the Knight Capital Group (KCG) end game: effective change of control

a recap

Last Wednesday morning, KCG started up a new software trading link, whose total purpose still isn’t clear, to the NYSE computers.

The new software went berserk, buying everything in sight–and without regard to price–as soon as it was turned on.  As subsequent media comment has made apparent, stuff like this happens every so often in today’s financial world.  Usually, though, the defective program is shut down within a minute or two.  Not so in the KCG case.  It took–for reasons also not clear–the better part of an hour for KCG to pull the plug.

The company subsequently announced it had lost $440 million due to the malfunction.

big problems

KCG faced a number of related problems because of this.  Specifically,

1.  If the average loss was 10% of the purchase price, KCG had bought $4.4 billion worth of stock that it would have to pay for three days later.   If the loss was 5%, KCG would have to come up with $8.8 billion.  In any event, KCG only had about $400 million in cash on hand.

2.  The software glitch was like a gigantic fireworks display.  Every trader on Wall Street knew KCG was in trouble–and might have difficulty settling (i.e., paying for) the trades it had made.  So selling out of the positions it had accidentally accumulated, without offering substantial discounts, would have been very difficult.  In some cases (see my previous post on KCG), KCG held far too much to be sold quickly.

KCG appealed to the NYSE to cancel the accidental trades, but was mostly refused.  After a similar incident last year, Wall Street drew up a set of rules for when such trades might be broken.  Only six of the 150-odd stocks Knight bought qualified.

KCG solved this issue–apparently on Wednesday–by selling the bulk of the erroneous position to Goldman.

3.  As a market maker, KCG makes money by collecting a fee for matching buyers and sellers of stock.  It’s a little like a bank.  Customers only deal with it if they believe it is financially sound.  And, regulators require that it put aside a little capital to back each trade it brokers during the three-day settlement period.  But the rogue software program had tied up all of KCG’s capital. The loss it generated had also wiped out all its cash.

So KCG couldn’t accept any new trading orders.  And long-time customers wouldn’t place any, for fear of potential problems (too geeky a topic, even for PSI) if KCG went out of business before trades could settle.

the solution

One part was the sale of stock to Goldman, which got KCG out from under the need to come up with the money to pay for the erroneous trades.

The second, reported in an 8-K filing with the SEC on Monday, is the sale of $400 million in convertible preferred stock in KCG to a group of the company’s long-time business partners.

There are two classes of convertible, one with limited voting rights.  Both earn interest at a 2% annual rate.  Each $1000 preferred can be exchanged for 666.667 shares of common, meaning an effective purchase price of $1.50 per KCG share.

According to the 8-K, conversion would leave the preferred holders owning 73% of KCG.

tidying up may still need to be done

The complicated structure of the preferred issue–two classes, each with different voting rights–seems to me to imply that some of KCG’s rescuers aren’t allowed to own a market maker, either because of conflict of interest considerations or market share concerns.

change of ownership has happened, though

…although in a deferred way (which, of course, is what convertibles are all about).  The directors of KCG have agreed to turn over almost three-quarters of the company to their rescuers in exchange for the bailout.

an attractive stock?

I’m not an expert at financials, so I don’t have a professional opinion.

The one think that strikes me is that, pre-crisis, the stock was trading at about $10 a share (down from the 52-week high of $14+ achieved last October).  If we assume that the $400 million injection from the preferreds offsets exactly the loss from the renegade trading software, then the only factor that’s really changed over the past week is that there are 4x as many shares outstanding.  That would imply the equivalent share price today would be $2.50.  But the stock is currently trading at well over $3.   Strange.   Very strange.

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