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

 

 

 

 

Form 10-Q

 

 

Commission file number. 001-32878

 

 

 

 

Penson Worldwide, Inc.

(Exact name of registrant as specified in its charter)

 

 

(214) 765-1100

(Registrant’s telephone number, including area code)

 

 

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o     No o

 

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

 

(Do not check if a smaller reporting company)

 

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

 

As of August 3, 2010, there were 28,309,415 shares of the registrant’s $.01 par value common stock outstanding.

 

 

Penson Worldwide, Inc.

 

INDEX TO FORM 10-Q

 

 

 

Penson Worldwide, Inc.
Condensed Consolidated Statements of Financial Condition

 

 

See accompanying notes to condensed consolidated financial statements.

Penson Worldwide, Inc.
Condensed Consolidated Statements of Operations

 

 

See accompanying notes to condensed consolidated financial statements.

Penson Worldwide, Inc.

 

Condensed Consolidated Statement of Stockholders’ Equity

 

 

See accompanying notes to condensed consolidated financial statements.

Penson Worldwide, Inc.

 

Condensed Consolidated Statements of Cash Flows

 

 

See accompanying notes to condensed consolidated financial statements.

Penson Worldwide, Inc.

 

Notes to the Unaudited Condensed Consolidated Financial Statements

(in thousands, except per share data or where noted)

 

 

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

 

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

 

The accompanying unaudited interim condensed consolidated financial statements include the accounts of PWI and its wholly-owned subsidiary SAI. SAI’s wholly owned subsidiaries include among others, PFSI, Nexa, Penson Execution Services, Inc., Penson Financial Futures, Inc. (“PFFI”), GHP1, Inc. (“GHP1”), which includes its subsidiaries GHP2, LLC (“GHP2”) and Penson GHCO, and Penson Holdings, Inc. (“PHI”), which includes its subsidiaries PFSC, PFSL, Penson Asia and PFSA. All significant intercompany transactions and balances have been eliminated in consolidation.

 

The unaudited interim condensed consolidated financial statements as of and for the three and six months ended June 30, 2010 and 2009 contained in this Quarterly Report (collectively, the “unaudited interim condensed consolidated financial statements”) were prepared in accordance with accounting principles generally accepted in the United States (“U.S. GAAP”) for all periods presented.

 

In the opinion of management, the accompanying unaudited interim condensed consolidated statements of financial condition and related statements of operations, cash flows, and stockholders’ equity include all adjustments, consisting only of normal recurring items, necessary for their fair presentation in conformity with U.S. GAAP. Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. GAAP have been condensed or omitted in accordance with rules and regulations of the SEC. These unaudited interim condensed consolidated financial statements should be read in conjunction with the Penson Worldwide, Inc. consolidated financial statements as of and for the year ended December 31, 2009, as filed with the SEC on Form 10-K. Operating results for the three and six months ended June 30, 2010 are not necessarily indicative of the results to be expected for the entire year.

 

In connection with the delivery of products and services to its clients and customers, the Company manages its revenues and related expenses in the aggregate. As such, the Company evaluates the performance of its business activities and evaluates clearing and commission, technology, and interest income along with the associated interest expense as one integrated activity.

Penson Worldwide, Inc.

 

Notes to the Unaudited Condensed Consolidated Financial Statements — (Continued)

 

The Company’s cost infrastructure supporting its business activities varies by activity. In some instances, these costs are directly attributable to one business activity and sometimes to multiple activities. As such, in assessing the performance of its business activities, the Company does not consider these costs separately, but instead, evaluates performance in the aggregate along with the related revenues. Therefore, the Company’s pricing considers both the direct and indirect costs associated with transactions related to each business activity, the client relationship and the demand for the particular product or service in the marketplace. As a result, the Company does not manage or capture the costs associated with the products or services sold, or its general and administrative costs by revenue line.

 

Management’s Estimates and Assumptions — The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the period. Actual results could differ from those estimates. The Company reviews all significant estimates affecting the financial statements on a recurring basis and records the effect of any necessary adjustments prior to their issuance.

 

 

Acquisition of Ridge

 

On November 2, 2009, the Company entered into an asset purchase agreement (“Ridge APA”) to acquire the clearing and execution business of Ridge Clearing & Outsourcing Solutions, Inc. (“Ridge”) from Broadridge Financial Solutions, Inc. (“Broadridge”), Ridge’s parent company. The acquisition closed on June 25, 2010, and under the terms of the Ridge APA, the Company paid approximately $35,189. The acquisition date fair value of consideration transferred was $31,912, consisting of 2,456 shares of PWI common stock with a fair value of approximately $14,611 (based on our closing share price of $5.95 on that date) and a $20,578 five-year subordinated note (the “Ridge Seller Note”) with an estimated fair value of approximately $17,301 on that date (see Note 9 for a description of the Ridge Seller Note discount), payable by the Company bearing interest at an annual rate equal to 90-day LIBOR plus 5.5%. Additionally, the Company recorded a liability of approximately $4,089 attributable to the estimated fair value of contingent consideration to be paid 14 months and 19 months after closing (subject to extension in the event the dispute resolution procedures set forth in the Ridge APA are invoked). The amount of contingent consideration ultimately payable will be added to the Ridge Seller Note. The contingent consideration is primarily composed of two categories. The first category includes a group of correspondents that had not generated at least six months of revenue as of May 31, 2010 (“Stub Period Correspondents”). Twelve months after closing a calculation will be performed to adjust the estimated annualized revenues as of May 31, 2010 to the actual annualized revenues based on a six-month review period as defined in the Ridge APA (“Stub Period Revenues”). The Ridge Seller Note will be adjusted 14 months after closing based on .9 times the difference between the estimated and actual annualized revenues. The undiscounted estimated range of outcomes for this category is $200 to $500. The second category includes a group of correspondents that had not yet begun generating revenues (“Non-revenue Correspondents”) as of May 31, 2010. A calculation will be performed 15 months after closing to determine the annualized revenues, based on a six-month review period, for each such non revenue correspondent (“Non-revenue Correspondent Revenues”). The Ridge Seller Note will be adjusted 19 months after closing by an amount equal to .9 times the Non-revenue Correspondent Revenues. The estimated undiscounted range of outcomes for this category is $4,000 to $5,000. There is no limit to the consideration to be paid. The Company recorded goodwill of $15,901, intangibles of $20,100 and a discount on the Ridge Seller Note of $3,277. The qualitative factors that make up goodwill recognized include value associated with an assembled workforce, value attributable to enhanced revenues related to various products and services offered by the Company and synergies associated with cost reductions from the elimination of certain fixed costs as well as economies of scale resulting from the additional correspondents. The goodwill is included in the United States segment and is expected to all be deductible for tax purposes over a period of 15 years. The Company has incurred acquisition related costs of approximately $5,251 with approximately $2,756 and $3,625 recognized in the three and six month periods ended

Penson Worldwide, Inc.

 

Notes to the Unaudited Condensed Consolidated Financial Statements — (Continued)

 

June 30, 2010. Net revenues of $444 and net income of $45 from Ridge were included in the unaudited interim condensed consolidated statement of operations as of the date of the acquisition for the three and six months ended June 30, 2010. The Company estimates that net revenues would have been $84,200 and $163,109 for the three and six months ended June 30, 2010, respectively compared to $89,124 and $166,217 for the three and six months ended June 30, 2009, respectively and net income (loss) would have been of $(6,728) and $(6,339), respectively for the three and six months ended June 30, 2010 compared to $6,550 and $8,306, respectively for the three and six months ended June 30, 2009 had the acquisition occurred as of January 1, 2009.

 

Acquisition of First Capitol Group, LLC

 

In November 2007, our subsidiary Penson GHCO acquired all of the assets of First Capitol Group LLC (“FCG”), an FCM and a leading provider of technology products and services to futures traders, and assigned the purchased membership interest to GHP1 effective immediately thereafter. We closed the transaction in November, 2007 and paid approximately $9,400 in cash and approximately 150 shares of common stock valued at approximately $2,200 to the previous owners of FCG. In addition, the Company agreed to pay an annual earnout in cash for the following three-year period based on average net income, subject to certain adjustments including cost of capital, for the acquired business. The Company paid approximately $8,700 related to the first year of the earnout period. The Company did not make an earnout payment related to the second year of the earnout period. The Company finalized the acquisition valuation during the third quarter of 2008 and recorded goodwill of approximately $4,000 and intangibles of approximately $7,600. FCG currently conducts business as a division of Penson GHCO.

 

Acquisition of Goldenberg Hehmeyer and Co.

 

In November 2006, the Company entered into a definitive agreement to acquire the partnership interests of Chicago-based GHCO, a leading international futures clearing and execution firm. The Company closed the transaction on February 16, 2007 and paid approximately $27,900, including cash and approximately 139 shares of common stock valued at approximately $3,900 to the previous owners of GHCO. Goodwill of approximately $2,800 and intangibles of approximately $1,000 were recorded in connection with the acquisition. In addition, the Company agreed to pay additional consideration in the form of an earnout over the next three years, in an amount equal to 25% of Penson GHCO’s pre-tax earnings, as defined in the purchase agreement executed with the previous owners of GHCO. The Company did not make an earnout payment related to the first or second years of the integrated Penson GHCO business and as of June 30, 2010 has accrued approximately $1,100 related to the third year of the earnout that was paid in July 2010. This balance is included in other liabilities in the unaudited interim condensed consolidated statement of financial condition as of June 30, 2010. The offset to this liability, goodwill, is included in other assets.

 

Acquisition of the clearing business of Schonfeld Securities, LLC

 

In November 2006, the Company acquired the clearing business of Schonfeld Securities LLC (“Schonfeld”), a New York-based securities firm. The Company closed the transaction in November 2006 and in January 2007, the Company issued approximately 1,100 shares of common stock valued at approximately $28,300 to the previous owners of Schonfeld as partial consideration for the assets acquired of which approximately $14,800 was recorded as goodwill and approximately $13,500 as intangibles. In addition, the Company agreed to pay an annual earnout of stock and cash over a four year period that commenced on June 1, 2007, based on net income, as defined in the asset purchase agreement (“Schonfeld Asset Purchase Agreement”), for the acquired business. A payment of approximately $26,600 was paid in connection with the first year earnout that ended May 31, 2008 and approximately $25,500 was paid in connection with the second year of the earnout that ended May 31, 2009. At June 30, 2010, a liability of approximately $16,943 was accrued as a result of the third year of the earnout ended May 31, 2010 ($15,131) and one month of the year four earnout ($1,812). This balance is included in other liabilities in the unaudited interim condensed consolidated statement of financial condition as of June 30, 2010. The offset to this liability, goodwill, is included in other assets.

Penson Worldwide, Inc.

 

Notes to the Unaudited Condensed Consolidated Financial Statements — (Continued)

 

On April 22, 2010, SAI and PFSI entered into a letter agreement (the “Letter Agreement”) with Schonfeld Group Holdings LLC (“SGH”), Schonfeld, and Opus Trading Fund LLC (“Opus”) that amends and clarifies certain terms of the Schonfeld Asset Purchase Agreement. The Letter Agreement, among other things,, for purpose of determining the total payment due to Schonfeld under the earnout provision of the Schonfeld Asset Purchase Agreement: (i) removes the payment cap; (ii) clarifies that PFSI has no obligation to compress tickets across subaccounts (unless PFSI does so for other of its correspondents at a later date); and (iii) reduces the SunGard synergy credit from $2,900 to $1,450 in 2010 and $1,000 in 2011. The Letter Agreement also assigns all of Schonfeld’s responsibilities under the Schonfeld Asset Purchase Agreement to its parent company, SGH, and extends the initial term of Opus’s portfolio margining agreement with PFSI from April 30, 2017 to April 30, 2019.

 

 

The following is a reconciliation of the numerators and denominators of the basic and diluted earnings per share computation. Common stock equivalents related to stock options are excluded from the diluted earnings per share calculation if their effect would be anti-dilutive to earnings per share.

 

 

At June 30, 2009, stock options and restricted stock units totaling 1,081 were excluded from the computation of diluted earnings per share as their effect would have been anti-dilutive. For periods with a net loss, basic weighted average shares are used for diluted calculations because all stock options and unvested restricted stock units outstanding are considered anti-dilutive.

 

 

Fair value is defined as the exit price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. In determining fair value, the Company uses various valuation techniques, including market, income and/or cost approaches. The fair value model establishes a hierarchy which prioritizes the inputs to valuation techniques used to measure fair value. This hierarchy increases the consistency and comparability of fair value measurements and related disclosures by maximizing the use of observable inputs and minimizing the use of unobservable inputs by requiring that observable inputs be used when available. Observable inputs reflect the assumptions market participants would use in pricing the assets or liabilities based on market data obtained from sources independent of the Company. Unobservable inputs reflect the Company’s own assumptions about the assumptions market participants would use

Penson Worldwide, Inc.

 

Notes to the Unaudited Condensed Consolidated Financial Statements — (Continued)

 

in pricing the asset or liability developed based on the best information available in the circumstances. The hierarchy prioritizes the inputs into three broad levels based on the reliability of the inputs as follows:

 

 

The following is a description of the valuation techniques applied to the Company’s major categories of assets and liabilities measured at fair value on a recurring basis:

 

U.S. government and agency securities

 

U.S. government and agency securities are valued using quoted market prices in active markets. Accordingly, U.S. government and agency securities are categorized in Level 1 of the fair value hierarchy.

 

Canadian government obligations

 

Canadian government securities include both Canadian federal obligations and Canadian provincial obligations. These securities are valued using quoted market prices. These bonds are generally categorized in Level 2 of the fair value hierarchy as the price quotations are not always from active markets.

 

Corporate equity

 

Corporate equity securities represent exchange-traded securities and are generally valued based on quoted prices in active markets. These securities are categorized in Level 1 of the fair value hierarchy.

 

Corporate debt

 

Corporate bonds are generally valued using quoted market prices and are generally classified in Level 2 of the fair value hierarchy as prices are not always from active markets.

 

Listed option contracts

 

Listed options are exchange traded and are generally valued based on quoted prices in active markets and are categorized in Level 1 of the fair value hierarchy.

Penson Worldwide, Inc.

 

Notes to the Unaudited Condensed Consolidated Financial Statements — (Continued)

 

Certificates of deposit and term deposits

 

The fair value of certificates of deposits and term deposits is estimated using third-party quotations. These deposits are categorized in Level 2 of the fair value hierarchy.

 

Money market

 

Money market funds are generally valued based on quoted prices in active markets. These securities are categorized in Level 1 of the fair value hierarchy.

 

The following table summarizes by level within the fair value hierarchy “Receivable from broker-dealers and clearing organizations”, “Securities owned, at fair value”, “Deposits with clearing organizations” and “Securities sold, not yet purchased, at fair value” as of June 30, 2010 and December 31, 2009.

 

 

Penson Worldwide, Inc.

 

Notes to the Unaudited Condensed Consolidated Financial Statements — (Continued)

 

 

 

Cash and securities segregated under U.S. federal and other regulations totaled $3,761,474 at June 30, 2010. Cash and securities segregated under federal and other regulations by PFSI totaled $3,372,190 at June 30, 2010. Of this amount, $3,371,477 was segregated for the benefit of customers under Rule 15c3-3 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), against a requirement as of June 30, 2010 of $3,421,883. An additional deposit of $115,000 was made on July 2, 2010 as allowed by Rule 15c3-3.  The remaining balance of $713 ($3,372,190 - $3,371,477) at the end of the period relates to the Company’s election to compute a reserve requirement for Proprietary Accounts of Introducing Broker-Dealers (“PAIB”) calculation, as defined, against a requirement as of June 30, 2010 of $16,037. An additional deposit of $45,000 was made on July 2, 2010. The PAIB calculation is completed in order for each correspondent firm that uses the Company as its clearing broker-dealer to classify its assets held by the Company as allowable assets in the correspondent’s net capital calculation. In addition, $488,628, including cash of $143,922 was segregated for the benefit of customers by Penson GHCO pursuant to CFTC Rule 1.20 at June 30, 2010. Finally, $122,979 and $122,383 was segregated under similar Canadian and United Kingdom regulations, respectively. At December 31, 2009, $3,605,651 was segregated for the benefit of customers under applicable U.S., Canadian and United Kingdom regulations.

Penson Worldwide, Inc.

 

Notes to the Unaudited Condensed Consolidated Financial Statements — (Continued)

 

 

Amounts receivable from and payable to broker-dealers and clearing organizations consists of the following:

 

 

Receivables from broker-dealers and clearing organizations include amounts receivable for securities failed to deliver, amounts receivable from clearing organizations relating to open transactions, good-faith and margin deposits, and floor-brokerage receivables. Payables to broker-dealers and clearing organizations include amounts payable for securities failed to receive, amounts payable to clearing organizations on open transactions, and floor-brokerage payables. In addition, the net receivable or payable arising from unsettled trades is reflected in these categories.

 

 

Securities owned and securities sold, not yet purchased consist of trading and investment securities at quoted market if available, or estimated fair values as follows:

 

Penson Worldwide, Inc.

 

Notes to the Unaudited Condensed Consolidated Financial Statements — (Continued)

 

 

At June 30, 2010 and December 31, 2009, the Company had $172,712 and $113,213, respectively in short-term bank loans outstanding with weighted average interest rates of approximately 2.7% and 1.4%, respectively. As of June 30, 2010, the Company had seven uncommitted lines of credit with seven financial institutions. Five of these lines of credit permitted the Company to borrow up to an aggregate of approximately $309,938 while two lines do not have specified borrowing limits. The fair value of short-term bank loans approximates their carrying values.

 

The Company also has the ability to borrow under stock loan arrangements. At June 30, 2010 and December 31, 2009, the Company had $256,233 and $411,162, respectively, in stock loan and no specific limitations on additional stock loan capacities. These arrangements bear interest at variable rates based on various factors including market conditions and the types of securities loaned, are secured primarily by our customers’ margin account securities, and are repayable on demand. The fair value of these borrowings approximates their carrying values. The remaining balance in securities loaned relates to the Company’s conduit stock loan business.

 

 

Senior convertible notes

 

On June 3, 2009, the Company issued $60,000 aggregate principal amount of 8.00% Senior Convertible Notes due 2014 (the “Convertible Notes”). The $60,000 aggregate principal amount of Convertible Notes includes $10,000 issued in connection with the exercise in full by the initial purchasers of their over-allotment option. The net proceeds from the sale of the convertible notes were approximately $56,200 after initial purchaser discounts and other expenses.

 

The Convertible Notes bear interest at a rate of 8.0% per year. Interest on the Convertible Notes is payable semi-annually in arrears on June 1 and December 1 of each year, beginning December 1, 2009. The Convertible Notes will mature on June 1, 2014, subject to earlier repurchase or conversion.

 

Holders may convert their Convertible Notes at their option at any time prior to the close of business on the business day immediately preceding the maturity date for such Convertible Notes under the following circumstances: (1) during any fiscal quarter (and only during such fiscal quarter), if the last reported sale price of the Company’s common stock for at least 20 trading days in the period of 30 consecutive trading days ending on the last trading day of the immediately preceding fiscal quarter is equal to or more than 120% of the conversion price of the Convertible Notes on the last day of such preceding fiscal quarter; (2) during the five business-day period after any five consecutive trading-day period in which the trading price per $1,000 (in whole dollars) principal amount of the Convertible Notes for each day of that period was less than 98% of the product of the last reported sale price of the Company’s common stock and the conversion rate of the Convertible Notes on each such day; (3) upon the occurrence of specified corporate transactions, including upon certain distributions to holders of the Company’s common stock and certain fundamental changes, including changes of control and dispositions of substantially all of the Company’s assets; and (4) at any time beginning on March 1, 2014. Upon conversion, the Company will pay or deliver, at the Company’s option, cash, shares of the Company’s common stock or a combination thereof. The initial conversion rate for the Convertible Notes was 101.9420 shares of the Company’s common stock per $1,000 (in whole dollars) principal amount of Convertible Notes (6,117 shares), equivalent to an initial conversion price of approximately $9.81 per share of common stock. Such conversion rate will be subject to adjustment in certain events, but will not be adjusted for accrued or additional interest. The Company has received consent from its stockholders to issue up to 6,117 shares of its common stock to satisfy its payment obligations upon conversion of the Convertible Notes.

 

Following certain corporate transactions, the Company will increase the applicable conversion rate for a holder who elects to convert its Convertible Notes in connection with such corporate transactions by a number of additional shares of common stock. The Company may not redeem the Convertible Notes prior to their stated maturity date. If the Company undergoes a fundamental change, holders may require the Company to repurchase all or a portion of

Penson Worldwide, Inc.

 

Notes to the Unaudited Condensed Consolidated Financial Statements — (Continued)

 

the holders’ Convertible Notes for cash at a price equal to 100% of the principal amount of the Convertible Notes to be purchased, plus any accrued and unpaid interest, including any additional interest, to, but excluding, the fundamental change purchase date.

 

The Convertible Notes are unsecured obligations of the Company and contain customary covenants, such as reporting of annual and quarterly financial results, and restrictions on certain mergers, consolidations and changes of control. The Convertible Notes also contain customary events of default, including failure to pay principal or interest, breach of covenants, cross-acceleration to other debt in excess of $20,000, unsatisfied judgments of $20,000 or more and bankruptcy events. The Convertible Notes contain no financial covenants.

 

The Company was required to separately account for the liability and equity components of the Convertible Notes in a manner that reflected the Company’s nonconvertible debt borrowing rate at the date of issuance. The Company allocated approximately $8,822, net of tax of $5,593, of the $60,000 principal amount of the Convertible Notes to the equity component, which represents a discount to the debt and is being amortized into interest expense using the effective interest method through June 1, 2014. Accordingly, the Company’s effective interest rate on the Convertible Notes was 15.0%. The Company is recognizing interest expense during the twelve months ending May 2011 on the Convertible Notes in an amount that approximates 15.0% of $47,700, the liability component of the Convertible Notes at June 1, 2010. The Convertible Notes were further discounted by approximately $2,850 for the costs associated with the initial purchasers. These costs are being accreted and other debt issuance costs are being amortized into interest expense over the life of the Convertible Notes. The interest expense recognized for the Convertible Notes in the twelve months ended May 2011 and subsequent periods will be greater as the discount is accreted and the effective interest method is applied. For the three and six months ended June 30, 2010, the Company recognized interest expense of $1,200 and $2,400 related to the coupon, $561 and $1,109 related to the conversion feature and $178 and $357 related to various issuance costs. For the three and six months ended June 30, 2009, the Company recognized interest expense of $373 related to the coupon, $170 related to the conversion feature and $60 related to various issuance costs.

 

The estimated fair value of the Convertible Notes was estimated using a discounted cash flow analysis based on our current borrowing rate for an instrument with similar terms (currently 12.5%). At June 30, 2010, the fair value of the Convertible Notes was approximately $51,838.

 

Senior second lien secured notes

 

On May 6, 2010, the Company issued $200,000 aggregate principal amount of its 12.50% Senior Second Lien Secured Notes due 2017 (the “Notes”). The Notes bear interest at a rate of 12.5% per year and are guaranteed by SAI and PHI. The Notes are secured, on a second lien basis, by a pledge by Penson, SAI and PHI of the equity interests of certain of PWI’s subsidiaries. The Notes were issued pursuant to an Indenture dated as of May 6, 2010 with U.S. Bank National Association as Trustee and Collateral Agent (the “Trustee”) and a Second Lien Pledge Agreement dated as of May 6, 2010 with the Trustee. The rights of the Trustee pursuant to the Second Lien Pledge Agreement are subject to an Intercreditor Agreement entered between PWI, the Trustee and the Administrative Agent for the Company’s senior secured credit facility.

 

The Notes contain customary representations and covenants, such as reporting of annual and quarterly financial results, and restrictions, among other things, on indebtedness, liens, certain restricted payments and investments, asset sales, certain mergers, consolidations and changes of control. The Notes also contain customary events of default, including failure to pay principal or interest, breach of covenants, cross-acceleration to other debt in excess of $20,000, unsatisfied judgments of $20,000 or more and bankruptcy events. Pursuant to the Notes PFSI is required to maintain net regulatory capital of at least 5.5% of its aggregate debt balances.

 

The Company used a part of the proceeds of the sale to pay down approximately $110,000 outstanding on its revolving credit facility (see discussion below), and used the balance of the proceeds to provide working capital,

Penson Worldwide, Inc.

 

Notes to the Unaudited Condensed Consolidated Financial Statements — (Continued)

 

among other things, to support the correspondents the Company acquired from Ridge and for other general corporate purposes.

 

The Company recorded a discount of $5,500 for the costs associated with the initial purchasers. These costs and other debt issuance costs are being amortized into interest expense over the life of the Notes. For the three and six months ended June 30, 2010 the Company recognized interest expense of $3,819 related to the coupon and $158 related to various issuance costs.

 

Revolving credit facility

 

On May 1, 2009, the Company signed a secured revolving credit facility (the “Credit Facility”) with a syndicate of financial institutions. The Credit Facility was subsequently amended on May 27, 2009, September 22, 2009, November 2, 2009 and April 1, 2010. The April 1, 2010 amendment to the Credit Facility, among other things, extended the maturity of the Credit Facility to September 30, 2010, increased the aggregate commitments of the Lenders to $125,000 and revised certain financial covenants in the Credit Facility. On May 6, 2010, the Company repaid the Credit Facility and concurrently with such repayment entered into a second amended and restated credit agreement (the “Amended and Restated Credit Facility”) with Regions Bank, as Administrative Agent, Swing Line Lender and Letter of Credit Issuer, the lenders party thereto and other parties thereto. The Amended and Restated Credit Facility provides for a $75,000 committed revolving credit facility and the lenders have, additionally, provided the Company with an uncommitted option to increase the principal amount of the facility to up to $125,000. The Company’s obligations under the Amended and Restated Credit Facility are supported by a guaranty from SAI and PHI and a pledge by the Company, SAI and PHI of equity interests of certain of the Company’s subsidiaries. The Amended and Restated Credit Facility is scheduled to mature on May 6, 2013. The Amended and Restated Credit Facility contains customary representations, and affirmative and negative covenants such as reporting of annual and quarterly financial results, and restrictions, among other things, on indebtedness, liens, investments, certain restricted payments, asset sales, certain mergers, consolidations and changes of control. The Amended and Restated Credit Facility also contains customary events of default, including failure to pay principal or interest, breach of covenants, cross-defaults to other debt in excess of $10,000, unsatisfied judgments of $10,000 or more and certain bankruptcy events. Pursuant to the Amended and Restated Credit Facility PFSI is required to maintain net regulatory capital of at least 5.5% of its aggregate debt balances. The Company is also required to comply with several financial covenants, including a minimum consolidated tangible net worth, minimum fixed charges coverage ratio, maximum consolidated leverage ratio, minimum liquidity requirement and maximum capital expenditures. As of June 30, 2010, the Amended and Restated Credit Facility was undrawn.

 

Ridge seller note

 

On June 25, 2010, in connection with the acquisition of the clearing and execution business of Ridge, the Company issued a $20,578 five-year subordinated note due June 25, 2015 (the “Ridge Seller Note”), payable by PWI bearing interest at an annual rate equal to 90-day LIBOR plus 5.5% to be paid quarterly (10.14% at June 30, 2010). The principal amount of the Ridge Seller Note is subject to adjustment in accordance with the terms of the Ridge APA (see Note 2). The Ridge Seller Note is unsecured and contains certain covenants, including certain reporting and notice requirements, restrictions on certain liens, guarantees by subsidiaries, prepayments of the Convertible Notes and certain mergers and consolidations. The Ridge Seller Note also contains customary events of default, including failure to pay principal or interest, breach of covenants, changes of control, cross-acceleration to other debt in excess of $50,000, certain bankruptcy events and certain terminations of the Company’s Master Services Agreement with Broadridge. The Ridge Seller Note contains no financial covenants. The Company determined that the stated rate of interest of the note was below the rate the Company could have obtained in the open market. The Company estimated that the interest rate it could obtain in the open market was 90-day LIBOR plus 9.6% (10.14% at June 25, 2010). The Company recorded a discount of approximately $3,277, which resulted in a fair value of approximately $17,301. The interest expense recognized for the Ridge Seller Note in the twelve months ending June 30, 2011 and subsequent periods will be greater as the discount is accreted and the effective

Penson Worldwide, Inc.

 

Notes to the Unaudited Condensed Consolidated Financial Statements — (Continued)

 

interest method is applied. For the three and six months ended June 30, 2010, the Company recognized interest expense of $10 related to the coupon and $0 related to the discount. The fair value of the Ridge Seller Note approximated its carrying value as of June 30, 2010.

 

 

In the normal course of business, the Company purchases and sells securities as both principal and agent. If another party to the transaction fails to fulfill its contractual obligation, the Company may incur a loss if the market value of the security is different from the contract amount of the transaction.

 

The Company deposits customers’ margin account securities with lending institutions as collateral for borrowings. If a lending institution does not return a security, the Company may be obligated to purchase the security in order to return it to the customer. In such circumstances, the Company may incur a loss equal to the amount by which the market value of the security on the date of nonperformance exceeds the value of the loan from the institution.

 

In the event a customer fails to satisfy its obligations, the Company may be required to purchase or sell financial instruments at prevailing market prices to fulfill the customer’s obligations. The Company seeks to control the risks associated with its customer activities by requiring customers to maintain margin collateral in compliance with various regulatory and internal guidelines. The Company monitors required margin levels daily and, pursuant to such guidelines, requires customers to deposit additional collateral or to reduce positions when necessary.

 

Securities purchased under agreements to resell are collateralized by U.S. Government or U.S. Government-guaranteed securities. Such transactions may expose the Company to off-balance-sheet risk in the event such borrowers do not repay the loans and the value of collateral held is less than that of the underlying contract amount. A similar risk exists on Canadian Government securities purchased under agreements to resell that are a part of other assets. These agreements provide the Company with the right to maintain the relationship between market value of the collateral and the contract amount of the receivable.

 

The Company’s policy is to regularly monitor its market exposure and counterparty risk. The Company does not anticipate nonperformance by counterparties and maintains a policy of reviewing the credit standing of all parties, including customers, with which it conducts business.

 

For customers introduced on a fully-disclosed basis by other broker-dealers, the Company has the contractual right of recovery from such introducing broker-dealers in the event of nonperformance by the customer.

 

In addition, the Company has sold securities that it does not currently own and will therefore be obligated to purchase such securities at a future date. The Company has recorded these obligations in the financial statements at June 30, 2010, at the fair value of the related securities and may incur a loss if the fair value of the securities increases subsequent to June 30, 2010.

 

 

The Company makes awards of stock options and restricted stock units (“RSUs”) under the Amended and Restated 2000 Stock Incentive Plan, as amended in May 2009 (the “2000 Stock Incentive Plan”), under which 4,722 shares of common stock have been authorized for issuance. Of this amount, options and RSUs to purchase 2,555 shares of common stock, net of forfeitures have been granted and 2,167 shares remain available for future grants at June 30, 2010. The Company also provides an employee stock purchase plan (“ESPP”).

 

The 2000 Stock Incentive Plan includes three separate programs: (1) the discretionary option grant program under which eligible individuals in the Company’s employ or service (including officers, non-employee board members and consultants) may be granted options to purchase shares of common stock of the Company; (2) the stock issuance program under which such individuals may be issued shares of common stock directly or stock awards that vest over time, through the purchase of such shares or as a bonus tied to the performance of services; and

Penson Worldwide, Inc.

 

Notes to the Unaudited Condensed Consolidated Financial Statements — (Continued)

 

(3) the automatic grant program under which grants will automatically be made at periodic intervals to eligible non-employee board members. The Company’s Board of Directors or its Compensation Committee may amend or modify the 2000 Stock Incentive Plan at any time, subject to any required stockholder approval.

 

Stock options

 

During the three and six months ended June 30, 2010 and 2009, the Company did not grant any stock options to employees.

 

The Company recorded compensation expense relating to options of approximately $165 and $322, respectively, for the three months ended June 30, 2010 and 2009, and $431 and $625, respectively for the six months ended June 30, 2010 and 2009.

 

A summary of the Company’s stock option activity is as follows:

 

 

The aggregate intrinsic value of options exercised during the three and six months ended June 30, 2010 and 2009 was $100 and $0, respectively. At June 30, 2010, the Company had approximately $134 of total unrecognized compensation expense, net of estimated forfeitures, related to stock option plans that will be recognized over the weighted average period of .92 years. Cash received from stock option exercises totaled approximately $88 and $0 for the three and six months ended June 30, 2010 and 2009, respectively.

 

Restricted Stock Units

 

A summary of the Company’s Restricted Stock Unit activity is as follows:

 

 

The Company recorded compensation expense relating to restricted stock units of approximately $1,259 and $1,039 during the three months ended June 30, 2010 and 2009, respectively, and $2,437 and $2,040 for the six months ended June 30, 2010 and 2009, respectively.

Penson Worldwide, Inc.

 

Notes to the Unaudited Condensed Consolidated Financial Statements — (Continued)

 

As of June 30, 2010, there is approximately $5,541 of unamortized compensation expense, net of estimated forfeitures, related to unvested restricted stock units outstanding that will be recognized over the weighted average period of 2.17 years.

 

Employee stock purchase plan

 

In July 2005, the Company’s Board of Directors adopted the ESPP, designed to allow eligible employees of the Company to purchase shares of common stock, at semiannual intervals, through periodic payroll deductions. A total of 313 shares of common stock were initially reserved under the ESPP. The share reserve will automatically increase on the first trading day of January each calendar year, beginning in calendar year 2007, by an amount equal to 1% of the total number of outstanding shares of common stock on the last trading day in December in the prior calendar year. Under the current plan, no such annual increase may exceed 63 shares.

 

The ESPP may have a series of offering periods, each with a maximum duration of 24 months. Offering periods will begin at semi-annual intervals as determined by the plan administrator. Individuals regularly expected to work more than 20 hours per week for more than five calendar months per year may join an offering period on the start date of that period. However, employees may participate in only one offering period at a time. Participants may contribute 1% to 15% of their annual compensation through payroll deductions, and the accumulated deductions will be applied to the purchase of shares on each semi-annual purchase date. The purchase price per share shall be determined by the plan administrator at the start of each offering period and shall not be less than 85% of the lower of the fair market value per share on the start date of the offering period in which the participant is enrolled or the fair market value per share on the semi-annual purchase date. The plan administrator shall have the discretionary authority to establish the maximum number of shares of common stock purchasable per participant and in total by all participants in that particular offering period. The Company’s Board of Directors or its Compensation Committee may amend, suspend or terminate the ESPP at any time, and the ESPP will terminate no later than the last business day of June 2015. As of June 30, 2010, 563 shares of common stock had been reserved and 462 shares of common stock had been purchased by employees pursuant to the ESPP plan. The Company recognized expense of $46 and $45 for the three months ended June 30, 2010 and 2009, respectively, and $99 and $86 for the six months ended June 30, 2010 and 2009, respectively.

 

 

From time to time, we are involved in legal proceedings arising in the ordinary course of business relating to matters including, but not limited to, our role as clearing broker for our correspondents. In some instances, but not all, where we are named in arbitration proceedings solely in our role as the clearing broker for our correspondents, we are able to pass through expenses related to the arbitration to the correspondent involved in the arbitration.

 

Under its bylaws, the Company has agreed to indemnify its officers and directors for certain events or occurrences arising as a result of the officer or director serving in such capacity. The Company has entered into indemnification agreements with each of its directors that require us to indemnify our directors to the extent permitted under our bylaws and applicable law. Although management is not aware of any claims, the maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited. However, the Company has a directors and officer liability insurance policy that limits its exposure and enables it to recover a portion of any future amounts paid. As a result of its insurance policy coverage, the Company believes the estimated fair value of these indemnification agreements is minimal and has no liabilities recorded for these agreements as of June 30, 2010 or December 31, 2009.

 

 

The Company’s effective income tax rate for the three and six months ended June 30, 2010 was 22.8% and 22.4%, respectively, and was 39.0% and 38.9%, respectively for the three and six months ended June 30, 2009. The primary factors contributing to the difference between the effective tax rates and the federal statutory income tax

Penson Worldwide, Inc.

 

Notes to the Unaudited Condensed Consolidated Financial Statements — (Continued)

 

rate of 35% are lower tax rates applicable to non-U.S. earnings, state and local income taxes, net of federal benefit, and stock-based compensation. The decrease in the effective income tax rate as compared to the three and six month periods ended June 30, 2009 is primarily due to current period losses and items deducted for books that are not deductible for tax primarily attributable to stock-based compensation.

 

 

The Company is organized into operating segments based on geographic regions. These operating segments have been aggregated into three reportable segments; United States, Canada and Other. The Company evaluates the performance of its operating segments based upon operating income before unusual and non-recurring items. The following table summarizes selected financial information.

 

 

 

 

Penson Worldwide, Inc.

 

Notes to the Unaudited Condensed Consolidated Financial Statements — (Continued)

 

 

 

PFSI is subject to the SEC Uniform Net Capital Rule (SEC Rule 15c3-1), which requires the maintenance of minimum net capital. PFSI elected to use the alternative method, permitted by Rule 15c3-1, which requires that PFSI maintain minimum net capital, as defined, equal to the greater of $250 or 2% of aggregate debit balances, as defined in the SEC’s Reserve Requirement Rule (Rule 15c3-3). At June 30, 2010, PFSI had net capital of $159,370, and was $114,312 in excess of its required net capital of $45,058. At December 31, 2009, PFSI had net capital of $94,738, and was $70,417 in excess of its required net capital of $24,321.

 

Our Penson GHCO, PFSL, PFSC and PFSA subsidiaries are also subject to minimum financial and capital requirements. All subsidiaries were in compliance with their minimum financial and capital requirements as of June 30, 2010.

 

 

In re Sentinel Management Group, Inc. is a Chapter 11 bankruptcy case filed on August 17, 2007 in the U.S. Bankruptcy Court for the Northern District of Illinois by Sentinel. Prior to the filing of this action, Penson GHCO and PFFI held customer segregated accounts with Sentinel totaling approximately $36,000. Sentinel subsequently sold certain securities to Citadel Equity Fund, Ltd. and Citadel Limited Partnership. On August 20, 2007, the Bankruptcy Court authorized distributions of 95 percent of the proceeds Sentinel received from the sale of those securities to certain FCM clients of Sentinel, including Penson GHCO. This distribution to the Penson GHCO and PFFI customer segregated accounts along with a distribution received immediately prior to the bankruptcy filing totaled approximately $25,400.

 

On May 12, 2008, a committee of Sentinel creditors, consisting of a majority of non-FCM creditors, together with the trustee appointed to manage the affairs and liquidation of Sentinel (the “Sentinel Trustee”), filed with the Court their proposed Plan of Liquidation (the “Committee Plan”) and on May 13, 2008 filed a Disclosure Statement related thereto. The Committee Plan allows the Sentinel Trustee to seek the return from FCMs, including Penson GHCO and PFFI, of a portion of the funds previously distributed to their customer segregated accounts. On June 19, 2008, the Court entered an order approving the Disclosure Statement over objections by Penson GHCO and others. On September 16, 2008, the Sentinel Trustee filed suit against Penson GHCO and PFFI along with several other FCMs that received distributions to their customer segregated accounts from Sentinel. The suit against Penson GHCO and PFFI seeks the return of approximately $23,600 of post-bankruptcy petition transfers and approximately $14,400 of pre-bankruptcy petition transfers. The suit also seeks to declare that the funds distributed to the customer segregated accounts of Penson GHCO and PFFI by Sentinel are the property of the Sentinel bankruptcy estate rather than the property of customers of Penson GHCO and PFFI.

 

On December 15, 2008, over the objections of Penson GHCO and PFFI, the court entered an order confirming the Committee Plan, and the Committee Plan became effective on December 17, 2008. On January 7, 2009 Penson GHCO

Penson Worldwide, Inc.

 

Notes to the Unaudited Condensed Consolidated Financial Statements — (Continued)

 

and PFFI filed their answer and affirmative defenses to the suit brought by the Sentinel Trustee. Also on January 7, 2009, Penson GHCO, PFFI and a number of other FCMs that had placed customer funds with Sentinel filed motions to withdraw the reference with the federal district court for the Northern District of Illinois, effectively asking the federal district court to remove the Sentinel suits against the FCMs from the bankruptcy court and consolidate them with other Sentinel related actions pending in the federal district court. On April 8, 2009, the Sentinel Trustee filed an amended complaint, which added a claim for unjust enrichment. On May 8, 2009, Penson GHCO and PFFI filed a response to the amended complaint seeking to dismiss the new unjust enrichment claim. On June 30, 2009, the Court denied the motion to dismiss without prejudice.

 

On July 31, 2009, Penson GHCO and PFFI filed their motion for reconsideration of the Court’s order denying their motion to dismiss the unjust enrichment claim. On September 1, 2009, the Court denied the motion for reconsideration without prejudice. On September 11, 2009, Penson GHCO and PFFI filed their amended answer and amended affirmative defenses to the Sentinel Trustee’s amended complaint. On October 28, 2009, the federal district court for the Northern District of Illinois granted the motions of Penson GHCO, PFFI, and certain other FCM’s requesting removal of the matters referenced above from the bankruptcy court, thereby removing these matters to the federal district court. On August 4, 2010, the federal district court held a status hearing, during which the Company and the Sentinel Trustee agreed that discovery with respect to the Sentinel suits was still proceeding. The Company currently does not anticipate that the trials for Penson GHCO or PFFI will take place prior to 2011.

 

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

 

 

On July 3, 2007, the Company’s Board of Directors authorized the Company to purchase up to $25,000 of its common stock in open market purchases and privately negotiated transactions. The repurchase program was completed in October 2007. On December 6, 2007, the Company’s Board of Directors authorized the Company to purchase an additional $12,500 of its common stock. No shares were repurchased during the three months ended June 30, 2010 and 2009. The Company had approximately $4,700 available under the current repurchase program as of June 30, 2010; however, our Amended and Restated Credit Facility limits our ability to repurchase our stock.

 

 

In June 2010, in connection with the recently signed outsourcing agreement with Broadridge, the Company announced a plan to reduce its headcount across several of its operating subsidiaries primarily over the next six to 15 months. The terms of the plan include both severance pay and bonus payments associated with continuing employment (“Stay Pay”) until the respective outsourcing is completed. These payments will occur at the end of the respective severance periods. In connection with the severance pay portion of the plan the Company recorded a severance charge of approximately $2,016 for the three and six month periods ended June 30, 2010 of which approximately $1,687 is included in the United States segment, $140 included in the Canada segment and $189 included in the Other segment. This charge was included in employee compensation and benefits in the statement of operations. The Company estimates that it will incur costs of approximately $2,141 associated with Stay Pay of which approximately $1,808 is related to the United States segment, $76 associated with the Canada segment and $257 related to the Other segment. No charges were recorded in connection with the Stay Pay as of June 30, 2010. These charges will be recorded on a straight line basis as the benefits are earned.

 

The following discussion and analysis should be read in conjunction with the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section and the consolidated financial statements and related notes thereto included in our December 31, 2009 Annual Report on Form 10-K (File No. 001-32878), filed with the SEC and with the unaudited interim condensed consolidated financial statements and related notes thereto presented in this Quarterly Report on Form 10-Q.

 

Overview

 

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

 

Since starting our business in 1995 with three correspondents, we have grown to serve approximately 327 active securities clearing correspondents and 58 futures clearing correspondents as of June 30, 2010. Our net revenues were $71.1 million and $76.5 million for the three months ended June 30, 2010 and 2009, respectively while our net revenues were $138.5 million and $143.2 million respectively, for the six months ended June 30, 2010 and 2009. Our revenues consist primarily of transaction processing fees earned from our clearing operations and net interest income earned from our margin lending activities, from investing customers’ cash and from stock lending activities. Our clearing and commission fees are based principally on the number of trades we clear. We receive interest income from financing the securities purchased on margin by the customers of our clients. We also earn licensing and development revenues from fees we charge to our clients for their use of our technology solutions.

 

The stock loan conduit business consists of a “matched book” where we borrow stock from an independent party in the securities business and then loan the exact same shares to a third party who needs the shares. We pay interest expense on the borrowings and earn interest income on the loans, earning an average net spread of 50 to 90 basis points on the transactions. Due to regulatory and marketplace changes regarding short-selling of certain securities, clearing brokers that violate certain short-selling rules, including the failure to timely deliver securities, are now subject to significantly more stringent penalties. These changes as well as potential future regulatory changes have had and may continue to have a negative impact on the earnings we have historically seen in our conduit business.

 

Fiscal 2010 Highlights

 

 

Financial overview

 

Net revenues

 

Revenues

 

We generate revenues from most clients in several different categories. Clients generating revenues for us from clearing transactions almost always also generate significant interest income from related balances. Revenues from clearing transactions are driven largely by the volume of trading activities of the customers of our correspondents

and proprietary trading by our correspondents. Our average clearing revenue per trade is a function of numerous pricing elements that vary based on individual correspondent volumes, customer mix, and the level of margin debit balances and credit balances. Our clearing revenue fluctuates as a result of these factors as well as changes in trading volume. We focus on maintaining the profitability of our overall correspondent relationships, including the clearing revenue from trades and net interest from related customer margin balances, and by reducing associated variable costs. We collect the fees for our services directly from customer accounts when trades are processed. We only remit commissions charged by our correspondents to them after deducting our charges. For this reason, we have no significant receivables to collect.

 

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

 

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

 

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

 

Revenues from clearing and commission fees represented 54% and 50% of our total net revenues for the three months ended June 30, 2010 and 2009, respectively, while revenues from clearing and commission fees represented 52% and 51% of our total net revenues for the six months ended June 30, 2010 and 2009, respectively.

 

Interest expense from securities operations

 

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

 

Net interest income represented 21% and 26% of our total net revenues for the three months ended June 30, 2010 and 2009 and 22% and 24% for the six months ended June 30, 2010 and 2009, respectively.

 

Expenses

 

Employee compensation and benefits

 

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

Other operating expenses

 

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

 

Profitability of services provided

 

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

 

Comparison of the three months ended June 30, 2010 and June 30, 2009

 

Overview

 

Results of operations declined for the three months ended June 30, 2010 compared to the three months ended June 30, 2009 primarily due to lower net interest income, higher employee compensation and benefits, higher interest expense on long-term debt and higher other expenses. Operating results decreased $11.3 million during the second quarter of 2010 as compared to the second quarter of 2009, for our U.S., Canadian and U.K. operating businesses. Our Australian business incurred an operating loss of $1.3 million in the second quarter of 2010. PFSA was established in the second quarter 2009 and began clearing for its first correspondent in December 2009.

 

Our U.S. operating subsidiaries experienced a decrease in operating profits of approximately $7.9 million due primarily to lower net interest income and higher interest expense on long-term debt and employee severance costs. Our Canadian business experienced an operating loss of $.4 million for the June 30, 2010 quarter compared to an operating profit of $2.5 million in the June 30, 2009 quarter primarily due to lower clearing and commission fees. The U.K. incurred an operating loss of $1.8 million in the current quarter compared to an operating loss of $1.3 million in the year ago quarter due primarily to lower net interest income. Australia incurred an operating loss of approximately $1.3 million in the quarter ended June 30, 2010.

 

The above factors resulted in lower operating results for the three months ended June 30, 2010 compared to the three months ended June 30, 2009.

The following is a summary of the increases (decreases) in the categories of revenues and expenses for the three months ended June 30, 2010 compared to the three months ended June 30, 2009.

 

 

Net Revenues

 

Net revenues decreased $5.4 million, or 7.0%, to $71.1 million from the quarter ended June 30, 2009 to the quarter ended June 30, 2010. The decrease is primarily attributed to the following:

 

Clearing and commission fees decreased $.1 million, or .2%, to $38.1 million during this same period primarily due to lower equity volumes in Canada from the loss of a major Canadian correspondent, offset in part by higher equity, option and futures volumes in the U.S. and U.K. and the addition of our new PFSA subsidiary.

 

Technology revenue decreased $1.2 million, or 19.3%, to $5.2 million primarily due to lower licensing fees of approximately $1.0 million due to the expiration of a licensing contract in the third quarter 2009 and lower recurring revenue of approximately $.2 million.

 

Interest, gross decreased $10.8 million or 34.9%, to $20.1 million during the quarter over quarter period. Interest revenues from customer balances decreased $4.3 million or 20.1% to $17.1 million due to a decrease in our average daily interest rate of 58 basis points, or 34.1%, to 1.12%, offset by an in increase in our average daily interest earning assets of $1.2 billion or 25.4% to $6.0 billion.

 

Interest from our stock conduit borrows operations decreased $6.5 million or 68.8% to $2.9 million, as a result of a decrease in our average daily interest rate of 382 basis points or 66.8% to 1.90% and a decrease in our average

daily assets of approximately $40.8 million, or 6.2% to $615.7 million. (See page 23 for a description of our conduit business.)

 

Other revenue increased $.8 million, or 6.5%, to $12.6 million primarily due to increased account servicing fees of approximately $1.8 million and $.5 million in our trade aggregation business offset by decreases in equity and foreign exchange trading of $1.2 million and decreases in execution services revenues of $.3 million.

 

Interest expense from securities operations decreased $6.0 million, or 55.1%, to $4.9 million from the quarter ended June 30, 2009 to the quarter ended June 30, 2010. Interest expense from clearing operations decreased approximately $.9 million, or 24.7%, to $2.8 million due to a 14 basis point or 41.2% decrease in our average daily interest rate to .20% offset by an increase in our average daily balances on our short-term obligations of $1.2 billion, or 27.9%, to $5.6 billion.

 

Interest from our stock conduit loans decreased $5.0 million, or 70.8% to $2.1 million due to a 299 basis point decrease, or 68.9% in our average daily interest rate to 1.35% and a $41.7 million, or 6.4% decrease in our average daily balances to $613.5 million.

 

Interest, net decreased from $20.0 million for the quarter ended June 30, 2009 to $15.2 million for the quarter ended June 30, 2010. This decrease was due to a lower interest rate spread of 44 basis points on customer balances and 83 basis points on conduit balances and lower conduit balances offset by higher customer balances.

 

Employee compensation and benefits

 

Total employee costs increased $2.7 million, or 9.4%, to $31.9 million from the quarter ended June 30, 2009 to the quarter ended June 30, 2010, primarily due to severance charges of approximately $3.3 million related to future outsourcing resulting from our recent Ridge acquisition (see Note 18 to our unaudited interim condensed consolidated financial statements) and a program to reduce overhead as a result of the current market environment and $.8 million associated with our PFSA subsidiary offset by lower incentive-based compensation expense. Employee count increased 5.6% to 1,094 as of June 30, 2010 primarily due to the start-up of our PFSA subsidiary and employees from the Ridge acquisition.

 

Floor brokerage, exchange and clearance fees

 

Floor brokerage, exchange and clearance fees increased $.8 million, or 9.1%, to $9.6 million for the quarter ended June 30, 2010 from the quarter ended June 30, 2009, primarily due to higher equity, options and futures volumes in the U.S., U.K. and Australia.

 

Communication and data processing

 

Total expenses for our communication and data processing requirements increased $.6 million, or 4.9%, to $12.1 million from the quarter ended June 30, 2009 to the quarter ended June 30, 2010 due primarily to the addition of our PFSA subsidiary.

 

Occupancy and equipment

 

Total expenses for occupancy and equipment increased $.6 million, or 7.6%, to $7.9 million from the quarter ended June 30, 2009 to the quarter ended June 30, 2010, primarily due to increased software amortization attributable to new computer systems.

 

Other expenses

 

Other expenses increased $4.0 million, or 51.6%, to $11.7 million from the quarter ended June 30, 2009 to the quarter ended June 30, 2010, primarily due to $2.5 million of costs associated with the closing of the Ridge acquisition and $1.5 million in legal expenses to conclude certain outstanding litigation.

Interest expense on long-term debt

 

Interest expense on long-term debt increased $5.5 million from $1.9 million for the quarter ended June 30, 2009 to $7.4 million for the quarter ended June 30, 2010. This increase is primarily attributable to approximately $4.0 million higher interest costs associated with our senior second lien secured notes issued on May 6, 2010, $1.3 million associated with our senior convertible notes issued on June 3, 2009 and approximately $.2 million from our revolving credit facility. These higher interest costs are associated with higher interest rates and higher average balances as compared to the prior period.

 

Provision for income taxes

 

Income tax benefit, based on an effective income tax rate of approximately 22.8%, was $2.2 million for the quarter ended June 30, 2010 as compared to an effective tax rate of 39.0% and income tax expense of $3.9 million for the quarter ended June 30, 2009. This decrease is primarily attributed to a current pretax loss of $9.5 million in the current quarter compared to pretax income of $10.0 million in the prior quarter. The lower effective income tax rate is primarily due to current period losses and items deducted for books that are not deductible for tax primarily attributable to stock-based compensation that create additional taxable income.

 

Net loss

 

As a result of the foregoing, we incurred a net loss of $7.4 million for the quarter ended June 30, 2010 compared to net income of $6.1 million for the quarter ended June 30, 2009.

 

Comparison of the six months ended June 30, 2010 and June 30, 2009

 

Overview

 

Results of operations declined for the six months ended June 30, 2010 compared to the six months ended June 30, 2009 primarily due to lower net interest income, higher floor brokerage, exchange and clearance fees and higher interest expense on long-term debt. Operating results declined $10.3 million during the first six months of 2010 as compared to the first six months of 2009, for our U.S., Canadian and U.K. operating businesses. PFSA, our Australian business incurred an operating loss of approximately $2.2 million in the first six months of 2010. It was established in the second quarter 2009 and began clearing for its first correspondent in December 2009.

 

Our U.S. operating subsidiaries experienced a decrease in operating profits of approximately $6.8 million due to lower net interest income, lower technology revenues, higher floor brokerage, exchange and clearance fees due to lower industry rebates and higher interest expense on long-term debt. Our Canadian business experienced an operating profit of $.8 million for the six months ended June 30, 2010 compared to an operating profit of $3.5 million in the June 30, 2009 period due to lower clearing and commission fees due to lower equity volumes and higher operating expenses offset by higher account servicing fees. The U.K. incurred an operating loss of $3.4 million in the current period compared to an operating loss of $2.6 million in the year ago period due primarily to lower net interest income and slightly higher operating expenses.

 

The above factors resulted in lower operating results for the six months ended June 30, 2010 compared to the six months ended June 30, 2009.

The following is a summary of the increases (decreases) in the categories of revenues and expenses for the six months ended June 30, 2010 compared to the six months ended June 30, 2009.