Knight Capital Group Inc. faced too much bankruptcy risk to make its share price the top priority as it negotiated a rescue, according to Thomas Joyce, the chairman and chief executive officer.
The Jersey City, New Jersey-based company, one of the country’s biggest market makers, had to lock up an infusion of capital to preserve its businesses, Joyce said in a telephone interview. Knight fell 21 percent to $3.19 as of 12:14 p.m. in New York as investors prepared for hundreds of millions of shares to enter the market via convertible securities.
“This was absolutely the right thing to do for this organization,” Joyce said. “We understand the dilution is a large amount, but for the future of Knight Capital Group, as tough as it was to see happen, it was the right thing to do.”
Knight, driven to the brink of bankruptcy by trading losses last week, received a $400 million cash infusion after a deal reached yesterday. Getco LLC, Blackstone Group LP, brokerages Stifel Nicolaus & Co. and TD Ameritrade Holding Corp., as well as the investment banks Stephens Inc. and Jefferies Group Inc. are investing, according to a statement.
The investors agreed to buy preferred stock that will be convertible into about 267 million common shares at $1.50 a share, the company said. The new investment in Knight will represent 73 percent of the company once the 2 percent preferred shares are converted into common stock in about a week.
“It’s not too surprising that among the sources of financing for Knight in their emergency are some of their customers,” David Whitcomb, founder of Automated Trading Desk LLC, a competitor of Knight owned by Citigroup Inc., said in a phone interview from Honolulu. “Their customers want to keep a diverse set of market makers going so as to maintain a high level of competition.”
Joyce, who intends to remain CEO, said retail brokers are “coming back from many, many corners” after they routed business away during and after the malfunctions. Knight sent mistaken orders into the market just after the start of trading on Aug. 1 because of a design flaw in software to connect with a New York Stock Exchange program for individual investors.
“It was obviously a greatly flawed application,” Joyce said. “It is perplexing. We have launched an investigation. We intend to come up with new and better ways to enhance the infrastructure.”
While owners of Knight stock saw the value of their shares shrink after a 61 percent plunge last week, the firms’s rescue may calm an equity market where it is one of the biggest partners for smaller traders. The company accounted for 29 percent of the average monthly volume in the U.S. by individuals in the first quarter, according to a June 7 presentation.
Obtaining capital to fund businesses such as market making was viewed as necessary to keep Knight afloat. Analysts at CLSA Credit Agricole Securities wrote last week that bankruptcy was a possibility if the firm failed to get financing.
“It is a permanent solution from where we sit,” Joyce said. “It’s a refinance and recapitalization of the balance sheet. We feel we’re in very good shape moving forward.”
The deal announced today came after “dozens and dozens” of inquiries were made over the weekend, Joyce said. “We had several alternatives and this was clearly the best one for our stakeholders.”
As part of the financing agreement, Knight said it will add three director to its board. Joyce is chairman of Knight’s existing seven-member board.
‘Everyone Makes Mistakes’
Knight’s market-making unit executes about 10 percent of U.S. shares. Its mishap, which causes shares to swing as much as 151 percent, spurred calls in Congress to examine whether increasing automation is harming markets.
“I’d like to think there is no long-term damage to the company because reputations are built on a series of actions and behaviors over time and our clients understand where we’re coming from,” Joyce said. “Our clients know that everybody makes mistakes, even rather large ones on occasion.”
Knight said in today’s statement that while the issuance of the convertibles would normally require shareholder approval, its audit committee determined that the delay would “seriously jeopardize the financial viability” of Knight.
The dilution to its equity leaves “very little” for existing shareholders, while likely ensuring the company’s survival, according to analysts at JPMorgan Chase & Co., who predicted Knight eventually may be broken up.
“We expect investors will look to value the KCG pieces, expecting the parts to be divested at more opportunistic times,” the JPMorgan analysts wrote in a note.
Knight is the dominant firm in equity wholesaling, the business of executing orders off exchanges primarily for retail brokerages, according to Larry Tabb, chief executive officer of research firm Tabb Group LLC in New York.
Stifel Nicolaus sent 38 percent of its market orders in New York Stock Exchange-listed shares to Knight last quarter, and TD Ameritrade did 9 percent, according to a public execution disclosure statement.
The New York Stock Exchange and NYSE MKT temporarily switched custodial responsibility for approximately 524 NYSE and 156 NYSE MKT-listed securities from Knight’s designated market maker unit to Getco, according to a statement today. The securities will be returned to Knight after the completion of its recapitalization plan.
“We did it because there was a question about whether Knight would reach a deal,” Larry Leibowitz, chief operating officer at NYSE Euronext, said in a phone interview. “We didn’t want to walk into Monday and have there be any doubts.”
Knight’s trading loss was bigger than the $365 million cash balance it reported as of June 30 and exceeded its market value of $398 million as of Aug. 3, data compiled by Bloomberg show. The firm made it to the weekend after receiving short-term financing for market making from Jefferies, according to a person familiar with the matter who requested anonymity.
The share decline brought the company’s market value to $253 million on Aug. 2, compared with a peak of $4.8 billion in 2000, data compiled by Bloomberg show.
Knight turned to Goldman Sachs Group Inc. on Aug. 1 to buy the firm out of trading positions acquired when a computer program malfunctioned, a person with knowledge of the matter said. It has until the close of business today to complete the transaction.
Knight’s computers flooded the market with unintended trades on Aug. 1, sending dozens of stocks into spasms. The fault caused shares to swing as much as 151 percent and left the firm with a “large error position,” Joyce told Bloomberg Television’s “Market Makers” program with Erik Schatzker and Stephanie Ruhle last week.
Joyce said Knight wanted the U.S. Securities and Exchange Commission to allow the NYSE to cancel more trades on Aug. 1. The regulator didn’t allow it and NYSE voided only trades that were at least 30 percent away from their price at the start of the session on Aug. 1, according to rules adopted in 2010.
“Let’s face it, it was one big error,” Joyce said. “There was no intention on our part to enter into one of these trades. Literally every trade we executed was an error so we were hoping they would have some flexibility and allow us to break a lot of them.”
Before the trading error, Knight posted an 81 percent drop in second-quarter net income after saying it lost $35 million in Facebook Inc.’s initial public offering. Revenue from the market-making unit dropped 52 percent last quarter in the third straight decline.
The software malfunction was the latest black eye for the computer infrastructure of an equity market still haunted by the May 2010 market crash, Facebook’s botched share offering, and the failed IPO of Bats Global Markets Inc.
MF Global Holdings Ltd., the holding company for the broker-dealer run by ex-Goldman Sachs co-chairman Jon Corzine, filed the eighth largest U.S. bankruptcy in October, days after a $6.3 billion trade on its own behalf on bonds of some of Europe’s most indebted nations led to credit downgrades and margin calls.
SEC Chairman Mary Schapiro, whose agency in Washington is the main market overseer, described the Knight event as “unacceptable,” and promised to issue regulations to help prevent similar mishaps.
Representative Maxine Waters of California, a senior Democrat on the House Financial Services Committee, said the panel should hold hearings to get to the bottom of the turmoil.
“With a drumbeat of financial market snafus continuing, it’s clear that the industry, with guidance from regulators, needs to strengthen their internal controls,” Waters said.
Knight’s investment came one day after the death of John Phelan, the former chairman and president of the New York Stock Exchange, who warned of an equity market “meltdown” spurred by trading technology one year before the crash of October 1987.
“From an overall market perspective, it would be helpful to not have yet another firm blow up,” Walter Todd, who oversees about $930 million as chief investment officer of Greenwood Capital in Greenwood, South Carolina, said in a telephone interview. “If they can come in and structure a deal to allow the firm to continue to operate and eventually get back on its feet, that’s a better outcome for the market.”
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