<PAGE>
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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2000
001-14223
COMMISSION FILE NUMBER
Knight Trading Group, Inc.
(Exact name of registrant as specified in its charter)
DELAWARE
(State or other jurisdiction
of incorporation or organization)
22-3689303
(I.R.S. Employer
Identification Number)
525 Washington Boulevard
Jersey City, NJ 07310
(Address of principal executive offices and zip code)
Registrant's telephone number, including area code: (201) 222-9400
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days, Yes [X] No [_]
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date:
At November 13, 2000 the number of shares outstanding of the registrant's
Class A common stock was 122,956,780 and there were no shares outstanding of
the registrant's Class B common stock.
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<PAGE>
KNIGHT TRADING GROUP, INC.
FORM 10-Q QUARTERLY REPORT
For the Quarter Ended SEPTEMBER 30, 2000
TABLE OF CONTENTS
<TABLE>
<CAPTION>
Page
----
<C> <S> <C>
PART I FINANCIAL INFORMATION:
Item 1. Financial Statements........................................... 3
Consolidated Statements of Income.............................. 3
Consolidated Statements of Financial Condition................. 4
Consolidated Statements of Cash Flows.......................... 5
Notes to Consolidated Financial Statements..................... 6
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations.......................................... 11
Item 3. Quantitative and Qualitative Disclosures About Market Risk..... 18
PART II OTHER INFORMATION:
Item 1. Legal Proceedings.............................................. 19
Item 2. Changes in Securities and Use of Proceeds...................... 19
Item 3. Defaults Upon Senior Securities................................ 20
Item 4. Submission of Matters to a Vote of Security Holders............ 20
Item 5. Other Information.............................................. 20
Item 6. Exhibits and Reports on Form 8-K............................... 20
Signatures.............................................................. 20
</TABLE>
2
<PAGE>
PART 1. FINANCIAL INFORMATION
Item 1. Financial Statements
KNIGHT TRADING GROUP, INC.
Consolidated Statements of Income
(unaudited)
<TABLE>
<CAPTION>
For the three months ended For the nine months ended
--------------------------- ----------------------------
September 30, September 30, September 30, September 30,
2000 1999 2000 1999
------------- ------------- ------------- -------------
<S> <C> <C> <C> <C>
Revenues
Net trading revenue... $165,546,668 $147,143,673 $ 935,634,409 $577,468,890
Asset management
fees................. 9,785,248 5,112,929 30,113,942 14,909,013
Interest and
dividends, net of
interest expense..... 5,837,510 2,888,649 13,468,138 7,031,863
Commissions and fees.. 5,866,883 4,721,878 17,940,494 11,687,932
Investment income and
other................ 412,010 1,157,573 6,252,428 2,954,486
------------ ------------ ------------- ------------
Total revenues...... 187,448,319 161,024,702 1,003,409,411 614,052,184
------------ ------------ ------------- ------------
Expenses
Employee compensation
and benefits......... 57,329,180 42,187,961 334,810,522 181,543,655
Payments for order
flow................. 37,270,268 31,068,701 134,907,102 98,850,717
Execution and
clearance fees....... 24,176,765 22,559,526 82,226,696 64,274,267
Communications and
data processing...... 8,060,354 5,322,280 22,290,632 13,595,170
Depreciation and
amortization......... 7,385,754 3,045,514 17,100,314 7,950,638
Professional fees..... 5,844,500 1,411,916 16,483,250 5,104,308
Occupancy and
equipment rentals.... 5,421,985 2,943,891 12,826,528 7,466,916
Business development.. 2,442,141 3,733,388 10,564,939 6,068,537
Other................. 4,993,821 657,370 11,215,276 4,747,195
------------ ------------ ------------- ------------
Total expenses...... 152,924,768 112,930,547 642,425,259 389,601,403
------------ ------------ ------------- ------------
Income before income
taxes and minority
interest............... 34,523,551 48,094,155 360,984,152 224,450,781
Income tax expense...... 14,117,335 12,894,648 136,477,888 75,718,211
------------ ------------ ------------- ------------
Income before minority
interest............... 20,406,216 35,199,507 224,506,264 148,732,570
Minority interest in
consolidated
subsidiaries........... 177,763 -- 177,763 --
------------ ------------ ------------- ------------
Net income.............. $ 20,583,979 $ 35,199,507 $ 224,684,027 $148,732,570
============ ============ ============= ============
Basic earnings per
share.................. $ 0.17 $ 0.29 $ 1.84 $ 1.24
============ ============ ============= ============
Diluted earnings per
share.................. $ 0.16 $ 0.28 $ 1.77 $ 1.19
============ ============ ============= ============
Pro forma adjustments
(see Note 1)
Income before income
taxes and minority
interest............. $ 48,094,155 $ 360,984,152 $224,450,781
Adjustment for pro
forma employee
compensation and
benefits............. (2,271,248) (267,109) (6,690,813)
------------ ------------- ------------
Pro forma income
before income taxes
and minority
interest............. 45,822,907 360,717,043 217,759,968
Pro forma income tax
expense.............. 17,611,967 137,121,175 89,574,106
------------ ------------- ------------
Pro forma income
before minority
interest............. 28,210,940 223,595,868 128,185,862
Minority interest in
consolidated
subsidiaries......... -- 177,763 --
------------ ------------- ------------
Pro forma net income.. $ 28,210,940 $ 223,773,631 $128,185,862
============ ============= ============
Pro forma basic
earnings per share... $ 0.23 $ 1.83 $ 1.06
============ ============= ============
Pro forma diluted
earnings per share... $ 0.22 $ 1.76 $ 1.02
============ ============= ============
Shares used in basic
earnings per share
calculations (see Note
7)..................... 122,661,830 121,708,801 122,350,107 120,426,172
============ ============ ============= ============
Shares used in diluted
earnings per share
calculations (see Note
7)..................... 126,565,409 126,855,862 126,930,997 125,348,986
============ ============ ============= ============
</TABLE>
--------
(1) Interest revenue is presented net of interest expense. Interest expense for
the three months ended September 30, 2000 and 1999 was $11,607,266 and
$2,808,069, respectively. Interest expense for the nine months ended
September 30, 2000 and 1999 was $26,834,684 and $7,393,228, respectively.
The accompanying notes are an integral part of these consolidated financial
statements
3
<PAGE>
KNIGHT TRADING GROUP, INC.
Consolidated Statements of Financial Condition
(unaudited)
<TABLE>
<CAPTION>
September 30, December 31,
2000 1999
-------------- --------------
<S> <C> <C>
Assets
Cash and cash equivalents..................... $ 347,989,686 $ 304,053,554
Securities owned, at market value............. 1,665,024,982 910,232,916
Receivable from clearing brokers.............. 197,030,172 215,423,208
Fixed assets and leasehold improvements at
cost, less accumulated depreciation.......... 57,274,866 26,820,045
Goodwill, less accumulated amortization....... 45,895,470 24,899,982
Investments................................... 42,950,479 40,408,554
Income taxes receivable....................... 10,421,043 --
Other assets.................................. 43,312,696 18,447,547
-------------- --------------
Total assets................................ $2,409,899,394 $1,540,285,806
============== ==============
Liabilities and Stockholders' Equity
Liabilities
Securities sold, not yet purchased, at market
value......................................... $1,389,772,941 $ 720,919,013
Securities sold under agreements to
repurchase.................................... -- 10,409,736
Payable to clearing broker.................... 196,950,609 159,943,018
Accrued compensation expense.................. 44,172,563 57,234,608
Accrued execution and clearance fees.......... 7,193,029 8,371,056
Accrued payments for order flow............... 10,348,122 13,978,854
Accounts payable, accrued expenses and other
liabilities................................... 19,148,285 54,205,482
Income taxes payable.......................... -- 15,992,937
-------------- --------------
Total liabilities........................... 1,667,585,549 1,041,054,704
-------------- --------------
Minority interest in consolidated subsidiaries.. 7,229,376 --
-------------- --------------
Stockholders' equity
Class A Common Stock.......................... 1,228,385 1,221,215
Additional paid-in capital.................... 312,431,791 300,355,094
Retained earnings............................. 422,321,246 197,637,219
Accumulated other comprehensive income
(loss)--foreign currency translation
adjustments, net of tax effect............... (896,953) 17,574
-------------- --------------
Total stockholders' equity.................. 735,084,469 499,231,102
-------------- --------------
Total liabilities and stockholders' equity.. $2,409,899,394 $1,540,285,806
============== ==============
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
4
<PAGE>
KNIGHT TRADING GROUP, INC.
Consolidated Statements of Cash Flows
(unaudited)
<TABLE>
<CAPTION>
For the nine months ended September 30,
----------------------------------------
2000 1999
------------------- -------------------
<S> <C> <C>
Cash flows from operating activities
Net income.......................... $ 224,684,027 $ 148,732,570
Adjustments to reconcile net income
to net cash provided by operating
activities
Depreciation and amortization..... 17,100,314 7,950,638
Minority interest in earnings of
consolidated subsidiary.......... (177,763) --
Income tax credit from stock options
exercised.......................... 6,832,031 6,919,975
(Increase) decrease in operating as-
sets
Securities owned.................. (754,792,066) (100,948,506)
Receivable from clearing brokers.. 18,393,036 (2,995,904)
Income taxes receivable........... (10,421,043) (4,902,306)
Other assets...................... (24,865,149) (26,555,866)
Increase (decrease) in operating li-
abilities
Securities sold, not yet pur-
chased........................... 668,853,928 83,963,076
Securities sold under agreements
to repurchase.................... (10,409,736) (921,467)
Payable to clearing broker........ 37,007,591 (6,934,602)
Accrued compensation expense...... (13,062,045) 5,835,460
Accounts payable, accrued expenses
and other liabilities............ (35,057,197) (13,627,975)
Accrued execution and clearance
fees............................. (1,178,027) 1,049,481
Accrued payments for order flow... (3,630,732) 189,633
Income taxes payable.............. (15,992,937) (2,031,392)
------------------- -------------------
Net cash provided by operating
activities..................... 103,284,232 95,722,815
------------------- -------------------
Cash flows from investing activities
Payment of contingent considera-
tion............................... (5,093,791) (4,141,017)
Investments......................... (12,348,175) (18,998,422)
Acquisitions........................ (10,784,255) (6,534,609)
Purchases of fixed assets and lease-
hold improvements.................. (42,866,327) (12,406,662)
------------------- -------------------
Net cash used in investing ac-
tivities....................... (71,092,548) (42,080,710)
------------------- -------------------
Cash flows from financing activities
Repayment of short term loan........ -- (3,748,938)
Proceeds from issuance of common
stock.............................. -- 80,219,537
Stock options exercised............. 5,251,836 3,298,060
Contributions from minority owners
in consolidated subsidiary......... 7,407,139 --
Capital contributions from members
of KFP............................. -- 14,256,627
------------------- -------------------
Net cash provided by financing
activities..................... 12,658,975 94,025,286
------------------- -------------------
Effect of exchange rate differences
on cash and cash equivalents....... (914,527) 99,293
------------------- -------------------
Increase in cash and cash equiva-
lents.............................. 43,936,132 147,766,684
Cash and cash equivalents at begin-
ning of period..................... 304,053,554 117,704,635
------------------- -------------------
Cash and cash equivalents at end of
period............................. $ 347,989,686 $ 265,471,319
=================== ===================
Supplemental disclosure of cash flow
information:
Cash paid for interest............ $ 26,697,274 $ 7,366,065
=================== ===================
Cash paid for income taxes........ $ 164,137,503 $ 83,957,075
=================== ===================
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
5
<PAGE>
KNIGHT TRADING GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2000
(unaudited)
1. Organization and Description of the Business
Knight Trading Group, Inc. (the "Company") and its subsidiaries operate in
market-making and asset management business lines. Knight Securities ("KS")
operates as a market maker in over-the-counter equity securities ("OTC
securities"), primarily those traded in the Nasdaq stock market and on the OTC
Bulletin Board. Knight Capital Markets ("KCM," formerly known as Trimark
Securities) operates as a market maker in the over-the-counter market for New
York Stock Exchange (NYSE)- and American Stock Exchange (AMEX)-listed
securities. Knight Financial Products ("KFP") makes markets in options on
individual equities, equity indices and fixed income instruments in the U.S.
and in Europe. The Company also maintains an asset management business for
institutional investors and high net worth individuals through its Deephaven
subsidiary. KS, KCM and KFP are registered as broker-dealers with the
Securities and Exchange Commission ("SEC" or the "Commission"). Additionally,
KS and KCM are members of the National Association of Securities Dealers, Inc.
("NASD").
The Company was organized in January 2000 as the successor to the business
of its predecessor, Knight/Trimark Group, Inc. (the "Predecessor") (see below).
The Predecessor was organized in April 1998 as the successor to the business of
Roundtable Partners, L.L.C. ("Roundtable"). In May 2000, the Company changed
its name from Knight/Trimark Group, Inc. to Knight Trading Group, Inc.
On January 12, 2000, the Company completed a merger (the "Merger") with
Arbitrade Holdings LLC ("Arbitrade"). The transaction resulted in the Company,
a newly formed parent holding company, issuing shares on a tax-free basis to
holders of the Predecessor's common stock and to the owners of Arbitrade.
Following the transaction, the Predecessor and Arbitrade became subsidiaries of
the Company, which assumed the name Knight/Trimark Group, Inc. and became the
publicly traded Nasdaq company under the same ticker symbol as the Predecessor
(NITE). Arbitrade's options market making unit subsequently changed its name to
"Knight Financial Products." The transaction was accounted for as a pooling of
interests, and, as such, the historical financial statements have been restated
to account for the merger on a retroactive basis. Pro forma adjustments for
compensation and income taxes have been made to the historical financial
statements of Arbitrade to adjust for partners' compensation, which was
previously paid as distributions of capital, and income taxes, which were
previously borne by the individual partners of Arbitrade. The foregoing
description of the Arbitrade transaction is a brief summary and is qualified in
its entirety by reference to the Merger Agreement, a copy of which was filed as
an exhibit to the Company's report on Form 8-K filed with the SEC on January
12, 2000. Unless otherwise indicated, all references to the "Company" refer to
the Company or the Predecessor, as appropriate.
2. Significant Accounting Policies
Basis of consolidation and form of presentation
The accompanying consolidated financial statements include the accounts of
the Company and its majority and wholly-owned subsidiaries (see Note 1) and, in
the opinion of management, reflect all adjustments, consisting only of normal
recurring adjustments, necessary for a fair statement of the results for the
interim period. All significant intercompany transactions and balances have
been eliminated. Certain footnote disclosures normally included in financial
statements prepared in accordance with generally accepted accounting principles
have been condensed or omitted pursuant to SEC rules and regulations, although
the Company believes that the disclosures are adequate to make the information
presented not misleading. The nature of the Company's business is such that the
results of an interim period are not necessarily indicative of
6
<PAGE>
the results for the full year. These consolidated financial statements should
be read in conjunction with the financial statements and notes thereto included
in the Company's audited financial statements as of December 31, 1999 included
in the Company's Report on Form 10-K as filed with the SEC. All share and per
share amounts presented in this document have been adjusted to reflect the
Company's two-for-one stock split on May 14, 1999.
Cash equivalents
Cash equivalents represent money market accounts, which are payable on
demand, or short-term investments with an original maturity of less than 30
days. The carrying amount of such cash equivalents approximates their fair
value due to the short-term nature of these instruments.
Investments
Investments on the Consolidated Statements of Financial Condition are
comprised of ownership interests in non-publicly traded companies which are
accounted for under the equity method or the cost basis of accounting.
Investments also include the Company's investments in private investment funds
for which the Company is the investment manager and sponsor.
Market-making activities
Securities owned and securities sold, not yet purchased, which primarily
consist of listed and OTC stocks, listed options contracts and futures
contracts are carried at market value and are recorded on a trade date basis.
Net trading revenue (trading gains, net of trading losses) and commissions and
related expenses, including compensation and benefits, execution and clearance
fees and payments for order flow, are also recorded on a trade date basis.
Payments for order flow represent payments to other broker-dealers for
directing their equity order executions to the Company.
Asset management fees
The Company earns asset management fees for sponsoring and managing the
investments of certain private investment funds. Such fees are recorded when
earned and are calculated as a percentage of the fund's quarterly net assets,
plus a percentage of a new high net asset value, as defined, for any six-month
period ended June 30th or December 31st.
Repurchase agreements
Securities sold under agreements to repurchase ("repurchase agreements") are
accounted for as collateralized financing transactions and are recorded at
their contracted repurchase amounts plus accrued interest. Counterparties are
major financial institutions. The Company is required to provide securities to
counterparties in order to collateralize securities sold under agreements to
repurchase.
Foreign currencies
The functional currency of the Company's consolidated foreign subsidiaries
are the U.S. dollar, the British Pound and the Japanese Yen. Assets and
liabilities in foreign currencies are translated into U.S. dollars using
current exchange rates at the date of the Consolidated Statements of Financial
Condition. Revenues and expenses are translated at average rates during the
periods. The foreign exchange gains and losses resulting from these
translations are included as a separate component of stockholders' equity in
the Consolidated Statements of Financial Condition.
Depreciation, amortization and occupancy
Fixed assets are being depreciated on a straight-line basis over their
estimated useful lives of three to seven years. Leasehold improvements are
being amortized on a straight-line basis over the life of the related office
lease. The Company records rent expense on a straight-line basis over the life
of the lease.
7
<PAGE>
Income taxes
Income tax expense in the Consolidated Statements of Income represents
actual income taxes incurred through September 30, 2000. Before the Merger, KFP
was a limited liability company which was treated as a partnership for tax
purposes and its federal and state income taxes were borne by KFP's individual
partners. As such, KFP's historical financial statements do not include a
provision for income taxes. Subsequent to the Merger, the Company is subject to
federal income taxes and state income taxes based on KFP's income. Pro forma
income tax expense reflects income taxes as if the Company was subject to
federal and state income taxes on KFP's income prior to the Merger.
The Company records deferred tax assets and liabilities based upon enacted
tax rates for the expected future tax consequences of temporary differences
between the financial reporting and tax bases of assets and liabilities.
Estimated fair value of financial instruments
The Company's securities owned and securities sold, not yet purchased are
carried at market value. Management estimates that the fair values of other
financial instruments recognized on the Consolidated Statements of Financial
Condition (including receivables, payables and accrued expenses) approximate
their carrying values, as such financial instruments are short-term in nature,
bear interest at current market rates or are subject to frequent repricing.
Minority Interest
Minority interest expense represents a minority owner's share of net income
in one of the Company's consolidated subsidiaries.
Other
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
Certain prior period amounts have been reclassified to conform to the
current period presentation.
3. Securities Owned and Securities Sold, Not Yet Purchased
Securities owned and securities sold, not yet purchased consist of the
following:
<TABLE>
<CAPTION>
September 30, December 31,
2000 1999
-------------- ------------
<S> <C> <C>
Securities owned:
Equities......................................... $ 805,242,294 $381,240,123
Options.......................................... 859,782,688 518,408,094
U.S. government obligations...................... -- 10,584,699
-------------- ------------
$1,665,024,982 $910,232,916
============== ============
Securities sold, not yet purchased:
Equities......................................... $ 534,828,991 $263,614,076
Options.......................................... 854,943,950 457,304,937
-------------- ------------
$1,389,772,941 $720,919,013
============== ============
</TABLE>
8
<PAGE>
4. Investments
The Company's wholly-owned subsidiary, Deephaven Capital Management LLC, is
the investment manager and sponsor of private investment funds that engage in
various trading strategies involving equities, debt instruments and
derivatives. The Company owns interests in these private investment funds. Such
investments amounted to approximately $13.7 million at September 30, 2000.
Certain officers of the Company also own interests in these private investment
funds.
5. Significant Customers
The Company considers significant customers to be customers who provide the
Company with 10% or more of its order flow, as measured in share volume, during
the period. For the three months ended September 30, 2000, the Company had no
significant customers.
6. Comprehensive Income
Comprehensive income includes net income and changes in equity except those
resulting from investments by, or distributions to, stockholders. Comprehensive
income is as follows:
<TABLE>
<CAPTION>
Three months ended Nine months ended
--------------------------- ----------------------------
September 30, September 30, September 30, September 30,
2000 1999 2000 1999
------------- ------------- ------------- -------------
<S> <C> <C> <C> <C>
Net income/ pro forma
net income............. $20,583,979 $28,210,940 $223,773,631 $128,185,862
Foreign currency
translation adjustment,
net of tax............. (567,480) 99,293 (914,527) 99,293
----------- ----------- ------------ ------------
Total comprehensive
income, net of tax..... $20,016,499 $28,310,233 $222,859,104 $128,285,155
=========== =========== ============ ============
</TABLE>
7. Earnings per Share
Basic and diluted earnings per common share have been calculated by dividing
net income by the sum of the weighted average shares of Class A Common Stock
and Class B Common Stock outstanding during each respective period.
Weighted-average shares outstanding for the three and nine month periods
ended September 30, 2000 and 1999 have been determined as if the Merger
described in Note 1 occurred as of the earliest date presented. The following
is a reconciliation of the numerators and denominators of the basic and diluted
earnings per share computations for the three and nine month periods ended
September 30, 2000 and 1999:
<TABLE>
<CAPTION>
Three months ended Three months ended
September 30, 2000 September 30, 1999
----------------------- -----------------------
Numerator / Denominator
Numerator / Denominator pro forma / pro forma
net income / shares net income shares
----------- ----------- ----------- -----------
<S> <C> <C> <C> <C>
Income and shares used in ba-
sic calculations............. $20,583,979 122,661,830 $28,210,940 121,708,801
Effect of dilutive stock op-
tions........................ -- 3,903,579 -- 5,147,061
----------- ----------- ----------- -----------
Income and shares used in di-
luted calculations........... $20,583,979 126,565,409 $28,210,940 126,855,862
=========== =========== =========== ===========
Pro forma basic earnings per
share...................... $ 0.17 $ 0.23
=========== ===========
Pro forma diluted earnings
per share.................. $ 0.16 $ 0.22
=========== ===========
</TABLE>
9
<PAGE>
<TABLE>
<CAPTION>
Nine months ended Nine months ended
September 30, 2000 September 30, 1999
------------------------ ------------------------
Numerator / Numerator / Denominator
pro forma Denominator pro forma / pro forma
net income / shares income shares
------------ ----------- ------------ -----------
<S> <C> <C> <C> <C>
Income and shares used in
basic calculations......... $223,773,631 122,350,107 $128,185,862 120,426,172
Effect of dilutive stock op-
tions...................... -- 4,580,890 -- 4,922,814
------------ ----------- ------------ -----------
Income and shares used in
diluted calculations....... $223,773,631 126,930,997 $128,185,862 125,348,986
============ =========== ============ ===========
Pro forma basic earnings
per share................ $ 1.83 $ 1.06
=========== ===========
Pro forma diluted earnings
per share................ $ 1.76 $ 1.02
=========== ===========
</TABLE>
8. Net Capital Requirements
As registered broker-dealers, KS, KCM and KFP are subject to the SEC's
Uniform Net Capital Rule (the "Rule") which requires the maintenance of
minimum net capital. KS and KCM have elected to use the basic method,
permitted by the Rule, which requires that they each maintain net capital
equal to the greater of $1.0 million or 6 2/3% of aggregate indebtedness, as
defined. KFP has elected to use the alternative method, permitted by the Rule,
which requires that it maintains net capital equal to the greater of $250,000
or 2% of aggregate debit items, as defined.
At September 30, 2000, KS had net capital of $321,449,204 which was
$318,529,286 in excess of its required net capital of $2,919,918, KCM had net
capital of $56,949,028 which was $55,949,028 in excess of its required net
capital of $1,000,000 and KFP had net capital of $24,780,359 which was
$24,530,359 in excess of its required net capital of $250,000.
9. Business Segments
The Company has two reportable business segments: securities market-making
and asset management. Securities market-making includes the operations of KS,
KCM and KFP and includes market-making in equity securities listed on Nasdaq,
on the OTCBB of the NASD, in the over-the-counter market for NYSE- and AMEX-
listed securities and in options on individual equities, equity indices, fixed
income instruments and certain commodities. The asset management segment
includes the operations of Deephaven Management LLC, Deephaven Capital LLC and
Deephaven Investment Advisers LLC and consists of investment management and
sponsorship for a series of private investment funds.
The Company's net revenues, income before income taxes and assets by
segment are summarized below:
<TABLE>
<CAPTION>
Securities Asset
Market Making Management Total
-------------- ----------- --------------
<S> <C> <C> <C>
For the three months ended September
30, 2000:
Revenues........................... $ 177,044,269 $10,404,050 $ 187,448,319
Income before income taxes and mi-
nority interest................... 26,865,534 7,658,017 34,523,551
Total Assets....................... 2,380,785,998 29,113,396 2,409,899,394
For the three months ended September
30, 1999:
Revenues........................... 155,016,071 6,008,631 161,024,702
Pro forma income before income tax-
es................................ 41,804,678 4,018,229 45,822,907
Total Assets....................... 1,514,069,485 26,216,321 1,540,285,806
For the nine months ended September
30, 2000:
Revenues........................... 969,513,269 33,896,142 1,003,409,411
Pro forma income before income
taxes and minority interest....... 334,248,326 26,468,717 360,717,043
Total Assets....................... 2,380,785,998 29,113,396 2,409,899,394
For the nine months ended September
30, 1999:
Revenues........................... 597,510,128 16,542,056 614,052,184
Pro forma income before income tax-
es................................ 206,406,423 11,353,545 217,759,968
Total Assets....................... 1,514,069,485 26,216,321 1,540,285,806
</TABLE>
10
<PAGE>
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following discussion of our results of operations should be read in
conjunction with our consolidated financial statements and notes thereto
included in our audited financial statements as of December 31, 1999 included
within our report on Form 10-K. This discussion contains forward-looking
statements that involve risks and uncertainties. Our actual results may differ
materially from those anticipated in these forward-looking statements as a
result of certain factors, including, but not limited to, those set forth
elsewhere in this document.
We have experienced and expect to continue to experience, significant
fluctuations in quarterly operating results due to a variety of factors,
including the value of our securities positions and our ability to manage the
risks attendant thereto, the volume of our market-making activities, volatility
in the securities markets, our ability to manage personnel, overhead and other
expenses, the number of limit orders received as a percentage of net trading
revenues, changes in payments for order flow, clearing costs, the addition or
loss of sales and trading professionals, regulatory changes, the amount and
timing of capital expenditures, the incurrence of costs associated with
acquisitions and general economic conditions. If demand for our market-making
services declines and we are unable to adjust our cost structure on a timely
basis, our operating results could be materially and adversely affected. We
have experienced, and may experience in the future, significant seasonality in
our business.
Due to all of the foregoing factors, period-to-period comparisons of our
revenues and operating results are not necessarily meaningful and such
comparisons cannot be relied upon as indicators of future performance. There
also can be no assurance that we will be able to sustain the rates of revenue
growth that we have experienced in the past, that we will be able to improve
our operating results or that we will be able to sustain our profitability on a
quarterly basis.
Overview
We are the leading market maker in equity securities listed on Nasdaq, the
OTCBB of the NASD, and the over-the-counter market for New York Stock Exchange
(NYSE) and American Stock Exchange (AMEX)-listed securities. We are also a
leading market maker in options on individual equities, equity indices and
fixed income instruments in the U.S. and Europe. The firm also maintains an
asset management business for institutional investors and high net worth
individuals through our Deephaven subsidiary.
KS commenced Nasdaq and OTC securities market-making operations on July 24,
1995. KS's share volume totaled 17.0 billion and 14.0 billion, or 77% and 78%
of our total equity market-making share volume, for the three months ended
September 30, 2000, and 1999, respectively. KCM's share volume totaled 5.0
billion and 3.8 billion, or 23% and 22% of our total equity market-making share
volume for the three months ended September 30, 2000 and 1999, respectively.
Revenues
Our revenues consist principally of net trading revenue from securities
market-making activities. Net trading revenue, which represents trading gains
net of trading losses, is primarily affected by changes in equity trade and
share volumes and option contract volumes, our ability to derive trading gains
by taking proprietary positions, changes in our execution standards, volatility
in the marketplace and by regulatory changes and evolving industry customs and
practices.
We continue to focus on increasing our sales to institutional customers. OTC
securities transactions with institutional customers are executed as principal,
and all related profits and losses are included within net trading revenue.
11
<PAGE>
Asset management fees represent fees earned for sponsoring and managing the
investments of private investment funds. Asset management fees are primarily
affected by the rates of return earned on the funds we manage and changes in
the amounts of assets under management.
Listed securities transactions with institutional customers are executed on
an agency basis, for which we earn commissions on a per share basis. We also
receive fees for providing certain information to market data providers.
Commissions and fees are primarily affected by changes in our trade and share
volumes in listed securities.
We also earn interest income from our cash and securities positions held at
banks and in trading accounts at clearing brokers. Interest income is primarily
affected by the changes in cash balances held at banks and clearing brokers.
Interest expense primarily consists of transaction-related interest charged by
clearing brokers for facilitating the settlement and financing of securities
sold, not yet purchased. Interest expense is primarily affected by the changes
in cash balances held at clearing brokers and the level of securities sold, not
yet purchased.
Expenses
Our operating expenses largely consist of employee compensation and
benefits, payments for order flow and execution and clearance fees. A
substantial portion of these expenses are variable in nature. Employee
compensation and benefits expense, which is largely profitability based,
fluctuates, for the most part, based on changes in net trading revenue and our
profitability. Payments for order flow fluctuate based on share volume, the mix
of market orders and limit orders and the mix of orders received from broker-
dealers who accept payments for order flow. Execution and clearance fees
fluctuate primarily based on changes in trade, share and contract volume, and
the clearance fees charged by clearing brokers.
Employee compensation and benefits expense primarily consists of salaries
paid to administrative and customer service personnel and profitability based
compensation, which includes compensation and benefits paid to market-making
and sales personnel based on their individual performance, and incentive
compensation paid to all other employees based on our overall profitability.
Approximately 72% of our employees are directly involved in market-making,
sales or customer service activities. Compensation for employees engaged in
market-making and sales activities, the largest component of employee
compensation and benefits, is determined primarily based on a percentage of
gross trading profits net of expenses including payments for order flow,
execution and clearance costs and overhead allocations. Employee compensation
and benefits will, therefore, be affected by changes in payments for order
flow, execution and clearance costs and the costs we allocate to employees
engaged in market-making and sales activities.
Payments for order flow primarily represent customary payments to broker-
dealers, in the normal course of business, for directing their order flow in
equity securities to us. We only pay broker-dealers for orders that provide us
with a profit opportunity. For example, we make payments on market orders, but
do not pay on limit orders.
Execution and clearance fees primarily represent clearance fees paid to
clearing brokers, transaction fees paid to Nasdaq, payments made to third
parties for exchange seat leases and execution fees paid to third parties,
primarily for executing trades in listed securities on the NYSE and AMEX and
for executing orders through electronic communications networks, commonly
referred to as ECNs. Due to our significant growth in share and trade volume,
we have been able to negotiate favorable rates and volume discounts from
clearing brokers and providers of execution services. As a result of these
lower rates and discounts and the increase in trade volume of OTC securities as
a percentage of total trade volume, execution and clearance fees per trade have
decreased.
Communications and data processing expense primarily consists of costs for
obtaining stock market data and telecommunications services.
12
<PAGE>
Business development expense primarily consists of advertising costs and
marketing expenses, including travel and entertainment and promotion costs.
Professional fees primarily consist of fees paid to computer programming and
systems consultants, as well as legal and other professional fees.
Depreciation and amortization expense results from the depreciation of fixed
assets purchased by us and the amortization of goodwill, which includes
contingent consideration resulting from the acquisitions of the listed
securities market-making businesses of KCM and Tradetech Securities, L.P.,
("Tradetech") which we acquired in November 1997. Depreciation and amortization
expense also includes the amortization of goodwill related to our purchases of
various options specialist businesses.
Occupancy and equipment rentals expense primarily consists of rental
payments on office and equipment leases.
Other expenses primarily consist of administrative expenses and other
operating costs incurred in connection with our business growth, as well as
director fees.
Income Tax
Income tax expense in the Consolidated Statements of Income represents
actual income taxes incurred through September 30, 2000. Before the Merger, KFP
was a limited liability company which was treated as a partnership for tax
purposes and its federal and state income taxes were borne by KFP's individual
partners. As such, KFP's historical financial statements do not include a
provision for income taxes. Subsequent to the Merger, the Company is subject to
federal income taxes and state income taxes based on KFP's income. Pro forma
income tax expense reflects income taxes as if the Company was subject to
federal and state income taxes on KFP's income prior to the Merger.
Results of Operations
Three Months Ended September 30, 2000 and 1999
Revenues
Net trading revenue increased 12.5% to $165.5 million for the three months
ended September 30, 2000, from $147.1 million for the comparable period in
1999. This increase was primarily due to higher equity share volume, which was
partially offset by decreased average revenue per equity share. Total equity
share volume increased 23.2% to 21.9 billion equity shares traded for the three
months ended September 30, 2000, from 17.8 billion equity shares traded for the
comparable period in 1999, while average revenue per equity share decreased to
$.0065 per share from $.0073 during the same period in 1999.
Asset management fees increased 91.4% to $9.8 million for the three months
ended September 30, 2000, from $5.1 million for the comparable period in 1999.
The increase in fees was primarily due to an increase in fund return from 4.41%
for the third quarter of 1999 to 6.37% for the third quarter of 2000 and an
increase in the amount of funds under management from $317.4 million at
September 30, 1999 to $630.0 million at September 30, 2000 in the Deephaven
Market Neutral Master Fund, which contained the majority of our funds under
management.
Interest income, net of interest expense increased 102.1% to $5.8 million
for the three months ended September 30, 2000, from $2.9 million for the
comparable period in 1999. This increase was primarily due to larger cash
balances held at banks and our clearing brokers, offset in part by higher
transaction-related interest expense resulting from a higher level of
securities sold, not yet purchased.
13
<PAGE>
Commissions and fees increased 24.2% to $5.9 million for the three months
ended September 30, 2000, from $4.7 million for the comparable period in 1999.
This increase is primarily due to higher share volumes from institutional
customers in listed securities.
Investment income and other income decreased 64.4% to $412,000 for the three
months ended September 30, 2000, from $1.2 million for the comparable period in
1999. This decrease was primarily due to a decrease in income from our
investments.
Expenses
Employee compensation and benefits expense increased 28.9% to $57.3 million
for the three months ended September 30, 2000, from $44.5 million for the
comparable pro forma period in 1999. As a percentage of total revenues,
employee compensation and benefits expense increased to 30.6% for the three
months ended September 30, 2000, from 27.6% for the comparable pro forma period
in 1999. The increase on a dollar and on a percentage basis was primarily due
to increased gross trading profits, growth in our institutional sales revenue
and growth in our number of employees. Due to increased net trading revenue,
profitability based compensation increased 11.1% to $35.3 million for the three
months ended September 30, 2000, from $31.8 million for the comparable pro
forma period in 1999, and represented 61.7% and 71.5% of total employee
compensation and benefits expense for the three months ended September 30, 2000
and for the three months ended September 30, 1999 on a pro forma basis,
respectively. Our number of employees increased to 1,209 employees as of
September 30, 2000, from 762 employees as of September 30, 1999.
Payments for order flow increased 20.0% to $37.3 million for the three
months ended September 30, 2000, from $31.1 million for the comparable period
in 1999. As a percentage of total revenues, payments for order flow was 19.9%
for the three months ended September 30, 2000 and 19.3% for the comparable
period in 1999. The increase in payments for order flow on a dollar basis was
primarily due to a 23.2% increase in equity shares traded for the three months
ended September 30, 2000 and the introduction of payment for order flow in the
options marketplace.
Execution and clearance fees increased 7.2% to $24.2 million for the three
months ended September 30, 2000, from $22.6 million for the comparable period
in 1999. As a percentage of total revenues, execution and clearance fees
decreased to 12.9% for the three months ended September 30, 2000 from 14.0% for
the comparable period in 1999. The increase on a dollar basis was primarily due
to an increase in equity trades executed for the three months ended September
30, 2000. Total equity trade volume increased 53.7% to 31.4 million equity
trades for the three months ended September 30, 2000 from 20.4 million equity
trades for the comparable period in 1999. This increase was offset, in part, by
a decrease in clearance rates charged by clearing brokers and volume discounts.
The decrease in our execution and clearance fees as a percentage of net trading
revenue was primarily due to a decrease in clearance rates charged by clearing
brokers, volume discounts and growth in the volume of OTC securities
transactions.
Communications and data processing expense increased 51.4% to $8.1 million
for the three months ended September 30, 2000, from $5.3 million for the
comparable period in 1999. This increase was generally attributable to higher
trading volumes and an increase in our number of employees.
Depreciation and amortization expense increased 142.5% to $7.4 million for
the three months ended September 30, 2000, from $3.0 million for the comparable
period in 1999. This increase was primarily due to the purchase of
approximately $50.1 million of additional fixed assets and leasehold
improvements between September 30, 1999 and September 30, 2000 and the
amortization of goodwill related to our acquisitions of the listed securities
market-making businesses of KCM and Tradetech and various options specialist
businesses.
Professional fees increased 313.9% to $5.8 million for the three months
ended September 30, 2000, up from $1.4 million for the comparable period in
1999. This increase was primarily due to increased consulting
14
<PAGE>
expenses related to our investments in technology, our European and Japanese
expansion efforts and legal and other professional fees.
Occupancy and equipment rentals expense increased 84.2% to $5.4 million for
the three months ended September 30, 2000, from $2.9 million for the comparable
period in 1999. This increase was primarily attributable to additional office
space and increased computer equipment lease expense. We occupied 271,924
square feet of office space at September 30, 2000, up from 138,004 square feet
of office space at September 30, 1999.
Business development expense decreased 34.6% to $2.4 million for the three
months ended September 30, 2000, from $3.7 million for the comparable period in
1999. This decrease was primarily the result of decreased advertising costs in
the third quarter of 2000 from the third quarter of 1999.
Other expenses increased 659.7% to $5.0 million for the three months ended
September 30, 2000, from $657,000 for the comparable 1999 period. This was
primarily the result of increased operating costs in connection with our
overall business growth.
Our effective and pro forma effective tax rates for the three months ended
September 30, 2000 and 1999, respectively, differ from the federal statutory
rate of 35% due to state income taxes, as well as nondeductible expenses,
including the amortization of goodwill resulting from the acquisition of KCM
and a portion of business development expenses. Our effective tax rate
increased to 41% for the three months ended September 30, 2000 from 38% for the
three months ended September 30, 1999 primarily due to state and local taxes.
Nine Months Ended September 30, 2000 and 1999
Revenues
Net trading revenue increased 62.0% to $935.6 million for the nine months
ended September 30, 2000, from $577.5 million for the comparable period in
1999. This increase was primarily due to higher equity share volume. Total
equity share volume increased 58.5% to 87.3 billion equity shares traded for
the nine months ended September 30, 2000, from 55.1 billion equity shares
traded for the comparable period in 1999.
Asset management fees increased 102.0% to $30.1 million for the nine months
ended September 30, 2000, from $14.9 million for the comparable period in 1999.
The increase in fees was primarily due to an increase in fund return from
14.43% for the first nine months of 1999 to 26.33% for the first nine months of
2000 and an increase in the amount of funds under management from $317.4
million at September 30, 1999 to $630.0 million at September 30, 2000 in the
Deephaven Market Neutral Master Fund, which contained the majority of our funds
under management.
Interest income, net of interest expense increased 91.5% to $13.5 million
for the nine months ended September 30, 2000, from $7.0 million for the
comparable period in 1999. This increase was primarily due to larger cash
balances held at banks and our clearing brokers offset in part by higher
transaction-related interest expense resulting from a higher level of
securities sold, not yet purchased.
Commissions and fees increased 53.5% to $17.9 million for the nine months
ended September 30, 2000, from $11.7 million for the comparable period in 1999.
This increase is primarily due to higher share volumes from institutional
customers in listed securities.
Investment income and other income increased 111.6% to $6.3 million for the
nine months ended September 30, 2000, from $3.0 million for the comparable
period in 1999. This increase was primarily due to an increase in income from
our investments, primarily our investments in the private hedge funds that we
sponsor and manage.
15
<PAGE>
Expenses
Pro forma employee compensation and benefits expense increased 78.0% to
$335.1 million for the nine months ended September 30, 2000, from $188.2
million for the comparable period in 1999. As a percentage of total revenues,
pro forma employee compensation and benefits expense increased to 33.4% for the
nine months ended September 30, 2000, from 30.7% for the comparable period in
1999. The increase on a dollar and on a percentage basis was primarily due to
increased gross trading profits, growth in our institutional sales revenue and
growth in our number of employees. Due to increased net trading revenue, pro
forma profitability based compensation increased 77.9% to $273.4 million for
the nine months ended September 30, 2000, from $153.7 million for the
comparable period in 1999, and represented 81.6% and 81.7% of total pro forma
employee compensation and benefits expense for the nine months ended September
30, 2000 and 1999, respectively. Our number of employees increased to 1,209
employees as of September 30, 2000, from 762 employees as of September 30,
1999.
Payments for order flow increased 36.5% to $134.9 million for the nine
months ended September 30, 2000, from $98.9 million for the comparable period
in 1999. As a percentage of total revenues, payments for order flow decreased
to 13.4% for the nine months ended September 30, 2000 from 16.1% for the
comparable period in 1999. The increase in payments for order flow on a dollar
basis was primarily due to a 58.5% increase in equity shares traded for the
nine months ended September 30, 2000 to 87.3 billion shares, up from 55.1
billion for the comparable period in 1999. The decrease in payments for order
flow as a percentage of total revenues was primarily due to increases in our
institutional, asset management and options revenues, respectively.
Execution and clearance fees increased 27.9% to $82.2 million for the nine
months ended September 30, 2000, from $64.3 million for the comparable period
in 1999. As a percentage of total revenues, execution and clearance fees
decreased to 8.2% for the nine months ended September 30, 2000, from 10.5% for
the comparable period in 1999. The increase on a dollar basis was primarily due
to a 79.6% increase in equity trades executed to 108.8 million equity trades
for the nine months ended September 30, 2000, from 60.6 million equity trades
in the comparable period in 1999. This increase was offset, in part, by a
decrease in clearance rates charged by clearing brokers and volume discounts.
The decrease in our execution and clearance fees as a percentage of net trading
revenue was primarily due to a decrease in clearance rates charged by clearing
brokers, volume discounts and growth in the volume of OTC securities
transactions.
Communications and data processing expense increased 64.0% to $22.3 million
for the nine months ended September 30, 2000, from $13.6 million for the
comparable period in 1999. This increase was generally attributable to higher
trading volumes and an increase in our number of employees.
Depreciation and amortization expense increased 115.1% to $17.1 million for
the nine months ended September 30, 2000, from $8.0 million for the comparable
period in 1999. This increase was primarily due to the purchase of
approximately $50.1 million of additional fixed assets and leasehold
improvements between September 30, 1999 and September 30, 2000 and the
amortization of goodwill related to our acquisitions of the listed securities
market-making businesses of KCM and Tradetech and various options specialist
businesses.
Professional fees increased 222.9% to $16.5 million for the nine months
ended September 30, 2000, up from $5.1 million for the comparable period in
1999. This increase was primarily due to increased consulting expenses related
to our investments in technology, our European and Japanese expansion efforts
and legal and other professional fees.
Occupancy and equipment rentals expense increased 71.8% to $12.8 million for
the nine months ended September 30, 2000, from $7.5 million for the comparable
period in 1999. This increase was primarily attributable to additional office
space and increased computer equipment lease expense. We occupied 271,924
square feet of office space at September 30, 2000, up from 138,004 square feet
of office space at September 30, 1999.
16
<PAGE>
Business development expense increased 74.1% to $10.6 million for the nine
months ended September 30, 2000, from $6.1 million for the comparable period in
1999. This increase was primarily the result of increased advertising and
higher travel and entertainment costs consistent with the growth in our
business and our increased focus on the institutional sales business.
Other expenses increased 136.3% to $11.2 million for the nine months ended
September 30, 2000, from $4.7 million for the comparable period in 1999. This
was primarily the result of increased operating costs in connection with our
overall business growth.
Our effective and pro forma effective tax rates for the nine months ended
September 30, 2000 and 1999, respectively, differ from the federal statutory
rate of 35% due to state income taxes, as well as nondeductible expenses,
including the amortization of goodwill resulting from the acquisition of KCM
and a portion of business development expenses. Our pro forma effective tax
rate declined to 38% for the nine months ended September 30, 2000 from 41% for
the nine months ended September 30, 1999 primarily due to lower state and local
income taxes.
Recently Issued Accounting Standards
In June 1998, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards (SFAS) No. 133, Accounting for
Derivative Instruments and Hedging Activities. This statement established
accounting and reporting standards for derivative instruments, including
certain derivative instruments imbedded in other contracts, and for hedging
activities. In June 1999, the FASB issued SFAS No. 137, Accounting for
Derivative Instruments and Hedging Activities--Deferral of the Effective Date
of FASB Statement No. 133-an amendment of FASB Statement No. 133. In June 2000,
the FASB issued SFAS 138 Accounting for Certain Derivative Instruments and
Certain Hedging Activities, which is an amendment to SFAS No. 133 and is
effective concurrently with SFAS No. 137. We anticipate adopting the provisions
of SFAS No. 133, 137 and 138 effective January 1, 2001 and do not believe that
the adoption of these statements will have a material impact on our financial
statements.
In September 2000, the FASB issued SFAS No. 140 Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities--a replacement
of FASB Statement No. 125. This statement resets standards for accounting for
securitizations and other transfers of financial assets that are sales from
transfers that are secured borrowings. We anticipate adopting the provisions of
SFAS No. 140 effective January 1, 2001 and do not believe that the adoption of
this statement will have a material impact on our financial statements.
Liquidity and Capital Resources
Historically, we have financed our business primarily through cash generated
by operations, as well as the proceeds from our stock offerings, the private
placement of preferred and common units and borrowings under subordinated
notes. As of September 30, 2000, we had $2.4 billion in assets, 92% of which
consisted of cash or assets readily convertible into cash, principally
receivables from clearing brokers and securities owned. Receivables from
clearing brokers include interest bearing cash balances held with clearing
brokers, including, or net of, amounts related to securities transactions that
have not yet reached their contracted settlement date, which is generally
within three business days of the trade date. Securities owned principally
consist of equity securities that trade in Nasdaq and on the NYSE and AMEX
markets and listed options contracts that trade on national exchanges.
Net income and pro forma net income plus depreciation and amortization was
$28.0 million and $31.3 million during the three months ended September 30,
2000 and 1999, respectively. Depreciation and amortization expense, which
related to fixed assets and goodwill, was $7.4 million and $3.0 million during
the three months ended September 30, 2000 and 1999, respectively. Capital
expenditures were $12.6 million and $6.2 million for the three months ended
September 30, 2000 and 1999, respectively, primarily related to the purchase of
data processing and communications equipment, as well as leasehold improvements
and additional
17
<PAGE>
office facilities to support our growth. Additionally, we made cash payments of
$463,000 for the three months ended September 30, 2000 in connection with our
acquisitions of the listed securities market-making businesses of Tradetech in
1997. We anticipate that we will meet our 2000 capital expenditure needs out of
operating cash flows.
As registered broker-dealers and market makers, KS, KCM and KFP are subject
to regulatory requirements intended to ensure the general financial soundness
and liquidity of broker-dealers and requiring the maintenance of minimum levels
of net capital, as defined in SEC Rule 15c3-1 ($2.9 million, $1.0 million and
$250,000, respectively as of September 30, 2000). These regulations also
prohibit a broker-dealer from repaying subordinated borrowings, paying cash
dividends, making loans to its parent, affiliates or employees, or otherwise
entering into transactions which would result in a reduction of its total net
capital to less than 120.0% of its required minimum capital. Moreover, broker-
dealers, including KS, KCM and KFP, are required to notify the SEC prior to
repaying subordinated borrowings, paying dividends and making loans to their
parents, affiliates or employees, or otherwise entering into transactions,
which, if executed, would result in a reduction of 30.0% or more of their
excess net capital (net capital less minimum requirement). The SEC has the
ability to prohibit or restrict such transactions if the result is detrimental
to the financial integrity of the broker-dealer. At September 30, 2000, KS had
net capital of $321.4 million, which was $318.5 million in excess of its
required net capital of $2.9 million, KCM had net capital of $56.9 million
which was $55.9 million in excess of its required net capital of $1.0 million
and KFP had net capital of $24.8 million which was $24.5 million in excess of
its required net capital of $250,000.
We currently anticipate that available cash resources and credit facilities
will be sufficient to meet our anticipated working capital and capital
expenditure requirements for at least the next 12 months.
Year 2000 Compliance
Many currently installed computer systems and software products were coded
to accept or recognize only two digit entries in the date code field. These
date code fields needed to accept four digit entries to distinguish 21st
century dates from 20th century dates. As a result, computer systems and/or
software used by many companies and governmental agencies had to be upgraded to
comply with such Year 2000 requirements or risk system failure or
miscalculations causing disruptions of normal business activities. We estimate
that the total cost of our Year 2000 project was approximately $550,000.
To date, we have not experienced any material outages or failures as a
result of Year 2000 related issues. We cannot make any assurances that we may
not experience any such failures in the future. We have finalized a business
continuity plan and have formulated action steps to be taken in the event that
a material Year 2000 related failure should arise.
Other
In July 2000, the Company and The Nikko Securities Co., Ltd. established a
joint venture operation that will provide wholesale market-making services in
Japanese equity securities.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Our market-making activities expose our capital to significant risks. These
risks include, but are not limited to, absolute and relative price movements,
price volatility and changes in liquidity, over which we have virtually no
control.
We employ automated proprietary trading and risk management systems which
provide real time, on-line risk management and inventory control. We monitor
our risks by a constant review of trading positions and their appropriate risk
measures. For each market maker, we have established a system whereby
transactions are monitored by senior management as are individual and aggregate
dollar and inventory position totals,
18
<PAGE>
appropriate risk measures and real-time profits and losses. The management of
trading positions is enhanced by review of mark-to-market valuations and
position summaries on a daily basis.
In the normal course of our OTC and exchange-listed market-making business,
we maintain inventories of exchange-listed and OTC securities. The fair value
of these securities at September 30, 2000 was $235.8 million in long positions
and $146.5 million in short positions. The potential change in fair value,
using a hypothetical 10.0% decline in prices, is estimated to be a $8.9 million
loss as of September 30, 2000 due to the offset of losses in long positions
with gains in short positions.
In the normal course of options market making, we maintain inventories of
options, futures and equities. Our main exposures are from equity price and
volatility risk. We manage these exposures by constantly monitoring and
diversifying our exposures and position sizes and establishing offsetting
hedges. Our market making staff and trading room managers continuously manage
our positions and our risk exposures. Our systems incorporate trades and update
our risk profile using options pricing models on a real time basis.
Our proprietary options risk management system allows us to stress test our
portfolio on a real-time basis. On a daily basis, risk reports are distributed
to senior management and the firm's risk managers who incorporate this
information in our daily market making decisions. These reports identify
potential exposures in terms of options and futures on individual securities
and index contracts, organized in different ways such as industry sectors,
under extreme price and volatility movements. At September 30, 2000, 10%
movements in volatility and stock prices on our equity options and equity index
options portfolios, which contain the majority of our market risk, would have
resulted in approximately the following gains (losses) in our options market
making portfolio:
<TABLE>
<CAPTION>
Change in Stock Prices
----------------------------------------
-10% None +10%
------------ ------------- ------------
Change in Volatility
<S> <C> <C> <C>
+10%................................. $5.5 million ($0.2 million) $8.8 million
None................................. 4.9 million -- 8.5 million
-10%................................. 4.4 million 0.8 million 8.5 million
</TABLE>
This stress analysis covers positions in options and futures, underlying
securities and related hedges. The 10% changes in stock prices and volatility
in the charts above make the assumption of a universal 10% movement in all of
our underlying positions. The analysis also includes a number of estimates that
we believe to be reasonable, but cannot assure that they produce an accurate
measure of future risk.
For working capital purposes, we invest in money market funds, commercial
paper, government securities or maintain interest bearing balances in our
trading accounts with clearing brokers, which are classified as cash
equivalents and receivable from clearing brokers, respectively, in the
Consolidated Statements of Financial Condition. These other amounts do not have
maturity dates or present a material market risk, as the balances are short-
term in nature and subject to daily repricing.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
We and certain of our officers and employees have been subject to legal
proceedings in the past and may be subject to legal proceedings in the future.
We are currently a party to certain legal proceedings; presently, we do not
believe the outcomes of these proceedings, individually or in the aggregate,
will have a material adverse effect on our business, financial condition or
operating results.
Item 2. Changes in Securities and Use of Proceeds
None.
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Item 3. Defaults Upon Senior Securities
None.
Item 4. Submission of Matters to a Vote of Security Holders
None.
Item 5. Other Information
None.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibit 27. Financial Data Schedule.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereto until duly authorized.
Knight Trading Group, Inc.
/s/ Robert I. Turner
-------------------------------------
By: Robert I. Turner
Title: Director, Executive Vice
President, Chief Financial
Officer and Treasurer (principal
financial and accounting
officer)
Date: November 13, 2000
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