EDELMAN FINANCIAL GROUP INC. 10-K 2009
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the Fiscal Year Ended December 31, 2008
Commission File No. 0-30066
Sanders Morris Harris Group Inc.
(Exact name of registrant as specified in its charter)
(Registrant's telephone number, including area code)
Securities Registered Pursuant to Section 12(b) of the Act:
Securities Registered Pursuant to Section 12(g) of the Act:
Common Stock, $0.01 Par Value
(Title of each class)
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
¨ Yes x No
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
¨ Yes x No
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. x Yes ¨ No
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). o Yes x No
As of June 30, 2008, the aggregate market value of the shares of Common Stock held by nonaffiliates of the registrant was $114.0 million. For purposes of this computation, all executive officers, directors and 10% beneficial owners of the registrant were deemed to be affiliates. Such determination is not an admission that such officers, directors, and beneficial owners are, in fact, affiliates of the registrant.
As of March 9, 2009, the registrant had 28,168,858 outstanding shares of Common Stock, par value $0.01 per share.
DOCUMENTS INCORPORATED BY REFERENCE
Information in the Registrant's definitive Proxy Statement pertaining to the 2009 Annual Meeting of Shareholders (the "Proxy Statement") to be filed with the SEC is incorporated herein by reference into Part III of this Report.
SANDERS MORRIS HARRIS GROUP INC. AND SUBSIDIARIES
Item 1. Business
Sanders Morris Harris Group Inc. (“SMHG” or “the Company”) is a holding company that, through our subsidiaries and affiliates, provides asset/wealth management and capital markets services. Our company, as it exists today, results largely from the merger in January 2000 of Sanders Morris Mundy Inc., a Houston-based full-service regional investment bank, and Harris, Webb & Garrison, Inc., a Houston-based investment management firm. Since the merger, we have grown significantly, both organically and through strategic acquisitions. From January 2000 through December 31, 2008, we have:
We were founded on the belief that a financial services company should be not only a counselor to its clients but also a partner. We and members of our executive management, where suitable and permissible, often invest in our products on the same basis as our clients, which we refer to as a “wealth partnership”. We believe that becoming wealth partners with our clients demonstrates our confidence in the investment opportunities that we recommend and differentiates us from our competitors. Consistent with this belief, we analyze every potential product that we offer to our clients as if we are investing in it ourselves, which we believe results in higher quality investments. Our wealth partnerships that we form with our clients not only help expand our client base but also help increase revenue from our existing clients by solidifying long-term relationships built upon high quality products and services.
As a result of our focus on creating wealth partnerships with our clients, our executive officers are directly and extensively involved in building client relationships and marketing our products and services. We focus on creating lasting relationships with our private, corporate, and institutional clients by providing a range of services throughout their financial life cycle, combining the personalized service and senior level attention of a smaller firm with the capabilities of a larger firm.
We believe that we have achieved strong brand recognition and a sound reputation in the southwestern United States. Additionally, our acquisitions have enabled us to add well-regarded asset managers and wealth advisors to our platform in other regions of the country. In all, we have 73 offices in 22 states. These factors have strengthened our brand recognition and reputation and have enabled us to attract new clients, not only in the Southwest but, increasingly, in other regions of the country.
We believe that our strategies have been successful. Our client assets have grown from approximately $3.2 billion at January 1, 2000 to $8.6 billion at December 31, 2008, representing a compound annual growth rate of 11.0%. Our revenue has grown from $43.9 million in 2000 to $196.3 million in 2008, representing a compound annual growth rate of 16.8%.
We think that these operating results validate our operating strategies. Further, we believe we have in place the people, infrastructure, and brand recognition at each of our businesses, which, combined with sufficient working capital, will enable us to leverage our operating platform to further increase our profitability and market share.
Our Products and Services
Our asset/wealth management business provides investment advisory, wealth and investment management, and financial planning to high net worth and mass affluent individuals and institutions.
Through our various asset and wealth management subsidiaries, divisions, and affiliates, we serve two distinct client bases:
Each of our business units generally focuses on a different portion of the asset and wealth management business in terms of client type and location, asset and product type, and distribution channel. These business units are generally operated as individual businesses that market their products under their own brand name, with certain products offered through multiple external and internal distribution channels and with certain administrative or back office functions being provided by the parent company. In addition, one or more of our executive officers serve on the board of directors or management committee of each of these businesses.
Our asset/wealth management business primarily earns revenue by charging fees for managing the investment assets of clients. Fees are typically calculated as a percentage of the value of assets under management and vary with the type of account managed, the asset manager, and the account size. Accordingly, the fee income of each of our asset and wealth management businesses typically increases or decreases as its average assets under management increases or decreases. Increases in assets under management result from appreciation in the value of client assets and from net inflows of additional assets from new and existing clients. Conversely, decreases in assets under management result from asset value depreciation and from net client redemptions and withdrawals. We believe an asset-based fee structure helps align our interests with the interests of our clients, particularly as compared to a commission-based fee structure, which is based on the number and value of securities trades executed. Our asset management business may also earn performance fees from certain assets if the investment performance of the assets in the account meets or exceeds a specified benchmark during a measurement period. We also generate a substantial portion of revenue from a traditional, commission-based structure where we earn commissions on client purchase and sale transactions.
At December 31, 2008, our asset and wealth management subsidiaries had approximately $8.6 billion in client assets. Our asset and wealth management revenue in 2008 was $102.7 million and pre-tax income from continuing operations was $24.7 million, accounting for 52.3% of our total revenue.
Our nine asset and wealth management businesses are described below.
SMH Capital Inc. SMH Capital Inc. (formerly Sanders Morris Harris Inc.) (“SMH”), member FINRA/SIPC, headquartered in Houston, Texas, provides asset and wealth management services directly through its private client business and through its affiliation with independent contractors who are members of the SMH Partners program. Its financial advisors (both internal and affiliated through SMH Partners) serve high net worth and mass affluent clients, many of whom have long-standing relationships with us. As a full service firm, SMH offers its clients asset and wealth management services and financial advice relating to corporate debt and equity securities, including the securities of companies followed by our research analysts, underwritings that we co-manage or in which we participate, and private placements of securities in which we serve as placement agent, as well as mutual funds, defined contribution plans, wrap-fee programs, money market funds, insurance products, and tax, trust, and estate advice. At December 31, 2008, SMH had $3.7 billion in client assets, exclusive of our proprietary funds.
SMH Partners is a select group of independent registered representatives affiliated with SMH that provides specialized asset and wealth management services and products to high net worth and mass affluent individuals and institutions. The services provided by SMH Partners include investment management, estate planning, and retirement planning. The financial planners who affiliate with us are able to offer their clients a broad range of new investment opportunities through several exclusive investment programs offered by SMH and SMH Capital Advisors, Inc., as well as by third parties.
Additionally, SMH has organized 17 proprietary funds for the purpose of investing primarily in equity or equity-linked securities, interest-bearing debt securities, and debt securities convertible into common stock. These funds invest primarily in small to mid-capitalization companies, both public and private, that we believe are either significantly undervalued relative to their growth potential or that have substantial prospects for capital appreciation. Companies in which the funds invest represent a number of industries, including life sciences, energy, technology, and industrial services. We account for our interests in all of these funds using the equity method, which approximates fair value. At December 31, 2008, the 14 remaining proprietary funds had approximately $245.1 million in assets under management and committed capital.
The Edelman Financial Center, LLC. The Edelman Financial Center, LLC (“Edelman”), headquartered in Fairfax, Virginia, provides financial advisory services primarily to mass affluent individuals. Edelman has won more than 70 financial, business, community, and philanthropic awards and has been named three times by Inc. magazine as the fastest-growing privately-held financial planning firm in the country. Edelman founder and chairman Ric Edelman is one of the nation’s leading advocates of financial literacy. In addition, Edelman offers its clients a variety of life, disability, and long-term care insurance solutions to fit their needs. At December 31, 2008, Edelman had more than 8,900 clients and approximately $2.9 billion in assets under management or advisement. We own 76% of Edelman at December 31, 2008.
SMH Capital Advisors, Inc. SMH Capital Advisors, Inc. (“Capital Advisors”), located in Fort Worth, Texas, provides investment management services primarily related to high-yield fixed income securities. This business is also known by its previous name of Cummer/Moyers. Nelson’s World’s Best Money Managers ranked Capital Advisors as the No. 1 ranked firm in its U.S. High Yield Income rankings for the one-year, five-year, and ten-year periods ended March 31, 2006 and the No. 2 ranked firm in its U.S. Intermediate Duration Fixed Income rankings for the five-year period ended March 31, 2006. At December 31, 2008, Capital Advisors had approximately $1.1 billion in client assets.
Kissinger Financial Services. Kissinger Financial Services (“Kissinger”), a division of SMH based in Hunt Valley, Maryland, provides financial planning and investment management services to high net worth and mass affluent individuals. Kissinger derives revenue from fees charged to clients for the preparation of financial plans and for monitoring services and earns commissions and fees from investment and insurance products sold to clients. At December 31, 2008, Kissinger had approximately $256.3 million in assets under management or advisement.
The Rikoon Group, LLC. The Rikoon Group, LLC (“Rikoon”), based in Santa Fe, New Mexico, provides asset and wealth management services to high net worth individuals including financial and estate planning, investment management services, wealth education, and family retreats. Rikoon operates nationally with fee only investment counsel and also offers comprehensive family office services. At December 31, 2008, Rikoon had approximately $363.1 million in assets under management. We own 75% of Rikoon at December 31, 2008.
Leonetti & Associates, LLC. Leonetti & Associates, LLC (“Leonetti”), based in Buffalo Grove, Illinois, provides fee-based investment advice for individuals and small businesses. Leonetti provides investment management and financial planning services to enhance client portfolios and help them reach their financial goals. At December 31, 2008, Leonetti had approximately $326.8 million in assets under management. We own 50.1% of Leonetti at December 31, 2008.
Miller-Green Financial Services, Inc. Miller-Green Financial Services, Inc. (“Miller-Green”), based in The Woodlands, Texas provides financial, investment, retirement, and/or estate planning services to individuals and families. At December 31, 2008, Miller-Green had approximately $243.6 million in assets under management.
The Dickenson Group, LLC. The Dickenson Group, LLC (“Dickenson”), based in Solon, Ohio, offers extensive expertise on insurance planning for individuals, families, and businesses as well as employee benefits communications and estate planning. We own 50.1% of Dickenson at December 31, 2008.
Select Sports Group Holdings, LLC. Select Sports Group Holdings, LLC, (“SSG”) and its affiliates, based in Houston, Texas, provide sports representation and management services to professional athletes, principally professional football and baseball players, in contract negotiation, marketing and endorsements, public relations, legal counseling, and related areas. SSG receives fees from its athlete clients for the representation and management services provided. Our SSG clients have access to our investment programs in the areas of stocks, bonds, private equity, and specialized investment vehicles. Additionally, we provide a deal-screening program that reviews the numerous investment opportunities offered to professional athletes. We own 50% of SSG.
Our capital markets business provides investment banking, institutional equity and fixed income brokerage, prime brokerage services to institutional customers and third party management of a portion of our assets.
We conduct our investment banking services through SMH. Our full-service investment banking business focuses primarily on middle market companies in the natural resources, environmental, converging technologies, business services, and health care industries. We have a well-established investment banking practice that combines our industry knowledge, the significant experience of our senior bankers, and our extensive corporate and professional relationships to serve the broad needs of emerging growth companies within our targeted industries. Our investment banking services include public offerings and private placements of equity and debt securities, financial advisory services, and merchant banking services. Our financial advisory services include advising on mergers, acquisitions, and divestitures, fairness opinions, and financial strategies. Our merchant banking activities focus on providing private equity capital for our own account to these companies. We also provide valuation and litigation support services.
Our goal is to provide our investment banking clients the personalized service and senior level attention of a boutique with the capabilities of a full-service firm. We focus on building lasting relationships with our clients by providing a range of services throughout their financial life cycle. Our execution capabilities and full range of services provide us with the opportunity to expand our business relationships with our clients as they evolve.
Our institutional brokerage business, which we also conduct through SMH, includes institutional equity and fixed income brokerage and institutional research.
Institutional Equity. Our institutional clients include a broad array of institutions throughout North America, Europe, and Asia, including banks, retirement funds, mutual funds, endowments, investment advisors, and insurance companies. Our institutional equity strategy is to provide equity research coverage and trading services focused on companies with a presence in the U.S. Areas of concentration include financial services, life sciences, oil and gas exploration and production, oilfield services, pipelines, entertainment and media, retailing, and technology. We provide our institutional clients with research and execution trading services in both exchange-listed equity securities and equity securities quoted on Nasdaq. We also distribute to institutional clients equity securities from offerings that we co-manage or underwrite. Commissions are charged on all institutional securities transactions based on rates formulated by us. These services are available to institutional clients of our financial advisors. As of December 31, 2008, we had institutional equity operations in Los Angeles, New Orleans, New York, Dallas/Fort Worth and Houston.
Institutional Fixed Income. Through our fixed income division, we provide bond brokerage and principal trading services to our institutional clients, adding to the range of investment products we offer. We offer U.S. government and agency securities, municipal securities, mortgage-related securities, and corporate investment-grade and high-yield bonds, as well as preferred stock and structured products. We are also active as a secondary market broker for residential, consumer, and commercial loans and derive revenue from the placement and servicing of mortgage loans. The high-yield bond group within our fixed income division complements our middle-market investment banking operations by providing a distribution channel for investment banking clients.
Institutional Research. We use our proprietary equity research analysis to drive our institutional equity business and, where regulatorily permitted, to assist our other businesses, such as our investment banking operations and proprietary funds. This research analysis is based on economic fundamentals, using tools such as price-to-earnings multiples, price-to-book value comparisons, both absolute and relative to historic norms, and our research department’s own earnings forecasts. We intend to rely primarily on our own research rather than on research products purchased from outside research organizations.
Prime Brokerage Services
The brokerage industry has developed a service known as prime brokerage in which a professional investor, usually a private investor or hedge fund, maintains a cash or margin account with a prime broker that provides trade execution, clearing, bookkeeping, reporting, custodial, securities borrowing, financing, research, and fund raising services. The Concept Capital division of SMH, based in New York, with 51 professionals as of December 31, 2008, provides prime brokerage services to 25 hedge fund managers. We earn commission income on the securities transactions that we process through the prime brokerage transaction and interest income from arranging financing for these hedge funds. The profitability of this division is directly related to the volume of transactions that we process and the borrowings of the funds.
In addition, SMH, through the Concept Capital division, has also entered into asset management agreements with a number of individual asset managers to manage a portion of SMH’s assets. SMH shares in the profits or losses of these accounts and receives the commissions generated in them. The accounts are designed to diversify the aggregate risks, thus limiting potential losses or gains. Most of the accounts have “first loss” deposits to insulate SMH from trading losses. We have procedures in place to monitor trading to ensure that in the event that any “first loss” deposits are depleted by a trader, trading is suspended.
In 2008, revenue from our capital markets business was $89.7 million and pre-tax loss from continuing operations was $2.1 million, accounting for 45.7% of our total revenue.
We believe that we are well positioned to capitalize on a number of trends in the financial services industry, including:
The ongoing consolidation trend in the financial services industry has provided us access to many highly skilled professionals who have chosen to be part of a smaller yet sophisticated firm that has flexibility and preserves an entrepreneurial environment when providing financial services to clients. We attribute our success and distinctiveness not only to our highly skilled professionals but also to the following strengths:
We believe there is an uncommon opportunity for a high quality asset and wealth management and capital markets services firm that can tailor its product and service offerings to fit the needs of its individual, corporate, and institutional clients. Further, we believe we have put in place the people, infrastructure, and brand recognition at each of our businesses, which, combined with sufficient working capital, will enable us to leverage our operating platform to further increase our profitability and market share. Specifically, we intend to:
We have increased our client assets through the acquisitions of Edelman in 2005, Rikoon in 2007, and Leonetti and Miller-Green in 2008. At December 31, 2008, Edelman’s assets under management were $2.9 billion, Rikoon’s assets under management were $363.1 million, Leonetti’s assets under management were $326.8 million, and Miller-Green’s assets under management were $243.6 million.
In one transaction at the end of the third quarter of 2008 and two transactions in the first quarter of 2009, we entered into agreements to make significant changes in our operations.
Edelman Financial Center, LLC and Edelman Financial Advisors, LLC
On January 29, 2009, the Company, entered into an agreement with Ric Edelman and Edward Moore pursuant to which the parties agreed to make certain amendments to (a) the Reorganization and Purchase Agreement dated as of May 10, 2005 (the “Purchase Agreement”), among the Company, The Edelman Financial Center, Inc. (“EFC Inc”), The Edelman Financial Center, LLC (“Edelman”), and Mr. Edelman, pursuant to which the Company had agreed to purchase 100% of the member interests in Edelman from EFC Inc. and Mr. Edelman and (a) the Letter Loan Agreement and Letter Agreement each dated December 8, 2006, between the Company and Edelman Financial Advisors, LLC (“EFA”), pursuant to which the Company had agreed to make certain loans to EFA and acquired a 10% interest in EFA. The new agreement provides that: (i) the Company will purchase an additional 66% interest in EFA from Mr. Edelman and Mr. Moore for an aggregate consideration consisting of (a) $25.0 million in cash and (b) a subordinated promissory note in the principal amount of $10.0 million and (ii) that the Third Closing under the Purchase Agreement, scheduled for May 8, 2009, will not occur and Mr. Edelman will retain a 24% interest in Edelman.
Capital Markets Business
On January 22, 2009, the Company and SMH entered into a Contribution Agreement with Pan Asia China Commerce Corp. (“PAC3”), Siwanoy Capital, LLC (“Siwanoy”) and Siwanoy Securities, LLC (“New BD”), pursuant to which (a) PAC3 agreed to subscribe for and purchase a 40% Class A membership interest in Siwanoy in exchange for a cash payment and note and (b) SMH agreed to contribute to New BD the assets, properties, working capital, and rights related and/or pertaining to its investment banking, institutional trading (including equity sales and fixed income sales), New York trading, and research businesses (excluding The Juda Group and the Concept Capital divisions) (the “Capital Markets Business”), including a specified amount of working capital (as adjusted for any profits of losses incurred in the Capital Markets Business between January 1, 2009, and the date of closing) less (i) the value of the accounts receivable contributed to Siwanoy, (ii) the value of the certain assets in SMH’s New Orleans, Louisiana office, (iii) the value of certain money security deposits and any advance payments, and (iv) the value of certain securities to be mutually agreed upon by the parties in exchange for a 20% Class A Membership Interest in Siwanoy, cash, and a note issued by Siwanoy to the Company. Current members of management of the Capital Markets Business will retain the remaining 40% membership interest in Siwanoy. The transaction is expected to close following the filing with and approval by the Financial Industry Regulatory Authority (“FINRA”) of a new member application by the New BD, which is anticipated to be in the second quarter of 2009.
Salient Partners and Endowment Advisers
On August 29, 2008, the Company entered into an Agreement to Retire Partnership Interest and Second Amendment to the Limited Partnership Agreement of Endowment Advisers, L.P. (the “EADV Agreement”) with Endowment Advisers, L.P. (“Partnership”), The Endowment Fund GP, L.P., (“TEF GP”), and The Endowment Fund Management, LLC, the sole general partner of each of TEF GP and the Partnership (the “General Partner”), and the Partnership’s limited partners (other than the Company) (collectively with the General Partner, the “Continuing Partners”). Prior to entry into the EADV Agreement, the Company was a limited partner of the Partnership and TEF GP and a member of the General Partner with approximately a 23.15% partnership or member interest. The Partnership is the investment adviser, and TEF GP is the general partner, of The Endowment Registered Fund, L.P. and The Endowment TEI Fund, L.P., each a limited partnership registered under the Investment Company Act of 1940 as a non-diversified, closed-end management investment company.
Pursuant to the EADV Agreement, the Company agreed to sell to the Partnership, and to withdraw from the Partnership, and the Partnership agreed to purchase from the Company all of the partnership interest held by the Company and the Partnership agreed to distribute to the Company consideration consisting of an aggregate amount equal to $86.0 million, plus a 6% per annum internal rate of return (the “Redemption Consideration”). The EADV Agreement provides that the Partnership shall, to the extent funds are available for distribution as determined by the General Partner in good faith, taking into account all facts and circumstances at the time, distribute cash to the Company in each calendar quarter period equal to the greater of (i) 23.15% of the aggregate cash distributions of the Partnership, or (ii) $3.0 million (the “Minimum Quarterly Distribution”), until such time as the Company has received the entire Redemption Consideration. The Redemption Consideration is subject to reduction by a portion of the Company’s liability under the Salient Incentive Plan (as defined below) not to exceed $3.3 million.
In addition, on August 29, 2008, the Company also entered into a Purchase and Sale Agreement (the “Salient Agreement”) with Salient Partners, L.P. (“Salient Partners”), and Salient Capital Management, LLC (“SCM”), and the respective limited partners and members of Salient Partners and SCM, pursuant to which the Company agreed to sell to Salient Partners its partnership interest in Salient Partners and to SCM its member interest in SCM for aggregate consideration of $9.3 million (the “Salient Purchase Price”). The Salient Purchase Price is payable pursuant to the terms of an Unsecured Subordinated Promissory Note dated August 29, 2008 (the “Note”), in the original principal amount of $9.3 million, bearing interest at the U.S. prime rate (adjusted on a quarterly basis), payable as to principal in quarterly payments of $467,000 each (subject to applicable setoff amounts as discussed below), payable on the 1st day of March, June, September, and December of each year beginning December 1, 2008, and continuing until September 1, 2013, when the entire amount of the Note, principal and interest then remaining unpaid, is due and payable. Pursuant to the terms of the Salient Agreement, the Company remains liable for its pro rata share of the liability under the Salient Partners, L.P. Key Employee Equity Incentive Plan in the maximum amount of $5.8 million (the “SMHG Ratable Incentive Payout”). The Company’s liability for the SMHG Ratable Incentive Payout will be satisfied (i) 43.5% ($2.5 million) by offset against the Note payments as they become due pro rated based upon the amount that the principal of the payment relates to then outstanding principal amount of the Note, and (ii) 56.5% ($3.3 million) by offset against the distributions due to the Company under the EADV Agreement pro rated based upon how the amount of a quarterly distribution relates to the base amount of the Redemption Consideration.
While we believe cross-selling opportunities exist among our various businesses based on the relationships developed by the individual companies, each major subsidiary has its own branding identity subject to an overall Sanders Morris Harris Group umbrella.
SMH markets through its 39 offices and through 34 offices of independent registered representatives who are affiliated with SMH through SMH Partners. SMH targets its client groups through financial advisor relationships, mailings, telephone calls, in-person presentations, and firm-sponsored workshops. Due to the nature of its business, its regional name recognition, and the reputation of its management, business is obtained through referrals from existing clients, corporate relationships, other investment bankers, or initiated directly by the client, as well as through senior level calling programs.
Edelman conducts its marketing efforts through media channels designed to educate individuals on the subject of personal finance. Ric Edelman hosts a nationally syndicated weekly radio program in the Washington, D.C. area and in 21 other markets. Ric Edelman is a nationally syndicated newspaper columnist, publishes a monthly newsletter, and is the author of a variety of books and video and audio educational systems that help people achieve their financial goals.
Capital Advisors focuses its marketing and business development efforts on specific client groups through consultants, mailings, telephone calls, and multi-media client presentations. Kissinger conducts its marketing and business development primarily through referrals from existing clients and other professional (i.e., accountants and attorneys) and sponsored or co-sponsored workshops and seminars. The seminars are sponsored by Kissinger, local employers, government agencies, and local colleges and universities.
Existing and potential clients can also gain a variety of information about our firm and the services we provide through the Internet websites for our various businesses. The information on those websites is not a part of this Annual Report on Form 10-K.
The asset and wealth management and capital markets services businesses are highly competitive. The principal competitive factors influencing our businesses are:
We compete directly with many other national and regional full service financial services firms and, to a lesser extent, with discount brokers, investment banking firms, investment advisers, broker-dealer subsidiaries of major commercial bank holding companies, and other companies offering financial services in the U.S., globally, and through the Internet. We also compete for asset management and fiduciary services with commercial banks, private trust companies, sponsors of mutual funds, insurance companies, financial planning firms, venture capital, private equity and hedge funds, and other asset managers. We believe that our principal competitive advantages include our regional and industry focus, focus on the growing high net worth and mass affluent markets, highly regarded distribution network and investment managers, ability to cross-sell our products, creating wealth partnerships with our clients, and proven management team.
The financial services industry has become considerably more concentrated as many securities firms have either ceased operations or been acquired by or merged into other firms. Many of these larger firms have significantly greater financial and other resources than we do and can offer their customers more product offerings, lower pricing, broader research capabilities, access to international markets, and other products and services we do not offer, which may give these firms a competitive advantage over us.
During 2008, many of our largest competitors were materially negatively affected by the global financial crisis. Certain of our larger competitors ceased to do business, while others merged, obtained substantial government assistance, and changed their business models and regulatory status, including becoming bank holding companies. The U.S. government is continuing to explore ways to revive the financial sector and the impact of these efforts is currently impossible to assess. It is likely that the companies that survive will remain competitors and that they will continue to have resources and product offerings that will continue to have a competitive impact on us.
As we seek to expand our asset management business, we face competition in the pursuit of clients interested in our services, the recruitment and retention of asset management professionals, and the identification and acquisition of other asset management firms that can be integrated in our group.
The securities industry is one of the nation's most extensively regulated industries. The U.S. Securities and Exchange Commission (“SEC”) is responsible for the administration of the federal securities laws and serves as a supervisory body over all national securities exchanges and associations. The regulation of broker-dealers has to a large extent been delegated by the federal securities laws to Self Regulatory Organizations (“SROs”). These SROs include, among others, all the national securities and commodities exchanges and the Financial Industry Regulatory Authority (formerly the NASD) (“FINRA”). Subject to approval by the SEC and certain other regulatory authorities, SROs adopt rules that govern the industry and conduct periodic examinations of the operations of our broker-dealer subsidiary. Our broker-dealer subsidiary is registered in all 50 states, Puerto Rico, and the province of Ontario, Canada and is also subject to regulation under the laws of these jurisdictions.
As a registered broker-dealer, SMH, our brokerage subsidiary, is subject to certain net capital requirements of Rule 15c3-1 under the Exchange Act. The net capital rules, which specify minimum net capital requirements for registered broker-dealers, are designed to measure the financial soundness and liquidity of broker-dealers. Failure to maintain the required net capital may subject a firm to suspension or revocation of registration by the SEC and suspension or expulsion by other regulatory bodies, and ultimately may require its liquidation. Further, a decline in a broker-dealer's net capital below certain “early warning levels”, even though above minimum capital requirements, could cause material adverse consequences to the broker-dealer.
As registered investment advisors under the Investment Advisers Act of 1940, SMH, Capital Advisors, Edelman, Rikoon, Leonetti, Miller-Green, and certain other subsidiaries are subject to the requirements of regulations under both the Investment Advisers Act and certain state securities laws and regulations. Such requirements relate to, among other things, (1) limitations on the ability of investment advisors to charge performance-based or non-refundable fees to clients, (2) record-keeping and reporting requirements, (3) disclosure requirements, (4) limitations on principal transactions between an advisor or its affiliates and advisory clients, and (5) general anti-fraud prohibitions.
Additional legislation, changes in rules promulgated by the SEC and SROs, or changes in the interpretation or enforcement of existing laws and rules may directly effect the mode of our operation and profitability.
At December 31, 2008, we had 639 employees. Of these, 38 in institutional sales and trading, 40 in investment banking, 16 in securities analysis and research, 51 in prime brokerage services, 413 in investment management, 17 in systems development, 4 in sports representation and management, and 60 in accounting, administration, legal, compliance, and support operations. None of our employees are subject to collective bargaining agreements. We believe our relations with our employees generally are good.
Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as well as proxy statements, are made available free of charge on our internet website, www.smhgroup.com, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC.
Additionally, we make available on our web site and in print upon request of any shareholder to our Chief Financial Officer, a number of our corporate governance documents. These include: the Audit Committee charter, the Nominating and Corporate Governance Committee charter, and the Business Ethics Policy for Employees. Within the time period required by the SEC and the Nasdaq Stock Market, we will post on our web site any modifications to any of the available documents. The information on our website is not incorporated by reference into this report.
Our Chief Financial Officer can be contacted at Sanders Morris Harris Group Inc., 600 Travis, Suite 5800, Houston, Texas 77002, telephone: (713) 224-3100.
Item 1A. Risk Factors
We face a variety of risks that are substantial and inherent in our businesses, including market, liquidity, credit, operational, legal, and regulatory risks. You should carefully consider the following risks and all of the other information in this Report, including the Consolidated Financial Statements and Notes thereto. The following are some of the more important factors that could affect our businesses.
Risks Relating to the Nature of Our Business
Recent government actions to stabilize credit markets and financial institutions may not be effective and could adversely affect our competitive position.
The U.S. Government recently enacted legislation and created several programs to help stabilize credit markets and financial institutions and restore liquidity, including the Emergency Economic Stabilization Act of 2008, the Troubled Asset Relief Program, the Federal Reserve's Commercial Paper Funding Facility and Money Market Investor Funding Facility and the Federal Deposit Insurance Corporation (“FDIC”) Temporary Liquidity Guarantee Program. Additionally, the governments of many nations have announced similar measures for institutions in their respective countries. There is no assurance that these programs individually or collectively will have beneficial effects in the credit markets, will address credit or liquidity issues of companies that participate in the programs or will reduce volatility or uncertainty in the financial markets. The failure of these programs to have their intended effects could have a material adverse effect on the financial markets, which in turn could materially and adversely affect our business, financial condition, and results of operation.
Difficult market conditions have adversely affected the financial services industry and could adversely affect us.
The financial services industry experienced unprecedented change and volatility in 2008. Several banks and securities firms in the United States and elsewhere have failed outright or have been acquired by other financial institutions, often in distressed sales. In the United States declines in the housing market, with falling home prices and increasing foreclosures, have adversely affected the credit performance of mortgage loans and resulted in material writedowns of asset values by financial institutions, including government-sponsored entities, banks, securities firms and insurers. These writedowns have caused many financial institutions to seek additional capital, either from the private markets at substantial discounts from previously reported stock prices or from the U.S. government sponsored “TARP” program, which also involves significant dilutive equity issues and additional regulatory oversight and restrictions. Concern about the stability of financial markets and the strength of counterparties has caused many traditional sources of credit, such as banks, securities firms, and insurers, as well as institutional and private investors, to reduce or cease providing funding to borrowers. The U.S. government has adopted and proposed numerous measures in an attempt to stabilize the financial markets and recapitalize major financial institutions. Despite substantial efforts by the U.S. and other governments to restore confidence and reopen sources of credit, it is not possible to predict the extent to which such measures will prove successful.
The continuation or worsening of current conditions may cause us to face some or all of the following risks:
• We may experience losses in securities trading activities or as a result of write-downs in the value of securities that we own as a result of deteriorations in the businesses or creditworthiness of the issuers of such securities.
• Declines in stock prices and trading volumes could result in declines in commission income, margin interest revenues, asset management and service fees and adversely affect our profitability.
• The number of investment banking transactions where we act as advisor could be adversely affected by continued uncertainties in valuations related to asset quality and creditworthiness, volatility in the equity markets, and diminished access to financing.
• Our opportunity to act as underwriter or placement agent in equity and debt offerings could be adversely affected by competing government sources of equity or by volatile equity or debt markets.
• Our plans for expansion of our client base or the services we provide may be delayed or impaired.
• We may incur unexpected costs or losses as a result of the bankruptcy or other failure of companies for which we have performed investment banking services to honor ongoing obligations such as indemnification or expense reimbursement agreements.
• As an introducing broker to clearing firms, we are responsible to the clearing firms and could be held liable for the defaults of our customers, including losses incurred as the result of a customer’s failure to meet a margin call. Although we review credit exposure to specific customers, default risk may arise from events or circumstances that are difficult to detect or foresee. When we allow customers to purchase securities on margin, we are subject to risks inherent in extending credit. This risk increases when a market is rapidly declining and the value of the collateral held falls below the amount of a customer’s indebtedness. If a customer’s account is liquidated as the result of a margin call, we are liable to our clearing firm for any deficiency.
• Competition in our investment banking, sales, and trading businesses could intensify as a result of the increasing pressures on financial services companies and larger firms competing for transactions and business that historically would have been too small for them to consider.
• Our industry could face increased regulation as a result of legislative or regulatory initiatives, and the responsibilities of the SEC and other federal agencies may be reallocated. Compliance with such regulation may increase our costs and limit our ability to pursue business opportunities.
• Government intervention may not succeed in stabilizing the financial and credit markets and may have negative consequences for our business.
If one or more of the foregoing risks occurs, we could experience an adverse effect, which may be material, on our business, financial condition, and results of operations.
Lack of sufficient liquidity or access to capital could impair our business and financial condition.
Historically, we have satisfied our need for funding from internally generated funds, sales of shares of our common stock to our employees and to the public, and a revolving credit facility with a financial institution. As a result of the low level of leverage that we have traditionally employed in our business model, we have not been forced to significantly curtail our business activities as a result of lack of credit sources and we believe that our capital resources are currently sufficient to continue to support our current business activities. However, to complete our acquisition of Edelman Financial Advisors, LLC we will need $25.0 million in available cash in March 2009. In the event existing internal and external financial resources do not satisfy our needs, we would have to seek additional outside financing. The availability of outside financing will depend on a variety of factors, such as our financial condition and results of operations, the availability of acceptable collateral, market conditions, the general availability of credit, the volume of trading activities, and the overall availability of credit to the financial services industry.
The soundness of other financial institutions could adversely affect us.
Our ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services institutions are interrelated as a result of trading, clearing, counterparty, or other relationships. We have exposure to many different counterparties and we routinely execute transactions with counterparties in the financial services industry, including brokers and dealers, commercial banks, investment banks, mutual and hedge funds, and other institutional clients. As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, have led to market-wide liquidity problems and could lead to losses or defaults by us or by other institutions. Many of these transactions expose us to credit risk in the event of default of our counterparty or client. In addition, our credit risk may be exacerbated when the collateral held by us cannot be realized upon or is liquidated at prices not sufficient to recover the full amount of the receivable due us. Any such losses could be material and could materially and adversely affect our business, financial condition, and results of operations.
The asset and wealth management, investment banking, and institutional services industries are highly competitive. If we are not able to compete successfully against current and future competitors, our business, financial condition, and results of operations will be adversely affected>.
The financial services business is highly competitive, and we expect it to remain so. The principal competitive factors influencing our asset and wealth management, investment banking and institutional services businesses are:
Our ability to compete effectively in our asset and wealth management and investment banking activities is also influenced by the adequacy of our capital levels and by our ability to raise additional capital.
We compete directly with many other national and regional full service financial services firms and, to a lesser extent, with discount brokers, investment banking firms, investment advisors, broker-dealer subsidiaries of major commercial bank holding companies, and other companies offering financial services in the U.S., globally, and through the Internet. We also compete for asset management and fiduciary services with commercial banks, private trust companies, sponsors of mutual funds, insurance companies, financial planning firms, venture capital, private equity and hedge funds, and other asset managers.
We are a relatively small firm with 639 employees as of December 31, 2008, and total revenue of $196.3 million in 2008. Many of our competitors have greater personnel and financial resources than we do. Larger competitors are able to advertise their products and services on a national or regional basis and may have a greater number and variety of products and distribution outlets for their products, larger customer bases, and greater name recognition. These larger and better capitalized competitors may be better able to respond to changes in the asset and wealth management and investment banking industries, to finance acquisitions, to fund internal growth, and to compete for market share generally. Also, many of our competitors have more extensive investment banking activities than we do and, therefore, may possess a relative advantage in accessing deal flow and capital. In addition to competition from firms currently in the securities business, there has been increasing competition from other firms offering financial services, including automated trading and other services based on technological innovations.
Increased pressure created by current or future competitors, individually or collectively, could materially and adversely affect our business and results of operations. Increased competition may result in reduced revenue and loss of market share. Further, as a strategic response to changes in the competitive environment, we may from time to time make certain pricing, service, or marketing decisions or acquisitions that also could materially and adversely affect our business and results of operations. In addition, new technologies and the expansion of existing technologies may increase competitive pressures on us. We cannot assure you that we will be able to compete successfully against current and future competitors.
Competition also extends to the hiring and retention of highly skilled employees. A competitor may be successful in hiring away an employee or group of employees, which may result in our losing business formerly serviced by them. Such competition can also raise our costs of hiring and retaining the key employees we need to effectively execute our business plan.
If we are unable to compete effectively, our business, financial condition, and results of operations will be adversely affected.
We may experience reduced revenue due to downturns or disruptions in the securities markets that reduce market volumes, securities prices, and liquidity, which can also cause counterparties to fail to perform>.
The securities business is, by its nature, subject to significant risks, particularly in volatile or illiquid markets, including:
We are an asset and wealth management, investment banking, and institutional services firm and changes in the financial markets or economic conditions in the U.S. and elsewhere in the world could adversely affect our business in many ways. The securities business is directly affected by many factors, including market, economic, and political conditions; broad trends in business and finance; investor sentiment and confidence in the financial markets; legislation and regulation affecting the national and international business and financial communities; currency values; inflation; the availability and cost of short-term and long-term funding and capital; the credit capacity or perceived creditworthiness of the securities industry in the marketplace; the level and volatility of equity prices and interest rates; and technological changes. These and other factors can contribute to lower price levels for securities and illiquid markets.
The capital and credit markets have been experiencing extreme volatility and disruption for more than twelve months. In recent weeks, the volatility and disruption have reached unprecedented levels. Concerns over inflation, energy costs, geopolitical issues, the availability and cost of credit, the U.S. mortgage market, and a declining real estate market in the U.S. have contributed to this increased volatility and have diminished expectations for the economy and the markets going forward. These factors, combined with volatile oil and gas prices, declining business and consumer confidence and increased unemployment, have precipitated an economic slowdown. Many economists are now predicting that the U.S. economy, and possibly the global economy, may enter into a prolonged recession or depression as a result of the deterioration in the credit markets and the related financial crisis, as well as a variety of other factors.
This market downturn could result in lower prices for securities, which may result in reduced management fees calculated as a percentage of assets managed. The market downturn could also lead to a decline in the volume of transactions that we execute for our customers and, therefore, to a decline in the revenue we receive from commissions and spreads. Fluctuations in market activity could impact the flow of investment capital into or from assets under management and advisement and the way customers allocate capital among money market, equity, fixed income, or other investment alternatives, which could negatively impact our asset and wealth management business. Unfavorable financial or economic conditions would likely reduce the number and size of transactions in which we provide underwriting, financial advisory, and other services. Our corporate finance revenue, in the form of financial advisory and underwriting fees, is directly related to the number and size of the transactions in which we participate and would therefore be adversely affected by a sustained market downturn. In periods of low volume or price levels, profitability is further adversely affected because certain of our expenses remain relatively fixed.
Sudden sharp declines in market values of securities can result in illiquid markets and the failure of counterparties to perform their obligations, which could make it difficult for us to sell securities, hedge securities positions, and invest funds under management. Market declines could also increase claims and litigation, including arbitration claims from customers. In such markets, we may incur reduced revenue or losses in our principal trading, market making, investment banking, merchant banking, and financial advisory activities.
We are also subject to risks inherent in extending credit to the extent our clearing brokers permit our customers to purchase securities on margin. The margin risk increases during rapidly declining markets when collateral values may fall below the amount our customer owes us. Any resulting losses could adversely affect our business, financial condition, and results of operations.
There are market, credit and counterparty, and liquidity risks associated with our market making, principal trading, merchant banking, arbitrage, and underwriting activities. We may experience significant losses if the value of our marketable security positions deteriorates.
We conduct principal trading, market making, merchant banking, and arbitrage activities for our own account, which subjects our capital to significant risks. These activities often involve the purchase, sale, or short sale of securities as principal in markets that are characterized as relatively illiquid or that may be susceptible to rapid fluctuations in liquidity and price. Current unfavorable market conditions could limit our resale of purchased securities or the repurchase of securities sold short. These risks involve market, credit and counterparty, and liquidity risks, which could result in losses for us. Market risk relates to the risk of fluctuating values and the ability of third parties to whom we have extended credit to repay us. Credit and counterparty risks represent the potential loss due to a client or counterparty failing to perform its contractual obligations, such as delivery of securities or payment of funds. Liquidity risk relates to our inability to liquidate assets or redirect illiquid investments. In any period we may experience losses as a result of price declines, lack of trading volume, or lack of liquidity.
In our underwriting and merchant banking, asset and wealth management, and other activities, we may have large concentrations in securities of, or commitments to, a single issuer or issuers engaged in a specific industry. As an underwriter, we may incur losses if we are unable to resell the securities we commit to purchase or if we are forced to liquidate our commitment at less than the agreed purchase price. Also, the trend, for competitive and other reasons, toward larger commitments on the part of lead underwriters means that, from time to time, as an underwriter (including a co-manager), we may retain significant concentrations in individual securities. These concentrations increase our exposure to market risks.
Our business depends on the services of our executive officers, senior management, and many other skilled professionals and may suffer if we lose the services of our executive officers, senior management, or other skilled professionals.
We depend on the continuing efforts of our executive officers and senior management. That dependence may be intensified by our decentralized operating strategy. If executive officers or members of senior management leave us, our business or prospects could be adversely affected until we attract and retain qualified replacements.
We derive a substantial portion of our revenue from the efforts of our financial services professionals. Therefore, our future success depends, in large part, on our ability to attract, recruit, and retain qualified financial services professionals. Demand for these professionals is high and their qualifications make them particularly mobile. These circumstances have led to escalating compensation packages in the industry. Up front payments, increased payouts, and guaranteed contracts have made recruiting these professionals more difficult and can lead to departures by current professionals. From time to time we have experienced, and we may in the future experience, losses of asset and wealth management, sales and trading, research, and investment banking professionals. Departures can also cause client defections due to close relationships between clients and the professionals. If we are unable to retain our key employees or attract, recruit, integrate, or retain other skilled professionals in the future, our business could suffer.
We have a number of investment advisor affiliates, including Edelman, Rikoon, Leonetti, and Miller-Green, which were founded by and are identified with one individual. The departure, death, or disability of that individual could result in the loss of clients and assets under management.
We generally do not have employment agreements with our senior executive officers or other professionals. We attempt to retain our employees with incentives such as the issuance of our stock subject to continued employment. These incentives, however, may be insufficient in light of increasing competition for experienced professionals in the securities industry, particularly if our stock price declines or fails to appreciate sufficiently to be a competitive source of a portion of a professional’s compensation.
An economic downturn in the U.S. generally, or in any of our target sectors, could adversely affect our revenue.
Asset and wealth management, investment banking, and institutional services for clients based in the U.S. account for a significant portion of our revenue. An economic downturn in the U.S. generally or in the energy sector or another of our target sectors could adversely affect our existing and potential asset and wealth management clients and the emerging and middle-market companies and industries within the region we predominantly serve, which could in turn reduce our asset and wealth management, underwriting, and institutional services businesses and adversely affect our financial results and the market value of our securities.
Litigation and potential securities laws liabilities may adversely affect our business.
Many aspects of our business involve substantial risks of liability, litigation, and arbitration, which could adversely affect us. As a normal part of our business, we are from time to time named as a defendant or co-defendant in civil litigation and arbitration proceedings and as a subject of regulatory investigations arising from our business activities as a financial services firm. Some of these proceedings involve claims for substantial amounts of damages, based on allegations such as misconduct by us or our failure to properly supervise our asset and wealth management advisors, bad investment advice, unsuitable investment recommendations or excessive trading in a client’s account by our asset and wealth management advisors, materially false or misleading statements made in connection with securities offerings and other transactions, the advice we provide to participants in corporate transactions, and disputes over the terms and conditions of complex trading arrangements. The risks of liability, litigation, and arbitration often may be difficult to assess or quantify, and their existence and magnitude often remain unknown for substantial periods of time. In view of the inherent difficulty of predicting the outcome of legal and regulatory proceedings, particularly where the plaintiffs or regulatory authorities seek substantial or indeterminate damages or fines or where novel legal theories or a large number of parties are involved, we cannot state with confidence what the eventual outcome of currently pending matters will be or what the timing of the ultimate resolution of these matters will be. Depending on our results for a particular period, an adverse determination could have a material effect on quarterly or annual operating results in the period in which it is resolved. See “Item 3. – Legal Proceedings”.
In recent years, there has been a substantial amount of litigation involving the investment banking industry, including class action lawsuits seeking substantial damages and other suits seeking punitive damages. Companies engaged in the underwriting of securities, as we are, are subject to substantial potential liability, including for material misstatements or omissions in prospectuses and other communications in underwritten offerings of securities or statements made by securities analysts. These liabilities can arise under federal securities laws, similar state statutes, and common law doctrines. The risk of liability may be higher for an underwriter that, like us, is active in the underwriting of securities offerings for emerging and middle-market companies because of the higher degree of risk and volatility associated with the securities of these companies. The defense of these or any other lawsuits or arbitration proceedings may divert the efforts and attention of our management and staff, and we may incur significant legal expense in defending litigation or arbitration proceedings.
Poor investment performance, in either relative or absolute terms, may reduce the profitability of our asset and wealth management business.
In 2008, our asset and wealth management revenue was $102.7 million, accounting for 52.3% of our total revenue. We derive our revenue from this business primarily from management fees that are based on committed capital, assets under management or advisement, and incentive fees, which are earned if the return of our proprietary funds exceeds certain threshold returns. Our ability to maintain or increase assets under management or advisement is subject to a number of factors, including investors’ perception of our past performance, in either relative or absolute terms, market or economic conditions, and competition from other fund managers.
Investment performance is one of the most important factors in retaining existing clients and competing for new asset and wealth management business. Poor investment performance could reduce our revenue and impair our growth in a number of ways:
Even when market conditions are generally favorable, our investment performance may be adversely affected by the investment style of our asset and wealth management and investment advisors and the particular investments that they make. To the extent our future investment performance is perceived to be poor in either relative or absolute terms, the revenue and profitability of our asset and wealth management business will likely be reduced and our ability to attract new clients and funds will likely be impaired.
Our asset and wealth management clients can terminate their relationships with us, reduce the aggregate assets under management or advisement, or shift their funds to other types of accounts with different rate structures for any number of reasons, including investment performance, changes in prevailing interest rates, inflation, changes in investment preferences of clients, changes in our reputation in the marketplace, changes in management or control of clients or third party distributors with whom we have relationships, loss of key investment management personnel or wealth advisors, and financial market performance.
We may experience substantial fluctuations in our operating results from period to period due to the nature of our business and therefore fail to meet profitability expectations.
Our operating results may fluctuate from quarter to quarter and from year to year due to a combination of factors. These factors include:
Our revenue from an underwriting transaction is recorded only when the underwriting is completed. Revenue from merger or acquisition transactions is recorded only when non-refundable retainer fees are received or the transaction closes. Accordingly, the timing of recognition of revenue from a significant transaction can materially affect our quarterly and annual operating results. Additionally, we have a certain level of fixed costs in our investment banking operations. As a result, we could experience losses in these operations if revenue from our services is lower than our fixed costs.
We depend on proprietary and third party systems, so a systems failure could significantly disrupt our business. These and other operational risks may disrupt our business, result in regulatory action against us, or limit our growth.
Our business depends highly on our ability to process, on a daily basis, a large number of transactions across numerous and diverse markets, and the transactions we process have become increasingly complex. Consequently, we rely heavily on our communications and financial, accounting, and other data processing systems, including systems provided by our clearing brokers and service providers. We face operational risk arising from mistakes made in the confirmation or settlement of transactions or from transactions not being properly recorded, evaluated, or accounted.
If any of these systems do not operate properly or are disabled, we could suffer financial loss, a disruption of our business, liability to clients, regulatory intervention, or reputational damage. Any failure or interruption of our systems, the systems of our clearing brokers, or third party trading systems could cause delays or other problems in our securities trading activities, which could have a material adverse effect on our operating results. In addition, our clearing brokers provide our principal disaster recovery system. We cannot assure you that we or our clearing brokers will not suffer any systems failures or interruption, including ones caused by earthquake, fire, other natural disasters, power or telecommunications failure, act of God, act of war, terrorism, or otherwise, or that our or our clearing brokers’ back-up procedures and capabilities in the event of any such failure or interruption will be adequate. The inability of our or our clearing brokers’ systems to accommodate an increasing volume of transactions could also constrain our ability to expand our business.
Strategic investments or acquisitions may result in additional risks and uncertainties in our business.
We intend to grow our core businesses through both internal expansion and through strategic investments and acquisitions. To the extent we make strategic investments or acquisitions, we face numerous risks and uncertainties combining or integrating the relevant businesses and systems, including the need to combine accounting and data processing systems and management controls, and to integrate relationships with clients, vendors, and business partners. Acquisitions pose the risk that any business we acquire may lose clients or employees or could under-perform relative to expectations.
Risks Related to the Regulation of Our Business
Our securities broker-dealer and investment advisor subsidiaries are subject to substantial regulation. If we fail to comply with applicable requirements, our business will be adversely affected.
Our businesses are subject to extensive regulation under both federal and state laws. SMH is registered as a broker-dealer with the SEC and FINRA; SMH, Capital Advisors, Edelman, Rikoon, Leonetti, and Miller-Green are registered with the SEC as investment advisors. All of the professional agents employed by SSG and SSG Baseball, L.P. are registered as certified contract advisors with either the National Football League Players Association or the Major League Baseball Players Association.
The SEC is the federal agency responsible for the administration of federal securities laws. In addition, self-regulatory organizations, principally FINRA and the securities exchanges, are actively involved in the regulation of broker-dealers. We are also subject to regulation by state securities commissions in those states in which we do business. The principal purpose of regulation and discipline of broker-dealers is the protection of clients and the securities markets rather than protection of creditors and shareholders of broker-dealers. Broker-dealers are subject to regulations that cover all aspects of the securities business, including sales methods, trade practices among broker-dealers, use and safekeeping of customers’ funds and securities, capital structure of securities firms, record-keeping, and the conduct of directors, officers, and employees.
The SEC, FINRA, other self-regulatory organizations, and state securities commissions may conduct administrative proceedings that can result in:
The imposition of any penalties or orders on us could have a material adverse effect on our business, financial condition, and results of operations. The investment banking and brokerage industries have recently come under scrutiny at both the state and federal levels, and the cost of compliance and the potential liability for non-compliance has increased as a result.
The regulatory environment in which we operate is also subject to change. Our business may be adversely affected as a result of new or revised legislation, or changes in rules promulgated by the SEC, FINRA, and other self-regulatory organizations. We may also be adversely affected by changes in the interpretation or enforcement of existing laws and rules by the SEC and FINRA.
Our financial services businesses may be materially affected not only by regulations applicable to our subsidiaries as financial market intermediaries but also by regulations of general application. For example, the volume of our underwriting, merger and acquisition, merchant banking, and principal investment business in a given period could be affected by existing and proposed tax legislation, antitrust policy, and other governmental regulations and policies, (including the monetary policies of the Federal Reserve Board), as well as changes in interpretation or enforcement of existing laws and rules that affect the business and financial communities.
Our ability to comply with laws and regulations relating to our financial services businesses depends in large part upon maintaining a system to monitor compliance and our ability to attract and retain qualified compliance personnel. Although we believe we are in material compliance with all applicable laws and regulations, we may not be able to comply in the future. Any noncompliance could have a material adverse effect on our business, financial condition, and results of operations.
The business operations of SMH may face limitations due to net capital requirements.
As a registered broker-dealer, SMH is subject to the net capital rules administered by the SEC and FINRA. These rules, which specify minimum net capital requirements for registered broker-dealers and FINRA members, are designed to assure that broker-dealers maintain adequate net capital in relation to their liabilities and the size of their customers’ business. These requirements have the effect of requiring that a substantial portion of a broker-dealer’s assets be kept in cash or highly liquid investments. Failure to maintain the required net capital may subject a firm to suspension or revocation of its registration by the SEC and suspension or expulsion by FINRA and other regulatory bodies. Compliance with these net capital rules could limit operations that require extensive capital, such as underwriting or trading activities.
These net capital rules could also restrict our ability to withdraw capital in situations where SMH has more than the minimum required capital. We may be limited in our ability to pay dividends, implement our strategies, pay interest or repay principal on our debt, and redeem or repurchase our outstanding shares. In addition, a change in these net capital rules or new rules affecting the scope, coverage, calculation, or amount of the net capital requirements, or a significant operating loss or significant charge against net capital, could have similar effects.
As a holding company, we depend on dividends, distributions, and other payments from our subsidiaries to fund any dividend payments and to fund all payments on our obligations. As a result, any regulatory action that restricts SMH’s ability to make payments to us could impede access to funds we need to make dividend payments or payments on our obligations.
Risks Relating to Owning Our Common Stock
The market price of our common stock may be volatile, which could adversely affect the value of your shares. Our common stock may trade at prices below your purchase price.
The market price of our common stock may be subject to significant fluctuations in response to many factors, including:
Many of these factors are beyond our control. Any one of the factors noted herein could have an adverse effect on the value of our common stock. Our common stock may trade at prices below your purchase price.
Because our board of directors can issue common stock without shareholder approval, you could experience substantial dilution.
Our board of directors has the authority to issue up to 100,000,000 shares of common stock, to issue options and warrants to purchase shares of our common stock, and to issue debt convertible into common stock without shareholder approval in certain circumstances. Future issuances of additional shares of our common stock could be at values substantially below the price at which you may purchase our stock and, therefore, could represent substantial dilution. In addition, our board of directors could issue large blocks of our common stock to fend off unwanted tender offers or hostile takeovers without shareholder approval.
Our ability to issue “blank check” preferred stock without approval by the holders of our common stock could adversely affect your rights as a common shareholder and could be used as an anti-takeover device.
Our charter allows our board of directors to issue preferred stock and to determine its rights, powers, and preferences without shareholder approval (“blank check preferred stock”). Future preferred stock issued under the board’s authority could contain preferences over our common stock as to dividends, distributions, and voting power. Holders of preferred stock could, for example, be given the right to separately elect some number of our directors in all or specified events or an independent veto right over certain transactions, and redemption rights and liquidation preferences assigned to preferred shareholders could affect the residual value of your common stock. We could also use the preferred stock to deter or delay a change in control that may be opposed by management even if the transaction might be favorable to you as a common shareholder.
Anti-takeover provisions of the Texas Business Corporation Act and our charter could discourage a merger or other type of corporate reorganization or a change in control even if it could be favorable to the interests of our shareholders.
Provisions of our corporate documents and Texas law may delay or prevent an attempt to obtain control of our company, whether by means of a tender offer, business combination, proxy contest, or otherwise. These provisions include:
Our officers and directors own a substantial amount of our common stock and, therefore, exercise significant control over our corporate governance and affairs, which may result in their taking actions with which you do not agree.
Our executive officers, directors, and affiliates, and entities affiliated with them, control approximately 30% of our outstanding common stock (including exercisable stock options held by them). These shareholders, if they act together, may be able to exercise substantial influence over the outcome of all corporate actions requiring approval of our shareholders, including the election of directors and approval of significant corporate transactions, which may result in corporate action with which you do not agree. This concentration of ownership may also have the effect of delaying or preventing a change in control and might affect the market price of our common stock.
Item 1B. Unresolved Staff Comments
Item 2. Properties
Our principal executive office together with certain brokerage and investment banking operations of SMH are located at 600 Travis, Houston, Texas and comprise approximately 67,000 square feet of leased office space pursuant to lease arrangements expiring in 2018. We lease 26 other office locations including Alexandria, Virginia; Bernardsville, New Jersey; Bethesda, Maryland; Boca Raton; Chicago (two locations); Cleveland (two locations); Colorado Springs; Dallas/Fort Worth (three locations); Fairfax, Virginia; Garden City, New York; Greenwich, Connecticut; Hunt Valley, Maryland; Jackson, Mississippi; Las Vegas; Los Angeles; New Orleans; New York City (three locations); Santa Fe; The Woodlands, Texas; and Tulsa. We lease all of our office space which management believes, at the present time, is adequate for our business. We also lease communication and other office equipment.
Item 3. Legal Proceedings
Many aspects of our business involve substantial risks of liability. In the normal course of business, we have been and in the future may be named as defendant or co-defendant in lawsuits and arbitration proceedings involving primarily claims for damages. We are also involved in a number of regulatory matters arising out of the conduct of our business. There can be no assurance that these matters will not have a material adverse effect on our results of operations in any future period and a significant judgment could have a material adverse impact on our consolidated financial position, results of operations, and cash flows. In addition to claims for damages and monetary sanctions that may be made against us, we incur substantial costs in investigating and defending claims and regulatory matters.
In May 2005, SMH acted as placement agent for a private placement of $50.0 million in convertible preferred stock of Ronco Corporation, a company involved in direct response marketing. Subsequent to the offering, Ronco experienced financial difficulties and ultimately filed a voluntary petition under Chapter 11 of the Bankruptcy Code on June 14, 2007. The bankruptcy court approved the sale of substantially all of Ronco’s assets in August 2007, and the case has been converted to liquidation under Chapter 7. In 2007, SMH wrote off a $3.0 million subordinated working capital loan that it made to Ronco in 2006.
In May 2007, two purchasers of Ronco convertible preferred stock filed a complaint against SMH, US Special Opportunities Trust PLC and Renaissance US Growth Investment Trust PLC, Case No. 07-04837, in the 193rd Judicial District Court, Dallas County, Texas, alleging common law fraud, statutory fraud in a stock transaction, violations of the Texas Securities Act, and negligent misrepresentation in connection with the plaintiffs’ purchase of $2.0 million in Ronco convertible preferred stock. SMH has filed an answer and special exceptions. SMH believes it has valid defenses to all claims made by the plaintiffs. However, there is no assurance that the Company will successfully defend such claims. We expect this case to go to trial in the second quarter of 2009.
In view of the inherent difficulty of predicting the outcome of legal proceedings, particularly where the plaintiffs seek substantial or indeterminate damages or where novel legal theories or a large number of parties are involved, we cannot state with confidence what the eventual outcome of currently pending matters will be, what the timing of the ultimate resolution of these matters will be, or what the eventual result in each pending matter will be. Based on currently available information, we have established reserves for certain litigation matters and our management does not believe that resolution of any matter will have a material adverse effect on our liquidity or financial position although, depending on our results for a particular period, an adverse determination could have a material effect on quarterly or annual operating results in the period in which it is resolved.
Item 4. Submission of Matters to a Vote of Security Holders
There were no matters submitted to a vote of our security holders during the fourth quarter of 2008.
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Our common stock trades on the Global Market Security tier of The Nasdaq Stock Market under the symbol “SMHG”. The following table sets forth the quarterly high and low sales prices for our common stock during 2008 and 2007 for the calendar quarters indicated, each as reported on the Nasdaq National Market, and cash dividends declared per share of common stock:
At March 9, 2009, there were 313 holders of record of our common stock.
In 2002, our board of directors instituted a policy of paying regular quarterly dividends on our common stock. During 2005, we increased the declared quarterly dividend payment to $0.045 per share (an annual amount of $0.18 per share). In February 2009, the board of directors declared a cash dividend for the first quarter of 2009 in the amount of $0.045 per share. Our declaration and payment of future dividends is subject to the discretion of our board of directors. In exercising this discretion, the board of directors will take into account various factors, including general economic and business conditions, our strategic plans, our financial results and condition, our expansion plans, any contractual, legal and regulatory restrictions on the payment of dividends, and such other factors the board considers relevant.
Securities Authorized for Issuance Under Equity Compensation Plans
For our equity compensation plans, the following table shows, at the end of fiscal year 2008, (a) the number of securities to be issued upon the exercise of outstanding options, warrants and rights, (b) the weighted-average exercise price of such options, warrants and rights, and (c) the number of securities remaining available for future issuance under the plans, excluding those issuable upon exercise of outstanding options, warrants and rights.
The following chart shows a comparison of the cumulative total shareholder return on our common stock for the five-year period ended December 31, 2008, as compared to the cumulative total return of the Nasdaq Stock Market Index and the Nasdaq Financial Stocks Index, a peer group, assuming $100 was invested at market close on December 31, 2003 in our common stock and the two indices and dividends were reinvested.
The foregoing performance graph is not deemed to be “soliciting material” or to be “filed” with the SEC or subject to Regulation 14A or 14C, other than as provided in Item 201 of Regulation S-K, or to the liabilities of Section 18 of the Securities Exchange Act of 1934, and will not be deemed to be incorporated by reference into any filing under the Securities Act of 1933 or Securities Exchange Act of 1934, except to the extent that we specifically incorporate it by reference.
Item 6. Selected Financial Data
The following data should be read together with the Consolidated Financial Statements and their related notes and “Management's Discussion and Analysis of Financial Condition and Results of Operations” included later in this report.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Special Cautionary Notice Regarding Forward-Looking Statements
This Annual Report on Form 10-K includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements may relate to such matters as anticipated financial performance, future revenue or earnings, business prospects, projected ventures, new products, anticipated market performance, and similar matters. We caution you that a variety of factors could cause our actual results to differ materially from the anticipated results or other expectations expressed in our forward-looking statements. These risks and uncertainties, many of which are beyond our control, include, but are not limited to (1) trading volume in the securities markets; (2) volatility of the securities markets and interest rates; (3) changes in regulatory requirements that could affect the demand for our services or the cost of doing business; (4) general economic conditions, both domestic and foreign, especially in the regions where we do business; (5) changes in the rate of inflation and related impact on securities markets; (6) competition from existing financial institutions and other new participants in the securities markets; (7) legal developments affecting the litigation experience of the securities industry; (8) successful implementation of technology solutions; (9) changes in valuations of our trading and warrant portfolios resulting from mark-to-market adjustments; (10) dependence on key personnel; (11) demand for our services; and (12) litigation and securities law liabilities. See “Risk Factors”. The Company does not undertake any obligation to publicly update or revise any forward-looking statements.
The following discussion should be read in conjunction with the Consolidated Financial Statements and their related notes and other detailed information appearing elsewhere in this Annual Report.
The Company is a holding company that, through its subsidiaries and affiliates, provides asset/wealth management and capital markets services to a large and diversified group of clients and customers, including individuals, corporations, and financial institutions. A summary of these services follows:
Our Asset/Wealth Management segment provides investment advisory, wealth and investment management, and financial planning services to high net worth and mass affluent individuals and institutions, including investment strategies and alternatives, tax efficient estate and financial planning, trusts, and agent/fiduciary investment management services, throughout their financial life cycle, as well as private client brokerage services. In addition, we provide specialized asset management products and services in specific investment styles to corporations and institutions both through internal marketing efforts and externally through formal sub-advisory relationships and other distribution arrangements with third parties.
Our Capital Markets segment provides investment banking, institutional equity and fixed income brokerage, and prime brokerage services to institutional clients, and third party management of a portion of our assets.
Investment Banking includes capital raising, public offerings, and private placements of equity and debt securities, financial advisory services, including advice on mergers, acquisitions and restructurings, and merchant banking services.
Institutional Brokerage provides institutional equity and fixed income brokerage and institutional research to a broad array of institutions throughout North America, Europe, and Asia, including banks, retirement funds, mutual funds, endowments, investment advisors, and insurance companies.
Prime Brokerage Services provides trade execution, clearing, bookkeeping, reporting, custodial, securities borrowing, financing, research, and fund raising to hedge fund clients. The Company maintains a number of asset management accounts on behalf of individual asset managers through this division.
We have expanded both the range and depth of services offered to our clients through a combination of acquisitions and internal expansion. This growth has necessitated that we add additional personnel, as well as production-related incentive compensation plans. We have also improved and expanded our infrastructure including facilities, technology, and information services, to enable us to better compete with other firms that offer services similar to ours.
Our financial services business is affected by general economic conditions. Our revenue relating to asset-based advisory services and managed accounts is typically from fees based on the market value of assets under management or advisement. The decline in assets under our management due to instability in the overall stock market resulted in lower management fees for us as well as lower trading volume and reduced commission rates which have had a negative impact on our commission revenue.
We closely monitor our operating environment to enable us to respond promptly to market cycles. In addition, we seek to lessen earnings volatility by controlling expenses, increasing fee-based business, and developing new revenue sources. Nonetheless, operating results of any specific period should not be considered representative of future performance.
Components of Revenue and Expenses
Revenue. Our revenue is comprised primarily of (1) fees from asset-based advisory services, asset management, and financial planning services, (2) commission revenue from wealth advisory, prime and institutional brokerage transactions, (3) investment banking revenue from corporate finance fees, merger and acquisition fees, and merchant banking fees, and (4) principal transactions. We also earn interest on cash held and receive dividends from the equity and fixed income securities held in our corporate capital accounts, earn fees through the sale of insurance products, and have realized and unrealized gains (or losses) on securities in our inventory account.
Expenses. Our expenses consist of (1) compensation and benefits, (2) floor brokerage, exchange, and clearance fees, and (3) other expenses. Compensation and benefits have both a variable component, based on revenue production, and a fixed component. The variable component includes institutional and retail sales commissions, bonuses, overrides, and other incentives. Wealth advisory and institutional commissions are based on competitive commission schedules. Employees of the investment banking group and the research group receive a salary and discretionary bonuses as compensation. The fixed component includes administrative and executive salaries, payroll taxes, employee benefits, and temporary employee costs. Compensation and benefits is our largest expense item and includes wages, salaries, and benefits. During 2008, compensation and benefits represented 51.9% of total expenses and 64.6% of total revenue, compared to 64.8% of total expenses and 57.8% of total revenue during 2007. The decrease in compensation and benefits as a percentage of expenses is principally due to a $56.5 million goodwill impairment charge recognized in 2008. The increase in compensation and benefits as a percentage of total revenue is principally due to an increase in revenue in our prime brokerage services division which has a higher payout than our other business lines.
Floor brokerage, exchange, and clearance fees include clearing and trade execution costs associated with the retail, prime, and institutional brokerage business at SMH. SMH clears its transactions through several clearing firms, including Pershing, an affiliate of The Bank of New York Mellon, Goldman Sachs Execution & Clearing, L.P., Ridge Clearing & Outsourcing Solutions, Inc., and First Clearing Corporation.
Other expenses include (1) communications and data processing expenses, such as third-party systems, data, and software providers, (2) occupancy expenses, such as rent and utility charges for facilities, (3) interest expense, (4) amortization of intangible assets, and (5) other general and administrative expenses.
Results of Operations
Year Ended December 31, 2008 Compared to Year Ended December 31, 2007
Total revenue increased $10.5 million to $196.3 million in 2008 from $185.8 million in 2007, while total expenses increased $79.0 million to $244.7 million in 2008 from $165.7 million in 2007. Equity in income of limited partnerships increased to $38.6 million in 2008 from $3.8 million in 2007, primarily due to the sale of our interests in Salient Partners, L.P. and Endowment Advisers, L.P. Income (loss) from continuing operations was $(25.3) million, or $(0.96) per diluted common share, in 2008 compared to $5.1 million, or $0.20 per diluted common share, in 2007.
Revenue from investment advisory and related services increased from $71.3 million during 2007 to $73.9 million in 2008, primarily due to the acquisitions of Rikoon, Leonetti, and Miller-Green. Commission revenue increased to $56.1 million in 2008 from $54.8 million during 2007 primarily due to an increase in trading volume in the institutional brokerage division. Investment banking revenue decreased to $14.3 million in 2008 from $35.0 million in 2007, principally due to a decrease in the number of banking transactions completed during 2008 caused by weakness in the financial markets. Principal transactions revenue increased from $10.2 million in 2007 to $33.5 million in 2008, primarily as the result of an increase in gains in our assets managed by third parties to $15.0 million in 2008 from $3.3 million in 2007. Also, principal transactions revenue from the sale of fixed income products increased to $11.9 million in 2008 from $2.5 million in 2007. Interest and dividends was constant at $6.7 million in 2008 and 2007. A decrease in the amount of money in the firm’s accounts that are earning interest income and a decline in interest rates in 2008 was offset by interest earned on notes receivable received in connection with the sale of our interests in Salient Partners, L.P. and Endowment Advisers, L.P. Other income increased to $11.8 million in 2008 from $7.7 million in 2007 reflecting growth in hedge fund servicing revenue and third-party marketing fees.
Employee compensation and benefits increased to $126.9 million in 2008 from $107.4 million in 2007 due to revenue growth in the prime brokerage services division. Expenses increased at a disproportionate rate to increased revenue due to a shift in a portion of revenue from lower compensation components (investment banking) to higher compensation components (prime brokerage services). Floor brokerage, exchange, and clearance fees increased to $7.0 million in 2008 from $6.4 million in 2007 reflecting the increase in trading volume. Communications and data processing increased to $11.3 million in 2008 from $10.0 million in 2007 primarily due to higher clearing firm service fees resulting from the increase in trading volume. Occupancy costs increased to $13.2 million in 2008 from $11.9 million in 2007 due to the increase in the amount of rental space occupied by SMH and the addition of Rikoon, Dickenson, Leonetti, and Miller-Green. Interest expense increased to $147,000 in 2008 from $35,000 in 2007 due to the imputed interest associated with an incentive compensation payable resulting from the sale of our interests in Salient Partners, L.P. and Endowment Advisers, L.P. The Company recognized a goodwill impairment charge of $56.5 million in 2008. No such charge was recognized in 2007. Amortization of intangible assets increased to $1.0 million in 2008 from $349,000 in 2007 due to the addition of Rikoon, Dickenson, Leonetti, and Miller-Green. Other general and administrative expenses decreased to $28.6 million in 2008 from $29.6 million in 2007 primarily due to a decrease in the provision for bad debts which was partially offset by an increase in outside sales commissions.
Our effective tax rate from continuing operations was 52.4% in 2008 compared to 37.2% in 2007. The effective tax rate exceeds the federal statutory income tax rate primarily as a result of nondeductible goodwill impairment charges.
RESULTS BY SEGMENT
Revenue from asset/wealth management decreased to $102.7 million in 2008 from $107.3 million in 2007 and income from continuing operations before income taxes decreased to $24.7 million in 2008 from $24.8 million in 2007. Sales credits from investment banking transactions decreased to $1.1 million in 2008 from $7.0 million in 2007. This decrease was partially offset by an increase in investment advisory and related services revenue to $73.7 million in 2008 from $71.1 million in 2007, primarily due to the acquisitions of Rikoon, Dickenson, Leonetti, and Miller-Green. Additionally, the conversion of Edelman’s assets under management from a commission-based to a fee-based compensation structure contributed to the growth in investment advisory fee revenue. Total expenses decreased to $72.6 million in 2008 from $75.1 million in 2007, primarily due to decreased employee compensation related to the lower revenue. Equity in income of limited partnerships decreased to $1.5 million in 2008 from $8.5 million in 2007, principally due to the decrease in the value of the investment portfolio of one of the limited partnerships that we manage. Minority interests in net income of consolidated companies reflect the portion of net income attributable to minority interest ownership of entities included in our consolidated financial statements. Income attributable to minority interests, which reduces our pretax income, decreased to $6.9 million in 2008 from $15.8 million in 2007, principally due to decreases in the values of the investment portfolio of one of the limited partnerships.
Revenue from investment banking decreased to $12.2 million in 2008 from $23.6 million in 2007 and income (loss) from continuing operations before income taxes decreased to a loss of $4.2 million in 2008 from income of $4.3 million in 2007. The revenue decrease is primarily due to a decrease in the number of banking transactions completed during 2008 caused by weakness in the financial markets. Total expenses decreased to $16.5 million in 2008 from $19.3 million in 2007. The decrease in expenses is attributable to decreased employee compensation, which is partially tied to revenue.
Revenue from institutional brokerage increased to $15.8 million in 2008 from $15.5 million in 2007 and income (loss) from continuing operations before income taxes decreased to a loss of $671,000 in 2008 from income of $1.2 million in 2007. Commission revenue increased to $12.5 million in 2008 from $9.9 million in 2007 reflecting a $3.2 million increase in commissions from the sale of collateralized debt obligations in our fixed income division. This increase was partially offset by a decline in sales credits from syndicate and investment banking activities to $627,000 in 2008 from $3.4 million in 2007 reflecting a lower volume of offerings sold by the institutional division. Total expenses increased to $16.5 million in 2008 from $14.3 million in 2007, primarily due to increased employee compensation related to the higher commission revenue.
Prime Brokerage Services
Revenue from prime brokerage services increased to $61.7 million in 2008 from $36.6 million in 2007 and income from continuing operations before income taxes increased to $2.9 million in 2008 from $2.8 million in 2007. Commission revenue and third-party marketing fees increased to $29.6 million in 2008 from $25.3 million in 2007 reflecting growth in hedge fund servicing revenue. In addition, principal transactions revenue increased to $30.6 million in 2008 from $7.8 million in 2007 reflecting an increase in revenue earned from the sale of fixed income products and trading activities. Total expenses increased to $58.8 million during 2008 from $33.8 million during 2007 reflecting increased compensation and outside sales commissions related to increased revenue. Our revenue sharing arrangement for prime brokerage services provides generally that we retain $2.75 million of the first $3.25 million of income and that we do not share in additional income until book profit of the division exceeds $5.5 million.
Corporate Support and Other
Revenue from corporate support and other increased to $3.9 million in 2008 from $2.8 million in 2007 and the loss from continuing operations before income taxes decreased to a loss of $39.2 million in 2008 from a loss of $25.0 million in 2007. Interest and dividend income increased to $5.2 million in 2008 from $3.8 million in 2007. Interest earned on notes receivable received in connection with the sale of our interests in Salient Partners, L.P. and Endowment Advisers, L.P. was partially offset by a decrease in the amount of money in the firm’s accounts that are earning interest income and a decline in interest rates in 2008. Total expenses increased to $80.3 million in 2008 from $23.2 million in 2007 primarily due to a $56.5 million goodwill impairment charge recognized in 2008. Equity in income (loss) of limited partnerships increased to income of $37.1 million in 2008 from a loss of $4.6 million in 2007, primarily due to the sale of our interests in Salient Partners, L.P. and Endowment Advisers, L.P. This income was partially offset by the decrease in the value of our direct investment in one limited partnership.
Year Ended December 31, 2007 Compared to Year Ended December 31, 2006
Total revenue increased $19.1 million to $185.8 million in 2007 from $166.7 million in 2006, while total expenses increased $19.9 million to $165.7 million in 2007 from $145.8 million in 2006. Equity in income of limited partnerships increased to $3.8 million in 2007 from $2.2 million in 2006, principally due to larger increases in the values of securities held in the investment portfolios of the limited partnerships managed by the Company. Income from continuing operations was $5.1 million, or $0.20 per diluted common share, in 2007 compared to $10.3 million, or $0.49 per diluted common share, in 2006. The loss from discontinued operations was $6.9 million, or $0.33 per diluted common share, in 2006. There was no such loss in 2007.
Investment advisory and related services increased from $41.7 million during 2006 to $71.3 million in 2007. The conversion of almost three-quarters of Edelman’s assets under management from a commission-based to a fee-based compensation structure has contributed in the rise in investment advisory fee revenue. Additionally, an increase in assets under management at Edelman and Salient and the acquisition of Rikoon also contributed to the growth in investment advisory fee revenue. Commission revenue declined to $54.8 million in 2007 from $57.2 million during 2006 primarily due to the conversion of assets under management at Edelman from a commission-based to a fee-based compensation structure. Investment banking revenue declined to $35.0 million in 2007 from $36.6 million in 2006 due to reduced revenue from investment banking advisory engagements. Principal transactions revenue declined from $18.7 million in 2006 to $10.2 million in 2007 as the result of declines in the value of our investment portfolios. Interest and dividends increased to $6.7 million in 2007 from $6.6 million in 2006. Other income increased to $7.7 million in 2007 from $5.9 million in 2006 due to an increase in fees earned on the Company’s cash balances and customer credit balances at its clearing firms resulting from higher deposit balances.
Employee compensation and benefits increased to $107.4 million in 2007 from $96.3 million in 2006 due to the higher revenue. Floor brokerage, exchange, and clearance fees declined to $6.4 million in 2007 from $7.4 million in 2006 as the result of lower trading volume in the trading operations of our Concept Capital division. Communications and data processing increased to $10.0 million in 2007 from $7.7 million in 2006 primarily due to higher clearing firm service fees at Edelman caused by the conversion of accounts from a commission-based to a fee-based fee structure. Occupancy costs increased to $11.9 million in 2007 from $11.0 million in 2006 due to the increase in the amount of rental space and related furniture and equipment necessary for the expansion of our asset and wealth management business. Interest expense declined to $35,000 in 2007 from $804,000 in 2006 due to the payoff of most of the Company’s debt during 2006. Amortization of intangible assets was $349,000 in 2007. There was no such amortization recorded in 2006. Other general and administrative expenses increased to $29.6 million in 2007 from $22.7 million in 2006 primarily due to the write-off of two notes receivable, representing bridge loans to investment banking clients, totaling $5.0 million.
Our effective tax rates from continuing operations were 37.2% in 2007 and 2006. The effective tax rate exceeds the federal statutory income tax rate primarily as a result of state income taxes, which was partially affected by certain interest and dividend income not subject to tax.
During 2006, the Company hired a 30-person fixed income team and established an expanded fixed income division headquartered in New York. Over the course of the year, the division was unable to achieve sufficient revenue to offset its costs, many of which were in the form of guaranteed salaries and bonuses. During the third and fourth quarters of 2006, we decided to close and closed the division. As a result, we recorded a loss from discontinued operations in 2006 of $3.8 million, net of tax, primarily consisting of operating losses.
Additionally, during 2006, Charlotte Capital, an investment advisor subsidiary of the Company, made the decision to terminate its existing advisory agreements and wind up its business. This decision was made due to the continuing decline of assets under management and to the fact that Charlotte Capital was not profitable. As a result, we recorded a loss from discontinued operations in 2006 of $3.1 million, net of tax, consisting of a write down of goodwill, operating losses, and abandoned leases.
No losses from discontinued operations were recorded in 2007.
RESULTS BY SEGMENT
Revenue from asset/wealth management increased to $107.3 million in 2007 from $80.5 million in 2006 and income from continuing operations before income taxes increased to $24.8 million in 2007 from $12.8 million in 2006. Commission revenue declined to $19.5 million in 2007 from $23.5 million in 2006 due to the conversion of assets under management at Edelman from a commission-based to a fee-based compensation structure. Investment advisory and related services increased to $71.1 million in 2007 from $41.6 million in 2006 as a result of this conversion. Growth in assets under management at Edelman and Salient, as well as the acquisition of Rikoon, has contributed to the increase in revenue from investment advisory fees. Compensation expense increased to $55.2 million in 2007 from $45.8 million in 2006 due to the higher revenue. The change in value of our investments in limited partnerships resulted in a gain of $8.5 million in 2007 compared to $1.5 million in 2006. Minority interests in net income of consolidated companies reflect the portion of net income attributable to minority interest ownership of entities included in our consolidated financial statements. Income attributable to minority interests, which reduces our pretax income, increased to $15.8 million in 2007 from $6.7 million in 2006, due to the increase in Edelman’s income, of which minority interests own 49%, and to the increased income from one of the limited partnerships, of which minority interests own 75%.
Revenue from investment banking declined to $23.6 million in 2007 from $25.2 million in 2006 and income from continuing operations before income taxes declined to $4.3 million in 2007 from $7.7 million in 2006. The revenue decrease is primarily due to lower revenue from advisory fees during 2007. Total expense increased to $19.3 million in 2007 from $17.5 million in 2006, principally due to additional compensation and other costs incurred in an effort to increase revenue.
Revenue from institutional brokerage declined to $15.5 million in 2007 from $21.3 million in 2006 and income from continuing operations before income taxes declined to $1.2 million in 2007 from $2.8 million in 2006. Commission revenue declined to $9.9 million in 2007 from $13.9 million in 2006 reflecting a decline in both the number of shares traded in our institutional equity division and the commission revenue per share traded. These declines are largely the result of the growth in electronic trading strategy execution software that replaces, in some cases, the role of traditional traders. Additionally, sales credits from syndicate and investment banking activities declined to $3.4 million in 2007 from $4.3 million in 2006 reflecting a lower volume of offerings sold by the institutional division. Total expenses declined to $14.3 million in 2007 from $18.5 million in 2006 primarily due to the decline in revenue.
Prime Brokerage Services
Revenue from prime brokerage services increased to $36.6 million in 2007 from $34.8 million in 2006 and income from continuing operations before income taxes increased to $2.8 million in 2007 from $2.6 million in 2006. Commission revenue increased to $25.3 million in 2007 from $19.7 million in 2006, while principal transaction revenue decreased to $7.8 million in 2007 from $12.6 million in 2006, reflecting growth in hedge fund servicing revenue and lower revenue from trading activities. Total expenses increased to $33.8 million during 2007 from $32.2 million during 2006 reflecting increased compensation and other costs related to increased revenue.
Corporate Support and Other
Revenue from corporate support declined to $2.8 million in 2007 from $4.9 million in 2006 and the loss from continuing operations before income taxes increased to $25.0 million in 2007 from $9.6 million in 2006. Total expenses increased to $23.2 million in 2007 from $15.2 million in 2006 primarily due to the write-off of two notes receivable that totaled $5.0 million. In addition, compensation expense increased to $13.7 million from $10.5 million primarily due to additional compensation expense related to the acquisition of Rikoon. Equity in income (loss) of limited partnerships decreased to a loss of $4.6 million from a gain of $728,000, principally due to a decrease in value of our investment in one limited partnership.
Liquidity and Capital Resources
The Company’s funding needs consist of (1) funds necessary to maintain current operations, (2) capital expenditure requirements, (3) debt repayment, and (4) funds used for acquisitions.
The Company had one credit facility in effect at December 31, 2008. In May 2005, the Company entered into a $15.0 million revolving credit facility with a bank. In May 2008, this credit agreement was amended to decrease the revolving credit facility to the lesser of $5.0 million or the loan value of certain collateral pledged to secure the revolving credit facility. The line of credit expires in May 2009, unless extended. There was no outstanding balance on the line of credit at December 31, 2008. The amount of available borrowings under the line of credit, which is reduced by letters of credit issued by the Company, was $4.0 million at December 31, 2008.
The Company and its subsidiaries have contractual obligations under operating leases that expire by 2018 with initial noncancelable terms in excess of one year. The aggregate annual rentals for these operating leases, consisting of leases for office space and computer and office equipment, along with the consideration for the acquisition of EFA, are as described in the following table:
Operating expenses consist of compensation and benefits, floor brokerage, exchange, and clearing costs, and other expenses. These expenses are primarily dependent on revenue and, with the exception of obligations for office rentals, should require a limited amount of capital in addition to that provided by revenue during 2009. Currently, obligations for non-cancelable office leases total $9.6 million during 2009. Funds required for other working capital items such as receivables, securities owned, and accounts payable, along with expenditures to repurchase stock, are expected to total between $1.0 million and $3.0 million during 2009. Capital expenditure requirements are expected to total between $2.0 million and $3.0 million during 2009, mainly consisting of leasehold improvements, furniture, and computer equipment and software. Funds needed for acquisitions will depend on the completion of transactions that may not be identifiable until such time as the acquisition is completed.
We intend to satisfy our funding needs with our own capital resources, consisting largely of internally generated earnings and liquid assets, and with borrowings from outside parties. At December 31, 2008, we had approximately $30.2 million in cash and cash equivalents, which together with liquid assets, consisting of receivables from broker-dealers, deposits with clearing organizations and marketable securities owned, totaled $53.4 million.
Receivables turnover, calculated as total revenue divided by average receivables, was three for the year ended December 31, 2008 compared to five for the year ended December 31, 2007. The allowance for doubtful accounts as a percentage of receivables was 1.3% at December 31, 2008 compared to 5.0% at December 31, 2007. The decrease in the receivables turnover and in the allowance for doubtful accounts as a percentage of receivables was the result of an increase in receivables from notes receivable issued in exchange for the sale of our interests in Salient Partners, L.P. and Endowment Advisers, L.P.
Sources and Uses of Cash
On October 4, 2006, we completed a sale of 5.0 million shares of common stock in an underwritten public offering, at a price to the public of $12.50 per share. Jefferies & Company, Inc. led the underwriting team, with Sandler O’Neill & Partners, L.P. as co-manager for the offering. We received net proceeds (before expenses) of $58.8 million, which were used to repay the outstanding balance of our revolving credit facility and to provide funds for general corporate purposes, including expansion of our business and working capital.
For the year ended December 31, 2008, net cash provided by operations totaled $27.0 million compared to $24.4 million during 2007. Receivables decreased by $3.1 million during the year ended December 31, 2008, due to repayment of the loan to EFA and a decline in fees receivable caused by market declines. These decreases were partially offset by an increase in the current tax receivable related to the 2008 loss from continuing operations.
Marketable securities owned increased by $3.4 million during the year ended December 31, 2008, while securities sold, not yet purchased decreased by $2.5 million and payables to broker-dealers and clearing organizations decreased by $922,000. The change in marketable securities owned, securities sold, not yet purchased, and payables to broker-dealers and clearing organizations is primarily due to the portfolios in accounts managed by third party managers. The Company’s accounts managed by third parties carry both long and short fixed income and equity securities. These accounts are managed to generate profits based on trading spreads, rather than through speculation on the direction of the market. We employ hedging strategies designed to insulate the net value of our trading inventories from fluctuations in the general level of interest rates and equity price variances. We finance a portion of our trading positions through our clearing broker-dealers.
Not readily marketable securities owned, primarily investments in limited partnerships, were $32.7 million at December 31, 2008 compared to $61.1 million at December 31, 2007. This decrease is the result of net dispositions of investment positions as well as changes in the values of our investment portfolios. Management believes its investment in limited partnerships is a critical part of its capital market investing activities that has historically generated favorable returns for the Company. These limited partnerships typically have a ten-year life.
Capital expenditures for the year ended December 31, 2008 were $7.9 million mainly for the purchase of leasehold improvements, furniture, and computer equipment and software necessary for our growth.
At December 31, 2008, SMH, our registered broker-dealer subsidiary, was in compliance with the net capital requirements of the SEC's Uniform Net Capital Rules and had capital in excess of the required minimum.
Critical Accounting Policies/Estimates
Valuation of Not Readily Marketable Securities. Securities not readily marketable include investment securities (1) for which there is no market on a securities exchange or no independent publicly quoted market, (2) that cannot be publicly offered or sold unless registration has been effected under the Securities Act of 1933 or other applicable securities acts, or (3) that cannot be offered or sold because of other arrangements, restrictions, or conditions applicable to the securities or to the company. Securities not readily marketable consist primarily of investments in private companies, limited partnerships, equities, options, and warrants.
Generally, investments in shares of public companies are valued at a discount of up to 30% to the closing market price on the balance sheet date if the shares are not readily marketable. Investments in unregistered shares of public companies are valued at up to a 30% discount from the most recent sales price of registered shares, except in cases where the securities may be sold pursuant to a currently effective registration statement or an exemption from registration and there exists sufficient trading volume in the securities, in which case the market price is used. The discounts reflect liquidity risk and contractual or statutory restrictions on transfer. Preferred stock of a public company is carried at its liquidation preference. Investments in private companies are valued at the purchase price, the best estimate of fair value, until there is a basis for revaluation. Revaluation may result from a subsequent public offering or private placement, an event that has occurred indicating valuation increase or impairment, or other pertinent factors and events. Investments in limited partnerships are accounted for using the equity method, which approximates fair value.
Investments in not readily marketable securities, marketable securities with insufficient trading volumes, and restricted securities have been valued at their estimated fair value by the Company in the absence of readily ascertainable market values. These estimated values may differ significantly from the values that would have been used had a readily available market existed for these investments. Such differences could be material to the financial statements. At December 31, 2008 and 2007, the Company’s investment portfolios included investments totaling $32.7 million and $61.1 million, respectively, whose values had been estimated by the Company in the absence of readily ascertainable market values.
Goodwill. Goodwill represents the excess of the aggregate purchase price over the fair value of the net assets acquired in a purchase business combination. Goodwill is reviewed for impairment at least annually in accordance with the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 142, Goodwill and Other Intangible Assets. SFAS No. 142 requires that goodwill be tested for impairment between annual test dates if an event or changing circumstances indicate that it is more likely than not that the fair value of the reporting unit is below its carrying amount. The goodwill impairment test is a two-step test. Under the first step, the fair value of the reporting unit is compared with its carrying value (including goodwill and other intangible assets). If the fair value of the reporting unit is less than its carrying value, an indication of goodwill impairment exists for the reporting unit and the enterprise must perform step two of the impairment test (measurement). Under step two, an impairment loss is recognized for any excess of the carrying amount of the reporting unit’s goodwill over the implied fair value of that goodwill. The implied fair value of goodwill is determined by allocating the fair value of the reporting unit in a manner similar to a purchase price allocation, in accordance with SFAS No. 141, Business Combinations. The residual fair value after this allocation is the implied fair value of the reporting unit goodwill.
Factors considered in determining fair value in accordance with SFAS No. 142 include, among other things, the Company’s market capitalization as determined by quoted market prices for its common stock and the value of the Company’s reporting units. The Company uses several methods to value its reporting units, including discounted cash flows, comparisons with valuations of public companies in the same industry, and multiples of assets under management. If the fair value of the reporting unit exceeds its carrying value, step two does not need to be performed.
In performing the first step of the goodwill impairment test, the estimated fair values of the reporting units were developed using the methods listed above. When performing the discounted cash flow analysis, the Company utilized observable market data to the extent available. The discount rates utilized in these analyses ranged from 11% to 16%, reflecting market based estimates of capital costs. The Company also calculates estimated fair values of the reporting units utilizing multiples of earnings, book value, and, when applicable, assets under management of the reporting unit. The estimated fair value using these techniques is compared with the carrying value of the reporting unit to determine if there is an indication of impairment.
The Company performed its annual review for goodwill impairment as of April 30, 2008. This review was updated to November 30, 2008 due to deterioration in overall macroeconomic conditions and the extended decline in the Company’s stock price. The first step of the November goodwill impairment test resulted in an indication of impairment at four of the Company’s reporting units. As such, the Company was required to perform step two of the goodwill impairment test for these reporting units. This assessment resulted in the recognition of a goodwill impairment charge of $56.5 million. A deferred tax benefit of $6.8 million was recognized as a result of this charge. In the event that the Company’s stock price continues to trade below its book value, the Company would expect to update its review for goodwill impairment quarterly. The future goodwill impairment tests may result in an additional charge to earnings.
Stock-Based Compensation. Effective January 1, 2006, the Company adopted the provisions of SFAS No. 123R, Share-Based Payment (Revised 2004), which requires the Company to recognize the cost of all stock-based compensation in its consolidated financial statements. The Company’s equity-classified awards are measured at grant-date fair value and are not subsequently remeasured. The valuation of equity instruments underlying stock-based compensation, and the period during which the expense is recognized, is based on assumptions related to stock volatility, interest rates, vesting terms, and dividend yields. Changes in these assumptions, including forfeiture rates, could have significant impacts on the expense recognized.
Effects of Inflation
Historically, inflation has not had a material effect on our consolidated financial position, results of operations or cash flows; however, the rate of inflation can be expected to affect our expenses, such as employee compensation, occupancy, and equipment. Increases in these expenses may not be readily recoverable in the prices that we charge for our services. Inflation can have significant effects on interest rates that in turn can affect prices and activities in the financial services market. These fluctuations could have an adverse impact on our financial services operations.
Recent Accounting Pronouncements
See “Note 1 — Nature of Operations and Summary of Significant Accounting Policies” in the accompanying notes to consolidated financial statements included elsewhere in this Annual Report on Form 10-K for details of recent accounting pronouncements and their expected impact on the Company’s financial statements.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
The following discussion relates to our market risk sensitive instruments as of December 31, 2008.
Our trading equity and debt securities are marked to market on a daily basis. At December 31, 2008, our trading equity and debt securities were recorded at a fair value of $21.9 million. These trading equity and debt securities are subject to equity price risk.
Our market making, investing, and underwriting activities often involve the purchase, sale, or short sale of securities and expose our capital to significant risks, including market risk, equity price risk, and credit risk. Market risk represents the potential loss we may incur as a result of absolute and relative price movements, price volatility, and changes in liquidity in financial instruments due to many factors over which we have no control. Our primary market risk arises from the fact that we own a variety of investments that are subject to changes in value and could result in material gains or losses. We also engage in proprietary trading and make dealer markets in equity securities. In doing this, we are required to maintain certain amounts of inventories in order to facilitate customer order flow. We are exposed to equity price risk due to changes in the level and volatility of equity prices primarily in Nasdaq and over-the-counter markets. Changes in market conditions could limit our ability to resell securities purchased or to purchase securities sold short. Direct market risk exposure to changes in foreign exchange rates is not material. We do not use derivatives for speculative purposes.
We seek to cover our exposure to market and equity price risk by limiting our net long and short positions and by selling or buying similar instruments. In addition, trading and inventory accounts are monitored on an ongoing basis, and we have established position limits. Position and exposure reports are prepared at the end of each trading day and are reviewed by traders, trading managers, and management personnel. These reports show the amount of capital committed to various issuers and industry segments. Securities held in our investment portfolio are guided by an investment policy and are reviewed on a regular basis.
Credit risk represents the potential loss due to a client or counterparty failing to perform its contractual obligations, such as delivery of securities or payment of funds, or the value of collateral held to secure obligations proving to be inadequate as related to our margin lending activities. This risk depends primarily on the creditworthiness of the counterparty. We seek to control credit risk by following an established credit approval process, monitoring credit limits, and requiring collateral where appropriate.
We monitor our market and counterparty risk on a daily basis through a number of control procedures designed to identify and evaluate the various risks to which we are exposed. We have established various committees to assess and to manage risk associated with our investment banking and other activities. The committees review, among other things, business and transactional risks associated with potential clients and engagements. We seek to control the risks associated with our investment banking activities by review and approval of transactions by the relevant committee prior to accepting an engagement or pursuing a material investment transaction.
Our financial services business is affected by general economic conditions. Our revenues relating to asset-based advisory services and managed accounts are typically from fees based on the market value of assets under management or advisement. The decline in assets under our management due to the instability in the overall stock market resulted in lower management fees for us as well as lower trading volume and reduced commission rates which have had a negative impact on our commission revenue. In addition, the instability in the credit markets, which sharply widened the spreads over treasuries of certain less than investment grade bonds held primarily in our newly established high yield hedge fund, created losses in our investment portfolio during 2008.
At December 31, 2008, securities owned by the Company were recorded at a fair value of $54.6 million, including $21.9 million in marketable securities, $29.4 million representing our investments in limited partnerships, and $3.3 million representing other not readily marketable securities.
We do not act as dealer, trader, or end-user of complex derivative contracts such as swaps, collars, and caps. However, SMH does act as a dealer and trader of mortgage-derivative securities, called collateralized mortgage obligations (CMOs or REMICs). Mortgage-derivative securities redistribute the risks associated with their underlying mortgage collateral by redirecting cash flows according to specific formulas or algorithms to various tranches or classes designed to meet specific investor objectives.
Operational risk generally refers to the risk of loss resulting from our operations, including, but not limited to, improper or unauthorized execution and processing of transactions, deficiencies in our operating systems, business disruptions, and inadequacies or breaches in our internal control processes. Our businesses are highly dependent on our and our third party providers’ ability to process, on a daily basis, a large number of transactions across numerous and diverse markets. In addition, the transactions we process have become increasingly complex. If any of our or our third party providers’ financial, accounting, or other data processing systems do not operate properly or are disabled or if there are other shortcomings or failures in our internal processes, people, or systems, we could suffer an impairment to our liquidity, financial loss, a disruption of our businesses, liability to clients, regulatory intervention, or reputational damage. These systems may fail to operate properly or become disabled as a result of events that are wholly or partially beyond our control, including a disruption of electrical or communications services or our inability to occupy one or more of our buildings. The inability of our systems to accommodate an increasing volume of transactions could also constrain our ability to expand our businesses.
We also face the risk of operational failure or termination of any of the clearing agents, exchanges, clearing houses or other financial intermediaries we use to facilitate our securities transactions. Any such failure or termination could adversely affect our ability to effect transactions and manage our exposure to risk.
In addition, despite the contingency plans we have in place, our ability to conduct business may be adversely impacted by a disruption in the infrastructure that supports our businesses and the communities in which they are located. This may include a disruption involving electrical, communications, transportation, or other services used by us or third parties with which we conduct business.
Our operations rely on the secure processing, storage, and transmission of confidential and other information in our computer systems and networks. Although we take protective measures and endeavor to modify them as circumstances warrant, our computer systems, software, and networks may be vulnerable to unauthorized access, computer viruses, or other malicious code, and other events that could have a security impact. If one or more of such events occur, this potentially could jeopardize our or our clients’ or counterparties’ confidential and other information processed and stored in, and transmitted through, our computer systems and networks, or otherwise cause interruptions or malfunctions in our, our clients’, our counterparties’ or third parties’ operations. We may be required to expend significant additional resources to modify our protective measures or to investigate and remediate vulnerabilities or other exposures, and we may be subject to litigation and financial losses that are either not insured or not fully covered through any insurance maintained by us.
Legal and Compliance Risk
Legal and compliance risk includes the risk of non-compliance with applicable legal and regulatory requirements. We are subject to extensive regulation in the different jurisdictions in which we conduct our business. We have various procedures addressing issues such as regulatory capital requirements, sales and trading practices, use of and safekeeping of customer funds, credit granting, collection activities, anti-money laundering, and record keeping.
New Business Risk
New business risk refers to the risk of entering into a new line of business or offering a new product. By entering a new line of business or offering a new product, we may face risks that we are unaccustomed to dealing with and may increase the magnitude of the risks we currently face. We review proposals for new businesses and new products to determine if we are prepared to handle the additional or increased risks associated with entering into such activities.
Other risks encountered by us include political, regulatory, and tax risks. These risks reflect the potential impact that changes in national, state, and local laws and tax statutes have on the economics and viability of current or future transactions. In an effort to mitigate these risks, we continuously review new and pending regulations and legislation and participate in various industry interest groups.
Item 8. Financial Statements and Supplementary Data
SANDERS MORRIS HARRIS GROUP INC. AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Report of Independent Registered Public Accounting Firm
The Board of Directors and Shareholders
Sanders Morris Harris Group Inc.:
We have audited the accompanying consolidated balance sheets of Sanders Morris Harris Group Inc. and subsidiaries (the Company) as of December 31, 2008 and 2007, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2008. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Sanders Morris Harris Group Inc. and subsidiaries as of December 31, 2008 and 2007, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2008, in conformity with U.S. generally accepted accounting principles.
As discussed in Note 1 to the consolidated financial statements, the Company changed it method of accounting for certain securities owned in 2008 due to the adoption of FASB Statement No. 157, Fair Value Measurements.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Sanders Morris Harris Group Inc. and subsidiaries’ internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 16, 2009, expressed an unqualified opinion on management’s assessment of, and the effective operation of, the Company’s internal control over financial reporting.
/s/ KPMG LLP
March 16, 2009
CONSOLIDATED BALANCE SHEETS
(in thousands, except share and per share amounts)
The accompanying notes are an integral part of these consolidated financial statements.
SANDERS MORRIS HARRIS GROUP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)