UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One)

For the quarterly period ended September 30, 2016

OR

For the transition period from                      to                     

Commission file number: 001-33518

 

FBR & CO.

(Exact name of Registrant as specified in its charter)

 

 

(703) 312-9500

(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  ☒    No  ☐

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ☒    No   ☐

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

 

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

The number of shares outstanding of the registrant’s common stock, $0.001 par value per share, as of October 31, 2016 was 6,915,653 shares.

 

 

 

 

 

 

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FBR & CO.

FORM 10-Q

FOR THE QUARTER ENDED SEPTEMBER 30, 2016

INDEX

 

 

 

 

 

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PART I

FINANCIAL INFORMATION

 

Item 1.Financial Statements

FBR & CO.

CONSOLIDATED BALANCE SHEETS

(Dollars in thousands, except per share data)

(Unaudited)

 

  

See notes to consolidated financial statements.

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FBR & CO.

CONSOLIDATED STATEMENTS OF OPERATIONS

(Dollars in thousands, except per share data)

(Unaudited)

 

 

See notes to consolidated financial statements.

 

 

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FBR & CO.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(Dollars in thousands)

(Unaudited)

 

 

See notes to consolidated financial statements.

 

 

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FBR & CO.

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

(Dollars and shares in thousands)

(Unaudited)

 

 

See notes to consolidated financial statements.

 

 

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FBR & CO.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)

(Unaudited)

 

 

See notes to consolidated financial statements.

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FBR & CO.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except per share data)

(Unaudited)

 

 

1. Basis of Presentation:

The consolidated financial statements of FBR & Co. and subsidiaries (collectively, the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q. Therefore, they do not include all information required by accounting principles generally accepted in the United States of America for complete annual financial statements.  The interim financial statements reflect all adjustments (consisting only of normal recurring adjustments) which are, in the opinion of management, necessary for a fair statement of the results for the periods presented. All significant intercompany accounts and transactions have been eliminated in consolidation. Certain reclassifications have been made to prior period amounts in order to conform with the current period presentation. The results of operations for the three and nine months ended September 30, 2016 and 2015 are not necessarily indicative of the results for the entire year or any subsequent interim period. These financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2015 (“2015 Form 10-K”).

During the first quarter of 2016, based on changes in the Company’s business profile since its IPO in 2007, including significant changes in capital allocation and revenue mix that have occurred over that time, the Company revised its segment reporting structure.  Beginning with the first quarter of 2016, the Company’s investment activities are included together with its other capital markets activities and not as a separate reportable segment.  In making this change the Company considered the diminished level of its investment balances, the relative insignificance of its investment-related revenues compared to total revenues and the nature of the financial information used by the Company’s Chief Operating Decision Maker (“CODM”).  In this case, as a result of changes in capital allocation, the Company’s investment assets have decreased to represent less than 5% of total assets in 2016.  Investment-related revenues are not a significant element of the Company’s total revenues ranging from 3% to 4% of the Company’s total revenues net of interest expense over the past three years.  In addition to the above, while the Company’s CODM reviews investment-related returns, there are no specific resource or overhead allocations made to investment activities separate from the Company as a whole.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions affecting 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 reporting period. Although the Company bases its estimates and assumptions on historical experience and market information (when available) and on various other factors that it believes to be reasonable under the circumstances, management exercises significant judgment in the final determination of its estimates. Actual results may differ from those estimates.

Recent Accounting Pronouncements

In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-09, “Revenue from Contracts with Customers” (“ASU 2014-09”), which supersedes nearly all existing revenue recognition guidance under U.S. Generally Accepted Accounting Principles (“U.S. GAAP”). The core principle of ASU 2014-09 is to recognize revenues when promised goods or services are transferred to customers in an amount that reflects the consideration to which an entity expects to be entitled for those goods or services. ASU 2014-09 defines a five step process to achieve this core principle and, in doing so, more judgment and estimates may be required within the revenue recognition process than are required under existing U.S. GAAP. The standard is effective for annual periods beginning after December 15, 2017, and interim periods therein, using either of the following transition methods: (i) a full retrospective approach reflecting the application of the standard in each prior reporting period with the option to elect certain practical expedients, or (ii) a retrospective approach with the cumulative effect of initially adopting ASU 2014-09 recognized at the date of adoption (which includes additional footnote disclosures). The Company is currently evaluating the impact of its pending adoption of ASU 2014-09 on its consolidated financial statements.

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In April 2015, the FASB issued ASU 2015-05, “Intangibles – Goodwill and Other Internal-Use Software (Subtopic 350-40): Customer’s Accounting for Fees Paid in a Cloud Computing Arrangement,” (“ASU 2015-05”). This ASU provides guidance to customers about whether a cloud computing arrangement includes a software license. If a cloud computing arrangement includes a software license, the customer should account for the software license element of the arrangement consistent with the acquisition of other software licenses. If a cloud computing arrangement does not include a software license, the customer should account for the arrangement as a service contract. The new guidance does not change the accounting for a customer’s accounting for service contracts. ASU 2015-05 is effective for interim and annual reporting periods beginning after December 15, 2015. The Company adopted ASU 2015-05 in the first quarter of 2016 with no material impact on its consolidated financial statements or disclosures.

In January 2016, the FASB issued ASU 2016-01, "Financial Instruments—Overall (Subtopic 825-10), Recognition and Measurement of Financial Assets and Financial Liabilities," ("ASU 2016-01"). The amendments in ASU 2016-01 address certain aspects of the recognition, measurement, presentation and disclosure of financial instruments. ASU 2016-01 is effective for annual and interim periods beginning after December 15, 2017. Except for the early application guidance outlined in ASU 2016-01, early adoption is not permitted. The Company is evaluating the impact of the new guidance on its consolidated financial statements.

In February 2016, the FASB issued ASU 2016-02, “Leases (Topic 842),” (“ASU 2016-02”). The new standard establishes a right-of-use (“ROU”) model that requires a lessee to record a ROU asset and a lease liability on the balance sheet for all leases with terms longer than 12 months.  Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement.  The new standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years.  A modified retrospective transition approach is required for lessees for capital and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available.  While the Company is still evaluating the impact of its pending adoption of the new standard on its consolidated financial statements, it expects that upon adoption it will recognize ROU assets and lease liabilities and that the amounts could be material.

In March 2016, the FASB issued ASU 2016-09, “Compensation—Stock Compensation (Topic 718), Improvements to Employee Share-Based Payment Accounting,” (“ASU 2016-09”).  ASU 2016-09 includes provisions intended to simplify various aspects related to how share-based payments are accounted for and presented in the financial statements. All tax benefits and deficiencies related to share-based payments will be recognized and recorded through the statement of operations for all awards settled or expiring after the adoption of ASU 2016-09. Currently, tax benefits in excess of compensation costs ("windfalls") are recorded in equity, and tax deficiencies ("shortfalls") are recorded in equity to the extent of previous windfalls and then to the statement of operations. ASU 2016-09 will also require, either prospectively or retrospectively, that all tax-related cash flows resulting from share-based payments be reported as operating activities on the statement of cash flows, a change from the current requirement to present windfall tax benefits as an inflow from financing activities and an outflow from operating activities on the statement of cash flows. Additionally, ASU 2016-09 will allow entities to make an accounting policy election for the impact of most types of forfeitures on the recognition of expense for share-based payment awards by allowing the forfeitures to be either estimated, as is currently required, or recognized when they actually occur. ASU 2016-09 will be effective for annual periods beginning after December 15, 2016, and interim periods within those annual periods. Early adoption is permitted in any interim or annual period.

The Company adopted ASU 2016-09 in the first quarter of 2016 resulting in the recording of a cumulative adjustment to accumulated deficit and deferred tax assets related to previously unrecognized tax benefits related to stock compensation awards of $513.  As discussed in note 5. Income Taxes, as of September 30, 2016, the Company recorded a full valuation allowance against its net deferred tax assets, including the assets noted above.  Accordingly, adoption of this provision, as well as the requirement to recognize excess tax benefits related to the vesting of stock compensation awards in the tax provision, did not have a significant impact on the Company’s financial statements as of, or for the three and nine months ended September 30, 2016.  Similarly, the adoption of the other provisions of the ASU did not have a significant impact on the Company’s financial statements as of, or for the three and nine months ended September 30, 2016.

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In June 2016, the FASB issued ASU 2016-13, “Financial Instruments — Credit Losses (Topic 326): Measurement of Credit Losses of Financial Instruments,” which changes the methodology for measuring credit losses on financial instruments and the timing of when such losses are recorded.  This guidance will be effective for reporting periods beginning after December 15, 2019 with early adoption permitted.  The Company is currently in the process of evaluating the impact of the adoption of this ASU on the Company’s consolidated financial statements.

In August 2016, the FASB issued ASU 2016-15, “Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments (a consensus of the Emerging Issues Task Force)”.  This ASU requires changes in the presentation of certain items including but not limited to debt prepayment or debt extinguishment costs; contingent consideration payments made after a business combination; proceeds from the settlement of insurance claims; proceeds from the settlement of corporate-owned life insurance policies and distributions received from equity method investees. This guidance will be effective for reporting periods beginning after December 15, 2017 with early adoption permitted. The Company is currently in the process of evaluating the impact of the adoption of this ASU on the Company’s consolidated financial statements.

 

 

2. Financial Instruments and Long-Term Investments:

Fair Value of Financial Instruments

The FASB’s ASC 820, “Fair Value Measurement” (“ASC 820”), defines fair value 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, not adjusted for transaction costs. ASC 820 also establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into three broad levels giving the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3) as described below:

 

The Company determines fair values for the following assets and liabilities:

Equity securities, listed options and warrants—The Company classifies marketable equity securities and listed options within Level 1 of the fair value hierarchy because quoted market prices from an exchange are used to value these securities. Non-public equity securities, which primarily include securities where the Company acted as a placement agent in an offering of equity securities and where the Company facilitates over-the-counter trading activity for the securities, are classified within Level 3 of the fair value hierarchy. In determining the fair value of these securities, the Company considers enterprise value and analyzes various financial, performance and market factors to estimate the value, including where applicable, over-the-counter market trading activity. Non-exchange traded warrants to purchase equity securities are classified as Level 3 as a Black-Scholes valuation model is used to value these securities.

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U.S. government securities, convertible and fixed income debt instruments—The Company classifies U.S. government securities, including highly liquid U.S. Treasury securities within Level 1 as quoted prices are used to value these securities. Convertible and fixed income debt instruments are classified within Level 2 of the fair value hierarchy as they are valued using quoted market prices provided by a broker or dealer, or alternative pricing services that provide reasonable levels of price transparency. The Company primarily uses price quotes from one independent broker-dealer who makes markets in or is a specialist with expertise in the valuation of these financial instruments.  The Company reviews broker or pricing service quotes it receives to assess the reasonableness of the values provided; such reviews include comparison to internal pricing models and, when available, prices observed for recently executed market transactions of comparable size. Based on this assessment, at each reporting date the Company will adjust price quotes it receives if such an adjustment is determined to be appropriate.

Investment Funds—The Company invests in proprietary investment funds that are valued at net asset value (“NAV”) determined by the fund administrator. The underlying securities held by these investment companies are primarily corporate and asset-backed fixed income securities and restrictions exist on the redemption of amounts invested by the Company. As a practical expedient, the Company relies on the NAV of these investments as their fair value. The NAVs that have been provided by the fund administrators are derived from the fair values of the underlying investments as of the reporting date.  As a result of the Company’s adoption of ASU 2015-07, “Fair Value Measurement (Topic 820): Disclosures for Investments in Certain Entities That Calculate Net Asset Value per Share (or Its Equivalent),” (“ASU 2015-07”) in 2015, these investment funds are no longer categorized within the fair value hierarchy.

Fair Value Hierarchy

The following tables set forth, by level within the fair value hierarchy, financial instruments and long-term investments accounted for under ASC 820 as of September 30, 2016 and December 31, 2015. As required by ASC 820, assets and liabilities that are measured at fair value are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.

Items Measured at Fair Value on a Recurring Basis 

 

 

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As of September 30, 2016, financial assets measured and reported at fair value on a recurring basis and classified within Level 3 were $12,607, or 1.3% of the Company’s total assets at that date. Regarding these Level 3 financial assets, in determining fair value, the Company analyzes various financial, performance and market factors to estimate the value, including where applicable, over-the-counter market trading activity. The following table provides the valuation technique and unobservable inputs primarily used in assessing the value of these securities as of September 30, 2016:

 

 

For those non-public equity securities valued using a market approach, adverse industry market conditions or events experienced by the underlying entities could result in lower over-the-counter trading prices for the securities. Such lower trading prices would result in a decline in the estimated fair value of these assets. For warrants valued using Black-Scholes, adverse industry market conditions or events experienced by the issuer could result in a lower trading price for the underlying equity security and therefore a lower value of these warrants. A reduction in the estimated volatility would also result in a lower value of the warrants. The Company assessed the reasonableness of the fair values of the non-public equity securities noted above based on its consideration of available financial data related to these issuers as well as an assessment of the nature of any over-the-counter trading activity during the period. The Company assessed the reasonableness of the fair value of the non-exchange traded warrants valued using a Black-Scholes valuation based on its consideration of the fair values of comparable exchange-traded options.

 

 

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As of December 31, 2015, financial assets measured and reported at fair value on a recurring basis and classified within Level 3 were $16,505, or 1.8% of the Company’s total assets at that date. Regarding these Level 3 financial assets, in determining fair value, the Company analyzes various financial, performance and market factors to estimate the value, including where applicable, over-the-counter market trading activity. The following table provides the valuation technique and unobservable inputs primarily used in assessing the value of these securities as of December 31, 2015:

 

 

For those non-public equity securities valued using a market approach, adverse industry market conditions or events experienced by the underlying entities could result in lower over-the-counter trading prices for the securities. Such lower trading prices would result in a decline in the estimated fair value of these assets. For warrants valued using Black-Scholes, adverse industry market conditions or events experienced by the issuer could result in a lower trading price for the underlying equity security and therefore a lower value of these warrants. A reduction in the estimated volatility would also result in a lower value of the warrants. The Company assessed the reasonableness of the fair values of the non-public equity securities noted above based on its consideration of available financial data related to these issuers as well as an assessment of the nature of any over-the-counter trading activity during the period. The Company assessed the reasonableness of the fair value of the non-exchange traded warrants valued using a Black-Scholes valuation based on its consideration of the fair values of comparable exchange-traded options.

Level 3 Gains and Losses

The table below sets forth a summary of changes in the fair value of the Company’s Level 3 financial assets and liabilities that are measured at fair value on a recurring basis for the three months ended September 30, 2016 and 2015. As of September 30, 2016 and 2015, the Company did not have any net unrealized gains (losses) included in accumulated other comprehensive income on Level 3 financial assets.

 

 

During the three months ended September 30, 2016, there was one transfer out of Level 3 and into Level 1 for an equity security that was previously a non-public equity security and during the applicable period became publicly traded.  There were no transfers into or out of Level 1, 2, and 3 during the three months ended September 30, 2015.

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The table below sets forth a summary of changes in the fair value of the Company’s Level 3 financial assets and liabilities that are measured at fair value on a recurring basis for the nine months ended September 30, 2016 and 2015.

 

 

During the nine months ended September 30, 2016, there was one transfer out of Level 3 and into Level 1 for an equity security that was previously a non-public equity security and during the applicable period became publicly traded. During the nine months ended September 30, 2015, there was one transfer out of Level 3 and into Level 1 for an equity security that was previously a non-public equity security and during the applicable period became publicly traded.

Gains and losses from Level 3 financial assets that are measured at fair value on a recurring basis, that are included in earnings for the three and nine months ended September 30, 2016 and 2015, are reported in the following line descriptions on the Company’s consolidated statements of operations:

 

 

 

Items Measured at Fair Value on a Non-Recurring Basis

The Company also measures certain financial assets and liabilities and other assets at fair value on a non-recurring basis including items such as cost method investments, intangibles, fixed assets and estimated contingent consideration payable. Adjustments to the fair value of these assets and liabilities usually result from the application of lower-of-cost-or-market accounting or impairments of individual assets.  Adjustments to the fair value of contingent consideration payable would result from differences between the underlying forecasted securities lending results and actual results. Due to the nature of these assets, unobservable inputs are used to value these assets and liabilities. In determining the fair value, the Company analyzes various financial, performance, and market factors to estimate the fair value, including where applicable, market activity. As a result, these assets and liabilities are classified within Level 3 of the fair value hierarchy.

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During the three and nine months ended September 30, 2016 and 2015, except for the impact of the scheduled payment of contingent consideration payable and the recognition of a goodwill impairment charge (see note 4. Goodwill and Intangible Assets), there were no assets or liabilities measured at fair value on a non-recurring basis for which there was a change in carrying value.  During the nine months ended September 30, 2016, the Company made a final contingent consideration payment of $1,332 related to its 2014 acquisition of a securities lending business.  As of September 30, 2016, the Company has no contingent consideration obligations payable.

Financial Instruments Held for Investment—Designated as Trading

As of September 30, 2016, and December 31, 2015, the Company had certain investments in marketable equity securities held by other than its broker-dealer subsidiaries that are classified as trading securities.  In addition, during the three and nine months ended September 30, 2015, the Company had short positions in U.S. Treasury securities held by other than its broker-dealer subsidiaries that were classified as trading securities.  These investments are designated as trading based on the Company’s intent at the time of designation.  In accordance with ASC 320, “Investments—Debt and Equity Securities” (“ASC 320”), these securities are carried at fair value with resulting realized and unrealized gains and losses reflected as net investment income (loss) in the consolidated statements of operations.  In addition, pursuant to ASC 825, “Financial Instruments” (“ASC 825”), from time-to-time the Company may elect to account for non-public equity securities acquired by other than the Company’s broker-dealer subsidiaries as part of its trading portfolio at fair value with resulting realized and unrealized gains and losses reflected as net investment income (loss) in the consolidated statements of operations.  During the three and nine months ended September 30, 2016, the Company did not make any such elections.  During the three months ended September 30, 2015, the Company elected to account for one non-public equity security, purchased at a cost of $2,511, at fair value.  During the nine months ended September 30, 2015, the Company elected to account for two non-public equity securities, purchased at a cost of $6,510, at fair value.  Net gains and losses on such trading securities as of the dates indicated were as follows:

 

 

As part of the Company’s investing activities, during the nine months ended September 30, 2015, the Company entered into two short sales, totaling $200,000 face value, of 4.625% U.S. Treasury securities maturing in November 2016. These two short sales were settled in the third quarter of 2015.  During 2014, the Company entered into one short-sale of a $75,000 face value 7.25% U.S. Treasury security maturing in May 2016, which was settled in the fourth quarter of 2015.  During the three and nine months ended September 30, 2015, the Company incurred $3,456 and $10,365, respectively, of interest expense related to these transactions.

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Fair Value of the Investments Valued at NAV

As of September 30, 2016 and December 31, 2015, the Company had $27,429 and $66,602, respectively, of investments that are valued at NAV. The following table presents information about the Company’s investments in hedge funds and private equity funds measured at fair value based on NAV at September 30, 2016 and December 31, 2015:

 

 

The investments in non-registered investment funds are valued at NAV as determined by the fund administrators. The underlying fund investments consist primarily of corporate and asset-backed fixed income securities. Considering the general lack of transparency necessary to conduct an independent assessment of the fair value of the securities underlying each of the NAVs provided by the fund administrators, the Company’s reporting process includes a number of assessment processes to assist the Company in the evaluation of the information provided by fund managers and fund administrators. These assessment processes include, but are not limited to, regular review and discussion of each fund’s performance with its manager and regular evaluation of performance against applicable benchmarks.

Investments in hedge funds may be subject to lock-up restrictions or gates. A hedge fund lockup provision is a provision that provides that an investor may not make a withdrawal from the fund or may be subject to withdrawal fees. The purpose of a gate is to restrict the level of redemptions that an investor in a particular hedge fund can demand at any redemption date. All of the Company’s hedge fund investments have the ability to impose redemption gates.  As of September 30, 2016, the Company had initiated redemptions for all of its remaining hedge fund investments.  Pursuant to the terms of these redemptions, the Company expects that it will receive the majority of these proceeds within the next six months.  During the nine months ended September 30, 2016, the Company received $39,442 of proceeds from investment fund redemptions.  

The Company’s fixed income and credit-related hedge fund investments include funds that primarily employ long-short or relative value strategies in order to benefit from investments in undervalued or overvalued securities that are primarily debt or credit related.  The Company’s multi-strategy fund investments include funds that pursue a variety of fixed income, credit and asset-backed strategies to realize short and long term gains. Management of these hedge funds has the ability to overweight or underweight different strategies to best capitalize on current investment opportunities.

The Company’s private equity fund investments include funds that pursue multiple strategies including direct lending, asset securitization and real estate development. These investments by the Company are generally not redeemable with the funds. The nature of these fund investments is that distributions are received through the liquidation of the underlying assets of the fund.  At September 30, 2016, it was estimated that the majority of these funds will be liquidated in the next 18 months.

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Other Comprehensive Income

The following tables set forth the changes in the Company’s accumulated other comprehensive income by component for the nine months ended September 30, 2015 along with detail regarding reclassifications from other comprehensive income. All such reclassifications from other comprehensive income are included in net investment income in the Company’s consolidated statements of operations.  As of September 30, 2016, and during the three and nine months then ended, there was no accumulated other comprehensive income or reclassifications from other comprehensive income.

 

 

Other Investments, at Cost

As of September 30, 2016, the Company had no non-public equity securities carried at cost.  As of December 31, 2015, other investments consisted of non-public equity securities of $6,539.  When applicable, the Company evaluates its non-public equity securities, carried at cost, for impairment as of each reporting date. This evaluation includes consideration of the operating performance of the respective companies, their financial condition and their near-term and long-term prospects. Based on its evaluations of these investments, the Company recorded no impairment losses during the three and nine months ended September 30, 2016 and 2015.  During the three and nine months ended September 30, 2016, one investment carried at cost with a cost basis of $5,000 became a publicly traded security and was designated as a trading security accounted for at fair value.  During the three and nine months ended September 30, 2016, the Company sold an investment carried at cost with a cost basis of $1,539 for proceeds of $1,503.  During the three and nine months ended September 30, 2015, there were no sales of investments carried at cost.

 

3. Securities Lending:

Securities borrowed and securities loaned are recorded based upon the amount of cash advanced or received. Securities borrowed transactions facilitate the settlement process and require the Company to deposit cash or other collateral with the lender. With respect to securities loaned, the Company receives collateral in the form of cash. The amount of collateral required to be deposited for securities borrowed, or received for securities loaned, is an amount generally in excess of the market value of the applicable securities borrowed or loaned. The Company monitors the market value of the securities borrowed and loaned on a daily basis, with additional collateral obtained, or excess collateral recalled, when deemed appropriate. As of September 30, 2016 and December 31, 2015, and during the nine months and year then ended, respectively, all collateral received or paid was in the form of cash.  

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The following table presents the contractual gross and net securities borrowing and lending balances and the related offsetting amount as of September 30, 2016 and December 31, 2015:

 

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4. Goodwill and Intangible Assets:

Goodwill

The Company performs its annual assessments of goodwill impairment during the third quarter of each year. Management’s assessment process includes determining the fair value of the Company’s equity capital markets (“ECM”) and securities lending reporting units based on current market information, including consideration of its market capitalization and other qualitative factors impacting the Company’s operations, and comparing such fair value to the carrying value of the respective reporting units.

Based on the results of the Company’s assessment in the third quarter of 2016, the Company determined that goodwill related to the ECM reporting unit was impaired and recognized an impairment charge of $1,259.  The impairment recorded in the third quarter of 2016 was the result of various factors, including the significant decline in investment banking revenues during the first nine months of 2016, market conditions related to investment banking, and the Company’s operating losses.  These factors coupled with the extended period in which the Company’s market capitalization has been below its carrying value resulted in the Company determining that it’s ECM reporting unit’s goodwill should be reduced to zero.  As of September 30, 2016, goodwill totaled $3,829 with an accumulated impairment loss of $1,259.  This net goodwill balance of $2,570 related to the securities lending business that was acquired in 2014.  In its annual assessment of this goodwill, based on actual results achieved compared to projections used in valuing the acquisition, the Company determined that the fair value of the securities lending reporting unit exceeded its carrying value.

Based on the Company’s assessments, no impairment charges were recognized during the three and nine months ended September 30, 2015.  As of December 31, 2015, goodwill totaled $3,829 with no accumulated impairment loss.

Intangible Assets

The following table reflects the components of intangible assets as of the dates indicated:

 

 

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These intangible assets were recognized in connection with transactions completed in 2015 and 2014 and are being amortized over their original estimated useful lives, of three to seven years, on a straight-line basis.  These assets are also tested for impairment if events or circumstances indicate that an asset’s carrying value may not be recoverable. For the three and nine months ended September 30, 2016, amortization expense recognized was $131 and $392, respectively.  For the three and nine months ended September 30, 2015, amortization expense recognized was $89 and $268, respectively.  

 

 

5. Income Taxes:

As a result of the Company’s application of the guidance in ASC 740, “Income Taxes” (“ASC 740”) and its assessment of the positive and negative evidence related to the realization of its deferred tax assets, as of September 30, 2016, the Company recorded a full valuation allowance against its net deferred tax assets. Accordingly, during the three and nine months ended September 30, 2016, the Company recorded tax provisions of $45,698 and $38,085, respectively.

The Company’s assessment of the positive and negative evidence related to the realization of its deferred tax assets and the potential need for a valuation allowance is a matter of significant judgement. In reaching its conclusion to establish a full valuation allowance as of September 30, 2016, the Company weighed various factors related to its performance and financial position as well as market conditions and prospective opportunities. Based primarily on the Company’s most recent operating results and its cumulative pre-tax results, the Company determined that it was no longer more likely than not that its deferred tax assets will be realized. The Company will continue to maintain a full valuation allowance on its deferred tax assets until there is sufficient evidence to support the reversal of all or some portion of this allowance. Realization of the Company’s deferred tax assets will be dependent on the Company’s ability to generate future taxable income.

During the three and nine months ended September 30, 2015, the Company recorded tax benefits of $2,881 and $2,703, respectively.  The Company’s 2015 quarterly tax provision was determined pursuant to ASC 740, which for the three and nine months ended September 30, 2015, was determined based on the actual year-to-date effective rate, as this was the Company’s best estimate of its annual effective tax rate for the full fiscal year.  The Company’s effective tax rates for the three and nine months ended September 30, 2015 were 45.7% and 47.0%, respectively.  These effective tax rates differed from statutory tax rates primarily due to the effects of capital loss carryforwards subject to a valuation allowance that were projected to be utilized during the year.

 

 

6. Regulatory Capital Requirements:

FBR Capital Markets & Co. (“FBRCM”) and MLV & Co. LLC (“MLV”), the Company’s broker-dealer subsidiaries, are registered with the Securities and Exchange Commission (“SEC”) and are members of the Financial Industry Regulatory Authority, Inc. (“FINRA”). As such, they are subject to the minimum net capital requirements promulgated by the SEC. As of September 30, 2016, FBRCM had net capital of $37,701, which was $36,483 in excess of its required net capital of $1,218.  In addition, MLV had net capital of $1,546, which was $1,446 in excess of its required net capital of $100.

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7. Income Per Share:

Basic earnings per share includes no dilution and is computed by dividing net income or loss available to common shareholders by the weighted average number of common shares outstanding for the period, including restricted stock units (“RSUs”) that are not subject to forfeiture. Diluted earnings per share includes the impact of dilutive securities such as stock options, unvested shares of restricted stock and RSUs that are subject to forfeiture.  Due to the Company’s reported net losses for the three and nine months ended September 30, 2016 and 2015, all stock options, unvested shares of restricted stock and unvested RSUs were considered anti-dilutive for these periods.  The following tables present the computations of basic and diluted income per share for the periods indicated:

 

 

The following table presents the number of anti-dilutive stock options, unvested restricted stock and unvested RSUs for the periods indicated (in thousands): 

 

 

 

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8. Commitments and Contingencies:

Litigation

As of September 30, 2016, except as described below, the Company was neither a defendant nor plaintiff in any lawsuits or arbitrations nor involved in any governmental or self-regulatory organization matters that are expected to have a material adverse effect on its financial condition, results of operations, or liquidity. The Company has been named as a defendant in a small number of civil lawsuits relating to its various businesses. In addition, the Company is subject to various reviews, examinations, investigations and other inquiries by governmental agencies and self-regulatory organizations. There can be no assurance that these matters individually or in aggregate will not have a material adverse effect on the Company’s financial condition, results of operations, or liquidity in a future period. However, based on management’s review with counsel, resolution of these matters is not expected to have a material adverse effect on the Company’s financial condition, results of operations or liquidity.

Many aspects of the Company’s business involve substantial risks of liability and litigation. Underwriters, broker-dealers and investment advisers are exposed to liability under federal and state securities laws, other federal and state laws and court decisions, including decisions with respect to underwriters’ liability and limitations on indemnification, as well as with respect to the handling of customer accounts. For example, underwriters may be held liable for material misstatements or omissions of fact in a prospectus used in connection with the securities being offered and broker-dealers may be held liable for statements made by their securities analysts or other personnel. In the past, FBRCM and MLV have been named as a defendant in a small number of securities claims involving their respective investment banking clients as a result of such broker-dealer’s role as an underwriter. In these cases, the underwriting agreement provides, subject to certain conditions, that the investment banking client is required to indemnify the underwriters against certain claims or liabilities, including claims or liabilities under the Securities Act of 1933, as amended (the “Securities Act”), or contribute to payments which the underwriters are required to make as a result of the litigation. There can be no assurance that such indemnification or contribution will ultimately be available to the Company or that an investment banking client will be able to satisfy its indemnity or contribution obligations when due.

On March 30, 2016, the previously disclosed putative class action lawsuit of Waterford Township Police & Fire, Retirement System, vs. Regional Management Corp. et al., pending in the United States District Court for the Southern District of New York, was dismissed in its entirety. The Court ruled that the operative amended complaint, filed on January 23, 2015, failed to allege any material misstatements. As previously disclosed, the Second Amended Complaint asserted claims against all the underwriters, including FBRCM, under Sections 11 and 12 of the Securities Act in connection with offerings in September and December 2013.  Plaintiffs have requested that the court grant them permission to amend their complaint a third time.  Briefing on that motion is complete as of June 23, 2016 and a ruling is pending.  Regional Management continues to indemnify all of the underwriters, including FBRCM, pursuant to the operative underwriting agreement.

In November 2015, MLV was named a defendant in two putative class action lawsuits alleging substantially identical claims against the officers and directors and underwriters of Miller Energy Resources, Inc. (“Miller”). The lawsuits, styled Goldberg v. Miller et al., and Gaynor v. Miller et al., are pending in the United States District Court for the Eastern District of Tennessee, and allege claims under Sections 11 and 12 of the Securities Act against nine underwriters for alleged material misrepresentations and omissions in the registration statement and prospectuses issued in connection with 6 offerings (February 13, 2013; May 8, 2013; June 28, 2013; September 26; 2013; October 17, 2013 (as to MLV only) and August 21, 2014) with an alleged aggregate offering price of approximately $151,000. The plaintiffs seek unspecified compensatory damages and reimbursement of certain costs and expenses. Although MLV is contractually entitled to be indemnified by Miller in connection with this lawsuit, Miller filed for bankruptcy in October 2015 and this likely will decrease or eliminate the value of the indemnity that MLV receives from Miller. A subsequent complaint was filed in the United States District Court for the Eastern District of Tennessee on May 12, 2016.  The lawsuit, styled Hull v. Miller et al., alleges identical claims to the previously filed complaints under Sections 11 and 12 of the Securities Act against eight of the same underwriters, including MLV, and the officers and directors of Miller. Briefing on the defendants’ motions to dismiss is pending.  

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In accordance with applicable accounting guidance, the Company establishes an accrued liability for litigation and regulatory matters when those matters present loss contingencies that are both probable and estimable. In such cases, there may be an exposure to loss in excess of any amounts accrued. When a loss contingency is not both probable and estimable, the Company does not establish an accrued liability. As a litigation or regulatory matter develops, management, in conjunction with counsel, evaluates on an ongoing basis whether such matter presents a loss contingency that is probable and estimable. The pending cases discussed above involving FBRCM and MLV are at a preliminary stage, and based on management’s review with counsel and present information known by management, a loss contingency for these matters was not probable and estimable as of September 30, 2016.

In certain circumstances, broker-dealers and asset managers may also be held liable by customers and clients for losses sustained on investments. In recent years, there has been an increasing incidence of litigation and actions by government agencies and self-regulatory organizations involving the securities industry, including class actions that seek substantial damages. The Company is also subject to the risk of litigation, including litigation that may be without merit. As the Company intends to actively defend any such litigation, significant legal expenses could be incurred. An adverse resolution of any future litigation against the Company could materially affect its financial condition, operating results and liquidity.

 

 

9. Shareholders’ Equity:

Share Repurchases

During the three and nine months ended September 30, 2016, the Company repurchased 27,830 shares and 755,535 shares, respectively, of its common stock in open market or privately negotiated transactions at weighted average share prices of $13.81 per share and $17.34 per share, respectively, for a total cost of $384 and $13,104, respectively. During the three and nine months ended September 30, 2015, the Company repurchased 482,976 shares and 1,573,640 shares, respectively, of its common stock in open market or privately negotiated transactions at weighted average share prices of $22.51 per share and $23.84 per share, respectively, for a total cost of $10,873 and $37,511, respectively.  As of September 30, 2016, the Company had remaining authority to repurchase 722,170 additional shares.

The Company also purchases shares of its common stock from recipients of stock-based compensation awards upon the vesting of RSU and restricted stock awards, and the exercise of options to purchase stock, as recipients sell shares to meet their tax obligations. During the three and nine months ended September 30, 2016, the Company purchased 5,985 shares and 544,460 shares, respectively, of common stock at weighted average share prices of $14.20 and $16.98 per share, respectively, for a total cost of $85 and $9,243, respectively, for this purpose. During the three and nine months ended September 30, 2015, the Company purchased 6,695 shares and 106,322 shares, respectively, of common stock at a weighted average share price of $22.71 per share and $23.20, respectively, for a total cost of $159 and $2,458, respectively, for this purpose.

Dividends

Since January 1, 2015, the Company’s Board of Directors has declared cash dividends on its common stock as summarized in the following table.

See note 10. Subsequent Events for information regarding dividends declared subsequent to the balance sheet date.

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Unvested RSUs and restricted shares carry dividend rights in which dividends are payable as the RSUs and restricted shares vest in accordance with the respective underlying grants.  As of September 30, 2016, the Company had $564 of dividends payable related to such unvested RSUs and restricted shares. With respect to RSUs that vest based on both individual service requirements and the Company’s achievement of specific performance goals, the Company’s dividend payable is consistent with the Company’s assessment of the rate at which these awards would vest.

FBR & Co. Employee Stock Purchase Plan

Under the Company’s Employee Stock Purchase Plan (the “Purchase Plan”), eligible employees may purchase common stock through payroll deductions at a price that is 85% of the lower of the market value of the common stock on the first day of the offering period or the last day of the offering period. In accordance with the provisions of ASC 718, “Compensation—Stock Compensation,” the Company is required to recognize compensation expense relating to shares offered under the Purchase Plan. For the nine months ended September 30, 2016 and 2015, the Company recognized compensation expense of $70 and $166, respectively, related to the Purchase Plan.

Stock Compensation Plans

FBR & Co. Amended 2006 Long-Term Incentive Plan (“FBR & Co. Long-Term Incentive Plan”)

Under the FBR & Co. Long-Term Incentive Plan, as amended, the Company may grant options to purchase stock, stock appreciation rights, performance awards, restricted and unrestricted stock and RSUs for up to an aggregate of 7,217,496 shares of common stock, subject to increase under certain provisions of the plan, to eligible participants. Participants include employees, officers and directors of the Company and its subsidiaries. The plan’s termination date is October 22, 2023 unless it is terminated sooner by the Company’s Board of Directors. The FBR & Co. Long-Term Incentive Plan has a term of 10 years and options granted may have an exercise period of up to 10 years. Options may be incentive stock options, as defined by Section 422 of the Internal Revenue Code, or nonqualified stock options.  

The Company grants options to purchase stock, restricted shares of common stock and RSUs to employees that vest based on meeting specified service conditions of three to five years and in certain cases achievement of specified market conditions or performance goals. The following table presents compensation expense related to these awards for the periods indicated:

 

 

The following table presents issuance activity related to grants of these awards for the period indicated:

 

 

For all RSU awards that vest based on individual service requirements and the Company’s achievement of specified performance goals, the Company assesses the probability of achieving these goals at each reporting date.

There were 230,258 RSU awards granted during the year ended December 31, 2015 and 277,405 RSU awards granted during the year ended December 31, 2014, that will vest based on both individual service requirements and the Company’s achievement of specified performance goals (the “2014 and 2015 performance condition RSUs”).  

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During the three and nine months ended September 30, 2016 and for the year ended December 31, 2015, no compensation was recognized for the 2014 and 2015 performance condition RSUs based on the Company’s assessment that the minimum performance thresholds will not be met.

There were 375,000 RSUs granted during the year ended December 31, 2013 that vested in 2016 based on both individual service requirements and the achievement of a specified performance goal (“2013 performance condition RSUs”). In order for the performance goal to be met at a minimum level and for the awards to vest at a 50% rate, the tangible book value of FBR & Co., measured on a per share basis, must have increased by an amount equal to a 4% compound annual growth rate over the three-year period beginning on April 1, 2013 (the “2013 performance period”).  The awards vest at a 100% level if FBR & Co. achieved a 7% compound annual growth rate over the 2013 performance period and at a proportionate rate at annual growth rates between a 4% and a 7%.  In May 2016, based on the Company’s tangible book value growth during the 2013 performance period, 258,681 shares of the 2013 performance condition RSUs vested.  As a result of activity during the three months ended March 31, 2016, this award vested at a lower rate than previously forecasted, as such $1,642 of stock compensation expense recognized in prior years was reversed during the three months ended March 31, 2016.

The following table presents the unrecognized compensation related to unvested options to purchase stock, restricted shares of common stock, and RSUs and the weighted average vesting period in which the expense will be recognized:

 

 

 

 

In addition, as part of the Company’s satisfaction of incentive compensation earned for past service under the Company’s variable compensation programs, employees may receive RSUs in lieu of cash payments. These RSUs are issued to an irrevocable trust for the benefit of the employees and are not returnable to the Company. In settlement of such accrued incentive compensation, for the nine months ended September 30, 2015, the Company granted 26,549 of such RSUs with an aggregate fair value upon grant date of $630. There were no comparable grants during the nine months ended September 30, 2016.   

 

 

10. Subsequent Events:

Dividend Declaration

On October 25, 2016, the Company’s Board of Directors declared a quarterly cash dividend of $0.20 per common share to be paid on November 25, 2016 to shareholders of record as of the close of business on November 14, 2016.

 

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Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis of the consolidated financial condition and results of operations of FBR & Co. and its subsidiaries (collectively, “we”, “us”, “our” or the “Company”) should be read in conjunction with the unaudited consolidated financial statements and the notes thereto appearing elsewhere in this report on Form 10-Q and the audited consolidated financial statements and notes thereto appearing in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2015.

The discussion of the Company’s consolidated financial condition and results of operations below may contain forward-looking statements. These statements, which reflect management’s beliefs and expectations, are subject to risks and uncertainties that may cause actual results to differ materially. For a discussion of the risks and uncertainties that may affect the Company’s future results, please see “Forward-Looking Statements” immediately preceding Part I of, and other items throughout, the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2015. Please also see “Risk Factors” in Part I, Item 1A of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2015.

Business Environment

While equity capital markets activity during the third quarter of 2016 increased from the prior two quarters, IPO activity during the first nine months of 2016 represented the worst year-to-date period for the U.S. IPO market since 2009.  Through September, year-over-year total IPO volume was down 50% at $13.4 billion and only 71 IPOs had successfully priced. New issue activity continued to be limited and narrow with year-to-date volume in Healthcare and Technology transactions representing a disproportionate percentage of the IPO market. The activity in 2016 was significantly reduced compared to 126 and 175 completed IPOs during the first nine months of 2015 and 2014, respectively, and related dollar volumes of $26.9 billion and $41.3 billion, respectively. Equity trading volumes continue to trend down in 2016 compared to 2015.

Competition in our business remains intense. Large banks continue to tie lending activity to capital markets mandates and electronic or high-frequency trading continues to capture a significant share of trading volume. Both of these dynamics put pressure on high-touch, idea-driven firms like FBR. Institutional investors continue to narrow the list of broker-dealers with whom they maintain trading relationships, leading to consolidation of smaller firms and to the need for mid-size firms to work intensely to demonstrate relevance through quality and scale of research offerings in order to grow relationships.

In spite of continuing stimulus from central banks worldwide, economic growth has been sluggish, at best.  Risk-free rates, including on many government bonds and insured deposit accounts, are now at or below 0%, leaving few conventional levers with respect to monetary policy.  In the U.S., presidential election uncertainty has added an additional layer of caution to investor decisions.  In Europe, the June vote in favor of Britain’s exit from the European Union has added to investor concerns about European growth and pushed rates down further.  Improvement in economic growth prospects and reduced anxiety over geopolitical events will be important to reestablishing momentum in the new issue market.

Executive Summary

For the third quarter of 2016 our revenues, net of interest expense, were $19.3 million, our pre-tax loss was $11.6 million and our net loss, reflecting a $45.7 million tax provision and a full valuation allowance against our net deferred tax assets, was $57.3 million. This compares to third quarter 2015 revenues, net of interest expense, of $25.6 million, pre-tax loss of $6.3 million, and net loss of $3.4 million. The increase in our net loss for the third quarter of 2016 compared to the third quarter of 2015 was primarily due to both the tax provision recognized in 2016 and the reduction in our total net revenues.

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As a result of the our application of the guidance in ASC 740, “Income Taxes” (“ASC 740”) and our assessment of the positive and negative evidence related to the realization of our deferred tax assets, we recorded a full valuation allowance against net our deferred tax assets as of September 30, 2016. Our assessment of this positive and negative evidence and the potential need for a valuation allowance is a matter of significant judgement. In reaching this conclusion to establish a full valuation allowance as of September 30, 2016, we weighed various factors related to our performance and financial position as well as market conditions and prospective opportunities. Based primarily on our most recent operating results and our cumulative pre-tax results, we determined that it was no longer more likely than not that our deferred tax assets will be realized. We will continue to maintain a full valuation allowance against our deferred tax assets until there is sufficient evidence to support the reversal of all or some portion of this allowance. Realization of our deferred tax assets will be dependent on our ability to generate future taxable income.

The difference in our operating results in the third quarter of 2016 compared to the third quarter of 2015 was primarily due to a $6.3 million decrease in our total net revenues, including a $5.6 million decrease in investment banking revenues and a $3.1 million decrease in institutional brokerage revenues, partially offset by decreased net losses, including interest expense, related to investment positions. The reduction in investment banking revenues reflects the impact of equity capital markets conditions, and the fact that we did not complete any large sole-managed private placements during the third quarter of 2016.  In comparison, our investment banking revenue in the third quarter of 2015 included one large sole-managed institutional private placement transaction.

Our total non-interest expenses in the third quarter of 2016 declined to $31.0 million, compared to $31.9 million in the third quarter of 2015. This decrease was primarily a result of reduced fixed expenses in the third quarter of 2016, in particular fixed compensation as well as corporate legal costs. Non-interest expenses in the third quarter of 2016 include a goodwill impairment charge of $1.3 million, reflecting our determination that the goodwill associated with our equity capital markets (“ECM”) reporting unit should be reduced to zero. Our total compensation and benefits costs decreased to $16.5 million in the third quarter of 2016 from $17.6 million in the third quarter of 2015, primarily as a result of reductions in stock compensation costs. In addition, within total expenses, non-compensation fixed expenses during the third quarter of 2016, excluding the goodwill impairment charge, were $9.2 million compared to $10.6 million in the third quarter of 2015.

For the nine months ended September 30, 2016 our revenues, net of interest expense, were $58.1 million, our pre-tax loss was $32.9 million and our net loss, reflecting a $38.1 million tax provision and a full valuation allowance against our deferred tax assets (see discussion above), was $71.0 million. This compares to the nine months ended September 30, 2015 revenues, net of interest expense, of $96.9 million, pre-tax loss of $5.8 million, and net loss of $3.1 million. The increase in our net loss for the first nine months of 2016 compared to the first nine months of 2015 was primarily due to both the tax provision recognized in 2016 and the reduction in our total net revenues.

The difference in our operating results in the nine months ended September 30, 2016 compared to the nine months ended September 30, 2015 was primarily due to a $38.8 million decrease in our total net revenues, including a $35.2 million decrease in investment banking revenues.  The reduction in investment banking revenues reflects the impact of equity capital markets conditions during the nine months ended September 30, 2016, in particular the decline in the volume of initial capital raising transactions compared to the nine months ended September 30, 2015.

Our total non-interest expenses in the nine months ended September 30, 2016 declined to $91.0 million, compared to $102.7 million in the nine months ended September 30, 2015. This decrease was primarily a result of the reduction in 2016 revenues noted above which generated lower variable expenses, including reduced compensation expenses. Our total compensation and benefits costs decreased to $51.2 million in the nine months ended September 30, 2016 from $59.8 million in the nine months ended September 30, 2015, primarily as a result of the lower level of 2016 revenues and reductions in stock compensation costs. In addition, within total expenses, non-compensation fixed expenses during the nine months ended September 30, 2016, excluding the goodwill impairment charge noted above, were $29.3 million compared to $30.2 million in the nine months ended September 30, 2015.

Results of Operations

We are a full-service investment banking and institutional brokerage firm with a deep expertise and focus on the equity capital markets.  Our business activities include investment banking and institutional sales, trading and research. These business units deliver capital raising, advisory and sales and trading services to corporate and

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institutional clients. Our investment banking and institutional brokerage businesses are focused on the consumer, energy and natural resources, financial institutions, healthcare, industrials, insurance, real estate and TMT sectors. Additionally, we provide securities lending services to a broad group of banks and broker-dealers. These services include facilitating the sourcing, borrowing and lending of equity and fixed income securities.  In addition to corporate treasury investments, from time-to-time we may also make merchant banking investments, primarily alongside our institutional clients in selected private transactions that we underwrite.  By their nature, our business activities are highly competitive and are subject to market conditions as well as to the conditions affecting the companies and markets in our areas of focus. As a result, our revenues and results are subject to significant volatility from period to period.

During the first quarter of 2016, based on changes in our business profile since our IPO in 2007, including significant changes in capital allocation and revenue mix that have occurred over that time, we revised our segment reporting structure.  Beginning with the first quarter of 2016, our investment activities are included together with our other capital markets activities and not as a separate reportable segment.  In making this change we considered the diminished level of our investment balances, the relative insignificance of our investment-related revenues compared to total revenues and the nature of the financial information used by our Chief Operating Decision Maker (“CODM”).  In this case, as a result of changes in capital allocation, our investment assets have decreased to represent less than 5% of total assets in 2016. Investment-related revenues are not a significant element of our total revenues ranging from 3% to 4% of our total revenues net of interest expense over the past three years.  In addition to the above, while our CODM reviews investment-related returns, there are no specific resource or overhead allocations made to investment activities separate from the Company as a whole.

The following table provides a summary of our revenues and non-interest fixed and variable expenses (dollars in thousands):

 

 

Revenue Analysis

Investment Banking

Our third quarter 2016 investment banking revenues decreased $5.6 million to $9.2 million from $14.8 million for the third quarter of 2015. Our investment banking revenue in 2016 was generated from 13 client transactions representing $1.6 billion in transaction volume. We did not complete any large sole-managed institutional private placements during the third quarter of 2016. In comparison, our investment banking revenue in the third quarter of 2015 was generated from nine client transactions representing $1.2 billion in transaction volume, including one large sole-managed institutional private placement transaction representing $9.9 million in capital raising revenue and $144.0 million in transaction volume.  Advisory revenue was not a significant component of investment banking revenue in either the third quarter of 2016 or 2015.

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For the first nine months of 2016, investment banking revenues decreased $35.3 million to $21.9 million from $57.2 million for the first nine months of 2015. Our 2016 revenue level reflects the impact of market conditions during the period, specifically, the narrow and limited nature of initial capital raising activity industry-wide during the first nine months of 2016. Our investment banking revenue in 2016 was generated from 42 client transactions representing $4.2 billion in transaction volume. We did not complete any large sole-managed institutional private placements during the first nine months of 2016. In comparison, our investment banking revenue in the first nine months of 2015 was generated from 35 client transactions representing $7.5 billion in transaction volume.  Included in those transactions and representing $31.2 million of our capital raising revenue were two sole-managed institutional private placements. Advisory revenue was $3.5 million in the first nine months of 2016 compared to $5.4 million in the first nine months of 2015. Reflecting the decrease in total investment banking revenue, advisory revenue represented 16% of investment banking revenues in the first nine months of 2016 compared to 9% in the first nine months of 2015.

Institutional Brokerage

The following table provides detail regarding the components of our institutional brokerage revenues (dollars in thousands):

 

Our third quarter 2016 institutional brokerage revenues decreased to $8.1 million from $11.2 million in the third quarter of 2015. This decrease reflects lower cash equity trading volume in the third quarter of 2016 compared to the third quarter of 2015.

For the first nine months of 2016, our institutional brokerage revenues decreased to $29.8 million from $35.9 million in the first nine months of 2015.  This decrease reflects lower cash equity trading volume in the first nine months of 2016 compared to the first nine months of 2015, and reduced revenues from our convertibles and credit trading desks during the period as we eliminated these positions early in 2016.

Securities Lending

We have an active securities borrowed and loaned business in which we borrow securities from one party and lend them to another.  Securities borrowed and securities loaned are recorded based upon the amount of cash advanced or received.  Securities borrowed transactions facilitate the settlement process and require us to deposit cash or other collateral with the lender.  With respect to securities loaned, we receive collateral in the form of cash. The amount of collateral required to be deposited for securities borrowed, or received for securities loaned, is an amount generally in excess of the market value of the applicable securities borrowed or loaned.  We monitor the market value of the securities borrowed and loaned on a daily basis, with additional collateral obtained or excess collateral recalled, when deemed appropriate.

During the third quarter of 2016, we generated net interest revenue of $2.3 million from securities lending, compared to $2.0 million in the third quarter of 2015. The increase in this net revenue was due to both higher average balances during the third quarter of 2016 and increased net interest spreads on these balances.

During the first nine months of 2016, we generated net interest revenue of $6.6 million from securities lending, compared to $5.4 million in the first nine months of 2015. The increase in this net revenue was due to both higher average balances during the first nine months of 2016 and increased net interest spreads on these balances.

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Investments

Net investment loss, including dividends, for the third quarter of 2016 was $0.2 million, a decrease of $1.1 million from net investment income, including dividends, for the third quarter of 2015 of $0.9 million.  Net investment income for the third quarter of 2015 included $3.2 million of gains from short-sales of U.S. Treasury securities, which were settled in the third and fourth quarters of 2015.  Total investing revenues in the third quarter of 2015 were offset by $3.5 million of interest expense related to the short-sales of U.S. Treasury securities. There was no comparable interest expense in the third quarter of 2016.

Net investment loss, including dividends, for the first nine months of 2016 was $0.4 million, a decrease of $8.8 million from net investment income for the first nine months of 2015 of $8.4 million.  Net investment income for the first nine months of 2015 included $9.2 million of gains from short-sales of U.S. Treasury securities, which were settled in the third and fourth quarters of 2015.  Total investing revenues in the first nine months of 2015 were offset by $10.4 million of interest expense related to the short-sales of U.S. Treasury securities. There was no comparable interest expense in the first nine months of 2016.

Non-Interest Expenses Analysis

Three months ended September 30, 2016 compared to the three months ended September 30, 2015

Total non-interest expenses decreased 2.8% to $31.0 million in the third quarter of 2016 from $31.9 million in the third quarter of 2015.  Fixed expenses decreased $2.2 million to $24.0 million in the third quarter of 2016 from $26.2 million in third quarter of 2015, and despite the decrease in total net revenues, variable expenses increased $1.3 million to $7.0 million in the third quarter of 2016 from $5.7 million in the third quarter of 2015.  The decrease in fixed expenses was primarily due to reductions in fixed compensation and corporate legal costs, partially offset by a $1.3 million goodwill impairment charge. The change in variable costs reflects a $1.0 million increase in variable compensation as well as an increase in costs related to investment banking transactions that were not completed. The increase in variable compensation in 2016 was due in part to changing certain compensation arrangements from fixed to variable.  

Total compensation and benefits expenses decreased 6.3% to $16.5 million in the third quarter of 2016 from $17.6 million in the third quarter of 2015.  The decrease in compensation and benefits expenses reflects a $2.1 million decrease in fixed stock compensation costs, partially offset by the increase in variable compensation noted above.

Occupancy and equipment expenses decreased 6.3% to $3.0 million in the third quarter of 2016 from $3.2 million in the third quarter of 2015. The decrease in occupancy costs was primarily the result of costs incurred in September 2015 related to our acquisition of MLV & Co. (“MLV”). Subsequent to this acquisition, we have taken steps to wind-down or eliminate MLV’s obligations related to occupancy and equipment.  

Communications expenses decreased 12.0% to $2.2 million in the third quarter of 2016 from $2.5 million in the third quarter of 2015.  The decrease in these expenses was primarily due to decreased costs related to data network and connectivity.

Professional services expenses decreased 7.1% to $2.6 million in the third quarter of 2016 from $2.8 million in the third quarter of 2015. This decrease was primarily due to a $0.9 million decrease in costs related to corporate legal and consulting costs, partially offset by a $0.7 million increase in costs related to investment banking transactions. The decrease in corporate legal and consulting costs was due to costs incurred in September 2015 related to our acquisition of MLV. Additionally, despite the decrease in investment banking revenue, our transaction related costs increased in 2016 due to an increase in costs related to investment banking transactions that were not completed.

Business development expenses decreased 8.7% to $2.1 million in the third quarter of 2016 from $2.3 million in the third quarter of 2015. This decrease was primarily due to a decrease in corporate travel and business development costs.

Clearing and brokerage fees remained unchanged at $1.4 million in both the third quarter of 2016 and the third quarter of 2015.  

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A $1.3 million impairment of goodwill was recognized in the third quarter of 2016 as a result of our annual assessment of goodwill.  There was no comparable charge in the third quarter of 2015.  The impairment recorded in the third quarter of 2016 related to our ECM reporting unit and was the result of various factors, including the significant decline in investment banking revenues during the first nine months of 2016, market conditions related to investment banking and our operating losses.  These factors coupled with the extended period in which our market capitalization has been below our carrying value resulted in the determination that the ECM reporting unit’s goodwill should be reduced to zero.

Other operating expenses decreased 5.0% to $1.9 million in the third quarter of 2016 from $2.0 million in the third quarter of 2015. The decrease in these expenses was primarily due to a decrease in bad debt expense, partially offset by an increase in state registration and other fees.

In the third quarter of 2016, we recognized a $45.7 million tax provision as a result of recording a full valuation allowance against net our deferred tax assets. See Executive Summary above for further information related to our third quarter 2016 tax provision. In the third quarter of 2015, we recognized a tax benefit of $2.9 million, which was based on the actual year-to-date effective rate as permitted by ASC 740, as this was our best estimate of our annual effective tax rate for the full year.  Our effective tax rate for the third quarter of 2015 was 45.7%, and it differed from statutory tax rates primarily due to the effects of capital loss carryforwards subject to a valuation allowance that were projected to be utilized during the year.

Nine months ended September 30, 2016 compared to the nine months ended September 30, 2015

Total non-interest expenses decreased 11.4% to $91.0 million in the first nine months of 2016 from $102.7 million in the first nine months of 2015. Variable expenses decreased $8.1 million to $20.1 million in the first nine months of 2016 from $28.2 million in the first nine months of 2015 and fixed expenses decreased $3.6 million to $70.9 million from $74.5 million.  The change in variable costs reflects a $4.7 million decrease in variable compensation and a $2.8 million decrease in costs related to investment banking transactions, both due to the overall decrease in revenues in the first nine months of 2016 compared to the first nine months of 2015.

Total compensation and benefits expenses decreased 14.4% to $51.2 million in the first nine months of 2016 from $59.8 million in the first nine months of 2015.  The decrease in compensation and benefits expenses reflects the reduction in variable compensation noted above, related to the lower level of revenues in the first nine months of 2016 compared to the first nine months of 2015, as well as $3.9 million reduction in fixed compensation that is primarily related to reduced stock compensation costs.

Occupancy and equipment expenses increased 2.2% to $9.5 million in the first nine months of 2016 from $9.3 million in the first nine months of 2015. The increase in occupancy costs was primarily the result of increases in rent and depreciation of leasehold improvements and office equipment related to our September 2015 acquisition of MLV, partially offset by decreases in software maintenance and license expenses.

Communications expenses decreased 13.6% to $7.0 million in the first nine months of 2016 from $8.1 million in the first nine months of 2015.  The decrease in these expenses was primarily due to decreased costs related to data network and connectivity.

Professional services expenses decreased 28.1% to $6.9 million in the first nine months of 2016 from $9.6 million in the first nine months of 2015. This decrease was primarily due to a $2.1 million decrease in costs related to investment banking transactions as well as a $0.7 million reduction in various fixed professional services costs.

Business development expenses decreased 11.8% to $6.0 million in the first nine months of 2016 from $6.8 million in the first nine months of 2015. This decrease was primarily due to a decrease in travel costs related to investment banking transactions.

Clearing and brokerage fees remained unchanged at approximately $4.0 million in both the first nine months of 2016 and the first nine months of 2015.

A $1.3 million impairment of goodwill was recognized in the first nine months of 2016 as a result of our annual assessment of goodwill.  There was no comparable charge in the first nine months of 2015.  The impairment recorded in the third quarter of 2016 related to our ECM reporting unit and was the result of various factors, including the significant decline in investment banking revenues during the first nine months of 2016, market conditions related to investment banking and our operating losses.  These factors coupled with the extended period

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in which our market capitalization has been below our carrying value resulted in the determination that the ECM reporting unit’s goodwill should be reduced to zero.

Other operating expenses increased 6.1% to $5.2 million in the first nine months of 2016 from $4.9 million in the first nine months of 2015. The increase in these expenses was primarily due to the recognition of $0.2 million of costs related to higher annual meeting expenses as a result of a contested proxy vote and an increase in intangible asset amortization costs as a result of our acquisition of MLV in the third quarter of 2015.

In the first nine months of 2016, we recognized a $38.1 million tax provision as a result of recording a full valuation allowance against our net deferred tax assets. See Executive Summary above for further information related to our 2016 tax provision.  In the first nine months of 2015, we recognized a tax benefit of $2.7 million which was based on the actual year-to-date effective rate as permitted by ASC 740, as this was our best estimate of our annual effective tax rate for the full year. Our effective tax rate for the first nine months of 2015 was 47.0% and it differed from statutory tax rates primarily due to the effects of capital loss carryforwards subject to a valuation allowance that were projected to be utilized during the year.

Liquidity and Capital Resources

Liquidity is a measurement of our ability to meet potential cash requirements for general business purposes. Regulatory requirements applicable to our broker-dealer subsidiaries require minimum capital levels.  The primary sources of funds for liquidity consist of existing cash balances (i.e., available liquid capital not invested in our operating businesses), proceeds from investment fund redemptions and sales of securities, internally generated funds, dividends on equity securities that we own, and credit provided by margin accounts, banks, clearing brokers, and affiliates of our principal clearing broker.  Potential future sources of liquidity for us include internally generated funds, borrowing capacity through margin accounts, corporate lines of credit and other credit facilities which we may enter into in the future, and future issuances of common stock, preferred stock or debt securities.

Cash Flows

As of September 30, 2016, our cash and cash equivalents totaled $53.5 million representing a net decrease of $16.6 million for the first nine months of 2016. The decrease is attributable to cash used in operating activities of $34.1 million and cash used in financing activities of $26.9 million, partially offset by $44.4 million of cash provided by investing activities. Due to the cyclical nature of our industry and the industries in which we provide services, we maintain liquid capital to cover potential cash outflows in periods of decreased revenues and earnings.

Net cash used in operating activities of $34.1 million during the first nine months of 2016, compares to $10.6 million of cash used in operating activities during the first nine months of 2015. The cash used in operating activities during the first nine months of 2016 primarily reflects our net operating loss for the period and $6.3 million of cash used to reduce accrued compensation, partially offset by reductions in our trading securities.  The cash used in operating activities during the first nine months of 2015 reflects our net operating loss for the period and $15.0 million of cash used to reduce accrued compensation, partially offset by reductions in our trading securities and amounts due from brokers, dealers and clearing organizations.

Net cash provided by investing activities of $44.4 million during the first nine months of 2016 compares to $6.0 million provided by investing activities during the first nine months of 2015.  The $44.4 million provided in the first nine months of 2016 reflects proceeds from investment fund redemptions and securities sold during the period of $47.6 million, offset partially by $1.1 million used for the settlement of financial instruments sold short, and a $1.3 million payment against our contingent consideration liability related to our securities lending business acquisition.  The $6.0 million provided in the first nine months of 2015 reflects proceeds from sales of, and distributions from, investments during the period of $17.8 million, offset partially by investment purchases, including $15.1 million of investment funds and $9.5 million related to short-sales of U.S. Treasury securities. In addition, during the first nine months of 2015 we made a $2.2 million payment against the contingent consideration liability for the acquisition of the securities lending business.

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Net cash used in financing activities of $26.9 million during the first nine months of 2016 compares to $40.2 million used during the first nine months of 2015. The 2016 activity reflects the repurchase of 1.3 million shares of our common stock for $22.3 million and dividends paid of $4.8 million. The 2015 activity primarily reflects the repurchase of 1.7 million shares of our common stock for $40.0 million.

Sources of Funding

We believe that our existing cash and cash equivalents balances (totaling $53.5 million at September 30, 2016) comprised primarily of investments in government money market funds investing in short-term U.S. Treasury securities, cash flows from operations, borrowing capacity, other sources of liquidity and execution of our financing strategies will be sufficient to meet our cash requirements. We have obtained, and believe we will be able to continue to obtain, short-term financing, such as margin financing and temporary subordinated financing, in amounts and at interest rates consistent with our financing objectives. We may, however, seek debt or equity financings, in public or private transactions, to provide capital for corporate purposes and/or strategic business opportunities, including possible acquisitions, joint ventures, alliances or other business arrangements which could require substantial capital outlays. Our policy is to evaluate strategic business opportunities, including acquisitions and divestitures, as they arise. There can be no assurance that we will be able to generate sufficient funds from future operations, or raise sufficient debt or equity on acceptable terms, to take advantage of investment opportunities that become available. Should our needs ever exceed these sources of liquidity, we believe that many of our investments could be sold, in most circumstances, to provide cash.

We monitor and manage our leverage and liquidity risk through various committees and processes we have established. We assess our leverage and liquidity risk based on considerations and assumptions of market factors, as well as factors specific to us, including the amount of our available liquid capital (i.e., the amount of our cash and cash equivalents not invested in our operating business).

Assets and Liabilities

As of September 30, 2016, our principal assets consisted of cash and cash equivalents, financial instruments at fair value and receivables. As of September 30, 2016 and December 31, 2015, our liquid assets consisted primarily of cash and cash equivalents, comprised primarily of investments in government money market funds, of $53.5 million and $70.1 million, respectively.

The increase in our total assets to $953.6 million as of September 30, 2016, compared to $933.4 million as of December 31, 2015, was primarily the result of a $134.2 million increase in securities borrowed, partially offset by a $50.5 million decrease in financial instruments owned, at fair value, a $37.5 million decrease in deferred tax assets and the $16.6 million decrease in cash noted above.

Regarding securities lending and our securities borrowed and securities loaned balances, securities borrowed and securities loaned are recorded based upon the amount of cash advanced or received.  Securities borrowed transactions facilitate the settlement process and require us to deposit cash or other collateral with the lender.  With respect to securities loaned, we receive collateral in the form of cash.  The amount of collateral required to be deposited for securities borrowed, or received for securities loaned, is an amount generally in excess of the market value of the applicable securities borrowed or loaned.  We monitor the market value of the securities borrowed and loaned on a daily basis, with additional collateral obtained or excess collateral recalled, when deemed appropriate. As of September 30, 2016 and December 31, 2015, and during the nine months and year then ended, respectively, all collateral received or paid was in the form of cash.

Our due from and to brokers, dealers, and clearing organizations balances primarily represent unsettled banking and securities trades as well as cash on deposit related to securities lending.

As of September 30, 2016, we held $39.0 million of investments which primarily consisted of investments in non-registered investment funds, marketable equity securities, and non-public equity securities. These investments are funded in cash and are not financed with debt.  During the nine months ended September 30, 2016, we received $39.5 million from investment fund redemptions and $8.1 million from sales of marketable and non-public equity securities. As of September 30, 2016, we have initiated redemptions for all of our remaining hedge fund investments.  Pursuant to the terms of these redemptions, we expect to receive the majority of these proceeds within the next six months.  The nature of the private equity fund investments is that distributions are received through the liquidation of the underlying assets of the fund.  At September 30, 2016, it was estimated that the majority of the

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private equity funds will be liquidated in the next 18 months.  The following table provides additional detail regarding our investments as of September 30, 2016 (dollars in thousands): 

As of September 30, 2016, the $27.4 million of investment funds reflects investments in 7 non-registered investment funds that are valued at net asset value (“NAV”) as determined by the fund administrators. As a practical expedient, the Company relies on the NAV of these investments as their fair value. The NAVs that have been provided by fund administrators are derived from the fair values of the underlying investments as of the reporting date. Considering the general lack of transparency necessary to conduct an independent assessment of the fair value of the securities underlying each of the NAVs provided by the fund administrators, our quarterly reporting process includes a number of assessment processes to assist the Company in the evaluation of the information provided by fund managers and fund administrators. These assessment processes include, but are not limited to, regular review and discussion of each fund’s performance with its manager and regular evaluation of performance against applicable benchmarks.

The increase in our total liabilities to $840.0 million as of September 30, 2016 compared to $722.6 million as of December 31, 2015 was primarily the result of a $132.5 million increase in securities loaned. This increase was partially offset by an $8.0 million decrease in accrued compensation and benefits, and a $5.1 million decrease in accounts payable, accrued expenses and other liabilities.

Regulatory Capital

FBR Capital Markets & Co. (“FBRCM”) and MLV, our broker-dealer subsidiaries, are registered with the Securities and Exchange Commission (“SEC”) and are members of the Financial Industry Regulatory Authority, Inc. (“FINRA”). As such, they are subject to the minimum net capital requirements promulgated by the SEC. As of September 30, 2016, FBRCM had total regulatory net capital of $37.7 million, which exceeded its required net capital of $1.2 million by $36.5 million.  MLV had total regulatory capital of $1.5 million, which exceeded its required net capital of $0.1 million by $1.4 million.  Regulatory net capital requirements increase when the broker-dealer is involved in underwriting activities based upon a percentage of the amount being underwritten.

Share Repurchases

During the nine months ended September 30, 2016, we repurchased 756 thousand shares of our common stock in open market or privately negotiated transactions at a weighted average share price of $17.34 per share, for a total cost of $13.1 million.  In July 2016, our Board of Directors approved an increase in the Company’s repurchase authorization to an aggregate of 750 thousand shares.  As of September 30, 2016, we had a remaining authority to repurchase up to 722 thousand additional shares.

We also purchase shares of our common stock from recipients of stock-based compensation awards upon the vesting of RSU and restricted stock awards, and the exercise of options to purchase stock, as recipients sell shares to meet their tax obligations. During the nine months ended September 30, 2016, we purchased 544 thousand shares of common stock at a weighted average share price of $16.98 per share for a total cost of $9.2 million for this purpose.

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Dividends

Since January 1, 2015, our board of directors has declared cash dividends on our common stock as summarized in the following table:

 

 

Off-Balance Sheet Arrangements

Institutional Brokerage

Through indemnification provisions in agreements with clearing organizations, customer activities may expose us to off-balance sheet credit risk. Financial instruments may have to be purchased or sold at prevailing market prices in the event a customer fails to settle on a trade on its original terms or in the event cash and securities in customer margin accounts are not sufficient to fully cover customer obligations. We seek to manage the risks associated with customer activities through customer screening and selection procedures as well as through requirements on customers to maintain margin collateral in compliance with various regulations and clearing organization policies.

Item 3.Quantitative and Qualitative Disclosures about Market Risk

Overall Risk Management

The audit committee of our board of directors has oversight of our risk management framework, and reports to the full board on a quarterly basis regarding our risk management profile. The audit committee regularly reviews our risk profile, our policies regarding market and credit risk limits and operations, and our risk tolerance levels and capital limits. Our board of directors has established risk limits applicable to our trading and investment activities that we monitor daily. In the event risk levels approach the limits, management is required to notify the audit committee, and audit committee approval is required to make any change to the limit levels. The audit committee also regularly meets with our general counsel to discuss legal and regulatory risk issues. In addition, the compensation committee of our board of directors considers the risk associated with overall compensation and how effective our compensation policies are in linking pay to performance and aligning the interest of our executives and shareholders.

We monitor market and business risk, including credit risk, operations, liquidity, compliance, legal, and reputational risk through a number of control procedures designed to identify and evaluate the various risks to which our business and investments are exposed. We have established various committees and processes to assess and to manage risk associated with our investment banking, institutional brokerage, and principal investing activities. We review, among other things, business and transactional risks associated with potential investment banking clients and engagements as well as our capital subjected to risk through our trading activities. We seek to manage the transactional and reputational risks associated with our investment banking and investment activities by review and approval of transactions by our management-level commitment committee and investment committee, respectively, prior to accepting an engagement or pursuing a material investment transaction. Our management risk committee oversees our institutional brokerage and investment risk management practices, including identifying risk that could expose us to loss, approving risk limits and policies to control for those risks. As a management oversight and monitoring tool, our management risk committee has set more extensive and lower risk limits applicable to our trading activities than the board-level limits discussed above. These management risk limits cannot be exceeded without obtaining exception approval by senior management.

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Our risk management function is designed to monitor and understand the risk profile of each of our trading areas and of our investing activities, to consolidate risk and liquidity monitoring company-wide, to assist in implementing effective hedging strategies, and to ensure accurate fair values of our financial instruments. In addition, the risk management function is responsible for bringing elevated-risk situations to the attention of senior management, such as the initiation of a large trading position, the granting of exceptions to position or market access limits, or significant changes in the level of our value at risk exposure.

Market Risk

Market risk is the risk that a change in the level of one or more market prices, rates, indices, or other market factors, such as market liquidity, will result in losses for a position or portfolio. Our activities as an underwriter, market maker and investor, as well as our activities in securities lending and as a financial intermediary in customer trading transactions, expose us to market risk.

Market risk in our securities lending business arises when the market value of securities borrowed declines relative to the cash we post as collateral with the lender; and when the market value of the securities we have loaned increases relative to the cash we have received as collateral from the borrower. Market value fluctuations in our securities lending business are measured daily and any exposure versus cash received or posted is settled daily with counterparties.

We use a number of quantitative measures to manage our exposure to market risk in our trading businesses. These measures include:

Inventory position limits—we establish inventory position limits on gross and net positions, at both the trading desk and individual position level, and we monitor exposures against limits on a daily basis.

Scenario analysis—we apply stress tests and scenario analysis to estimate the potential impact on our trading revenues of highly stressful market environments in both the credit and equity markets.

Value at Risk—we utilize a statistical measure of potential trading loss, called Value at Risk (“VaR”), to estimate the potential loss from adverse market moves in an ordinary market environment. We also establish VaR limits, as appropriate.

Value at Risk. We calculate VaR for our trading businesses using a parametric model that estimates VaR from the standard deviation of portfolio returns. This approach, which captures both the linear and non-linear risks from our trading positions, requires individual positions to be expressed as individual risk factors, then the volatilities and correlations for these risk factors are calculated directly based on data from the previous twelve months. The resulting VaR is expressed over a one-day time horizon and at a 95% confidence level. A 95% confidence level implies that, on average, we anticipate that 5% of the time we may realize trading losses in excess of our VaR amount.  The table below presents the Company’s 95%/one-day VaR for the nine months ended September 30, 2016 and 2015 (dollars in thousands):

 

 

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The Company’s VaR of eleven thousand dollars at September 30, 2016 is 0.01% of our shareholders’ equity as of that date and the change in period end VaR from year to year shows a decrease of $62 thousand.  The low, stable level of VaR reflects the low amount of inventory held in trading businesses. The chart below reflects our daily VaR over the last four quarters:

VaR is a model that quantifies potential losses using historical data. We could incur losses greater than the reported VaR because the historical market prices used may not be an accurate measure of future market events and conditions, especially in highly stressful market environments. In addition, the VaR model measures the risk of the current net trading positions and does not take into account future position changes arising from transaction and/or hedging activity. It also includes the market risk associated with financial instruments sold but not yet purchased on our trading desks. Our VaR includes positions actively managed and held by our trading desks and does not include positions associated with investment banking transactions that may be held on our trading desk in order to facilitate distribution if the underlying stock has not yet commenced trading on a national securities exchange. In most instances, these positions are held only for a short period and sold at or above our costs. Such positions totaled $5.2 million at September 30, 2016. To the extent we hold these positions on a long-term basis, they are reflected as long-term investments and risk related to these positions are discussed below under the section Equity Price Risk.

The primary method used to test the reasonableness of the VaR measure is to compare actual daily trading revenue fluctuations with the daily VaR estimate. If the lowest 5th percentile of daily trading revenues in the revenue fluctuations analysis are less than the loss predicted by the 95th percentile VaR estimate, then the VaR estimate is considered a reasonable predictor of actual trading results. In performing this comparison, the Company’s definition of trading revenues and losses includes commissions, sales credits, net interest income, and gains and losses from intraday trading in the Company’s market-making trading businesses. It does not include the activities of investments in equity that are described in detail in the section Equity Price Risk below.

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The following table provides the actual daily trading revenue fluctuations during the nine months ended September 30, 2016. Over this nine month period, the lowest 5th percentile of all trading days is represented by the first column from the left in the table below, which reflects the nine lowest days of daily trading revenue.  Although not specifically shown in the table, during this nine-day period, the average daily trading revenues were net gains of $52 thousand and the lowest one-day trading revenue was $28 thousand.

Equity Price Risk. Equity price risk represents the potential loss in value of a position due to adverse changes in the level or volatility of equity prices. We generally attempt to limit exposure to equity price risk on securities held as a result of our daily equity trading activities by limiting our intra-day and overnight inventory of trading securities to that needed to provide the appropriate level of liquidity in the securities for which we are a market maker. We also seek to manage these risks by diversifying exposures, controlling position sizes, and establishing economic hedges in related securities, principally through short sale transactions.

While it is impossible to project exactly what factors may affect the prices of equity securities and how much the effect might be, the impact of a ten percent increase and a ten percent decrease in the price of equities held by us would be as follows as of September 30, 2016. The fair value of the $5.2 million of trading equity securities held at our broker-dealer subsidiaries would increase or decrease to $5.7 million and $4.7 million, respectively, and the fair value of the $11.6 million of other equity investments would increase or decrease to $12.8 million and $10.4 million, respectively. Any such increase or decrease in the value of trading securities held by our broker-dealer subsidiaries, investment securities designated as trading, or investment funds will directly affect our earnings.

Credit Risk. Our broker-dealer subsidiaries clear all of their securities transactions through clearing brokers on a fully disclosed basis. Pursuant to the terms of the agreements between our broker-dealer subsidiaries and the clearing brokers, the clearing brokers have the right to charge us for losses that result from a counterparty’s failure to fulfill its contractual obligations. As the right to charge us has no maximum amount and applies to all trades executed through the clearing brokers, we believe there is no maximum amount assignable to this right. At September 30, 2016 and December 31, 2015, we have recorded no liabilities with regard to this right. During the nine months ended September 30, 2016 and 2015, amounts paid to the clearing brokers related to these guarantees have been immaterial. In addition, we have the right to pursue collection of performance from the counterparties who do not perform under their contractual obligations. We monitor the credit standing of the clearing brokers and all counterparties with which we conduct business.

Credit risk from our securities lending operations arises if a lender or borrower defaults on an outstanding loan or borrow transaction and the cash or securities we are holding is insufficient to cover the amount they owe us for that receivable. We assign credit limits and collateral posting thresholds for each counterparty and these limits and thresholds are reviewed periodically.

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The securities industry is subject to numerous risks, including the risk of loss associated with the underwriting, ownership, and trading of securities, and the risk of reduced revenues in periods of reduced demand for security offerings and activity in secondary trading markets. Changing economic and market trends may negatively impact the liquidity and value of our investments and the level of security offerings underwritten by us, which may adversely affect our revenues and profitability.

Our equity investments include securities of privately held issuers with no ready markets. The concentration and illiquidity of these investments expose us to a higher degree of risk than associated with readily marketable securities.

Interest Rate Risk. Interest rate risk represents the potential loss in value of a position or portfolio from adverse changes in market interest rates. We may be exposed to interest rate risk through our trading activities in convertible and fixed income securities as well as U.S. Treasury securities, however, based on our daily monitoring of this risk, we believe we currently have limited exposure to interest rate risk in these activities.

 

 

Item 4.Controls and Procedures

Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures

As of the end of the period covered by this report on Form 10-Q, our management carried out an evaluation, with the participation of our Chief Executive Officer, Richard J. Hendrix, and our Chief Financial Officer, Bradley J. Wright, of the effectiveness of our disclosure controls and procedures (as defined under Rule 13a-15(e) of the Securities Exchange Act of 1934 (the “Exchange Act”)) pursuant to Rule 13a-15(b) under the Exchange Act. Based upon that evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that our disclosure controls and procedures, as of September 30, 2016, are effective to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding disclosure.

Changes in Internal Controls over Financial Reporting

During the three months ended September 30, 2016, we have not made any changes that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act).

 

 

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PART II

OTHER INFORMATION

 

 

Item 1.Legal Proceedings

As of September 30, 2016, except as described below, we were neither a defendant nor plaintiff in any lawsuits or arbitrations nor involved in any governmental or self-regulatory organization matters that are expected to have a material adverse effect on our financial condition, results of operations, or liquidity. We have been named as a defendant in a small number of civil lawsuits relating to our various businesses. In addition, we are subject to various reviews, examinations, investigations and other inquiries by governmental agencies and self-regulatory organizations. There can be no assurance that these matters individually or in aggregate will not have a material adverse effect on our financial condition, results of operations, or liquidity in a future period. However, based on management’s review with counsel, resolution of these matters is not expected to have a material adverse effect on our financial condition, results of operations or liquidity.

Many aspects of our business involve substantial risks of liability and litigation. Underwriters, broker-dealers and investment advisers are exposed to liability under federal and state securities laws, other federal and state laws and court decisions, including decisions with respect to underwriters’ liability and limitations on indemnification, as well as with respect to the handling of customer accounts. For example, underwriters may be held liable for material misstatements or omissions of fact in a prospectus used in connection with the securities being offered and broker-dealers may be held liable for statements made by their securities analysts or other personnel. In the past, FBRCM and MLV have been named as a defendant in a small number of securities claims involving their respective investment banking clients as a result of such broker-dealer’s role as an underwriter. In these cases, the underwriting agreement provides, subject to certain conditions, that the investment banking client is required to indemnify the underwriters against certain claims or liabilities, including claims or liabilities under the Securities Act of 1933, as amended (the “Securities Act”), or contribute to payments which the underwriters are required to make as a result of the litigation. There can be no assurance that such indemnification or contribution will ultimately be available to us or that an investment banking client will be able to satisfy its indemnity or contribution obligations when due.

On March 30, 2016, the previously disclosed putative class action lawsuit of Waterford Township Police & Fire, Retirement System, vs. Regional Management Corp. et al., pending in the United States District Court for the Southern District of New York, was dismissed in its entirety. The Court ruled that the operative amended complaint, filed on January 23, 2015, failed to allege any material misstatements. As previously disclosed, the Second Amended Complaint asserted claims against all the underwriters, including FBRCM, under Sections 11 and 12 of the Securities Act in connection with offerings in September and December 2013.  Plaintiffs have requested that the court grant them permission to amend their complaint a third time.  Briefing on that motion is complete as of June 23, 2016 and a ruling is pending.  Regional Management continues to indemnify all the underwriters, including FBRCM, pursuant to the operative underwriting agreement.

In November 2015, MLV was named a defendant in two putative class action lawsuits alleging substantially identical claims against the officers and directors and underwriters of Miller Energy Resources, Inc. (“Miller”). The lawsuits, styled Goldberg v. Miller et al., and Gaynor v. Miller et al., are pending in the United States District Court for the Eastern District of Tennessee, and allege claims under Sections 11 and 12 of the Securities Act against nine underwriters for alleged material misrepresentations and omissions in the registration statement and prospectuses issued in connection with 6 offerings (February 13, 2013; May 8, 2013; June 28, 2013; September 26; 2013; October 17, 2013 (as to MLV only) and August 21, 2014) with an alleged aggregate offering price of approximately $151 million. The plaintiffs seek unspecified compensatory damages and reimbursement of certain costs and expenses. Although MLV is contractually entitled to be indemnified by Miller in connection with this lawsuit, Miller filed for bankruptcy in October 2015 and this likely will decrease or eliminate the value of the indemnity that MLV receives from Miller. A subsequent complaint was filed in the United States District Court for the Eastern District of Tennessee on May 12, 2016.  The lawsuit, styled Hull v. Miller et al., alleges identical claims to the previously filed complaints under Sections 11 and 12 of the Securities Act against eight of the same underwriters, including MLV, and the officers and directors of Miller.  Briefing on the defendants’ motions to dismiss is pending.

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In accordance with applicable accounting guidance, we establish an accrued liability for litigation and regulatory matters when those matters present loss contingencies that are both probable and estimable. In such cases, there may be an exposure to loss in excess of any amounts accrued. When a loss contingency is not both probable and estimable, we do not establish an accrued liability. As a litigation or regulatory matter develops, management, in conjunction with counsel, evaluates on an ongoing basis whether such matter presents a loss contingency that is probable and estimable. The pending cases discussed above involving FBRCM and MLV are at a preliminary stage, and based on management’s review with counsel and present information known by management, a loss contingency for these matters was not probable and estimable as of September 30, 2016.

In certain circumstances, broker-dealers and asset managers may also be held liable by customers and clients for losses sustained on investments. In recent years, there has been an increasing incidence of litigation and actions by government agencies and self-regulatory organizations involving the securities industry, including class actions that seek substantial damages. We are also subject to the risk of litigation, including litigation that may be without merit. As we intend to actively defend any such litigation, significant legal expenses could be incurred. An adverse resolution of any future litigation against us could materially affect our financial condition, operating results and liquidity.

Item 1A.Risk Factors

As of September 30, 2016, there have been no material changes to our risk factors as previously disclosed in Item 1A of Part I of our Annual Report on Form 10-K for the fiscal year ended December 31, 2015.

Item 2.Unregistered Sales of Equity Securities and Use of Proceeds

The following table provides information on our share repurchases during the third quarter of 2016:

 

 

Item 3.Defaults Upon Senior Securities

Not applicable.

Item 4.Mine Safety Disclosures

Not applicable.

Item 5.Other Information

Not applicable.

 

 

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Item 6.Exhibits

 

 

39

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SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

 

 

40