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FORM 10-K
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1999
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
COMMISSION FILE NUMBER: 001-13731
FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
VIRGINIA 54-1837743
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
1001 NINETEENTH STREET NORTH
ARLINGTON, VA 22209
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
(703) 312-9500
(REGISTRANT'S TELEPHONE NUMBER INCLUDING AREA CODE)
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
TITLE OF SECURITIES EXCHANGES ON WHICH REGISTERED
CLASS A COMMON STOCK, PAR VALUE $0.01 NEW YORK STOCK EXCHANGE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
NONE
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 ____
------
Aggregate market value of the voting stock held by non-affiliates of the
Registrant: $358,768,250 as of March 10, 2000.
Indicate the number of shares outstanding of each of the registrant's classes
of common stock, as of the latest practicable date:
13,554,564 shares of Class A Common Stock as of March 10, 2000 and
35,484,329 shares of Class B Common Stock as of March 10, 2000.
DOCUMENTS INCORPORATED BY REFERENCE:
Portions of the Registrant's definitive Proxy Statement to be filed with
the Securities and Exchange Commission no later than 120 days after the
Registrant's fiscal year ended December 31, 1999 and to be delivered to
stockholders in connection with the 2000 Annual meeting of Stockholders in Part
III, Items 10 (as related to Directors), 11, 12 and 13.
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. [ ]
TABLE OF CONTENTS
Page
----
PART I
Item 1. Business............................................. 1
Item 2. Properties........................................... 37
Item 3. Legal Proceedings.................................... 37
Item 4. Submission of Matters to a Vote of Security Holders.. 38
PART II
Item 5. Market for Registrant's Common Equity and Related
Stockholders Matters................................. 40
Item 6. Selected Consolidated Financial Data................. 40
Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations.................. 41
Item 8. Financial Statements and Supplementary Data.......... 55
PART III
Item 10. Directors and Executive Officers of the Registrant... 55
Item 11. Executive Compensation............................... 55
Item 12. Security Ownership of Certain Beneficial Owners and
Management........................................... 55
Item 13. Certain Relationships and Related Transactions....... 55
PART IV
Item 14. Exhibits, Consolidated Financial Statement Schedules,
and Reports on Form 8-K.............................. 55
SIGNATURES............................................................. 58
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS............................. F-1
i
PART I
CAUTIONS ABOUT FORWARD-LOOKING INFORMATION
This Form 10-K and the information incorporated by reference in this Form
10-K include forward-looking statements within the meaning of Section 27A of the
Securities Act of 1933, as amended, and Section 21E of the Securities Exchange
Act of 1934, as amended. Some of the forward-looking statements can be
identified by the use of forward-looking words such as "believes", "expects,"
"may," "will," "should," "seeks," "approximately," "intends," "plans,"
"estimates" or "anticipates" or the negative of those words or other comparable
terminology. Such statements include, but are not limited to, those relating to
the effects of growth, our principal investment activities, levels of assets
under management and our current equity capital levels. Forward-looking
statements involve risks and uncertainties. You should be aware that a number of
important factors could cause our actual results to differ materially from those
in the forward-looking statements. These factors include, but are not limited
to, competition among venture capital firms and the high degree of risk
associated with venture capital investments, the effect of demand for public
offerings, mutual fund and 401(k) and pension plan inflows or outflows,
volatility of the securities markets, available technologies, government
regulation, economic conditions and competition for business and personnel in
the business areas in which we focus, fluctuating quarterly operating results,
the availability of capital to us and risks related to online commerce. We will
not necessarily update the information presented or incorporated by reference in
this Form 10-K if any of these forward-looking statements turn out to be
inaccurate. Risks affecting our business are described throughout this Form 10-K
and especially in the section "Business--Factors Affecting Our Business,
Operating Results and Financial Condition" (page 21). This entire Form 10-K,
including the Consolidated Financial Statements and the notes and any other
documents incorporated by reference into this Form 10-K should be read for a
complete understanding of our business and the risks associated with that
business.
ITEM 1. BUSINESS
GENERAL
Friedman, Billings, Ramsey Group, Inc. ("FBR"), is a financial services and
investment firm focused on three businesses:
(1) Investment banking and capital markets. This business is conducted
primarily through Friedman, Billings, Ramsey & Co., Inc. ("FBRC") our
principal registered broker-dealer subsidiary.
(2) Venture capital and other specialized asset management products. This
business is conducted primarily through two registered investment
adviser subsidiaries, Friedman, Billings, Ramsey Investment
Management, Inc. ("FBRIM") and FBR Venture Capital Managers, Inc.
("FBRVCM").
(3) Online investment banking, brokerage and securities distribution
services. This business is conducted through our online investment
bank and brokerage unit, fbr.com, a division of FBR Investment
Services, Inc. ("FBRIS"), a registered broker-dealer subsidiary.
Through these businesses, we provide a broad array of financial products
and services in the following industry sectors: Internet and related information
technology, financial services, real estate and middle market consumer and
industrial companies, particularly energy and healthcare, that we believe offer
significant growth opportunities. Throughout our 10 year existence, and in
particular since late 1996, we have strengthened our business by adding new
products and services, diversifying into new industry sectors, and building a
wider customer base. We have also increased our principal investment activities,
both through investment in our own asset management products, and through direct
investment, including in new companies that we ourselves create.
We believe that our goal of building shareholder value is best achieved by
strengthening our competitive position and our financial position. In order for
us to remain competitive, it is important for us to offer a broad range of
products and services both to corporate issuers who are seeking advice and
finance, and to our brokerage and asset management customers. We also believe
it is important for us to be involved with companies early in their lifecycles
(or even to be involved in creating businesses) in order to establish
relationships that will provide us with ongoing revenues as these companies'
finance and advisory needs grow. We seek to provide our corporate clients with
the financing and advisory services that they will need at all stages of their
corporate lifecycle.
We are a Virginia corporation, and the successor company to that founded in
1989 by our Co-Chief Executive Officers, Emanuel J. Friedman, Eric F. Billings,
and W. Russell Ramsey. As of December 31, 1999, we had 390 employees engaged in
the following activities: 58 in research, 85 in corporate finance and investment
banking, 142 in sales, trading and syndicate, 26 in venture capital, private
equity and asset management and 79 in accounting, administration and operations.
Our employees are not subject to any collective bargaining agreement and we
believe that we have excellent relations with our employees.
As of December 31, 1999, our employees owned approximately 75% of our
common stock, while our three founders owned approximately 51% of our common
stock. Our principal executive offices are located at Potomac Tower, 1001
Nineteenth Street North, Arlington, Virginia 22209. We also have offices in
Reston, Virginia; Irvine and Los Angeles, California; Boston, Massachusetts;
Charlotte, North Carolina; Chicago, Illinois; Seattle, Washington; Portland,
Oregon; Vienna, Austria; and London, England.
STRATEGY
As of December 31, 1999, we had shareholders equity of $189 million and
virtually no long-term debt. We achieve operating leverage in two ways. First,
we leverage our return on investment by investing in our own asset management
funds that provide us with incentive income on all of the assets invested in the
funds by our customers. As a result, we receive a return that is
disproportionate to our investment. Second, we have a variable cost structure
that has low fixed costs, and a large variable element of compensation and other
expense related to revenue levels.
We seek to combine businesses that provide relatively predictable revenues
and moderate growth from diverse business lines and customer bases, with higher
margin businesses that have greater potential for significant growth. In the
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first category, we include our brokerage business, corporate finance advisory
business and that portion of our asset management business that generates fees
based on a percentage of assets under management. In the second category, we
include our capital raising business, that portion of our asset management
businesses that provides for incentive income based on gains above a certain
level, and our principal investing activity.
Revenues
Our goal is to maintain revenues from our base businesses at a level to
cover our fixed costs, including base compensation, and to provide bonus
compensation and significant profit margins from our other businesses. In 1999,
approximately half of our revenues were in the category that we consider our
base business, and approximately half were from venture capital and capital
raising activities.
Our revenues for the years ended December 31, 1999, 1998 and 1997 were
$139.0 million, $122.9 million and $256.1 million respectively. The increase in
revenue from 1998 to 1999 is primarily due to increased revenues from our
venture capital business that is focused on the Internet and related information
technology sectors and, to a lesser extent, to our investment banking business
in the same sectors. See the table on page 47 for the percentage of total
revenues contributed by each of our principal products and services.
We began in 1989 as an institutional brokerage firm offering specialized
research, sales and trading. We have maintained and enhanced this business, and
in 1999 it contributed about one-third of our revenues.
In late 1992, we added investment banking to our institutional brokerage.
In late 1996, we added a dedicated merger and acquisition team. Since we began
our investment banking activities, we have been involved in more than 270
capital raising, advisory and other transactions, with total transaction value
in excess of $270 billion. In 1999, investment banking contributed about one-
third of our revenues.
In late 1996, we initiated several new asset management businesses and
hired professionals to lead those efforts. Among these were our venture capital,
private equity and mutual fund businesses. Our assets under management have
increased from $119.3 million at the beginning of 1996 to $879 million at the
end of 1999. We earn base management fees at a blended rate of more than 1% on
our assets under management, and on $736 million of these assets we have the
potential to earn incentive income. We also invest in our own asset management
products, and earn a return on our investment. In 1999, asset management
(primarily venture capital) contributed about one-third of our revenues
(including unrealized gains included in incentive income).
A significant portion of our 1999 asset management revenue was from
incentive fees of up to 20% of the gains (above certain levels) of the venture
capital partnerships that we manage. We record compensation expense against
those fees. These gains include unrealized "mark to market" gains resulting from
the valuation of public securities held in the partnerships' portfolios by
reference to the public trading price of the securities, discounted to reflect
restrictions on liquidity. Accordingly, the partnerships' gains and our
incentive income may fluctuate with market prices, and may be reversed from one
period to the next. Please see footnotes 2 and 3 to our Financial Statements,
for more information about how we account for revenue from our venture capital
business, and "Factors Affecting our Business, Operating Results and Financial
3
Condition" for a discussion of the risks and volatility associated with our
venture capital revenue.
We continued to diversify our businesses and related revenue streams in
1999 with the launch of fbr.com, our online investment bank, and the announced
purchase, subject to regulatory approval, of Money Management Associates, LP
("MMA") a mutual fund family of fixed income and money market funds, and its
affiliated bank, Rushmore Trust and Savings, FSB ("Rushmore"). If this
acquisition is completed as planned during 2000, we expect that it will increase
our assets under management by about $850 million to more than $1.7 billion, on
which we will earn base management fees at a rate in excess of 1%.
Industry Sectors
We began our business focussed on the middle market financial services
sector, in particular thrifts and small banks. We extended sector coverage to
the related areas of real estate and non-depository institutions during 1994 to
1996. In 1996 we began to actively expand our sector coverage to industries
with significant growth potential and capital needs, that are less closely
related to the financial sector. In doing this, we sought to build our business
in sectors that we believed would be somewhat counter-cyclical to each other,
with some providing active business opportunities to us when others are not. In
particular we focused on the Internet and related information technology
sectors. Starting in late 1997, we have also built new capabilities with the
addition of new personnel and through our strategic alliance with PNC Bank, to
expand in the middle market areas of energy, consumer and industrial growth and
healthcare.
Customer Base
The customer base of our brokerage business has historically been
primarily institutional, including large national institutions such as
well-known mutual fund complexes, as well as smaller, private investment pools.
We have built increased business from this existing base, and from new
institutional customers, by providing research, sales and trading in dedicated
teams by industry and by customer. We believe that this strategy allows us to
better serve the needs of our institutional customers, and is rewarded by
increased brokerage business from these institutions.
Starting in late 1997, we have also pursued a strategy of building our
client base of corporate and high net worth individuals through a specialized
private client group that offers brokerage and asset management services
specifically designed to meet the needs of corporate executives, major
shareholders, corporate investment offices, pension plans and foundations.
In early 1999, we completed our customer coverage by adding a retail
group for the first time. Our retail effort is entirely online, through our
fbr.com online investment bank, which we believe to be a much more efficient and
cost-effective platform to serve the needs of our retail customers than a retail
branch network of commission brokers.
Principal Investing
We invest in companies within our sectors of focus both as a partner with
our customers in the asset management vehicles that we manage, and as a direct
investor. We pursue this investing strategy to provide diversification of our
invested assets across industry sectors, and to invest strategically in sectors
and companies that can provide us with future business opportunities. As of the
end of 1999, our principal investments were primarily focused on three sectors -
Internet and related information technology, financial and real estate, with a
weighting
4
towards Internet and related information technology investment as a result of
substantial appreciation in our managed technology venture capital funds.
STRATEGIC RELATIONSHIPS
In 1997, PNC Bank Corp. ("PNC") acquired slightly less than 5% of the
outstanding shares of FBR common stock as part of a strategic business
relationship between us and PNC with respect to selected capital markets and
related activities. We work with PNC on an arms-length basis to refer potential
business to each other. PNC is an investor in certain of our private equity,
venture and proprietary products.
PNC is one of the largest diversified financial services companies in the
United States. PNC offers a variety of financial products and services in its
primary geographic locations in Pennsylvania, New Jersey, Delaware, Ohio and
Kentucky and nationally through retail distribution networks and alternative
delivery channels.
We have built strategic relationships with other financial companies such
as Fidelity Investments initiated in August 1999 and Dawnay, Day, Lander, Ltd.,
a United Kingdom firm focused on capital finance and venture investing in the
Internet sector, initiated in January 2000. We have also built strategic
alliances with non-financial partners such as fbr.com's relationship with
Strategy.com, a personalized Internet information network, initiated in May
1999.
We will continue to pursue strategic partnerships as part of our strategy
to strengthen our revenue sources by increasing our product offerings and
providing increased services to our customers. In addition, we may pursue joint
ventures or other business combinations or raise additional capital in order to
build our businesses. If we choose to raise additional capital, we may do so by
selling additional stock in or issuing debt of Friedman, Billings, Ramsey Group,
Inc. or by seeking investors or partners in one particular subsidiary or sector
of our businesses.
CAPITAL MARKETS
Historically, we have derived the majority of our revenues from our
capital markets activities. We have maintained the strength of our investment
banking business in the financial services and real estate sector and expanded
our capabilities by adding research and investment banking personnel in areas
such as Internet and information technology, energy and insurance. Since 1996,
we have used our traditional investment banking and research operations and our
location in the Washington D.C. "Netplex" region, home to many Internet and
information technology companies, to build a technology investment banking
franchise with national scope. We currently provide research coverage on over 50
technology companies and have raised capital or executed merger and acquisition
("M&A") transactions for 20 technology companies in 1999. Technology-related
transactions accounted for approximately one-third of our investment banking
revenues in 1999, with financial services and all other industry groups each
accounting for a third of such revenues.
Our research activities and institutional sales and trading activities are
a part of our primary broker-dealer/investment banking subsidiary - FBRC. Our
underwriting and corporate finance activities consist of a broad range of
services, including public and private offerings of a wide variety of securities
and financial advisory services in mergers and acquisitions, mutual to stock
conversions, strategic partnering transactions and other advisory assignments.
5
Capital Raising Activities
Our capital raising activities include a wide range of securities,
structures and amounts. We are a leading underwriter of securities in our areas
of focus and are dedicated to the successful completion and aftermarket
performance of each underwriting transaction we execute. Our investment banking,
research, and sales and trading professionals work as a team to execute
successfully capital raising assignments.
Our strategy is to maintain long-term relationships with our corporate
clients by serving their capital needs beyond their initial access to capital
markets. We seek to increase our base of public company clients by serving as a
lead or co-manager or syndicate member in follow-on offerings for companies that
we believe have attractive investment characteristics, whether or not we
participated as a lead or co-manager in the IPOs for such companies.
Mergers and Acquisitions Advisory Services
Our mergers and acquisitions group uses the firm's research capability,
business valuation skills and secondary market experience to evaluate merger and
acquisition candidates and opportunities for our clients. We believe that our
research capacity and capital raising activities have created a network of
relationships that enables us to identify and engineer mutually beneficial
combinations between companies. As a financial adviser, we rely upon our
experience gained through in-depth and daily involvement in the capital markets.
Financial advisory services have included advice on mergers and on
acquisitions (including ongoing review of merger and acquisition opportunities),
market comparable performance analysis, advice on dividend policy, and
evaluation of stock repurchase programs. During 1998 and 1999, FBRC provided
merger and acquisition and other advisory services in transactions valued at
$4.5 billion in the aggregate.
Research
A key part of our strategy is to support our businesses with specialized
and in-depth research. Our analysts cover a universe of over 400 companies in
our chosen industry sectors. We leverage the ideas generated by our research
teams across our entire organization, using them to attract underwriting and
institutional brokerage clients, to advise corporate finance clients, to inform
the direction of the various investment funds we advise or sponsor, and to
attract retail investors through fbr.com. We make almost all of our analyst's
research reports available online at fbr.com, making us one of the few
investment banks to allow the public direct access to its research product. In
addition, we increase our visibility to corporate clients and to investors by
holding annual investor conferences - each focused on a broad industry sector.
In 1999, these conferences featured over 150 company presentations and drew more
than 1,000 attendees over three days.
Our research analysts operate under two guiding principles: (i) to identify
undervalued investment opportunities in the capital markets and (ii) to
communicate effectively the
6
fundamentals of these investment opportunities to our investment banking and
sales and trading professionals and to potential investors. To achieve these
objectives, we believe that industry specialization is necessary, and, as a
result, we organize our research staff along industry lines. Each industry team
works together to identify and evaluate industry trends and developments. Within
industry groups, analysts are further subdivided into specific areas of focus so
that they can maintain and apply specific industry knowledge to each investment
opportunity they address.
We have focused our research efforts in some of the fastest growing and
most rapidly changing sectors of the United States and world economies. These
sectors include Internet and information technology, electronic commerce,
telecommunications, e-health, financial technology, banks, thrifts, real estate
investment trusts, specialty finance companies, energy and insurance. We believe
these industry sectors will have great demand for the products and services we
offer and will provide ample diversification opportunities for our business.
After initiating coverage on a company, our analysts seek to maintain a
long-term relationship with that company and a long-term commitment to ensuring
that new developments are effectively communicated to our sales force and
institutional investors. We produce full-length research reports, notes or
earnings estimates on the companies we cover. In addition, our analysts
distribute written updates on these issuers both internally and to our clients
through the use of daily morning meeting notes, real-time electronic mail and
other forms of immediate communication. Our clients can also receive analyst
comments through our web site (www.fbr.com) and through electronic media,
including Multex and First Call.
Sales and Trading
FBRC and our United Kingdom subsidiary, Friedman, Billings, Ramsey
International Ltd., focus on institutional sales to and trading services for
equity and high-yield investors in the United States, Europe and elsewhere. We
execute securities transactions for institutional investors such as banks,
mutual funds, insurance companies, hedge funds, money managers and pension and
profit-sharing plans. Institutional investors normally purchase and sell
securities in large quantities, which requires special marketing and trading
expertise.
Our sales professionals provide services to a nationwide institutional
client base as well as to institutional clients in Europe and elsewhere. Sales
professionals work closely with our research analysts to provide the most up-
to-date information to our institutional clients. Our sales professionals are
organized into teams that focus on particular industry sectors in order to
facilitate the communication of in-depth information to our clients. Each team
maintains regular contact with our research staff and with the specialized
portfolio managers and buy-side analysts of each institutional client.
Our trading professionals facilitate trading in equity and high-yield
securities. We are involved in market-making in Nasdaq and other OTC securities,
trading listed securities and servicing the trading desks of major institutions
in the United States and Europe. Our trading professionals have direct access to
the major stock exchanges, including the New York Stock Exchange and the
American Stock Exchange through FBRC's clearing broker. At year-end 1999, FBRC
made a market in more than 400 securities.
Private Client Group
Since our inception in 1989, we have provided services to corporate
executives and small institutions, as well as to other sophisticated high net
worth clients. In late 1997, we formed the
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Private Client Group ("PCG") to focus on the growth of this business for FBR's
growing corporate client base. Given our strong investment banking relationships
with both public and private companies, we believe that the executives of these
companies form a natural customer base for the PCG.
The PCG seeks to offer creative money management solutions and investment
ideas suited to high net worth individuals. Using a consultative approach, PCG
professionals research, interpret, evaluate and recommend sophisticated
investment strategies. PCG specializes in hedging and monetizing significant
equity positions. Additionally, PCG professionals are knowledgeable in various
aspects of the sale of restricted and control stocks, as well as the financing
of employee stock option exercises. Individuals who own restricted or control
stock receive PCG assistance with the complex regulations and paperwork required
to sell such securities. For individuals unable to sell positions, PCG offers a
number of strategies for preserving value in such assets, as well as the ability
to borrow funds at favorable rates to provide liquidity.
Internet
In April 1999, we opened an Internet securities distribution channel,
fbr.com, creating one of the world's first "online investment banks." We
account for fbr.com's operations in our capital markets segment reporting. In
addition to traditional online brokerage services such as low-cost trades,
quotes and news, fbr.com offers investors access to our own research and the
opportunity to participate in IPOs and secondary offerings in which we
participate as an underwriter. In addition, fbr.com offers online brokerage and
online access to a mutual fund supermarket with over 6,400 funds. fbr.com
currently has more than 21,000 registered users receiving offering alerts, about
25% of whom maintain accounts at fbr.com.
In August 1999, we entered into a partnership with Fidelity Investments
through which we invite Fidelity to participate in selected offerings, combining
our pipeline of IPOs and secondary offerings with Fidelity's vast retail
distribution network. In January 2000, we launched Offering MarketplaceSM, the
first service in the industry that uses Internet browser based technology for
automated customer order capture, share allocation and order execution
technologies to enable an entire offering to be distributed online.
Although fbr.com is not yet profitable on a stand-alone basis, we are using
its Internet presence across our capital markets business as part of our
strategy to leverage our strengths in research, underwriting and brokerage. We
believe that fbr.com's combination of proprietary products and services presents
a significant growth opportunity for us.
ASSET MANAGEMENT
Since 1996, we have added specialized asset management capabilities, such
as private equity and technology venture capital, as part of an effort to
diversify our revenue stream and create additional revenue opportunities by
leveraging our unique research perspectives and our "Netplex" location. We
believe that our 1999 financial results demonstrate the value of this strategy.
Assets under management increased by 28% from $689 million at year-end 1998 to
$879 million as of December 31, 1999 due to our development of new venture
capital and private equity funds. Approximately one-third of our revenues for
1999 was attributable to our asset management business.
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The successful track record of our 1997 FBR Technology Venture Partners
L.P. fund ("TVP I"), which provides early stage financing for non-public
technology companies, allowed us to create a second fund in 1999 ("TVP II") with
$150 million of committed capital that closed in May 1999. We anticipate
launching new funds during 2000 to further build on our successful venture
capital record.
In October 1999, we announced a definitive agreement to acquire MMA and its
savings bank subsidiary, Rushmore FSB. We believe that this acquisition will
allow us to provide a broader array of asset management services and products to
our clients. MMA had approximately $850 million of assets under management as of
December 31, 1999, including fixed income mutual funds and cash management
accounts that are complementary to our more specialized asset management product
offerings. MMA is the investment adviser or administrator for 20 mutual funds.
Rushmore is a federally chartered savings bank that brings traditional banking
services to our product offering (e.g., lending, deposits, cash management,
trust, transfer agency and custody services). We plan to convert Rushmore to a
federally chartered bank. The acquisition is subject to regulatory approval by
federal banking authorities. We currently expect the acquisition to be
completed in 2000.
We use the expertise of our research professionals and portfolio managers
to develop and implement investment products for institutional and high net
worth individual investors. Following is a description of our primary asset
management products.
VENTURE CAPITAL/PRIVATE EQUITY TYPE OF INVESTMENT Year Commenced
FUNDS
FBR Private Equity Fund, L.P. Private equity/mezzanine financing up to 1996
("PEF") $3million
FBR Technology Venture Pre-IPO stage financings of $1-4 million 1997
Partners, L.P. ("TVP I")
FBR Financial Fund II, L.P. Financial services private equity 1998
("Fin Fund II")
FBR Technology Venture Pre-IPO stage financings of $2-10 million 1999
Partners II, L.P.
("TVP II")
INVESTMENT PARTNERSHIPS
FOCUSED ON PUBLIC EQUITY
FBR Weston, L.P. Long-term opportunistic 1989
FBR Ashton, L.P. Financial equities 1992
FBR Braddock, L.P. Long-term small cap value 1993
FBR Opportunity Fund, LLC Financial equities offshore 1995
FBR Arbitrage, LLC Merger/special situation arbitrage 1998
MUTUAL FUNDS
FBR Family of Funds Mutual Funds 1997
REIT
FBR Asset Investment Corp. Real estate related investments 1997
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Private Equity and Venture Capital Funds
At December 31, 1999, our private equity and venture capital funds had
$480.9 million in assets under management, a 208% increase over December 31,
1998. In addition to base fees, these funds provide for incentive income
(generally, 20% of the net investment gains), if certain benchmarks are met.
The following table shows our assets under management, capital committed
and current capital employed for our private equity and venture capital funds at
December 31, 1999 (dollars in millions):
Assets Under Capital
Fund Management Commitments Current Capital Employed
- ---- ------------ ----------- ------------------------
Cost Value
---- -----
TVP I $ 222.8 $ 50.0 $ 35.5 $ 222.8
TVP II 150.0 150.0 31.8 35.1
PEF 19.9 19.9 13.9 19.9
Fin Fund II 82.4 82.4 22.5 23.0
Other 5.8
-------- -------- -------- --------
Total $ 480.9 $ 302.3 $ 103.7 $ 300.8
======== ======== ======== ========
Asset
Composition Cost Value
- ----------- ------ -------
Public Securities $ 12.7 $ 180.1
Public Merger Candidates 5.5 8.9
Public Registration 7.2 28.7
-------- --------
Private Investment 25.4 217.7
Investment Partnerships 78.3 83.1
-------- --------
Total $ 103.7 $ 300.8
======== ========
At December 31, 1999, our investment partnerships focused on private equity
had approximately $189.6 million under management. In addition to base fees,
these partnerships provide for incentive income, if certain benchmarks are met.
The largest of these partnerships uses investment strategies primarily involving
publicly-traded financial services companies' equity and fixed income
securities.
Mutual Funds
The FBR Family of Funds, an open-end management type investment company
registered under the Investment Company Act of 1940, began business in 1997 and
currently is comprised of four no-load funds: the FBR Financial Services Fund,
the FBR Small Cap Financial Services Fund, the FBR Small Cap Growth/Value Fund
and the FBR Realty Growth Fund, added in 1998. At December 31, 1999, total
assets managed in The FBR Family of Funds were $66.1 million.
FBR Asset Investment Corp.
FBR Asset Investment Corp. (FBR-Asset) is a publicly traded real estate
investment trust (FB-NYSE) that we manage and which is 23% owned by us. FBR-
Asset invests in real-estate related assets, including mortgage loans and
mortgage-backed securities, as well as securities of companies engaged in real
estate-related activities. At December 31, 1999, FBR-Asset had total assets of
$330 million, shareholders' equity of $104.5 million and book value of $18 per
share. We receive dividend income on our investment in FBR-Asset, as well as
base management fees, and are entitled to receive performance based incentive
income if certain performance benchmarks are met.
ACCOUNTING, ADMINISTRATION AND OPERATIONS
Our accounting, administration and operations personnel are responsible
for financial controls, internal and external financial reporting, office and
personnel services, management information and telecommunications systems, and
the processing of securities transactions. With the exception of payroll
processing, which is performed by an outside service bureau, and customer
account processing, which is performed by our clearing brokers, most data
processing functions are performed by our management information systems
department. We believe that future growth will require implementation of new and
enhanced communications and information systems and training of our personnel to
operate such systems, as well as the hiring of additional personnel.
COMPETITION
We are engaged in the highly competitive financial services and investment
industries. We compete directly with large Wall Street securities firms,
securities subsidiaries of major commercial bank holding companies, U.S.
subsidiaries of large foreign institutions, major
10
regional firms, venture capital firms and smaller niche players, and those
offering competitive services via the Internet. To an increasing degree, we also
compete for various segments of the financial services business with other
institutions, such as commercial banks, savings institutions, mutual fund
companies, life insurance companies and financial planning firms.
In addition to competing for customers and investments, companies in the
financial services and investment industries compete to attract and retain
experienced and productive investment professionals. See "Factors Affecting the
Our Business, Operations and Financial Condition - Competition for Retaining and
Recruiting Personnel."
Many competitors have greater personnel and financial resources than we do.
Larger competitors are able to advertise their products and services on a
national or regional basis and may have a greater number and variety of
distribution outlets for their products, including retail distribution. Discount
and Internet brokerage firms market their services through aggressive pricing
and promotional efforts. In addition, some competitors have much more extensive
investment banking activities than we do and therefore, may possess a relative
advantage with regard to access to deal flow and capital. Some of our venture
capital competitors have been established for a longer period of time and have
more established relationships, which may give them greater access to deal flow
and to capital.
Recent rapid advancements in computing and communications technology,
particularly the Internet, are substantially changing the means by which
financial services are delivered. These changes are providing consumers with
more direct access to a wide variety of financial and investment services,
including market information and on-line trading and account information.
Advancements in technology also create demand for more sophisticated levels of
client services. We are committed to using technological advancements to provide
a high level of client service to our target markets. Provision of these
services may entail considerable cost without an offsetting source of revenue.
For a further discussion of the competitive factors affecting our business,
see "Factors Affecting Our Business, Operating Results and Financial Condition".
11
RISK MANAGEMENT
We have established various policies and procedures for the management of
our exposure to operating, principal and credit risk. There can be no assurance
that our risk management procedures and internal controls will prevent or reduce
any such risks. Operating risk arises out of the daily conduct of our business
and relates to the possibility that one or more of our employees could engage in
an imprudent business activity that adversely impacts us. Principal risk relates
to the fact that we hold securities, directly and through entities that we
manage and in which we invest, that are subject to changes in value, and such
changes could result in our incurring material losses. Credit risk occurs
because we extend credit through our clearing brokers to various of our
customers in the form of margin and other types of loan activities, such as
subordinated and mezzanine loans.
Operating risk is monitored by business group managers, and by the
directors of each of our operating subsidiaries. These directors review the
overall business activities of each of our subsidiaries, and issue directions to
address issues which, in the judgment of the directors, could result in material
losses.
Principal risk is managed primarily by conducting real-time monitoring of
the amount and types of securities that we hold from time to time and by
limiting our exposure to any one investment or type of investment. The most
common categories of securities owned are those related to the daily trading
activities of our brokerage operations and those which arise out of our
underwriting, asset management, venture capital and mezzanine financing
activities and other securities held for investment and available for sale. We
attempt to limit our exposure to market risk on securities held as a result of
our daily trading activities by limiting our inventory of trading securities to
the amount needed to provide the appropriate level of liquidity in the
securities for which we are a market maker.
Credit risk for our broker-dealer operations is monitored both by our
operations personnel and by our clearing brokers. Margin calls are issued if the
value of collateral declines below established margin requirements, and margin
maintenance requirements are increased in the event that the concentration in a
client's account exceeds certain levels. Credit risk for subordinated and
mezzanine loans are monitored by the portfolio managers assigned to the loans.
Regulation
In the United States, a number of federal regulatory agencies are charged
with safeguarding the integrity of the securities and other financial markets
and with protecting the interests of customers participating in those markets.
The Securities and Exchange Commission ("SEC") is the federal agency that is
primarily responsible for the regulation of broker-dealers and investment
advisers doing business in the United States, and the Federal Reserve Board
promulgates regulations applicable to securities credit (margin) transactions
involving broker-dealers and certain other institutions in the United States.
Much of the regulation of broker-dealers has been delegated to self-regulatory
organizations ("SROs"), principally the NASD (and its subsidiaries NASD
Regulation, Inc. and the Nasdaq Stock Market ("Nasdaq")), and the national
securities exchanges. These organizations (which are subject to oversight by the
SEC) that govern the industry, monitor daily activity and conduct periodic
examinations of member broker-dealers. While FBRC and our other broker-dealer
subsidiaries are not members of the New York Stock Exchange ("NYSE"), our
business is impacted by the exchange's rules and our Class A common stock is
listed for trading on the NYSE.
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Securities firms are also subject to regulation by state securities
commissions in the states in which they are required to be registered. FBRC is
registered as a broker-dealer with the SEC and in 49 states, Puerto Rico and the
District of Columbia, and is a member of, and subject to regulation by the NASD
and the Municipal Securities Rulemaking Board. FBRIS is registered as a broker-
dealer with the SEC and in all 50 states, Puerto Rico and the District of
Columbia; it is a member of the NASD.
As a result of federal and state registration and SRO memberships, FBRC
and FBRIS are subject to overlapping schemes of regulation which cover all
aspects of their securities business. Such regulations cover matters including
capital requirements, uses and safe-keeping of clients' funds, conduct of
directors, officers and employees, record-keeping and reporting requirements,
supervisory and organizational procedures intended to assure compliance with
securities laws and to prevent improper trading on material nonpublic
information, employee- related matters, including qualification and licensing of
supervisory and sales personnel, limitations on extensions of credit in
securities transactions, clearance and settlement procedures, requirements for
the registration, underwriting, sale and distribution of securities, and rules
of the SROs designed to promote high standards of commercial honor and just and
equitable principles of trade. A particular focus of the applicable regulations
concerns the relationship between broker-dealers and their customers. As a
result, many aspects of the broker-dealer customer relationship are subject to
regulation including, in some instances, "suitability" determinations as to
certain customer transactions, limitations on the amounts that may be charged to
customers, timing of proprietary trading in relation to customers' trades and
disclosures to customers.
FBRC and FBRIS are also subject to "Risk Assessment Rules" imposed by the
SEC which require, among other things, that certain broker-dealers maintain and
preserve certain information, describe risk management policies and procedures
and report on the financial condition of certain affiliates whose financial and
securities activities are reasonably likely to have a material impact on the
financial and operational condition of the broker-dealers. Certain "Material
Associated Persons" (as defined in the Risk Assessment Rules) of the broker-
dealers and the activities conducted by such Material Associated Persons may
also be subject to regulation by the SEC. In addition, the possibility exists
that, on the basis of the information it obtains under the Risk Assessment
Rules, the SEC could seek authority over our unregulated subsidiaries either
directly or through its existing authority over our regulated subsidiaries.
Three of our asset management subsidiaries are registered as investment
advisers with the SEC. As investment advisers registered with the SEC, they are
subject to the requirements of the Investment Advisers Act of 1940 and the SEC's
regulations thereunder. Such requirements relate to, among other things,
limitations on the ability of investment advisers to charge performance-based or
non-refundable fees to clients, record-keeping and reporting requirements,
disclosure requirements, limitations on principal transactions between an
adviser or its affiliates and advisory clients, as well as general anti-fraud
prohibitions. They may also be subject to certain state securities laws and
regulations. The state securities law requirements applicable to registered
investment advisers are in certain cases more comprehensive than those imposed
under the federal securities laws. In addition, FBR Fund Advisers, Inc. and the
mutual funds it manages are subject to the requirements of the Investment
Company Act of 1940 and the SEC's regulations thereunder.
In the event of non-compliance by us or one of our subsidiaries with an
applicable regulation, governmental regulators and one or more of the SROs may
institute administrative or judicial proceedings that may result in censure,
fine, civil penalties (including treble damages in the case of insider trading
violations), the issuance of cease-and-desist orders, the deregistration
13
or suspension of the non-compliant broker-dealer or investment adviser, the
suspension or disqualification of officers or employees or other adverse
consequences. The imposition of any such penalties or orders on us or our
personnel could have a material adverse effect on our operating results and
financial condition.
Our business is also subject to regulation by various foreign governments
and regulatory bodies. FBRC is registered with and subject to regulation by the
Ontario Securities Commission in Canada. Friedman, Billings, Ramsey
International, Ltd. ("FBRIL"), our United Kingdom brokerage subsidiary, is
subject to regulation by the Securities and Futures Authority in the United
Kingdom ("SFA") pursuant to the United Kingdom Financial Services Act of 1986.
Foreign regulation may govern all aspects of the investment business, including
regulatory capital, sales and trading practices, use and safekeeping of customer
funds and securities, record-keeping, margin practices and procedures,
registration standards for individuals, periodic reporting and settlement
procedures.
In connection with much of our asset management activities, we, and the
private investment vehicles that we manage, are relying on exemptions from
registration under the Investment Company Act of 1940, and under certain state
securities laws and the laws of various foreign countries. Failure to comply
with the initial and continuing requirements of any such exemptions could have a
material adverse effect on the manner in which we and these vehicles carry on
their activities.
Additional legislation and regulations, including those relating to the
activities of broker-dealers and investment advisers, changes in rules
promulgated by the SEC or other United States or foreign governmental regulatory
authorities and SROs or changes in the interpretation or enforcement of existing
laws and rules may adversely affect our manner of operation and our
profitability. Our businesses may be materially affected not only by regulations
applicable to us as a financial market intermediary, but also by regulations of
general application. For example, the volume of our underwriting, merger and
acquisition, securities trading and asset management activities in any year
could be affected by, among other things, existing and proposed tax legislation,
antitrust policy and other governmental regulations and policies (including the
interest rate policies of the Federal Reserve Board) and changes in
interpretation or enforcement of existing laws and rules that affect the
business and financial communities.
NET CAPITAL REQUIREMENTS
As broker-dealers registered with the SEC and as member firms of the
NASD, FBRC and FBRIS are subject to the net capital requirements of the SEC and
the NASD. FBRIL is subject to the capital regulations of the SFA. These capital
requirements specify minimum levels of capital, computed in accordance with
regulatory requirements, that each firm is required to maintain and also limit
the amount of leverage that each firm is able to obtain in its respective
business.
"Net capital" is essentially defined as net worth (assets minus
liabilities, as determined under generally accepted accounting principles), plus
qualifying subordinated borrowings, less the value of all of a broker-dealer's
assets that are not readily convertible into cash (such as furniture, prepaid
expenses and unsecured receivables), and further reduced by certain percentages
(commonly called "haircuts") of the market value of a broker-dealer's positions
in securities and other financial instruments. The amount of net capital in
excess of the regulatory minimum is referred to as "excess net capital."
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The SEC's capital rules also (i) require that broker-dealers notify it,
in writing, two business days prior to making withdrawals or other distributions
of equity capital or lending money to certain related persons if those
withdrawals would exceed, in any 30-day period, 30% of the broker-dealer's
excess net capital, and that they provide such notice within two business days
after any such withdrawal or loan that would exceed, in any 30-day period, 20%
of the broker-dealer's excess net capital, (ii) prohibit a broker-dealer from
withdrawing or otherwise distributing equity capital or making related party
loans if, after such distribution or loan, the broker-dealer would have net
capital of less than $300,000 or if the aggregate indebtedness of the broker-
dealer's consolidated entities would exceed 1,000% of the broker-dealer's net
capital and in certain other circumstances, and (iii) provide that the SEC may,
by order, prohibit withdrawals of capital from a broker-dealer for a period of
up to 20 business days, if the withdrawals would exceed, in any 30-day period,
30% of the broker-dealer's excess net capital and if the SEC believes such
withdrawals would be detrimental to the financial integrity of the firm or would
unduly jeopardize the broker-dealer's ability to pay its customer claims or
other liabilities.
Compliance with regulatory net capital requirements could limit those
operations that require the intensive use of capital, such as underwriting and
trading activities, and also could restrict our ability to withdraw capital from
our affiliated broker-dealers, which in turn could limit our ability to pay
dividends, repay debt and redeem or repurchase shares of our outstanding capital
stock.
We believe that at all times FBRC and FBRIS have been in compliance in all
material respects with the applicable minimum net capital rules of the SEC and
the NASD and that FBRIL has been in compliance in all material respects with the
applicable minimum net capital rules of the SFA.
A failure of a broker-dealer to maintain its minimum required net capital
would require it to cease executing customer transactions until it came back
into compliance, and could cause it to lose its NASD membership, its
registration with the SEC or require its liquidation. Further, the decline in a
broker-dealer's net capital below certain "early warning levels," even though
above minimum net capital requirements, could cause material adverse
consequences to the broker-dealer and to us.
REGULATION FOLLOWING ACQUISITION OF MMA AND RUSHMORE
Supervision and Regulation
As noted above, we have signed a definitive agreement to acquire MMA and
Rushmore. MMA is a privately-held investment adviser and is also the holding
company for Rushmore, a federally chartered and federally insured savings bank.
The consummation of the acquisition is subject to customary federal regulatory
approvals and closing conditions. We are applying to convert Rushmore into a
national bank, immediately upon acquisition, at which time we would become a
bank holding company regulated under the Bank Holding Company Act of 1956, as
amended (the "BHC Act").
If we do successfully complete the acquisition and receive the requisite
approvals, we will be subject to extensive supervision, regulation and
examination by federal banking regulatory agencies. The following description
summarizes some of the laws to which we and Rushmore will be subject upon
consummation of the acquisition.
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On November 12, 1999, the President signed into law the Gramm-Leach-Bliley
Act, or GLB Act, which significantly changed the regulatory structure and
oversight of the financial services industry. The GLB Act amended the BHC Act
to permit a qualifying bank holding company, called a financial holding company
(an "FHC"), to engage in a full range of financial activities, including
banking, insurance, and securities activities, as well as merchant banking and
additional activities that are "financial in nature" or "incidental" to such
financial activities. In order for a bank holding company to qualify as an FHC,
all its subsidiary depository institutions must be "well-capitalized" and "well-
managed" and must also maintain at least a "satisfactory" rating under the
Community Reinvestment Act. We expect that Rushmore will meet these
qualification requirements, and we intend to file a declaration with the Federal
Reserve Board (the "Board") electing to be a FHC. Thus, we expect to be
permitted to engage in financial activities as permitted by the BHC Act, as
amended.
In general, the BHC Act and other federal laws subject all bank holding
companies, including FHC's, to restrictions on the types of activities in which
they may engage, and to a range of supervisory requirements and activities,
including regulatory enforcement actions for violations of laws and regulations.
As noted above, the GLB Act eliminated the barriers to affiliations among banks,
securities firms, insurance companies and other financial service providers, but
does not generally permit a FHC to engage in any non-financial activity. It
permits bank holding companies to become FHCs, to affiliate with securities
firms and insurance companies, and to engage in other activities that are
financial in nature. Under the GLB Act, the Board serves as the "umbrella"
regulator for FHCs and has the power to supervise, regulate and examine FHCs and
their non-banking affiliates, subject to statutory functional regulation
provisions.
Rushmore is a federally insured savings bank, the deposits of which are
insured by the Savings Association Insurance Fund of the FDIC. However, as
noted above, simultaneous with the consummation of the acquisition, we intend to
convert Rushmore into a national bank. National banks are subject to
supervision and regulation by the Office of the Comptroller of Currency ("OCC").
Because the Board will regulate the FHC parent of Rushmore, the Board also has
supervisory authority that may affect Rushmore.
Regulatory Restrictions on Dividends; Source of Strength
It is the policy of the Board that bank holding companies should pay cash
dividends on common stock only out of income available over the past year and
only if prospective earnings retention is consistent with the organization's
expected future needs and financial condition. The policy provides that bank
holding companies should not maintain a level of cash dividends that undermines
the bank holding company's ability to serve as a source of strength to its
banking subsidiaries.
Under Board policy, a bank holding company is expected to act as a source
of financial strength to each of its banking subsidiaries and commit resources
to their support. Such support may be required at times when, absent this Board
policy, a holding company may not be inclined to provide it. As discussed
below, a bank holding company in certain circumstances could be required to
guarantee the capital plan of an undercapitalized banking subsidiary.
In the event of a bank holding company's bankruptcy under Chapter 11 of the
U.S. Bankruptcy Code, the trustee will be deemed to have assumed and is required
to cure immediately any deficit under any commitment by the debtor holding
company to any of the
16
federal banking agencies to maintain the capital of an insured depository
institution, and any claim for breach of such obligation will generally have
priority over most other unsecured claims.
Safe and Sound Banking Practices
Bank holding companies are not permitted to engage in unsafe and unsound
banking practices. The Board's Regulation Y, for example, generally requires a
holding company to give the Board prior notice of any redemption or repurchase
of its own equity securities, if the consideration to be paid, together with the
consideration paid for any repurchases or redemptions in the preceding year, is
equal to 10% or more of the holding company's consolidated net worth. The Board
may oppose the transaction if it believes that the transaction would constitute
an unsafe or unsound practice or would violate any law or regulation. Depending
upon the circumstances, the Board could take the position that paying a dividend
would constitute an unsafe or unsound banking practice.
The Board has broad authority to prohibit activities of bank holding
companies and their non-banking subsidiaries which represent unsafe and unsound
banking practices or which constitute violations of laws or regulations, and can
assess civil money penalties for certain activities conducted on a knowing and
reckless basis, if those activities caused a substantial loss to a depository
institution. The penalties can be as high as $1.0 million for each day the
activity continues.
Anti-Tying Restrictions
Bank holding companies and their affiliates are prohibited from tying the
provision of certain services, such as extensions of credit, to other services
offered by a holding company or its affiliates.
Capital Adequacy Requirements
The Board has adopted a system using risk-based capital guidelines to
evaluate the capital adequacy of bank holding companies. Under the guidelines,
specific categories of assets are assigned different risk weights, based
generally on the perceived credit risk of the asset. These risk weights are
multiplied by corresponding asset balances to determine a "risk-weighted" asset
base. The guidelines require a minimum total risk-based capital ratio of 8.0%
(of which at least 4.0% is required to consist of Tier 1 capital elements).
Total capital is the sum of Tier 1 and Tier 2 capital.
In addition to the risk-based capital guidelines, the Board uses a leverage
ratio as an additional tool to evaluate the capital adequacy of bank holding
companies. The leverage ratio is a company's Tier 1 capital divided by its
average total consolidated assets. Certain highly-rated bank holding companies
may maintain a minimum leverage ratio of 3.0%, but other bank holding companies
may be required to maintain a leverage ratio of up to 200 basis points above the
regulatory minimum.
The OCC has also adopted regulations establishing minimum requirements for
the capital adequacy of national banks. The OCC's risk-based capital guidelines
parallel the Board's requirements for bank holding companies. As discussed
above, for us to qualify for FHC status, Rushmore must be continuously "well
capitalized" under OCC regulations: it must have at a minimum a total risk-based
capital ratio of 10%, a Tier I capital ratio of 6%, and a leverage capital ratio
of 5%.
17
The federal banking agencies' risk-based and leverage ratios are minimum
supervisory ratios generally applicable to banking organizations that meet
certain specified criteria, assuming that they have the highest regulatory
rating. Banking organizations not meeting these criteria are expected to
operate with capital positions well above the minimum ratios. The federal bank
regulatory agencies may set capital requirements for a particular banking
organization that are higher than the minimum ratios when circumstances warrant.
Board guidelines also provide that banking organizations experiencing internal
growth or making acquisitions will be expected to maintain strong capital
positions substantially above the minimum supervisory levels, without
significant reliance on intangible assets. As discussed above, failure of
Rushmore to maintain capital significantly in excess of these minimum ratios
will jeopardize our status as a FHC and may lead to restrictions on activities
that would adversely affect our business.
Imposition of Liability for Undercapitalized Subsidiaries
Bank regulators are required to take "prompt corrective action" to resolve
problems associated with insured depository institutions whose capital declines
below certain levels. In the event an institution becomes "undercapitalized,"
it must submit a capital restoration plan. The capital restoration plan will
not be accepted by the regulators unless each company having control of the
undercapitalized subsidiary guarantees the subsidiary's compliance with the
capital restoration plan up to a certain specified amount. Any such guarantee
from a depository institution's holding company is entitled to a priority of
payment in bankruptcy.
The aggregate liability of the holding company of an undercapitalized bank
is limited to the lesser of 5% of the institution's assets at the time it became
undercapitalized or the amount necessary to cause the institution to be
"adequately capitalized." The bank regulators have greater power in situations
where an institution becomes "significantly" or "critically" undercapitalized or
fails to submit a capital restoration plan. For example, a bank holding company
controlling such an institution can be required to obtain prior Board approval
of proposed dividends, or might be required to consent to a consolidation or to
divest the troubled institution or other affiliates.
Acquisitions by Bank Holding Companies of Banks
The BHC Act requires every bank holding company to obtain the prior
approval of the Board before it may acquire all or substantially all of the
assets of any bank, or ownership or control of any voting shares of any bank, if
after such acquisition it would own or control, directly or indirectly, more
than 5% of the voting shares of such bank. In approving bank acquisitions by
bank holding companies, the Board is required to consider the financial and
managerial resources and future prospects of the bank holding company and the
banks concerned, the convenience and needs of the communities to be served, and
various competitive factors.
Control Acquisitions
The Change in Bank Control Act prohibits a person or group of persons from
acquiring "control" of a bank holding company unless the Board has been notified
and has not objected to the transaction. Under a rebuttable presumption
established by the Board, the acquisition of 10% or more of a class of voting
stock of a bank holding company with a class of securities registered under
Section 12 of the Exchange Act would, under the circumstances set forth in the
presumption, constitute acquisition of control of a bank holding company.
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In addition, any company is required to obtain the prior approval of the
Board under the BHC Act before acquiring 25% (5% in the case of an acquirer that
is a bank holding company) or more of any class of outstanding voting stock of a
bank holding company, having a majority of its Board of Directors, or otherwise
obtaining control or exercising a "controlling influence" over a bank holding
company.
Restrictions on Transactions with Affiliates and Insiders
Transactions between a bank holding company and its non-banking
subsidiaries are subject to Section 23A of the Federal Reserve Act. In general,
Section 23A imposes limits on the amount of such transactions, and also requires
certain levels of collateral for loans to affiliated parties. It also limits the
amount of advances to third parties, which are collateralized by the securities
or obligations of the holding company or its subsidiaries.
Affiliate transactions are also subject to Section 23B of the Federal
Reserve Act which generally requires that certain transactions between a bank
and its affiliates be on terms substantially the same, or at least as favorable
to the bank, as those prevailing at the time for comparable transactions with or
involving nonaffiliated persons.
The restrictions on loans to directors, executive officers, principal
shareholders and their related interests (collectively referred to herein as
"insiders") contained in the Federal Reserve Act and regulations apply to all
insured institutions and their subsidiaries and holding companies. These
restrictions include limits on loans to one borrower and conditions that must be
met before such a loan can be made. There is also an aggregate limitation on
all loans to insiders and their related interests. These loans cannot exceed
the institution's total unimpaired capital and surplus, and the appropriate
federal regulator may determine that a lesser amount is appropriate. Insiders
are subject to enforcement actions for knowingly accepting loans in violation of
applicable restrictions.
Restrictions on Distribution of Subsidiary Bank Dividends and Assets
Capital adequacy requirements serve to limit the amount of dividends that
may be paid by a bank. Under federal law, a bank cannot pay a dividend if,
after paying the dividend, the bank will be "undercapitalized." The OCC may
declare a dividend payment to be unsafe and unsound even though the bank would
continue to meet its capital requirements after the dividend.
Because a bank holding company is a legal entity separate and distinct from
its subsidiaries, its right to participate in the distribution of assets of any
subsidiary upon the subsidiary's liquidation or reorganization will be subject
to the prior claims of the subsidiary's creditors. In the event of a
liquidation or other resolution of an insured depository institution, the claims
of depositors and other general or subordinated creditors are entitled to a
priority of payment over the claims of holders of any obligation of the
institution to its shareholders, including any depository institution holding
company or any shareholder or creditor thereof.
Examinations
The OCC periodically examines and evaluates insured national banks. Based
upon such an evaluation, the OCC may revalue the assets of the institution and
require that it establish specific reserves to compensate for the difference
between the examination-determined value and the book value of such assets.
19
Deposit Insurance Assessments
Rushmore will be required to pay assessments to the Federal Deposit
Insurance Corporation ("FDIC") for federal deposit insurance protection. The
FDIC has adopted a risk-based assessment system, under which FDIC-insured
depository institutions pay insurance premiums at rates based on their risk
classification
Enforcement Powers
The OCC and the other federal banking agencies have broad enforcement
powers, including the power to terminate deposit insurance, impose substantial
fines and other civil and criminal penalties and appoint a conservator or
receiver. Failure to comply with applicable laws, regulations and supervisory
agreements could subject us or Rushmore, as well as officers, directors and
other institution-affiliated parties of these organizations, to administrative
sanctions and potentially substantial civil money penalties. The appropriate
federal banking agency may appoint the FDIC as conservator or receiver for a
banking institution if any one or more of a number of circumstances exist,
including, without limitation, the fact that the banking institution is
undercapitalized and has no reasonable prospect of becoming adequately
capitalized; fails to become adequately capitalized when required to do so;
fails to submit a timely and acceptable capital restoration plan; or materially
fails to implement an accepted capital restoration plan. The OCC will also have
broad enforcement powers over Rushmore, including the power to impose orders,
remove officers and directors, impose fines and appoint supervisors and
conservators.
Community Reinvestment Act
The Community Reinvestment Act and the regulations issued thereunder are
intended to encourage insured depository institutions to help meet the credit
needs of their service area, including low and moderate income neighborhoods,
consistent with the safe and sound operations of the banks. These regulations
also provide for regulatory assessment of a bank's record in meeting the needs
of its service area when considering applications to establish branches, merger
applications and applications to acquire the assets and assume the liabilities
of another bank. Under the GLB Act, in order for an FHC to engage in new
financial activities, or to acquire, directly or indirectly, a company engaged
in new financial activities, its subsidiary insured depository institutions must
maintain at least a satisfactory rating under the CRA.
Consumer Laws and Regulations
In addition to the laws and regulations discussed herein, Rushmore will
also be subject to certain consumer laws and regulations that are designed to
protect consumers in transactions with banks. While the list set forth herein
is not exhaustive, these laws and regulations include the Truth in Lending Act,
the Truth in Savings Act, the Electronic Funds Transfer Act, the Expedited Funds
Availability Act, the Equal Credit Opportunity Act, and the Fair Housing Act,
among others. In addition, the GLB Act imposes extensive privacy requirements
applicable to all financial institutions. These laws and regulations impose
certain disclosure requirements and regulate the manner in which financial
institutions must deal with nonpublic personal information of consumers and
consumer customers in connection with offering and providing financial services.
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FACTORS AFFECTING OUR BUSINESS, OPERATING RESULTS AND FINANCIAL CONDITION
We are adversely affected by the general risks of the investment business
The financial and investment business is, by its nature, subject to
numerous and substantial risks, particularly in volatile or illiquid markets,
and in markets influenced by sustained periods of low or negative economic
growth. As a financial and investment firm, our operating results are adversely
affected by a number of factors, which include:
. the risk of losses resulting from the ownership or underwriting of
securities;
. the risks of trading securities for ourselves (i.e., principal
activities) and for our customers;
. reduced cash inflows from investors into our venture capital and asset
management businesses;
. the risk of losses from lending to small, privately-owned companies;
. counterparty failure to meet commitments;
. customer default and fraud;
. customer complaints;
. employee errors, misconduct and fraud (including unauthorized
transactions by traders);
. failures in connection with the processing of securities transactions;
. litigation and arbitration;
. the risks of reduced revenues in periods of reduced demand for public
offerings or reduced activity in the secondary markets; and
. the risk of reduced fees we receive for selling securities on behalf
of our customers (i.e., underwriting spreads).
We may experience significant losses if the value of our principal, trading and
investment activities, or the value of our venture capital funds' investments,
deteriorates.
From time to time in connection with our underwriting, asset management and
venture capital activities, we own large amounts, or have commitments to
purchase large amounts, of the securities of companies. This ownership subjects
us to significant risks.
We conduct our securities trading, market-making and investment activities
primarily for our own account, which subjects our capital to significant risks.
These risks include market, credit, leverage, real estate, counterparty and
liquidity risks, which could result in losses for us. These activities often
involve the purchase, sale or short sale of securities as principal in markets
21
that may be characterized as relatively illiquid or that may be particularly
susceptible to rapid fluctuations in liquidity and price.
In addition, at December 31, 1999, our two technology venture funds valued
their investments in their portfolio companies at approximately $257.9 million.
These portfolio companies are primarily Internet and information technology
companies, the valuations of which are extremely volatile. Since these are
largely private companies, their securities are illiquid and we would generally
not be able to sell them except as part of or after an initial public offering
or in connection with the sale of a portfolio company. General market conditions
affecting the Internet and information technology sectors or conditions inherent
in these companies themselves, could cause a drop in their valuations and lead
to losses for us before we have an opportunity to lock in gains through the sale
of their securities.
We experience reduced revenues during periods of declining prices or reduced
demand for public offerings and merger and acquisition transactions or reduced
activity in the secondary markets in sectors on which we focus.
Our revenues are likely to be lower during periods of declining prices or
inactivity in the markets for securities of companies in the sectors in which we
are focused. These markets have historically experienced significant volatility
not only in the number and size of equity offerings and merger and acquisition
transactions, but also in the aftermarket trading volume and prices of
securities.
In particular, Internet and information technology company stocks, in which
we have focused in both our venture capital and investment banking activities,
are extremely volatile. Recently, our revenues have been favorably affected by
an increase in the value of the securities, based on current market prices, in
our venture capital investment portfolio. As a result, a decrease in the stock
prices of Internet and information technology companies would lead to a
reduction in the value of securities owned by us and to a significant decrease
in our revenues, which could adversely affect the price of our stock. In
addition, since we anticipate that a substantial portion of our returns from
venture capital investments will be realized through initial public offerings of
our portfolio companies, a decrease in the number of underwritten transactions
in the technology sector, particularly of initial public offerings, could
significantly hinder our ability to realize such returns. Returns may also be
realized through sales of portfolio companies, which are dependent on the
availability of strategic or financial acquirers. Acquirers may be unavailable
or available only at unattractive prices during economic downturns or periods of
declining prices in the technology sector.
A significant amount of our revenues historically has resulted from
underwritten transactions by companies in our targeted industries, from
aftermarket trading for such companies, and from proprietary investments and
fees and incentive income received from assets under management. Underwriting
activities in our targeted industries can decline for a number of reasons
including increased competition for underwriting business or periods of market
uncertainty caused by concerns over inflation, rising interest rates or related
issues. For example, during the second half of 1998, the market for equity
offerings deteriorated and the market prices of many of the securities which we
had underwritten and made a market in, and securities in which we and our asset
management vehicles were invested in, were subject to considerable volatility
and declines in price. These factors led to a significant reduction in
underwriting revenues, to significant market making losses for us, and to a
significant reduction in the stream of fees received from our asset management
vehicles. Venture capital, underwriting, brokerage
22
and asset management activities can also be materially adversely affected for a
company or industry segment by disappointments in quarterly performance relative
to analysts' expectations or by changes in long-term prospects.
We experience reduced revenues due to economic, political and market conditions
Reductions in public offering, merger and acquisition, portfolio company
valuation and securities trading activities, due to any one or more changes in
economic, political or market conditions could cause our revenues from
investment banking, venture capital, trading, lending, sales and asset
management activities to decline materially. Many national and international
factors affect the amount and profitability of these activities, including:
. economic, political and market conditions;
. level and volatility of interest rates;
. legislative and regulatory changes;
. currency values;
. inflation;
. flows of funds into and out of mutual funds, pension funds and venture
capital funds; and
. availability of short-term and long-term funding and capital.
For example, in 1998, concerns about the economies of Russia and some Asian
countries adversely affected underwriting and securities trading activity in the
United States.
In addition, we have organized, and will continue to organize, regional
venture capital funds in Northern Virginia and other regions. Any of these
regions may be affected by severe economic downturns or lack of growth of
Internet and e-business, which could have an adverse effect on the availability
and profitability of investments in the region.
We experience reduced revenues due to declining market volume, price and
liquidity, which can also cause counterparties to fail to perform
Our revenues may decrease in the event of a decline in the market volume of
securities transactions, prices or liquidity. Declines in the volume of
securities transactions and in market liquidity generally result in lower
revenues from trading activities and commissions. Lower price levels of
securities may also result in a reduced volume of underwriting transactions, and
could cause a reduction in our revenues from corporate finance fees, as well as
losses from declines in the market value of securities held by us in trading and
other investment, venture capital, lending and underwriting positions, reduced
asset management fees and incentive income and withdrawals of funds under
management. Sudden sharp declines in market values of securities can result in
illiquid markets and the failure of issuers and counterparties to perform their
obligations, as well as increases in claims and litigation, including
arbitration claims from customers. In such markets, we have incurred, and may
incur in the future, reduced revenues or losses in our principal trading,
market-making, investment banking, venture capital, lending and asset management
activities.
23
We may incur losses as a result of our venture capital activities.
Our venture capital funds' investments are generally in technology
companies in the early stages of their development. Our business and prospects
must be considered in light of the risks, expenses and difficulties frequently
encountered by companies in early stages of development, particularly companies
in new and rapidly evolving markets. Moreover, our venture funds invest
primarily in privately held companies as to which little public information is
available. Accordingly, we depend on our venture capital managers to obtain
adequate information to evaluate the potential returns from investing in these
companies. Fund managers may or may not be successful in this task. Also, these
companies frequently have less diverse product lines and smaller market presence
than larger competitors. They are thus generally more vulnerable to economic
downturns and may experience substantial variations in operating results.
Venture capital investment is an inherently risky business. Many venture capital
investments are unsuccessful and the future performance of our portfolio
companies is uncertain.
We may incur losses associated with our underwriting activities.
Participation in underwritings involves both economic and regulatory risks.
As an underwriter, we may incur losses if we are unable to resell the securities
we are committed to purchase or if we are forced to liquidate our commitment at
less than the agreed purchase price. In addition, the trend, for competitive and
other reasons, toward larger commitments on the part of lead underwriters means
that, from time to time, an underwriter (including a co-manager) may retain
significant ownership of individual securities. Increased competition has eroded
and is expected to continue to erode underwriting spreads. Another result of
increased competition is that revenues from individual underwriting transactions
have been increasingly allocated among a greater number of co-managers, which
has resulted in reduced revenues per transaction. Our business will continue to
be adversely affected if this trend continues or worsens.
We may incur losses associated with our lending to small, privately-owned
businesses.
At December 31, 1999, our investments included $25.4 million in
subordinated and mezzanine loans outstanding to and securities issued by small,
privately-owned businesses. There is generally no publicly available
information about such companies and we must rely on the diligence of our
employees and agents to obtain information in connection with our investment
decisions. Small companies may be more vulnerable to economic downturns and
often need substantial additional capital to expand or compete. Such businesses
may also experience substantial variations in operating results and there will
generally be no established trading market for their securities. As a result of
our lending activities, we are exposed to:
. credit risks;
. interest rate risks;
. risks related to the illiquidity of our investments;
. leverage risks; and
. risks resulting from the competitive market for investment
opportunities.
24
Our lending activities, which are conducted through FBR Business
Development Fund, one of our wholly-owned subsidiaries, are relatively new and
we cannot assure you that we will be successful in these activities.
Our focus on relatively few industries limits our revenues
We are dependent on revenues related to securities issued by companies in
specific industry sectors. The Internet and information technology, financial
services, real estate and middle market sectors, account for the majority of our
investment banking, asset management and research activities and our venture
capital business is concentrated almost exclusively in the Internet and
information technology sectors. For example, in 1999 revenues from our
technology-related investment banking transactions and our technology-based
venture capital business accounted for 41% of our total revenues. Therefore, any
downturn in the market for the securities of companies in these industries, or
factors affecting such companies, would adversely affect our operating results
and financial condition. In 1998 and 1999, the specialty finance companies,
equity real estate investment trusts ("REITs") and mortgage REITs on which we
focused experienced a significant downturn which in turn adversely affected us.
Securities offerings can vary significantly from industry to industry due to
economic, legislative, regulatory and political factors. Underwriting activities
in a particular industry can decline for a number of reasons. For example,
underwriting activities in the financial services industry decreased
significantly starting in the third quarter of calendar year 1998 and continuing
through 1999.
We also derive a significant portion of our revenues from institutional
brokerage transactions related to the securities of companies in these sectors.
In the past, our revenues from such institutional brokerage transactions have
declined when underwriting activities in these industry sectors declined, the
volume of trading on The Nasdaq Stock Market or the New York Stock Exchange
declined, or when industry sectors or individual companies reported results
below investors' expectations.
We experience significant fluctuations in our quarterly operating results due to
the nature of our business and therefore may fail to meet profitability
expectations.
Our revenues and operating results may fluctuate from quarter to quarter
and from year to year due to a combination of factors, including:
. the number of underwriting and merger and acquisition transactions
completed by our clients;
. the valuations of our principal investments, the investments of funds
we manage and our venture capital portfolio companies;
. the number of initial public offerings or sales of our venture capital
portfolio companies;
. access to public markets for companies in which we have invested as a
principal;
. the realization of profits or losses on principal investments or
warrants we hold;
. the level of institutional and retail brokerage transactions;
25
. the timing of recording of asset management fees and special
allocations of income; and
. variations in expenditures for personnel, litigation expenses, and
expenses of establishing new business units, including marketing and technology
expenses.
We record our revenues from an underwriting transaction only when the
underwriting is completed. We record revenues from merger and acquisition
transactions only when we have rendered the services and the client is
contractually obligated to pay; generally, most of the fee is earned only after
the transaction closes. Accordingly, the timing of our recognition of revenue
from a significant transaction can materially affect our quarterly operating
results. We have structured our operations based on expectations of a high
level of demand for underwriting and corporate finance transactions. As a
result, we have many fixed costs. Accordingly, we could experience losses if
demand for these transactions is lower than expected.
Our revenues in 1999 were impacted favorably by increases in the valuations
of our Internet and related information technology venture capital funds'
portfolio companies. We recognize revenues and losses in this portfolio based
upon valuations of our portfolio companies that occur from time to time,
generally in connection with additional financings. Changes in these valuations
or the timing of additional financings, public offerings or sales involving our
venture capital portfolio companies can cause our quarterly operating results to
fluctuate. Due to the foregoing and other factors, we cannot assure you that we
will be able to sustain profitability on a quarterly or annual basis.
We face significant competition from larger financial services firms with
greater resources which could reduce our market share and harm our financial
performance.
We are engaged in the highly competitive financial services, venture
capital, underwriting and securities brokerage businesses. We compete directly
with large Wall Street securities firms, established venture capital funds,
securities subsidiaries of major commercial bank holding companies, major
regional firms, smaller "niche" players and those offering competitive services
via the Internet. To an increasing degree, we also compete for various segments
of the financial services business with other institutions, such as commercial
banks, savings institutions, mutual fund companies, life insurance companies and
financial planning firms. Our industry focus also subjects us to direct
competition from a number of specialty securities firms, smaller investment
banking boutiques and venture capital funds that specialize in providing
services to those industry sectors. If we are not able to compete successfully
in this environment, our business, operating results and financial condition
will be adversely affected.
There has been a significant amount of new capital invested in venture
capital funds in recent years and we expect this trend to continue. With the
amount of capital available, some companies that may have had difficulty in
obtaining venture funding in the past may be able to do so, notwithstanding that
the chances for success in these investments may be marginal. In addition,
there is likely to be an increasing amount of competition among venture capital
funds for the best investment prospects, particularly in the Internet and
information technology sectors in which we focus. Thus, our success will be
largely dependent on our ability to identify and invest in the most favorable
opportunities in a highly competitive venture capital market.
Competition from commercial banks has increased because of recent
acquisitions of securities firms by commercial banks, as well as internal
expansion by commercial banks into the
26
securities business. In addition, we expect competition from domestic and
international banks to increase as a result of recent legislation and regulatory
initiatives in the United States to remove or relieve certain restrictions on
commercial banks. Our pending acquisition of a bank will lead to direct
competition from commercial banks, most of which will be larger and have greater
resources than our bank subsidiary. This competition could adversely affect our
operating results.
We also face intense competition in our asset management business from a
variety of sources, including venture capital funds, private equity funds,
mutual funds, hedge funds and other asset managers. We compete for investor
funds as well as for the opportunity to participate in transactions.
We offer many of our investment banking and brokerage services online. The
market for these services over the Internet is new, rapidly evolving and
intensely competitive. We expect competition in this area to continue and
intensify in the future. Our online brokerage services business faces direct
competition from other brokerage firms providing either touch-tone telephone or
online investing services, or both.
Many of our competitors have greater personnel and financial resources than
we do. Larger competitors are able to advertise their products and services on
a national or regional basis and may have a greater number and variety of
distribution outlets for their products, including retail distribution.
Discount brokerage firms market their services through aggressive pricing and
promotional efforts. In addition, some competitors have a much longer history
of investment activities than we do and, therefore, may possess a relative
advantage with regard to access to business and capital.
In addition, our venture capital portfolio companies will likely face
significant competition, both from other early-stage companies and from more
established companies. Early-stage competitors may have strategic capabilities
such as an innovative management team or an ability to react quickly to changing
market conditions, while more experienced companies may possess significantly
more experience and greater financial resources than our portfolio companies.
We face intense competition for personnel which could adversely affect our
business.
Our business is dependent on the highly skilled, and often highly
specialized, individuals we employ. The skills of our management personnel will
be of increasing importance to us in the future as we continue to integrate our
expanding venture capital business and our pending investment advisory and bank
acquisition into our ongoing investment activities. Retention of research,
investment banking, venture capital, sales and trading, asset management,
technology, lending and management and administrative professionals is
particularly important to our prospects. Our failure to recruit and retain
qualified employees would materially and adversely affect our future operating
results.
We are highly dependent on specially-trained individuals
The loss of professionals, particularly a senior professional with a broad
range of contacts in an industry, could materially and adversely affect our
operating results. Our strategy is to establish relationships with prospective
corporate clients in advance of any transaction, and to maintain these
relationships over their lifecycle by providing advisory services to corporate
clients in equity, debt and merger and acquisition transactions. These
relationships depend in part upon the individual employees who represent us in
our dealings with our clients. In addition, research
27
professionals contribute significantly to our ability to secure a role in
managing public offerings and in executing trades in the secondary market. From
time to time, other companies in the investment industry have experienced losses
of professionals in all areas of the investment business. The level of
competition for key personnel has increased recently, particularly due to the
market entry efforts of non-brokerage U.S. and foreign financial services
companies, commercial banks, other investment banks and venture capital firms
targeting or increasing their efforts in some of the same industries that we
serve. In particular, in recent periods, competition has grown dramatically for
experienced venture capital managers of the type on which our business is highly
dependent. We cannot assure you that losses of key personnel due to competition
or otherwise will not occur.
In addition, the success of our venture capital portfolio companies will
depend in large part upon the abilities of their key personnel. Competition for
qualified personnel is intense at any stage of a company's development and high
turnover of personnel is common in Internet and information technology
companies. The loss of one or a few key managers can hinder or delay a
company's implementation of its business plan. Our portfolio companies may not
be able to attract and retain qualified personnel. Any inability to do so may
negatively affect our investment returns.
Competition results in increased compensation costs
Competition for the recruiting and retention of employees has recently
increased elements of our compensation costs, and we expect that continuing
competition will cause our compensation costs to continue to increase. We
cannot assure you that we will be able to recruit and hire a sufficient number
of new employees with the desired qualifications in a timely manner. We
regularly review our compensation policies, including stock incentives.
Nonetheless, our incentives may be insufficient in light of the increasing
competition for experienced professionals in the investment industry,
particularly if the value of our stock declines or fails to appreciate
sufficiently to be a competitive source of a portion of professional
compensation.
We are subject to extensive government regulation which could adversely affect
our results
The securities business is subject to extensive regulation under federal
and state laws in the United States, and also is subject to regulation in the
foreign countries in which we conduct our activities. Compliance with these
laws can be expensive, and any failure to comply could have a material adverse
effect on our operating results.
One of the most important regulations with which our broker-dealer
subsidiaries must continually comply is the SEC's net capital rule (Rule 15c3-1)
and a similar rule of the United Kingdom's Securities and Futures Authority.
These regulations require our broker-dealer subsidiaries to maintain minimum
levels of net capital, as defined under such regulations, and limit the amount
of leverage we can obtain in our business. Underwriting commitments require a
charge against net capital and, accordingly, our ability to make underwriting
commitments may be limited by our capital. Compliance with these regulatory net
capital requirements could limit other operations that require intensive use of
capital, such as trading activities, and also could restrict our ability to
withdraw capital from our affiliated broker-dealers, which in turn could limit
our ability to pay dividends, repay debt and redeem or repurchase shares of our
outstanding capital stock.
Compliance with many of the regulations applicable to us involves a number
of risks, particularly in areas where applicable regulations may be subject to
interpretation. In the event of
28
non-compliance with an applicable regulation, governmental regulators and self-
regulatory organizations such as the National Association of Securities Dealers
may institute administrative or judicial proceedings that may result in:
. censure, fines or civil penalties (including treble damages in the
case of insider trading violations);
. issuance of cease-and-desist orders;
. deregistration or suspension of the non-compliant broker-dealer or
investment adviser;
. suspension or disqualification of the broker-dealer's officers or
employees; or
. other adverse consequences.
The imposition of any such penalties or orders on us could have a material
adverse effect on our operating results and financial condition.
The regulatory environment in which we operate is also subject to change.
Our business may be adversely affected as a result of new or revised legislation
or regulations imposed by the SEC, other United States or foreign governmental
regulatory authorities or the NASD. We also may be adversely affected by
changes in the interpretation or enforcement of existing laws and rules by these
governmental authorities and the NASD.
Additional regulation, changes in existing laws and rules, or changes in
interpretations or enforcement of existing laws and rules often directly affect
the method of operation and profitability of securities firms such as ours. We
cannot predict what effect any such changes might have. Our businesses may be
materially affected not only by regulations applicable to us as a financial
market intermediary, but also by regulations of general application. For
example, the volume of our venture capital, underwriting, merger and
acquisition, asset management and principal investment businesses in a given
time period could be affected by, among other things, existing and proposed tax
legislation, antitrust policy and other governmental regulations and policies
(including the interest rate policies of the the Federal Reserve Board) and
changes in interpretation or enforcement of existing laws and rules that affect
the business and financial communities. The level of business and financing
activity in each of the industries on which we focus can be affected not only by
such legislation or regulations of general applicability, but also by industry-
specific legislation or regulations.
Furthermore, due to the increasing popularity of the Internet, legislators
and regulators may pass laws and regulations dealing with issues such as user
privacy, advertising, customer suitability, taxation and the pricing, content
and quality of products and services. Increased attention to these issues could
adversely affect the growth of the Internet, which could in turn decrease the
demand for online services such as those we and our venture capital funds
provide or could otherwise have a material adverse effect on our business,
financial condition or operating results.
If we successfully complete our pending acquisition, we will become subject to
extensive banking regulation
29
With regard to our proposed acquisition of MMA and Rushmore, the
consummation of the acquisition is subject to customary approvals and closing
conditions. We cannot assure you that we will successfully complete the
acquisition. If we do not consummate the acquisition, we will be unable to
recover the financial and personnel resources that we have dedicated to this
acquisition, and we will be unable to achieve the benefits that could have
arisen from the acquisition.
If we do successfully complete the acquisition, we intend to convert
Rushmore into a national bank and we would thus become a bank holding company
regulated under the Bank Holding Company Act of 1956, as amended (the "BHC
Act"). As a bank holding company, we will be subject to extensive supervision,
regulation and examination by banking regulatory agencies. In general, the BHC
Act prohibits or restricts a bank holding company's engagement in a wide variety
of businesses, some of which are businesses in which we currently engage,
including venture capital, merchant banking and investment banking.
On November 12, 1999, the President signed into law the Gramm-Leach-Bliley
Act, or GLB Act, which significantly changed the regulatory structure and
oversight of the financial services industry. The GLB Act permits a qualifying
bank holding company, called a financial holding company (an "FHC"), to engage
in a full range of financial activities, including banking, insurance, and
securities activities, as well as merchant banking and additional activities
that are "financial in nature" or "incidental" to such financial activities. In
order for a bank holding company to qualify as an FHC, its subsidiary depository
institutions must be "well-capitalized" and "well-managed" and have at least a
"satisfactory" Community Reinvestment Act rating. We expect that Rushmore will
meet these qualification requirements and we intend to file a declaration with
the Federal Reserve Board electing to engage in FHC activities in connection
with our application to become a bank holding company.
We currently engage in a wide variety of businesses, including venture
capital, merchant banking and investment banking, that existing law would
prohibit us from engaging in as a bank holding company in the manner in which we
currently engage in such businesses, but which the GLB Act appears to permit an
FHC to engage in a similar fashion as we do today. Although we believe that we
will be able to qualify and maintain our qualification as an FHC under the GLB
Act and continue to engage in the businesses in which we currently engage, there
can be no assurance that we will be able to do so or that we will not be
required to incur substantial costs to maintain compliance with the GLB Act. In
addition, even if we are successful in qualifying as an FHC and maintaining FHC
status, the GLB Act is a very recently enacted law and there is a great deal of
uncertainty surrounding its scope and interpretation. Currently, there are only
interim regulations clarifying or interpreting the enhanced powers granted under
the GLB Act for bank holding companies. There can be no assurance that these
regulations and subsequent interpretations will not prevent us from engaging in
one or more lines of businesses in which we currently engage or will not impose
restrictions that could limit the profitability of such businesses or otherwise
restrict our flexibility in engaging in them.
Although we do not anticipate that we will fail to qualify as an FHC, any
such failure would subject us to the existing restrictions applicable to bank
holding companies under the BHC Act. In such a case, two years from the date on
which we become a bank holding company, we will be required to conform any
activities that are not considered to be closely related to banking under the
BHC Act. This two-year period may be extended by the Federal Reserve Board for
three additional one-year periods if the Federal Reserve Board finds that such
an extension would not be detrimental to the public interest. Therefore, if we
do not qualify as a financial holding
30
company under the GLB Act before the end of this period (including any
extensions), we may be required to conform our investment banking, venture
capital and merchant banking businesses to those permitted under the BHC Act or
to cease being a bank holding company subject to the BHC Act by divesting our
bank. Any such actions could result in significant losses.
In addition, as a bank holding company (whether or not we qualify as an
FHC), we will be subject to a wide variety of restrictions, liabilities and
other requirements applicable to bank holding companies, including required
capital levels, restrictions on transactions with our bank subsidiary,
restrictions on payment or receipt of dividends and community reinvestment
requirements. Federal banking regulators possess broad powers to take
supervisory action, including the imposition of potentially large fines, against
both us and Rushmore as they deem appropriate if we violate any of these
requirements or engage in unsafe or unsound practices. Such supervisory actions
could result in higher capital requirements and limitations on both our banking
and non-banking activities, any and all of which could have a material adverse
effect on our businesses and profitability. Finally, the GLB Act will impose
customer privacy requirements on any company engaged in financial activities
such as those engaged in by Rushmore and by us. Any failure to comply with such
privacy requirements could result in significant penalties or fines.
We are highly dependent upon the availability of capital and funding for our
operations
We are highly dependent upon the availability of adequate funding and
regulatory capital to operate our business and to meet applicable regulatory
requirements. Historically, we have satisfied these needs from equity
contributions, internally generated funds and loans from third parties. We
cannot assure you that any, or sufficient, funding or regulatory capital will
continue to be available to us in the future on terms that are acceptable to us.
Moreover, most of our venture capital portfolio companies will require
additional equity funding to satisfy their continuing working capital
requirements. Because of the circumstances of those companies or market
conditions, it is possible that one or more of our portfolio companies will not
be able to raise additional financing or may be able to do so only at a price or
on terms that are unfavorable to them. To date, there has been a substantial
number of initial public offerings of Internet-related companies. If the market
for such offerings were to weaken for an extended period of time, the ability of
our venture capital portfolio companies to grow and access the capital markets
would be impaired.
We have potential conflicts of interest with our employees, officers and
directors
From time to time, our executive officers, directors and employees invest,
or receive a profit interest, in investments in private or public companies or
investment funds in which we, or one of our affiliates, is or could potentially
be an investor or for which we carry out investment banking assignments, publish
research or act as a market maker. In addition, we have in the past organized
and will likely in the future organize businesses, such as our private
investment vehicles and venture capital funds, in which our employees may
acquire minority interests. There are risks that, as a result of such
investment or profit interest, a director, officer or employee may take actions
that would conflict with our best interests. There is also a risk that
investment opportunities directed to our employees through private investment
vehicles or venture capital funds could have been beneficial to our shareholders
if they had been made as our own investments. In addition, members of our
senior management are actively involved in managing investment funds and venture
capital funds operated by us which could create a conflict of interest to the
extent these officers are aware of inside information concerning potential
31
investment targets or to the extent these officials wish to invest in companies
for which we are underwriting securities. We have in place compliance
procedures and practices designed to ensure that inside information is not used
for making investment decisions on behalf of the funds and to monitor funds
invested in our investment banking clients. We cannot assure you that these
procedures and practices will be effective. In addition, this conflict and
these procedures and practices may limit the freedom of these officials to make
potentially profitable investments on behalf of those funds, which could have an
adverse effect on our operations. Our asset management activities may also
preclude or delay the release of research reports on companies in which we
invest, which could negatively affect our ability to compete for underwriting
business in connection with such companies. Also, we may have conflicts among
our various subsidiaries for investment opportunities and legal or regulatory
restrictions may prevent one or more of our subsidiaries from taking action to
benefit other subsidiaries.
Litigation and potential securities laws liabilities may adversely affect our
business
Many aspects of our business involve substantial risks of liability,
litigation and arbitration, which could adversely affect us. As an underwriter,
a broker-dealer and an investment adviser we are exposed to substantial
liability under federal and state securities laws, other federal and state laws
and court decisions, including decisions with respect to underwriters' liability
and limitations on the ability of issuers to indemnify underwriters, as well as
with respect to the handling of customer accounts. For example, underwriters
may be held liable for material misstatements or omissions of fact in a
prospectus used in connection with the securities being offered and broker-
dealers may be held liable for statements made by their securities analysts or
other personnel. Broker-dealers and asset managers may also be held liable by
customers and clients for losses sustained on investments if it is found that
they caused such losses. In recent years there has been an increasing incidence
of litigation involving the securities industry, including class actions that
seek substantial damages and frequently name as defendants underwriters of a
public offering and investment banks that provide advisory services in merger
and acquisition transactions. We are also subject to the risk of other
litigation, including litigation that may be without merit. As we intend
actively to defend any such litigation, we could incur significant legal
expenses. We carry very limited insurance that may cover only a portion of any
such expenses. An adverse resolution of any future lawsuits against us could
materially adversely affect our operating results and financial condition. In
addition to these financial costs and risks, the defense of litigation or
arbitration may materially divert the efforts and attention of our management
and staff from their other responsibilities.
Our charter documents also allow indemnification of our officers, directors
and agents to the maximum extent permitted by Virginia law. We have entered
into indemnification agreements with these persons. We have been, and in the
future may be, the subject of indemnification assertions under these charter
documents or agreements by our officers, directors or agents who are or may
become defendants in litigation.
Our business is dependent on cash inflows to mutual funds
A slowdown or reversal of cash inflows to mutual funds and other pooled
investment vehicles could lead to lower underwriting and brokerage revenues for
us since mutual funds purchase a significant portion of the securities offered
in public offerings and traded in the secondary markets. Demand for new equity
offerings has been driven in