 60 in sales and marketing and 234 in finance and administration. Of our 985 employees, 689 are employed in the U.S., 58 in the U.K., 196 in Canada, 10 in Asia and 32 in Australia. Our employees are not represented by any collective bargaining organization or covered by a collective bargaining agreement. We believe that our relationship with our employees is good.

 

Our continued success depends largely on our ability to attract and retain highly skilled personnel. Competition for such personnel is intense, and should we be unable to recruit and retain the necessary personnel, the development, sale and performance of new or enhanced services would likely be delayed or prevented. In addition, difficulties we encounter in attracting and retaining qualified personnel may result in higher than anticipated salaries, benefits and recruiting costs, which could adversely affect our business.

 

Public reporting

 

Once filed with the SEC, our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act are available free of charge at www.penson.com. The information found on our website is not part of this or any other report we file with or furnish to the SEC. Any materials we file with the SEC may be read and copied at the SEC’s Public Reference Room at 100 F Street, NE, Washington, D.C. 20549. The SEC maintains a website at www.sec.gov that contains the reports we file with the SEC. We also make available on our website, free of charge, our Code of Business Conduct and Ethics, our Corporate Business Principles and Governance Guidelines, and the charters for our Nominating and Corporate Governance, Audit and Compensation Committees. Any stockholder who so requests may obtain a printed copy of any of these documents, free of charge, by writing to us at 1700 Pacific Avenue, Suite 1400, Dallas, Texas 75201, Attention: Corporate Secretary.

 

Many factors could have an effect on PWI’s financial condition, cash flows and results of operations. We are subject to various risks resulting from changing economic, environmental, political, industry, business and financial conditions. The principal factors are described below.

 

Risks related to our business and our industry

 

We face substantial competition from other securities and commodities processing and infrastructure firms, which could harm our financial performance and reduce our market share.

 

The market for securities and futures processing infrastructure products and services is rapidly evolving and highly competitive. We compete with a number of firms that provide similar products and services to our market. Our competitors include Goldman Sachs Execution & Clearing, L.P.; Pershing LLC, a member of BNY Securities Group; National Financial Services LLC, a Fidelity Investments company; Merrill Lynch & Co., Inc., a subsidiary of Bank of America; MF Global Ltd. (formerly Man Financial) and RJ Obrien & Associates LLC. Many of our competitors have significantly greater financial, technical, marketing and other resources than we have. Some of our competitors also offer a wider range of services and financial products than we do and have greater name recognition and more extensive client bases than ours. These competitors may be able to respond more quickly to new or changing opportunities, technologies and client requirements and may be able to undertake more extensive promotional activities, offer more attractive terms to clients and adopt more aggressive pricing policies than ours. There can be no assurance that we will be able to compete effectively with current or future competitors. If we fail to compete effectively, our market share could decrease and our business, financial condition and operating results could be materially harmed.

 

Increased competition has contributed to the decline in net clearing revenue per transaction that we have experienced in recent years and may continue to create downward pressure on our net clearing revenue per transaction. In the past, we have responded to the decline in net clearing revenue by reducing our expenses, but if the decline continues, we may be unable to reduce our expenses at a comparable rate. Our failure to reduce expenses comparably would reduce our profit margins.

 

We depend on a limited number of clients for a significant portion of our clearing revenues.

 

Our ten largest current clients accounted for approximately 26.1% of our total net revenues for the year ended December 31, 2010, while no client accounted for more than 6.8% of net revenues. The loss of even a small number of these clients at any one time could cause our revenues to decline. As previously announced, we will be losing a significant amount of the revenues generated from our largest correspondent during 2011; however, we believe we will be able to replace a substantial portion of that revenue from new correspondents we have signed. Our clearing contracts generally have an initial term of two years, and allow the correspondent to cancel our services upon providing us with 45 days of notice, in most cases after the expiration of the fixed term. Many of our futures clearing contracts with correspondents may be terminated with a 30-day notice. Our clearing contracts with these correspondents can also terminate automatically if we are suspended from any of the national exchanges of which we are a member for failure to comply with the rules or regulations thereof. In past periods, we have experienced temporary declines in our revenues when large clients have switched to other service providers. There can be no assurance that our largest clients will continue to use our products and services.

 

Our clearing operations could expose us to legal liability for errors in performing clearing functions and improper activities of our correspondents.

 

Any intentional failure or negligence in properly performing our clearing functions or any mishandling of funds and securities held by us on behalf of our correspondents and their customers could lead to censures, fines or other sanctions by applicable authorities as well as actions in tort brought by parties who are financially harmed by those failures or mishandlings. Any litigation that arises as a result of our clearing operations could harm our reputation and cause us to incur substantial expenses associated with litigation and damage awards that could exceed our liability insurance by unknown but significant amounts. In the normal course of business, we purchase and sell securities as both principal and agent. If another party to the transaction fails to fulfill its contractual

obligations, we may incur a loss if the market value of the security is different from the contract amount of the transaction.

 

In the past, clearing firms in the U.S. have been held liable for failing to take action upon the receipt of customer complaints, failing to know about the suspicious activities of correspondents or their customers under circumstances where they should have known, and even aiding and abetting, or causing, the improper activities of their correspondents. Although our correspondents provide us with indemnity under our contracts, we cannot assure you that our procedures will be sufficient to properly monitor our correspondents or protect us from liability for the acts of our correspondents under current laws and regulations or that securities industry regulators will not enact more restrictive laws or regulations or change their interpretations of current laws and regulations. If we fail to implement proper procedures or fail to adapt our existing procedures to new or more restrictive regulations, we may be subject to liability that could result in substantial costs to us and distract our management from our business.

 

Our provision of sponsored and direct market access could expose us to legal liabilities for trading activity by third parties

 

We provide sponsored access to certain entities, which allows those entities to submit trades to certain exchanges through our market participant identification (MPID). We are responsible for any trades submitted by those entities that use our MPID. In addition, we provide certain of our correspondents with direct market access to various exchanges. Recently, the SEC and certain domestic and foreign SROs have increased scrutiny and enacted stringent regulation of sponsored and direct market access providers. If we cannot or do not adequately assess and successfully control the risks involved with all of the trading activities of our correspondents, we may be unable to protect ourselves from those risks. Though we have indemnification provisions in our contracts with each of those entities, given the increased regulatory scrutiny in this area, these indemnification provisions may not adequately protect us from liabilities incurred due to our provision of these services. We will be required to follow such regulations as soon as they become effective, which may limit or eliminate our provision of these services and could adversely affect our revenues and profitability. Even if we are able to continue to offer this service, we may have to incur substantial costs related to implementation of risk controls with low latency to comply with new regulations.

 

Market weaknesses and lower trading volumes may negatively affect our results of operations and profitability.

 

We are subject to risks as a result of volume fluctuations in the securities and futures markets. A prolonged period of market weakness and low trading volumes could adversely impact the business of our customers and our business. There is a direct correlation between the volume of our customers’ trading activity and our results of operations. If our customers’ trading activity decreases, we expect that it would have a negative impact on our results of operations and profitability. We, along with other participants in the equity and futures markets, have experienced a substantial decrease in trading volumes over the most recent quarters that has materially adversely affected our profitability during such time.

 

Continuing low, short-term interest rates have negatively impacted the profitability of our margin lending business.

 

The profitability of our margin lending activities depends to a great extent on the difference between interest income earned on margin loans and investments of customer cash and the interest expense paid on customer cash balances and borrowings. While they are not linearly connected, if short-term interest rates fall, we generally expect to receive a smaller gross interest spread, causing the profitability of our margin lending and other interest-sensitive revenue sources to decline. Recent decreases in short-term interest rates have contributed to a decrease in our profitability and will continue to do so while lower rates continue to be in effect. Assuming constant customer balances, we expect that a 25 basis point change in the federal funds rate would affect our pre-tax income by approximately $1.3 million per quarter.

 

Short-term interest rates are highly sensitive to factors that are beyond our control, including general economic conditions and the policies of various governmental and regulatory authorities. In particular, decreases in the federal funds rate by the Federal Reserve usually lead to decreasing interest rates in the U.S., which generally lead to a

decrease in the gross spread we earn. This is most significant when the federal funds rate is on the lower end of its historical range, as it is today. Interest rates in Canada, the U.K. and Australia are also subject to fluctuations based on governmental policies and economic factors and these fluctuations could also affect the profitability of our margin lending operations in these markets.

 

Our margin lending business subjects us to credit risks and if we are unable to liquidate an investor’s securities when the margin collateral becomes insufficient, the profitability of our business may suffer.

 

We provide margin loans to investors; therefore, we are subject to risks inherent in extending credit. As of December 31, 2010, our receivables from customers and correspondents were $2.3 billion, which predominantly reflected margin loans. The Company generally recognizes interest income on an accrual basis as it is earned. At December 31, 2010 and 2009, the Company had approximately $97.4 million and $52.4 million in receivables, respectively, primarily from customers and correspondents, that were substantially collateralized and considered collectable, for which interest income was being recorded only when received. Our credit risks include the risk that the value of the collateral we hold could fall below the amount of an investor’s indebtedness. This risk is especially great when the market is rapidly declining. Agreements with margin account investors permit us to liquidate their securities with or without prior notice in the event that the amount of margin collateral becomes insufficient. Despite those agreements and our house policies with respect to margin, which may be more restrictive than is required under applicable laws and regulations, we may be unable to liquidate the customers’ securities for various reasons, including:

 

 

In the U.S., our margin lending is subject to the margin rules of the Federal Reserve, NYSE and FINRA, whose rules generally permit margin loans of up to 50% of the value of the securities collateralizing the margin account loan at the time the loan is made, subject to requirements that the customer deposit additional securities or cash in its accounts so that the customer’s equity in the account is at least 25% of the value of the securities in the account. We are also subject to rules and regulations in Canada and the U.K. with regard to our margin lending activities in those markets. In certain circumstances, we may provide a higher degree of margin leverage to our correspondents with respect to their proprietary trading businesses than otherwise permitted by the margin rules described above based on an exemption for correspondents that purchase a class of preferred stock of PFSI. In addition, for our portfolio margining accounts, we are able to extend substantially more credit than permitted by the margin rules described above to approved customers pursuant to a risk formula adopted by the SEC. As a result, we may increase the risks otherwise associated with margin lending with respect to these correspondent and customer accounts.

 

We rely, in part, on third parties to provide and support the software and systems we use to provide our services. Any interruption or cessation of service by these third parties could harm our business.

 

We have contracted with SunGard Data Systems and, more recently, Broadridge to provide a major portion of the software and systems necessary for our execution and clearing services. On September 25, 2008, we entered into an amendment to our current agreement with SunGard that requires SunGard to provide a dedicated processing platform for the processing of our U.S. clearing operations. Our current agreement with SunGard will expire in February, 2014, but can be terminated by SunGard upon written notice in the event that we breach the agreement. In the past, we have experienced limited processing delays, occasional hardware and software outages with third party service providers, including SunGard. Any major interruption in our ability to process our transactions through SunGard or Broadridge would harm our relationships with our clients and impact our growth. We also license many additional generally available software packages. Failures in any of these applications could also harm our business operations. We rely on similar systems for other subsidiaries, problems with each of which could cause similar problems and results in us suffering significant financial harm.

 

We rely on SunGard, Broadridge and other third parties to enhance their current products, develop new products on a timely and cost-effective basis, and respond to emerging industry standards and other technological changes. Now that we have converted our Canadian operations and as we continue to transition our United States operations to Broadridge’s

systems, we expect to be able to rely on Broadridge to be able to provide similar future product developments for our U.S., U.K. and Canadian securities operations. See “Business — Strategic Acquisitions” for a description of the Broadridge transaction. Certain of our subsidiaries will continue to use SunGard to provide the software and systems necessary to provide services to our clients, including Penson Futures. SunGard’s provision of a dedicated processing platform allowed us to process our increased U.S. trade volume in 2010 and we expect to be able to continue to increase or U.S. trade volume after converting to Broadridge’s systems in 2011 and beyond. If in the future, however, enhancements or upgrades of third-party software and systems cannot be integrated with our technologies or if the technologies on which we rely fail to respond to industry standards or technological changes, we may be required to redesign our proprietary systems. Software products may contain defects or errors, especially when first introduced or when new versions or enhancements are released. The inability of third parties to supply us with software or systems on a reliable, timely basis or to allocate sufficient capacity to meet our trading volume requirements could harm relationships with our clients and our ability to achieve our projected level of growth.

 

Our anticipated transition of certain support services to Ridge and Broadridge may involve unforeseen delays, costs or technological complications. If we are unable to transition our services efficiently to Broadridge, we may experience interruptions or difficulties with respect to the services Broadridge is expected to provide.

 

We have signed a technology services and outsourcing agreement with Broadridge whereby Broadridge is expected to replace SunGard and our PFSL service providers as our provider of certain software and systems necessary for our execution and clearing services. See “Business — Strategic Acquisitions” for a description of the Broadridge transaction. We completed the conversion of our Canadian operations to Broadridge in February, 2011. We anticipate completing the transition of our U.S. and PFSL operations to those software and systems over the next one to two years. Any delays, technology issues or unexpected costs could substantially impair our ability to continue to provide clearing and execution services to our clients that could cause us to suffer material financial loss. In addition, there can be no guarantees that we will not experience additional issues with respect to processing delays, hardware and software outages, or other service issues with Broadridge than we experience with our current providers. Any additional processing delays or issues we experience could impair our ability to provide services to our clients, which could impact our growth and cause significant financial loss.

 

Our products and services, and the products and services provided to us by third parties, may infringe upon intellectual property rights of third parties, and any infringement claims could require us to incur substantial costs, distract our management or prevent us from conducting our business.

 

Although we attempt to avoid infringing upon known proprietary rights of third parties and typically incorporate indemnification provisions in any agreements where we license third party software, we are subject to the risk of claims alleging infringement of third-party proprietary rights and have incurred litigation expenses in the past, and are continuing to incur expenses due to the ongoing Realtime Data case, related to our defense of our intellectual property rights. If we infringe upon the rights of third parties through use of our proprietary software or software licensed to us by third parties, we may be unable to obtain licenses to use those or similar rights on commercially reasonable terms. In either of these events, we would need to undertake substantial reengineering to continue offering our services and may not be successful. In addition, any claim of infringement could cause us to incur additional, substantial costs defending the claim, even if the claim is invalid, and could distract our management from our business. Furthermore, a party making such a claim could secure a judgment that requires us to pay substantial damages. A judgment could also include an injunction or other court order that could prevent us from conducting our business.

 

We may not be able to protect our intellectual property rights against unauthorized use and infringement by third parties, and our failure to do so may weaken our competitive position, and any legal claim we seek to pursue may require us to incur substantial cost and distract management and us from conducting our business.

 

Despite the precautions we take to protect our intellectual property rights, it is possible that third parties may copy or otherwise obtain and use our proprietary technology without authorization or otherwise infringe upon our proprietary rights. It is also possible that third parties may independently develop technologies similar to ours. It may be difficult for us to police unauthorized use of our intellectual property. We cannot be certain that our

intellectual property rights are sufficiently protected against unauthorized use and infringement by third parties, and our failure to do so may weaken our competitive position. In addition, litigation may be necessary in the future to enforce our intellectual property rights and to protect our trade secrets, which may require us to incur substantial cost and distract our management and us from conducting our business. See also “Business — Intellectual property and other proprietary rights.”

 

If our clients’ account information is misappropriated, we may be held liable or suffer harm to our reputation.

 

Increased public attention regarding the corporate use of personal information has led to increasingly complex legislation and regulations intended to strengthen data protection, information security and consumer privacy. The law in these areas is not consistent or settled. While we employ what we believe to be a high degree of care in protecting our clients’ confidential information, if third parties penetrate our network security or otherwise misappropriate our clients’ personal or account information, or we were to otherwise release any such confidential information without our clients’ permission, unintentionally or otherwise, we could be subject to liability arising from claims related to impersonation or similar fraud claims or other misuse of personal information, as well as suffer harm to our reputation. To effect secure transmissions of confidential information over computer systems and the Internet, we rely on encryption and authentication technology. While we periodically test the integrity and security of our systems, we cannot assure you that our efforts to maintain the confidentiality of our clients’ account information will be successful.

 

Internet security concerns have been a barrier to the acceptance of online trading, and any well-publicized compromise of security could hinder the growth of the online brokerage industry. We cannot assure you that advances in computer capabilities, new discoveries in the field of cryptography or other events or developments will not result in a compromise or breach of the technology we use to protect clients’ transactions and account data. We may incur significant costs to protect against the threat of network or Internet security breaches or to alleviate problems caused by such breaches.

 

Our risk management policies and procedures may leave us exposed to unidentified risks or an unanticipated level of risk.

 

We seek to control our risk exposure through a risk management framework that is designed to monitor, identify and measure the types of risk we face. While our management believes that our risk management framework effectively evaluates and manages the financial, operational, market, credit and other risks we face, risk management tools, no matter how well designed, have inherent limitations, which could cause them to be ineffective. As a result, we face the risk of losses, including losses resulting from firm errors, customer defaults or fraud. Unexpectedly large or rapid movements or disruptions in one or more markets may cause adverse changes in securities values, decreases in liquidity and trading positions and increased volatility, all of which could increase our risk exposure to our customers and to other third parties. In addition, while we monitor every customer account that is less than fully collateralized with liquid securities daily, our risk controls may not be able to protect us from substantial losses in those accounts. If our risk management tools are unable to control our risk exposure, we may suffer material losses or suffer other adverse consequences that could impair our ability to continue our operations.

 

We may be subject to material litigation proceedings that could cause us significant reputational harm and financial loss.

 

We are subject from time-to-time to legal claims or regulatory matters involving stockholder, customer, and other issues on a global basis, based on our activity or the activity of our correspondents. As described in “Item 3: Legal Proceedings,” we are currently engaged in a number of litigation matters. These matters include our involvement in a bankruptcy proceeding concerning Sentinel Management Group, Inc. (“Sentinel”), which is described in detail in Item 3. The bankruptcy trustee in this matter is seeking the return of pre- and post-bankruptcy petition transfers made to Penson Futures and Penson Financial Futures, Inc. (“PFFI”), a subsidiary of PWI, to which we have objected. We intend to vigorously defend this position, but we are not able to predict the outcome of this dispute at this time. In the event that Penson Futures and PFFI are obligated to return a substantial portion of previously distributed funds to the Sentinel estate, it could have a material adverse effect on our operating results for

the period in which the payment is made. In addition, we are currently involved in a matter regarding Nexa’s use of certain intellectual property rights. An unfavorable outcome in that matter may require us to terminate use of certain intellectual property we currently employ, or to license such intellectual property at a high cost.

 

Litigation generally is subject to inherent uncertainties, and unfavorable rulings can occur. An unfavorable ruling in any matter could include monetary damages or, in cases for which injunctive relief is sought, an injunction prohibiting us from providing clearing or technology services. If we were to receive an unfavorable ruling in a matter, our business and results of operations could suffer significant reputational and financial loss.

 

Any slowdown or failure of our computer or communications systems could subject us to liability for losses suffered by our clients or their customers.

 

Our services depend on our ability to store, retrieve, process and manage significant databases, and to receive and process securities and futures orders through a variety of electronic media. Our principal computer equipment and software systems, including backup systems, are maintained at various locations in Texas, Chicago, Boston, New Jersey, Minnesota, Toronto, Montreal, Sydney and London. Our systems or any other systems in the trading process could slow down significantly or fail for a variety of reasons, including:

 

 

While we continue to monitor system loads and performance and implement system upgrades to handle predicted increases in trading volume and volatility, we cannot assure you that we will be able to accurately predict future volume increases or volatility or that our systems will be able to accommodate these volume increases or volatility without failure or degradation. Any significant degradation or failure of our computer systems, communications systems or any other systems in the clearing or trading processes could cause the customers of our clients to suffer delays in the execution of their trades. These delays could cause substantial losses for our clients or their customers and could subject us to claims and losses, including litigation claiming fraud or negligence, damage our reputation, increase our service costs, cause us to lose revenues or divert our technical resources.

 

If our operational systems and infrastructure fail to keep pace with our anticipated growth, we may experience operating inefficiencies, client dissatisfaction and lost revenue opportunities.

 

We have experienced significant growth in our client base, business activities and the number of our employees. The growth of our business and expansion of our client base has placed, and will continue to place, a significant strain on our management and operations. We believe that our current and anticipated future growth will require the implementation of new and enhanced communications and information systems, the training of personnel to operate these systems and the expansion and upgrade of core technologies. While many of our systems are designed to accommodate additional growth without redesign or replacement, we may nevertheless need to make significant investments in additional hardware and software to accommodate growth. In addition, we cannot assure you that we will be able to accurately predict the timing or rate of this growth or expand and upgrade our systems and infrastructure on a timely basis.

 

In addition, the scope of procedures for assuring compliance with applicable rules and regulations has changed as the size and complexity of our business has increased. We have implemented and continue to implement formal compliance procedures to respond to these changes and the impact of our growth. Our future operating results will depend on our ability:

 

 

 

Our growth has required and will continue to require increased investments in management personnel and systems, financial systems and controls and office facilities. In the absence of continued revenue growth, the costs associated with these investments would cause our operating margins to decline from current levels. We cannot assure you that we will be able to manage or continue to manage our recent or future growth successfully. If we fail to manage our growth, we may experience operating inefficiencies, dissatisfaction among our client base and lost revenue opportunities.

 

A failure in the operational systems of third parties could significantly disrupt our business and cause losses.

 

We face the risk of operational failure, termination or capacity constraints of any of the clearing agents, exchanges, clearing houses or other financial intermediaries we use to facilitate our securities transactions. In recent years, there has been significant consolidation among clearing agents, exchanges, clearing houses and other financial intermediaries, which has increased our exposure to operational failure, termination or capacity constraints of the particular financial intermediaries that we use and could affect our ability to find adequate and cost-effective alternatives in the event of any such failure, termination or constraint. Any such failure, termination or constraint could adversely affect our ability to effect transactions, service our clients and manage our exposure to risk.

 

If we are unable to respond to the demands of our existing and new clients, our ability to reach our revenue goals or maintain our profitability could be diminished.

 

The global securities and futures industry is characterized by increasingly complex infrastructures and products, new and changing business models and rapid technological changes. Our clients’ needs and demands for our products and services evolve with these changes. For example, an increasing number of our clients are from market segments including hedge funds, algorithmic traders and direct access customers who demand increasingly sophisticated products. Our future success will depend, in part, on our ability to respond to our clients’ demands for new services, products and technologies on a timely and cost-effective basis, to adapt to technological advancements and changing standards and to address the increasingly sophisticated requirements of our clients.

 

Our existing correspondents may choose to perform their own clearing services as their operations grow, in which case we would lose the revenues generated by such correspondents.

 

We market our clearing services to our existing correspondents on the strength of our ability to process transactions and perform related back-office functions at a lower cost than the correspondents could perform these functions themselves. As our correspondents’ operations grow, they often consider the option of performing clearing functions themselves, in a process referred to in the securities industry as “self-clearing.” As the transaction volume of a correspondent grows, the cost of implementing the necessary infrastructure for self-clearing may eventually be offset by the elimination of per-transaction processing fees that would otherwise be paid to a clearing firm. Additionally, performing their own clearing services allows self-clearing firms to retain their customers’ margin balances, free credit balances and securities for use in margin lending activities. If our clients choose to self-clear, we would lose their revenue and our business could be adversely affected.

 

We are also subject to the risk that one or more of our correspondents may be acquired by a firm which is already self clearing, or clears through another broker-dealer. Our largest correspondent, thinkorswim, was acquired by TD Ameritrade in 2009. We anticipate that approximately two-thirds of the business we currently clear for thinkorswim will be converted to TD Ameritrade in 2011.

 

Our ability to sell our services and grow our business could be significantly impaired if we lose the services of key personnel.

 

Our business is highly dependent on a small number of key executive officers. We have entered into compensation agreements with various personnel, but we do not have employment agreements with most of our employees. The loss of the services of any of the key personnel or the inability to identify, hire, train and retain other qualified personnel in the future could harm our business. Competition for key personnel and other highly qualified technical and managerial personnel in the securities and futures processing infrastructure industry is intense, and there is no assurance that we would be able to recruit management personnel to replace these individuals in a timely manner, or at all, on acceptable terms.

We may face risks associated with potential future acquisitions that could reduce our profitability or hinder our ability to successfully expand our operations.

 

Over the past few years, our business strategy has included engaging in acquisitions which have facilitated our ability to provide technology infrastructure and establish a presence in international markets. We have completed five acquisitions since 2006, including the acquisitions of GHCO and FCG in 2007 that significantly expanded our futures business. Additionally we completed the acquisition of substantially all of Ridge’s contracts with its securities clearing clients in June, 2010. In the future, we may acquire additional businesses or technologies as part of our growth strategy. We cannot assure you that we will be able to successfully integrate future acquisitions, which potentially involve the following risks:

 

 

Failure to manage our acquisitions to avoid these risks could harm our business, financial condition and operating results.

 

Our ability to borrow a limited amount of funds under our Amended and Restated Credit Facility may adversely affect our liquidity and our results of operations.

 

Currently, we have the capacity to borrow up to $25,000 under the Amended and Restated Credit Facility. While we believe we are in a very solid financial position, and our broker-dealer subsidiaries continue to have access to capital to finance day-to-day operations through separate secured facilities, the relatively limited current availability under this facility could adversely affect us if we have an unanticipated need for additional capital and cannot obtain capital, or can only obtain capital on terms that are not favorable to us, from other sources when such funds are required. While we believe that we would be able to find alternative sources of capital should we need to raise additional funds, we cannot guarantee that we will be able to do so or that we will be able to do so on terms that are sufficiently favorable or in a timely manner.

 

Covenants in our credit agreement and certain other debt instruments restrict our business in many ways.

 

Our Amended and Restated Credit Facility, the Notes and other outstanding debt instruments include various covenants that limit our ability to engage in specified types of transactions. These covenants limit our ability to, among other things: incur additional indebtedness, pay dividends on our capital stock or redeem, repurchase or retire our capital stock or prepay certain indebtedness, make investments, make capital expenditures, engage in certain transactions with our affiliates, enter into acquisitions, consolidate, merge or sell assets, incur liens and change the business conducted by us and our subsidiaries.

 

In addition, the Amended and Restated Credit Facility contains covenants that require us to maintain specified financial ratios and satisfy other financial condition tests. Our Amended and Restated Credit Facility and the Notes also require that PFSI maintain net regulatory capital of at least 5.5% of its aggregate debt balances. Our ability to meet those financial ratios and tests can be affected by events beyond our control, and we may not be able to meet those tests. A breach of any of these covenants could result in a default under the Amended and Restated Credit Facility, the Notes and other outstanding debt instruments.

Our Amended and Restated Credit Facility, the Notes and other outstanding debt instruments include various events of default. Upon the occurrence of an event of default under the Amended and Restated Credit Facility the Notes or other outstanding debt instruments, the lenders could elect to declare all amounts outstanding under such credit facility to be immediately due and payable and terminate all commitments to extend further credit. If the obligations under our Amended and Restated Credit Facility, the Notes or the Convertible Notes were accelerated, we may not have sufficient assets to repay the amounts outstanding thereunder which would have a material adverse effect on us.

 

Our revenues may decrease due to declines in trading volume, market prices, liquidity of securities markets or proprietary trading activity.

 

We generate revenues primarily from transaction processing fees we earn from our clearing operations and interest income from our margin lending activities and interest earned by investing customers’ cash. These revenue sources are substantially dependent on customer trading volumes, market prices and liquidity of securities markets. Over the past several years the U.S. and foreign securities markets have experienced significant volatility. Sudden or gradual but sustained declines in market values of securities can result in:

 

 

The occurrence of any of these events would likely result in reduced revenues and decreased profitability from our clearing operations and margin lending activities.

 

Certain of our subsidiaries engage in proprietary trading activities. Please see our discussion in “Business — Securities-processing” and “Proprietary trading.” Historically these activities have accounted for a very small portion of our total revenues and net income/loss. With respect to most of such trading, we endeavor to limit our exposure to markets through, among other means, employing hedging strategies and by limiting the period of time that we have market exposure. However, we are not completely protected against market risk from such trading at any particular point in time and proprietary trading risks could adversely impact operating results in a specific financial period.

 

Continued market instability could negatively affect our operations and financial condition.

 

As a financial services provider, our business is sensitive to conditions in the global financial markets and economic conditions generally, as well as to the soundness of particular financial services institutions with which we transact business. Among other things, national and international markets have continued through 2010 to suffer significant turmoil initially caused by a sharp downturn in markets for mortgage-related securities and non-investment grade debt securities and loans. Several large financial institutions including, without limitation, commercial banks, insurance companies, and brokerage firms, have either filed for bankruptcy or been the subject of governmental intervention in the form of loans, equity infusions or direct government ownership in receivership. Others have been sold in whole or in part to third parties. Financial services institutions that deal with each other are often interrelated as a result of trading, clearing, counterparty, or other relationships. As a result, a default or failure by, or even concerns about the stability or liquidity of, one or more financial services institutions could lead to significant market-wide liquidity problems, or losses or defaults by other institutions, including us. In addition, our operations may suffer to the extent that ongoing market volatility causes individuals and institutional traders and other market participants to curtail or forego trading activities, which could adversely affect our operations and financial conditions.

Our significant non-U.S. operation exposes us to global exchange rate fluctuations that could impact our profitability.

 

We are exposed to market risk through commercial and financial operations. Our market risk consists principally of exposure to fluctuations in currency exchange and interest rates. As we conduct a significant portion of our operations outside the U.S., fluctuations in currencies of other countries, especially the British Pound and the Canadian and Australian dollars, may materially affect our operating results. As we continue to expand our business operations globally, our exposure to fluctuations in currencies of other countries will continue to increase.

 

We do not typically use financial instruments to hedge our income statement exposure to foreign currency fluctuations. A substantial portion of our revenues and cost of operating expenses are denominated in currencies other than the U.S. dollar. In our consolidated financial statements, we translate our local currency financial results into U.S. dollars based on average exchange rates prevailing during a reporting period and financial position based on the exchange rate at the end of that period. During times of a strengthening U.S. dollar, at a constant level of business, our reported international revenues, earnings, assets and liabilities will be reduced because the local currency will translate into fewer U.S. dollars.

 

Given the volatility of exchange rates, we may not be able to manage our currency transaction and/or translation risks effectively, or volatility in currency exchange rates may expose our financial condition or results of operations to significant additional risk.

 

Requirements to close out fails resulting from short sales could increase our costs and adversely affect our securities lending business.

 

We are subject to Rule 204 under the Exchange Act, which requires clearing broker-dealers to make delivery on short sales effected in the U.S. no later than T+3. Under Rule 204, clearing broker-dealers that do not purchase or borrow securities to cover certain fail positions as of the opening of trading on T+4 are subject to a borrowing penalty for each security that the clearing-broker fails to deliver (subject to the allocation provision noted below). The borrowing penalty, which requires pre-borrowing in connection with short sales, will apply until the clearing broker purchases a sufficient amount of the security to make full delivery on the fail position and that purchase clears and settles. If a clearing broker becomes subject to the borrowing penalty, the penalty will prohibit the clearing broker from effecting short sales in that security for its own account or for that of any introducing broker or customer unless the clearing broker has borrowed the securities in question or has entered into a bona fide arrangement to borrow the securities. Clearing broker-dealers are permitted to reasonably allocate the close-out requirement to an introducing broker that is responsible for the fail position. As the clearing broker-dealer, if we are unable to timely cover a fail position and cannot allocate the close-out responsibility to the broker-dealer that is responsible for the fail position, we would be subject to the borrowing penalty until such time as we have purchased a sufficient amount of the security to make full delivery on the fail position and that purchase has cleared and settled, which generally is three business days after the purchase. Foreign jurisdictions in which we operate also have restrictions on short selling. Because of the requirements of Rule 204 and foreign restrictions on short selling, our costs associated with handling short sales, including the costs associated with closing out fail positions and borrowing securities to facilitate short selling may increase significantly. In addition, if we become subject to the borrowing penalty, our customers may be less likely to use our securities lending department for short sale transactions and the scope of our securities lending business may significantly decrease, which will adversely affect our operations and financial condition.

 

On February 24, 2010, the SEC adopted additional restrictions on short selling stock. These restrictions, known as the alternative uptick rule, restrict short selling in securities that have dropped more than 10% in one day. These changes and potential future regulatory changes related to short-selling of securities may have a negative impact on our ability to earn the spreads we have historically collected.

General economic and political conditions and broad trends in business and finance that are beyond our control may contribute to reduced levels of activity in the securities markets, which could result in lower revenues from our business operations.

 

Trading volume, market prices and liquidity are affected by general national and international economic and political conditions and broad trends in business and finance that result in changes in volume and price levels of securities transactions. These factors include:

 

 

These factors are beyond our control and may contribute to reduced levels of activity in the securities markets. Our largest source of revenues has historically been revenues from clearing operations, which are largely driven by the volume of trading activities of the customers of our correspondents and proprietary trading by our correspondents. Our margin lending revenues and technology revenues are also impacted by changes in the trading activities of our correspondents and customers. Accordingly, any significant reduction in activity in the securities markets would likely result in lower revenues from our business operations.

 

Our quarterly revenue and operating results are subject to significant fluctuations.

 

Our quarterly revenue and operating results may fluctuate significantly in the future due to a number of factors, including:

 

 

Our expense structure is based on historical expense levels and the expected levels of demand for our clearing, margin lending and other services. If demand for our services declines, we may be unable to adjust our cost structure on a timely basis in order to achieve profitability.

 

Due to the foregoing factors, period-to-period comparisons of our historical revenues and operating results are not necessarily meaningful, and you should not rely upon such comparisons as indicators of future performance. We

also cannot assure you that we will be able to sustain the rates of revenue growth we have experienced in the past, or improve our operating results.

 

Our involvement in futures and options markets subjects us to risks inherent in conducting business in those markets.

 

We principally clear futures and options contracts on behalf of our correspondents and their respective customers. Trading in futures and options contracts is generally more highly leveraged than trading in other types of securities. This additional leverage increases the risk associated with trading in futures and options contracts, which in turn raises the risk that a correspondent, introducing broker, or customer may not be able to fully repay its creditors, including us, if it experiences losses in its futures and options contract trading business.

 

We may not be able to or determine not to hedge our foreign exchange risk.

 

As a foreign exchange trade dealer, we enter into currency transactions with certain of our institutional clients or other institutions using modeled prices that we determine and may seek to hedge our risk by executing similar transactions on the various exchanges or electronic communication networks of which we are a participant. While we expect to be able to limit our risk in our transactions with our clients through hedging transactions on exchanges or ECNs or through other counterparty relationships, there is no guarantee that we will be able to enter into these transactions at prices similar to those which we entered into with our clients. In addition, while we may intend to enter into the hedging transactions after we enter into a transaction with our client or the relevant institution, it is possible that currency prices could fluctuate before we are able to enter into such hedging transactions or, for other reasons, we may determine not to hedge such risk.

 

The securities and futures businesses are highly dependent on certain market centers that may be targets of terrorism.

 

Our business is dependent on exchanges and market centers being able to process trades. Terrorist activities in September 2001 caused the U.S. securities markets to close for four days. This impacted our revenue and profitability for that period of time. If future terrorist incidents cause interruption of market activity, our revenues and profits may be negatively impacted.

 

Extreme market volatility may cause investors to avoid participation in equity markets, which could lead to substantially reduced trading volumes.

 

On May 6, 2010, the Dow Jones Industrial Average plunged over 900 points and then rapidly rebounded. This “Flash Crash” caused many investors and traders to reduce their trading activity in equity markets, or to suspend all trading activity. Any further market disruptions that cause investors and traders to reduce trading activity could lead to significantly reduced trading volumes, which could adversely affect our revenue and profitability.

 

Risks related to government regulation

 

All aspects of our business are subject to extensive government regulation. If we fail to comply with these regulations, we may be subject to disciplinary or other action by regulatory organizations, and we could suffer significant reputational and financial loss.

 

The securities industry in the U.S. is subject to extensive regulation under both federal and state laws. In addition to these laws, we must comply with rules and regulations of the SEC, NYSE, FINRA, the CFTC, the NFA, various stock and futures exchanges, state securities commissions and other regulatory bodies charged with safeguarding the integrity of the securities markets and other financial markets and protecting the interests of investors participating in these markets. Broker-dealers and FCMs are subject to regulations covering all aspects of the securities and futures businesses, including:

 

 

 

Our ability to comply with these regulations depends largely on the establishment and maintenance of an effective compliance system as well as our ability to attract and retain qualified compliance personnel. We could be subject to disciplinary or other actions due to claimed non-compliance with these regulations in the future and even for the claimed non-compliance of our correspondents with such regulations. If a claim of non-compliance is made by a regulatory authority, the efforts of our management could be diverted to responding to such a claim and we could be subject to a range of possible consequences, including the payment of fines and the suspension of one or more portions of our business. Additionally, our clearing contracts generally include automatic termination provisions which are triggered in the event we are suspended from any of the national exchanges of which we are a member for failure to comply with the rules or regulations thereof.

 

We and certain of our officers and employees have been subject to claims of non-compliance in the past, and may be subject to claims and legal proceedings in the future.

 

We also operate clearing and related businesses in the U.K., Canada and Australia and execute transactions in global markets. These non-U.S. businesses are also heavily regulated. To the extent that different regulatory regimes impose inconsistent or iterative requirements on the conduct of our business, we will face complexity and additional costs in our compliance efforts. In addition, as we expand into new non-U.S. markets with which we may have relatively less experience, there is a risk that our lack of familiarity with the regulations impacting such markets may affect our performance and results.

 

The regulatory environment in which we operate has experienced increasing scrutiny by regulatory authorities in recent years and further changes in legislation or regulations may affect our ability to conduct our business or reduce our profitability.

 

The legislative and regulatory environment in which we operate has undergone significant change in the past and may undergo further change in the future. The CFTC, SEC, NYSE, FINRA, NFA, various securities or futures exchanges and other U.S. and foreign governmental or regulatory authorities continuously review legislative and regulatory initiatives and may adopt new or revised laws and regulations. These legislative and regulatory initiatives may affect the way in which we conduct our business and may make our business less profitable. Changes in the interpretation or enforcement of existing laws and regulations by those entities may also adversely affect our business. Certain regulatory authorities have been more likely in recent years to commence enforcement actions against companies in our industry and penalties and fines sought by certain regulatory authorities have increased substantially in recent years.

 

In addition, because our industry is heavily regulated, regulatory approval may be required prior to expansion of our business activities. We may not be able to obtain the necessary regulatory approvals for any desired expansion. Even if approvals are obtained, they may impose restrictions on our business and could require us to incur significant compliance costs or adversely affect the development of business activities in affected markets.

 

Recently enacted financial reform legislation and related regulations may negatively affect our business activities, results of operations and profitability.

 

While certain provisions of the Dodd-Frank Act will be effective immediately, many other provisions will be effective only following extended transition periods of varying lengths. Therefore, it is impractical at present to forecast the comprehensive effects of the legislation. The Dodd-Frank Act also mandates the preparation of studies on a wide range of issues, which could lead to additional legislation or regulatory changes. This legislation makes extensive changes to the laws regulating financial services firms and requires significant rule-making. The legislation and regulation of financial institutions, both domestically and internationally, include calls to increase capital and liquidity requirements, limit the size and types of the activities permitted and increase taxes on some institutions.

While we are currently assessing the impact that these initiatives will have directly on our business, we are also assessing the indirect effect on us due to the impact on certain of our customers. As a result of the effect of these new legislative and regulatory changes on our customers, our revenue may materially decrease, our ability to pursue certain business opportunities may be limited, we may be required to change certain of our business practices, we may incur significant additional costs and we may otherwise have our business adversely affected. If we do not comply with current or future legislation and regulations that apply to our operations, we may be subject to fines, penalties or material restrictions on our businesses in the jurisdiction where the violation occurred. Accordingly, we cannot provide assurance that any such new legislation or regulation would not have an adverse effect on our business, results of operations, profitability or financial condition.

 

If we do not maintain the capital levels required by regulations, we may be subject to fines, suspension, revocation of registration or expulsion by regulatory authorities.

 

We are subject to stringent rules imposed by the SEC, NYSE, FINRA, and various other regulatory agencies which require broker-dealers to maintain specific levels of net capital. Net capital is the net worth of a broker-dealer, less deductions, for other types of assets including assets not readily convertible into cash and specified percentages of a broker-dealer’s proprietary securities positions. If we fail to maintain the required net capital, we may be subject to suspension or revocation of registration by the SEC and suspension or expulsion by NYSE and/or FINRA, which, if not cured, could ultimately lead to our liquidation. If the net capital rules are changed or expanded, or if there is an unusually large charge against our net capital, we might be required to limit or discontinue our clearing and margin lending operations that require the intensive use of capital. In addition, our ability to withdraw capital from our subsidiaries could be restricted, which in turn could limit our ability to pay dividends, repay or repurchase debt, including the notes, at the parent company level and redeem or purchase shares of our outstanding stock, if necessary. A large operating loss or charge against net capital could impede our ability to expand or even maintain our present volume of business.

 

Our futures clearing business is subject to the capital and segregation rules of the NFA and CFTC. If we fail to maintain the required capital, or if we violate the customer segregation rules, we may be subject to monetary fines, and the suspension or revocation of our license to clear futures contracts. Any interruption in our ability to continue this business would impact our revenues and profitability.

 

Outside of the U.S., we are subject to other regulatory capital requirements. Our U.K. subsidiary is subject to capital adequacy rules that require our subsidiary to maintain stockholders’ equity and qualifying subordinated loans at specified minimum levels. If we fail to maintain the required regulatory capital, we may be subject to fine, suspension or revocation of our license with the FSA. If our license is suspended or revoked or if the capital adequacy requirements are changed or expanded, we may be required to discontinue our U.K. operations, which could result in diminished revenues.

 

As a member of IIROC, an approved participant with the Montreal Exchange, a participating organization with the Toronto Stock Exchange and a member of the TSX Venture Exchange and various Canadian alternative trading systems, PFSC is subject to the rules and policies of IIROC and other rules relating to the maintenance of regulatory capital. Specifically, to ensure that the IIROC members will be able to meet liabilities as they become due, IIROC requires its investment dealer members to periodically calculate their risk adjusted capital in accordance with a prescribed formula. If PFSC fails to maintain the required risk adjusted capital, it may be subject to monetary sanctions, suspensions or other sanctions, including expulsion as a member. If PFSC is sanctioned or expelled or if the risk adjusted capital requirements are changed or expanded, PFSC may be required to discontinue operations in Canada, which could result in diminished revenues.

 

PFSA holds an Australian Financial Services License and is a market participant of the ASX and is an ASX Clear participant. As such, PFSA is subject to, amongst other things, the rules established by the ASX and ASX Clear governing the minimum risk based capital requirements for participants in the ASX and ASX Clear. The ASX Clear capital requirements establish minimum core liquid capital requirements and minimum requirements for a participant’s liquid capital as compared to a number of different risk based metrics which make up the participant’s total risk requirement. The risk requirements vary depending on the operations undertaken by the participant. A participant’s core liquid capital is based principally on a participant’s equity and retained profits, while the liquid capital adjusts core liquid capital to take account of reserves and in certain cases subordinated debt and preferred

stock. If PFSA should fail to comply with the requirements of these various measures of capital, we may be required to discontinue our Australian operations, which could result in diminished revenues.

 

In addition, some of the investments we make in our business may impact our regulatory capital. We have made large investments into Nexa and expect to continue to do so in the future. Investments in non-regulated subsidiaries and increases in illiquid assets, including unsecured customer accounts decrease the capital available for our regulated subsidiaries. If we experience increased levels of unsecured and partially secured accounts in the future, we could suffer significant financial loss.

 

Procedures and requirements of the USA PATRIOT Act may expose us to significant costs or penalties.

 

As participants in the financial services industry, our subsidiaries are subject to laws and regulations, including the USA PATRIOT Act of 2001, which require that they know certain information about their customers and monitor transactions for suspicious financial activities. The cost of complying with the PATRIOT Act and related laws and regulations is significant. We may face particular difficulties in identifying our international customers, gathering the required information about them and monitoring their activities. We face risks that our policies, procedures, technology and personnel directed toward complying with the PATRIOT Act are insufficient and that we could be subject to significant criminal and civil penalties due to noncompliance. Such penalties could have a material adverse effect on our business, financial condition and operating results and cash flows.

 

Risks related to our corporate structure

 

Our discontinued operations expose us to legal and other risks.

 

In May, 2006, we completed the disposal by split off of certain non-core business operations that were placed into the subsidiaries of a newly formed holding company known as SAMCO Holdings, Inc. (SAMCO). Our then existing stockholders exchanged $10.4 million of SAMCO net assets and $7.3 million of cash for 1.0 million Penson shares. The split off transaction was structured to be tax free to the Company and our stockholders, and the net assets were distributed at net book value. Though there was substantial common ownership between the Company and SAMCO, we did not retain any ownership interest in SAMCO, which is operated independently. Although the split off transaction occurred over three years ago, we may incur future liabilities related to the operations of the SAMCO entities. Due to the Company’s indirect ownership of the SAMCO entities prior to our initial public offering we may be exposed to additional liabilities beyond what we may ordinarily encounter in our typical customer relationships.

 

Provisions in our certificate of incorporation and bylaws and under Delaware law may prevent or frustrate a change in control or a change in management that stockholders believe is desirable.

 

Provisions of our certificate of incorporation and bylaws may discourage, delay or prevent a merger, acquisition or other change in control that stockholders may consider favorable, including transactions in which our stockholders might otherwise receive a premium for their shares. These provisions may also prevent or frustrate attempts by our stockholders to replace or remove our management. These provisions include:

 

 

In addition, our Board of Directors has the ability to designate the terms of and issue new series of preferred stock without stockholder approval, which could be used to institute a rights plan, or a poison pill, that would work to dilute the stock ownership of a potential hostile acquirer, effectively preventing acquisitions that have not been approved by our Board of Directors.

 

The affirmative vote of the holders of at least 75% of our shares of capital stock entitled to vote is necessary to amend or repeal the above provisions of our certificate of incorporation. In addition, absent approval of our Board of

Directors, our bylaws may only be amended or repealed by the affirmative vote of the holders of at least 75% of our shares of capital stock entitled to vote.

 

In addition, Section 203 of the Delaware General Corporation Law prohibits a publicly held Delaware corporation from engaging in a business combination with an interested stockholder, generally a person which together with its affiliates owns or within the last three years has owned 15% of our voting stock, for a period of three years after the date of the transaction in which the person became an interested stockholder, unless the business combination is approved in a prescribed manner. Accordingly, Section 203 may discourage, delay or prevent a change in control of our Company.

 

Risks related to our requirements as a public company

 

Our stockholders could be harmed if our management and larger stockholders use their influence in a manner adverse to other stockholders’ interests.

 

At the date of this report, our executive officers, directors and 5% stockholders beneficially own, in the aggregate, approximately 52.7% of our outstanding common stock. As a result, these stockholders may have the ability to control all fundamental matters affecting us, including the election of the majority of the board of directors and approval of significant corporate transactions. This concentration of ownership may also delay or prevent a change in our control even if beneficial to stockholders. The interests of these stockholders with respect to such matters could conflict with the interests of public stockholders.

 

The price of our common stock may be volatile.

 

Since the completion of our initial public offering in May 2006, the price at which our common stock has traded has been subject to significant fluctuation. The price of our common stock may continue to be volatile in the future and could be subject to wide fluctuations in response to:

 

 

As a result, shareholders may be unable to sell their stock at or above the price they paid for it.

 

Our internal control over financial reporting may not be effective and our independent registered public accounting firm may not be able to provide an attestation report as to their effectiveness, which could have a significant and adverse effect on our business and reputation.

 

We are continuously evaluating our internal controls over financial reporting in order to allow management to report on, and our independent registered public accounting firm to attest to, our internal controls over financial reporting, as required by Section 404 of the Sarbanes-Oxley Act of 2002, as amended (“Sarbanes-Oxley Act”) and rules and regulations of the SEC thereunder, which we refer to as Section 404. While we have not identified material weaknesses to date, we may from time to time identify conditions that may result in material weaknesses.

 

 

None

 

Description of property

 

Our headquarters are located in Dallas, Texas, under a lease that expires in June 2016. This lease covers approximately 94,690 square feet at our headquarters, and our fixed rent is approximately $134,000 per month. We have one five-year option to extend the lease at the prevailing market rate. We sublease approximately 18,000 square feet of this space to SAMCO Holdings. In addition, our Canadian subsidiary leases approximately 42,420 square feet in the Montreal and Toronto. We also lease additional office space at locations in California, Illinois, New York, Minnesota, Wisconsin, Texas, London, Hong Kong, Tokyo, Sydney and other locations to support our operations. We believe that our present facilities, together with our current options to extend lease terms and occupy additional space, are adequate for our current needs.

 

 

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

 

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

 

On December 15, 2008, over the objections of Penson Futures and PFFI, the court entered an order confirming the Committee Plan, and the Committee Plan became effective on December 17, 2008. On January 7, 2009 Penson Futures and PFFI filed their answer and affirmative defenses to the suit brought by the Sentinel Trustee. Also on January 7, 2009, Penson Futures, PFFI and a number of other FCMs that had placed customer funds with Sentinel filed motions with the federal district court for the Northern District of Illinois, effectively asking the federal district court to remove the Sentinel suits against the FCMs from the bankruptcy court and consolidate them with other Sentinel related actions pending in the federal district court. On April 8, 2009, the Sentinel Trustee filed an amended complaint, which added a claim for unjust enrichment. Following an unsuccessful attempt to dismiss that claim on September 1, 2009, the Court denied the motion for reconsideration without prejudice. On September 11, 2009, Penson Futures and PFFI filed their amended answer and amended affirmative defenses to the Sentinel Trustee’s amended complaint. On October 28, 2009, the federal district court for the Northern District of Illinois granted the motions of Penson Futures, PFFI, and certain other FCM’s requesting removal of the matters referenced above from the bankruptcy court, thereby removing these matters to the federal district court.

 

On February 23, 2011, the federal district court held a continued status hearing, during which Penson Futures, PFFI and the Sentinel Trustee agreed that coordinated discovery with respect to the Sentinel suits against the Company and other FCMs was still proceeding. No trial date has been set.

In one of the actions brought by the Sentinel Trustee against an FCM whose customer segregated accounts received similar distributions to those made to the customer segregated accounts of Penson Futures and PFFI, the Sentinel Trustee has brought a motion for summary judgment on certain counts asserted against such FCM that may implicate the claims brought by the Sentinel Trustee against the Company. There is no date set for the resolution of that motion.

 

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

 

Various Claimants v. Penson Financial Services, Inc., et al. On July 18, 2006, three claimants filed separate arbitration claims with the NASD (which is now known as FINRA) against PFSI related to the sale of certain collateralized mortgage obligations by SAMCO Financial Services, Inc. (“SAMCO Financial”), a former correspondent of PFSI, to its customers. In the ensuing months, additional arbitration claims were filed against PFSI and certain of our directors and officers based upon substantially similar underlying facts. These claims generally allege, among other things, that SAMCO Financial, in its capacity as broker, and PFSI, in its capacity as the clearing broker, failed to adequately supervise certain registered representatives of SAMCO Financial, and otherwise acted improperly in connection with the sale of these securities during the time period from approximately June, 2004 to May, 2006. Claimants have generally requested compensation for losses incurred through the depreciation in market value or liquidation of the collateralized mortgage obligations, interest on any losses suffered, punitive damages, court costs and attorneys’ fees. In addition to the arbitration claims, on March 21, 2008, Ward Insurance Company, Inc., et al, filed a claim against PFSI and Roger J. Engemoen, Jr., the Company’s Chairman of the Board, in the Superior Court of California, County of San Diego, Central District, based upon substantially similar facts. The Company has now settled, or agreed in principle to settle, all claims with respect to this matter of which the Company is aware. No further claims based on this matter are expected at this time.

 

Mr. Engemoen, the Company’s Chairman of the Board, is the Chairman of the Board, and beneficially owns approximately 52% of the outstanding stock, of SAMCO Holdings, Inc., the holding company of SAMCO Financial and SAMCO Capital Markets, Inc. (SAMCO Holdings, Inc. and its affiliated companies are referred to as the “SAMCO Entities”). Certain of the SAMCO Entities received certain assets from the Company when those assets were split-off immediately prior to the Company’s initial public offering in 2006 (the “Split-Off”). In connection with the Split-Off and through contractual and other arrangements, certain of the SAMCO Entities have agreed to indemnify the Company and its affiliates against liabilities that were incurred by any of the SAMCO Entities in connection with the operation of their businesses, either prior to or following the Split-Off. During the third quarter of 2008, the Company’s management determined that, based on the financial condition of the SAMCO Entities, sufficient risk existed with respect to the indemnification protections to warrant a modification of these arrangements with the SAMCO Entities, as described below.

 

On November 5, 2008, the Company entered into a settlement agreement with certain of the SAMCO Entities pursuant to which the Company received a limited personal guaranty from Mr. Engemoen of certain of the indemnification obligations of various SAMCO Entities with respect to claims related to the underlying facts described above, and, in exchange, the Company agreed to limit the aggregate indemnification obligations of the SAMCO Entities with respect to certain matters described above to $2,965,243. Unpaid indemnification obligations of $800,000 were satisfied prior to February 15, 2009. Of the $800,000 obligation, $86,000 was satisfied through a setoff against an obligation owed to the SAMCO Entities by PFSI, with the balance paid in cash prior to December 31, 2009. Effective as of December 31, 2009, the Company and the SAMCO entities entered into an amendment to the settlement agreement, whereby SAMCO Holdings, Inc. agreed to pay an additional $133,333 on the last business day of each of the first six calendar months of 2010 (a total of $800,000). SAMCO Holdings, Inc. has fully satisfied its obligations under the amendment. The SAMCO Entities remain responsible for the payment of their own defense costs and any claims from any third parties not expressly released under the settlement agreement, irrespective of amounts paid to indemnify the Company. The settlement agreement only relates to the matters described above and does not alter the indemnification obligations of the SAMCO Entities with respect to unrelated matters.

To account for liabilities related to the aforementioned claims that may be borne by the Company, we recorded a pre-tax charge of $2.35 million in the third quarter of 2008 and a $1.0 million in the second quarter of 2010. The Company does not anticipate further liabilities with respect to this matter.

 

Realtime Data, LLC d/b/a IXO v. Thomson Reuters et al. In July and August 2009, Realtime Data, LLC (“Realtime”) filed lawsuits against the Company and Nexa (along with numerous other financial institutions, exchanges, and financial data providers) in the United States District Court for the Eastern District of Texas in consolidated cases styled Realtime Data, LLC d/b/a IXO v. Thomson Reuters et al. Realtime alleges, among other things, that the defendants’ activities infringe upon patents allegedly owned by Realtime, including our use of certain types of data compression to transmit or receive market data. Realtime is seeking both damages for the alleged infringement as well as a permanent injunction enjoining the defendants from continuing infringing activity. Discovery with respect to this matter is proceeding.

 

A trial of Realtime’s claims is now tentatively scheduled for July 9, 2012. Based on its investigation to date and advice from legal counsel, the Company believes that resolution of these claims will not result in any material adverse effect on its business, financial condition, or results of operation. Nevertheless, the Company has incurred and will likely continue to incur significant expense in defending against these claims, and there can be no assurance that future liability will be avoided.

 

In the general course of business, the Company and certain of its officers have been named as defendants in other various pending lawsuits and arbitration and regulatory proceedings. These other claims allege violation of federal and state securities laws, among other matters. The Company believes that resolution of these claims will not result in any material adverse effect on its business, financial condition, or results of operation.

 

 

 

Market information

 

The common stock of the Company has been traded on the NASDAQ Global Select Market under the symbol PNSN since the Company’s initial public offering on May 16, 2006. Prior to that time there was no public market for the Company’s common stock or other securities.

 

The following table sets forth the high and low closing sales prices of our common stock, for the periods indicated.

 

Holders

 

No shares of the Company’s preferred stock are issued and outstanding. As of February 22, 2011, there were 48 holders of record of our common stock. By including persons holding shares in brokerage accounts under street names, however, we estimate our shareholder base to be approximately 2,673 as of February 22, 2011.

 

Dividend policy

 

We currently intend to retain any earnings to develop and expand our business and do not anticipate paying cash dividends in the foreseeable future. Any future determination with respect to the payment of dividends will be at the discretion of our Board of Directors and will depend upon, among other things, our operating results, financial condition and regulatory capital requirements, the terms of then-existing indebtedness, general business conditions and other factors our Board of Directors deems relevant.

 

Our Board of Directors may, at any time, modify or revoke our dividend policy on our common stock.

 

Under Delaware law, our Board of Directors may declare dividends only to the extent of our “surplus” (which is defined as total assets at fair market value minus total liabilities, minus statutory capital), or if there is no surplus, out of our net profits for the then current and/or immediately preceding fiscal year. The value of a corporation’s assets can be measured in a number of ways and may not necessarily equal their book value. The value of our capital may be adjusted from time to time by our Board of Directors but in no event will be less than the aggregate par value of our issued stock. Our Board of Directors may base this determination on our consolidated financial statements, a fair valuation of our assets or another reasonable method. Our Board of Directors will seek to assure itself that the statutory requirements will be met before actually declaring dividends. In future periods, our Board of Directors may seek opinions from outside valuation firms to the effect that our solvency or assets are sufficient to allow payment of dividends, and such opinions may not be forthcoming. If we sought and were not able to obtain such an opinion, we likely would not be able to pay dividends. In addition, pursuant to the terms of our preferred stock (were any to be issued), we would be prohibited from paying a dividend on our common stock unless all payments due and payable under the preferred stock have been made.

 

PWI’s purchases of its equity securities

 

The following table sets forth the repurchases we made during the three months ended December 31, 2010 for shares withheld to cover tax-withholding requirements relating to the vesting of restricted stock units issued to employees pursuant to the Company’s shareholder-approved stock incentive plan:

 

 

On December 6, 2007, our Board of Directors authorized us to purchase up to $12.5 million of our common stock in open market purchases and privately negotiated transactions. The plan is set to expire after $12.5 million of our common stock is purchased. No shares were repurchased under this plan in the fourth quarter of 2010. The maximum number of shares that could have been purchased under this plan for the months of October, November and December 2010 was 910,417, 919,343 and 958,824 respectively based on the remaining dollar amount authorized divided by the average purchase price in the month.

 

Recent sales of unregistered securities

 

None.

 

Stock Performance Graph
Cumulative Total Return to Stockholders
Penson Worldwide, Inc., NASDAQ Composite Index and NASDAQ Financial Stocks Index
% Return to Stockholders, May 16, 2006 to December 31, 2010

 

Total Return Performance

 

 

This comparison is based on a return assuming $100 invested May 16, 2006 in Penson Worldwide, Inc. Common Stock, the NASDAQ Composite Index and the NASDAQ Financial Stocks Index, assuming the reinvestment of all dividends. May 16, 2006 is the date the Company’s Common Stock commenced trading on the NASDAQ Global Select Market.

 

The above Stock Performance Graph and related information shall not be deemed “soliciting material” or to be “filed” with the Securities and Exchange Commission, nor shall such information be incorporated by reference into any future filing under the Securities Act of 1933 or the Securities Exchange Act of 1934, each as amended, except to the extent that the Company specifically incorporates it by reference into such filing.

 

The following table sets forth summary consolidated financial data for our company for the periods indicated below. The summary consolidated statements of operations data for the three years ended December 31, 2010 and the summary consolidated balance sheet data as of December 31, 2010 and 2009 has been derived from our audited consolidated financial statements included elsewhere in this document, and should be read in conjunction with the “Management’s discussion and analysis of financial condition and results of operations” section below and our consolidated financial statements and the accompanying notes included in this Annual Report on pages F-2 through F-39. The consolidated statements of operations data for the years ended December 31, 2007 and 2006 and the consolidated balance sheet data as of December 31, 2008, 2007 and 2006, all of which are set forth below, are based on the Company’s historical audited consolidated financial statements and the underlying accounting records.

 

 

 

 

 

 

The following discussion and analysis should be read in conjunction with Part II, Item 6 “Selected Financial Data” and our audited consolidated financial statements and the related notes included elsewhere in this annual report on Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in the forward-looking statements as a result of certain factors including the risks discussed in Item 1A “Risk Factors”, “Special Note Regarding Forward-Looking Statements” and elsewhere in this annual report on Form 10-K.

 

Market and Economic Conditions in 2010

 

Much of the economic uncertainty of 2008 and 2009 continued to have an effect on the securities and credit markets in 2010.

 

 

Market and Economic Conditions in 2009

 

The financial crisis of 2008 continued to have an effect on the securities and credit markets in 2009.

 

 

Market and Economic Conditions in 2008

 

During 2008, financial and credit market dislocations, and the recession, caused increased volatility and rapid changes among a wide variety of financial indicators and markets:

 

 

Overview

 

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

Since starting our business in 1995 with three correspondents, we have grown to serve approximately 371 active securities clearing correspondents and 59 futures clearing correspondents as of December 31, 2010. Our net revenues were approximately $288.3 million in 2010, $289.9 million in 2009 and $293.2 million in 2008, and consist primarily of transaction processing fees earned from our clearing operations and net interest income earned from our margin lending activities, from investing customers’ cash and from stock lending activities. Our clearing and commission fees are based principally on the number of trades we clear. We receive interest income from financing the securities purchased on margin by the customers of our correspondents. We also earn licensing and development revenues from fees we charge to our clients for their use of our technology solutions.

 

Fiscal 2010 Highlights

 

 

Acquisition of Ridge

 

On November 2, 2009, the Company entered into an asset purchase agreement (“Ridge APA”) to acquire the clearing and execution business of Ridge Clearing & Outsourcing Solutions, Inc. (“Ridge”) from Ridge and Broadridge Financial Solutions, Inc. (“Broadridge”), Ridge’s parent company. The acquisition closed on June 25, 2010, and under the terms of the Ridge APA, as later amended, the Company paid $35.2 million. The acquisition date fair value of consideration transferred was $31.9 million, consisting of 2.5 million shares of PWI common stock with a fair value of $14.6 million (based on our closing share price of $5.95 on that date) and a $20.6 million five-year subordinated note (the “Ridge Seller Note”) with an estimated fair value of $17.3 million on that date (see Note 14 to our consolidated financial statements for a description of the Ridge Seller Note discount), payable by the Company bearing interest at an annual rate equal to 90-day LIBOR plus 5.5%.

 

The Company recorded a liability of $4.1 million attributable to the estimated fair value of contingent consideration to be paid 14 months and 19 months after closing (subject to extension in the event the dispute resolution procedures set forth in the Ridge APA are invoked). The amount of contingent consideration ultimately payable will be added to the Ridge Seller Note. The contingent consideration is primarily composed of two categories. The first category includes a group of correspondents that had not generated at least six months of revenue as of May 31, 2010 (“Stub Period Correspondents”). Twelve months after closing a calculation will be performed to adjust the estimated annualized revenues as of May 31, 2010 to the actual annualized revenues based on a six-month review period as defined in the Ridge APA (“Stub Period Revenues”). The Ridge Seller Note will be adjusted 14 months after closing based on .9 times the difference between the estimated and actual annualized revenues. As of December 31, 2010 all of the correspondents in this category had generated at least six months of revenues. The Company reduced its contingent consideration liability by $.3 million, which is included in other expenses in the consolidated statements of operations for the year ended December 31, 2010. The second category includes a group of correspondents that had not yet begun generating revenues (“Non-revenue Correspondents”) as of May 31, 2010. A calculation will be performed 15 months after closing to determine the annualized revenues, based on a six-month review period, for each such non revenue correspondent (“Non-revenue Correspondent Revenues”). The Ridge Seller Note will be adjusted 19 months after closing by an amount equal to .9 times the Non-

revenue Correspondent Revenues. The estimated undiscounted range of outcomes for this category is $4.0 million to $5.0 million. There is no limit to the consideration to be paid.

 

The Company recorded goodwill of $15.9 million, intangibles of $20.1 million and a discount on the Ridge Seller Note of $3.3 million. The qualitative factors that make up the recorded goodwill include value associated with an assembled workforce, value attributable to enhanced revenues related to various products and services offered by the Company and synergies associated with cost reductions from the elimination of certain fixed costs as well as economies of scale resulting from the additional correspondents. The goodwill is included in the United States segment. A portion of the recorded goodwill associated with the contingent consideration may not be deductible for tax purposes if future payments are less than the $4.1 million initially recorded. The tax goodwill will be deductible for tax purposes over a period of 15 years. The Company has incurred acquisition related costs of approximately $5.3 million with $3.7 million and $1.6 million, respectively recognized in the years ended December 31, 2010 and 2009. Net revenues of $26.4 million and net income of approximately $1.5 million from Ridge were included in the consolidated statement of operations as of the date of the acquisition for the year ended December 31, 2010. The Company estimates that net revenues would have been $312.9 million for the year ended December 31, 2010, respectively compared to $337.2 million and $345.8 million, respectively for the years ended December 31, 2009 and 2008, and net income (loss) would have been $(19.0) million for the year ended December 31, 2010 compared to $17.3 million and $12.8 million, respectively for the years ended December 31, 2009 and 2008 had the acquisition occurred as of January 1, 2008.

 

Acquisition of FCG

 

In November 2007, our subsidiary Penson Futures acquired all of the assets of FCG, an FCM and a leading provider of technology products and services to futures traders, and assigned the purchased membership interest to GHP1 effective immediately thereafter. We closed the transaction in November, 2007 and paid approximately $9.4 million in cash and approximately 150,000 shares of common stock valued at approximately $2.2 million to the previous owners of FCG. In addition, the Company agreed to pay an annual earnout in cash for the following three-year period based on average net income, subject to certain adjustments including cost of capital, for the acquired business. The Company paid approximately $8.7 million related to the first year of the earnout period. The Company did not make an earnout payment related to the second or third year of the earnout period. The Company finalized the acquisition valuation during the third quarter of 2008 and recorded goodwill of approximately $4.0 million and intangibles of approximately $7.6 million. FCG currently conducts business as a division of Penson Futures.

 

Acquisition of GHCO

 

In November 2006, the Company entered into a definitive agreement to acquire the partnership interests of Chicago-based GHCO, a leading international futures clearing and execution firm. The Company closed the transaction on February 16, 2007 and paid approximately $27.9 million, including cash and approximately 139,000 shares of common stock valued at approximately $3.9 million to the previous owners of GHCO. Goodwill of approximately $2.8 million and intangibles of approximately $1.0 million were recorded in connection with the acquisition. In addition, the Company agreed to pay additional consideration in the form of an earnout over the next three years, in an amount equal to 25% of Penson Futures’ pre-tax earnings, as defined in the purchase agreement executed with the previous owners of GHCO. The Company did not make an earnout payment related to the first or second years of the integrated Penson Futures business. The Company paid approximately $1.1 million related to the third year of the earnout in July 2010.

 

Acquisition of Schonfeld

 

In November 2006, the Company acquired the clearing business of Schonfeld Securities LLC (“Schonfeld”), a New York-based securities firm. The Company closed the transaction in November 2006 and in January 2007, the Company issued approximately 1.1 million shares of common stock valued at approximately $28.3 million to the previous owners of Schonfeld as partial consideration for the assets acquired of which approximately $14.8 million was recorded as goodwill and approximately $13.5 million as intangibles. In addition, the Company agreed to pay an annual earnout of stock and cash over a four-year period that commenced on June 1, 2007, based on net income,

as defined in the asset purchase agreement (“Schonfeld Asset Purchase Agreement”), for the acquired business. On April 22, 2010, SAI and PFSI entered into a letter agreement (the “Letter Agreement”) with Schonfeld Group Holdings LLC (“SGH”), Schonfeld, and Opus Trading Fund LLC (“Opus”) that amends and clarifies certain terms of the Schonfeld Asset Purchase Agreement. The Letter Agreement, among other things, for purpose of determining the total payment due to Schonfeld under the earnout provision of the Schonfeld Asset Purchase Agreement: (i) removes the payment cap; (ii) clarifies that PFSI has no obligation to compress tickets across subaccounts (unless PFSI does so for other of its correspondents at a later date); and (iii) reduces the SunGard synergy credit from $2.9 million to $1.5 million in 2010 and $1.0 million in 2011. The Letter Agreement also assigns all of Schonfeld’s responsibilities under the Schonfeld Asset Purchase Agreement to its parent company, SGH, and extends the initial term of Opus’s portfolio margining agreement with PFSI from April 30, 2017 to April 30, 2019.

 

A payment of approximately $26.6 million was paid in connection with the first year earnout that ended May 31, 2008 and approximately $25.5 million was paid in connection with the second year of the earnout that ended May 31, 2009. At December 31, 2010, a liability of approximately $20.5 million was accrued as result of the third year of the earnout ended May 31, 2010 ($15.2 million) and the first seven months of the year four earnout, which we do not expect to pay prior to the second half of 2011 ($5.3 million). This balance is included in other liabilities in the consolidated statement of financial condition. The offset of this liability, goodwill, is included in other assets. In January, 2011, the Company and SGH entered into a letter agreement setting the amount due for the third year earnout at $6.0 million due to the provisions in various agreements related to the Schonfeld transaction, including the termination/compensation agreement, which reduced the amount that we are required to pay under the Schonfeld Asset Purchase Agreement. This will result in a reduction in goodwill and other liabilities of $9.2 million in the first quarter of 2011. The letter agreement also stipulated that the third year earnout will be paid evenly over a 12 month period commencing on September 1, 2011.

 

Financial overview

 

Net revenues

 

Revenues

 

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

 

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

 

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

 

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

Revenues from clearing and commission fees represented 53%, 50% and 51% of our total net revenues for the years ended December 31, 2010, 2009 and 2008, respectively.

 

Interest expense from securities operations

 

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

 

Net interest income represented 24%, 23% and 26% of our total net revenues for years ended December 31, 2010, 2009 and 2008, respectively.

 

Expenses

 

Employee compensation and benefits

 

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

 

Other operating expenses

 

Expenses incurred to process trades include floor brokerage, exchange and clearance fees, and those expenses tend to vary significantly with the level of trading activity. The related data processing and communication costs vary less with the level of trading activity. Occupancy and equipment expenses include lease expenses for office space, computers and other equipment that we require to operate our businesses. Other expenses include legal, regulatory, professional consulting, accounting, travel and miscellaneous expenses. In addition, as a public company, we incur additional costs for external advisers such as legal, accounting, auditing and investor relations services.

 

Profitability of services provided

 

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

Results of operations

 

The following table summarizes our operating results as a percentage of net revenues for each of the periods shown.

 

 

Comparison of years ended December 31, 2010 and December 31, 2009

 

Overview

 

Results of operations declined for the year ended December 31, 2010 compared to the year ended December 31, 2009. Clearing and commission fees increased $8.1 million and net interest revenues increased $2.6 million while technology revenues decreased $3.4 million and other revenues decreased $8.9 million. The addition of the Ridge business in June 2010 resulted in higher clearing and commission fees of $16.2 million and higher net interest revenues of $7.1 million resulting in decreases to both revenue categories when compared to our existing business in 2009. The decline in clearing and commission fees resulted from weaker equity and options volumes in the U.S. and Canada. These declines were offset by higher futures volumes and higher equity volumes in the U.K. and the addition of PFSA, our Australian clearing business which began clearing for its first correspondent in December 2009. The volume declines followed the trend across the industry with equity average daily volumes in the U.S. down over 12% and options average daily volumes down over 8%. The decline in net interest revenues is primarily attributed to lower net spreads which were offset in part by higher average balances. We also incurred higher operating expenses, primarily in employee compensation and benefits, communications and data processing, floor brokerage, exchange and clearance fees and interest expense on long-term debt. These higher costs are attributable to the aforementioned Ridge acquisition, $6.1 million in severance charges and higher levels of long-term debt associated with the $200 million debt offering completed in the second quarter of 2010 and the $20.6 million Ridge Seller Note offset by a $110 million reduction in our revolving credit facility during the second quarter 2010 ($88.5 million as of December 31, 2009).

Operating results declined $35.4 million for 2010 as compared to 2009, for our U.S., Canadian and U.K. operating businesses. Our U.S. operating subsidiaries experienced a decrease in operating profits of approximately $25.8 million due to lower net interest income, lower technology revenues, higher expenses related to communications and data processing, floor brokerage, exchange and clearance fees due to lower industry rebates and higher interest expense on long-term debt. Our Canadian business experienced an operating profit of $2.0 million for 2010 compared to an operating profit of $10.4 million for 2009 due primarily to lower clearing and commission fees due to lower equity volumes from the loss of a major correspondent as well as its conversion to the Broadridge system which impacted the addition of new business. The U.K. business incurred an operating loss of $8.2 million in the current year compared to an operating loss of $7.1 million in the prior year due primarily to higher operating expenses. PFSA incurred an operating loss of approximately $2.7 million in 2010 compared to an operating loss of $1.4 million in 2009. PFSA began clearing operations for its first correspondent in December, 2009 and became profitable in the fourth quarter of 2010.

 

The above factors resulted in an operating loss for the year ended December 31, 2010 compared to an operating profit for the year ended December 31, 2009.

 

The following is a summary of the increases (decreases) in the categories of net revenues and expenses for the year ended December 31, 2010 compared to the year ended December 31, 2009.

 

Net revenues

 

Net revenues decreased $1.5 million, or .5%, to $288.3 million from the year ended December 31, 2009 to the year ended December 31, 2010. The decrease is primarily attributed to the following:

 

Clearing and commission fees increased approximately $8.1 million, or 5.6%, to $153.2 million during this same period. This increase is attributable to clearing and commission fees of approximately $16.2 million related to the Ridge acquisition, approximately $6.2 million from PFSA which began clearing in December 2009, approximately $3.8 million from our futures business and $.2 million in the U.K offset by a decrease of approximately $10.1 million associated with our existing securities clearing businesses in the U.S and $8.5 million in Canada. The increase in clearing and commission fees in our futures business is attributable to higher futures volumes. The decrease in clearing and commission fees is primarily due to lower equity volumes in Canada from the loss of a major Canadian correspondent and lower equity and option volumes in the U.S during the second half of 2010.

 

Technology revenue decreased $3.4 million, or 14.2%, to $20.4 million due to lower licensing fees of approximately $2.6 million due to the expiration of a licensing contract, lower development revenues of approximately $.5 million and lower recurring revenues of approximately $.3 million.

 

Interest, gross decreased $9.5 million or 9.4%, to $90.8 million during the year ended December 31, 2010 compared to the year ended December 31, 2009. Interest revenues from customer balances increased $4.9 million or 6.6% to $80.1 million due to an increase in our average daily interest earning assets of $1.6 billion or 30.6% to $6.7 billion offset by a decrease in our average daily interest rate of 27 basis points or 19.0% to 1.15%.

 

Interest from our stock conduit borrows operations decreased $14.4 million or 57.4% to $10.7 million, as a result of a decrease in our average daily interest rate of 221 basis points or 55.1% to 1.80% and a decrease in our average daily assets of approximately $31.6 million, or 5.0% to $593.4 million.

 

Other revenue decreased $8.9 million, or 16.1%, to $46.2 million primarily due to decreases in execution services revenues of $4.3 million and $1.8 million decrease in our trade aggregation business resulting from lower volumes, a decrease of approximately $4.1 million in equity and foreign exchange trading as well as a $4.8 million of investment income in 2009 related to the sale of LCH.Clearnet stock offset primarily by increased account servicing fees of approximately $6.6 million.

 

Interest expense from securities operations decreased $12.0 million, or 35.0%, to $22.3 million from the year ended December 31, 2009 to the year ended December 31, 2010. Interest expense from clearing operations decreased approximately $.5 million, or 3.0%, to $15.0 million due to a 9 basis point or 26.5% decrease in our average daily interest rate to .25% offset by an increase in our average daily balances on our short-term obligations of $1.5 billion, or 32.6%, to $6.1 billion.

 

Interest from our stock conduit loans decreased $11.5 million, or 61.5% to $7.2 million due to a 179 basis point decrease, or 59.5% in our average daily interest rate to 1.22% and a $30.3 million, or 4.9% decrease in our average daily balances to $592.7 million.

 

Interest, net increased from $65.9 million for the year ended December 31, 2009 to $68.5 million for the year ended December 31, 2010. This increase was due to higher customer balances attributable to our Ridge acquisition as well a higher correspondent count from our existing businesses offset by a lower interest rate spread of 18 basis points on customer balances and 42 basis points on conduit balances as well as slightly lower conduit balances.

 

Employee compensation and benefits

 

Total employee costs increased $6.6 million, or 5.9%, to $119.7 million from the year ended December 31, 2009 to the year ended December 31, 2010, primarily due to severance charges of approximately $6.1 million and $.9 million of costs related to future outsourcing resulting from our recent Ridge acquisition (see Note 28 to our consolidated financial statements) and a program to reduce overhead as a result of the current market environment, $2.6 million associated with our PFSA subsidiary and $1.8 million associated with the Ridge acquisition offset by lower incentive-based compensation expense of approximately $1.7 million and lower continuing employee costs from a lower headcount. Employee headcount decreased by 46 as a result of reductions in force offset by increases in headcount at PFSA of 11 and 30 employees associated with the Ridge acquisition. Employee headcount was 985 as of December 31, 2010.

Floor brokerage, exchange and clearance fees

 

Floor brokerage, exchange and clearance fees increased $8.0 million, or 24.6%, to $40.4 million for the year ended December 31, 2010 from the year ended December 31, 2009, due to higher equity, options and futures volumes, a change in mix, lower industry rebates and the addition of the Ridge business and PFSA.

 

Communication and data processing

 

Total expenses for our communication and data processing requirements increased $14.8 million, or 32.6%, to $60.3 million from the year ended December 31, 2009 to the year ended December 31, 2010 due primarily to the addition of the Ridge business on June 25, 2010 and PFSA which began clearing operations in December 2009.

 

Occupancy and equipment

 

Total expenses for occupancy and equipment increased $2.8 million, or 9.4%, to $32.2 million from the year ended December 31, 2009 to the year ended December 31, 2010 primarily due to increased software amortization attributable to new computer systems and the addition of the Ridge business and PFSA.

 

Other expenses

 

Other expenses increased $.8 million, or 2.4%, to $34.2 million from the year ended December 31, 2009 to the year ended December 31, 2010, primarily due to $3.0 million of costs associated with the closing of the Ridge acquisition compared to $1.4 million in 2009, $1.1 million in higher legal expenses incurred to conclude certain outstanding litigation, higher professional fees associated with our Broadridge conversion and the addition of our PFSA subsidiary, offset by lower expense controls in all other categories.

 

Interest expense on long-term debt

 

Interest expense on long-term debt increased $20.5 million from $10.3 million for the year ended December 31, 2009 to $30.8 million for the year ended December 31, 2010 resulting primarily from approximately $17.0 million associated with our senior second lien secured notes issued on May 6, 2010, $3.4 million of additional interest expense associated with our senior convertible notes issued on June 3, 2009, $.9 million related to the Ridge Seller Note offset by approximately $.9 million lower interest costs on our revolving credit facility. These higher interest costs are associated with higher interest rates and higher average balances as compared to the prior year.

 

Provision for income taxes

 

Income tax benefit, based on an effective income tax rate of approximately 32.1%, was $9.4 million for the year ended December 31, 2010 as compared to an effective tax rate of 38.0% and income tax expense of $9.8 million for the year ended December 31, 2009. The lower effective income tax rate is primarily due to current period losses and items deducted for books that are not deductible for tax primarily attributable to stock-based compensation that create additional taxable income.

 

Net income (loss)

 

As a result of the foregoing, we incurred a net loss of $19.8 million for the year ended December 31, 2010 compared to net income of $16.0 million for the year ended December 31, 2009.

 

Comparison of years ended December 31, 2009 and December 31, 2008

 

Overview

 

Results of operations declined for the year ended December 31, 2009 compared to the year ended December 31, 2008 primarily due to lower clearing and commission fees, lower net interest revenue, higher floor brokerage, exchange and clearance fees due to the timing of rebates received in the prior year and higher communications and data processing fees resulting from a move to SunGard’s latest generation system consisting of equipment dedicated to our U.S. clearing business, partially offset by higher technology and other revenues. Technology revenues increased

due to licensing revenue for the current year that did not begin until the third quarter of 2008. The decline in net interest earned is a result of higher customer average paying balances, lower average balances in our conduit business and lower interest spreads on our customer balances in the current period as compared to the year ago period, offset slightly by higher interest rate spreads on our conduit business and higher customer average earning balances. Results of operations from our U.S., Canadian and U.K. operating businesses were $69.5 million in 2009 as compared to $49.6 million in 2008. This increase was a result of the correspondent asset loss related to the unsecured receivable from Evergreen Capital Partners, Inc. in 2008 (see Note 26 to our consolidated financial statements).

 

Our U.S. operating subsidiaries experienced an increase in operating profits of approximately $4.3 million due primarily to higher other revenues and higher technology revenue offset by lower net interest income, higher floor brokerage, exchange and clearance fees and higher communications and data processing costs. Our Canadian business experienced an operating profit of $10.4 million for the year ended December 31, 2009 compared to an operating loss of $9.6 million for the year ended December 31, 2008. This increase is primarily due to the previously mentioned correspondent asset loss in 2008, offset by lower net interest income and higher floor brokerage, exchange and clearance fees. The U.K. incurred an operating loss of $7.1 million in the current period compared to an operating loss of $2.7 million in the year ago period, due primarily to the loss of the contracts for difference business, lower net interest income and additional data processing expenses of approximately $1 million related to the transition to a new back office system.

 

The above factors resulted in higher operating income for the year ended December 31, 2009 compared to the year ended December 31, 2008.

 

The following is a summary of the increases (decreases) in the categories of net revenues and expenses for the year ended December 31, 2009 compared to the year ended December 31, 2008.

 

Net revenues

 

Net revenues decreased $3.3 million, or 1.1%, to $289.9 million from the year ended December 31, 2008 to the year ended December 31, 2009. The decrease is primarily attributed to the following:

 

Clearing and commission fees decreased $5.5 million, or 3.7%, to $145.0 million during this same period primarily due to a lower volume of equity and futures transactions, partially offset by an increase in options contracts.

 

Technology revenue increased $1.6 million, or 7.2%, to $23.8 million primarily due to approximately $.6 million in licensing revenue and higher recurring revenue of $3.2 million, offset by lower development revenue of $2.2 million resulting from a decline in new projects resulting from the current economic conditions.

 

Interest, gross decreased $65.5 million or 39.5%, to $100.2 million in 2009 compared to 2008. Interest revenues from customer balances decreased $41.1 million or 35.4% to $75.2 million as our average daily interest rate decreased 98 basis points or 40.8% to 1.42% (during this same period the average federal funds rate decreased 184 basis points) offset by an increase in our average daily interest earning assets of $552.6 million, or 12.1% to $5.1 billion.

 

Interest from our stock conduit borrows operations decreased $24.4 million or 49.3% to $25.1 million, due to decrease in our average daily assets of $842.5 million or 57.4% to $625.0 million, offset by an increase in our average daily interest rate of approximately 64 basis points, or 19.0% to 4.01%.

 

Other revenue increased $9.7 million, or 21.5%, to $55.1 million due to increased revenues of $1.0 million from our trade aggregation business in the U.S, increased execution services revenues of $5.1 million and investment income of $4.8 million related to the sale of LCH.Clearnet stock obtained as part of the February 2007 GHCO acquisition, offset by decreases in foreign exchange trading.

 

Interest expense from securities operations decreased $56.4 million, or 62.2%, to $34.3 million from the year ended December 31, 2008 to the year ended December 31, 2009. Interest expense from clearing operations decreased approximately $36.3 million, or 70.1%, to $15.5 million due to a 99 basis point or 74.4% decrease in our average daily interest rate to .34%, offset by an increase in our average daily balances of our short-term obligations of $724.4 million, or 18.7%, to $4.6 billion.

 

Interest from our stock conduit loans decreased $20.1 million, or 51.7% to $18.8 million due to a $835.4 million, or 57.3% decrease in our average daily balances to $623.0 million, offset by a 34 basis point increase, or 12.7% in our average daily interest rate to 3.01%.

 

Interest, net decreased from $75.1 million for the year ended December 31, 2008 to $65.9 million for the year ended December 31, 2009. This decrease was due to a higher ratio of customer interest paying balances to interest earning balances combined with significantly lower conduit balances, offset slightly by a higher interest rate spread of one basis point on customer balances and 30 basis points on conduit balances.

 

Employee compensation and benefits

 

Total employee costs decreased $0.6 million, or 0.5%, to $113.1 million from the year ended December 31, 2008 to the year ended December 31, 2009, primarily due to lower incentive-based compensation expense, partially offset by $.8 million of severance costs in the first quarter. Employee count remained fairly constant, decreasing slightly to 1,031 as of December 31, 2009 from 1,058 at December 31, 2008.

 

Floor brokerage, exchange and clearance fees

 

Floor brokerage, exchange and clearance fees increased $6.3 million, or 24.0% to $32.4 million for the year ended December 31, 2009 from the year ended December 31, 2008, primarily due to lower industry rebates received in 2009 as compared to 2008. These expenses also reflected increased fees due to higher option volumes, offset in part by lower futures volumes.

Communications and data processing

 

Total expenses for our communication and data processing requirements increased $6.2 million, or 15.7%, to $45.4 million from the year ended December 31, 2008 to the year ended December 31, 2009. This increase reflects costs associated with additional data processing capacity resulting from a move to SunGard’s latest generation system consisting of equipment dedicated to our U.S. clearing business and approximately $1 million related to the transition to a new back office system.

 

Occupancy and equipment

 

Total expenses for occupancy and equipment increased $0.5 million, or 1.8%, to $29.4 million from the year ended December 31, 2008 to the year ended December 31, 2009. This increase is primarily related to increased rental expense associated with our occupancy leases.

 

Correspondent asset loss

 

In the fourth quarter of 2008 the Company recorded a charge of approximately $26.4 million, net of estimated recoveries and professional fees related to nonpayment of an unsecured receivable as a result of a number of transactions involving listed Canadian equity securities by Evergreen Capital Partners, Inc. See Note 26 to our consolidated financial statements.

 

PFSC has now obtained from Evergreen’s bankruptcy estate an assignment of Evergreen’s claims against certain of Evergreen’s customers, and in June, 2009, PFSC commenced legal proceedings against, among others, those customers of Evergreen in an attempt to recover lost funds.

 

Other expenses

 

Other expenses decreased $4.9 million, or 13.1%, to $32.5 million from the year ended December 31, 2008 to the year ended December 31, 2009. The decrease relates to the $2.4 million litigation charge recorded in the quarter ended September 30, 2008 (see Part I, Item 3. Legal Proceedings) as well as lower travel expenses, legal and consulting fees.

 

Interest expense on long-term debt

 

Interest expense on long-term debt increased $6.5 million, from $3.8 million for the year ended December 31, 2008 to $10.3 million for the year ended December 31, 2009, as a result of additional interest expense of approximately $4.4 million associated with our senior convertible notes issued on June 3, 2009 ($2.8 million cash interest) and higher interest expense on our revolving credit facility due to higher interest rates and higher average balances.

 

Income tax expense

 

Income tax expense, based on an effective income tax rate of approximately 38.0%, was $9.8 million for the year ended December 31, 2009 as compared to an effective tax rate of 36.0% and income tax expense of $6.0 million for the year ended December 31, 2008. This increase is attributable to a higher operating profit in the current year combined with a higher effective tax rate. The higher effective tax rate is primarily attributable to international trade tax credits in Canada in the prior year offset by a lower ratio of state and local taxes.

 

Net income

 

As a result of the foregoing, net income increased to $16.0 million for the year ended December 31, 2009 from $10.7 million for the year ended December 31, 2008.

 

Liquidity and capital resources

 

Operating Liquidity — Our clearing broker-dealer subsidiaries typically finance their operating liquidity needs through secured bank lines of credit and through secured borrowings from stock lending counterparties in the

securities business, which we refer to as “stock loans.” Most of our borrowings are driven by the activities of our clients or correspondents, primarily the purchase of securities on margin by those parties. As of December 31, 2010, we had seven uncommitted lines of credit with seven financial institutions for the purpose of facilitating our clearing business as well as the activities of our customers and correspondents. Five of these lines of credit permitted us to borrow up to an aggregate of approximately $325.4 million while two lines had no stated limit. As of December 31, 2010, we had approximately $338.1 million in short-term bank loans outstanding, which left approximately $229.8 million available under our lines of credit with stated limitations.

 

As noted above, our clearing broker businesses also have the ability to borrow through stock loan arrangements. There are no specific limitations on our borrowing capacities pursuant to our stock loan arrangements. Borrowings under these arrangements bear interest at variable rates based on various factors including market conditions and the types of securities loaned, are secured primarily by our customers’ margin account securities, and are repayable on demand. At December 31, 2010, we had approximately $619.8 million in borrowings under stock loan arrangements, the majority of which relates to our customer activities.

 

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

 

Capital Resources — PWI provides capital to its subsidiaries. PWI has the ability to obtain capital through equipment leases, typically secured by the equipment itself and through the Amended and Restated Credit Facility. Currently we have the capacity to borrow up to $25 million under our Amended and Restated Credit Facility. As of December 31, 2010, the Company had no borrowings outstanding on this line of credit. On June 3, 2009, the Company issued $60 million aggregate principal amount of 8.00% Senior Convertible Notes due 2014. The net proceeds from the sale of the convertible notes were approximately $56.2 million after initial purchaser discounts and other expenses. On May 6, 2010, the Company issued $200 million aggregate principal amount of 12.5% senior second lien secured notes, due May 15, 2017. The net proceeds from the sale of the senior second lien secured notes were approximately $193.3 million after initial purchaser discounts and other expenses. The Company used a part of the net proceeds of the sale to pay down approximately $110 million outstanding on its previous Credit Facility, to provide working capital to support the correspondents the Company acquired from Ridge and for other general corporate purposes. Concurrent with the closing of its Notes offering, the Company paid off its existing Credit Facility and entered into the Amended and Restated Credit Facility. Our obligations under the Amended and Restated Credit Facility are supported by a guaranty from SAI and PHI and a pledge by the Company, SAI and PHI of equity interests of certain of our subsidiaries. The Amended and Restated Credit Facility is scheduled to mature on May 6, 2013.

 

We incur a significant amount of interest on our outstanding debt obligations. In 2010, we paid $2.2 in interest under our Amended and Restated Credit Facility and predecessor facility, $4.8 million in interest under our Senior Convertible Notes, $13.1 million in interest under our Senior Second Lien Secured Notes (estimated to be $25 million per year beginning in 2011) and $.3 million in interest under the Ridge Seller Note. We expect to continue to pay a significant amount of interest under these debt instruments in 2011 and for the next several years. Our significant debt obligations may restrict our ability to effectively utilize the capital available to us, and may adversely affect our business or operations.

 

On November 18, 2009, we filed a registration statement on Form S-3, which was declared effective by the SEC on December 17, 2009. We may utilize the registration statement in connection with our capital raising; however, we cannot guarantee that we will be able to issue debt or equity securities on terms acceptable to the Company.

 

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

 

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

greater of $250,000 or 2% of aggregate debit balances, as defined in the SEC’s Reserve Requirement Rule (“Rule 15c3-3”). At December 31, 2010, PFSI had net capital of $139.5 million, which was $96.5 million in excess of its required net capital of $43.0 million.

 

Our Penson Futures, PFSL, PFSC and PFSA subsidiaries are also subject to minimum financial and capital requirements. These requirements are not material either individually or collectively to the consolidated financial statements as of December 31, 2010. All subsidiaries were in compliance with their minimum financial and capital requirements as of December 31, 2010.

 

Contractual obligations

 

We have contractual obligations to make future payments under long-term debt and long-term non-cancelable lease agreements and have contingent commitments under a variety of commercial arrangements. See Note 20 to our consolidated financial statements for further information regarding our commitments and contingencies. There were no amounts outstanding under repurchase agreements at December 31, 2010. The table below shows our contractual obligations and commitments as of December 31, 2010, including our payments due by period:

 

 

 

 

As of December 31, 2010 the Company had accrued income tax liabilities for uncertain tax positions of approximately $1.2 million. These liabilities have not been presented in the table above due to uncertainty as to amounts and timing regarding future payments.

 

Off-balance sheet arrangements

 

We do not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which are established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.

 

See Note 16 to the consolidated financial statements for information on off-balance sheet arrangements and Note 24 to the consolidated financial statements for information on exchange member guarantees.

 

Critical accounting policies

 

Our discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the U.S. The preparation of these consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. We review our estimates on an on-going basis. We base our estimates on our experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. While our significant accounting policies are described in more detail in the notes to the consolidated financial statements, we believe the accounting policies that require management to make assumptions and estimates involving significant judgment are those relating to revenue recognition, fair value, software development and the valuation of stock-based compensation.

Revenue recognition

 

Revenues from clearing transactions are recorded in the Company’s consolidated financial statements on a trade date basis. Cash received in advance of revenue recognition is recorded as deferred revenue.

 

There are three major types of technology revenues: (1) completed products that are processing transactions every month generate revenues per transaction which are recognized on a trade date basis; (2) these same completed products may also generate monthly terminal charges for the delivery of data or processing capability that are recognized in the month to which the charges apply; (3) technology development services are recognized when the service is performed or under the terms of the technology development contract as described below. Interest and other revenues are recorded in the month that they are earned.

 

To date, the majority of our technology development contracts have not required significant production, modification or customization such that the service element of our overall relationship with the client generally does meet the criteria for separate accounting under the FASB Codification. All of our products are fully functional when initially delivered to our clients, and any additional technology development work that is contracted for is as outlined below. Technology development contracts generally cover only additional work that is performed to modify existing products to meet the specific needs of individual customers. This work can range from cosmetic modifications to the customer interface (private labeling) to custom development of additional features requested by the client. Technology revenues arising from development contracts are recorded on a percentage-of-completion basis based on outputs unless there are significant uncertainties preventing the use of this approach in which case a completed contract basis is used. The Company’s revenue recognition policy is consistent with applicable revenue recognition guidance in the FASB Codification and Staff Accounting Bulletin No. 104, Revenue Recognition (“SAB 104”).

 

Fair value

 

Fair value is defined as the exit 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. The Company’s financial assets and liabilities are primarily recorded at fair value.

 

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

 

 

 

See Note 6 to our consolidated financial statements for a description of the financial assets carried at fair value.

 

Software development

 

Costs associated with software developed for internal use are capitalized based on the applicable guidance in the FASB Codification. Capitalized costs include external direct costs of materials and services consumed in developing or obtaining internal-use software and payroll for employees directly associated with, and who devote time to, the development of the internal-use software. Costs incurred in development and enhancement of software that do not meet the capitalization criteria, such as costs of activities performed during the preliminary and post- implementation stages, are expensed as incurred. Costs incurred in development and enhancements that do not meet the criteria to capitalize are activities performed during the application development stage such as designing, coding, installing and testing. The critical estimate related to this process is the determination of the amount of time devoted by employees to specific stages of internal-use software development projects. We review any impairment of the capitalized costs on a periodic basis.

 

Goodwill

 

Goodwill is tested for impairment annually or more frequently if an event or circumstance indicates that an impairment loss may have been incurred. Application of the goodwill impairment test requires judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit.

 

We review goodwill for impairment utilizing a two-step process. The first step of the impairment test requires a comparison of the fair value of each of our reporting units to the respective carrying value. If the carrying value of a reporting unit is less than its fair value, no indication of impairment exists and a second step is not performed. If the carrying amount of a reporting unit is higher than its fair value, there is an indication that an impairment may exist and a second step must be performed. In the second step, the impairment is computed by comparing the implied fair value of the reporting unit’s goodwill with the carrying amount of the goodwill. If the carrying amount of the reporting unit’s goodwill is greater than the implied fair value of its goodwill, an impairment loss must be recognized for the excess and charged to operations.

 

At December 31, 2010, our goodwill totaled $141.5 million. Our assessment is based upon a discounted cash flow analysis and analysis of our market capitalization. The estimate of cash flow is based upon, among other things, certain assumptions about expected future operating performance and an appropriate discount rate determined by our management. Our estimates of discounted cash flows may differ from actual cash flows due to, among other things, economic conditions, changes to our business model or changes in operating performance. Significant differences between these estimates and actual cash flows could materially adversely affect our future financial results. These factors increase the risk of differences between projected and actual performance that could impact future estimates of fair value of all reporting units. We conducted our annual impairment test of goodwill as of October 1, 2010. As a result of this test we determined that no adjustment to the carrying value of goodwill for any reporting units was required.

 

Stock-based compensation

 

The Company’s accounting for stock-based employee compensation plans focuses primarily on accounting for transactions in which an entity exchanges its equity instruments for employee services, and carries forward prior guidance for share-based payments for transactions with non-employees. Under the modified prospective transition method, the Company is required to recognize compensation cost, after the effective date, for the portion of all

previously granted awards that were not vested, and the vested portion of all new stock option grants and restricted stock. The compensation cost is based upon the original grant-date fair market value of the grant. The Company recognizes expense relating to stock-based compensation on a straight-line basis over the requisite service period which is generally the vesting period. Forfeitures of unvested stock grants are estimated and recognized as a reduction of expense.

 

 

Prior to the fourth quarter of 2007, we did not have material exposure to reductions in the targeted federal funds rate. Beginning in the fourth quarter of 2007, there were significant decreases in these rates. We encountered a 50 basis point decrease in the federal funds rate in the fourth quarter of 2007. Actual rates fell approximately 400 basis points during 2008, to a federal funds rate of approximately .25% as of December 31, 2008, which is the current rate as of December 31, 2010. Based upon the December quarter average customer balances, assuming no increase, and adjusting for the timing of these rate reductions, we believe that each 25 basis point increase or decrease will affect pretax income by approximately $1.3 million per quarter. Despite such interest rate changes, we do not have material exposure to commodity price changes or similar market risks. Accordingly, we have not entered into any derivative contracts to mitigate such risk. In addition, we do not maintain material inventories of securities for sale, and therefore are not subject to equity price risk.

 

We extend margin credit and leverage to our correspondents and their customers, which is subject to various regulatory and clearing firm margin requirements. Margin credit is collateralized by cash and securities in the customers’ accounts. Our directors and executive officers and their associates, including family members, from time to time may be or may have been indebted to one or more of our operating subsidiaries or one of their respective correspondents or introducing brokers, as customers, in connection with margin account loans. Such indebtedness is in the ordinary course of business, is on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unaffiliated third parties who are not our employees and does not involve more than normal risk of collectability or present other unfavorable features. Leverage involves securing a large potential future obligation with a proportional amount of cash or securities. The risks associated with margin credit and leverage increase during periods of fast market movements or in cases where leverage or collateral is concentrated and market movements occur. During such times, customers who utilize margin credit or leverage and who have collateralized their obligations with securities may find that the securities have a rapidly depreciating value and may not be sufficient to cover their obligations in the event of liquidation. Although we monitor margin balances on an intra-day basis in order to control our risk exposure, we are not able to eliminate all risks associated with margin lending.

 

We are also exposed to credit risk when our correspondents’ customers execute transactions, such as short sales of options and equities, which can expose them to risk beyond their invested capital. We are indemnified and held harmless by our correspondents from certain liabilities or claims, the use of margin credit, leverage and short sales of their customers. However, if our correspondents do not have sufficient regulatory capital to cover such conditions, we may be exposed to significant off-balance sheet risk in the event that collateral requirements are not sufficient to fully cover losses that customers may incur and those customers and their correspondents fail to satisfy their obligations. Our account level margin credit and leverage requirements meet or exceed those required by Regulation T of the Board of Governors of the Federal Reserve, or similar regulatory requirements in other jurisdictions. The SEC and other self-regulated organizations (“SROs”) have approved new rules permitting portfolio margining that have the effect of permitting increased leverage on securities held in portfolio margin accounts relative to non-portfolio accounts. We began offering portfolio margining to our clients in 2007. We intend to continue to meet or exceed any account level margin credit and leverage requirements mandated by the SEC, other SROs, or similar regulatory requirements in other jurisdictions as we expand the offering of portfolio margining to our clients.

 

The profitability of our margin lending activities depends to a great extent on the difference between interest income earned on margin loans and investments of customer cash and the interest expense paid on customer cash balances and borrowings. If short-term interest rates fall, we generally expect to receive a smaller gross interest spread, causing the profitability of our margin lending and other interest-sensitive revenue sources to decline. Short-term interest rates are highly sensitive to factors that are beyond our control, including general economic conditions

and the policies of various governmental and regulatory authorities. In particular, decreases in the federal funds rate by the Federal Reserve System usually lead to decreasing interest rates in the U.S., which generally lead to a decrease in the gross spread we earn. This is most significant when the federal funds rate is on the low end of its historical range, as is the case now. Interest rates in Canada, Europe and Australia are also subject to fluctuations based on governmental policies and economic factors and these fluctuations could also affect the profitability of our margin lending operations in these markets.

 

Given the volatility of exchange rates, we may not be able to manage our currency transaction and/or translation risks effectively, or volatility in currency exchange rates may expose our financial condition or results of operations to a significant additional risk.

 

 

The Company’s consolidated financial statements and supplementary data are included in pages F-2 through F-41 of this Annual Report on Form 10-K. See accompanying “Item 15. Exhibits and Financial Statement Schedules” and Index to the consolidated financial statements on page F-1.

 

Quarterly results of operations (unaudited)

 

 

None.

 

 

Management’s evaluation of disclosure controls and procedures

 

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as that term is defined in Rule 13a-15(e) of the Exchange Act) as of the end of the period covered by this annual report. Based on that evaluation, our management, including our Chief Executive Officer and our Chief Financial Officer, concluded that our disclosure controls and procedures were effective in recording, processing, summarizing and reporting information required to be disclosed by us in reports that we file or submit under the Exchange Act, within the time periods specified by the SEC’s rules and regulations.

 

Changes in internal control over financial reporting

 

There have been no changes in our internal controls or in other factors that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting during the quarter ended December 31, 2010.

 

Management’s report on internal control over financial reporting

 

Our management is responsible for establishing and maintaining adequate internal control over financial reporting as defined by Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended. Our internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.

 

Because of inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

Our management assessed the effectiveness of our internal control over financial reporting as of December 31, 2010. In making this assessment, we used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control-Integrated Framework. Based on our assessment, management concluded that, as of December 31, 2010, we have maintained effective internal control over financial reporting.

 

The Company’s independent registered public accounting firm has audited the Company’s internal control over financial reporting as of December 31, 2010 as stated in their report.

 

Inherent limitation of the effectiveness of internal control

 

A control system, no matter how well conceived, implemented and operated, can provide only reasonable, not absolute, assurance that the objectives of the internal control system are met. Because of such inherent limitations, no evaluation of controls can provide absolute assurance that all control issues, if any, within a company or any division of a company have been detected.

 

 

None.

 

 

The information required by this Item 10 is incorporated herein by reference from the section captioned “Corporate Governance,” and “Section 16(a) Beneficial Ownership Reporting Compliance” of the Company’s definitive proxy statement for the 2011 annual meeting of stockholders to be filed not later than April 30, 2011 with the SEC pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended (the “2011 Proxy Statement”).

 

 

The information required by this Item 11 is incorporated by reference from the section captioned “Executive Compensation” of the 2011 Proxy Statement.

 

 

Equity compensation plans

 

 

 

 

Other information required by this Item 12 is incorporated by reference from the section captioned “Security Ownership of Certain Beneficial Owners and Management” of the 2011 Proxy Statement.

 

 

The information required by this Item 13 is incorporated by reference from the section captioned “Certain Relationships and Related Party Transactions” of the 2011 Proxy Statement.