Item 1. Business
Introduction - ------------
First Montauk Financial Corp. ("FMFC") is a holding company, which, through its wholly-owned subsidiary, First Montauk Securities Corp. ("FMSC"), is primarily engaged as a retail and institutional securities brokerage firm. FMFC also sells insurance products through its subsidiary Montauk Insurance Services, Inc. ("MISI"). FMSC is a registered broker/dealer with the Securities and Exchange Commission ("SEC"), a member of the National Association of Securities Dealers Regulation, Inc. ("NASD"), the Municipal Securities Rule Making Board ("MSRB"), and the Securities Investor Protection Corporation ("SIPC"). FMSC's business activities consist primarily of retail sales and trading of listed and unlisted equity and fixed-income securities; government, municipal and corporate securities; and options. FMSC earns commissions from individual and institutional securities transactions and market making activities. All securities transactions are cleared through FMSC's clearing firm on a fully disclosed basis. FMSC also provides investment banking services such as private and public securities offerings.
FMSC is currently licensed to conduct its broker/dealer business in 49 states, the District of Columbia, and the Commonwealth of Puerto Rico. FMSC maintains approximately 148 branch and/or satellite offices, all of which are maintained by affiliates. The Company has approximately 360 registered representatives and services approximately 46,000 retail and institutional customer accounts.
FMSC's primary method of operation is the affiliate program, which allows registered representatives to operate as independent contractors. An affiliate of FMSC establishes his own office and is solely responsible for the payment of all expenses associated with the operation of the branch office, including rent, utilities, furniture, equipment, stock quotation machines, and general office supplies. In return, the affiliate representative is entitled to retain a significantly higher percentage of the commissions generated by his sales than a registered representative in a standard brokerage arrangement. The affiliate program is designed to attract experienced brokers with existing clientele who desire to operate their own office.
FMSC has also expanded its general securities business by adding registered representatives to its main corporate office. FMSC is continuously seeking to establish additional branch offices at sites and locations to be selected, the timing and location of which will be based upon prevailing business and economic conditions.
In 1991, MISI was formed for the purpose of offering and selling variable annuity, variable life as well as traditional life and health insurance products. Currently, MISI is licensed in the states of Alabama, Alaska, Arizona, California, Colorado, Connecticut, Delaware, Florida, Georgia, Illinois, Indiana, Iowa, Kansas, Kentucky, Maine, Maryland, Massachusetts, Michigan, Minnesota, Montana (pending), Missouri, New Hampshire, New Jersey, New Mexico, New York, North Carolina, North Dakota, Oklahoma, Pennsylvania, Rhode Island, South Carolina, Tennessee, Texas, Vermont, Virginia, Washington, West Virginia and Wisconsin. MISI derives revenue from insurance-related products and services from the existing customer base of FMSC's Registered Representatives, who are insurance licensed. In fiscal year 1998, the Company earned gross commissions of $2,544,092 from the sale of insurance and annuity policies.
In 1998, FMSC registered with the Securities and Exchange Commission under the Investment Advisers Act of 1940 in order to provide investment advisory services and offer fee-based managed accounts to its clientele. Currently, FMSC is licensed as an Investment Advisor in the States of Alaska, Arizona, California, Connecticut, Florida, Hawaii, Indiana, New Jersey, New York, North Carolina, Pennsylvania, Texas, and West Virginia. Although to date FMSC has received minimal revenue from its advisory services, management intends to promote this area of operation during the next fiscal year.
FMFC and its subsidiaries maintain their principal executive offices at Parkway 109 Office Center, 328 Newman Springs Road, Red Bank, New Jersey 07701, (732) 842-4700.
Recent Developments - -------------------
Global Loans
In 1996, the Company formed Montauk Advisors, Inc. ("MAI") as a wholly-owned subsidiary to act as an agent for various leasing companies to offer business equipment leases to its clientele. In fiscal year 1997, MAI ceased doing business due to concerns over the financial condition of Global Financial Corp. ("Global"), the company that sold and currently services the leases, and an affiliated equipment vendor, Fem-Com Systems Inc. ("FCS"). Since 1997 MAI has made loans to Global totaling approximately $2,217,000. These loans were made for the purpose of assisting Global in meeting cash flow deficiencies arising from the nonpayment of scheduled monthly installments on certain delinquent, canceled and non-performing leases. The loans, some of which bear interest at 8% per annum and were due at various times during 1998, are currently in default. The notes are guaranteed by Global, FCS, Biblio, Inc. ("Biblio") and the shareholder of FCS and Biblio. The notes are partially collateralized by mortgage liens on real estate owned by the principal shareholder of FCS and Biblio, a pledge of the shares of Global and FCS, and various liens on the assets of FCS. The Company does not believe the collateral will be sufficient to cover the unpaid balance of the loans and therefore has reserved for the portion of the loans deemed to be uncollectible. As of December 31, 1998, MAI had loaned $2,066,045 to Global, and had established a reserve against the loans totaling $1,775,000.
In August 1998, Global informed the purchasers of the leases that it was reducing the monthly payments to 60% of the original amount. The Company is reevaluating its continued financial support of Global through loan advances, and is attempting to formulate a final resolution of the Global leases. There can be no assurance that the Company will not incur significant expenditures in respect of this matter in the future.
Century Discount Investments
In June 1997, FMSC established a discount brokerage division "Century Discount Investments" ("Century"), to offer investors convenient and prompt retail brokerage services at significantly reduced commission rates. Century is designed to serve investors who do their own research and make their own investment decisions. These customers seek to avoid the higher brokerage commissions for securities research, market recommendations or portfolio management associated with full service brokerage firms. FMSC believes that this market segment has become increasingly significant to the brokerage industry and will continue to grow in the future. Century's business will concentrate on the execution of unsolicited transactions on an agency basis from retail customers. Century is able to offer customers reduced commission rates since its service is not dependent on individual broker-customer relationships to generate orders. Century does not assign customer accounts to individual brokers and all Century registered representatives have immediate access to customer accounts and market information necessary to respond to any customer inquiry and order.
In February 1999, FMSC appointed Seth Rosen to fill the newly created position of President of Century. FMSC intends to use Mr. Rosen's experience in the discount brokerage industry to expand Century's services and customer base in 1999, including offering online discount brokerage and related investment services. The online service will provide customers with automated securities order placement, market information and research capabilities through the Internet. Eventually, Century intends to offer a broad range of investment services to the self-directed, sophisticated online retail customer.
Description of Business - -----------------------
FMSC is a New Jersey based broker-dealer registered with the Securities and Exchange Commission, and a member of the National Association of Securities Dealers, Inc., the Municipal Securities Rule Making Board and the Securities Investor Protection Corporation. Its business activities include sales and trading of listed and OTC equity and fixed-income securities; sales of government, municipal and corporate securities; options and market making activities. FMSC is registered to conduct its business in 49 states, the District of Columbia and the Commonwealth of Puerto Rico.
As of February 23, 1999, FMSC operated 148 affiliate branch and/or satellite offices in addition to its main office located in Red Bank, New Jersey. There are approximately 360 registered representatives in these offices, as well as 68 support staff employees in the main office. Affiliate branch and satellite offices are located in the following 28 states and Saudi Arabia:
AFFILIATE BRANCH/ STATE SATELLITE OFFICE
Alaska 1 Arizona 2 California 7 Connecticut 4 Delaware 1 Florida 8 Georgia 2 Illinois 1 Indiana 1 Massachusetts 1 Minnesota 3 Mississippi 1 Missouri 2
AFFILIATE BRANCH/ STATE SATELLITE OFFICE
New Hampshire 1 North Carolina 6 North Dakota 2 New Jersey 27 New Mexico 1 New York 36 Ohio 2 Pennsylvania 18 Rhode Island 2 Tennessee 1 Texas 2 Virginia 5 Washington 8 West Virginia 1 Wisconsin 1 Saudi Arabia 1
FMSC transacts business in the following areas:
Equities: Listed 26% Over-The-Counter 35% Municipal, Government 3% Corporate Bonds 4% Unit Investment Trusts 1% Mutual Funds 16% Options 9% Insurance 6%
The following table reflects FMSC's various sources of revenues and the percentage of total revenues for fiscal 1998. Revenues from agency transactions in securities for individual customers of FMSC are shown as commissions. Revenues from transactions in securities for individual customers where FMSC acted in a principal capacity are reflected in principal transactions. Also reflected in principal transactions are trading profits from market making and other trading activities.
Year Ended December 31, 1998 ----------------------------
Amount Percent ------ -------
Agency commissions from Equity Securities, Options and Mutual Funds $30,741,404 73.4%
Principal Transactions in Equity Securities, Municipal, Government and Corporate Bonds$ 8,795,599 21.0%
Interest and other Income(1) $ 1,572,063 3.8%
Investment Banking(2) $ 767,312 1.8% ---------- ---
Total Revenues $41,876,378 100.0%
(1) "Other Income" consists primarily of rental income and dividends.
(2) Investment banking revenues consists of commissions, selling concessions, consulting fees and other income from syndicate activities and placement agent fees.
Registered Representative Recruitment and Registered Representative Affiliate Program - -------------------------------------------
FMSC's goal is to recruit well-trained, experienced registered representatives who require little training and who have proven production records with an established customer account base. Since all registered representatives are paid on a commission earned basis, the costs associated with the hiring of new registered representatives are limited to general expenses consisting of orientation materials, compliance manuals and operational information.
FMSC continues to experience significant competition from other securities brokerage firms for registered representatives. Larger, more established firms with greater financial resources possess an advantage in competing with FMSC and attracting representatives, clients and investment dollars. (See "Business - Competition".)
The Affiliate Program - ---------------------
FMSC's affiliate program is designed to attract professionals in all facets of the financial services industry to affiliate with FMSC as registered representatives. These individuals must possess a sufficient level of commission brokerage business and experience to enable the individual to independently support his own office. The program also enables financial professionals such as insurance agents, real estate brokers, financial planners, and accountants, who already provide some type of financial or brokerage services to their clients, to become a registered representative with FMSC. This is intended to allow the professional to offer securities products and services to their clients through FMSC, and insurance products through MISI. Affiliates operate in their own office, which functions as either a registered branch office or a satellite location. A location is considered a registered branch if it contains three or more registered individuals, and publicly offers brokerage services. A registered branch is designated as either an Office of Supervisory Jurisdiction (OSJ) or non-OSJ branch office depending on whether the office contains a registered principal responsible for the supervision of registered representatives at that location. A satellite location has fewer than three individuals who conduct business, does not have a registered principal on site, and does not publicly offer brokerage services. Registered representatives within a satellite location are supervised by a registered principal at an OSJ or FMSC's headquarters. Management believes the affiliate program is attractive to established brokers because it combines the flexibility of operating an independent office with the structure and support of an established firm.
In each case, the affiliate is solely responsible for the payment of all expenses associated with the operation of his office, including rent, utilities, furniture, equipment, stock quotation machines, supplies etc. Under the program, the affiliate receives a significantly higher percentage of the commissions generated by his sales than a registered representative would normally receive. FMSC believes, based on the experience of management and information derived from professional associations, that standard commission payout rates for registered representatives of retail firms is approximately 40%-50%, whereas affiliates receive payouts averaging 80%-85%. FMSC receives a percentage (averaging 15%-20% after deduction of clearing costs) of the affiliate's commissions with no operating expenses directly attributable to the maintenance of the specific affiliate office. (See "Administration, Operations, Transaction Processing and Customer Accounts").
FMSC provides full support services to each of the affiliates, including access to stock and options execution and over-the-counter stock trading; products such as insurance, mutual funds and investment advisory programs; and research, compliance, supervision and related services. Currently, Schroder & Co., Inc. provides clearing services for FMSC, and E D & F Man International Securities, Inc. and others provide execution services.
Each affiliate is required to obtain and maintain in good standing each license required by the SEC and NASD to conduct the type of securities business in which the affiliate will engage and to register in the various states in which he intends to service customers. If the affiliate wishes to expand his operation, he controls the hiring and immediate supervision of any additional registered representatives subject to FMSC's policies and procedures and overall approval and supervision. If the affiliate office contains three or more registered representatives, the affiliate must obtain a principal's license to ensure proper supervision. The office will then be designated as an Office of Supervisory Jurisdiction.
FMSC is ultimately responsible for supervising each and every affiliate and related registered representative. FMSC can incur substantial liability from improper actions of any of the affiliate representatives. (See "Legal Proceedings"). Effective January 1, 1996, the Company obtained a professional liability errors and omissions insurance policy which provides coverage for certain actions taken by the Company's registered representatives, employees and other agents in connection with the purchase and sale of securities and the administration of individual retirement plans. The program provides coverage for each incident up to $1,000,000 with an aggregate policy limit of $5,000,000, with a deductible per incident of $50,000. The first $10,000 of the deductible is the responsibility of individual representatives. These limits apply through January 31, 2000, when the policy is up for renewal. Each registered representative is required to pay a portion of the policy premium. The policy excludes claims involving the sale of low-priced securities (penny stocks) and partnerships; criminal or deliberate fraudulent acts, defamation, as well as certain other activities.
Retail Commission Business - --------------------------
Most of FMSC's revenues are derived from agency and principal commissions from retail (individual) and institutional customers on brokerage transactions in exchange-listed and over-the-counter equity and fixed income securities. When FMSC receives an order for a security in which FMSC makes a market or has inventory, FMSC may act as a principal and purchase from, or sell to, its customer the desired security on a disclosed basis at a price set in accordance with applicable securities regulations.
Investment Banking Activities - -----------------------------
The Company's investment banking revenues are principally derived from participation in public offerings of equity securities and acting as placement agent in the private placement of securities. The Company does not generally derive a significant or material portion of its revenues from its investment banking operation. For the fiscal year ended December 31, 1998, investment banking activities, including sales concessions earned as a syndicate or selling group member, accounted for approximately 2% of the Company's revenues. FMSC acted as a placement agent in three private placements and participated as a syndicate or selling group member in approximately 105 offerings in fiscal 1998.
Participation as a managing underwriter or in an underwriting syndicate or a selling group involves both economic and regulatory risks. An underwriter may incur losses if it is unable to resell the securities it is committed to purchase, or if it is forced to liquidate its commitment at less than the purchase price. In addition, under federal securities law, other laws and court decisions with respect to underwriters' liabilities and limitations on the indemnification of underwriters by issuers, an underwriter is subject to substantial potential liability for misstatements or omissions of material facts in prospectuses and other communications with respect to such offerings. Acting as a managing underwriter increases these risks. Underwriting commitments constitute a charge against net capital and FMSC's ability to make underwriting commitments may be limited by the requirement that it must at all times be in compliance with the Net Capital Rule. See "Net Capital Requirements".
Principal Transactions - ----------------------
FMSC acts as both principal and agent in the execution of its customers' orders in the over-the-counter market. FMSC buys, sells and maintains an inventory of various securities in order to "make a market" in those securities. In executing customer orders for over-the-counter securities in which it does not make a market, the Company charges a commission and acts as agent between its customers and another firm which is a market-maker. However, when the buy or sell order is in a security in which FMSC makes a market, the Company may act as principal and purchase securities from or sell securities to its customers, which includes the permissible mark-up or mark-down from the current market price, in accordance with applicable regulations.
Trading profits or losses depend upon the skills of the employees engaged in market-making activities, the capital allocated to positions in securities and the general trend of prices in the securities markets. Trading as principal requires the commitment of capital and creates an opportunity for profits and risk of loss due to market fluctuations. FMSC may take both long and short positions in those securities in which it makes a market.
Investment Activities - ---------------------
FMSC also seeks to realize investment gains by purchasing, selling and holding securities for its own account. FMSC is required to commit the capital necessary for use in these investment activities. The amount of such capital to be committed at any particular time will vary according to market, economic and financial factors, including the other aspects of the Company's business. Additionally, in connection with its investment banking activities, FMSC from time to time receives warrants that entitle it to purchase securities of the corporate issuers for which FMSC raises capital or provides advisory services. These warrants, which are placed in FMSC's investment account, vary in value based upon the market price, if any, of the underlying security and the terms of the warrant.
Research Services - -----------------
Research activities include the review and analysis of general market conditions, industry segments and specific companies; the issuance of in-depth written reports on companies, with recommendations on specific actions to buy, sell or hold; the furnishing of information to retail and institutional customers; and responses to inquiries from customers and account executives. Research services are directed primarily at identifying attractive investment opportunities in small, medium and emerging growth companies, and in special situation investments. FMSC presently conducts a limited amount of research activities directly through a research analyst employed by it and also utilizes external sources. These direct research activities principally relate to the preparation of specialized reports on selected securities for general distribution to FMSC's retail customers, and/or research assistance to the Company's retail sales force. The Company also obtains additional research reports and information from various other sources, such as Schroder & Co., Inc., Emerald Research, Argus, and others.
Asset Management and Portfolio Advisory Service Fees - ----------------------------------------------------
FMSC is an SEC Registered Investment Adviser, providing investment advisory services to clients through independent, third-party sponsored advisory programs offered to individual and institutional clients. FMSC is registered as an investment adviser in those states requiring registration, including:
Alaska New Jersey California New York Connecticut North Carolina Delaware Pennsylvania Florida Rhode Island Indiana Texas Massachusetts Washington Michigan West Virginia
Managed account programs generally require the client to pay a single fee for portfolio advisory services, brokerage execution and custody and periodic account performance evaluation, rather than a fee plus commissions. Revenues from asset-managed accounts and portfolio advisory services are generated from accounts that charge a fee based on a percentage of assets under management.
In October 1998, FMSC signed a limited clearing agreement with Wexford Clearing Services Corp. ("Wexford"), a division of Prudential Securities to offer its "Mutual Fund Choice" program. The program, managed by Prudential Advisors, Inc., enables the registered representatives to prepare an asset allocation model for the client choosing from a selected universe of mutual funds suitable for the client. The funds are purchased at net asset value, without a sales charge, and included in the designed portfolio. For this service, the client is charged a quarterly fee based upon the value of the assets in the portfolio. A portion of the fee is retained by Prudential for managing the accounts and providing statements to the clients.
Management's goal is to increase fee-based revenues by continuing to provide diversified advisory services and products to its affiliates.
Competition - -----------
FMSC encounters intense competition in all aspects of its business and competes directly with many other securities firms for clients, as well as registered representatives. A significant number of such competitors offer their customers a broader range of financial services and have substantially greater resources. Retail firms such as Merrill Lynch Pierce Fenner & Smith Incorporated, Smith Barney, Inc. and Morgan Stanley/Dean Witter dominate the industry; however, the Company also competes with numerous regional and local firms. FMSC also competes for experienced brokers with other firms offering an independent affiliate program such as Corporate Securities Group, Inc., Robert Thomas Securities, Inc. and Linsco/Private Ledger Corp.
In addition, a number of firms offer discount brokerage services to individual retail customers and generally effect transactions at substantially lower commission rates on an "execution only" basis, without offering other services such as investment recommendations and research. Moreover, there is substantial commission discounting by full-service broker-dealers competing for institutional and individual brokerage business. The Company has recently entered the discount brokerage arena through its Century Discount Investments division. (See "Recent Developments".) Additionally, the recent emergence of online trading has further intensified the competition for brokerage customers. The continued expansion of discount brokerage firms and online trading could adversely affect the Company's retail business.
Other financial institutions, notably commercial banks and savings and loan associations, offer customers some of the same services and products presently provided by securities firms. In addition, certain large corporations have entered the securities industry by acquiring securities firms. While it is not possible to predict the type and extent of competitive services which banks and other institutions ultimately may offer to customers, FMSC may be adversely affected to the extent those services are offered on a large scale basis.
FMSC competes through its advertising and recruiting programs for registered representatives interested in joining its affiliate program. FMSC often offers incentives to qualified registered representatives to join the Company. These incentives can include cash loans, both forgivable based on duration of association and/or production levels, as well as non-forgivable, incentive stock options and a higher payout during a transitional period. FMSC is currently implementing new computer programs developed by the Clearing Broker, Schroder & Co., Inc., to better service its affiliates and to attract new brokers. The system will enable brokers at any office to instantly access customer accounts, determine cash positions, send and receive electronic mail, and receive research reports and compliance memoranda through a computer work station.
Administration, Operations, Transaction Processing and Customer Accounts - ------------------------------------------------------------------------
FMSC currently utilizes the services of Schroder & Co., Inc. as its primary clearing broker (the "Clearing Broker"). FMSC does not hold any funds or securities of its customers. The Clearing Broker, on a fee basis, processes all securities transactions for FMSC's account and the accounts of its customers. Services of the Clearing Broker include billing and credit control, and receipt, custody and delivery of securities, for which FMSC pays a portion of the commissions it receives from customer transactions. By engaging the processing services of a clearing broker, FMSC is exempt from certain reserve requirements imposed by Rule 15c3-3 under the Securities Exchange act of 1934 (the "1934 Act"). (See "Net Capital Requirements".) The Clearing Broker is neither a partner nor a joint venturer with FMSC, nor does the Clearing Broker have any direct or indirect interest in FMSC, financial or otherwise, or any control of FMSC's business, affairs or internal operations. The Clearing Broker, however, does provide secured margin loans to FMSC and its customers to finance the purchase of securities. Under its clearing agreement with the Clearing Broker, FMSC has agreed to indemnify and hold the Clearing Broker harmless from certain liabilities or claims. As required by the NASD and certain other authorities, FMSC carries a fidelity bond covering loss or theft of securities, as well as embezzlement and forgery. The bond provides total coverage of $5,000,000 (with a $10,000 deductible provision per incident). In addition, the accounts of its customers are protected by the Securities Investor Protection Corporation ("SIPC") for up to $500,000 for each customer, subject to a limitation of $100,000 for claims for cash balances, with an additional $50,000,000 of protection provided by a private insurance company for the benefit of each customer. SIPC is funded through assessments on registered broker-dealers. SIPC fees are assessed at the rate of .00065% of net operating revenues (as defined).
Government Regulation - ---------------------
The securities industry is subject to extensive and constantly evolving federal and state regulations promulgated by the SEC and various state agencies, as well as self-regulatory organizations such as the NASD. The principal purpose of such regulations is the protection of customers and the securities markets rather than the protection of creditors and shareholders of broker-dealers. The SEC is the federal agency charged with the administration of the federal securities laws. Much of the regulation of broker-dealers, however, has been delegated to self-regulatory organizations, principally the NASD and the national securities exchanges. These self-regulatory organizations adopt rules (subject to approval by the SEC) which govern the industry and conduct periodic examinations of member broker-dealers. Securities firms are also subject to regulation by state securities commissions in the states in which they are registered. FMSC is registered with, and subject to, the state securities commissions in 49 states, the District of Columbia and the Commonwealth of Puerto Rico.
The regulations to which broker-dealers are subject cover all aspects of the securities industry, including sales methods, trading practices among broker/dealers, capital structure of securities firms, record keeping and the conduct of directors, officers, employees and registered representatives. Additional legislation, changes in rules promulgated by the SEC and by self-regulatory bodies or changes in the interpretation or enforcement of existing laws and rules often directly affect the method of operation and profitability of broker/dealers. The SEC and the self-regulatory bodies may conduct administrative proceedings which can result in censure, fine, suspension or expulsion of a broker/dealer, its officers, employees or registered representatives.
Net Capital Requirements - ------------------------
As a registered broker/dealer and member of the NASD, FMSC is subject to the SEC's Net Capital Rule which is designed to measure the general financial integrity and liquidity of a broker/dealer.
Net capital is defined as the net worth of a broker/dealer subject to certain adjustments, and computed pursuant to the "aggregate indebtedness method". Aggregate Indebtedness is the total of certain liabilities of a broker/dealer arising from or in connection with any transaction whatsoever, and includes, among other things, money borrowed, money payable against securities loaned and securities "failed to receive," the market value of securities borrowed to the extent to which no equivalent value is paid or credited. For broker/dealers using this method, the Net Capital Rule requires that the ratio of aggregate indebtedness, as defined, to net capital, as defined, not exceed 15 to 1, and imposes restrictions on operations as described below. In computing net capital, various adjustments to net worth are made with a view to excluding assets which are not readily convertible into cash and making a conservative statement of other assets, such as a firm's position in securities. Compliance with the Net Capital Rule limits those operations of securities firms which require the intensive use of their capital, such as underwriting commitments and principal trading activities, and limits the ability of securities firms to pay dividends.
In addition to the above requirements, funds invested as equity capital may not be withdrawn, nor may any unsecured advances or loans be made to any stockholder of a registered broker-dealer, if, after giving effect to such withdrawal, advance or loan and to any other such withdrawal, advance or loan as well as to any scheduled payments of subordinated debt which are scheduled to occur within six months, the net capital of the broker-dealer would fail to equal 120% of the minimum dollar amount of net capital required or the ratio of aggregate indebtedness to net capital would exceed 10 to 1. Further, any funds invested in the form of subordinated debt generally must be invested for a minimum term of one year and repayment of such debt may be suspended if the broker-dealer fails to maintain certain minimum net capital levels. For example, scheduled payments of subordinated debt are suspended in the event that the ratio of aggregate indebtedness to net capital of the broker-dealer would exceed 12 to 1 or if its net capital would be less than 120% of the minimum dollar amount of net capital required.
At December 31, 1998, FMSC had net capital of $1,668,964 which was $1,418,964 in excess of required net capital, and its ratio of aggregate indebtedness to net capital was 2.17 to 1. Failure to maintain the required net capital may subject a firm to suspension or expulsion by the NASD, the Commission and other regulatory bodies and ultimately may require its liquidation. The net capital rule also prohibits payments of dividends, redemption of stock and the prepayment or payment in respect of principal of subordinated indebtedness if net capital, after giving effect to the payment, redemption or repayment, would be less than specified percentage (120%) of the minimum net capital requirement. Compliance with the net capital rule could limit those operations of the Company's brokerage subsidiaries that require the intensive use of capital, such as underwriting and trading activities, and also could restrict the Company's ability to withdraw capital from its operating subsidiaries, which in turn, could limit the Company's ability to pay dividends, repay debt and redeem or purchase shares of its outstanding capital stock.
Employees - ---------
The Company currently has approximately 360 registered representatives of which 315 are associated with affiliate offices. In addition, the Company employs 88 support employees in the areas of operations, compliance, accounting, and administration.
There is an intense competition among securities firms for executives with extensive securities industry experience. To a large degree, FMSC's future success will depend upon its continuing ability to locate, hire and retain highly skilled executives. FMSC considers its relations with its employees to be satisfactory.
Item 2.
Item 2. Properties
Offices and Facilities - ----------------------
In March 1997, the Company entered into a new seven year lease (the "Master Lease"), commencing February 1, 1998 for 22,762 square feet of gross rentable area at its executive offices which are located at Parkway 109 Office Center, 328 Newman Springs Road, Red Bank, New Jersey. The rent for the premises is $35,850 per month, and in addition to the base rent, the Company pays as additional rent, a proportional share of any increases in real estate taxes above the amount paid during the 1998 calendar year, insurance premiums relating to the premises, and all utility charges relating to the use of the premises. In March 1998, the Company signed a First Amendment to the Master Lease incorporating all of the other rented space in the Red Bank facility into the March 1997 Master Lease. The First Amendment to the Lease covers an aggregate of 32,442 gross rentable square feet at a monthly rental payment of $52,000 through January 2005. The Master Lease and First Amendment also contain a six-year option to renew providing for a base rental payment of approximately $65,000 per month.
In June 1996, Montauk Insurance Services, the Company's insurance subsidiary, leased 3,150 square feet in Paramus, New Jersey to house its administrative offices. In September 1997 the Paramus office also became the home of Century Discount Investments, the Company's new discount brokerage operation. The three year lease provides for monthly base rent of $5,053 for the first year, $5,315 for the second year, and $5,578 for the third year. MISI extended the term of this lease for an additional one year term.
Facilities for all branch and/or satellite offices are the responsibility of the Affiliate and FMSC incurs no cost, expense or obligation for these facilities. Similarly, all furnishings, fixtures, telephone systems, office equipment and quote and market data systems are likewise solely the responsibility of the Affiliate.
Item 3.
Item 3. Legal Proceedings
Many aspects of the Company's business involve substantial risks of liability. In recent years, there has been an increasing incidence of litigation and arbitration involving the securities industry.
In June 1997, the Securities and Exchange Commission entered an Order against FMSC relating to an alleged failure to supervise a former affiliate office in Houston, TX. Without admitting or denying the findings of the SEC, FMSC consented to the issuance of an Order, making findings and imposing remedial sanctions and a Cease-and-Desist Order. FMSC was (1) ordered to cease and desist from present or future violations of Securities (15)(c) and 17(a) of the Securities Exchange Act of 1934 ("Exchange Act") and Rules 15c3-1, 17a-3, 17a-5 and 17a-11 thereunder, (2) censured and required to pay a fine of $50,000, and (3) required to pay disgorgement and interest of $227,042, which was credited towards previously paid customer settlements.
In addition, FMSC was required to, and did retain, an independent Consultant to conduct a review of, and to report and make recommendations as to FMSC's supervisory and compliance policies and procedures, particularly as they relate to the firm's affiliate program and the supervision of the firm's branch offices by the main office. On February 1, 1999, FMSC submitted its Affidavit of Compliance setting forth the details of its adoption and implementation of the recommendations contained in the Consultant's Final Report. In summary, FMSC developed and implemented substantial changes to its supervisory and compliance policies and procedures, including the development of a hierarchical regional supervisory structure. As part of this restructuring, FMSC hired a National Supervisor, appointed three Regional Supervisors for the East, Central and West Regions, and designated other branch office managers as Divisional Supervisors. In addition, FMSC revised its internal audit and recruiting procedures, developed supervisory compliance policies and procedures, and during early 1999 held its first Regional/Divisional Supervisory training program.
In February 1997, FMSC entered into a Consent Decree with the State of Florida, without admitting or denying the findings, relating to the alleged failure to supervise a former affiliate office in Houston. FMSC agreed to pay a fine of $15,000, engage an independent consultant, as well as other provisions temporarily limiting brokerage activities in the State of Florida. During 1998, FMSC conducted internal audits of its Florida branches and was inspected by examiners from the State of Florida. The State's examination has not been completed, but FMSC expects that this matter will be concluded during Spring 1999. In the interim, FMSC has been granted permission to recruit brokers in existing branch offices within the State.
FMSC has been the subject of other legal actions relating to the sale of securities by the Houston office. In 1996, the Company, without admitting liability or wrongdoing, settled various claims asserted by Escambia County, Florida for $900,000 in cash. In January 1997, the Company settled another customer lawsuit for $750,000, with $500,000 payable upon execution of settlement documents, and the balance of $250,000 payable in five annual installments of $50,000 plus interest at 8% per annum. The five installments are evidenced by notes payable, which have been subordinated to the claims of the Company's general creditors under a subordination agreement approved by the NASD.
The Company was a defendant in a civil action brought by the City of Painesville, Ohio in connection with its purchase of mortgage-backed securities related to the activities of the former Houston branch office representatives. The Company settled this claim for $500,000 in June 1998.
FMSC is both a claimant and counter-respondent in an arbitration, which it brought against another securities firm arising out of the trading activities of the former Houston branch office. The firm has filed a counter-claim against FMSC seeking an unspecified amount of damages.
FMSC is a respondent in various customer arbitrations seeking damages of various amounts. In one arbitration a customer seeks damages in excess of $1,000,000 as a result of alleged forgery and misappropriation by a former registered representative who was the executor of the estate and trustee under the client's will. Another claimant seeks damages as a result of the alleged mishandling of a customer account, seeking damages that aggregate $650,000. FMSC is vigorously defending both of these actions and believes it has meritorious defenses.
FMSC is a respondent in another customer arbitration seeking to hold it liable as a successor in interest to another broker-dealer with whom the customer conducted securities transactions upon which the claim was brought. FMSC has strongly asserted that it is not a successor to any other broker-dealer and is vigorously defending this claim.
FMSC is also named as a respondent in other pending customer arbitrations and litigations relating to its securities business. These claims are in various stages of progress and are being vigorously contested or settled as warranted under the specific facts and circumstances of each case. Although management is unable to derive a meaningful estimate of the possible costs that may arise from these pending claims, they believe it will not have a significant impact on future earnings.
The Company continues to review the extent to which settled and pending claims, including Houston customer settlements, may be covered under its insurance policies. In January 1997, the Company negotiated a $650,000 settlement with one of its insurance carriers in consideration of a general release from coverage on various matters. The Company has also filed suit against one of its insurers to compel coverage of several settled claims. There can be no assurance that the Company will be successful in its efforts to recover additional funds from its insurers on settled claims, or that monetary losses, if any, from future claims, settlements or adverse judgments will be covered under the Company's existing insurance policies.
Item 4.
Item 4. Submission of Matters on a Vote of Security Holders Not Applicable.
PART II
Item 5.
Item 5. Market of and Dividends on the Company's Common Equity and Related Stockholder Matters
A. Principal Market
The Company's Common Stock is traded in the over-the-counter market. Trading in the Company's Common Stock is reported on the NASD Bulletin Board system and by the National Daily Quotation Service published by the National Quotation Bureau, Inc. The Company believes that there is an established public trading market for the Company's Common Stock based on the volume of trading in the Company's Common Stock and the existence of market makers who regularly publish quotations for the Company's Common Stock. The Company's Class A, Class B and Class C Warrants commenced trading in the over-the-counter market upon their issuance in March 1998.
B. Market Information
The Company's Common Stock commenced trading in the over-the-counter market in 1987. On April 14, 1999, the Company's common stock had a high and low bid price of $2.75 and $2.66, respectively.
The following is the range of high and low bid prices for such securities for the periods indicated below:
Common Stock
Fiscal Year 1998 High $ Low $
1st Quarter 2.875 2.00 2nd Quarter 3.28 2.41 3rd Quarter 2.53 1.01 4th Quarter 1.875 1.125
Fiscal Year 1997 High $ Low $
1st Quarter 3.125 .96 2nd Quarter 2.78125 2.4375 3rd Quarter 2.75 2.15625 4th Quarter 2.875 2.1875
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Results of Operations - Three Years Ended December 31, 1998
Fiscal 1998 was the Company's tenth consecutive year of record revenues, surpassing 1997 record levels of $37,743,000. Total revenues of $41,876,000 represented an increase of 11% over the prior year. The Company benefited along with the rest of the brokerage industry as fiscal 1998 continued the extremely favorable market trends of the prior two fiscal years. Almost every revenue category realized higher revenues when compared with the prior two years; the sole exception being investment banking, which is discussed below.
Year Ended December 31, 1998 1997 1996 (000's) % Change (000's) % Change (000's) ------- -------- ------- -------- ------- Revenues: Commissions $30,741 14 $ 27,018 5 $ 25,750 Net dealer inventory and trading gains 8,796 21 7,258 (5) 7,661 Investment banking 767 ( 46) 1,433 126 634 Insurance recovery -- (100) 650 100 -- Interest and other income 1,572 14 1,384 32 1,045 $41,876 11 $37,743 8 $35,090
The rise in revenues in fiscal years 1998 and 1997 resulted from increased commissions, both in absolute dollars and as a percentage, from agency transactions in general securities (stocks, bonds and options). The increase in agency transactions is primarily attributable to the addition of several high- volume affiliated brokers. Commissions from mutual fund transactions accounted for the largest dollar increase from 1996 to 1997.
Net trading profits increased 21% in 1998 from the prior year, primarily as a result of increased principal trading in fixed income securities. Investment banking revenues significantly declined in 1998 as compared to 1997, the year in which FMSC earned significant fees from the underwriting of an initial public offering for Pacific Health Laboratories, Inc. However, revenues from other investment banking activities, including participation in syndicates and selling groups, increased in 1998 over 1997 levels as a direct result of FMSC's increased focus and efforts in this area.
Year Ended December 31, 1998 1997 1996 (000's) % Change (000's) % Change (000's) ------- -------- ------- -------- -------
Expenses: Commissions, employee compensation and benefits $ 31,766 19 $ 26,785 5 $ 25,428 Clearing and floor brokerage 3,675 22 3,022 (4) 3,139 Communications and occupancy 2,557 37 1,860 12 1,663 Legal matters and related costs 2,377 63 1,452 (47) 2,732 Write-down of Note Receivable - Global Financial Corp. 1,775 100 -- 0 -- Other operating expenses 2,962 41 2,094 4 2,007 Interest 131 54 85 (20) 106 ------ -- ------ --- ------ Total expenses $ 45,243 28 $ 35,298 1 $35,075
During 1998, the Company paid commissions, employee compensation and employee benefits of $31,766,000 (76% of total revenues) as compared to $26,785,000 (71% of total revenues) in 1997. This category includes salaries, commission expense, and benefits for salaried employees. Commissions paid to registered representatives for fiscal 1998 totaled $26,622,000 and accounted for more than $4,200,000, or 85% of the total increase in this expense category over fiscal 1997. This is due to a combination of higher payouts utilized to attract the larger producing registered representatives, and an increase in transactions revenue in 1998.
For 1998, the Company paid salaries of $4,247,000 for management, operations and clerical personnel, as compared to $3,658,000 in 1997 and $2,753,000 in 1996. The increase in 1997 and 1998 was due primarily to the compensation of employees of the Century Discount division, who are paid a salary rather than on a commission basis. The Company also hired additional trading assistants, compliance and operational personnel.
Clearing costs increased by $653,000 from 1997 to 1998 and decreased by $117,000 from 1996 to 1997. The dollar increase in 1998 reflects the increased volume in securities transactions, which carry clearance and floor brokerage charges. Clearing costs as a percentage of revenues have remained fairly constant over the period from 1996 to 1998.
Communications and occupancy costs rose by $697,000 in 1998, an increase of over 37% from 1997. The largest increase in this category is in the area of rent expense. This is a result of a new master lease agreement effective February 1998, which expanded the Company's facilities. The new seven-year lease, as amended, covers an aggregate of 32,442 gross rentable square feet at a monthly rental payment of $52,000 through January 2005. The amended master lease also contains a six-year renewal option providing for a base rental payment of approximately $65,000 per month. The continuing increases in communication and information processing expenses in fiscal 1998 and 1997 reflect the costs of further enhancement and expansion of the Company's systems of internal communication and information dissemination, as well as higher general business volume which gave rise to increased costs for telephone, postage and market data services.
Legal matters and related costs include payments to defend and settle customer claims, provisions for pending litigation and general corporate matters. These costs totaled $2,377,000 in 1998, an increase of 63% over the prior year.
The Company was a defendant in a civil action relating to FMSC's former Houston affiliate office that sold mortgage-backed securities to its customers. The Company settled this claim for $500,000 in June 1998. A similar arbitration proceeding, which was reserved for in 1998, was settled in early 1999 for $100,000. The Company either settled or accrued for various other customer arbitrations throughout 1998, aggregating $750,000.
FMSC is both a claimant and counter-respondent in an arbitration, which it brought against another securities firm arising out of the trading activities of the former Houston branch office. The firm has filed a counter-claim against FMSC seeking an unspecified amount of damages.
FMSC is also a respondent in other pending customer arbitrations and litigations relating to its securities business. These claims are in various stages of progress and are being vigorously contested. Management is unable to derive a meaningful estimate of the amount or range of possible loss that may arise out of pending litigation (including litigation costs) in any particular subsequent quarter or annual period, or in the aggregate. However, it is possible that the financial condition, results of operation, or cash flows of the Company in subsequent quarterly or annual periods could be materially affected by the ultimate outcome of such pending litigation.
The Company continues to review the extent to which settled and pending claims, including Houston customer settlements, may be covered under its insurance policies. In January 1997, the Company negotiated a $650,000 settlement with one of its insurance carriers in consideration of a general release from coverage on various matters. The Company has also filed suit against one of its insurers to compel coverage of several settled claims. There can be no assurance that the Company will be successful in its efforts to recover additional funds from its insurers on settled claims, or that monetary losses, if any, from future claims, settlements or adverse judgments will be covered under the Company's existing insurance policies.
As required by SEC Order, and in an effort to reduce future legal claims and liabilities, the Company retained an independent consultant to conduct a review of, and to report and make recommendations as to FMSC's supervisory and compliance policies and procedures, particularly as they relate to the firm's affiliate program and the supervision of the firm's branch offices by the main office. FMSC developed and implemented substantial changes to its supervisory and compliance policies and procedures, including the development of a hierarchical regional supervisory structure. As part of this restructuring, FMSC hired a National Supervisor, appointed three Regional Supervisors for the East, Central and West Regions, and designated other branch office managers as Divisional Supervisors. In addition, FMSC revised its recruiting procedures, developed supervisory compliance materials and held its first Regional/Divisional Supervisory training program.
Management believes that these measures, along with other planned action, will assist in the reduction of customer claims. However, there is no assurance that the Company will be successful in its efforts to reduce such claims in the future.
During 1997 and 1998, the Company, through its wholly-owned subsidiary Montauk Advisors Inc., ("MAI"), made various loans to Global Financial Corp. ("Global"). These loans have a balance as of April 15, 1999 of $2,217,000 before reserves. Global is a lease servicing company that sold leases through MAI. These loans were made for the purpose of assisting Global in meeting cash flow deficiencies arising from the nonpayment of scheduled monthly installments on certain delinquent, canceled and non-performing leases. The loans, some of which bear interest at 8% per annum and were due at various times during 1998, are currently in default. The notes are guaranteed by Global, FemCom Systems, Inc., ("FCS"), Biblio, Inc. ("Biblio") and the shareholder of FCS and Biblio. The notes are partially collateralized by mortgage liens on real estate owned by the principal shareholder of FCS and Biblio, a pledge of the shares of Global and FCS, and various liens on the assets of FCS.
During 1998, the Company undertook a full review of the Global loans to evaluate their collectability, and determined that, based on various events and circumstances, including the default status of the loans, the insolvency of Global and FCS, and steadily declining collections on the lease portfolio serviced by Global, the loans to Global have been impaired. Accordingly, the Company has recorded an impairment loss of $1,775,000 in its financial statements for 1998. This amount reflects management's best estimate of the extent of the loan impairment based on available current information, including the amount and value of the collateral.
Other operating expenses increased from $2,094,000 in 1997 to $2,962,000 in 1998. The majority of the $868,000 increase, or $394,000, is the result of reserves and write-offs of customer unsecured debits and broker receivables. Advertising and business development costs increased by $139,000 in 1998. The increase reflects the Company's continued use of advertising and marketing campaigns to attract registered representatives to affiliate program. The Company expects advertising and business development costs to increase with respect to the promotion of its new discount brokerage division, Century Discount Investments.
The Company's effective tax rate in 1998 and 1997 was (18)% and 40%, respectively. The rate in 1998 is lower than expected because of management's decision to reduce the future tax benefits available from net operating loss carryforwards and other deferred tax assets by recording a valuation allowance of $731,000 in the 1998 Statement of Operations. The decision was based on uncertainties regarding the resolution of various pending legal claims and the previously discussed Global matter. Offsetting these concerns in part is management's favorable view of market conditions in 1999, and the settlement of practically all claims related to the Houston office.
The Company's record revenues were achieved as a result of the combination of a robust economy and favorable investment climate in the United States, and the addition of new affiliated registered representatives during 1998. In expectation of future revenue growth, the Company is continuing to invest in its infrastructure. This investment includes expansion of its corporate headquarters, development of new marketing and advertising campaigns, acquisition of a new data management system, and the hiring of additional legal, trading and compliance personnel.
Despite continued strong revenue growth, the Company's performance was again negatively impacted by costs totaling $ 2,377,000 to defend and settle various legal matters during 1998, as well as the write-down of a note receivable from Global Financial Corp. of $1,775,000. These costs, in large part, accounted for the net loss of $2,763,000 suffered by the Company for fiscal 1998.
Liquidity and Capital Resources
The Company maintains a highly liquid balance sheet with more than 50% of the Company's assets consisting of cash and cash equivalents, securities owned, and receivables from the Company's clearing firm and other broker-dealers. Market making and other securities dealer activities require the Company to carry significant levels of securities inventories in order to meet customer and internal trading needs. The balances in the Company's cash, inventory and clearing firm accounts can and do fluctuate significantly from day to day, depending on market conditions, daily trading activity, and investment opportunities. The Company monitors these accounts on a daily basis in order to ensure compliance with regulatory capital requirements and to preserve liquidity.
Operating activities used cash of $378,000 during 1998. Inventory positions of securities held by the Company decreased by $924,000, while securities sold but not yet purchased decreased by $482,000. Loan reserves, specifically the reserve against Global loans, increased by $1,775,000.
In 1998 and 1997, the Company realized tax benefits of $116,000 and $723,000, respectively, related to the exercise of stock options during the fiscal year. (See Notes to the consolidated financial statements). These tax benefits are available to reduce actual corporate tax liabilities. Under applicable accounting rules, such benefits are reported as an increase in stockholders' equity rather than as an item of income.
Investing activities required cash of $1,847,000 during the year. Additions to capital expenditures consumed $986,000, most of which was for the renovation of the newly acquired lease space at the headquarters complex. The remainder of capital expenditures were for the purchase of new computers to support the Company's upgraded and enhanced market data services, office furniture and equipment for the home office expansion and the development of the sales tracking and operations management system. The Company projects 1999 expenditures for technology and other capital needs to be approximately $600,000.
Net amounts advanced to brokers and affiliates increased by $329,000 to $598,000. The increase is attributable to loans to new affiliates as an inducement to join the Company, advances to employees, and receivables from brokers as a result of trading losses and customer debits which are broker obligations.
MAI made loans to Global, net of repayments, of $1,497,000 in 1998, and additional net loans to Global of $176,000 to date in 1999. The Company is reevaluating its continued financial support of Global through loan advances, and is attempting to formulate a final resolution of the Global leases in order to minimize further economic losses. There can be no assurance that the Company will not incur significant expenditures in respect to this matter in the future. (See Notes to Consolidated Financial Statements and Recent Developments in Business Section)
Financing activities provided cash of $2,049,000 in 1998. In March 1998 the Company received gross proceeds of $1,383,000 from the offering of 3,072,779 units; each unit consisting of one Class A Warrant, one Class B Warrant and one Class C Warrant exercisable at various prices over the next six years. Should the market price of the Company's common stock increase to the level where any or all of the classes or a portion of the classes of warrants become exercisable, the Company will obtain additional proceeds from the exercise of the warrants. An additional $347,000 was received from the exercise of 432,050 stock options by various individuals during the year. In October 1998, the Company issued a series of Convertible Promissory Notes aggregating $570,000 to a private investor in consideration of $300,000 in cash and an income stream from equipment lease investments with a remaining balance of approximately $270,000. The notes carry interest at the rate of 10% per annum, payable semi-annually, and are convertible into a maximum of 380,000 shares of the Company's Common Stock at the rate of $1.50 per share. The notes mature in five years; however, the Company is required to pay 20% of the original outstanding principle amount into a sinking fund on or before each annual anniversary date of the Notes. The equipment lease investments are serviced by Global and were originally sold to investors through MAI. The Company has recorded a loan discount of $99,899, representing the difference between the note principal of $570,000, and the cash received plus the estimated discounted payment stream from the leases. The discount is being amortized over the term of the notes.
The Company has various bank notes totaling $244,844. These notes bear interest at the prime rate (7.75% at December 31, 1998), and are collateralized by equipment owned by the Company. Principal payments are scheduled as follows: 1999 - $95,925, 2000 - $95,925, and 2001 - $52,944.
In 1998, the Company entered into a capital lease arrangement with Sun Data to acquire new equipment costing $88,000 and to refinance through a sale/leaseback transaction existing fixed assets with a book value of approximately $340,000. The net cash received by the Company as a result of this transaction was approximately $270,000.
At December 31, 1998, the Company's broker-dealer subsidiary had net capital of $1,669,000, which was $1,419,000 in excess of its required net capital of $250,000, and the ratio of aggregate indebtedness to net capital was 2.17 to 1.
In 1997 the Company converted a portion of one of its legal settlement obligations into a subordinated loan with the debtor. The five year $250,000 loan bears interest at the rate of 8% per annum, with payments of $50,000 principal and interest on the declining balance due on the first of April of each of the five years of the loan. The first payment of principal and interest was made on April 1, 1998. The loan is subordinated to the liabilities of FMSC's general creditors, and has been approved as to its form by the NASD.
Purchase Commitments
In 1997, the Company entered into a three-year agreement with a long distance carrier under which the Company has committed to pay minimum annual charges of $300,000 in each of the three contract years, in consideration of favorable rates on telephone and data communications service during the commitment period.
Year 2000 Issue
The onset of the year 2000 brings challenges to companies who use and rely on computers and technology as a function of their businesses. Many existing computer programs were designed and developed without considering the impact of the upcoming change in the century. If not corrected, many computer applications could fail or create erroneous results by or at the year 2000.
The Company has reviewed its compliance with what has come to be known as the Year 2000 Issue ("Y2K"). The Company does not create or develop its own proprietary computer programs. Rather, it is reliant on outside vendors or providers for verification of the compliance of their applications, which are utilized by the Company. The Company has currently identified 17 programs and applications that were purchased/licensed by the Company for various departments as mission critical systems requiring compliance with Y2K. We have requested each vendor to supply verification that the program and/or application utilized by the firm is, or will be, Y2K compliant before the Year 2000.
The most significant of these outside vendors is the Company's clearing firm, Schroder & Co., Inc. Schroder & Co. has been mandated by the NYSE to participate in industry testing of all computer interfaces relating to securities processing. These tests have been ongoing since early Spring 1999. To date, the Company has not been advised of any problems relating to the clearing firm's compliance with Y2K readiness. The Company voluntarily agreed to participate with Schroder in point to point testing of the interfaces and applications provided by them. We anticipate that such tests will be completed by August 31, 1999.
The Company has designated an individual within the organization to coordinate the Y2K compliance issues and to communicate with each software and service provider, to ensure Y2K compliance before the turn of the century. While management has not finalized an estimate of the cost of internal system modifications, it does not believe that these costs will have a material impact on the Company's operations in fiscal 1999.
In addition, FMSC inventoried its computer and systems operations that could be affected by Y2K issues, including steps to remediate systems requiring such attention. This has included a review of our facilities, office equipment, telecommunications systems, market data services and third-party products and services used by our company, and retention of consultants, where necessary. During February, 1999, FMSC issued a letter to securities account clients reporting on the progress of its Y2K readiness program. The Company is working to take the necessary steps to ensure, as far as practicable, that the firm's systems will function without interruption after the millennium change. FMSC expects to continue its evaluation process relating to contingency planning.
FMSC, as a registered broker-dealer and investment adviser, is required to and has made required filings with various regulatory authorities concerning the status of its preparedness progress for Y2K compliance. FMSC has also contracted with an independent public accounting firm to conduct a special Y2K audit and to complete its report prior to April 30, 1999. Such report is required pursuant to applicable SEC and NASD rules and regulations.
Impact of Inflation and Other Factors
Management of the Company believes that the impact of inflation has an effect upon the amount of capital generally available for investment purposes and also may affect the attitude or willingness of investors to buy and sell securities. The nature of the business of the Company's broker-dealer subsidiary and the securities industry in general is directly affected by national and international economic and political conditions, broad trends in business and finance and volatility of interest rates, changes in and uncertainty regarding tax laws, and substantial fluctuation in the volume and price levels of securities transactions and the securities markets. To the extent inflation results in higher interest rates and has other adverse effects on the securities markets and the value of securities held in inventory, it may adversely affect the Company's financial position and results of operations.
Factors Affecting "Forward-Looking Statements"
From time to time, the Company may publish "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities and Exchange Act of 1934, as amended, or make oral statements that constitute forward-looking statements. These forward-looking statements may relate to /such matters as anticipated financial performance, future revenues or earnings, business prospects, projected ventures, new products, anticipated market performance, and similar matters. The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. In order to comply with the terms of the safe harbor, the Company cautions readers that a variety of factors could cause the Company's actual results to differ materially from the anticipated results or other expectations expressed in the Company's forward-looking statements. These risks and uncertainties, many of which are beyond the Company's control, include, but are not limited to: (i) transaction volume in the securities markets, (ii) the volatility of the securities markets, (iii) fluctuations in interest rates, (iv) changes in regulatory requirements which could affect the cost of doing business, (v) fluctuations in currency rates, (vi) general economic conditions, both domestic and international, (vii) changes in the rate of inflation and related impact on securities markets, (viii) competition from existing financial institutions and other new participants in competition from existing financial institutions and other new participants in the securities markets, (ix) legal developments affecting the litigation experience of the securities industry, and (x) changes in federal and state tax laws which could affect the popularity of products sold by the Company. The Company does not undertake any obligation to publicly update or revise any forward-looking statements.
Recently Issued Accounting Pronouncement
In June 1998, the Financial Accounting Standards Board issued SFAS No. 133 "Accounting for Derivative Instruments and Hedging Activities", which establishes accounting and reporting standards for all derivative instruments. SFAS No. 133 is effective for fiscal years beginning after June 15, 1999. The adoption of SFAS No. 133 is not expected to have a material impact on the Company's financial position or results of operations.
Item 8.
Item 8. Financial Statements
See Financial Statements attached hereto.
Item 9.
Item 9. Disagreements on Accounting and Financial Disclosure
Not Applicable.
PART III
Item 10.
Item 10. Directors and Executive Officers
The Directors and Executive Officers of the Company and its subsidiaries are as follows:
Name Age Position
Herbert Kurinsky 67 Director, President and Chief Executive Officer of FMFC and of FMSC and Registered Options Principal of FMSC
William J. Kurinsky 38 Director, Vice President, Chief Operating and Chief Financial Officer and Secretary of FMFC and of FMSC and Financial/Operations Principal of FMSC
Robert I. Rabinowitz, Esq. 41 General Counsel, FMFC, Chief Administrative Officer, Vice President and General Securities Principal of FMSC
Norma Doxey 59 Director, VP of Operations, FMSC
Ward R. Jones, Jr. 68 Director
David I. Portman 58 Director
The Company's Certificate of Incorporation provides for the classification of the Board of Directors into three classes of Directors, each class as nearly equal in number as possible but not less than one Director, each director to serve for a three-year term, staggered by class. The Certificate of Incorporation further provides that a Director or the entire Board of Directors may be removed only for cause and only by the affirmative vote of the holders of at least 70% of the combined voting power of the Company's voting stock, with vacancies on the Board being filled only by a majority vote of the remaining Directors then in office. "Cause" is defined as the willful failure of a director to perform in any substantial respect such Director's duties to the Corporation (other than any such failure resulting from incapacity due to physical or mental illness), willful malfeasance by a Director in the performance of his duties to the Corporation which is materially and demonstrably injurious to the Corporation, the commission by a Director of an act of fraud in the performance of his duties, the conviction of a Director for a felony punishable by confinement for a period in excess of one year, or the ineligibility of a Director for continuation in office under any applicable rules, regulations or orders of any federal or state regulatory authority.
All officers serve at the discretion of the Board of Directors. Family relationships exist among the following officers and directors: Mr. Herbert Kurinsky is the uncle of Mr. William J. Kurinsky. Mr. Robert I. Rabinowitz is the brother-in-law of Mr. William J. Kurinsky.
Herbert Kurinsky became a Director and the President of the Company on November 16, 1987. Mr. Kurinsky is a co-founder of First Montauk Securities Corp. and has been its President, one of its Directors and its Registered Options Principal since September of 1986. From March 1984 to August 1986, Mr. Kurinsky was the President of Homestead Securities, Inc., a New Jersey broker/dealer. From April 1983 to March 1984, Mr. Kurinsky was a branch office manager for Phillips, Appel & Waldon, a securities broker/dealer. From February 1982 to March 1983, Mr. Kurinsky was a branch office manager for Fittin, Cunningham and Lauzon, a securities broker/dealer. From November 1977 to February 1982, he was a branch office manager for Advest Inc., a securities broker/dealer. Mr. Kurinsky received a B.S. degree in economics from the University of Miami, Florida in 1954.
William J. Kurinsky became Vice President, a Director and Financial and Operations Principal of the Company on November 16, 1987. He is a co-founder of First Montauk Securities and has been one of its Vice Presidents, a Director and its Financial/Operations Principal since September of 1986. Prior to that date, Mr. Kurinsky was Treasurer, Chief Financial Officer and Vice President of Operations of Homestead Securities, Inc., a securities broker/dealer. Mr. Kurinsky received a B.S. from Rutgers University in 1984. He is the nephew of Herbert Kurinsky.
Robert I. Rabinowitz, Esq. is General Counsel of the Company since 1987. He concurrently served as General Counsel of First Montauk Securities from 1986 until 1998 when a new general counsel was named. Thereafter, he became the Chief Administrative Officer of FMSC as well as a General Securities Principal. From January 1986 until November 1986, he was an associate attorney for Brodsky, Greenblatt & Renahan, a private practice law firm in Rockville, Maryland. Mr. Rabinowitz is an attorney at law licensed to practice in New Jersey, Maryland and the District of Columbia, and is a member of the Board of Arbitrators for the National Association of Securities Dealers, Department of Arbitration. Mr. Rabinowitz's wife is a neice of Mr. Herbert Kurinsky and a sister of Mr. William Kurinsky.
Norma L. Doxey has been a Director of the Company since December 6, 1988. Ms. Doxey has been a Vice President of Operations and a Registered Representative with First Montauk Securities Corp. since September 1986. From August through September, 1986, she was operation's manager and a Registered Representative with Homestead Securities, Inc. From July 1984 through August 1985 she held the same position with Marvest Securities.
Ward R. Jones, Jr. has been a director of the Company since June 1991. From 1955 through 1990, Mr. Jones was employed by Shearson Lehman Brothers as a registered representative, eventually achieving the position of Vice President. Mr. Jones is currently a registered representative of First Montauk Securities Corp., but does not engage in any securities business.
David I. Portman has been a director of the Company since June 15, 1993. From 1978 to the present, Mr. Portman served as the President of Triad Property Management, Inc., a private corporation which builds, invests in and manages real estate properties in the State of New Jersey. Mr. Portman was a Director of Ultra Med, Inc. from 1986 to 1991, a high tech medical equipment manufacturer. Mr. Portman also serves as a director and officer of Pacific Health Laboratories, Inc., a position he has held since August 1995. In 1997, FMSC underwrote an initial public offering of the common stock of Pacific Health Laboratories, Inc., and is currently a market maker in the stock.
Significant Employees
Mark D. Lowe, 40, has been President of Montauk Insurance Services, Inc. since October 1998. From 1982 to 1998 Mr. Lowe was a Senior Consultant with Congilose & Association, a financial services firm specializing in insurance and estate planning. Mr. Lowe became a Certified Financial Planner (CFP) in July 1991. Mr. Lowe attended Ocean County College in Toms River, NJ. Mr. Lowe is the Treasurer of the Estate and Financial Planning Council of Central New Jersey.
Seth Rosen, 46, has been President of Century Discount Investments since September 1998. From December 1997 to June 1998, Mr. Rosen served as an executive consultant with Cowen & Co. From 1994 to 1997, Mr. Rosen served as a Managing Director of National Discount Brokers, a division of Sherwood Securities.
Certain Reports
No person who, during the fiscal year ended December 31, 1998, was a Director, officer or beneficial owner of more than ten percent of the Company's Common Stock (which is the only class of securities of the Company registered under Section 12 of the Securities Exchange Act of 1934 (the "Act") (a "Reporting Person") failed to file on a timely basis, reports required by Section 16 of the Act during the most recent fiscal year or prior years. The foregoing is based solely upon a review by the Company of Forms 3 and 4 during the most recent fiscal year as furnished to the Company under Rule 16a-3(d) under the Act, and Forms 5 and amendments thereto furnished to the Company with respect to its most recent fiscal year, and any representation received by the Company from any reporting person that no Form 5 is required.
Item 11.
Item 11. Executive Compensation ----------------------
Summary of Cash and Certain Other Compensation
The following provides certain information concerning all Plan and Non-Plan (as defined in Item 402 (a)(ii) of Regulation S-K) compensation awarded to, earned by, paid or accrued by the Company during the years ended December 31, 1998, 1997 and 1996 to each of the named executive officers of the Company.
SUMMARY COMPENSATION TABLE
Annual Compensation Long Term Compensation
Securities Underlying Name & Principal Other Annual Options/ SARs Position Year Salary Bonus Compensation Granted(1)
Herbert Kurinsky 1998 $175,000 $ 0 $ 10,096(2) 100,000 Chairman, Chief 1997 $168,269 $ 0 $ 2,724(2) 50,000 Executive Officer (3) 1996 $175,000 $ 40,000 $ 41,072(2) 0
William J. Kurinsky 1998 $175,000 $ 0 $ 10,221(4) 100,000 Vice President, 1997 $158,173 $ 0 $ 1,534(4) 75,000 Chief Operating and 1996 $175,000 $ 0 $ 11,884(4) 0 Financial Officer and Secretary (5)
Robert I. Rabinowitz 1998 $125,000 $15,000 $ 295(6) 100,000 General Counsel, FMFC, 1997 $111,154 $10,000 $ 5,676(6) 75,000 Chief Administrative 1996 $100,000 $ 5,000 $ 383(6) 0 Officer, FMSC (7)
1) In 1997, the Board of Directors authorized a grant to purchase 50,000, 75,000 and 75,000 shares of the Company's Common Stock each to Herbert Kurinsky, William J. Kurinsky and Robert I. Rabinowitz at exercise prices of $.96, $1.05 and $1.0625, respectively. These options have vested and are exercisable until January 14, 2002. In 1998, the Board of Directors authorized an additional grant to purchase 100,000 shares at exercise prices of $1.9375, $2.13 and $1.9375 to Herbert Kurinsky, William J. Kurinsky and Robert I. Rabinowitz, respectively. See "Aggregated Options/Sar Exercises in Last Fiscal Year and Fy-End Option/Sar Values."
2) Includes (i) for 1998, vacation pay of $10,096; (ii) for 1997, commissions of $2,724; (iii) for 1996, an automobile allowance of $7,512, commissions of $10,512, dues of $7,440 and loan forgiveness of $15,606.
3) Mr. Herbert Kurinsky is the beneficial owner of 1,518 shares of the Company's Common Stock as of December 31, 1998, which shares had a market value of $2,182 as of that date, without giving effect to the diminution in value attributable to the restriction on said shares.
4) Includes: (i) for 1998, commissions of $125 and vacation pay of $10,096; (ii) for 1997, commissions of $1,534; (ii) for 1996, loan forgiveness in the amount of $11,884.
5) Mr. William Kurinsky is the beneficial owner of 1,348,423 shares of the Company's Common Stock as of December 31, 1998, which shares had a market value of $1,938,358 as of that date, without giving effect to the diminution in value attributable to the restriction on said shares.
6) Includes commissions of $295 in 1998; (ii) $5,676 for 1997, (iii) $383 for 1996.
7) Mr. Robert I. Rabinowitz is the beneficial owner of 2,500 shares of the Company's Common Stock as of December 31, 1998, which shares had a market value of $3,594 as of that date, without giving effect to the diminution in value attributable to the restriction on said shares.
Compensation of Directors
The Company pays directors, who are not employees of the Company, a retainer of $250 per meeting of the Board of Directors attended and for each meeting of a committee of the Board of Directors not held in conjunction with a Board of Directors meeting. Directors employed by the Company are not entitled to any additional compensation as such. During fiscal year 1998, the Board of Directors met on three occasions and all directors were present.
Committees of the Board of Directors
The Board of Directors has established an Audit Committee comprised of Ward R. Jones and David Portman. The Audit Committee met on 1 occasion during fiscal year 1998. The Audit Committee reviews (i) the Company's audit functions, (ii) the finances, financial condition, and interim financial statements of the Company with management, and (iii), the year end financial statements of the Company with the Company's independent auditors. Members of the Audit Committee do not receive additional compensation for such service.
OPTION/SAR GRANTS IN LAST FISCAL YEAR
The following table contains information with respect to the named executive officers concerning options granted during the year ended December 31,
INDIVIDUAL GRANTS
Number of % of Total Underlying Granted to Exercise Options/SARs Employees in or Base Expiration Name Granted(#) Fiscal Year Price ($Sh) Date
Herbert Kurinsky 100,000 7.2% $1.9375 8/02/03 William J. Kurinsky 100,000 7.2% $2.13 8/02/03 Robert I. Rabinowitz 100,000 7.2% $1.9375 8/02/03
AGGREGATED OPTION/SAR EXERCISES IN LAST FISCAL YEAR AND FY-END OPTION/SAR VALUES
Value of Shares Number of Unexercised Acquired Unexercised In-the-money on Value Options as of Options at Name Exercise Realized December 31,1998 December 31,1998(1) - ---- -------- -------- ---------------- ------------------- Exercisable Exercisable /Unexercisable /Unexercisable Herbert Kurinsky -- $0 390,000/0 $ 560,625/$0 William J. Kurinsky 200,000 $550,000 415,000/0 $ 596,563/$0 Robert I. Rabinowitz -- $0 230,000/0 $ 330,625/$0
(1) Based upon the closing bid price of the Company's Common Stock on December 31, 1998 ($1.4375 per share), less the exercise price for the aggregate number of shares subject to the options.
Employment Agreements
In January 1996, the Company entered into new three-year employment contracts with Herbert Kurinsky, as President and William J. Kurinsky, as Executive Vice President. The contracts provide for base salaries of $175,000 for the first year of the agreement for each, increasing in each case at the rate of 10% per year. Each will also be entitled to receive a portion of a bonus pool consisting of 10% of the pre-tax profits of the Company, to be determined by the executive management (e.g. Herbert Kurinsky and William J. Kurinsky). The bonus pool would require a minimum of $500,000 pretax profit per year in order to become effective. The agreements have been renewed for an additional year. Each is also entitled to receive commissions at the same rate as paid to other non-affiliate registered representatives of the Company. They are also entitled to purchase from FMSC, up to 20% of all underwriters and/or placement agent warrants or options which are granted to FMSC upon the same price, terms and conditions afforded to FMSC as the underwriter or placement agent. Each employee also receives health insurance benefits and life insurance as generally made available to regular full-time employees of the Company, and reimbursement for expenses incurred on behalf of the Company and the use of an automobile, or in the alternative, an automobile allowance. The contracts also provide for severance benefits equal to three times the previous year's salary in the event either of the employees is terminated or their duties significantly changed after a change in management of the Company as defined in the agreement.
Incentive Stock Option Plan
In September 1992, the Company adopted the 1992 Incentive Stock Option Plan (the "1992 Plan"). The 1992 Plan provided for the grant of options to purchase up to 2,000,000 shares of the Company's Common Stock and is intended for employees of the Company and consultants. In June 1998, the Company's shareholders approved an amendment to the 1992 Plan (the "Amended Plan") to increase the number of shares reserved for issuance from 3,500,000 to 6,000,000. Under the terms of the Amended Plan, options granted thereunder may be designated as options which qualify for incentive stock option treatment ("ISOs") under Section 422A of the Code, or options which do not so qualify ("Non-ISOs").
The Amended Plan is administered by the Board of Directors or by a Stock Option Committee designated by the Board of Directors. The Board or the Stock Option Committee, as the case may be, has the discretion to determine the eligible employees to whom, and the times and the price at which, options will be granted; whether such options shall be ISOs or Non-ISOs; the periods during which each option will be exercisable; and the number of shares subject to each option. The Board or Committee has full authority to interpret the Amended Plan and to establish and amend rules and regulations relating thereto.
Under the Amended Plan, the exercise price of an option designated as an ISO shall not be less than the fair market value of the Common Stock on the date the option is granted. However, in the event an option designated as an ISO is granted to a ten percent stockholder (as defined in the Amended Plan) such exercise price shall be at least 110% of such fair market value. Exercise prices of Non-ISO options may be less than such fair market value. The aggregate fair market value of shares subject to options granted to a participant which are designated as ISOs which become exercisable in any calendar year may not exceed $100,000.
The Board or the Stock Option Committee, as the case may be, may, in its sole discretion, grant bonuses or authorize loans to or guarantee loans obtained by an optionee to enable such optionee to pay any taxes that may arise in connection with the exercise or cancellation of an option. Unless sooner terminated, the Amended Plan will expire in 2006. To date, options to purchase a total of 4,156,500 shares of the Company's Common Stock have been issued under the Amended 1992 Plan.
Director Plan
In September 1992, the Company adopted the Non-Executive Director Stock Option Plan (the "Director Plan"). The Director Plan provides for issuance of a maximum of 1,000,000 shares of Common Stock upon the exercise of stock options granted under the Director Plan. Options are granted under the Director Plan until 2002 to (i) non-executive directors as defined and (ii) members of any advisory board established by the Company who are not full time employees of the Company or any of its subsidiaries. The Director Plan provides that each non-executive director will automatically be granted an option to purchase 20,000 shares each September 1, provided such person has served as a director for the 12 months immediately prior to such September 1st.
In June 1996, the Company's shareholders approved an amendment to the Non-Executive Director Stock Option Plan to provide for the elimination of non-discretionary stock grants to members of any advisory board established by the Company. An eligible member of an advisory board may receive an option to purchase shares of the Company's Common Stock under the Director Plan as provided for in the discretion of the Company's Board of Directors.
The exercise price for options granted under the Director Plan shall be 100% of the fair market value of the Common Stock on the date of grant. Until otherwise provided in the Stock Option Plan the exercise price of options granted under the Director Plan must be paid at the time of exercise, either in cash, by delivery of shares of Common Stock of the Company or a combination of both. The term of each option commenced on the date it is granted and unless terminated sooner as provided in the Director Plan, expires five years from the date of grant. The Director Plan is administered by a committee of the board of directors composed of not fewer than three persons who are officers of the Company (the "Committee"). The Committee has no discretion to determine which non-executive director will receive options or the number of shares subject to the option, the term of the option or the exercisability of the option. However, the Committee will make all determinations of the interpretation of the Director Plan. Options granted under the Director Plan are not qualified for incentive stock option treatment. To date, a total of 180,000 options have been granted to the Company's Non-Executive members of the Board of Directors.
Senior Management Plan
In 1996, the Company adopted the 1996 Senior Management Incentive Plan (the "Management Plan"). The Management Plan provides for the issuance of up to 2,000,000 shares of Common Stock either upon issuance of options issued under the Plan or grants of restricted stock or incentive stock rights. Awards may be granted under the Management Plan to executive management employees by the Board of Directors or a committee of the board, if one is appointed for this purpose. The Management Plan provides for four types of awards: stock options, incentive stock rights, stock appreciation rights ("SARs"), and restricted stock purchase agreements. The stock options granted under the Management Plan can be either ISOs or non-lSOs similar to the options granted under the Employee Stock Option Plan, except that the exercise price of non-lSOs shall not be less than 85% of the fair market value of the Common Stock on the date of grant. Incentive stock rights consist of incentive stock units equivalent to one share of Common Stock in consideration for services performed for the Company. If services of the holder terminate prior to the incentive period, the rights become null and void unless termination is caused by death or disability. Stock appreciation rights allow a Grantee to receive an amount in cash equal to the difference between the fair market value of the stock and the exercise price, payable in cash or shares of Common Stock. The Board or committee may grant limited SARs, which become exercisable upon a "change of control" of the Company. A change of control includes the purchase by any person of 25% or more of the voting power of the Company's outstanding securities, or a change in the majority of the Board of Directors.
Awards granted under the Management Plan are also entitled to certain acceleration provisions that cause awards granted under the Plan to immediately vest in the event of a change of control or sale of the Company. Awards under the Management Plan may be made until 2006. To date the Company has granted a total of 1,185,000 options under the Senior Management Plan.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management --------------------------------
The following table sets forth, as of April 14, 1999, the number and percentage of outstanding shares of Common Stock beneficially owned by each person known by the Company to own beneficially more than 5% of the Company's outstanding shares of Common Stock and Common Stock Warrants, by each director of the Company, and by all directors and officers of the Company as a group.
Directors, Officers Amount and Percentage and 5% Shareholders (1) of Beneficial Ownership (1) - ----------------------- --------------------------- Number of Shares Percent ---------------- -------
Herbert Kurinsky 391,518(2) 3.8% Parkway 109 Office Center 328 Newman Springs Road Red Bank, NJ 07701
William J. Kurinsky 1,773,423(3) 16.6% Parkway 109 Office Center 328 Newman Springs Road Red Bank, NJ 07701
Robert I. Rabinowitz, Esq. 286,999(4) 2.8% Parkway 109 Office Center 328 Newman Springs Road Red Bank, NJ 07701
Ward R. Jones 90,000(5) * 7 Leda Lane Guilderland, NY 12084
Norma Doxey 42,400(6) * Parkway 109 Office Center 328 Newman Springs Road Red Bank, NJ 07701
David I. Portman 179,800(7) 1.8% 300 Ocean Avenue, Apt. 6A Long Branch, NJ 07740
All Directors and 2,764,140(2-7) 23.9% Officers as a group (7 persons in number)
* Less than 1%. _____________________ (1) Unless otherwise indicated below, each director, officer and 5% shareholder has sole voting and sole investment power with respect to all shares that he beneficially owns.
(2) Includes vested and presently exercisable options of Mr. Herbert Kurinsky to purchase 390,000 shares of Common Stock.
(3) Includes vested and presently exercisable options of Mr. William J. Kurinsky to purchase 415,000 shares of Common Stock, and 120,000 Class A Warrants, 120,000 Class B Warrants and 120,000 Class C Warrants.
(4) Includes 265,000 shares of Common Stock reserved for issuance upon the exercise of vested and presently exercisable stock options, 35,000 of which are owned by Mr. Rabinowitz's wife, of which he disclaims beneficial ownership, and 2,000 shares are owned by his children. Mr. Rabinowitz also owns 5,833 Class A Warrants, 5,833 Class B Warrants and 5,833 Class C Warrants.
(5) Includes 90,000 shares of Common Stock reserved for issuance upon the exercise of vested and presently exercisable stock options.
(6) Includes 35,000 shares of Common Stock reserved for issuance upon the exercise of 25,000 vested and presently exercisable stock options and 10,000 shares non-vested stock options.
7) Includes 80,000 shares of Common Stock reserved for issuance upon the exercise of vested and presently exercisable stock options, 16,600 Class A Warrants, 16,600 Class B Warrants and 16,600 Class C Warrants.
NOTE:All Class A Warrants are exercisable at $3.00 per share for a period of three (3) years from February 17, 1998. All Class B Warrants are exercisable at $5.00 per share for a period of five (5) years from February 17, 1998. All Class C Warrants are exercisable at $7.00 per share for a period of seven (7) years from February 17, 1998.
Item 13.
Item 13. Certain Relationships and Related Transactions
For information concerning the terms of the employment agreements entered into between the Company and Messrs. Herbert Kurinsky and William J. Kurinsky, see "Executive Compensation".
PART IV
Item 14.
Item 14. Exhibits, Financial Statements and Reports on Form 8-K ------------------------------
(A) 1. Financial Statements --------------------
See Financial Statements Attached Hereto.
2. Exhibits --------
Incorporated by reference to the Exhibit Index at the end of this report.
(B) Reports on Form 8-K -------------------
During the last quarter of the period covered by this Report, there were no reports filed on Form 8-K.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
FIRST MONTAUK FINANCIAL CORP.
By /s/ Herbert Kurinsky ----------------------------- Herbert Kurinsky, President Dated: April 15, 1999
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Company and in the capacities and on the dates indicated.
/s/ Herbert Kurinsky April 15, 1999 - ------------------------------- Herbert Kurinsky President, Chief Executive Officer and Director
/s/ William J. Kurinsky - ------------------------------- April 15, 1999 William J. Kurinsky Vice-President, Chief Operating and Chief Financial Officer, and Principal Accounting Officer, Secretary and Director
/s/ Norma Doxey April 15, 1999 - ------------------------------- Norma Doxey, Director
/s/ Ward R. Jones, Jr. - ------------------------------- April 15, 1999 Ward R. Jones, Jr., Director
/s/ David I. Portman - ------------------------------- April 15, 1999 David I. Portman, Director
EXHIBITS INDEX
The exhibits designated with an asterisk (*) have previously been filed with the Commission in connection with the Company's Registration Statement on Form S-l, File No. 33-24696, those designated (**) have been filed with the Company's Form 10-KSB for the fiscal year ended December 31, 1993, those designated (***) have been previously filed with the Company's Registration Statement on Form S-3, File No. 33-65770, and pursuant to 17 C.F.R. Sections 201.24 and 240.12b-32, are incorporated by reference to the document referenced in brackets following the description of such exhibits. Those designated (****) denotes exhibits which have been filed with the Company's Form 10-KSB for the fiscal year ended December 31, 1994. Those designated (******) denotes exhibits which have been filed with the Company's Proxy Statement dated May 30, 1996. Those designated (*******) denotes exhibits which have been filed with the Company's Form 10-KSB for the fiscal year ended December 31, 1996. Those designated (********) denotes exhibits which have been filed with the Company's Form 10-K for the fiscal year ended December 31, 1997, and (++) denotes exhibits filed herewith.
Exhibit No. Description
3.1* Amended and Restated Certificate of Incorporation adopted at 1989 Special Meeting in lieu of Annual Meeting of Shareholders.
3.2* Amended and Restated By-Laws.
4.1* Form of Common Stock Certificate.
4.4* Form of Underwriter's Warrant.
10.7* Sublease between Prime Asset Management Corp. and the Registrant dated December 6, 1989.
10.8* Clearing Agreement between the Registrant and Wertheim Schroder & Co., Incorporated dated January 21, 1991.
10.10* Lease Agreement between the Registrant and Hovchild dated May 25, 1990.
10.11*** Employment Agreement between First Montauk Financial Corp. and Herbert Kurinsky dated January 1, 1993.
10.12*** Employment Agreement between First Montauk Financial Corp. and William Kurinsky dated January 1, 1993.
10.13*** Lease Agreement between First Montauk Securities Corp. and River Office Equities dated September 7, 1993.
10.14**** Lease Addendum Agreement between First Montauk Securities Corp. and River Office Equities dated June 21, 1994.
10.15***** Sublease Agreement between First Montauk Securities Corp. and Pilot Laboratories, Inc. dated September 19, 1995, and Master Lease Agreement between River Office Equities and Pilot Laboratories, Inc. dated August 31, 1987.
10.16***** Office Lease Agreement between First Montauk Securities Corp. and River Office Equities dated January 31, 1996.
10.17******* Office Lease Agreement between First Montauk Securities Corp. and River Office Equities dated March 5, 1997.
10.18++ Employment Agreement between First Montauk Securities Corp. and Mark Lowe dated October 15, 1998.
10.19++ Employment Agreement between First Montauk Securities Corp. and Seth Rosen dated January 25, 1999.
27++ Financial Data Schedule
28.1* 1992 Incentive Stock Option Plan.
28.2* 1992 Non-Executive Director Stock Option Plan.
28.3****** Amended and Restated 1992 Incentive Stock Option Plan.
28.4****** Non-Executive Director Stock Option Plan - Amended and Restated June 28, 1996
28.5****** 1996 Senior Management Incentive Stock Option Plan.
28.6******* Employment Agreement between First Montauk Financial Corp. and Herbert Kurinsky dated January 1, 1996.
28.7******* Employment Agreement between First Montauk Financial Corp. and William J. Kurinsky dated January 1, 1996.
28.8******** First Amendment to Office Lease Agreement dated March 5, 1997 between First Montauk Securities Corp. and River Office Equities dated March 3, 1998.
REPORT OF INDEPENDENT AUDITORS
The Board of Directors and Stockholders First Montauk Financial Corp.
We have audited the accompanying consolidated statements of financial condition of First Montauk Financial Corp. and subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of operations, changes in stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1998. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. 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 First Montauk Financial Corp. and subsidiaries as of December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1998 in conformity with generally accepted accounting principles.
Schneider Ehrlich & Associates LLP (successor to Schneider Ehrlich & Wengrover LLP)
Jericho, New York March 17, 1999
FIRST MONTAUK FINANCIAL CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
December 31, 1998 1997
ASSETS
Cash $ 613,513 $ 789,883 Due from clearing firm 2,876,202 2,707,782 Securities owned, at market 2,685,879 3,150,772 Securities owned, not readily marketable, at estimated fair value 47,381 506,732 Commissions receivable 250,803 246,250 Employee and broker receivables 598,212 927,195 Furniture, equipment and leasehold improvements - net 2,074,470 1,357,854 Notes receivable 477,729 938,054 Due from officers 131,501 146,691 Other assets 1,087,289 1,164,753 Deferred tax assets - net 700,755 35,968 ---------- ---------- Total assets $11,543,734 $11,971,934 =========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES
Securities sold, but not yet purchased, at market $ 327,047 $ 809,523 Notes payable - bank 244,844 340,769 Subordinated notes payable 200,000 250,000 Convertible promissory notes payable 473,625 -- Commissions payable 1,531,644 1,624,316 Accounts payable 802,497 501,267 Accrued expenses 905,154 812,590 Capitalized lease payable 373,579 -- Other liabilities 461,717 394,002 --------- --------- Total liabilities 5,320,107 4,732,467 --------- ---------
Common stock issued with guaranteed selling price - no par value, 18,000 and 173,000 shares issued and outstanding, respectively 36,500 346,500
Commitments and contingencies (See Notes)
STOCKHOLDERS' EQUITY
Preferred Stock, 5,000,000 shares authorized, $.10 par value, no shares issued and outstanding -- -- Common Stock, no par value, 30,000,000 shares authorized, 9,801,493 and 9,198,444 shares issued and outstanding, respectively 4,980,977 4,334,173 Additional paid-in capital 2,979,831 1,173,437 Retained earnings (accumulated deficit) (1,192,471) 1,570,376 Less: Deferred compensation (581,210) (185,019) -------- -------- Total stockholders' equity 6,187,127 6,892,967 --------- ---------
Total liabilities and stockholders' equity $11,543,734 $11,971,934 =========== ===========
See notes to consolidated financial statements.
FIRST MONTAUK FINANCIAL CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS
Years ended December 31, 1998 1997 1996 Revenues:
Commissions $30,741,404 $27,018,244 $25,749,690 Principal transactions 8,795,599 7,257,576 7,660,700 Investment banking 767,312 1,433,100 634,329 Insurance recovery -- 650,000 -- Interest and other income 1,572,063 1,383,713 1,044,969 --------- --------- ---------
41,876,378 37,742,633 35,089,688 ---------- ---------- ----------
Costs and expenses:
Commissions, employee compensation and benefits 31,766,060 26,785,205 25,428,184 Clearing and floor brokerage 3,674,859 3,021,709 3,139,142 Communications and occupancy 2,557,313 1,860,350 1,662,936 Legal matters and related costs 2,377,336 1,452,001 2,731,997 Write-down of Note Receivable - Global Financial Corp. 1,775,000 -- -- Other operating expenses 2,961,974 2,093,670 2,006,615 Interest 131,215 84,695 105,772 --------- --------- ---------
45,243,757 35,297,630 35,074,646 ---------- ---------- ----------
Income (loss) before income taxes (3,367,379) 2,445,003 15,042
Income taxes (tax benefit) (604,532) 968,178 (17,747) -------- ------- -------
Net income (loss) $(2,762,847) $ 1,476,825 $ 32,789 =========== =========== =========== Per share of Common Stock:
Basic $ (0.28) $ .17 $ .01 =========== =========== ===========
Diluted $ (0.28) $ .14 $ .01 =========== =========== ===========
Number of common shares used in basic earnings per share 9,725,116 8,788,734 7,767,224 Incremental shares from assumed conversion of options -- 1,562,298 856,314 --------- --------- ---------
Number of common shares used in diluted earnings per share 9,725,116 10,351,032 8,623,538 ========= ========== =========
See notes to consolidated financial statements.
FIRST MONTAUK FINANCIAL CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS
Years ended December 31, 1998 1997 1996
INCREASE (DECREASE) IN CASH
Cash flows from operating activities: Net income (loss) $(2,762,847) $1,476,825 $ 32,789 ----------- --------- -------- Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: Common stock issued with guaranteed selling price 30,000 28,125 421,500 Shares issued to settle legal claims -- - 178,650 Tax benefit related to exercise of stock options 115,781 722,605 23,789 Depreciation and amortization 357,831 348,508 272,050 Amortization of deferred compensation 147,988 21,852 -- Amortization of bond discount 3,524 -- -- Loan reserves 1,775,000 69,000 -- Payment of common stock guarantees (40,610) -- -- Other 22,000 -- -- Increase (decrease) in cash attributable to changes in assets and liabilities: Due from clearing firm (168,420) (842,357) (4,171,457) Securities owned - at market 464,893 (1,021,337) 4,985,072 Securities owned - not readily marketable 459,351 (506,732) -- Commissions receivable (4,553) (89,837) 227,455 Other assets 22,224 (532,728) (338,846) Deferred income taxes (664,787) 516,200 (182,995) Securities sold but not yet purchased (482,476) 681,896 (38,755) Commissions payable (92,672) 72,098 85,028 Income taxes payable -- -- (621,690) Accounts payable 301,229 12,570 105,385 Accrued expenses 70,564 (749,307) 419,782 Other liabilities 67,715 213,486 (315,240) --------- ---------- --------- Total adjustments 2,384,582 (1,055,958) 1,049,728 --------- ---------- --------- Net cash provided by (used in) operating activities (378,265) 420,867 1,082,517 -------- ---------- ---------
Cash flows from investing activities: Due from officers 15,190 25,287 (16,454) Employee and broker receivables 328,983 (185,592) (384,078) Issuance of notes receivable (2,091,704) (788,414) -- Collection of notes receivable 777,029 11,360 52,000 Purchase of stock in ECM -- -- (60,000) Sale of stock in ECM -- -- 36,000 Capital expenditures (986,315) (534,005) (668,314) Other assets 109,344 15,087 (87,460) ---------- --------- --------- Net cash used in investing activities (1,847,473) (1,456,277) (1,128,306) ---------- ---------- ----------
Cash flows from financing activities: Proceeds from notes payable 300,000 -- 479,625 Payments of notes payable (145,925) (117,536) (68,864) Proceeds from capital lease financing 304,068 -- -- Issuance of common stock -- 23,027 -- Repurchase of common stock -- -- (230,506) Payments of capitalized lease payable (18,621) -- -- Proceeds from rights offering 1,382,751 -- -- Registration costs (120,320) -- -- Proceeds from exercise of common stock options and warrants 347,415 850,254 89,611 --------- ---------- --------- Net cash provided by financing activities 2,049,368 755,745 269,866 --------- ---------- --------- Net increase (decrease) in cash (176,370) (279,665) 224,077 Cash at beginning of year 789,883 1,069,548 845,471 --------- ---------- --------- Cash at end of year $ 613,513 $ 789,883 $1,069,548 ========== ========== =========
FIRST MONTAUK FINANCIAL CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS
(continued)
Supplemental disclosures of cash flow information: Cash paid (refunded) during the period for: Interest $ 131,215 $ 84,695 $ 105,772 Income taxes $ (223,871) $ (203,480) $ 1,019,242
Debt issued in exchange for lease investment $ 170,101 -- --
Equipment financed under capital lease $ 88,132 -- --
Transfer of temporary equity to permanent capital $ 340,000 $ 103,125 --
See notes to consolidated financial statements.
NOTE 1 - NATURE OF BUSINESS
First Montauk Financial Corp. and subsidiaries (the "Company") are primarily engaged in securities brokerage, investment banking and trading. The Company's principal subsidiary, First Montauk Securities Corp. ("FMSC"), is a broker-dealer registered with the Securities and Exchange Commission ("SEC") and the National Association of Securities Dealers, Inc. ("NASD"). Through FMSC, the Company executes principal and agency transactions, makes markets in over-the-counter securities, and performs underwriting and investment banking services. Customers are located throughout the United States.
FMSC clears all customer transactions on a fully disclosed basis through an independent clearing firm. Accordingly, FMSC does not carry securities accounts for customers nor does it perform custodial functions related to those securities.
The Company also has two other wholly-owned subsidiaries, Montauk Insurance Services, Inc. ("MISI") and Montauk Advisors, Inc. ("MAI"). MISI sells a range of insurance products; MAI previously sold investments in equipment leases.
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
The consolidated financial statements include the accounts of the Company and its subsidiaries. All intercompany accounts and transactions are eliminated in consolidation.
Revenue Recognition
Securities transactions, investment banking revenues, and commission income and related expenses are recorded on a trade date basis. Securities owned and securities sold but not yet repurchased are stated at quoted market values with unrealized gains and losses reflected in earnings. Investment account securities not readily marketable are carried at estimated fair value as determined by management with unrealized gains and losses included in earnings.
Commissions earned from the sale of insurance products are recognized upon approval of the customer application by the insurance carrier.
Depreciation and Amortization
Furniture and equipment and leasehold improvements are stated at cost. Depreciation of furniture and equipment and amortization of capital leases are computed generally on a straight-line basis over the estimated useful lives of the assets, ranging from three to seven years or terms of the leases, respectively. Leasehold improvements are amortized over the shorter of either the asset's useful life or the related lease term.
Statement of Cash Flows
For purposes of the Statement of Cash Flows, the Company considers all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents.
Net Income (Loss) per Share
The Company has adopted Statement of Financial Accounting Standards No.128 (SFAS 128), "Earnings per Share," which supersedes APB Opinion No. 15 (APB No. 15). SFAS 128 requires dual presentation of basic and diluted earnings per share (EPS) for complex capital structures on the face of the Statements of Operations. Basic EPS is computed by dividing net income by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution from the exercise or conversion of other securities into common stock. Earnings per share data have been restated to conform with the provisions of SFAS 128. The impact of the change was not material.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the year. Actual results could differ from those estimates.
Long-lived Assets
In accordance with SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of", the Company records impairment losses on long-lived assets used in operations, when events and circumstances indicate that the assets might be impaired and the undiscounted cash flows estimated to be generated by those assets are less than the carrying amounts of those assets.
Stock-based Compensation
The Company accounts for stock-based compensation in accordance with the provisions of SFAS No. 123. SFAS No. 123 requires that the Company either recognize in its financial statements costs related to its employee stock-based compensation plans, such as stock option and stock purchase plans, or make pro forma disclosures of such costs in a footnote to the financial statements. The Company has elected to continue to use the intrinsic value-based method of APB Opinion no. 25, as allowed under SFAS 123, to account for all of its employee stock-based compensation plans. The compensatory value of options issued to outside directors, affiliate brokers, and other non-employees is charged to operations over the vesting period of the option grants.
Income Taxes
The Company uses the liability method to determine its income tax expense as required under Statement of Financial Accounting Standards No. 109 (SFAS 109). Under SFAS 109, deferred tax assets and liabilities are computed based on differences between financial reporting and tax basis of assets and liabilities, and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse.
Deferred tax assets are reduced by a valuation allowance if, based on the weight of the available evidence, it is more likely than not that all or some portion of the deferred tax assets will not be realized. The ultimate realization of the deferred tax asset depends on the Company's ability to generate sufficient taxable income in the future.
The Company and its subsidiaries file a consolidated federal income tax return and separate state returns.
Under APB No. 25, compensation expense arising from the exercise of certain employee stock options is deductible for income tax purposes only. Accordingly, the related tax benefits from these deductions do not affect net income for financial reporting purposes, and are accounted for as increases in additional paid-in capital.
Recently Issued Accounting Pronouncement
In June 1998, the Financial Accounting Standards Board issued SFAS No. 133 "Accounting for Derivative Instruments and Hedging Activities", which establishes accounting and reporting standards for all derivative instruments. SFAS No. 133 is effective for fiscal years beginning after June 15, 1999. The adoption of SFAS No. 133 is not expected to have a material impact on the Company's financial position or results of operations.
NOTE 3 - TRADING AND INVESTMENT SECURITIES
Marketable securities owned and sold but not yet purchased consist of trading securities stated at quoted market values, as indicated below:
December 31, 1998 1997 Sold but Sold but not yet not yet Owned Purchased Owned Purchased
Obligations of U. S. government and its agencies $ 20,900 $ -- $ 304,815 $ -- State and municipal obligations 41,415 -- 515,781 -- Corporate stocks and bonds 2,353,286 243,119 2,042,020 799,503 Corporate bonds 270,278 50,738 288,156 2,466 Options and warrants -- 33,190 -- 7,554 --------- ------- --------- ------- $2,685,879 $327,047 $ 3,150,772 $809,523 ========== ======== =========== ========
Securities not readily marketable include investment securities (a) for which there is no market on a securities exchange or no independent publicly quoted market, (b) that cannot be publicly offered or sold unless registration has been effected under the Securities Act of 1933, or (c) that cannot be offered or sold because of other arrangements, restrictions or conditions applicable to the securities or to the Company. At December 31, 1998 and 1997, these securities at estimated fair values consisted of the following:
December 31, 1998 1997
Corporate stocks $ -- $236,640 Options and warrants 47,381 270,092 ------ ------- $ 47,381 $506,732 ====== =======
NOTE 4 - EMPLOYEE AND BROKER RECEIVABLES
This account consists of the following: December 31, 1998 1997
Commission advances $ 79,317 $215,119 Loans to brokers and non-executive employees 518,895 712,076 ------- ------- $598,212 $927,195 ======= =======
Receivables are generally non-interest bearing and due on demand.
NOTE 5 - FURNITURE, EQUIPMENT AND LEASEHOLD IMPROVEMENTS
Furniture, equipment and leasehold improvements consist of the following:
December 31, 1998 1997
Furniture and fixtures $ 812,360 $ 672,988 Computer and office equipment 2,033,729 1,442,108 Leasehold improvements 513,014 169,560 --------- --------- 3,359,103 2,284,656 Less: Accumulated depreciation and amortization (1,284,633) (926,802) ---------- --------- $ 2,074,470 $1,357,854 ========== =========
Depreciation expense was $357,831, $348,508 and $272,050 in 1998, 1997 and 1996, respectively.
NOTE 6 - NOTES RECEIVABLE December 31, 1998 1997
Environmental Coupon Marketing, Inc. (ECM) $149,640 $149,640 Global Financial Corp. (Global) 322,237 582,804 Fem-Com Copy Systems, Inc. (FCS) 5,852 205,610 ------- ------- $477,729 $938,054 ======= =======
a) ECM is a closely-held marketer of recycling programs to retailers. The loan is currently in default and stated at approximate net realizable value. The 1997 financial statements reflect a $69,000 write-down of the loan.
Also in 1997, the Company wrote off its $84,000 investment in ECM common stock.
b) Beginning in 1997, MAI has made loans to Global, the financing company that packaged and sold leasing investments through MAI, in order to assist Global in meeting cash flow deficiencies arising from the nonpayment of scheduled monthly installments on certain delinquent and non-performing leases. Most of the arrears are due from leases originated by FCS, Global's affiliated equipment vendor, and Biblio, Inc. ("Biblio"), an affiliate of FCS. The MAI notes are guaranteed by Global, FCS, Biblio, and the shareholder of FCS and Biblio. The notes are further collateralized by mortgage liens on real estate owned by the shareholder of FCS and Biblio, a pledge of all of the outstanding shares in Global, and various recorded liens on the assets of FCS and Biblio.
During 1998, the Company undertook a full review of the Global loans to evaluate their collectability, and determined that, based on various events and circumstances, including the default status of the loans, the insolvency of Global and FCS, and steadily declining collections on the lease portfolio serviced by Global, the loans to Global have been impaired. Accordingly, the Company has recorded an impairment loss of $1,775,000 in its financial statements for 1998. The loan reserve reflects management's best estimate of the extent of loan impairment based on available current information. Eventual outcomes could differ from estimated amounts.
c) MAI has provided FCS with working capital financing to purchase equipment for resale to FCS customers. The balance is payable on demand.
NOTE 7 - DUE FROM OFFICERS
Advances to officers are unsecured and currently bear interest at the rate of 6% per annum. These loans are due on demand. Interest on these loans totaled $8,223, $7,817 and $9,428 in 1998, 1997 and 1996, respectively.
NOTE 8 - NOTES PAYABLE - BANK
These notes evidence two secured term loans bearing interest at the prime rate (7.75% at December 31, 1998), and are collateralized by equipment owned by the parent corporation. Principal maturities are scheduled as follows: 1999 - $95,925, 2000 - $95,925, and 2001 - $52,994.
NOTE 9 - SUBORDINATED NOTES PAYABLE
The notes are payable in four remaining annual installments of $50,000 plus interest at 8% per annum. Each note is subordinated to the claims of FMSC's general creditors under a subordination agreement approved by the NASD.
NOTE 10 - CONVERTIBLE PROMISSORY NOTES PAYABLE
In 1998, the Company issued a series of convertible promissory notes aggregating $570,000 to a private investor in consideration of $300,000 in cash and an income stream from the assignment of equipment lease investments. The notes carry interest at the rate of 10% per annum, payable semi-annually, and are convertible into up to 380,000 shares of the Company's Common Stock at the rate of $1.50 per share. The notes mature in five years; however, the Company is required to pay 20% of the original outstanding principal into a sinking fund on or before each annual anniversary date of the notes. The notes are callable at the Company's option upon thirty days written notice at 105% above par. The equipment lease investments assigned to the Company in the transaction are serviced by Global and were originally sold to the investor through MAI.
The Company has recorded a loan discount of $99,899, representing the difference between the note principal of $570,000, and the cash received plus the estimated discounted payment stream from the leases. The discount is being amortized over the term of the notes. Amortization expense was $3,524 in 1998.
NOTE 11 - ACCRUED EXPENSES
Accrued expenses consist of the following:
December 31, 1998 1997
Reserves for legal matters $661,531 $640,000 Other 243,623 172,590 ------- ------- $905,154 $812,590 ======= =======
NOTE 12 - INCOME TAXES
The provision (benefit) for income taxes consists of the following:
December 31, 1998 1997 1996
Currently payable (refundable): Federal $ -- $ 299,584 $ 150,505 State 60,255 161,134 37,103 ---------- ------- -------- 60,255 460,718 187,608 ---------- ------- --------
Deferred: Federal (1,008,591) 470,277 (198,875) State (387,665) 37,183 (6,480) Valuation allowance 731,469 -- -- ---------- ------- -------- (664,787) 507,460 (205,355) ---------- ------- -------- $ (604,532) $ 968,178 $ (17,747) ========== ======= ========
The current portion of the federal income tax benefit in 1997 reflects refundable taxes of approximately $193,000 from the carryback of net operating losses. At December 31, 1998 the Company had federal net operating loss carryforwards of $173,000 available to offset future federal taxable income. The carryforwards expire at various dates through 2018.
Following is a reconciliation of the income tax provision (benefit) with income taxes based on federal statutory rates:
December 31, 1998 1997 1996
Expected statutory federal income tax $(1,144,909) $831,301 $ 2,256 Non-taxable income -- (12,080) (5,457) Non-deductible expenses 11,456 10,200 4,576 State taxes, net of federal tax benefit (200,021) 146,700 (19,122) Other (2,527) (7,943) -- Valuation allowance 731,469 -- -- ---------- ------- ------- $ (604,532) $968,178 $(17,747) ========== ======= =======
The tax effects of the temporary differences that give rise to significant portions of the deferred tax assets and liabilities as of December 31, 1998 and 1997 are:
December 31, 1998 1997
Deferred tax assets: Accrued reserves $1,205,632 $171,465 Net operating loss 160,190 87,504 Other 146,697 33,349 --------- ------- 1,512,519 292,318 --------- -------
Deferred tax liabilities: Unrealized investment gains 16,952 197,990 Depreciation 54,176 58,360 Other 9,167 -- --------- ------- 80,295 256,350 --------- ------- 1,432,224 35,968 Valuation allowance (731,469) -- -------- ------- Net deferred tax asset $ 700,755 $ 35,968 ========= =======
Based on its review of available evidence, management has established a valuation allowance to offset a portion of the benefits of the Company's net deferred tax assets because their realization is uncertain.
NOTE 13 - COMMITMENTS AND CONTINGENT LIABILITIES
Leases
The Company leases office facilities and equipment under operating leases expiring at various dates through 2005. The lease for the Company's headquarters has a six-year renewal option through 2011.
In 1998, the Company entered into a capital lease to acquire new equipment costing $88,000 and to refinance through a sale/leaseback transaction existing fixed assets with a book value of approximately $304,000.
Future minimum lease payments as of December 31, 1998 were:
Capital Operating Lease Leases
1999 $142,704 $ 836,005 2000 142,704 719,047 2001 146,986 648,758 2002 -- 642,184 2003 -- 639,993 Thereafter -- 693,325 ------- ---------
Total minimum lease payments 432,394 $4,179,312 Less: Amount representing ========= interest on capital lease 58,815 ------- $373,579 =======
Operating lease expense for 1998, 1997 and 1996 totaled $857,715, $498,815 and $426,172, respectively.
Legal Matters
The Company has been involved in a number of lawsuits and regulatory investigations relating to the sale of securities by a former affiliate office located in Houston, Texas. In 1996, the Company, without admitting liability or wrongdoing, settled various claims asserted by Escambia County, Florida, a former customer of the Houston office, for $900,000 in cash. In January 1997, the Company settled another customer lawsuit for $750,000, with $500,000 payable upon execution of settlement documents, and the balance of $250,000 payable in five annual installments of $50,000 plus interest at 8% per annum. The five installments are evidenced by notes payable, which have been subordinated to the claims of FMSC's general creditors under a subordination agreement approved by the NASD. In 1997, FMSC entered into an Offer of Settlement with the SEC relating to the activities of the Houston office. Under terms of the settlement, FMSC paid a $50,000 fine and agreed to engage an independent compliance examiner to audit FMSC's compliance procedures. FMSC was permitted to offset other SEC monetary assessments totalling approximately $227,000 against Houston customer settlements previously paid by the firm. FMSC entered into a similar consent decree with the State of Florida, pursuant to which FMSC paid a $15,000 fine and agreed to temporary restrictions on brokerage activities in the state. In 1998, the Company settled another Houston customer lawsuit for $500,000 in cash. In March 1999, the Company reached a $100,000 settlement in the last pending customer lawsuit involving the Houston office.
FMSC is also both a claimant and a counter-respondent in an arbitration which it brought against another securities firm arising out of the trading activities of the former Houston office. The securities firm has filed a counterclaim against FMSC seeking an unspecified amount of damages.
In an unrelated matter, FMSC settled a customer arbitration for $500,000 in cash in 1997. Under terms of the settlement, the Company also issued to the customer and her counsel a total of 150,000 five-year warrants to purchase FMFC common stock for $1.25 per share. Two of the Company's officers agreed to guarantee a minimum selling price of $1.917 per share with respect to the shares underlying the warrants and established a $100,000 escrow account with personal funds to secure the guarantee. The warrantholders had a sixty-day period in which to exercise the warrants and sell the shares, commencing from the date that the warrants were registered for resale. The warrant registration became effective in June 1997. The individuals exercised their warrants and sold their shares in 1997 at prices exceeding the guaranteed minimum.
FMSC is currently a respondent in certain pending customer arbitrations and other matters relating to its securities business. These claims are in various stages of progress and are being vigorously contested. Management is unable to derive a meaningful estimate of the amount or range of possible loss that may arise out of pending litigation (including litigation costs) in any particular subsequent quarterly or annual period, or in the aggregate. However, it is possible that the financial condition, results of operations, or cash flows of the Company in subsequent quarterly or annual periods could be materially affected by the ultimate outcome of such pending litigation.
The Company continues to review the extent to which settled and pending claims, including Houston customer settlements, may be covered under its insurance policies. In January 1997, the Company negotiated a $650,000 settlement with one of its insurance carriers in consideration of a general release from coverage on various matters. The Company has also filed suit against one of its insurers to compel coverage of several settled claims. There can be no assurance that the Company will be successful in its efforts to recover additional funds from its insurers on settled claims, or that monetary losses, if any, from future settlements or adverse judgments will be covered under the Company's existing insurance policies.
Purchase commitments
In 1997, the Company entered into a three-year agreement with a long distance carrier under which the Company has committed to pay minimum annual charges of $300,000 in each of the three contract years, in consideration of favorable rates on telephone and data communications service during the commitment period.
Income tax audit
The Internal Revenue Service is currently conducting a field audit of the Company's federal income tax returns for 1995, 1996 and 1997. The Company is unable to determine at this time what impact, if any, the outcome of the audit will have on its business, financial condition or results of operations.
NOTE 14 - FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK and CONCENTRATION OF CREDIT RISK
The Company executes securities transactions on behalf of its customers. If either the customer or a counter-party fail to perform, the Company by agreement with its clearing broker may be required to discharge the obligations of the non-performing party. In such circumstances, the Company may sustain a loss if the market value of the security is different from the contract value of the transaction. As part of its normal brokerage activities, FMSC also assumes short positions in its inventory. The establishment of short positions exposes FMSC to off-balance-sheet risk in the event prices increase, as FMSC may be obligated to acquire the securities at prevailing market prices.
FMSC seeks to control off-balance-sheet risk by monitoring the market value of securities held or given as collateral in compliance with regulatory and internal guidelines. Pursuant to such guidelines, FMSC's clearing firm requires additional collateral or reduction of positions, when necessary. FMSC also completes credit evaluations where there is thought to be credit risk.
Financial instruments that potentially subject the Company to significant concentrations of credit risk consist principally of cash and securities inventories. The Company places its cash primarily in commercial checking accounts. Balances may from time to time exceed federally insured limits. Cash and securities inventories maintained at FMSC's clearing firm are uninsured.
NOTE 15 - DEFINED CONTRIBUTION PLAN
The Company sponsors a defined contribution pension plan [401(k)] covering all participating employees. The Company may elect to contribute up to 100% of each participant's annual contribution to the plan. Employer contributions for 1998, 1997 and 1996 amounted to $38,077, $33,060, and $44,400, respectively.
NOTE 16 - COMMON STOCK ISSUED WITH GUARANTEED SELLING PRICE
From time to time, the Company has issued unregistered shares of its Common Stock in settlement of various customer claims and invoices for legal services. With respect to these shares, the Company provides a guarantee to pay to the selling stockholder the difference between a target price and the actual selling price of the shares upon expiration of the statutory holding period. The holders of the shares may elect to retain the shares once the holding period lapses. Such an election will release the Company from any further obligation to the stockholders.
The Company has established a temporary equity account to record its maximum liability from the guarantees. Payment of any shortfall is charged to this account. Any balance remaining at the end of the respective holding periods is credited to permanent capital. Following is a schedule of activity in this account for 1998 and 1997:
Shares Amount
Balance, January 1, 1997 210,500 $ 421,500
Increase in guarantee with respect to 37,500 at $.75 per share -- 28,125
Reclassification of shares to permanent capital (37,500) (103,125) ------- ------- Balance, December 31, 1997 173,000 346,500
Issuance of additional shares 15,000 30,000
Payment of guarantee -- (40,610)
Reclassification of shares to permanent capital (170,000) (299,390) ------- ------- Balance, December 31, 1998 18,000 $ 36,500 ======= =======
NOTE 17 - STOCK OPTION PLANS
The Company currently has three option plans in place: The 1992 Incentive Stock Option Plan (the "1992 Plan"), the 1992 Non-Executive Director Stock Option Plan (the "Director Plan"), and the 1996 Senior Management Incentive Plan (the "1996 Plan").
In June 1998, the Company's stockholders approved an amendment to the 1992 Plan to increase the number of shares reserved for issuance from 3,500,000 to 6,000,000 shares. Under the 1992 Plan, options may be granted to employees, consultants and registered representatives of the Company, but only options issued to employees will qualify for incentive stock option treatment (ISOs). The exercise price of an option designated as an ISO shall not be less than the fair market value of the Common Stock on the date of grant. However, ISOs granted to a ten percent stockholder shall have an exercise price of at least 110% of such fair market value. At the time an option is granted, the Board of Directors shall fix the period within which it may be exercised. Such exercise period shall not be less than one year nor more than ten years from the date of grant. The 1992 plan will expire in May 2002.
The Company has reserved 1,000,000 shares of its Common Stock for issuance under the Director Plan. Options to purchase 20,000 shares of Common Stock are granted to each Non-Executive Director on August 1 of each year, provided such individual has continually served as a Non-Executive Director for the twelve-month period immediately preceding the date of grant. The options will expire in five years from the date of grant. The exercise price of such options shall be equal to the fair market value of the Company's Common Stock on the date of grant. The Director Plan will terminate in May 2002.
In 1996, the Company's stockholders also ratified the 1996 Plan. The Company has reserved 2,000,000 shares for issuance to key management employees. Awards can be granted through the issuance of incentive stock rights, stock options, stock appreciation rights, limited stock appreciation rights, and shares of restricted Common Stock. The exercise price of an option designated as an ISO shall in no event be less than 100% of the then fair market price of the stock (110% with respect to ten percent stockholders), and not less than 85% of the fair market price in the case of other options. The 1996 Plan will terminate in June 2006.
A summary of the activity in the Company's stock option plans for the three-year period ended December 31, 1998 is presented below:
Range of Exercise Shares Prices
Options outstanding, December 31, 1995 2,117,500 $ .41 - 1.75 Granted 279,000 .875 - 1.33 Canceled (123,000) .56 - 1.00 Exercised (137,375) .50 - 1.00
Options outstanding, December 31, 1996 2,136,125 $ .41 - 1.75 Granted 1,517,500 .96 - 2.75 Canceled (56,500) .56 - .875 Exercised (973,025) .41 - 1.75
Options outstanding, December 31, 1997 2,624,100 $ .41 - 2.75 Granted 1,442,500 1.00 - 2.50 Canceled (381,250) .50 - 2.75 Exercised (432,050) .41 - 2.25
Options outstanding, December 31, 1998 3,253,300 $ .69 - 2.75
Additional information with respect to options under the Company's option plans is as follows:
Shares of common stock available for future grant 4,108,550 Weighted-average grant date fair value of options granted during each year using the Black-Scholes option pricing model 1996 $.55 1997 $.73 1998 $.71
The Company applies APB No. 25 in accounting for employee stock options. Accordingly, compensation is recognized in the financial statements only for the fair value of options issued to non-employee directors, consultants and affiliate brokers. Such compensation is amortized to expense over the related options' vesting periods. Compensation expense recognized in 1998 and 1997 totaled $147,988 and $21,652, respectively.
Pro forma net earnings and earnings per share information, as required by SFAS No. 123, have been determined as if the Company had accounted for employee stock options under the fair value method. The fair value of these options was estimated at grant date using a Black-Scholes option pricing model with the following weighted-average assumptions for 1998, 1997 and 1996:
1998 1997 1996
Risk free interest rates 5.03% 6.23% 6.05% Expected option lives 2.4 years 3.75 years 5 years Expected volatilities 46.5% 46.5% 76.5% Expected dividend yields 0% 0% 0%
The Company's pro forma information follows:
Net income (loss) 1998 1997 1996
As reported $(2,762,847) $1,476,825 $ 32,789 Proforma (3,292,291) 1,246,276 (26,597)
Basic income (loss) per share As reported $(.28) $.17 $ .01 Proforma $(.34) .14 (.01)
Diluted income (loss) per share As reported $(.28) $.14 $ .01 Proforma $(.34) .12 (.01)
The full impact of calculating compensation expense for stock options under SFAS No. 123 is not reflected in pro forma net income, since such expense is amortized over the vesting period of those options as they vest.
Additional information as of December 31, 1998 with respect to all outstanding options is as follows:
Options Outstanding Options Exercisable Weighted Average Weighted Weighted Remaining Average Average Number Contractual Exercise Number Exercise Range of prices Outstanding Life Price Exercisable Price
$.69 - .96 737,600 1.61 $0.80 627,400 $0.81 1.00 - 1.38 789,200 3.43 1.14 387,080 1.12 1.56 - 1.94 702,500 4.36 1.79 352,500 1.87 2.00 - 2.75 1,024,000 4.05 2.43 422,440 2.41
3,253,300 3.41 $1.61 1,789,420 $1.46
NOTE 18 - STOCKHOLDERS' EQUITY
Rights offering
In February 1998, the Company completed an offering of 3,072,779 Units, each Unit consisting of one Class A Redeemable Common Stock Purchase Warrant, one Class B Redeemable Common Stock Purchase Warrant, and one Class C Redeemable Common Stock Purchase Warrant. The Warrants have the following exercise prices and terms:
Exercise Price Exercise Period Warrant Per Share from Date of Issuance
Class A $3.00 Three years Class B 5.00 Five years Class C 7.00 Seven years
Each shareholder of record as of December 15, 1997 received three rights for each share of Common Stock held as of the record date, with three rights required to subscribe for a single Unit at a price of $.45 per Unit. The offering raised gross proceeds of $1,382,750 before deducting registration costs of approximately $236,000. There are currently 3,072,446 Class A, Class B and Class C warrants outstanding, respectively.
Recapitalization
In June 1997, the Company's stockholders approved an amendment to the Company's Certificate of Incorporation to increase the number of shares of Common Stock authorized for issuance from 15,000,000 to 30,000,000.
Preferred Stock
The Company is presently authorized to issue 5,000,000 shares of Preferred Stock, none of which have been issued at December 31, 1998. The preference, if any, to be given to preferred shares is determinable at the time of issuance.
Stock Repurchases
In 1996, the Company repurchased a total of 196,802 shares of its Common Stock in the open market for $230,506 under now expired stock buy-back programs authorized by the Board of Directors. All of the repurchased shares have been cancelled.
Sale of Restricted Stock
In 1997, the Company sold 12,240 unregistered shares of its Common Stock to an affiliate broker for total consideration of $23,027.
Issuance of Common Stock
During fiscal 1996, the Company issued a total of 165,000 shares of its Common Stock to settle various customer claims. The Company recorded a charge to earnings of $178,650 upon issuance of the shares.
NOTE 19 - FAIR VALUE OF FINANCIAL INSTRUMENTS
The Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 107, Disclosures About Fair Value of Financial Instruments, which requires that all entities disclose the fair value of financial instruments, as defined, for both assets and liabilities recognized and not recognized in the statement of financial condition. Substantially all of the Company's financial instruments at December 31, 1998, consisting primarily of marketable debt and equity securities, amounts due from FMSC's clearing firm, accounts payable and accrued expenses, and notes payable are carried at, or approximate fair value due to their short-term nature, the use of mark-to-market accounting for trading securities, or because they carry market rates of interest.
NOTE 20 - NET CAPITAL REQUIREMENTS
FMSC is subject to the Securities and Exchange Commission Uniform Net Capital Rule (Rule 15c3-1), which requires FMSC to maintain minimum net capital, as defined. At December 31, 1998, FMSC had net capital of $1,668,964, which was $1,418,964 in excess of its required net capital of $250,000. FMSC's ratio of aggregate indebtedness to net capital was 2.17 to 1.
NOTE 21 - RELATED PARTY TRANSACTION
In 1997, FMSC served as underwriter for an initial public offering of PacificHealth Laboratories ("PHL") common stock. One of the directors of the Company is a director, officer and major stockholder of PHL. FMSC also served as placement agent for two private placements of PHL securities in 1996, from which it earned placement fees of $366,000. Management believes that the fees earned by FMSC on the PHL financings represent arm's-length compensation.