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| LAB > SEC Filings for LAB > Form 10-K on 16-Mar-2009 | All Recent SEC Filings |
16-Mar-2009
Annual Report
You should read the following discussion of our financial condition and results of operations together with the financial statements and the notes to such statements included elsewhere in this filing. This discussion contains forward-looking statements based on our current expectations, assumptions, estimates and projections about us and our industry. These forward-looking statements involve risks and uncertainties including, but not limited to those discussed in "Risk Factors" set forth in Item 1A of this annual report. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors. We undertake no obligation to update publicly any forward-looking statements for any reason, even if new information becomes available or other events occur in the future.
Executive Overview
For the year ended December 31, 2008, our US GAAP net loss was $66.0 million, or $1.07 per share, compared to a net loss of $350.5 million, or $5.71 per share, for the same period in 2007. These GAAP results were affected by significant unrealized losses of $181.2 million in 2008 and $15.8 million in 2007 in connection with the change in value of our NYX shares, $5.4 million in expenses on our early extinguishment of debt in 2008 and $499.4 in impairment charges related to our goodwill and stock listing rights in 2007. Excluding these items in each year, our pro-forma net income for the year ended December 31, 2008 was $46.0 million, or $0.75 per share, compared to pro-forma net income for the year ended December 31, 2007 of $1.6 million, or $0.03 per share.
Virtually all of the markets in which we provide liquidity experienced significantly higher levels of volatility in the third and fourth quarters of 2008, with periods of extreme volatility in September and October. Although we do not expect that these levels of extreme volatility will continue to be sustained, we do believe that these volatile conditions and market imbalances in the third and fourth quarters of 2008 evidence that there is a continued need for, and at times, opportunities for profitability for market makers, which is where our expertise and history of committing capital has generated most of our revenues. The market environment to date in 2009 has weakened significantly, with reductions in volume and volatility on the exchanges on which we compete, and our market-making business operations have been adversely affected by these changes. However, we believe that if volatility and market imbalances continue to occur, our liquid balance sheet puts us in a strong position to provide added liquidity in securities markets.
In the third and fourth quarters of 2008, our newer business lines, such as options and ETFs market-making in the United States and the United Kingdom, performed extremely well and constituted a substantial majority of our revenues. Our traditional cash equities specialist business posted its best results during the second half of 2008 since the introduction of the NYSE's HYBRID market. In addition, the steps we have taken in reducing costs and overhead during past years enabled us to improve margins and cash flows at our operating companies throughout 2008.
The recent convergence of new trading venues and global securities markets have meant that there is less concentration of trading in one market over another, and trading opportunities are becoming more fragmented. Therefore, our strategy has been, and will continue to be, looking for opportunities in markets outside our traditional cash equities DMM business. Our newer businesses are continuing to grow as a percentage of our market-making segment revenues, especially as we rely upon and further develop our electronic trading strategies to interact with the global electronic marketplace.
In addition, we are seeking additional opportunities to build our Institutional Brokerage business. Although our Institutional Brokerage segment showed a loss in 2008, we believe that start-up costs and our initial facilitation trading results contributed to the bulk of these losses. Our sales trading revenues in the Institutional Brokerage revenues have increased significantly as we have made key hires of sales and position traders and increased market trading in over-the-counter and pink sheets securities. We are in the process of commencing a
In 2008, we successfully reduced our operating expenses, the most significant of which was the interest on our public debt. We repurchased approximately $260.5 million of our public debt in 2008, which reduced our annual interest payments related to this debt from $47.6 million in 2007 to approximately $21.9 million by the end of 2008. These repurchases of our public debt and our third and fourth quarter performance also has enabled us to improve our consolidated fixed charge coverage ratio to 5:1 at December 31, 2008, which allows us to be much more flexible in how we deploy our capital under the terms of the indenture governing our remaining outstanding indebtedness. Historically, the operating expense related to our outstanding debt has been the negative carry on our debt, which is the interest we pay on our outstanding indebtedness, less the interest income we receive as a result of having that cash on-hand. Prior to the repurchases described above, our negative carry would have been $10.2 million per quarter, based on current short-term interest rates. Following our repurchases in 2008, the negative carry was reduced to approximately $5.2 million per quarter, based on current short-term interest rates.
As we have explained in the past, our ownership of 3.1 million shares of NYSE Euronext Inc. common stock (the "NYX shares") resulted from the exchange of our exchange memberships, or "seats" in connection with the NYSE's mergers and we believed that our seat ownership was integral to our position in the industry. Though the value of our NYX shares has been volatile over the past two years, the value of our seats prior to their exchange were volatile as well. Our management will remain flexible regarding our continued ownership of NYX shares. We are also mindful that our ownership of exchange seats and exchange-related securities, such as our NYX shares, have been beneficial to our Company over time.
Our balance sheet is still strong and very liquid despite the continued decline in price of or NYX shares and despite the decline in market conditions to date in 2009. We believe we have ample capital to maintain and grow our business. We are continuing to concentrate on building our business in London and Hong Kong, in which we see trading opportunities in those markets in ETFs and other products.
Our Market-Making segment is in a period of significant transition during the first quarter of 2009, due to the implementation of the NYSE's new market model, turnover in senior management in our options market-making business and poor market conditions. Our trading results in this period of transition have been significantly adversely affected due to these circumstances, as more fully described below. Coupled with the continued decline of our NYX shares to date in 2009, we currently expect to report a GAAP and pro-forma loss in the first quarter of 2009.
In December 2008, the NYSE implemented its new market model, changing the name of specialists to "DMMs," who will still provide liquidity, but without the bulk of the negative and affirmative obligations that existed prior to the change. The rule changes would modify the timing of when the DMM can see orders, but could provide flexibility in the timing and occasions in which we can trade. It is still early in the new market model process to determine the actual effects it can have on our profitability for the long run, but extremely poor market conditions and significantly lower volumes since the new market model became effective has adversely affected our market-making revenues to date in the first quarter of 2009. One possible outcome of the new market model is that some of the restraints on our ability to trade and manage our risk will be lessened. The timing and effect of these rule changes are not certain and we, therefore, cannot predict the outcome of these changes. However, the new market model is requiring us to redesign our trading algorithms and technology. To date in the first quarter of 2009, our trading revenues have significantly declined, and we cannot yet be sure if these results have declined due to poor market conditions or the change in market structure.
In January 2009, we announced the departure of the head of our options trading unit and chief investment officer of LSP. This was a significant departure for us, since he had helped build our options market-making
New Accounting Developments
Fair Value Measurements
In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements" ("SFAS 157"). SFAS 157 defines fair value, establishes a framework for measuring fair value and enhances disclosures about fair value measurements required under other accounting pronouncements, but does not change existing guidance as to whether or not an instrument is carried at fair value. SFAS 157 nullifies the guidance in EITF 02-3 which precluded the recognition of a trading profit at the inception of a derivative contract, unless the fair value of such derivative is obtained from a quoted market price, or other valuation technique incorporating observable market data. SFAS 157 also precludes the use of a liquidity or block discount, when measuring instruments traded in an active market at fair value. SFAS 157 requires that costs related to acquiring financial instruments carried at fair value should not be capitalized, but rather should be expensed as incurred. SFAS 157 also clarifies that an issuer's credit standing should be considered when measuring liabilities at fair value. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and was adopted by us as of January 1, 2008. SFAS 157 must be applied prospectively, except that the provisions related to block discounts and the guidance in EITF 02-3 are to be applied as a one time cumulative effect adjustment to opening retained earnings in the first interim period for the fiscal year in which SFAS 157 is initially applied. The adoption of SFAS 157 resulted in no cumulative change to the accumulated deficit. Please refer to Footnote 21 of our Consolidated Financial Statements for additional information and disclosure.
In February 2008, the FASB issued FSP FAS 157-2 which delays the effective date of Statement 157 to all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value in an entity's financial statements on a recurring basis (at least annually to fiscal years beginning after November 15, 2008. Such items include a) nonfinancial assets acquired and liabilities assumed in purchase business combinations and b) intangible assets and goodwill.
In October of 2008, the FASB issued FSP FAS 157-3 which clarifies the application of SFAS 157 in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that asset is not active. The FSP shall be effective upon issuance, including prior periods for which financial statements have not been issued. Revisions resulting from a change in the valuation technique or its application shall be accounted for as a change in accounting estimate pursuant to FASB 154. The disclosure provisions of Statement 154 for a change in accounting estimate are not required for revisions resulting from a change in valuation technique or its application. As of December 31, 2008, we do not hold any securities that would be subject to change based on FSP FAS 157-3.
Accounting for Fair Value Option for Financial Assets and Financial Liabilities
In February 2007, the FASB issued SFAS No. 159, "Accounting for Fair Value Option for Financial Assets and Financial Liabilities" ("SFAS 159"). SFAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. We currently report the majority of our financial assets and liabilities at fair value in compliance with industry guidelines for brokers and dealers in securities. We elected not to apply the fair value option for any applicable assets or liabilities.
In April 2007, the FASB issued a Staff Position ("FSP") FIN No. 39-1, "Amendment of FASB Interpretation No. 39." FSP FIN No. 39-1 defines "right of setoff" and specifies what conditions must be met for a derivative contract to qualify for this right of setoff. It also addresses the applicability of a right of setoff to derivative instruments and clarifies the circumstances in which it is appropriate to offset amounts recognized for those instruments in the statement of financial position. In addition, this FSP permits offsetting of fair value amounts recognized for multiple derivative instruments executed with the same counterparty under a master netting arrangement and fair value amounts recognized for the right to reclaim cash collateral (a receivable) or the obligation to return cash collateral (a payable) arising from the same master netting arrangement as the derivative instruments. The provisions of this FSP are consistent with our current accounting practice. This interpretation is effective for fiscal years beginning after November 15, 2007, with early application permitted. The adoption of FSP FIN No. 39-1 did not have a material impact on our consolidated financial statements.
In March 2008, the FASB issued FASB Statement No. 161, "Disclosures about Derivative Instruments and Hedging Activities, an amendment of FASB Statement 133". SFAS 161 amends and expands the disclosures required by SFAS 133 so that they provide an enhanced understanding of 1) how and why an entity uses derivative instruments, 2) how derivative instruments and related hedged items are accounted for under SFAS 133 and its related interpretations, and 3) how derivative instruments affect an entity's financial position, financial performance, and cash flows. SFAS 161 is effective for both interim and annual reporting periods beginning after November 15, 2008, with early adoption encouraged. We are not subject to SFAS 133 at this time. Since this amendment relates solely to disclosures related to SFAS 133, there is no potential effect on our financial position.
The Hierarchy of Generally Accepted Accounting Principles
In May 2008, the FASB issued SFAS No. 162, "The Hierarchy of Generally Accepted Accounting Principles" ("SFAS 162"). SFAS 162 identifies the sources of accounting principles and the framework for selecting the principles used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles (GAAP) in the United States (the GAAP hierarchy). SFAS 162 is effective 60 days following the SEC's approval of the Public Company Accounting Oversight Board amendments to AU Section 411, The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles. The Adoption of SFAS 162 will not have a material effect on the Consolidated Financial Statements.
Critical Accounting Estimates
Goodwill and Other Intangible Assets
We determine the fair value of each of our reporting units and the fair value of each reporting unit's goodwill under the provisions of SFAS No. 142, "Goodwill and Other Intangible Assets." In determining fair value, we use standard analytical approaches to business enterprise valuation ("BEV"), such as the market comparable approach and the income approach. The market comparable approach is based on comparisons of the subject company to similar companies engaged in an actual merger or acquisition or to public companies whose stocks are actively traded. As part of this process, multiples of value relative to financial variables, such as earnings or stockholders' equity, are developed and applied to the appropriate financial variables of the subject company to indicate its value. The income approach involves estimating the present value of the subject company's future cash flows by using projections of the cash flows that the business is expected to generate, and discounting these cash flows at a given rate of return. Each of these BEV methodologies requires the use of management estimates and assumptions. For example, under the market comparable approach, we assigned a certain control premium to the public market price of our common stock as of the valuation date in estimating the fair value of our specialist reporting unit. Similarly, under the income approach, we assumed certain growth rates for our revenues, expenses, earnings before interest, income taxes, depreciation and amortization, returns on working capital, returns on other assets and capital expenditures, among others. We also assumed certain
We review the reasonableness of the carrying value of our goodwill annually as of December 31, unless an event or change in circumstances requires an interim reassessment of impairment. During the year ended December 31, 2008, there were no changes in circumstances that necessitated goodwill impairment testing prior to our required year-end test date. We cannot provide assurance that a change in circumstances requiring an interim assessment or future goodwill impairment testing will not result in impairment charges in subsequent periods.
Another of our intangible assets, as defined under SFAS No. 142, is our trade name. We determine the fair value of our trade name by applying the income approach using the royalty savings methodology. This method assumes that the trade name has value to the extent we are relieved of the obligation to pay royalties for the benefits received from it. Application of this methodology requires estimating an appropriate royalty rate, which is typically expressed as a percentage of revenue. Estimating an appropriate royalty rate includes reviewing evidence from comparable licensing agreements and considering qualitative factors affecting the trade name. Given the subjectivity involved in selecting which BEV approach to use and in determining the input variables for use in our analyses, it is possible that a different valuation model and the selection of different input variables could produce a materially different estimate of fair value of our trade name.
We review the reasonableness of the carrying amount of our trade name on an annual basis in conjunction with our goodwill impairment assessment. During the year ended December 31, 2008, there were no changes in circumstances that necessitated trade name impairment testing prior to our required year-end test date. We cannot provide assurance that a change in circumstances requiring an interim assessment or future trade name and stock listing rights impairment testing will not result in impairment charges in subsequent periods.
Financial Instruments
"Financial instruments owned, at fair value" and "Financial instruments sold, but not yet purchased, at fair value" are reported in our consolidated financial statements, at fair value, on a recurring basis. Pursuant to SFAS No. 157, the fair value of a financial instrument is defined as the amount that would be received to sell an asset or paid to transfer a liability, or the "exit price," in an orderly transaction between market participants at the measurement date.
Effective January 1, 2008, we adopted Statement of Financial Accounting Standards, or SFAS No. 157 "Fair Value Measurements," which defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. SFAS No. 157 outlines a fair value hierarchy that is used to determine the value to be reported. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets and liabilities (which are considered "level 1" measurements) and the lowest priority to unobservable inputs (which are considered "level 3" measurements). The three levels of the fair value hierarchy under SFAS No. 157 are as follows:
Level 1 - Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities;
Level 2 - Quoted prices for similar instruments in active markets, quoted prices in markets that are not active or financial instruments for which all significant inputs are observable, either directly or indirectly;
Level 3 - Valuation is generated from model-based techniques that use significant assumptions not observable in the market. These unobservable assumptions would reflect our own estimates of assumptions that market participants would use in pricing the asset or liability. Such valuation techniques include the use of option pricing models, discounted cash flow models and similar techniques.
The measurement of non-marketable securities is a critical accounting estimate.
Investments in non-marketable securities consist of investments in equity
securities of private companies and limited liability company interests and are
included in other assets in the condensed consolidated statements of financial
condition. Certain investments in non-marketable securities are initially
carried at cost, unless there are third-party transactions evidencing a change
in value. For certain other investments in non-marketable securities we adjust
their carrying value by applying the equity method of accounting pursuant to APB
18. Under the equity method the investor recognizes its share of the earnings
and losses of an investee in the periods for which they are reported by the
investee in its financial statements. The assets included in this section
represent limited liability companies that are service providers and whose value
is affected by nonfinancial components. In addition, if and when available,
management considers other relevant factors relating to non-marketable
securities in estimating their value, such as the financial performance of the
entity, its cash flow forecasts, trends within that entity's industry and any
specific rights associated with our investment-such as conversion features-among
others.
Non-marketable investments are tested for potential impairment whenever events or changes in circumstances suggest that such investment's carrying value may be impaired.
Use of Estimates
The use of accounting principles generally accepted in the United States of America requires management to make certain estimates. In addition to the estimates we make in connection with fair value measurements and the accounting for goodwill and identifiable intangible assets, the use of estimates is also important in determining provisions for potential losses that may arise from litigation, regulatory proceedings and tax audits.
We estimate and provide for potential losses that may arise out of litigation, regulatory proceedings and tax audits to the extent that such losses are probable and can be estimated, in accordance with SFAS No. 5, "Accounting for Contingencies" and FIN 48, "Accounting for Uncertainty in Income Taxes". Significant judgment is required in making these estimates and our final liabilities may ultimately be materially different. Our total liability in respect of litigation and regulatory proceedings is determined on a case-by-case basis and represents an estimate of probable losses after considering, among other factors, the progress of each case or proceeding, our experience and the experience of others in similar cases or proceedings, and the opinions and views of legal counsel. Given the inherent difficulty of predicting the outcome of our litigation and regulatory matters, particularly in cases or proceedings in which substantial or indeterminate damages or fines are sought, we cannot estimate losses or ranges of losses for cases or proceedings where there is only a reasonable possibility that a loss may be incurred. See "Legal Proceedings" in Part II, Item 1 of this Quarterly Report on Form 10-Q for information on our judicial, regulatory and arbitration proceedings.
Recent Regulatory Developments
Regulation SHO and Short Selling Rules.
On October 14, 2008, the Securities and Exchange Commission adopted several final rules concerning short selling practices in US securities markets. Among the rules were (a) an "interim final temporary rule" that extends, until July 31, 2009, the recently imposed Rule 204T requiring that firms buy or borrow securities to close-out any fail to deliver position in an equity security resulting from a long or a short sale by the beginning of regular trading hours on the next settlement day following the date the fail to deliver position arose; (b) a rule eliminating the options market maker exception to the close-out requirement for short sales under Regulation SHO; and (c) an antifraud rule prohibiting misrepresentations by a "short" seller regarding its ability or intention to deliver securities by the settlement date in connection with both long and short sales. The rules are generally consistent with the series of emergency orders issued by the SEC in September and October 2008. Included in the interim final temporary Rule 204T are certain exemptions and extends the time to deliver securities to cover such
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