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 þ     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 5, 2011, there were 27,606,392 shares of the registrant’s $.01 par value common stock outstanding.

 

 

Penson Worldwide, Inc.

 

INDEX TO FORM 10-Q

 

PART I. FINANCIAL INFORMATION

 

 

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 Futures, formerly known as Penson GHCO (“Penson Futures”), 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 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 (“NYSE”) 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 and certain territories. PFSC is an investment dealer registered in all provinces and territories in Canada and is a dealer member of the Investment Industry Regulatory Organization of Canada (“IIROC”). PFSL provides settlement services to the European financial community and is regulated by the Financial Services Authority (“FSA”) and is a member of the London Stock Exchange. Penson Futures is a registered Futures Commission Merchant (“FCM”) with the Commodity Futures Trading Commission (“CFTC”) and is a member of the National Futures Association (“NFA”), 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 the Australian Securities Exchange (“ASX”) and a clearing participant of the Australian Clearing House.

 

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 Futures, 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, 2011 and 2010 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, 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, 2010, as filed with the SEC on Form 10-K. Operating results for the three and six months ended June 30, 2011 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

Penson Worldwide, Inc.

 

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

 

activities and evaluates clearing and commission, technology, and interest income along with the associated interest expense as one integrated activity.

 

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.

 

Reclassifications — The Company has reclassified prior period amounts associated with bad debt expense to conform to the current year’s presentation. The reclassifications had no effect on the condensed consolidated statements of operations, stockholders’ equity or cash flows as previously reported.

 

Recent Accounting Pronouncements

 

In June 2011, the FASB issued ASU No. 2011-05, Presentation of Comprehensive Income. This standard eliminates the current option to report other comprehensive income and its components in the statement of changes in equity. Under this guidance, an entity can elect to present items of net income and other comprehensive income in one continuous statement or in two separate, but consecutive, statements. This guidance is effective for publicly traded companies for fiscal years beginning after December 15, 2011 and interim and annual periods thereafter. Early adoption is permitted, but full retrospective application is required. As the Company reports comprehensive income within its consolidated statement of stockholders’ equity, the adoption of this guidance will result in a change in the presentation of comprehensive income in the Company’s consolidated financial statements beginning in the first quarter of 2012.

 

 

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 Ridge and Broadridge Financial Solutions, Inc. (“Broadridge”), Ridge’s parent company. The acquisition closed on June 25, 2010, and under the terms of the Ridge APA, as later amended, the Company paid $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 $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 $17,301 on that date (see Note 10 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%.

 

The Company recorded a liability of $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

Penson Worldwide, Inc.

 

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

 

Period Correspondents”). Twelve months after closing a calculation was 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. As of December 31, 2010, all of the correspondents in this category had generated at least six months of revenues. The Company reduced its contingent consideration liability by $343, which was included in other expenses in the consolidated statements of operations for the year ended December 31, 2010. 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 the recorded goodwill 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. A portion of the recorded goodwill associated with the contingent consideration may not be deductible for tax purposes if future payments are less than the $4,089 initially recorded. The tax goodwill will be deductible for tax purposes over a period of 15 years. The Company incurred acquisition related costs of $5,251.

 

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. 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.

 

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, 2011, a liability of $15,705 was accrued as result of the third year of the earnout ended May 31, 2010 ($6,000) and the year four earnout, which the Company does not expect to pay prior to the second half of 2011 ($9,705). This balance is included in other liabilities in the condensed consolidated statements of financial condition. The offset of this liability, goodwill, is included in other assets. In January, 2011, the Company and SGH entered into a letter agreement setting the amount due for the third year earnout at $6,000, due to the provisions in various agreements related to the Schonfeld transaction, including the termination/compensation agreement, which reduced the amount that the Company is required to pay under the Schonfeld Asset Purchase Agreement. This

Penson Worldwide, Inc.

 

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

 

resulted in a reduction in goodwill and other liabilities of $9,184 in the first quarter of 2011 offset by increases related to the fourth year of the earnout. The letter agreement also stipulated that the third year earnout will be paid evenly over a 12 month period commencing on September 1, 2011.

 

 

The following is a reconciliation of the numerators and denominators of the basic and diluted loss 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 loss per share.

 

 

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. See Note 20 to our unaudited interim consolidated financial statements for a discussion of stock repurchased subsequent to June 30, 2011.

 

 

Fair value is defined as the 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 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:

 

Penson Worldwide, Inc.

 

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

 

 

 

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.

 

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.

Penson Worldwide, Inc.

 

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

 

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, 2011 and December 31, 2010.

 

 

Penson Worldwide, Inc.

 

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

 

 

 

Cash and securities segregated under U.S. federal and other regulations totaled $5,747,924 at June 30, 2011. Cash and securities segregated under federal and other regulations by PFSI totaled $4,962,637 at June 30, 2011. Of this amount, $4,904,896 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, 2011 of $4,859,792. The remaining balance of $57,741 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, 2011 of $61,014. An additional deposit of $12,000 was made on July 5, 2011. 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, $802,293, including $459,626 in cash and securities, was segregated for the benefit of customers by Penson Futures pursuant to Commodity Futures Trading Commission Rule 1.20. Finally, $139,289, $134,403 and $51,969 was segregated under similar Canadian, United Kingdom and Australian regulations, respectively. At December 31, 2010, $5,407,645 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.

 

 

Receivable from and payable to customers and correspondents include amounts due on cash and margin transactions. Securities owned by customers and correspondents are held as collateral for receivables. This collateral includes financial instruments that are actively traded with valuations based on quoted prices and financial instruments in illiquid markets with valuations that involve considerable judgment. Such collateral is not reflected in the condensed consolidated financial statements. Payable to correspondents also includes commissions due on customer transactions.

 

Typically, the Company’s loans to customers or correspondents are made on a fully collateralized basis because they are generally margin loans and the amount advanced is less than the then current value of the margin collateral. When the value of that collateral declines, when the collateral decreases in liquidity, or margin calls are not met, the Company may consider a variety of credit enhancements such as, but not limited to, seeking additional collateral or guarantees. In certain circumstances it may be necessary to acquire third party valuation reports for illiquid financial instruments held as collateral. These reports are used to assist management in its assessment of the collectability of its receivables. In valuing receivables that become less than fully collateralized, the Company compares the estimated fair value of the collateral, deposits and any additional credit enhancements to the balance of the loan outstanding and evaluates the collectability based on various qualitative factors such as, but not limited to, the creditworthiness of the counterparty, the potential impact of any outstanding litigation or arbitration and the nature of the collateral and available realization methods. To the extent that the collateral, the guarantees and any other rights the Company has against the customer or the related introducing broker are not sufficient to cover potential losses, the Company records an appropriate allowance for doubtful accounts. In the ordinary course of business the Company carries less than fully collateralized balances for which no allowance has been recorded due to the Company’s judgment that the amounts are collectable. The Company monitors every account that is less than fully collateralized with liquid securities every trading day. The Company reviews these accounts on a monthly basis to determine if a change in the allowance for doubtful accounts is necessary. This specific, account-by-account review is supplemented by the risk management procedures that identify positions in illiquid securities and other

Penson Worldwide, Inc.

 

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

 

market developments that could affect accounts that otherwise appear to be fully collateralized. The corporate and local country risk management officers monitor market developments on a daily basis. The Company maintains an allowance for doubtful accounts that represents amounts, in the judgment of the Company, necessary to adequately reflect anticipated losses in outstanding receivables. Typically, when a receivable is deemed not to be fully collectable, it is generally reserved at an amount correlating with the amount of the balance that is considered undersecured. Provisions made to this allowance are charged to operations based on anticipated recoverability.

 

The Company generally nets receivables and payables related to its customers’ transactions on a counterparty basis pursuant to master netting or customer agreements. It is the Company’s policy to settle these transactions on a net basis with its counterparties. The Company generally recognizes interest income on an accrual basis as it is earned. Interest on margin loans is typically accrued monthly and, therefore, increases the margin loan balance reflected on the Company’s financial statements. However, there may be cases when the Company believes that, while the outstanding amount of the receivable is collectable, amounts greater than the current carrying value of the loan may not be collectable. At that point the Company may elect, even though the outstanding amount of the receivable is considered collectable, to recognize interest income only when received rather than reflecting any additional accrued interest in the receivable (“Nonaccrual Receivables”).

 

Generally, when an account has been reserved, no additional interest is accrued. Margin loan payments are generally recorded against the outstanding loan balance, which includes accrued interest. The Company’s policy with regard to loans with stated terms is to apply payments as set forth in the individual loan agreement. The accrual of interest does not resume until such time as the Company has determined that the amount is fully collectable. This would be evidenced by payments on margin loans resulting in the account becoming fully secured or loans with stated terms becoming current. Margin loans become delinquent at the point that margin calls are not met while loans with stated terms become delinquent in accordance with their stated terms. When either a margin loan or a loan with stated terms becomes delinquent, the Company undertakes a collectability review and generally requires customers to deposit additional collateral or to reduce positions.

 

The Nonaccrual Receivables that the Company presently has are secured by a variety of collateral, consisting principally of various municipal bonds. When assessing collectability of these Nonaccrual Receivables, the Company considers a variety of factors relating to such collateral such as, but not limited to, the macroeconomic environment, the underlying value of the projects associated with the bonds, the value of assets (often real estate) held in those projects and the liquidity of the collateral. Of the Nonaccrual Receivables, at June 30, 2011, approximately $42,580 were collateralized by bonds issued by the Retama Development Corporation (“RDC”) and certain other interests in the horse racing track and real estate project (“Project”) financed by the RDC’s bonds. In each case these bonds are owned by customers and pledged to the Company and/or its affiliates. When evaluating the value of the RDC bonds in addition to third party pricing indications the Company looked at additional factors such as, but not limited to (i) the value of the real estate and racing license rights held by the issuer, which were supported by a recent third party appraisal of the Retama property, (ii) the potential for the issuer to find additional partners (such as, but not limited to, gaming companies); and (iii) the potential expansion of gaming in Texas.

 

Consistent with its policy for the evaluation of collateral securing receivables from customers and correspondents, the Company continues to monitor the collateral securing the Nonaccrual Receivables. As noted above, one factor the Company looked at when evaluating the RDC bonds was the potential for expanded gaming rights in Texas. With the adjournment of the Texas Legislature on June 29, 2011 without taking up the bills that had been proposed to permit such expansion, the Company determined that, since the prospects for further consideration of legislation before the next Texas legislative session in 2013 appeared unlikely, it would be appropriate to reevaluate the value of the RDC bonds and other collateral securing the Nonaccrual Receivables. Based upon the Company’s re-assessment of the value of collateral securing the Nonaccrual Receivables, including review of recent appraisals of underlying real estate and the Retama Project, among other factors, the Company’s determined that the carrying value of the Nonaccrual Receivables was not fully realizable and recorded a charge of $43,000. Consequently, at

Penson Worldwide, Inc.

 

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

 

June 30, 2011 and December 31, 2010, the Company had approximately $53,648 and $97,427 in Nonaccrual Receivables, net of reserves of $45,379 and $2,379 respectively.

 

The Company has also determined that it is appropriate at this time to commence enforcement action in respect of certain Nonaccrual Receivables. The Company has, therefore, exercised its rights against the most liquid collateral securing these Nonaccrual Receivables, including the Company’s common stock, and intends to commence foreclosure actions against certain other collateral, including certain of the RDC bonds. There can be no assurances that the Company’s enforcement and/or foreclosure plans, including anticipated funding and/or other actions by third parties, will be effectuated as currently contemplated, or that the Company will be able to realize the full value on the collateral securing the Nonaccrual Receivables as is currently contemplated. Given the illiquid nature of much of the collateral, the Company anticipates that ultimate realization upon the collateral may require investment of significant time and resources, including active participation in the restructuring of the investments, in order to execute upon a plan of liquidation. The Company anticipates that in the near future it may advance $400 to the RDC. The Company would advance these funds to assist RDC in its efforts to eventually arrange a financing transaction with a third party. The Company believes such a financing transaction by RDC with a third party could benefit the value of the Company’s collateral. The Company is not legally committed to advance any funds. The Company’s final determination regarding any advancement of funds will be subject to further evaluation of RDC’s operations and the likelihood that RDC can complete a larger financing transaction.. The Company will continue to assess the collateral value as it continues with, and in light of, its efforts to, liquidate the collateral securing these Nonaccrual Receivables

 

The changes in the allowance for doubtful accounts during 2011 were as follows:

 

Penson Worldwide, Inc.

 

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

 

 

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

 

 

 

At June 30, 2011 and December 31, 2010, the Company had $421,524 and $338,110, respectively in short-term bank loans outstanding with weighted average interest rates of approximately 1.5% and 1.1%, respectively. As of June 30, 2011, the Company had 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 $332,892 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, 2011 and December 31, 2010, the Company had $554,212 and $619,833, respectively, in stock loan with 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.

Penson Worldwide, Inc.

 

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

 

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 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 $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 $2,850 for fees paid to the initial purchasers. These fees 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 ending May 2011 and subsequent periods will be greater as the discount is accreted and the effective interest method is applied. The Company recognized interest expense of $1,200 and $1,200, related to the coupon, $648 and $561 related to the conversion feature and $178 and $178 related to various issuance costs for the three

Penson Worldwide, Inc.

 

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

 

months ended June 30, 2011 and 2010, respectively. For the six month periods ended June 30, 2011 and 2010 the Company recognized interest expense of $2,400 and $2,400, related to the coupon, $1,282 and $1,109 related to the conversion feature and $357 and $357 related to various issuance costs.

 

The 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, 2011, the estimated fair value of the Convertible Notes was $53,570.

 

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 PWI, 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, 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 months ended June 30, 2011 and 2010 the Company recognized interest expense of $6,250 and $3,819 related to the coupon and $239 and $158 related to various issuance costs. The Company recognized interest expense of $12,500 and $3,819, related to the coupon and $479 and $158 related to various issuance costs for the six months ended June 30, 2011 and 2010, respectively. The fair value of the 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, 2011, the estimated fair value of the Notes was approximately $200,000.

 

Revolving credit facility

 

On May 6, 2010, the Company 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

Penson Worldwide, Inc.

 

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

 

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, 2011 the Company was in compliance with all financial covenants. On October 29, 2010, the Company entered into an amendment to the Amended and Restated Credit Facility (the “First Amendment”). The First Amendment, among other things, revises certain financial covenants in the Amended and Restated Credit Facility and provides for the addition of a minimum consolidated EBITDA covenant. The First Amendment also provides additional availability under the facility in certain circumstances. On August 4, 2011, the Company entered into a second amendment to the Amended and Restated Credit Facility (the “Second Amendment”). The Second Amendment, among other things, adjusts the timing of the clean down provisions of the Amended and Restated Credit Agreement that require a periodic pay down of outstanding loans, and provides for prepayments, subject to conditions set forth in the Second Amendment, upon certain dispositions and certain increases in capital. The Second Amendment also amends certain other covenants to provide additional flexibility for the realization, by the Company and its subsidiaries, upon collateral held by the Company or its subsidiaries, including with respect to the Nonaccrual Receivables, and the provision of greater flexibility for the Company to pursue certain strategic initiatives including certain asset sales. Currently, the Company has the capacity to borrow up to $25,000 under the Amended and Restated Credit Facility. As of June 30, 2011, $25,000 was outstanding under the Amended and Restated Credit Facility.

 

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 (5.81% at June 30, 2011). 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 $3,277, which resulted in an estimated fair value of $17,301 at issuance. 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 interest method is applied. For the three months ended June 30, 2011 and 2010, respectively, the Company recognized interest expense of $303 and $10 related to the coupon and $138, and $0 related to the discount. The Company recognized interest expense of $601 and $10, related to the coupon and $272 and $0 related to the discount for the six months ended June 30, 2011 and 2010, respectively. The fair value of the Ridge Seller Note approximated its carrying value of $17,832 as of June 30, 2011.

Penson Worldwide, Inc.

 

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

 

 

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 generally 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 on an intra-day basis and, pursuant to such guidelines, generally requires customers to deposit additional collateral or to reduce positions when necessary. Although the Company monitors margin balances on an intra-day basis in order to control our risk exposure, the Company is not able to eliminate all risks associated with margin lending.

 

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 and maintains a policy of reviewing the credit exposure 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, 2011, at fair values of the related securities and may incur a loss if the fair value of the securities increases subsequent to June 30, 2011.

 

 

The Company grants awards of stock options and restricted stock units (“RSUs”) under the Amended and Restated 2000 Stock Incentive Plan, as amended in April 2011 (the “2000 Stock Incentive Plan”), under which 6,006 shares of common stock have been authorized for issuance. Of this amount, options and RSUs to purchase 3,377 shares of common stock, net of forfeitures and tax withholdings have been granted and 2,629 shares remain available for future grants at June 30, 2011. 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 (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.

Penson Worldwide, Inc.

 

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

 

Stock options

 

During the three and six months ended June 30, 2011 and 2010, the Company did not grant any stock options to employees.

 

The Company recorded compensation expense relating to options of approximately $13 and $165, respectively, for the three months ended June 30, 2011 and 2010, and $38 and $431, respectively for the six months ended June 30, 2011 and 2010.

 

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, 2011 and 2010 was $0 and $100, respectively. At June 30, 2011, the Company had approximately $8 of total unrecognized compensation expense, net of estimated forfeitures, related to stock option plans that will be recognized over the weighted average period of .16 years. Cash received from stock option exercises totaled approximately $0 and $88 for the three and six months ended June 30, 2011 and 2010, 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 $799 and $1,259 during the three months ended June 30, 2011 and 2010, respectively and $1,720 and $2,437 for the six months ended June 30, 2011 and 2010, respectively.

 

As of June 30, 2011, there was approximately $6,793 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 2.25 years.

Penson Worldwide, Inc.

 

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

 

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 has discretionary authority to establish the maximum number of shares of common stock purchasable per participant and in total by all participants for each 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, 2011, 625 shares of common stock had been reserved and 540 shares of common stock had been purchased by employees pursuant to the ESPP plan. The Company recognized expense of $33 and $46 for the three months ended June 30, 2011 and 2010, respectively, and $63 and $99 for the six months ended June 30, 2011 and 2010, respectively.

 

 

From time to time, we are involved in other 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’s 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, 2011.

 

 

The Company’s effective income tax rate for the three and six months ended June 30, 2011 was 38.0% and 38.0%, respectively, and was 22.8% and 22.4%, respectively for the three and six months ended June 30, 2010. The primary factors contributing to the difference between the effective tax rates and the federal statutory income tax rate of 35% are lower tax rates applicable to non-U.S. earnings, state and local income taxes, net of federal benefit, stock-based compensation and the return to provision true-up associated with the filing of the Company’s U.S. federal tax return.

Penson Worldwide, Inc.

 

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

 

 

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, 2011, PFSI had net capital of $159,532, and was $109,345 in excess of its required net capital of $50,187. At December 31, 2010, PFSI had net capital of $139,495, and was $96,493 in excess of its required net capital of $43,002.

 

The Company’s Penson Futures, 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, 2011.

 

The regulatory rules referred to above may restrict the Company’s ability to withdraw capital from its regulated subsidiaries, which in turn could limit the Subsidiaries’ ability to pay dividends and the Company’s ability to satisfy its debt obligations. PFSC, PFSL and PFSA are subject to regulatory requirements in their respective countries which also limit the amount of dividends that they may be able to pay to their parent.

 

 

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 Futures and PFFI held customer segregated accounts with Sentinel totaling approximately $36 million. 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 Futures and PFFI. This distribution to the Penson Futures and PFFI customer segregated accounts along with a distribution received immediately prior to the bankruptcy filing totaled approximately $25.4 million.

 

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 Futures 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 Futures, PFFI and others. On September 16, 2008, the Sentinel Trustee filed suit against Penson Futures and PFFI along with several other FCMs that received distributions to their customer segregated accounts from Sentinel. The suit against Penson Futures and PFFI seeks the return of approximately $23.6 million of post-bankruptcy petition transfers and

Penson Worldwide, Inc.

 

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

 

approximately $14.4 million of pre-bankruptcy petition transfers. The suit also seeks to declare that the funds distributed to the customer segregated accounts of Penson Futures and PFFI by Sentinel are the property of the Sentinel bankruptcy estate rather than the property of customers of Penson Futures and PFFI.

 

On December 15, 2008, over the objections of Penson Futures 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 Futures and PFFI filed their answer and affirmative defenses to the suit brought by the Sentinel Trustee. Also on January 7, 2009, Penson Futures, PFFI and a number of other FCMs that had placed customer funds with Sentinel filed motions 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. Following an unsuccessful attempt to dismiss that claim on September 1, 2009, the Court denied the motion for reconsideration without prejudice. On September 11, 2009, Penson Futures 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 Futures, 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 February 23, 2011, the federal district court held a continued status hearing, during which Penson Futures, PFFI and the Sentinel Trustee agreed that coordinated discovery with respect to the Sentinel suits against the Company and other FCMs was still proceeding. No trial date has been set.

 

In one of the actions brought by the Sentinel Trustee against an FCM whose customer segregated accounts received similar distributions to those made to the customer segregated accounts of Penson Futures and PFFI, the Sentinel Trustee has brought a motion for summary judgment on certain counts asserted against such FCM that may implicate the claims brought by the Sentinel Trustee against the Company. There is no date set for the resolution of that motion.

 

The Company believes that the Court was correct in ordering the prior distributions and Penson Futures and PFFI intend to continue to vigorously defend their position. However, there can be no assurance that any actions by Penson Futures or PFFI will result in a limitation or avoidance of potential repayment liabilities. Management cannot currently estimate a range of reasonably possible loss. In the event that Penson Futures 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 Futures 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. From December, 2007 through 2008, the Company repurchased approximately 654 shares at an average price of $10.32 per share. No shares were repurchased during the three and six month periods ended June 30, 2011 and 2010. The Company had approximately $4,700 available under the current repurchase program as of June 30, 2011; however, our Amended and Restated Credit Facility limits our ability to repurchase our stock.

 

 

In June 2010, in connection with the Company’s outsourcing agreement with Broadridge, the Company announced a plan to reduce its headcount across several of its operating subsidiaries primarily over the following six to 21 months. The terms of the plan include both severance pay and bonus payments associated with continuing

Penson Worldwide, Inc.

 

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

 

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 $2,016 for the year ended December 31, 2010 of which $1,687 was 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 condensed consolidated statement of operations. In the first quarter of 2011, the Company reduced its severance reserve by approximately $140 related to the Company’s Canada segment as none of the affected employees remained employed through the respective employment period. During the second quarter of 2011 the Company reduced its severance reserve in its United States segment by $1,060 due to a reduction in the number of employees eligible to receive severance payments due to voluntary terminations or transfers to other areas. The severance reserve is $816 as of June 30, 2011. The Company estimates that it will incur costs of $1,211 associated with Stay Pay of which $954 is related to the United States segment, and $257 related to the Other segment. The Company recorded a charge of $864 in connection with the Stay Pay for the year ended December 31, 2010 of which $723 was associated with the United States segment, $60 was related to the Canada segment and $81 was associated with the Other segment. For the three months ended June 30, 2011, the Company reduced its Stay Pay by $91. This was comprised of a reduction of $131 in the United States segment based on a lower number of employees eligible for Stay Pay and a charge of $40 in the Other segment. For the six months ended June 30, 2011 the Company has recorded a charge of $251 of which $230 is associated with the United States segment, $(60) in the Canada segment and $81 in the Other segment. These charges are being recorded on a straight line basis as the benefits are earned. No charges were recorded for the three and six months ended June 30, 2010. The Company has accrued $1,116 as of June 30, 2011 related to Stay Pay.

 

 

On August 4, 2011, as part of the foreclosure on the assets that collateralize the Nonaccrual Receivables, the Company purchased 1,001 shares of its common stock at a price of $2.61 per share, the then current market price, totaling $2,612, which proceeds were applied to reduce the applicable Nonaccrual Receivable. The purchased shares increased the total number of treasury shares as of that date.

 

On August 4, 2011, the Company entered into a non-binding letter of intent (“LOI”) with its current strategic partner, Broadridge Financial Solutions, Inc. The LOI contains provisions relating to the extension of the Master Services Agreement (“MSA”) between the Company and Broadridge to 15 years from the date of conversion of PFSI, the expansion of services subject to the MSA, as to be determined by the parties, and a cost of inflation adjustment after the fifth year of the contract. The adjustment is subject to certain conditions based on minimum margins for the Company and revenue growth for Broadridge. The adjustment is capped at a maximum of two percent in any year. After the tenth year of the contract, the Company and Broadridge have agreed to review pricing for the balance of the contract and will negotiate in good faith any appropriate adjustment. The LOI also contains provisions regarding the elimination of the termination penalty for PFSL, and an increase of the termination penalty for PFSI. The terms of the LOI are non-binding and subject to further negotiation between the Company and Broadridge.

 

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, 2010 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 390 active securities clearing correspondents and 62 futures clearing correspondents as of June 30, 2011. Our net revenues were $78.5 million and $71.1 million for the three months ended June 30, 2011 and 2010, respectively, while our net revenues were $160.8 million and $138.5 million respectively, for the six months ended June 30, 2011 and 2010. 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 correspondents. We also earn licensing and development revenues from fees we charge to our clients for their use of our technology solutions.

 

Fiscal 2011 focal points

 

 

Strategic initiatives

 

The current low interest environment and lower industry volumes have continued to negatively impact the Company’s performance. We believe that this macro-economic environment may persist for some time and we have, therefore, started to implement several strategic initiatives designed to better position the Company to operate under these economic conditions. These initiatives are designed to increase our regulatory and other capital positions, further reduce our operating expenses and sharpen our strategic focus. Among the significant initiatives started are the following:

 

 

Combination of the operations of Penson Futures and PFSI into one operating company

 

We have been evaluating the benefits of combining the Company’s U.S.-based futures business, operated by Penson Futures, with its U.S.-based broker dealer business, operated by PFSI, over the past several quarters. Such a consolidation offers a number of significant advantages to the Company. Most importantly, the combination of the futures and broker dealer operations will eliminate the need to maintain separate regulatory capital bases for the respective businesses. We estimate that a combination of the futures and broker dealer businesses will free-up approximately $30 million of regulatory capital, which may then be available for other uses. We also expect that it will achieve savings from synergies between the futures and broker dealer operations and estimates that it may be able to reduce costs by up to $2 million annually. The Company also anticipates that the combination of the futures and broker dealer operations will enhance the product offering for customers. The Company’s subsidiaries have applied to their respective regulators for the approval of the transfer of the futures business to PFSI and the initial feedback has been encouraging. The Company currently anticipates, subject to regulatory and other approvals, that the combination of Penson Futures and PFSI will occur in the third quarter of 2011.

 

Expansion of outsourcing to Broadridge

 

With the successful conversion of our Canadian operations to the Broadridge technology platform and preparations for a conversion at PFSI well under way, we believe that the outsourcing of additional services to Broadridge offers significant cost savings, product enhancements and strategic flexibility for the Company. Consequently, we have been evaluating with Broadridge the ways in which this important relationship might be enhanced. The Company and Broadridge have entered into a non-binding letter of intent with respect to a proposed expansion. The letter of intent contemplates the extension of the term of the Master Services Agreement between the Company and Broadridge to 15 years from the date of conversion of PFSI. The services subject to this agreement will be expanded, resulting in anticipated annual cost savings of up to $15 million to $18 million. The expanded services are anticipated to include the outsourcing of our data centers and related telecommunications (other than in the U.K. and Australia) to Broadridge in conjunction with IBM. The letter of intent contemplates a cost of inflation adjustment after the fifth year of the agreement, subject to certain conditions based on minimum margins for the Company and revenue growth for Broadridge. The adjustment is capped at a maximum of two percent in any year. After the tenth year of the agreement, the Company and Broadridge have agreed to review pricing for the balance of the agreement and will negotiate in good faith any appropriate adjustment.

 

Streamlining operations

 

In addition to the expansion of outsourcing to Broadridge the Company has been proceeding with its plans to further streamline its internal operations. We anticipate that these plans to further streamline business operations will reduce costs by an additional $6 million annually.

 

Strategic partnerships with or potential sale of PFSL and Penson Australia

 

In line with the Company’s commitment to considering all strategic alternatives, we recently conducted a review of our operations with a view to identifying operations potentially ancillary to the Company’s core operations. As a result of this review, we have been exploring strategic options for our U.K. and Australian operations. In the case of the U.K., we are in discussions with a potential purchaser of PFSL and have received several other inquiries expressing interest in this business. With respect to the Company’s operations in Australia, after receiving several inquiries, we have decided to explore opportunities for a strategic partnership with a third party or an outright sale.

 

Liquidation of certain Nonaccrual Receivables

 

As discussed in Note 7 to our June 30, 2011 unaudited interim condensed consolidated financial statements above, the Company has commenced enforcement actions with respect to certain of its Nonaccrual Receivables. In connection with such enforcement actions, we have determined to write down the value of the Nonaccrual Receivables. We recognize that it may take a significant time and investment of resources to execute upon a plan of liquidation for certain of the collateral securing the Nonaccrual Receivables. Given the illiquid nature of some of the

collateral securing the Nonaccrual Receivables, the Company is likely to be more heavily involved in restructurings of the collateral than it would be typically. We believe it is necessary to do so in this case so that the Company may maximize the value received in connection with the liquidation of these receivables. These Nonaccrual Receivables relate primarily to a number of older accounts. In recent years, we have further enhanced our procedures regarding the monitoring and handling of margin debits and we are confident that these procedures are adequate to prevent similar concentrations arising with respect to new margin loans. We believe that the write down of these Nonaccrual Receivables and the associated enforcement actions are important steps to resolving the issues related to the Nonaccrual Receivables. Further, as noted in Note 7 to our June 30, 2011 condensed consolidated financial statements above, the Nonaccrual Receivables have already been fully reserved for regulatory capital purposes and, consequently, neither the write down of the Nonaccrual Receivables, nor the ultimate realization upon the collateral securing these receivables, will have a negative impact on the regulatory capital of any of the Company’s operating subsidiaries. See Note 7 to our June 30, 2011 unaudited interim condensed consolidated financial statements above for a more complete description of this liquidation process.

 

Conversion Away of Certain TD Ameritrade, f/k/a thinkorswim, Accounts to TD Ameritrade

 

We currently anticipate that TD Ameritrade, Inc., f/k/a thinkorswim, Inc., will convert approximately two-thirds of its accounts to its own systems in the third quarter of this year. Upon the conversion of these accounts, we anticipate that there will be a net improvement to the regulatory capital position of PFSI of approximately $30 million.

 

Pay down debt

 

We anticipate that, as we complete these various strategic initiatives, we will be in a position to potentially pay down the loans under the Amended and Restated Credit Agreement, reducing interest costs, on an annualized basis, of up to $2 million.

 

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 typically only remit commissions charged by our correspondents to them after deducting our charges.

 

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 51% and 54% of our total net revenues for the three months ended June 30, 2011 and 2010, respectively, while revenues from clearing and commission fees represented 52% and 52% of our total net revenues for the six months ended June 30, 2011 and 2010, 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 enter into 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 27% and 21% of our total net revenues in each of the three months ended June 30, 2011 and 2010, respectively and 26% and 22% for the six months ended June 30, 2011 and 2010, 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, 2011 and June 30, 2010

 

Overview

 

Results of operations declined for the three months ended June 30, 2011 compared to the three months ended June 30, 2010 primarily due to a $43.0 million write down to certain Nonaccrual Receivables, higher floor brokerage, exchange and clearance fees, higher communications and data processing costs, higher other expenses and higher interest expense on long-term debt, partially offset by higher clearing and commission fees and net interest income. Operating results decreased $42.9 million during the second quarter of 2011 as compared to the second quarter of 2010, for our U.S., Canadian, U.K. and Australian operating businesses.

 

Our U.S. operating subsidiaries experienced a decrease in operating profits of approximately $44.9 million due primarily to a $43.0 million write down to certain Nonaccrual Receivables, higher communications and data processing, floor brokerage, exchange and clearance fees and interest expense on long-term debt, lower clearing and commission fees and lower other revenue offset by higher net interest income, lower employee compensation and benefits and lower other expenses. The second quarter 2011 U.S. operating results were also impacted by the addition of the Ridge business that closed on June 25, 2010. Our Canadian business experienced an operating loss of $.4 million for both quarters ended June 30, 2011 and 2010. The U.K. incurred an operating loss of $1.7 million for the quarter ended June 30, 2011 compared to an operating loss of $1.8 million for the quarter ended June 30, 2010. Australia incurred an operating profit of $.6 million for the quarter ended June 30, 2011 compared to an operating loss of approximately $1.3 million in the quarter ended June 30, 2010. Australia increased net revenues approximately $4.2 million while expenses increased only $2.3 million. This is primarily related to increased revenues in the June 2011 quarter as the Australian business has continued to grow since it began clearing operations in December 2009, offset by higher expenses primarily attributable to its expanded operations.

 

The above factors resulted in lower operating results for the three months ended June 30, 2011 compared to the three months ended June 30, 2010.

The following is a summary of the increases (decreases) in the categories of revenues and expenses for the three months ended June 30, 2011 compared to the three months ended June 30, 2010.

 

 

Net Revenues

 

Net revenues increased $7.3 million, or 10.3%, to $78.5 million from the quarter ended June 30, 2010 to the quarter ended June 30, 2011. The increase is primarily attributed to the following:

 

Clearing and commission fees increased $1.9 million, or 5.1%, to $40.0 million during this same period. This increase is primarily due to clearing and commission fees of $7.4 million related to the Ridge acquisition in June 2010, an increase of $2.8 million in Australia as that business has continued to grow, $.2 million in our futures business and $.2 million in the U.K. offset by a decrease of approximately $8.2 million in our existing U.S. securities business and $.5 million in Canada. During the quarter we encountered lower equity and option volumes in the U.S. and Canada while Australia and the U.K. experienced higher equity and option volumes. Our futures business benefited from higher commissions from its execution business and a stronger mix.

 

Technology revenue increased $.1 million, or 1.3%, to $5.3 million due to higher recurring revenues of $.1 million.

 

Interest, gross increased $9.9 million or 49.4%, to $30.0 million during the quarter over quarter period. Interest revenues from customer balances increased $11.0 million or 64.0% to $28.1 million due to increases in our interest income on asset balances of $10.6 million and $.4 million in money market revenues The increase in our interest

income on assets balances is attributable to an increase in our average daily interest earning assets of $3.0 billion or 50.7% to $9.1 billion and an increase in our average daily interest rate of 9 basis points or 8.0% to 1.21%.

 

Interest from our stock conduit borrows operations decreased $1.0 million or 35.6% to $1.9 million, as a result of a decrease in our average daily interest rate of 76 basis points or 40.0% to 1.14%, offset by an increase in our average daily assets of approximately $45.9 million, or 7.5% to $661.6 million.

 

Other revenue decreased $.4 million, or 3.6%, to $12.1 million primarily due to decreases in equity and foreign exchange trading of $.4 million and approximately $.9 million in our trade aggregation business offset by increased account servicing fees of approximately $.3 million and increased execution services revenues of $.5 million.

 

Interest expense from securities operations increased $4.1 million, or 85.4%, to $9.0 million from the quarter ended June 30, 2010 to the quarter ended June 30, 2011. Interest expense from clearing operations increased approximately $5.0 million, or 181.4%, to $7.8 million due to an increase in our average daily balances on our short-term obligations of $2.9 billion, or 52.2%, to $8.5 billion and a 17 basis point or 85.0% increase in our average daily interest rate to .37%.

 

Interest expense from our stock conduit loans decreased $.9 million, or 43.2% to $1.2 million due to a 64 basis point decrease, or 47.4% in our average daily interest rate to .71% offset by a $47.4 million, or 7.7% increase in our average daily balances to $660.9 million.

 

Interest, net increased from $15.2 million for the quarter ended June 30, 2010 to $21.0 million for the quarter ended June 30, 2011. This increase was due to higher customer balances, higher money market revenues and higher conduit balances offset by a lower interest rate spread of 8 basis points on customer balances and 12 basis points on conduit balances.

 

Employee compensation and benefits

 

Total employee costs decreased $4.6 million, or 14.4%, to $27.3 million from the quarter ended June 30, 2010 to the quarter ended June 30, 2011, primarily due to $3.2 million in severance costs recorded in the second quarter of 2010 and a $1.1 million reversal of severance costs related to the outsourcing agreement with Broadridge (see Note 19 to our unaudited interim consolidated financial statements), lower stock-based compensation of approximately $.6 million, lower compensation costs of approximately $1.2 million in our existing U.S. securities business due to reduced headcount and lower incentive compensation of approximately $.4 million offset by higher compensation expense of approximately $.8 million in Australia as a result of the expansion of that business and approximately $1.1 million of compensation costs associated with the Ridge acquisition. Employee count decreased 8.1% to 976 as of June 30, 2011 primarily due to lower headcounts in our U.S. and Canadian operations.

 

Floor brokerage, exchange and clearance fees

 

Floor brokerage, exchange and clearance fees increased $2.4 million, or 25.6%, to $11.9 million for the quarter ended June 30, 2011 from the quarter ended June 30, 2010, primarily related to costs of $2.6 million resulting from the additional volumes from the Ridge acquisition, and $.8 million in Australia due to higher equity and option volumes as that business has grown offset by approximately $.9 million in lower costs in our existing U.S. securities business due to lower equity and option volumes and approximately $.2 million in Canada resulting from lower equity and option volumes.

 

Communication and data processing

 

Total expenses for our communication and data processing requirements increased $7.2 million, or 59.6%, to $19.4 million from the quarter ended June 30, 2010 to the quarter ended June 30, 2011 primarily due to outsourcing costs of approximately $6.3 million associated with the Ridge acquisition and increased communications and data processing costs of $.5 million associated with our Australian business and higher data processing costs of $.3 million in our futures business attributable to costs associated with higher maintenance fees associated with its trade processing system as well as higher communications line charges.

Occupancy and equipment

 

Total expenses for occupancy and equipment increased $.1 million, or 1.2%, to $8.0 million from the quarter ended June 30, 2010 to the quarter ended June 30, 2011 primarily due to higher depreciation resulting from computer equipment and software associated with our conversion to the Broadridge technology platform.

 

Bad debt expense

 

Bad debt expense increased approximately $43.1 million primarily due to a $43.0 million write down to certain Nonaccrual receivables. Typically, our loans to customers or correspondents are made on a fully collateralized basis because they are generally margin loans and the amount advanced is less than the then current value of the margin collateral. When the value of that collateral declines, or the collateral decreases in liquidity, we consider a variety of credit enhancements such as, but not limited to, seeking additional collateral or guarantees. When valuing receivables that become less than fully collateralized, we compare what we determine to be the market value of the collateral, deposits and any additional credit enhancements to the balance of the loan outstanding and evaluate the collectability based on various qualitative factors, such as, but not limited to, the creditworthiness of the counterparty, the potential impact of any outstanding litigation or arbitration and nature of the collateral and available realization methods. We monitor every account that is less than fully collateralized with liquid securities every trading day. This specific, account-by-account review is supplemented by the risk management procedures to identify illiquid securities and other market developments that it is anticipated would affect accounts that otherwise appear to be fully collateralized. The corporate and local country risk management officers monitor market developments on a daily basis. At the culmination of this review, we record an appropriate allowance for doubtful accounts, which in our judgment is necessary to reflect anticipated losses in outstanding receivables. When a receivable is deemed not to be collectable it is generally reserved at 100% as the applicable reserve would correlate with the amount of the balance that is unsecured.

 

Our review of accounts receivable is an active, continuing process during which, among other factors, we seek to assess the fair value and liquidity of the assets collateralizing the receivables. As discussed in Note 7 to our unaudited interim consolidated financial statements, following the failure of the Texas legislature to enact legislation expanding gaming rights, we determined to reassess the value of the collateral securing the Nonaccrual Receivables and in particular the value of the RDC bonds. This review resulted in our determination that the carrying value of the Nonaccrual Receivables was not fully realizable and we recorded a bad debt charge of $43.0 million for the three months ended June 30, 2011. We have commenced enforcement actions with respect to certain of the Nonaccrual Receivables and realized immediate benefits from some of the more liquid collateral. Determining the ultimate collectability of illiquid collateral with multiple interested parties is necessarily a subjective determination that requires a consideration of multiple realization strategies. There can be no assurances that our enforcement and/or foreclosure plans, including anticipated funding and/or other actions by third parties, will be effectuated as currently contemplated, or that we will be able to realize the full value on the collateral securing the Nonaccrual Receivables as is currently contemplated. We recognize that it may take a significant time and investment of resources to execute upon a plan of liquidation for such illiquid collateral. We anticipate that in the near future we may advance $400,000 to the RDC. We would advance these funds to assist RDC in its efforts to eventually arrange a financing transaction with a third party. We believe such a financing transaction by RDC with a third party could benefit the value of our collateral. We are not legally committed to advance any funds. Our final determination regarding any advancement of funds will be subject to further evaluation of RDC’s operations and the likelihood that RDC can complete a larger financing transaction. We will continue to assess the collateral value as we continue with, and in light of, our efforts to, liquidate the collateral securing these Nonaccrual Receivables.

 

Other expenses

 

Other expenses decreased $4.1 million, or 35.4%, to $7.5 million from the quarter ended June 30, 2010 to the quarter ended June 30, 2011, due primarily to $2.5 million of costs associated with the closing of the Ridge transaction and $1.5 million in legal expenses to conclude certain outstanding litigation in the second quarter of 2010 as well as lower professional fees of approximately $.6 million offset by higher amortization of $.5 million associated with the Ridge acquisition.

Interest expense on long-term debt

 

Interest expense on long-term debt increased $2.4 million from $7.4 million for the quarter ended June 30, 2010 to $9.8 million for the quarter ended June 30, 2011 resulting primarily from approximately $2.5 million associated with our senior second lien secured notes issued on May 6, 2010 and $.4 million associated with the Ridge Seller Note issued on June 25, 2010 offset by $.6 million in lower interest costs on our revolving credit facility due to lower balances as compared to the prior year.

 

Provision for income taxes

 

Income tax benefit, based on an effective income tax rate of 38.0%, was $18.5 million for the quarter ended June 30, 2011 as compared to an effective tax rate of 22.8% and an income tax benefit of approximately $2.2 million for the quarter ended June 30, 2010. This change is primarily attributed to a larger operating loss in the current quarter.

 

Net loss

 

As a result of the foregoing, our net loss was approximately $30.2 million for the quarter ended June 30, 2011 compared to a net loss of $7.4 million for the quarter ended June 30, 2010.

 

Comparison of the six months ended June 30, 2011 and June 30, 2010

 

Overview

 

Results of operations declined for the six months ended June 30, 2011 compared to the six months ended June 30, 2010 primarily due to a $43.0 million write down to certain Nonaccrual Receivables, higher floor brokerage, exchange and clearance fees, increased communications and data processing costs, higher other expenses and elevated interest expense on long-term debt, partially offset by higher clearing and commission fees and net interest income. Operating results decreased $44.9 million during the first half of 2011 as compared to the first half of 2010, for our U.S., Canadian, U.K. and Australian operating businesses.

 

Our U.S. operating subsidiaries experienced a decrease in operating profits of approximately $47.0 million due primarily to a $43.0 million write down to certain Nonaccrual Receivables, higher communications and data processing, floor brokerage, exchange and clearance fees and interest expense on long-term debt and lower other revenue offset by higher clearing and commission fees, higher net interest income, lower employee compensation and benefits and lower other expenses. The six month 2011 U.S. operating results were also impacted by the addition of the Ridge business that closed on June 25, 2010. Our Canadian business experienced an operating loss of $.5 million for the six months ended June 30, 2011 compared to an operating profit of $.8 million for the six months ended June 30, 2010 due to higher operating expenses offset by higher net revenues. The U.K. incurred an operating loss of $3.3 million for the six months ended June 30, 2011 compared to an operating loss of $3.4 million for the six months ended June 30, 2010. Australia incurred an operating profit of $1.0 million for the six months ended June 30, 2011 compared to an operating loss of approximately $2.2 million for the six months ended June 30, 2010. Australia increased net revenues approximately $7.9 million while expenses increased only $4.7 million. This is a result of continued growth of its clearing operations since December 2009.

 

The above factors resulted in lower operating results for the six months ended June 30, 2011 compared to the six months ended June 30, 2010.

The following is a summary of the increases (decreases) in the categories of revenues and expenses for the six months ended June 30, 2011 compared to the six months ended June 30, 2010.