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KNIGHT CAPITAL GROUP, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion of our results of operations should be read in conjunction with our audited Consolidated Financial Statements and notes for the year ended December 31, 2011 included in our Current Report on Form 8-K dated August 6, 2012 as filed with the U.S. Securities and Exchange Commission ("SEC"). On August 6, 2012, we entered into a securities purchase agreement where we raised $400.0 million in equity financing through a convertible preferred share offering with several investors. The Form 8-K filed on this date updated the historical consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2011 by revising the order of presentation of the Company's Consolidated Statement of Comprehensive Income and Consolidated Statements of Changes in Equity. This discussion contains forward-looking statements that involve risks and uncertainties, including those discussed in our Form 10-K for the year ended December 31, 2011, our Quarterly Report on Form 10-Q for the period ended June 30, 2012 and herein. 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, in our Form 10-K for the year ended December 31, 2011 and in our Quarterly Report on Form 10-Q for the period ended June 30, 2012. Certain statements contained in this Quarterly Report on Form 10-Q, including, without limitation, those under "Management's Discussion and Analysis of Financial Condition and Results of Operations" herein ("MD&A"), "Quantitative and Qualitative Disclosures About Market Risk" in Part I, Item 3, "Legal Proceedings" and "Risk Factors" in Part II and the documents incorporated by reference, may constitute forward-looking statements. These forward-looking statements are not historical facts and are based on current expectations, estimates and projections about the Company's industry, management's beliefs and certain assumptions made by management, many of which, by their nature, are inherently uncertain and beyond our control. Accordingly, readers are cautioned that any such forward-looking statements are not guarantees of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict including, without limitation, risks associated with the August 1, 2012 technology issue that resulted in the Company's broker-dealer subsidiary, Knight Capital Americas LLC ("KCA"), sending numerous erroneous orders in NYSE-listed and NYSE Arca securities into the market and the impact to the Company's capital structure and business as well as actions taken in response thereto and consequences thereof, risks associated with the Company's ability to recover all or a portion of the damages that are attributable to the manner in which NASDAQ OMX handled the Facebook IPO, risks associated with changes in market structure, legislative, regulatory or financial reporting rules, risks associated with the Company's changes to its organizational structure and management and the costs, integration, performance and operation of businesses previously acquired or developed organically, or that may be acquired or developed organically in the future. Readers should carefully review the risks and uncertainties disclosed in the Company's reports with the SEC including, without limitation, those detailed under "Certain Factors Affecting Results of Operations" within MD&A herein and under "Risk Factors" herein and in the Company's Annual Report on Form 10-K for the year ended December 31, 2011 and in other reports or documents the Company files with, or furnishes to, the SEC from time to time. This information should also be read in conjunction with the Company's Consolidated Financial Statements and the Notes thereto contained in this Form 10-Q, and in other reports or documents the Company files with, or furnishes to, the SEC from time to time. 51-------------------------------------------------------------------------------- Table of Contents Executive Overview We are a global financial services firm that provides access to the capital markets across multiple asset classes to a broad network of clients, including broker-dealers, institutions and corporations. We seek to continually apply our expertise and innovation to the market making and trading process to build lasting client relationships through consistent performance and superior client service. We also provide capital markets services to corporate issuers and private companies. We have four operating segments: (i) Market Making; (ii) Institutional Sales and Trading; (iii) Electronic Execution Services; and (iv) Corporate and Other. • Market Making - Our Market Making segment principally consists of market making in global equities and listed domestic options. As a market maker, we commit capital for trade executions by offering to buy securities from, or sell securities to, institutions and broker-dealers. Our Market Making segment primarily includes client, and to a lesser extent, non-client electronic market making activities in which we operate as a market maker in equity securities quoted and traded on the Nasdaq Stock Market, the over-the-counter ("OTC") market for New York Stock Exchange ("NYSE"), NYSE Amex Equities ("NYSE Amex"), NYSE Arca listed securities and several European exchanges. As a complement to electronic market making, our cash trading business handles specialized orders and also transacts on the OTC Bulletin Board, the OTC Pink Markets, and the Alternative Investment Market ("AIM") of the London Stock Exchange. We provide trade executions as an equities Designated Market Maker ("DMM") on the NYSE and NYSE Amex. Market Making also includes our option market making business which trades on substantially all domestic electronic exchanges. • Institutional Sales and Trading - Our Institutional Sales and Trading segment includes global equity, exchange traded fund ("ETF") and fixed income sales; reverse mortgage origination and securitization; capital markets; and asset management activities. The primary business of the Institutional Sales and Trading segment is to execute and facilitate equities, ETFs, and fixed income transactions as agent on behalf of institutional clients, and we commit capital on behalf of our clients when needed. This is predominantly a full-service execution business, in which much of the interaction is based on the Company's client relationships. This segment also facilitates client orders through program and block trades and riskless principal trades and provides capital markets services, including equity and debt private placement. • Electronic Execution Services - Our Electronic Execution Services segment offers access via our electronic agency-based platforms to markets and self-directed trading in equities, options, fixed income, foreign exchange and futures. In contrast to Market Making, we generally do not act as a principal to transactions that are executed within this segment and generally earn commissions for acting as agent between the principals to the trade. • Corporate and Other - Our Corporate and Other segment invests in strategic financial services-oriented opportunities, allocates, deploys and monitors all capital, and maintains corporate overhead expenses and all other income and expenses that are not attributable to the other segments. The Corporate and Other segment houses functions that support our other segments such as self-clearing services, including securities lending activities. Beginning in the second quarter of 2012, our Corporate and Other segment includes our futures commission merchant ("FCM") which comprises certain assets and liabilities which we acquired or assumed from the futures division of Penson Financial Services, Inc. on June 1, 2012. This business primarily provides futures execution, clearing and custody services to facilitate transactions among brokers, institutions and non-clearing FCMs on major U.S. and European futures and options exchanges. 52 -------------------------------------------------------------------------------- Table of Contents The following table sets forth: (i) Revenues; (ii) Expenses; and (iii) Pre-tax earnings or loss from our segments and on a consolidated basis (in millions): For the three months ended For the nine months ended September 30, September 30, 2012 2011 2012 2011 Market Making Revenues(1)(3) $ (341.2 ) $ 204.9 $ (75.5 ) $ 517.1 Expenses(2)(5) 110.8 135.7 325.4 345.4 Pre-tax (loss) earnings (452.0 ) 69.2 (400.9 ) 171.7 Institutional Sales and Trading Revenues(3) 101.7 145.4 353.7 407.7 Expenses(2)(5) 242.5 161.0 487.3 434.9 Pre-tax loss (140.8 ) (15.6 ) (133.6 ) (27.2 ) Electronic Execution Services Revenues 34.8 45.1 122.3 127.3 Expenses(5) 28.5 31.3 92.4 90.3 Pre-tax earnings 6.3 13.8 29.9 37.0 Corporate and Other Revenues(4) 14.8 2.0 48.0 11.0 Expenses(2)(5) 31.2 25.1 86.8 68.6 Pre-tax loss (16.4 ) (23.0 ) (38.8 ) (57.5 ) Consolidated Revenues (189.8 ) 397.4 448.4 1,063.2 Expenses 413.0 353.0 991.9 939.2 Pre-tax (loss) earnings $ (602.9 ) $ 44.4 $ (543.5 ) $ 124.0 * Totals may not add due to rounding. (1) - Included in revenues for the three and nine months ended September 30, 2012 is a trading loss of $457.6 million related to the August 1st technology issue. (2) - Included in expenses for the three and nine months ended September 30, 2012 is a writedown of assets of $143.0 million which includes $11.9 million for Market Making and $131.1 million for Institutional Sales and Trading. Additionally, the Corporate and Other segment includes $3.5 million in professional fees related to the August 1st technology issue. (3) - Included in revenues for the nine months ended September 30, 2012 is a Facebook IPO trading loss of $35.4 million which includes $26.0 million for Market Making and $9.4 million for Institutional Sales and Trading. (4) - Included in revenues for the nine months ended September 30, 2012 is a gain on a strategic investment of $10.0 million. (5) - Included in expenses for the three and nine months ended September 30, 2011 is a Restructuring charge of $28.6 million which includes $0.5 million for Market Making, $23.9 million for Institutional Sales and Trading, $0.4 million for Electronic Execution Services, and $3.8 million for Corporate and Other. Consolidated revenues for the three months ended September 30, 2012 decreased $587.3 million from the same period a year ago, while consolidated expenses increased $60.0 million. Consolidated pre-tax loss for the three months ended September 30, 2012 was $602.9 million as compared to consolidated pre-tax earnings of $44.4 million for the same period a year ago. 53-------------------------------------------------------------------------------- Table of Contents Consolidated revenues for the nine months ended September 30, 2012 decreased $614.8 million from the same period a year ago, while consolidated expenses increased $52.7 million. Consolidated pre-tax loss for the nine months ended September 30, 2012 was $543.5 million as compared to consolidated pre-tax earnings of $124.0 million for the same period a year ago. On August 1, 2012, we experienced a technology issue at the open of trading at the NYSE. This issue was related to the installation of trading software and resulted in KCA sending numerous erroneous orders in NYSE-listed and NYSE Arca securities into the market. Although this software was subsequently removed from our systems, it resulted in trading losses and subsequent related costs of $461.1 million ("August 1, 2012 Loss"). This event was deemed a triggering event requiring us to assess the carrying amount and recoverability of our goodwill and intangible assets. As a result of this assessment, we recorded a non-cash impairment charge of $143.0 million, representing $126.4 million of goodwill related to our acquisitions of Libertas and Astor, and $16.7 million of intangible assets primarily related to our acquisitions of Astor, Kellogg and Urban. On August 6, 2012 we raised $400.0 million in equity financing through a convertible preferred share offering with several investors. We incurred approximately $40.5 million in fees and costs related to the offering, resulting in net proceeds of $359.5 million. As a result of our ability to obtain these capital resources we no longer believe there is a substantial doubt in our ability to continue as a going concern. In the second quarter of 2012, we recorded pre-tax trading losses of $35.4 million related to the Facebook IPO. On August 1, 2012 Nasdaq's proposed voluntary accommodation program (the "Accommodation Program") was published in the Federal Register by the SEC. The Accommodation Program creates a fund for voluntary accommodations for qualifying Nasdaq members disadvantaged by problems that arose during the Facebook IPO. Under the Accommodation Program as proposed by Nasdaq, we would recover a portion of our pre-tax trading losses. The Accommodation Program, however, remains subject to SEC approval and there can be no assurance will be approved by the SEC or that the terms will not change from those proposed. As previously disclosed, there are no assurances that we will be able to recover our pre-tax trading losses relating to the Facebook IPO. The changes in our pre-tax earnings (loss) by segment from the three and nine months ended September 30, 2011 are summarized as follows: • Market Making - Our pre-tax losses from Market Making for the three and nine months ended September 30, 2012 were $452.0 million and $400.9 million, respectively, compared to pre-tax earnings of $69.2 million and $171.7 million, respectively, during the comparable periods in 2011. Excluding the $457.6 million effects of the August 1, 2012 Loss, which resulted in trading losses of $457.6 million, and subsequent review of our intangible assets that resulted in an $11.9 million writedown to intangible assets, and the second quarter 2012 $26.0 million trading loss related to the Facebook IPO, our pre-tax results from Market Making for the three and nine months ended September 30, 2012 decreased $51.7 million and $77.2 million, respectively, to pre-tax earnings of $17.5 million and $94.6 million, respectively. The reason for the decrease in results, excluding the noted items, was primarily a decrease in volumes, which were impacted by the August 1, 2012 technology issue as well as lower overall market volumes. The lower volumes had a negative impact on both our client and non-client quantitative trading models. • Institutional Sales and Trading - Our pre-tax losses from Institutional Sales and Trading for the three and nine months ended September 30, 2012 increased by $125.3 million and $106.4 million, respectively, from the comparable periods in 2011. Excluding the effects of the third quarter 2012 asset impairment assessment that resulted in a writedown of $131.1 million 54 -------------------------------------------------------------------------------- Table of Contents related to goodwill and intangible assets primarily within our institutional fixed income and asset management businesses and as well as the second quarter 2012 $9.4 million trading loss related to the Facebook IPO, our pre-tax results from Institutional Sales and Trading for the three and nine months ended September 30, 2012 improved by $5.9 million and $34.1 million, respectively, to a pre-tax loss of $9.7 million and pre-tax earnings of $6.9 million, respectively. The improvement in segment results, excluding the noted items, was primarily attributable to improved results from our reverse mortgage business, a decrease in guaranteed compensation in our fixed income business and the absence of restructuring costs offset, in part, by a decrease in client volumes as a result of the events surrounding the August 1 technology issue. • Electronic Execution Services - Our pre-tax earnings from Electronic Execution Services for the three and nine months ended September 30, 2012 decreased by $7.6 million and $7.1 million, respectively, from the comparable periods in 2011. The quarter over quarter and year over year decrease is primarily due to temporary lower volumes as a result of the August 1, 2012 Loss. By the end of the third quarter of 2012, volumes were substantially back to pre-August 1 levels. • Corporate and Other - Our pre-tax results from our Corporate and Other segment for the three months ended September 30, 2012 improved by $6.7 million from the comparable period in 2011. The improved results quarter over quarter is primarily due to a $5.3 million grant received in August 2012 from the State of New Jersey related to the Business Employment Incentive Program ("BEIP") offset, in part, by higher professional fees related to the August 1, 2012 technology issue. Our pre-tax results from our Corporate and Other segment for the nine months ended September 30, 2012 improved by $18.7 million from the comparable period in 2011. The improved results year over year is primarily due to a $10.0 million gain related to a change in the tax status of a strategic investment accounted for under the equity method of accounting and a $5.3 million BEIP grant received in August 2012 offset, in part, by higher interest expense related to our long-term debt and securities lending activity and higher professional fees related to the August 1, 2012 technology issue. Certain Factors Affecting Results of Operations We may experience significant variation in our future results of operations. These fluctuations may result from numerous factors, including, among other things, market conditions and the resulting volatility, credit and counterparty risks that may result; introductions of, or enhancements to, trade execution services by us or our competitors; the value of our securities positions and other financial instruments and our ability to manage the risks attendant thereto; the volume of our trade execution activities; the dollar value of securities and other instruments traded; the composition and profile of our order flow; our market share with institutional and broker-dealer clients; the performance and size of, and volatility in, our client market making and program trading portfolios; the performance of our non-client principal trading activities; movements of credit spreads; home equity conversion mortgages ("HECMs") origination and HECM Mortgage Backed Securities ("HMBS") securitization volumes; the overall size of our balance sheet and capital usage; further impairment of goodwill and/or intangible assets; the performance of our global operations, trading technology and trading infrastructure; costs associated with overall business growth; the effectiveness of our self-clearing and futures platforms and our ability to manage risk related thereto; the availability of credit and liquidity in the marketplace; erroneous trade orders submitted by us on account of technology or other issues (such as occurred on August 1, 2012) and consequences thereof; the performance, operation and connectivity to various market centers; our ability to manage personnel, compensation, overhead and other expenses; the strength of our client relationships; changes in payments for order flow; changes to execution quality and changes in clearing, execution and regulatory transaction costs; interest rate movements; the 55 -------------------------------------------------------------------------------- Table of Contents addition or loss of executive management, sales, trading and technology professionals; legislative, legal, regulatory and financial reporting changes; legal, regulatory matters or proceedings; geopolitical risk; the amount, timing and cost of capital expenditures, acquisitions and divestitures; the integration, performance and operation of acquired businesses; the incurrence of costs associated with acquisitions and dispositions; investor sentiment; technological changes and events; seasonality; competition; and other economic conditions. Such factors may also have an impact on our ability to achieve our strategic objectives, including, without limitation, increases in market share, growth and profitability in our four operating segments. If demand for our services declines or our performance deteriorates significantly due to any of the above factors, and we are unable to adjust our cost structure on a timely basis, our operating results could be materially and adversely affected. As a result 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 continue the rates of revenue growth that we have experienced in the past or that we will be able to improve our operating results. Trends Global Economic Trends Our businesses are affected by many factors in the global financial markets and worldwide economic conditions. These factors include the growth level of gross domestic product in the U.S., Europe and Asia, and the existence of transparent, efficient and liquid equity and debt markets and the level of trading volumes and volatility in such markets. During the quarter ended September 30, 2012, volatility levels across equity markets decreased as compared to the previous quarter, while in the debt markets, credit spreads narrowed. Secondary trading volumes in the equity and fixed income markets were down significantly from prior periods. Overall, there are still concerns about global stability and growth, inflation and declining asset values. Trends Affecting Our Company We believe that our businesses are affected by the aforementioned global economic trends as well as more specific trends. Some of the specific trends that impact our operations, financial condition and results of operations are: • Clients continue to focus on statistics measuring the quality of equity executions (including speed of execution and price improvement). In an effort to improve the quality of their executions as well as increase efficiencies, market makers have increased the level of sophistication and automation within their operations and the extent of price improvement. The greater focus on execution quality has resulted in greater competition in the marketplace, which, along with market structure changes and market conditions, has negatively impacted the revenue capture and margin metrics of the Company and other market making firms. • Market Making, Institutional Sales and Trading and Electronic Execution Services transaction volumes executed by clients have fluctuated over the past few years due to retail and institutional investor sentiment, market conditions and a variety of other factors. Market Making, Institutional Sales and Trading and Electronic Execution Services transaction volumes may not be sustainable and are not predictable. • Over the past several years exchanges have become far more competitive, and market participants have created alternative trading systems ("ATS"), ECN and other execution 56 -------------------------------------------------------------------------------- Table of Contents venues which compete within the OTC and listed trading venues. For example, on July 3, 2012, the SEC approved proposed rules submitted by the NYSE and NYSE Amex to establish a Retail Liquidity Program ("RLP") on a pilot basis for one year. The RLP seeks to attract retail flow to the NYSE and NYSE Amex. This new program (as well as any similar program established by other national stock exchanges) could draw market share away from Knight, and thus negatively impact our business. In addition, there are many new entrants into the market, including ATS, Multilateral Trading Facilities, systematic internalizers, dark liquidity pools, high frequency trading firms, and market making firms competing for retail and institutional order flow. Further, many broker-dealers are offering their own internal crossing networks. These factors continue to create further fragmentation and competition in the marketplace. • Market structure changes, competition, market conditions and a steady increase in electronic trading have resulted in a reduction in institutional commission rates and volumes which may continue in the future. Additionally, many institutional clients allocate commissions to broker-dealers based not only on the quality of executions, but also in exchange for research, or participation in soft dollar and commission recapture programs. • There continues to be growth in electronic trading, as evidenced by increased volumes in direct market access platforms, algorithmic and program trading, high frequency trading and ECNs and dark liquidity pools. In addition, electronic trading continues to expand to other asset classes, including options, currencies and fixed income. The expansion of electronic trading may result in the growth of innovative electronic products and competition for order flow and may further reduce demand for traditional institutional voice services. • Market structure changes, competition and technology advancements have also led to a dramatic increase in electronic message traffic. These increases in message traffic place heavy strains on the technology resources, bandwidth and capacities of market participants. • There has been continued scrutiny of the capital markets industry by the regulatory and legislative authorities, both in the U.S. and abroad. New legislation or new or modified regulations and rules could occur in the future. Members of the U.S. Congress have asked the SEC and other regulators to take a close look at the regulatory structure and make the changes necessary to insure the rule framework governing the U.S. financial markets is comprehensive and complete. The SEC and other regulators have stated that they will propose and adopt rules where necessary, on a variety of marketplace issues - including, but not limited to: high frequency trading, indications of interest, off-exchange trading, dark liquidity pools, internalization, post-trade attribution, co-location, market access, short sales, consolidated audit trails and market volatility rules (including, circuit breakers and limit-up, limit-down rules). • We expect increases, possibly substantial, in Section 31 fees and fees imposed by other regulators. In addition, DTCC and NSCC are considering proposals which could require substantial increases in clearing margin and collateral requirements. • The Dodd-Frank Act affects nearly all financial institutions that operate in the U.S. While the weight of the Dodd-Frank Act falls more heavily on large, complex financial institutions, smaller institutions will continue to face a more complicated and expensive regulatory framework. • Reverse mortgages can be a cost-effective way to help seniors (age 62 and older) meet their financial needs in retirement, by enabling them to tap the equity in their home. Reverse mortgages have been popular with seniors who have equity in their homes and want to 57 -------------------------------------------------------------------------------- Table of Contents supplement their income and enhance their liquidity. This popularity may continue as the Baby Boomer generation enters retirement age. However, there is no guarantee that current volumes or the referenced popularity will continue. • In 2011, two of the largest reverse mortgage originators exited the reverse mortgage business. Declining home values and the inability to assess borrowers' financial health were cited as factors contributing to their respective decisions. In 2012, the largest reverse mortgage lender also exited the reverse mortgage business citing its focus on other business lines. • In January 2011, the U.S. Department of Housing and Urban Development ("HUD") provided loss mitigation guidance for the resolution of HECMs that are delinquent due to, among other things, unpaid property charges (including taxes and homeowners insurance). HUD also discussed what steps lenders could take to get mortgagors back on track (e.g., establishing a repayment plan). HUD noted that foreclosure is and must remain a method of last resort for the resolution of unpaid property charges. It has also been reported that HUD is developing procedures that would allow lenders to assess a prospective borrower's income and expenses, and possibly require homeowners to set aside money to pay for taxes and homeowners insurance. However, no formal guidelines have yet been published. Income Statement Items The following section briefly describes the key components of, and drivers to, our significant revenues and expenses. Revenues Our revenues consist principally of Commissions and fees and Net trading revenue from all of our business segments. Revenues on transactions for which we charge explicit commissions or commission equivalents, which include the majority of our institutional client orders, commissions on futures transactions, as well as the mark-to-market of securitized HECM loan inventory, are included within Commissions and fees. Commissions and fees are primarily affected by changes in our equity, fixed income, futures and foreign exchange transaction volumes with institutional clients, changes in commission rates, level of volume based fees from providing liquidity to other trading venues, loan origination and securitization volume and spreads, assets under management and the level of our soft dollar and commission recapture activity. Trading profits and losses on principal transactions primarily relate to our global market making activities and are included within Net trading revenue. These revenues are primarily affected by changes in the amount and mix of equity trade and share volumes, our revenue capture, dollar value of equities traded, our ability to derive trading gains by taking proprietary positions, changes in our execution standards, development of, and enhancement to, our market making models, performance of our non-client trading models, volatility in the marketplace, our mix of broker-dealer and institutional clients, regulatory changes and evolving industry customs and practices. Interest income, net is earned from our cash held at banks, cash held in trading accounts at third party clearing brokers and from collateralized financing arrangements, such as securities borrowing, carry interest on loans and bonds held, and interest income net of interest expense on securitized HECM loan inventory. The Company's third party clearing agreements call for payment or receipt of interest income, net of transaction-related interest charged by clearing brokers for facilitating the 58-------------------------------------------------------------------------------- Table of Contents settlement and financing of securities transactions. Net interest is primarily affected by interest rates, the level of cash balances held at banks and third party clearing brokers including those held for customers, the level of our securities borrowing activity, our level of securities positions in which we are long compared to our securities positions in which we are short, the extent of our collateralized financing arrangements and the level of securitized HECM loan inventory. Investment income and other, net primarily represents returns on our strategic and deferred compensation investments. Such income or loss is primarily affected by the performance and activity of our strategic investments and changes in value of certain deferred compensation investments. Expenses Employee compensation and benefits expense, our largest expense, primarily consists of salaries and wages paid to all employees, profitability-based compensation, which includes compensation paid to sales personnel and incentive compensation paid to all other employees based on our profitability, employee benefits, and changes in value of certain deferred compensation liabilities. Employee compensation and benefits expense fluctuates, for the most part, based on changes in our revenues and business mix, profitability and the number of employees. Compensation for employees engaged in sales activities is determined primarily based on a percentage of their gross revenues net of certain transaction-based expenses. Execution and clearance fees primarily represent fees paid to third party clearing brokers for clearing equities, options and fixed income transactions; transaction fees paid to Nasdaq and other exchanges, clearing organizations and regulatory bodies; execution fees paid to third parties, primarily for executing trades on the NYSE, other exchanges and ECNs; and loan processing fees. Execution and clearance fees primarily fluctuate based on changes in trade and share volume, execution strategies, rate of clearance fees charged by clearing brokers and rate of fees paid to ECNs, exchanges and certain regulatory bodies and loan origination volume. Communications and data processing expense primarily consists of costs for obtaining market data, connectivity, telecommunications services and systems maintenance. Payments for order flow primarily represent payments to broker-dealer clients, in the normal course of business, for directing to us their order flow in U.S. equities and options. Payments for order flow also include fees paid to third party brokers with respect to reverse mortgage wholesale loan production and fluctuate as we modify our rates and as our percentage of clients whose policy is not to accept payments for order flow varies. Payments for order flow also fluctuate based on U.S. equity share and option volumes, reverse mortgage loan production and channel mix, our profitability and the mix of market orders, limit orders, and customer mix. Interest expense consists primarily of costs associated with our long-term debt and for collateralized financing arrangements such as securities lending and sale of financial instruments under our agreements to repurchase. Depreciation and amortization expense results from the depreciation of fixed assets, which consist of computer hardware, furniture and fixtures, and the amortization of purchased software, capitalized software development costs, acquired intangible assets and leasehold improvements. We depreciate our fixed assets and amortize our purchased software, capitalized software development costs and acquired intangible assets on a straight-line basis over their expected useful lives. We amortize leasehold improvements on a straight-line basis over the lesser of the life of the improvement or the remaining term of the lease. Professional fees consist primarily of legal, accounting and consulting fees. 59 -------------------------------------------------------------------------------- Table of Contents Occupancy and equipment rentals consist primarily of rent and utilities related to leased premises and office equipment. Business development consists primarily of costs related to sales and marketing, advertising, conferences and relationship management. Restructuring charges consist of employee severance and other benefit costs, writedown of assets, inclusive of capitalized software, intangible assets and goodwill, and lease and contract terminations in connection with restructuring plans set in place in order to lower operating expenses. Writedown of assets and lease loss accrual consist primarily of costs associated with the writedown of assets, primarily goodwill and intangible assets, and lease losses related to excess office space. Other expenses include regulatory fees, corporate insurance, employment fees, partial month interest reserves associated with our Government National Mortgage Association ("GNMA") issuances, and general office expense. Three Months Ended September 30, 2012 and 2011 Revenues Market Making For the three months ended September 30, 2012 2011 Change % of Change Commissions and fees (millions) $ 15.5 $ 41.2 $ (25.8 ) -62.4 % Net trading revenue (millions) (353.5 ) 161.9 (515.4 ) -318.3 % Interest, net (millions) (3.2 ) 1.7 (4.9 ) N/M Total Revenues from Market Making (millions) $ (341.2 ) $ 204.9 $ (546.0 ) -266.5 % U.S. equity Market Making statistics: Average daily dollar value traded ($ billions)* 16.7 29.3 (12.6 ) -42.8 % Average daily trades (thousands)* 2,507.5 4,189.6 (1,682.1 ) -40.1 % Nasdaq and Listed shares traded (billions)* 37.9 60.6 (22.8 ) -37.5 % FINRA OTC Bulletin Board and Other shares traded (billions)* 151.2 174.6 (23.4 ) -13.4 % Average revenue capture per U.S. equity dollar value traded (bps)* (3.29 ) 1.04 (4.34 ) -415.5 % Average revenue capture per U.S. equity dollar value traded, excluding impact of August 1st technology issue (bps)** 1.04 1.04 (0.00 ) 0.0 % * Represents new presentation for U.S. equity Market Making for all periods presented as described more fully in text below. ** Statistic excludes $456.6 million in trading losses related to the August 1, 2012 technology issue. Totals may not add due to rounding. N/M - Not meaningful 60 -------------------------------------------------------------------------------- Table of Contents Total revenues from the Market Making segment, which primarily comprises Net trading revenue from our domestic businesses, decreased to net negative revenues of $341.2 million for the three months ended September 30, 2012, from positive revenues of $204.9 million for the comparable period in 2011. Revenues for the three months ended September 30, 2012 were negatively impacted by the August 1, 2012 Loss which resulted in a $457.6 million trading loss and the effects that the August 1, 2012 Loss had on client volumes immediately after the event as well as a decrease in overall market volumes which drove down our average daily dollar volumes. In the first quarter of 2012, we modified our quarterly revenue capture and monthly equity volume statistics in order to provide data specific to the U.S. equity market making activity within the Market Making segment. Our revenue capture and volume statistics previously also included U.S. institutional sales activity. Average revenue capture per U.S. equity dollar value traded was a loss of 3.29 basis points ("bps") for the third quarter of 2012, down significantly from the third quarter of 2011. Excluding the impact of the August 1, 2012 Loss, average revenue capture per U.S. equity dollar value traded for the third quarter of 2012 remained unchanged at 1.04 bps from the comparable period in 2011. The primary driver for the stability in revenue capture was due in part to growth and enhancements to our trading models and infrastructure. Average revenue capture per U.S. equity market making dollar value traded is calculated as the total of net domestic market making trading revenues plus volume based fees from providing liquidity to other trading venues (included in Commissions and fees), less certain transaction-related regulatory fees (included in Execution and clearance fees) (collectively "Domestic U.S. Equity Market Making Revenues"), divided by the total dollar value of the related equity transactions. Domestic U.S. Equity Market Making Revenues for the three months ended September 30, 2012 were net negative $347.5 million, or positive $109.0 million excluding the impact of August 1, 2012 for the three months ended September 30, 2012, as compared to revenues of $195.8 million for the three months ended September 30, 2011. Institutional Sales and Trading For the three months ended September 30, 2012 2011 Change % of Change Commissions and fees (millions) $ 89.2 $ 119.8 $ (30.6 ) -25.5 % Net trading revenue (millions) 10.1 24.7 (14.6 ) -58.9 % Interest, net (millions) 2.0 (6.5 ) 8.5 130.3 % Investment income and other, net (millions) 0.4 7.5 (7.1 ) -94.7 % Total Revenues from Institutional Sales and Trading (millions) $ 101.7 $ 145.4 $ (43.7 ) -30.1 % Totals may not add due to rounding. Total revenues from the Institutional Sales and Trading segment, which primarily comprises Commissions and fees from institutional equities, ETFs, fixed income sales and reverse mortgage originations, decreased 30.1% to $101.7 million for the three months ended September 30, 2012, from $145.4 million for the comparable period in 2011. Revenues were negatively impacted by the significant slowdown in client activity as a result of the August 1, 2012 Loss offset, in part by increased revenues from our reverse mortgage business. 61-------------------------------------------------------------------------------- Table of Contents Electronic Execution Services For the three months ended September 30, 2012 2011 Change % of Change Commissions and fees (millions) $ 34.9 $ 45.6 $ (10.7 ) -23.5 % Investment income and other, net (millions) (0.1 ) (0.5 ) 0.4 N/M Total Revenues from Electronic Execution Services (millions) $ 34.8 $ 45.1 $ (10.3 ) -22.9 % Average daily Knight Direct equity shares (millions) 174.8 196.7 (21.8 ) -11.1 % Average daily Knight Hotspot FX notional dollar value traded ($ billions)* 24.1 32.2 (8.1 ) -25.1 % Totals may not add due to rounding. * In the second quarter of 2012, Knight modified the reporting of Knight Hotspot FX notional dollar value traded volume to count one side of the transaction. The Company previously counted total client volume to include both sides of the transaction. The Company posts Knight Hotspot FX volume statistics each month to its web site, which has been updated to show one-sided volume statistics dating back to the beginning of 2010. N/M - Not meaningful Total revenues from the Electronic Execution Services segment, which primarily comprises Commissions and fees from agency execution activity, decreased 22.9% to $34.8 million for the three months ended September 30, 2012, from $45.1 million for the comparable period in 2011. Revenues were negatively impacted by lower overall market volumes made more apparent post August 1, 2012; however, by the end of the quarter volumes were substantially back to pre-August 1, 2012 levels. Corporate and Other For the three months ended September 30, 2012 2011 Change % of Change Total Revenues from Corporate and Other (millions) $ 14.8 $ 2.0 $ 12.8 628.5 % Total revenues from the Corporate and Other segment, which primarily represent interest income from our securities borrowing activity, gains or losses on strategic investments, and deferred compensation investments related to certain employees and directors, increased to $14.8 million for the three months ended September 30, 2012, from $2.0 million for the comparable period in 2011, primarily due to the $5.3 million BEIP grant received in August 2012, and from the first full quarter of revenues from our newly acquired futures business which we acquired in June 2012. Expenses Employee compensation and benefits expense decreased to $124.6 million for the three months ended September 30, 2012 from $157.2 million for the comparable period in 2011. The decrease on a dollar basis was primarily due to reduced bonus accruals and sales commissions expense related to the overall decrease and change in the mix of our revenues across businesses and a decrease in guaranteed compensation from our Institutional Sales and Trading segment. As a percentage of total revenue, excluding the effects of the August 1, 2012 Loss, Employee compensation and benefits increased to 46.6% for the three months ended September 30, 2012, from 39.6% for the comparable period in 2011. The increase as a percentage of revenues was primarily due to a decrease in revenues as well as additional compensation related to retention and acceleration of certain stock-based awards as a result of the recapitalization which resulted in additional stock-based compensation of $1.6 million in the third quarter of 2012. 62 -------------------------------------------------------------------------------- Table of Contents The number of full time employees increased to 1,545 at September 30, 2012, from 1,391 at September 30, 2011, primarily due to the acquisition of our futures business and the expansion of our market making and reverse mortgage businesses. Employee compensation and benefits expense fluctuates, for the most part, based on changes in our business mix, revenues, profitability, and the number of employees. Execution and clearance fees decreased to $46.7 million for the three months ended September 30, 2012, from $63.6 million for the comparable period in 2011. As a percentage of total revenue, excluding the effects of the August 1, 2012 Loss, execution and clearance fees increased slightly to 17.5% for the three months ended September 30, 2012, from 16.0% for the comparable period in 2011. This increase as a percentage of revenues was due to lower revenue base and the effect of lower volumes on tier-based pricing. Execution and clearance fees fluctuate based on changes in transaction volumes, shift in business mix, regulatory fees and operational efficiencies and scale. Payments for order flow decreased 12.6% to $20.1 million for the three months ended September 30, 2012, from $23.0 million for the comparable period in 2011. As a percentage of total revenue, excluding the effects of the August 1, 2012 Loss, payments for order flow increased to 7.5% for the three months ended September 30, 2012, from 5.8% for the comparable period in 2011. The increase as a percentage of revenues is due to lower revenue base and additional cost as we begin to regain market share. Payments for order flow fluctuate as a percentage of revenue due to changes in volume, reverse mortgage loan production, client and product mix, profitability, and competition. There was no restructuring charge for the three months ended September 30, 2012. The restructuring charge of $28.6 million for the three months ended September 30, 2011 is related to employee severance and other employee benefits, writedown of assets and lease and contract termination costs in connection with our plan to discontinue certain initiatives and decrease operating expenses. Writedown of assets and lease loss accrual of $143.0 million for the three months ended September 30, 2012 relate to the impairment of goodwill and intangibles triggered by the August 1, 2012 Loss. Writedown of assets and lease loss accrual of $1.3 million for the three months ended September 30, 2011, related to excess real estate space. All other expenses decreased by 0.9%, or $0.8 million, to $78.5 million for the three months ended September 30, 2012 from $79.3 million for the comparable period in 2011. Excluding the August 1, 2012 related professional fees of $3.5 million, all other expenses decreased by 5.4%, or $4.2 million, to $75.0 million for the three months ended September 30, 2012. Business development expense decreased due to fewer client related events. Other expenses decreased due to lower reserves associated with our GNMA issuances, offset in part by higher administrative expenses. Communications and data processing expense increased primarily due to higher market data and connectivity expenses as a result of our overall growth. Interest expense increased primarily due to our increased securities lending activity and long-term debt. Professional fees increased due to higher consulting expenses and costs related to the August 1, 2012 Loss. Our effective tax rate from continuing operations of 35.3% for the three months ended September 30, 2012, differed from the federal statutory rate of 35% primarily due to non-deductible charges. Our effective rate of 39.3% for the three months ended September 30, 2011 differed from the federal statutory rate of 35% primarily due to state and local income taxes and non-deductible charges. 63 -------------------------------------------------------------------------------- Table of Contents Nine Months Ended September 30, 2012 and 2011 Revenues Market Making For the nine months ended September 30, 2012 2011 Change % of Change Commissions and fees (millions) $ 60.9 $ 97.5 $ (36.7 ) -37.6 % Net trading revenue (millions) (134.5 ) 413.3 (547.7 ) -132.5 % Interest, net (millions) (1.9 ) 6.3 (8.2 ) N/M Total Revenues from Market Making (millions) $ (75.5 ) $ 517.1 $ (592.6 ) -114.6 % U.S. equity Market Making statistics: Average daily dollar value traded ($ billions)* 19.9 26.0 (6.1 ) -23.6 % Average daily trades (thousands)* 3,050.6 3,632.7 (582.1 ) -16.0 % Nasdaq and Listed shares traded (billions)* 130.9 165.5 (34.6 ) -20.9 % FINRA OTC Bulletin Board and Other shares traded (billions)* 489.3 757.2 (267.9 ) -35.4 % Average revenue capture per U.S. equity dollar value traded (bps)* (0.27 ) 1.00 (1.27 ) -127.2 % Average revenue capture per U.S. equity dollar value traded, excluding impact of Facebook IPO and August 1st technology issue (bps)** 1.02 1.00 0.02 2.5 % * Represents new presentation for U.S. equity Market Making for all periods presented as described more fully in text below. ** Statistic for 2012 excludes $26.0 million in trading losses related to the Facebook IPO and $456.6 million in trading losses related to the August 1, 2012 technology issue. Totals may not add due to rounding. N/M - Not meaningful Total revenues from the Market Making segment, which primarily comprises Net trading revenue from our domestic businesses, decreased to net negative revenues of $75.5 million for the nine months ended September 30, 2012, from positive revenues of $517.1 million for the comparable period in 2011. Revenues for the nine months ended September 30, 2012 were negatively impacted by $26.0 million of trading losses related to the Facebook IPO the $457.6 million August 1, 2012 Loss and the effects that the August 1, 2012 Loss had on client volumes immediately after the event as well as a decrease in overall market volumes, which drove down our average daily dollar volumes. Average revenue capture per U.S. equity dollar value traded was a loss of 0.27 bps for the nine months ended September 30, 2012, down from the comparable period in 2011. Excluding the impact of August 1, 2012 Loss and Facebook IPO, average revenue capture per U.S. equity dollar value traded was 1.02 bps for the nine months ended September 30, 2012, up 2.5% from the comparable period in 2011. The primary driver for the increase in revenue capture excluding the impact of the August 1, 2012 Loss and the Facebook IPO loss was the growth and enhancements to our trading models and infrastructure. Domestic U.S. Equity Market Making revenues were net negative $101.3 million, or $381.2 million when excluding the impact of August 1, 2012 Loss and Facebook IPO for the nine months ended September 30, 2012, and $491.0 million for the nine months ended September 30, 2011. 64 -------------------------------------------------------------------------------- Table of Contents Institutional Sales and Trading For the nine months ended September 30, 2012 2011 Change % of Change Commissions and fees (millions) $ 310.5 $ 358.6 $ (48.1 ) -13.4 % Net trading revenue (millions) 44.8 51.7 (6.9 ) -13.3 % Interest, net (millions) (2.3 ) (12.1 ) 9.8 81.1 % Investment income and other, net (millions) 0.7 9.5 (8.9 ) -92.7 % Total Revenues from Institutional Sales and Trading (millions) $ 353.7 $ 407.7 $ (54.0 ) -13.3 % Totals may not add due to rounding. Total revenues from the Institutional Sales and Trading segment, which primarily comprises Commissions and fees from institutional equities, ETFs, fixed income sales and reverse mortgage originations, decreased 13.3% to $353.7 million for the nine months ended September 30, 2012, from $407.7 million for the comparable period in 2011. Revenues were negatively impacted by $9.4 million of trading losses related to the Facebook IPO and lower revenues from our capital markets and equity sales businesses, exacerbated by a slowdown in client activity as a result of the August 1, 2012 Loss as well as a decrease in overall market volumes offset, in part, by higher revenues from our reverse mortgage business Electronic Execution Services For the nine months ended September 30, 2012 2011 Change % of Change Commissions and fees (millions) $ 122.6 $ 128.4 $ (5.8 ) -4.5 % Investment income and other, net (millions) (0.3 ) (1.0 ) 0.7 N/M Total Revenues from Electronic Execution Services (millions) $ 122.3 $ 127.3 $ (5.1 ) -4.0 % Average daily Knight Direct equity shares (millions) 203.1 174.9 28.2 16.1 % Average daily Knight Hotspot FX notional dollar value traded ($ billions)* 26.7 30.4 (3.7 ) -12.3 % Totals may not add due to rounding. * In the second quarter of 2012, Knight modified the reporting of Knight Hotspot FX notional dollar value traded volume to count one side of the transaction. The Company previously counted total client volume to include both sides of the transaction. The Company posts Knight Hotspot FX volume statistics each month to its web site, which has been updated to show one-sided volume statistics dating back to the beginning of 2010. N/M - Not meaningful Total revenues from the Electronic Execution Services segment, which primarily comprises Commissions and fees from agency execution activity, decreased 4.0% to $122.3 million for the nine months ended September 30, 2012, from $127.3 million for the comparable period in 2011. Revenues were negatively impacted by lower overall market volumes made more apparent post-August 1, 2012; however, by the end of the quarter volumes were substantially back to pre-August 1, 2012 levels. 65 -------------------------------------------------------------------------------- Table of Contents Corporate and Other For the nine months ended September 30, 2012 2011 Change % of Change Total Revenues from Corporate and Other (millions) $ 48.0 $ 11.0 $ 37.0 334.4 % Total revenues from the Corporate and Other segment, which primarily represent interest income from our securities borrowing activity, gains or losses on strategic investments, and deferred compensation investments related to certain employees and directors, increased to $48.0 million for the nine months ended September 30, 2012, from $11.0 million for the comparable period in 2011. The primary drivers for the increase in revenues were a $10.0 million gain from a strategic investment that we account for under the equity method of accounting, the $5.3 million BEIP grant received in August 2012 and revenues from our newly acquired futures business which we acquired in June 2012. The $10.0 million investment gain represents our share of the investee's net income which we recorded under the equity method of accounting which was due to an income tax benefit recognized by the investee that arose from a change in its tax status during 2010, but which was reported and disclosed to us in the second quarter of 2012. Expenses Employee compensation and benefits expense decreased to $402.8 million for the nine months ended September 30, 2012 from $446.3 million for the comparable period in 2011. As a percentage of total revenue, excluding the August 1, 2012 Loss, the Facebook IPO trading loss and the one-time $10.0 million investment gain from a strategic investment, Employee compensation and benefits increased to 43.2% for the nine months ended September 30, 2012, from 42.0% for the comparable period in 2011. The decrease on a dollar basis was primarily due to an overall decrease in revenues and profitability and change in the mix of our revenues across businesses as well as by a decrease in guaranteed compensation from our Institutional Sales and Trading segment. Execution and clearance fees decreased to $153.2 million for the nine months ended September 30, 2012, from $175.8 million for the comparable period in 2011. Excluding the August 1, 2012 Loss, Facebook IPO trading loss and the one-time $10.0 million investment gain from a strategic investment, execution and clearance fees as a percentage of revenues decreased to 16.4% for the nine months ended September 30, 2012, from 16.5% for the comparable period in 2011. Execution and clearance fees fluctuate based on changes in transaction volumes, shift in business mix, regulatory fees and operational efficiencies and scale. Payments for order flow decreased 6.2% to $61.9 million for the nine months ended September 30, 2012, from $66.0 million for the comparable period in 2011. Excluding the August 1, 2012 Loss, the Facebook IPO trading loss and the one-time $10.0 million investment gain from a strategic investment, payments for order flow as a percentage of revenues increased to 6.7% for the nine months ended September 30, 2012, from 6.2% for the comparable period in 2011. The increase is due to lower revenue base and additional cost as we begin to regain market share. Payments for order flow fluctuate as a percentage of revenue due to changes in volume, reverse mortgage loan production, client and product mix, profitability, and competition. There was no restructuring charge for the nine months ended September 30, 2012. The restructuring charge of $28.6 million for the nine months ended September 30, 2011 is related to employee severance and other employee benefits, writedown of assets and lease and contract termination costs in connection with our plan to discontinue certain initiatives and decrease operating expenses. Writedown of assets and lease loss accrual of $143.0 million for the nine months ended 66 -------------------------------------------------------------------------------- Table of Contents September 30, 2012 which relate to the impairment of goodwill and intangibles triggered by the August 1, 2012 Loss. Writedown of assets and lease loss accrual of $2.3 million for the nine months ended September 30, 2011 relate to excess real estate space. All other expenses increased by 4.9%, or $10.8 million, to $231.0 million for the nine months ended September 30, 2012 from $220.2 million for the comparable period in 2011. Excluding August 1, 2012 related professional fees of $3.5 million, all other expenses increased by 3.3%, or $7.3 million to $227.5 million for the nine months ended September 30, 2012. Communications and data processing expense increased primarily due to higher market data and connectivity expenses as a result of our overall growth. Interest expense increased primarily due to our increased securities lending activity and long-term debt. Professional fees increased due to higher consulting expenses and costs related to the August 1, 2012 Loss. Occupancy and equipment rentals expense decreased primarily due to the reduction in lease costs. Business development expense decreased due to fewer client related events. Other expenses decreased due to lower reserves associated with our GNMA issuances, offset, by higher administrative expenses. Our effective tax rate from continuing operations of 35.0% for the nine months ended September 30, 2012, differed from the federal statutory rate of 35% primarily due to non-deductible charges. Our effective rate of 39.2% for the nine months ended September 30, 2011 differed from the federal statutory rate of 35% primarily due to state and local taxes and non deductible charges. Reconciliation of GAAP Pre-Tax to Non-GAAP Pre-Tax Earnings. We believe that certain non-GAAP financial presentations, when taken into consideration with the corresponding GAAP financial presentations, are important in understanding our operating results. Selected financial information is included in our non-GAAP financial presentations for the three and nine months ended September 30, 2012. This information includes the effects due to the August 1, 2012 Loss, the writedown of goodwill and intangible assets, trading losses related to the Facebook IPO and a gain resulting from a change in the tax status of a strategic investment. We believe these presentations provide meaningful information to shareholders and investors as it provides comparability for our results of operations for the three and nine months ended September 30, 2012 with the results for the periods ended September 30, 2011. See schedules below for a full reconciliation of GAAP to non-GAAP financial presentations (in thousands): Institutional Electronic Market Sales and Execution Corporate Three months ended September 30, 2012 Making Trading Services and Other Consolidated Reconciliation of GAAP Pre-Tax to Non-GAAP Pre-Tax: GAAP Pre-Tax (Loss) Income $ (451,964 ) $ (140,807 ) $ 6,267 $ (16,356 ) $ (602,860 ) August 1st trading loss and related costs 457,570 - - 3,520 461,090 Writedown of assets 11,917 131,117 - - 143,034 Non-GAAP Pre-Tax Income (Loss) $ 17,522 $ (9,690 ) $ 6,267 $ (12,836 ) $ 1,263 * Totals may not add due to rounding 67 -------------------------------------------------------------------------------- Table of Contents Institutional Electronic Market Sales and Execution Corporate Nine months ended September 30, 2012 Making Trading Services and Other Consolidated Reconciliation of GAAP Pre-Tax to Non-GAAP Pre-Tax: GAAP Pre-Tax (Loss) Income $ (400,901 ) $ (133,639 ) $ 29,882 $ (38,847 ) $ (543,505 ) August 1st trading loss and related costs 457,570 - - 3,520 461,090 Writedown of assets 11,917 131,117 - - 143,034 Facebook IPO trading losses 25,975 9,385 78 - 35,438 Investment gain - - - (9,992 ) (9,992 ) Non-GAAP Pre-Tax Income (Loss) $ 94,561 $ 6,863 $ 29,960 $ (45,319 ) $ 86,064 * Totals may not add due to rounding Financial Condition, Liquidity and Capital Resources Financial Condition We have historically maintained a highly liquid balance sheet, with a substantial portion of our total assets consisting of cash, highly liquid marketable securities and short term receivables. As of September 30, 2012 and December 31, 2011, we had $8.59 billion and $7.15 billion, respectively, in assets, a portion of which consisted of cash or assets readily convertible into cash as follows (in millions): September 30, December 31, 2012 2011 Cash and cash equivalents $ 420.8 $ 467.6 Financial instruments owned, at fair value: Equities 1,170.8 1,416.1 U.S. government and Non-U.S. government obligations 57.8 44.3 Corporate debt 76.5 73.9 Mortgage-backed securities 112.4 16.4 Listed equity options 132.4 280.4 Collateralized agreements: Securities borrowed 1,060.0 1,494.6 Receivables from brokers, dealers and clearing organizations 944.2 623.9 Total cash and assets readily convertible to cash $ 3,975.0 $ 4,417.3 Totals may not add due to rounding. Substantially all of the amounts disclosed in the table above can be liquidated to cash within five business days under normal market conditions, however, the liquidated values may be subjected to haircuts during distressed market conditions as we saw following the August 1, 2012 Loss. Financial instruments owned principally consist of equities and listed equity options that trade on the NYSE, NYSE Amex and NYSE Arca markets, Nasdaq and on the OTC Bulletin Board as well as securitized HECM loan inventories. Securities borrowed represent the value of cash or other collateral deposited with securities lenders to facilitate our trade settlement process. 68-------------------------------------------------------------------------------- Table of Contents Receivables from brokers, dealers and clearing organizations include interest bearing cash balances held with third party 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. As of September 30, 2012 and December 31, 2011, $812.2 million and $798.2 million, respectively, of equities have been pledged as collateral to third-parties under financing arrangements. Other assets primarily represent deposits and other miscellaneous receivables. Total assets increased $1.43 billion, or 20.0%, from $7.15 billion at December 31, 2011 to $8.59 billion at September 30, 2012. The majority of the increase in assets relates to the growth of our financial instruments owned. Financial instruments owned increased by $1.33 billion, or 35.2%, from $3.78 billion at December 31, 2011, to $5.11 billion at September 30, 2012, primarily due to the $1.69 billion increase in securitized HECM loan inventory, which represents HECM loans that have been securitized into GNMA securities which have been sold to third parties but where the securitization is not accounted for as a sale under current accounting standards. Offsetting this increase is a decrease of approximately $280.0 million related to a net reduction in our trading inventory. Our securities inventory fluctuates based on trading volumes, market conditions, trading strategies utilized and our pre-determined risk limits. Receivable from brokers, dealers and clearing organizations increased by $320.3 million, from $623.9 million at December 31, 2011 to $944.2 million at September 30, 2012, due to increased deposits at third party clearing organizations including customer balances related to our futures business as well as timing relating to trade date versus settlement date differences. Securities borrowed decreased by $434.6 million, from $1.49 billion at December 31, 2011 to $1.06 billion at September 30, 2012. This decrease is related to the decrease in our trading inventory as well as the effect of reduced levels of business with some of our counterparties as a result of the August 1, 2012 Loss. Income taxes receivable increased $163.9 million from $9.8 million at December 31, 2011 to $173.6 million at September 30, 2012, primarily due to the August 1, 2012 Loss. Cash and securities segregated under federal and other regulations increased $126.8 million from $11.0 million at December 31, 2011 to $137.8 million at September 30, 2012, primarily due to the acquisition of our futures business. Total liabilities increased $1.42 billion, or 24.9%, from $5.69 billion at December 31, 2011 to $7.11 billion at September 30, 2012. The majority of the increase in liabilities relates to increases in Collateralized financings and Payable to customers. Collateralized financings increased by $1.44 billion, or 49.7%, from $2.89 billion at December 31, 2011, to $4.32 billion at September 30, 2012 primarily due to the increased Liability to GNMA trusts, at fair value associated with the securitization of HECM loans into GNMA securities, where such securitization is not accounted for as a sale offset by a decrease in lending activity to facilitate transaction settlements relating to self-clearing. Financial instruments sold, not yet purchased decreased by $425.8 million, or 24.7%, from $1.72 billion at December 31, 2011, to $1.30 billion at September 30, 2012, primarily due to a decrease in the size of the securities inventory utilized in our equity market making and ETF activities and for trade execution services. Our securities inventory fluctuates based on trading volumes, market conditions, trading strategies utilized and our pre-determined risk limits and is consistent with the decrease in our long securities position within our market making business. Payable to customers increased by $437.2 million, from $23.7 million at December 31, 2011 to $460.8 million at September 30, 2012, primarily due to the acquisition of our futures business. Accrued compensation expense decreased from $188.9 million at December 31, 2011 to $132.0 million at September 30, 2012 primarily as a result of the payment of 2011 incentive compensation offset, in part, by the accrual of current period incentive compensation. Our Series A convertible preferred stock balance of $259.3 million is a result of our $400.0 million issuance of convertible preferred securities, which netted $359.5 million after $40.5 million in related 69-------------------------------------------------------------------------------- Table of Contents fees. This initial balance was reduced by $100.5 million as a result of the conversion of a portion of the, Series A Shares into Class A common stock. Since the Series A Shares can become redeemable at the option of the holder upon the occurrence of certain merger or acquisition transactions or fundamental changes, which may not be solely within the control of the Company, the Series A Shares are classified as temporary equity on the Company's Consolidated Statements of Financial Condition. Stockholders' equity decreased by $245.2 million, from $1.46 billion at December 31, 2011 to $1.22 billion at September 30, 2012. The decrease in stockholders' equity from December 31, 2011 was primarily a result of the August 1, 2012 loss, offset in part by an increase of $100.5 million as a result of the aforementioned conversion of a portion of the Series A Shares into Class A common stock. Liquidity and Capital Resources Historically we have financed our business primarily through cash generated by operations, our long-term debt and other borrowings. As a result of the August 1, 2012 Loss, on August 6, 2012 we raised $400.0 million in equity financing through a convertible preferred share offering with several investors. We incurred approximately $40.5 million of fees and costs related to the offering, resulting in net proceeds of $359.5 million. At September 30, 2012, we had net current assets, which consist of net assets readily convertible into cash less current liabilities, of $1.15 billion. We have acquired several businesses over the last few years. In July 2010, we completed the acquisition of Urban Financial Group, Inc. ("Urban") for $28.4 million, comprising $19.4 million in cash, approximately 350,000 shares of unregistered Knight Class A common stock valued at $5.0 million and a potential earn-out based on future performance valued at $4.7 million. Urban achieved its first and second year performance targets as of July 31, 2011 and 2012, respectively. Therefore, the seller received $1.3 million split evenly between cash and unregistered shares of Knight common stock in each of those years. In June 2012, we completed the acquisition of certain assets and assumption of certain liabilities of Penson Futures, the futures division of Penson Financial Services, Inc. for $5.0 million in cash and a potential earn-out based on future performance with an estimated fair value of $8.4 million. We expect to fund the purchase price of any future acquisitions with our current cash position or, in some cases, through the issuance of our stock or debt. We had net loss of $389.9 million for the three months ended September 30, 2012 and net income of $26.9 million for the three months ended September 30, 2011. Included in these amounts were certain non-cash expenses such as stock-based compensation, depreciation and amortization, and writedown of assets. Stock-based compensation was $14.2 million and $10.7 million for the three months ended September 30, 2012 and 2011, respectively. Depreciation and amortization expense was $11.9 million and $13.7 million for the three months ended September 30, 2012 and 2011, respectively. Non-cash writedown of assets were $143.0 million for the three months ended September 30, 2012 which related to goodwill and intangible assets. There were no non-cash writedowns for the three months ended September 30, 2011. Capital expenditures were $8.4 million and $9.9 million during the three months ended September 30, 2012 and 2011, respectively. Purchases of investments were $5.5 million and $3.4 million and distributions from investments were $10.3 million and $0.4 million for the three months ended September 30, 2012 and 2011, respectively. There were no payments relating to acquisitions of businesses, trading rights and other items for the three months ended September 30, 2012. Cash payment relating to purchase of business, net of cash acquired for the three months ended September 30, 2011 was $0.6 million which related to the first year of Urban earn-out. 70 -------------------------------------------------------------------------------- Table of Contents In March 2010, we issued Cash Convertible Senior Subordinated Notes ("Notes") with a face amount of $375.0 million in a private offering. Net proceeds from the offering were $167.5 million, which included $15.0 million from the sale of warrants, less $140.5 million for the termination and required repayment of the borrowings under our previous $140.0 million credit agreement including accrued interest, $73.7 million for the purchase of call options and $8.5 million of offering expenses. The Notes bear interest at a rate of 3.50% per year, payable semi-annually in arrears, on March 15 and September 15 of each year, commencing on September 15, 2010 and will mature on March 15, 2015, subject to earlier repurchase or conversion. For the three months ended September 30, 2012 and 2011, we recognized interest expense related to the Notes of $6.9 million and $6.7 million, respectively. In June 2011, we entered into a $100.0 million three-year Term Loan Credit Agreement (the "Term Credit Agreement") with the same consortium of banks. As of September 30, 2012, the Company has borrowed all the funds under the Term Credit Agreement and the interest rate was 2.75% per annum, which is based on the one month LIBOR rate plus 2.50%. Interest is paid monthly. The Term Credit Agreement is repayable in three installments as follows: $25.0 million on June 28, 2013, $25.0 million on December 27, 2013 and $50.0 million on June 27, 2014. For the three months ended September 30, 2012, we recognized interest expense related to the Term Credit Agreement of $0.7 million. In June 2011, we also entered into a $200.0 million one-year Revolving Credit Agreement (the "Revolving Credit Agreement") with Knight Execution & Clearing Services LLC and Knight Capital Americas, L.P., as borrowers, with a consortium of banks. Borrowings under the Revolving Credit Agreement bear interest at a rate equal to the greater of the federal funds rate or the one month LIBOR rate plus a margin ranging from 1.50% - 2.00% per annum. Interest is payable quarterly. In June 2012, we renewed our Revolving Credit Agreement with substantially the same consortium of banks on substantially the same terms and conditions as the Revolving Credit Agreement. In August 2012, we drew down the full $200.0 million available under our Revolving Credit Agreement and repaid in full by the next business day. As of September 30, 2012, and December 31, 2011 there were no outstanding borrowings under the Revolving Credit Agreement. We are charged an annual commitment fee of 0.25% on the average daily amount of the unused portion of the Revolving Credit Agreement. For the three months ended September 30, 2012, we recorded $0.1 million in commitment fees. In August 2012, we raised $400.0 million in equity financing through a convertible preferred share offering with several investors. Under the terms, we sold 400,000 shares of Series A Convertible Preferred Stock, par value $0.01 per share. We incurred approximately $40.5 million of fees and costs related to the issuance resulting in net proceeds of $359.5 million. Dividends on the Series A Shares accrue daily and are payable on a cumulative basis, as and if declared by the Board of Directors, in cash at a rate per annum equal to 2%. Declared dividends on the Series A Shares are payable quarterly, in arrears, on each January 15, April 15, July 15 and October 15, with the first dividend paid on October 15, 2012 of $1.1 million. See Footnote 11 "Long-Term Debt" and Footnote 4 "Series A Convertible Preferred Stock" included in Part I, Item 1 "Financial Statements" of this Form 10-Q for further information regarding the Notes, Term Credit Agreement and Revolving Credit Agreement; and Series A Convertible Preferred Stock, respectively. We declared a cash dividend at the end of September 2012 for holders of our Series A convertible preferred stock totaling $1.1 million, which was paid in October 2012. See Footnote 4 "Series A Convertible Preferred Stock," included in Part I, Item 1 "Financial Statements" of this Form 10-Q for further information regarding our August 6, 2012 equity financing. We have an authorized stock repurchase program of $1.00 billion. We did not repurchase any shares under the stock repurchase program during the third quarter of 2012. Through September 30, 71-------------------------------------------------------------------------------- Table of Contents 2012, we had repurchased 76.7 million shares for $879.1 million under this program. We may repurchase shares from time to time in open market transactions, accelerated stock buyback programs, tender offers, privately negotiated transactions or by other means. Repurchases may also be made under Rule 10b5-1 plans. The timing and amount of repurchase transactions will be determined by our management based on its evaluation of market conditions, share price, legal requirements and other factors. The program may be suspended, modified or discontinued at any time without prior notice. We caution that there are no assurances that any further repurchases will actually occur. The terms of our Series A-1 Cumulative Perpetual Convertible Preferred Stock terms prohibit us from repurchasing any shares if dividends on such shares are in arrears. We had 181.5 million shares of Class A common stock outstanding as of September 30, 2012. Our U.S. registered broker-dealer is subject to regulatory requirements intended to ensure the general financial soundness and liquidity of broker-dealers and futures commission merchants ("FCM") and require the maintenance of minimum levels of net capital, as defined in SEC Rule 15c3-1 as well as other capital requirements from several commodity organizations including the Commodities Futures Trading Commission ("CFTC") and the National Futures Association ("NFA"). 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% of its required minimum capital. Moreover, broker-dealers are required to notify the SEC, CFTC and other regulators prior to repaying subordinated borrowings, paying dividends and making loans to its parent, affiliates or employees, or otherwise entering into transactions, which, if executed, would result in a reduction of 30% or more of its excess net capital (net capital less minimum requirement). The SEC and the CFTC have the ability to prohibit or restrict such transactions if the result is detrimental to the financial integrity of the broker-dealer. As of September 30, 2012, our broker-dealers were in compliance with the applicable regulatory net capital rules. The following table sets forth the net capital levels and requirements for the following regulated U.S. broker-dealer subsidiary at September 30, 2012, as reported in their respective regulatory filings (in millions): Net Capital Excess Net Entity Net Capital Requirement Capital Knight Capital Americas LLC $ 289.3 $ 20.7 $ 268.6 Effective as of the close of business on June 30, 2012, we merged our broker-dealer subsidiary Knight Capital Americas, L.P. into Knight Execution & Clearing Services LLC ("KECS") with KECS as the surviving entity and only U.S. broker-dealer. KECS was then immediately renamed Knight Capital Americas LLC and remains an indirect, wholly-owned subsidiary of Knight Capital Group, Inc. Our foreign registered broker-dealers are subject to certain financial resource requirements of either the Financial Services Authority ("FSA") or the Securities and Futures Commission ("SFC"). The following table sets forth the financial resource requirement for the following significant foreign regulated broker-dealer at September 30, 2012 (in millions): Financial Resource Excess Financial Entity Resources Requirement Resources Knight Capital Europe Limited $ 125.7 $ 34.7 $ 91.0 Off-Balance Sheet Arrangements As of September 30, 2012, we did not have any off-balance sheet arrangements, as defined in Item 303(a) (4) (ii) of SEC Regulation S-K. 72-------------------------------------------------------------------------------- Table of Contents Effects of Inflation Because the majority of our assets are liquid in nature, they are not significantly affected by inflation. However, the rate of inflation may affect our expenses, such as employee compensation, office leasing costs and communications expenses, which may not be readily recoverable in the prices of the services offered by us. To the extent inflation results in rising interest rates and has other adverse effects on the securities markets, it may adversely affect our financial position and results of operations. Critical Accounting Policies Our Consolidated Financial Statements are based on the application of GAAP which requires us to make estimates and assumptions about future events that affect the amounts reported in our financial statements and the accompanying notes. Future events and their effects cannot be determined with certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results could differ from those estimates and any such differences may be material to our Consolidated Financial Statements. We believe that the estimates set forth below may involve a higher degree of judgment and complexity in their application than our other accounting estimates and represent the critical accounting estimates used in the preparation of our consolidated financial statements. We believe our judgments related to these accounting estimates are appropriate. However, if different assumptions or conditions were to prevail, the results could be materially different from the amounts recorded. Financial Instruments and Fair Value - We value our financial instruments using a hierarchy of fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs when measuring fair value. The fair value hierarchy can be summarized as follows: • Level 1 - Valuations based on quoted prices in active markets for identical assets or liabilities that we have the ability to access. Since valuations are based on quoted prices that are readily and regularly available in an active market, valuation of these products does not entail a significant degree of judgment. • Level 2 - Valuations based on quoted prices in markets that are not active or for which all significant inputs are observable, either directly or indirectly. • Level 3 - Valuations based on inputs that are unobservable and significant to the overall fair value measurement. Changes in fair value are recognized in earnings each period for financial instruments that are carried at fair value. Our financial instruments owned and financial instruments sold, not yet purchased will generally be classified within Level 1 of the fair value hierarchy because they are valued using quoted market prices or broker or dealer quotations with reasonable levels of price transparency. The types of instruments that trade in markets that are not considered to be active, but are valued based on observable inputs such as quoted market prices or alternative pricing sources with reasonable levels of price transparency are generally classified within Level 2 of the fair value hierarchy. 73-------------------------------------------------------------------------------- Table of Contents As discussed in Footnote 11 "Long-Term Debt," included in Part I, Item 1 "Financial Statements" of this Form 10-Q, we entered into purchased call options and recorded an embedded conversion derivative concurrent with our issuance of the Notes. The fair value of these options and derivative are determined using an option pricing model based on observable inputs such as implied volatility of our common stock, risk-free interest rate, and other factors and, as such, are classified within Level 2 of the fair value hierarchy. Our loan inventory including securitized HECM loan inventory, foreign currency forward contracts, investment in the Deephaven Funds, deferred compensation investments and certain mortgage-backed securities are also classified within Level 2. Certain instruments are classified within Level 3 of the fair value hierarchy because they trade infrequently and therefore have little or no price transparency. For those instruments that are not traded in active markets or are subject to transfer restrictions, valuations are adjusted to reflect illiquidity and/or non-transferability, and such adjustments are generally based on available market evidence. In the absence of such evidence, management's best estimate is used. As of September 30, 2012 and December 31, 2011, we did not hold any financial instruments that met the definition of Level 3. There were no transfers of financial instruments between levels of the fair value hierarchy for any periods presented. Securitization activities - We securitize HECMs under our GNMA issuance authority. Securitization and transfer of financial assets are generally accounted for as sales when an issuer has relinquished control over the transferred assets. Based upon the current structure of the GNMA securitization program, we believe that we have not met the GAAP criteria for relinquishing control over the transferred assets and therefore our securitizations fail to meet the GAAP criteria for sale accounting. As such, we continue to recognize the HECMs in Financial instruments owned, at fair value, and we recognize a corresponding liability in Liability to GNMA trusts, at fair value on the Consolidated Statements of Financial Condition. Goodwill and Intangible Assets - As a result of our various acquisitions, we have acquired goodwill and identifiable intangible assets. We determine the values and useful lives of intangible assets upon acquisition. Goodwill is the cost of acquired companies in excess of the fair value of net assets, including identifiable intangible assets, at the acquisition date. We test goodwill and intangible assets with an indefinite useful life for impairment at least annually or when an event occurs or circumstances change that signifies the existence of impairment. Goodwill Goodwill of $218.6 million at September 30, 2012 primarily relates to our Institutional Sales and Trading and Electronic Execution Services segments. We test the goodwill in each of our reporting units for impairment at least annually by comparing the estimated fair value of each reporting unit with its estimated net book value. We derive the fair value of each of our reporting units based on valuation techniques we believe market participants would use for each segment (observable market multiples and discounted cash flow analyses) and we derive the net book value of our reporting units by estimating the amount of shareholders' equity required to support the activities of each reporting unit. As part of our test for impairment, we also consider the profitability of the applicable reporting unit as well as our overall market value, compared to our book value. We performed our annual test for impairment of goodwill in the second quarter of 2012 and determined that goodwill was not impaired at that time. Subsequent to that annual impairment test, we experienced a technology issue on August 1, 2012 which resulted in a substantial trading loss and required us to reassess goodwill for impairment and resulted in a writedown of goodwill totaling $143.0 million. 74-------------------------------------------------------------------------------- Table of Contents Intangible Assets Intangible assets, less accumulated amortization, of $68.2 million at September 30, 2012 are primarily attributable to our Institutional Sales and Trading and Electronic Execution Services segments. We amortize these assets, which primarily consist of customer relationships on a straight-line basis over their useful lives, the majority of which have been determined to range from two to 18 years. We test amortizable intangibles for recoverability whenever events indicate that the carrying amounts may not be recoverable. On August 1, 2012 we incurred a technology issue which resulted in a substantial trading loss. Consequently we assessed our amortizable intangibles assets for impairment and recorded a writedown of intangible assets totaling $16.7 million. Investments - Investments primarily comprise strategic investments and deferred compensation investments. Strategic investments include noncontrolling equity ownership interests and debt instruments held by us within our non-broker-dealer subsidiaries, primarily in financial services-related businesses. Strategic investments are accounted for under the equity method, at cost or at fair value. We use the equity method of accounting where we are considered to exert significant influence on the investee. We hold strategic investments at cost, less impairment if any, when we are not considered to exert significant influence on operating and financial policies of the investee. We account for our deferred compensation investments, which primarily consist of mutual funds, at fair value. We review investments on an ongoing basis to ensure that the carrying values of the investments have not been impaired. If we assess that an impairment loss on a strategic investment has occurred due to a decline in fair value or other market conditions, we write the investment down to its estimated impaired value. We maintain a deferred compensation plan related to certain employees and directors. This plan provides a return to the participants based upon the performance of various investments. In order to hedge our liability under this plan, we generally acquire the underlying investments and hold such investments until the deferred compensation liabilities are satisfied. We record changes in the values of such investments in Investment income and other, net, with a corresponding charge or credit to Employee compensation and benefits on the Consolidated Statements of Operations. Market Making, Sales, Trading and Execution Activities - Financial instruments owned and Financial instruments sold, not yet purchased, which relate to market making and trading activities, include listed and OTC equity securities, listed equity options and fixed income securities which are recorded on a trade date basis and carried at fair value. Net trading revenue (trading gains, net of trading losses) and commissions (which includes commission equivalents earned on institutional client orders, futures transactions, and HECM loan originations and securitization activities) and related expenses are also recorded on a trade date basis. Our third party clearing agreements call for payment or receipt of interest income, net of transaction-related interest charged by clearing brokers for facilitating the settlement and financing of securities transactions. The Company also nets interest income on its securitized HECM loan inventory against interest expense on its liability to GNMA trusts. Dividend income relating to securities owned and dividend expense relating to securities sold, not yet purchased, derived from our market making activities are included as a component of Net trading revenue on our Consolidated Statements of Operations. Lease Loss Accrual - It is our policy to identify excess real estate capacity and where applicable, accrue for related future costs, net of estimated sublease income. Other Estimates - The preparation of financial statements in conformity with GAAP requires management to make certain estimates and assumptions. In addition to the estimates that we make in 75-------------------------------------------------------------------------------- Table of Contents connection with accounting for the items noted above, the use of estimates is also important in determining provisions for potential losses that may arise from litigation, regulatory proceedings and tax audits. When determining stock-based employee compensation expense, we make certain estimates and assumptions relating to volatility and forfeiture rates. We estimate volatility based on several factors including implied volatility of market-traded options on our common stock on the grant date and the historical volatility of our common stock. We estimate forfeiture rates based on historical rates of forfeiture of employee stock awards. A portion of our Employee compensation and benefits expense on the Consolidated Statements of Operations represents discretionary bonuses, which are accrued for throughout the year and paid after the end of the year. Among many factors, discretionary bonus accruals are generally influenced by our overall performance and competitive industry compensation levels. We estimate and accrue for potential losses that may arise out of litigation and regulatory proceedings to the extent that such losses are probable and can be estimated. Significant judgment is required in making these estimates and our final liabilities may ultimately be materially different. Our total liability accrued with respect to litigation and regulatory proceedings is determined on a case-by-case basis and represents an estimate of probable losses based on, among other factors, the progress of each case, our experience and industry experience with similar cases and the opinions and views of internal and external legal counsel. Given the inherent difficulty of predicting the outcome of our litigation and regulatory matters, particularly in cases or proceedings in which substantial or indeterminate damages or fines are sought, or where cases or proceedings are in the early stages, we cannot estimate losses or ranges of losses for cases or proceedings where there is only a reasonable possibility that a loss may be incurred. For more information on our legal and regulatory matters, see "Legal Proceedings" in Part I, Item 3 of our Annual Report on Form 10-K for the year ended December 31, 2011, Part II, Item 1 included in this Form 10-Q and other reports or documents the Company files with, or furnishes, to the SEC from time to time. Accounting Standards Updates In December 2011, the Financial Accounting Standards Board ("FASB") issued an Accounting Standard Update ("ASU") that requires additional disclosures about financial assets and liabilities that are subject to netting arrangements. Under the ASU, financial assets and liabilities must be disclosed at their respective gross asset and liability amounts, the amounts offset on the balance sheet and a description of the respective netting arrangements. The new disclosures are required for annual reporting periods beginning on or after January 1, 2013, and are to be applied retrospectively. Other than the change in disclosures, we have determined that the adoption of this ASU will not have an impact on our Consolidated Financial Statements. In July 2012 the FASB issued an ASU, which allows a company to first assess qualitative factors to determine whether it is necessary to perform a quantitative impairment test of an indefinite-lived intangible asset. This ASU simplifies the guidance for impairment testing of indefinite-lived intangible assets other than goodwill and gives companies the option to assess qualitative factors to determine whether it is necessary to perform a quantitative impairment test. Companies electing to perform a qualitative assessment are no longer required to calculate the fair value of an indefinite-lived intangible asset unless the company determines, based on a qualitative assessment, that it is "more likely than not" that the asset is impaired. This update is effective for annual impairment tests, or more frequently if deemed appropriate, performed in fiscal years beginning after September 15, 2012; however, early adoption is permitted. We are currently evaluating the impact, if any that this ASU will have on our Consolidated Financial Statements. 76-------------------------------------------------------------------------------- Table of Contents |