ITEM 1. BUSINESS.
THE COMPANY
Salomon Smith Barney Holdings Inc. ("SSBH") operates through its subsidiaries in two business segments: (i) Investment Services and (ii) Asset Management. Salomon Smith Barney provides investment banking, securities and commodities trading, capital raising, asset management, advisory, research and brokerage services to its customers, other financial services and executes proprietary trading strategies on its own behalf. As used in this Form 10-K, unless the context otherwise requires, "Salomon Smith Barney" and the "Company" refer to SSBH and its consolidated subsidiaries.
In February 1999, the Company and The Nikko Securities Co., Ltd ("Nikko") formed a joint venture. Nikko Salomon Smith Barney Limited ("Nikko Salomon Smith Barney") provides investment banking, sales and trading and research services for corporate and institutional clients in Japan and other foreign jurisdictions. Nikko Salomon Smith Barney combines the Japanese institutional and corporate business of the Company with Nikko's domestic and international institutional and corporate business. Nikko's retail business and other activities, including asset management, will remain under Nikko's management. Nikko Salomon Smith Barney is headquartered in Tokyo and maintains offices and staff worldwide. Nikko Salomon Smith Barney is owned 51% by Nikko and 49% by the Company.
Citigroup Inc. ("Citigroup"), SSBH's parent, is a diversified holding company whose businesses provide a broad range of financial services to consumer and corporate customers around the world. Citigroup's activities are conducted through Global Consumer, Global Corporate and Investment Bank, Asset Management, and Investment Activities. The periodic reports of Citigroup provide additional business and financial information concerning that company and its consolidated subsidiaries.
The principal offices of the Company are located at 388 Greenwich Street, New York, New York 10013, telephone number (212) 816-6000. The Company was incorporated in Delaware in 1960.(1)
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(1) Certain items in this Form 10-K, including certain matters discussed under Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" (the "MD&A"), are forward- looking statements. The matters referred to in such statements could be affected by the risks and uncertainties involved in the Company's business, including the effect of economic and market conditions, the level and volatility of interest rates and currency values, the impact of current or pending legislation and regulation and the other risks and uncertainties detailed in "Outlook" in the MD&A. INVESTMENT SERVICES
Salomon Smith Barney is a global, full-service investment banking and securities brokerage firm with more than 514 offices in 26 countries worldwide. Salomon Smith Barney provides a full range of financial advisory, research and capital raising services to corporations, governments and individuals. The firm's 10,800 Financial Consultants, located in approximately 450 offices across the United States, service over 5.7 million client accounts, representing over $770 billion in assets.
INVESTMENT BANKING AND TRADING
Salomon Smith Barney's global investment banking services encompass a full range of capital market activities, including the underwriting and distribution of debt and equity securities for United States and foreign corporations and for state, local and other governmental and government sponsored authorities. The Company frequently acts as an underwriter or private placement agent in corporate and public securities offerings and provides alternative financing options. It also provides financial advice to investment banking clients on a wide variety of transactions including mergers and acquisitions, divestitures, leveraged buyouts, financial restructurings and a variety of cross-border transactions.
Salomon Smith Barney executes securities and commodity futures brokerage transactions on all major United States securities and futures exchanges and major international exchanges on behalf of customers and for its own account. The Company's significant capital base and extensive distribution capabilities also enable it to provide liquidity to investors across a broad range of markets and financial instruments, and to execute capital-intensive transactions on behalf of its customers and for its own account. It executes transactions in large blocks of exchange-listed stocks, usually with institutional investors, and often acts as principal to facilitate these transactions. It makes markets, buying and selling as principal, in over 1,329 equity securities traded on the NASDAQ system. Additionally, the firm makes markets in convertible and preferred stocks, warrants and other equity securities.
Salomon Smith Barney also engages in principal transactions in fixed income securities. Through its subsidiaries, it is a major dealer in government securities in New York, London, Frankfurt and Tokyo. Salomon Smith Barney makes inter-dealer markets and trades as principal in corporate debt and equity securities, including those of United States and foreign corporate issuers, United States and foreign government and agency securities, mortgage-related securities, whole loans, municipal and other tax-exempt securities, commercial paper and other money market instruments as well as emerging market debt securities and foreign exchange. It also enters into repurchase and reverse repurchase agreements to provide financing for itself and its customers, and engages in securities lending and borrowing transactions.
Salomon Smith Barney is a major participant in the over-the-counter ("OTC") market for derivative instruments involving a wide range of products, including interest rate, equity and
currency swaps, caps and floors, options, warrants and other derivative products. It also creates and sells various types of structured securities. The Company's ability to execute transactions is enhanced by its established presence in international capital markets, its use of information technology and quantitative risk management tools, its research capabilities, and its knowledge and experience in various derivative markets.
Salomon Smith Barney also trades for its own account in various markets throughout the world, and uses many different strategies involving a broad spectrum of financial instruments and derivative products. Historically, these trading strategies have primarily involved the fixed income securities of the G-7 countries, but they also involve the trading of fixed income securities globally (including emerging markets) as well as currencies and equities. Because these trading strategies are often designed with time horizons of one year or more, profits or losses reported in interim periods can be volatile and may not reflect the ultimate success or failure of these strategies. For a discussion of certain of the risks involved in Salomon Smith Barney's securities trading and investment activities, and the firm's strategies to manage these risks, see Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations."
RETAIL BROKERAGE AND RELATED SERVICES
The Private Client Division provides investment advice and financial planning and brokerage services for almost six million client accounts, primarily through the network of Salomon Smith Barney Financial Consultants. A significant portion of Salomon Smith Barney's revenues is generated from the commissions that it earns as a broker for its clients in the purchase and sale of securities. Financing customers' securities transactions through secured margin lending provides Salomon Smith Barney with an additional source of income. While credit losses may arise as a result of this financing activity, to date such losses have not been material. The Financial Consultants also sell proprietary mutual funds and a large number of mutual funds sponsored and managed by others, and Salomon Smith Barney receives commissions and other sales and services revenues from these activities.
Qualified Salomon Smith Barney Financial Consultants also offer individual insurance products, primarily variable annuities. Some of these products, such as Travelers Life and Annuity's Vintage Life(R) and Vintage Annuity(R), single premium variable annuity and universal life products, 401(k) Blueprint(R) and Travelers Target Maturity(R), a market value-adjusted fixed annuity, are manufactured by other subsidiaries of Citigroup.
The Company's Corporate Client Group provides retirement plan services and stock plan services to a wide variety of corporations. These services involve the management of defined benefit and defined contribution plan products such as 401(k) plans, as well as the provision of administrative and brokerage services for sponsors of and participants in stock option and other stock-based benefit plans.
In addition to more traditional brokerage services, Salomon Smith Barney Financial Consultants also deliver the programs and services offered by Salomon Smith Barney's Consulting Group
("CG"). CG sponsors a number of different "wrap fee" programs, in which CG and Salomon Smith Barney typically provide a range of services, such as an analysis of the client's financial situation, investment needs and risk tolerance; recommendations and ongoing monitoring of the performance and suitability of the investment manager(s) retained; and securities execution, custody, reporting and recordkeeping. In such programs, the client generally pays a single bundled fee for these services. CG also offers "wrap fee" programs in which separate accounts are managed by selected, specially trained Salomon Smith Barney Financial Consultants. Assets in the Financial Consultant managed programs at December 31, 1998, totaled $16.5 billion, as compared to $11.6 billion and $7.9 billion at year-end 1997 and 1996, respectively.
In addition, CG provides traditional investment management consulting services to institutions, including assisting clients in formulating investment objectives and policies and in selecting investment management firms for the day-to-day management of client portfolios. As of December 31, 1998, the Company provided consulting services with respect to externally managed client assets aggregating approximately $59.0 billion, excluding the TRAK(R) program described below, as compared to approximately $49.2 billion at December 31, 1997 and approximately $37.5 billion at December 31, 1996.
Salomon Smith Barney's TRAK(R) program provides clients with non-discretionary asset allocation advice based on the client's identification of investment objectives and risk tolerances. TRAK(R) clients include both individuals and institutions, including participant-directed 401(k) plans. Clients can choose to allocate assets among the CG Capital Markets funds, a series of 14 mutual funds each corresponding to a particular asset class and investment style, or from among the selected fund offerings of 40 no-load or load-waived mutual fund families (including Smith Barney proprietary funds) corresponding to the same asset class and investment style criteria. At December 31, 1998, TRAK(R) assets exceeded $12.8 billion, as compared to approximately $10.5 billion at December 31, 1997 and approximately $7.2 billion at December 31, 1996. Salomon Smith Barney also offers a separate offshore TRAK(R) program to non-resident alien clients, which includes client investment in a series of asset class/investment style funds domiciled outside the United States.
TRUST SERVICES
Certain subsidiaries of Citigroup are chartered as trust companies and provide a full range of fiduciary services with a particular emphasis on personal trust services. Another Citigroup subsidiary offers a broad range of trustee services for qualified retirement plans, with particular emphasis on the 401(k) plan market. Each of these trust companies is subject to supervision by either federal or state banking authorities, as appropriate based upon the jurisdiction in which such trust company is chartered, and uses the distribution network of Salomon Smith Barney to market its services. Salomon Smith Barney provides certain advisory and support services to the trust companies and receives fees for such services. Certain subsidiaries of SSBH also operate a private trust services business that is licensed as a bank and trust company in the Cayman Islands.
PHIBRO AND OTHER
Phibro conducts a global commodities dealer business through its principal offices in Westport (Connecticut), London and Singapore. Commodities traded include crude oil, refined oil products, natural gas, electricity, metals and various soft commodities. During 1998, Phibro continued its downsizing effort to significantly reduce the scope of some of its activities. Phibro makes extensive use of futures markets and is a participant in the OTC derivatives market. Its principal competitors are major integrated oil companies, other commodity trading companies, certain investment banks and other financial institutions.
As a dealer, Phibro's strategy is to focus on taking positions in commodities on a longer-term horizon while also engaging in counterparty flow business on a short-term basis. Phibro's operating results are subject to a high degree of volatility, particularly on a quarterly basis, due to the predominance of directional positions in commodities that have a longer-term horizon until realization. Thus, results are better evaluated over the longer term.
For a summary of the Company's operations by geographic area, see Note 7 of Notes to Consolidated Financial Statements.
DERIVATIVES AND RISK MANAGEMENT
Derivative instruments are contractual commitments or payment exchange agreements between counterparties that "derive" their value from some underlying asset, index, interest rate or exchange rate. The Company enters into various bilateral financial contracts involving future settlement, which are based upon a predetermined principal or par value (referred to as the "notional" amount). Such instruments include swaps, swap options, caps and floors, futures contracts, forward purchase and sale agreements, option contracts and warrants. Derivatives activities, like Salomon Smith Barney's other ongoing business activities, give rise to market, credit and operational risks, although the Company also uses derivative instruments to manage these risks in its other businesses. For a more complete discussion of Salomon Smith Barney's use of derivative financial instruments and certain of the related risks, see Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Notes 4, 5, 9, 17 and 18 of Notes to Consolidated Financial Statements.
COMPETITION
The businesses in which Salomon Smith Barney is engaged are highly competitive. The principal factors affecting competition in the investment banking and brokerage industry are the quality and ability of professional personnel and the relative prices of services and products offered. In addition to competition from other investment banking firms, both domestic and international, and securities brokerage companies and discount and on-line securities brokerage operations, including regional firms in the United States, there has been increasing competition from other sources, such as commercial banks, insurance companies and other major companies that have entered the investment banking and securities brokerage industry, in many cases
through acquisitions. Certain of those competitors may have greater capital and other resources than the Company.
ASSET MANAGEMENT
The Asset Management segment is comprised of two primary asset management business platforms: Salomon Brothers Asset Management and the Smith Barney Asset Management division of Salomon Smith Barney Inc. These companies offer a broad range of asset management products and services from global investment centers, including mutual funds, closed-end funds, managed accounts and unit investment trusts.
Clients include private and public retirement plans, endowments, foundations, banks, central banks, insurance companies, other corporations, government agencies, high net worth and other individuals. Client relationships may be introduced through the cross-marketing and distribution opportunities within the Citigroup structure, through Asset Management's own sales force or through independent sources.
The Company receives ongoing fees, generally stated as a percentage of the client's assets, from asset management clients. At December 31, 1998, client assets managed by Salomon Smith Barney Asset Management were approximately $186.0 billion, as compared to approximately $152.5 billion at December 31, 1997 and approximately $126.5 billion at December 31, 1996. These amounts include separately managed accounts with assets of approximately $68.3 billion at December 31, 1998, $54.1 billion at December 31, 1997 and $44.5 billion at December 31, 1996.
The following table shows the aggregate assets in, and number of, mutual funds managed by the Company at December 31 for each of the last three years.
SMITH BARNEY ASSET MANAGEMENT
At December 31, 1998, Smith Barney Asset Management sponsored 70 mutual funds (open-end investment companies), including taxable and tax-exempt money market funds, equity funds, taxable fixed income funds and tax-exempt fixed income funds sold primarily through Salomon Smith Barney Financial Consultants and the Primerica Financial Services sales force, affiliates of the Company. Smith Barney Asset Management also serves as the primary investment manager to twelve closed-end investment companies, the shares of which are listed for trading on one or more securities exchanges. In addition, at December 31, 1998, Smith Barney Asset Management managed 27 mutual fund portfolios serving as funding vehicles for variable annuity contracts, including certain variable annuities and other individual products of the Travelers Life and Annuity unit of Citigroup, which are sold by Salomon Smith Barney Financial Consultants. Smith Barney Asset Management also sponsors and manages 18 mutual funds domiciled outside the United States, which are offered to Salomon Smith Barney's non-resident alien client base as well as to the general public.
Smith Barney Asset Management also provides separate account discretionary and non-discretionary investment management services to a wide variety of individual and institutional clients, including private and public retirement plans, endowments, foundations, banks, central banks, insurance companies, other corporations and governmental agencies. Client relationships may be introduced either through Salomon Smith Barney's network of Financial Consultants or independently of that network.
Smith Barney Asset Management also sponsors and oversees the portfolios of a large number of unit investment trusts, which are unmanaged investment companies, the portfolios of which are generally static. Such unit investment trusts may hold domestic and foreign equity and debt securities, including municipal bonds. Certain trusts are sponsored and overseen solely by Smith Barney Asset Management; other trusts are jointly sponsored through a syndicate of major broker-dealers of which Smith Barney is a member. At December 31, 1998, outstanding unit trust assets held by Smith Barney's clients were approximately $13.2 billion, as compared to approximately $11.8 billion at December 31, 1997 and approximately $8.6 billion at December 31, 1996.
SALOMON BROTHERS ASSET MANAGEMENT
Salomon Brothers Asset Management provides separate account discretionary and non-discretionary investment management services to pension funds, investment companies, endowments, foundations, banks, central banks, insurance companies, other corporations, governmental agencies and individuals. Client relationships may be introduced through traditional independent consultant evaluations as well as through the individual and institutional client relationships of the Company's broker-dealer subsidiaries.
At December 31, 1998, Salomon Brothers Asset Management sponsored 16 mutual funds, including taxable and tax-exempt money market funds, equity funds, taxable fixed income funds
and tax-exempt fixed income funds sold primarily through dealer agreements with a variety of national and regional brokerage firms, including Salomon Smith Barney Inc. Salomon Brothers Asset Management serves as investment manager to these mutual funds, as well as to 5 mutual portfolios serving as funding vehicles for variable annuity contracts as well as to 11 closed-end investment companies, the shares of which are listed for trading on one or more securities exchanges. Salomon Brothers Asset Management also manages 15 mutual funds domiciled outside the United States, which are offered to Salomon Smith Barney's non-resident alien client base as well as to the general public.
COMPETITION
Competitors of the mutual funds and asset management groups include a large number of mutual fund management and sales companies, asset management firms and banks. Competition in mutual fund sales and investment management is based on investment performance, service to clients and product design.
OTHER INFORMATION
REGULATION
Certain of SSBH's subsidiaries are subject to various securities and commodities regulations and capital adequacy requirements promulgated by the regulatory and exchange authorities of the jurisdictions in which they operate. Some subsidiaries are registered as broker-dealers and as investment advisers with the U.S. Securities and Exchange Commission (the "SEC") and as futures commission merchants and as commodity pool operators with the Commodity Futures Trading Commission ("CFTC"). Certain of SSBH's subsidiaries are also members of the New York Stock Exchange, Inc. (the "NYSE") and other principal United States securities exchanges, as well as the National Association of Securities Dealers, Inc. ("NASD") and the National Futures Association ("NFA"), a not-for-profit membership corporation designated as a registered futures association by the CFTC. The Company's primary broker-dealer subsidiaries, Salomon Smith Barney Inc. ("SSB") and The Robinson-Humphrey Company, LLC ("R-H"), are registered as broker-dealers in all 50 states, the District of Columbia and Puerto Rico, and in addition are registered as investment advisers in certain states that require such registration. SSB is also a registered broker-dealer in Guam. SSB is also a reporting dealer to the Federal Reserve Bank of New York and a member of the principal United States futures exchanges. SSB and R-H are subject to extensive regulation, primarily for the benefit of their customers, including minimum capital requirements, which are promulgated and enforced by, among others, the SEC, the CFTC, the NFA, the NYSE, various self-regulatory organizations of which these subsidiaries are members and the securities administrators of the 50 states, the District of Columbia and Puerto Rico and, in the case of SSB, Guam. The SEC and the CFTC also require certain registered broker-dealers (including SSB) to maintain records concerning certain financial and securities activities of affiliated companies that may be material to the broker-dealer, and to file certain financial and other information regarding such affiliated companies.
Salomon Smith Barney's operations abroad are conducted through various subsidiaries, principally Salomon Brothers International Limited ("SBIL") in London, Nikko Salomon Smith Barney in Tokyo and Salomon Brothers AG ("SBAG") in Frankfurt. Its activities in the United Kingdom, which include investment banking, trading, brokerage and asset management services, are subject to the Financial Services Act 1986, which regulates organizations that conduct investment businesses in the United Kingdom (including imposing capital and liquidity requirements), and to the rules of the Securities and Futures Authority and the Investment Management Regulatory Organisation. Nikko Salomon Smith Barney is a registered foreign securities company in Japan and, as such, its activities in Japan are subject to Japanese law applicable to non-Japanese securities firms and are regulated by the Japanese Ministry of Finance and Financial Supervisory Agency. SBAG is a German bank, principally engaged in securities trading and investment banking and is regulated by Germany's Banking Supervisory Authority. These and other subsidiaries of SSBH are also members of various securities and commodities exchanges and are subject to the rules and regulations of those exchanges. Salomon Smith Barney's other offices are also subject to the jurisdiction of local financial services regulatory authorities.
In connection with the mutual funds business, SSBH and its subsidiaries must comply with regulations of a number of regulatory agencies and organizations, including the SEC, the NASD and regulatory agencies in the United Kingdom and Germany. SSBH is the direct or indirect parent of investment advisers registered and regulated under the Investment Advisers Act of 1940 and the Investment Company Act of 1940. Under those Acts, the advisory contracts between SSBH's investment adviser subsidiaries and the mutual funds they serve ("Affiliated Funds") would automatically terminate upon an assignment of such contracts by the investment adviser. Such an assignment would be presumed to have occurred if any party were to acquire more than 25% of Citigroup's voting securities. In that event, consent to the assignment from the shareholders of the Affiliated Funds involved would be needed for the advisory relationships to continue. In addition, the Company's registered investment advisers and the Affiliated Funds are subject to certain restrictions in their dealings with each other. For example, SSB may act as broker to an Affiliated Fund in a transaction involving an exchange-traded security only when that fund maintains procedures that govern, among other things, the execution price of the transaction and the commissions paid; it may not, however, conduct principal transactions with an Affiliated Fund. Further, an Affiliated Fund may acquire securities during the existence of an underwriting where SSB is a principal underwriter only in certain limited situations.
SSB and R-H are members of the Securities Investor Protection Corporation ("SIPC"), which, in the event of liquidation of a broker-dealer, provides protection for customers' securities accounts held by the firm of up to $500,000 for each eligible customer, subject to a limitation of $100,000 for claims for cash balances. In addition, SSBH has purchased additional coverage of up to $150 million for eligible customers, approximately $50 million of which is from a subsidiary of Citigroup.
Citigroup, SSBH's parent, is a bank holding company subject to the Bank Holding Company Act of 1956 (the "BHCA"). For a discussion of the BHCA and its application to the Company, see Note 2 of Notes to Consolidated Financial Statements.
President Clinton's recent budget proposal (the "Budget Proposal") contains a number of tax provisions that could adversely impact Salomon Smith Barney, for example, provisions relating to tax-exempt interest obligations. The Budget Proposal, which is in its early stages of consideration, has not yet been introduced as part of any legislation in Congress. It is unclear which if any of the President's proposals will become law.
Capital Requirements
As registered broker-dealers, SSB and R-H are subject to the SEC's net capital rule, Rule 15c3-1 (the "Net Capital Rule"), promulgated under the Exchange Act. These companies compute net capital under the alternative method of the Net Capital Rule, which requires the maintenance of minimum net capital, as defined. A member of the NYSE may be required to reduce its business if its net capital is less than 4% of aggregate debit balances (as defined) and may also be prohibited from expanding its business or paying cash dividends if resulting net capital would be less than 5% of aggregate debit balances. Furthermore, the Net Capital Rule does not permit withdrawal of equity or subordinated capital if the resulting net capital would be less than 5% of such debit balances.
The Net Capital Rule also limits the ability of broker-dealers to transfer large amounts of capital to parent companies and other affiliates. Under the Net Capital Rule, equity capital cannot be withdrawn from a broker-dealer without the prior approval of the SEC in certain circumstances, including when net capital after the withdrawal would be less than (i) 120% of the minimum net capital required by the Net Capital Rule, or (ii) 25% of the broker-dealer's securities position "haircuts," i.e., deductions from capital of certain specified percentages of the market value of securities to reflect the possibility of a market decline prior to disposition. In addition, the Net Capital Rule requires broker-dealers to notify the SEC and the appropriate self- regulatory organization two business days before a withdrawal of excess net capital if the withdrawal would exceed the greater of $500,000 or 30% of the broker-dealer's excess net capital, and two business days after a withdrawal that exceeds the greater of $500,000 or 20% of excess net capital. Finally, the Net Capital Rule authorizes the SEC to order a freeze on the transfer of capital if a broker-dealer plans a withdrawal of more than 30% of its excess net capital and the SEC believes that such a withdrawal would be detrimental to the financial integrity of the firm or would jeopardize the broker-dealer's ability to pay its customers.
Compliance with the Net Capital Rule could limit those operations of the Company that require the intensive use of capital, such as underwriting and trading activities and the financing of customer account balances, and also could restrict SSBH's ability to withdraw capital from its broker-dealer subsidiaries, which in turn could limit SSBH's ability to pay dividends and make payments on its debt.
SSB had net capital, computed in accordance with the Net Capital Rule, of $3.195 billion, which exceeded the minimum net capital requirement by $2.841 billion. For further discussion of capital requirements related to the Company's principal regulated subsidiaries, see Note 12 of Notes to Consolidated Financial Statements.
GENERAL BUSINESS FACTORS
In the judgment of the Company, no material part of the business of the Company and its subsidiaries is dependent upon a single customer or group of customers, the loss of any one of which would have a materially adverse effect on the Company, and no one customer or group of affiliated customers accounts for as much as 10% of the Company's consolidated revenues.
At December 31, 1998, the Company had approximately 34,930 full-time and 1,363 part-time employees.
SOURCE OF FUNDS
For a discussion of the Company's sources of funds and maturities of the long-term debt of the Company and its subsidiaries, see Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources," and Notes 8 and 9 of Notes to Consolidated Financial Statements.
TAXATION
For a discussion of tax matters affecting the Company and its operations, see Note 14 of Notes to Consolidated Financial Statements.
ITEM 2.
ITEM 2. PROPERTIES.
The Company's principal executive offices are located in New York City. In addition, the Company owns two office buildings in New York City, which total approximately 627,000 square feet. The Company also owns an office building in Rutherford, New Jersey, totaling approximately 249,000 square feet and an office building in Tampa, Florida, totaling approximately 135,000 square feet. In addition, the Company owns an office building in London, England, that contains approximately 212,760 net square feet. The building is subject to a mortgage that becomes due in 2007, but which may be prepaid without premium at any time with notice. Most of the Company's other offices are located in leased premises, the leases for which expire at various times.
The Company leases two buildings located at 388 and 390 Greenwich Street, New York and totaling approximately 2,300,000 square feet, through March, 2003. The Company has a purchase option with respect to these properties. The Company also leases approximately 1,018,000 square feet of office space at Seven World Trade Center in New York City, through 2010.
The Company believes that these facilities are adequate for the purposes for which they are used and are well maintained. For further information concerning leases, see Note 10 of Notes to Consolidated Financial Statements.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
This section describes the major pending legal proceedings, other than ordinary routine litigation incidental to the business, to which the Company or its subsidiaries is a party or to which any of their property is subject.
In September 1992, Harris Trust and Savings Bank (as trustee for Ameritech Pension Trust ("APT"), Ameritech Corporation, and an officer of Ameritech filed suit against Salomon Brothers Inc. ("SBI") and Salomon Brothers Realty Corporation ("SBRC") in the U.S. District Court for the Northern District of Illinois (Harris Trust Savings Bank, not individually but solely as trustee for the Ameritech Pension Trust, Ameritech Corporation and John A. Edwardson v. Salomon Brothers Inc and Salomon Brothers Realty Corp.). The second amended complaint alleges that three purchases by APT from defendants of participation interests in net cash flow or resale proceeds of three portfolios of motels owned by Motels of America, Inc. ("MOA"), as well as a fourth purchase by APT of a similar participation interest with respect to a portfolio of motels owned by Best Inns, Inc. ("Best"), violated the Employee Retirement Income Security Act ("ERISA"), and that the purchase of the participation interests for the third MOA portfolio and for the Best portfolio violated the Racketeer Influenced and Corrupt Organization Act ("RICO") and state law. SBI had acquired the participation interests in transactions in which it purchased as principal mortgage notes issued by MOA and Best to finance purchases of motel portfolios; 95% of three such interests and 100% of one such interest were sold to APT for purchase prices aggregating approximately $20.9 million. Plaintiffs' second amended complaint seeks (a) judgment on the ERISA claims for the purchase prices of the four participation interests (approximately $20.9 million), for rescission and for disgorgement of profits, as well as other relief, and (b) judgment on the claims brought under RICO and state law in the amount of $12.3 million, with damages trebled to $37 million on the RICO claims and punitive damages in excess of $37 million on certain of the state law claims as well as other relief. The court dismissed the RICO, breach of contract, and unjust enrichment claims. The court also found that defendants did not qualify as an ERISA fiduciary and dismissed the claims based on that allegation. Defendants moved for summary judgment on the sole remaining claim. The motion was denied, and defendants appealed to the U.S. Court of Appeals for the Seventh Circuit. Defendants are awaiting a decision.
Both the Department of Labor and the Internal Revenue Service have advised SBI that they were or are reviewing the transactions in which APT acquired such participation interests. With respect to the Internal Revenue Service review, SSBH, SBI and SBRC have consented to extensions of time for the assessment of excise taxes that may be claimed to be due with respect to the transactions for the years 1987, 1988 and 1989. In August 1996, the IRS sent SSBH, SBI and SBRC what appeared to be draft "30-day letters" with respect to the transactions and SSBH, SBI and SBRC were given an opportunity to comment on whether the IRS should issue 30-day
letters, which would actually commence the assessment process. In October 1996, SSBH, SBI and SBRC submitted a memorandum setting forth reasons why the IRS should not issue 30-day letters with respect to the transactions.
In December 1996, a complaint seeking unspecified monetary damages was filed by Orange County, California against numerous brokerage firms, including Smith Barney, in the U.S. Bankruptcy Court for the Central District of California (County of Orange et al. v. Bear Stearns & Co. Inc. et al.). Plaintiff alleges, among other things, that defendants recommended and sold to plaintiff unsuitable securities and that such transactions were outside the scope of plaintiff's statutory and constitutional authority (ultra vires). Defendants' motion for summary judgment was granted with respect to the ultra vires claims in February 1999. The court allowed the filing of an amended complaint asserting claims based on alleged breaches of fiduciary duty.
In June 1998, complaints were filed in the U.S. District Court for the Eastern District of Louisiana in two actions (Board of Liquidations, City Debt of the City of New Orleans v. Smith Barney Inc. et ano. and The City of New Orleans v. Smith Barney Inc. et ano.), in which the City of New Orleans seeks a declaratory judgment that Smith Barney Inc. and another underwriter are responsible for any damages that the City may incur in the event the Internal Revenue Service denies tax exempt status to the City's General Obligation Refunding Bonds Series 1991. The Company filed a motion to dismiss the complaints in September 1998, and the complaints were subsequently amended. The Company has filed a motion to dismiss the amended complaints.
In November 1998, a purported class action complaint was filed in the United States District Court for the Middle District of Florida (Dwight Brock as Clerk for Collier County v. Merrill Lynch, et al.). The complaint alleges that, pursuant to a nationwide conspiracy, 17 broker-dealer defendants, including SSB, charged excessive mark-ups in connection with advanced refunding transactions. The Company intends to contest this complaint vigorously.
ENVIRONMENTAL MATTERS
In July 1996, the City and County of Denver ("Denver") enacted an ordinance imposing a substantial fee on any radioactive waste or radium-contaminated material disposed of in the City of Denver. Under this ordinance, Denver assessed a subsidiary of Salomon, the S.W. Shattuck Chemical Company, Inc. ("Shattuck"), $9.35 million for certain disposal already carried out. Shattuck sued to enjoin imposition of the fee on constitutional grounds. The United States also sued, seeking to enjoin imposition of the fee on constitutional grounds. Denver counterclaimed and moved to add SSBH as a defendant for past costs. These cases have been consolidated before the U.S. District Court in Colorado, which granted Shattuck's motion for a preliminary injunction enjoining Denver from enforcing the ordinance during the pendency of the litigation. The parties have reached a settlement.
The Company and various subsidiaries have also been named as defendants in various matters incident to and typical of the businesses in which they are engaged. These include numerous civil actions, arbitration proceedings and other matters in which the Company's broker-dealer subsidiaries have been named, arising in the normal course of business out of activities as a
broker and dealer in securities, as an underwriter of securities, as an investment banker or otherwise. In the opinion of the Company's management, none of these actions is expected to have a material adverse effect on the consolidated financial condition of the Company and its subsidiaries.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
Pursuant to General Instruction I of Form 10-K, the information required by Item 4 is omitted.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
All of the outstanding common stock of the Company is owned by Citigroup.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA.
Pursuant to General Instruction I of Form 10-K, the information required by Item 6 is omitted.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
In 1998, the Company recorded income from continuing operations, including the Citigroup restructuring charge and credits relating to the restructuring charge booked in the fourth quarter of 1997, of $818 million compared to $1,145 million and $1,865 million for the years ended December 31, 1997 and 1996, respectively. Income from continuing operations in 1997 includes the restructuring charge booked in connection with the merger of Salomon and Smith Barney (see Notes 1 and 2 to the consolidated financial statements for further discussion of the restructuring charges). Revenues, net of interest expense were $9.2 billion in 1998 compared to $10.9 billion and $10.7 billion in 1997 and 1996, respectively.
Gain on sale of subsidiaries and affiliates in 1996 includes a pre-tax gain of $48 million related to the sale of the Company's indirect wholly owned subsidiary The Mortgage Corporation Limited, which originated and serviced residential mortgages in the United Kingdom. This gain has not been allocated to either of the Company's operating segments.
The Company's 1996 results also reflect losses from discontinued operations, including a $290 after-tax loss related to the sale of Basis Petroleum. As discussed in the "Discontinued Operations" section that follows, Basis Petroleum is reflected as a discontinued operation in this report.
Following is a discussion of the results of operations of the Company's two operating segments, Investment Services and Asset Management.
RESULTS OF OPERATIONS
INVESTMENT SERVICES
The Company's investment services segment recorded income from continuing operations for 1998, including the Citigroup restructuring charge and the credits related to the restructuring charge booked in the fourth quarter of 1997, of $566 million compared to $937 million and $1,659 million for the years ended December 31, 1997 and 1996, respectively. Income from continuing operations in 1997 includes the restructuring charge booked in connection with the merger of Salomon and Smith Barney (see Notes 1 and 2 to the consolidated financial statements for further discussion of the restructuring charges).
Revenues, net of interest in 1998 declined 18% to $8.3 billion, primarily due to a decline in principal transaction revenue from fixed income and global arbitrage activities offset to an extent by increases in commissions, asset management and administration fees and investment banking revenues. Revenues, net of interest in 1997 were $10.2 billion, a 2% improvement over the $10.0 billion in 1996, primarily reflecting increases in commissions and asset management and administration fees, offset by a decline in principal transaction revenues from fixed income trading and the global arbitrage business.
Commission revenues increased 8% in 1998 to $3.2 billion, from $3.0 billion in 1997 and $2.6 billion in 1996. The 1998 and 1997 increases reflect growth in sales of listed and over-the-counter ("OTC") securities. The 1997 results also reflect higher commissions from mutual funds activity, as well as increased insurance and annuity sales.
Investment banking revenues were $2.28 billion in 1998 compared to $2.08 billion in 1997 and $1.98 billion in 1996. The increases in 1998 and 1997 reflect revenue growth in unit trust, public finance, and high grade debt underwritings, and mergers and acquisitions. This was offset somewhat by a decline in equity underwritings. Investment banking revenues in 1998 were favorably impacted by an increase in private placement fees, offset by a decline in high yield underwritings. Investment banking revenues in 1997 were also favorably impacted by increased high yield underwriting revenues. For 1998, the Company was ranked #1 in the industry in municipal underwritings, and #2 in domestic and #3 in global debt and equity underwriting, according to Securities Data Corp.
Principal transaction revenues declined to a loss of ($116) million in 1998. Decreases in fixed income trading results include losses due to risk reductions in the U.S. fixed income arbitrage business, and losses in other global arbitrage. These decreases were offset to an extent by an increase in equity trading results. Fixed income trading results were adversely impacted by significant dislocations in the global fixed income markets, including greatly reduced liquidity and widening credit spreads. Also included in fixed income results are Russian-related credit losses. In 1997 principal transaction revenues decreased to $2.5 billion compared to $3.0 billion in 1996. This was the result of a decrease in long-term fixed income trading strategies, partially offset by an increase in customer sales and trading. Also contributing to the 1997 decline was increased volatility in the global equity markets and a loss on risk arbitrage positions in British Telecommunications PLC and MCI Communications Corporation, partially offset by improved results in long-term equity strategies.
Asset management and administration fees were $1.31 billion in 1998 compared to $997 million in 1997 and $777 million in 1996. The investment services segment includes results from assets managed by the Company's Financial Consultants as well as assets that are externally managed by the consulting group. Assets under fee-based management in these two categories increased significantly over the three-year period, causing the corresponding increase in revenue.
Total assets under fee-based management were as follows:
- --------------- * Related results included in Investment Services segment.
Total noninterest expenses, excluding the net restructuring charge relating to the merger of Salomon and Smith Barney and the Citigroup restructuring charge, were $7.7 billion in 1998 compared to $7.9 billion in 1997 and $7.3 billion in 1996. Total expenses were relatively unchanged in 1998 while the 8% increase in 1997 primarily reflects an increase in production-related compensation and benefits expense, reflecting increased revenues as well as higher floor brokerage and other production-related costs. The Company continues to maintain its focus on controlling fixed expenses.
ASSET MANAGEMENT
The asset management segment revenues net of interest expense rose 19% to $904 million in 1998 compared to $760 million in 1997 and $637 million in 1996. The primary revenue component for the asset management segment is asset management and administration fees, which were $857 million in 1998, compared to $718 million in 1997 and $613 million in 1996. The 19% overall increase in 1998 fees reflects broad growth in all asset management products, led by a 27% increase in revenues from separately managed accounts and an 18% increase in money market and long-term mutual fund fees. Assets under management for the segment reached $186 billion at the end of 1998, a 22% increase over 1997 (see table on preceding page for detail of the segment's assets under fee-based management). This increase includes the mid-year acquisition of JP Morgan's Australian asset management business with $5 billion in assets under management. Other revenues include the net revenue contribution to the asset management segment for the structuring of unit investment trusts.
Total noninterest expenses were $487 million in 1998 compared to $415 million in 1997 and $376 million in 1996. The 17% increase in 1998 and 10% increase in 1997 reflect continuing investments in the portfolio management and sales and marketing infrastructure of the asset management segment to support sustained business growth.
OUTLOOK
The Company's business is significantly affected by the levels of activity in the securities markets, which in turn are influenced by the level and trend of interest rates, the general state of the global economy and the national and worldwide political environments, among other factors.
DISCONTINUED OPERATIONS
In March 1997, the Board of Directors of Salomon Inc approved a non-binding letter of intent to sell all of the outstanding stock of Basis Petroleum, the Company's oil refining and marketing business, to Valero Energy Corporation and a plan of disposition for Basis. Consequently, the Company recorded an after-tax loss of $290 million in the fourth quarter of 1996. For a description of the terms of the sale see Note 6 to the consolidated financial statements.
In 1996, Basis and Howell Corporation contributed their respective crude oil gathering, marketing and transportation activities to form Genesis Energy, L.P. ("Genesis"). The Company's investment in Genesis was not transferred to Valero.
Basis Petroleum had an after-tax operating loss of $75 million in 1996. Basis' 1996 results included an after-tax gain of $37 million ($60 million pretax) related to a Genesis public offering and an after-tax gain of $14 million ($23 million pretax) related to the reduction of its minimum physical inventories needed to support its refining operations. In addition, 1996 results include an after-tax charge of $13 million ($22 million pretax) related to the shutdown of Basis' chemical processing facility in Houston.
CAPITAL AND LIQUIDITY MANAGEMENT
Capital is an expensive resource. To maximize the return on equity, it is essential that the Company deploy its capital in an efficient manner. Liquidity management is integral to capital management and is especially critical for a financial institution such as the Company. Access to funding must be assured under all market conditions. The confidence of creditors and counterparties in the Company's ability to perform pursuant to its contractual obligations is important to the Company's continued success.
LIQUIDITY AND CAPITAL RESOURCES
The Company's total assets were $212 billion at December 31, 1998, down from $277 billion at year-end 1997. Due to the nature of the Company's trading activities, including its matched book activities, it is not uncommon for the Company's asset levels to fluctuate from period to period. A "matched book" transaction involves a security purchased under an agreement to resell (i.e., reverse repurchase transaction) and simultaneously sold under an agreement to repurchase (i.e., repurchase transaction). Financial instruments and commodities owned and contractual commitments declined during 1998 as a result of decreased inventory positions in U.S. and Non-U.S. government and agency securities. These declines can, in large part, be attributed to the risk reduction in the Company's global arbitrage businesses.
The Company's balance sheet is highly liquid, with the vast majority of its assets consisting of marketable securities and collateralized short-term financing agreements arising from securities transactions. The highly liquid nature of these assets provides the Company with flexibility in financing and managing its business. The Company monitors and evaluates the adequacy of its capital and borrowing base on a daily basis in order to allow for flexibility in its funding, to maintain liquidity, and to ensure that its capital base supports the regulatory capital requirements of its subsidiaries.
The Company funds its operations through the use of collateralized and uncollateralized short-term borrowings, long-term borrowings, mandatorily redeemable securities of subsidiary trusts, and its equity. Collateralized short-term financing, including repurchase agreements and secured loans, is the Company's principal funding source. Such borrowings are reported net by counterparty, when applicable, pursuant to the provisions of Financial Accounting Standards Board Interpretation 41, Offsetting of Amounts Related to Certain Repurchase and Reverse Repurchase Agreements ("FIN 41"). Excluding the impact of FIN 41, short-term collateralized borrowings totaled $121.8 billion at December 31, 1998. Uncollateralized short-term borrowings provide the Company with a source of short-term liquidity and are also utilized as an alternative to secured financing when they represent a cheaper funding source. Sources of short-term uncollateralized borrowings include commercial paper, unsecured bank borrowings and letters of credit, deposit liabilities, promissory notes and corporate loans. Short-term uncollateralized borrowings totaled $12.9 billion at December 31, 1998.
The Company has committed uncollateralized revolving lines of credit totaling $5.0 billion, which it may borrow from at various interest rate options (LIBOR, CD or base rate), and compensates the banks for the facilities through facility fees. At December 31, 1998 there were no outstanding borrowings under these facilities. Under these facilities the Company is required to maintain a certain level of consolidated adjusted net worth (as defined in the agreement). At December 31, 1998, this requirement was exceeded by approximately $2.8 billion. The Company also has substantial borrowing arrangements consisting of facilities that the Company has been advised are available, but where no contractual lending obligation exists. These arrangements are reviewed on an ongoing basis to ensure flexibility in meeting the Company's short-term requirements.
Unsecured term debt is a significant component of the Company's long-term capital. Term debt totaled $20.2 billion at December 31, 1998, compared with $19.1 billion at December 31, 1997. The Company utilizes interest rate swaps to convert the majority of its fixed rate term debt used to fund inventory-related working capital requirements into variable rate obligations. Term debt issuances denominated in currencies other than the U.S. dollar that are not used to finance assets in the same currency are effectively converted to U.S. dollar obligations through the use of cross-currency swaps and forward currency contracts. The average remaining maturity of the Company's term debt was 4.0 years at December 31, 1998 and 3.7 years at December 31, 1997. See Note 9 to the consolidated financial statements for additional information regarding term debt and an analysis of the impact of interest rate swaps on term debt.
In July 1996, the Company issued $345 million of mandatorily redeemable securities of subsidiary trusts, which pay interest and fees at an annual rate of 9.50%. In January 1998, the Company issued $400 million of mandatorily redeemable securities of subsidiary trusts, which pay interest at an annual rate of 7.20%. For a detailed description of these securities see Note 11 to the consolidated financial statements.
The Company's borrowing relationships are with a broad range of banks, financial institutions and other firms from which it draws funds. The volume of the Company's borrowings generally fluctuates in response to changes in the level of the Company's financial instruments, commodities and contractual commitments, customer balances, the amount of reverse repurchase transactions outstanding and securities borrowed transactions. As the Company's activities increase, borrowings generally increase to fund the additional activities. Availability of financing to the Company can vary depending upon market conditions, credit ratings, and the overall availability of credit to the securities industry. The Company seeks to expand and diversify its funding mix as well as its creditor sources. Concentration levels for these sources, particularly for short-term lenders, are closely monitored both in terms of single investor limits and daily maturities.
The Company monitors liquidity by tracking asset levels, collateral and funding availability to maintain flexibility to meet its financial commitments. As a policy, the Company attempts to maintain sufficient capital and funding sources in order to have the capacity to finance itself on a fully collateralized basis in the event that the Company's access to uncollateralized financing is temporarily impaired. The Company's liquidity management process includes a contingency
funding plan designed to ensure adequate liquidity even if access to unsecured funding sources is severely restricted or unavailable. This plan is reviewed periodically to keep the funding options current and in line with market conditions. The management of this plan includes an analysis used to determine the Company's ability to withstand varying levels of stress, which could impact its liquidation horizons and required margins. In addition, the Company monitors its leverage and capital ratios on a daily basis.
Other
High Yield Portfolio
The Company's activities include trading securities that are less than investment grade, characterized as "high yield." High yield securities include corporate debt, convertible debt, preferred and convertible preferred equity securities rated lower than "triple B-" by internationally recognized rating agencies, unrated securities with market yields comparable to entities rated below "triple B-," as well as sovereign debt issued by certain countries in currencies other than their local currencies and which are not collateralized by U.S. government securities. For example, high yield securities exclude the collateralized portion of the Company's holdings of "Brady Bonds," but include such securities to the extent they are not collateralized. The Company's trading portfolio of high yield securities owned is carried at market or fair value and totaled $4.8 billion and $6.8 billion at December 31, 1998 and 1997, respectively; the largest high yield exposure to one counterparty was $716 million and $785 million at December 31, 1998 and 1997, respectively.
Other
At December 31, 1998, the Company had mark-to-market exposure to hedge funds of $1,853 million, collateralized by $1,859 million of cash and government securities, resulting in excess collateral of $6 million. Within these amounts, certain hedge funds have collateral in excess of the mark-to-market deficit, and others have deficits in excess of the collateral held. The total exposure to hedge funds with mark-to-market deficits in excess of collateral held is $36 million. No single hedge fund had a mark-to-market deficit of more than $14 million in excess of collateral held from that hedge fund. Mark-to-market exposure includes those hedge funds that owe the Company on foreign exchange and derivative contracts such as swaps, swap options, and other over-the-counter options and only the uncollateralized portion of receivables on reverse repurchase and repurchase agreements. This exposure can change significantly as a result of extreme market movements. The Company has no unsecured loans or loan commitments to hedge funds. During 1998, the Company made an investment of $300 million in Long-Term Capital Management, LP, a hedge fund, in concert with a consortium of banks and securities firms.
DERIVATIVE INSTRUMENTS
Derivatives are an integral element of the world's financial and commodity markets. Globalization of economic activity has brought more market participants in contact with foreign exchange and interest rate risk at a time when market volatility has increased. The Company has developed many techniques using derivatives to enhance the efficiency of capital and trading risk management.
DERIVATIVE INSTRUMENTS -- OVERVIEW
Derivative instruments are contractual commitments or payment exchange agreements between counterparties that "derive" their value from some underlying asset, index, interest rate or exchange rate. The markets for these instruments have grown tremendously over the past decade. A vast increase in the types of derivative users and their motivations in using these products has resulted in an expansion of geographic coverage, transaction volume and liquidity, and the number of underlying products and instruments.
Derivatives have been used quite successfully by multinational corporations to hedge foreign currency exposure, by financial institutions to manage gaps in maturities between assets and liabilities, by investment companies to reduce transaction costs and take positions in foreign markets without assuming currency risk, and by non-financial companies to fix the prices of inputs into the manufacturing process or prices of the products they sell. Derivatives are also used by investors when, considering such factors as taxes, regulations, capital, and liquidity, they provide the most efficient means of taking a desired market position. These are just a few of the business objectives for which derivatives are used. The list of objectives is large and continues to grow.
Derivatives are accounted for and settled differently than cash instruments and their use requires special management oversight. Such oversight should ensure that management understands the transactions to which it commits the firms and that the transactions are executed in accordance with sensible corporate risk policies and procedures.
Derivatives activities, like the Company's other ongoing business activities, give rise to market, credit, and operational risks. Market risk represents the risk of loss from adverse market price movements. While market risk relating to derivatives is clearly an important consideration for intermediaries such as the Company, such risk represents only a component of the Company's overall market risk, which arises from activities in non-derivative instruments as well. Consequently, the scope of the Company's market risk management procedures extends beyond derivatives to include all financial instruments and commodities. Credit risk is the loss that the Company would incur if counterparties failed to perform pursuant to their contractual obligations. While credit risk is not a principal consideration with respect to exchange-traded instruments, it is a major factor with respect to non-exchange-traded OTC instruments. Whenever possible, the Company uses industry master netting agreements to reduce aggregate credit exposure. Swap and foreign exchange agreements are documented utilizing counterparty
master netting agreements supplemented by trade confirmations. Over the past several years, the Company has enhanced the funding and risk management of its derivatives activities through the increased use of bilateral security agreements. The Company, in particular, has been an industry leader in promoting the use of this risk reduction technique. Based on notional amounts, at both December 31, 1998 and 1997 approximately 90% of the Company's swap portfolio was subject to the bilateral exchange of collateral. This initiative, combined with the success of Salomon Swapco Inc, the Company's triple-A rated derivatives subsidiary, has greatly strengthened the liquidity profile of the Company's derivative trading activities. See "Risk Management" for discussions of the Company's management of market, credit, and operational risks.
NATURE AND TERMS OF DERIVATIVE INSTRUMENTS
The Company and its subsidiaries enter into various bilateral financial contracts involving future settlement, which are based upon a predetermined principal or par value (referred to as the "notional" amount). Such instruments include swaps, swap options, caps and floors, futures contracts, forward purchase and sale agreements, option contracts and warrants. Transactions are conducted either through organized exchanges or OTC. For a discussion of the nature and terms of these instruments see Note 17 to the consolidated financial statements.
THE COMPANY'S USE OF DERIVATIVE INSTRUMENTS
The Company's use of derivatives can be broadly classified between trading and non-trading activities. The vast majority of the Company's derivatives use is in its trading activities, which include market-making activities for customers and the execution of trading strategies for its own account ("proprietary trading"). The Company's derivative counterparties consist primarily of other major derivative dealers, financial institutions, insurance companies, pension funds and investment companies, and other corporations. The scope of permitted derivatives activities both for trading and non-trading purposes for each of the Company's businesses is defined by senior management.
Trading Activities
A fundamental activity of the Company is to provide market liquidity to its customers across a broad range of financial instruments, including derivatives. The Company also seeks to generate returns by executing proprietary trading strategies. By their very nature, proprietary trading activities represent the assumption of risk. However, trading positions are constructed in a manner that seeks to define and limit risk taking only to those risks that the Company intends to assume. The most significant derivatives-related activity conducted by the Company is in fixed-income derivatives, which includes interest rate swaps, financial futures, swap options, and caps and floors. Other derivative transactions, such as currency swaps, forwards and options as well as derivatives linked to equities, are also regularly executed by the Company. The Company generally earns a spread from market-making transactions involving derivatives, as it generally does from its market-making activities for non-derivative transactions. The Company also utilizes derivatives to manage the market risk inherent in the securities inventories and derivative portfolios it maintains for market-making purposes as well as its "book" of swap agreements and
related transactions with customers. The Company conducts its commodities dealer activities in organized futures exchanges as well as in OTC forward markets. The Company executes transactions involving commodities options, forwards and swaps, much in the same manner as it does in the financial markets.
Non-Trading Activities
The Company also makes use of financial derivatives for non-trading, or end user, purposes. As an end user, these instruments provide the Company with added flexibility in the management of its capital and funding costs. Interest rate swaps are utilized to effectively convert the majority of the Company's fixed-rate term debt and a portion of its short-term borrowings to variable-rate obligations. Cross-currency swaps and forward currency contracts are utilized to effectively convert a portion of its non-U.S. dollar denominated term debt to U.S. dollar denominated obligations and to minimize the variability in equity otherwise attributable to exchange rate movements.
For additional derivatives-related disclosures contained in the consolidated financial statements see the following:
- Note 4 -- Summary of Significant Accounting Policies
- Note 5 -- Principal Transaction Revenues
- Note 9 -- Term Debt
- Note 17 -- Financial Instruments, Commodities and Contractual Commitments and Related Risks
- Note 18 -- Fair Value Information
RISK MANAGEMENT
Effective management of the risks inherent in the Company's businesses is critical. The following section discusses certain of the risks inherent in the Company's businesses, procedures in place to manage such risks, and initiatives underway to continue to enhance the Company's management of risk.
MARKET RISK
Market risk represents the potential loss the Company may incur as a result of absolute and relative price movements in financial instruments, commodities and contractual commitments due to price volatility, changes in yield curves, currency fluctuations and changes in market liquidity. The Company manages aggregate market risk across both on- and off-balance sheet products and, therefore, separate discussion of market risk for individual products, including derivatives, is not meaningful. The distinguishing risks relative to derivatives are credit risk and funding (liquidity) risk, which is roughly equivalent to the risk of margin calls. Each type of risk can be increased or decreased by market movements. See "Risk Management -- Credit Risk -- Credit Exposure from Derivative Activities."
Within the Company's trading businesses, sound management of market risk has always been a critical consideration. The sections that follow discuss organizational elements of market risk management, as well as specific risk management tools and techniques. The Company has sought to institutionalize these elements across all its businesses. Efforts to further strengthen the Company's management of market risk are ongoing and the enhancement of risk management systems and reporting, including the development and utilization of quantitative tools, is of major importance.
The Company's Risk Management Control Framework
The Company's risk management control framework is based upon the ongoing participation of senior management, business unit managers and the coordinated efforts of various support units throughout the firm.
The Company's risk management efforts include the establishment of appropriate market and credit risk controls, policies and procedures; appropriate senior management risk oversight with thorough risk analysis and reporting; and independent risk management with capabilities to evaluate and monitor risk limits.
Valuation and Control of Trading Positions
With regard to the Company's trading positions (financial instruments, commodities and contractual commitments), the Chairman and Chief Executive Officer determines the appropriate
risk profile of the Company with assistance from the Risk Management Committee. This committee is comprised of the Chief Executive Officer, senior business managers, the Chief Financial Officer, the Chief Risk Officer and the Global Risk Manager and reviews and recommends appropriate levels of risk, reviews risk capital allocations, balance sheet and regulatory capital usage by business units and recommends overall risk policies and controls. Lastly, an independent Global Risk Management Group provides technical and quantitative analysis of the market risk associated with trading positions to the Chairman and Chief Executive Officer and members of the Risk Management Committee on a frequent basis.
Trading positions are necessary for an active market maker, but can be a major source of liquidity risk. Monitoring the Company's trading inventory levels and composition and oversight for pricing is the responsibility of the Global Risk Management Group and various support units, which monitor trading positions on a position by position level, and employ specific risk models to track inventory exposure in credit markets, emerging markets and the mortgage market. The Company also provides for liquidity risk by imposing markdowns as the age of the inventory increases. Inventory event risk, both for issuer credit and emerging markets, is analyzed with the involvement of senior traders, economists and credit department personnel. Market scenarios for the major emerging markets are maintained and updated to reflect the event risk for the emerging market positions. In addition, the Company, as a dealer of securities in the global capital markets, has risk to issuers of fixed income securities for the timely payment of principal and interest. Principal risk is reviewed by the Global Risk Management Group, which identifies and reports major risks undertaken by the trading businesses. The Credit Department (the "Department") combines principal risk positions with credit risks resulting from market and delivery risk to review aggregate exposures by counterparty, industry and country.
Risk Limits
The Company's trading businesses have implemented business unit limits on exposure to risk factors. These limits, which are intended to enforce the discipline of communicating and gaining approval for higher risk positions, are periodically reviewed by the Global Risk Management Group. Business units may not exceed risk limits without the approval of the appropriate member of the Risk Management Committee.
Tools for Risk Management and Reporting
The Company's market risk measurement begins with the identification of relevant market risk factors. These core risk factors vary from market to market, and region to region. Risk factors are used in three types of analysis: stress analysis, scenario analysis and value-at-risk analysis.
Stress Analysis
The Company performs stress analysis by repricing inventory positions for specified upward and downward moves in risk factors, and computing the revenue implications of these repricings. Stress analysis is a useful tool for identifying exposures that appear to be relatively small in the current environment but grow more than proportionately with changes in risk factors. Such risk is typical of a number of derivative instruments, including options sold, many mortgage derivatives and a number of structured products. Stress analysis provides for the
measurement of the potential impact of extremely large moves in risk factors, which, though infrequent, can be expected to occur from time to time.
Scenario Analysis
Scenario analysis is a tool that generates forward-looking "what-if" simulations for specified changes in market factors. For example, the scenario analysis simulates the impact of significant changes in domestic and foreign interest rates. The revenue implications of the specified scenario are quantified on a business unit and geographic basis.
Value at Risk
Value at risk ("VAR") is a statistical tool for measuring the variability of trading revenue. The VAR reported reflects a potential range of revenue loss, over a one-day period, at the "99% confidence level." This level implies that on 99 trading days out of 100, the mark-to-market of the portfolio will likely result in either (1) an increase in revenue, or (2) a decrease from average revenue that is less than the VAR estimate; and that on 1 trading day out of 100, the mark-to-market of the portfolio will likely result in a decrease from average revenue that will likely exceed the VAR estimate.
Value at risk is calculated by performing simulation analysis of the volatilities and correlations of key underlying market risk factors (e.g., interest rates, interest rate spreads, equity prices, foreign exchange rates, commodity prices, option volatilities) to estimate the range of possible changes in the market value of the Company's market risk sensitive financial instruments.
Measuring market risk using statistical risk management models has recently become the main focus of risk management efforts by many companies whose earnings are exposed to changes in the fair value of financial instruments. Management believes that statistical models alone do not provide a reliable method of monitoring and controlling risk. While VAR models are relatively sophisticated, they are of limited value for internal risk management in that they do not capture all of the risks inherent in all positions nor do they give an indication of which individual exposures could potentially represent large exposures to the Company.
The following table summarizes the Company's VAR at the 99% confidence level as of December 31, 1998 and 1997 along with the 1998 average, and the high and low (based on quarter-end VARs). The VAR relating to non-trading financial instruments has been excluded from this analysis.
- --------------- * In 1998, the Company adopted the use of the 99% confidence level rather than the previously used 95% confidence level, primarily for consistency with capital guidelines issued by the Federal Reserve Board and other U.S. banking regulators.
The quantification of market risk using VAR analysis requires a number of key assumptions. In calculating VAR at December 31, 1998, the Company used a 99% confidence interval based upon a normal distribution assumption, over a one-day period. The standard deviations and correlation assumptions are based upon the six months of historical data from June 4 through December 4, 1998. In calculating these standard deviations and correlations, the Company determined that using six months of data, rather than 12 months or more, more accurately and conservatively reflected the current volatile market environment. With the inception of the European Monetary Union ("EMU"), the Company determined that the correlations within the foreign exchange and swap markets of the European countries participating in the EMU should be set to 1.0 rather than based upon historical information. This has been done to better reflect the prospective VAR to the Company given the positions at December 31, 1998 and the inception of the EMU. Over 200 risk factors are used in the VAR simulations. VAR reflects the risk profile of the Company at December 31, 1998 and is not a predictor of future results.
The following describes the components of market risk:
Interest Rate Risk
Interest rate risk arises from the possibility that changes in interest rates will affect the value of financial instruments. In connection with the Company's dealer and proprietary trading activities, including market-making in OTC derivative contracts, the Company is exposed to interest rate risk, arising from changes in the level or volatility of interest rates, mortgage prepayment speeds or the shape and slope of the yield curve. The Company's corporate bond activities expose it to the risk of loss related to changes in credit spreads. When appropriate, the Company attempts to hedge its exposure to interest rate risk by entering into transactions such as interest rate swaps, options, U.S. and non-U.S. government securities and futures and forwards contracts designed to mitigate such exposure.
Equity Price Risk
The Company is exposed to equity price risk as a consequence of making markets in equity securities and equity derivatives. Equity price risk results from changes in the level or volatility of equity prices, which affect the value of equity securities, or instruments that derive their value from a particular stock, a basket of stock or a stock index. The Company attempts to reduce the risk of loss inherent in its inventory in equity securities by entering into hedging transactions, including equity options and futures, designed to mitigate the Company's market risk profile.
Commodity Price Risk
Commodity price risk results from the possibility that the price of the underlying commodity may rise or fall. Commodity contracts principally relate to energy and precious metals.
Currency Risk
Currency risk arises from the possibility that changes in foreign exchange rates will impact the value of financial instruments. When the Company buys or sells a foreign currency or financial instrument denominated in a currency other than the U.S. dollar, exposure exists from a net open currency position. Until the position is covered by selling or buying an equivalent amount of the
same currency or by entering into a financing arrangement denominated in the same currency, the Company is exposed to a risk that the exchange rate may move against it.
CREDIT RISK
Credit risk represents the loss the Company could incur if an issuer or counterparty is unable or unwilling to perform on its commitments, including the timely payment of principal and interest or settlement of swap and foreign exchange transactions, repurchase agreements, securities purchases and sales, and other contractual obligations. The Company's credit risk management process considers the many factors that influence the probability of a potential loss, including, but not limited to, the issuer's or counterparty's financial profile, its business prospects and reputation, the specific terms and duration of the transactions, the exposure of the transactions to market risk, macroeconomic developments and sovereign risk.
Origin of Credit Risk
In the normal course of its operations, the Company and its subsidiaries enter into various transactions that give rise to credit risk. Credit risk is generally attributable to one or more of the following risks: market, delivery and default of principal. Market and delivery risks create credit risk with respect to transactions with counterparties. Default of principal risk is the risk of nonpayment of the principal and interest of a security.
The components of market risk such as absolute and relative price movements, price volatility, changes in yield curves, currency fluctuations, and changes in market liquidity, result in credit risk when a counterparty's obligation to the Company exceeds the obligation of the Company to the counterparty. Delivery risk arises from the requirement, in certain circumstances, to release cash or securities before receiving payment. For both market and delivery risk, the Department sets credit limits or requires specific approvals that anticipate the potential exposure of transactions.
Credit Risk Management at Salomon Smith Barney Holdings Inc.
The Chief Credit Officer, who is independent of any revenue-generating function, manages the Department, whose professionals assess, approve, monitor, and coordinate the extension of credit on a global basis. In considering such risk, the Department evaluates the risk/return trade-offs as well as current and potential credit exposures to a counterparty or to groups of counterparties that are related because of industry, geographic, or economic characteristics. The Department also has established various credit policies and control procedures used singularly or in combination, depending upon the circumstances.
Credit Risk Management of Commodities-Related Transactions
Phibro's credit department determines the credit limits for counterparties in its commodities-related activities. Exposure reports, which contain detailed information about cash flows with customers, goods in transit and forward mark-to-market positions, are reviewed daily.
Credit Exposure from Derivatives Activities
The Company's credit exposure for swap agreements, swap options, caps and floors and foreign exchange contracts and options at December 31, 1998, as represented by amounts reported on the
Company's consolidated balance sheet, are primarily with investment grade counterparties. These amounts do not present potential credit exposure that may result from factors that influence market risk or from the passage of time. Severe changes in market factors may cause credit exposure to increase suddenly and dramatically. Swap agreements, swap options, caps and floors include transactions with both short- and long-term periods of commitment. See Note 17 to the consolidated financial statements for further discussion of credit exposure from derivative activities.
With respect to sovereign risk related to derivatives, credit exposure at December 31, 1998 was primarily to counterparties in the U.S. ($2.8 billion), Germany ($1.1 billion), Italy ($.5 billion), Spain ($.4 billion), Japan ($.3 billion) and France ($.3 billion).
OPERATIONAL RISK
As a major intermediary in financial and commodities markets, the Company is directly exposed to market risk and credit risk, which arise in the normal course of its business activities. Slightly less direct, but of critical importance, are risks pertaining to operational and back office support. This is particularly the case in a rapidly changing and increasingly global environment with increasing transaction volumes and an expansion in the number and complexity of products in the marketplace.
Such risks include:
- Operational/Settlement Risk -- the risk of financial and opportunity loss and legal liability attributable to operational problems, such as inaccurate pricing of transactions, untimely trade execution, clearance and/or settlement, or the inability to process large volumes of transactions. The Company is subject to increased risks with respect to its trading activities in emerging market securities, where clearance, settlement, and custodial risks are often greater than in more established markets.
- Technological Risk -- the risk of loss attributable to technological limitations or hardware failure that constrain the Company's ability to gather, process, and communicate information efficiently and securely, without interruption, with customers, among units within the Company, and in the markets where the Company participates.
- Legal/Documentation Risk -- the risk of loss attributable to deficiencies in the documentation of transactions (such as trade confirmations) and customer relationships (such as master netting agreements) or errors that result in noncompliance with applicable legal and regulatory requirements.
- Financial Control Risk -- the risk of loss attributable to limitations in financial systems and controls. Strong financial systems and controls ensure that assets are safeguarded, that transactions are executed in accordance with management's authorization, and that financial information utilized by management and communicated to external
parties, including the Company's stockholder, creditors, and regulators, is free of material errors.
YEAR 2000
Many computer applications have been written using two digits rather than four to define the applicable year, and therefore may not recognize a date using "00" as the Year 2000. This could result in the inability of the application to properly process transactions with the dates in the Year 2000 or thereafter. To ensure the Company's computer systems will correctly handle the date change, a firm-wide initiative was established to identify and resolve all problems. The Year 2000 Readiness Program (the "Project") was approved by the Board of Directors of the Company's sole stockholder and commenced early in 1996. The total cost of the Project is expected to be approximately $130 million to $150 million. Through 1998 the Company has expended approximately $100 million on the Project. The majority of the remaining costs are expected to be directed to testing activities. These costs have been and will continue to be funded through operating cash flow and are expensed in the period in which they are incurred. The Project is comprised of five phases: 1) inventory, 2) assessment, 3) corrections where necessary, 4) testing and certification, and 5) deployment of Year 2000 compliant components to all locations worldwide. The Project began with a comprehensive inventory of hardware, vendor products, software developed in-house, market data feeds, and physical facilities around the world. The inventory also included electronic data exchanges with industry participants such as the New York Stock Exchange, the National Association of Securities Dealers, the Securities Industry Automation Company, the National Securities Clearing Corporation, The Depository Trust Company and other counterparties. To eliminate any processing errors associated with the millennium date change and other associated dates such as 9/9/99 and the leap year in the Year 2000, elements of the inventory were assessed to determine necessary changes and upgrades or replacement of vendor products. The inventory and assessment phases of the project were completed in the third quarter of 1997.
At this time, the correction phase of the project is nearing completion. Specifically, corrections have been made to 93% of systems developed in-house, and 63% of vendor products in use by the firm have been upgraded.
Testing and certification is the most complex part of the Project. The Company began testing in October 1997. Special mainframe and distributed system test environments were constructed in which dates can be advanced to create a variety of conditions that will be encountered as the millennium date change occurs. Applications are put through a rigorous series of tests at the unit, integration and enterprise levels, with sign-off by the relevant business areas at each level, before they are certified as Year 2000 compliant. Approximately 68% of the in-house applications are now certified. In addition to rigorous testing of each component, an enterprise level front-to-back test is being planned to test multiple systems working together to support business processes.
The Project remains on schedule. Correction work is expected to be substantially completed by March 31, 1999; internal and external testing, application certification and global deployment is expected to be completed by June 30, 1999.
The Company fully supports initiatives by the Securities Industry Association and other industry groups in conducting tests among industry participants, including the completed industry Beta Test, the government securities clearing test with the Federal Reserve Bank of New York and The Depository Trust Company, and the Futures Industry Association test. The Company has achieved successful results in each of these industry-wide tests in which it participated. The Company is participating in the Streetwide Test which commenced in March 1999, and expects to continue its testing program during 1999 with counterparties and selected clients.
There are many risks associated with the Year 2000 issue. Even if the Company successfully remediates its Year 2000 issues, it can be materially and adversely affected by failures of third parties to remediate their own Year 2000 issues. The failure of third parties with which the Company has financial or operational relationships such as vendors, clients, or regulators to resolve their own Year 2000 compliance issues in a timely manner could result in material financial risk to the Company. Consequently, comprehensive, written contingency plans are being prepared so that alternative procedures and a framework for critical decisions are defined before any crisis occurs. Contingency plans are nearing completion. These plans define alternate processes to be used in the event of extended system outage. The plans cover each business area and location around the world. Contingency plans will be validated in the first half of 1999.
The Company's expectation about future costs and the timely completion of its Year 2000 modifications are subject to uncertainties that could cause actual results to differ materially from what has been discussed above. The Project will remain one of the Company's top priorities until these issues are resolved.
EUROPEAN ECONOMIC AND MONETARY UNION
European Economic and Monetary Union ("EMU") is an historic event in Europe involving the unification of currency in eleven major countries. The new unified currency, called the Euro, is expected to compete on a global scale with the U.S. Dollar and the Japanese Yen.
Introduction of the Euro began on January 1, 1999, when the European Central Bank assumed control of the monetary policy for participating nations. Exchange rates between the participating countries were fixed and the Euro is available for electronic payments. Also on January 1, 1999, various issuers re-denominated their securities and harmonized bond payment conventions. A three-year transition period began on January 1, 1999, after which Euro notes and coins will be issued by the European Central Bank and national currencies will be phased out.
The Company completed a successful conversion to the Euro and has commenced trading and settlement in the new currency with no major exceptions.
As the preceding risks are largely interrelated, so are the Company's actions to mitigate and manage them. The Company's Chief Administrative Officer is responsible for, among other things, oversight of global operations and technology. An essential element in mitigating the risks noted above is the optimization of information technology and the ability to manage and
implement change. To be an effective competitor in an information-driven business of a global nature requires the development of global systems and databases that ensure increased and more timely access to reliable data.
ENVIRONMENTAL RISK
The Company is subject to environmental risk from two primary sources: discontinued commodities processing and oil refining operations, and existing energy-related transportation activities.
The Company is subject to uncertain remedial liability as a result of commodities-related industrial operations, which were discontinued in or prior to 1984. Such liability arises under the Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended ("CERCLA" or "Superfund"), which provides that potentially responsible parties ("PRPs"), including waste generators and past and present site owners and operators, may be held jointly and severally liable for the entire cost of site clean-up. The Company may also be subject to liability under state or other U.S. environmental laws.
The process of remediating hazardous waste sites under CERCLA is normally lengthy and involves a series of events including initial site identification, environmental site studies and evaluations, issuance of the "Preliminary Identification of Remedial Alternatives," completion of the "Remedial Investigation and Feasibility Study," selection of an appropriate site remedy and its related cost estimate known as the "Record of Decision," performance of site remediation and post-remediation site monitoring. Factors that influence the cost and time of completion include the remediation method selected; the number of financially solvent PRPs responsible for payment; whether PRPs were owners, operators or generators; determination of cost allocation among PRPs, and the ongoing development of more efficient and effective remediation technologies. The process may take ten years or more from site identification to completion and may be further complicated by protracted legal proceedings involving numerous PRPs.
The ultimate share of remediation costs that will be borne by the Company and its subsidiaries cannot be predicted with accuracy. Although certain exposures may be covered by insurance contracts or indemnification agreements from other parties, the Company has incurred and will continue to incur costs related to remediation at certain sites already identified. Further, it is possible that the Company will be named as a PRP at additional sites. Management believes, based upon currently known facts and established reserves, that the ultimate disposition of these matters will not have a material adverse effect on the Company's financial condition.
Phibro has potential environmental exposure in connection with activities in which cargoes of products are transported and stored. Phibro mitigates this exposure through insurance coverage and consideration of ports of delivery and storage terminals.
FORWARD LOOKING STATEMENTS
Certain of the statements contained herein that are not historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act. The Company's actual results may differ materially from those included in the forward-looking statements. Forward-looking statements are typically identified by the words "believe," "expect," "anticipate," "intend," "estimate," and similar expressions. These forward-looking statements involve risks and uncertainties including, but not limited to, the following: changes in general economic conditions, including the performance of global financial markets, and risks associated with fluctuating currency values and interest rates; competitive, regulatory or tax changes that affect the cost of or demand for the Company's products; the resolution of legal proceedings and environmental matters; the ability of the Company and third party vendors to modify computer systems for the year 2000 date conversion in a timely manner; and the ability of the Company generally to achieve anticipated levels of operational efficiencies related to recent mergers and acquisitions, as well as achieving its other cost-savings initiatives. Readers are also directed to other risks and uncertainties discussed in documents filed by the Company with the Securities and Exchange Commission.
ITEM 7a.
ITEM 7a. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
See Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" above.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
See Index to Consolidated Financial Statements and Schedules on page hereof. There is also incorporated by reference herein in response to this Item the Company's Consolidated Financial Statements and the notes thereto and the material under the caption "Quarterly Financial Data (Unaudited)" set forth in the Consolidated Financial Statements, and the Independent Accountants' Report filed as Exhibit 99.01 herewith.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
Pursuant to General Instruction I of Form 10-K, the information required by Item 10 is omitted.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION.
Pursuant to General Instruction I of Form 10-K, the information required by Item 11 is omitted.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
Pursuant to General Instruction I of Form 10-K, the information required by Item 12 is omitted.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
Pursuant to General Instruction I of Form 10-K, the information required by Item 13 is omitted.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(a) Documents filed as a part of the report:
(1) Financial Statements. See Index to Consolidated Financial Statements and Schedules on page hereof.
(2) Financial Statement Schedules. See Index to Consolidated Financial Statements and Schedules on page hereof.
(3) Exhibits:
See Exhibit Index.
(b) Reports on Form 8-K:
On October 14, 1998, the Company filed a Current Report on Form 8-K, dated October 8, 1998, reporting under Item 5 thereof the consummation of the Travelers/Citicorp merger and certain results of the Company's operations for the quarter ended September 30, 1998 and certain other selected financial data.
On October 23, 1998, the Company filed a Current Report on Form 8-K, dated October 21, 1998, reporting under Item 5 thereof the results of the Company's operations for the quarter ended September 30, 1998, and certain other selected financial data.
On October 29, 1998, the Company filed a Current Report on Form 8-K, dated October 27, 1998, filing certain exhibits under Item 7 thereof relating to the offer and sale of its Principal-Protected Equity Linked Notes due December 30, 2005.
On November 3, 1998, the Company filed a Current Report on Form 8-K, dated November 1, 1998, reporting under Item 5 thereof certain information regarding the integration of its corporate business with the corporate business of Citicorp and related executive matters.
No other reports on Form 8-K were filed during the fourth quarter of 1998; however, on January 25, 1999, the Company filed a Current Report on Form 8-K, dated January 25, 1999, reporting under Item 5 thereof the results of its operations for the three and twelve months ended December 31, 1998 and 1997.
EXHIBIT INDEX
- --------------- + Filed herewith.
The total amount of securities authorized pursuant to any instrument defining rights of holders of long-term debt of the Company does not exceed 10% of the total assets of the Company and its consolidated subsidiaries. The Company will furnish copies of any such instrument to the SEC upon request.
Copies of any of the exhibits referred to above will be furnished at a cost of $.25 per page to security holders who make written request therefor to Salomon Smith Barney Holdings Inc., 388 Greenwich Street, New York, New York 10013, Attention: Corporate Secretary.
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, on the 16th day of March, 1999.
SALOMON SMITH BARNEY HOLDINGS INC. (Registrant)
By: /s/ MICHAEL A. CARPENTER ------------------------------------ Michael A. Carpenter, Chairman and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities indicated on the 16th day of March, 1999.
SALOMON SMITH BARNEY HOLDINGS INC. AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholder of Salomon Smith Barney Holdings Inc. and Subsidiaries:
In our opinion, based upon our audits and the report of other auditors, the accompanying consolidated statements of financial condition and the related consolidated statements of income, changes in stockholder's equity and cash flows present fairly, in all material respects, the financial position of Salomon Smith Barney Holdings Inc. and its Subsidiaries (the "Company") at December 31, 1998 and December 31, 1997, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1998, in conformity with generally accepted accounting principles. 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. The consolidated financial statements as of December 31, 1997 and 1996 give retroactive effect to the merger of Salomon Inc and Smith Barney Holdings Inc. on November 28, 1997, which has been accounted for in a manner similar to a pooling of interests as described in Note 1 to the consolidated financial statements. We did not audit the consolidated financial statements of Salomon Inc and subsidiaries as of December 31, 1996, and for the year then ended, which statements reflect total revenues, net of interest expense of $4,367 million for the year ended December 31, 1996, and net income of $617 million for the year ended December 31, 1996. Those statements were audited by other auditors whose report thereon has been furnished to us, and our opinion expressed herein, insofar as it relates to the amounts included for Salomon Inc and subsidiaries, is based solely on the report of the other auditor. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits and the report of other auditors provide a reasonable basis for the opinion expressed above.
/s/ PRICEWATERHOUSECOOPERS LLP
New York, New York January 25, 1999, except for Note 3 for which the date is February 26, 1999
SALOMON SMITH BARNEY HOLDINGS INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
The accompanying notes are an integral part of these consolidated financial statements.
SALOMON SMITH BARNEY HOLDINGS INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
The accompanying notes are an integral part of these consolidated financial statements.
SALOMON SMITH BARNEY HOLDINGS INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
The accompanying notes are an integral part of these consolidated financial statements.
SALOMON SMITH BARNEY HOLDINGS INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDER'S EQUITY
- --------------- * Net of after-tax impact of related interest rate swaps that effectively convert fixed rate dividend obligations to variable rate obligations.
The accompanying notes are an integral part of these consolidated financial statements.
SALOMON SMITH BARNEY HOLDINGS INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
Interest paid did not differ materially from the amount of interest expense recorded for financial statement purposes in 1998, 1997 and 1996.
The accompanying notes are an integral part of these consolidated financial statements.
SALOMON SMITH BARNEY HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. THE MERGER
On November 28, 1997, a newly formed, wholly owned subsidiary of Travelers Group Inc. ("Travelers") was merged into Salomon Inc ("Salomon"). Pursuant to the merger agreement, Salomon common stockholders received 1.695 shares of Travelers Group Inc. common stock for each share of Salomon common stock; each share of preferred stock of Salomon was exchanged for a share of Travelers preferred stock having substantially identical terms, except that the Travelers preferred stock has certain voting rights; and Salomon became a wholly owned subsidiary of Travelers. Following this merger, Salomon and Smith Barney Holdings Inc. ("Smith Barney") were merged (the "Merger") to form Salomon Smith Barney Holdings Inc. (the "Parent Company" and, collectively, with its subsidiaries the "Company"). The transaction was a tax free exchange.
The 1997 and 1996 consolidated financial statements give retroactive effect to the Merger as a combination of entities under common control in a transaction accounted for in a manner similar to a pooling of interests. The pooling of interests method of accounting requires the restatement of all periods presented as if Salomon and Smith Barney had always been combined. Certain reclassifications have been made to conform the accounting policies of Salomon and Smith Barney.
As a result of the Merger, the Company recorded a pre-tax restructuring charge of $838 million ($496 million after tax) in the fourth quarter of 1997. The material components of the restructuring reserve were as follows:
- --------------- * In the second quarter of 1998,the Company recorded an adjustment of $324 million ($191 million after tax) to the restructuring reserve relating to the Seven World Trade Center lease. This reduction in the reserve resulted from negotiations on a sublease which indicated that excess space would be disposed of on terms more favorable than had been originally estimated. A current reassessment of space needs, including the Citicorp merger (discussed in Note 2 to the consolidated financial statements), could indicate a need for increased occupancy by the Company of space previously considered excess, and could result in a further adjustment to reduce the restructuring reserve.
** In the fourth quarter of 1998, the Company recorded an adjustment of $30 million ($18 million after tax) to the restructuring reserve. The components of the reduction are as follows: severance $10 million; other facilities $11 million; other $9 million. The reduction in severance reserves was due to a higher level of attrition than originally anticipated. The reduction in reserves related to other facilities was mainly due to the abandonment of space on terms more favorable than originally anticipated. The other reserve reversal was mainly due to anticipated duplicate contract payments which were avoided due to favorable negotiations.
*** Consists of $101 million cash component and $212 million non-cash component.
All of the amounts were determined in accordance with the guidelines included in Emerging Issues Task Force ("EITF") 94-3 and represent costs that are not associated with future revenues and are either incremental or contractual with no economic benefit.
SALOMON SMITH BARNEY HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
At December 31, 1998, the portion of the cash and non-cash balances of the restructuring reserve that related to facilities were $93 million and $212 million, respectively. Such costs include lease costs, which represent the difference between contractual obligations and the estimated fair market rental obtainable through sublease from the date that such facilities are expected to be vacated, and other costs incidental to sublease. These contractual lease payments are estimated to be made over the remaining term and the remaining cash costs are expected to be paid in 1999.
Non-cash costs of other facilities reflect the write-off of leasehold improvements, furniture and equipment upon abandonment and represent the remaining depreciated book value at the estimated dates of abandonment. Depreciation and amortization of these assets will continue during the period they are in use. The facilities are located primarily in the United States and generally support multiple lines of business. The assets have not been reclassified to a held for sale category since substantially all are subject to abandonment and will not be realized through sale.
The balance of severance costs are expected to be paid by the first quarter of 1999. As of December 31, 1998, 1,602 employees were severed, of which 1,474 employees were in the United States. None of the amounts included in the restructuring charge represent operating losses or income. The cash component of these restructuring costs will be funded from working capital and will not require any incremental funding source.
NOTE 2. TRAVELERS MERGER WITH CITICORP
On October 8, 1998, Travelers and Citicorp completed their merger of equals, pursuant to which Citicorp merged with and into a wholly owned subsidiary of Travelers. The subsidiary changed its name to Citicorp and Travelers changed its name to Citigroup Inc. ("Citigroup").
Upon consummation of the merger, Citigroup became a bank holding company subject to regulation under the U.S. Bank Holding Company Act of 1956 (the "BHCA"), the requirements of the Glass-Steagall Act and certain other laws and regulations.
Section 20 of the Glass-Steagall Act prohibits a member bank of the Federal Reserve System from being affiliated with a company that is principally engaged in underwriting and dealing in securities. The Federal Reserve Board has determined by regulation that underwriting and dealing in certain "eligible" securities is an activity closely related to banking and is therefore permissible for bank holding companies and their subsidiaries. The Federal Reserve Board has also determined that a securities firm that does not generate more than 25% of its gross revenues from underwriting and dealing in certain, ineligible, securities is not deemed for purposes of the Glass-Steagall Act to be "principally engaged" in securities underwriting and dealing. The Company believes that the ineligible revenues of its securities businesses are below this threshold.
The activities of U.S. bank holding companies are generally limited to the business of banking, managing or controlling banks and other activities that the Federal Reserve Board determines to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. Under the BHCA in its current form, after two years from the date as of which Citigroup became a bank holding company, Citigroup will be required to conform any activities that are not considered to be closely related to banking under the BHCA. This two-year period may be
SALOMON SMITH BARNEY HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
extended by the Federal Reserve Board for three additional one-year periods, upon application by Citigroup and finding by the Federal Reserve Board that such an extension would not be detrimental to the public interest.
Nonbank acquisitions in the U.S. are generally limited to 5% of voting shares unless the Federal Reserve Board determines that the acquisition is so closely related to banking as to be a proper incident to banking or managing or controlling banks. Subject to prior specific or general Federal Reserve Board consent, a bank holding company may generally acquire less than 20% of the voting securities of a company that does not do business in the United States, and 20% or more of the voting securities of any such company if the Federal Reserve Board finds by regulation or order that its activities are usual in connection with banking or finance outside the United States. In general, bank holding companies may engage in a broader set of activities outside of the United States. Outside the United States, for example, bank holding company subsidiaries may sponsor, distribute, and advise open-end mutual funds without regard to the 20% revenue limit discussed above. Bank holding companies may also underwrite and deal in debt, and to a limited extent, equity securities, subject to local country laws. In addition, a bank holding company and its bank subsidiaries may, subject to certain requirements for prior Federal Reserve Board consent or notice, acquire banks and establish branches subject to local country laws and to United States laws prohibiting companies from doing business in certain countries.
Various legislation, including proposals to overhaul the bank regulatory system and expand the powers of bank holding companies and their affiliates, is from time to time introduced in Congress. Such legislation may change banking statutes and the operating environment of Citigroup and the Company in substantial and unpredictable ways. The Company cannot determine whether such potential legislation will ultimately be enacted, and if enacted, the ultimate effect that any such potential legislation or implementing regulations would have upon the financial condition or results of operations of the Company or its subsidiaries.
The Company does not believe that its compliance with applicable law as a result of the Citigroup merger will have a material adverse effect on its ability to continue to operate the businesses in which it is presently engaged.
There is pending federal legislation that would, if enacted, amend the BHCA and the Glass-Steagall Act to authorize a bank holding company and its affiliates to conduct certain activities which are currently prohibited. There is no assurance that such legislation will be enacted. At the expiration of the BHCA Compliance Period, the Company and Citigroup each will evaluate its alternatives to comply with whatever laws are then applicable.
As a result of the Citigroup merger, the Company recorded a pre-tax restructuring charge of $80 million ($47 million after tax) in the fourth quarter of 1998. The material components of the restructuring reserve were as follows:
- --------------- * All cash components
All the amounts were determined in accordance with the guidelines included in EITF 94-3 and represent costs that are not associated with future revenues and are either incremental or contractual with no economic benefits.
Facilities costs include lease payments, which represent the difference between contractual obligations and the estimated fair market rental obtainable through sublease from the date that such facilities are expected to be vacated, and other costs incidental to sublease. These contractual lease payments are estimated to be expended over the remaining term and are expected to be paid in 1999 and 2000. The facilities are located in various foreign locations and generally support multiple lines of business. The assets have not been reclassified to a held for sale category since substantially all are subject to abandonment and will not be realized through sale.
The balance of severance costs, which apply to 1,195 employees (1,062 employees in the United States and 133 employees overseas), are expected to be paid by the end of 1999. None of the amounts included in the restructuring charge represent operating losses or income. All components of these restructuring costs will be funded from working capital and will not require any incremental funding source.
SALOMON SMITH BARNEY HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
NOTE 3. THE NIKKO SECURITIES CO., LTD.
On February 26, 1999, the Company and The Nikko Securities Co., Ltd ("Nikko") formed a joint venture. The joint venture, Nikko Salomon Smith Barney Limited ("Nikko Salomon Smith Barney"), provides investment banking, sales and trading and research services for corporate and institutional clients in Japan and other foreign jurisdictions. Nikko Salomon Smith Barney combined the Japanese institutional and corporate business of the Company with Nikko's domestic and international institutional and corporate business. Nikko's retail business and other activities, including asset management, will remain under Nikko's management. Nikko Salomon Smith Barney is headquartered in Tokyo and maintains offices and staff worldwide.
Nikko Salomon Smith Barney is owned 51% by Nikko and 49% by the Company.
NOTE 4. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
The consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States, which require the use of management's best judgment and estimates. Estimates, including the fair value of financial instruments, commodities and contractual commitments, may vary from actual results.
The Company provides investment banking, asset management, brokerage, securities trading, advisory and other financial services to customers, and engages in proprietary trading activities for its own account.
Material intercompany transactions have been eliminated in consolidation. Long-term investments in operating joint ventures and affiliated (20% to 50% owned) companies are carried on the equity method of accounting and are included in "Other assets." The Company's equity in the earnings of joint ventures and affiliates is reported in "Other" revenues.
Assets and liabilities denominated in non-U.S. dollar currencies are translated into U.S. dollar equivalents using year-end spot foreign exchange rates. Revenues and expenses are translated monthly at amounts that approximate weighted average exchange rates, with resulting gains and losses included in income. The effects of translating the statements of financial condition of non-U.S. subsidiaries with functional currencies other than the U.S. dollar are recorded, net of related hedge gains and losses and income taxes, as "Cumulative translation adjustments," a separate component of "Stockholder's equity." Hedges of such exposure include forward currency contracts and, to a lesser extent, designated issues of non-U.S. dollar term debt.
As discussed in Note 6 to the consolidated financial statements, Basis Petroleum, Inc. ("Basis Petroleum") is classified as a discontinued operation in the Company's consolidated financial statements.
SALOMON SMITH BARNEY HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Certain prior period amounts have been restated to conform to the current year's presentation.
Cash and Cash Equivalents
The Company defines "Cash and cash equivalents" as highly liquid investments with original maturities of three months or less at the time of purchase, other than investments held for sale in the ordinary course of business.
Collateralized Short-Term Financing Agreements
Securities purchased under agreements to resell ("reverse repurchase agreements") and securities sold under agreements to repurchase ("repurchase agreements") are collateralized principally by government and government agency securities and generally have terms ranging from overnight to up to five years and are carried at their contractual amounts, including accrued interest as specified in the respective agreements. In the determination of income, certain financing transactions are marked to fair value, which has no material effect on the Company's results of operations.
It is the Company's policy to take possession of the underlying collateral, monitor its market value relative to the amounts due under the agreements, and, when necessary, require prompt transfer of additional collateral or reduction in the loan balance in order to maintain contractual margin protection. In the event of counterparty default, the financing agreement provides the Company with the right to liquidate the collateral held. Reverse repurchase and repurchase agreements are reported net by counterparty, when applicable, pursuant to the provisions of Financial Accounting Standards Board ("FASB") Interpretation 41, Offsetting of Amounts Related to Certain Repurchase and Reverse Repurchase Agreements ("FIN 41"). Excluding the impact of FIN 41, reverse repurchase agreements totaled $89.2 billion and $114.3 billion at December 31, 1998 and 1997, respectively. At December 31, 1998, and 1997, the market value of securities collateralizing reverse repurchase agreements was $91.2 billion and $116.6, respectively.
Deposits paid for securities borrowed ("securities borrowed") and deposits received for securities loaned ("securities loaned") are recorded at the amount of cash advanced or received and are collateralized principally by government and government agency securities, corporate debt and equity securities. The Company monitors the market value of securities borrowed and securities loaned daily, and additional collateral is obtained as necessary. Excluding the impact of FIN 41, securities borrowed totaled $50.2 and $40.5 billion, respectively at December 31, 1998 and 1997. At December 31, 1998 and 1997, the market value of securities collateralizing securities borrowed was $49.3 billion and $40.1 billion, respectively.
Financial Instruments, Commodities and Contractual Commitments
Financial instruments, commodities and contractual commitments (also referred to as "derivative instruments"), including derivatives used for trading purposes, are recorded at either market value or, when market prices are not readily available, fair value, which is determined under an alternative approach, such as matrix or model pricing. Fair value includes related accrued interest or dividends. The determination of market or fair value considers various factors, including: closing exchange or over-the-counter market price quotations; time value and volatility factors underlying options, warrants and contractual commitments; price activity for equivalent or synthetic instruments in markets located in different time zones; counterparty credit quality; and the potential impact on
SALOMON SMITH BARNEY HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
market prices or fair value of liquidating the Company's positions in an orderly manner over a reasonable period of time under current market conditions.
The majority of the Company's financial instruments, commodities and contractual commitments are recorded on a trade date basis. Recording the remaining instruments on a trade date basis would not materially affect the consolidated financial statements. Commissions, underwriting, and principal transaction revenues and related expenses are recognized in income on a trade date basis. Customer security transactions are recorded on a settlement date basis.
Derivative Instruments
Derivatives Used for Trading Purposes
Derivatives used for trading purposes include interest rate, currency and commodity swap agreements, swap options, caps and floors, options, warrants and financial and commodity futures and forward contracts. The market values (unrealized gains and losses) associated with contractual commitments are reported net by counterparty, provided a legally enforceable master netting agreement exists, and are netted across products and against cash collateral when such provisions are stated in the master netting agreement. Contractual commitments in a net receivable position, as well as options owned and warrants held, are reported as assets in "Contractual commitments." Similarly, contractual commitments in a net payable position, as well as options written and warrants issued, are reported as liabilities in "Contractual commitments." This category also includes the Company's long-term obligations that have principal repayments directly linked to equity securities of unaffiliated issuers for which the Company holds in inventory a note exchangeable for the same equity securities. Cash collateral received in connection with interest rate swaps totaled $4,178 million and $340 million at December 31, 1998 and 1997, respectively, and cash collateral paid totaled $4,385 million and $2,507 million, respectively, at these dates. Revenues generated from derivative instruments used for trading purposes are reported as "Principal transactions" and include realized gains and losses as well as unrealized gains and losses resulting from changes in the market or fair value of such instruments.
Margin on futures contracts is included in "Receivables -- Brokers, dealers and clearing organizations" and "Payables and accrued liabilities -- Brokers, dealers and clearing organizations."
Derivatives Used for Non-Trading Purposes
Non-trading derivative instruments that are designated as hedges must be effective at reducing the risk associated with the exposure being hedged and must be designated as a hedge at the inception of the derivative contract. Accordingly, changes in the market or fair value of the derivative instrument must be highly correlated with changes in the market or fair value of the underlying hedged item. The Company monitors the effectiveness of its hedges by periodically comparing the change in value of the derivative instrument with the change in value of the underlying hedged item. Derivatives used as hedges include interest rate swaps, cross currency swaps and forward currency contracts.
Interest rate and cross currency swaps are utilized to effectively convert a portion of the Company's short-term borrowings and the majority of its fixed rate term debt to variable rate instruments. These swaps are recorded "off-balance sheet," with
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accrued inflows and outflows reflected as adjustments to interest expense. Upon early termination of an underlying hedged instrument, the derivative is accounted for at market or fair value and the impact is recognized currently in income. Changes in market or fair value of such instruments, or realized gains or losses resulting from the termination of such instruments, are also recognized currently in income.
The Company utilizes forward currency contracts to hedge a portion of the currency exchange rate exposure relating to non-U.S. dollar term debt issued by the Company. The impact of translating the forward currency contracts and the related debt to prevailing exchange rates is recognized currently in income. The Company also utilizes forward currency contracts to hedge certain investments in subsidiaries with functional currencies other than the U.S. dollar. The impact of marking open contracts to prevailing exchange rates and the impact of realized gains or losses on maturing contracts, both net of the related tax effects, are included in "Cumulative translation adjustments" in "Stockholder's equity" as is the impact of translating the investments being hedged. Upon the disposition of an investment in a subsidiary with a functional currency other than the U.S. dollar, accumulated gains or losses previously included in "Cumulative translation adjustments" are recognized currently in income.
Derivative instruments that do not meet the criteria to be designated as a hedge are considered trading derivatives and are recorded at market or fair value.
See Note 9 to the consolidated financial statements for a further discussion of the use of interest rate swaps and forward currency contracts for non-trading purposes.
Property, Equipment and Leasehold Improvements
Property, equipment and leasehold improvements are carried at cost less accumulated depreciation and amortization. Depreciation and amortization are recorded substantially on a straight-line basis over the lesser of the estimated useful lives of the related assets or noncancelable lease terms, as appropriate. Maintenance and repairs are charged to occupancy expense as incurred.
Intangible Assets
The excess of purchase price over fair value of net assets acquired, which amounted to $447 million at December 31, 1998, is being amortized over remaining periods ranging from 20 to 30 years. The Company amortizes other intangible assets, which are included in "Other assets," on a straight-line basis over remaining periods ranging from 5 to 15 years.
New Accounting Pronouncements
Effective January 1, 1998, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 127, Deferral of the Effective Date of Certain Provisions of SFAS 125 ("SFAS 127"), which was effective for transfers and pledges of certain financial assets and collateral made after December 31, 1997. The adoption of SFAS 127 created additional assets and liabilities on the Company's consolidated statement of financial condition related to the recognition of securities provided and received as collateral. At December 31, 1998, the impact of SFAS 127 on the Company's consolidated statement of financial position was an increase to total assets and liabilities of approximately $200 million. In addition, as a result of SFAS 127, certain inventory positions, primarily "Non-U.S. government and government
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agency securities," have been reclassified to receivables or payables.
Effective January 1, 1998, the Company adopted SFAS No. 130, Reporting Comprehensive Income ("SFAS 130"). SFAS 130 establishes standards for the reporting and display of comprehensive income and its components in a full set of general-purpose financial statements. This statement stipulates that comprehensive income reflect the change in equity of an enterprise during a period from transactions and other events and circumstances from nonowner sources. Comprehensive income will thus represent the sum of net income and other changes in stockholder's equity from nonowner sources. The accumulated balance of changes in equity from nonowner sources is required to be displayed separately from retained earnings and additional paid-in-capital in the statement of financial position. Other than net income, cumulative translation adjustments is the only change in the Company's equity from nonowner sources. The Company's comprehensive income, net of tax, is as follows:
During the third quarter of 1998, the Company adopted the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants' Statement of Position 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use ("SOP 98-1"). SOP 98-1 provides guidance on accounting for costs of computer software developed or obtained for internal use and for determining when specific costs should be capitalized and when they should be expensed. The impact of adopting SOP 98-1 on the Company's consolidated financial statements was not material.
In the fourth quarter of 1998 the Company adopted SFAS 131, Disclosures about Segments of an Enterprise and Related Information ("SFAS 131"). SFAS 131 defines the management approach as the basis for determining the entity's reportable segments. The management approach designates the internal organization that is used by management for making operating decisions and assessing performance as the source of the entity's reportable segments. The adoption of SFAS 131 did not affect the Company's financial postion, liquidity or results of operations. See Note 7 to the consolidated financial statements for a discussion of the Company's segments.
In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities ("SFAS 133"). SFAS 133 requires that an entity recognize all derivatives in the statement of financial condition and measure those instruments at fair value. If certain conditions are met, a derivative may be specifically designated as a hedge of the exposure to changes in the fair value of a recognized asset or liability or an unrecognized firm commitment, or a hedge of the exposure to variable cash flows of a forecasted transaction, or a hedge of the foreign currency exposure of a net investment in a foreign operation, an unrecognized firm commitment, an available-for-sale
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security or a foreign-currency-denominated forecasted transaction. SFAS 133 is effective for fiscal years beginning after June 15, 1999. The Company is in the process of evaluating the potential impact of the new accounting standard.
NOTE 5. PRINCIPAL TRANSACTION REVENUES
The following table presents principal transaction revenues by business activity from continuing operations for the years ended December 31, 1998, 1997 and 1996.
Fixed Income
Fixed income revenues include realized and unrealized gains and losses arising from the trading of government and government agency securities, investment and non-investment grade corporate debt, municipal securities, and preferred stock, mortgage securities (primarily U.S. government agencies, including interest only and principal only strips), and emerging market fixed income securities and derivatives. Revenues also include realized and unrealized gains and losses generated from a variety of fixed income securities utilized in arbitrage strategies for the Company's own account, and realized and unrealized gains and losses arising from the spot and forward trading of currencies and exchange-traded and over-the-counter ("OTC") currency options. In 1998, the Company restructured and significantly decreased the risk profile of the global fixed income arbitrage groups because of lessening profit opportunities and growing risk and volatility. Realized and unrealized gains and losses resulting from changes in the market or fair value of options on fixed income securities, interest rate swaps, currency swaps, swap options, caps and floors, financial futures, options and forward contracts on fixed income securities are reflected as fixed income revenue.
Equities
Revenues from equities consist of realized and unrealized gains and losses arising from proprietary and customer trading of U.S. and non-U.S. equity securities, including common and convertible preferred stock, convertible corporate debt, equity-linked notes and exchange-traded and OTC equity options and warrants. Revenues also include realized and unrealized gains and losses on equity securities and related derivatives utilized in arbitrage strategies for the Company's own account.
Commodities
The Company, primarily through its wholly owned subsidiary Phibro Inc. and its wholly owned subsidiaries (collectively, "Phibro"), conducts a commodities trading and dealer business. Commodities traded include crude oil, refined
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oil products, natural gas, electricity, metals and various soft commodities. During 1998, Phibro continued its downsizing effort to significantly reduce the scope of some of its activities. In 1997, Phibro discontinued trading petrochemicals. Commodity revenues consist of realized and unrealized gains and losses from trading these commodities and related derivative instruments.
NOTE 6. DISCONTINUED OPERATIONS
In March 1997, the Board of Directors of Salomon Inc approved a non-binding letter of intent to sell all of the outstanding stock of Basis Petroleum to Valero Energy Corporation ("Valero") and a plan of disposition for Basis Petroleum. This transaction resulted in a pretax loss in 1996 of approximately $505 million ($290 million after tax). The sale was completed on May 1, 1997. Proceeds from the sale included cash of $365 million, Valero common stock with a market value of $120 million and participation payments based on a fixed notional throughput and the difference, if any, between an average market crackspread, as defined, and a base crackspread, as defined, over each of the next ten years. The total of the participation payments is capped at $200 million, with a maximum of $35 million per year. During 1998, the Company received $11 million in participation payments from Valero. In addition, as a result of Valero's merger agreement with PG&E Corporation, Valero's common stock was exchanged for stock of PG&E Corporation and a new stock of the "spin-off" company ("New Valero"), representing Valero's refining assets. In the third quarter of 1997, the Company liquidated its interest in the PG&E and New Valero common stock. In July 1997, the Company paid Valero $3 million in connection with the final determination of working capital. The loss included severance costs and anticipated operating losses to be incurred prior to the completion of the sale, and reflects other estimates of value at time of closing. The Company's investment in Genesis Energy, L.P., a publicly traded crude oil gathering, marketing and transportation partnership, was not transferred to Valero.
The following table presents Basis Petroleum's results of operations and the loss on the disposal of Basis Petroleum, which are included in "Discontinued operations" on the consolidated statements of income.
NOTE 7. SEGMENT INFORMATION
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The Company's reportable segments include investment services and asset management. The investment services segment includes investment banking and trading, and retail brokerage as well as related derivative and commodity trading. The Company's global investment banking services encompasses a full range of capital market activities, including the underwriting and distribution of debt and equity securities for United States and foreign corporations and for state, local and other governmental and government sponsored authorities. Investment services executes securities and commodities futures brokerage transactions on all major exchanges on behalf of its customers and its own account. Investment services engages in principal transactions in fixed income securities and is a major participant in the over-the-counter ("OTC") market for various derivative instruments. The segment earns commissions as a broker for its clients in the purchase and sale of securities. Investment services also generates revenue from fees received from the internal management of client assets by Financial Consultants, as well as client assets managed externally by the segment's Consulting Group. The asset management segment provides discretionary and non-discretionary asset management services to a wide array of mutual funds and institutional and individual investors, with respect to domestic and foreign equity and debt securities, municipal bonds, money market instruments, and related options and futures contracts. The segment receives ongoing fees, generally stated as a percentage of the clients assets, from asset management clients.
Segment data presented includes the allocation of all corporate overhead to each segment. Intersegment revenue and expense are eliminated between segments. Information concerning operations in the Company's segments of business is as follows:
- --------------- * The 1996 sale of The Mortgage Company Limited which resulted in a pre-tax gain of $48 million has not been allocated to either segment.
The accompanying table summarizes the Company's operations by geographic area. Amounts are determined principally by the respective legal jurisdictions of the Company's subsidiaries. Substantially all amounts for the asset management segment are included in North America. North America consists of the United States and Canada; Europe primarily consists of the United Kingdom and Germany; Asia and other primarily consists of Japan and Australia. Because of the global nature of the markets in which the Company competes and the integration of the Company's worldwide business activities, the Company believes that amounts determined in this manner are not particularly useful in understanding its business.
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- --------------- * The net realizable value of Basis Petroleum, $490 million, is included in North America in 1996.
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NOTE 8. COMMERCIAL PAPER AND OTHER SHORT-TERM BORROWINGS
Information regarding the Company's short-term borrowings used to finance operations, including the securities settlement process is presented below. Average balances were computed based on month-end outstanding balances.
Outstanding bank borrowings include both U.S. dollar and non-U.S. dollar denominated loans. The non-U.S. dollar loans are denominated in multiple currencies including Japanese yen, German mark and U.K. sterling. All of the Company's
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commercial paper outstanding at December 31, 1998 and 1997 was U.S. dollar denominated. Also included in short-term borrowings are deposit liabilities and other short-term obligations.
The Company has a $3.5 billion 364-day revolving credit agreement that extends through May 1999. The Company may borrow under its revolving credit facility at various interest rate options (LIBOR, CD or base rate) and compensates the banks for the facility through facility fees. Under this facility the Company is required to maintain a certain level of consolidated adjusted net worth (as defined in the agreement). At December 31, 1998, this requirement was exceeded by $2.8 billion.
At December 31, 1998, there were no outstanding borrowings under this facility. In addition, the Company also has substantial borrowing arrangements consisting of facilities that the Company has been advised are available, but where no contractual lending obligation exists.
NOTE 9. TERM DEBT
Term debt consists of issues with original maturities in excess of one year. Certain issues are redeemable, in whole or in part, at par or at premiums prior to maturity.
The maturity structure of the Company's term debt, based on contractual maturities or the earliest date on which the debt is repayable at the option of the holder, was as follows at December 31, 1998:
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The Company issues U.S. dollar and non-U.S. dollar denominated fixed and variable rate term debt. Fixed rate debt matures at various dates through 2023. The contractual interest rates on fixed rate debt ranged from 1.25% (U.S. dollar denominated) to 23.0% (Korean won denominated) at December 31, 1998 and 1.25% (U.S. dollar denominated) to 11.82% (U.S. dollar denominated) at December 31, 1997. The weighted average contractual rate on total fixed rate term debt (both U.S. dollar denominated and non-U.S. dollar denominated) was 6.69% at December 31, 1998 and 6.76% at December 31, 1997. The Company utilizes interest rate swap agreements to convert most of its fixed rate term debt to variable rate obligations. The maturity structure of the swaps generally corresponds with the maturity structure of the debt being hedged.
The Company's non-U.S. dollar fixed rate term debt includes Japanese yen, German mark, U.K. sterling, Italian lira, French franc, Portuguese escudos, European currency unit and the Korean won and, consequently, bears a wide range of interest rates.
At December 31, 1998, the Company had outstanding approximately $2.9 billion of non-U.S. dollar denominated term debt, of which, $1.3 billion was German mark denominated and $.8 billion was U.K. sterling denominated, $.3 billion was Japanese yen denominated (converted at the December 31, 1998 spot rates). Of the $2.9 billion, approximately $.3 billion of Parent Company non-U.S. dollar denominated debt has been designated as a hedge of investments in subsidiaries with functional currencies other than the U.S. dollar. Another $1.2 billion of Parent Company debt has been effectively converted to U.S. dollar denominated obligations using cross-currency swaps. The remaining $1.4 billion is used for general corporate purposes.
The following table summarizes the Company's fixed rate term debt that is swapped to variable rate obligations using interest rate swaps at December 31, 1998 and 1997. The variable rates presented are indicative of the Company's actual costs related to such obligations.
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Variable rate term debt matures at various dates through 2018. The interest rates are determined periodically by reference to money market rates, or in certain instances, are calculated based on stock or bond market indices as specified in the agreements governing the respective issues. The interest rates on variable rate term debt ranged from .96% (Japanese yen denominated) to 8.75% (U.S. dollar denominated) at December 31, 1998 and 0.82% (Japanese yen denominated) to 11.63% (U.S. dollar denominated) at December 31, 1997. The weighted average contractual rate on total variable rate term debt (both U.S. dollar denominated and non-U.S. denominated) was 5.14% at December 31, 1998 and 5.83% at December 31, 1997.
Term debt includes subordinated debt, which totaled $30 million at December 31, 1998 and $28 million at December 31, 1997. At December 31, 1998 and 1997, subordinated debt included approximately $6 million of convertible restricted notes, convertible at the rate of $8.19 per share into 668,888 shares of Citigroup common stock. At December 31, 1998, the Company had outstanding $87 million of term debt for which the principal repayment is linked to certain equity securities of unaffiliated issuers.
The Company has a $1.5 billion revolving credit agreement with a bank syndicate that extends through May 2001, under which it may borrow at various interest rate options (LIBOR, CD or base rate) and compensates the banks for the facility through facility fees. At December 31, 1998, there were no outstanding borrowings under this facility. Under this facility the Company is required to maintain a certain level of consolidated adjusted net worth (as defined in the agreement). At December 31, 1998, this requirement was exceeded by $2.8 billion.
NOTE 10. LEASE COMMITMENTS
The Company has noncancelable leases covering office space and equipment expiring on various dates through 2012. Presented below is a schedule of minimum future rentals on noncancelable operating leases, net of subleases, as of December 31, 1998. Various leases contain provisions for lease renewals and escalation of rent based on increases in certain costs incurred by the lessors.
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Minimum future rentals include $130 million related to space the Company has vacated or intends to vacate. The Company has provided reserves for these premises. Rent expense under operating leases from continuing operations totaled $259 million, $258 million and $251 million for the years ended December 31, 1998, 1997 and 1996, respectively.
NOTE 11. MANDATORILY REDEEMABLE SECURITIES OF SUBSIDIARY TRUSTS
The Parent Company has formed two statutory business trusts under the laws of the state of Delaware that exist for the exclusive purposes of (i) issuing trust securities representing undivided beneficial interests in the assets of the Trust; (ii) investing the gross proceeds of the trust securities in subordinated debt securities of the Parent Company (in the case of SI Financing Trust I) and junior subordinated deferrable interest debt securities of the Parent Company (in the case of SSBH Capital I); and (iii) engaging in only those activities necessary or incidental thereto. These subordinated debt securities and the related income effects are eliminated in the consolidated financial statements. Distributions on the mandatorily redeemable securities of subsidiary trusts below have been classified as interest expense in the consolidated statement of income. The following table summarizes the financial structure of the Parent Company's subsidiary trusts at December 31, 1998:
SI Financing Trust I, a wholly owned subsidiary of the Parent Company, issued TRUPS(R) units to the public. Each TRUPS(R) unit includes a security of SI Financing Trust I, as shown in the table above, and a purchase contract that requires the holder to purchase, in 2021 (or earlier if the Parent Company elects to accelerate the contract), one depositary share representing a one-twentieth interest in a share of Citigroup 9.50% Cumulative Preferred Stock, Series L. The Parent Company is obligated under the terms of each purchase contract to pay contract fees of 0.25% per annum.
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NOTE 12. CAPITAL REQUIREMENTS
Certain U.S. and non-U.S. subsidiaries are subject to various securities and commodities regulations and capital adequacy requirements promulgated by the regulatory and exchange authorities of the countries in which they operate. Capital requirements related to the Company's principal regulated subsidiaries are as follows:
- --------------- * On September 1, 1998, Salomon Brothers Inc and Smith Barney Inc. merged to form Salomon Smith Barney Inc.
** Prior to April 1, 1998, this entity was known as Salomon Brothers Asia Limited.
Advances, dividend payments and other equity withdrawals from regulated subsidiaries are restricted by the regulations of the U.S. Securities and Exchange Commission, the New York Stock Exchange and other regulatory agencies and by certain covenants contained in the Company's revolving credit facilities. See Notes 8 and 9 to the consolidated financial statements. These restrictions may limit the amounts that these subsidiaries pay as dividends or advances to the Company.
In addition, in order to maintain its triple-A rating, Salomon Swapco Inc ("Swapco"), an indirect wholly owned subsidiary of the Company, must maintain minimum levels of capital in accordance with agreements with its rating agencies. At December 31, 1998, Swapco was in compliance with all such agreements. Swapco's capital requirements are dynamic, varying with the size and concentration of its counterparty receivables.
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NOTE 13. EMPLOYEE BENEFIT PLANS
Retirement Plans
The Company participates in defined benefit pension plans that cover certain U.S. and Non-U.S. employees. These plans resulted in expenses from continuing operations of $53 million, $53 million and $46 million in 1998, 1997 and 1996, respectively.
The Company has defined contribution employee savings plans covering certain eligible employees. The costs relating to these plans were $23 million, $34 million and $49 million in 1998, 1997 and 1996, respectively.
Health Care and Life Insurance
The Company provides certain health care and life insurance benefits for its active employees, qualifying retired U.S. employees and certain non-U.S. employees who reach the retirement criteria specified by the various plans. At December 31, 1998, there were approximately 31,800 active and 1,600 retired employees eligible for such benefits.
Expenses recorded for health care and life insurance benefits from continuing operations were $109 million, $121 million, and $110 million in 1998, 1997 and 1996, respectively.
Employee Incentive Plans
The Company participates in a stock option plan sponsored by Citigroup that provides for the granting of stock options in Citigroup common stock to officers and key employees. The Company also participates in the Salomon Incentive Plan ("SIP") which provides for the issuance of up to 5.9 million shares of Citigroup common stock in the form of options, restricted stock and stock bonuses, as well as an additional grant of up to 2.5 million shares of Citigroup common stock in the form of stand-alone stock appreciation rights, phantom stock and cash bonuses to certain key employees, including officers of the Company who were former employees of Salomon. In December 1996, 2.7 million options were awarded under the SIP with an exercise price set at the market value on the date of grant ($26.48). The awards expire five years after the grant date and vest 100% three years after the grant date. At December 31, 1998 there were 1,627, 200 options outstanding relating to the SIP plan. SFAS 123, Accounting for Stock-Based Compensation ("SFAS 123"), allows the fair value of stock-based compensation to be included in expense over the period earned; alternatively, if the fair value of stock-based compensation awards is not included in expense, SFAS 123 requires disclosure of net income, on a pro forma basis, as if expense treatment had been applied. As permitted by SFAS 123, the Company continues to account for such compensation under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees ("APB 25"), pursuant to which no compensation cost has been recognized in connection with the issuance of stock options. Had the Company applied SFAS 123 in accounting for stock options, net income would have been reduced by $79 million, $40 million and $15 million in 1998, 1997 and 1996, respectively. The following assumptions were used to calculate the effect of SFAS 123:
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Certain provisions of the Citigroup incentive plan have changed. Certain employees of the Company will receive Deferred Stock Awards ("DSA's"). A DSA award is an unfunded promise to deliver shares at the end of a three-year deferral period. It is comprised of a basic award representing a portion of the participant's prior year incentive award which vests immediately upon grant, and an additional premium award amounting to 33% of the basic award which vests one-third per year over a three year period. The entire award is forfeited if the participant leaves the Company to join a competitor within three years after the award date. Participants may elect to receive a portion of their award in the form of stock options. The basic portion of the award is expensed in the bonus year that it was earned. The expense associated with the additional 33% premium award is amortized over the appropriate vesting period. After-tax expense of approximately $150 million was recognized during 1998 for 1998 awards that were granted in January 1999.
The Company has various incentive plans under which stock of Citigroup is purchased for subsequent distribution to employees, subject to vesting requirements. These plans resulted in expenses of $313 million, $253 million and $171 million for the years ended December 31, 1998, 1997 and 1996, respectively.
The Equity Partnership Plan (EPP)
Under EPP, qualifying employees of the Company received a portion of their compensation in the form of common stock. EPP deferred payment of the stock for three years and required the contribution of an additional 25% of the deferred compensation amount to the participant's account. The EPP award is forfeited if the participant's employment is terminated for cause within the three-year vesting period. The award is forfeited if the participant leaves the Company to join a competitor within three years after the award date. If a participant leaves other than by virtue of death, disability, retirement or as a result of downsizing during the three years following the award, the entire additional contribution of 25% is forfeited.
Total purchases of shares by the EPP totaled $192 million (4.8 million shares) in 1997, and $153 million (6.1 million shares) in 1996, there were no purchases of shares in 1998. Stock awarded under the EPP totaled $191 million (5.4 million shares), and $147 million (6.1 million shares) in 1997 and 1996 respectively. There was no stock awarded under EPP in 1998. These amounts are included as a component of compensation expense. The net asset related to the EPP, which represents the cost of the unawarded shares held by the EPP less the Company's liability related to the EPP, payable in common stock, is included in "Other assets."
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In December 1998, restrictions on transferability were lifted on approximately 8 million shares (net of withholding tax requirements) awarded by the EPP in 1993.
NOTE 14. INCOME TAXES
The components of income taxes from continuing operations reflected on the consolidated statements of income are:
Under SFAS 109, Accounting for Income Taxes, temporary differences between recorded amounts and the tax bases of assets and liabilities are accounted for at current income tax rates.
At December 31, 1998 and December 31, 1997, respectively, the Company's consolidated statements of financial condition included net deferred tax assets from continuing operations of $1,100 million and $844 million, comprised of the following:
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The Company had no deferred tax valuation allowance at December 31, 1998 or December 31, 1997.
Tax benefits (liabilities) allocated directly to stockholder's equity were as follows:
The Company paid taxes, net of refunds, of $693 million, $918 million and $1,696 million in 1998, 1997 and 1996, respectively.
The Company provides income taxes on the undistributed earnings of foreign subsidiaries except to the extent that such earnings are indefinitely invested outside the United States. At December 31, 1998, $1.3 billion of the Company's accumulated undistributed earnings was indefinitely invested. At the existing U.S. federal income tax rate, additional taxes of $376 million would have to be provided if such earnings were remitted to the United States.
The following table reconciles the U.S. federal statutory income tax rate to the Company's effective tax rate from continuing operations:
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NOTE 15. PLEDGED ASSETS, COMMITMENTS AND CONTINGENCIES
At December 31, 1998, the approximate market values of securities sold under agreements to repurchase or other assets pledged by the Company, excluding the impact of FIN 41, were:
At December 31, 1998, the Company had $2.2 billion of outstanding letters of credit from banks to satisfy various collateral and margin requirements.
Other Contingencies
The Company has provided a residual guarantee of $586 million in connection with the lease of buildings occupied by the Company's executive offices and New York operations.
On July 31, 1993, Smith Barney, along with certain of its affiliates and Travelers Group, acquired the domestic retail brokerage and asset management businesses (the "Shearson Acquisition") of Lehman Brothers Holdings Inc. (then known as Shearson Lehman Brothers Holdings Inc.) and its subsidiaries. In conjunction with the Shearson Acquisition, Smith Barney Inc. has agreed to pay American Express Company additional amounts contingent upon Smith Barney Inc.'s future performance, including 10% of its after-tax profits in excess of $250 million per year over a five-year period (1998 was the final year for this portion of the payout.) The amount to be paid under this agreement in 1998 has yet to be determined,
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while the amount paid under this agreement amounted to $75 million in 1997. The contingent consideration is accounted for prospectively, as additional purchase price, and results in amortization over periods of up to 20 years.
NOTE 16. LEGAL PROCEEDINGS
The Company has been named as a defendant in legal actions relating to its operations, some of which seek damages of material or indeterminate amounts. In addition, from time to time the Company is a party to examinations and inquiries by various regulatory and self-regulatory bodies. In connection with its discontinued commodities processing operations, the Company and certain of its subsidiaries are subject to claims asserted by the U.S. Environmental Protection Agency, certain state agencies and private parties in connection with environmental matters. Management of the Company, after consultation with outside legal counsel, believes that the ultimate resolution of legal proceedings and environmental matters (net of applicable reserves) will not have a material adverse effect on the Company's financial condition; however, such resolution could have a material adverse impact on operating results in future periods depending in part on the results for such periods.
NOTE 17. FINANCIAL INSTRUMENTS, COMMODITIES AND CONTRACTUAL COMMITMENTS AND RELATED RISKS
The Company and its subsidiaries enter into a variety of contractual commitments, such as swaps, cap and floor agreements, swap options, futures contracts, forward currency contracts, forward purchase and sale agreements, option contracts and warrants. These transactions generally require future settlement, and are either executed on an exchange or traded as OTC instruments. Contractual commitments have widely varying terms, and durations that range from a few days to a number of years depending on the instrument.
Interest rate swaps are OTC instruments where two counterparties agree to exchange periodic interest payment streams calculated on a predetermined notional principal amount. The most common interest rate swaps generally involve one party paying a fixed interest rate and the other party paying a variable rate. Other types of swaps include basis swaps, cross-currency swaps, equity swaps and commodity swaps. Basis swaps consist of both parties paying variable interest streams based on different reference rates. Cross-currency swaps involve the exchange of coupon payments in one currency for coupon payments in another currency. An equity swap is an agreement to exchange cash flows on a notional amount based on changes in the values of a referenced index, such as the Standard & Poor's 500 Index. Commodity swaps involve the exchange of a fixed price of a commodity for a floating price, which is usually the prevailing spot price, throughout the swap term. The most common commodity swaps are petroleum-based; other types are based on metals or soft commodities.
Caps are contractual commitments that require the writer to pay the purchaser an excess amount, if the reference rate exceeds a contractual rate at specified times during the contract. Likewise, a floor is a contractual commitment that requires the writer to pay an excess amount, if any, of a contractual rate over a reference rate at specified times over the life of the contract. Swap options are OTC contracts that entitle the holder to either enter into an interest rate swap at a future date or to cancel an existing swap at a future date.
SALOMON SMITH BARNEY HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Futures contracts are exchange-traded contractual commitments to either receive (purchase) or deliver (sell) a standard amount or value of a commodity or financial instrument at a specified future date and price (or, with respect to futures contracts on indices, the net cash amount). Maintaining a futures contract will typically require the Company to deposit with the futures exchange (or other financial intermediary), as security for its obligations, an amount of cash or other specified asset ("initial margin") that typically ranges from 1% to 10% of the face amount of the contract (but may be higher in some circumstances). Additional cash or assets ("variation margin") may be required to be deposited daily as the mark-to-market value of the futures contract fluctuates. Futures contracts may be settled by physical delivery of the underlying asset or cash settlement (for index futures) on the settlement date, or by entering into an offsetting futures contract with the futures exchange prior to the settlement date. Forward contracts are OTC contractual commitments to purchase or sell a specified amount of foreign currency, financial instruments, or commodities at a future date at a predetermined price. The notional amount for forward settling securities transactions represents the amount of cash that will be paid or received by the counterparties when the transaction settles. Upon settlement, the security is reflected on the statement of financial condition as either long or short inventory.
Option contracts are contractual agreements that give the purchaser the right, but not the obligation, to purchase or sell a currency, financial instrument or commodity at a predetermined price. In return for this right, the purchaser pays a premium to the seller (or writer) of the option. Option contracts also exist for various indices and are similar to options on a security or other instruments except that, rather than settling by physical delivery of the underlying instrument, they are settled in cash. Options on futures contracts give the purchaser the right, in return for the premium paid, to assume a position in a futures contract. Warrants have characteristics similar to those of options whereby the buyer has the right, but not the obligation, to purchase a certain instrument at a specific future date and price. The seller (or writer) of the option/warrant is subject to the risk of an unfavorable change in the underlying financial instrument, commodity, or currency. The purchaser is subject to market risk to the extent of the premium paid and credit risk. The Company is obligated to post margin for options on futures. Option contracts may be either exchange-traded or OTC. Exchange-traded options issued by certain regulated intermediaries, such as the Options Clearing Corporation, are the obligations of the issuing intermediary. In contrast to such options, which generally have standardized terms and performance mechanics, all of the terms of an OTC option, including the method of settlement, term, exercise price, premium, guarantees and security, are determined by negotiation of the parties, and there is no intermediary between the parties to assume the risks of performance. The Company issues warrants that entitle holders to cash settlements on exercise based upon movements in market prices of specific financial instruments and commodities, foreign exchange rates and equity indices.
The Company sells various financial instruments that have not been purchased ("short sales"). In order to sell them short, the Company borrows these securities, or receives the securities as collateral in conjunction with short-term financing agreements and, at a later date, must deliver (i.e. replace) like or substantially the same financial instruments or commodities to the parties from which they were originally borrowed. The Company is exposed to market risk for short sales. If the market value of an instrument sold short increases, the Company's obligation, reflected as a liability, would increase and revenues from principal transactions would be reduced.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The way in which the Company accounts for and presents contractual commitments in its financial statements depends on both the type and purpose of the contractual commitment held or issued. As discussed in Note 4 to the consolidated financial statements, the Company records all derivatives used for trading purposes, including those used to hedge trading positions, at market or fair value. Consequently, changes in the amounts recorded in the Company's consolidated statements of financial condition resulting from movements in market or fair value are included in "Principal transactions" in the period in which they occur. The accounting and reporting treatment of derivatives used for non-trading purposes varies, depending on the nature of exposure being hedged.
Contractual commitments and short sales risk may expose the Company to both market risk and credit risk in excess of the amount recorded on the consolidated statements of financial condition. These off-balance sheet risks are discussed in more detail below.
Market Risk
Market risk is the potential loss the Company may incur as a result of changes in the market or fair value of a particular financial instrument, commodity or contractual commitment. All financial instruments, commodities and contractual commitments, including short sales, are subject to market risk. The Company's exposure to market risk is determined by a number of factors, including the size, duration, composition and diversification of positions held, the absolute and relative levels of interest rates and foreign currency exchange rates, as well as market volatility and illiquidity. For instruments such as options and warrants, the time period during which the options or warrants may be exercised and the relationship between the current market price of the underlying instrument and the option's or warrant's contractual strike or exercise price also affect the level of market risk. The most significant factor influencing the overall level of market risk to which the Company is exposed is its use of hedging techniques to mitigate such risk. The Company manages market risk by setting risk limits and monitoring the effectiveness of its hedging policies and strategies.
SFAS 105, Disclosure of Information about Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments with Concentrations of Credit Risk, and SFAS 119, Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments, require the disclosure of the notional amounts of derivative financial instruments, distinguishing between those used for trading purposes and those used for purposes other than trading. The determination of notional amounts does not consider any of the market risk factors discussed above. Notional amounts are indicative only of the volume of activity and are not a measure of market risk. Market risk is influenced by the nature of the items that comprise a particular category of financial instrument. Market risk is also influenced by the relationship among the various off-balance sheet categories as well as the relationship between off-balance sheet items and items recorded in the Company's consolidated statements of financial condition. For all of these reasons, the interpretation of notional amounts as a measure of market risk could be materially misleading.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
A summary of contractual commitments as of December 31, 1998 and 1997 is as follows:
- --------------- (a) Margin on futures contracts is included in receivables/payables to brokers, dealers and clearing organizations on the consolidated statements of financial condition.
(b) Includes notional values of swap agreements and forward currency contracts for non-trading activities (primarily related to the Company's fixed-rate long-term debt) of $16.2 billion and $6.1 billion at December 31, 1998 and $17.6 billion and $4.1 billion at December 31, 1997, respectively.
The annual average balances of the Company's contractual commitments, based on month-end balances, are as follows:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Credit Risk
The Company regularly transacts business with retail customers, and transacts with or owns securities issued by a broad range of corporations, governments, international organizations, central banks and other financial institutions. Phibro regularly transacts business with independent and government-owned oil producers, a wide variety of end users, trading companies and financial institutions. Credit risk is measured by the loss the Company would record if its counterparties failed to perform pursuant to the terms of their contractual obligations and the value of collateral held, if any, was not adequate to cover such losses. The Company has established controls to monitor the creditworthiness of counterparties, as well as the quality of pledged collateral, and uses bilateral security agreements and master netting agreements whenever possible to mitigate the Company's exposure to counterparty credit risk. Master netting agreements enable the Company to net certain assets and liabilities by counterparty. The Company also nets across product lines and against cash collateral, provided such provisions are established in the master netting and cash collateral agreements. The Company may require counterparties to submit additional collateral pursuant to the above agreements when deemed necessary.
The Company enters into collateralized financing agreements in which it extends short-term credit, primarily to major financial institutions. The Company controls access to the collateral pledged by the counterparties, which consists largely of securities issued by the G-7 governments or their agencies that may be liquidated in the event of counterparty default.
In addition, margin levels are monitored daily and additional collateral must be deposited as required. If customers cannot meet collateral requirements, the Company will liquidate sufficient underlying financial instruments to bring the account in compliance with the required margin level.
Concentrations of Credit Risk
Concentrations of credit risk from financial instruments, including contractual commitments, exist when groups of issuers or counterparties have similar business characteristics or are engaged in like activities that would cause their ability to meet their contractual commitments to be adversely affected, in a similar manner, by changes in the economy or other market conditions. The Company monitors credit risk on both an individual and group counterparty basis. The Company's largest single concentration of credit risk is with securities issued by the U.S. government and its agencies, which totaled $24.6 billion at December 31, 1998 and $52.1 billion at December 31, 1997. With the addition of U.S. government and U.S. government agency securities pledged as collateral by counterparties in connection with collateralized financing activity, the Company's total holdings of U.S. government securities were $114.1 billion or 43% of the Company's total assets, before FIN 41 netting, at December 31, 1998 and $132.8 billion or 41% of the Company's total assets, before FIN 41 netting, at December 31, 1997. Similarly, concentrations with non-U.S. governments totaled $47.6 billion at December 31, 1998 and $103.5 billion at December 31, 1997. These consist predominantly of securities issued by the governments of major industrial nations. Remaining concentrations arise principally from contractual commitments with counterparties in financial or commodities transactions involving future settlement and fixed income securities owned. Excluding governments, no concentration with a single counterparty exceeded 1% of total assets at December 31, 1998 or 1997. North America and Europe represent the largest geographic concentrations. Among industries, other major derivatives dealers represent the largest group of counterparties. The Company has one year remaining on a three-year credit support agreement
SALOMON SMITH BARNEY HOLDINGS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
with Genesis Energy, L.P., pursuant to which it is committed to provide Genesis with working capital support of up to $300 million until December 31, 1999.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
NOTE 18. FAIR VALUE INFORMATION
SFAS 107, Disclosures about Fair Value of Financial Instruments, requires the disclosure of the fair value of all financial instruments. The following information is presented to help users gain an understanding of the relationship between the amounts reported in the Company's financial statements and the related market or fair values. Specific accounting policies are discussed in Note 4 to the consolidated financial statements.
At December 31, 1998, $206 billion or 97% of the Company's total assets and $188 billion or 93% of the Company's total liabilities were carried at market value or fair value or at amounts that approximate such values. At December 31, 1997, $272 billion or 98% of the Company's total assets and $253 billion or 94% of the Company's total liabilities were carried at either market or fair values or at amounts that approximate such values. Financial instruments recorded at market or fair value include cash and cash equivalents, financial instruments, commodities and contractual commitments used for trading purposes.
Financial instruments recorded at contractual amounts that approximate market or fair value include collateralized short-term financing agreements, receivables, commercial paper and other short-term borrowings, payables and accrued liabilities, and variable rate term debt. The market values of such items are not materially sensitive to shifts in market interest rates because of the limited term to maturity of many of these instruments and/or their variable interest rates.
The following table reflects financial instruments which are recorded at contractual or historical amounts that do not necessarily approximate market or fair value. Such instruments include U.S. dollar denominated collateralized mortgage obligations ("CMOs") and the assets securing U.S. dollar denominated CMOs, the Company's fixed rate term debt, as well as the fair value of derivative instruments that are used for non-trading, or end user, purposes.
The fair value of fixed rate term debt has been estimated by using a discounted cash flow analysis. The Company's U.S. dollar denominated fixed rate CMOs and assets securing U.S. dollar denominated fixed rate CMOs are carried at their contractual amounts. CMOs and the assets that secure them should not be viewed independently. Taken together, the fair
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
value of the Company's dollar denominated CMOs and the assets securing them is the present value of the difference between future cash inflows from the CMO collateral and cash outflows to service the CMOs.
NOTE 19. RELATED PARTY BALANCES
The Company has related party balances with Citigroup and certain of its subsidiaries. These balances include cash accounts, collateralized financing transactions, margin accounts and derivative trading. These transactions are entered into in the ordinary course of business and are not material to the Company's consolidated statement of financial condition.
NOTE 20. OTHER EVENTS
In 1996, the Company sold its indirect wholly owned subsidiary, The Mortgage Corporation Limited ("TMC"), resulting in an after-tax gain of $31 million ($48 million pre-tax). TMC originated and serviced residential mortgages in the United Kingdom.
NOTE 21. PARENT COMPANY ONLY CONDENSED FINANCIAL STATEMENTS
The following are condensed financial statements of Salomon Smith Barney Holdings Inc. (Parent Company Only):
PARENT COMPANY ONLY CONDENSED STATEMENTS OF INCOME
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
PARENT COMPANY ONLY CONDENSED STATEMENTS OF FINANCIAL CONDITION
- --------------- (1) Includes $3.8 billion and $3.1 billion of subordinated note receivables at December 31, 1998 and December 31, 1997, respectively.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
PARENT COMPANY ONLY CONDENSED STATEMENTS OF CASH FLOWS
BASIS OF PRESENTATION
The accompanying condensed financial statements, which include the accounts of Salomon Smith Barney Holdings Inc. ("SSBH"), a wholly owned subsidiary of Citigroup, should be read in conjunction with the consolidated financial statements of SSBH and its subsidiaries.
Investments in subsidiaries are accounted for under the equity method. For information regarding the Company's term debt see Note 9 of the consolidated financial statements.
RELATED PARTY TRANSACTIONS
SSBH engages in various transactions with its subsidiaries that are characteristic of a consolidated group under common control. As a public debt issuer, SSBH has access to long-term sources of funds that are loaned from SSBH to certain of its subsidiaries. Such intercompany advances are payable on demand and bear interest at varying rates.
SALOMON SMITH BARNEY HOLDINGS INC. AND SUBSIDIARIES
QUARTERLY FINANCIAL DATA (UNAUDITED)
Quarterly results for the year ended December 31, 1998 were as follows:
Quarterly results for the year ended December 31, 1997 were as follows:
EXHIBIT INDEX
- --------------- + Filed herewith.