ITEM 1. BUSINESS.
Jefferies Group, Inc. is a holding company which, through its four primary subsidiaries, Jefferies & Company, Inc., Investment Technology Group, Inc., Jefferies International Limited and Jefferies Pacific Limited, is engaged in securities brokerage and trading, corporate finance and other financial services. The term "Company" refers, unless the context requires otherwise, to Jefferies Group, Inc., its subsidiaries, predecessor entities, and W & D Securities, Inc. The Company was originally incorporated in 1973 as a holding company for Jefferies & Company, Inc. and was reincorporated in Delaware on August 10, 1983. The Company and its various subsidiaries maintain offices in Los Angeles, New York, Short Hills, Jersey City, Chicago, Dallas, Boston, Atlanta, New Orleans, Houston, San Francisco, Stamford, London, Hong Kong, Zurich and Tokyo.
As of December 31, 1996, the Company and its subsidiaries had 909 full-time employees, including 429 representatives registered with the National Association of Securities Dealers, Inc. ("NASD"). The Company's executive offices are located at 11100 Santa Monica Boulevard, Los Angeles, California 90025, and its telephone number is (310) 445-1199.
JEFFERIES & COMPANY, INC.
Jefferies & Company, Inc. ("Jefferies") was founded in 1962 and is engaged in equity, convertible debt and taxable fixed income securities brokerage and trading and corporate finance. Jefferies is one of the leading national firms engaged in the distribution and trading of blocks of equity securities both on the national securities exchanges and in the "third market." The term "third market" refers to transactions in listed equity securities effected away from national securities exchanges. Jefferies' revenues are derived primarily from commission revenues and market making or trading as principal in equity, taxable fixed income and convertible securities with or on behalf of institutional investors, with the balance generated by corporate finance and other activities. Jefferies has continued to add to its equity research capabilities and currently provides equity research in the areas of energy, health care, telecommunications, consumer, real estate investment trusts, gaming and entertainment, business services, and financial services.
INVESTMENT TECHNOLOGY GROUP, INC.
Investment Technology Group, Inc. is a holding company which is publicly traded (Nasdaq: ITGI) and is approximately 82% owned by Jefferies Group, Inc. Its wholly-owned subsidiary, ITG Inc. ("ITG"), is a leading provider of technology-based equity trading services and transaction research to institutional investors and brokers. ITG services help clients to access liquidity, execute trades more efficiently, and make better trading decisions. ITG's expanding range of services includes: POSIT(R), the world's largest intra-day electronic equity matching system; QuantEX(R), a fully-integrated trade routing, analysis, and management system; and ISIS, a set of analytical tools for systematically lowering the costs of trading.
JEFFERIES INTERNATIONAL LIMITED AND JEFFERIES PACIFIC LIMITED
Jefferies International Limited ("JIL"), a broker-dealer subsidiary of the Company, was incorporated in 1986 in England. JIL is a member of The International Stock Exchange and The Securities and Futures Authority. JIL introduces customers trading in U.S. securities to Jefferies and also trades as a broker-dealer in international equity and convertible securities and American Depository Receipts ("ADRs"). In 1995, JIL formed a wholly owned Swiss subsidiary, Jefferies (Switzerland) Ltd. In 1996, JIL formed a wholly owned English subsidiary, Jefferies (Japan) Limited, which maintains a branch office in Tokyo.
Jefferies Pacific Limited ("JPL"), a broker subsidiary of the Company, was incorporated in 1992 in Hong Kong. JPL presently introduces foreign customers trading in U.S. securities to Jefferies. JPL commenced operations in 1993 and has not yet generated material revenues.
W & D SECURITIES, INC.
W & D Securities, Inc. ("W & D") primarily provides execution services on the New York Stock Exchange ("NYSE") and other exchanges to Jefferies and ITG. In order to comply with regulatory requirements of the NYSE that generally prohibit NYSE members and their affiliates from executing, as principal and, in certain cases, as agent, transactions in NYSE-listed securities off the NYSE, the Company gave up its formal legal control of W & D, effective January 1, 1983, by exchanging all of the W & D common stock owned by it for non-voting preferred stock of W & D. The common stock of W & D is presently held by an officer of W & D who has agreed with the Company that, at the option of the Company, he will sell such stock to the Company for nominal consideration. In the event that the Company were to regain ownership of such common stock, the Company believes that the NYSE would assert that W & D would be in violation of the NYSE's rules unless similar arrangements satisfactory to the NYSE were made with respect to the ownership of the common stock.
While the NYSE has generally approved the above arrangements, there can be no assurance that it will not raise objections in the future. In light of these arrangements and the high proportion of the equity of W & D represented by the non-voting preferred stock held by the Company, W & D is consolidated as a subsidiary of the Company for financial statement purposes. The Company believes that it can make satisfactory alternative arrangements for executing transactions in listed securities on the NYSE if it were precluded from doing so through W & D.
COMMISSION BUSINESS
A substantial portion of the Company's revenues is derived from customer commissions on brokerage transactions in equity (primarily listed) and debt securities for domestic and international investors such as investment advisors, banks, mutual funds, insurance companies and pension and profit sharing plans. Such investors normally purchase and sell securities in block transactions, the execution of which requires special marketing and trading expertise. The Company is one of the leading national firms in the execution of equity block transactions, and believes that its institutional customers are attracted by the quality of the Company's execution (with respect to considerations of quantity, timing and price) and its competitive commission rates, which are negotiated on the basis of market conditions, the size of the particular transaction and other factors. In addition to domestic equity securities, the Company executes transactions in taxable fixed income securities, domestic and international convertible securities, international equity securities, ADRs, options, preferred stocks, financial futures and other similar products.
All of the Company's equity account executives are electronically interconnected through a system permitting simultaneous verbal and graphic communication of trading and order information by all participants. The Company believes that its execution capability is significantly enhanced by this system, which permits its account executives to respond to each other and to negotiate order indications directly with customers rather than through a separate trading department.
PRINCIPAL TRANSACTIONS
In the regular course of its business, the Company takes securities positions as a market-maker to facilitate customer transactions and for investment purposes. In making markets and when trading for its own account, the Company exposes its own capital to the risk of fluctuations in market value. Trading profits (or losses) depend primarily upon the skills of the employees engaged in market making and position taking, the amount of capital allocated to positions in securities and the general trend of prices in the securities markets.
The Company monitors its risk by maintaining its securities positions at or below certain pre-established levels. These levels reduce certain opportunities to realize profits in the event that the value of such securities increases. However, they also reduce the risk of loss in the event of a decrease in such value and result in controlled interest costs incurred on funds provided to maintain such positions.
Equities. The Equities Division makes markets in over 400 over-the-counter equity and ADR securities, and trades securities for its own account, as well as to accommodate customer transactions. The International Division engages in hedged trading involving securities listed or traded in both domestic and foreign markets.
Taxable Fixed Income. The Taxable Fixed Income Division trades high grade and non-investment grade public and private debt securities. The Division specializes in trading and making markets in over 300 unrated or less than investment grade corporate debt securities and accounts for these positions at market value. At December 31, 1996, the aggregate long and short market value of these positions was $9.0 million and $12.3 million, respectively. Risk of loss upon default by the borrower is significantly greater with respect to unrated or less than investment grade corporate debt securities than with other corporate debt securities. These securities are generally unsecured and are often subordinated to other creditors of the issuer. These issuers usually have high levels of indebtedness and are more sensitive to adverse economic conditions, such as recession or increasing interest rates, than are investment grade issuers. There is a limited market for some of these securities and market quotes are generally available from a small number of dealers.
Convertible Securities and Warrants. The Company also trades domestic and international convertible securities and warrants and assists corporate and institutional clients in identifying attractive investments in these securities and warrants.
Other Proprietary Trading. In 1994, the Company started the Analytical Trading Division to engage in statistically-defined market-neutral strategies in the equities markets to earn above market rates on invested capital. In 1995, the Analytical Trading Division added a commodities trading group to engage in a hedged strategy involving exchange listed commodity index futures and the underlying commodity futures. The Company also invests in merger-related arbitrage activities through relationships with independent management firms pursuant to which the Company delegates investment decisions to the managers.
CORPORATE FINANCE
Jefferies' Corporate Finance Division offers corporations a full range of advisory as well as debt and equity financing services which include private placements and public offerings of debt and equity securities, debt refinancings, recapitalizations, mergers and acquisitions advice, exclusive sales advice, structured financings and securitizations, consent and waiver solicitations, and company and bondholder representations in corporate restructurings.
Investment banking activity involves both economic and regulatory risks. An underwriter may incur losses if it is unable to sell the securities it is committed to purchase or if it is forced to liquidate its commitments at less than the agreed upon purchase price. In addition, under the Securities Act of 1933 and other laws and court decisions with respect to underwriters' liability and limitations on indemnification of underwriters by issuers, an underwriter is subject to substantial potential liability for material misstatements or omissions in prospectuses and other communications with respect to underwritten offerings. Further, underwriting commitments constitute a charge against net capital and the Company's underwriting commitments may be limited by the requirement that it must, at all times, be in compliance with the Uniform Net Capital Rule 15c3-1 of the Securities and Exchange Commission (the "Commission").
The Company intends to continue to pursue opportunities for its corporate customers which may require it to finance and/or underwrite the issuance of securities. Under circumstances where the Company is required to act as an underwriter or to trade on a proprietary basis with its customers, the Company may assume greater risk than would normally be assumed in certain other principal transactions.
INTEREST
The Company derives a substantial portion of its interest revenues, and incurs a substantial portion of its interest expenses, in connection with its securities borrowed/securities loaned activity. The Company also earns interest on its securities portfolio, on its operating and segregated balances, on its margin lending activity and on certain of its investments.
Securities Borrowed/Securities Loaned. In connection with both its trading and brokerage activities, the Company borrows securities to cover short sales and to complete transactions in which customers have failed to deliver securities by the required settlement date, and lends securities to other brokers and dealers for similar purposes. The Company has an active securities borrowed and lending matched book business ("Matched Book"), in which the Company borrows securities from one party and lends them to another party. When the Company borrows securities, the Company provides cash to the lender as collateral, which is reflected in the Company's financial statements as receivable from brokers and dealers. The Company earns interest revenues on this cash collateral. Similarly, when the Company lends securities to another party, that party provides cash to the Company as collateral, which is reflected in the Company's financial statements as payable to brokers and dealers. The Company pays interest expense on the cash collateral received from the party borrowing the securities. A substantial portion of the Company's interest revenues and interest expense results from the Matched Book activity.
Margin Lending. Customers' transactions are executed on either a cash or margin basis. In a margin transaction, the Company extends credit to the customer, collateralized by securities and cash in the customer's account, for a portion of the purchase price, and receives income from interest charged on such extensions of credit.
In permitting a customer to purchase securities on margin, the Company is subject to the risk that a market decline could reduce the value of its collateral below the amount of the customer's indebtedness and that the customer might otherwise be unable to repay the indebtedness.
In addition to monitoring the creditworthiness of its customers, the Company also considers the trading liquidity and volatility of the securities it accepts as collateral for its margin loans. Trading liquidity and volatility may be dependent, in part, upon the market on which the security is traded, the number of outstanding shares of the issuer, events affecting the issuer and/or securities markets in general, and whether or not there are any legal restrictions on the sale of the securities. Certain types of securities have historical trading patterns which may assist the Company in making its evaluation. Historical trading patterns, however, may not be good indicators over relatively short time periods or in markets which are affected by unusual or unexpected developments. The Company considers all of these factors at the time it agrees to extend credit to customers and continues to review its extensions of credit on an ongoing basis.
The majority of the Company's margin loans are made to United States citizens or to corporations which are domiciled in the United States. The Company may extend credit to investors or corporations who are citizens of foreign countries or who may reside outside the United States. The Company believes that should such foreign investors default upon their loans with the Company and should the collateral for those loans be insufficient to satisfy the investors' obligations to the Company, the Company may experience more difficulty in collecting investors' outstanding indebtedness than would be the case if investors were citizens or residents of the United States.
Although the Company attempts to minimize the risk associated with the extension of credit in margin accounts, there is no assurance that the assumptions on which the Company bases its decisions will be correct or that the Company is in a position to predict factors or events which will have an adverse impact on any individual customer or issuer, or the securities markets in general.
COMPETITION
All aspects of the business of the Company are intensely competitive. The Company competes directly with numerous other brokers and dealers, investment banking firms and banks. In addition to competition from firms currently in the securities business, there has been increasing competition from others offering financial services. These developments and others have resulted, and may continue to result, in significant additional competition for the Company.
Member firms of the NYSE generally are prohibited from effecting transactions when acting as principal and, in certain cases, as agents, in listed equity securities off the NYSE, and therefore, unlike Jefferies, are precluded from effecting such transactions in the third market. Such firms may execute certain transactions in
listed equity securities in the third market for customers, although typically they do not do so. Since firms which the Company regards as its major competitors in the execution of transactions in equity securities for institutional investors are members of the NYSE, any removal of these prohibitions could adversely affect the Company's business.
REGULATION
The securities industry in the United States is subject to extensive regulation under both federal and state laws. The Commission is the federal agency responsible for the administration of federal securities laws. In addition, self-regulatory organizations, principally the NASD and the securities exchanges, are actively involved in the regulation of broker-dealers. These self-regulatory organizations conduct periodic examinations of member broker-dealers in accordance with rules they have adopted and amended from time to time, subject to approval by the Commission. Securities firms are also subject to regulation by state securities commissions in those states in which they do business. Jefferies is registered as a broker-dealer in 50 states, the District of Columbia and Puerto Rico. ITG is registered as a broker-dealer in 49 states and the District of Columbia. W & D is registered as a broker-dealer in 23 states.
Broker-dealers are subject to regulations which cover all aspects of the securities business, including sales methods, trade practices among broker-dealers, use and safekeeping of customers' funds and securities, capital structure of securities firms, record-keeping and the conduct of directors, officers and employees. Additional legislation, changes in rules promulgated by the Commission and self-regulatory organizations, or changes in the interpretation or enforcement of existing laws and rules, may directly affect the mode of operation and profitability of broker-dealers. The Commission, self-regulatory organizations and state securities commissions may conduct administrative proceedings which can result in censure, fine, suspension, expulsion of a broker-dealer, its officers or employees, or revocation of broker-dealer licenses. The principal purpose of regulation and discipline of broker-dealers is the protection of customers and the securities markets, rather than protection of creditors and stockholders of broker-dealers.
As registered broker-dealers, Jefferies, ITG and W & D are required by law to belong to the Securities Investor Protection Corporation ("SIPC"). In the event of a member's insolvency, the SIPC fund provides protection for customer accounts up to $500,000 per customer, with a limitation of $100,000 on claims for cash balances.
Net Capital Requirements. Every U.S. registered broker-dealer doing business with the public is subject to the Commission's Uniform Net Capital Rule (the "Rule"), which specifies minimum net capital requirements. Jefferies Group, Inc. is not a registered broker-dealer and is therefore not subject to the Rule; however, its United States broker-dealer subsidiaries are subject thereto.
The Rule provides that a broker-dealer doing business with the public shall not permit its aggregate indebtedness to exceed 15 times its adjusted net capital (the "basic method") or, alternatively, that it not permit its adjusted net capital to be less than 2% of its aggregate debit balances (primarily receivables from customers and broker-dealers) computed in accordance with such Rule (the "alternative method"). Jefferies, ITG and W & D use the alternative method of calculation.
Compliance with applicable net capital rules could limit operations of Jefferies or ITG, such as underwriting and trading activities, that require use of significant amounts of capital, and may also restrict loans, advances, dividends and other payments by Jefferies or ITG to the Company. As of December 31, 1996, Jefferies', ITG's and W & D's net capital was $54.4 million, $29.8 million and $950,000, respectively, which exceeded minimum net capital requirements by $50.8 million, $29.6 million and $700,000, respectively. See note 13 of Notes to Consolidated Financial Statements.
ITEM 2.
ITEM 2. PROPERTIES.
The Company maintains sales offices in Los Angeles, New York, Short Hills, Chicago, Dallas, Boston, Atlanta, New Orleans, Houston, San Francisco, Stamford, London, Hong Kong, Zurich and Tokyo. In addition, the Company maintains operations offices in Los Angeles and Jersey City. The Company leases all of
its office space which management believes is adequate for the Company's business. For information concerning leasehold improvements and rental expense, see notes 1, 6 and 11 of Notes to Consolidated Financial Statements.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
In re Nasdaq Market-Makers Antitrust Litigation. Beginning in July 1994, antitrust class actions were commenced against Jefferies and 33 other defendants in various federal courts (the "Lawsuits"). Following the filing of the Lawsuits, the Antitrust Division of the United States Department of Justice ("DOJ") and the Commission commenced investigations into certain issues related to the allegations of the Lawsuits. In August 1996, the DOJ entered into a proposed antitrust consent decree with 24 defendants who are market makers in Nasdaq stocks. Jefferies was neither asked nor required to settle with the DOJ. The settlement has not yet been approved by the court. Shortly after the DOJ settlement, the Commission filed a Section 21(a) report against the NASD, criticizing various practices by market makers, and the NASD for failing to adequately police or discipline the market makers for those practices. However, the Commission did not take any action at that time against the market maker firms. Jefferies has been informed that the Commission is continuing its investigation of the market maker firms.
In October 1994, the Lawsuits were consolidated for discovery purposes in the United States District Court for the Southern District of New York. The consolidated complaint alleges that the defendants violated the antitrust laws by conspiring to fix the spread paid by plaintiffs and class members to trade in certain Nasdaq securities, by refusing to quote bids and asks in so-called odd-eighths. The cases purport to be brought on behalf of all persons who purchased or sold certain securities on the Nasdaq National Market System during the period May 1, 1989 to May 27, 1994. The plaintiffs seek damages in an unspecified amount.
In November 1996, the court granted, in part, the plaintiffs' motion to certify a class, and a motion to further define what types of purchasers and sellers of stock are included and not included in the definition of the certified class is pending before the court. Discovery will now proceed as appropriate. Jefferies denies any wrongdoing and intends to vigorously defend the Lawsuits. At this stage of the litigation, it is not possible to evaluate the likelihood of an unfavorable outcome or to estimate the amount or range of potential damages in the event of an adverse finding on the merits.
Other. Many aspects of the Company's business involve substantial risks of liability. In the normal course of business, the Company and its subsidiaries have been named as defendants or co-defendants in lawsuits involving primarily claims for damages. The Company's management believes that pending litigation will not have a material adverse effect on the Company.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS.
The Company's Common Stock began trading on the NYSE on March 15, 1996, under the symbol JEF. Previously, the Common Stock traded in the Nasdaq National Market System under the symbol JEFG. The following table sets forth for the periods indicated, the range of high and low representative bid prices per share for the Common Stock as reported by Nasdaq, which prices do not include retail mark-ups, mark-downs or commissions and represent prices between dealers and not necessarily actual transactions. All price range and dividends per share information has been restated to retroactively reflect the effect of the two-for-one stock split approved by the Board of Directors on March 2, 1996.
There were approximately 296 holders of record of the Company's Common Stock at December 31, 1996.
In 1988, the Company instituted a policy of paying regular quarterly cash dividends. There are no restrictions on the Company's present ability to pay dividends on Common Stock, other than the applicable provisions of the Delaware General Corporation Law.
Dividends per Common Share (declared and paid):
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA.
The selected data presented below as of and for each of the years in the five-year period ended December 31, 1996, are derived from the consolidated financial statements of Jefferies Group, Inc. and its subsidiaries, which financial statements have been audited by KPMG Peat Marwick LLP, independent auditors. Such data should be read in connection with the consolidated financial statements contained on pages 14 through 35. All share and per share information has been restated to retroactively reflect the effect of the two-for-one stock split approved by the Board of Directors on March 2, 1996.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
The Company's principal activities, securities brokerage and the trading of and market making in securities, are highly competitive.
The earnings of the Company are subject to wide fluctuations since many factors over which the Company has little or no control, particularly the overall volume of trading and the volatility and general level of market prices, may significantly affect its operations. The following provides a summary of revenues by source for the past three years.
1996 COMPARED TO 1995
Revenues, net of interest expense, increased $137.6 million, or 38%, in 1996 as compared to 1995. The increase was due to a $61.5 million, or 35%, increase in commissions, a $46.0 million, or 47%, increase in principal transactions, a $30.8 million, or 42%, increase in corporate finance, a $765,000 increase in other revenues, offset by a $1.5 million, or 13%, decrease in net interest income (interest revenues less interest expense). Commission revenues increased, led by ITG, the Equities Division, the International Division and the Convertibles Division. Revenues from principal transactions increased primarily due to increased trading gains in the Equities Division, the Taxable Fixed Income Division, the Analytical Trading Division and the International Division. Corporate finance revenues grew due to an increase in equity underwritings and advisory fees. Other revenues increased largely due to a one time expense reimbursement related to prior years. Net interest income decreased as the $18.0 million decrease in interest revenues exceeded the $16.5 million decrease in interest expense. Interest revenues decreased due primarily to lower securities borrowed. The related decrease in interest on securities loaned and customer credit balances only partially offset the drop in interest revenues.
Total non-interest expenses increased $107.6 million, or 34%, in 1996 as compared to 1995. Compensation and benefits increased $68.8 million, or 35% primarily due to a $30.3 million increase in performance-based compensation, a $19.1 million increase in sales commissions and a $10.2 million increase in salaries. Salaries increased due largely to expansion in ITG, the Corporate Finance Division, the Equity Research Division and the Equities Division. The compensation costs of the Technology Department increased to support expansion and to strengthen the trading and management information systems. Other expense increased $13.0 million, or 34%, largely due to higher soft dollar expenses. Telecommunications and data processing services increased $10.2 million, or 41%, primarily due to increased trade volume and personnel. Floor brokerage and clearing fees increased $7.1 million, or 35%, mostly due to increased volume of business
executed on the various exchanges. Travel and promotional expense increased $4.6 million, or 42%, mostly due to increased business travel. Software royalties increased $2.8 million, or 47%, due to an increase in POSIT(R) commissions. Occupancy and equipment rental increased $1.2 million, or 8%, mostly due to the relocation and addition of office space.
As a result of the above, earnings before income taxes and minority interest were up $29.9 million, or 56%.
Net earnings were up 53% to $43.6 million, as compared to $28.5 million in 1995. Minority interest of $4.2 million in 1996 represents approximately 18% of Investment Technology Group, Inc.'s net earnings. The effective tax rate was approximately 42.6% in 1996 compared to approximately 41.2% in 1995.
Primary earnings per share were $3.68 in 1996 on 11.7 million shares compared to $2.39 in 1995 on 12.0 million shares. Fully diluted earnings per share were $3.66 in 1996 on 11.8 million shares compared to $2.37 in 1995 on 12.0 million shares.
1995 COMPARED TO 1994
Revenues, net of interest expense, increased $90.9 million, or 33%, in 1995 as compared to 1994. The increase was due to a $32.8 million, or 81%, increase in corporate finance, a $30.9 million, or 46%, increase in principal transactions, a $23.0 million, or 15%, increase in commissions, a $2.3 million increase in other revenues and a $1.8 million, or 19%, increase in net interest income (interest revenues less interest expense). Commission revenues increased, led by ITG and the Equities Division. Revenues from principal transactions increased primarily due to increased trading gains in the Equities Division, the Taxable Fixed Income Division and the International Division. Corporate finance revenues benefited from increases in underwriting and advisory fees. Other revenues increased largely due to higher ITG-related investment income. Net interest income increased as the $14.6 million increase in interest revenues exceeded the $12.7 million increase in interest expense. Interest revenues increased due primarily to higher securities borrowed and customer margin interest income. The related increase in interest on securities loaned only partially offset the growth in interest revenues.
Total non-interest expenses increased $68.4 million, or 28%, in 1995 as compared to 1994. Compensation and benefits increased $49.9 million, or 34% primarily due to a $29.1 million increase in performance-based compensation, a $13.4 million increase in sales commissions and a $1.8 million increase in salaries. Salaries increased due largely to expansion in the Corporate Finance Division and equity research. Other expense increased $8.4 million, or 27%, largely due to higher technology development expenses. Telecommunications and data processing services increased $4.0 million, or 19%, primarily due to increased trade volume and personnel. Travel and promotional expense increased $1.9 million, or 21%, mostly due to an increase in ITG's advertising and promotional costs as well as increased travel related to the Corporate Finance Division. Occupancy and equipment rental increased $1.7 million, or 12%, mostly due to the relocation and addition of offices. Floor brokerage and clearing fees increased $1.6 million, or 9%, mostly due to increased volume of business executed on the various exchanges. Software royalties increased $959,000, or 19%, due to an increase in POSIT(R) commissions.
As a result of the above, operating income increased $22.5 million, or 73%.
In 1994, Jefferies Group, Inc. recorded a pre-tax gain of $8.3 million on the initial public offering of Investment Technology Group, Inc. The minority stockholders' ownership interest reduced Jefferies Group, Inc.'s ownership of Investment Technology Group, Inc. to approximately 80%. (See Initial Public Offering of Investment Technology Group, Inc. in the Notes to Consolidated Financial Statements.)
Earnings before income taxes and minority interest were up $14.2 million, or 36%.
Net earnings were up 41% to $28.5 million, as compared to $20.2 million in 1994. Minority interest of $2.8 million in 1995 represents approximately 20% of Investment Technology Group, Inc.'s net earnings. The effective tax rate was approximately 41.2% in 1995 compared to approximately 45.0% in 1994. The 1995
effective tax rate was lower due to a reduction in the effective state tax rates and research and development tax credits.
Primary earnings per share were $2.39 in 1995 on 12.0 million shares compared to $1.63 in 1994 on 12.4 million shares. Fully diluted earnings per share were $2.37 in 1995 on 12.0 million shares compared to $1.63 in 1994 on 12.4 million shares.
LIQUIDITY AND CAPITAL RESOURCES
A substantial portion of the Company's assets are liquid, consisting of cash or assets readily convertible into cash. The majority of securities positions (both long and short) in the Company's trading accounts are readily marketable and actively traded. Receivables from brokers and dealers are primarily current open transactions or securities borrowed transactions which can be settled or closed out within a few days. Receivables from customers, officers and directors include margin balances and amounts due on uncompleted transactions. Most of the Company's receivables are secured by marketable securities.
The Company's assets are funded by equity capital, senior debt, subordinated debt, securities loaned, customer free credit balances, bank loans and other payables. Bank loans represent secured and unsecured short-term borrowings (usually overnight) which are generally payable on demand. Secured bank loans are collateralized by a combination of customer, noncustomer and firm securities. The Company has always been able to obtain necessary short-term borrowings in the past and believes that it will continue to be able to do so in the future. Additionally, the Company has letters of credit outstanding which are used in the normal course of business to satisfy various collateral requirements in lieu of depositing cash or securities.
Jefferies, ITG and W & D are subject to the net capital requirements of the Commission and other regulators, which are designed to measure the general financial soundness and liquidity of broker-dealers. Jefferies, ITG and W & D have consistently operated in excess of the minimum requirements. As of December 31, 1996, Jefferies', ITG's and W & D's net capital was $54.4 million, $29.8 million and $950,000, respectively, which exceeded minimum net capital requirements by $50.8 million, $29.6 million and $700,000, respectively. Jefferies, ITG and W & D use the alternative method of calculating their regulatory net capital.
In 1996, Jefferies Group, Inc. redeemed $3.6 million face value of its 8.875% Subordinated Notes due 1997 in accordance with sinking fund requirements. Also in 1996, the Company repurchased 1,160,176 shares (including 207,312 shares purchased in connection with the Company's Capital Accumulation Plan) of its Common Stock at prices ranging from $22.63 to $37.25.
In 1995, Jefferies Group, Inc. redeemed $3.6 million face value of its 8.875% Subordinated Notes due 1997 in accordance with sinking fund requirements. Also in 1995, the Company repurchased 727,738 shares (including 267,936 shares purchased in connection with the Company's Capital Accumulation Plan) of its Common Stock at prices ranging from $14.31 to $23.25.
The repurchased shares of Common Stock are presently being held as treasury shares.
EFFECT OF THE COMMISSION'S ORDER HANDLING RULES
In late 1996 the Commission adopted a series of rules which may have a significant impact on the Company's market making activities in Nasdaq securities. These rules, referred to as the Commission's Order Handling rules, require market makers to display, in certain circumstances, a customer's limit order. The implementation of these rules is being phased in during 1997. The impact on the profitability of the Company's activities as a market maker in Nasdaq securities is unclear, although these rules may have the effect of reducing the spread for certain Nasdaq securities, thereby decreasing, potentially, the profitability from such market making activity.
EFFECTS OF CHANGES IN FOREIGN CURRENCY RATES
The Company maintains a foreign securities business in its foreign offices (London, Hong Kong, Zurich and Tokyo) as well as in some of its domestic offices. Most of these activities are hedged by related foreign
currency liabilities or by forward exchange contracts. However, the Company is still subject to some foreign currency risk. A change in the foreign currency rates could create either a foreign currency transaction gain/loss (recorded in the Company's Consolidated Statements of Earnings) or a foreign currency translation adjustment to the stockholders' equity section of the Company's Consolidated Statements of Financial Condition.
NEW ACCOUNTING STANDARD ON STOCK-BASED COMPENSATION
Statement of Financial Accounting Standards (SFAS) 123, "Accounting for Stock-Based Compensation," defines a fair value based method of accounting for an employee stock option or similar instrument and encourages all entities to adopt that method of accounting for all of their employee stock compensation plans. However, it allows an entity to continue to measure compensation cost for these plans using the intrinsic value based method of accounting prescribed by Accounting Principles Board (APB) Opinion No. 25, "Accounting for Stock Issued to Employees." Entities electing to remain with the accounting in APB Opinion No. 25 must make pro forma disclosures of net earnings and earnings per share, as if the fair value based method of accounting defined in SFAS 123 had been applied. The Company elected to remain with the accounting in APB Opinion No. 25. Accordingly, no compensation cost has been recognized for fixed stock option plans.
For an assessment of risk, see Part I, Item 1, Business sections "Principal Transactions," "Corporate Finance," "Interest," and "Competition."
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Stockholders JEFFERIES GROUP, INC.:
We have audited the accompanying consolidated statements of financial condition of Jefferies Group, Inc. and subsidiaries as of December 31, 1996 and 1995 and the related consolidated statements of earnings, changes in stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 1996. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Jefferies Group, Inc. and subsidiaries as of December 31, 1996 and 1995 and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1996 in conformity with generally accepted accounting principles.
KPMG Peat Marwick LLP
Los Angeles, California January 24, 1997
JEFFERIES GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION DECEMBER 31, 1996 AND 1995 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
See accompanying notes to consolidated financial statements.
JEFFERIES GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF EARNINGS THREE YEARS ENDED DECEMBER 31, 1996 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
See accompanying notes to consolidated financial statements.
JEFFERIES GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY THREE YEARS ENDED DECEMBER 31, 1996 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
See accompanying notes to consolidated financial statements.
JEFFERIES GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS THREE YEARS ENDED DECEMBER 31, 1996 (DOLLARS IN THOUSANDS)
Supplemental disclosure of non-cash financing activities:
In 1994, the additional minimum pension liability included in stockholders' equity of $149,000 resulted from a decrease of $914,000 to accrued expenses and other liabilities and an offsetting increase in stockholders' equity. In 1995, the additional minimum pension liability included in stockholders' equity of $586,000 resulted from an increase of $437,000 to accrued expenses and other liabilities and an offsetting decrease in stockholders' equity. In 1996, the additional minimum pension liability included in stockholders' equity of $553,000 resulted from a decrease of $33,000 to accrued expenses and other liabilities and an offsetting increase in stockholders' equity.
See accompanying notes to consolidated financial statements.
JEFFERIES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1996 AND 1995
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION
The accompanying consolidated financial statements include the accounts of Jefferies Group, Inc. (Company) and all subsidiaries, including Jefferies & Company, Inc. (Jefferies) and Investment Technology Group, Inc. (ITGI) and its wholly owned subsidiary, ITG Inc. (ITG). The accounts of W & D Securities, Inc. (W & D) are also consolidated because of the nature and extent of the Company's ownership interest in W & D. The Company and its subsidiaries are primarily engaged in equity, convertible debt and taxable fixed income securities brokerage and trading and corporate finance. Operations of the Company include agency and principal transactions and other securities-related financial services.
All significant intercompany accounts and transactions are eliminated in consolidation.
SECURITIES TRANSACTIONS
All transactions in securities, commission revenues and related expenses are recorded on a trade-date basis.
Securities owned and securities sold, not yet purchased, are valued at market, and unrealized gains or losses are reflected in revenues from principal transactions.
RECEIVABLE FROM, AND PAYABLE TO, CUSTOMERS, OFFICERS AND DIRECTORS
Receivable from, and payable to, customers includes amounts receivable and payable on cash and margin transactions. Securities owned by customers and held as collateral for these receivables are not reflected in the accompanying consolidated financial statements. Receivable from officers and directors represents balances arising from their individual security transactions. Such transactions are subject to the same regulations as customer transactions.
FAIR VALUE OF FINANCIAL INSTRUMENTS
Substantially all of the Company's financial instruments are carried at fair value or amounts approximating fair value. Assets, including cash and cash equivalents, securities borrowed or purchased under agreements to sell, and certain receivables, are carried at fair value or contracted amounts, which approximate fair value due to the short period to maturity. Similarly, liabilities, including bank loans, securities loaned or sold under agreements to repurchase, long-term debt and certain payables, are carried at amounts approximating fair value. Securities owned and securities sold, not yet purchased, are valued at quoted market prices, if available. For securities without quoted prices, the reported fair value is estimated using various sources of information, including quoted prices for comparable securities.
The Company has derivative financial instrument positions in option contracts, foreign exchange forward contracts and index futures contracts which are measured at fair value with gains and losses recognized in earnings. The gross contracted or notional amount of these contracts is not reflected in the consolidated statements of financial condition (see note 12 of the notes to consolidated financial statements.)
PREMISES AND EQUIPMENT
Premises and equipment are depreciated using the straight-line method over the estimated useful lives of the related assets (generally three to ten years). Leasehold improvements are amortized using the straight-line method over the term of related leases or the estimated useful lives of the assets, whichever is shorter.
JEFFERIES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DECEMBER 31, 1996 AND 1995
GOODWILL
Goodwill, which represents the excess of cost over net assets acquired, is amortized on a straight-line basis over ten years. The Company assesses the recoverability of this intangible asset by determining whether the amortization of the goodwill balance over its remaining life can be recovered through future operating cash flows of the acquired business.
CAPITALIZED SOFTWARE
The Company capitalizes software development costs where technological feasibility of the product has been established. The establishment of technological feasibility and the ongoing assessment of recoverability of capitalized software development costs requires considerable judgment by management with respect to certain external factors, including, but not limited to, technological feasibility, anticipated future gross revenues, estimated economic life and changes in software and hardware technologies. The Company is amortizing capitalized software costs using the straight-line method over one to two years, with an average remaining life of under two years. Amortization begins when the product is available for release to the customers. As of December 31, 1996 and 1995, respectively, the Company had $3.0 million and $2.8 million of capitalized software costs, net of accumulated amortization included in other assets. In 1996, 1995 and 1994, the Company amortized software costs of $1.4 million, $894,000 and $173,000, respectively.
INCOME TAXES
The Company files a consolidated U.S. Federal income tax return which includes all qualifying subsidiaries. Amounts provided for income taxes are based on income reported for financial statement purposes and do not necessarily represent amounts currently payable. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Deferred income taxes are provided for temporary differences in reporting certain items, principally state income taxes, depreciation, deferred compensation and unrealized gains and losses on securities owned. Tax credits are recorded as a reduction of income taxes when realized.
RESEARCH AND DEVELOPMENT
Research and development costs were $6.0 million, $4.9 million and $3.2 million in 1996, 1995 and 1994, respectively. In 1996, 1995 and 1994, $1.6 million, $2.1 million and $1.3 million, respectively, were capitalized.
CASH EQUIVALENTS
The Company generally invests its excess cash in money market funds and other short-term investments. At December 31, 1996 and 1995, such cash equivalents amounted to $95,650,000 and $40,299,000, respectively. Cash equivalents are part of the cash management activities of the Company and generally mature within 90 days.
JEFFERIES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DECEMBER 31, 1996 AND 1995
REPURCHASE AND REVERSE REPURCHASE AGREEMENTS
Repurchase agreements consist of sales of U.S. Treasury notes under agreements to repurchase. They are treated as collateralized financing transactions and are recorded at their contracted repurchase amount.
Reverse repurchase agreements consist of purchases of U.S. Treasury notes under agreements to re-sell. They are treated as collateralized financing transactions and are recorded at their contracted re-sale amount. At December 31, 1996, the Company had a reverse repurchase agreement outstanding with Wells Fargo Bank N.A., which had a weighted average maturity of two days. The market value of the securities to be re-sold was $35,001,000.
EARNINGS PER COMMON SHARE
Earnings per share of common stock are computed by dividing net earnings by the average number of shares of common stock and dilutive common stock equivalents outstanding during the period. All shares used in the earnings per share calculations were restated to retroactively reflect the two-for-one stock split approved by the Board of Directors on March 2, 1996.
COMMON STOCK
On March 2, 1996, the Company's Board of Directors approved a two-for-one split of all of the outstanding shares of the Company's common stock, payable March 29, 1996 to stockholders of record at the close of business on March 15, 1996. The stated par value of each share was not changed from $0.01. All share, share price and per share information included in the consolidated financial statements has been restated to retroactively reflect the effect of the two-for-one stock split.
In addition, the Board of Directors, approved continuation of the quarterly cash dividend rate at $0.05 on the approximately 12,000,000 common shares to be outstanding after the split (effectively doubling the dividend rate), as well as repurchase of up to 1 million of the new common shares, on the open market or otherwise, from time to time. The Board of Directors also approved the filing of an application to list the Company's common shares for trading on the New York Stock Exchange.
TRANSFERS OF FINANCIAL ASSETS
In June 1996, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities." SFAS 125 establishes, among other things, new criteria for determining whether a transfer of financial assets should be accounted for as a sale or as a pledge of collateral in a secured borrowing. SFAS 125 also establishes new accounting requirements for pledged collateral. As issued, SFAS 125 is effective for transfers and servicing of financial assets and extinguishments of liabilities occurring after December 31, 1996, and is to be applied prospectively. Earlier or retroactive application of SFAS 125 is not permitted. In November 1996, the FASB deferred for one year the effective date of significant provisions of SFAS 125. SFAS 125 is not expected to have a material impact on the Company.
IMPAIRMENT OF LONG-LIVED ASSETS AND LONG-LIVED ASSETS TO BE DISPOSED OF
In 1995, the Company adopted the provisions of SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and Long-Lived Assets to be Disposed Of." SFAS No. 121 requires that long-lived assets and certain identifiable intangibles be reviewed for impairment whenever events or changes in circumstance indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and
JEFFERIES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DECEMBER 31, 1996 AND 1995
used is measured by a comparison of the carrying amount of an asset to future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceed the fair value of the assets. Assets to be disposed of are reported at the lower of carrying amount or fair value less costs to sell. Adoption of SFAS No. 121 did not have a material impact on the Company's consolidated financial position, results of operations, or liquidity.
FOREIGN CURRENCY TRANSLATION
The Company's foreign revenues and expenses are translated at average current rates during each reporting period. Foreign currency transaction gains and losses are included in the consolidated statement of earnings. Gains and losses resulting from translation of financial statements are excluded from the consolidated statement of earnings and are recorded directly to a separate component of stockholders' equity.
RECLASSIFICATIONS
Certain reclassifications have been made to the prior years' amounts to conform to the current year's presentation.
USE OF ESTIMATES
Management of the Company has made a number of estimates and assumptions relating to the reporting of assets and liabilities and the disclosure of contingent assets and liabilities to prepare these financial statements in conformity with generally accepted accounting principles. Actual results could differ from those estimates.
(2) GOODWILL
At December 31, 1996 and 1995, excess of purchase price over net assets acquired remaining was $2,471,000 and $3,021,000, net of accumulated amortization of $2,811,000 and $2,261,000, respectively, and is included in other assets.
(3) RECEIVABLE FROM, AND PAYABLE TO, BROKERS AND DEALERS
The following is a summary of the major categories of receivable from, and payable to, brokers and dealers as of December 31, 1996 and 1995 (in thousands of dollars):
The Company has a securities borrowed versus securities loaned business with other brokers. The Company also borrows securities to cover short sales and to complete transactions in which customers have
JEFFERIES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DECEMBER 31, 1996 AND 1995
failed to deliver securities by the required settlement date, and lends securities to other brokers and dealers for similar purposes. From these activities, the Company derives interest revenue and interest expense.
(4) RECEIVABLE FROM, AND PAYABLE TO, CUSTOMERS, OFFICERS AND DIRECTORS
The following is a summary of the major categories of receivables from customers, officers and directors as of December 31, 1996 and 1995 (in thousands of dollars):
Interest is paid on free credit balances in accounts of customers who have indicated that the funds will be used for investment at a future date. The rate of interest paid on such free credit balances varies between the thirteen-week treasury bill rate and 1% below that rate, depending upon the size of the customers' free credit balances.
Uncollectible accounts expense amounted to $18,000, $81,000 and $712,000 for the years ended December 31, 1996, 1995 and 1994, respectively, and is included in other expense.
(5) SECURITIES OWNED AND SECURITIES SOLD, NOT YET PURCHASED
The following is a summary of the market value of major categories of securities owned and securities sold, not yet purchased, as of December 31, 1996 and 1995 (in thousands of dollars):
JEFFERIES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DECEMBER 31, 1996 AND 1995
(6) PREMISES AND EQUIPMENT
The following is a summary of premises and equipment as of December 31, 1996 and 1995 (in thousands of dollars):
Depreciation and amortization expense amounted to $11,480,000, $7,934,000 and $6,878,000 for the years ended December 31, 1996, 1995 and 1994, respectively.
Included in furniture, fixtures and equipment is leased computer and office equipment totaling $5,290,000 with related accumulated amortization of $5,272,000 and $4,734,000 at December 31, 1996 and 1995, respectively.
(7) BANK LOANS
Bank loans represent short-term borrowings that are payable on demand and generally bear interest at the brokers' call loan rate. At December 31, 1996 and 1995, there were no bank loans.
(8) TERM DEBT
The following summarizes term debt outstanding at December 31, 1996 and 1995 (in thousands of dollars):
Beginning October 1, 1995, the Subordinated Notes have sinking fund requirements to redeem $3,577,000 annually through October 1, 1997.
(9) INCOME TAXES
Total income taxes for the years ended December 31, 1996, 1995 and 1994 were allocated as follows (in thousands of dollars):
JEFFERIES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DECEMBER 31, 1996 AND 1995
Income taxes (benefits) for the years ended December 31, 1996, 1995 and 1994 consists of the following (in thousands of dollars):
Income taxes differed from the amounts computed by applying the Federal income tax rate of 35% for 1996, 1995 and 1994 as a result of the following (in thousands of dollars):
JEFFERIES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DECEMBER 31, 1996 AND 1995
The cumulative tax effects of temporary differences that give rise to significant portions of the deferred tax assets and liabilities at December 31, 1996 and 1995 are presented below (in thousands of dollars):
There was no valuation allowance for deferred tax assets as of December 31, 1996, 1995 and 1994.
Management believes it is more likely than not that the Company will generate sufficient taxable income in the future to realize the deferred tax asset.
(10) BENEFIT PLANS
PENSION PLAN
The Company has a defined benefit pension plan which covers substantially all employees of the Company and its subsidiaries. The plan is subject to the provisions of the Employee Retirement Income Security Act of 1974. Benefits are based on years of service and the employee's career average pay. The Company's funding policy is to contribute to the plan at least the minimum amount that can be deducted for Federal income tax purposes.
JEFFERIES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DECEMBER 31, 1996 AND 1995
The following tables set forth the plan's funded status and amounts recognized in the Company's accompanying consolidated statements of financial condition and consolidated statements of earnings (in thousands of dollars):
The plan assets consist of approximately 60% equities and 40% fixed income securities.
The weighted average discount rate and rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation were 7.50% and 5.00%, respectively, in both 1996 and 1995. The expected long-term rate of return on assets was 8.40% in both 1996 and 1995.
STOCK COMPENSATION PLANS
In October 1995, the FASB issued SFAS 123, "Accounting for Stock-Based Compensation." SFAS 123 defines a fair value based method of accounting for an employee stock option or similar instrument and encourages all entities to adopt that method of accounting for all of their employee stock compensation plans. However, it allows an entity to continue to measure compensation cost for these plans using the intrinsic value based method of accounting prescribed by Accounting Principles Board (APB) Opinion No. 25, "Accounting for Stock Issued to Employees." Entities electing to remain with the accounting in APB Opinion No. 25 must make pro forma disclosures of net earnings and earnings per share, as if the fair value based method of accounting defined in SFAS 123 had been applied. The Company implemented the statement during the year ended December 31, 1996.
At December 31, 1996, the Company had six stock-based compensation plans and ITGI had two stock-based compensation plans, which are described below. The Company and ITGI applied APB Opinion No. 25
JEFFERIES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DECEMBER 31, 1996 AND 1995
in accounting for their plans. Accordingly, no compensation cost has been recognized for fixed stock option plans. Had compensation cost for the Company's and ITGI's stock-based compensation plans been determined consistent with SFAS 123, the Company's net earnings and earnings per share would have been reduced to the pro forma amounts indicated below (in thousands of dollars, except per share amounts):
1993 PLAN
The Company has a Stock Ownership and Long-Term Incentive Plan (1993 Plan) which allows awards in the form of incentive stock options (within the meaning of Section 422 of the Internal Revenue Code), nonqualified stock options, stock appreciation rights, restricted stock, unrestricted stock, performance awards, dividend equivalents or other stock based awards. The maximum number of shares of common stock of the Company with respect to which any awards may be made in any calendar year during the term of the 1993 Plan may not exceed 20% of the number of shares of common stock issued and outstanding as of the first day of the calendar year in which awards are made, less the number of shares of common stock reserved for issuance with respect to, or underlying, any award, made pursuant to the 1993 Plan or any predecessor plan, as of such date. The 1993 Plan provides flexibility as to exercise price and term of each option.
DIRECTOR PLAN
The Company, also, has a Non-Employee Directors' Stock Option Plan (Director Plan) which provides for an annual grant to each non-employee director of an option to purchase 2,000 shares of the Company's common stock. Such grants will be made automatically on the date directors are elected or reelected at the Company's annual meeting. In addition, the Director Plan provides for the automatic grant to a non-employee director, at the time he or she is first elected or appointed, of an option to purchase 10,000 shares of the Company's common stock. A total of 150,000 shares of the Company's common stock are reserved under the Director Plan. Under the Director Plan, the exercise price of each option equals the market price of the Company's stock on the date of grant and the option's maximum term is five years.
1996 PLAN
Additionally, in 1996, the Company established a Non-Employee Directors' Deferred Compensation Plan (1996 Plan). The 1996 Plan permits each non-employee director to elect to be paid annual retainer fees and annual fees for service as chairman or a member of a Board committee in the form of stock options and to defer receipt of any director fees in an interest-bearing cash account or as deferred shares in a deferred share account. A total of 100,000 shares of the Company's common stock are reserved under the 1996 Plan. Under the 1996 Plan, the exercise price of each option equals the market price of the Company's stock on the date of grant and the options expire ten years after the date of grant.
JEFFERIES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DECEMBER 31, 1996 AND 1995
UNITED KINGDOM CAPITAL ACCUMULATION PLAN
The Company has a United Kingdom Capital Accumulation Plan (UK CAP) for certain officers and key employees of the Company who work in the United Kingdom. Participation in the plan is optional, with those who elect to participate agreeing to defer graduated percentages of their compensation. The UK CAP allows selected employees to acquire the Company's common stock (through the granting of stock options) at a 15% discount with 40% of the amount deferred. The remaining 60% of the amount deferred is placed in a Profit-Based Deferred Compensation Account that earns interest at a rate based on the performance of the Company.
OPTIONS ISSUED UNDER ALL PLANS
The fair value of all option grants for all the Company's plans are estimated on the date of grant using the Black-Scholes option-pricing model with the weighted-average assumptions used for all fixed option grants in 1996 and 1995, respectively: dividend yield of 0.6%, and 0.7%; expected volatility of 33.3%, and 32.8%; risk-free interest rates of 5.4%, and 7.0%; and expected lives of 3.3 years, and 4.0 years.
A summary of the status of Company stock options in all its stock-based plans as of December 31, 1996, 1995 and 1994 and changes during the year then ended is presented below:
- ---------------
*** SFAS 123 required fair value calculations for 1996 and 1995 only.
The following table summarizes information about stock options outstanding at December 31, 1996:
JEFFERIES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DECEMBER 31, 1996 AND 1995
INVESTMENT TECHNOLOGY GROUP, INC.'S PLANS
In 1994 ITGI, established the 1994 Employee Stock Option and Long-Term Incentive Plan (ITGI Plan) which allows for the granting of options to purchase a total of 3,650,000 shares of ITGI common stock. In 1995, the ITGI Board of Directors adopted, subject to ITGI stockholder approval, the Non-Employee Directors' Plan (ITGI Director Plan). The ITGI Director Plan generally provides for an annual grant to each non-employee director an option to purchase 2,500 shares of ITGI common stock. In addition, the ITGI Director Plan provides for the automatic grant to a non-employee director, at the time he or she is initially elected, a stock option to purchase 10,000 shares of ITGI common stock. Stock options granted under the ITGI Director Plan are non-qualified stock options having an exercise price equal to 100% of the fair market value of ITGI common stock at the date of grant. A total of 125,000 shares of ITGI common stock are reserved for issuance under the ITGI Director Plan. There were a total of 2,271,351 fixed stock options outstanding and 18,389,800 ITGI common stock shares outstanding as of December 31, 1995. There were a total of 2,318,461 fixed stock options outstanding and 18,254,800 ITGI common stock shares outstanding as of December 31, 1996.
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the weighted-average assumptions used for all fixed option grants in 1996, and 1995, respectively: dividend yield of 0.0%, and 0.0%; expected volatility of 49%, and 51%; risk-free interest rates of 6.1%, and 6.3%; and expected lives of 5 years, and 4 years.
The following table summarizes information about stock options outstanding at December 31, 1996:
PERFORMANCE-BASED STOCK OPTIONS
While the 1993 Plan allows for the granting of performance-based stock options, no such options were granted during 1996, 1995 and 1994, and no such options were outstanding at December 31, 1996, 1995 and 1994.
JEFFERIES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DECEMBER 31, 1996 AND 1995
RESTRICTED STOCK
The 1993 Plan allows for the issuance of restricted stock awards. During 1996, 1995 and 1994, there were restricted stock awards of 24,632 shares, 128,046 shares and 56,400 shares, respectively, with a corresponding market value of $623,724, $2,187,000 and $1,019,000, respectively. As of December 31, 1996, 1995 and 1994, restricted stock shares outstanding were 47,580 shares, 117,338 shares and 113,734 shares, respectively. The compensation cost charged against earnings was $394,000, $1,788,000 and $850,000 in 1996, 1995 and 1994, respectively.
EMPLOYEE STOCK PURCHASE PLAN
The Company has an Employee Stock Purchase Plan (ESPP). All regular full-time employees are eligible for the ESPP. Employee contributions are voluntary and are made via payroll deduction. The employee contributions are used to purchase the Company's common stock which is then held in an outside trust account. The Company matches employee contributions at a rate of 15% (more, if profits exceed targets set by the Company's Board of Directors). The Company's match vests after two years. The Company recognizes compensation cost related to its ESPP matching. The compensation cost charged against earnings was $250,000, $161,000 and $174,000 in 1996, 1995 and 1994, respectively.
CAPITAL ACCUMULATION PLAN
The Company has a Capital Accumulation Plan (CAP) for certain officers and key employees of the Company. Participation in the plan is optional, with those who elect to participate agreeing to defer graduated percentages of their compensation. The plan allows selected employees to acquire the Company's common stock at a 15% discount with 50% of the amount deferred. The remaining 50% of the amount deferred is placed in a Profit-Based Deferred Compensation Account that earns interest at a rate based on the performance of the Company.
The Company will from time to time repurchase shares of its common stock in the open market for use in both the CAP and UK CAP plans. The Company has acquired 977,708 shares since the inception of the plans (CAP in 1993 and UK CAP in 1995) and has made distributions of 102,237 shares. The Company recognizes compensation cost related to the 15% discount and interest on Profit-Based Deferred Compensation Accounts. The compensation cost charged against earnings was $2,742,000, $2,200,000 and $1,207,000 in 1996, 1995 and 1994, respectively.
PROFIT SHARING PLAN
The Company has a profit sharing plan, covering substantially all employees, which includes a salary reduction feature designed to qualify under Section 401-K of the Internal Revenue Code. Expenses related to this plan amounted to $5,713,000, $3,565,000 and $1,919,000 in 1996, 1995 and 1994, respectively.
PERFORMANCE SHARE PLAN
The Company had a Performance Share Plan, until May 1994, awarding ownership in ITG in the form of phantom equity interest to key ITG employees, of which a 12.7% interest was outstanding at December 31, 1993. In connection with the initial public offering of ITGI (see note 15), the Performance Share Plan was terminated in May 1994. The Performance Share Plan expense for 1994 was $1,528,000, prior to the termination of the plan.
JEFFERIES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DECEMBER 31, 1996 AND 1995
(11) LEASES
As lessee, the Company leases certain premises and equipment under noncancelable agreements expiring at various dates through 2012. Future minimum lease payments for all noncancelable operating leases at December 31, 1996 are as follows (in thousands of dollars):
Rental expense for the Company was $6,759,000 in 1996, $5,996,000 in 1995 and $5,507,000 in 1994.
(12) FINANCIAL INSTRUMENTS
OFF-BALANCE SHEET RISK
The Company has contractual commitments arising in the ordinary course of business for securities loaned or purchased under agreements to sell, securities sold but not yet purchased, repurchase agreements, future purchases and sales of foreign currencies, securities transactions on a when-issued basis, options contracts, futures index contracts, commodities futures contracts, and underwriting. Each of these financial instruments and activities contains varying degrees of off-balance sheet risk whereby the market values of the securities underlying the financial instruments may be in excess of, or less than, the contract amount. The settlement of these transactions is not expected to have a material effect upon the Company's consolidated financial statements.
In the normal course of business, the Company had letters of credit outstanding aggregating $22,915,000 at December 31, 1996 to satisfy various collateral requirements in lieu of depositing cash or securities.
The Company has derivative financial instrument positions in foreign exchange forward contracts, option contracts, and index futures contracts and derivative positions in commodities futures contracts, all of which are measured at fair value with realized and unrealized gains and losses recognized in earnings. The foreign exchange forward contract positions are generally taken to lock in the dollar cost or proceeds of foreign currency commitments associated with unsettled foreign denominated securities purchases or sales. The average maturity of the forward contracts is generally less than two weeks. The option positions taken are generally part of a strategy in which offsetting equity positions are taken. Most of the index futures positions taken are commodity index futures and are part of a strategy in which offsetting positions in the underlying individual commodities futures are also taken.
The gross contracted or notional amount of index futures contracts, commodities futures contracts, options contracts, and foreign exchange forward contracts, which are not reflected in the consolidated statement of financial condition, is set forth in the table below and provide only a measure of the Company's involvement in these contracts at December 31, 1996 and 1995. They do not represent amounts subject to
JEFFERIES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DECEMBER 31, 1996 AND 1995
market risk and, in many cases, serve to reduce the Company's overall exposure to market and other risks (in thousands of dollars):
FAIR VALUE OF DERIVATIVE FINANCIAL INSTRUMENTS
The following is an aggregate summary of the average 1996 and 1995 and December 31, 1996 and 1995 fair values of derivative financial instruments (in thousands of dollars):
CREDIT RISK
In the normal course of business, the Company is involved in the execution, settlement and financing of various customer and principal securities transactions. Customer activities are transacted on a cash, margin or delivery-versus-payment basis. Securities transactions are subject to the risk of counterparty or customer nonperformance. However, transactions are collateralized by the underlying security, thereby reducing the associated risk to changes in the market value of the security through settlement date or to the extent of margin balances.
The Company seeks to control the risk associated with these transactions by establishing and monitoring credit limits and by monitoring collateral and transaction levels daily. The Company may require counterparties to deposit additional collateral or return collateral pledged. In the case of aged securities failed to receive, the Company may, under industry regulations, purchase the underlying securities in the market and seek reimbursement for any losses from the counterparty.
CONCENTRATION OF CREDIT RISK
As a major securities firm, the Company's activities are executed primarily with and on behalf of other financial institutions, including brokers and dealers, banks and other institutional customers. Concentrations of credit risk can be affected by changes in economic, industry or geographical factors. The Company seeks to
JEFFERIES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DECEMBER 31, 1996 AND 1995
control its credit risk and the potential risk concentration through a variety of reporting and control procedures, including those described in the preceding discussion of credit risk.
(13) NET CAPITAL REQUIREMENTS
As registered broker-dealers, Jefferies, ITG and W & D are subject to the Securities and Exchange Commission Uniform Net Capital Rule (Rule 15c3-1), which requires the maintenance of minimum net capital. Jefferies, ITG and W & D have elected to use the alternative method permitted by the Rule, which requires that they each maintain minimum net capital, as defined, equal to the greater of $250,000 or 2% of the aggregate debit balances arising from customer transactions, as defined.
At December 31, 1996, Jefferies', ITG Inc.'s and W & D's net capital was $54.4 million, $29.8 million and $950,000, respectively, which exceeded minimum net capital requirements by $50.8 million, $29.6 million and $700,000, respectively.
(14) CONTINGENCIES
In re Nasdaq Market-Makers Antitrust Litigation. Beginning in July 1994, antitrust class actions were commenced against Jefferies and 33 other defendants in various federal courts (the "Lawsuits"). Following the filing of the Lawsuits, the Antitrust Division of the United States Department of Justice ("DOJ") and the Securities and Exchange Commission ("SEC") commenced investigations into certain issues related to the allegations of the Lawsuits. In August 1996, the DOJ entered into a proposed antitrust consent decree with 24 defendants who are market makers in Nasdaq stocks. Jefferies was neither asked nor required to settle with the DOJ. The settlement has not yet been approved by the court. Shortly after the DOJ settlement, the SEC filed a Section 21(a) report against the NASD, criticizing various practices by market makers, and the NASD for failing to adequately police or discipline the market makers for those practices. However, the SEC did not take any action at that time against the market maker firms. Jefferies has been informed that the SEC is continuing its investigation of the market maker firms.
In October 1994, the Lawsuits were consolidated for discovery purposes in the United States District Court for the Southern District of New York. The consolidated complaint alleges that the defendants violated the antitrust laws by conspiring to fix the spread paid by plaintiffs and class members to trade in certain Nasdaq securities, by refusing to quote bids and asks in so-called odd-eighths. The cases purport to be brought on behalf of all persons who purchased or sold certain securities on the Nasdaq National Market System during the period May 1, 1989 to May 27, 1994. The plaintiffs seek damages in an unspecified amount.
In November 1996, the court granted, in part, the plaintiffs' motion to certify a class, and a motion to further define what types of purchasers and sellers of stock are included and not included in the definition of the certified class is pending before the court. Discovery will now proceed as appropriate. Jefferies denies any wrongdoing and intends to vigorously defend the Lawsuits. At this stage of the litigation, it is not possible to evaluate the likelihood of an unfavorable outcome or to estimate the amount or range of potential damages in the event of an adverse finding on the merits.
Other. Many aspects of the Company's business involve substantial risks of liability. In the normal course of business, the Company and its subsidiaries have been named as defendants or co-defendants in lawsuits involving primarily claims for damages. The Company's management believes that pending litigation will not have a material adverse effect on the Company.
JEFFERIES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) DECEMBER 31, 1996 AND 1995
(15) INITIAL PUBLIC OFFERING OF INVESTMENT TECHNOLOGY GROUP, INC.
The Company formed a new subsidiary (ITGI) in March 1994 for the purpose of holding 100% of the stock of ITG. ITGI provides automated securities trade execution and analysis services to institutional equity investors. In May 1994, ITGI issued 3,700,000 shares of common stock at $13 per share, in an initial public offering for net proceeds of $43.6 million ($48.1 million, less underwriting discounts and commissions of $3.4 million and offering expenses of $1.1 million). Following the offering, the Company owned over 80% of the outstanding common stock of ITGI.
In conjunction with the offering, certain management employment agreements, the ITG Performance Share Plan and non-compensatory ITG stock options were terminated on May 1, 1994 in exchange for $40.5 million, of which $900,000 was recorded as expense in 1994 prior to the offering and $9.4 million had been accrued at December 31, 1993. The remaining liability of $30.2 million was recorded as a plan termination expense at the time of the offering. A portion of the total plan termination payments amounting to $19.1 million was used to purchase 876,984 shares of Jefferies Group, Inc. common stock at $21.75 per share. The remaining $21.4 million of plan termination cost was to be paid in cash of which $20.6 million and $.8 million was paid during 1994 and 1995, respectively. Additionally, non-compensatory options to purchase 2,726,178 shares of ITGI common stock were granted to senior management and other employees at an exercise price equal to the initial public offering price.
The net proceeds from the offering of $43.6 million, less the ownership interest sold in the offering of $5.1 million and plan termination expenses of $30.2 million, resulted in a pretax gain of $8.3 million in 1994. The Company recorded deferred taxes as a result of the gain recognized from the offering.
ITEM 9.
ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
Information with respect to this item will be contained in the Proxy Statement for the 1997 Annual Meeting of Shareholders, which is incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION.
Information with respect to this item will be contained in the Proxy Statement for the 1997 Annual Meeting of Shareholders, which is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
Information with respect to this item will be contained in the Proxy Statement for the 1997 Annual Meeting of Shareholders, which is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
Information with respect to this item will be contained in the Proxy Statement for the 1997 Annual Meeting of Shareholders, which is incorporated herein by reference.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES AND REPORTS ON FORM 8-K.
All Schedules are omitted because they are not applicable or because the required information is shown in the financial statements or notes thereto.
(a)3. EXHIBITS
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* Filed herewith.
ALL OTHER EXHIBITS ARE OMITTED BECAUSE THEY ARE NOT APPLICABLE.
(b) No reports on Form 8-K have been filed by the Registrant.
(c) Index to Exhibits.
See list of exhibits at Item 14(a)3 above and exhibit following.
Exhibits 10.1 to and including 10.13 are management contracts or compensatory plans or arrangements.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
JEFFERIES GROUP, INC.
By: FRANK E. BAXTER ------------------------------------ Frank E. Baxter Chairman of the Board of Directors Dated: March 27, 1997
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons in the capacities and on the dates indicated.