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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended March 31, 2011
Commission File Number: 001-33590
MF GLOBAL HOLDINGS LTD.
(Exact name of registrant as specified in its charter)
| Delaware | 98-0551260 | |
| (State or other jurisdiction of incorporation or organization) | (I.R.S. employer Identification no.) | |
| 717 Fifth Avenue New York, NY |
10022 | |
| (Address of principal executive offices) | (Zip Code) | |
(212) 589-6200
(Registrant’s telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
| Title of Each Class | Name of Each Exchange on Which Registered | |
| Common Stock, $1.00 par value per share | New York Stock Exchange |
Securities registered pursuant to Section 12(g) of the Act:
None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x No ¨
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. Yes ¨ No x
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
| Large accelerated filer x | Accelerated filer ¨ | |||||
| Non-accelerated filer ¨ | Smaller reporting company ¨ |
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
As of September 30, 2010, the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was approximately $1,173.2 million. As of April 30, 2011, there were 163,840,634 shares of the registrant’s common stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of MF Global Holdings Ltd.’s Proxy Statement for its 2011 Annual Meeting of Stockholders to be held on August 11, 2011 are incorporated by reference in this Annual Report on Form 10-K in response to Part III, Items 10, 11, 12, 13 and 14.
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MF GLOBAL HOLDINGS LTD.
ANNUAL REPORT ON FORM 10-K FOR THE FISCAL YEAR ENDED MARCH 31, 2011
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CERTAIN FREQUENTLY USED TERMS
Throughout this Annual Report on Form 10-K, unless otherwise specified or if the context otherwise requires:
| • | “MF Global”, “we”, “us” and “our” refer to MF Global Holdings Ltd., a holding company incorporated under the laws of Delaware, and its subsidiaries. |
| • | “Man Group” refers to our former parent company, Man Group plc, a U.K. public limited company, and its subsidiaries. |
| • | “fiscal 2008”, “fiscal 2009”, “fiscal 2010” and “fiscal 2011” mean the 12-month periods ended March 31, 2008, 2009, 2010 and 2011, respectively. |
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FORWARD-LOOKING STATEMENTS
This report contains forward-looking statements that are based on our present beliefs and assumptions and on information currently available to us. You can identify forward-looking statements by terminology such as “may”, “will”, “should”, “could”, “would”, “targets”, “goal”, “expect”, “intend”, “plan”, “anticipate”, “believe”, “estimate”, “predict”, “potential”, “continue”, or the negative of these terms or other comparable terminology. These statements relate to future events or our future financial performance and involve known and unknown risks, uncertainties and other factors that may cause our actual results, levels of activity, performance or achievements to differ materially from those expressed or implied by these forward-looking statements. There are important factors that could cause our actual results, levels of activity, performance or achievements to differ materially from the results, levels of activity, performance or achievements expressed or implied by the forward-looking statements. In particular, you should consider the risks and uncertainties described under “Item 1.A. Risk Factors”. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. We caution you not to place undue reliance on these forward-looking statements. Forward-looking statements in this report include, but are not limited to, statements about:
| • | expectations regarding the business environment in which we operate and the trends in our industry such as changes in trading volumes and interest rates; |
| • | our liquidity requirements and our ability to obtain access to necessary liquidity; |
| • | our ability to execute our business strategy and strategic plan; |
| • | our planned transition of our business from a broker into a commodities and capital markets focused investment bank; |
| • | fluctuations in interest rates and currency exchange rates and their possible effects on our business; |
| • | our ability to continue to provide value-added brokerage services; |
| • | our ability to maintain trading volumes and market share; |
| • | our ability to continue to diversify our service offerings; |
| • | our ability to pursue opportunities to improve operating margins or profitability; |
| • | our ability to expand our business in existing or new geographic regions; |
| • | our ability to continue to expand our business through acquisitions or organic growth; |
| • | the effects of pricing and other competitive pressures on our business as well as our perceptions regarding our business’ competitive position; |
| • | our accuracy regarding our expectations of our revenues and various costs and of expected cost savings; |
| • | the timing of, and our ability to, return to profitability; |
| • | our exposure to client and counterparty default risks as well as the effectiveness of our risk management; |
| • | our exposure to market, issuer default and other risks from our principal transactions; |
| • | our exposures to credit, counterparty, and concentration risk; |
| • | our ability to maintain our credit rating and the effects that changes to our credit ratings would have on our business and operations; |
| • | our ability to retain existing clients and attract new ones; |
| • | our ability to retain our management team and other key employees; |
| • | the likelihood of success in, and the impact of, litigation or other legal or regulatory challenges involving our business; |
| • | the impact of any changes in domestic and foreign regulations or government policy, including any changes or reviews of previously issued regulations and policies; |
| • | changes in exchange membership requirements; |
| • | changes in our taxes and tax rate; |
| • | our ability to maintain our existing technology systems and to keep pace with rapid technological developments; and |
| • | the effects of financial reform legislation and related rule making of regulatory agencies. |
We caution that you should not place undue reliance on any of our forward-looking statements. Further, any forward-looking statement speaks only as of the date on which it is made. New risks and uncertainties arise from time to time, and it is impossible for us to predict those events or how they may affect us. Except as required by law, we have no duty to, and do not intend to, update or revise the forward-looking statements in this report after the date of this report.
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PART I
ITEM 1. BUSINESS
PART I
Business Overview
We are one of the world’s leading brokers in markets for commodities and listed derivatives. We provide access to more than 70 exchanges globally and are a leader by volume on many of the world’s largest derivatives exchanges. We are also an active broker-dealer in markets for commodities, fixed income securities, equities, and foreign exchange. We are one of 20 primary dealers authorized to trade U.S. government securities with the Federal Reserve Bank of New York. In addition to executing client transactions, we provide research and market commentary to help clients make trading decisions, as well as providing clearing and settlement services. We are also active in providing client financing and securities lending services.
We are headquartered in the United States, and have operations globally, including the United Kingdom, Australia, Singapore, India, Canada, Hong Kong, and Japan. Our priority is serving the needs of our diversified global client base, which includes a wide range of institutional asset managers and hedge funds, professional traders, corporations, sovereign entities, and financial institutions. We also offer a range of services for individual traders and introducing brokers.
As of March 31, 2011, we had 2,847 employees. We have organized our business on a global basis to offer clients an extensive array of products across a broad range of markets and geographies. We seek to tailor our offerings from market to market to meet the demands of our clients by providing the best products and services possible, while remaining within the regulations of a particular jurisdiction.
We derive revenues from three main sources: (i) commissions generated from execution and clearing services; (ii) principal transactions revenue, generated both from client facilitation and proprietary activities, and (iii) net interest income from cash balances in client accounts maintained to meet margin requirements, as well as interest related to our collateralized financing arrangements and principal transactions activities.
For fiscal 2011, 2010 and 2009, we generated (i) total revenues of $2,233.6 million, $1,994.7 million, and $2,851.6 million, respectively, (ii) revenues net of interest and transaction-based expenses of $1,069.1 million, $1,015.0 million and $1,426.7 million, respectively, and (iii) incurred net loss attributable to MF Global Holdings Ltd. of $81.2 million, $137.0 million and $49.1 million, respectively.
Products and Services
We execute transactions for a large and diverse group of institutional and retail clients and provide a number of prime services, including clearing, settlement, portfolio reporting and record-keeping services. We also provide financing and securities lending services and other prime services to select clients, including a number of other broker-dealers, and investment management products in select areas.
Product Offerings
We provide execution services for five broad categories of products: commodities, equities, fixed income, foreign exchange, and listed futures and options. Many of the contracts and securities that we trade are listed on exchanges, while others are traded over-the-counter (“OTC”).
We execute orders for our clients on either an agency or principal basis. When we execute a client order on a principal basis, we may take the other side of the trade for our own account to facilitate client orders. In some cases, we may simultaneously enter into an offsetting “back to back” trade with another party or we may retain a position for our own account. In addition, we sometimes build or trade proprietary positions for our own account, independent of client activities in the instruments we trade. Principal transactions also include proprietary positions that we take in fixed income and related interest rate products, equities, foreign exchange and commodities to monetize our views on future movements in market prices and volatilities in commodities, securities and other instruments and products, which may be affected by, among other things, changes in credit spreads, potential rating changes, and possibility of issuer default.
The instruments we trade, broken down by product, are described below:
COMMODITIES
Metals
We provide clients execution services for transactions relating to derivative contracts, including futures, options, forward sale agreements and other types of instruments based on the price of metals and industrial materials. Metal derivatives are traded both on exchanges and in the OTC markets. We are one of 12 designated ring dealing members of the world’s largest metals exchange, the London Metal Exchange (“LME”). This status enables us to offer our clients special trading access and other rights on the LME. We are also a member of COMEX, a division of the CME Group, Inc., and other major exchanges.
Energy
We execute trades in the energy derivatives market, including futures, options, swaps and forwards on a range of energy products, including crude oil, natural gas, heating oil, gasoline, propane, electricity and other energy commodities. We are an active market participant in both exchange-listed and OTC-traded energy derivatives, and we have consistently been ranked as one of the leading providers by volume of clearing and execution services on both the New York Mercantile Exchange (“NYMEX”) and ICE Futures Europe.
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Agriculture
With a long history of trading agricultural commodities, we deliver our clients targeted hedging and risk management solutions and help clients locate trading opportunities in a broad array of agricultural commodities markets. We provide trade execution services for a wide range of OTC and listed agricultural commodities markets, including the grain and oilseed futures and options markets and for soft commodities, such as coffee, cocoa, and sugar, on exchanges in North America, Europe and Asia Pacific.
EQUITIES
We provide execution services in both cash equities and equity derivative products around the globe. Equity derivative products include futures, ETFs, options (single stock, index and ETF), contracts for difference (where legally available), and other securities whose underlying value is related to the price of one or more stocks, a basket of stocks, or stock indices. During fiscal 2011, we expanded our global cash equity, equity derivatives, portfolio trading, and electronic trading services teams to provide improved service for our clients in a variety of major markets around the world.
FIXED INCOME
We provide execution services for a variety of fixed income products. These include U.S. Treasury and agency securities and bonds issued by European governments and by multinational institutions. We also trade corporate bonds, mortgage-backed and asset-backed securities, emerging market securities, as well as credit default swaps and interest rate swaps. We have been designated as a primary dealer of U.S. treasury securities, enabling us to serve as a counterparty to the Federal Reserve Bank of New York in open-market operations, and participate directly in U.S. Treasury auctions. We also provide analysis and market intelligence to the Federal Reserve’s trading desks and to our clients.
FOREIGN EXCHANGE
We deliver access to a range of products and trading opportunities in the foreign exchange markets worldwide. Many of these foreign exchange transactions are undertaken by our clients in connection with the purchase or sale of other instruments. Most foreign exchange trades are conducted on an OTC basis. Our foreign exchange teams, located in key financial centers around the world, provide comprehensive coverage delivered by dedicated sales professionals.
FUTURES AND OPTIONS
As a leader by volume on a number of the world’s major futures exchanges, we provide execution services for listed futures and options, including interest rate, government bond, and index futures and options. Our floor brokers offer clients access to traditional floor execution for futures and options that continue to have price discovery on trading floors. Where futures and options have moved to electronic trading platforms, we provide extensive electronic connectivity to global markets.
Service Offerings
In addition to executing client transactions, we provide clearing services, which are a critical component of the futures and options business, as well as a range of services designed to assist clients in developing trading ideas and managing their trading portfolios.
CLEARING AND FINANCING
We provide a number of prime services, including clearing and settlement of trades, client financing, securities lending, and a range of administrative services. The revenue we earn from prime services activities consists of commissions, interest income on client custodial accounts, principal transactions and fees.
In addition to the clearing transactions we execute for our own clients, we also clear transactions for clients that are using other executing brokers or executing their orders directly on an exchange. Moreover, we have developed a substantial business in clearing transactions on behalf of other brokers.
RESEARCH AND MARKET COMMENTARY
We offer a broad array of market research, analysis, and commentaries that provide clients with actionable insights they can use to inform their trading strategies and investment decisions. Our proprietary offerings include research on a wide range of instruments, markets and industries, equity research on many of the world’s largest companies and industry sectors, policy-focused research on U.S. legislative and regulatory topics, and analysis of macroeconomic trends and issues driving financial markets.
Growth Strategy
In fiscal 2011, senior management introduced and began implementing a new strategic plan, which is intended to transform our business ultimately to a commodities and capital markets focused investment bank during the next three to five years.
Our plan seeks to take advantage of several trends and opportunities in the market for financial services. For example, the financial services industry continues to consolidate and the largest global investment banks and brokerage firms have increased their scale of operations, while at the same time new and proposed regulations and other trends have led global banks to de-leverage and reduce proprietary risks on their balance sheets. We believe that one result of these developments is that large investment banks have focused their attention, energy and capital on their largest clients, creating opportunities for us to service smaller and mid-sized clients that are currently underserved by larger firms.
Our strategic plan, which was announced early in calendar 2011, is designed to leverage our company’s strengths, including our heritage and expertise in commodities trading and our broad global footprint. Our plan includes reorganizing our business in the short to medium term into the following four categories:
CAPITAL MARKETS
We provide institutional clients with access to, liquidity in, and insight into commodities, equities, fixed income and foreign exchange, as well as derivative futures and options markets. We intend to build on our extensive position in the brokerage business by deepening our involvement in certain markets and by extending into principal market-making activities to facilitate more of our clients’ transactions. While we frequently take
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principal positions to facilitate client trades, we intend to expand our role in client facilitation, market making and principal activities. For example, we may take proprietary positions in fixed income and related interest rate products, equities, foreign exchange and commodities to monetize our views on future movements in market prices and volatilities in commodities, securities and other instruments and products. This year we established a principal strategies group and intend to grow these activities. Over the longer term, we intend to complement this expanded role in principal trading by participating in other elements of traditional investment banking, including the underwriting of new issue securities, structured finance and the provision of advisory services to issuers, with a continuing focus on the commodities and natural resources markets.
RETAIL SERVICES
We have developed a substantial retail business, built through the acquisition and development of retail businesses in various markets, which offers assorted products under several brand names. We have now initiated the process of transforming these of activities into a consolidated, centrally managed, global business operating under a unified global brand. We will continue to focus on high net worth individuals, self-directed traders, individual traders seeking broker assistance and introducing brokers. We plan to develop an integrated electronic platform on which clients can pursue their trading and investing objectives in a broad range of markets, instruments and currencies through an efficient, single point of access. We believe that delivering a unified global platform, broad product offerings and worldwide market connectivity will differentiate us from our competitors in this space.
PRIME SERVICES
We intend to undertake a substantial realignment of our clearing and financing activities to further diversify our revenue streams. In this area, we intend to consolidate these services, under one business group to take advantage of our scalable infrastructure to deliver solutions to clients. We believe that clearing services are increasingly attractive to a substantial number of clients underserved by large global banks and firms that would prefer to outsource these activities rather than make the extensive capital investments required to self-clear. As financial services regulatory reform places increased emphasis on centralized clearing, we believe that we have the capabilities to meet expanding demand for this expertise. Furthermore, we believe that we are well positioned to grow our clearing services activities, given our global footprint on more than 70 exchanges and our extensive experience providing clearing solutions to clients in a variety of asset classes.
ASSET MANAGEMENT
In the future, we will seek to diversify our revenue base and generate fee income by providing clients with access to markets through asset management business. There has been growing investor interest in alternative investment vehicles, and we believe this area represents an important opportunity for us. Over time, we intend to leverage our skills and our brand to build a family of alternative investment vehicles. We are examining strategic opportunities to build an asset management capability that leverages our core competencies in commodities growth. The timeframe for developing this business will depend in part on the availability of appropriate strategic opportunities.
Sales and Marketing
We offer our products and services through three primary distribution channels: employee-brokers and sales professionals, introducing brokers, and online platforms.
Our employee-brokers and sales professionals conduct the majority of our sales and marketing activities. They are primarily responsible for attracting new clients and maintaining existing client relationships by providing a range of services including risk intermediation.
We also obtain clients through relationships with introducing brokers. These brokers are individuals or organizations that have ongoing relationships with their own sets of retail, professional or institutional clients. While introducing brokers may offer clients the typical functions of a broker, they direct their client orders to us for execution and clearing.
We also provide market access, products and services to clients through multiple online trading platforms. These online trading platforms enable our clients to trade a variety of financial products online. In addition to offering our own proprietary online trading platforms, we support major third-party order entry systems.
We serve our clients through sales and trading operations located in three geographic regions: North America, Europe, and the Asia Pacific region. There are a number of countries in which we do not currently maintain offices but conduct a significant amount of business. For example, we are a leading provider of financial risk management products to the Chinese metals industry and service these clients though our offices around the world.
Our global model allows us to provide each of our clients with services that encompass any combination of our products and markets, subject to applicable laws and regulations. We believe that this global presence, combined with our expertise in a wide variety of products, enables us to meet the highly diverse needs of our clients.
Competitive Advantages
We believe we have a number of key competitive strengths that help differentiate us in the marketplace and on which our strategic plan relies:
LEADING POSITION IN LISTED DERIVATIVES MARKETS
We are a leading broker in markets for commodities and listed derivatives markets, measured by the volume of transactions we execute, the number of clients we serve, the client balances we maintain and the extent of our global presence. In addition to our leadership role in the derivatives markets, we also play a growing role in cash markets for fixed income and equities securities.
EXTENSIVE EXPERTISE IN COMMODITIES AND NATURAL RESOURCES
We are consistently ranked as a leader in commodities trading. Our clients value the in-depth industry experience and market knowledge that our brokers, product specialists, traders, and
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research analysts can share with them. Because our staff is actively involved in so many exchanges, markets, and products, we are constantly expanding the expertise and insights that we can deliver to clients in facilitating their transactions. We are one of 12 designated ring dealing members of the LME, which enables us to offer our clients special trading access and other rights on the LME. We are also an active market participant in both exchange-listed and OTC-traded energy derivatives, and we have consistently been ranked as one of the leading providers by volume of clearing and execution services on both the NYMEX, COMEX and ICE Futures Europe.
PROVEN CLEARING EXPERTISE
We support our client transactions with a well-developed infrastructure for clearing trades. We have leveraged this infrastructure to build an extensive business in clearing trades on behalf of other broker-dealers and market intermediaries. Because our transaction processing operations have massive scale and have been operating for many years, we can deliver these services with a high level of efficiency. Further, we believe that recent regulatory reform within the financial services industry requiring the clearing of a larger variety of products, places a greater premium on these value-added services, while increasing demand.
DESIGNATION AS PRIMARY DEALER
As one of only 20 firms that have been designated primary dealers, we serve as a counterparty to the Federal Reserve Bank of New York in its open-market operations, participate directly in U.S. Treasury auctions, and provide analysis and market intelligence to the Federal Reserve’s trading desks. This status creates significant benefits for our clients because as a primary dealer we can offer a high level of access to U.S. government securities and related markets, and greater liquidity, broader market insights, and enhanced ease of execution. In addition, we believe the designation enhances our reputation as a valued counterparty.
BROAD GLOBAL FOOTPRINT AND DIVERSE PRODUCT OFFERINGS
We offer our clients a single point of access to the world’s most active financial marketplaces through our global distribution network. We operate on four continents and provide access to more than 70 exchanges, enabling clients to readily access a vast array of products within the global derivatives and cash markets. Our global footprint, which provides clients with the ability to seamlessly execute transactions in markets for everything from equities and fixed income to commodities, foreign exchange and the derivative futures and options markets, is substantial by comparison to a number of our competitors.
Clients
We believe that providing risk intermediation services to our diverse range of clients enables us to offer efficient execution across a range of products, markets and regions and that providing market and policy research and commentary to our clients gives them insights useful to their trading or hedging strategies.
CORPORATIONS
Companies rely on us to provide them with access to an array of markets as they seek to manage risk exposures in commodities, foreign exchange, interest rates, or securities. These corporate clients not only include producers and users of various commodities, but also a wide range of other industrial companies seeking price protection on raw materials.
ASSET MANAGERS AND HEDGE FUNDS
Our asset manager and hedge fund clients include managers of large mutual funds, commodity trading advisors (CTAs), commodity pool operators (CPOs), and other investment advisors. As hedge funds and other asset managers have become a significant factor driving demand for sophisticated risk-management products, we have been active in sourcing these products and delivering them to clients.
GOVERNMENT ENTITIES AND SOVEREIGN INSTITUTIONS
We provide a number of government entities, central banks, sovereign wealth funds and multinational official institutions with a range of services, including execution, clearing and settlement, market research and economic analyses.
In February 2011, we were named one of 20 primary dealers to the Federal Reserve Bank of New York. This designation enables us to serve as a counterparty to the Federal Reserve Bank of New York in open-market operations, participate directly in U.S. Treasury auctions, and provide analysis and market intelligence to the Federal Reserve’s trading desks.
BROKER-DEALERS
A number of financial institutions and financial market intermediaries, such as broker-dealers, utilize our execution services to carry out their business and trading strategies. These clients may be taking a view on market movements or relative value on the expectation of generating returns. These clients may also seek to hedge an exposure in order to manage their risks. In either case, we are often the broker of choice for executing their transactions.
We also clear transactions for other broker-dealers who have chosen to outsource this activity and leverage our clearing infrastructure. We offer the expertise and geographic reach to meet their needs.
PROFESSIONAL TRADERS
Professional traders are typically high-volume clients who require an operating platform that facilitates rapid execution at a low cost. This client segment serves an important role in the market by providing order flow, thus adding liquidity to the markets. Professional traders include clients who trade electronically from dedicated facilities built to service their needs, as well as floor traders—individual members of derivatives exchanges who trade for their own account on the floors of exchanges. As floor-based trading has migrated to electronic platforms, floor traders have also transitioned to the use of electronic platforms. By delivering ready access to numerous markets and execution platforms, we provide professional traders with the speed and efficiency required to pursue their trading strategies.
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RETAIL
Through internal initiatives and a series of acquisitions, we have developed a significant retail business. Our retail clients include many high-net-worth individuals who have trading and investment accounts to facilitate investment, speculation and hedging activities related to the management of their portfolios. Our individual investor clients also include accounts managed on behalf of the account owner by a third party, such as a broker or investment advisor. Additionally, some of our retail business is generated through a network of introducing brokers, who direct futures and options order flows from individual investors to us for execution and clearing.
Competition
The business of serving as a broker and dealer for derivatives and securities is very fragmented and highly competitive, and we believe competition will continue to intensify. We compete for clients on the basis of our client service, our range of product offerings, the level and nature of our fees and the speed and quality of our execution as well as the quality of our research and market expertise.
Although no single competitor operates in all of our markets, we compete with several large firms around the world. Within our broker-dealer activities, we compete with mid-sized investment banks such as Jefferies and the broker Newedge in many of our markets. In addition, affiliates and divisions of the largest commercial and investment banks, including Bank of America, Citigroup, Goldman Sachs, JP Morgan, UBS and other major multi-national banks compete with our brokerage and dealing services in certain markets. Our competitors within clearing services include Cantor Fitzgerald and ING. There are also a growing number of online trading platforms that compete directly with our retail and trading operations in a range of markets, such as Interactive Brokers. As our strategy is implemented, we expect that we will face many of our existing, as well as new competitors in the new lines of business we plan to enter into, such as investment banking and asset management. Although our strategy contemplates that we will eventually become an investment bank, we cannot guarantee that we will be able to compete more effectively with the investment banks that we now compete against or that we can capitalize on any of the synergies that investment banks are commonly assumed to have.
Our competitive landscape is also being altered by the impact of recent regulatory changes. Many financial institutions have sought to de-leverage and reduce proprietary risk on their balance sheets, creating opportunities for us and other firms to compete and meet outstanding demand for our products and services.
We believe that this reduction of risk, along with consolidation in the financial services industry, has created an opportunity for the emergence of a global investment bank that can service many of the smaller and mid-sized clients that are currently underserved by larger firms.
We believe that the net impact of developments in global markets has been to create opportunities for us because we can offer clients efficient access to more products, markets, and regions on a basis that continues to compare favorably with those that our competitors are willing and able to offer.
Risk Management
We believe that effective risk management is critical to the success of our business and is the responsibility of all of our employees. All of our employees are risk managers. Employees are expected and encouraged to escalate incidents and any matters of concern to management and to our compliance and risk departments in order to effectively manage risk. Consequently, we have established—and continue to evolve and improve—a global enterprise wide risk management framework that is intended to manage all aspects of our risks. The risk-management framework is designed to establish a global, robust risk-management environment through a strong governance structure that (i) defines roles and responsibilities, (ii) delegates authority for risk control and risk taking to specific businesses and risk managers, and (iii) documents approved methodologies for the identification, measurement, control and mitigation of risk.
We seek to identify, assess, measure, monitor and limit market, credit and operational risks across our businesses. Business areas, pursuant to delegated authority, have primary responsibility for risk management by balancing our ability to profit from our revenue-generating activities with our exposure to potential losses. Working with the business areas, the Risk department serves as an advisor and facilitates operation within established risk tolerances while seeking to provide acceptable risk-adjusted returns in a controlled manner. Risk-department teams also regularly communicate with our regional officers and to local decision-making bodies to allow us to react rapidly to address any developing risks.
Our Chief Risk Officer, who reports to our President and Chief Operating Officer, leads the risk department and monitors and reports on our risk matters, including regular reports to our Board of Directors and Audit and Risk Committee. The Chief Risk Officer promotes company-wide adherence to MF Global’s enterprise risk management framework and has global responsibility for monitoring and facilitating control of market, credit and operational risks.
Senior management takes an active role in the risk management process and expects employees to understand and comply with their delegated risk responsibilities, relevant risk policies, and compliance requirements. Additionally, employees are expected and encouraged to escalate risk incidents and any matters of concern to management in accordance with our internal escalation policy to promote timely risk-mitigation action by the appropriate personnel.
Reports detail global risk exposures and escalate risks that exceed defined thresholds. Our risk reporting process is designed to enable us to assess the levels of risk present throughout our operating environment and to take any necessary remedial action in a timely manner. As part of this reporting process, risk reports detailing global risk exposures and escalating risks that exceed defined thresholds are regularly generated.
See also “Item 7A. Quantitative and Qualitative Disclosures about Market Risk.”
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PART I
ITEM 1. BUSINESS
Technology Systems and Business Continuity
We operate our business using a series of integrated platforms, enabling us to offer our products across an array of markets to clients located around the world. These platforms employ several principal trade processing systems, each with multiple points of access. Automated connectivity among the core segments of our processing platform enables us to execute and clear cross-border client trades on a global basis both directly and through omnibus accounts maintained between our operating subsidiaries. In each case, we have long-term licensing agreements for the continued use of these industry-leading technologies, which enable us to run our operations effectively without having to incur additional costs to develop proprietary technology. We also employ complementary systems in other products such as cash securities.
The security and integrity of our processing and other support systems are of great importance to our business. We regularly maintain and test our business-critical systems, and we are continually working to enhance our remote back-up and disaster recovery systems.
Regulation and Exchange Memberships
We have a long history of operating in a highly regulated industry. Our business activities are extensively regulated by a number of U.S. and foreign regulatory agencies and exchanges. These regulatory bodies and exchanges are charged with protecting investors by imposing requirements relating typically to capital adequacy, licensing of personnel, conduct of business, protection of client assets, record-keeping, trade-reporting and other matters. They have broad powers to monitor compliance and punish non-compliance with their rules. If we fail to comply with applicable regulations, we may be subject to censure, fines, cease-and-desist orders, suspension of our business, removal of personnel, civil and criminal litigation, revocation of operating licenses or other sanctions. Furthermore, new regulations, changes in current regulations as well as changes in the interpretation or enforcement of existing laws or rules in the United States, United Kingdom or elsewhere, may affect our business and operations and the policies and procedures we follow.
Minimum capital requirements are a significant part of the regulatory framework in which we operate. We are subject to stringent minimum capital requirements in the United States, the United Kingdom and several other jurisdictions. These rules, which specify the minimum amounts of capital that we must have available to support our clients and our own open trading positions, including the amount of assets we must maintain in relatively liquid form, are designed to measure general financial integrity and liquidity. Compliance with minimum capital requirements may limit our operations, or limit our ability to implement our strategic plan, if we cannot maintain the required levels of capital, or if we cannot increase them following changes in regulation. Moreover, any change in these rules or the imposition of new rules affecting the scope, coverage, calculation or amount of capital we are required to maintain could restrict our ability to operate our business and adversely affect our operations. We currently maintain regulatory capital in excess of all applicable requirements.
From time to time, we receive inquiries or requests from our regulators (for example, the Commodity Futures Trading Commission or the Financial Services Authority) which require us to undertake compliance reviews and/or remedial action with respect to our policies and procedures.
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SECURITIES AND FUTURES REGULATION
The principal geographic regions in which we operate and the primary regulators, self-regulatory organizations and exchanges that have supervisory authority over us in those regions include:
| Country/Region |
Principal Regulators and Self-Regulatory Organizations |
Principal Exchanges and Clearinghouses | ||
| United States | Commodity Futures Trading Commission Securities and Exchange Commission National Futures Association Financial Industry Regulatory Authority Chicago Board Options Exchange Chicago Mercantile Exchange |
New York Stock Exchange NYSE Amex BATS Exchange Fixed Income Clearing Corporation The Depository Trust & Clearing Corporation CME Group (Chicago Mercantile Exchange/ Chicago Board of Trade/ New York Mercantile Exchange, Commodity Exchange) IntercontinentalExchange ICE Futures U.S. International Securities Exchange Chicago Board Options Exchange Options Clearing Corporation Boston Options Exchange NASDAQ NYSE Arca | ||
| Canada | Investment Industry Regulatory Organization of Canada | Bourse de Montréal Toronto Stock Exchange TSX Venture Exchange ICE Futures Canada, Inc. ICE Clear Canada, Inc. CDS Clearing and Depository Services Inc. Canadian Derivatives Clearing Corporation | ||
| Europe | Financial Services Authority | Eurex Euronext.liffe ICE Futures London Metal Exchange London Stock Exchange LCH.Clearnet | ||
| India | Forward Markets Commission Securities and Exchange Board of India |
Multi Commodity Exchange National Commodities & Derivatives Exchange National Stock Exchange Bombay Stock Exchange MCX Stock Exchange | ||
| Singapore | Monetary Authority of Singapore | Singapore Exchange Ltd. | ||
| Australia | Australian Securities & Investments Commission | Australian Securities Exchange | ||
| Hong Kong | Securities and Futures Commission | Hong Kong Futures Exchange Hong Kong Stock Exchange | ||
| Japan | Financial Services Agency (Kanto Local Finance Bureau) Securities and Exchange Surveillance Commission Ministry of Economy, Trade and Industry Ministry of Agriculture, Forestry and Fisheries Japan Securities Dealers Association The Financial Futures Association of Japan The Commodity Futures Association of Japan |
Tokyo Stock Exchange Osaka Securities Exchange | ||
| Taiwan | Securities and Futures Bureau | Taiwan Futures Exchange | ||
| U.A.E. (Dubai) | Dubai Financial Services Authority Emirates Securities and Commodities Authority Dubai Multi Commodities Centre |
Dubai Gold & Commodities Exchange | ||
In addition to those rules and regulations that are imposed by the various regulators, self-regulatory organizations and exchanges, the U.S. federal and state governments as well as non-U.S. governments have imposed a number of other regulations with which we must comply.
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REGULATIONS APPLICABLE IN AND OUTSIDE THE UNITED STATES
The U.S. and non-U.S. government agencies, regulatory bodies and self-regulatory organizations, as well as state securities commissions and other state regulators in the United States, are empowered to conduct administrative proceedings that can result in censure, fine, the issuance of cease and desist orders, or the suspension or expulsion of a broker-dealer or its directors, officers or employees. From time to time, our subsidiaries have been subject to investigations and proceedings, and sanctions have been imposed for infractions of various regulations relating to our activities, none of which has had a material adverse effect on us or our businesses.
The USA PATRIOT Act of 2001 (PATRIOT Act), contains anti-money laundering and financial transparency laws and mandates the implementation of various regulations applicable to all financial institutions, including standards for verifying client identification at account opening, and obligations to monitor client transactions and report suspicious activities. Through these and other provisions, the PATRIOT Act seeks to promote the identification of parties that may be involved in terrorism, money laundering or other suspicious activities. Many anti-money laundering laws outside the United States contain similar provisions. The obligation of financial institutions, including ours, to identify their clients, to monitor for and report suspicious transactions, to respond to requests for information by regulatory authorities and law enforcement agencies, and to share information with other financial institutions, has required the implementation and maintenance of internal practices, procedures and controls that have increased, and may continue to increase, our costs, and any failure with respect to our programs in this area could subject us to substantial liability and regulatory fines.
The United States government maintains various economic sanctions programs which are administered by the U.S. Treasury Department’s Office of Foreign Assets Control (“OFAC”) and generally prohibit or restrict trade and investment in and with sanctions targets or the blocking of the sanctions targets’ assets. Some of these programs are broad and impose country—specific economic sanctions (such as those targeting Burma (Myanmar), Cuba, Iran, North Korea, Sudan and Syria); other programs target “specially designated” individuals and entities that are engaged in certain activities, such as proliferation of weapons of mass destruction, terrorism and narcotics trafficking, as well as activities particular to certain countries, such as undermining democratic processes or institutions in Zimbabwe. Penalties for violating the OFAC-administered sanctions can be severe, including significant civil and criminal monetary penalties as well as potential imprisonment. We have established policies and procedures designed to assist our company’s and our personnel’s compliance with applicable OFAC sanctions. Although we believe that our policies and procedures are effective, there can be no assurance that our policies and procedures will effectively prevent us from violating the OFAC-administered sanctions in every transaction in which we may engage.
As discussed above, many of our subsidiaries are subject to regulatory capital requirements in jurisdictions throughout the world. Subsidiaries not subject to separate regulation may hold capital to satisfy local tax guidelines, rating agency requirements or internal policies, including policies concerning the minimum amount of capital a subsidiary should hold based upon its underlying risk.
Certain of our businesses are subject to compliance with regulations enacted by U.S. federal and state governments, the European Union or other jurisdictions and/or enacted by various regulatory organizations or exchanges relating to the privacy of the information of clients, employees or others, and any failure to comply with these regulations could expose us to liability and/or reputational damage
Available Information
Our website can be found at www.mfglobal.com. We are not including the information contained on our website as part of, or incorporating it by reference into, this Annual Report on Form 10-K. Through our website, we make available free of charge our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, our proxy statements on Schedule 14A, Forms 3, 4 and 5 filed on behalf of directors and executive officers, and amendments to those reports, filed or furnished pursuant to the Securities Exchange Act of 1934, as amended. In addition, the SEC maintains an Internet site that contains our reports, proxy and information statements, and other information regarding the company that we file electronically with the SEC at http://www.sec.gov.
Information relating to our corporate governance is also available on our website, including our Corporate Governance Guidelines, committee charters and our Code of Business Conduct and Ethics governing our directors, officers and all employees.
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Executive officers of MF Global
SET FORTH BELOW IS INFORMATION REGARDING OUR EXECUTIVE OFFICERS AS OF MAY 20, 2011:
| Name |
Age | Position | ||||
| Jon S. Corzine |
64 | Chairman and Chief Executive Officer | ||||
| Bradley I. Abelow |
52 | President and Chief Operating Officer | ||||
| Michael C. Blomfield |
40 | Managing Director, Asia Pacific | ||||
| Thomas F. Connolly |
53 | Global Head of Human Resources | ||||
| Laurie R. Ferber |
58 | General Counsel | ||||
| J. Randy MacDonald |
55 | Global Head of Retail | ||||
| Richard M. Moore |
49 | Managing Director, Europe | ||||
| Henri J. Steenkamp |
35 | Chief Financial Officer | ||||
| Michael G. Stockman |
54 | Chief Risk Officer | ||||
Executive officers are appointed by and serve at the pleasure of our board of directors. A brief biography of each person who serves as an executive officer is set forth below.
JON S. CORZINE. Mr. Corzine is our Chairman and Chief Executive Officer. Before joining MF Global in March 2010, Mr. Corzine most recently served as New Jersey’s 54th governor from January 2006 until January 2010. Prior to that time, he was elected to represent New Jersey in the United States Senate from January 2001 until January 2006. During his tenure as a United States Senator, Mr. Corzine served on the Senate Banking, Budget, Energy and Natural Resources, and Intelligence Committees. Prior to serving in the United States Senate, Mr. Corzine was the Chairman and Senior Partner of The Goldman Sachs Group, L.P. from December 1994 to June 1998 and Co-Chairman and Co-Chief Executive Officer of The Goldman Sachs Group, L.P. from June 1998 to January 1999. Mr. Corzine began his career at Goldman Sachs as a bond trader in 1975. Mr. Corzine is also an operating partner and advisor at J.C. Flowers & Co. LLC (“JCF”), which is an affiliate of one of our largest shareholders. He holds the title of John L. Weinberg/Goldman, Sachs & Co. Visiting Professor at Princeton University’s Woodrow Wilson School of Public and International Affairs for the 2010-2011 academic year.
BRADLEY I. ABELOW. Mr. Abelow is our President and Chief Operating Officer. He joined our company in September of 2010 as our Chief Operating Officer and in March 2011, he assumed the additional position as our President. He oversees the day-to-day execution of MF Global’s strategy and holds direct responsibility for risk, operations, client services, human resources, information technology, procurement and real estate activities for all MF Global entities in 11 countries around the world. Prior to joining MF Global, Mr. Abelow was a founding partner of NewWorld Capital Group, a private equity firm investing in businesses active in environmental opportunities, such as alternative energy, energy efficiency, waste and water treatment, and environmental services. Before co-founding NewWorld, he was chief of staff to Mr. Corzine during Mr. Corzine’s tenure as governor of the state of New Jersey. Prior to that, Mr. Abelow served as treasurer of the state of New Jersey. Mr. Abelow also previously was a partner and managing director of The Goldman Sachs Group, where he managed the firm’s operations division, responsible for the global processing and corporate services functions of the firm. Earlier, he was responsible for Goldman Sachs’ operations, technology, risk and finance functions in Asia, based in Hong Kong.
MICHAEL C. BLOMFIELD. Mr. Blomfield is our Managing Director of Asia Pacific. In this role, Mr. Blomfield is responsible for developing and leading the firm’s Asian growth strategy as well as overall responsibility for business activities in the region. He joined MF Global in November 2010. Mr. Blomfield has nearly two decades of experience in financial services including banking, equities, and derivatives-related activities. He was formerly head of Commonwealth Bank of Australia’s (CBA) CommSec (Australia’s largest retail brokerage), head of CBA’s Equities Division, and most recently the chief executive officer of Dendiri Advisory Pty Ltd., a consulting practice providing buy-side mergers and acquisitions and strategy advice to financial services businesses primarily in China and Indonesia. He is a former director of the Australian Securities and Derivatives Industry Association (now named the Australian Stockbrokers’ Association).
THOMAS F. CONNOLLY. Mr. Connolly is our Head of Human Resources. Before joining our company in January 2009, he served as a senior vice president of human resources operations at Lehman Brothers from 2007 through 2009. From 2004 through 2007, he served as vice president, compensation and international benefits at The Hartford Financial Services Group, and from 1998 through 2003, he served as Managing Director, Human Resources at UBS. He has also held various human resources management positions at Aetna, Citicorp and Goldman Sachs. Mr. Connolly received a B.A. from the University of Connecticut, an M.S. from the Stevens Institute of Technology, and an M.B.A. from New York University’s – Stern School of Business.
LAURIE R. FERBER. Ms. Ferber is our General Counsel and is responsible for our legal and compliance functions, has operational and administrative responsibility for our internal audit function, and is also responsible for our regulatory relationships. Prior to joining MF Global in 2009, Ms. Ferber was general counsel and chief regulatory officer for International Derivatives Clearing Group (IDCG). She began her more than 20 year career at Goldman Sachs in 1987 as general counsel of J. Aron & Company and then as co-general counsel of the Fixed Income, Currency and Commodities Division. Beginning in 2000, Ms. Ferber held a number of business roles, including in new business development and launching and running the economic derivatives business, and also served as chief of staff for the Business Selection and Conflicts group. Prior to joining Goldman Sachs, Ms. Ferber was general counsel of Drexel Burnham Lambert Trading Corp. and also traded energy products. She began her legal career in 1980 as an associate at Skadden, Arps, Slate, Meagher & Flom, and then at Schulte, Roth & Zabel. Ms. Ferber earned her J.D. from New York University School of Law where she serves on the Board of Trustees. She currently serves as a director of the Futures Industry Association and on the Board of Trustees of the Institute for Financial Markets, and is a member of the Lincoln Center Business Council.
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J. RANDY MACDONALD. Mr. MacDonald is our Head of Retail. He leads the company’s global retail business and is responsible for leveraging the firm’s broad geographic reach and substantial product offering to deliver value to retail clients around the world. Mr. MacDonald joined the company in April 2008 and served as Chief Financial Officer for three years, overseeing the company’s financial operations, including finance, tax, treasury, marketing, investor relations and corporate communications, and prior to Mr. Abelow joining our company in September 2010, also overseeing corporate strategy, human resources, procurement and facilities management. From May 2006 to July 2008, Mr. MacDonald served as a director on the board for GFI Group. He was on the Audit and Compensation committees. Before joining MF Global, Mr. MacDonald held a number of positions at TD Ameritrade Holding Corp. from 2000 to 2007. Over the course of his seven-year tenure at TD Ameritrade, Mr. MacDonald served as executive vice president, chief financial officer and treasurer, chief administrative officer and chief operating officer. He retired from TD Ameritrade in April 2007. Prior to joining TD Ameritrade, Mr. MacDonald was chief financial officer of Investment Technology Group, Inc., a public company that specializes in agency brokerage and technology. From 1989 to 1994, Mr. MacDonald was a vice president and group manager for Salomon Brothers. Earlier in his career, Mr. MacDonald was an audit senior manager at Deloitte & Touche focused on commercial banking, real estate joint ventures and financial services. He began his career at Ernst & Young performing financial audits with a focus on international operations. Mr. MacDonald holds a Bachelor of Science degree in Accounting from Boston College.
RICHARD W. MOORE. Mr. Moore is our Managing Director of Europe. He was appointed to the role in April 2011 and is responsible for developing the firm’s pan-European growth strategy, as well as overseeing business activities in the region. Mr. Moore has spent more than 25 years in the financial services industry. Beginning his career at Citigroup in 1986, he held various trading and management roles. In 1998, Mr. Moore became Citigroup’s European head of foreign exchange and went on to become global head of rates and currencies, before being appointed head of fixed income, Europe, Middle East and Africa in 2007. From 2009 to 2011 Mr. Moore served as a senior advisor for Storm Harbour, a financial services partnership focused on the fixed income markets. He has sat on several board and committee appointments, including as a non-executive director at Standard & Poor’s and a member of the Bank of England’s Fixed Income Liaison Committee and the London Foreign Exchange Joint Standing Committee.
HENRI J. STEENKAMP. Mr. Steenkamp is our Chief Financial Officer. He oversees the company’s financial operations, including treasury, accounting and all global financial control and reporting functions. He is responsible for aligning MF Global’s finance and capital structures to support the firm’s strategy. Prior to assuming the role of chief financial officer in April 2011, Mr. Steenkamp held the position of chief accounting officer and global controller for four years. He joined the company, then Man Financial, in 2006 as vice president of External Reporting. With a specialization in U.S. Generally Accepted Accounting Principles and International Financial Reporting Standards and capital markets transactions, he played an instrumental role in preparing the company for its initial public offering in July 2007. Before joining MF Global, Mr. Steenkamp spent eight years with PricewaterhouseCoopers (“PwC”) including four years in Transaction Services in the company’s New York office, managing a variety of capital-raising transactions on a global basis. He focused primarily on the SEC registration and filing process as well as technical accounting. He spent four years with PwC in South Africa, where he served as an auditor primarily for SEC registrants and assisted South African companies as they went public in the U.S. Mr. Steenkamp is a chartered accountant and holds an honors degree in Finance.
MICHAEL G. STOCKMAN. Mr. Stockman is our Chief Risk Officer. He joined the firm in January 2011 and oversees management of the firm’s global risk department including market, credit, and operational risk. Mr. Stockman has more than 25 years of domestic and global experience in risk management, trading, and capital markets. Prior to joining MF Global, Mr. Stockman helped build a risk management and capital markets advisory practice including a quantitative real estate solutions business, initially in a joint venture with State Street Global Markets, at financial services boutique CQ Solutions, LLC. From 1995 to 2008, he held several senior positions at UBS Investment Bank, including as chief risk officer for the Americas and as a managing director in the fixed income, currencies, and commodities divisions. Prior to joining UBS, he held senior mortgage and asset-backed trading positions at Morgan Stanley and Goldman Sachs and began his career in mortgage trading at Salomon Brothers. Additionally, while serving as a visiting scholar at the Tuck School of Business at Dartmouth College, he co-authored a paper on the credit crisis that included risk management insights and recommendations to avoid the next crisis. Mr. Stockman has a Master of Business Administration from the Tuck School of Business at Dartmouth College, a Master of Science degree in Mechanical Engineering from the University of Colorado, and a Bachelor of Science degree in Mechanical Engineering from Union College.
We face risks in operating our business, including risks that may prevent us from achieving our business objectives or that may adversely affect our business, financial condition and operating results. We present these risks according to the following categories: Risks related to Our Business and Industry;
Risks related to Our Capital Needs and Financial Position; Risks related to Regulation and Litigation; and Risks related to Our Operations and Technology.
RISKS RELATED TO OUR BUSINESS AND INDUSTRY
Failure to successfully implement our strategic plans could adversely affect our business.
Our management team and board of directors have developed a multi-year strategic plan to evolve and transition, in the long term, our business from primarily a broker to a commodities and capital markets-focused investment bank. This is a multi-year strategy and we may not benefit from the strategy immediately. Further, there can be no assurance that we will implement our strategy in the timeframe that we project, or in the manner that we describe. Although we believe that the implementation of this strategy should result in diversifying our revenue and
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increasing our profitability in the long term, the implementation of our plan could in the near and medium term adversely affect certain aspects of our business and may delay our return to profitability. As we execute our strategy, our risk profile will change, and we may need to develop or enhance, among other things, our information technology systems, risk management systems and controls, including hiring associated personnel, which may result in higher costs.
The development and transition of our business in accordance with our strategy may be disruptive and could adversely affect our business, operations and employees in a number of ways, including:
| • | delays in decision-making and issue resolution as we reorganize our business lines and staff to execute our strategy and as new structures and formal processes are implemented; |
| • | failure to retain key personnel or an increase in general employee turn-over resulting from any dislocation associated with the transition to a more sales-driven culture or a new organizational structure or from employee disagreement with the direction of our company; |
| • | failure to attract new employees because of the uncertainties associated with the on-going implementation of our strategic plan; and |
| • | diversion of our management’s and employees’ attention from operations and other business concerns while executing our new strategy and adjusting to the new organizational structure. |
We also expect that, as we implement our strategic plan, our exposure to market, credit and operational risk will increase as we expand our principal trading activities relating to client facilitation, market-making and proprietary activities. Among other things, these developments may lead to greater uncertainty and volatility in our results of operations and require us to increase our capital.
We have already incurred severance expenses and are likely to incur other charges in connection with the strategic plan and other expenses and charges may be incurred, but we are unable at this time to estimate the likelihood, timing or the amount of those charges and expenses. These charges and expenses may be significant and could materially adversely impact our financial performance as we implement our strategic plan. Furthermore, as we transition to a commodities and capital markets-focused investment bank, we will likely require additional capital to execute our strategic plan. If our access to capital becomes constrained or the cost or amounts of capital required becomes unreasonably high, whether due to our credit rating, the constraints imposed upon us by our existing creditors or counterparties, prevailing industry conditions or regulatory changes, the volatility of the capital markets, or other factors, then the implementation of our strategic plan could be adversely affected. To the extent that we raise additional equity capital, our existing shareholders would likely be diluted. In addition, aspects of the planned expansion of our business under our strategic plan may also be subject to regulatory review and approval, and regulators, including our current regulators, may request, or regulatory provisions may require, that we enhance our infrastructure, increase our capital, or place other restrictions as a condition to the expansion of our business.
As part of our strategic plan, we expect to grow organically in areas where we have strength or a competitive advantage. If we expand our operations too rapidly or otherwise beyond our ability to manage them effectively, we could encounter serious operational issues and expose ourselves to increased operational and regulatory risk. For example, we may lack sufficient personnel with the requisite expertise or skills to manage or oversee new products or businesses. Organic growth may also impair our ability to manage risk and ensure regulatory compliance, which may result in financial loss, regulatory violations, or reputational harm any of which could adversely affect our business, operating results, or financial condition.
Our business may be materially affected by market conditions and by global and economic conditions and other factors beyond our control, including overall slowdowns in securities trading.
We generate revenues principally from commissions from execution and clearing services, principal transactions and net interest income earned on cash balances in certain of our clients’ accounts as well as interest related to our fixed income and principal transaction activities. These revenue sources are dependent on a combination of factors beyond our control including the level of trading volumes, interest rates, credit spreads, and market liquidity. In addition, like other brokerage and financial services firms, our results of operations in the past have been, and in the future may continue to be, materially affected by many other factors (and many of which are beyond our control), including one or a combination of the following:
| • | the effect of political and economic conditions and geopolitical events, including changes in government monetary policy; |
| • | the effect of market conditions, particularly in the global commodities, fixed income, equity and credit markets; |
| • | changes in customer trading demand and speculative trading activities in the markets; |
| • | the financial strength of market participants; |
| • | the impact of current, pending and future legislation (including the Dodd-Frank Act), regulation (including capital requirements), and legal actions in the U.S. and worldwide; |
| • | introduction of new products or new market entrants; |
| • | the level and volatility of equity, fixed income and commodity prices and interest rates, |
| • | currency values and other market indices; |
| • | the availability and cost of both credit and capital both for us and our counterparties; |
| • | the credit ratings assigned to our unsecured short-term and long-term debt; |
| • | investor sentiment and confidence in the financial markets; |
| • | our reputation; |
| • | inflation, natural disasters, and acts of war or terrorism; and |
| • | the actions and initiatives of current and potential competitors and technological changes. |
In addition, legislative, legal and regulatory developments related to our current and future businesses, are likely to increase costs, thereby affecting our results of operations. These factors also may have an impact on our ability to achieve our strategic objectives.
Reduced trading volumes could hurt our business.
During fiscal 2011, we derived approximately 64.2% of our total revenues, and approximately 70.4% of our revenues, net of interest and transaction-based expenses, from executing and clearing client trades. This revenue source is dependent on client trading volumes. A decrease in trading volumes or market liquidity could adversely affect our business and profitability.
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The volume of transactions our clients execute or clear with us and the revenue we generate from interest income is directly affected by a number of U.S. and international market factors described under the risk factor “Our business may be materially affected by market conditions and by global and economic conditions and other factors beyond our control, including overall slowdowns in securities trading.”
For example, starting in calendar year 2008, the global financial services industry and the securities and futures markets experienced significant, adverse conditions, including a substantial contraction of credit, significantly increased volatility, outflows of customer assets and investments, losses resulting from declining asset values, defaults on securities and loans and substantially reduced liquidity. Many of the firms that have been adversely affected by the financial crisis were or are our clients or our counterparties. As a result of these events, we believe that many of our clients and counterparties decreased their trading volume and risk exposure, which decreased our revenue and adversely affected our financial performance.
Factors affecting trading volume are complex and historical precedent may not necessarily be meaningful. For example, historically, trading volume on U.S. derivatives exchanges tend to increase during periods of uncertainty due to increased hedging activity and the desire to manage the risks associated with, or to speculate on, volatility in the financial markets (including the fixed income and commodities markets) and fluctuations in interest rates. However, during the recent economic downturn, we experienced significant decreases in trading volume starting in 2008, which we believe was due primarily to our clients and other market participants decreasing risk exposure and the lack of available capital.
A reduction in our overall trading volume could also render the markets in which we operate less attractive to participants as a source of liquidity and could result in further losses of trading volume and the associated transaction-based revenues. Such diminution of liquidity could also make it more difficult for us to generate profit margins on principal transactions. Accordingly, any reduction in trading volumes or market liquidity could have a material adverse effect on our business and financial results.
Interest income earned in connection with collateralized financing transactions, which include resale agreements and securities lending transactions we enter into in conjunction with our principal transactions, depends on credit spreads and the difference between the interest rates we pay to our clients on their cash collateral and the interest rates we receive from investing that collateral. Our revenue from this source also depends in part upon the volume of collateralized financing arrangements that we transact, which in turn is affected by the factors described under the risk factor “Our business may be materially affected by market conditions and by global and economic conditions and other factors beyond our control, including overall slowdowns in securities trading.”
Continued low interest rates in the U.S. could hurt our business.
Before the financial crisis in 2008, we derived a significant portion of our total revenue from interest income and revenues, net of interest and transaction-based expenses from net interest income. In response to the financial crisis, interest rates declined precipitously and as a result, our interest income also declined significantly. Revenues that we derive from interest income are affected by the level of interest rates, as we generate revenue from net interest earned on the investment of the margin funds used for futures and derivatives trading as well as other cash that our clients place with us. Our interest income is also directly affected by the spread between the interest rates we pay our clients on their cash balances and the interest rates we earn from re-investing their cash balances. While these spreads have remained within a relatively constant range over time, they can widen or narrow when interest rate trends change. In addition, a portion of our interest income relates to client balances on which we do not pay interest, and thus in these cases, interest income directly depends on the absolute level of interest rates, rather than on the spread of interest that determines most of our interest income. As a result, because the majority of our client margin funds are located in the U.S. and the use of which is regulated by U.S. law, our interest income may decline or remain at current depressed levels if interest rates in the U.S. persist at their current low levels. As a general matter, our financial performance benefits from higher interest rate environments, which typically increase our net interest income, and is negatively affected when short- term interest rates are low (as has been the case over the past several years), because those environments reduce our interest income. Our net interest income may also decline if clients reduce surplus margin balances they hold with us, either because they are removing excess cash or reducing their trading activity in the wider market generally (for example, during the financial crisis in 2008) or with us specifically. As a result of the continued low interest rate environment over the past few years, our interest income has substantially decreased, which has adversely impacted our financial results, and if interest rates remain at low levels, our business could continue to be adversely affected, we may be unable to be as profitable as we were before the financial crisis, and our return to profitability would likely be delayed.
Fluctuations in interest rates are caused by many of the factors identified above as well as others. Any significant narrowing in short-term interest rate spreads or overall levels could have a material adverse effect on our business and operating results.
Our principal transactions and investments related to our treasury operations expose us to market and issuer risk.
Our principal transactions incurred through our normal business activities, as well as investments related to our treasury operations, expose us to market risk and issuer risk, either of which could result in losses that adversely affect our business and results of operations. Market risk refers to the risk that a change in the level of one or more market prices of commodities or securities, currency exchange rates, interest rates, credit spreads, yield curves, mortgage repayment rates, indices, implied volatilities (i.e. the price volatility of the underlying instrument imputed from option prices), correlations or other market factors, such as liquidity, will result in losses for a position or portfolio. Other elements that we include within the definition of market risk include the risk of price movements on securities and other obligations in tradable form resulting from general credit or country risk factors or events specific to individual issuers. Issuer risk refers to the risk of loss on securities and other obligations in tradable form, arising from credit-related and other events specific to the issuer and, ultimately, default and insolvency of the issuer or debtor.
Principal transactions incurred through our normal business activities arise when we act as principal in connection with our market making activities or when we facilitate client business. Principal transactions also include proprietary positions that we take in fixed income and related interest rate products, equities,
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foreign exchange and commodities to monetize our views on future movements in market prices and volatilities in commodities, securities and other instruments and products, which may be affected by, among other things, changes in credit spreads, potential rating changes, and possibility of issuer default. These future movements and events can differ substantially from our expectations (as well as, among other things, any instrument correlations or market conditions that we believed to be existent) and therefore result in substantial losses. For example, in 2010, concerns were raised about certain European countries, including Italy, Spain, Belgium, Portugal and Ireland, regarding perceived weaknesses in their economic and fiscal condition, and the extent to which such weaknesses might affect other economies as well as financial institutions such as ours, which did business with these countries or invested in securities issued by them. For a discussion of these risks, see “Item 7A. Quantitative and Qualitative Disclosures About Market Risk”. Changes in regulatory and tax rules can also change the expected profitability or outcome of these trades, and in the worst case result in losses. These changes can even be applied retroactively. Additionally, regulatory, liquidity and other capital restrictions may also force us to exit certain positions prematurely, or in adverse market conditions, resulting in significant losses.
Because our treasury operations involves the management of our capital, including investments made for cash and asset-liability management, we consider these investments to be principal transactions, although much of the revenue recognized in connection with these transactions is presented in our financial statements as interest earned. In connection with our treasury operations we may, at our discretion, take positions for asset-liability management, including yield enhancement and investments made in our held-to-maturity portfolio, and to hedge our exposure to changes in foreign currency exchange rates and interest rate risks arising from the global character and financial focus of our operations. These transactions expose us to various market risks, including those from interest rate movements, currency rate changes, credit spread changes, issuer rating changes and possibility of issuer default. Because of the limitations and uncertainties inherent in hedging strategies, our exposure to market risk from these transactions may not be fully offset or may not always be fully known.
Although we try to manage our market risk and issuer risk by, where appropriate, diversifying our exposures, controlling position sizes (i.e. limiting concentration risk), and establishing hedges in related securities or derivatives, market fluctuations that are different than what we expect, including changes in instrument correlations or market correlations, could result in us incurring substantial losses. Principal transactions may also expose us to concentration risk, as discussed below under “Concentration of credit and market risk could expose us to potentially significant losses.” Furthermore, to the extent that we may not be able to efficiently or advantageously hedge or reverse our principal transaction positions from our market making activities, client facilitation activities, or otherwise, or to the extent that such principal transactions remain unhedged, our capital will be exposed to risk of loss. For more information about our market risk and risk management methods, see disclosures set forth under “Item 1 – Business—Risk Management”, of this Form 10-K and under “Item 7A. Qualitative and Quantitative Disclosure about Market Risk—Market Risk”.
Historically, our trading activities have largely been limited to effecting client transactions as a broker, involving minimal principal exposure of generally short duration. As we implement our new strategic plan, we expect to increase our principal trading activities significantly, in connection with facilitating our clients’ transactions, our market-making and our proprietary activities and investing, and as a result, our exposure to market risk and trading losses will increase. Although we expect to increasingly recognize trading income as part of our ongoing activity for our clients and to continue monetizing our market views with unhedged principal transactions, there can be no assurance that we can increase the level of this activity or that it will be profitable. Because of the market risk and issuer risk that we face, we may incur significant losses at any time with respect to any of our principal transactions, including those executed for client facilitation and market making, proprietary activities, or asset-liability management; and particularly in the event of severe market stress.
Many of our principal transactions depend on external funding and financing and we also depend on third parties to monetize our gains from principal trading.
Our ability to earn the returns that we expect in connection with our principal transactions, including our proprietary activities, depends on our ability to fund and finance these transactions through internal and external sources. We also depend on other counterparties to provide us with the liquidity and opportunity to enter, maintain and exit these transactions. To the extent such funding and financing resources become too expensive, unavailable or capital intensive, we may be forced to exit prematurely or in adverse market conditions, which could result in substantial losses.
Similarly, if the market experiences a decrease in availability of liquidity to enter, maintain or exit these transactions, we may find it difficult to monetize our gains. Events that would affect the funding or financing of our proprietary transactions include systemic events in the market such as, but not limited to; deterioration of broader market conditions or a global contraction of liquidity as occurred starting in 2007, as well as events unique to MF Global such as, but not limited to, a rating down-grade. In either case both funding and liquidity restrictions can result in significant losses for the firm. For example, as of March 31, 2011, we maintained an inventory of European sovereign indebtedness, which we financed using repo-to-maturity transactions; to the extent that the value of these investments decreased due to a ratings change with respect to the issuer’s long term indebtedness, we would likely be required to furnish additional margin to our counterparty.
Collateralized financing arrangements used in connection with proprietary activities expose our company to issuer default and liquidity risk.
To the extent that we have financed a position through a collateralized financing arrangement with a counterparty (for example, by means of a repurchase transaction), our counterparty will often have the right to require us, at any time during the term of the repurchase agreement, to meet margin calls resulting from decreases in the market value of the collateral that we post for financing. Accordingly, repurchase agreements and other similar financing tools create liquidity risk for us because if the value of the collateral underlying the repurchase agreement decreases, whether because of market conditions or because there are issuer-specific concerns with respect to the collateral, we will be required to post additional margin, which we may not readily have. If the value of the
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collateral was permanently impaired (for example, if the issuer of the collateral defaults on its obligations), we would be required to repurchase the collateral at full value upon the expiration of the repurchase agreement, causing us to recognize a loss, which could be significant.
Our business exposes us to significant client, issuer and counterparty credit risks.
Credit risk arises from the possibility that we may suffer losses due to the failure of clients and counterparties to satisfy their financial obligations to us at all or in a timely manner. We are subject to credit risk in connection with many of our business activities and we may be materially and adversely affected in the event of a default by our clients or counterparties. Credit risks we face include, among others:
| • | exposure to financial institutions, clearing organizations, custodians, exchanges and other counterparties with whom we place both our own funds or securities and those of our clients, including the posting of margins; exposure to counterparties with whom we have resale or repurchase agreements or securities borrowing and lending activities; |
| • | exposure to counterparties, including clients, that are unable or unwilling to meet their additional margin obligations due to losses arising from adverse market moves or where clients’ posted margin is insufficient to satisfy a debit; |
| • | failing to monitor client positions and accurately evaluate risk exposures, leading to our failure to require clients to post adequate initial margins or increase margins as necessary to keep pace with market movements and subsequent account deficits; |
| • | exposure to clients and counterparties to whom we extend secured, unsecured and risk-based financing lines to cover initial and variation margin; |
| • | exposure to clients with whom we trade on an OTC basis for OTC transactions that are not fully collateralized; |
| • | exposure to clients and counterparties through clearing and settlement operations, and market risk exposure due to delayed or failed settlement, which, if not corrected, could become our responsibility as a clearing broker, or which could cause us losses if we were the counterparty and principal; |
| • | exposure to the risk that a clearing member of an exchange or clearing house where we are also a clearing member may default—should the amount of the default exceed the member’s margin and clearing fund deposits, we may suffer losses as the shortfall is absorbed pro rata from the deposits of the remaining clearing members or we are subject to additional capital calls in some cases; |
| • | exposure to the possibility that execution-only clients will not pay us, or will delay paying us, the commission owed on trades we have executed; |
| • | exposure to the risk that political or economic failure, action, or embargo imposed on or by a specific country will prevent a transaction, or prevent a client or counterparty, or a group of clients or counterparties from completing a transaction as expected; and |
| • | exposure to concentration risk, that is, a large exposure to a single client or counterparty, exposure to a group of connected clients or counterparties, or multiple exposures to a group of unrelated clients or counterparties whose risk of default is driven by common factors—for example, a similar business, industry, geographical location or product exposure. |
Clients and counterparties that owe us money or securities may default on their obligations to us due to bankruptcy, lack of liquidity, operational failure or other reasons. Our reputation may be damaged if we are associated with a client or counterparty that defaults, even if we do not have any direct losses from such an event.
Although we have procedures for reviewing the creditworthiness of our clients and counterparties, the risk of default may arise from events or circumstances that are difficult to detect or foresee. Some of our risk management methods depend upon the evaluation of information regarding clients and markets that is provided to us by the client or is publicly available or otherwise accessible by us. That information may not, in all cases, be accurate, complete, up-to-date or properly evaluated.
In addition, concerns about, or a default by, one institution could lead to significant liquidity problems, losses or defaults by other institutions, which in turn could adversely affect us. We may also be adversely affected if settlement, clearing or payment systems, such as Euroclear or Continuous Linked Settlement, become unavailable, fail or are subject to systemic delays for any reason outside our control.
For more information about our credit risk and risk management methods, see disclosures set forth under “Item 1 – Business—Risk Management” in PART I, ITEM 1. BUSINESS, of this Form 10-K.
Concentration of credit and market risk could expose us to potentially significant losses.
Credit concentration risk is the risk arising from a large exposure to a single client or counterparty, exposure to a group of connected clients or counterparties, or multiple exposures to a group of unrelated clients or counterparties whose risk of default is driven by common factors—for example, a similar business, industry, geographical location or product exposure. Although we monitor client and counterparty concentrations, our efforts to mitigate concentration risks may not be successful and we may become exposed to potentially significant losses.
Market concentration risk is the risk arising from large exposures to a single financial instrument or market, group of related financial instruments or markets, or group of unrelated financial instruments or markets whose risk is driven by common factors. We may from time to time (and currently do) hold large position concentrations in a single issuer (which include sovereign issuers) or industry sector within our proprietary and principal portfolios, including those that may have been acquired for asset-liability management purposes. Maintaining this inventory exposes us to potentially higher market risk and associated losses than would occur if our positions were less concentrated. To the extent that we borrow money or otherwise finance our purchases of these securities and other instruments, our exposure to potential losses would likely be greater than our initial investment or the collateral that we have posted to secure the financing. Successful management of concentrated positions depends upon:
| • | our ability to finance and fund the transactions through internal or external means; |
| • | the ability to meet regulatory capital and margin requirements; |
| • | our ability to assess the risk and return of market and default risks; |
| • | market interaction and general market conditions; |
| • | the skills and quality of our trading personnel; |
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| • | the effectiveness of our hedging strategies and risk management processes; |
| • | the price volatility of the specific securities or other instruments held in inventory; and |
| • | the availability and allocation of capital. |
We cannot guarantee that we will be able to manage such risk successfully or that we will not experience significant losses from such activities.
In addition, disruptions in the liquidity or transparency of the financial markets, such as in 2008 and the first half of 2009, may result in our inability to transact in certain instruments or positions held by us for client-facilitation or principal trading purposes, thereby leading to increased concentrations of those newly-illiquid positions and, subsequently, exposing us to market concentration risk. These concentrations could expose us to losses if the mark-to-market values of the securities or other instruments or positions held on our balance sheet decline causing us to recognize losses on our financial statements. Moreover, the inability to reduce our positions not only increases the market and credit risks associated with such positions, but also increases the level of risk-weighted assets on our balance sheet, thereby increasing our capital requirements and funding costs, all of which could adversely affect our businesses’ operations and profitability.
Our risk management policies, procedures and systems might not be effective in mitigating risk and loss to us.
To manage the significant risks inherent in our business, we must maintain effective policies, procedures and systems that enable us to identify, monitor and control our exposure to financial, operational, and business risks. For a description of our risk management approach, see “Item 1. Business—Risk Management”. This risk management function requires, among other things, that we properly record and verify many hundreds of thousands of transactions and events each day and that we continuously monitor and evaluate the size and nature of our clients’ positions and their associated risks. Because of extremely high transaction volumes, it is not practicable for us to review and assess every single transaction or to monitor at every moment in time our clients’ positions and their attendant risks.
We must rely upon our analysis of publicly or otherwise available information about markets, personnel, counterparties, clients or other matters. That information may not in all cases be accurate, complete, up-to-date or properly analyzed. Further, we rely on a combination of technical and human controls and supervision that are subject to error and potential failure, the challenges of which are exacerbated by the 24-hour-a-day, global nature of our business.
Our risk-management framework was designed using internally-developed risk-control methods, documented historical behavior, and our observation of industry practices. The effectiveness of our risk management framework, however, may be limited by the lack of sufficient or accurate historical information or because our risk management methods may not identify a risk or link a risk to a potential loss. If our risk management efforts are not effective, we may not prevent losses that could have a material adverse effect on our financial condition or operating results. In addition, a failure to exercise reasonable risk oversight could subject us to litigation, particularly from our clients, and sanctions or fines from regulators.
Although we have designed a risk management framework that evaluates and manages the financial, operational, market, credit and other risks we face, risk management tools, no matter how well designed, have inherent limitations, which could cause them to be ineffective. As a result, we face the risk of losses, including losses resulting from firm errors, customer defaults or fraud. For example, in 2008, we suffered a significant loss from unauthorized trading by a former broker. See “Item 3. Legal Proceedings”. Unexpectedly large or rapid movements or disruptions in one or more markets may cause adverse changes in the things that our clients trade, decreases in liquidity and trading positions and increased volatility, all of which could increase our risk exposure to our customers, to other third parties and on our inventory. In addition, while we monitor customer accounts that are less than fully collateralized with liquid securities, our risk controls may not be able to protect us from substantial losses in those accounts. Moreover, as we implement our strategic plan and expand our principal trading activities and risk exposure, our risk management functions will be tested in new ways, and need to address greater risks, than in the past. If our risk management tools are unable to control our risk exposure, we may suffer material losses or suffer other adverse consequences that could impair our ability to continue our operations.
If we are unable to attract and maintain our highly skilled management team, employee-brokers, sales professionals, traders and other employees, our business could be adversely affected.
Our performance and future success largely depends on the talents and efforts of highly skilled individuals. Therefore, our ability to continue to compete effectively in our business, to manage our businesses effectively and to expand into new businesses and geographic areas depends on our ability to attract new employees and to retain and motivate our existing employees. Furthermore, failure to retain one or more members of our management team, particularly Jon Corzine, our Chairman and Chief Executive Officer, and Bradley Abelow, our President and Chief Operating Officer, or other key employees, or failure to attract skilled personnel, could adversely affect our ability to manage our business effectively and execute our business strategy.
Due to the complexity and risks associated with financial services and the specialized knowledge required to conduct and grow our business, the demand and competition for qualified personnel is intense. Many of our employee-brokers, sales professionals and traders have long-standing relationships with particular clients. The departure of any such employee could adversely affect our relationships with those clients, potentially resulting in the loss of one or more of such clients and related revenues. In addition, the time and costs required to identify, recruit and train replacements should we fail to retain our current employees could be significant. If we fail to continue to provide competitive levels of compensation, or if we otherwise fail to provide a desirable work environment, many of our employees could find employment at other firms. Furthermore, failure to attract and retain experienced personnel, including qualified risk, compliance and technology and other support personnel could result in regulatory infractions or operational errors or otherwise be disruptive to our business. In emerging markets, we are often competing for qualified employees with entities that have a significantly greater presence or more extensive experience in the region. Because our strategic plan calls for us to develop and grow new lines of business, our ability to attract and retain new employees in these areas will be important to the successful implementation of our strategic plan, and if we are unable to attract and retain sufficient qualified employees, we may not be able to implement the plan as we initially contemplated.
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Our ability to attract and retain highly skilled employees—both management and non-management—could depend heavily on the level of compensation we can offer. Consequently, our profitability could decline as we compete for personnel. The imposition on us or our employees of restrictions on employee compensation, some of which has been proposed, and others (as in the U.K.) which have been enacted, may adversely affect our ability to attract and retain qualified senior management and employees.
We face intense competition from other companies within the financial services industry, and if we are not able to compete successfully with them, our business may be harmed.
The financial services industry is highly competitive, and we expect that competition will continue to remain intense in the future. Further, as we implement our strategic plan and expand into new areas of business, such as asset management, we expect to continue to compete in these new areas against some of our existing competitors and to also face new competitors with whom we are unfamiliar and in areas of business in which our present management may have less experience. Many of our current and potential competitors have larger client bases, more established name recognition and greater financial, marketing, technological and personnel resources than we do. Our larger competitors (both current and future) may also benefit from economies of scale that we have not yet achieved, and that we may never achieve, in either our existing areas of business (such as retail) or future areas of business (such as asset management) and these economies of scale could put us at a competitive disadvantage or cause us to be less profitable. Further, some of our competitors may be better capitalized, and some may have received or continue to receive direct or indirect subsidies from their respective national governments following the global economic crisis. As a result, these competitors may have lower operating costs due to lower costs of capital or may be perceived by clients as more financially sound, whether due to their size or their having the benefit of the implicit guarantee of their home government or both. Furthermore, because some of our competitors are better capitalized, they have in the past been able to and may continue to be able to participate in certain markets that we are excluded from because of our smaller capital base, such as clearing for credit default swaps. Therefore, our current and potential competitors may be able to, among other things:
| • | maintain a stronger credit rating than we do, thus making them more attractive counterparties; |
| • | enjoy greater access to, and have a lower cost of, capital, whether because of their greater size, better credit rating or maturity of business, which may allow them to provide more favorable financing or liquidity to clients than we can provide; |
| • | develop and provide products and services that are more attractive to clients than ours in one or more of our markets; |
| • | provide products and services we do not offer; |
| • | offer products and services at prices below ours to gain market share; |
| • | provide execution and clearing services that are more rapid, reliable or comprehensive, or less expensive than ours; |
| • | outbid us for desirable acquisition targets; |
| • | market, promote and sell their products and services more effectively; and |
| • | develop stronger relationships with clients. |
Increased competition has contributed to the decline in net clearing revenue per transaction that we have experienced in recent years and may continue to create downward pressure on our net clearing revenue per transaction. In the past, we have responded to the decline in net clearing revenue by reducing our expenses, but if the decline continues, we may be unable to reduce our expenses at a comparable rate. Our failure to reduce expenses comparably would reduce our profitability.
We compete with a significant number of brokers in the U.S. and throughout the world in one or more markets. Although no one competitor operates in all of our markets, one broker, Newedge, which is a large broker owned by two large French banks with global operations, competes in many of our markets. We also compete with a large number of independent brokerage firms, as well as regional brokers in particular markets around the world. In addition, affiliates of the largest financial institutions, including Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, and UBS compete with us in brokerage and dealing services in certain markets. Our competitors within clearing services, which is a significant source of our revenue, include Cantor Fitzgerald and ING. In markets where we act as a securities broker-dealer, we compete against mid-sized investment banks such as Jefferies Group. We have also witnessed the continuing increase of online trading platforms that provide direct competition to our retail and trading operations in a range of markets, such as Saxo Bank and Interactive Brokers.
New or existing competitors could make it difficult for us to maintain our current market share or increase it in desirable markets or adversely affect the implementation of our strategic plan. Even if competitors do not significantly erode or limit our market share, they may offer their services at lower prices, and we may be required to reduce our fees significantly to remain competitive. A fee reduction without a commensurate reduction in expenses or increase in volume would decrease our profitability and less capital would be available for us to use in implementing our strategic plan.
Our business could be adversely affected if we are unable to retain our existing clients or attract new clients.
The success of our business depends in part on our ability to maintain and increase our client base because a significant part of our business depends on commissions earned from execution and clearing services. Our clients are particularly sensitive to the diversity and flexibility of the services, products, markets and regions that we make available; the quality, speed and reliability of our order execution and clearing services; our perceived and actual creditworthiness; and the costs of using our services. Because the financial services industry in general, and the futures brokerage industry in particular, is subject to rapid innovation in products and services, particularly with regard to technological development, we face intense competitive pressure to continuously enhance our product and service offerings in order to maintain and increase our client base. Fast and reliable systems technology with global reach has been a critical aspect of client service, and we must be able to keep pace with important industry innovations, an effort which could be costly and present operational and other risks. We may also face difficulties in attracting new clients if we fail to offer a range of services as broad as our competitors offer. Further, if our reputation for quality, speed and reliability is impaired, or if we fail to enhance existing or create new products and services or enter into new markets and regions, we may not be able to attract new clients which may inhibit our growth.
Our clients are not obligated to use our services and at any time could easily and quickly switch providers of execution and clearing services, transfer their positions or decrease their
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trading activity conducted through us. This is particularly true for our professional trader, asset manager, and hedge fund clients who are sophisticated users of brokerage services, often have relationships with a number of competing brokers, and generate a disproportionately large share of our client trading volumes. As a result, we are vulnerable to potentially significant and sudden loss of revenues from our institutional client base. Similarly, while individual investors in the past have generally been less likely to change brokers, their demand for brokerage services has generally been sensitive to broader market trends, so a significant downturn in the markets or unusually heightened volatility in the derivatives or cash markets could lead to a substantial decline in revenues from our individual investor client base. Many of our clients have longstanding relationships with individuals or teams within our company. To the extent any of those individuals or teams seek alternative employment, we may be in jeopardy of losing those clients.
Our growth strategy may involve growth through acquisitions, and if we are unable to manage our acquisitions effectively, our business may be materially harmed.
Historically, acquisitions have expanded our presence into new markets as well as delivered scale within existing markets. Although elements of our strategic plan will be based on organic growth, particularly in areas where we have experience or competitive advantages, we intend to continue to opportunistically pursue acquisitions of entire businesses or customer relationships as well as talented teams specializing in particular products or services offerings.
Acquisitions entail numerous risks and challenges, including but not limited to the following:
| • | difficulties in the integration of the acquired business (including acquired employees, back-office functions, risk and compliance systems and deployment of operations and technology) and retention of acquired client accounts and personnel; for example, the timely transfer of client accounts is key to the success of our acquisitions, and failure to quickly integrate our software systems with those of an acquired company could result in errors or service disruptions, which could adversely affect our ability to maintain an ongoing relationship with any affected clients; |
| • | strain on our operations, information technology, compliance and financial systems, managerial controls and procedures (including risk oversight), and our people as we integrate an acquired business; |
| • | the need to modify our systems or to add management resources to manage and integrate acquired businesses; |
| • | unforeseen difficulties in the acquired operations, causing disruption of our ongoing business; |
| • | challenges in identifying pre-existing weaknesses or deficiencies in the acquired business’ risk management, internal controls or technology systems; |
| • | increased regulatory oversight and obligations, including higher capital requirements; |
| • | failure to achieve transaction-related cost savings or other financial, operating, or strategic objectives; |
| • | required amortization of acquired intangible assets, which would reduce future reported earnings; |
| • | possible adverse short-term effects on our cash flows or operating results, for example, when we acquire another company, we could incur severance, guarantee or retention payments and other acquisition-related costs that could reduce our net income; diversion of management’s attention from other business concerns; |
| • | assumption of unknown material liabilities or regulatory non-compliance issues; and |
| • | inability to obtain necessary regulatory approvals without significant concessions, costs or delays. |
We may be unable to pursue our acquisition strategy. Competition for suitable acquisition targets is intense. Many of our largest competitors have substantially greater financial resources than we do and are able to outbid us on the most desirable targets. We may lack the financial resources necessary to consummate acquisitions in the future or may be unable to secure financing on favorable terms. We may not be able to identify suitable acquisition targets, or to complete any transactions we identify on sufficiently favorable terms, to meet our strategic goals. In addition, any future acquisitions may entail significant transaction costs and risks associated with entry into new markets or products. Even when we complete an acquisition, we may not realize the benefits we expected to attain.
Failure to manage risks that arise from acquisitions could have a material adverse effect on our business, financial condition and operating results.
Our international operations present special challenges that we may not be able to meet, and this could adversely affect our financial results.
We currently conduct business internationally and expect to continue to expand our international operations. During fiscal 2011, we generated approximately 36.3% of our revenues, net of interest and transaction-based expenses, in Europe and 14.4% in Asia. We face significant risks and challenges in conducting business in international markets, particularly in developing regions. These risks and challenges include, but may not be limited to:
| • | difficulty in complying with the diverse regulatory requirements of multiple jurisdictions, which may be more burdensome, subject to unexpected changes, or not clearly defined, potentially exposing us to significant compliance costs and regulatory penalties; |
| • | local laws that could be unfavorable to our business or foreign investors; |
| • | potentially unstable or adverse political climates; |
| • | less developed technological infrastructure and higher costs, which could make our products and services less attractive or accessible in emerging markets; |
| • | difficulties and costs associated with staffing and managing foreign operations; |
| • | inability to enforce contracts in some jurisdictions;difficulties and costs associated with commencing operations in new jurisdictions; |
| • | fluctuations in foreign currency exchange rates; |
| • | tariffs and other trade barriers; |
| • | regulatory requirements that limit our ability to expand our presence outside of the United States; |
| • | currency and tax laws that may prevent or restrict the transfer of capital and profits among our various operations around the world; |
| • | changes in the geographic mix of revenues could affect our overall tax rate or ability to manage capital; |
| • | time zone, language and cultural differences among personnel in different areas of the world; and |
| • | other barriers to entry that make it difficult or costly to establish our business. |
Furthermore, due to cultural, regulatory and other factors, we may be at a competitive disadvantage in those regions relative
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to local firms or to international firms that have a well-established local presence. In some locations, we may need to acquire local capacity or enter into joint ventures with local firms in order to gain a presence, and we may face intense competition from other international firms over relatively scarce opportunities for market entry. This competition could make it difficult for us to expand our business as planned. In addition, due to the intense competition from other international firms seeking to enter markets where we wish to expand, we may have difficulty finding suitable local firms willing to enter into the kinds of relationships with us that we may need to gain access to these markets.
In order to be competitive in some local non-U.S. markets, or in some cases because of restrictions on the ability of foreign firms to do business locally, we have sought and may in the future seek to operate through joint ventures with local firms. For example, in India, we own a 70.2% interest in MF Global Sify Securities India Private Ltd. and a 75.0% interest in MF Global Finance and Investment Services India Private Limited, and in Taiwan, we currently own a 73.2% interest in MF Global Futures Trust Co. Ltd. and a 19.5% interest in Polaris MF Global Futures Co. Ltd., a publicly traded company. Doing business through joint ventures may limit our ability to control the conduct of the business, require us to allow our joint-venture partners veto rights over material actions, or could expose us to reputational and operational risks.
Our business may be adversely affected if we do not maintain our network of introducing brokers.
We receive a significant amount of our retail business through our network of introducing brokers, who assist us in establishing new client relationships for whom we execute and clear trades. Our introducing brokers also often provide marketing and other services for us to attract and retain clients for whom we execute and clear trades. We compensate these introducing brokers for introducing clients to us. Many of our relationships with introducing brokers are non-exclusive or may be terminated by the brokers with relatively short notice or no notice. In addition, our introducing brokers have no obligation to provide us with new client relationships or minimum transaction volumes. Our failure to maintain relationships with these introducing brokers or the failure of these introducing brokers to establish and maintain client relationships could result in a loss of revenues, which could adversely affect our business. To the extent any of our competitors offer more favorable compensation to one of our introducing brokers, we could lose the broker’s services or need to increase the compensation we pay to retain the broker. Our relationship with introducing brokers is complex. Although we benefit from our relationships with introducing brokers, this may expose us to significant reputational and other risks. See “—Risks Related to Regulation and Litigation—We could be harmed by misconduct that is difficult to detect or deter”.
The current trend toward electronic trade execution has diminished the role of some brokers or traders in the execution process. We must continue to offer attractive, value-added services to keep pace with this trend and other industry changes or our business could be adversely affected.
While clients have traditionally relied on brokers to execute trades, many exchanges have developed systems that permit orders to be routed through brokers electronically, thereby enabling clients to avoid more-costly voice-execution services and pressuring brokers to lower their execution-commission rates. In a number of cases, exchanges provide large clients with direct electronic access, enabling them to bypass brokers in the trade-execution process altogether – a trend known as “broker disintermediation”. For example, some of our largest institutional clients now execute orders on some exchanges directly by electronic means and, as a result, the portion of the fees we earn from these clients for execution services has, in some cases, declined relative to the portion we earn from providing clearing services for these trades. As exchanges devote substantial resources to developing more efficient ways for clients to execute orders with reduced broker involvement, our revenues and profitability could suffer to the extent we are unsuccessful in continuing to attract clients to execute through us by, among other things, enhancing the value-added execution services we offer. Furthermore, to maintain our client relationships as they transition to electronic trade execution, we may be required to make substantial investments in upgrading and maintaining our information technology systems and these additional expenses could further erode the profitability of servicing these clients. Additionally, market structure and practices in our industry could change significantly in other ways, including some we may not foresee, and we may not be able to adapt on a timely and cost-effective basis. To the extent that we do not adapt as rapidly or efficiently to industry changes as our competitors do, our business could suffer. We believe that it is possible that new U.S. legislation requiring the clearing of OTC derivatives contracts may also threaten to disintermediate our brokers.
MF Global Holdings Ltd. is a holding company and its liquidity depends, in part, on payments from its subsidiaries, which are subject to restrictions.
MF Global Holdings Ltd., is a holding company and, therefore, depends on dividends, distributions and other payments from its subsidiaries to fund dividend payments and to fund all payments on its obligations, including debt obligations. Many of our subsidiaries, including our broker-dealer and our regulated UK subsidiaries, are subject to laws that restrict dividend payments or authorize regulatory bodies to block or reduce the flow of funds from those subsidiaries to our parent. In addition, our broker-dealer and our regulated subsidiaries are subject to restrictions on their ability to lend or transact with affiliates and to minimum regulatory capital requirements, as well as restrictions on their ability to use funds deposited with them in brokerage accounts to fund their businesses. Additional restrictions on related-party transactions, increased capital requirements and additional limitations on the use of funds on deposit in brokerage accounts, as well as lower earnings, can reduce the amount of funds available to meet the obligations of our parent and even require our parent to provide additional funding to such subsidiaries. Restrictions or regulatory action of that kind could impede access to funds that we need to make payments on our obligations, including debt obligations, or dividend payments. In addition, our right to participate in a distribution of assets upon a subsidiary’s liquidation or reorganization is subject to the prior claims of the subsidiary’s creditors.
Furthermore, we guarantee many of the obligations of our consolidated subsidiaries. These guarantees may require us to provide substantial funds or assets to our subsidiaries or their creditors or counterparties at a time when we are in need of liquidity to fund our own obligations. See “Item 1. Business—Regulation and Exchange Memberships”.
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We may be required to recognize further impairments of our goodwill or other intangible assets, which could adversely affect our results of operations or financial condition.
The determination of the value of goodwill and intangible assets requires management to make estimates and assumptions that affect our consolidated financial statements. We are required to test goodwill for impairment annually, or in interim periods if certain events occur indicating that the carrying value may be impaired. We assess potential impairments to intangible assets when there is evidence that events or changes in circumstances indicate that the carrying amount of an asset may not be recovered. Our judgments regarding the existence of impairment indicators and future cash flows related to goodwill and intangible assets are based on several factors, which include:
| • | the operational performance of our acquired businesses; |
| • | management’s current business plans, which factor in current market conditions including contract and product volumes and pricing for future periods; |
| • | the estimated fair value and yield of our debt, preferred securities, and equity, market capitalization; |
| • | the trading price of our common stock; |
| • | changes in customer attrition and trading volumes; and |
| • | other relevant factors. |
When estimating impairment assessments, management uses discounted cash flow analysis, which requires the subjective selection and interpretation of data inputs; depending on market conditions at the testing date, a very limited amount of observable market data may exist from which to select inputs for use in the discounted cash flow model.
In fiscal 2011, our market capitalization was lower than our book value. We performed impairment tests of our goodwill and during the year ended March 31, 2011 we recognized a charge of $3.8 million to impair all of our goodwill. Also during the fourth quarter of fiscal 2011, we recorded a charge of $16.0 million to impair certain intangible assets. These non-cash charges materially impacted our equity and results of operations in 2011, but did not affect our ongoing business operations, liquidity, cash flow or compliance with covenants for our credit facilities. We may record additional goodwill and potential impairments in future periods related to our existing earn out arrangements or future acquisitions. Changes to our business plan, continued macroeconomic weakness, declines in operating results, and continued low market capitalization may result in our having to perform an interim goodwill impairment test or an interim intangible asset impairment test. These types of events and the resulting analysis could result in further goodwill or intangible asset impairment charges in future periods.
We have recorded significant deferred tax assets in certain jurisdictions. If we are unable to generate positive earnings in such jurisdictions, we may be required to record valuation allowances against previously-booked deferred tax assets, which could have a significant adverse impact on our financial results.
In certain jurisdictions, we have generated pre-tax losses that, in accordance with applicable tax law, we expect to be able to carry forward and offset against future profits to reduce relevant taxes going forward. We have recorded significant deferred tax assets reflecting our expectation of using these loss carryforwards against future income. If we are not able to generate profits in these jurisdictions in future periods, we may be required to record valuations allowances against these deferred tax assets. Recording valuation allowances against these deferred tax assets could have a significant adverse impact on our financial results.
Realization of deferred tax assets is dependent upon multiple variables including available loss carrybacks, future taxable income projections, the reversal of current temporary differences, and tax planning strategies. U.S. GAAP requires that we continually assess the need for a valuation allowance against all or a portion of our deferred tax assets. We are in a three-year cumulative pre-tax loss position at March 31, 2011 in many jurisdictions in which we do business. A cumulative loss position is considered negative evidence in assessing the realizability of deferred tax assets. We have concluded that the weight given this negative evidence is diminished due to significant non-recurring loss and expense items recognized during the prior three years, including IPO-related costs, asset impairments and costs related to exiting unprofitable business lines. We have also concluded that there is sufficient positive evidence to overcome this negative evidence. The positive evidence includes three means by which we are able to fully realize our deferred tax assets. The first is the reversal of existing taxable temporary differences. Second, we forecast sufficient taxable income in the carry forward period. We believe that future projections of income can be relied upon because the income forecasted is based on key drivers of profitability that we began to see evidenced in fiscal 2011. Most notable of these drivers are plans and assumptions relating to the significant changes to our compensation structure implemented in fiscal 2011, increased trading volumes, and other macro-economic conditions. Third, in certain of our key operating jurisdictions, we have a sufficient tax planning strategy which includes potential shifts in investment policies, which should permit realization of our deferred tax assets. Management believes this strategy is both prudent and feasible. The amount of the deferred tax asset considered realizable, however, could be significantly reduced in the near term if our actual results are significantly less than forecast. If this were to occur, it is likely that we would record a material increase in our valuation allowance. Loss carryforwards giving rise to a portion of the overall net deferred tax asset either do not expire or expire no earlier than fiscal 2031.
Risks Related to Our Capital Needs and Financial Position
We must maintain substantial amounts of capital and liquidity to conduct and grow our business.
If we have insufficient capital and liquidity we may not be able to maintain our operations or grow our business in accordance with our strategy. Our ability to provide clearing services, which is a critical part of our business, depends heavily on our ability to maintain capital, including equity capital at or above specified minimum levels required by various regulators throughout the world. Our failure to do so could expose us to significant penalties and sanctions, which we describe under “—Risks Related to Regulation and Litigation—We are subject to regulatory capital requirements which could constrain our growth and subject us to regulatory sanctions”. We also need capital and liquidity to protect us against the risk of default by
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our clearing clients and against clearing and settlement payment delays, caused by systemic problems outside our control in one country or between countries. Thus, as a clearing broker, we must maintain capital and liquidity not only to comply with applicable laws and regulations, but to manage the risks inherent in our clearing operations in accordance with guidelines that we believe appropriate. Therefore, we maintain capital and liquidity at levels determined in accordance with our internal risk management guidelines, which may be greater than regulatory requirements. If our risk management guidelines are insufficient or if we do not apply them properly we may not hold sufficient capital or liquidity to cover our needs. To the extent the levels we hold either on a consolidated basis or in an individual entity are insufficient, the firm and/or the entity is exposed to failure.
Our credit ratings could be adversely affected if we do not maintain sufficient capital and liquidity. A discussion of the effects of a downgrade to our credit ratings is described below under the risk factor “Our business may be adversely affected by a reduction in our credit ratings.”
Furthermore, we rely on uncommitted credit lines to finance our day-to-day clearing operations. Liquidity or capital issues, whether perceived or real, could prompt these lenders to reduce the amount of financing we use to conduct our clearing operations, which in turn could prompt us to reduce the amount of business we conduct and could accelerate client withdrawals. Thus, if we are unable to maintain capital at levels that the rating agencies or the market generally consider appropriate for our business, if we experience actual or perceived liquidity issues, or if for any other reason the market loses confidence in our financial condition, we may not be able to provide competitive clearing services, which are a major part of our business, and our clients could withdraw assets from their accounts, which could impair a substantial source of our interest income. Generally, clients clear their trades—and clearinghouses and other clearing firms deal—only with firms that are regarded as well capitalized and that maintain acceptable credit ratings from the independent rating agencies, such as Standard and Poor’s, Moody’s and Fitch.
Generally, principal trading activities have higher regulatory capital requirements than many other types of activities. Accordingly, our principal trading activities, including those relating to the facilitation of client transactions, could be curtailed if we do not have access to adequate capital and liquidity. We expect that we would obtain this additional capital and liquidity through multiple channels, including by:
| • | obtaining additional credit lines from banks; |
| • | raising short-term unsecured debt through commercial paper and promissory note issuances and other methods; |
| • | raising long-term unsecured debt through registered offerings of debt or hybrid securities, medium-term note offerings and other methods; or |
| • | increasing our equity, by among other things, increasing internally generated cash flow and expanding our activities in prime services, asset management and other areas of our business, or expanding access to deposits made through cash sweep programs in our internal broker networks. |
Therefore, we must maintain continuous access to adequate and sufficiently liquid sources of capital, including equity capital and external committed facilities on acceptable terms. Failure to do so could have severe consequences from a regulatory, operational or credit counterparty and solvency perspective. Even a less severe outcome, such as retaining the ability to obtain capital and liquidity but only at a higher cost, could significantly increase our interest expense and impair our earnings. As we implement our new strategic plan, we expect our liquidity and capital needs to grow.
Our business may be adversely affected by a reduction in our credit ratings.
If we do not demonstrate sufficient profitability in the future, we face the possibility of having our credit rating downgraded. In the event of a downgrade of our credit rating by one or more credit rating agencies, our business may be adversely affected. Some of the factors that could lead to a downgrade in our credit rating include, but are not limited to, our profitability each quarter as compared against rating agency expectations, our ability to maintain a conservative risk and liquidity profile, our ability to maintain the value of our franchise, deterioration in our trading volumes or operating cash flows, and a decline in maintenance margin funds or excess capital levels at our regulated subsidiaries.
A reduction in our credit ratings could increase our borrowing costs or trigger our obligations under certain bilateral provisions in some of our collateralized financing contracts or our bilateral contracts in the OTC markets. Under these provisions, if one or more of our credit ratings were decreased, counterparties could be permitted to terminate contracts made with us or require us to post additional collateral pursuant to ratings maintenance requirements. Termination of our OTC contracts or collateralized financing contracts could cause us to sustain losses and impair our liquidity by requiring us to find other sources of financing or to make significant cash payments or securities movements. Should we be unable to readily access capital and liquidity, our clients may be unwilling to clear their transactions through us. A reduction in our credit ratings could harm the way we are perceived by clients and could limit our attractiveness as a counterparty in OTC transactions.
In addition, any announcement by a rating agency that our credit rating is being downgraded, or even that we are being placed on “negative watch”, could have a serious adverse impact on our operating results and our financial condition, as was the case following the February 2008 unauthorized trading incident when we were put on “negative watch” by our rating agencies and downgraded by two out of three of them. Moreover, concerns about our credit ratings may limit our ability to pursue acquisitions and, to the extent we pursue acquisitions that affect our credit ratings, our business may suffer. To avoid placing our credit rating at risk, we may need to limit the growth of our business, or we may even need to reduce our operations or other expenses to improve profitability.
A credit-rating downgrade could also compel us to raise additional capital on unfavorable terms, which could result in substantial additional interest or other expenses and lower earnings. If we were forced to raise equity capital, that action could result in substantial dilution to our existing shareholders.
Fluctuations in currency exchange rates could reduce our earnings.
Our revenues and expenses are denominated primarily in U.S. dollars, British pounds and Euros. The largest percentage of our revenue is denominated in U.S. dollars, while the largest percentage of our non-U.S. expenses is denominated in British pounds and Euros. As a result, our earnings could be affected
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by changes in the U.S. dollar/British pound and U.S. dollar/Euro exchange rate and, to a lesser extent, changes in the U.S. dollar versus Asian currencies. Such changes have occurred in recent years, which exerted downward pressure on our earnings in fiscal 2010. For example, we realized net currency translation gains of $0.4 million for fiscal 2011, $12.6 million for fiscal 2009 and $3.9 million for fiscal 2008, but a net currency translation loss of $15.6 million for fiscal 2010. Although we may seek to mitigate our exposure to currency exchange rates through hedging transactions in accordance with our policies on hedging, these efforts may not always be successful. See “Item 7A. Quantitative and Qualitative Disclosures about Market Risk—Market Risk.” Adverse trends in currency exchange rates could negatively affect our earnings. Although we have realized net currency translation gains in some recent periods, we could incur significant currency translation losses in the future. Moreover, changes in currency exchange rates from one period to the next could make historical and future period-to-period comparisons of our performance more difficult.
Our operating results are subject to significant fluctuations due to seasonality and, as a result, our operating results in any particular period may not be a reliable indicator of our future or annual performance.
In prior years, our business has experienced seasonal fluctuations, reflecting reduced trading activity during summer months, particularly in August. We also generally experience reduced trading activity in December due to seasonal holidays. In addition, trading in some commodity derivatives, such as energy, is affected by the supply of, and demand for, the underlying commodity, which is seasonal and may change significantly. We also may experience reduced revenues in a quarter due to a decrease in the number of business days in that quarter. As a result of these seasonal fluctuations, our operating results in any particular period may not be a reliable indicator of our future or annual performance.
Risks Related to Regulation and Litigation
We operate in a heavily regulated environment that imposes significant compliance requirements. Non-compliance with these requirements could subject us to sanctions and adversely affect our business.
We are extensively regulated by governmental bodies and self-regulatory organizations worldwide. Many of the regulations we are governed by are intended to protect the public, our clients and the integrity of the markets, and not necessarily our shareholders. In the United Kingdom, we have been principally regulated by the Financial Services Authority, or FSA. In the United States, we are principally regulated in the futures markets by the Commodity Futures Trading Commission (CFTC), the Chicago Mercantile Exchange (CME), and the National Futures Association (NFA) and in the securities markets by the Securities and Exchange Commission (SEC), the Financial Industry Regulatory Authority (FINRA) and the Chicago Board Options Exchange (CBOE). Further, as participants in the financial services industry, our business must comply with the anti-money laundering laws of the jurisdictions in which we do business, including, in the U.S., the USA PATRIOT Act, which requires us to know certain information about our clients and to monitor their transactions for suspicious activities, as well as the laws of the various states in which we do business or where the accounts with which we do business reside. Our business is also subject to rules promulgated by the U.S. Office of Foreign Assets Control, or OFAC, which require that we refrain from doing business, or allow our clients to do business through us, in certain countries or with certain organizations or individuals on a prohibited list maintained by the U.S. government. We are also regulated in all regions by local regulatory authorities and the various exchanges of which we are members. For example, we are regulated by the Monetary Authority of Singapore, the Securities and Exchange Board of India, and the Australian Securities and Investment Commission, among others. These regulators and self-regulatory organizations influence the conduct of our business and regularly examine our business to monitor our compliance with their regulatory requirements. Among other things, we are subject to regulation with regard to:
| • | our sales practices, including our interaction with and solicitation of clients and our marketing activities; |
| • | the custody, control and safeguarding of our clients’ assets; |
| • | account statements, record keeping and retention; |
| • | client privacy; |
| • | maintaining specified minimum amounts of capital and limiting withdrawals of funds from our regulated operating subsidiaries; |
| • | regular financial and other reporting to regulators; |
| • | anti-money laundering and other reporting practices; |
| • | licensing for our operating subsidiaries and our employees; |
| • | identifying our clients and determining the beneficial ownership of assets held by our clients, gathering required information about them and monitoring their account activities; |
| • | payments made to foreign-government officials and control practices designed to prevent such payments; |
| • | the conduct of our directors, officers, employees and affiliates; and |
| • | supervision of our business. |
We face risks that our policies, procedures, technology and personnel directed toward complying with the foregoing types of laws and regulations may be insufficient and that we could be subject to significant regulatory, criminal and civil penalties due to non-compliance. These penalties could have a material adverse effect on our business, financial condition and operating results. See “Item 1. Business—Regulation and Exchange Memberships” for further discussion of these matters.
Many of the laws and regulations by which we are governed grant regulators broad powers to investigate and enforce compliance with their rules and regulations and to impose penalties and other sanctions for non-compliance. See “Item 3. Legal Proceedings”. If a regulator finds that we have failed to comply with its rules and regulations, we may be subject to fines or other sanctions, which could adversely affect our reputation and operations. In particular, certain of the requirements that we must comply with are focused on protecting our individual investor clients. If we fail to comply with applicable laws, rules or regulations, we may be subject to censure, fines, cease-and-desist orders, suspension of our business, removal of personnel, civil litigation or other sanctions, including, in some cases, increased reporting requirements or other undertakings, revocation of our operating licenses or criminal conviction. In addition, if we fail to comply with applicable laws, rules or regulations, we may also be subject to the loss of clients, negative publicity and litigation. Our ability to monitor compliance with all applicable laws and regulations is dependent in large part on our internal
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compliance function and our ability to attract and retain qualified compliance personnel as well as the supervision our business managers provided. Non-compliance with applicable laws or regulations could adversely affect our reputation, prospects, revenues and earnings.
Pending as well as proposed legislation and regulatory initiatives may significantly affect our businesses.
The global economic downturn starting in 2007 led to legislation and numerous proposals for changes in the regulation of the financial services industry, including increases in capital and liquidity requirements and limits on the size and types of activities permitted by certain types of financial institutions. In the United States, the Dodd Frank Wall Street Reform and Consumer Protection Act (the “Dodd Frank Act”) was enacted in July 2010, which imposes more comprehensive regulation over the financial services industry and will likely subject portions of our business to additional regulation, through, for example, new regulations on major swaps participants and swap dealers. In addition, initiatives are under way in the European Union and Japan, among other jurisdictions, that would require centralized clearing, reporting and recordkeeping with respect to various kinds of financial transactions and other regulatory requirements that are in some cases similar to those required under the Dodd-Frank Act.
These initiatives and legislation not only affect us but also certain of our customers and counterparties. For example, increased capital requirements for certain market participants may increase transaction costs, resulting in decreased transaction volumes, which could adversely affect our earnings. As a result, these new (and other) legislative and regulatory changes could affect our revenue, limit our ability to pursue business opportunities, require us to hold additional capital, impact the value of assets that we hold, require us to change certain of our business practices, impose additional costs on us, or otherwise adversely affect our business. Because of the sweeping nature of the changes to be made pursuant to the Dodd-Frank Act, among other legislative and regulatory initiatives, as well as the need for implementing these changes at this time, we cannot predict whether or how our business will be impacted with any degree of certainty. Accordingly, we cannot provide assurance that any such new legislation or regulation, or any legislation or regulation that may be proposed in the future, would not have an adverse effect on our business, results of operations, cash flows or financial condition.
If we do not comply with current or future legislation and regulations that apply to our operations, we may be subject to fines, penalties or material restrictions on our businesses in the jurisdiction where the violation occurred. In recent years, regulatory oversight and rulemaking enforcement have increased substantially, thereby increasing the costs and risks associated with our operations. As these regulatory trends continue, our financial results may be adversely affected.
The regulatory environment in which we and our clients operate is subject to continual change.
The legislative and regulatory environment in which we operate has undergone significant changes in the recent past and future regulatory changes in our industry are likely given the events observed since 2008. The governmental bodies and self-regulatory organizations that regulate our business may propose and consider additional legislative and regulatory initiatives and may adopt new or revised laws and regulations. As a result, in the future, we or our clients may become subject to new regulations that could affect the way in which we conduct our business and could make our business less profitable.
For example, recent market disruptions have led to new and proposed regulations in the United States and internationally for changes in the regulation and taxation of the financial services industry, including increased capital requirements, as well as new liquidity or leverage requirements. These new laws and regulations will likely affect our clients’ businesses and will likely affect our business. Furthermore, the recent implementation of a remuneration code will affect our compensation strategy with respect to many of our employees located in the UK.
Changes in the interpretation or enforcement of existing laws and regulations by our regulators may also adversely affect our business. In addition, changes in the regulatory enforcement environment may create uncertainty over certain practices or types of transactions that in the past were considered permissible and appropriate among financial services firms, but that later have been called into question or have had additional regulatory requirements imposed on them. Legal or regulatory uncertainty and additional regulatory requirements could result in a loss of business. As discussed above, new and changing regulatory requirements may make it more difficult or less profitable for us to operate our business.
If our clients’ account information is publicly disclosed or misappropriated, we may be held liable or suffer harm to our reputation.
Increased public attention regarding the corporate use of personal information has led to increasingly complex legislation and regulations intended to strengthen data protection, information security and consumer privacy. While we employ what we believe to be an appropriate degree of care in protecting our clients’ confidential information, if third parties penetrate our network security or otherwise misappropriate our clients’ personal or account information, or we were to otherwise release any such confidential information without our clients’ permission, unintentionally or otherwise, we could be subject to liability arising from claims related to impersonation or similar fraud claims or other misuse of personal information, as well as suffer harm to our reputation. While we periodically test the integrity and security of our systems, we cannot assure you that our efforts to maintain the confidentiality of our clients’ account information will be successful.
We cannot assure you that advances in computer capabilities, new discoveries in the field of cryptography or other events or developments will not result in a compromise or breach of the technology we use to protect clients’ transactions and account data. We may incur significant costs to protect against the threat of network or Internet security breaches or to alleviate problems caused by such breaches.
We are subject to regulatory capital requirements which could constrain our growth and subject us to regulatory sanctions.
The CFTC, SEC, FSA and other U.S. and non-U.S. regulators require us to maintain specific minimum levels of regulatory capital in our operating subsidiaries that conduct our futures and securities business. As of March 31, 2011, we were required to maintain approximately $1.4 billion minimum capital, which includes regulatory early warning requirements, in the aggregate across all jurisdictions (including $39.6 million in respect of goodwill and other intangible assets).
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Regulators require a minimum amount of shareholders’ equity to support the regulatory requirements, the percentage of which will vary by regulator and jurisdiction, while the balance of the regulatory requirements may be satisfied by subordinated liabilities (including intercompany subordinated debt). We generally maintain total regulatory capital in excess of the minimum requirements in order to meet our internal risk management guidelines and, as a result, our capital costs could be substantially higher than those attributable solely to applicable regulatory or self-regulatory requirements.
Regulators continue to evaluate and modify regulatory capital requirements from time to time in response to market events and to improve the stability of the international financial system. For example, in the UK, the FSA has periodically reviewed and assessed our company’s UK subsidiary and the businesses that we operate in the UK and Europe to determine the minimum capital requirements that our UK regulated entities must maintain, and in response to the global financial crisis, has significantly raised industry-wide the capital requirements for FSA-regulated entities.
Even if regulators do not change existing regulations or adopt new ones, our minimum capital requirements could generally increase in proportion to the size of the business conducted by our regulated subsidiaries as noted above. If we are unable to cost-effectively meet higher regulatory capital requirements, whether internally through earnings or externally through the capital markets such as the sale of senior indebtedness or equity, we may not be able to maintain or expand our operations and increase our revenues or execute our corporate growth strategy. In addition, our ability to allocate our capital resources more efficiently throughout our global operations may be constrained to the extent that we are not permitted to withdraw regulatory capital (including excess regulatory capital) maintained by our subsidiaries without prior regulatory approval or notice. In particular, these restrictions could limit our ability to withdraw funds needed to satisfy our ongoing operating expenses, debt service and other cash needs.
Regulators monitor our levels of capital closely. We are required to report periodically the amount of regulatory capital we maintain to our regulators on a regular basis, and we must report any deficiencies or material declines promptly. While we expect that our current amount of regulatory capital will be sufficient to meet anticipated short-term increases in requirements, any failure to maintain the required levels of regulatory capital, or to report any capital deficiencies or material declines in capital could result in severe sanctions, including fines, censure, restrictions on our ability to conduct business and suspension or revocation of our registrations. The imposition of one or more of these sanctions could ultimately lead to our liquidation, or the liquidation of one or more of our subsidiaries. For more information on the minimum regulatory capital requirements for our subsidiaries, see “Item 1. Business—Regulation and Exchange Memberships”.
We could be harmed by misconduct that is difficult to detect and deter.
A number of highly publicized cases involving fraud or other misconduct by employees of financial services firms have come to light in recent years. Like our peers, we are exposed to risks relating to misconduct by our employees, our clients’ or our clients’ employees, introducing brokers and other third parties with whom we have relationships, notwithstanding our efforts to mitigate fraud or other misconduct through internal controls and risk oversight.
For example, our employees could:
| • | execute unauthorized transactions for our clients, for themselves or any of our accounts; represent (either intentionally or inadvertently) that they are acting on behalf of our company when in fact they are acting beyond the scope of their duties, |
| • | use client assets improperly or without authorization; |
| • | perform improper activities on behalf of clients; |
| • | use confidential client or company information for improper purposes; or |
| • | mis-record or otherwise try to hide improper activities from us. |
Such exposures could be heightened in the case of individual investors’ accounts over which our brokers, in limited circumstances, exercise discretionary authority.
Misconduct by employees of our clients could also expose us to claims for financial losses or regulatory proceedings when it is alleged that we or our employees knew or should have known that an employee of our client was not authorized to undertake certain transactions. For example, in a recent investigation and enforcement action, the CFTC has indicated that it may hold a clearing firm accountable (and liable) for failing to spot suspicious behavior by a client who buys, sells and does other business through the securities firm. Dissatisfied clients could make claims against us, including but not limited to claims for negligence, fraud, unauthorized trading, failure to supervise, inadequate disclosure of risks, breach of fiduciary duty, intentional misconduct or unauthorized transactions.
Although we do not control the activities of our introducing brokers, we could be held responsible for their improper conduct. If an introducing broker executes trades through us that are improper or unauthorized, our regulators could hold us responsible if they were to conclude that we knew or should have known that the trades were unlawful. Moreover, a substantial number of our introducing brokers in the United States are “guaranteed” introducing brokers, meaning that we have agreed to use our capital to effectively guarantee their capital in exchange for their agreement to affect client trades exclusively through us. Under the Commodity Exchange Act, we are financially responsible for the obligations of our guaranteed introducing brokers, and we are also effectively responsible for their obligation to comply with the Commodity Exchange Act and CFTC rules and regulations. Because we cannot exercise the same level of control and oversight over a “guaranteed introducing broker” as compared to our employees, our financial responsibilities for the obligations of our “guaranteed introducing brokers” present additional risk to our company.
Accordingly, employee or introducing broker misconduct could subject us to financial losses or regulatory sanctions and seriously harm our reputation. Our controls may not be effective in detecting this type of activity.
Inadvertent employee error could subject us to financial loss, litigation, or regulatory action.
Our employees or introducing brokers may commit errors that our risk management framework and internal controls fail to deter or detect and that could subject us to financial losses, claims for negligence or regulatory actions. Employee errors, including but not limited to, mistakes in executing, recording or reporting transactions for clients, could cause us to enter transactions that clients disavow and refuse to settle. Employee
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errors expose us to the risk of material losses until the errors are detected and the transactions are unwound or reversed. The risk of employee error or miscommunication may be greater for products that are new or have non-standardized terms. Further, such errors may be more likely to occur during the integration of or migration from technological systems, whether from acquisitions or the evolution of our information technology systems.
We are subject to significant litigation risk, which could adversely affect our business.
Many aspects of our business involve risks that expose us to substantial liability under U.S. federal and state and non-U.S. laws and court decisions, as well as the rules and enforcement efforts of our regulators and self-regulatory organizations worldwide. These risks include, among others, disputes with clients and other market participants over terms of a trade, client losses resulting from system delay or failure and client claims that we or our employees executed unauthorized transactions, recommended unsuitable trades, made materially false or misleading statements, or lost or diverted client assets in our custody. We may also be subject to regulatory investigation and enforcement actions seeking to impose significant fines or other sanctions, which in turn could trigger civil litigation. Our legal liability with respect to these risks can extend to events that occurred well-before our IPO, as well as to businesses we no longer engage in, and with respect to which our management has no knowledge.
The volume of claims and the amount of damages and fines claimed in litigation and regulatory proceedings against financial intermediaries have continued to increase. The large notional values of the trades we execute, together with rapid price movements in our markets, could result in potentially large damage claims in any litigation resulting from trading activity. Clients make claims against their brokers, including us, regarding the quality of trade execution, improperly settled trades, mismanagement or even fraud, and these claims may increase as our business expands, or generally speaking, during financial market downturns. Litigation may also arise from disputes over the exercise of our rights with respect to client accounts and collateral and our efforts to recover client debits. Furthermore, if the client or broker has declared or been forced into bankruptcy, the bankruptcy trustee may pursue similar actions against us, as well as actions relating to fraudulent conveyance and other equitable bankruptcy relief. We are obligated to defend ourselves in many client disputes by means of arbitration: arbitral decisions resolving these disputes may be based on perceived equities rather than solely upon legal precedent, and accordingly, our losses in connection with arbitration awards are difficult to estimate for purposes of settlement negotiations and for the purposes of creating appropriate loss reserves.
Even if we prevail in any litigation or enforcement proceedings against us, we could incur significant legal expenses defending against the claims, even those without merit. Moreover, because even meritless claims could damage our reputation or raise concerns among our clients, we may feel compelled to settle claims at significant cost. An adverse resolution of any claims or proceedings against us could have a material adverse effect on our reputation, financial condition or operating results. In addition, we may be named as one of a number of defendants in a matter that attracts significant public attention and even if we are ultimately found not to be the main liable party and even if we have no legal liability, our reputation could be adversely affected, and as a result, our business could be adversely affected as well.
Our business may be adversely affected if our reputation is harmed.
Our business is subject to significant reputational risks. If we fail, or appear to fail, to address various issues that may affect our reputation, our business, firm and shareholders could be seriously harmed. Issues could include real or perceived legal or regulatory violations or be the result of a failure in governance, risk-management, technology or operations. Similarly, market rumors and actual or perceived association with counterparties whose own reputation is under question could seriously harm our business. Claims of employee misconduct, adverse publicity, conflict of interests, ethical issues, money laundering, privacy concerns and unfair sales and trading practices could also cause significant reputational damages. Such reputational damage could result not only in an immediate financial loss to the business, but also loss of clients, capital, liquidity and shareholder value to the firm. In recent years, a number of financial services firms have suffered significant damage to their reputations from highly publicized incidents or rumors that in turn resulted in sudden and in some cases irreparable harm to their business.
Risks Related to Our Operations and Technology
A failure in our operational systems or infrastructure, or those of third parties, could impair our liquidity, disrupt our business, result in the disclosure of confidential information, damage our reputation and cause losses.
Rapid, reliable processing of orders and information is critical to our business and our clients, since any delay or disruption could cause significant financial losses. Moreover, if our clients become concerned about the reliability of our systems, they could quickly move their business to our competitors.
Our computer and communications systems could slow down, malfunction or fail for a variety of reasons, including loss of power, vendor or network failure, acts of war or terrorism, human error, natural disasters, fire, sabotage, hardware or software malfunctions or defects, computer viruses or worms, heavy stress placed on our systems during peak trading times, intentional acts of vandalism, client error or misuse, lack of proper maintenance or monitoring and similar events. Our systems could also fail in the event of a sudden, unpredicted surge in trading volume, which could occur in times of severe market stress. Many of these risks are beyond our control.
If events of the kind described above were to occur in the future, they could cause material disruption or failure of our computer and communications systems, with any number of severe consequences, including:
| • | unanticipated disruptions to our business and operations; |
| • | unanticipated disruptions in service to our clients; |
| • | slower response times; |
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| • | delays in our or our clients’ trade execution; |
| • | failed settlement of trades; and |
| • | incomplete or inaccurate recording, reporting or processing of trades. |
Any upgrades or expansions to our systems or networks may require significant expenditures of funds and may also increase the probability that we could suffer system degradations and failures. Relocations of our data center or offices, such as our current London office relocation and the relocation of our New York data center, are logistically and technically complicated, and may increase the probability that we suffer system degradation or failure. Future system expansions, implementations, back-ups and disaster recovery plans may not be effective and may not address unanticipated or predicted changes to our business or service disruption scenarios entirely. The same may be true for our third-party service providers. If enhancements or upgrades of third-party software and systems cannot be integrated with our technologies or if the technologies on which we rely fail to respond to industry standards or technological changes, we may be required to design our own proprietary systems. Software products may contain defects or errors, especially when first introduced or when new versions or enhancements are released.
Delay, disruption or failure of our communications and computer systems may lead to financial losses, litigation, arbitration claims by our clients, or investigations and sanctions by our regulators. Our reputation could also be harmed, causing us to lose existing clients and business and making it more difficult for us to attract new clients. Further, any resulting financial losses could be magnified by price movements of contracts involved in trades that are delayed or fail due to these events, and we may be unable to take corrective action to mitigate these losses.
Our systems and those of our third-party service providers may be vulnerable to security risks, which could, among other things, result in wrongful use of our information, or make our electronic platforms unattractive to participants.
The networks we use, including our online trading platforms and those of our third-party service providers, as well as the networks of the exchanges and other market participants with whom we interact, may be vulnerable to unauthorized access, computer viruses and other security problems, including the inadvertent dissemination of non-public information. Any such problems or security breaches could result in our having liability to one or more third parties. Persons who circumvent security measures or gain access to client information could wrongfully use our or our clients’ information, or cause interruptions or malfunctions in our operations, any of which could have a material adverse effect on our business, financial condition and operating results. While we rely in part on security services and software provided by outside vendors to reduce this risk, we may nonetheless be subject to serious security breaches and other disruptions.
If an actual, threatened or perceived breach of our or our service providers’ security measures were to occur, or if we were to release confidential client information inadvertently, our reputation could be impaired and the market perception of the effectiveness of our security measures could be harmed. As a result, clients may reduce or stop their use of our services, including our online trading platforms. We or our service providers may be required to expend significant resources to protect against the threat of security breaches or to alleviate problems caused by any breaches. The security measures we rely on may prove to be inadequate and could cause incidental system failures and delays, and thus could lower trading volumes and adversely affect our reputation, business, financial condition and operating results. Further, breaches in client privacy could result in legal fines or penalties.
We rely on third-party providers and other suppliers for a number of services that are important to our business. An interruption or cessation of an important service or supply by any third party could have a material adverse effect on our business.
We depend on a number of suppliers, such as third-party electronic platforms to process trades, online service providers, hosting service and software providers, data processors, software and hardware vendors, banks, and telephone companies, for elements of our trading, clearing and other systems. The general trend toward industry consolidation may increase the risk that these services may not be available to us in the future. Moreover, we rely on access to certain data used in our business through licenses with third parties. If these companies were to discontinue providing services to us, we would likely experience significant disruption to our business.
We cannot provide assurance that any of these providers will be able to continue to provide these services in an efficient, cost-effective manner or that they will be able to adequately expand their services to meet our needs. We also cannot assure you that any of these providers will not terminate our business relationship with them for competitive reasons or otherwise. An interruption in or the cessation of an important service or supply by any third party and our inability to make alternative arrangements in a timely manner, or at all, would result in lost revenues and higher costs. In addition, even if we made alternative arrangements, these arrangements may prove to be less effective or reliable or more costly. Further, changing systems could also result in service interruptions or failures during an initial transition period, which could subject us to loss, including loss of client business, and make us less competitive over the longer term.
The software that we license from third-parties may, without our knowledge at the time of licensing, infringe upon the intellectual property rights of others. In the event that claims of such infringement are made, we may be required to expend funds to defend our rights to use the software, to pay damages, or to seek indemnification from our third party suppliers, or we may required to discontinue the use of such software and seek a replacement, and our business may be adversely affected, either because of the disruption in services or because we would face significant costs, if we cannot find and implement a suitable substitute to the infringing software.
We must regularly maintain and upgrade our computer and communications systems in response to technological change and client and regulatory demands in order to remain competitive, which is resource intensive.
The markets in which we compete are characterized by rapidly changing technology, evolving client demand and the emergence of new industry standards and practices that could render our existing technology and systems inadequate or obsolete. Our future success depends in part on our ability to respond to demand for new services, products and technologies on a timely and cost-effective basis, and to adapt to technological advancements and changing standards, so as to address the increasingly sophisticated and varied needs of our clients and prospective clients. We may not be successful in
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developing, introducing or marketing new services, products and technologies. Any new service, product or technology we develop may not be accepted by the market. Any failure on our part to anticipate or respond adequately to technological advancements, client requirements or changing industry standards, could have a material adverse effect on our business, financial condition and operating results. We must also devote resources to the regular maintenance of our systems, which, together with any necessary upgrades or expansions, could require significant expenditures of funds.
We depend on outside vendors to provide some of the principal computerized systems we use to execute and clear client trades. Our ability to modify these outside systems is limited. As a result, as our markets expand and our clients’ trading and investment needs evolve, we may need to develop further our own proprietary systems to supplement or even replace some existing systems. That process would require a very significant capital investment and could involve difficult transition periods when service may be interrupted or may fail.
If and when we decide, or are required, to upgrade or expand our systems (including our own proprietary systems), we may not have the funds necessary and the changes we make or undertake to make may not be successful or accepted by our clients. Our failure to maintain our systems as necessary or to upgrade and expand them in response to evolving client demands or emerging industry standards would have a material adverse effect on our business and results of operations.
ITEM 1B. UNRESOLVED STAFF COMMENTS
There are no material unresolved written comments that were received from the SEC staff 180 days or more before the end of our fiscal year relating to our periodic or current reports under the Securities Exchange Act of 1934, as amended.
Our principal executive offices are located at 717 Fifth Avenue, New York, New York. We lease office space throughout North America, Europe and the Asia Pacific region, including offices in New York, Chicago, Washington, Miami, Boston, Kansas City, San Francisco, Toronto, Montreal, London, Geneva, Dublin, Singapore, Shanghai, Hong Kong, Taipei, Tokyo, Dubai, Mumbai, New Delhi, Bangalore, Sydney and Brisbane. Certain leases are subject to escalation clauses and include leasehold improvements, furniture, fixtures and equipment located in our offices. We believe that our leased facilities are adequate to meet anticipated requirements for our current lines of business for the foreseeable future.
LEGAL AND REGULATORY MATTERS
Our company and our subsidiaries are currently, and in the future may be, named as defendants in or made parties to various legal actions and regulatory proceedings (“legal and regulatory matters” or “these matters”). Some of these matters that are currently pending are described below under “Description of Particular Matters”. Claims for significant monetary damages are often asserted in many of these matters involving legal actions, although a number of these actions seek an unspecified or indeterminate amount of damages, including punitive damages, while claims for disgorgement, penalties and other remedial sanctions may be sought by governmental or other authorities in regulatory proceedings. It is inherently difficult to predict the eventual outcomes of these matters given their complexity and the particular facts and circumstances at issue in each of them.
In view of the inherent unpredictability of outcomes in legal and regulatory matters, particularly where (1) the damages sought are unspecified or indeterminate, (2) the proceedings are in the early stages or (3) the matters involve unsettled questions of law, multiple parties or complex facts and circumstances, there is considerable uncertainty surrounding the timing or ultimate resolution of these matters, including a possible eventual loss, fine, penalty or business impact associated with each matter. In accordance with applicable accounting guidance, we accrue amounts for legal and regulatory matters where we believe they present loss contingencies that are both probable and reasonably estimable. In such cases, however, we may be exposed to losses in excess of any amounts accrued and may need to adjust the accruals from time to time to reflect developments that could affect our estimate of potential losses. Moreover, in accordance with applicable accounting guidance, if we do not believe that the potential loss from a particular matter is both probable and reasonably estimable, we do not make an accrual and will monitor the matter for any developments that would make the loss contingency both probable and reasonably estimable. The actual results of resolving these matters may involve losses that are substantially higher than amounts accrued (and insurance coverage, if any).
Although we have made accruals for only some of the legal and regulatory matters, we believe that loss contingencies may, in the future, be reasonably possible for a number of these matters, including both matters for which no accruals have been made and matters for which they have. Under applicable accounting guidance, an event is “reasonably possible” if the chance of the event occurring is more than “remote” or “slight.” For matters as to which we believe a loss is reasonably possible and estimable, we currently estimate that the range of reasonably possible losses, in excess of amounts accrued, could be up to approximately $150.0 million in the aggregate. This estimated range, however, is subject to the following considerations. For one of these matters, although we believe that losses are reasonably possible, we are currently unable to make a reasonable estimate of such losses. We discuss this matter below under “Description of Particular Matters—In re: Platinum and Palladium Commodities Litigation.”
The estimated range also does not include the BMO matter, which is discussed below under “Description of Particular Matters—Bank of Montreal (“BMO”)”. While we currently believe that losses are reasonably possible for the BMO matter, we believe it is difficult to make any estimate of the potential losses at this stage of the proceedings, other than to refer to a range up to the amount of the claims made against us in that matter. Those claims, for which we have not made any accruals, are described in the next section under the heading relating to the BMO matter.
For the matters that are covered by the estimated range, the range reflects the following amounts. For some of the covered matters, where we believe we are able to do so, we have
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estimated the losses based on our current assessment of the particular facts and circumstances and legal issues relating to the matters as known and understood by us. For each of the remaining covered matters, however, the estimated range simply reflects the amount of compensatory damages claimed against us in the matter or, where such damages are not specified or we believe it is otherwise appropriate, our estimate of the value of the contract, account or transaction that is the subject of the matter. Although some of the covered matters include claims for punitive or statutory (e.g., treble) damages, the estimated range does not reflect any potential losses from claims of this kind because at this point we believe amounts are too remote or unpredictable. In addition, a number of covered matters involve claims or counterclaims relating to debit balances in customer accounts, in which we have asserted or intend to assert offsetting claims to recover the debits, and for matters of this kind the estimated range reflects only the net amount of the claims against us. Also, the estimated range does not reflect any potential losses from the matters described below in the Description of Particular Matters under the headings “Unauthorized Trading Incident of February 26/27 2008—Class Action Suits” (as to which the parties have agreed to a preliminary settlement, although the settlement remains subject to court approval and other conditions, and cannot be assured) and “Agape World” (which, as it relates to us, was dismissed by the lower court but remains subject to possible future appeal).
Finally, the estimated range reflects losses only in excess of amounts currently accrued for the covered matters, does not give effect to any potential insurance coverage, which might reduce the amounts owed in some contingencies, and does not reflect any legal fees or other expenses incurred in defending or investigating any matters (which at times have been and in the future could be substantial) or that may be demanded by a counterparty.
The losses reflected in the estimated range could occur over a period of several years or longer. The estimated range is based on currently available information, is subject to modification in light of future developments and changes in our management’s assessments and may not reflect the actual outcome of any matters. For all the reasons described above, the estimated range does not represent our maximum loss exposure from legal and regulatory matters.
Description of Particular Matters
Unauthorized Trading Incident of February 26/27, 2008
One of the brokers of our U.S. operating subsidiary MF Global Inc. (MFGI), Evan Dooley, trading for his own account out of a Memphis, Tennessee branch office through one of MFGI’s front end order entry systems, Order Express, put on a significant wheat futures position during the late evening of February 26, 2008 and early morning of February 27, 2008. The positions were liquidated at a loss of $141.0 million on February 27, 2008. The trades were unauthorized and because the broker had no apparent means of paying for the trades, MFGI, as a clearing member of the exchange, was required to pay the $141.0 million shortfall (the “Dooley Trading Incident”). As a result of the Dooley Trading Incident:
| • | Class Action Suits. We, Man Group, certain of its current and former officers and directors, and certain underwriters for the IPO have been named as defendants in five actions filed in the United States District Court for the Southern District of New York. These actions, which purport to be brought as class actions on behalf of purchasers of MF Global stock between the date of the IPO and February 28, 2008, seek to hold defendants liable under §§ 11, 12 and 15 of the Securities Act of 1933 for alleged misrepresentations and omissions related to our risk management and monitoring practices and procedures. The five purported shareholder class actions have been consolidated for all purposes into a single action. We made a motion to dismiss which had been granted, with plaintiff having a right to replead and/or appeal the dismissal. Plaintiffs made a motion to replead by filing an amended complaint, which was denied. Plaintiffs appealed. The Second Circuit Court of Appeals vacated the decision and remanded the case for further consideration. The parties engaged in mediation and have agreed to a preliminary settlement, which is subject to various customary conditions, including confirmatory discovery, preliminary approval by the United States District Court for the Southern District of New York, notice to class members, class member opt-out thresholds, a final hearing, and final approval by the District Court. The settlement provides for a total payment of $90.0 million to plaintiffs. Of this total payment, $2.5 million relates to us and has been accrued. |
| • | Insurance Claim. MFGI filed a claim for payment of its $141.0 million loss plus statutory interest under its Fidelity Bond Insurance (the “Bond”), which provides coverage for wrongful or fraudulent acts of employees, seeking indemnification for the loss on the Dooley trading incident. After months of investigation, MFGI’s Bond insurers denied payment of this claim based on certain definitions and exclusions to coverage in the Bond. They also initiated an action against MFGI in the Supreme Court of the State of New York, New York County, seeking a declaration that there is no coverage for this loss under the Bond. MFGI believes the insurers’ position to be in error and filed a counterclaim in order to seek to enforce its right to payment in court. The Bond insurers sought partial summary judgment, which the Court denied. The Bond insurers have filed a Notice of Appeal to the Appellate Division, First Department and also filed a motion to Renew or Reargue with the Supreme Court, challenging the portion of the decision that found that Dooley was an employee of ours. Insurers’ motion to Renew or Reargue has been denied and they have filed a Notice of Appeal on that issue as well. |
Bank of Montreal (“BMO”)
On August 28, 2009, BMO instituted suit against MFGI and its former broker, Joseph Saab (as well as a firm named Optionable, Inc. (“Optionable”) and five of its principals or employees), in the United States District Court for the Southern District of New York. In its complaint, BMO asserts various claims based upon on allegations that Optionable and MFGI provided BMO with price indications on natural gas option contracts that BMO allegedly believed were independent but the indications had been provided by BMO’s trader, David Lee, and were passed on to BMO, thereby enabling Lee substantially to overvalue BMO’s natural gas options book. BMO further alleges that MFGI and Saab aided and abetted Lee’s fraud and breach of his fiduciary duties by sending price indications to BMO. There are additional separate claims against other defendants. The Complaint seeks to hold all defendants jointly and severally liable. Although the Complaint does not specify an exact damage claim, BMO claims that the cash loss resulting from Lee’s fraudulent trading activity, which allegedly could have been prevented had BMO received “correct pricing information”, is in excess of $500.0 million. In
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addition, BMO claims that it would not have paid brokerage commissions to MFGI (and Optionable), would not have continued Lee and his supervisor as employees at substantial salaries and bonuses, and would not have incurred substantial legal costs and expenses to deal with the overvaluation of its natural gas options book but for defendants’ alleged conduct. All defendants, including MFGI, made a motion to dismiss the complaint, which was denied by the court.
Amacker v. Renaissance Asset Management Fund et. al.
In December 2007, MFGI, along with four other futures commission merchants (“FCMs”), was named as a defendant in an action filed in the United States District Court in Corpus Christi, Texas by 47 individuals who were investors in a commodity pool (RAM I LLC) operated by Renaissance Asset Management LLC. The complaint alleges that MFGI and the other defendants violated the Commodity Exchange Act and alleges claims of negligence, common law fraud, violation of a Texas statute relating to securities fraud and breach of fiduciary duty for allegedly failing to conduct due diligence on the commodity pool operator and commodity trading advisor, having accepted executed trades directed by the commodity trading advisor, which was engaged in a fraudulent scheme with respect to the commodity pool, and having permitted the improper allocation of trades among accounts. The plaintiffs claim damages of $32.0 million, plus exemplary damages, from all defendants. All of the FCM defendants moved to dismiss the complaint for failure to state a claim upon which relief may be granted. Following an initial pre-trial conference, the court granted plaintiffs leave to file an amended complaint. On May 9, 2008, plaintiffs filed an amended complaint in which plaintiffs abandoned all claims except a claim alleging that the FCM defendants aided and abetted violations of the Commodity Exchange Act. Plaintiffs now seek $17.0 million in claimed damages plus exemplary damages from all defendants. MFGI filed a motion to dismiss the amended complaint, which was granted by the court and appealed by the plaintiffs.
Voiran Trading Limited
On December 29, 2008, we received a letter before action from solicitors on behalf of Voiran Trading Limited (“Voiran”) which has now brought an LME arbitration proceeding. Claimant alleges that our U.K. affiliate was grossly negligent in advice it gave to Voiran between April 2005 and April 2006 in relation to certain copper futures contracts and claims $37.6 million in damages. This arbitration is scheduled for 2012.
Sentinel Bankruptcy
The Liquidation Trustee (“Trustee”) for Sentinel Management Group, Inc. (“Sentinel”) sued MFGI in June 2009 on the theory that MFGI’s withdrawal of $50.2 million within 90 days of the filing of Sentinel’s bankruptcy petition on August 17, 2007 is a voidable preference under Section 547 of the Bankruptcy Code and, therefore, recoverable by the Trustee, along with interest and costs. MFGI believes there are meritorious defenses available to it and it intends to resist the Trustee’s attempt to recover those funds from MFGI. In addition, to the extent the Trustee recovered any funds from MFGI it would be able to assert an offsetting claim in that amount against the assets available in Sentinel’s bankruptcy case.
Agape World
In May 2009, investors in a venture set up by Nicholas Cosmo sued Bank of America and MFGI, among others, in the United States District Court for the Eastern District of New York, in two separate class actions and one case brought by certain individuals, alleging that MFGI, among others, aided and abetted Cosmo and related entities in a Ponzi scheme in which investors lost $400.0 million. MFGI made motions to dismiss all of these cases, which were granted with prejudice. The time when plaintiffs are able to appeal the dismissal will not begin to run until the action against the remaining defendants is decided.
Phidippides Capital Management/Mark Trimble
In the late spring of 2009, MFGI was sued in Oklahoma State Court by customers who were substantial investors with Mark Trimble and/or Phidippides Capital Management. Plaintiffs allege that Trimble and Phidippides engaged in a Ponzi scheme and that MFGI “materially aided and abetted” Trimble’s and Phidippides’ violations of the anti-fraud provisions of the Oklahoma securities laws. They are seeking damages in the amount of $20.0 million. MFGI made a motion to dismiss which was granted by the court. Plaintiffs have appealed. The Court of Civil Appeals for the State of Oklahoma upheld MFGI’s dismissal. Plaintiffs have filed a petition for certiorari with the Supreme Court of Oklahoma.
Man Group Receivable
In late April 2009, we formally requested payment of certain amounts that Man Group (our largest shareholder at the time and former parent company) owed to us. Man Group demanded arbitration and, as a result of this unresolved claim, we recorded a receivable for the amount owed in equity. In June and July 2010, this matter was heard by the LCIA which in September 2010 issued an award in favor of us. Man Group paid us $32.6 million, which was comprised of the full amount owed plus an agreed upon amount for costs and interest. Of the amounts paid, $29.8 million has been recorded against Equity on the consolidated balance sheet, plus an additional payment of $2.8 million for legal costs and interest, which has been recorded within Other revenues in the consolidated statement of operations.
Morgan Fuel/Bottini Brothers
MFGI and MF Global Market Services LLC (“Market Services”) were involved in litigation with the principals (the “Bottinis”) of a former customer of Market Services, Morgan Fuel & Heating Co., Inc. (“Morgan Fuel”). The litigation arose out of trading losses incurred by Morgan Fuel in over-the-counter derivative swap transactions, which were unconditionally guaranteed by the Bottini principals. Market Services commenced an arbitration against the Bottinis before the Financial Industry Regulatory Authority (“FINRA”) to recover $8.3 million, which was the amount of the debt owed to Market Services by Morgan Fuel after the liquidation of the swap transactions. Market Services asserted a claim of breach of contract based upon the Bottinis’ failure to honor the personal and unconditional guarantees they had issued for the obligations of Morgan Fuel.
Morgan Fuel commenced a separate arbitration proceeding before FINRA against MFGI and Market Services seeking $14.2 million in trading losses. Morgan Fuel sought recovery of $5.9 million in margin payments that it allegedly made to Market Services and a declaration that it had no responsibility to pay Market Services for the remaining $8.3 million in trading losses. MFGI obtained an injunction in the New York courts to permanently stay this arbitration on the ground that there was
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no agreement to arbitrate. The parties resolved all claims they may have against each other through a cash payment to MFGI and a write off of part of the debit, which has been reflected in the litigation charge taken for the fourth quarter of fiscal 2011.
In re: Platinum and Palladium Commodities Litigation
On August 4, 2010, MFGI was added as a defendant to a consolidated class action complaint filed against Moore Capital Management and related entities in the United States District Court for the Southern District of New York which alleged claims of manipulation and aiding and abetting manipulation in violation of the Commodities Exchange Act. Specifically, the complaint alleged that, between October 25, 2007 and June 6, 2008, Moore Capital directed MFGI, as its executing broker, to enter “large” market on close orders (at or near the time of the close) for platinum and palladium futures contracts, which allegedly caused artificially inflated prices. On August 10, 2010, MFGI was added as a defendant to a related class action complaint filed against the Moore-related entities on behalf of a class of plaintiffs who traded the physical platinum and palladium commodities in the relevant time frame, which alleges price fixing under the Sherman Act and violations of the civil Racketeer Influenced and Corrupt Organizations Act. On September 30, 2010 plaintiffs filed an amended consolidated class action complaint that includes all of the allegations and claims identified above on behalf of subclasses of traders of futures contracts of platinum and palladium and physical platinum and palladium. A motion to dismiss was heard on February 4, 2011. Plaintiffs’ claimed damages have not been quantified.
Marion Hecht as Receiver for Joseph Forte, L.P.
On December 21, 2010, Marion Hecht, as Receiver for Joseph Forte, L.P. (the “Partnership”), filed a complaint against MFGI in the United States District Court for the Eastern District of Pennsylvania that alleges one claim of negligence. Specifically, the complaint alleges that the Partnership had a trading account with MFGI and that MFGI violated its duties imposed by state law and under the Commodity Exchange Act by failing to recognize that the Partnership was not properly registered with the CFTC or the National Futures Association, or take reasonable action in response to a false claimed exemption, failing to require the Partnership to provide financial reports or other financial records, failing to make sufficient inquiries or take action regarding the registration when discrepancies in Partnership documents existed, failing to reasonably recognize or to take action upon the unusual activity in the Partnership account, and that MFGI’s conduct enabled the Partnership to operate a Ponzi scheme and cause damage to the investors. The Receiver claims MFGI caused losses in excess of $10.0 million.
In re: Agape World Inc. Bankruptcy
On January 28, 2011, Kenneth Silverman as Chapter 7 Trustee of Agape World, Inc. (a substantively consolidated bankruptcy estate of various Agape entities, collectively, “Agape”) filed a complaint against MFGI in the United States Bankruptcy Court, Eastern District of New York seeking to recover the transfers made by Agape to MFGI totaling $27.1 million plus any fees earned in connection with the trades. Specifically, the Trustee alleges that the transfers and the fees received by MFGI are recoverable as fraudulent conveyances because MFGL allegedly received these funds not in good faith. The basis for the alleged bad faith is that MFGI failed to conduct sufficient diligence when opening the account, failed to respond to red flags about how account principal Nicholas Cosmo was using Agape’s funds and failed to provide proper oversight and monitoring which, if conducted, would have caused termination of the accounts and trading, and prevented losses to the investors.
German Introducing-Broker Litigation
In recent years, two of our subsidiaries have been named as defendants in numerous lawsuits filed in German federal courts by plaintiffs who had accounts introduced by German introducing brokers. Plaintiffs allege that the introducing brokers had contractual relationships with the two subsidiaries, and executed equity options and other derivatives transactions for them through the subsidiaries, and that the subsidiaries should be liable for certain alleged tortious acts of both the introducing brokers and the subsidiaries. Plaintiffs seek to recover investment losses, statutory interest, attorney’s fees and costs. The Company has not conducted retail business through German introducing firms since 2006. None of the damages claimed by any individual claimant is material and to date many of the claims have been settled or adjudicated with minimal impact on us, however, the number of these lawsuits has increased in the past year. In addition, in 2010, the German Supreme Court ruled in favor of plaintiffs in a similar case against another firm and since that time the trend in cases involving our subsidiaries has increasingly been to find foreign clearing brokers liable for the alleged tortious conduct of local introducing brokers.
Other Matters
In addition to the matters described above, our company and our subsidiaries currently are, and in the future may be, named as defendants or otherwise made parties to various legal actions and regulatory matters that arise in the ordinary course of our business. Aside from the matters described above under “Description of Particular Matters” and those reflected in the estimated range of reasonably possible losses, we do not believe, on the basis of management’s current knowledge and assessments, that we are party to any pending or threatened legal or regulatory matters that, either individually or in the aggregate, after giving effect to applicable accruals and any insurance coverage, will have a material adverse effect on our consolidated financial condition, operating results or cash flows.
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PART II
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
PART II
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
The principal market on which shares of our common stock are traded is the NYSE. As of May 18, 2011, there were approximately 22 holders of record, which does not reflect those shares of common stock held beneficially or those shares held in a “street” name. Accordingly, the number of beneficial owners of our common stock exceeds this number. On May 18, 2011, the last reported sales price for our common stock on the NYSE was $7.96 per share.
Common Stock Price Range
The following table sets forth, for the fiscal quarters indicated, the high and low sales prices per share of our common stock as reported by the Consolidated Tape Association.
| 2011 | 2010 | |||||||||||||||||||
| High | Low | High | Low | |||||||||||||||||
| First quarter |
$ | 9.94 | $ | 5.69 | $ | 6.68 | $ | 4.13 | ||||||||||||
| Second quarter |
7.74 | 5.38 | 7.84 | 4.88 | ||||||||||||||||
| Third quarter |
8.64 | 7.10 | 8.22 | 5.88 | ||||||||||||||||
| Fourth quarter |
9.28 | 7.75 | 8.93 | 6.10 | ||||||||||||||||
See table in Item 12, “Equity Compensation Plan Information,” for information relating to compensation plans under which our equity securities are authorized for issuance.
Dividends
We currently do not intend to pay any cash dividends on our common stock in the foreseeable future. We intend to retain all our future earnings, if any, to fund the development and growth of our business. Any future determination whether or not to pay dividends on our common stock will be made, subject to applicable law, by our board of directors and will depend upon our results of operations, financial condition, capital requirements, regulatory and contractual restrictions, our business and investment strategy and other factors that our board of directors deem relevant.
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ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Cumulative Total Return
The following chart shows a comparison of cumulative total return for our shares of common stock, the NYSE Composite Market Index, the Morningstar Capital Markets Index and the Hemscott National Investment Brokerage Index. The Morningstar Capital Markets Index has been added from previously disclosed graphs because the Hemscott Investment Brokerage Index will be discontinued during the next year. The total stockholder return assumes $100 invested on July 20, 2007 and assumes all dividends are reinvested.
COMPARISON OF CUMULATIVE TOTAL RETURN
| MF Global 2011 Form 10-K | 35 |
Table of Contents
PART II
ITEM 6. SELECTED FINANCIAL DATA
ITEM 6. SELECTED FINANCIAL DATA
The following tables present certain selected financial data for our business. These tables should be read in conjunction with our financial statements and related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this Annual Report on Form 10-K.
| YEAR ENDED MARCH 31, | ||||||||||||||||||||
| (Dollars in millions, except per share and share amounts) |
2011 | 2010 | 2009 | 2008 | 2007 (1) | |||||||||||||||
| Statement of Operations |
||||||||||||||||||||
| Revenues |
||||||||||||||||||||
| Commissions |
$ | 1,433.9 | $ | 1,386.0 | $ | 1,642.4 | $ | 2,014.8 | $ | 1,666.5 | ||||||||||
| Principal transactions |
243.2 | 151.0 | 280.1 | 283.7 | 313.6 | |||||||||||||||
| Interest income |
516.5 | 415.3 | 816.6 | 3,440.0 | 4,010.1 | |||||||||||||||
| Other |
39.9 | 42.4 | 112.4 | 54.1 | 37.8 | |||||||||||||||
| Total revenues |
2,233.6 | 1,994.7 | 2,851.6 | 5,792.6 | 6,028.0 | |||||||||||||||
| Interest and transaction-based expenses: |
||||||||||||||||||||
| Interest expense |
229.7 | 137.3 | 431.9 | 2,937.9 | 3,673.0 | |||||||||||||||
| Execution and clearing fees |
681.1 | 601.8 | 741.0 | 927.4 | 700.4 | |||||||||||||||
| Sales commissions |
253.7 | 240.6 | 252.0 | 291.0 | 275.9 | |||||||||||||||
| Total interest and transaction-based expenses |
1,164.5 | 979.7 | 1,424.9 | 4,156.3 | 4,649.3 | |||||||||||||||
| Revenues, net of interest and transaction-based |
1,069.1 | 1,015.0 | 1,426.7 | 1,636.3 | 1,378.7 | |||||||||||||||
| Expenses |
||||||||||||||||||||
| Employee compensation and benefits (excluding non-recurring IPO awards) |
620.7 | 668.4 | 787.6 | 889.5 | 833.9 | |||||||||||||||
| Employee compensation related to non-recurring |
12.4 | 31.8 | 44.8 | 59.1 | — | |||||||||||||||
| Communications and technology |
134.4 | 118.6 | 122.6 | 118.7 | 102.2 | |||||||||||||||
| Occupancy and equipment costs |
51.2 | 39.4 | 44.8 | 35.6 | 29.8 | |||||||||||||||
| Depreciation and amortization |
44.4 | 55.1 | 57.8 | 54.8 | 46.8 | |||||||||||||||
| Professional fees |
75.2 | 85.6 | 97.9 | 80.7 | 50.3 | |||||||||||||||
| General and other |
117.2 | 115.7 | 102.5 | 112.2 | 97.4 | |||||||||||||||
| PAAF legal settlement |
— | — | — | 76.8 | — | |||||||||||||||
| Broker related loss |
— | — | — | 141.0 | — | |||||||||||||||
| IPO-related costs |
— | 0.9 | 23.1 | 56.1 | 33.5 | |||||||||||||||
| Restructuring charges |
25.5 | — | — | — | — | |||||||||||||||
| Impairment of intangible assets and goodwill |
19.8 | 54.0 | 82.0 | — | — | |||||||||||||||
| Total other expenses |
1,101.0 | 1,169.5 | 1,363.1 | 1,624.6 | 1,193.9 | |||||||||||||||
| Gains on exchange seats and shares |
2.7 | 8.5 | 15.1 | 79.5 | 126.7 | |||||||||||||||
| Net gain on settlement of legal proceeding |
— | — | — | — | 21.9 | |||||||||||||||
| Loss on extinguishment of debt |
4.1 | 9.7 | — | 18.3 | — | |||||||||||||||
| Interest on borrowings |
42.9 | 39.7 | 68.6 | 69.3 | 43.8 | |||||||||||||||
| (Loss)/ income before provision for income taxes |
(76.3 | ) | (195.4 | ) | 9.9 | 3.6 | 289.7 | |||||||||||||
| Provision/ (benefit) for income taxes |
5.2 | (56.3 | ) | 41.9 | 66.6 | 100.0 | ||||||||||||||
| Equity in income/ (loss) of unconsolidated companies |
2.7 | 3.8 | (16.2 | ) | (1.7 | ) | 0.1 | |||||||||||||
| Net (loss)/ income |
(78.8 | ) | (135.3 | ) | (48.1 | ) | (64.7 | ) | 189.7 | |||||||||||
| Net income attributable to noncontrolling interest |
2.4 | 1.7 | 1.0 | 4.9 | 1.7 | |||||||||||||||
| Net (loss)/ income attributable to MF Global Holdings Ltd. |
$ | (81.2 | ) | $ | (137.0 | ) | $ | (49.1 | ) | $ | (69.5 | ) | $ | 188.0 | ||||||
| 36 | MF Global 2011 Form 10-K |
Table of Contents
PART II
ITEM 6. SELECTED FINANCIAL DATA
| YEAR ENDED MARCH 31, | ||||||||||||||||||||
| (Dollars in millions, except per share and share amounts) |
2011 | 2010 | 2009 | 2008 | 2007 (1) | |||||||||||||||
| Weighted average number of basic shares outstanding (2) |
154,405,951 | 123,222,780 | 121,183,447 | 115,027,797 | 103,726,453 | |||||||||||||||
| Weighted average number of diluted shares outstanding (2) |
154,405,951 | 123,222,780 | 121,183,447 | 115,027,797 | 103,726,453 | |||||||||||||||
| Basic (loss)/earnings per share (3) |
$ | (1.00 | ) | $ | (1.36 | ) | $ | (0.58 | ) | $ | (0.60 | ) | $ | 1.81 | ||||||
| Diluted (loss)/earnings per share (3) |
$ | (1.00 | ) | $ | (1.36 | ) | $ | (0.58 | ) | $ | (0.60 | ) | $ | 1.81 | ||||||
| Dividends declared per share (4) |
$ | — | $ | — | $ | — | $ | 0.01 | $ | 0.03 | ||||||||||
| Balance Sheet Data |
||||||||||||||||||||
| Total assets |
$ | 40,541.6 | $ | 50,966.1 | $ | 38,835.6 | $ | 49,254.9 | $ | 51,670.3 | ||||||||||
| Long-term borrowings |
414.1 | 499.4 | 938.0 | — | 594.6 | |||||||||||||||
| (1) | Prior to July 1, 2007 our financial statements were prepared on a combined basis in conformity with U.S. GAAP as if we had existed on a stand-alone basis. The combined financial statements were carved out from Man Group and include our accounts and our majority and wholly owned subsidiaries, in each case using the historical basis of accounting for the results of operations and assets and liabilities of the respective businesses. |
| (2) | The weighted average number of shares of common stock outstanding for periods prior to the reorganization and separation is calculated using the number of shares of common stock outstanding immediately following the reorganization and separation. |
| (3) | Net earnings per share for fiscal 2007 is calculated by dividing historical net income by the weighted average number of shares of common stock outstanding (basic and diluted) during fiscal 2007. |
| (4) | These dividends were paid to Man Group when we were wholly owned by Man Group and are not indicative of future dividends. We currently do not expect to pay any cash dividends on our common shares in the foreseeable future. Dividends declared per share is calculated by dividing dividends paid to Man Group by the number of shares of common stock outstanding (basic) during fiscal 2008 and fiscal 2007. |
| MF Global 2011 Form 10-K | 37 |
Table of Contents
PART II
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to help you understand MF Global Holdings Ltd. and its consolidated subsidiaries (the “Company”, “we”, “us” or “our”). Our MD&A should be read in conjunction with our consolidated financial statements and the accompanying notes, included elsewhere in this Annual Report on Form 10-K.
Business Overview
We are one of the world’s leading brokers in markets for commodities and listed derivatives. We provide access to more than 70 exchanges globally and are a leader by volume on many of the world’s largest derivatives exchanges. We are also an active broker-dealer in markets for commodities, fixed income securities, equities, and foreign exchange. We are one of 20 primary dealers authorized to trade U.S. government securities with the Federal Reserve Bank of New York. In addition to executing client transactions, we provide research and market commentary to help clients make trading decisions as well as clearing and settlement services. We are also active in providing client financing and securities lending services.
We are headquartered in the United States, and have operations globally, including in the United Kingdom, Australia, Singapore, India, Canada, Hong Kong and Japan, as well as other countries. Our diversified global client base includes a wide range of institutional asset managers and hedge funds, professional traders, corporations, sovereign entities, and financial institutions. We also offer a range of services for individual traders and introducing brokers.
We have organized our business on a global basis to offer clients an extensive array of products across a broad range of markets and geographies. We seek to tailor our offerings from market to market to meet the demands of our clients by providing the most compelling products and services possible, while remaining within the regulations of a particular jurisdiction. We execute transactions for a large and diverse group of institutional and retail clients, including broker-dealers and other financial institutions, corporations, hedge funds and other assets managers, government entities and sovereign institutions, and professional traders, and we also provide a number of prime services, including clearing, settlement and portfolio reporting and record-keeping services. We provide our execution services for five broad categories of products, consisting of commodities, equities, fixed income, foreign exchange, and listed futures and options. We also provide financing and securities lending services and other prime services to select clients, including a number of other broker-dealers. We operate and manage our business as a single operating segment. We do not manage our business by services or product lines, market types, geographic regions, client segments or any other exclusive category. As management continues to implement its strategy to reorganize our business model into the four lines of business discussed below, we may change our reporting and disclosures in the future to reflect the segmentation of our business.
As discussed below under “—Significant Business Developments—Our Strategic Plan,” over the past year, we have begun the process of transforming our company into a commodities and capital markets—focused investment bank. As part of this change, we anticipate that principal transaction revenue both from revenue generated as part of our developing market making and client facilitation business, as well as revenue generated from proprietary activities will increase, both in absolute size as well as a percentage of our total revenue. Also, our qualitative and quantitative disclosures about market risk, and in our risk factors, our strategic plan and, in particular, the increasing amount of the principal transaction activities we engage in—both as to market making and client facilitation as well as proprietary activities will change the level of market risk to which we are exposed. See “Item 1A. Risk Factors,” “—Liquidity and Capital Resources,” and “Item 7A. Qualitative and Quantitative Disclosures about Market Risk—Market Risk” elsewhere in this Annual Report.
We derive revenues from three main sources: (i) commissions generated from execution and clearing services; (ii) principal transactions revenue, generated both from client facilitation and proprietary activities, and (iii) net interest income from cash balances in client accounts maintained to meet margin requirements as well as interest related to our collateralized financing arrangements and principal transactions activities.
Consistent with trading activity on major exchanges, the total volume of exchange-traded futures and options we executed and/or cleared increased 12.8% to 1,891.4 million contracts in fiscal 2011 from 1,676.5 million contracts in fiscal 2010. This is as a result of improved global market conditions as compared to fiscal 2010, and increased client activity driven by the volatility in the currency markets and uncertainty in European and Japanese markets. For a discussion of the manner in which we calculate our volumes, see “—Factors Affecting our Results—Trading Volumes and Volatility”.
Significant Business Developments
OUR STRATEGIC PLAN
In fiscal 2011, senior management introduced and began implementing a new strategic direction for our company. Under our new strategic plan, we intend to transform our business from a broker to a commodities and capital markets focused investment bank during the next three to five years.
We have assessed the opportunities in the marketplace and are reshaping our company to take advantage of several trends in the market for financial services. For example, the financial services industry continues to consolidate and the largest global investment banks and brokerage firms have increased their scale of operations, while at the same time new and proposed regulations and other trends have forced global banks to de-leverage and reduce risks on their balance sheets. We believe that one result of these developments is that large investment banks have focused their attention, energy and capital on their largest clients, creating opportunities for us to service smaller and mid-sized clients that are currently overlooked by larger firms.
Our strategic plan is designed to leverage our company’s strengths, including our heritage and expertise in commodities trading and our broad global footprint. Our plan includes reorganizing our business into the following four categories in the short to medium term:
| 38 | MF Global 2011 Form 10-K |
Table of Contents
PART II
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Capital Markets
We provide institutional clients with access to, liquidity in, and insight into commodities, equities, fixed income and foreign exchange, as well as futures and options markets. We will build on our strong position in the brokerage business by deepening our involvement in certain markets, by extending our involvement as a principal to facilitate more of our client’s transactions and widening our range of services. Although we have frequently taken a principal position to facilitate clients complete trades and, in the past year, have begun to trade for our own account, we intend to expand our role in market making and principal trading, and to use our capital to trade on a proprietary basis. This year we established a principal strategies group and expanded our principal trading activities. Over the longer term, we intend to complement this expanded role in principal trading by participating in other elements of traditional investment banking, including underwriting new issues of securities, structuring trades and providing advisory services to issuers, with a continuing focus on the commodities and natural resources markets.
Retail Services
We have developed a substantial retail business, built through the acquisition and development of retail businesses in various markets, and which offer assorted products under several brand names. We have now initiated the process of transforming these of activities into a consolidated, centrally managed, global business operating under a unified global brand. We will continue to focus on high net worth individuals, self-directed traders, individual traders seeking broker assistance and introducing brokers. We plan to develop an integrated platform on which clients can pursue their trading and investing objectives in a broad range of markets, instruments and currencies through an efficient, single point of access. We believe that delivering a unified global platform, broad product offerings and worldwide market connectivity will differentiate us from our competitors in the retail space.
Prime Services
We intend to undertake a substantial realignment of our clearing and financing activities to further diversify the company’s revenue streams. In this area, we intend to consolidate our management focus to take advantage of our scalable infrastructure to deliver solutions to clients. We believe that clearing services are increasingly attractive to a substantial number of clients underserved by large global banks and firms that would prefer to outsource these activities rather than make the extensive capital investments required to self-clear. As financial services regulatory reform places increased emphasis on centralized clearing, we believe that we have the capabilities to meet expanding demand for global clearing expertise. Furthermore, we believe that we are well positioned to grow our clearing services activities, given our global footprint on more than 70 exchanges around the world and our extensive experience providing clearing solutions to clients in a variety of asset classes.
Asset Management
In the future, we intend to diversify our revenue base and generate fee income by providing clients with access to managed products through an asset management business. We will examine strategic opportunities to develop an asset management capability that leverages our core competencies in commodities trading. There has been growing investor interest in alternative investment vehicles, and we believe this area represents an important opportunity for us. Over time, we intend to leverage our skills and our brand to build a family of alternative investment vehicles.
For additional discussion regarding risks related to the execution and development of our strategy see “Item 1A. Risk Factors.”
REPURCHASE OF 9% CONVERTIBLE NOTES
In March 2011, we repurchased $7.9 million in aggregate principal amount of our outstanding 9.00% Convertible Senior Notes due 2038 (the “9% Convertible Notes”) in the open market. We paid cash in the amount of $9.6 million and recorded a loss on the early extinguishment of debt of $1.4 million, which includes the accelerated amortization of debt issuance costs of approximately $0.5 million. After the repurchase, $187.8 million in aggregate principal amount of 9% Convertible Notes remain outstanding. See Note 10 to our consolidated financial statements for further details.
ISSUANCE OF 1.875% CONVERTIBLE NOTES
On February 11, 2011, we completed an offering of $287.5 million aggregate principal amount of our 1.875% Convertible Senior Notes due 2016 (the “1.875% Convertible Notes”). In connection with the issuance of the 1.875% Convertible Notes we entered into privately negotiated convertible bond hedge and warrant transactions with the intention of minimizing the potential dilutive impact of any future conversions of the 1.875% Convertible Notes. We used approximately $27.5 million of the net proceeds from the offering of the 1.875% Convertible Notes to pay the cost of the convertible bond hedge transactions after such cost was partially offset by the aggregate proceeds of approximately $36.5 million from the warrant transactions, which were recorded in Equity on the consolidated balance sheet. In addition, we used $150.5 million of the remaining net proceeds to repay outstanding indebtedness under the liquidity facility (as referenced below). See Note 10 to our consolidated financial statements for further details.
OFFER TO EXCHANGE
On July 15, 2010, we completed our offer to exchange any and all of our outstanding 9% Convertible Notes and 9.75% Non-Cumulative Convertible Preferred Stock, Series B (the “Series B Preferred Stock”) for shares of our common stock, par value $1.00 per share (“Common Stock”), and a cash premium (which we refer to as the “Exchange Offer”). As of the expiration of the Exchange Offer, 1.1 million shares of Series B Preferred Stock ($109.6 million in aggregate liquidation preference) were validly tendered and we issued 10.5 million shares of Common Stock, paid a cash premium of $48.8 million and paid accrued dividends of $1.8 million. The cash premium is presented as a deemed dividend in the consolidated statement of operations to calculate Net loss applicable to common shareholders. In addition, $9.3 million in aggregate principal amount of the 9% Convertible Notes were validly tendered and we issued 0.9 million shares of Common Stock, paid a cash premium of $4.5 million and paid accrued interest of $0.1 million. We recorded a loss on extinguishment of debt of $2.7 million as a result of exchanging our 9% Convertible Notes for cash and Common Stock. See Notes 10 and 12 to our consolidated financial statements for further details.
| MF Global 2011 Form 10-K | 39 |
Table of Contents
PART II
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
LIQUIDITY FACILITY
At March 31, 2010, we had a $1,500.0 million five-year unsecured committed revolving credit facility (the “liquidity facility”) with a syndicate of banks. On June 29, 2010, we amended our liquidity facility to (i) permit us, in addition to certain of our subsidiaries, to borrow funds under the liquidity facility and (ii) extend the lending commitments of certain of the lenders by two years, from June 15, 2012 to June 15, 2014. Aggregate commitments under the amended liquidity facility are $1,200.9 million of which $689.6 million terminates on July 15, 2014 and $511.3 million terminates on June 15, 2012. In connection with the amendment, we paid a one-time fee of $6.8 million to the lenders. In February 2011, we repaid $150.5 million of the outstanding balance on our liquidity facility with the proceeds from the issuance of the 1.875% Convertible Notes, as discussed above. In March 2011, for purposes of prudent liquidity management, we borrowed $75.0 million from the liquidity facility, which was subsequently repaid in April 2011. As of March 31, 2011, $367.0 million, which we classify as short term debt, was outstanding under the liquidity facility with the remainder available to us. See Note 10 to our consolidated financial statements for further details.
EQUITY OFFERING
On June 8, 2010, we completed a public offering and sale of 25,915,492 shares of our Common Stock, pursuant to an underwriting agreement, dated June 2, 2010. We received $174.3 million in proceeds, net of an underwriting discount and other associated costs. We used the net proceeds from the equity offering to pay all fees and expenses that we incurred in connection with the Exchange Offer discussed above and we used the remainder of the net proceeds for general corporate purposes. See Note 2 to our consolidated financial statements for further details.
RESTRUCTURING
During the first quarter of fiscal 2011, we completed a critical assessment of our cost base, including reviews of our compensation structure and non-compensation expenses and as a result of this evaluation, we reduced our workforce by 12%. In addition, in the fourth quarter of fiscal 2011, management announced a new strategic business model which required the realignment of existing resources, and as a result we further reduced our headcount by 6%. As a result of both of these plans, we recorded restructuring charges of $25.5 million during fiscal 2011. These charges include $23.4 million for severance and other employee compensation costs and $2.1 million for contract termination costs related to office closures. The employee terminations occurred mainly in North America and Europe. As of March 31, 2011, we paid approximately $22.6 million in restructuring costs and have a remaining accrual of $2.9 million, substantially all of which will be paid out within one year. Although we have reduced headcount overall as compared to fiscal 2010, we have also strategically hired personnel in anticipation of fully implementing our new business model. As of March 31, 2011, we anticipate that the restructuring actions taken during fiscal 2011, will result in compensation expense savings, however when coupled with additional personnel hired in 2011, these actions together are estimated to save approximately $67.0 million of net compensation expense, on an annualized basis. See Note 2 to our consolidated financial statements for further details.
ISSUANCE OF NON-CUMULATIVE CONVERTIBLE PREFERRED STOCK AND CONVERTIBLE NOTES
In June 2008, we completed the issuance and sale of (i) $150.0 million aggregate principal amount of our 9% Convertible Notes and (ii) $150.0 million in aggregate liquidation preference of our Series B Preferred Stock. In August 2008, the initial purchasers of the Convertible Notes exercised their option to purchase an additional $60.0 million aggregate principal amount of such notes. In March 2009, we completed our cash tender offer to repurchase all of our then outstanding $210.0 million 9% Convertible Notes at a purchase price equal to $0.64 per $1.00 of the principal amount, plus accrued interest. We validly repurchased $5.0 million aggregate principal amount of the 9% Convertible Notes. We paid $3.3 million in cash including accrued interest and related bank fees.
ISSUANCE OF CUMULATIVE CONVERTIBLE PREFERRED STOCK AND BACKSTOP COMMITMENT
We signed a definitive agreement, dated as of May 20, 2008 and as amended on June 10, 2008, which we refer to as the “backstop commitment”, with an affiliate of J.C. Flowers & Co. LLC in which J.C. Flowers agreed to provide a commitment of up to $300.0 million toward the sale of equity or equity-linked securities. Under the terms of the backstop commitment, on July 18, 2008, J.C. Flowers purchased $150.0 million in aggregate liquidation preference of a new series of equity securities in the form of cumulative convertible preferred stock, Series A, or the Series A Preferred Stock. In February 2010, we entered into a Transfer Agreement with JCF Fund II, whereby JCF Fund II and certain controlled affiliates transferred their ownership interest in the Series A Shares to JCF MFG Holdco LLC (“JCF LLC”), another controlled affiliate, and JCF LLC agreed to be bound by certain terms and conditions of the investment agreement. For this purpose, the term “controlled affiliate” means a controlled affiliate of J.C. Flowers, of which JCF Fund II is a controlled affiliate. See Note 12 to our consolidated financial statements for further details.
TWO-YEAR TERM FACILITY
On July 18, 2008, we entered into a credit agreement with several banks that provided for a two-year, $300.0 million unsecured term loan facility (the “Two-Year Term Facility”), which enabled us to prepay loans under our previously outstanding bridge facility that were otherwise due and payable on December 12, 2008. On April 16, 2009, we paid the outstanding balance of $240.0 million on the Two-Year Term Facility ahead of its maturity date of July 16, 2010 thus terminating all remaining obligations under the Two-Year Term Facility. During fiscal 2010, in connection with the early repayment of the Two-Year Term Facility, we recorded a loss on extinguishment of debt of $9.7 million related to the accelerated amortization of debt issuance costs.
PARABOLA/TANGENT
On May 6, 2009, a High Court Judge in the U.K. ruled that MF Global UK Ltd. was vicariously liable to pay damages and claimants’ costs to Parabola Investments Limited and Aria Investments Limited. We appealed the decision. An expense of $8.0 million was recorded in fiscal 2009 in connection with this litigation, based on the judgment rendered, after adjusting for insurance proceeds of $23.5 million. In May 2010, the Court of
| 40 | MF Global 2011 Form 10-K |
Table of Contents
PART II
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Appeals denied our appeal and affirmed the judgment. We are considering our options for further appeal to the Supreme Court.
Factors Affecting Our Results
The global business environment directly affects our results of operations. Our results of operations have been and will continue to be affected by many factors, including economic, political and market conditions, broad trends in the brokerage and finance industry, changes in the level of trading activity in the broader marketplace, price levels and price volatility in the derivatives, interest rate, equity, foreign exchange and commodity markets, legislative and regulatory changes and competition, among other factors. Specifically, our business has been impacted by turmoil in global markets during fiscal 2010 and improvement in certain financial markets during fiscal 2011. Financial markets have experienced elevated levels of volatility due to concerns about the outlook for global growth, the solvency of certain European sovereign nations and inflation, while in some instances certain markets have begun to recover during fiscal 2011. In addition, the global equity markets experienced a significant appreciation during fiscal 2011 and are significantly up from year-ago levels. Mortgage and corporate credit spreads widened in the first half of fiscal 2010, narrowed subsequently, but have begun to widen again, and the U.S. dollar appreciated against the Euro and British pound in the first half of fiscal 2010 and again in the first quarter of fiscal 2011, before depreciating in the remainder of fiscal 2011. Furthermore, short-term interest rates have continued to remain very low over the past year, and as a result our net interest income has been negatively affected over the same period. All of these factors have contributed to our results for the periods presented. Our revenues are dependent on the volume of client transactions we execute and clear and the volatility in the principal markets in which we operate, as well as prevailing interest rates, each of which are described below.
Trading Volumes and Volatility
Our trading volumes are particularly dependent on our clients’ demand for exchange-traded and OTC derivative products, which relate to interest rates, equities, foreign exchange and commodities. Demand for these products is driven by a number of factors, including the degree of volatility of the market prices of the underlying assets—that is, the extent to which and how rapidly those prices change during a given period. Historically, higher price volatility increases the need for certain clients to manage price risk and creates opportunities for speculative trading for others. Although higher price volatility does not necessarily lead to increases in trading volumes, changes in the absolute price levels of financial assets or commodities can have a significant impact on trading volumes. During times of significant economic and political disruptions, clients may seek to manage their exposure to, or speculate on, market volatility. However, as was seen during fiscal 2010 and 2009, extreme volatility and widespread uncertainly can impact the client’s ability to take on or maintain positions, which has the effect of decreasing volumes.
In addition to affecting trading volumes of exchange-traded and OTC derivative products, moderate to high levels of volatility can affect our market making and client facilitation business, as our clients either seek more risk exposure or limit their risk exposure at such levels. Furthermore, volatility in markets may also create investment and trading opportunities for our principal strategies group.
The total volume of exchange-traded futures and options transactions we executed and/or cleared increased 12.8% to 1,891.4 million contracts in fiscal 2011 from 1,676.5 million contracts in fiscal 2010. All volume statistics presented herein for fiscal 2011 and 2010 include exchange-traded futures and options contract volumes as derived from our reporting systems, excluding intercompany volumes. We are continuing to enhance our reporting systems in order to improve the analysis of operating data generated by our business.
Interest
Our net interest income, calculated as interest income less interest expense, is directly affected by the spread between short-term interest rates we pay our clients on their account balances and the short-term interest rates we earn from cash balances we hold as well as the duration of the portfolio of client balances invested. Client balances can be impacted by a variety of market factors, including changes in margin requirements at exchanges, market volatility, declining asset values, as well as changes in the composition of margin. Clients, for example, may elect to deposit securities, rather than cash, as margin, which will result in a reduction in our client balances because the securities deposited as margin are not carried on our balance sheet. As a result of these market factors, client balances fluctuate, often significantly, from day to day and may not be indicative of future business.
Our net interest income is also directly affected by interest earned in connection with principal transactions, such as fixed income, securities lending and collateralized financing transactions. While spreads on these transactions remained within a relatively constant range over time, they can widen or narrow when interest rate trends change, as was seen in the narrowing of spreads experienced during fiscal 2010 and the slight widening of spreads during early fiscal 2011. Accordingly, we carefully monitor and seek to economically hedge our risk exposure as appropriate. In addition, a smaller portion of our interest income relates to client balances on which we do not pay interest and thus is directly affected by the absolute level of interest rates. As a result, our net interest income is impacted by the level and volatility of interest rates, as well as the duration of our portfolio investments made with client balances. Any fair value adjustments to the investments in which client balances are invested are not included in interest but presented in Principal transactions, although they form part of the return on client balances. Included within interest income is the interest we earn on our excess cash. Our interest on borrowings is also affected by changes in interest rates, which could increase or decrease our interest expense on our variable rate debt. Accordingly, the historically low interest rates have negatively affected our net interest income and we cannot offer any assurance that interest rates will increase in the future. As we transform ourselves into a full-service broker-dealer and eventually an investment bank, we expect that the proportion of our net interest income earned in connection with principal transactions will increase relative to the interest we earn from our client’s cash balances.
Sources of Revenues
We derive our revenues from commissions, principal transactions, net interest income and other revenues.
| MF Global 2011 Form 10-K | 41 |
Table of Contents
PART II
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
COMMISSIONS
Commissions are recorded on a trade-date basis as customer transactions occur and include transaction fees we earn for executing trades on an agency basis for clients that do not have clearing accounts with us and clear through another brokerage firm. We provide these services primarily to corporate and broker-dealer clients and asset managers. We charge a per-contract fee that is generally established at market rates and varies based on the product traded. We negotiate these fees individually with clients and as a result, our transaction rates generally vary among our clients. When we execute client trades on a principal basis in the OTC area, our commissions are included within the mark-up that we earn, and accordingly we record the mark-up from principal transactions under Principal transactions. The amount of fees we earn in any period fluctuates primarily based on the volume of client transactions and the types of products traded, and to a lesser extent on the rates we charge. These fees are also impacted by volume mix in different markets where rates differ.
Commissions also consist of transaction fees we earn for executing and clearing trades for clients that have clearing accounts with us. There are two ways of providing these services to our clients: (1) by both executing and clearing the transaction for the client, or (2) by providing clearing services where the trade is executed by another brokerage firm and then routed to our system for clearing, or “given up” to us because the client has a clearing account with us. We provide these services for a broad range of clients trading in multiple markets. Types of commission activity include equity broking, energy OTC brokerage, futures, contracts for differences (“CFDs”) and financial spread commissions.
PRINCIPAL TRANSACTIONS
We execute orders for our clients either on an agency or principal basis. When we execute for a client on an agency basis, we typically direct the order to an exchange or OTC market where it is matched with a corresponding order for execution. When we execute a client order on a principal basis, we take the other side of the trade for our own account to facilitate client orders. In some cases, we will simultaneously enter into an offsetting “back to back” trade with another party (which we refer to as “matched principal transactions”). In certain other cases, we will look to enter into offsetting trades or hedging positions with another party relatively quickly or we may retain the exposure for a longer period of time. In order to gain ongoing insight into market depth and liquidity, or to facilitate client transactions, we may also take positions in the market for our own account, and we may not always hedge such transactions. We may also enter into unhedged principal transactions in order to monetize our market views, an activity we increasingly engaged in during fiscal 2011. As part of our strategic plan, we expect to significantly increase our proprietary activities and to recognize more trading income as part of our ongoing activity for our clients in various markets, and to selectively increase our risk taking, while operating within the authority delegated by our Board of Directors. Principal transactions generally yield higher profit margins than commissions that we earn by executing client trades, but also subject us to greater risk. To a lesser extent, principal transactions also reflect revenues we earn from derivatives transactions we execute for our own account to hedge our corporate exposure to foreign currency and interest rate risk. Principal transactions do not include the net interest earned on related financing arrangements entered into as part of transactions that generate principal transaction revenues, although the net interest is an integral part of the profitability of the trade.
Revenues earned in matched-principal transactions consist of the mark-ups, or profits, we earn on these trades and are net of the value of the trades. Because of our significant order flow and the liquidity in our trading markets generally, in the case of matched-principal transactions, we are usually able to find an appropriate offsetting transaction with another party relatively quickly. By entering into offsetting trades, we reduce or eliminate our exposure to market risk. The offsetting trades we execute may differ from the client trades in some respects, such as duration or other terms. Therefore, we do not completely eliminate our exposure to market risk. In some circumstances, we may not enter into offsetting transactions, thereby exposing us fully to market risk. In conjunction with ongoing or anticipated client activity, or because we have a market view, we may enter into principal transactions to take advantage of temporary price differentials or price movements.
When we engage in principal transactions, including to facilitate customer transactions in OTC commodities and other products in the foreign exchange and fixed income markets and in the listed metals markets in London, what we would otherwise charge as a commission is built into our markup. We seek to price these transactions so that we earn a positive spread, or markup, on the offsetting transaction. The mark-ups represent our compensation for executing these clients’ orders. These revenues are a function of both the price of the underlying asset as well as the spread between the buy and sell prices for the underlying asset. This spread is affected by market conditions, including volatility and volume. Mark-ups are recorded on trade date.
Because we act as principal, rather than as agent, in these transactions, we are required to record realized and unrealized gains and losses relating to these transactions. We also recognize in principal transactions any unrealized gains or losses on our equity swaps and CFDs, together with the unrealized gains and losses on the related matching equity hedges that are entered into on a matched-principal basis. Types of principal transaction activity include foreign exchange, metals, fixed income, equities and equity swaps.
We also record, as part of revenue from principal transactions, the gains on purchases of securities under agreements to resell (“resale agreements”) and sales of securities under agreements to repurchase (“repurchase agreements”) accounted for as sales and purchase transactions, and dividends earned or paid in our structured equity trading strategies. For a discussion of these resale and repurchase agreements, see “—Off-Balance Sheet Arrangements and Risk,” “Item 7A. Quantitative and Qualitative Disclosures about Market Risk—Disclosures about Market Risk—Risk Management” and “—Supplementary Data”. During fiscal 2011, we established a principal strategies group and expanded our principal trading activities. Over the longer term, we intend to complement this expanded role in trading by participating in other traditional investment banking activities, including underwriting new issues of securities, structuring trades and providing advisory services to issuers, with a continued focus on the commodities and natural resources markets.
We also enter into principal transactions in order to hedge our corporate exposure to foreign currency and interest rate risk. Our economic hedging transactions typically involve cash and
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derivative products in the foreign exchange market and fixed income derivatives. We enter into derivative transactions to economically hedge our exposure to British pounds and other currencies in which we pay our expenses, including our employee compensation and related expenses. We may economically hedge forecasted expenditures in advance of payment. In addition, we enter into derivatives transactions to economically hedge our exposure to changes in interest rates, which could affect the revenues we earn on cash balances and collateralized refinancing transactions as well as our cost of borrowing. We may engage in more interest rate hedging transactions in the future. In accordance with our risk management policies, our hedging transactions do not fully offset our associated risk exposure.
We also enter into principal transactions to invest and manage our liquid corporate assets for asset-liability management purposes. Our investment transactions typically involve government and investment-grade corporate debt securities, agency securities as well as money-market funds. Profits and losses arising from all securities and commodities transactions entered into for our own account and risk are recorded on a trade date basis, including to a lesser extent from derivatives transactions executed for our own account to hedge foreign currency exposure. The net interest earned on the financing related to these investment transactions is recorded within net interest income. We do not separately amortize purchase premiums and discounts associated with proprietary securities transactions, as these are a component of the recorded fair value. Changes in the fair value of such securities are recorded as unrealized gains and losses within principal transactions.
NET INTEREST INCOME
Net interest income represents interest income less interest expense.
We earn interest income from investment of balances in our clients’ accounts, balances in our accounts, collateralized financing arrangements, such as securities lending and resale and repurchase agreements we enter into in conjunction with our principal transactions, and on the notional amounts of clients’ positions in CFDs. We also earn interest from investing our capital. We incur related interest expense in connection with many of the transactions from which we derive interest income including payments to customers.
Our net interest income is driven by the amount of client deposits placed with our brokerage operations, the level of prevailing interest rates, the duration of the investments on which we receive interest, the portion of client balances on which we do not pay interest, the level of secured financing transactions provided to our clients and the degree to which we are able to optimize our capital structure. Typically, the net interest that we earn is lower in a lower interest rate environment and higher in a higher interest rate environment.
Revenues from interest income principally represent interest we earn from the investment of client funds deposited with us as margin for trading activities, interest we earn on excess cash balances in our accounts and interest we earn from investing our capital. The majority of the interest income we earn relates to client balances on which we also pay interest to our clients, and therefore the net interest income we earn will depend on the spread between the rates we pay and the rates we earn. A portion of the interest income we earn relates to the client balances of some clients on which we do not pay interest. As a result, the interest income we earn on those client balances will depend on the absolute level of interest rates.
We also earn interest from collateralized financing arrangements, which include resale and repurchase agreements and securities borrowing or lending transactions we enter into in conjunction with our principal transactions. When we enter into resale transactions, we earn interest on the cash payment we make to clients in exchange for securities deposited with us as collateral under agreements to resell at future dates. Conversely, when we enter into repurchase transactions, we pay interest on the cash we receive in exchange for pledging securities we own or have received from clients and are permitted to repledge. The amount of interest we earn depends on client activity and the difference between the interest rate we pay to our clients on their cash collateral and the interest rate we receive from investing the cash received by, or the collateral deposited with, us. These transactions result in a gross-up of Interest income and Interest expense in our consolidated statements of operations, which are effectively netted as part of our revenues, net of interest and transaction-based expenses. Similarly, we enter into transactions where we borrow securities and pay related interest expense on the securities borrowed.
We also earn interest on the notional amount of clients’ positions in CFDs. In these transactions, the parties agree to settle a contract based on the difference between the opening and the closing prices of the contract, and our client posts with us as margin only a small percentage of the initial contract value. We charge these clients interest on the notional amount of the contract for effectively financing the cost of the trade.
The comparison of our period-to-period results described below presents our interest income and interest expense on a net basis. For purposes of presenting revenues, net of interest and transaction-based expenses, interest expense excludes interest paid on short-term and long-term debt, which we disclose separately.
OTHER REVENUES
Other revenues consist of revenues we earn from normal business operations that are not otherwise included above. These types of revenues include:
| • | certain ancillary services provided to clients; |
| • | fees charged to clients for the use of software products; |
| • | insurance proceeds on legal settlements and fees from prior years; and |
| • | profits or losses on the sale or disposal of fixed assets and other long-term investments. |
Components of Expenses
Our expenses consist of three principal components: (1) interest expense, (2) transaction-based expenses and (3) other expenses. A significant portion of our expenses is variable.
INTEREST EXPENSE
Interest expense includes interest paid to our clients on the funds they maintain with us and interest paid to counterparties in connection with secured financing transactions, such as
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repurchase agreements and for securities we borrow. As discussed above, a substantial portion of our interest expense pertains to related client transactions from which we derive interest income but with respect to which we also incur interest expense. Our interest income and interest expense are effectively netted in our consolidated statements of operations as part of our revenues, net of interest and transaction-based expenses. The comparison of our period-to-period results described below also presents our interest income and interest expense on a net basis. For purposes of calculating revenues, net of interest and transaction-based expenses, interest expense excludes interest paid on short-term and long-term debt, which are recorded in other expenses.
TRANSACTION-BASED EXPENSES
Transaction-based expenses are variable expenses we incur directly to generate revenues from providing execution and clearing services and consist of (1) execution and clearing fees paid to third parties and (2) sales commissions paid to introducing brokers.
Execution and clearing fees reflect our costs of executing, clearing and settling trades on behalf of our clients. We pay execution- and clearing-related fees primarily to clearing brokers, exchanges, clearinghouses and regulatory and self-regulatory bodies at contractually agreed rates. These expenses are variable and depend on the volume of transactions we execute or clear through these third parties, the types of products traded and the markets in which the products are traded. Execution and clearing fees also include losses due to transactional errors.
Sales commissions consist of fees paid to introducing brokers. We pay introducing brokers a percentage of the commission fees we receive from their clients for providing execution and/or clearing services. We enter into clearing agreements with introducing brokers and customer agreements with their clients, pursuant to which we negotiate our transaction fees and corresponding sales commission for the individual introducing broker. The amount of sales commission we pay is variable and depends on the fee arrangement we have negotiated, which is generally based on the volume of business introduced by the broker or a percentage of the revenues we earn.
OTHER EXPENSES
Other expenses consist of expenses relating to (1) employee compensation and benefits (excluding non-recurring IPO awards), (2) employee compensation and benefits related to non-recurring IPO awards, (3) communications and technology, (4) occupancy and equipment costs, (5) depreciation and amortization, (6) professional fees, (7) general and other, (8) IPO-related costs, (9) restructuring charges, and (10) impairment of intangible assets and goodwill.
Employee Compensation and Benefits
Employee compensation and benefits expense is the principal component of our expenses. These expenses include all compensation paid to employees and any related expenses, such as salaries, sign-on bonuses, incentive compensation and related employee benefits and taxes. The most significant component of our overall employee compensation and benefits expense is the employment costs of our producer staff, which includes our brokers, traders and other personnel interacting with our clients.
Our employee compensation and benefits expense for all employees has both a fixed and variable component. The fixed component consists of base salaries and benefit costs. The variable component depends on whether the employee is classified as producer or professional staff. Producer staff receives production-based compensation, or earnouts, under negotiated arrangements based on the profitability of their team. Professional staff, which generally includes our executive officers and corporate, administrative, accounting, information technology and related support personnel, receive discretionary bonuses on an annual basis that are based broadly on corporate and personal performance and are paid in the first quarter of our fiscal year. Production-based compensation payments are paid periodically during the year, in accordance with the negotiated arrangement. For many of our producer staff, their production-based compensation constitutes a significant component of their overall compensation. Discretionary bonuses for professional staff, excluding members of our executive management team, are generally a smaller component of overall compensation. Production-based compensation and discretionary bonus costs, and therefore employee compensation and benefits expense, vary based on our operating results. We accrue our discretionary bonus costs monthly.
Employee compensation and benefits also includes expenses related to awards granted to our employees under several stock-based incentive plans (excluding non-recurring IPO awards). In particular, our Long-term Incentive Plan (“LTIP”) provides for equity compensation awards in the form of stock options, restricted stock and restricted stock units to eligible producer and professional staff. Producer staff receive awards throughout the year at the same time as their earnouts, while professional staff generally receive awards on an annual basis. Stock compensation expense as a percentage of employee compensation and benefits (excluding non-recurring IPO awards) was 7.4%, 4.9% and 4.5% for fiscal 2011, 2010 and 2009, respectively.
Employee compensation and benefits related to non-recurring IPO awards refers to stock-based compensation expense for restricted stock and restricted stock units issued in connection with our IPO. During fiscal 2011, all remaining restricted stock and restricted stock units issued in connection with our IPO became fully vested. Employee compensation and benefits related to non-recurring IPO awards are considered non-recurring and directly attributable to the IPO.
The restricted stock units granted pursuant to the IPO awards vested in full on the third anniversary of the pricing of the IPO. The stock options granted pursuant to the IPO awards had an exercise price equal to the $30 IPO price of our shares of common stock and vested in equal installments over the three-year period and therefore were not exercisable for the first year following the IPO. In fiscal 2010 we initiated a tender offer that enabled eligible employees to exchange options that were granted to them at the time of our IPO for a lower number of restricted stock units. In connection with this tender offer, 3,301,162 options were tendered and exchanged for 284,455 restricted stock units. For additional information on this tender offer, see Note 13 of our consolidated financial statements.
We expect that our employee compensation and benefits expenses will vary from quarter to quarter due to the performance of our business, the hiring of additional employees associated with the growth of our business and the product and
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geographic mix of our business, which affects our compensation structure. In addition, during fiscal 2011 we completed a reduction in workforce and initiated a cap on some bonus pools which we expect will result in future cost savings. However, we cannot assure you that all of these savings will be successfully realized as there may be unexpected events or overlooked or unknown contingencies that may cause us to alter our plans or reassess our estimates. As of March 31, 2011, we had 2,847 employees.
Communications and Technology
Communications and technology expenses consist of expenses incurred to purchase, lease, use and maintain the technology-related hardware, software and communications systems we use to operate our business. These types of expenses include expenses incurred to make network or data connections to market platforms, clients or other clearing agents, fees paid for access to external market data, software licenses, repairs and maintenance of hardware and software (including service agreements), as well as expenses for disaster recovery and redundancy systems. These expenses are impacted by the number of producer staff as well as the number of clients that require direct lines or data transfer capabilities. Communications and technology expenses are recognized on an accrual basis.
Occupancy and Equipment Costs
Occupancy and equipment costs consist of expenses incurred to lease, furnish and maintain our offices and other facilities, including rent, real estate broker fees, maintenance fees, utilities, other fixed asset-service fees, repair and leasehold improvement expenses and rents for exchange floor booths. Occupancy and equipment costs are recognized on an accrual basis.
Depreciation and Amortization
Depreciation and amortization expenses consist of expenses related to the depreciation of facilities, furniture, fixtures and equipment and the amortization of intangible assets, including acquired client relationships and internally developed software. Depreciation and amortization expenses are recognized over the asset’s useful life.
Professional Fees
Professional fees consist of fees paid to consultants and advisors, including audit, legal, information technology and recruiting costs. Professional fees do not include any legal settlement costs, which are recorded as part of general and other expenses below. Professional fee expenses are recognized on an accrual basis.
As a public company, we are subject to various reporting, corporate governance and regulatory compliance requirements, including the requirements of the Sarbanes-Oxley Act of 2002 and the SEC rules and regulations implementing that Act, the Exchange Act, the NYSE listing standards and regulatory requirements such as the BASEL II capital adequacy framework and the Markets in Financial Instruments Directive. To continue to comply with these requirements, we expect to incur additional professional fees in fiscal 2012.
General and Other
General and other expenses consist of other expenses that have not been separately classified in our statement of operations. These types of expenses include, among other items, travel and entertainment, advertising, promotion, insurance premiums, bad debts, legal settlement costs, foreign currency transaction gains and losses, and general banking expenses. The amount of general and other expenses incurred by a particular team will impact the profitability of that team and, therefore, the amount of the production-based compensation received by its staff. We believe that this compensation structure encourages our producer staff to manage their travel and entertainment and other general expenses accordingly. General and other expenses for fiscal 2009 also included Refco integration costs that were incurred in connection with our acquisition of the Refco assets in November 2005, including retention costs and bonuses, redundancy and severance payments and professional fees. These costs did not reflect new contracts but rather the performance of previously existing agreements. General and other expenses are recognized on an accrual basis.
IPO-Related Costs
In connection with the reorganization, separation and recapitalization transactions during our initial public offering (“IPO”), we incurred legal, consulting and other non-recurring professional fees, including fees relating to implementing new reporting and corporate governance requirements, adapting our accounting systems and marketing activities undertaken as part of our rebranding effort. As we did not receive any proceeds from the IPO, these costs were expensed. The fiscal 2010 costs were primarily related to continuing compliance with the Sarbanes-Oxley Act. We did not record any IPO-related costs during fiscal 2011.
Restructuring
During the first quarter of fiscal 2011, we completed a critical assessment of our cost base, including reviews of our compensation structure and non-compensation expenses and as a result of this evaluation, we reduced our workforce. In addition, in the fourth quarter of fiscal 2011, management announced a new strategic business model which required the realignment of existing resources, and as a result we further reduced our headcount. We recorded restructuring charges during fiscal 2011 due to these plans. These charges include severance and other employee compensation costs as well as occupancy and equipment costs related to office closures. Although we have reduced headcount overall as compared to fiscal 2010, we have also strategically hired personnel in anticipation of fully implementing our new business model.
Impairment of intangible assets and goodwill
As discussed in Note 9 to our consolidated financial statements, during fiscal 2011, 2010 and 2009, we completed impairment testing of goodwill and identified triggering events that required an impairment analysis to be performed related to certain intangible assets. As a result of our analyses, we determined all of our goodwill and a portion of our intangible assets were impaired. Consequently, we recorded the impairment charge in our consolidated statements of operations.
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GAINS ON EXCHANGE SEATS AND SHARES
Gains on exchange seats and shares consist of unrealized gains or losses we recognize on exchange seats or shares we hold in excess of the exchange seats and shares we are required to hold to conduct our business, which we refer to as excess seats and shares. The amount of any unrealized gain or loss is based on changes in the mark-to-market value of the excess seats or shares. We also recognize realized gains or losses on the sale of any seats and/or shares. The amount of any realized gain is based on the difference between the book value of such seats and/or shares and the sale price. Finally, gains on exchange seats and shares also include dividend income we earn from exchange seats or shares. All exchange seats or shares that we are required to hold in order to conduct our business are recorded at cost and do not impact our statements of operations. Certain exchange shares are subject to restrictions on resale.
LOSS ON EXTINGUISHMENT OF DEBT
Loss on extinguishment of debt in fiscal 2011 was incurred as the result of the repurchase of some of our 9% Convertible Notes in the open market and the exchange of securities in the Exchange Offer, both discussed above. Loss on extinguishment of debt in fiscal 2010 resulted from the early repayment of the Two-Year Term Facility in April 2009, also discussed above. The losses have been disclosed separately within our consolidated statement of operations for fiscal 2011 and 2010.
INTEREST ON BORROWINGS
Interest on borrowings consists of interest expense incurred on borrowings from third parties, including third-party liquidity facilities. This interest expense is incurred separately from trading activities and client transactions. For a discussion of our borrowings, see Note 10 to our consolidated financial statements.
PROVISION/BENEFIT FOR INCOME TAXES
Our provision or benefit for income taxes includes all current and deferred provisions for federal, state, local and foreign taxes.
We account for income taxes under the asset and liability method prescribed by U.S. GAAP. Under this method, deferred income taxes reflect the net tax effects of temporary differences between the carrying amount of assets and liabilities for financial statement and income tax purposes, as determined under applicable tax laws and rates. A valuation allowance is provided for deferred tax assets when it is more likely than not that some portion of the deferred tax assets will not be realized. Any increase or decrease in a valuation allowance could have a material adverse or beneficial impact on our income tax benefit or provision and net income or loss in the period in which the determination is made. Our effective income tax rate can vary from period to period, depending on, among other factors, the geographic and business mix of our earnings, the availability of losses, the level of non-deductible expenses and the effect of tax audits.
Our effective tax rates for fiscal 2011, 2010 and 2009 were (6.8%), 28.8% and 420.9% respectively. For fiscal 2009, the tax expense was impacted by the effects of certain non-deductible expenses, including the impairment of goodwill, an increase in the valuation allowance associated with deferred tax assets unlikely to be monetized, the impact of our reduced share price on the value of vested equity awards to employees and a greater percentage of income being generated in higher-tax jurisdictions. For fiscal 2010, our tax benefit was impacted by higher non-deductible expenses, increased valuation allowance, changes in uncertain tax positions, the impact of our reduced share price on the value of vested equity awards to employees and a greater percentage of our results in higher tax jurisdictions. Partially offsetting these items in fiscal 2010 were certain tax credits, reductions in tax liabilities related to prior years and a one-time benefit from the change in our corporate domicile. For fiscal 2011, the impact of our reduced share price on the value of vested equity awards to employees was partially offset by more of our income being earned in lower tax jurisdictions, a reduction in non-deductible expenses and the impact of the reduction in tax liabilities related to prior years. Our tax rate from ongoing operations for fiscal 2011 was 34.4%.
Man Group plc (“Man Group”), the entity from which we separated prior to our IPO, previously agreed to indemnify us against certain specified tax and other liabilities that may arise in connection with the reorganization and separation transactions during our IPO, subject to various limitations and conditions. To the extent that we incur a tax or other liability for which we are indemnified, our payment of the liability should generally be offset from a financial perspective by our receipt of the indemnity payments (subject to timing differences and the extent of the indemnification). Even if we are fully indemnified against a particular tax or other liability, however, our financial results of operations as reflected in our consolidated financial statements could be adversely affected. For accounting purposes, an indemnity payment would generally be treated as a net capital contribution to us from Man Group, and the incurrence of the related liability could reduce our net income as reported in our consolidated financial statements. The reorganization and separation transactions in connection with our IPO have caused us to incur tax liabilities for which we received the economic benefit of an indemnity payment under the tax matters deed. While those liabilities do not affect our cash flow, assuming we receive full indemnification, they do have a significant non-cash impact on our statement of operations for the period following the offering. The $75.7 million reorganization tax charge reflected in our results for fiscal 2008 and 2009 is one such case. While not all of this charge is required to be paid currently, we received $63.1 million to date from Man Group, including $8.1 million in fiscal 2009, and we have paid these deposits over to the relevant tax authorities.
Realization of deferred tax assets is dependent upon multiple variables including available loss carrybacks, future taxable income projections, the reversal of current temporary differences, and tax planning strategies. U.S. GAAP requires that we continually assess the need for a valuation allowance against all or a portion of our deferred tax assets. We are in a three-year cumulative pre-tax loss position at March 31, 2011 in many jurisdictions in which we do business. A cumulative loss position is considered negative evidence in assessing the realizability of deferred tax assets. We have concluded that the weight given this negative evidence is diminished due to significant non-recurring loss and expense items recognized during the prior three years, including IPO-related costs, asset impairments and costs related to exiting unprofitable business lines. We have also concluded that there is sufficient positive evidence to overcome this negative evidence. The positive evidence includes three means by which we are able to fully
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realize our deferred tax assets. The first is the reversal of existing taxable temporary differences. Second, we forecast sufficient taxable income in the carry forward period. We believe that future projections of income can be relied upon because the income forecasted is based on key drivers of profitability that we began to see evidenced in fiscal 2011. Most notable in this regard are plans and assumptions relating to the significant changes to our compensation structure implemented in fiscal 2011, increased trading volumes, and other macro-economic conditions. Third, in certain of our key operating jurisdictions, we have a sufficient tax planning strategy which includes potential shifts in investment policies, which should permit realization of our deferred tax assets. Management believes this strategy is both prudent and feasible. The amount of the deferred tax asset considered realizable, however, could be significantly reduced in the near term if our actual results are significantly less than forecast. If this were to occur, it is likely that we would record a material increase in our valuation allowance. Loss carryforwards giving rise to a portion of the overall net deferred tax asset either do not expire or expire no earlier than fiscal 2031.
We currently have deferred tax assets recorded on our consolidated balance sheets related to stock compensation awards issued in connection with the IPO. Due to declines in our stock price, the amount of these assets may not equal the tax benefit ultimately realized at the date of delivery of these awards, as the deferred tax assets are based on the stock awards’ grant date fair value; any shortfall will result in a charge to the income statement. During fiscal 2011, the shortfall of $35.1 million, of which $28.2 million was related to stock compensation awards issued in connection with the IPO, was recorded as tax expense in the consolidated statement of operations as we have no pool of windfall tax benefits.
EQUITY IN EARNINGS OF UNCONSOLIDATED COMPANIES (NET OF TAX)
Equity in earnings of unconsolidated companies includes our pro rata share of earnings for entities in which we own between 20% and 50% of the entity’s common equity and over which we have the ability to exert influence, although not control, relating to such entities’ operating and financial policies. As of March 31, 2011, we owned a 19.5% interest in Polaris MF Global Futures Co Ltd.
NONCONTROLLING INTEREST IN INCOME OF CONSOLIDATED COMPANIES (NET OF TAX)
We consolidate the results of operations and financial position of entities we control, but do not wholly own. We own 70.2% of MF Global Sify Securities India Private Limited, 75.0% of MF Global Finance and Investment Services India Private Limited and 73.2% of MF Global Futures Trust Co. Ltd. Earnings for these entities are consolidated on a post-tax basis.
Results of Operations
Basis of Presentation
We operate and manage our business on an integrated basis as a single operating segment. We derive our revenues principally from execution and clearing services we provide to our clients, including interest income related to providing these services, and from principal transactions. Although we provide these services to a diverse client base across multiple products, markets and geographic regions, we do not manage our business, allocate resources or review our operating results based on the type of client, product or trading market or the geographic region in which these services are provided. As management continues to implement its strategy to reorganize our business model into the four lines of business, we may change our reporting and disclosures in the future to reflect the realignment of our business. For information related to our geographic regions, see Note 17 to our consolidated financial statements.
On April 1, 2009, we adopted two new accounting standards each of which was effective for fiscal 2010 and interim periods within such fiscal year. These standards required retrospective application and resulted in an adjustment to prior period financial statements. The first standard discusses accounting for noncontrolling interests in consolidated financial statements and resulted in a $12.8 million increase to total equity for fiscal 2009 upon adoption. The second standard discusses accounting for convertible debt instruments that may be settled in cash upon conversions including partial cash settlements and resulted in a $0.4 million increase to Net loss attributable to MF Global Holdings Ltd., $1.0 million decrease to total assets, $7.0 million decrease to total liabilities and a $6.0 million increase to total equity for fiscal 2009 upon adoption.
Certain prior year amounts have been reclassified to conform to current year presentation. In the first quarter of fiscal 2011, we reclassified certain amounts in the statements of operations to better present our business transactions and explain our financial results. Specifically, expenses incurred related to temporary staff and contractors have been reclassified out of Employee compensation and benefits (excluding non-recurring IPO awards) and into Professional fees. Tuition and training costs have also been reclassified out of Employee compensation and benefits (excluding non-recurring IPO awards) and into General and other. In total, for fiscal 2010 and 2009, $4.5 million and $8.6 million, respectively, was reclassified out of Employee compensation and benefits (excluding non-recurring IPO awards) and into Professional fees and General and Other. In addition, all dividends earned or paid in structured equity trading strategies previously classified within Interest income and Interest expense have been reclassified into Principal transactions. For fiscal 2010 and 2009 the net reclassification made for dividends was $74.5 million and $7.5 million, respectively. These consolidated changes have been voluntarily reclassified by us and do not reflect an error or misstatement. We do not believe that these adjustments are quantitatively or qualitatively material to the results of the respective reporting periods.
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Year Ended March 31, 2011 Compared to the Year Ended March 31, 2010:
| FOR THE YEAR ENDED MARCH 31, | ||||||||||||
| (Dollars in millions, except per share and share amounts) |
2011 | 2010 | % Change | |||||||||
| Revenues |
||||||||||||
| Commissions |
$ | 1,433.9 | $ | 1,386.0 | 3.5 | % | ||||||
| Principal transactions |
243.2 | 151.0 | 61.1 | |||||||||
| Interest income |
516.5 | 415.3 | 24.4 | |||||||||
| Other |
39.9 | 42.4 | (5.9 | ) | ||||||||
| Total revenues |
2,233.6 | 1,994.7 | 12.0 | |||||||||
| Interest and transaction-based expenses: |
||||||||||||
| Interest expense |
229.7 | 137.3 | 67.3 | |||||||||
| Execution and clearing fees |
681.1 | 601.8 | 13.2 | |||||||||
| Sales commissions |
253.7 | 240.6 | 5.4 | |||||||||
| Total interest and transaction-based expenses |
1,164.5 | 979.7 | 18.9 | |||||||||
| Revenues, net of interest and transaction-based expenses |
1,069.1 | 1,015.0 | 5.3 | |||||||||
| Expenses |
||||||||||||
| Employee compensation and benefits (excluding non-recurring IPO awards) |
620.7 | 668.4 | (7.1 | ) | ||||||||
| Employee compensation related to non-recurring IPO awards |
12.4 | 31.8 | (61.0 | ) | ||||||||
| Communications and technology |
134.4 | 118.6 | 13.3 | |||||||||
| Occupancy and equipment costs |
51.2 | 39.4 | 29.9 | |||||||||
| Depreciation and amortization |
44.4 | 55.1 | (19.4 | ) | ||||||||
| Professional fees |
75.2 | 85.6 | (12.1 | ) | ||||||||
| General and other |
117.2 | 115.7 | 1.3 | |||||||||
| IPO-related costs |
— | 0.9 | (100.0 | ) | ||||||||
| Restructuring charges |
25.5 | — | 100.0 | |||||||||
| Impairment of intangible assets and goodwill |
19.8 | 54.0 | (63.3 | ) | ||||||||
| Total other expenses |
1,101.0 | 1,169.5 | (5.9 | ) | ||||||||
| Gains on exchange seats and shares |
2.7 | 8.5 | (68.2 | ) | ||||||||
| Loss on extinguishment of debt |
4.1 | 9.7 | (57.7 | ) | ||||||||
| Interest on borrowings |
42.9 | 39.7 | 8.1 | |||||||||
| Loss before provision for income taxes |
(76.3 | ) | (195.4 | ) | (61.0 | ) | ||||||
| Provision/(benefit) for income taxes |
5.2 | (56.3 | ) | (109.2 | ) | |||||||
| Equity in income of unconsolidated companies (net of tax) |
2.7 | 3.8 | (28.9 | ) | ||||||||
| Net loss |
(78.8 | ) | (135.3 | ) | (41.8 | ) | ||||||
| Net income attributable to noncontrolling interest (net of tax) |
2.4 | 1.7 | 41.2 | |||||||||
| Net loss attributable to MF Global Holdings Ltd. |
$ | (81.2 | ) | $ | (137.0 | ) | (40.7 | ) | ||||
| Loss per share: |
||||||||||||
| Basic |
$ | (1.00 | ) | $ | (1.36 | ) | ||||||
| Diluted |
$ | (1.00 | ) | $ | (1.36 | ) | ||||||
| Weighted average number of shares of common stock outstanding: |
||||||||||||
| Basic |
154,405,951 | 123,222,780 | ||||||||||
| Diluted |
154,405,951 | 123,222,780 | ||||||||||
| 48 | MF Global 2011 Form 10-K |
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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION
Overview
Revenues, net of interest and transaction-based expenses (“net revenues”), increased $54.1 million, or 5.3%, to $1,069.1 million for fiscal 2011 from $1,015.0 million for fiscal 2010. The increase was due in part to higher net revenues of $46.3 million generated from the investment of client funds and $54.7 million from increased principal transactions and related net interest revenue. The increase of $54.7 million in principal transactions was primarily driven by $85.3 million of revenues generated from certain repurchase transactions accounted for as sales, as well as increased structured equity trades revenue, offset by lower fixed income balances causing a $33.1 million decline in net interest generated from principal transactions and related financing transactions. In addition, principal transactions were also offset by decreases in foreign exchange and commodities transactions. See “—Supplementary Data” for further details. In addition, the increases in net revenues from the investment of client funds and principal transactions and related financing transactions were partially offset by a $31.4 million decrease in commissions, net of execution and clearing fees, a $13.1 million increase in sales commissions and a $2.5 million decrease in other revenues. The decrease in commissions, net of execution and clearing fees was due to a decrease in commissions on equity transactions and execution only futures and options, partially offset by an increase in introducing broker volumes and commodities trading. Despite the decrease in commissions, net of execution and clearing fees, we experienced a 12.8% increase in our total volumes of executed and/or cleared exchange-traded futures and option transactions to 1,891.4 million contracts for fiscal 2011 from 1,676.5 million contracts for fiscal 2010, because higher volume businesses more than offset the reductions in equities and futures and options trading. The increase of 214.9 million contracts in our total volumes of executed and/or cleared exchange-traded futures and option transactions was spread across many of our primary products, markets and geographic regions, but was primarily due to increased clearing on transactions.
Other expenses, which refer to our expenses other than interest and transaction-based expenses, decreased $68.5 million, or 5.9%, to $1,101.0 million for fiscal 2011 from $1,169.5 million for fiscal 2010. The decrease was primarily due to a reduction of $47.7 million in employee compensation and benefits (excluding non-recurring IPO awards) which was the result of a decrease in headcount due to our restructuring and a change in our compensation structure. The decrease in our other expenses was also attributed to (i) a reduction of $34.2 million in impairment of intangible assets and goodwill, (ii) a reduction of $19.4 million of stock-based compensation expense on our equity awards issued in connection with the completion of our IPO, (iii) a reduction of $10.7 million in depreciation and amortization, and (iv) a reduction of $10.4 million in professional fees. These reductions for fiscal 2011 were partially offset by an increase of $25.5 million related to restructuring charges, an increase of $15.8 million in communications and technology costs, an increase of $11.8 million in occupancy and equipment costs and an increase in general and other of $1.5 million.
Loss before provision for income taxes decreased $119.1 million to $76.3 million for fiscal 2011 from $195.4 million for fiscal 2010. This was primarily due to a decrease in other expenses and increased net revenues as detailed above, as well as a $5.6 million decrease in loss on extinguishment of debt. The decrease in loss before provision for income taxes was partially offset by a $5.8 million decrease in gains on exchange seats and shares and an increase of $3.2 million in interest on borrowings.
Net loss decreased $55.8 million to $81.2 million for fiscal 2011 from $137.0 million for fiscal 2010. Net loss is impacted by the items discussed above, plus a change in the effective tax rate resulting from the impact of our share price on the value of vested equity compensation, which increased the tax provision by $35.1 million, a significant reduction in loss before provision for taxes as compared to fiscal 2010, generating more revenue in lower tax jurisdictions, and a decrease in tax liabilities related to prior years.
Revenues
Commissions
Commissions increased $47.9 million, or 3.5%, to $1,433.9 million for fiscal 2011 from $1,386.0 million for fiscal 2010. The increase was due to a 12.8% increase in our total volumes of executed and/or cleared exchange-traded futures and options transactions, which increased to 1,891.4 million contracts for fiscal 2011, compared with 1,676.5 million contracts for fiscal 2010. These increases were partially offset by decreases in commissions on equity transactions and trading in futures and options due to lower volumes. Commissions consist of both execution-only and cleared commissions. The increase in our transaction volumes and commissions was attributed to (i) increased volumes from middle market and smaller clients, which tend to be more profitable, due to increased trading activity as a result of the recovery of certain market, (ii) increased volumes from larger corporate customers as the recovering economic climate led them to re-evaluate their risk appetite, (iii) increases in trading by individual investor clients, and (iv) increases in professional trader volumes during fiscal 2011. Particularly, the increases in professional trader volume reduced our yields on our total trades, as commissions on professional traders do not increase in proportion to their volumes, which lead to higher volumes but lower margins.
Principal Transactions
Principal transactions increased $92.2 million, or 61.1%, to $243.2 million for fiscal 2011 from $151.0 million for fiscal 2010. The increase in principal transactions was attributable to an $89.7 million increase in fixed income and securities borrowing and lending revenue, which increased to $107.1 million for fiscal 2011 from $17.4 million for fiscal 2010. Of the $89.7 million increase in fixed income and securities borrowing and lending revenues, $85.3 million was generated from certain repurchase transactions that mature on the same date as the underlying collateral. These transactions are accounted for as sales and we de-recognize the related liabilities from our consolidated balance sheets, recognize a gain on the sale of the collateral assets, and record a forward repurchase commitment, in accordance with the accounting standard for transfers and servicing. For these specific repurchase transactions that are accounted for as sales, we maintain the exposure to the risk of default of the issuer of the underlying collateral assets, as well as margin calls, to the extent the value of the collateral decreases. These repurchase transactions will not result in additional revenues (but could result in losses) in future periods. For information about these forward repurchase commitments, see “—Off Balance Sheet Arrangements and Risk” and “Item 7A. Quantitative and Qualitative Disclosures
| MF Global 2011 Form 10-K | 49 |
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about Market Risk—Disclosures about Market Risk—Risk Management.” The increase in principal transactions revenue was also attributed to increased structured equity trades revenue partially offset by decreased revenues earned in foreign exchange, equities and commodities markets.
Principal transactions do not reflect the net interest income earned from principal transactions and related financing transactions, which is included in interest income and expense. Net interest income earned from these principal transactions and related financing transactions was $85.9 million compared to $119.0 million for fiscal 2011 and 2010, respectively. When factoring in net interest income from principal transactions and related financing transactions, which is how our management views the business, principal transactions revenues increased $54.7 million to $328.5 million from $273.8 million for fiscal 2011 and 2010, respectively. Principal transactions also include dividends earned and paid on equity positions we held as hedges to equity futures contracts purchased from customers through a central clearing counterparty. As we increase our client facilitation activities and engage in more proprietary transactions as we continue to implement our new strategic plan, our risk profile has and may continue to increase as we are exposed to more market and credit risk in certain areas. See “—Supplementary Data” for further information on principal transactions revenues as well as “Item 7A. Quantitative and Qualitative Disclosures about Market Risk.”
Interest Income, Net
Interest income, net, increased $8.8 million, or 3.2%, to $286.8 million for fiscal 2011 from $278.0 million for fiscal 2010. This increase was primarily due to an increase of $41.9 million in net interest generated from client payables and excess cash partially offset by a decrease of $33.1 million in net interest generated from principal transactions and related financing transactions. Net interest generated from client payables and excess cash increased to $200.9 million for fiscal 2011 from $159.0 million for fiscal 2010, driven by improved customer activity, increasing yields earned through extending durations and the slight recovery of the Fed funds effective interest rate and other global interest rates. This increase was partially offset by a decrease in our net interest generated from principal transactions and related financing transactions to $85.9 million from $119.0 million for fiscal 2011 and 2010, respectively. See “— Supplementary Data” for further information on the components of net interest income.
Other Revenues
Other revenues decreased $2.5 million, or 5.9%, to $39.9 million for fiscal 2011 from $42.4 million for fiscal 2010. This decrease was attributed to a $3.2 million decrease in clearing services income received from clients and other counterparties for the use of equity research, various trading systems, data and other professional staff and support services, which was partially offset by an increase of $1.9 million in facilities management and other fees. During fiscal 2011 we received a $2.8 million reimbursement of legal costs and interest related to the settlement of arbitration with Man Group plc, while during fiscal 2010 we received a $3.2 million settlement in relation to settlement of litigation regarding our prior acquisition of Refco assets.
Transaction-based Expenses
Execution and Clearing Fees
Execution and clearing fees increased $79.3 million, or 13.2%, to $681.1 million for fiscal 2011 from $601.8 million for fiscal 2010. This increase was primarily due to a 12.8% increase in our volume of executed and/or cleared exchange-traded futures and options transactions to 1,891.4 million contracts for fiscal 2011 from 1,676.5 million contracts for fiscal 2010. During fiscal 2011, we experienced increased transaction volumes spread across many of our primary markets, products and geographic regions except for futures and options and equities. Our execution and clearing fees are not fixed, but instead are calculated on a per-contract basis, and vary based on the market on which transactions are executed and cleared. Not all transactions that generate execution-only revenue generate corresponding execution or clearing fees, while some matched principal transactions do. Included within execution and clearing fees are losses due to transactional errors, which decreased from 0.7% of revenues, net of interest and transaction based expenses, for fiscal 2010, to 0.4% of revenues, net of interest and transaction based expenses, for fiscal 2011.
Sales Commissions
Sales commissions increased $13.1 million, or 5.4%, to $253.7 million for fiscal 2011 from $240.6 million for fiscal 2010. This increase was due to increased trading activity as a result of the volatility and recovery of certain market conditions. Though specific arrangements with introducing brokers may vary, increased volumes from individual investor clients transacting through introducing brokers usually result in a proportionate increase in commissions paid to those brokers. However, a large part of our business is not generated by introducing brokers and, therefore, not all changes to volumes result in a proportionate change to sales commissions.
Other Expenses
Employee Compensation and Benefits (Excluding Non-Recurring IPO Awards)
These expenses refer to all employee compensation, including stock based compensation expense for equity instruments, but excluding restricted stock and restricted stock units issued in connection with the IPO, which are referred to as “IPO awards”. Employee compensation and benefits (excluding IPO awards) decreased $47.7 million, or 7.1%, to $620.7 million for fiscal 2011 from $668.4 million for fiscal 2010. This decrease was primarily due to (i) reduced fixed compensation and headcount
| 50 | MF Global 2011 Form 10-K |
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from the newly implemented restructuring plan and (ii) reduced variable compensation expense paid to employees in connection with our expanded use of stock-based awards as payment for employees’ incentive compensation and our realignment of compensation to achieve certain net revenue ratios. These decreases were partially offset by a $5.2 million increase in severance expenses to $11.6 million for fiscal 2011 from $6.4 million for fiscal 2010 and a one-time expense in fiscal 2011 to discontinue certain U.K. fringe benefits.
Fixed compensation as a percentage of total employee compensation and benefits (excluding IPO awards) was 65.9% for fiscal 2011 compared to 62.6% for fiscal 2010. Excluding severance costs, the ratio of fixed compensation as a percentage of total employee compensation and benefits (excluding IPO awards) was 67.2% for fiscal 2011 compared to 63.2% for fiscal 2010. Employee compensation and benefits (excluding IPO awards) as a percentage of net revenues decreased to 58.1% for fiscal 2011 from 65.9% for fiscal 2010.
In December 2009, the U.K. government introduced legislation that imposed a 50% charge on certain discretionary bonus payments in excess of £0.025 million, made between December 9, 2009 and April 5, 2010 to U.K. employees within the financial services industry. This law was enacted in April 2010 and during fiscal 2011 we paid $3.0 million in respect of this tax. On December 17, 2010, the U.K.’s Financial Services Authority published its final text of its revised Code of Practice on remuneration. Some of our employees in the U.K. will be subject to these rules, which will affect the form of remuneration these employees can receive. For example, for certain employees, the new remuneration code requires the establishment of an appropriate ratio of fixed to variable compensation and requires that at least 40% of variable remuneration must be deferred, rising to 60% if variable remuneration exceeds £0.5 million. We are studying the new rules closely to assess their future impact upon our business.
Employee Compensation and Benefits Related to Non-Recurring IPO Awards
These expenses refer to stock-based compensation expense for restricted stock and restricted stock units issued in connection with our IPO. These expenses are recorded under the guidance of ASC 718 and also include other costs associated with the vesting of these awards. Employee compensation and benefits related to non-recurring IPO awards decreased $19.4 million, or 61.0%, to $12.4 million for fiscal 2011 from $31.8 million for fiscal 2010. During fiscal 2011, all remaining restricted stock and restricted stock units issued in connection with our IPO became fully vested and we do not expect to incur further costs in future periods.
Communications and Technology
Communications and technology expenses increased $15.8 million, or 13.3%, to $134.4 million for fiscal 2011 from $118.6 million for fiscal 2010. This increase was due to increased market data research and communications expenses, reflecting increased client trades during fiscal 2011 as compared to fiscal 2010 as well as the expansion of equities trading in the U.S. and Asia Pacific region. This caption also includes software licenses and costs related to our trading systems. Communications and technology, as a percentage of net revenues, increased to 12.6% for fiscal 2011 from 11.7% for fiscal 2010.
Occupancy and Equipment Costs
Occupancy and equipment costs increased $11.8 million, or 29.9%, to $51.2 million for fiscal 2011 from $39.4 million for fiscal 2010, primarily due to higher costs as a result of additional leased office space in New York, Japan and London. Occupancy and equipment costs, as a percentage of net revenues, increased to 4.8% for fiscal 2011 from 3.9% for fiscal 2010.
Depreciation and Amortization
Depreciation and amortization decreased $10.7 million, or 19.4%, to $44.4 million for fiscal 2011 from $55.1 million for fiscal 2010, primarily due to reduced amortization expense on intangible assets as a result of certain intangible asset impairments related to customer relationships recognized in fiscal 2010, partially offset by an increase in depreciation expense on fixed assets related to the Oracle reengineering initiative. Depreciation and amortization, as a percentage of net revenues, decreased to 4.2% for fiscal 2011 from 5.4% for fiscal 2010.
Professional Fees
Professional fees decreased $10.4 million, or 12.1%, to $75.2 million for fiscal 2011 from $85.6 million for fiscal 2010, primarily due to a $7.2 million decrease in legal and consulting fees and a $3.2 million decrease in other professional fees. We continued to reduce professional fees through enhanced internal accounting, legal and regulatory processes and by internalizing certain functions. Professional fees, as a percentage of net revenues, decreased to 7.0% for fiscal 2011 compared to 8.4% for fiscal 2010.
General and Other
General and other expenses increased $1.5 million, or 1.3%, to $117.2 million for fiscal 2011 from $115.7 million for fiscal 2010. This increase was primarily due to a $31.1 million increase in legal reserves and settlements and a $1.4 million increase in travel and entertainment expenses. The increase in legal reserves primarily relate to new reserves made for numerous legacy lawsuits filed by German retail clients for losses incurred through introducing broker relationships, and these new reserves were made following a recent development in German case law that began to affect our pending litigation outcomes. These increases were partially offset by a $16.1 million change in foreign currency transaction expenses, as reflected in a move to gains of $0.5 million during fiscal 2011 from losses of $15.6 million during fiscal 2010. The foreign currency transaction loss during fiscal 2010 included (i) a $4.1 million currency transaction loss related to the Parabola litigation, which was recorded in May 2009, but applied retrospectively to March 31, 2009, due to accounting requirements and (ii) a $15.6 million currency transaction loss driven by adverse movements of the British Pound and Euro to U.S. Dollar exchange rates. In addition, expenses related primarily to trading membership leases and irrecoverable taxes decreased $3.8 million, our other operating expenses decreased $3.0 million, insurance premiums decreased $1.9 million, advertising expenses decreased $1.0 million, and bad debt expense decreased $5.3 million in fiscal 2011 from fiscal 2010. Bad debt decreased to 0.4% of net
| MF Global 2011 Form 10-K | 51 |
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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
revenues for fiscal 2011 compared to 1.0% for fiscal 2010. General and other expenses, as a percentage of net revenues, decreased to 11.0% for fiscal 2011 from 11.4% for fiscal 2010.
IPO-related Costs
We incurred $0.9 million or 0.1% of our net revenues for fiscal 2010, in connection with the reorganization, separation and recapitalization transactions during our IPO, which we refer to as IPO-related costs. These costs consisted primarily of legal, accounting and consulting fees. Since we did not receive proceeds from the IPO, we expensed these costs. The fiscal 2010 costs were primarily related to continuing compliance with the Sarbanes-Oxley Act.
Restructuring Charges
During the first quarter of fiscal 2011, we completed a critical assessment of our cost base, including reviews of our compensation structure and non-compensation expenses and as a result of this evaluation, we reduced our workforce by 12%. In addition, in the fourth quarter of fiscal 2011, management announced a new strategic business model which required the realignment of existing resources, and as a result we further reduced our headcount by 6%. During fiscal 2011, due to these restructuring activities, we incurred costs of $25.5 million or approximately 2.4% of our net revenues. These costs consisted of severance expense and contract termination costs related office closures. Although we have reduced headcount overall as compared to fiscal 2010, we have also strategically hired personnel in anticipation of fully implementing our new business model. As of March 31, 2011, we anticipate that the restructuring actions taken during fiscal 2011, will result in compensation expense savings, however when coupled with additional personnel hired in 2011, these actions together are estimated to save approximately $67.0 million of net compensation expense, on an annualized basis.
Impairment of Intangible Assets and Goodwill
We recorded a total impairment charge of $19.8 million and $54.0 million, or approximately 1.9% and 5.3% of our net revenues in fiscal 2011 and 2010, respectively, based on our impairment testing of goodwill and certain intangible assets. Based on the results of our analyses, we determined that our market capitalization and the fair value derived from the discounted cash flow model was less than the estimated fair value of our balance sheet and we therefore recorded a charge of $3.8 million and $3.4 million for fiscal 2011 and 2010, respectively, to write-off the entire amount of our goodwill. We have an earn-out arrangement that could result in additional goodwill being recorded in future periods and will continue to assess our goodwill annually or whenever events or changes in circumstances indicate that an interim assessment is necessary.
We also identified triggering events during fiscal 2011 and 2010 that required an impairment analysis to be performed related to certain intangible assets. Due to the decrease in expected cash flows from certain long-lived intangible assets related to higher customer attrition and lower velocity as originally estimated in the purchase accounting model, we concluded that such assets were not fully recoverable. As a result of our analyses, we recorded impairment charges of $16.0 million and $50.6 million for fiscal 2011 and 2010, respectively, related to customer relationships, technology assets and trade names.
Gains on Exchange Seats and Shares
Gains on exchange seats and shares decreased $5.8 million to $2.7 million for fiscal 2011 from $8.5 million for fiscal 2010. These gains are unrealized gains and the amounts recorded are based on the fair market value movements of our remaining excess seats and shares. Absent future demutualizations or changes in trading requirements, we do not expect to recognize material amounts of gains on seats and shares in future periods.
Loss on Extinguishment of Debt
Loss on extinguishment of debt decreased $5.6 million, or 57.7%, to $4.1 million for fiscal 2011 from $9.7 million for fiscal 2010. Loss on extinguishment of debt for fiscal 2011 was incurred as the result of (i) the Exchange Offer, in which some of our 9% Convertible Notes were exchanged for a cash premium and Common Stock, resulting in a loss on the early extinguishment of debt of $2.7 million in the second quarter of fiscal 2011 and (ii) our open repurchase of some of our 9% Convertible Notes, resulting in a loss on the early extinguishment of debt of $1.4 million in the fourth quarter of fiscal 2011. Loss on extinguishment of debt for fiscal 2010 was incurred as the result of the early repayment of a two-year term loan facility in April 2009. In repaying the two-year term loan facility prior to its scheduled maturity, we incurred a loss on the early extinguishment of debt of $9.7 million in the first quarter of fiscal 2010.
Interest on Borrowings
Interest on borrowings increased $3.2 million, or 8.1%, to $42.9 million for fiscal 2011 from $39.7 million for fiscal 2010. This increase was primarily due to higher levels of outstanding debt driven by the issuance of 1.875% Convertible Notes in the fourth quarter of fiscal 2011, borrowing from the liquidity facility during the third and fourth quarters of fiscal 2011 as well as an increase in facility fees resulting from the amendment of the liquidity facility, including a one-time fee of $6.8 million paid to the lenders which is amortized over the life of the facility. These increases were partially offset by lower interest payments on the reduced aggregate principal amount of outstanding 9% Convertible Notes as a result of the Exchange Offer in the second quarter of fiscal 2011. We intend to continue using, from time to time, the liquidity facility for the purposes of prudent liquidity management. Interest on borrowings, as a percentage of net revenues increased to 4.0% for fiscal 2011 from 3.9% for fiscal 2010.
| 52 | MF Global 2011 Form 10-K |
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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION
Provision for Income Taxes
Income tax expense increased $61.5 million to a tax provision of $5.2 million for fiscal 2011 from a tax benefit of $56.3 million for fiscal 2010. Our effective income tax rate was (6.8%) for fiscal 2011, as compared to 28.8% for fiscal 2010. The change in the effective tax rate results from the impact of our share price on the value of vested equity compensation (which increased the tax provision by $35.1 million), a significant reduction in the loss before provision for income taxes as compared to fiscal 2010, generating more revenue in lower tax jurisdictions, and a decrease in tax liabilities related to prior years. Our effective tax rate on ongoing operations (excluding discrete items) was approximately 34.4% for fiscal 2011 compared to 30.5% for fiscal 2010.
| MF Global 2011 Form 10-K | 53 |
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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Year Ended March 31, 2010 Compared to the Year Ended March 31, 2009:
| FOR THE YEAR ENDED MARCH 31, | ||||||||||||
| (Dollars in millions, except per share and share amounts) | 2010 | 2009 | % Change | |||||||||
| Revenues |
||||||||||||
| Commissions |
$ | 1,386.0 | $ | 1,642.4 | (15.6 | )% | ||||||
| Principal transactions |
151.0 | 280.1 | (46.1 | ) | ||||||||
| Interest income |
415.3 | 816.6 | (49.1 | ) | ||||||||
| Other |
42.4 | 112.4 | (62.3 | ) | ||||||||
| Total revenues |
1,994.7 | 2,851.6 | (30.0 | ) | ||||||||
| Interest and transaction-based expenses: |
||||||||||||
| Interest expense |
137.3 | 431.9 | (68.2 | ) | ||||||||
| Execution and clearing fees |
601.8 | 741.0 | (18.8 | ) | ||||||||
| Sales commissions |
240.6 | 252.0 | (4.5 | ) | ||||||||
| Total interest and transaction-based expenses |
979.7 | 1,425.0 | (31.2 | ) | ||||||||
| Revenues, net of interest and transaction-based expenses |
1,015.0 | 1,426.7 | (28.9 | ) | ||||||||
| Expenses |
||||||||||||
| Employee compensation and benefits (excluding non-recurring IPO awards) |
668.4 | 787.6 | (15.1 | ) | ||||||||
| Employee compensation related to non-recurring IPO awards |
31.8 | 44.8 | (29.0 | ) | ||||||||
| Communications and technology |
118.6 | 122.6 | (3.3 | ) | ||||||||
| Occupancy and equipment costs |
39.4 | 44.8 | (12.1 | ) | ||||||||
| Depreciation and amortization |
55.1 | 57.8 | (4.7 | ) | ||||||||
| Professional fees |
85.6 | 97.8 | (12.5 | ) | ||||||||
| General and other |
115.7 | 102.5 | 12.9 | |||||||||
| IPO-related costs |
0.9 | 23.1 | (96.1 | ) | ||||||||
| Impairment of intangible assets and goodwill |
54.0 | 82.0 | (34.1 | ) | ||||||||
| Total other expenses |
1,169.5 | 1,363.1 | (14.2 | ) | ||||||||
| Gains on exchange seats and shares |
8.5 | 15.1 | (43.7 | ) | ||||||||
| Loss on extinguishment of debt |
9.7 | — | 100.0 | |||||||||
| Interest on borrowings |
39.7 | 68.6 | (42.1 | ) | ||||||||
| (Loss)/income before provision for income taxes |
(195.4 | ) | 9.9 | (2,073.7 | ) | |||||||
| (Benefit)/provision for income taxes |
(56.3 | ) | 41.9 | (234.4 | ) | |||||||
| Equity in income/(loss) of unconsolidated companies (net of tax) |
3.8 | (16.2 | ) | (123.5 | ) | |||||||
| Net loss |
(135.3 | ) | (48.1 | ) | 181.3 | |||||||
| Net income attributable to noncontrolling interest (net of tax) |
1.7 | 1.0 | 70.0 | |||||||||
| Net loss attributable to MF Global Holdings Ltd. |
$ | (137.0 | ) | $ | (49.1 | ) | 179.0 | |||||
| Loss per share: |
||||||||||||
| Basic |
$ | (1.36 | ) | $ | (0.58 | ) | ||||||
| Diluted |
$ | (1.36 | ) | $ | (0.58 | ) | ||||||
| Weighted average number of shares of common stock outstanding: |
||||||||||||
| Basic |
123,222,780 | 121,183,447 | ||||||||||
| Diluted |
123,222,780 | 121,183,447 | ||||||||||
| 54 | MF Global 2011 Form 10-K |
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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION
Overview
Revenues, net of interest and transaction-based expenses, decreased $411.7 million, or 28.9%, to $1,015.0 million for fiscal 2010 from $1,426.7 million for fiscal 2009. The decrease in revenues, net of interest and transaction based expenses, was due in part to lower net interest generated from client funds due to declining interest rates, the narrowing of short-term credit spreads in fixed income and reduced volatility and bid-ask spreads in the commodities and foreign exchange markets. See “—Supplementary Data” for further details. The decrease was also due to an 8.5% decrease in our total volumes of executed and/or cleared exchange-traded futures and options transactions from 1,832.6 million contracts for fiscal 2009 to 1,676.5 million contracts for fiscal 2010. The decrease of 156.1 million contracts in our total volumes of executed and/or cleared exchange-traded futures and options transactions was spread across many of our primary products, markets and geographic regions. In addition, during fiscal 2009, there was an increase in other revenues that reflected a $62.1 million insurance reimbursement in connection with the litigation brought by a court appointed receiver for Philadelphia Alternative Asset Fund Ltd. (“PAAF”) and its fund manager and commodity pool operator, Philadelphia Asset Management Co. LLC. Excluding the litigation insurance reimbursement, revenues, net of interest and transaction-based expenses would have decreased $349.6 million or 25.6%.
Our other expenses, which refer to our expenses other than interest and transaction-based expenses, decreased $193.6 million, or 14.2%, to $1,169.5 million for fiscal 2010 from $1,363.1 million for fiscal 2009. The decrease was primarily due to a reduction of $119.2 million in employee compensation and benefits (excluding non-recurring IPO awards) which correlates with decreased net revenues, a reduction in impairment of intangible assets and goodwill of $28.0 million, a reduction of $22.9 million related to lower IPO-related and Refco integration costs, a reduction of $13.0 million of stock-based compensation expense on our equity awards issued in connection with the completion of our IPO, a reduction of $12.2 million in professional fees, a reduction of $5.4 million in occupancy and equipment costs and a reduction of $4.0 million in communications and technology costs. These reductions for fiscal 2010 were partially offset by an increase in general and other expenses of $13.2 million. This increase in general and other expenses was due to $15.6 million in foreign exchange translation losses arising during fiscal 2010 compared to foreign exchange translation gains of $12.6 million for fiscal 2009, offset by a decrease of $9.9 million in bad debt expense.
Loss before provision for income taxes was $195.4 million for fiscal 2010 compared to income of $9.9 million for fiscal 2009. This loss was primarily due to decreased revenues, net of interest and transaction-based expenses, the $9.7 million loss on extinguishment of debt that we incurred in relation to the early repayment of the Two-Year Term Facility and a decrease of $6.6 million in gains on exchange seats and shares. The loss was partially offset by the decrease in other expenses mentioned above and a decrease of $28.9 million in interest on borrowings.
Net loss increased $87.2 million to $135.3 million for fiscal 2010 from $48.1 million for fiscal 2009. Net loss is impacted by the items discussed above, plus a decreased effective tax rate while in a loss position resulting from higher non-deductible costs, increased valuation allowance and uncertain tax position reserves, the impact of our share price on the value of vested equity compensation and an increase in our operating results being earned in higher tax jurisdictions. Partially offsetting these items are tax credits, a one-time benefit due to our change in corporate domicile and reductions in prior year liabilities.
Revenues
Commissions
Commissions decreased $256.4 million, or 15.6% to $1,386.0 million for fiscal 2010 from $1,642.4 million for fiscal 2009. The decrease was partially due to an 8.5% decrease in our total volumes of executed and/or cleared exchange-traded futures and options transactions from 1,832.6 million contracts for fiscal 2009 to 1,676.5 million contracts for fiscal 2010. Commissions consist of both execution-only and cleared commissions. The decrease in our transaction volumes and commissions was attributed to (i) reduced volumes due to middle market and smaller clients, which tend to be more profitable, reducing their trading activity as a result of the unprecedented volatility and unstable market conditions, (ii) the continuing self-execution of trades by clients on NYMEX as they shift from floor based to screen based executions, (iii) volume decreases impacted by a depressed economic climate as larger corporate customers are affected by market turmoil and have reduced their risk appetite, (iv) reductions in equity transactions as a result of declining stock market values in Europe and India upon which certain commissions are calculated and (v) decreases in trading in interest rate and commodities products and by individual investor clients, which are not always driven by valuation. These changes also reduced our yields on our total trades, as market dislocations reduced rates earned from large corporate clients, thereby further decreasing commissions.
Principal Transactions
Revenue from principal transactions decreased $129.1 million, or 46.1%, to $151.0 million for fiscal 2010 from $280.1 million for fiscal 2009. Principal transactions do not reflect the net interest income earned from principal transactions and related financing transactions, which is included in interest income and expense. Net interest income earned from these principal transactions and related financing transactions was $119.0 million for fiscal 2010 compared to $141.2 million for fiscal 2009. When factoring in net interest income from principal transactions and related financing transactions, which is how our management views the business, principal transactions revenues decreased $128.0 million, or 31.9%, to $273.8 million for fiscal 2010 from $401.8 million for fiscal 2009. The decrease in principal transactions was attributable to reduced matched principal brokerage in foreign exchange, equities and commodities markets which decreased from $224.5 million to $137.4 million for fiscal 2009 and 2010, respectively, as well as a reduction in fixed income revenue resulting from narrowing short-term credit spreads, which decreased from $34.5 million to $9.5 million for fiscal 2009 and 2010, respectively. See “—Supplementary Data” for further information on principal transactions revenues.
Interest Income, Net
Interest income, net, decreased $106.7 million, or 27.7%, to $278.0 million for fiscal 2010 from $384.7 million for fiscal 2009. This decrease was primarily due to declining interest rates and a
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decrease in net interest generated from principal transactions and related financing transactions as described further below. The average federal funds rate in the United States decreased from 1.03% during fiscal 2009 to 0.15% during fiscal 2010. This contributed to net interest from client funds and excess cash decreasing $84.5 million from $243.5 million for fiscal 2009 to $159.0 million for fiscal 2010 due to (i) reduced rates earned on excess cash during fiscal 2010, (ii) narrower spreads earned on client funds as we reduced the duration of our investment portfolio of client balances from last year to ensure we had significant liquidity in the current volatile environment to meet client needs and (iii) clients withdrawing some of their excess cash since last year, consistent with the trend in the market, to increase their own liquidity during these volatile times. The decline in interest income, net, was also driven by a 15.7% decrease in net interest generated from principal transactions and related financing transactions from $141.2 million for fiscal 2009 to $119.0 million for fiscal 2010. This decrease was due to the narrower spreads earned by our fixed income products during fiscal 2010, consisting of both repurchase and resale transactions, and stock borrowing and lending activities. See “— Supplementary Data” for further information on the components of net interest income.
Other Revenues
Other revenues decreased $70.0 million, or 62.3%, to $42.4 million for fiscal 2010 compared to $112.4 million for fiscal 2009. This decrease was primarily due to the $62.1 million one-time PAAF litigation settlement reimbursement that we received during fiscal 2009. In the absence of this settlement, other revenues decreased $7.9 million, or 15.7% reflecting a reduction in recharges to clients for local taxes in certain European markets and decreased ancillary third-party fees received from clients and other counterparties for the use of various trading systems, data and other professional staff and support services, all of which were affected by declining trading volumes. These decreases were partially offset by a $3.2 million settlement we received in fiscal 2010, in relation to litigation regarding our prior acquisition of Refco assets.
Transaction-based Expenses
Execution and Clearing Fees
Execution and clearing fees decreased $139.2 million, or 18.8%, to $601.8 million for fiscal 2010 from $741.0 million for fiscal 2010. This decrease was primarily due to an 8.5% decrease in our volume of executed and/or cleared exchange-traded futures and options transactions from 1,832.6 million contracts for fiscal 2009 to 1,676.5 million contracts for fiscal 2010. During fiscal 2010, we experienced decreased transaction volumes, spread across many of our primary markets, products and geographic regions. Our execution and clearing fees are not fixed, but instead are calculated on a per-contract basis, and vary based on the market on which transactions are executed and cleared. Not all transactions that generate execution-only revenue generate corresponding execution or clearing fees, while some matched principal transactions do. Included within execution and clearing fees are losses due to transactional errors, which increased from 0.6% of revenues, net of interest and transaction based expenses, for fiscal 2009 to 0.7% of revenues, net of interest and transaction based expenses, for fiscal 2010.
Sales Commissions
Sales commissions decreased $11.4 million, or 4.5% to $240.6 million for fiscal 2010 from $252.0 million for fiscal 2009. This decrease was primarily due to declining trading volume as a result of lack of client confidence in the markets, unstable market conditions and investors not trading with the same frequency during fiscal 2010 as compared to fiscal 2009. Depending on the specific arrangements with introducing brokers, decreased volumes from individual investor clients transacting through introducing brokers usually result in a proportionate decrease in commissions paid to brokers. However, a large part of our business is not generated by introducing brokers and therefore not all changes to volumes result in a proportionate change to sales commissions.
Other Expenses
Employee Compensation and Benefits (Excluding Non-Recurring IPO Awards)
These expenses refer to all employee compensation, including stock based compensation expense for equity instruments, but excludes restricted stock and restricted stock units issued in connection with the IPO. Employee compensation and benefits (excluding IPO awards) decreased $119.2 million, or 15.1%, to $668.4 million for fiscal 2010 from $787.6 million for fiscal 2009. This decrease was primarily due to (i) reduced variable compensation paid to employees based on lower net revenues, volume and profit contributions, (ii) a reduction in termination expenses from $38.1 million for fiscal 2009 to $6.4 million for fiscal 2010, (iii) the $27.5 million write-down of upfront compensation costs, and (iv) reduced discretionary bonus expense of $11.7 million. Related to the write-down of upfront compensation costs, we commenced a strategic assessment of our cost base, including reviews of our compensation structure and non-compensation expenses. As a result of these reviews, we eliminated future service requirements on the majority of previously granted sign-on bonuses and other retention payments which resulted in a one-time write-down of upfront compensation payments. Related to the discretionary bonus expense, we have elected to expand our use of stock-based awards as payment for employees’ incentive compensation, which we believe will further align the interests of our employees with the interests of shareholders. Accordingly, during fiscal 2010, management decided to increase the percentage of compensation paid in three-year vesting stock awards, and reduced discretionary bonus expense by $11.7 million.
This overall 15.1% decrease was partially offset by increases in payroll expenses due to increased professional headcount. Fixed producer and professional compensation as a percentage of total employee compensation and benefits (excluding IPO awards) was 62.6% for fiscal 2010 compared to 41.9% for fiscal 2009. Excluding termination costs and the write-down of upfront compensation payments, the ratio of fixed producer and professional compensation as a percentage of total employee compensation and benefits (excluding IPO awards) was 65.9% for fiscal 2010 compared to 44.0% for fiscal 2009. Employee compensation and benefits (excluding IPO awards), as a percentage of revenues, net of interest and transaction-based expenses, increased to 65.9% for fiscal 2010 from 55.2% for fiscal 2009. Excluding termination costs and the write-down
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of upfront compensation payments, employee compensation and benefits (excluding IPO awards), as a percentage of revenues, net of interest and transaction based expenses increased to 62.5% for fiscal 2010 from 52.5% for fiscal 2009.
In December 2009, the U.K. government introduced legislation which would impose a 50% charge on certain discretionary bonus payments in excess of £0.025 million, made between December 9, 2009 and April 5, 2010 to U.K. employees within the financial services industry. As of March 31, 2010, this law had not been enacted and no accrual had been made with respect to this item in our financial statements. This law was enacted in April 2010.
Employee Compensation and Benefits Related to Non-Recurring IPO Awards
These expenses refer to stock-based compensation expense for restricted stock and restricted stock units issued in connection with our IPO. Employee compensation and benefits related to non-recurring IPO awards decreased $13.0 million, or 29.0%, to $31.8 million for fiscal 2010 from $44.8 million for fiscal 2009. This decrease is primarily attributable to the accelerated vesting of certain awards in fiscal 2009 as well as the impact in fiscal 2010 of reduced expense from forfeitures during the prior fiscal year. These expenses are considered non-recurring and directly attributable to the IPO.
Communications and Technology
Communications and technology expenses decreased $4.0 million, or 3.3%, to $118.6 million for fiscal 2010 from $122.6 million for fiscal 2009. This decrease was due to reduced software licensing and maintenance costs, a reduction in outsourced computer services and decreased telecommunication expenses resulting from the consolidation of the CBOT and CME exchange floors as a result of which we now require less equipment to participate on the combined CME/CBOT exchange floors. In addition, we experienced reduced market data research and communications expenses, reflecting fewer client trades during fiscal 2010 as compared to fiscal 2009. This caption also includes software licenses and costs related to our trading systems. Communications and technology, as a percentage of revenues, net of interest and transaction-based expenses, increased to 11.7% for fiscal 2010 from 8.6% for fiscal 2009.
Occupancy and Equipment Costs
Occupancy and equipment costs decreased $5.4 million, or 12.1%, to $39.4 million for fiscal 2010 from $44.8 million for fiscal 2009, primarily due to higher costs incurred during fiscal 2009 as a result of the relocation to new leased premises in London and the renewal of and additional leased office space in New York. This decrease was offset by increased costs in fiscal 2010 due to the leasing of additional office space in Chicago. Occupancy and equipment costs, as a percentage of revenues, net of interest and transaction-based expenses, increased to 3.9% for fiscal 2010 as compared to 3.1% for fiscal 2009.
Depreciation and Amortization
Depreciation and amortization expenses decreased $2.7 million, or 4.7%, to $55.1 million for fiscal 2010 from $57.8 million for fiscal 2009, primarily due to reduced amortization expense on intangible assets of $2.8 million as a result of certain intangible asset impairments related to customer relationships and trade names recognized in fiscal 2009. Depreciation and amortization, as a percentage of revenues, net of interest and transaction-based expenses, increased to 5.4% for fiscal 2010 from 4.1% for fiscal 2009.
Professional Fees
Professional fees decreased $12.2 million, or 12.5%, to $85.6 million for fiscal 2010 from $97.8 million for fiscal 2009, primarily due to $7.3 million of legal and consulting fees that are included in fiscal 2009 which were incurred in relation to a one-time broker-related loss in fiscal 2008. In addition, we reduced professional fees through enhanced internal accounting, legal and regulatory processes and by internalizing certain functions which are now partially reflected in increased professional headcount. Professional fees, as a percentage of revenues, net of interest and transaction-based expenses, increased to 8.4% for fiscal 2010 from 6.9% for fiscal 2009.
General and Other
General and other expenses increased $13.2 million, or 12.9%, to $115.7 million for fiscal 2010 from $102.5 million for fiscal 2009. This increase was due primarily to a $28.2 million variance in foreign currency translation expenses, as reflected in a move from gains of $12.6 million during fiscal 2009 to losses of $15.6 million during fiscal 2010. The foreign currency translation loss during fiscal 2010 included (i) a $4.1 million currency translation loss related to the Parabola litigation, which was recorded in May 2009, but applied retrospectively to March 31, 2009, due to accounting requirements and (ii) a $15.6 million currency translation loss driven by adverse movements of the British Pound and Euro to U.S. Dollar exchange rates. In addition, our higher insurance premiums increased $0.5 million and non-trading related expenses increased $1.4 million. The increases in foreign currency expense, insurance premiums and non-trading related expenses were partially offset by lower travel and entertainment costs of $3.4 million, decreased legal settlements of $2.5 million, decreased Refco integration costs of $0.7 million as well as lower bad debt expense, which decreased from $19.7 million of expense for fiscal 2009 to $9.7 million for fiscal 2010. This decrease in bad debt expense was primarily due to the bankruptcy of Lehman Brothers and the resulting bad debt reserve established during fiscal 2009. Bad debts decreased to 1.0% of revenues, net of interest and transaction based expenses for fiscal 2010 compared to 1.4% for fiscal 2009. General and other expenses, as a percentage of revenues, net of interest and transaction-based expenses, increased to 11.4% for fiscal 2010 from 7.2% for fiscal 2009.
IPO-related Costs
We incurred costs of $0.9 million and $23.1 million, or approximately 0.1% and 1.6% of our revenues, net of interest and transaction-based expenses, for fiscal 2010 and 2009, respectively in connection with the Reorganization, Separation and Recapitalization transactions and the IPO, which we refer to as IPO-related costs. These costs consisted primarily of legal, accounting and consulting fees. Since we did not receive proceeds from the IPO, we expensed these costs. The current
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year costs are primarily related to continuing compliance with the Sarbanes-Oxley Act. We do not expect these costs to continue in future years.
Impairment of Intangible assets and Goodwill
We recorded a total impairment charge of $54.0 million and $82.0 million, or approximately 5.3% and 5.7% of our revenues, net of interest and transaction-based expenses in fiscal 2010 and 2009, respectively based on our annual impairment testing of goodwill and intangible assets. Based on the results of our analyses, we determined that our market capitalization and the fair value derived from the discounted cash flow model was less than the estimated fair value of our balance sheet and we therefore recorded a charge of $3.4 million and $76.8 million for fiscal 2010 and 2009, respectively, to write-off the entire amount of our goodwill. We have an earn-out arrangement that could result in additional goodwill being recorded in future periods and will continue to assess our goodwill annually or whenever events or changes in circumstances indicate that an interim assessment is necessary.
We also identified triggering events during the fourth quarters of fiscal 2010 and 2009 that required an impairment analysis to be performed related to certain intangible assets. Due to the decrease in expected cash flows from certain long-lived intangible assets related to higher customer attrition and lower velocity as originally estimated in the purchase accounting model, we concluded that such assets were not fully recoverable. As a result of our analyses, we recorded impairment charges of $50.6 million for fiscal 2010 related to customer relationships and $5.2 million for fiscal 2009 related to customer relationships and trade names.
Gains on Exchange Seats and Shares
Gains on exchange seats and shares decreased $6.6 million to $8.5 million for fiscal 2010 from $15.1 million for fiscal 2009. The amount of unrealized gains recorded is based on the fair market value movements of the remaining excess seats and shares. The gains for fiscal 2010 were primarily due to gains on the sale of CME, NYMEX and BOTCC shares, and dividends received from CME, LME and LCH. The gains for fiscal 2009 were primarily due to gains on the sale of NYMEX shares and dividends received following the CME/NYMEX merger. Absent future demutualizations or changes in trading requirements, we do not expect to recognize material amounts of gains on seats and shares in future periods.
Loss on Extinguishment of Debt
Loss on extinguishment of debt was a result of the early repayment of the Two-Year Term Facility in April 2009. In repaying the Two-Year Term Facility prior to its scheduled maturity, we incurred a loss on the early extinguishment of debt of $9.7 million in the first quarter of fiscal 2010. The loss has been disclosed separately within our consolidated statement of operations.
Interest on Borrowings
Interest on borrowings decreased $28.9 million, or 42.1%, to $39.7 million for fiscal 2010 from $68.6 million for fiscal 2009. This decrease was primarily due to lower levels of outstanding debt and a decrease in interest rates, particularly the LIBOR rate. During fiscal 2010 we repaid $200.0 million of the outstanding balance on our liquidity facility and, as mentioned above, we also paid the remaining outstanding balance of $240.0 million on the Two-Year Term Facility. Interest from borrowings, as a percentage of revenues, net of interest and transaction-based expenses, decreased to 3.9% for fiscal 2010 from 4.8% for fiscal 2009.
Provision for Income Taxes
Income taxes decreased $98.2 million from a tax provision of $41.9 million for fiscal 2009, to tax benefits of $56.3 million for fiscal 2010. Our effective income tax rate was 28.8%, down from 420.9% for fiscal 2009. The decrease in the effective tax rate results from (i) increased taxes offsetting the tax benefit, primarily from higher non-deductible costs, increased valuation allowance and uncertain tax position reserves, (ii) the impact of our share price on the value of vested equity compensation, and (iii) an increase in our operating results being earned in higher tax jurisdictions. Partially offsetting these items are certain tax credits, a one-time benefit due to our change in corporate domicile and reductions in prior year liabilities due to changes in tax law and the filing of our tax returns. Our effective tax rate on ongoing operations (excluding discrete items) was approximately 30.5% for fiscal 2010 compared to 38.8% for fiscal 2009.
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Supplementary Data
The table below calculates total principal transactions revenue, including the net interest generated from financing transactions related to principal transactions:
| THREE MONTHS ENDED | YEARS ENDED MARCH 31, |
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| JUNE 30, | SEPTEMBER 30, | DECEMBER 31, | MARCH 31, | |||||||||||||||||||||||||||||||||||||
| 2010 | 2009 | 2010 | 2009 | 2010 | 2009 | 2011 | 2010 | 2011 | 2010 | |||||||||||||||||||||||||||||||
| Principal transactions, excluding revenues from investment of client payables |
$ | 69.4 | $ | 49.6 | $ | 41.8 | $ | 40.1 | $ | 42.2 | $ | 33.3 | $ | 89.2 | $ | 31.8 | $ | 242.6 | $ | 154.8 | ||||||||||||||||||||
| Net interest generated from principal transactions and related financing transactions |
18.0 | 37.3 | 23.0 | 32.9 | 25.1 | 26.4 | 19.8 | 22.4 | 85.9 | 119.0 | ||||||||||||||||||||||||||||||
| Principal transactions and related net interest revenue |
$ | 87.4 | $ | 86.9 | $ | 64.8 | $ | 73.0 | $ | 67.3 | $ | 59.7 | $ | 109.0 | $ | 54.2 | $ | 328.5 | $ | 273.8 | ||||||||||||||||||||
The table below provides an analysis of the components of principal transactions:
| THREE MONTHS ENDED | YEARS ENDED MARCH 31, |
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| JUNE 30, | SEPTEMBER 30, | DECEMBER 31, | MARCH 31, | |||||||||||||||||||||||||||||||||||||
| 2010 | 2009 | 2010 | 2009 | 2010 | 2009 | 2011 | 2010 | 2011 | 2010 | |||||||||||||||||||||||||||||||
| Principal transactions, excluding revenues from investment of client payables |
$ | 69.4 | $ | 49.6 | $ | 41.8 | $ | 40.1 | $ | 42.2 | $ | 33.3 | $ | 89.2 | $ | 31.8 | $ | 242.6 | $ | 154.8 | ||||||||||||||||||||
| Principal transactions revenues from investment of client payables |
(3.1 | ) | 0.1 | 3.4 | 1.2 | (1.3 | ) | (0.1 | ) | 1.6 | (5.0 | ) | 0.6 | (3.8 | ) | |||||||||||||||||||||||||
| Principal transactions |
$ | 66.3 | $ | 49.7 | $ | 45.2 | $ | 41.3 | $ | 40.9 | $ | 33.2 | $ | 90.8 | $ | 26.8 | $ | 243.2 | $ | 151.0 | ||||||||||||||||||||
The table below provides an analysis of the components of net interest income:
| THREE MONTHS ENDED | YEARS ENDED MARCH 31, |
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| JUNE 30, | SEPTEMBER 30, | DECEMBER 31, | MARCH 31, | |||||||||||||||||||||||||||||||||||||
| 2010 | 2009 | 2010 | 2009 | 2010 | 2009 | 2011 | 2010 | 2011 | 2010 | |||||||||||||||||||||||||||||||
| Net interest generated from client payables and excess cash |
$ | 50.8 | $ | 34.8 | $ | 49.8 | $ | 31.7 | $ | 51.4 | $ | 44.5 | $ | 48.9 | $ | 48.0 | $ | 200.9 | $ | 159.0 | ||||||||||||||||||||
| Net interest generated from principal transactions and related financing transactions |
18.0 | 37.3 | 23.0 | 32.9 | 25.1 | 26.4 | 19.8 | 22.4 | 85.9 | 119.0 | ||||||||||||||||||||||||||||||
| Net interest income |
$ | 68.8 | $ | 72.1 | $ | 72.8 | $ | 64.6 | $ | 76.5 | $ | 70.9 | $ | 68.7 | $ | 70.4 | $ | 286.8 | $ | 278.0 | ||||||||||||||||||||
The table below calculates net revenues from client payables and excess cash:
| THREE MONTHS ENDED | YEARS ENDED MARCH 31, |
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| JUNE 30, | SEPTEMBER 30, | DECEMBER 31, | MARCH 31, | |||||||||||||||||||||||||||||||||||||
| 2010 | 2009 | 2010 | 2009 | 2010 | 2009 | 2011 | 2010 | 2011 | 2010 | |||||||||||||||||||||||||||||||
| Net interest generated from client payables and excess cash |
$ | 50.8 | $ | 34.8 | $ | 49.8 | $ | 31.7 | $ | 51.4 | $ | 44.5 | $ | 48.9 | $ | 48.0 | $ | 200.9 | $ | 159.0 | ||||||||||||||||||||
| Principal transactions revenues from investment of client payables |
(3.1 | ) | 0.1 | 3.4 | 1.2 | (1.3 | ) | (0.1 | ) | 1.6 | (5.0 | ) | 0.6 | (3.8 | ) | |||||||||||||||||||||||||
| Net revenues from client payables and excess cash |
$ | 47.7 | $ | 34.9 | $ | 53.2 | $ | 32.9 | $ | 50.1 | $ | 44.4 | $ | 50.5 | $ | 43.0 | $ | 201.5 | $ | 155.2 | ||||||||||||||||||||
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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
REPURCHASE AGREEMENTS
The table below presents the ending balance, average and maximum of repurchase agreements accounted for as collateralized financing transactions in each quarterly period ended:
| JUNE 30, | SEPTEMBER 30, | DECEMBER 31, | MARCH 31, | |||||||||||||||||||||||||||||
| 2010 | 2009 | 2010 | 2009 | 2010 | 2009 | 2011 | 2010 | |||||||||||||||||||||||||
| (in billions) | ||||||||||||||||||||||||||||||||
| Ending balance |
$ | 27.0 | $ | 28.5 | $ | 18.7 | $ | 32.4 | $ | 18.6 | $ | 31.3 | $ | 16.6 | $ | 29.1 | ||||||||||||||||
| Quarterly average |
34.6 | 18.1 | 24.4 | 32.7 | 19.6 | 36.8 | 20.3 | 35.6 | ||||||||||||||||||||||||
| Quarterly maximum |
42.0 | 28.5 | 28.4 | 33.5 | 20.3 | 39.8 | 23.9 | 39.8 | ||||||||||||||||||||||||
The table below presents the amount, average and maximum of repurchase agreements qualifying for sales accounting in each quarterly period ended:
| JUNE 30, | SEPTEMBER 30, | DECEMBER 31, | MARCH 31, | |||||||||||||||||||||||||||||
| 2010 | 2009 | 2010 | 2009 | 2010 | 2009 | 2011 | 2010 | |||||||||||||||||||||||||
| (in billions) | ||||||||||||||||||||||||||||||||
| Balances de-recognized |
$ | 4.1 | $ | 12.3 | $ | 4.0 | $ | 14.2 | $ | 7.6 | $ | 8.0 | $ | 14.5 | $ | 5.7 | ||||||||||||||||
| Quarterly average |
4.4 | 12.8 | 3.0 | 13.3 | 5.8 | 11.9 | 11.3 | 6.6 | ||||||||||||||||||||||||
| Quarterly maximum |
5.0 | 13.3 | 4.0 | 14.2 | 7.6 | 14.3 | 14.5 | 7.4 | ||||||||||||||||||||||||
The movements in the notional size of these portfolios are the result of the tightening and expansion of spreads in the cash and repurchase markets. When there is less room for spreads between the two markets, there is less opportunity to take advantage of the anomalies in the market. In the year ended March 31, 2011 we expanded our trading in repurchase agreements qualifying for sales accounting as there were opportunities available in the European market.
Non-GAAP Financial Measures
In addition to our consolidated financial statements presented in accordance with U.S. GAAP, we use, both internally as well as in some of our discussions with investors, certain non-GAAP financial measures of our financial performance for the reasons described further below. The presentation of these measures is not intended to be considered in isolation from, as a substitute for or as superior to, the financial information prepared and presented in accordance with U.S. GAAP, and our presentation of these measures may be different from non-GAAP financial measures used by other companies. In addition, these non-GAAP measures have limitations in that they do not reflect all of the amounts associated with our results of operations as determined in accordance with GAAP. The non-GAAP financial measures we use are (1) non-GAAP adjusted income/ (loss) before provision for income taxes, which we refer to as “adjusted income/ (loss) before taxes”, (2) non-GAAP adjusted net income/ (loss), which we refer to as “adjusted net income/ (loss)”, (3) non-GAAP adjusted net income/ (loss) per adjusted diluted common shares, which we refer to as “adjusted net income/ (loss) per fully diluted share”, (4) non-GAAP adjusted employee compensation and benefits (excluding non-recurring IPO awards), and (5) non-GAAP adjusted non-compensation expenses. These non-GAAP financial measures currently exclude certain of the following items from our consolidated statements of operations, each of which are discussed in greater detail below:
| • | Certain legal reserves, settlements and related expenses |
| • | Restructuring charges |
| • | Impairment of intangible assets and goodwill |
| • | Stock compensation expense related to IPO awards |
| • | Severance and benefits expense |
| • | Loss on extinguishment of debt |
| • | U.K. bonus tax |
| • | Gains on exchange seats and shares |
| • | Write-down of upfront compensation payments |
| • | Foreign currency transaction losses and gains |
| • | February 2008 broker-related loss costs |
| • | IPO-related costs |
| • | Lehman bad debt |
| • | Other adjustments |
| • | Certain defined tax adjustments |
| • | USFE impairment loss |
| • | Deemed dividend resulting from the Exchange Offer |
We do not believe that these items are representative of our future operating performance from normal operations. In particular, we exclude restructuring charges, stock compensation expense related to IPO awards, a U.K. bonus tax, the write-down of upfront compensation payments, costs associated with the February 2008 broker-related loss, IPO-related costs, Lehman bad debt and USFE impairment loss because we believe that they reflect losses or expenses arising from particular events that are not reasonably likely to recur. In addition, we exclude severance and benefits expense, loss on extinguishment of debt, certain legal reserves, settlements and related expenses, gains on exchange seats and shares, impairment of intangible assets and goodwill, foreign currency transaction losses and gains, certain defined tax adjustments, the deemed dividend resulting from exchange offer and other adjustments because we believe that these gains and losses do not reflect our operating performance and can make it difficult for our shareholders to understand and compare our past or future financial performance.
In addition, we may consider whether other significant items that arise in the future should also be excluded in calculating the non-GAAP financial measures we use. The non-GAAP financial measures also take into account income tax adjustments with respect to the excluded items.
CERTAIN LEGAL RESERVES, SETTLEMENTS AND RELATED EXPENSES
We have excluded certain legal reserves, settlements and the related costs during fiscal 2011 related to the February 2008
| 60 | MF Global 2011 Form 10-K |
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broker-related loss class action suits and other cases. Among these cases, the most significant relate to lawsuits filed by former German retail clients for losses incurred through introducing broker relationships. For fiscal 2010, we excluded settlements related to three specific legal disputes. In fiscal 2009, we excluded reimbursement related to litigation with Philadelphia Alternative Asset Fund Ltd. The February 2008 broker-related loss relates solely to the unauthorized trading event in fiscal 2008 by a broker operating out of our branch office in Memphis, Tennessee. We do not believe that the reserves, settlements and related expenses, which related solely to specific proceedings, are representative of our future performance from normal operations. Although we have excluded certain legal reserves, settlements and related costs, our practice is to include in earnings all amounts that we are awarded in affirmative litigation.
RESTRUCTURING CHARGES
During fiscal 2011, we completed a critical assessment of our cost base, including reviews of our compensation structure and non-compensation expenses as well as announcing a new strategic business model. As a result of these restructuring activities, we reduced our workforce and recorded restructuring charges of $27.1 million during fiscal 2011 related to severance, the accelerated vesting of stock compensation expense related to these terminations and contract termination costs for office closures. At this time, we do not anticipate a wide scale global restructuring program that would require further material charges, however we will continue to assess this as we move to implement our new strategic plan. We do not believe that these costs are representative of our future performance from normal operations.
IMPAIRMENT OF INTANGIBLE ASSETS AND GOODWILL
During fiscal 2011, 2010 and 2009 we identified triggering events that required an impairment analysis to be performed related to goodwill and certain intangible assets. Based on the results of our analyses, we determined that our market capitalization and the fair value derived from the discounted cash flow model was less than the estimated fair value of our balance sheet and we determined the entire amount of our goodwill was impaired. Due to the decrease in expected cash flows from certain long-lived intangible assets related to higher customer attrition and lower velocity as originally estimated in the purchase accounting model, we concluded that such assets were not fully recoverable and recorded impairment charges related to customer relationships, technology assets and trade names. We will continue to assess our goodwill and intangible assets annually or whenever events or changes in circumstances indicate that an interim assessment is necessary. We do not believe that this expense is representative of our future performance from normal operations.
STOCK COMPENSATION EXPENSE RELATED TO IPO AWARDS
We incurred stock based compensation expense during fiscal 2011, 2010 and 2009 for the restricted shares and restricted share units awarded to our employees in connection with the IPO. These costs were incurred solely because of our IPO, and as a result we do not believe that they are representative of our future performance from normal operations.
SEVERANCE AND BENEFITS EXPENSE
We incurred severance expense during fiscal 2011, 2010 and 2009 related to payments made to employees in conjunction with employee termination, redundancy, separation and similar agreements. In fiscal 2011, we also made a one-time payment to certain U.K. employees to compensate them for a pre-IPO fringe benefit that will be discontinued. We do not believe that these costs are representative of our future performance from normal operations.
LOSS ON EXTINGUISHMENT OF DEBT
During fiscal 2011, in connection with the Exchange Offer, some of our 9% Convertible Notes were exchanged for a cash premium and Common Stock. As a result, we incurred a loss on the early extinguishment of debt of $2.7 million. We also incurred an additional loss on the early extinguishment of debt of $1.4 million during the fourth quarter of fiscal 2011 from repurchasing some of our 9% Convertible Notes in the open market. During fiscal 2010, as the result of repaying the Two-Year Term Facility prior to its scheduled maturity in April 2009, we incurred a loss on the early extinguishment of debt of $9.7 million. These losses result directly from the Exchange Offer, repurchase and early repayment of debt, and we do not believe they are representative of our future performance from normal operations.
U.K. BONUS TAX
In December 2009, the U.K. government introduced legislation that imposed a 50% charge on certain discretionary bonus payments in excess of £0.025 million made between December 9, 2009 and April 5, 2010 to U.K. employees within the financial services industry. During fiscal 2011, we paid $3.0 million in respect of this tax. We do not believe that this additional tax expense is representative of our future performance from normal operations.
GAINS ON EXCHANGES SEATS AND SHARES
We recognize unrealized gains or losses on exchange seats and shares that we hold in excess of the number of shares we need to conduct our operations as an executing broker or clearing member. The amount of unrealized gain or loss recorded for each period is based on the fair market value movements of these seats or shares, which can be highly volatile and subject to significant change from period to period. Since these assets are not an integral part of our business and normal operations, we believe that the use of a non-GAAP measure to exclude these gains is more meaningful to investors in understanding our historical and future results of operations. Absent future demutualizations or changes in trading requirements, we do not expect to recognize material amounts of gains on seats and shares in future periods.
WRITE-DOWN OF UPFRONT COMPENSATION PAYMENTS
We completed a strategic assessment of our cost base, including reviews of our compensation structure and non-compensation expenses. As a result of these reviews, in fiscal 2011 and 2010, we eliminated future service requirements on the majority of previously granted sign-on bonuses and other retention payments, which resulted in a one-time write-down of upfront compensation payments. We do not believe that this expense is representative of our future performance from normal operations.
| MF Global 2011 Form 10-K | 61 |
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FOREIGN CURRENCY TRANSACTION LOSSES AND GAINS
We incurred a foreign currency transaction loss in fiscal 2010 that included a loss related to the Parabola litigation, which was recorded in May 2009, but applied retrospectively to March 31, 2009, due to accounting requirements and a loss driven by adverse movements of the British Pound and Euro to U.S. Dollar exchange rates. These losses and gains are not representative of our future performance from normal operations.
FEBRUARY 2008 BROKER-RELATED LOSS COSTS
During fiscal 2010 and 2009 we incurred additional expenses related to the February 2008 broker-related loss that included legal and consulting fees. These items arose from and related solely to the unauthorized trading event in fiscal 2008 by a broker operating out of our branch office in Memphis, Tennessee. We do not believe that the related costs are representative of our future performance from normal operations, as we do not expect such costs with similar materiality to recur or impact future periods.
IPO-RELATED COSTS
We have excluded costs related to our IPO consisting of legal, accounting, consulting and other professional fees, as well as the costs associated with the first time implementation of our control processes and procedures due to the Sarbanes-Oxley Act. During fiscal 2010 we incurred costs primarily related to continuing compliance with the Sarbanes-Oxley Act. We incurred these costs solely because of our IPO, and as a result we do not believe that they are representative of our future performance from normal operations. We did not incur any additional IPO-related costs in fiscal 2011.
LEHMAN BAD DEBT
During fiscal 2009, we excluded a bad debt expense related to the bankruptcy of Lehman Brothers and our resulting provision on all receivables with them. This additional bad debt related to a unique event as it was incurred solely because of the bankruptcy of Lehman Brothers, and as a result we do not believe that it is representative of our future performance from normal operations.
OTHER ADJUSTMENTS
Other adjustments for fiscal 2011 consist of the impairment of a loan related to an abandoned project that is not recoverable. Other adjustments for fiscal 2009 consist of Refco integration costs and costs related to the reorganization of our offices in France and Canada. We believe that these expenses are not representative of our future performance from normal operations.
CERTAIN DEFINED TAX ADJUSTMENTS
We have excluded certain defined tax adjustments related to our IPO and change in corporate domicile. During fiscal 2011 we incurred a write-off of deferred tax assets associated with equity compensation awards, primarily related to stock compensation awards issued in connection with the IPO and the restructuring, which vested at a lower fair market value on the vesting date. During fiscal 2010 we incurred tax expense related to a change in corporate domicile from Bermuda to the State of Delaware. During fiscal 2009 we recorded a net adjustment to a previously-booked tax expense related to our reorganization and separation from Man Group. These additional tax expenses relate to unique events as they were incurred solely because of our IPO and change in corporate domicile, and as a result we do not believe that they are representative of our future performance from normal operations.
USFE IMPAIRMENT LOSS
During fiscal 2009, we announced our strategic decision to no longer participate in U.S. Futures Exchange LLC (“USFE”), after which USFE decided to liquidate its operations. As a result, we experienced a decline in the value of our equity investment and recorded an impairment loss of $14.6 million, net of tax. This impairment loss is infrequent and unusual and results from highly unusual facts and circumstances. It is not representative of our future performance from normal operations, as we do not expect such impairment losses with similar materiality to recur or impact future periods.
DEEMED DIVIDEND RESULTING FROM EXCHANGE OFFER
During fiscal 2010, we completed our offer to exchange shares of our Common Stock and a cash premium for any and all of our outstanding 9% Convertible Notes and Series B Preferred Stock. As of the expiration of the Exchange Offer, some shares of Series B Preferred Stock were validly tendered for which we issued Common Stock, paid a cash premium of $48.8 million and paid accrued dividends. U.S. GAAP stipulates that the cash premium be presented as a deemed dividend in the statement of operations to calculate Net loss applicable to common shareholders. This loss results directly from our offer to exchange and is not representative of our future performance from normal operations.
OUR USE OF NON-GAAP FINANCIAL MEASURES
We use certain non-GAAP financial measures internally to evaluate our operating performance and make financial and operational decisions. We believe that our presentation of these measures provides investors with greater transparency and supplemental data relating to our results of operations. In addition, we believe the presentation of these measures is useful for period-to-period comparison of results because (1) restructuring charges, stock compensation expense related to IPO awards, a U.K. bonus tax, the write-down of upfront compensation payments, costs associated with the February 2008 broker-related loss, IPO-related costs, certain defined tax adjustments, Lehman bad debt, USFE impairment loss, the deemed dividend resulting from the exchange offer and other adjustments described above do not reflect our historical operating performance and (2) severance and benefits expense, loss on extinguishment of debt, certain legal reserves, settlements and related expenses, gains on exchange seats and shares, impairment of intangible assets and goodwill, and foreign currency transaction losses and gains fluctuate significantly from period to period and are not indicative of our core operating performance and, with respect to gains on exchange seats and shares, are not expected to be significantly realized in the future.
When viewed with our GAAP results and the accompanying reconciliation, we believe adjusted net income/ (loss), adjusted income/ (loss) before taxes, adjusted net income/ (loss) per fully diluted share, adjusted employee compensation and benefits (excluding non-recurring IPO awards) and adjusted non-compensation expenses provide a more complete understanding of the factors affecting our business than GAAP
| 62 | MF Global 2011 Form 10-K |
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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION
measures alone. We believe these financial measures enable us to make a more focused evaluation of our operating performance and management decisions made during a reporting period, because they exclude the effects of certain items that we believe have less significance in the day-to-day performance of our business. Our internal budgets and reporting are based on these financial measures, and we communicate them to our board of directors. In addition, these measures are among the criteria used in determining performance-based compensation. We understand that analysts and investors often rely on non-GAAP financial measures, including per-share measures, to assess core operating performance, and thus may consider adjusted net income/ (loss), adjusted income/ (loss) before taxes, adjusted net income/ (loss) per fully diluted share, adjusted employee compensation and benefits (excluding non-recurring IPO awards) and adjusted non-compensation expenses important in analyzing our performance going forward. These measures may be helpful in more clearly highlighting trends in our business that may not otherwise be apparent from GAAP financial measures alone.
GAAP Reconciliation
The table below reconciles (loss)/ income before provision for income taxes (GAAP) to adjusted income/ (loss) before taxes (non-GAAP) and net loss applicable to common shareholders (GAAP) to adjusted net income/ (loss) (non-GAAP), for the periods presented:
| YEAR ENDED MARCH 31, | ||||||||||||
| (in millions except per share data) | 2011 | 2010 | 2009 | |||||||||
| (Loss)/ income before provision for income taxes (unadjusted) |
$ | (76.3 | ) | $ | (195.4 | ) | $ | 9.9 | ||||
| Add/(Less): Certain legal reserves, settlements and related expenses |
36.6 | 3.4 | (46.6 | ) | ||||||||
| Add: Restructuring charges |
27.1 | — | — | |||||||||
| Add: Impairment of intangible assets and goodwill |
19.8 | 54.0 | 82.0 | |||||||||
| Add: Stock compensation expense related to IPO awards |
12.4 | 31.8 | 44.8 | |||||||||
| Add: Severance and benefits expense |
14.9 | 6.4 | 38.1 | |||||||||
| Add: Loss on extinguishment of debt |
4.1 | 9.7 | — | |||||||||
| Add: U.K. bonus tax |
3.0 | — | — | |||||||||
| Less: Gains on exchange seats and shares |
(2.7 | ) | (8.5 | ) | (15.1 | ) | ||||||
| Add: Write-down of upfront compensation payments |
1.3 | 27.5 | — | |||||||||
| Add: Foreign currency transaction losses/(gains) |
— | 16.0 | (12.6 | ) | ||||||||
| Add: February 2008 broker-related loss costs |
— | 2.2 | 7.3 | |||||||||
| Add: IPO-related costs |
— | 0.9 | 23.1 | |||||||||
| Add: Lehman bad debt |
— | — | 5.7 | |||||||||
| Add: Other adjustments |
0.5 | — | 4.4 | |||||||||
| Adjusted income/ (loss) before taxes |
$ | 40.7 | $ | (52.0 | ) | $ | 141.0 | |||||
| Net loss applicable to common shareholders (unadjusted) |
$ | (154.4 | ) | $ | (167.7 | ) | $ | (69.7 | ) | |||
| Add/(Less): Certain legal reserves, settlements and related expenses |
25.1 | 2.1 | (37.3 | ) | ||||||||
| Add: Restructuring charges |
18.5 | — | 2.5 | |||||||||
| Add: Impairment of intangible assets and goodwill |
13.1 | 35.6 | 79.9 | |||||||||
| Add: Stock compensation expense related to IPO awards |
8.8 | 26.6 | 35.5 | |||||||||
| Add: Severance and benefits expense |
10.2 | 4.3 | 27.6 | |||||||||
| Add: Loss on extinguishment of debt |
3.2 | 6.0 | — | |||||||||
| Add: U.K. Bonus Tax |
3.0 | — | — | |||||||||
| Less: Gains on exchange seats and shares |
(1.8 | ) | (6.0 | ) | (8.6 | ) | ||||||
| Add: Write-down of upfront compensation payments |
0.8 | 18.6 | — | |||||||||
| Add: Foreign currency transaction losses/(gains) |
— | 11.5 | (9.1 | ) | ||||||||
| Add: February 2008 broker-related loss costs |
— | 1.2 | 7.6 | |||||||||
| Add: IPO-related costs |
— | 0.6 | 19.5 | |||||||||
| Add: Lehman bad debt |
— | — | 4.0 | |||||||||
| Add: Other adjustments |
0.5 | — | 1.8 | |||||||||
| Add: Certain defined tax adjustments |
28.5 | (5.2 | ) | (0.8 | ) | |||||||
| Add: USFE impairment loss |
— | — | 14.6 | |||||||||
| Add: Deemed dividend resulting from exchange offer |
48.8 | — | — | |||||||||
| Add: Anti-dilutive impact of fully diluted number of shares (1) |
42.3 | 54.1 | 38.0 | |||||||||
| Adjusted net income/ (loss) |
$ | 46.6 | $ | (18.3 | ) | $ | 105.5 | |||||
| Adjusted net income/ (loss) per fully diluted share (2) |
$ | 0.25 | $ | (0.11 | ) | $ | 0.66 | |||||
| Fully diluted shares outstanding (in millions) (3) |
189.0 | 172.6 | 159.8 | |||||||||
| (1) | The anti-dilutive impact of using a fully diluted number of shares requires adding back to net loss applicable to common shareholders the cumulative and participative dividends on our Series A Preferred Stock and declared dividends on our Series B Preferred Stock, as well as the interest and amortization of issuance cost on our 1.875% and 9% Convertible Notes, net of tax. |
| (2) | Calculated by dividing adjusted net income by fully diluted shares outstanding. |
| (3) | We believe it is meaningful to investors to present adjusted net income per fully diluted share. Weighted average shares of common stock outstanding are adjusted at March 31, 2011, 2010 and 2009 to include the impact of our outstanding Series A Preferred Stock, Series B Preferred Stock and 9% Convertible Notes, on an if-converted basis. In addition, weighted average shares of common stock outstanding are also adjusted at March 31, 2010 and 2009 to add back shares underlying restricted stock and stock unit awards (“IPO awards”) granted in connection with our IPO which are not considered dilutive under U.S. GAAP and, therefore, not included in diluted shares of common stock outstanding. For fiscal 2011 weighted average shares of common stock outstanding are adjusted by 12.0 million, 3.9 million and 18.7 million shares, related to the Series A Preferred Stock, Series B Preferred Stock and 9% Convertible Notes, respectively. For fiscal 2010 weighted average shares of common stock outstanding are adjusted by 12.0 million, 14.4 million, 19.6 million and 3.4 million shares, related to the Series A Preferred Stock, Series B Preferred Stock, 9% Convertible Notes and IPO awards, respectively. For fiscal 2009 weighted average shares of common stock outstanding are adjusted by 8.4 million, 11.0 million, 14.6 million and 4.6 million shares, related to the Series A Preferred Stock, Series B Preferred Stock, 9% Convertible Notes and IPO Awards, respectively. We believe it is meaningful to investors to present ratios based on fully diluted shares because it demonstrates the dilution that investors will experience at the end of the three-year vesting period of our IPO awards and when our Series A Preferred Stock, Series B Preferred Stock and 9% Convertible Notes are converted. It is also how our management internally views dilution. |
| MF Global 2011 Form 10-K | 63 |
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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The table below reconciles Employee compensation and benefits (excluding non-recurring IPO awards) to Adjusted employee compensation and benefits (excluding non-recurring IPO awards) for the periods presented.
| YEAR ENDED MARCH 31, | ||||||||||||
| (dollars in millions) | 2011 | 2010 | 2009 | |||||||||
| Employee compensation and benefits (excluding non-recurring IPO awards) |
$ | 620.7 | $ | 668.4 | $ | 787.6 | ||||||
| Less: Severance and benefits expense |
(14.9 | ) | (6.4 | ) | (38.1 | ) | ||||||
| Less: U.K. bonus tax |
(3.0 | ) | — | — | ||||||||
| Less: Restructuring charges |
(1.6 | ) | — | — | ||||||||
| Less: Write-down of upfront compensation payments |
(1.3 | ) | (27.5 | ) | — | |||||||
| Adjusted employee compensation and benefits (excluding non-recurring IPO awards) |
$ | 599.9 | $ | 634.5 | $ | 749.5 | ||||||
The table below reconciles Non-compensation expenses to Adjusted non-compensation expenses for the periods presented.
| YEAR ENDED MARCH 31, | ||||||||||||
| (dollars in millions) | 2011 | 2010 | 2009 | |||||||||
| Non-compensation expenses |
$ | 467.9 | $ | 469.3 | $ | 530.7 | ||||||
| Less: Certain legal reserves, settlements and related expenses |
(36.6 | ) | (3.4 | ) | (8.0 | ) | ||||||
| Less: Restructuring charges |
(25.5 | ) | — | — | ||||||||
| Less: Impairment of intangible assets and goodwill |
(19.8 | ) | (54.0 | ) | (82.0 | ) | ||||||
| Less: Foreign currency transaction (losses)/gains |
— | (16.0 | ) | 12.6 | ||||||||
| Less: February 2008 broker-related loss costs |
— | (2.2 | ) | (7.3 | ) | |||||||
| Less: IPO-related costs |
— | (0.9 | ) | (23.1 | ) | |||||||
| Less: Lehman bad debt |
— | — | (5.7 | ) | ||||||||
| Less: Other adjustments |
(0.5 | ) | — | (4.4 | ) | |||||||
| Adjusted non-compensation expenses |
$ | 385.5 | $ | 392.8 | $ | 412.8 | ||||||
In addition to the above, the 1.875% Convertible Notes and related call spread overlay (purchased calls and sold warrants) may also impact Diluted EPS, a GAAP financial measure, and such impact is determined by application of the treasury stock method. Under this method, there is no impact to Diluted EPS until our stock price exceeds the contractual conversion price in the 1.875% Convertible Notes, which is $10.37. At that time, the denominator would be adjusted to include only the incremental shares required to settle the excess value over par of the 1.875% Convertible Notes upon conversion. While the purchased calls are designed to economically offset the dilutive effect of the 1.875% Convertible Notes, under U.S. GAAP the anti-dilutive effect of the purchased calls cannot be reflected in Diluted EPS until the instrument is settled. For the sold warrants, there is a dilutive impact once our stock price exceeds $14.23 and it is measured under the treasury stock method assuming the proceeds from exercised warrants are used to repurchase outstanding shares.
The following table illustrates the U.S. GAAP based diluted impact from the 1.875% Convertible Notes and related call spread overlay under the treasury stock method assuming our stock price trades in the range of $10 to $30 per share:
| (in millions except stock price data) | Average stock price during the period | |||||||||||||||||||
| $ | 10.00 | $ | 12.50 | $ | 15.00 | $ | 20.00 | $ | 30.00 | |||||||||||
| Weighted average shares of common stock outstanding |
154.4 | 154.4 | 154.4 | 154.4 | 154.4 | |||||||||||||||
| Dilutive impact of: |
||||||||||||||||||||
| Convertible bond |
— | 4.7 | 8.6 | 13.4 | 18.2 | |||||||||||||||
| Purchased call |
— | — | — | — | — | |||||||||||||||
| Sold warrant |
— | — | 1.0 | 5.8 | 10.6 | |||||||||||||||
| Total shares outstanding after dilution of 1.875% Convertible Notes |
154.4 | 159.1 | 164.0 | 173.6 | 183.2 | |||||||||||||||
| % dilution |
0 | % | 3.1 | % | 6.2 | % | 12.4 | % | 18.6 | % | ||||||||||
We also use adjusted net income/ (loss) per fully diluted share, a non-GAAP financial measure, and have prepared the economic dilution impact of the 1.875% Convertible Notes and related call spread overlay. As mentioned above, the impact is determined by the application of the treasury stock method and there is no impact to Diluted EPS (GAAP) until our stock price exceeds the contractual conversion price of $10.37. At that time, the denominator would be adjusted to include only the incremental shares required to settle the excess value over par of the 1.875% Convertible Notes upon conversion. For the related sold warrants, there is a dilutive impact once our stock price exceeds $14.23 and it is also measured under the treasury stock method assuming the proceeds from exercised warrants are used to repurchase outstanding shares. In calculating adjusted net income per fully diluted share, we would also include the effect of the purchased calls upon settlement. The anti-dilutive impact of the purchased calls would fully offset the dilutive impact of the 1.875% Convertible Notes.
| 64 | MF Global 2011 Form 10-K |
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PART II
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION
The follow table illustrates the economic diluted impact reflected in the adjusted net income/ (loss) per fully diluted share from the 1.875% Convertible Notes and related call spread overlay under the treasury stock method assuming our stock price trades in the range of $10 to $30 per share:
| (in millions except stock price data) | Average stock price during the period: | |||||||||||||||||||
| $ | 10.00 | $ | 12.50 | $ | 15.00 | $ | 20.00 | $ | 30.00 | |||||||||||
| Fully diluted shares outstanding |
189.0 | 189.0 | 189.0 | 189.0 | 189.0 | |||||||||||||||
| Dilutive impact of: |
||||||||||||||||||||
| Convertible bond |
— | 4.7 | 8.6 | 13.4 | 18.2 | |||||||||||||||
| Purchased call |
— | (4.7 | ) | (8.6 | ) | (13.4 | ) | (18.2 | ) | |||||||||||
| Sold warrant |
— | — | 1.0 | 5.8 | 10.6 | |||||||||||||||
| Total shares outstanding after dilution of 1.875% Convertible Notes |
189.0 | 189.0 | 190.0 | 194.8 | 199.6 | |||||||||||||||
| % dilution |
0 | % | 0 | % | 0.6 | % | 3.1 | % | 5.6 | % | ||||||||||
Liquidity and Capital Resources
We have multiple sources of liquidity. We expect our primary liquidity needs over the next 12 months to be for working capital, debt service obligations and preferred dividend obligations. Subject to the discussion below regarding our changing liquidity needs as a result of the implementation of our strategic plan, we believe we will have sufficient liquidity to meet these obligations given our expected cash flows from operations and our available sources of liquidity. Our available sources of liquidity as of March 31, 2011 included: (i) our committed $1,200.9 million unsecured revolving liquidity facility with various banks, which we refer to as our “liquidity facility”, of which $511.3 million terminates in June 2012 and $689.6 million terminates in June 2014, and under which we currently have $367.0 million outstanding and $833.9 million that is undrawn under this facility at March 31, 2011, (which includes $75.0 million drawn in March 2011 for the purposes of prudent liquidity management and subsequently repaid in April 2011); (ii) available excess capital in our regulated subsidiaries, the withdrawal of which is subject to regulatory approval; and (iii) available excess cash held in the bank accounts of non-regulated subsidiaries. See “—Credit Facilities and Sources of Liquidity” for further information. In addition, we have customer collateral that is not included on our balance sheet but can be re-hypothecated by us, and non-segregated customer payables, both of which may be considered (depending, among other things, on where the collateral is located and the regulatory rules applicable to the collateral) an additional layer of liquidity. Non-segregated customer cash in some jurisdictions is also available for other client liquidity demands which helps mitigate the use of our own cash. We also rely on uncommitted lines of credit from multiple sources to fund our day-to-day execution and clearing operations.
On February 11, 2011, we completed an offering of $287.5 million aggregate principal amount of our 1.875% Convertible Senior Notes. The 1.875% Convertible Notes bear interest at a rate of 1.875% per year, payable semi-annually in arrears on February 15 and August 1 of each year, beginning August 1, 2011. The 1.875% Convertible Notes mature on February 1, 2016. Holders may convert the 1.875% Convertible Notes at their option prior to August 1, 2015 upon the occurrence of certain events relating to the price of our Common Stock or various corporate events. On or after August 1, 2015, the holders may convert at the applicable conversion rate at any time prior to maturity. The initial conversion rate for the 1.875% Convertible Notes is 96.4716 shares of common stock per $1,000 principal amount of 1.875% Convertible Notes, equivalent to an initial conversion price of approximately $10.37 per share of common stock. The conversion rate will be subject to adjustment given certain events. We may not redeem the notes prior to maturity. We used $150.5 million of the net proceeds from the offering to repay outstanding indebtedness under the liquidity facility.
In connection with the issuance of the 1.875% Convertible Notes, on February 7, 2011, we entered into privately negotiated convertible bond hedge and warrant transactions. The convertible bond hedge transactions cover, subject to anti-dilution adjustments, approximately 27,735,585 shares of our Common Stock, which is the same number of shares initially issuable upon conversion of the 1.875% Convertible Notes, and are expected to reduce the potential dilution with respect to the common stock and/or reduce our exposure to potential cash payments that may be required to be made by us upon conversion of the 1.875% Convertible Notes. The warrant transactions cover the same initial number of shares of Common Stock, subject to anti-dilution adjustments. The warrants have an initial strike price equal to $14.23, or 75% above the closing price of the Common Stock on the New York Stock Exchange on February 7, 2011. We may, subject to certain conditions, settle the warrants in cash or on a net-share basis. The warrant transactions could have a dilutive effect with respect to the Common Stock or, if we so elect, obligate us to make cash payments or issue additional shares of Common Stock to the extent that the market price per share of Common Stock exceeds the applicable strike price of the warrant transactions on or before any expiration date of the warrants.
We used approximately $27.5 million of the net proceeds from the offering of the 1.875% Convertible Notes to pay the cost of the convertible bond hedge transactions after such cost of $64.0 million was partially offset by the aggregate proceeds of approximately $36.5 million to us from the warrant transactions. The convertible bond hedge transactions and the warrant transactions are separate transactions, each entered into by us with the counterparties, are not part of the terms of the 1.875% Convertible Notes, and will not change any holders’ rights under the 1.875% Convertible Notes. Holders of the 1.875% Convertible Notes will not have any rights with respect to the convertible bond hedge transactions or warrant transactions.
On June 8, 2010, we completed our public offering and sale of 25,915,492 shares of our Common Stock, pursuant to an underwriting agreement, dated June 2, 2010. The agreement provided for the sale of 22,535,211 shares of Common Stock to the underwriters at a price of $6.745 per share. In addition, we granted the underwriters a 30—day option to purchase up to an additional 3,380,281 shares of Common Stock at a price of
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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
$6.745 per share, which was exercised in full on June 3, 2010. The price to the public was $7.10 per share of Common Stock. Net of underwriting discount and other costs, we received $174.3 million as proceeds. The shares have been registered under the Securities Act of 1933 pursuant to a Registration Statement on Form S-3 previously filed with the SEC.
As the credit markets and our financial position and business continue to evolve, we regularly assess our capital structure and evaluate opportunities to access the capital markets to reposition or restructure it including by extending the maturities of our outstanding debt. In particular, our management has been considering the appropriate debt structure, for our business, as well as the level of preferred stock and convertible notes we have outstanding. Factors that our management considers with respect to any such repositioning or restructuring include rating agency viewpoints, our growth strategy and strategic plan, adequacy of our permanent capital, attaining profitability in the near term, and the return on investment for our shareholders. As a result, from time to time, we may repay existing debt, repurchase or exchange all or a portion of our preferred stock or convertible notes for cash or other securities, or issue new debt or equity securities pursuant to our shelf registration statement or otherwise pursuant to private offerings. The issuance of debt or equity securities will depend on future market conditions, funding needs and other factors and there can be no assurance that any such issuance will occur or be successful.
Working Capital Needs
Our cash flows are complex, interrelated, and highly dependent upon our operating performance, levels of client activity and financing activities. We view our working capital exclusive of non-earning assets and inclusive of our borrowings. Our working capital increased to $1,772.3 million as of March 31, 2011 from $1,588.1 million as of March 31, 2010 primarily due to the $174.3 million net proceeds received from our Common Stock offering and the issuance of our 1.875% Convertible Notes of $287.5 million (offset by an underwriting discount and fees of $9.3 million and net cost of $27.5 million on convertible spread) and $150.0 million draw down on our liquidity facility. These net proceeds are partially offset by $225.5 million repayment on our liquidity facility and the Exchange Offer on the 9% Convertible Notes and Series B Preferred Stock of $4.5 million and $48.8 million, respectively.
As of March 31, 2011 and 2010, total working capital was calculated as follows:
| MARCH 31, | ||||||||
| (dollars in millions) | 2011 | 2010 | ||||||
| TOTAL ASSETS |
$ | 40,541.6 | $ | 50,966.1 | ||||
| Less Non-earning assets: |
||||||||
| Receivables—Other |
65.4 | 44.4 | ||||||
| Memberships in exchanges, at cost |
5.9 | 6.3 | ||||||
| Furniture, equipment and leasehold improvements, net |
138.4 | 73.0 | ||||||
| Intangible assets, net |
41.9 | 73.4 | ||||||
| Other assets |
277.4 | 222.7 | ||||||
| Subtotal non-earning assets |
529.0 | 419.8 | ||||||
| Less Total liabilities: |
39,037.3 | 49,600.5 | ||||||
| Add Borrowings |
797.0 | 642.3 | ||||||
| TOTAL WORKING CAPITAL |
$ | 1,772.3 | $ | 1,588.1 | ||||
Our primary requirement for working capital relates to funds we are required to maintain at exchanges and clearing organizations to support our clients’ trading activities. We require that our clients deposit collateral with us in support of their trading activities, which we in turn deposit with exchanges or clearing organizations to satisfy our obligations. These required deposits account for the majority of our working capital requirements. As discussed in Note 18 to our consolidated financial statements, we are subject to the requirements of the regulatory bodies and exchanges of which we or our subsidiaries are a member or with which we conduct business. The regulatory bodies and exchanges each have defined capital requirements we must meet on a daily basis. We were in compliance with all of these requirements at March 31, 2011 and 2010. For the purposes of prudential supervision, we as a consolidated group are not subject to consolidated regulatory capital requirements under the European Union’s Capital Requirements Directive.
We have satisfied our primary requirements for working capital in the past from internally generated cash flow, offering of Common Stock, issuance of convertible debt and other available funds. We believe that our current working capital is more than sufficient for our present requirements. In OTC or non-exchange traded transactions, the amount of collateral we post is based upon our credit rating. Pursuant to our trading agreements with certain liquidity providers, if our credit rating falls, the amount of collateral we are required to post may increase. Some of the factors that could lead to a downgrade in our credit rating have been described in reports issued by certain of the rating agencies, and these factors include, but are not limited to, our profitability each quarter as compared against rating agency expectations, whether we suffer material principal losses, our ability to maintain a conservative liquidity profile, our ability to maintain the value of our franchise, deterioration in our trading volumes or operating cash flows, our ability to implement our strategic plan, a decline in maintenance margin funds or excess capital levels at our regulated subsidiaries and increases in leverage. We maintain investment grade ratings from all three rating agencies.
Notwithstanding the self-funding nature of our operations, we may be required to fund timing differences arising from counterparty defaults on large transactions due to futures, foreign exchange or securities failures or clients going to delivery without proper instructions or the delayed receipt of client funds. Historically, these timing differences have been funded either with internally generated cash flow or, if needed, with short-term borrowings.
As discussed above, we rely on uncommitted lines of credit from multiple sources to fund day-to-day clearing operations. If these lines of credit are not available to us, we may have to reduce our clearing business, which may negatively impact our revenues.
As a matter of policy, we maintain excess capital to provide liquidity during periods of unusual market volatility, which has been sufficient historically to absorb the impact of volatile market events. Similarly, for our brokerage activities in the OTC markets involving transactions when we act as principal rather than as agent, we have adopted a futures-style margin methodology to protect us against price movements. A futures-style margin methodology allows us to reduce the amount of capital required to conduct this type of business because we are able to post client deposits, rather than our own funds, with
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PART II
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION
clearing organizations or other counterparties, if required. In determining our required capital levels, we also consider the potential for counterparty default on a large transaction, which would require liquidity to cover such default, or a settlement failure due to mismatched settlement instructions. In many cases, other stock or securities can be pledged as collateral for secured lending to guard against such failure. As a result, we are able to execute a substantial volume of transactions without the need for large amounts of working capital.
Funding for purposes other than working capital requirements, including the financing of acquisitions, has been provided either through internally generated cash flow or through specific long-term financing arrangements.
The resale and repurchase transactions we enter into are generally collateralized with investment grade securities, including obligations of the U.S. government, government sponsored entity and federal agency obligations as well as European sovereign debt. Certain of these resale and repurchase transactions mature on the same date as the underlying collateral, and are accounted for as sales and purchases, in accordance with the accounting standard for transfers and servicing.
Under our repurchase agreements, including those repurchase agreements accounted for as sales, our counterparties may require us to post additional margin at any time, as a means for securing our ability to repurchase the underlying collateral during the term of the repurchase agreement. Accordingly, repurchase agreements create liquidity risk for us because if the value of the collateral underlying the repurchase agreement decreases, whether because of market conditions or because there are issuer-specific concerns with respect to the collateral, we will be required to post additional margin, which we may not readily have. If the value of the collateral were permanently impaired (for example, if the issuer of the collateral defaults on its obligations), we would be required to repurchase the collateral at the contracted-for purchase price upon the expiration of the repurchase agreement, causing us to recognize a loss. For information about these exposures and forward purchase commitments, see “—Off Balance Sheet Arrangements and Risk” and “Item 7A. Quantitative and Qualitative Disclosures about Market Risk—Disclosures about Market Risk—Risk Management.”
As we increase our principal transactions activities, we will require additional working capital from channels in addition to our current liquidity sources, including by raising additional long-term unsecured debt and establishing commercial paper and medium-term note programs.
As discussed above under “Significant Business Developments—Our Strategic Plan”, we intend to transform our company into a commodities and capital markets—focused investment bank. As part of this change we anticipate that the volume and notional amount of principal trading that we do—whether by making markets for clients or facilitating their trading, or by taking positions for our own account to monetize our market views—will increase over the next several years. To support this increased activity, we will need additional working capital beyond the amount that is currently available to us through our revolving credit facility and other credit lines. We expect to seek this additional working capital through multiple channels, including by:
| • | obtaining additional credit lines from banks, |
| • | raising short-term unsecured debt through commercial paper and promissory note issuances and other methods, |
| • | raising long-term unsecured debt through registered offerings of debt or hybrid securities, medium-term note offerings and other methods, |
| • | increasing our equity, by among other things, increasing internally generated cash flow and expanding our activities in prime services, asset management and other areas of our business, or |
| • | expanding access to deposits made through cash sweep programs in our internal broker networks. |
In addition, we may be required to raise additional regulatory capital, either in the form of equity or debt, to support our planned expansion into new business areas. In particular, we will need additional capital as we increase our risk exposure through principal trading.
As we proceed to implement our strategic plan, our liquidity needs and sources are likely to change significantly from what they historically have been.
Credit Facilities and Sources of Liquidity
At March 31, 2010, we had a $1,500.0 million unsecured committed revolving credit facility maturing June 15, 2012 (the “liquidity facility”) with a syndicate of banks.
On June 29, 2010, the liquidity facility was amended (the “Amendment”) (i) to permit us, in addition to certain of our subsidiaries, to borrow funds under the liquidity facility and (ii) to extend the lending commitments of certain of the lenders by two years, from June 15, 2012 (the “Old Maturity Date”) to June 15, 2014 (the “Extended Maturity Date”). Aggregate commitments under the amended liquidity facility are approximately $1,200.9 million, of which approximately $689.6 million is available to us for borrowing until the Extended Maturity Date, and approximately $511.3 million is available for borrowing until the Old Maturity Date. On June 15, 2012, outstanding borrowings subject to the Old Maturity Date (currently equal to approximately $156.2 million) will become due. Under the terms of the amended liquidity facility, we may borrow under the available loan commitment subject to the Extended Maturity Date to repay the outstanding balance on the Old Maturity Date.
With respect to commitments and loans maturing on the Old Maturity Date (and at the current rating level and utilization), we pay a facility fee of 10 basis points per annum and LIBOR plus 1.90% per annum on the outstanding borrowing. The liquidity facility is subject to a ratings-based pricing grid. In the event credit ratings are downgraded, the highest rate on the grid would bring the facility fee to 12.5 basis points per annum and the rate on the outstanding borrowing to LIBOR plus 2.375% per annum.
With respect to commitments and loans maturing on the Extended Maturity Date (and at the current rating level and utilization), we pay a facility fee of 40 basis points per annum and LIBOR plus 2.35% per annum on the outstanding borrowing. In the event credit ratings are downgraded, the highest rate on the grid would bring the facility fee to 75 basis points per annum and the rate on the outstanding borrowing to LIBOR plus 2.75% per annum.
On borrowings in excess of $500.0 million related to the total liquidity facility, we will only pay a facility fee of 10 basis points per annum and LIBOR plus 0.40% per annum with respect to
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