Piper Jaffray Companies Annual Report 2005

Plain-text annual report

p i p e r ja f f r ay c o m pa n i e s ...................................................... Annual Report 2005 c h a i r m a n ’ s l e t t e r ...................................................... ............................................................................................................................................................. Dear fellow shareholders, Being a trusted guide requires a deep understanding of your clients and their ﬁnancial goals. Your client might be a growing company ready to go public, a large city needing to issue bonds to fund the building of a new convention center, or new parents ready to start planning for their child’s education. In each of these cases, a trusted guide couples his or her expertise with a wide array of products and resources to create a solution speciﬁcally tailored to that client’s need. By becoming a trusted guide for our clients, we earn the privilege to serve as their primary ﬁnancial advisor. Piper Jaffray continues to pursue a primary advisor business strategy. We believe this strategy will help us attain our goal of becoming the best full-service securities ﬁrm focused on middle-market clients. We made demonstrable progress against this strategy in 2005. 1 c h a i r m a n ’ s l e t t e r ...................................................... during 2005, we faced a number of ﬁnancial challenges. We confronted these challenges head-on and rebounded from a difﬁcult ﬁrst half of the year to deliver strong back-to-back results in the last two quarters of the year. In the third quarter, revenues were up 12.4 percent year-over-year, and in the fourth quarter we saw revenues rise 6.4 percent year- over-year. Our fourth quarter pre-tax operating margin was 12.1 percent, the highest level we have achieved since becoming a public company. primary advisor in action To achieve primary advisor status, we must: Maintain a Tight Focus on Our Targeted Client Segments. Our success will come from fully aligning resources around client and market segments where we can differentiate ourselves, while redirecting resources away from areas where we cannot. We already are distinguishing ourselves in a number of markets. For instance, in 2005, our health care investment banking team ranked ﬁrst domestically based on number of completed initial public offerings (Source: Dealogic). We strengthened this global franchise during the year when we added new talent to our United Kingdom-based subsidiary, Piper Jaffray Ltd. With the expansion of this platform, through the addition of a new team comprising 14 of the uk’s leading health care investment bankers, research analysts, traders and sales professionals, we can now provide health care companies in Europe with the best available investment banking skills. We can also provide access to the uk markets in addition to the u.s. capital and transatlantic m&a markets. Already the team has served as sole ﬁnancial advisor and underwriter on the largest secondary offering in the uk biotech sector in the last ﬁve years. At the same time, we responded to changing marketplace dynamics, most notably price transparency and the growing prominence of electronic communications networks (ecns) to facilitate trading, in particular ﬁxed-income trading. We restructured in the second quarter, directing resources away from those parts of the business that were impacted by these trends or that did not provide direct client support. This, in turn, has freed up capital that we are reinvesting in areas of greater opportunity. Through the restructuring we are achieving approximately $10 million in annualized savings. Grow Our Product Breadth to Meet the Full Range of Our Clients’ Needs. Whether we develop new products or partner with existing market leaders, we continue to expand the range of products we offer to address our clients’ varied needs. In 2005, we realigned and strengthened our high-yield and structured product capabilities within our Corporate and Institutional Services group, which serves corporate issuers, private equity groups and institutional investors. By adding our high-yield and structured product resources to this group, we can offer a wider array of services to our corporate and private equity group clients and a greater breadth of product to our institutional clients. In November 2005, we successfully issued Piper Jaffray Equipment Trust Securities, or pjets. pjets is an innovative structured product based on aircraft 2 c h a i r m a n ’ s l e t t e r ...................................................... enhanced equipment trust certiﬁcate (eetc) securities—a market in which Piper Jaffray has established industry-leading expertise— that we repackaged to better meet our clients’ investing needs. the best people advising our clients and living our ﬁrm’s values and goals. The best people afﬁrm our Guiding Principles and ensure that we always place our clients’ interests ﬁrst. The best people people think like owners because they are owners. At Piper Jaffray, we have actively promoted employee ownership since our spin-off. Currently, 84 percent of Piper Jaffray employees are shareholders. The best people hold themselves accountable for delivering strong results for our shareholders and our communities. This is happening in key segments across our ﬁrm. I am grateful to the talented individuals who are achieving these results. We are working to strengthen this culture of discipline within our organization in order to generate greater success in 2006. Sincerely, Andrew S. Duff Chairman and CEO Piper Jaffray Companies Put Our Individual Knowledge to Work for Our Clients. The greatest beneﬁt we provide our clients is customized advice that springs from our understanding of our clients and the expertise and experiences of our nearly 3,000 employees. Our Private Client Services business is transitioning from a traditional, transaction-based business model to an advisory model centered on long-term client relationships and comprehensive wealth management. Though our proﬁtability in this business is not yet competitive, we have made progress advancing our new model. To help our ﬁnancial advisors deepen their expertise, we signiﬁcantly increased our spending on professional training this year. We formed a strategic alliance with leading industry experts to help us deliver a targeted curriculum for our ﬁnancial advisors. More than 400 of our approximately 840 ﬁnancial advisors participated in this training in 2005. In addition, we added to our Wealth Advisory Services team, a group of industry experts that partner with our advisors and provide access to specialized knowledge like estate and wealth transfer planning. the best people create the best company All of these actions demonstrate our commitment to executing our primary advisor strategy. Ultimately, though, we know that being the best takes more than just a solid business strategy. We must have 3 Ultimately, though, we know that being the best takes more than just solid business strategy. We must have the best people advising our clients and living our ﬁrm’s values and goals. Andrew S. Duff Chairman and Chief Executive Ofﬁcer f i n a n c i a l h i g h l i g h t s ...................................................... Year ended December 31 (Amounts in thousands) Revenues Commissions and fees Principal transactions Investment banking Interest Other income Total revenues Interest expense Net revenues Non-Interest expenses Compensation and beneﬁts Cash award program Restructuring-related Royalty fee Other non-compensation beneﬁts 2005 $ 283,481 143,391 270,758 71,471 45,688 814,789 39,736 775,053 471,674 4,206 8,595 – 229,472 2004 $ 263,730 188,526 257,932 54,784 57,967 822,939 25,441 2003 $ 256,747 215,191 229,945 50,536 59,082 811,501 24,771 797,498 786,730 488,394 4,717 – – 224,766 482,397 24,000 – 3,911 235,539 Total non-interest expenses 713,947 717,877 745,847 Income before income tax expense Income tax expense 61,106 21,023 79,621 29,273 40,883 14,884 Net income $ 40,083 $ 50,348 $ 25,999 5 $2.10$2.60$1.357.9%10.0%5.2%$40.1$50.3$26.0$775.1$797.5$786.7‘05‘04‘03‘05‘04‘03‘05‘04‘03‘05‘04‘03Net revenuesIn millionsNet incomeIn millionsPretaxoperatingmarginEarnings per common shareDilutedp i p e r ja f f r ay c o m pa n i e s ...................................................... Capital Markets with approximately 800 employees, our Capital Markets business serves public and private corporations, private equity groups, public entities, nonproﬁt clients and institutional investors. We provide a multitude of products and services for these clients, including investment banking and public ﬁnance; middle-market mergers and acquisitions; equity and debt capital markets; high-yield and structured products; institutional equity, tax-exempt and taxable sales and trading; and equity and ﬁxed-income research. The investment banking team focuses on four sectors: health care, technology, consumer and ﬁnancial institutions. In 2005, we completed 64 equity offerings, raising a total of $8.7 billion in capital for our clients. We increased the number of deals in which we were the lead manager by 70 percent. Our mergers and acquisitions professionals completed 48 m&a transactions in 2005 with an enterprise value of $8.1 billion, ranking the ﬁrm 15th nationally (Source: Thomson Financial and Piper Jaffray). Record revenue from our m&a team, combined with strong lead-managed revenue, resulted in more than 75 percent of our investment banking revenues coming from primary advisor activities. The public ﬁnance team focuses on four sectors: state and local governments, housing and real estate, health care, and higher education. In 2005, we completed 473 tax-exempt issues with a total par value of $6.1 billion, ranking the ﬁrm fourth nationally based on number of completed issues (Source: Thomson Financial). In the Upper Midwest, the team completed 290 public ﬁnance issues for the year with a total par value of $2.5 billion, again ranking the ﬁrm ﬁrst based on number of completed issues. Piper Jaffray equity research analysts’ stock-picking abilities were recognized in 2005. The ﬁrm ranked fourth among 73 ﬁrms highlighted in the 2005 Wall Street Journal Best on the Street Survey. The ﬁrm also tied for eighth place in the annual Forbes.com/StarMine rankings for top equity research analysts based on their stock-picking and earnings- predicting abilities. National Recognition IPO activity for our four focus sectors1,2: M&A activity 3: Public ﬁnance activity 4,5 National : Upper Midwest: 1Based on number of initial public offerings. 2Source: Dealogic. 3Source: Thomson Financial and Piper Jaffray. 4Based on number of completed issues. 5Source: Thomson Financial. No.1 No.15 No.4 No.1 6 p i p e r ja f f r ay c o m pa n i e s ...................................................... Private Client Services Our ﬁnancial advisors help clients develop comprehensive ﬁnancial strategies and select from an array of products and solutions based on their investment objectives. Tools such as our online account access and portfolio performance reports allow clients to monitor their progress and ensure their ﬁnancial journey stays on course. At the end of 2005, private client fee-based revenue was at its highest level ever: 21 percent of total business line net revenue, and 17 percent of assets under management were in fee-based accounts. private client services has approximately 840 ﬁnancial advisors in more than 90 ofﬁces in 17 Midwest, Mountain and West Coast states and $52 billion in assets under management. We focus on helping middle-income and afﬂuent individuals plan for their ﬁnancial futures and enhance and manage their wealth. Using a disciplined advisory process, our ﬁnancial advisors develop customized solutions for our clients’ unique needs. They provide guidance in the following areas, all of which are tailored to an individual’s risk and wealth enhancement goals: < retirement planning; < estate planning/wealth transfer; < investment consulting; < education funding; < insurance protection; < philanthropic planning; < asset allocation strategies. 7 $8,807$7,795$6,55620.8%17.3%14.6%‘05‘04‘03‘05‘04‘03Growth in fee-based business revenuesAs a percentage of net revenue Growth in assets under managementin fee-basedaccountsIn millionsOur Guiding Principles We create and implement superior ﬁnancial solutions for our clients. Serving clients is our fundamental purpose. ................ We earn our clients’ trust by delivering the best guidance and service. ................ Great people are our competitive advantage. ................ As we serve, we are committed to these core values: Always place our clients’ interests ﬁrst. Conduct ourselves with integrity and treat others with respect. Work in partnership with our clients and each other. Maintain a high-quality environment that attracts, retains and develops the best people. Contribute our talents and resources to serve the communities in which we live and work. 8 b oa r d o f d i r e c to rs Andrew S. Duff Chairman and CEO Addison (Tad) L. Piper Vice Chairman Michael R. Francis Executive Vice President of Marketing, Target Corporation B. Kristine Johnson President, Afﬁnity Capital Management Samuel L. Kaplan Partner and Founding Member, Kaplan, Strangis and Kaplan, P.A. Frank L. Sims Corporate Vice President, Cargill, Inc. Jean M. Taylor President, Taylor Corporation Richard A. Zona Chairman and Chief Executive Ofﬁcer, Zona Financial LLC e x e c u t i v e l e a d e rs h i p Andrew S. Duff Chairman and CEO Addison (Tad) L. Piper Vice Chairman James L. Chosy General Counsel Frank E. Fairman Head of Public Finance Services R. Todd Firebaugh Chief Administrative Ofﬁcer Robert W. Peterson Head of Private Client Services Thomas P. Schnettler Head of Corporate and Institutional Services Sandra G. Sponem Chief Financial Ofﬁcer Piper Jaffray Companies SELECTED FINANCIAL DATA The following table presents our selected consolidated ﬁnancial data for the periods and dates indicated. The information set forth below should be read in con- junction with ‘‘Management’s Discussion and Analy- sis of Financial Condition and Results of Operations’’ and our consolidated ﬁnancial statements and notes thereto. FOR THE YEAR ENDED DECEMBER 31, (Dollars and Shares in Thousands, Except Per Share Data) 2005 2004 2003 2002 2001 Revenues: Commissions and fees Principal transactions Investment banking Interest Other income Total revenues Interest expense Net revenues Non-interest expenses: Compensation and beneﬁts Cash award program Regulatory settlement Amortization of acquisition-related compensation and goodwill Merger and restructuring Royalty fee Other $ 283,481 $ 263,730 $ 256,747 $ 275,682 $ 302,289 143,391 270,758 71,471 45,688 814,789 39,736 188,526 257,932 54,784 57,967 822,939 25,441 215,191 229,945 50,536 59,082 811,501 24,771 171,957 208,740 61,898 47,303 765,580 36,528 181,469 247,929 95,436 52,865 879,988 79,216 775,053 797,498 786,730 729,052 800,772 471,674 4,206 488,394 4,717 482,397 24,000 – – 8,595 – – – – – 229,472 224,766 – – – 3,911 235,539 449,329 513,623 – 32,500 – 7,976 7,482 – – 17,641 65,697 55,753 226,966 221,940 Total non-interest expenses 713,947 717,877 745,847 724,253 874,654 Income (loss) before income tax expense (benefit) Income tax expense (beneﬁt) 61,106 21,023 79,621 29,273 40,883 14,884 4,799 4,693 (73,882) (23,831) Net income (loss) $ 40,083 $ 50,348 $ 25,999 $ 106 $ (50,051) Earnings per common share Basic Diluted Weighted average number of common shares Basic Diluted Other data Total assets Long-term debt Shareholders’ equity Total employees Total Private Client Services ofﬁces $ $ 2.13 2.10 $ $ 2.60 2.60 $ $ 1.35 1.35 $ $ 0.01 0.01 $ $ (2.60) (2.60) 18,813 19,081 19,333 19,399 19,237 19,237 19,160 19,160 19,279 19,279 $ 2,354,191 $ 2,828,257 $ 2,380,647 $ 2,032,452 $ 2,734,370 $ 180,000 $ 180,000 $ 180,000 $ 215,000 $ 475,000 $ 754,827 $ 725,428 $ 669,795 $ 609,857 $ 378,724 2,871 90 3,027 91 2,991 96 3,227 103 3,255 107 Piper Jaffray Annual Report 2005 9 Management’s Discussion and Analysis of Financial Condition and Results of Operations MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS vices to individual investors through our network of branch ofﬁces. Revenues are generated primarily through commissions earned on equity and ﬁxed in- come transactions and for distribution of mutual funds and annuities, fees earned on fee-based client accounts and net interest from customers’ margin loan balances. The following information should be read in conjunc- tion with the accompanying consolidated ﬁnancial statements and related notes and exhibits included elsewhere in this report. Certain statements in this report may be considered forward-looking. State- ments that are not historical or current facts, includ- ing statements about beliefs and expectations, are forward-looking statements. These forward-looking statements cover, among other things, the future pros- pects of Piper Jaffray Companies. Forward-looking statements involve inherent risks and uncertainties, and important factors could cause actual results to differ materially from those anticipated, including those factors discussed below under ‘‘External Factors Impacting Our Business’’ as well as ‘‘Risk Factors’’ in Part 1, item 1A of our Annual Report on Form 10-K The securities business is a human capital business; accordingly, compensation and beneﬁts comprise the for the year ended December 31, 2005, as updated in largest component of our expenses, and our perform- our subsequent reports ﬁled with the SEC. These re- ance is dependent upon our ability to attract, develop ports are available at our Web site at and retain highly skilled employees who are motivated www.piperjaffray.com and at the SEC Web site at to serve the best interests of our clients, thereby serv- www.sec.gov. Forward-looking statements speak only as of the date they are made, and we undertake no ing the best interests of our company. obligation to update them in light of new information or future events. ) Corporate Support and Other – This segment includes the costs of being a public company, long-term ﬁnanc- ing costs and the results of our private equity busi- nesses, which generate revenues the management of private equity funds. This segment also includes results related to our investments in these funds and in venture capital funds. EXTERNAL FACTORS IMPACTING OUR BUSINESS through Executive Overview We are principally engaged in providing securities brokerage, investment banking and related ﬁnancial services to individuals, corporations and public sector and non-proﬁt entities in the United States, with lim- ited activity in Europe. We operate through three re- portable segments: ) Capital Markets – This segment consists of our equity and ﬁxed income institutional sales, trading and re- search and investment banking businesses. Revenues are generated primarily through commissions and sales credits earned on equity and ﬁxed income trans- actions, fees earned on investment banking and public ﬁnance activities, and net interest earned on securities inventories. While we maintain securities inventories primarily to facilitate customer transactions, our Cap- ital Markets business also realizes proﬁts and losses from trading activities related to these securities inventories. ) Private Client Services – This segment comprises our retail brokerage business, which provides ﬁnancial ad- vice and a wide range of ﬁnancial products and ser- Performance in the ﬁnancial services industry in which we operate is highly correlated to the overall strength of economic conditions and ﬁnancial market activity. Overall market conditions are a product of many fac- tors, which are mostly unpredictable and beyond our control. These factors may affect the ﬁnancial deci- sions made by investors, including their level of par- ticipation in the ﬁnancial markets. In turn, these decisions may affect our business results. With respect to ﬁnancial market activity, our proﬁtability is sensi- tive to a variety of factors, including the volume and value of trading in securities, the volatility of the eq- uity and ﬁxed income markets, the trading margin on principal transactions, the level and shape of various yield curves and the demand for investment banking services as reﬂected by the number and size of public offerings and merger and acquisition transactions. Factors that differentiate our business within the ﬁ- nancial services industry also may affect our ﬁnancial results. For example, our Capital Markets business focuses primarily on speciﬁc sectors such as the con- sumer, ﬁnancial institutions, health care and technol- ogy industries within the corporate sector and on health care, higher education, housing, and state and local government entities within the government/non- 10 Piper Jaffray Annual Report 2005 Management’s Discussion and Analysis of Financial Condition and Results of Operations growth that nomic proﬁt sector. These products and sectors may experi- ence growth or downturns independently of general disproportionately impacts one or all of these regions economic and market conditions, or may face market may disproportionately affect our business compared conditions that are disproportionately better or worse with companies operating in other regions or more nationally or globally. Given the variability of the than those impacting the economy and markets gener- ally. In either case, our business could be affected capital markets and securities businesses, our earnings differently than overall market trends. Our Private may ﬂuctuate signiﬁcantly from period to period, and results of any individual period should not be consid- Client Services business primarily operates in the Mid- ered indicative of future results. west, Mountain and West Coast states, and an eco- downturn spurt or MARKET DATA The following table provides a summary of relevant market data over the past three years. YEAR ENDED DECEMBER 31, Dow Jones Industrials a NASDAQ a NYSE Average Daily Value Traded ($ BILLIONS) NASDAQ Average Daily Value Traded ($ BILLIONS) Mergers and Acquisitions (NUMBER OF TRANSACTIONS) b Public Equity Offerings (NUMBER OF TRANSACTIONS) c e Initial Public Offerings (NUMBER OF TRANSACTIONS) c Managed Municipal Underwritings (NUMBER OF TRANSACTIONS) d Managed Municipal Underwritings (VALUE OF TRANSACTIONS IN BILLIONS) d 10-Year Treasuries Average Rate 3-Month Treasuries Average Rate (a) Data provided is at period end. (b) Source: Securities Data Corporation. (c) Source: Dealogic (offerings with reported market value greater than $10 million). (d) Source: Thomson Financial. (e) Number of transactions includes convertible offerings. RESULTS FOR THE YEAR ENDED DECEMBER 31, 2005 For the year ended December 31, 2005, our net in- come was $40.1 million, or $2.10 per diluted share, down from net income of $50.3 million, or $2.60 per diluted share, for the year-ago period. Net revenues for the year ended December 31, 2005 decreased to $775.1 million, a decline of 2.8 percent compared to the prior year. For the year ended December 31, 2005, return on average tangible shareholders’ equity1 was 9.7 percent, compared to 12.9 percent for the year ended December 31, 2004. Our full-year performance reﬂects mixed results for the year. Strong advisory services revenue and in- creased ﬁxed income underwriting offset a decline in equity underwriting and decreased institutional sales and trading revenues. Reduced revenues in our ﬁxed 2005 2004 2003 $ $ 10,718 2,205 56.1 39.5 8,645 811 183 $ $ 10,783 2,175 46.1 34.6 8,188 1,005 214 $ $ 10,454 2,003 38.5 28.0 7,130 861 79 13,827 13,603 15,033 $ 407.0 $ 360.1 $ 383.7 4.29% 3.15% 4.27% 1.37% 4.02% 1.01% 129.9 2005 v 2004 2004 v 2003 (0.6)% 3.1% 1.4 21.7 14.2 5.6 (19.3) (14.5) 1.6 13.0 0.5 8.6 19.7 23.6 14.8 16.7 170.9 (9.5) (6.2) 6.2 35.6 income and equity institutional sales and trading busi- nesses were affected by structural changes in the in- dustry, primarily increased price transparency, which created downward pressure on trading margins. Addi- tionally, higher interest rates and a ﬂattened yield curve compared to a year ago, led to a further reduc- tion in the volume of trading activity related to ﬁxed in reduced revenues. income products, resulting Throughout the year, Private Client Services results remained relatively ﬂat. In the second quarter of 2005, we implemented certain expense reduction measures throughout our businesses as a means to better align our cost infrastructure with our revenues, resulting in an $8.6 million restructuring charge. Piper Jaffray Annual Report 2005 11 Management’s Discussion and Analysis of Financial Condition and Results of Operations (1) Tangible shareholders’ equity equals total shareholders’ equity less goodwill and identiﬁable intangible assets. For the period presented, return on average tangible shareholders’ equity is computed by dividing net income by the average monthly tangible shareholders’ equity. Given the signiﬁcant goodwill on our balance sheet, we believe that return on tangible shareholders’ equity is a meaningful measure of our performance because it reﬂects the tangible equity deployed in our business. This measure excludes the portion of our shareholders’ equity attributable to goodwill and identiﬁable intangible assets. The majority of the goodwill recorded on our balance sheet relates to U.S. Bancorp’s acquisition of our predecessor company, Piper Jaffray Companies Inc., and its subsidiaries in 1998. The goodwill reﬂects the premium paid by U.S. Bancorp for our business, and is reﬂected on our books in accordance with U.S. generally accepted accounting principles (‘‘GAAP’’). The following table sets forth a reconciliation of shareholders’ equity to tangible shareholders’ equity. Shareholders’ equity is the most directly comparable GAAP ﬁnancial measure to tangible shareholders’ equity. (Dollars in Thousands) Shareholders’ equity Deduct: Goodwill and identiﬁable intangible assets AVERAGE FOR THE Year Ended December 31, 2005 Year Ended December 31, 2004 As of December 31, 2005 $735,580 321,034 $ 699,747 308,122 $ 754,827 320,234 Tangible shareholders’ equity $414,546 $ 391,625 $ 434,593 Information Regarding Our Spin-Off from U.S. Bancorp Results of Operations Our consolidated ﬁnancial statements are prepared in conformity with U.S. generally accepted accounting On February 19, 2003, U.S. Bancorp announced its principles (‘‘GAAP’’). The consolidated ﬁnancial intention to organize its capital markets business unit statements for periods prior to the spin-off include the into a new company and to effect a tax-free distribu- adjustments necessary to reﬂect our operations as if tion of its shares in that company to U.S. Bancorp’s the organizational changes resulting from our spin-off shareholders. This type of distribution is commonly referred to as a ‘‘spin-off.’’ On April 28, 2003, Piper had been consummated prior to the distribution. Jaffray Companies was incorporated in Delaware as a However, the consolidated ﬁnancial statements for pe- riods prior to the spin-off may not necessarily be in- subsidiary of U.S. Bancorp to effect the proposed dicative of our results of operations, ﬁnancial position spin-off of U.S. Bancorp’s capital markets business to and cash ﬂows in the future or what our results of its shareholders. On December 31, 2003, after receiv- operations, ﬁnancial position and cash ﬂows would ing regulatory approval, U.S. Bancorp distributed to have been had we operated as a stand-alone company its shareholders all of its interest in our new company. On that date, 19,334,261 shares of Piper Jaffray during those periods. Companies common stock were Bancorp shareholders based on a distribution ratio of one share of Piper Jaffray Companies common stock for every 100 shares of U.S. Bancorp common stock owned. issued to U.S. Generally, our consolidated results for periods prior to the spin-off include revenues generated and ex- penses incurred based on customer relationships and related business activities. In certain situations, afﬁli- ated entities of U.S. Bancorp may have provided ser- vices to us. These services primarily related to employee services and beneﬁts, technology and data processing services, and corporate functions including audit, tax and real estate management. Costs included in the consolidated ﬁnancial statements for these types of shared services were determined based on actual costs to U.S. Bancorp and allocated to us based on our proportionate usage of those services. Proportionate usage was determined based on the number of our employees, actual hours used, square footage of ofﬁce space or other similar methodologies. Our manage- ment believes the assumptions underlying the consoli- dated ﬁnancial statements are reasonable. In connection with our spin-off from U.S. Bancorp, we established a cash award program pursuant to which we granted cash awards to a broad-based group of our employees. The award program was de- signed to aid in retention of employees and to com- pensate for the value of U.S. Bancorp stock options and restricted stock lost by our employees as a result of the spin-off. We incurred a $24.0 million charge at the time of the spin-off from U.S. Bancorp and $4.2 million and $4.7 million of cash awards expense in 2005 and 2004, respectively. The cash awards are being expensed over a four-year period ending De- cember 31, 2007, and will result in charges of approx- imately $4.0 million and $3.5 million in 2006 and 2007, respectively. 12 Piper Jaffray Annual Report 2005 Management’s Discussion and Analysis of Financial Condition and Results of Operations Prior to the spin-off, income taxes were determined on a separate return basis as if we had not been eligible to be included in the consolidated income tax return of U.S. Bancorp and its afﬁliates. U.S. Bancorp was man- aging its tax position for the beneﬁt of its entire port- folio of businesses, and its tax strategies are not necessarily reﬂective of the tax strategies that we would have followed had we been a stand-alone entity. FINANCIAL SUMMARY The following table provides a summary of the results of our operations and the results of our operations as a percentage of net revenues for the periods indicated. AS A PERCENTAGE OF NET REVENUES FOR THE YEAR ENDED DECEMBER 31, FOR THE YEAR ENDED DECEMBER 31, (Dollars in Thousands) 2005 2004 2003 2005 v 2004 2004 v 2003 2005 2004 2003 Revenues: Commissions and fees Principal transactions Investment banking Interest Other income $ 283,481 143,391 270,758 71,471 45,688 $ 263,730 188,526 257,932 54,784 57,967 $ 256,747 215,191 229,945 50,536 59,082 7.5% (23.9) 5.0 30.5 (21.2) 2.7% (12.4) 12.2 8.4 (1.9) 36.6% 33.1% 32.6% 23.6 18.5 32.3 34.9 6.9 9.2 7.3 5.9 27.4 29.2 6.4 7.5 Total revenues Interest expense 814,789 (39,736) 822,939 (25,441) 811,501 (24,771) Net revenues 775,053 797,498 786,730 Non-interest expenses: Compensation and beneﬁts Occupancy and equipment Communications Floor brokerage and clearance Marketing and business development Outside services Cash award program Restructuring-related expense Royalty fee Other operating expenses 471,674 57,627 39,791 17,568 39,863 46,978 4,206 8,595 – 27,645 488,394 57,066 42,198 17,309 42,468 41,477 4,717 – – 24,248 482,397 58,025 37,599 22,755 39,030 38,511 24,000 – 3,911 39,619 (1.0) 56.2 (2.8) (3.4) 1.0 (5.7) 1.5 (6.1) 13.3 (10.8) N/M N/M 14.0 1.4 2.7 1.4 1.2 (1.7) 12.2 (23.9) 8.8 7.7 (80.3) N/M N/M (38.8) Total non-interest expenses 713,947 717,877 745,847 (0.5) (3.8) Income before taxes Income tax expense 61,106 21,023 79,621 29,273 40,883 14,884 (23.3) (28.2) 94.8 96.7 105.1 (5.1) 103.2 (3.2) 103.1 (3.1) 100.0 100.0 100.0 60.9 7.4 5.1 2.3 5.1 6.1 0.5 1.1 – 3.6 92.1 7.9 2.7 61.2 7.2 5.3 2.2 5.3 5.2 0.6 – – 3.0 90.0 10.0 3.7 61.3 7.4 4.8 2.9 5.0 4.9 3.1 – 0.5 4.9 94.8 5.2 1.9 Net income $ 40,083 $ 50,348 $ 25,999 (20.4)% 93.7% 5.2% 6.3% 3.3% NM – Not Meaningful Net income was $40.1 million for the year ended increased 5.0 percent to $270.8 million compared December 31, 2005, down from $50.3 million for the with $257.9 million in 2004, driven by record advi- year ended December 31, 2004. Net revenues were sory services activity. Other income for the year ended $775.1 million in 2005, a decline of 2.8 percent from December 31, 2005 decreased by 21.2 percent to $45.7 million, compared with $58.0 million for the the prior year. Commissions and fees increased prior year. This decrease was due to higher gains re- 7.5 percent over the prior year to $283.5 million in corded on private equity investments in 2004. Also, 2005, driven by increases in equity commissions and 2004 included revenues associated with our venture fee-based account revenues. Principal transactions capital business, the management of which was transi- revenues decreased 23.9 percent from 2004 due pri- tioned to an independent company effective Decem- marily to signiﬁcant declines in ﬁxed income volumes, ber 31, 2004. Net interest income in 2005 increased lower spreads on ﬁxed income products due to the to $31.7 million, up 8.2 percent compared to 2004. NASD’s Trade Reporting and Compliance Engine The increase was due to the impact of rising short- (‘‘TRACE’’) requirements and reduced equity sales term interest rates on net interest income earned on and trading revenues. Investment banking revenues Piper Jaffray Annual Report 2005 13 Management’s Discussion and Analysis of Financial Condition and Results of Operations costs, primarily base salaries and beneﬁts, are more ﬁxed in nature. The timing of bonus payments, which generally occur in February, have a greater impact on our cash position and liquidity as they are paid, than is reﬂected in our statement of operations. our customer margin balances, net inventories and other net earning assets, and the growth in sales of interest rate products. Non-interest expenses were $713.9 million in 2005, down slightly compared to 2004. Compensation and beneﬁts expense declined due to lower revenues and proﬁtability. Non-compen- sation expenses increased due to an $8.6 million re- structuring charge taken in the second quarter of 2005 in connection with certain expense reduction measures, and higher litigation-related expenses. ended December 31, 2004. increased Compensation and beneﬁts expenses 1.2 percent to $488.4 million in 2004, from $482.4 million in 2003. Compensation and beneﬁts expenses as a percentage of net revenues were essen- tially ﬂat at 61.2 percent for 2004, versus 61.3 percent for 2003. Compensation and beneﬁts expenses decreased 3.4 percent to $471.7 million in 2005, from $488.4 million in the prior year. The decrease was attributable to lower net revenues and proﬁtability and the savings from the restructuring actions taken in Net income increased to $50.3 million for the year the second quarter of 2005. Compensation and bene- ended December 31, 2004, up from $26.0 million for ﬁts expenses as a percentage of net revenues decreased slightly to 60.9 percent for the year ended Decem- the year ended December 31, 2003. Net revenues in- creased 1.4 percent to $797.5 million in 2004, from ber 31, 2005, compared to 61.2 percent for the year $786.7 million in 2003, as increased revenues in in- vestment banking and commissions and fees were nearly offset by a decline in principal transactions. Investment banking revenues increased 12.2 percent to $257.9 million in 2004, compared with $229.9 million in 2003, as a result of increased advi- sory services and equity underwriting activity. Com- missions and fees revenues totaled $263.7 million in 2004, an increase of 2.7 percent from 2003. The in- Occupancy and Equipment – Occupancy and equipment expenses were $57.6 million in 2005, compared with crease in commissions and fees was driven by in- $57.1 million in the prior year. Increased costs associ- fee-based account revenues. Principal creased ated with additional ofﬁce space and software costs transactions decreased 12.4 percent from 2003, related to our algorithmic and program trading largely due to a decline in our ﬁxed income institu- (‘‘APT’’) capabilities, which we acquired in the fourth tional sales and trading business. Our ﬁxed income quarter of 2004, were partially offset by prior invest- institutional sales and trading revenues hit record levels in the second and third quarters of 2003, but ments in technology becoming fully depreciated. rising interest rates created a more challenging ﬁxed income environment in 2004. Non-interest expenses decreased 3.8 percent to $717.9 million for 2004, from $745.8 million for 2003. This decrease was pri- marily attributable to the cash award charge of $24.0 million taken in the fourth quarter of 2003. Additionally, in 2004 we recorded lower loan losses litigation-related on employee charges, which were partially offset by new costs re- lated to our status as a public company. Occupancy and equipment expenses were $57.1 mil- lion in 2004, compared with $58.0 million in 2003. Occupancy and equipment expenses in 2004 included $1.5 million of accelerated depreciation expense relat- ing to an information system conversion and higher software amortization costs reﬂecting the fact that we recorded a full year of amortization associated with the implementation of a new ﬁxed income trading system in late 2003. Expenses for 2003 included a $4.1 million write-off of internally developed software associated with the new ﬁxed income trading system implementation. CONSOLIDATED NON-INTEREST EXPENSES loans and lower Compensation and Benefits – Compensation and bene- ﬁts expenses to secure the services of our employees are the largest component of our expenses. Compen- sation and beneﬁts expenses include salaries, commis- sions, bonuses, beneﬁts, employment taxes and other employee costs. A substantial portion of compensa- tion expense is comprised of variable incentive ar- rangements, including commissions and discretionary bonuses, the amount of which ﬂuctuates in proportion to the level of business activity, increasing with higher Communications expenses were $42.2 million in 2004, compared with $37.6 million in 2003. This revenues and operating proﬁts. Other compensation Communications – Communication expenses include costs for telecommunication and data communica- tion, primarily consisting of expense for obtaining third-party market data information. Communication expenses were $39.8 million in 2005, down 5.7 per- cent from 2004. The decrease was primarily attributa- ble to lower market data service expenses as a result of cost savings initiatives. 14 Piper Jaffray Annual Report 2005 Management’s Discussion and Analysis of Financial Condition and Results of Operations Cash Award Program – As discussed above under the increase was due primarily to higher communication infrastructure costs resulting from our separation caption, ‘‘Information Regarding Our Spin-off from from U.S. Bancorp and increased costs to support our U.S. Bancorp,’’ we granted cash awards to a broad- based group of our employees in connection with our ﬁxed income sales and trading capabilities. spin-off from U.S. Bancorp. At the time of the spin- off, we incurred a $24.0 million charge related to these awards. This charge was included in our 2003 results of operations. In 2005 and 2004, we incurred additional expense related to the cash awards of $4.2 million and $4.7 million, respectively. We expect to incur charges of approximately $4.0 million and $3.5 million related to these awards in 2006 and 2007, respectively. Floor Brokerage and Clearance – Floor brokerage and clearance expenses in 2005 were essentially ﬂat as compared with 2004. Increased costs associated with APT were offset by our continued efforts to reduce expenses associated with accessing electronic commu- nication networks. Floor brokerage and clearance expenses were $17.3 million in 2004, compared with $22.8 million in 2003, a decrease of 23.9 percent. This decrease was a result of our efforts to reduce expenses associated with accessing electronic communication networks and our efforts to execute a greater number of trades through our own trading desks. Marketing and Business Development – Marketing and business development expenses include travel and en- tertainment, postage, supplies and promotional and advertising costs. Marketing and business develop- ment expenses decreased 6.1 percent to $39.9 million in 2005, compared with $42.5 million in the prior year. This decrease was largely driven by the impact of cost savings initiatives to reduce travel and supplies costs. Restructuring-Related Expense – In the second quarter of 2005, we implemented certain expense reduction mea- sures as a means to better align our cost infrastructure with our revenues. This resulted in a restructuring charge of $8.6 million, consisting of $4.9 million in severance beneﬁts and $3.7 million related to the re- duction of leased ofﬁce space. We anticipate realizing approximately $10.0 million in annual cost savings as a result of these expense reduction measures. Based on the timing of these actions, approximately $5.0 mil- lion in savings was recognized during the second half of 2005. Royalty Fee – As a subsidiary of U.S. Bancorp, we were charged royalty fees for the use of U.S. Bancorp tradenames and trademarks. These charges were dis- continued at the time of our spin-off from U.S. Bancorp. Marketing and business development expenses were $42.5 million in 2004, compared with $39.0 million in 2003, an increase of 8.8 percent. This increase was attributable to increased travel and entertainment costs related to equity underwritings, which increased by 54.1 percent over 2003, and higher travel costs related to our ﬁxed income corporate sales and trad- ing efforts. Other Operating Expenses – Other operating expenses include insurance costs, license and registration fees, ﬁnancial advisor loan loss contingencies, expenses re- lated to our charitable giving program, amortization on intangible assets and litigation-related expenses, Outside Services – Outside services expenses include which consist of the amounts we reserve and/or pay out related to legal and regulatory settlements, awards securities processing expenses, outsourced technology or judgments, and ﬁnes. Other operating expenses in- and operations functions, outside legal fees and other creased to $27.6 million in 2005, compared with professional fees. Outside services expenses increased $24.2 million in 2004, an increase of 14.0 percent. to $47.0 million in 2005, compared with $41.5 mil- This increase was driven primarily by increased litiga- lion in the prior year. This increase reﬂects the costs tion-related expenses and intangible asset amortiza- for outsourcing additional technology and operations tion expense that we began to record in late 2004 in functions, which were previously performed in-house, conjunction with the acquisition of our APT capabili- and higher legal fees. ties. Additionally, other operating expenses were lower in 2004 due to the fact that we reduced our ﬁnancial advisor loan loss reserve by $2.1 million as we determined that the attrition of our ﬁnancial advi- sors related to the implementation of a new compen- sation plan in 2003 was largely complete. Partially offsetting the higher costs in 2005 was a decline in insurance premiums and lower minority interest ex- pense related to our private equity investments. Outside services expenses increased to $41.5 million in 2004, compared with $38.5 million for the prior year. This 7.7 percent increase primarily reﬂects the costs for outsourcing the operation of our network and mainframe to a third-party vendor, a change we made in 2004, and additional costs resulting from our new status as a public company. Piper Jaffray Annual Report 2005 15 Management’s Discussion and Analysis of Financial Condition and Results of Operations of products and services provided and the distribution Other operating expenses decreased to $24.2 million channels used to provide those products and services. in 2004, compared with $39.6 million in 2003, a decrease of 38.8 percent. In the second quarter of Segment pre-tax operating income or loss and seg- 2003, we increased our allowance for ﬁnancial advi- ment operating margin are used to evaluate and mea- sure segment performance by our management team sor loan losses by $8.8 million in conjunction with in deciding how to allocate resources and in assessing implementing a new compensation plan that we ex- performance in relation to our competitors. Segment pected would result in attrition of certain ﬁnancial pre-tax operating income or loss is derived from our advisors. During the ﬁrst and second quarters of business unit proﬁtability reporting systems by speciﬁ- 2003, we communicated to ﬁnancial advisors certain cally attributing customer relationships and their re- changes to our production-based compensation plans that were effective in the third quarter of 2003. These lated revenues and expenses to the business unit that compensation changes reﬂected a shift from a prod- maintains the relationship and generates the revenues. Expenses directly managed by the business unit are uct-based payout to a production-based payout. This accounted for within each segment’s pre-tax operating change more closely aligned our new compensation income or loss. In addition, operations, technology plan with the compensation plans of our competitors. and other business activities managed on a corporate Subsequent to these communications, we experienced basis are allocated to the segments based on each attrition of certain ﬁnancial advisors, primarily those segment’s use of these functions to support its busi- with low levels of production. We expected this trend ness. Expenses related to being a public company and to continue and, based on historical collection efforts, long-term ﬁnancing are included within Corporate to result in employee loan losses. Accordingly, we Support and Other. To enhance the comparability of increased our allowance for our exposure to employee business segment results over time, the cash awards loan losses in 2003. In 2004, we reduced the loan loss granted to employees in connection with our separa- reserve by $2.1 million, reﬂecting our belief that we tion from U.S. Bancorp and restructuring charges are would not experience further attrition of ﬁnancial ad- not included in segment pre-tax operating income or visors related to the new compensation plan, as well loss. The presentation reﬂects our current manage- as the fact that attrition related to the plan was lower ment structure. than originally expected. In the ﬁrst quarter of 2005, we began to more fully Further contributing to the decrease in other operat- allocate corporate expenses previously included in ing expenses in 2004 were reduced litigation-related costs, which totaled $4.4 million in 2004 in compari- Corporate Support and Other to Capital Markets and Private Client Services. Early in 2005, we concluded son with $16.1 million in 2003, a decrease of an extensive study of costs included in Corporate Sup- 72.7 percent. The decrease in other operating ex- port and Other to determine how these costs related penses was offset in part by a $3.1 million increase in costs for corporate insurance as a result of being a to and were driven by business activities conducted in stand-alone public company and new expenses associ- Capital Markets and Private Client Services. As a re- sult of this study, certain expenses such as ﬁnance, ated with our charitable giving program. human resources and other corporate administration costs are included in the results of the revenue-produc- ing segments. Approximately $27.4 million and $28.0 million in expenses were allocated in 2004 and 2003, respectively, from Corporate Support and Other to Capital Markets and Private Client Services. Internally, we manage and allocate resources to our business segments based on these results. All periods presented have been restated and are presented on a comparable basis. This restatement did not affect our aggregate ﬁnancial results. Income Taxes – Our provision for income taxes in 2005 was $21.0 million, an effective tax rate of 34.4 per- cent, compared with $29.3 million, an effective tax rate of 36.8 percent, for 2004, and compared with $14.9 million, an effective tax rate of 36.4 percent, for 2003. The decreased effective tax rate in 2005 com- pared to 2004 is attributable to an increase in the ratio of municipal interest income, which is non-taxa- ble, to total taxable income and a reduction in our state taxes. SEGMENT PERFORMANCE We measure ﬁnancial performance by business seg- ment. Our three segments are Capital Markets, Pri- vate Client Services, and Corporate Support and Other. We determined these segments based on fac- tors such as the type of customers served, the nature Our primary revenue-producing segments, Capital Markets and Private Client Services, have different compensation plans and non-compensation cost struc- tures that impact the operating margins of the two segments differently during periods of increasing or decreasing business activity and revenues. Compensa- 16 Piper Jaffray Annual Report 2005 Management’s Discussion and Analysis of Financial Condition and Results of Operations tion expense for Capital Markets is driven primarily by pre-tax operating income of the segment, whereas compensation expense for Private Client Services is driven primarily by revenues. In addition, Private Cli- ent Services has a higher proportion of ﬁxed non- compensation expenses than Capital Markets. FOR THE YEAR ENDED DECEMBER 31, (Dollars in Thousands) Net revenues Capital Markets Private Client Services Corporate Support and Other The following table provides our segment perform- ance for the periods presented: 2005 2004 2003 PERCENT INC/(DEC) 2005 v 2004 2004 v 2003 $ 435,808 $ 431,302 $ 430,846 1.0% 0.1% 346,951 (7,706) 359,668 6,528 355,563 321 (3.5) N/M 1.2 N/M Total $ 775,053 $ 797,498 $ 786,730 (2.8)% 1.4% Pre-tax operating income (loss) before unallocated charges a Capital Markets Private Client Services Corporate Support and Other $ 70,586 $ 68,053 $ 69,065 3.7% (1.5)% 18,281 (14,960) 26,959 (10,674) 7,906 (8,177) (32.2) 40.2 241.0 30.5 Total $ 73,907 $ 84,338 $ 68,794 (12.4)% 22.6% Pre-tax operating margin before unallocated charges Capital Markets Private Client Services Total 16.2% 5.3% 9.5% 15.8% 7.5% 10.6% 16.0% 2.2% 8.7% (a) See reconciliation to pre-tax operating income including unallocated charges for detail on expenses excluded from segment performance. Reconciliation to pre-tax operating income including unallocated charges: Pre-tax operating income before unallocated charges $ 73,907 $ 84,338 $ 68,794 Cash award program Restructuring-related Royalty fee 4,206 8,595 – 4,717 – – 24,000 – 3,911 Consolidated income before income tax expense $ 61,106 $ 79,621 $ 40,883 Piper Jaffray Annual Report 2005 17 Management’s Discussion and Analysis of Financial Condition and Results of Operations CAPITAL MARKETS FOR THE YEAR ENDED DECEMBER 31, (Dollars in Thousands) Net revenues: Institutional sales and trading Fixed income Equities 2005 2004 2003 PERCENT INC/(DEC) 2005 v 2004 2004 v 2003 $ 75,201 $ 84,685 $ 106,138 (11.2)% (20.2)% 114,789 117,272 122,492 (2.1) (4.3) Total institutional sales and trading 189,990 201,957 228,630 (5.9) (11.7) Investment banking Underwriting Fixed income Equities Advisory services 67,649 75,026 100,672 62,096 87,505 78,066 64,762 70,202 63,258 8.9 (14.3) 29.0 (4.1) 24.6 23.4 Total investment banking 243,347 227,667 198,222 6.9 14.9 Other income Total net revenues 2,471 1,678 3,994 47.3 (58.0) $ 435,808 $ 431,302 $ 430,846 1.0% 0.1% Pre-tax operating income before unallocated charges $ 70,586 $ 68,053 $ 69,065 3.7% (1.5)% Pre-tax operating margin 16.2% 15.8% 16.0% and trading volumes in ﬁxed income products. Addi- Capital Markets net revenues were $435.8 million, up tionally, trading margins declined in 2005, due largely 1.0 percent compared with the prior year. These re- sults reﬂected record advisory services revenues, offset to increased price transparency in the corporate bond primarily by lower institutional sales and trading reve- markets and growth in electronic trading. In February 2005, certain high-yield bonds for which we issue nues. Institutional sales and trading revenues de- proprietary research became subject to TRACE disclo- creased as a result of structural changes in the trading sure requirements. These high-yield bonds represent a markets. The structural changes include increased substantial portion of our overall corporate bond price transparency in the corporate bond market, de- creased revenue per equity share traded and increased sales and trading. use of electronic and direct market access trading, which have created downward pressure on sales and trading margins. We expect to experience continued downward pressure on trading margins over time. Equity institutional sales and trading revenue de- creased 2.1 percent in 2005, to $114.8 million. In 2005, we experienced downward pressure on net commissions in the cash equities business as a result of increased pressure from institutional clients to reduce transaction costs. The decline in net commissions in our cash equities business was offset by increased elec- tronic trading revenue from our APT capabilities ac- quired in the fourth quarter of 2004. Investment banking revenues increased 6.9 percent to $243.3 million in 2005, compared with $227.7 mil- lion in 2004. This increase was primarily attributable to strong advisory services revenues, as we achieved record full-year advisory services revenues of $100.7 million, an increase of 29.0 percent compared with 2004. We completed 48 mergers and acquisitions deals valued at $8.1 billion in 2005, compared with 49 deals valued at $6.8 billion in 2004. Additionally, ﬁxed income underwriting revenues increased 8.9 per- cent to $67.6 million in 2005 compared with Institutional sales and trading revenues comprise all the revenues generated through trading activities. These revenues, which are generated primarily through the facilitation of customer trades, include principal transaction revenues, commissions and the interest income or expense associated with ﬁnancing or hedging our inventory positions. To assess the prof- itability of institutional sales and trading activities, we aggregate principal transactions, commissions and net interest revenues. In 2005, institutional sales and trad- ing revenues decreased 5.9 percent to $190.0 million, compared with $202.0 million in the prior year. Fixed income institutional sales and trading revenues declined 11.2 percent to $75.2 million in 2005, com- pared with $84.7 million in 2004. Rising interest rates and a ﬂattened yield curve resulted in reduced sales 18 Piper Jaffray Annual Report 2005 Management’s Discussion and Analysis of Financial Condition and Results of Operations $62.1 million in 2004. We underwrote 473 municipal issues with a par value of $6.1 billion during 2005, compared with 504 municipal issues with a par value of $5.9 billion during 2004. Equity underwriting reve- nues decreased 14.3 percent to $75.0 million in 2005. Driving this decline in equity underwriting revenues were less favorable capital market conditions, particu- larly during the ﬁrst half of 2005, that led to a decline in offering activity compared with the prior year. Dur- ing 2005, we completed 64 equity offerings, raising $8.7 billion in capital for our clients, compared with 94 equity offerings, raising $12.9 billion in capital, during 2004. Segment pre-tax operating margin for 2005 increased to 16.2 percent from 15.8 percent for the prior year as a result of the increase in net revenues and the impact of cost savings initiatives. In 2004, institutional sales and trading revenues de- creased 11.7 percent to $202.0 million, compared with $228.6 million in 2003. This decline was prima- rily due to reduced ﬁxed income institutional sales and trading revenues, which decreased 20.2 percent to $84.7 million in 2004, compared with $106.1 million in 2003. The signiﬁcant decline in ﬁxed income reve- nues from the prior year was attributable to substan- tially reduced institutional client order ﬂow and reduced trading proﬁts. The decrease in 2004 also reﬂected the fact that our ﬁxed income business achieved record revenues in the second and third mained ﬂat. quarters of 2003, driven by high-yield corporate bonds where we have proprietary research capabili- ties, while the rising interest rate environment in 2004 created a more challenging ﬁxed income trading envi- ronment. In addition, equity institutional sales and trading decreased 4.3 percent in 2004, to $117.3 mil- lion, compared with $122.5 million in the prior year. This decline was primarily attributable to a reduction in revenue related to convertible sales and trading activity as a result of challenging market conditions for convertible securities. Investment banking revenue increased to $227.7 mil- lion in 2004, compared with $198.2 million in the prior year, up 14.9 percent. This increase reﬂects higher equity underwriting activity during the ﬁrst half of 2004 compared with the corresponding period of 2003. During 2004, we completed 94 equity offer- ings, raising $12.9 billion in capital for our clients, compared with 61 equity offerings, raising $8.2 bil- lion in capital, during 2003. Additionally, advisory services activity rose. We completed 49 merger and acquisition deals valued at $6.8 billion in 2004, com- pared with 38 deals valued at $5.1 billion in 2003. This increase was offset in part by ﬁxed income in- vestment banking revenues, which decreased 4.1 per- cent from the prior year to $62.1 million in 2004. Segment pre-tax operating margin for 2004 decreased to 15.8 percent from 16.0 percent for 2003 as ﬁxed compensation costs increased while net revenues re- PRIVATE CLIENT SERVICES FOR THE YEAR ENDED DECEMBER 31, (Dollars in Thousands) Net revenues 2005 2004 2003 PERCENT INC/(DEC) 2005 v 2004 2004 v 2003 $ 346,951 $ 359,668 $ 355,563 (3.5)% 1.2% Pre-tax operating income before unallocated charges $ 18,281 $ 26,959 $ 7,906 (32.2)% 241.0% Pre-tax operating margin Number of ﬁnancial advisors (period end) 5.3% 842 7.5% 860 2.2% 874 Private Client Services ﬁnancial performance in 2005 reﬂected decreased transaction revenues driven by fewer ﬁnancial advisors and reduced spreads on ﬁxed income products, offset partially by increased fee- based revenues. We are in the process of transitioning our business to an advisory, rather than a transac- tional, model. We are working to improve the proﬁt- ability of the business by increasing ﬁnancial advisor productivity, increasing the number of ﬁnancial advi- sors by selectively recruiting experienced ﬁnancial ad- visors and training developing ﬁnancial advisors, and diligently managing costs. We continue to anticipate that returning this business to competitive perform- ance will be a multi-year process. Private Client Services net revenues decreased 3.5 per- cent to $347.0 million in 2005, compared with net revenues of $359.7 million in the prior year. Fewer ﬁnancial advisors and reduced ﬁxed income product revenue led to the decline. Offsetting these declines, in part, were increased fee-based account revenues, which are charged as a percentage of an account’s asset balance rather than on a transaction basis. Total client assets under management increased approxi- mately 2.0 percent from $51 billion at December 31, Piper Jaffray Annual Report 2005 19 Management’s Discussion and Analysis of Financial Condition and Results of Operations 2004 to $52 billion at December 31, 2005. Fee-based account revenues increased 16.4 percent from 2004, while client assets in fee-based accounts increased 13.0 percent from the prior year. As of December 31, 2005, 16.9 percent of client assets were held in fee- based accounts. off from U.S. Bancorp as a result of the uncertainty surrounding the future of our business. Despite net revenues being up only 1.2 percent year over year, segment pre-tax operating margin for Pri- vate Client Services increased to 7.5 percent for 2004 compared to 2.2 percent in 2003, due to lower ﬁnan- cial advisor loan loss reserves, a reduction in litiga- tion-related expenses and diligent cost control efforts. CORPORATE SUPPORT AND OTHER Segment pre-tax operating margin for Private Client Services decreased to 5.3 percent for 2005, compared with 7.5 percent in 2004. The decline in pre-tax oper- ating margin was due to lower net revenues and higher litigation-related expenses in 2005. Addition- ally, the results for 2004 included the reduction of our ﬁnancial advisor loan loss reserve by $2.1 million as we determined that the attrition of ﬁnancial advisors related to the implementation a new compensation plan in 2003 was largely complete. Corporate Support and Other includes revenues pri- marily attributable to our private equity business and our investments in private equity and venture capital funds. The Corporate Support and Other segment also includes interest expense on our subordinated debt, which is recorded as a reduction of net revenues. The number of ﬁnancial advisors includes both devel- Prior to January 1, 2005, Corporate Support and oping and experienced ﬁnancial advisors. We continue Other also included revenues associated with our ven- ture capital business. Effective December 31, 2004, to work to grow our ﬁnancial advisor ranks, which the management of our venture capital funds was we expect to accomplish over the long term by train- ing professionals to become ﬁnancial advisors and by transitioned to an independent company, however, we selectively recruiting experienced ﬁnancial advisors. maintained our existing investments in these funds. In 2005, Corporate Support and Other recorded nega- Our ﬁnancial advisors continue to make the transition tive net revenues of $7.7 million, compared with from a transactional model to an advisory model, and $6.5 million in revenues during the prior year. This we have seen increases in assets under management $14.2 million ﬂuctuation in revenues was primarily per ﬁnancial advisor. The number of ﬁnancial advi- due to management fees recorded in 2004 pertaining sors continued to decline in 2005 as departures of to our venture capital business, capital gains recorded lower level producers was not offset with new ﬁnan- in 2004 pertaining to our private equity investments cial advisor hiring. and an increase in long-term ﬁnancing costs in 2005. Our subordinated debt is variable-rate debt based on the London Interbank Offered Rate, which increased by approximately 200 basis points from Decem- ber 31, 2004 to December 31, 2005. Private Client Services net revenues increased slightly to $359.7 million in 2004 compared with 2003. Fee- based account revenues increased as a result of higher client asset balances in fee-based accounts in 2004, reﬂecting improved conditions in the equity markets. This increase was partially offset by decreased trans- We anticipate realizing a signiﬁcant gain in Corporate Support and Other in 2006 related to our ownership actional business due to a decline in individual inves- of two seats on the New York Stock Exchange, Inc. tor sentiment that began during the second half of (‘‘NYSE’’). The NYSE and Archipelago Holdings, Inc. 2004. Total client assets under management increased (‘‘Archipelago’’) have entered into a merger agreement from $50 billion at December 31, 2003, to $51 billion providing for the combination of the NYSE and Ar- at December 31, 2004, largely due to 2004 equity chipelago under a new holding company named market gains. NYSE Group, Inc. In the proposed merger, NYSE seat members will be entitled to receive $300,000 in cash and 80,177 restricted shares of NYSE Group, Inc. common stock. We currently value our two NYSE seats at a cost basis of $0.6 million. Another factor that limited 2004 net revenues was the decline in the number of our ﬁnancial advisors when compared to 2003. The decreased number of ﬁnancial advisors reﬂected the attrition of certain ﬁnancial ad- visors following the change in our compensation pro- gram described caption ‘‘Consolidated Non-Interest Expenses – Other Oper- Other segment ating Expenses’’ and the difﬁculty we experienced in recruiting experienced ﬁnancial advisors following the announcement in early 2003 of our impending spin- In 2004, net revenues for the Corporate Support and increased to $6.5 million from $0.3 million in 2003. This change was due primarily to capital gains recorded in 2004 pertaining to our private equity investments as discussed above. In addi- tion, interest expense on our subordinated debt de- above under the 20 Piper Jaffray Annual Report 2005 Management’s Discussion and Analysis of Financial Condition and Results of Operations creased, as we reduced our subordinated debt balance by $35.0 million in the fourth quarter of 2003. Recent Accounting Pronouncements Recent accounting pronouncements are set forth in Note 3 to our consolidated ﬁnancial statements in- cluded in our Annual Report to Shareholders, and are incorporated herein by reference. Critical Accounting Policies Our accounting and reporting policies comply with GAAP and conform to practices within the securities industry. The preparation of ﬁnancial statements in compliance with GAAP and industry practices re- quires us to make estimates and assumptions that could materially affect amounts reported in our con- solidated ﬁnancial statements. Critical accounting pol- icies are those policies that we believe to be the most important to the portrayal of our ﬁnancial condition and results of operations and that require us to make estimates that are difﬁcult, subjective or complex. Most accounting policies are not considered by us to be critical accounting policies. Several factors are con- sidered in determining whether or not a policy is criti- cal, including, among others, whether the estimates are signiﬁcant to the consolidated ﬁnancial statements taken as a whole, the nature of the estimates, the ability to readily validate the estimates with other in- formation, independent including third-party or sources, the sensitivity of the estimates to changes in economic conditions and whether alternative account- ing methods may be used under GAAP. For a full description of our signiﬁcant accounting policies, see Note 2 to our consolidated ﬁnancial statements included in our Annual Report to Share- holders. We believe that of our signiﬁcant accounting policies, the following are our critical accounting policies: VALUATION OF FINANCIAL INSTRUMENTS Trading securities owned, trading securities owned and pledged as collateral, and trading securities sold, but not yet purchased on our consolidated statements of ﬁnancial condition consist of ﬁnancial instruments recorded at fair value. Unrealized gains and losses related to these ﬁnancial instruments are reﬂected on our consolidated statements of operations. The fair value of a ﬁnancial instrument is the amount at which the instrument could be exchanged in a cur- rent transaction between willing parties, other than in a forced or liquidation sale. When available, we use observable market prices, observable market parame- ters, or broker or dealer prices (bid and ask prices) to derive the fair value of the instrument. In the case of ﬁnancial instruments transacted on recognized ex- changes, the observable market prices represent quo- tations for completed transactions from the exchange on which the ﬁnancial instrument is principally traded. Bid prices represent the highest price a buyer is willing to pay for a ﬁnancial instrument at a particular time. Ask prices represent the lowest price a seller is willing to accept for a ﬁnancial instrument at a partic- ular time. A substantial percentage of the fair value of our trad- ing securities owned, trading securities owned and pledged as collateral, and trading securities sold, but not yet purchased are based on observable market prices, observable market parameters, or derived from broker or dealer prices. The availability of observable market prices and pricing parameters can vary from product to product. Where available, observable mar- ket prices and pricing or market parameters in a prod- uct may be used to derive a price without requiring signiﬁcant judgment. In certain markets, observable market prices or market parameters are not available for all products, and fair value is determined using techniques appropriate for each particular product. These techniques involve some degree of judgment. For investments in illiquid or privately held securities that do not have readily determinable fair values, the determination of fair value requires us to estimate the value of the securities using the best information avail- able. Among the factors considered by us in determin- ing the fair value of ﬁnancial instruments are the cost, terms and liquidity of the investment, the ﬁnancial condition and operating results of the issuer, the quoted market price of publicly traded securities with similar quality and yield, and other factors generally pertinent to the valuation of investments. In instances where a security is subject to transfer restrictions, the value of the security is based primarily on the quoted price of a similar security without restriction but may be reduced by an amount estimated to reﬂect such restrictions. In addition, even where the value of a security is derived from an independent source, cer- tain assumptions may be required to determine the security’s fair value. For instance, we assume that the size of positions in securities that we hold would not be large enough to affect the quoted price of the secu- rities if we sell them, and that any such sale would happen in an orderly manner. The actual value real- ized upon disposition could be different from the cur- rently estimated fair value. Piper Jaffray Annual Report 2005 21 Management’s Discussion and Analysis of Financial Condition and Results of Operations Fair values for derivative contracts represent amounts monitored over the life of the derivative product. If estimated to be received from or paid to a third party there are any changes in the underlying inputs, the in settlement of these instruments. These derivatives model is updated for those new inputs. are valued using quoted market prices when available or pricing models based on the net present value of estimated future cash ﬂows. Management deemed the net present value of estimated future cash ﬂows model to be the best estimate of fair value as most of our derivative products are interest rate products. The val- uation models used require inputs including contrac- tual terms, market prices, yield curves, credit curves and measures of volatility. The valuation models are The following table presents the carrying value of our trading securities owned, trading securities owned and pledged as collateral and trading securities sold, but not yet purchased for which fair value is measured based on quoted prices or other independent sources versus those for which fair value is determined by management. DECEMBER 31, 2005 (Dollars in Thousands) Trading Securities Owned or Pledged Trading Securities Sold, But Not Yet Purchased Fair value of securities excluding derivatives, based on quoted prices and independent sources Fair value of securities excluding derivatives, as determined by management Fair value of derivatives based on quoted prices and independent sources Fair value of derivatives as determined by management $ 706,671 25,617 – 21,610 $ 327,587 – – 4,617 $ 753,898 $ 332,204 GOODWILL AND INTANGIBLE ASSETS Financial instruments carried at contract amounts that make judgments in determining what assumptions to use in the calculation. The ﬁrst step of the process approximate fair value have short-term maturities consists of estimating the fair value of each operating (one year or less), are repriced frequently or bear mar- segment based on a discounted cash ﬂow model using ket interest rates and, accordingly, are carried at amounts approximating fair value. Financial instru- revenue and proﬁt forecasts and comparing those esti- ments carried at contract amount on our consolidated mated fair values with carrying values, which includes the allocated goodwill. If the estimated fair value is statements of ﬁnancial condition include receivables less than the carrying values, a second step is per- from and payables to brokers, dealers and clearing formed to compute the amount of the impairment by organizations, securities purchased under agreements determining an ‘‘implied fair value’’ of goodwill. The to resell, securities sold under agreements to repur- determination of a reporting unit’s ‘‘implied fair chase, receivables from and payables to customers, value’’ of goodwill requires us to allocate the esti- short-term ﬁnancing and subordinated debt. mated fair value of the reporting unit to the assets and liabilities of the reporting unit. Any unallocated fair value represents the ‘‘implied fair value’’ of goodwill, which is compared to its corresponding carrying value. We completed our last goodwill impairment test as of October 31, 2005, and no impairment was identiﬁed. We record all assets and liabilities acquired in purchase acquisitions, including goodwill, at fair value as required by Statement of Financial Account- ing Standards No. 141, ‘‘Business Combinations.’’ Determining the fair value of assets and liabilities ac- quired requires certain management estimates. At De- As noted above, the initial recognition of goodwill and other intangible assets and the subsequent impair- cember 31, 2005, we had goodwill of $317.2 million, principally as a result of the 1998 acquisition of our ment analysis requires management to make subjec- tive judgments concerning estimates of how the predecessor, Piper Jaffray Companies Inc., and its acquired assets or businesses will perform in the fu- subsidiaries by U.S. Bancorp. ture using valuation methods including discounted cash ﬂow analysis. Events and factors that may signiﬁ- cantly affect the estimates include, among others, competitive forces and changes in revenue growth trends, cost structures, technology, discount rates and market conditions. Additionally, estimated cash ﬂows may extend beyond ten years and, by their nature, are difﬁcult to determine over an extended time period. Under Statement of Financial Accounting Standards No. 142, ‘‘Goodwill and Other Intangible Assets’’, we are required to perform impairment tests of our good- will and intangible assets annually and more fre- quently in certain circumstances. We have elected to test for goodwill impairment in the fourth quarter of each calendar year. The goodwill impairment test is a two-step process, which requires management to 22 Piper Jaffray Annual Report 2005 Management’s Discussion and Analysis of Financial Condition and Results of Operations To assess the reasonableness of cash ﬂow estimates and validate assumptions used in our estimates, we review historical performance of the underlying assets or similar assets. the award, which is usually three years, and is in- cluded in our results of operations as compensation expense, net of estimated forfeitures. A substantial percentage of our restricted stock issued to employees has a substantive non-compete agreement. Restricted stock that contains a non-compete agreement is ex- pensed over the non-compete period. Stock-based compensation granted to our non-employee directors is in the form of stock options. Stock-based compen- sation paid to directors is immediately vested and is included in our results of operations as outside ser- vices expense. In assessing the fair value of our operating segments, the volatile nature of the securities markets and our industry requires us to consider the business and mar- ket cycle and assess the stage of the cycle in estimating the timing and extent of future cash ﬂows. In addition to estimating the fair value of an operating segment based on discounted cash ﬂows, we consider other information to validate the reasonableness of our val- In determining the estimated fair value of stock op- uations, including public market comparables, multi- ples of recent mergers and acquisitions of similar tions, we use the Black-Scholes option-pricing model, businesses and third-party assessments. Valuation which requires judgment regarding certain assump- tions, including the expected life of the options multiples may be based on revenues, price-to-earnings granted, dividend yields and stock volatility. Certain and tangible capital ratios of comparable public com- assumptions are estimated using industry comparisons panies and business segments. These multiples may be due to a lack of historical data. For instance, because adjusted to consider competitive differences including our stock has been publicly traded for just over two size, operating leverage and other factors. We deter- years, we have limited information on which to base mine the carrying amount of an operating segment our volatility estimates; therefore, to develop a rea- based on the capital required to support the segment’s sonable estimate, we have used industry comparisons activities, including its tangible and intangible assets. to determine an appropriate volatility level. Similarly, The determination of a segment’s capital allocation as none of our employee options are vested, we do not requires management judgment and considers many have historical data regarding employee option exer- factors, including the regulatory capital requirements cises or post-termination behaviors; therefore, indus- and tangible capital ratios of comparable public com- try comparisons were used to estimate the expected panies in relevant industry sectors. In certain circum- life of the options. Additional information regarding stances, we may engage a third party to validate assumptions used in the Black-Scholes pricing model independently our assessment of the fair value of our can be found in Note 19 to our consolidated ﬁnancial operating segments. If during any future period it is determined that an impairment exists, the results of statements. operations in that period could be materially ad- versely affected. CONTINGENCIES STOCK-BASED COMPENSATION We are involved in various pending and potential legal proceedings related to our business, including litiga- tion, arbitration and regulatory proceedings. Some of As part of our compensation to employees and direc- these matters involve claims for substantial amounts, tors, we use stock-based compensation, including including claims for punitive and other special dam- stock options and restricted stock. Effective Janu- ages. The number of these legal proceedings has in- ary 1, 2004, we elected to account for stock-based creased in recent years. We have, after consultation employee compensation on a prospective basis under the fair value method, as prescribed by Statement of with outside legal counsel and consideration of facts currently known by management, recorded estimated Financial Accounting Standards No. 123, ‘‘Account- losses in accordance with Statement of Financial Ac- ing and Disclosure of Stock-Based Compensation,’’ counting Standards No. 5, ‘‘Accounting for Contin- and as amended by Statement of Financial Accounting gencies,’’ to the extent that claims are probable of loss Standards No. 148, ‘‘Accounting for Stock-Based Compensation – Transition and Disclosure.’’ The fair and the amount of the loss can be reasonably esti- value method requires an estimate of the value of mated. The determination of these reserve amounts requires signiﬁcant judgment on the part of manage- stock options to be recognized as compensation over ment. In making these determinations, we consider the vesting period of the awards. many factors, including, but not limited to, the loss and damages sought by the plaintiff or claimant, the basis and validity of the claim, the likelihood of a Compensation paid to employees in the form of stock options or restricted stock is generally amortized on a straight-line basis over the requisite service period of Piper Jaffray Annual Report 2005 23 Management’s Discussion and Analysis of Financial Condition and Results of Operations cash. Securities inventories are stated at fair value and successful defense against the claim, and the potential for, and magnitude of, damages or settlements from are generally readily marketable. Customers’ margin such pending and potential litigation and arbitration loans are collateralized by securities and have ﬂoating proceedings, and ﬁnes and penalties or orders from interest rates. Other receivables and payables with customers and other brokers and dealers usually settle regulatory agencies. within a few days. As part of our liquidity strategy, we emphasize diversiﬁcation of funding sources. We utilize a mix of funding sources and, to the extent possible, maximize our lower-cost ﬁnancing associ- ated with securities lending and repurchasing agree- ments. Our assets are ﬁnanced by our cash ﬂows from operations, equity capital, subordinated debt, bank lines of credit and proceeds from securities lending and securities sold under agreements to repurchase. The ﬂuctuations in cash ﬂows from ﬁnancing activities are directly related to daily operating activities from our various businesses. Under the terms of our separation and distribution agreement with U.S. Bancorp and ancillary agree- ments entered into in connection with the spin-off, we generally are responsible for all liabilities relating to our business, including those liabilities relating to our business while it was operated as a segment of U.S. Bancorp under the supervision of its management and board of directors and while our employees were em- ployees of U.S. Bancorp servicing our business. Simi- larly, U.S. Bancorp generally is responsible for all liabilities relating to the businesses U.S. Bancorp re- tained. However, in addition to our established reserves, U.S. Bancorp agreed to indemnify us in an We do not intend to pay cash dividends on our com- amount up to $17.5 million for losses that result from mon stock for the foreseeable future. certain matters, primarily third-party claims relating to research analyst independence. U.S. Bancorp has the right to terminate this indemniﬁcation obligation in the event of a change in control of our company. As of December 31, 2005, approximately $13.4 million of the indemniﬁcation remained. To optimize our use of capital, in January 2005 our board of directors authorized the repurchase of up to 1.3 million shares of our common stock for a maxi- mum aggregate purchase price of $65 million. The program commenced in the ﬁrst quarter of 2005 and was completed on October 4, 2005. We repurchased the 1,300,000 shares of common stock authorized by the board at an average price of $32.78 per share. Over the long-term, one of our objectives in repur- chasing common stock on the open market is to offset dilution from stock-based compensation. Subject to the foregoing, we believe, based on our current knowledge, after appropriate consultation with outside legal counsel and after taking into ac- count our established reserves and the U.S. Bancorp indemnity agreement, that pending litigation, arbitra- tion and regulatory proceedings will be resolved with no material adverse effect on our ﬁnancial condition. However, if, during any period, a potential adverse contingency should become probable or resolved for Cash and cash equivalents decreased $6.5 million in 2005 to $60.9 million at December 31, 2005. Operat- an amount in excess of the established reserves and ing activities provided cash of $99.7 million, as cash indemniﬁcation, the results of operations in that pe- received from earnings and operating assets and liabil- riod could be materially adversely affected. ities exceeded cash utilized to increase net trading se- curities owned. Cash of $19.7 million was used for investing activities toward the purchase of ﬁxed as- sets. Cash of $86.3 million was used in ﬁnancing ac- tivities, including a $55.5 million reduction of our secured ﬁnancing activities and $42.6 million utilized to repurchase common stock in conjunction with the share repurchase program discussed above. The cash used in ﬁnancing activities was offset by an increase in securities loaned activities of $11.8 million. Liquidity is of critical importance to us given the na- ture of our business. Insufﬁcient liquidity resulting from adverse circumstances contributes to, and may be the cause of, ﬁnancial institution failure. Accord- ingly, we regularly monitor our liquidity position, in- cluding our cash and net capital positions, and we have implemented a liquidity strategy designed to en- able our business to continue to operate even under adverse circumstances, although there can be no as- surance that our strategy will be successful under all circumstances. Liquidity and Capital Resources Cash and cash equivalents decreased $17.0 million in 2004 to $67.4 million at December 31, 2004. Operat- ing activities used cash of $2.1 million, as cash re- ceived from earnings and operating assets and liabilities was exceeded by cash utilized toward fails to deliver, stock borrowed and for processing ac- CASH FLOWS We have a liquid balance sheet. Most of our assets consist of cash and assets readily convertible into 24 Piper Jaffray Annual Report 2005 Management’s Discussion and Analysis of Financial Condition and Results of Operations age of $244 million in securities lending arrangements counts. Cash of $31.3 million was used for investing in 2005. This compares to an average of $34 million activities toward the purchase of ﬁxed assets and the in short-term bank loans and $211 million in average acquisition of Vie Securities, LLC. Cash of $16.4 mil- securities lending arrangements in 2004. Average re- lion was generated by ﬁnancing activities, including purchase agreements (excluding hedging) of $176 mil- $133.6 million received from secured ﬁnancing activi- ties and $41.7 million from securities loaned. The lion and $165 million in 2005 and 2004, respectively, cash generated through repurchase agreements and were primarily used to ﬁnance inventory. Growth in securities loaned ﬁnancing was offset by a net reduc- margin loans to customers is generally ﬁnanced through increases in securities lending to third parties tion of short-term borrowings of $159.0 million. while growth in our securities inventory is generally ﬁnanced through repurchase agreements or securities lending. Bank ﬁnancing supplements these sources as necessary. On December 31, 2005, we had no out- standing short-term bank ﬁnancing. Cash and cash equivalents increased $51.8 million in 2003 to $84.4 million at December 31, 2003. Operat- ing activities used cash of $1.3 million as cash re- ceived from earnings and operating assets and liabilities was exceeded by cash utilized toward the purchase of repurchase agreements and reverse repur- As of December 31, 2005, we had uncommitted credit agreements with banks totaling $675 million, com- chase agreements. Cash of $15.1 million was used for prising $555 million in discretionary secured lines and investing activities toward the purchase of ﬁxed as- $120 million in discretionary unsecured lines. We sets. Cash of $68.3 million was generated by ﬁnancing have been able to obtain necessary short-term bor- activities, including $153.9 million received from se- rowings in the past and believe we will continue to be cured ﬁnancing activities and $33.9 million in capital able to do so in the future. We have also established contributions from U.S. Bancorp. The cash generated arrangements to obtain ﬁnancing using as collateral through ﬁnancing was offset by a net reduction of our securities held by our clearing bank or by another short-term borrowings of $91.0 million and a broker dealer at the end of each business day. $35.0 million reduction in our subordinated debt. FUNDING SOURCES We have available discretionary short-term ﬁnancing on both a secured and unsecured basis. Secured ﬁ- nancing is obtained through the use of securities lend- ing agreements, repurchase agreements and secured bank loans. Securities lending agreements are prima- rily secured by client collateral pledged for margin loans while bank loans and repurchase agreements are typically collateralized by the ﬁrm’s securities inven- tory. Short-term funding is generally obtained at rates based upon the federal funds rate. In addition to the $675 million of credit agreements described above, our broker dealer subsidiary is party to a $180 million subordination agreement with an afﬁliate of U.S. Bancorp, which has been approved by the NYSE for regulatory net capital purposes as al- lowable in our broker dealer subsidiary’s net capital computation. The interest on the $180 million subor- dination agreement is based on the three-month London Interbank Offer Rate. The entire amount out- standing matures October 31, 2008. CASH REQUIREMENTS To ﬁnance customer receivables we utilized an average of $38 million in short-term bank loans and an aver- The following table provides a summary of our con- tractual obligations as of December 31, 2005: (Dollars in Millions) Long-term borrowings Operating leases Cash award program Venture fund commitments a 2007 Through 2008 2006 $ – $ 180.0 27.2 4.0 – 51.2 3.5 – 2009 Through 2010 $ – 47.6 – – 2011 and Thereafter Total $ – $ 180.0 69.1 – – 195.1 7.5 13.5 (a) The venture fund commitments have no speciﬁed call dates. The timing of capital calls is based on market conditions and investment opportunities. As of December 31, 2005, our long-term borrowings options and clauses for escalation and operation cost were $180.0 million, all due in 2008. Our minimum adjustments. We have commitments to invest an addi- lease commitments for non-cancelable office space leases were $195.1 million. Certain leases have renewal tional $13.5 million in venture capital funds. Piper Jaffray Annual Report 2005 25 Management’s Discussion and Analysis of Financial Condition and Results of Operations CAPITAL REQUIREMENTS No. 140 (‘‘SFAS 140’’), ‘‘Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities – a Replacement of FASB Statement No. 125,’’ to account for securitizations and other transfers of ﬁnancial assets. Therefore, we derecognize ﬁnancial assets transferred in securitizations provided that such transfer meets all of the SFAS 140 criteria. See Note 5, ‘‘Securitizations,’’ in the notes to the con- solidated ﬁnancial statements for a complete discus- sion of our securitization activities. As a registered broker dealer and member ﬁrm of the NYSE, our broker dealer subsidiary is subject to the uniform net capital rule of the SEC and the net capital rule of the NYSE. We have elected to use the alterna- tive method permitted by the uniform net capital rule, which requires that we maintain minimum net capital of the greater of $1.0 million or 2 percent of aggregate debit balances arising from customer transactions, as this is deﬁned in the rule. The NYSE may prohibit a member ﬁrm from expanding its business or paying We have investments in various entities, typically part- nerships or limited liability companies, established for dividends if resulting net capital would be less than the purpose of investing in emerging growth compa- 5 percent of aggregate debit balances. Advances to nies. We commit capital or act as the managing part- afﬁliates, repayment of subordinated liabilities, divi- ner or member of these entities. These entities are dend payments and other equity withdrawals are sub- reviewed under variable interest entity and voting in- ject to certain notiﬁcation and other provisions of the terest entity standards. If we determine that an entity uniform net capital rule and the net capital rule of the NYSE. We expect these provisions will not impact our should not be consolidated, we record these invest- ability to meet current and future obligations. In addi- ments on the equity method of accounting. The lower of cost or market method of accounting is applied to tion, we are subject to certain notiﬁcation require- investments where we do not have the ability to exer- ments related to withdrawals of excess net capital cise signiﬁcant inﬂuence over the operations of an from our broker dealer subsidiary. Our broker dealer entity. See Note 6, ‘‘Variable Interest Entities,’’ in the subsidiary is also registered with the Commodity Fu- notes to consolidated ﬁnancial statements for a com- tures Trading Commission (‘‘CFTC’’) and therefore is plete discussion of our activities related to these types subject to CFTC regulations. Piper Jaffray Ltd., our registered United Kingdom broker dealer subsidiary, of partnerships. is subject to the capital requirements of the U.K. Fi- nancial Services Authority. At December 31, 2005, net capital under the SEC’s Uniform Net Capital Rule was $314.0 million or 57.0 percent of aggregate debit balances, and $303.0 million in excess of the minimum required net capital. Off-Balance Sheet Arrangements We enter into various types of off-balance sheet ar- rangements in the ordinary course of business. We hold retained interests in nonconsolidated entities, in- cur obligations to commit capital to nonconsolidated entities, enter into derivative transactions, enter into non-derivative guarantees and enter into other off- balance sheet arrangements. We use derivative products in a principal capacity as a dealer to satisfy the ﬁnancial needs of clients. We also use derivative products to manage the interest rate and market value risks associated with our security positions. For a complete discussion of our activities related to derivative products, see Note 4, ‘‘Deriva- tives,’’ in the notes to the consolidated ﬁnancial statements. Our other types of off-balance-sheet arrangements in- clude contractual commitments and guarantees. For a discussion of our activities related to these off-balance sheet arrangements, see Note 14, ‘‘Contingencies, Commitments and Guarantees,’’ in the notes to the consolidated ﬁnancial statements. Enterprise Risk Management We enter into arrangements with special-purpose enti- Risk is an inherent part of our business. In the course of conducting business operations, we are exposed to ties (‘‘SPEs’’), also known as variable interest entities. a variety of risks. Market risk, credit risk, liquidity SPEs are corporations, trusts or partnerships that are risk, operational risk, and legal, regulatory and com- established for a limited purpose. SPEs, by their na- pliance risk are the principal risks we face in operating ture, generally are not controlled by their equity own- our business. We seek to identify, assess and monitor ers, as the establishing documents govern all material each risk in accordance with deﬁned policies and pro- decisions. Our primary involvement with SPEs relates cedures. The extent to which we properly identify and to securitization transactions in which highly rated effectively manage each of these risks is critical to our ﬁxed rate municipal bonds are sold to an SPE. We ﬁnancial condition and proﬁtability. follow Statement of Financial Accounting Standards 26 Piper Jaffray Annual Report 2005 Management’s Discussion and Analysis of Financial Condition and Results of Operations With respect to market risk and credit risk, the cor- nerstone of our risk management process is daily com- munication among traders, trading department management and senior management concerning our inventory positions and overall risk proﬁle. Our enter- prise risk management functions supplement this com- munication process by providing their independent perspectives on our market and credit risk proﬁle on a daily basis through a series of reports. The broader goals of our enterprise risk management functions are to understand the risk proﬁle of each trading area, to consolidate risk monitoring company-wide, to articu- late large trading or position risks to senior manage- ment, to provide traders with perspectives on their positions and to ensure accurate mark-to-market pricing. These interest rate swap contracts are recorded at fair value with the changes in fair value recognized in earnings. ) Equity Price Risk — Equity price risk represents the potential loss in value due to adverse changes in the level or volatility of equity prices. We are exposed to equity price risk through our trading activities in both listed and over-the-counter equity markets. We at- tempt to reduce the risk of loss inherent in our mar- ket-making and in our inventory of equity securities by establishing limits on the level of our position in any individual security and by managing net position levels with those limits. VALUE-AT-RISK MARKET RISK In addition to supporting daily risk management processes on the trading desks, our enterprise risk management functions support our market risk, insti- tutional credit risk and asset/liability committees. These committees oversee risk management practices, including deﬁning acceptable risk tolerances and ap- proving risk management policies. Value-at-Risk (‘‘VaR’’) is the potential loss in value of Piper Jaffray’s trading positions due to adverse market movements over a deﬁned time horizon with a speci- ﬁed conﬁdence level. We perform a daily VaR analysis on substantially all of our trading positions, including ﬁxed income, equities, convertible bonds and all asso- ciated hedges. We use a VaR model because it pro- vides a common metric for assessing market risk across business lines and products. The modeling of the market risk characteristics of our trading positions involves a number of assumptions and approxima- Market risk represents the risk of ﬁnancial loss that tions. While we believe that these assumptions and may result from the change in value of a ﬁnancial approximations are reasonable, different assumptions instrument due to ﬂuctuations in its market price. Our and approximations could produce materially differ- exposure to market risk is directly related to our role ent VaR estimates. For example, we include the risk- as a ﬁnancial intermediary for our clients and to our reducing diversiﬁcation beneﬁt between various secu- market-making activities. Market risk is inherent in both cash and derivative ﬁnancial instruments. The rities because it is highly unlikely that all securities scope of our market risk management policies and would have an equally adverse move on a typical procedures instruments. includes all market-sensitive ﬁnancial Our different types of market risk include: Consistent with industry practice, when calculating VaR we use a 95 percent conﬁdence level and a one- day time horizon for calculating the VaR numbers reported below. This means there is a 1 in 20 chance that daily trading net revenues will fall below the expected daily trading net revenues by an amount at least as large as the reported VaR. As a result, shortfalls from expected trading net revenues on a single trading day that are greater than the reported VaR would be anticipated to occur, on average, about once a month. ) Interest Rate Risk — Interest rate risk represents the potential loss from adverse changes in market interest rates. We are exposed to interest rate risk arising from changes in the level and volatility of interest rates, changes in the shape of the yield curve, changes in credit spreads, and the rate of mortgage prepayments. Interest rate risk is managed through the use of short positions in U.S. government securities, agency securi- ties, mortgage-backed securities, corporate debt secu- interest rate swaps, options, futures and VaR has inherent limitations, including reliance on rities, historical data to predict future market risk and the forward contracts. We utilize interest rate swap con- parameters established in creating the models that tracts to hedge a portion of our ﬁxed income inven- limit quantitative risk information outputs. There can tory, to hedge residual cash ﬂows from our tender be no assurance that actual losses occurring on any option bond program, and to hedge rate lock agree- ments and forward bond purchase agreements we given day arising from changes in market conditions may enter into with our public ﬁnance customers. will not exceed the VaR amounts shown below or that trading day. Piper Jaffray Annual Report 2005 27 Management’s Discussion and Analysis of Financial Condition and Results of Operations 99.9 percent VaR estimates both with and without such losses will not occur more than once in a 20-day diversiﬁcation beneﬁts for each risk category and trading period. In addition, different VaR methodolo- gies and distribution assumptions could produce ma- ﬁrmwide. These stress tests allow us to measure the terially different VaR numbers. Changes in VaR potential effects on net revenue from adverse changes in market volatilities, correlations and trading between reporting periods are generally due to changes in levels of risk exposure, volatilities and/or liquidity. correlations among asset classes. The following table quantiﬁes the estimated VaR for each component of market risk for the periods presented: In addition to daily VaR estimates, we calculate the potential market risk to our trading positions under selected stress scenarios. We calculate the daily AT DECEMBER 31, (Dollars in Thousands) Interest Rate Risk Equity Price Risk Aggregate Undiversiﬁed Risk Diversiﬁcation Beneﬁt Aggregate Diversiﬁed Value-at-Risk The table below illustrates the daily high, low and average value-at-risk calculated for each component of market risk during the years ended 2005, 2004 and 2003, respectively. FOR THE YEAR ENDED DECEMBER 31, 2005 (Dollars in Thousands) Interest Rate Risk Equity Price Risk Aggregate Undiversiﬁed Risk Aggregate Diversiﬁed Value-at-Risk FOR THE YEAR ENDED DECEMBER 31, 2004 (Dollars in Thousands) Interest Rate Risk Equity Price Risk Aggregate Undiversiﬁed Risk Aggregate Diversiﬁed Value-at-Risk FOR THE YEAR ENDED DECEMBER 31, 2003 (Dollars in Thousands) Interest Rate Risk Equity Price Risk Aggregate Undiversiﬁed Risk Aggregate Diversiﬁed Value-at-Risk 28 Piper Jaffray Annual Report 2005 2005 2004 2003 $ 309 288 597 (239) $ 381 232 613 (242) $ 828 299 1,127 (613) $ 358 $ 371 $ 514 High Low Average $ 825 $ 259 $ 463 766 1,406 760 201 551 253 466 929 589 High Low Average $1,446 $ 238 $ 557 578 1,695 945 209 482 267 312 869 421 High Low Average $1,193 $ 544 $ 870 1,051 1,971 944 256 1,028 481 536 1,406 664 Management’s Discussion and Analysis of Financial Condition and Results of Operations LIQUIDITY RISK Market risk can be exacerbated in times of trading illiquidity when market participants refrain from limits for our Private Client Services customers. transacting in normal quantities and/or at normal bid- offer spreads. Depending on the speciﬁc security, the structure of the ﬁnancial product, and/or overall mar- ket conditions, we may be forced to hold onto a secur- ity for days or weeks longer than we had planned. committee, establishes and reviews appropriate credit Our institutional credit committee reviews risk associ- ated with institutional counterparties with whom we hold repurchase and resale agreement facilities, stock borrow or loan facilities, derivatives, TBAs and other documented institutional counterparty agreements that may give rise to credit exposure. Counterparty levels are established relative to the level of counterparty ratings and potential levels of activity. We carefully watch our aged inventory to minimize the amount of illiquid securities we own at any one time. Also, given that we attempt to hedge away most of our market risk, it is likely that changes in value of our long positions in an illiquid market would be largely offset by changes in value of our short positions. We are also exposed to liquidity risk in our day-to-day funding activities. In addition to the beneﬁt of having a strong capital structure, we manage this risk by diversifying our funding sources across products and among individual counterparties within those prod- ucts. For example, our treasury department, working under the guidance of our asset/liability committee, can switch between securities lending, repurchase agreements, box loans and bank borrowings on any given day depending on the pricing and availability of funding from any one of these sources. We are subject to credit concentration risk if we hold large individual securities positions, execute large transactions with individual counterparties or groups of related counterparties, extend large loans to indi- vidual borrowers or make substantial underwriting commitments. Concentration risk can occur by indus- try, geographic area or type of client. Potential credit concentration risk is carefully monitored and is man- aged through the use of policies and limits. We are also exposed to the risk of loss related to changes in the credit spreads of debt instruments. Credit spread risk arises from potential changes in an issuer’s credit rating or the market’s perception of the issuer’s credit worthiness. Credit spread risk is man- aged through offsetting long or short positions in sim- ilar securities. In addition to managing our capital and funding, the asset/liability committee oversees the management of net interest income risk, portfolio collateral, and the OPERATIONAL RISK overall use of our capital, funding, and balance sheet. CREDIT RISK Operational risk refers to the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events. Credit risk in our Capital Markets business arises We rely on the ability of our employees, our internal systems and processes and systems at computer cen- from potential non-performance by counterparties, ters operated by third parties to process a large num- customers, borrowers or issuers of securities we hold ber of transactions. In the event of a breakdown or in our trading inventory. We are exposed to credit risk improper operation of our systems or processes or in our role as a trading counterparty to dealers and improper action by our employees or third-party ven- customers, as a holder of securities and as a member dors, we could suffer ﬁnancial loss, regulatory sanc- of exchanges and clearing organizations. Our client tions and damage to our reputation. We have business activities involve the execution, settlement and ﬁnanc- continuity plans in place that we believe will cover ing of various transactions. Client activities are trans- critical processes on a company-wide basis, and re- acted on a cash, delivery versus payment or margin dundancies are built into our systems as we have basis. Our credit exposure to institutional client busi- deemed appropriate. ness is mitigated by the use of industry-standard deliv- ery versus payment through depositories and clearing banks. Credit exposure associated with our Private Client Services business consists primarily of customer mar- gin accounts, which are monitored daily and are col- lateralized. Our treasury and credit services departments, in conjunction with our retail credit In order to mitigate and control operational risk, we have developed and continue to enhance a quarterly risk proﬁle review that is designed to identify and assess operational risk throughout the organization. These control mechanisms attempt to ensure that op- erations policies and procedures are being followed Piper Jaffray Annual Report 2005 29 Management’s Discussion and Analysis of Financial Condition and Results of Operations and that our various businesses are operating within We have established internal policies relating to ethics and business conduct, and compliance with applicable established corporate policies and limits. legal and regulatory requirements, as well as training and other procedures designed to ensure that these policies are followed. LEGAL, REGULATORY AND COMPLIANCE RISK Legal, regulatory and compliance risk includes the risk of non-compliance with applicable legal and regu- latory requirements and the risk that a counterparty’s Effects of Inﬂation performance obligations will be unenforceable. We are generally subject to extensive regulation in the various jurisdictions in which we conduct our busi- ness. We have established procedures that are de- signed to ensure compliance with applicable statutory and regulatory requirements, including, but not lim- ited to, those related to regulatory net capital require- ments, sales and trading practices, use and safekeeping of customer funds and securities, credit and extension, money-laundering, recordkeeping. Because our assets are liquid in nature, they are not signiﬁcantly affected by inﬂation. However, the rate of inﬂation affects our expenses, such as employee compensation, ofﬁce space leasing costs and commu- nications charges, which may not be readily recover- able in the price of services offered by us. To the extent inﬂation results in rising interest rates and has other adverse effects upon the securities markets, it may adversely affect our ﬁnancial position and results of operations. privacy CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS This Annual Report contains forward-looking statements. Statements that are not historical or current facts, including statements about beliefs and expectations, are forward-looking statements. These forward-looking statements cover, among other things, the future prospects of Piper Jaffray Companies. Forward-looking statements involve inherent risks and uncertainties, and important factors could cause actual results to differ materially from those anticipated, including the following: (1) developments in market and economic conditions have in the past adversely affected, and may in the future adversely affect, our business and proﬁtability, (2) developments in speciﬁc sectors of the economy have in the past adversely affected, and may in the future adversely affect, our business and proﬁtability, (3) we may not be able to compete successfully with other companies in the ﬁnancial services industry who are often larger and better capitalized than we are, (4) we have experienced signiﬁcant pricing pressure in areas of our business, which may impair our revenues and proﬁtabil- ity, (5) our ability to attract, develop and retain highly skilled and productive employees is critical to the success of our business, (6) our underwriting and market-making activities may place our capital at risk, (7) an inability to readily divest or transfer trading positions may result in ﬁnancial losses to our business, (8) use of derivative instruments as part of our risk management techniques may place our capital at risk, while our risk manage- ment techniques themselves may not fully mitigate our market risk exposure, (9) an inability to access capital readily or on terms favorable to us could impair our ability to fund operations and could jeopardize our ﬁnancial condition, (10) we may make strategic acquisitions of businesses, engage in joint ventures or divest or exit existing businesses, which could cause us to incur unforeseen expense and have disruptive effects on our business but may not yield the beneﬁts we expect, (11) our technology systems, including outsourced systems, are critical components of our operations, and failure of those systems or other aspects of our operations infrastructure may disrupt our business, cause ﬁnancial loss and constrain our growth, (12) our business is subject to extensive regulation that limits our business activities, and a signiﬁcant regulatory action against our company may have a material adverse ﬁnancial effect or cause signiﬁcant reputational harm to our company, (13) regulatory capital requirements may limit our ability to expand or maintain present levels of our business or impair our ability to meet our ﬁnancial obligations, (14) our exposure to legal liability is signiﬁcant, and could lead to substantial damages, (15) the business operations that we conduct outside of the United States subject us to unique risks, (16) we may suffer losses if our reputation is harmed, (17) our stock price may ﬂuctuate as a result of several factors, including but not limited to changes in our revenues and operating results, (18) provisions in our certiﬁcate of incorporation and bylaws and of Delaware law may prevent or delay an acquisition of our company, which could decrease the market value of our common stock, and (19) other factors identiﬁed under ‘‘Risk Factors’’ in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2005, and updated in our subsequent reports ﬁled with the SEC. These reports are available at our Web site at www.piperjaffray.com and at the SEC Web site at www.sec.gov. Forward-looking statements speak only as of the date they are made, and we undertake no obligation to update them in light of new information or future events. 30 Piper Jaffray Annual Report 2005 INDEX TO AUDITED CONSOLIDATED FINANCIAL STATEMENTS Piper Jaffray Companies Management’s Report on Internal Control Over Financial Reporting Report of Independent Registered Public Accounting Firm Report of Independent Registered Public Accounting Firm Consolidated Financial Statements: Consolidated Statements of Financial Condition Consolidated Statements of Operations Consolidated Statements of Changes in Shareholders’ Equity Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements Note 1 Background Note 2 Summary of Signiﬁcant Accounting Policies Note 3 Recent Accounting Pronouncements Note 4 Derivatives Note 5 Securitizations Note 6 Variable Interest Entities Note 7 Receivables from and Payables to Brokers, Dealers and Clearing Organizations Note 8 Receivables from and Payables to Customers Note 9 Collateralized Securities Transactions Note 10 Goodwill and Intangible Assets Note 11 Trading Securities Owned and Trading Securities Sold, but Not Yet Purchased Note 12 Fixed Assets Note 13 Financing Note 14 Contingencies, Commitments and Guarantees Note 15 Restructuring Note 16 Shareholders’ Equity Note 17 Earnings Per Share Note 18 Employee Beneﬁt Plans Note 19 Stock-Based Compensation and Cash Award Program Note 20 Transactions with U.S. Bancorp Prior to the Distribution Note 21 Net Capital Requirements and Other Regulatory Matters Note 22 Income Taxes Note 23 Business Segments Page 32 33 34 35 36 37 38 39 40 44 44 44 45 46 46 47 47 48 48 48 49 51 51 52 53 56 59 59 60 61 Piper Jaffray Annual Report 2005 31 Piper Jaffray Companies MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING Our management is responsible for establishing and maintaining adequate internal control over our ﬁnancial reporting. Our internal control system is designed to provide reasonable assurance regarding the reliability of ﬁnancial reporting and the preparation of ﬁnancial statements for external purposes in accordance with U.S. generally accepted accounting principles. All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to ﬁnancial statement preparation and presentation. Our management assessed the effectiveness of our internal control over ﬁnancial reporting as of December 31, 2005. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. Based on its assessment and those criteria, management has concluded that we maintained effective internal control over ﬁnancial reporting as of December 31, 2005. Our independent registered public accounting ﬁrm has issued an attestation report on management’s assessment of our internal control over ﬁnancial reporting. 32 Piper Jaffray Annual Report 2005 Piper Jaffray Companies REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Shareholders of Piper Jaffray Companies We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that Piper Jaffray Companies maintained effective internal control over ﬁnancial reporting as of December 31, 2005, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Piper Jaffray Companies’ management is responsible for maintaining effective internal control over ﬁnancial reporting and for its assessment of the effectiveness of internal control over ﬁnancial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over ﬁnancial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over ﬁnancial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over ﬁnancial reporting, evaluating manage- ment’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal control over ﬁnancial reporting is a process designed to provide reasonable assurance regarding the reliability of ﬁnancial reporting and the preparation of ﬁnancial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over ﬁnancial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reﬂect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of ﬁnancial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the ﬁnancial statements. Because of its inherent limitations, internal control over ﬁnancial reporting may not prevent or detect misstate- ments. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, management’s assessment that Piper Jaffray Companies maintained effective internal control over ﬁnancial reporting as of December 31, 2005, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Piper Jaffray Companies maintained, in all material respects, effective internal control over ﬁnancial reporting as of December 31, 2005, based on the COSO criteria. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the 2005 consolidated ﬁnancial statements of Piper Jaffray Companies and our report dated February 24, 2006 expressed an unqualiﬁed opinion thereon. Minneapolis, Minnesota February 24, 2006 Piper Jaffray Annual Report 2005 33 Piper Jaffray Companies REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Shareholders of Piper Jaffray Companies We have audited the accompanying consolidated statements of ﬁnancial condition of Piper Jaffray Companies as of December 31, 2005 and 2004, and the related consolidated statements of operations, changes in share- holders’ equity, and cash ﬂows for each of the three years in the period ended December 31, 2005. These ﬁnancial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these ﬁnancial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the ﬁnancial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the ﬁnancial statements. An audit also includes assessing the accounting principles used and signiﬁcant estimates made by management, as well as evaluating the overall ﬁnancial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the ﬁnancial statements referred to above present fairly, in all material respects, the consolidated ﬁnancial position of Piper Jaffray Companies and subsidiaries at December 31, 2005 and 2004, and the consolidated results of their operations and their cash ﬂows for each of the three years in the period ended December 31, 2005 in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Piper Jaffray Companies’ internal control over ﬁnancial reporting as of December 31, 2005, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 24, 2006 expressed an unqualiﬁed opinion thereon. Minneapolis, Minnesota February 24, 2006 34 Piper Jaffray Annual Report 2005 CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION DECEMBER 31, (Dollars in Thousands, Except Share Data) Assets Cash and cash equivalents Receivables: Customers (net of allowance of $1,793) Brokers, dealers and clearing organizations Deposits with clearing organizations Securities purchased under agreements to resell Trading securities owned Trading securities owned and pledged as collateral Piper Jaffray Companies 2005 2004 $ 60,869 $ 67,387 472,987 299,056 64,379 222,844 517,310 236,588 433,173 536,705 70,886 251,923 694,222 290,499 Total trading securities owned 753,898 984,721 Fixed assets (net of accumulated depreciation and amortization of $98,952 and $110,928, respectively) Goodwill and intangible assets (net of accumulated amortization of $54,264 and $52,664, respectively) Other receivables Other assets Total assets Liabilities and Shareholders’ Equity Payables: Customers Checks and drafts Brokers, dealers and clearing organizations Securities sold under agreements to repurchase Trading securities sold, but not yet purchased Accrued compensation Other liabilities and accrued expenses Total liabilities Subordinated debt Shareholders’ equity: Common stock, $0.01 par value; Shares authorized: 100,000,000 at December 31, 2005 and December 31, 2004; Shares issued: 19,487,319 at December 31, 2005 and 19,333,261 at December 31, 2004; Shares outstanding: 18,365,177 at December 31, 2005 and 19,333,261 at December 31, 2004 Additional paid-in capital Retained earnings Less common stock held in treasury, at cost: 1,122,142 shares at December 31, 2005 Other comprehensive loss Total shareholders’ equity Total liabilities and shareholders’ equity See Notes to Consolidated Financial Statements 55,124 53,968 320,234 34,610 70,190 321,834 31,832 75,828 $ 2,354,191 $2,828,257 $ 216,652 $ 189,153 53,304 259,597 245,786 332,204 171,551 140,270 63,270 287,217 312,273 746,604 184,608 139,704 1,419,364 1,922,829 180,000 180,000 195 704,005 90,431 (35,422) (4,382) 193 678,755 50,348 – (3,868) 754,827 725,428 $ 2,354,191 $2,828,257 Piper Jaffray Annual Report 2005 35 2005 2004 2003 $ 283,481 $ 263,730 $ 256,747 143,391 270,758 71,471 45,688 814,789 39,736 188,526 257,932 54,784 57,967 822,939 25,441 215,191 229,945 50,536 59,082 811,501 24,771 775,053 797,498 786,730 471,674 488,394 482,397 57,627 39,791 17,568 39,863 46,978 4,206 8,595 – 27,645 57,066 42,198 17,309 42,468 41,477 4,717 – – 24,248 58,025 37,599 22,755 39,030 38,511 24,000 – 3,911 39,619 713,947 717,877 745,847 61,106 21,023 79,621 29,273 40,883 14,884 $ 40,083 $ 50,348 $ 25,999 $ $ 2.13 2.10 $ $ 2.60 2.60 $ $ 1.35 1.35 18,813 19,081 19,333 19,399 19,237 19,237 Piper Jaffray Companies CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE YEAR ENDED DECEMBER 31, (Amounts in Thousands, Except Per Share Data) Revenues: Commissions and fees Principal transactions Investment banking Interest Other income Total revenues Interest expense Net revenues Non-interest expenses: Compensation and beneﬁts Occupancy and equipment Communications Floor brokerage and clearance Marketing and business development Outside services Cash award program Restructuring-related expense Royalty fee Other operating expenses Total non-interest expenses Income before income tax expense Income tax expense Net income Earnings per common share Basic Diluted Weighted average number of common shares Basic Diluted See Notes to Consolidated Financial Statements 36 Piper Jaffray Annual Report 2005 CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY Piper Jaffray Companies Common Shares Common Stock Outstanding Additional Paid-In Capital Retained Earnings Invested Capital Other Treasury Comprehensive Loss Stock Total Shareholders’ Equity (Dollars in Thousands, Except Share Amounts) Balance at December 31, 2002 Net income Capital contribution from U.S. Bancorp Distribution to U.S. Bancorp Recapitalization upon spin-off from – – – – $ – – – – $ – $ – $ 609,857 $ – – – – – – – 25,999 37,500 (3,561) (669,795) U.S. Bancorp 19,334,261 193 669,602 Balance at December 31, 2003 19,334,261 $ 193 $ 669,602 $ – $ – $ Net income Amortization of restricted stock Amortization of stock options Minimum pension liability adjustment – – – – Retirement of common stock (1,000) – – – – – – 50,348 7,119 2,034 – – – – – – – – – – – Balance at December 31, 2004 19,333,261 $ 193 $ 678,755 $ 50,348 $ – $ Net income Amortization of restricted stock Amortization of stock options Minimum pension liability adjustment Foreign currency translation adjustment – – – – – Issuance of common stock 154,058 Repurchase of common stock (1,300,000) Reissuance of treasury shares 177,858 – – – – – 2 – – – 40,083 15,914 3,341 – – 6,010 – (15) – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – (42,612) 7,190 $ $ – – – – – – – – – $ – – – – 669,795 $ 669,795 50,348 7,119 2,034 (3,868) (3,868) – – $ (3,868) $ 725,428 – – – 40,083 15,914 3,341 (73) (73) (441) – – – (441) 6,012 (42,612) 7,175 Balance at December 31, 2005 18,365,177 $ 195 $ 704,005 $ 90,431 $ – $ (35,422) $ (4,382) $ 754,827 See Notes to Consolidated Financial Statements Piper Jaffray Annual Report 2005 37 Piper Jaffray Companies CONSOLIDATED STATEMENTS OF CASH FLOWS YEAR ENDED DECEMBER 31, (Dollars in Thousands) Operating Activities: 2005 2004 2003 Net income Adjustments to reconcile net income to net cash provided by (used in) operating $ 40,083 $ 50,348 $ 25,999 activities: Depreciation and amortization Deferred income taxes Loss on disposal of ﬁxed assets Stock-based compensation Amortization of intangible assets Forgivable loan reserve Decrease (increase) in operating assets: Cash and cash equivalents segregated for regulatory purposes Receivables: Customers Brokers, dealers and clearing organizations Deposits with clearing organizations Securities purchased under agreements to resell Net trading securities owned Other receivables Other assets Increase (decrease) in operating liabilities: Payables: Customers Checks and drafts Brokers, dealers and clearing organizations Securities sold under agreements to repurchase Accrued compensation Other liabilities and accrued expenses 18,135 (475) 320 19,255 1,600 – 21,391 6,553 233 9,153 133 (2,100) 19,031 (6,491) 4,380 3,859 – 8,800 – 66,000 (66,000) (39,493) 237,624 6,507 29,079 (183,634) (2,778) 6,046 30,384 (297,405) (4,316) 55,064 27,039 7,782 11,302 27,503 (9,966) (39,699) (11,031) 110 497 (37,010) (1,333) 21,273 (64) (9,975) 43,478 10,445 (20,936) (29,988) (66,973) 32,231 27,067 19,469 82,583 6,519 10,559 (90,988) 53,611 (24,526) Net cash provided by (used in) operating activities 99,683 (2,070) (1,349) Investing Activities: Purchases of ﬁxed assets, net Acquisition, net of cash acquired Net cash used in investing activities Financing Activities: Increase in securities loaned Increase (decrease) in securities sold under agreements to repurchase Decrease in short-term bank ﬁnancing, net Decrease in subordinated debt, net Repurchase of common stock Capital contribution from U.S. Bancorp Capital distribution to U.S. Bancorp Net cash provided by (used in) ﬁnancing activities Currency adjustment: Effect of exchange rate changes on cash Net increase (decrease) in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year Supplemental disclosures of cash ﬂow information Cash paid (received) during the year for: Interest Income taxes Non-cash ﬁnancing activities (19,743) – (14,712) (16,624) (15,109) – (19,743) (31,336) (15,109) 11,774 (55,456) – – (42,612) – – 41,736 133,621 (159,000) – – – – 6,467 153,913 (91,040) (35,000) – 37,500 (3,561) (86,294) 16,357 68,279 (164) – (6,518) 67,387 (17,049) 84,436 – 51,821 32,615 $ 60,869 $ 67,387 $ 84,436 $ 40,174 $ 20,131 $ 16,647 $ 18,949 $ 19,427 $ (1,937) Issuance of 331,434 shares of common stock for retirement plan obligations $ 13,187 $ – $ – See Notes to Consolidated Financial Statements 38 Piper Jaffray Annual Report 2005 Notes to Consolidated Financial Statements NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1 Background Piper Jaffray Companies is the parent company of among all the various units comprising the Company, Piper Jaffray & Co. (‘‘Piper Jaffray’’), a securities bro- USB and its subsidiaries’ interest in the Company is shown in the consolidated ﬁnancial statements as in- ker dealer and investment banking ﬁrm; Piper Jaf- vested capital. The consolidated ﬁnancial statements, fray Ltd., a ﬁrm providing securities brokerage and for periods prior to the Distribution, include the ad- investment banking services in Europe through an of- justments necessary to reﬂect the Company’s opera- ﬁce located in London, England; Piper Jaffray Finan- tions as if the organizational changes had been cial Products Inc. and Piper Jaffray Financial consummated prior to the Distribution. However, the Products II Inc., two entities that facilitate Piper Jaf- consolidated ﬁnancial statements for periods prior to fray Companies customer derivative transactions; and the Distribution included herein may not necessarily Piper Jaffray Ventures Inc. (‘‘Piper Jaffray Ventures’’), be indicative of the Company’s results of operations, which served until December 31, 2004, as a venture ﬁnancial position and cash ﬂows in the future or what capital ﬁrm managing funds that invested in emerging its results of operations, ﬁnancial position and cash growth companies. Effective December 31, 2004, the ﬂows would have been had Piper Jaffray Companies management of these funds transitioned to an inde- pendent company. The Company, through its subsidi- been a stand-alone company prior to the Distribution. aries, operates in three business segments: Capital Markets, Private Client Services, and Corporate Sup- port and Other. Capital Markets includes institutional sales, trading and research services and investment banking services. Private Client Services provides ﬁ- nancial advice and investment products and services to individual investors. Corporate Support and Other includes the Company’s results from its private equity business and certain public company and long-term ﬁnancing costs. The Company’s business segments are described more fully in Note 23. Prior to the Distribution, the consolidated results in- cluded revenues generated and expenses incurred based on customer relationships and related business activities. In certain situations, afﬁliated entities of USB may have provided services to, and thus charged expense to, the Company. These expenses primarily relate to providing employee-related services and ben- eﬁts, technology and data processing services, and corporate functions including audit, tax and real es- tate management services. Costs included on the con- solidated ﬁnancial statements for shared services were determined based on actual costs to USB and allocated based on the Company’s proportionate usage of those services. Proportionate usage was determined based on the number of employees, actual hours used, square footage of ofﬁce space or other similar meth- odologies. Management believes the assumptions un- derlying the consolidated ﬁnancial statements are reasonable. On April 28, 2003, Piper Jaffray Companies was incor- porated in Delaware as a subsidiary of U.S. Bancorp (‘‘USB’’) to effect the spin-off of USB’s capital markets business to its shareholders. On December 31, 2003, after receiving regulatory approval, USB distributed to its shareholders all of its interest in Piper Jaffray Com- panies and its subsidiaries (collectively, the ‘‘Com- pany’’). On that date, 19,334,261 shares of Piper Jaffray Companies common stock were issued to USB shareholders (the ‘‘Distribution’’). Prior to the Distribution, income taxes were deter- mined on a separate return basis as if the Company had not been eligible to be included in the consoli- Prior to the Distribution, the consolidated ﬁnancial statements included the accounts and operations of dated income tax return of USB and its afﬁliates. Piper Jaffray Companies and its subsidiaries as well as However, USB was managing its tax position for the beneﬁt of its entire portfolio of businesses, and its tax certain assets, liabilities and related operations trans- strategies are not necessarily reﬂective of the tax strat- ferred to Piper Jaffray Companies from USB immedi- egies that the Company would have followed as a ately prior to the Distribution. Because prior to the stand-alone entity. Distribution no direct ownership relationship existed Piper Jaffray Annual Report 2005 39 Notes to Consolidated Financial Statements Note 2 Summary of Signiﬁcant Accounting Policies PRINCIPLES OF CONSOLIDATION The consolidated ﬁnancial statements include the ac- QSPE. A QSPE can generally be described as an entity counts of Piper Jaffray Companies, its subsidiaries, with signiﬁcantly limited powers that are intended to limit it to passively holding ﬁnancial assets and dis- and all other entities in which the Company has a tributing cash ﬂows based upon predetermined crite- controlling ﬁnancial interest. All material intercom- pany accounts and transactions have been eliminated. ria. Based upon the guidance in SFAS 140, the The Company determines whether it has a controlling Company does not consolidate such QSPEs. The ﬁnancial interest in an entity by ﬁrst evaluating Company accounts for its involvement with such whether the entity is a voting interest entity, a variable QSPEs under a ﬁnancial components approach in interest entity (‘‘VIE’’), a special-purpose entity which the Company recognizes only its retained residual interest in the QSPE. The Company accounts (‘‘SPE’’), or a qualifying special-purpose entity (‘‘QSPE’’) under U.S. generally accepted accounting for such retained interests at fair value. principles. Certain SPEs do not meet the QSPE criteria due to their permitted activities not being sufﬁciently limited or to control remaining with one of the owners. These SPEs are typically considered VIEs and are reviewed under FIN 46(R) the primary beneﬁciary. Voting interest entities are entities in which the total equity investment at risk is sufﬁcient to enable each entity to ﬁnance itself independently and provides the equity holders with the obligation to absorb losses, the right to receive residual returns and the right to make decisions about the entity’s activities. Voting interest entities are consolidated in accordance with Accounting Research Bulletin No. 51 (‘‘ARB 51’’), ‘‘Consolidated Financial Statements,’’ as amended. ARB 51 states that the usual condition for a control- ling ﬁnancial interest in an entity is ownership of a majority voting interest. Accordingly, the Company consolidates voting interest entities in which it has all, or a majority of, the voting interest. When the Company does not have a controlling ﬁnan- cial interest in an entity but exerts signiﬁcant inﬂuence over the entity’s operating and ﬁnancial policies (gen- erally deﬁned as owning a voting or economic interest of between 20 percent to 50 percent), the Company accounts for its investment in accordance with the equity method of accounting prescribed by Account- ing Principles Board Opinion No. 18 (‘‘APB 18’’), ‘‘The Equity Method of Accounting for Investments in As deﬁned in Financial Accounting Standards Board Common Stock.’’ If the Company does not have a controlling ﬁnancial interest in, or exert signiﬁcant Interpretation No. 46(R) (‘‘FIN 46(R)’’), ‘‘Consolida- inﬂuence over, an entity, the Company accounts for tion of Variable Interest Entities,’’ VIEs are entities its investment at fair value. that lack one or more of the characteristics of a voting interest entity described above. FIN 46(R) states that a controlling ﬁnancial interest in an entity is present when an enterprise has a variable interest, or combi- nation of variable interests, that will absorb a major- ity of the entity’s expected losses, receive a majority of the entity’s expected residual returns, or both. The enterprise with a controlling ﬁnancial interest, known as the primary beneﬁciary, consolidates the VIE. Ac- cordingly, the Company consolidates VIEs in which the Company is deemed to be the primary beneﬁciary. USE OF ESTIMATES The preparation of ﬁnancial statements and related disclosures in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the ﬁnancial statements and the reported amounts of reve- nues and expenses during the reporting period. Actual results could differ from those estimates. to determine SPEs are trusts, partnerships or corporations estab- lished for a particular limited purpose. The Company follows the accounting guidance in Statement of Fi- nancial Accounting Standards No. 140 (‘‘SFAS 140’’), ‘‘Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities,’’ to deter- mine whether or not such SPEs are required to be consolidated. The Company establishes SPEs to securitize ﬁxed rate municipal bonds. The majority of these securitizations meet the SFAS 140 deﬁnition of a CASH AND CASH EQUIVALENTS Cash and cash equivalents consist of cash and highly liquid investments with maturities of 90 days or less at the date of purchase. In accordance with Rule 15c3-3 of the Securities Ex- change Act of 1934, Piper Jaffray, as a registered bro- ker dealer carrying customer accounts, is subject to requirements related to maintaining cash or qualiﬁed 40 Piper Jaffray Annual Report 2005 securities in a segregated reserve account for the ex- clusive beneﬁt of its customers. under management. These revenues are recognized over the periods for which services are rendered. Notes to Consolidated Financial Statements Principal Transactions. Gains and losses related to inventory positions trading securities and other owned, trading securities and other inventory posi- tions pledged, and trading securities and other inven- tory positions sold, but not yet purchased are reﬂected on a trade date basis in principal transactions on the consolidated statements of operations. COLLATERALIZED SECURITIES TRANSACTIONS Securities purchased under agreements to resell and securities sold under agreements to repurchase are carried at the contractual amounts at which the secu- rities will be subsequently resold or repurchased, in- cluding accrued interest. It is the Company’s policy to take possession or control of securities purchased under agreements to resell at the time these agree- Investment banking revenues, ments are entered into. The counterparties to these which include underwriting fees, management fees and advisory fees, are recorded when services for the typically are primary dealers of agreements transactions are completed under the terms of each U.S. government securities and major ﬁnancial institu- engagement. Expenses associated with such transac- tions. Collateral is valued daily, and additional collat- tions are deferred until the related revenue is recog- eral is obtained from or refunded to counterparties nized or the engagement is otherwise concluded. when appropriate. Investment banking revenues are presented net of re- lated expenses. Investment Banking. Securities borrowed and loaned result from transac- tions with other broker dealers or ﬁnancial institu- tions and are recorded at the amount of cash collateral advanced or received. These amounts are included in receivables from and payable to brokers, dealers and clearing organizations on the consolidated statements of ﬁnancial condition. Securities borrowed transactions require the Company to deposit cash or other collateral with the lender. Securities loaned transactions require the borrower to deposit cash with the Company. The Company monitors the market value of securities borrowed and loaned on a daily basis, with additional collateral obtained or refunded as necessary. Interest is accrued on securities bor- rowed and loaned transactions and is included in other assets and other liabilities and accrued expenses on the consolidated statements of ﬁnancial condition and the respective interest income and expense bal- ances on the consolidated statements of operations. CUSTOMER TRANSACTIONS Customer securities transactions are recorded on a settlement date basis, while the related revenues and expenses are recorded on a trade date basis. Customer receivables and payables include amounts related to both cash and margin transactions. Securities owned by customers, including those that collateralize mar- gin or other similar transactions, are not reﬂected on the consolidated statements of ﬁnancial condition. REVENUE RECOGNITION Commissions and Fees. The Company generates commissions from executing and clearing client trans- actions. These commissions are recorded on a trade date basis. The Company charges fees to certain pri- vate client accounts based on the value of client assets ALLOWANCE FOR DOUBTFUL ACCOUNTS Management estimates an allowance for doubtful ac- counts to reserve for probable losses from unsecured and partially secured customer accounts. Manage- ment is continually evaluating its receivables from customers for collectibility and possible write-off by examining the facts and circumstances surrounding each customer where a loss is deemed possible. FIXED ASSETS Fixed assets include furniture and equipment, software and leasehold improvements. Depreciation of furniture and equipment and software is provided using the straight-line method over estimated useful lives of three to ten years. Leasehold improvements are amortized over their estimated useful life or the life of the lease, whichever is shorter. Additionally, certain costs incurred in connection with internal-use software projects are capitalized and amortized over the expected useful life of the asset, generally three to seven years. LEASES The Company leases its corporate headquarters and retail branches under various non-cancelable leases. The leases require payment of real estate taxes, insur- ance and common area maintenance, in addition to rent. The terms of the Company’s lease agreements generally range up to 10 years. Some of the leases contain renewal options, escalation clauses, rent free holidays and operating cost adjustments. For leases that contain escalations and rent-free holi- days, the Company recognizes the related rent ex- pense on a straight-line basis from the date the Piper Jaffray Annual Report 2005 41 Notes to Consolidated Financial Statements Company takes possession of the property to the end OTHER ASSETS of the initial lease term. The Company records any Other assets include exchange memberships valued at cost; including two seats on the New York Stock Ex- difference between the straight-line rent amounts and change, Inc. (‘‘NYSE’’), investments in partnerships amounts payable under the leases as part of other valued at fair value, investments to fund deferred liabilities and accrued expenses. compensation liabilities valued at fair value, prepaid expenses, and net deferred tax assets. Refer to Note 6 for additional information regarding investments in partnerships. Refer to Note 22 for additional informa- tion regarding income taxes. Cash or lease incentives received upon entering into certain leases are recognized on a straight-line basis as a reduction of rent expense from the date the Com- pany takes possession of the property or receives the cash to the end of the initial lease term. The Company records the unamortized portion of lease incentives as As noted above, included in other assets are invest- ments that the Company has made to fund certain part of other liabilities and accrued expenses. deferred compensation liabilities for employees. The Company has fully funded these deferred compensa- GOODWILL AND INTANGIBLE ASSETS tion liabilities by investing in venture capital stage Statement of Financial Accounting Standards No. 142 companies or by investing in partnerships that invest (‘‘SFAS 142’’), ‘‘Goodwill and Other Intangible As- in venture capital stage companies. Future payments, sets,’’ addresses the accounting for goodwill and in- if any, to participants in these deferred compensation tangible assets subsequent to their acquisition. plans are directly linked to the performance of these Goodwill represents the excess of purchase price over investments. No further deferrals of compensation are the fair value of net assets acquired using the purchase expected under these deferred compensation plans. method of accounting. The recoverability of goodwill is evaluated annually, at a minimum, or on an interim Also included in other assets are the Company’s other venture capital investments. Investments are carried at basis if events or circumstances indicate a possible estimated fair value based on valuations set forth in inability to realize the carrying amount. The evalua- statements obtained from the underlying fund man- tion includes assessing the estimated fair value of the ager or based on published market quotes, with the goodwill based on market prices for similar assets, resulting gains and losses recognized in other income where available, and the present value of the esti- on the consolidated statements of operations. In the mated future cash ﬂows associated with the goodwill. event a security is thinly traded or the market price of an investment is not readily available, management estimates fair value using other valuation methods de- pending on the type of security and related market. Intangible assets with determinable lives consist of unpatented technologies that are amortized on a straight-line basis over three years. OTHER RECEIVABLES Included in other receivables are loans made to ﬁnan- cial advisors and other revenue-producing employees, typically in connection with their recruitment. These loans are forgiven based on continued employment and are amortized to compensation and beneﬁts using the straight-line method over the respective terms of the loans, which generally range from three to ﬁve years. In conjunction with these loans, management esti- mates an allowance for loan losses. This allowance is established for situations where loan recipients leave the Company prior to full forgiveness of their loan balance and the Company is subsequently not able to recover the remaining balances. The Company deter- mines adequacy of the allowance based upon an eval- the loan portfolio, uation of collectibility of unforgiven balances of departed em- ployees, recent experience related to attrition of cer- tain revenue-producing employees and other pertinent factors. including the FAIR VALUE OF FINANCIAL INSTRUMENTS Substantially all of the Company’s ﬁnancial instru- ments are recorded on the Company’s consolidated statements of ﬁnancial condition at fair value or the contract amount. The fair value of a ﬁnancial instru- ment is the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. Trading securities owned and trading securities sold, but not yet purchased are recorded on a trade date basis and are stated at market or fair value. The Com- pany’s valuation policy is to use quoted market or dealer prices from independent sources where they are available and reliable. A substantial percentage of the fair values recorded for the Company’s trading securi- ties owned and trading securities sold, but not yet purchased are based on observable market prices. The fair values of trading securities for which a quoted market or dealer price is not available are based on management’s estimate, using the best information 42 Piper Jaffray Annual Report 2005 available, of amounts that could be realized under current market conditions. Among the factors consid- ered by management in determining the fair value of these securities are the cost, terms and liquidity of the investment, the ﬁnancial condition and operating re- sults of the issuer, the quoted market price of securi- ties with similar quality and yield that are publicly traded, and other factors generally pertinent to the valuation of investments. The fair value of over-the-counter derivative contracts are valued using valuation models. The model prima- rily used by the Company is the present value of cash ﬂow model, as most of the Company’s derivative products are interest rate swaps. This model requires inputs including contractual terms, market prices, yield curves, credit curves and measures of volatility. Financial instruments carried at contract amounts that approximate fair value either have short-term maturi- ties (one year or less), are repriced frequently, or bear market interest rates and, accordingly, are carried at amounts approximating fair value. Financial instru- ments carried at contract amounts on the consolidated statements of ﬁnancial condition include receivables from and payables to brokers, dealers and clearing organizations, securities purchased under agreements to resell, securities sold under agreements to repur- chase, receivables from and payables to customers, short-term ﬁnancing and subordinated debt. The carrying amount of subordinated debt closely ap- proximates fair value based upon market rates of in- terest available to the Company at December 31, 2005. Notes to Consolidated Financial Statements ‘‘Accounting for Stock-Based Compensation – Transi- tion and Disclosure.’’ Prior to the Distribution, certain employees of the Company were eligible to participate in USB employee incentive plans pursuant to which they received stock option and restricted stock awards that are described more fully in Note 19. The Company accounted for these stock option grants under the intrinsic value method in accordance with Accounting Principles Board Opinion No. 25 (‘‘APB 25’’), ‘‘Accounting for Stock Issued to Employees,’’ and accordingly, recog- nized no compensation expense for the stock option grants as all options granted under those plans had an exercise price equal to the market value of the under- lying common stock on the date of grant. EARNINGS PER SHARE Basic earnings per common share is computed by di- viding net income by the weighted average number of common shares outstanding for the year. Diluted earnings per common share is calculated by adjusting the weighted average outstanding shares to assume conversion of all potentially dilutive restricted stock and stock options. Because Piper Jaffray Companies common stock was not publicly issued until Decem- ber 31, 2003, the date of the Distribution, the weighted average number of common shares out- standing for each year presented prior to the Distribu- tion was calculated by applying the distribution ratio utilized in the spin-off to the historical USB weighted average number of common shares outstanding for the same periods presented. to FOREIGN CURRENCY TRANSLATION The Company consolidates a foreign subsidiary, INCOME TAXES Income tax expense is recorded using the asset and which has designated its local currency as its func- tional currency. Assets and liabilities of this foreign liability method. Deferred tax assets and liabilities are subsidiary are translated at year-end rates of ex- recognized for the expected future tax consequences change, and statement of operations accounts are attributable temporary differences between amounts reported for income tax purposes and ﬁnan- translated at an average rate for the period. In accor- cial statement purposes, using current tax rates. A dance with Statement of Financial Accounting Stan- dards No. 52 (‘‘SFAS 52’’), ‘‘Foreign Currency valuation allowance is recognized if it is anticipated Translation,’’ gains or losses resulting from translating that some or all of a deferred tax asset will not be foreign currency ﬁnancial statements are reﬂected in realized. other comprehensive loss, a separate component of shareholders’ equity. Gains or losses resulting from foreign currency transactions are included in net income. STOCK-BASED COMPENSATION Effective January 1, 2004, the Company adopted the fair value method of accounting for grants of stock- based compensation, as prescribed by Statement of Fi- nancial Accounting Standards No. 123 (‘‘SFAS 123’’), ‘‘Accounting and Disclosure of Stock-Based Compen- Certain prior period amounts have been reclassiﬁed to sation,’’ as amended by Statement of Financial Ac- (‘‘SFAS 148’’), counting Standards No. 148 conform to the current year presentation. RECLASSIFICATIONS Piper Jaffray Annual Report 2005 43 Notes to Consolidated Financial Statements Note 3 Recent Accounting Pronouncements In December 2004, the Financial Accounting Stan- ment-eligible employees. However, awards granted subject to a substantive non-compete agreement are dards Board issued Statement of Financial Accounting generally expensed over the non-compete period. Standards No. 123R (‘‘SFAS 123(R)’’), ‘‘Share-Based SFAS 123(R) also requires expected forfeitures to be Payment.’’ SFAS 123(R), which is effective for public included in determining the expense related to share- companies for annual periods beginning after June 15, based payments. The Company has evaluated the im- 2005, supersedes APB 25 and amends Statement of pact of the adoption of SFAS 123(R) and does not Financial Accounting Standards No. 95, ‘‘Statement believe the impact will be signiﬁcant to the Company’s of Cash Flows.’’ SFAS 123(R) clariﬁes and expands overall results of operations or ﬁnancial position as the guidance in SFAS 123 in several areas. The ap- the Company elected to account for stock-based com- proach under SFAS 123(R) requires all share-based pensation under the fair value method as prescribed payments to employees, including grants of employee by SFAS 123, effective January 1, 2004. The Com- stock options and restricted stock, to be recognized in pany adopted the provisions of SFAS 123(R) on Janu- the income statement based on their fair values. Pro ary 1, 2006, using forma disclosure the modiﬁed prospective longer an alternative. application. SFAS 123(R) also generally requires the immediate expensing of share-based payments granted to retire- is no Note 4 Derivatives The market or fair values related to derivative con- Derivative contracts are ﬁnancial instruments such as tract transactions are reported in trading securities forwards, futures, swaps or option contracts that de- owned and trading securities sold, but not yet pur- rive their value from underlying assets, reference rates, chased on the consolidated statements of ﬁnancial indices or a combination of these factors. A derivative condition and any unrealized gain or loss resulting contract generally represents future commitments to from changes in fair values of derivatives is recognized purchase or sell ﬁnancial instruments at speciﬁed terms on a speciﬁed date or to exchange currency or in principal transactions on the consolidated state- interest payment streams based on the contract or ments of operations. Derivatives are reported on a net-by-counterparty basis when a legal right of offset notional amount. Derivative contracts exclude certain exists under a legally enforceable master netting cash instruments, such as mortgage-backed securities, interest-only and principal-only obligations and in- agreement in accordance with FASB Interpretation dexed debt instruments that derive their values or con- No. 39 (‘‘FIN 39’’), ‘‘Offsetting of Amounts Related tractually required cash ﬂows from the price of some other security or index. Fair values for derivative contracts represent amounts estimated to be received from or paid to a The Company uses interest rate swaps, interest rate counterparty in settlement of these instruments. These locks, and forward contracts to facilitate customer transactions and as a means to manage risk in certain derivatives are valued using quoted market prices inventory positions. The Company also enters into when available or pricing models based on the net present value of estimated future cash ﬂows. The valu- interest rate swap agreements to manage interest rate ation models used require inputs including contrac- exposure associated with holding residual interest se- tual terms, market prices, yield curves, credit curves curities from its tender option bond program. As of and measures of volatility. The net fair value of deriv- December 31, 2005 and 2004, the Company was ative contracts was approximately $17.0 million and counterparty to notional/contract amounts of $2.5 million as of December 31, 2005 and 2004, $4.6 billion and $2.5 billion, respectively, of deriva- respectively. tive instruments. to Certain Contracts.’’ Note 5 Securitizations pany had $298.5 million and $246.9 million, respec- In connection with its tender option bond program, the Company securitizes highly rated municipal tively, of municipal bonds in securitization. Each bonds. At December 31, 2005 and 2004, the Com- municipal bond is sold into a separate trust that is 44 Piper Jaffray Annual Report 2005 Notes to Consolidated Financial Statements in a particular assumption on the fair value of the funded by the sale of variable rate certiﬁcates to insti- retained interests is calculated independent of changes tutional customers seeking variable rate tax-free in- in any other assumption; in practice, changes in one vestment products. These variable rate certiﬁcates reprice weekly. Securitization transactions meeting factor may result in changes in another, which might certain SFAS 140 criteria are treated as sales, with the magnify or counteract the sensitivities. In addition, the sensitivity analysis does not consider any correc- resulting gain included in principal transactions on the tive action that the Company might take to mitigate consolidated statements of operations. If a securitiza- tion does not meet the sale-of-asset requirements of the impact of any adverse changes in key assumptions. SFAS 140, the transaction is recorded as a borrowing. The Company retains a residual interest in each struc- ture and accounts for the residual interest as a trading security, which is recorded at fair value on the consol- idated statements of ﬁnancial condition. The fair value of retained interests was $7.3 million and $10.1 million at December 31, 2005 and 2004, re- spectively, with a weighted average life of 9.3 years and 9.7 years, respectively. The fair value of retained interests is estimated based on the present value of future cash ﬂows using management’s best estimates of the key assumptions – expected yield, credit losses of 0 percent and a 12 percent discount rate. The Com- pany receives a fee to remarket the variable rate certif- icates derived from the securitizations. Certain cash ﬂow activity for the municipal bond securitizations described above during 2005 and 2004 includes: Cash ﬂows received on retained Remarketing fees received Proceeds from new sales (Dollars in Thousands) interests $ 98,822 $ 22,655 6,725 8,465 2005 2004 132 98 During 2004, two securitization transactions were de- signed such that they did not meet the asset sale re- quirements of SFAS 140; therefore, the Company consolidated these trusts. As a result, the Company recorded an asset for the underlying bonds of $45.1 million and $46.5 million as of December 31, 2005 and 2004, respectively, in trading securities owned and a liability for the certiﬁcates sold by the trust for $44.9 million and $46.3 million, respectively, in other liabilities and accrued expenses on the consol- idated statement of ﬁnancial condition. The Company has hedged the activities of these securitizations with interest rate swaps, which have been recorded at fair value and resulted in a liability of approximately $0.2 million at each of December 31, 2005 and 2004. At December 31, 2005, the sensitivity of the current fair value of retained interests to immediate 10 per- cent and 20 percent adverse changes in the key eco- nomic assumptions was not material. The sensitivity analysis does not include the offsetting beneﬁt of ﬁ- nancial instruments the Company utilizes to hedge risks inherent in its retained interests and is hypotheti- cal. Changes in fair value based on a 10 percent or 20 percent variation in an assumption generally can- not be extrapolated because the relationship of the change in the assumption to the change in the fair value may not be linear. Also, the effect of a variation Note 6 Variable Interest Entities In the normal course of business, the Company regu- December 31, 2005, the Company’s aggregate net in- vestment in these partnerships and LLCs totaled larly creates or transacts with entities that may be $4.6 million. The Company’s remaining commitment VIEs. These entities are either securitization vehicles to these partnerships and LLCs was $13.5 million at or investment vehicles. December 31, 2005. The Company acts as transferor, seller, investor, or The Company has identiﬁed one LLC described above structurer in securitizations. These transactions typi- cally involve entities that are qualifying special pur- as a VIE. Furthermore, it was determined that the pose entities as deﬁned in SFAS 140. For further Company is not the primary beneﬁciary of this VIE. discussion on these types of transactions, see Note 5. However, the Company owns a signiﬁcant variable interest in the VIE. The VIE had assets approximating $5.5 million at December 31, 2005. The Company’s exposure to loss from this entity is $1.1 million, which is the value of its capital contribution at December 31, 2005. The Company has investments in and/or acts as the managing partner or member to approximately 25 partnerships and liability companies (‘‘LLCs’’). These entities were established for the pur- pose of investing in emerging growth companies. At limited Piper Jaffray Annual Report 2005 45 Notes to Consolidated Financial Statements The Company also consolidates those partnerships and LLCs in which it has the ability to exercise con- trol over major operating and ﬁnancial policies. Any partnership or LLC that is not consolidated is ac- counted for on the equity or cost method of account- ing, depending upon the ownership percentage and/or the ability to exercise signiﬁcant inﬂuence over the business activities. Note 7 Receivables from and Payables to Brokers, Dealers and Clearing Organizations Amounts receivable from brokers, dealers and clear- Amounts payable to brokers, dealers and clearing or- ing organizations at December 31 included: ganizations at December 31 included: (Dollars in Thousands) 2005 2004 (Dollars in Thousands) 2005 2004 Receivable arising from unsettled Deposits received for securities securities transactions, net $ 108,454 $ 264,471 loaned 92,495 116,041 Securities failed to receive Payable to clearing organizations Other $ 234,676 $ 222,902 8,117 16,609 195 44,226 19,986 103 Deposits paid for securities borrowed Receivable from clearing organizations Securities failed to deliver Other 50,236 34,946 12,925 52,822 88,286 15,085 Total receivables $ 299,056 $ 536,705 Total payables $ 259,597 $ 287,217 Securities failed to deliver and receive represent the contract value of securities that have not been deliv- ered or received by the Company on settlement date. Deposits paid for securities borrowed and deposits received for securities loaned approximate the market value of the related securities. Note 8 Receivables from and Payables to Customers Amounts receivable from customers at December 31 Amounts payable to customers at December 31 included: included: (Dollars in Thousands) Cash accounts Margin accounts 2005 2004 (Dollars in Thousands) 2005 2004 $ 48,850 $ 27,211 Cash accounts 424,137 405,962 Margin accounts $ 191,541 $ 120,572 25,111 68,581 Total receivables $ 472,987 $ 433,173 Total payables $216,652 $ 189,153 Securities owned by customers are held as collateral for margin loan receivables. This collateral is not re- ﬂected on the consolidated ﬁnancial statements. Mar- gin loan receivables earn interest at ﬂoating interest rates based on prime rates. Payables to customers primarily comprise certain cash balances in customer accounts consisting of customer funds pending settlement of securities transactions and customer funds on deposit. Except for amounts arising from customer short sales, all amounts payable to customers are subject to withdrawal by customers upon their request. 46 Piper Jaffray Annual Report 2005 Note 9 Collateralized Securities Transactions Notes to Consolidated Financial Statements others. The Company obtained securities with a fair The Company’s ﬁnancing and customer securities ac- value of approximately $904.3 million and tivities involve the Company using securities as collat- $931.6 million at December 31, 2005 and 2004, re- eral. In the event that the counterparty does not meet spectively, of which $454.0 million and $489.8 mil- its contractual obligation to return securities used as lion, respectively, has been either pledged or otherwise collateral, or customers do not deposit additional se- transferred to others in connection with the Com- curities or cash for margin when required, the Com- pany’s ﬁnancing activities or to satisfy its commit- pany may be exposed to the risk of reacquiring the securities or selling the securities at unfavorable mar- ments under trading securities sold, but not yet ket prices in order to satisfy its obligations to its cus- tomers or counterparties. The Company seeks to control this risk by monitoring the market value of securities pledged or used as collateral on a daily basis and requiring adjustments in the event of excess mar- ket exposure. At December 31, 2005, the Company’s securities sold under agreements to repurchase (‘‘Repurchase Liabili- ties’’) exceeded 10 percent of total assets. The major- ity of Repurchase Liabilities at December 31, 2005, consisted of U.S. Government agency obligations. purchased. In the normal course of business, the Company ob- tains securities purchased under agreements to resell, securities borrowed and margin agreements on terms that permit it to repledge or resell the securities to The following is a summary of Repurchase Liabilities as of December 31, 2005: (Dollars in Thousands) Overnight maturity 1-30 days maturity On demand maturity Carrying Amount of Assets Sold Repurchase Liabilities Interest Rates $ 234,255 $ 232,078 3.90%-4.40% 5,428 8,528 5,310 8,398 2.25%-3.65% 3.75%-3.90% $ 248,211 $ 245,786 Note 10 Goodwill and Intangible Assets The following table presents the changes in the carry- ing value of goodwill and intangible assets by reportable segment for the year ended December 31, 2005: (Dollars in Thousands) Goodwill Balance at December 31, 2004 Goodwill acquired Impairment losses Balance at December 31, 2005 Intangible assets Balance at December 31, 2004 Intangible assets acquired Amortization of intangible assets Impairment losses Balance at December 31, 2005 Total goodwill and intangible assets $234,634 $ 85,600 Capital Markets Private Client Services Corporate Support and Other Consolidated Company $231,567 $ 85,600 – – – – $231,567 $ 85,600 $ 4,667 $ – (1,600) – $ 3,067 $ – – – – – $ – – – $ – $ – – – – $ – $ – $ 317,167 – – $ 317,167 $ 4,667 – (1,600) – $ 3,067 $ 320,234 Piper Jaffray Annual Report 2005 47 Notes to Consolidated Financial Statements Note 11 Trading Securities Owned and Trading Securities Sold, but Not Yet Purchased At December 31, trading securities owned and trading At December 31, 2005 and 2004, trading securities in the amount of $236.6 million and owned securities sold, but not yet purchased were as follows: $290.5 million, respectively, had been pledged as col- 2004 lateral for the Company’s secured borrowings, repur- chase agreements and securities loaned activities. (Dollars in Thousands) Owned: 2005 Trading securities sold, but not yet purchased repre- sent obligations of the Company to deliver the speci- ﬁed security at the contracted price, thereby creating a liability to purchase the security in the market at pre- vailing prices. The Company is obligated to acquire the securities sold short at prevailing market prices, which may exceed the amount reﬂected on the consol- idated statements of ﬁnancial condition. The Com- pany hedges changes in market value of its trading securities owned utilizing trading securities sold, but not yet purchased, interest rate swaps, futures and exchange-traded options. It is the Company’s practice to hedge a signiﬁcant portion of its trading securities owned. For the years ended December 31, 2005, 2004 and 2003, depreciation and amortization of furniture and equipment, software and leasehold improvements to- taled $18.1 million, $21.4 million and $19.0 million, respectively, and are included in occupancy and equipment on the consolidated statements of operations. Corporate securities: Equity securities Convertible securities Fixed income securities Mortgage-backed securities U.S. government securities Municipal securities Other Sold, but not yet purchased: Corporate securities: Equity securities Convertible securities Fixed income securities Mortgage-backed securities U.S. government securities Municipal securities Other $ 13,260 $ 9,490 9,221 76,733 329,057 26,652 278,156 20,819 93,480 208,494 459,322 37,244 165,435 11,256 $ 753,898 $ 984,721 $ 8,367 $ 59,106 2,572 31,588 157,132 127,833 93 4,619 12,600 155,534 406,621 103,148 – 9,595 $ 332,204 $ 746,604 Note 12 Fixed Assets The following is a summary of ﬁxed assets as of De- cember 31, 2005 and 2004: (Dollars in Thousands) 2005 2004 Furniture and equipment Leasehold improvements Software Projects in process Total Less accumulated depreciation and $ 69,885 $ 82,589 35,007 47,879 1,305 30,538 45,431 6,338 154,076 164,896 amortization 98,952 110,928 $ 55,124 $ 53,968 Note 13 Financing The Company had uncommitted credit agreements with banks totaling $675 million at December 31, 2005, composed of $555 million in discretionary se- cured lines under which no amount was outstanding at December 31, 2005 and 2004, and $120 million in discretionary unsecured lines under which no amount 48 Piper Jaffray Annual Report 2005 Notes to Consolidated Financial Statements The Company’s subordinated debt and short-term was outstanding at December 31, 2005 and 2004. In bank ﬁnancing bear interest at rates based on the addition, the Company has established arrangements to obtain ﬁnancing using as collateral the Company’s London Interbank Offered Rate or federal funds rate. securities held by its clearing bank and by another At December 31, 2005 and 2004, the weighted aver- age interest rate on borrowings was 5.55 percent and broker dealer at the end of each business day. Repur- 3.51 percent, respectively. At December 31, 2005 and chase agreements and securities loaned to other bro- 2004, no formal compensating balance agreements ker dealers are also used as sources of funding. existed, and the Company was in compliance with all debt covenants related to these facilities. The Com- pany recognized and paid to USB and afﬁliates $9.0 million of interest expense related to borrowings for the year ended December 31, 2003. Piper Jaffray has executed a $180 million subordi- nated debt agreement with an afﬁliate of USB, which satisﬁes provisions of Appendix D of Securities and Exchange Commission (‘‘SEC’’) Rule 15c3-1 and has been approved by the NYSE and is therefore allowa- ble in the net capital computation for Piper Jaffray. The entire amount of the subordinated debt will ma- ture in 2008. Note 14 Contingencies, Commitments and Guarantees In the normal course of business, the Company main- tains contingency reserves and enters into various commitments and guarantees, the most signiﬁcant of which are as follows: LEGAL CONTINGENCIES The Company has been the subject of customer com- plaints and also has been named as a defendant in various legal proceedings arising primarily from secu- rities brokerage and investment banking activities, in- cluding certain class actions that primarily allege violations of securities laws and seek unspeciﬁed dam- ages, which could be substantial. Also, the Company is involved from time to time in investigations and proceedings by governmental agencies and self-regula- tory organizations. count its established reserves and the USB indemnity agreement entered into in connection with the spin- off, that pending legal actions, investigations and pro- ceedings will be resolved with no material adverse effect on the ﬁnancial condition of the Company. However, if during any period a potential adverse contingency should become probable or resolved for an amount in excess of the established reserves and indemniﬁcation, the results of operations in that pe- riod could be materially adversely affected. Litigation-related expenses charged to operations in- cluded within other operating expenses were $9.6 mil- lion, $4.4 million, and $16.1 million for the years ended December 31, 2005, 2004 and 2003, respectively. The Company has established reserves for potential CONTRACTUAL COMMITMENTS The Company leases ofﬁce space throughout the losses that are probable and reasonably estimable that may result from pending and potential complaints, United States and one location in London, England. The Company’s only material lease is for its corporate legal actions, investigations and proceedings. In addi- headquarters located in Minneapolis, Minnesota. Ag- tion to the Company’s established reserves, USB has gregate minimum lease commitments under operating agreed to indemnify the Company in an amount up to $17.5 million for certain legal and regulatory matters. leases as of December 31, 2005 are as follows: Approximately $13.4 million of this amount remained available as of December 31, 2005. (Dollars in Thousands) Given uncertainties regarding the timing, scope, vol- ume and outcome of pending and potential litigation, arbitration and regulatory proceedings and other fac- tors, the amounts of reserves are difﬁcult to determine and of necessity subject to future revision. Subject to the foregoing, management of the Company believes, based on its current knowledge, after consultation with outside legal counsel and after taking into ac- 2006 2007 2008 2009 2010 Thereafter $ 27,158 25,540 25,679 24,776 22,784 69,117 $ 195,054 Piper Jaffray Annual Report 2005 49 Notes to Consolidated Financial Statements Total minimum rentals to be received in the future under noncancelable subleases were $2.4 million at December 31, 2005. Rental expense, including operating costs and real es- tate taxes, charged to operations was $29.2 million, $28.1 million and $27.5 million for the years ended December 31, 2005, 2004 and 2003, respectively. VENTURE CAPITAL COMMITMENTS As of December 31, 2005, the Company had commit- ments to invest approximately $13.5 million in lim- ited partnerships that make private equity investments. The commitments will be funded, if called, through the end of the respective investment periods ranging from 2006 to 2011. OTHER COMMITMENTS The Company is a member of numerous exchanges and clearinghouses. Under the membership agree- ments with these entities, members generally are re- quired to guarantee the performance of other members, and if a member becomes unable to satisfy its obligations to the clearinghouse, other members would be required to meet shortfalls. To mitigate these performance risks, the exchanges and clearing- houses often require members to post collateral. The Company’s maximum potential liability under these arrangements cannot be quantiﬁed. However, the like- lihood that the Company would be required to make payments under these arrangements is remote. Ac- cordingly, no liability is recorded in the consolidated ﬁnancial statements for these arrangements. SECURITIES LENDING GUARANTEE As a funding source for the Company, the Company participates in securities lending activities by using customer excess margin securities. The Company in- demniﬁes customers for the difference between the market value of the securities loaned and the market value of the collateral received. These transactions are collateralized with cash. At December 31, 2005, fu- ture payments guaranteed by the Company under these arrangements were approximately $221.9 mil- lion and represent the market value of the customer securities loaned to third parties. At December 31, 2005, the Company received cash of $232.3 million as collateral for these arrangements. The value of this collateral is included on the consolidated statements of ﬁnancial condition within payables to brokers, dealers and clearing organizations. At December 31, 2005, the Company had collateral in excess of the market value of the securities loaned and, therefore, no liability is recorded related to potential future pay- ments made under these guarantees. REIMBURSEMENT GUARANTEE The Company has contracted with a major third- party ﬁnancial institution to act as the liquidity pro- vider for the Company’s tender option bond securi- tized trusts. The Company has agreed to reimburse this party for any losses associated with providing liquidity to the trusts. The maximum exposure to loss at December 31, 2005 and 2004 was $298.5 million and $246.9 million, respectively, representing the out- standing amount of all trust certiﬁcates at those dates. This exposure to loss is mitigated by the underlying bonds in the trusts, which are either AAA or AA rated. These bonds had a market value of approxi- mately $282.0 million and $260.0 million at Decem- ber 31, 2005 and 2004, respectively. The Company believes the likelihood it will be required to fund the reimbursement agreement obligation under any provi- sion of the arrangement is remote, and accordingly, no liability for such guarantee has been recorded in the accompanying consolidated ﬁnancial statements. CONCENTRATION OF CREDIT RISK The Company provides investment, capital-raising and related services to a diverse group of domestic and foreign customers, including governments, corpo- rations, and institutional and individual investors. The Company’s exposure to credit risk associated with the non-performance of customers in fulﬁlling their contractual obligations pursuant to securities transactions can be directly impacted by volatile secu- rities markets, credit markets and regulatory changes. This exposure is measured on an individual customer basis and on a group basis for customers that share similar attributes. To alleviate the potential for risk concentrations, credit limits are established and con- tinually monitored in light of changing customer and market conditions. As of December 31, 2005 and 2004, the Company did not have signiﬁcant concen- trations of credit risk with any one customer or counterparty, or any group of customers or counterparties. 50 Piper Jaffray Annual Report 2005 Note 15 Restructuring Notes to Consolidated Financial Statements The Company recorded a pre-tax restructuring-re- equipment disposed of as part of the restructuring lated expense of $8.6 million in the second quarter of plan. Payments related to terminated lease contracts continue through the original terms of the leases, 2005. The expense was incurred to restructure the Company’s operations as a means to better align its which run for various periods, with the longest lease cost infrastructure with its revenues. The Company determined restructuring charges and related accruals based on a speciﬁc formulated plan. The following table presents a summary of activity with respect to the restructuring-related liability: term running through 2014. The components of these charges are shown below: (Dollars in Thousands) (Dollars in Thousands) Severance and employee-related Lease terminations and asset write-downs Total Balance at December 31, 2004 Provision charged to operating expense Cash outlays Noncash write-downs Balance at December 31, 2005 $4,886 3,709 $8,595 $ – 8,595 (4,432) (1,138) $ 3,025 Severance and employee-related charges included the cost of severance, other beneﬁts and outplacement costs associated with the termination of employees. The severance amounts were determined based on the Company’s severance pay program in place at the time of termination and will be paid out over a beneﬁt period of up to one year from the time of termination. Approximately 100 employees received severance. Lease terminations and asset write-downs represented costs associated with redundant ofﬁce space and Note 16 Shareholders’ Equity The certiﬁcate of incorporation of Piper Jaffray Com- panies provides for the issuance of up to 100,000,000 shares of common stock with a par value of $0.01 per share and up to 5,000,000 shares of undesignated preferred stock with a par value of $0.01 per share. COMMON STOCK The holders of Piper Jaffray Companies common stock are entitled to one vote per share on all matters to be voted upon by the shareholders. Subject to pref- erences that may be applicable to any outstanding preferred stock of Piper Jaffray Companies, the hold- ers of its common stock are entitled to receive ratably such dividends, if any, as may be declared from time to time by the Piper Jaffray Companies board of direc- tors out of funds legally available for that purpose. In the event that Piper Jaffray Companies is liquidated, dissolved or wound up, the holders of its common stock are entitled to share ratably in all assets remain- ing after payment of liabilities, subject to any prior distribution rights of Piper Jaffray Companies pre- ferred stock, if any, then outstanding. The holders of The adequacy of the restructuring-related liability is reviewed regularly, taking into consideration actual payments and projected liabilities. Adjustments are made to increase or decrease the accrual as needed. Reversals of expenses, if any, can reﬂect a lower-than- expected use of beneﬁts by affected employees and changes in initial assumptions as a result of subse- quent events. the common stock have no preemptive or conversion rights or other subscription rights. There are no re- demption or sinking fund provisions applicable to Piper Jaffray Companies common stock. Piper Jaffray Companies does not intend to pay cash dividends on its common stock for the foreseeable fu- ture. Instead, Piper Jaffray Companies intends to retain all available funds and any future earnings for use in the operation and expansion of its business and to repur- chase outstanding common stock to the extent autho- rized by its board of directors. Additionally, as set forth in Note 21, there are dividend restrictions on Piper Jaffray. The Company issued 154,058 shares of the Company’s common stock and reissued 177,376 common shares out of treasury in fulfillment of $13.2 million in obliga- tions under the Piper Jaffray Companies Retirement Plan. In 2005, the board of directors of Piper Jaffray Com- panies authorized the Company to repurchase up to 1.3 million shares of the outstanding common stock Piper Jaffray Annual Report 2005 51 Notes to Consolidated Financial Statements of Piper Jaffray Companies for a maximum aggregate purchase price of $65.0 million. The Company com- pleted the purchase of 1.3 million shares on Octo- ber 4, 2005. Purchases were made on the open market pursuant to a 10b5-1 plan established with an inde- pendent agent. holders of preferred stock. However, the effects might include, among other things, the following: restricting dividends on its common stock, diluting the voting power of its common stock, impairing the liquidation rights of its common stock and delaying or preventing a change in control of Piper Jaffray Companies with- out further action by its shareholders. PREFERRED STOCK RIGHTS AGREEMENT The Piper Jaffray Companies board of directors has Piper Jaffray Companies adopted a rights agreement the authority, without action by its shareholders, to prior to the Distribution date. The issuance of a share of designate and issue preferred stock in one or more Piper Jaffray Companies common stock also constitutes series and to designate the rights, preferences and the issuance of a preferred stock purchase right associ- privileges of each series, which may be greater than ated with such share. These rights are intended to have the rights associated with the common stock. It is not possible to state the actual effect of the issuance of any anti-takeover effects in that the existence of the rights shares of preferred stock upon the rights of holders of may deter a potential acquirer from making a takeover proposal or a tender offer for Piper Jaffray Companies common stock until the Piper Jaffray Companies stock. board of directors determines the speciﬁc rights of the Note 17 Earnings Per Share Basic earnings per common share is computed by di- ber 31, 2003, the date of the Distribution, the viding net income by the weighted average number of weighted average number of common shares out- standing for 2003 was calculated by applying the dis- common shares outstanding for the period. Diluted tribution ratio utilized in the spin-off to USB’s earnings per common share is calculated by adjusting historical weighted average number of common shares the weighted average outstanding shares to assume outstanding for the applicable period. The computa- conversion of all potentially dilutive restricted stock and stock options. Because Piper Jaffray Companies tion of earnings per share is as follows: common stock was not publicly issued until Decem- YEAR ENDED DECEMBER 31, (Amounts in Thousands, Except Per Share Data) Net income Shares for basic and diluted calculations: Average shares used in basic computation Stock options Restricted stock Average shares used in diluted computation Earnings per share: Basic Diluted 2005 2004 2003 $ 40,083 $50,348 $25,999 18,813 19,333 19,237 4 264 19,081 – 66 19,399 – – 19,237 $ $ 2.13 2.10 $ 2.60 $ 1.35 $ 2.60 $ 1.35 The Company has excluded 0.6 million and 0.3 mil- tively, as they represented anti-dilutive stock options. lion options to purchase shares of common stock from There were no anti-dilutive effects for the period en- its calculation of diluted earnings per share for the periods ended December 31, 2005 and 2004, respec- ded December 31, 2003. 52 Piper Jaffray Annual Report 2005 Note 18 Employee Beneﬁt Plans Notes to Consolidated Financial Statements PENSION AND POST-RETIREMENT MEDICAL PLANS component of the plan was operated as a stand-alone plan. The Company expensed $2.9 million, $7.3 mil- lion and $9.5 million related to proﬁt-sharing contri- butions in 2005, 2004 and 2003, respectively. The Company has various employee beneﬁt plans, and substantially all employees are covered by at least one plan. The plans include a tax-qualiﬁed retirement plan with 401(k) and proﬁt-sharing components, a non-qualiﬁed retirement plan, a post-retirement bene- ﬁt plan, and health and welfare plans. During the years ended December 31, 2005, 2004 and 2003, the Certain employees participate in the Piper Jaffray Company incurred employee beneﬁt expenses of Companies Non-Qualiﬁed Retirement Plan, an un- funded, non-qualiﬁed cash balance pension plan. This $26.0 million, $28.2 million and $31.3 million, plan is substantially similar to a non-qualiﬁed cash respectively. balance pension plan maintained by USB, which Com- pany employees participated in prior to the Distribu- RETIREMENT PLAN tion. Effective upon the Distribution, the existing Effective with the Distribution, the Company estab- non-qualiﬁed pension liability relating to Company lished the Piper Jaffray Companies Retirement Plan employees was transferred from the USB cash balance (‘‘Retirement Plan’’), which has two components: a pension plan to the Company’s new plan. As most of deﬁned contribution retirement savings plan and a tax-qualiﬁed, non-contributory proﬁt-sharing plan. in the the Company’s employees participating The deﬁned contribution retirement savings plan al- USB plan were fully vested with respect to their bene- ﬁts, the Company froze the new plan immediately lows qualiﬁed employees, at their option, to make upon establishment, thereby eliminating future bene- contributions through salary deductions under Sec- ﬁts related to pay increases and excluding new partici- tion 401(k) of the Internal Revenue Code. Employee pants from the plan. In 2004, the Company recorded contributions are 100 percent matched by the Com- a $1.1 million pre-tax curtailment gain as a result of pany to a maximum of 4 percent of recognized com- freezing the plan. pensation up to the social security taxable wage base. Although the Company’s matching contribution vests immediately, a participant must be employed on De- cember 31 to receive that year’s matching contribu- tion. The matching contribution can be made in cash or Piper Jaffray Companies common stock, in the Company’s discretion. In 2005, the Company paid out amounts under the plan that exceeded its service cost and interest cost. These payouts triggered settlement accounting under Statement of Financial Accounting Standard No. 88 (‘‘SFAS 88’’), ‘‘Employers’ Accounting for Settlements and Curtailments of Deﬁned Beneﬁt Pension Plans and for Termination Beneﬁts.’’ Therefore, the Com- pany recognized a pre-tax settlement loss of $1.2 mil- lion in 2005. Prior to the Distribution, Company employees partici- pated in a similar USB deﬁned contribution retirement savings plan. Effective upon the Distribution, employ- ees of the Company became inactive participants in the USB plan, similar to terminated employees. All employees of the Company who meet deﬁned age and service requirements are eligible to receive post- retirement health care beneﬁts provided under a post- The tax-qualiﬁed, non-contributory proﬁt-sharing retirement beneﬁt plan established by the Company in component of the Retirement Plan covers substan- 2004. The estimated cost of these retiree health care tially all employees. Company proﬁt-sharing contribu- beneﬁts is accrued during the employees’ active ser- tions are discretionary, subject to some limitations to ensure they qualify as deductions for income tax pur- vice. Prior to the Distribution, Company employees poses. Employees are fully vested after ﬁve years of were eligible for retiree health care beneﬁts as part of a substantially similar USB post-retirement beneﬁt service. Prior to the establishment of the Retirement plan. Plan at the time of the Distribution, the proﬁt-sharing Piper Jaffray Annual Report 2005 53 Notes to Consolidated Financial Statements The Company uses a September 30 measurement date for the pension and post-retirement beneﬁt plans. December 31, 2005 and 2004, is as follows: Financial information on changes in beneﬁt obligation and plan assets funded and balance sheet status as of (Dollars in Thousands) Change in beneﬁt obligation: Beneﬁt obligation at beginning of year Service cost Interest cost Plan participants’ contributions Actuarial loss (gain) Curtailments Settlements Beneﬁts paid Pension Beneﬁts Post-retirement Medical Beneﬁts 2005 2004 2005 2004 $ 29,389 $ 27,254 $ 1,687 $ 1,448 – 1,643 – 1,577 – (5,033) – 1,363 – 2,753 (819) – (26) (1,162) 306 99 – (80) – – – 185 66 – (12) – – – Beneﬁt obligation at measurement date $ 27,550 $ 29,389 $ 2,012 $ 1,687 Change in plan assets: Fair value of plan assets at beginning of year Actual return on plan assets Employer contribution Plan participants’ contributions Settlements Beneﬁts paid $ $ – – $ – – 5,059 – (5,033) 1,162 – – (26) (1,162) Fair value of plan assets at measurement date $ – $ – $ – – – – – – – $ $ – – – – – – – Funded status Adjustment for fourth quarter contributions Unrecognized net actuarial loss Unrecognized prior service cost Net amount recognized Amounts recognized in the Consolidated Statements of Financial Condition: Accrued beneﬁt liability Accumulated other comprehensive loss Net amount recognized Accumulated beneﬁt obligation $ (27,550) $ (29,389) $ (2,012) $ (1,687) 1,217 6,395 – 1,260 6,381 – – 235 (360) – 328 (424) $ (19,938) $ (21,748) $ (2,137) $ (1,783) $ (26,333) $ (28,129) $ (2,137) $ (1,783) 6,395 6,381 – – $ (19,938) $ (21,748) $ (2,137) $ (1,783) $ 27,550 $ 29,389 The minimum pension liability adjustment included in was $3.9 million, which is net of a $2.5 million de- ‘‘other comprehensive loss’’ at December 31, 2005, ferred tax beneﬁt. 54 Piper Jaffray Annual Report 2005 The components of the net periodic beneﬁts costs for the years ended December 31, 2005, 2004 and 2003, are as follows: (Dollars in Thousands) Service cost Interest cost Expected return on plan assets Amortization of prior service cost Amortization of net loss Curtailment gain Net periodic beneﬁt cost The assumptions used in the measurement of our ben- eﬁt obligations as of December 31, 2005 and 2004, are as follows: Discount rate used to determine year-end obligation Discount rate used to determine ﬁscal year expense Expected long-term rate of return on participant balances Rate of compensation increase Health care cost trend rate assumed for next year (pre-medicare/post-medicare) Rate to which the cost trend rate is assumed to decline (the ultimate trend rate) (pre-medicare/post-medicare) Year that the rate reaches the ultimate trend rate (pre-medicare/post-medicare) Notes to Consolidated Financial Statements Pension Beneﬁts Post-retirement Medical Beneﬁts 2005 2004 2003 2005 2004 2003 $ – $ – $ – $ 306 $ 185 $ 246 1,643 1,363 1,817 – – 395 – – (158) 145 (1,124) 99 – 66 – 88 – – (210) (64) (48) (64) 185 – 13 – 22 – 25 – $ 2,038 $ 226 $ 1,792 $ 354 $ 225 $ 295 Pension Beneﬁts Post-retirement Beneﬁts 2005 2004 2005 2004 5.85% 6.00% 6.50% N/A 6.00% 6.20% 6.50% N/A 5.85% 6.00% N/A N/A 2005 6.00% 6.20% N/A N/A 2004 9%/11% 10%/12% 5.0%/5.0% 5.0%/5.0% 2012/2013 2012/2013 The health care cost trend rate assumption does not have a signiﬁcant impact on the Company’s post-re- tirement medical beneﬁt obligations because the Com- pany’s obligations are largely ﬁxed dollar amounts in future years. To illustrate, a one-percentage-point change in assumed health care cost trends would have the following effects: (Dollars in Thousands) Effect on total of service and interest cost Effect on post-retirement beneﬁt obligation 1-Percentage-Point Increase 1-Percentage-Point Decrease $ 1 3 $ (1) (4) The pension plan and post-retirement medical plan do not have assets and are not funded. The Company expects to contribute cash of $4.5 million to the pen- sion plan and $0.2 million to the post-retirement ben- eﬁt plan to fund anticipated withdrawals in 2006. Piper Jaffray Annual Report 2005 55 Notes to Consolidated Financial Statements Pension and post-retirement beneﬁt payments, which HEALTH AND WELFARE PLANS reﬂect expected future service, are expected to be paid Company employees who meet certain work schedule and service requirements are eligible to participate in as follows: the Company’s health and welfare plans. The Com- pany subsidizes the cost of coverage for employees. The medical plan contains cost-sharing features such as deductibles and coinsurance. Post- Retirement Beneﬁts Pension Beneﬁts (Dollars in Thousands) 2006 2007 2008 2009 2010 Thereafter $ 4,494 $ 159 2,739 2,248 2,109 2,272 9,554 201 218 255 263 1,832 $ 23,416 $ 2,928 Note 19 Stock-Based Compensation and Cash Award Program The Company maintains one stock-based compensa- tion plan, the Piper Jaffray Companies Amended and Restated 2003 Annual and Long-Term Incentive Plan. The plan permits the grant of equity awards, includ- ing stock options and restricted stock, to the Com- pany’s employees and directors for up to 4.1 million shares of common stock. In 2004 and 2005, the Com- pany granted shares of restricted stock and options to purchase Piper Jaffray Companies common stock to employees and granted options to purchase Piper Jaf- fray Companies common stock to its non-employee directors. The Company believes that such awards better align the interests of employees with those of shareholders and serve as an employee retention tool. The awards granted to employees have three-year cliff vesting periods. The director awards are fully vested upon grant. The maximum term of the stock option awards granted is ten years. The plan provides for accelerated vesting of option and restricted stock awards if there is a change in control of the Company (as deﬁned in the plan) and in the event of a partici- pant’s death. 56 Piper Jaffray Annual Report 2005 The following table summarizes the Company’s stock options and restricted stock outstanding for the years ended December 31, 2003, 2004 and 2005: Notes to Consolidated Financial Statements Options Outstanding Weighted Average Exercise Price Shares of Restricted Stock Outstanding December 31, 2003 Granted: Stock options Restricted stock Exercised options Vested restricted stock Canceled options Canceled restricted stock December 31, 2004 Granted: Stock options Restricted stock Exercised options Vested restricted stock Canceled options Canceled restricted stock December 31, 2005 Options exercisable at December 31, 2004 Options exercisable at December 31, 2005 Additional information regarding Piper Jaffray Com- panies stock options outstanding as of December 31, 2005, is as follows: Range of Exercise Prices $28.01 $33.40 $39.62 $47.30 – $51.05 – – 322,005 $ 47.49 – – – 25,975 – – – – 47.30 – 296,030 $ 47.50 426,352 $ 38.78 – – – 42.91 – – – – 79,350 – 643,032 21,249 54,041 – – 550,659 – – – 18,774 531,885 – 993,919 – 482 – 107,878 $ 42.29 1,417,444 Options Outstanding Exercisable Options Weighted Average Weighted Average Exercise Price Remaining Contractual Life (Years) 9.3 9.6 9.1 8.1 $ 28.01 $ 33.40 $ 39.62 $ 47.53 Weighted Average Exercise Price $ 28.01 $ 33.40 $ 39.62 $ 50.12 Shares 28,565 4,001 99 21,376 Shares 28,565 4,001 348,378 262,088 Effective January 1, 2004, the Company elected to account for stock-based compensation under the fair value method as prescribed by SFAS 123 and as amended by SFAS 148. Therefore, employee and di- rector stock options granted on and after January 1, 2004, are expensed by the Company on a straight-line basis over the option vesting period, based on the estimated fair value of the award on the date of grant using a Black-Scholes option-pricing model. Re- stricted stock expense is based on the market price of Piper Jaffray Companies stock on the date of the grant and is amortized on a straight-line basis over the vest- ing period. For the years ended December 31, 2005 and 2004, the Company recorded compensation ex- pense, net of estimated forfeitures, of $19.0 million and $8.9 million, respectively, related to employee stock option and restricted stock grants and $0.3 mil- lion in each year in outside services expense related to director stock option grants. Piper Jaffray Annual Report 2005 57 Notes to Consolidated Financial Statements The following table provides a summary of the valua- tion assumptions used by the Company to determine the estimated value of awards of stock options to purchase Piper Jaffray Companies common stock: Weighted average assumptions in option valuation Risk-free interest rates Dividend yield Stock volatility factor Expected life of options (in years) Weighted average fair value of options 2005 3.77% 0.00% 38.03% 5.83 granted $ 16.58 Prior to the Distribution, certain of the Company’s employees were eligible to participate in the stock incentive plans maintained by USB, which included non-qualiﬁed and incentive stock options, restricted stock and other stock-based awards. While part of 2004 USB, the Company applied APB 25 to account for USB employee stock incentive plans. Because the exer- 3.20% cise price of the USB employee stock options equaled 0.00% the market price of the underlying stock on the date of 40.00% the grant, under APB 25 no compensation expense 5.79 was recognized at the grant date. Options granted under the USB plans were generally exercisable up to ten years from the date of grant and vested over three to ﬁve years. Restricted shares vested over three to ﬁve years. Expense for restricted stock was based on the market price of USB stock at the time of the grant and was amortized on a straight-line basis over the vesting period. Expense related to restricted stock grants was $3.9 million in 2003. Based on the USB plans, these options and restricted stock either terminated within 90 days following the Distribution or remained with USB. $ 21.24 In connection with the Company’s spin-off from USB, the Company established a cash award program pur- suant to which it granted cash awards to a broad- based group of employees. The cash award program was intended to aid in retention of employees and to compensate employees for the value of USB stock op- tions and restricted stock lost by employees as a result of the Distribution. The cash awards are being ex- pensed over a four-year period ending December 31, 2007. Participants must be employed on the date of The following table summarizes USB stock options payment to receive the award. Expense related to the and restricted stock outstanding and exercised under cash award program is included as a separate line item various equity plans of USB while the Company’s em- on the Company’s consolidated statements of operations. ployees were employed by USB: December 31, 2002 Exercised Canceled options and canceled/vested restricted stock Options /restricted stock remaining with USB December 31, 2003 Options Outstanding 20,552,381 4,992,438 3,821,652 11,738,291 – Weighted Average Exercise Price Shares of Restricted Stock Outstanding $ 23.47 25.87 24.49 24.19 399,667 – 327,754 71,913 – Pro forma information regarding net income is re- quired to be disclosed by SFAS 123 and has been determined as if the Company had accounted for em- ployee stock option and stock purchase plans (collec- tively, the ‘‘options’’) under the fair value method of SFAS 123. The fair value of the options was estimated at the grant date using a Black-Scholes option-pricing model. The pro forma disclosures include USB options granted to the Company’s employees while employed by USB and therefore should not be viewed as repre- sentative of future years. Furthermore, the value of certain of USB options that terminated as a result of the Distribution were replaced by cash awards to our employees. 58 Piper Jaffray Annual Report 2005 Notes to Consolidated Financial Statements The following table shows pro forma compensation expense, net income and earnings per share adjusted for the impact of applying the fair value method of accounting for stock-based compensation for the year ended December 31, 2003. (Dollars in Thousands, Except Per Share Data) Reported compensation expense Stock-based compensation Pro forma compensation expense Reported net income Stock-based compensation, net of tax Pro forma net income Pro forma earnings per share $ 482,397 21,457 $ 503,854 $ 25,999 (12,874) $ 13,125 $ 0.68 Note 20 Transactions with U.S. Bancorp Prior to the Distribution Prior to the Distribution, the Company regularly en- During 2003, Piper Jaffray repaid its outstanding sub- ordinated debt of $215.0 million and entered into a tered into transactions with USB and its afﬁliates. These transactions resulted in either charges to or re- new subordinated debt agreement of $180.0 million imbursements from the Company, including fees for with an afﬁliate of USB. The Company received capi- referrals and for underwriting and selling USB afﬁli- tal contributions of $37.5 million in 2003 from USB. ated mutual funds, and costs for occupancy, technol- Additionally, the Company made distributions of ogy support and general and administrative services. Royalty fees for the use of the USB brand names and other USB trademarks were charged to the Company by a USB afﬁliate in the amount of $3.9 million for the year ended December 31, 2003. $3.6 million to USB in 2003. Note 21 Net Capital Requirements and Other Regulatory Matters As a registered broker dealer and member ﬁrm of the NYSE, Piper Jaffray is subject to the uniform net capi- tal rule of the SEC and the net capital rule of the NYSE. Piper Jaffray has elected to use the alternative method permitted by the SEC rule, which requires that it maintain minimum net capital of the greater of $1.0 million or 2 percent of aggregate debit balances arising from customer transactions, as such term is deﬁned in the SEC rule. Under the NYSE rule, the NYSE may prohibit a member ﬁrm from expanding its business or paying dividends if resulting net capital would be less than 5 percent of aggregate debit bal- ances. Advances to afﬁliates, repayment of subordi- nated debt, dividend payments and other equity withdrawals by Piper Jaffray are subject to certain notiﬁcation and other provisions of the SEC and NYSE rules. In addition, Piper Jaffray is subject to certain notiﬁcation requirements related to withdraw- als of excess net capital. At December 31, 2005, net capital calculated under the SEC rule was $314.0 million, or 57.0 percent of aggregate debit balances; this amount exceeded the minimum net capital required under the SEC rule by $303.0 million. Piper Jaffray also is registered with the Commodity Futures Trading Commission (‘‘CFTC’’) and therefore is subject to CFTC regulations. Piper Jaffray Ltd., which is a registered United King- dom broker dealer, is subject to the capital require- ments of the Financial Services Authority (‘‘FSA’’). As of December 31, 2005, Piper Jaffray Ltd. was in com- pliance with the capital requirements of the FSA. Piper Jaffray Annual Report 2005 59 Notes to Consolidated Financial Statements Note 22 Income Taxes Income tax expense is provided using the asset and liability method. Deferred tax assets and liabilities are recognized for the expected future tax consequences attributable temporary differences between amounts reported for income tax purposes and ﬁnan- cial statement purposes, using current tax rates. Prior to to the Distribution, income taxes were determined on a separate return basis as if the Company had not been eligible to be included in the consolidated in- come tax return of USB and its afﬁliates. The components of income tax expense are as follows: YEAR ENDED DECEMBER 31, (Dollars in Thousands) Current: Federal State Foreign Deferred: Federal State Total income tax expense A reconciliation of the statutory federal income tax rates to the Company’s effective tax rates for the ﬁscal years ended December 31, is as follows: (Dollars in Thousands) Federal income tax at statutory rates Increase (reduction) in taxes resulting from: State income taxes, net of federal tax beneﬁt Net tax-exempt interest income Other, net Total income tax expense 2005 2004 2003 $ 19,693 $15,008 $17,528 1,695 116 3,839 489 3,429 418 21,504 19,336 21,375 (2,076) 1,595 8,222 1,715 (5,529) (962) (481) 9,937 (6,491) $ 21,023 $29,273 $14,884 2005 2004 2003 $ 21,387 $ 27,867 $ 14,642 2,139 3,610 1,319 (3,426) (3,677) (2,933) 923 1,473 1,856 $ 21,023 $ 29,273 $ 14,884 Deferred income tax assets and liabilities reﬂect the tax effect of temporary differences between the carry- ing amount of assets and liabilities for ﬁnancial re- porting purposes and the amounts used for the same items for income tax reporting purposes. 60 Piper Jaffray Annual Report 2005 The net deferred tax asset included in other assets on the consolidated statements of ﬁnancial condition consisted of the following items at December 31: (Dollars in Thousands) 2005 2004 Deferred tax assets: Liabilities /accruals not currently deductible $ 19,205 $ 20,975 Pension and retirement costs Deferred compensation Partnership investments Other Deferred tax liabilities: Partnership investments Fixed assets Other 10,962 15,108 – 4,406 11,811 9,640 233 4,855 49,681 47,514 440 2,379 270 3,089 – 1,101 296 1,397 Net deferred tax asset $ 46,592 $ 46,117 Note 23 Business Segments Within the Company, ﬁnancial performance is mea- sured by lines of business. The Company’s reportable business segments include Capital Markets, Private Client Services, and Corporate Support and Other. The business segments are determined based upon fac- tors such as the type of customers served, the nature of products and services provided and the distribution channels used to provide those products and services. Certain services that the Company offers are provided to clients through more than one business segment. These business segments are components of the Com- pany about which ﬁnancial information is available and is evaluated on a regular basis in deciding how to allocate resources and assess performance relative to competitors. BASIS FOR PRESENTATION In the ﬁrst quarter of 2005, the Company began to more fully allocate corporate expenses previously in- cluded in Corporate Support and Other to Capital Markets and Private Client Services. This change in how the Company reports segment results was made as a result of the Company completing an extensive study of costs included in Corporate Support and Other to determine how these costs were related to and driven by business activities conducted in the Capital Markets and Private Client Services segments. As a result of this study, certain expenses such as Notes to Consolidated Financial Statements The Company has reviewed the components of the deferred tax assets and has determined that no valua- tion allowance is deemed necessary based on manage- ment’s expectation of future taxable income. As part of the Distribution, the Company entered into a tax-sharing agreement with USB that governs each parties’ responsibilities going forward related to in- come taxes. Pursuant to this agreement, USB generally is responsible for any future liabilities resulting from Internal Revenue Service audits for those years when the Company was part of the USB consolidated in- come tax return. ﬁnance, human resources and other corporate admin- istration are included in the results of the revenue- producing segments. The Company manages and allo- cates resources to its business segments based on these results. In connection with this change, the Company has restated prior period business results to conform to the current period presentation. The restatement does not affect the Company’s aggregate ﬁnancial results. Segment results are derived from the Company’s ﬁ- nancial reporting systems by speciﬁcally attributing customer relationships and their related revenues and expenses to the appropriate segment. Revenue-sharing of sales credits associated with underwritten offerings is based on the distribution channel generating the sales. Expenses directly managed by the business line, including salaries, commissions, incentives, employee beneﬁts, occupancy, marketing and business develop- ment and other direct expenses, are accounted for within each segment’s pre-tax operating income or loss. In addition, operations, technology and other business activities managed on a corporate basis are allocated based on each segment’s use of these func- tions to support its business. Expenses related to costs of being a public company and long-term ﬁnancing are included within Corporate Support and Other. Cash award plan charges related to the Distribution, restructuring-related charges and income taxes are not Piper Jaffray Annual Report 2005 61 Notes to Consolidated Financial Statements assigned to the business segments. The ﬁnancial man- PRIVATE CLIENT SERVICES (‘‘PCS’’) agement of assets, liabilities and capital is performed This segment comprises our retail brokerage business, on an enterprise-wide basis. Net revenues from the which provides ﬁnancial advice and a wide range of ﬁnancial products and services to individual investors Company’s non-U.S. operations were $14.4 million, through our network of branch ofﬁces. Revenues are $11.3 million and $9.2 million for the years ended generated primarily through commissions earned on December 31, 2005, 2004 and 2003, respectively, and equity and ﬁxed income transactions and for distribu- are included in the Capital Markets business segment. tion of mutual funds and annuities, fees earned on fee- Non-U.S. long-lived assets were $1.0 million and based client accounts and net interest from customers’ $0.6 million at December 31, 2005 and 2004, margin loan balances. As of December 31, 2005, PCS respectively. had 842 ﬁnancial advisors operating in 90 branch ofﬁces in 17 Midwest, Mountain and West Coast states. CORPORATE SUPPORT AND OTHER Corporate Support and Other includes costs of being a public company, long-term ﬁnancing costs and the results of the Company’s private equity business, which generates revenues through the management of private equity funds. This segment also includes re- sults related to the Company’s investments in these funds and in venture capital funds. Prior to January 1, 2005, Corporate Support and Other also included the results of the Company’s venture capital business. Ef- fective December 31, 2004, the Company exited this business and the management of the Company’s ven- ture capital funds was transitioned to an independent company. Therefore, the Company no longer earns management fees for those funds. Designations, assignments and allocations may change from time to time as ﬁnancial reporting sys- tems are enhanced and methods of evaluating per- formance change or segments are realigned to better serve the clients of the Company. Accordingly, prior periods are reclassiﬁed and presented on a comparable basis. CAPITAL MARKETS (‘‘CM’’) This segment consists of equity and ﬁxed income insti- tutional sales, trading and research and investment banking services. Revenues are generated primarily through commissions and sales credits earned on eq- uity and ﬁxed income transactions, fees earned on investment banking and public ﬁnance activities, and net interest earned on securities inventories. While CM maintains securities inventories primarily to facil- itate customer transactions, CM also realizes proﬁts and losses from trading activities related to these secu- rities inventories. 62 Piper Jaffray Annual Report 2005 Reportable segment ﬁnancial results for the respective year ended December 31, were as follows: (Dollars in Thousands) Capital Markets Institutional sales Fixed income Equities Total Institutional sales Investment banking Underwriting Fixed income Equities Advisory services Total investment banking Other income Net revenues Operating expenses Segment pre-tax operating income Segment pre-tax operating margin Private Client Services Net revenues Operating expenses Segment pre-tax operating income Segment pre-tax operating margin Corporate Support and Other Net revenues Operating expenses Segment pre-tax operating loss Segment pre-tax operating margin Reconciliation to total income before taxes: Total segment pre-tax operating income Royalty fee Cash award program Restructuring-related expense Total income before tax expense Pre-tax operating margin N/M – Not Meaningful Notes to Consolidated Financial Statements 2005 2004 2003 $ 75,201 $ 84,685 $106,138 114,789 117,272 122,492 189,990 201,957 228,630 67,649 75,026 100,672 62,096 87,505 78,066 64,762 70,202 63,258 243,347 227,667 198,222 2,471 1,678 3,994 435,808 365,222 431,302 363,249 430,846 361,781 $ 70,586 $ 68,053 $ 69,065 16.2% 15.8% 16.0% $ 346,951 $359,668 $355,563 328,670 332,709 347,657 $ 18,281 $ 26,959 $ 7,906 5.3% 7.5% 2.2% $ (7,706) $ 6,528 $ 321 7,254 17,202 8,498 $ (14,960) $ (10,674) $ (8,177) N/M N/M N/M $ 73,907 $ 84,338 $ 68,794 – 4,206 8,595 – 4,717 – 3,911 24,000 – $ 61,106 $ 79,621 $ 40,883 7.9% 10.0% 5.2% Piper Jaffray Annual Report 2005 63 Piper Jaffray Companies SUPPLEMENTAL INFORMATION Quarterly Information (Unaudited) 2005 FISCAL QUARTER (Amounts in Thousands, Except Per Share Data) Total revenues Interest expense Net revenues Non-interest expenses Income before income taxes Net income Earnings per common share Basic Diluted Weighted average number of common shares Basic Diluted 2004 FISCAL QUARTER Total revenues Interest expense Net revenues Non-interest expenses Income before income taxes Net income Earnings per common share Basic Diluted Weighted average number of common shares Basic Diluted First Second Third Fourth $ 187,675 $ 189,380 $ 219,340 $ 218,394 8,607 179,068 167,589 11,479 7,335 0.38 0.38 19,378 19,523 $ $ $ 9,715 179,665 178,073(1) 1,592 9,979 209,361 186,296 23,065 11,435 206,959 181,989 24,970 1,237 $ 15,148 $ 16,363 0.07 0.06(1) $ $ 0.80 0.79 $ $ 0.89 0.87 19,028 19,195 18,841 19,107 18,365 18,850 $ $ $ First Second Third Fourth $ 214,177 $ 214,474 $ 192,737 $ 201,551 4,777 209,400 187,228 22,172 7,171 207,303 186,613 20,690 6,512 186,225 167,650 18,575 6,981 194,570 176,386 18,184 $ 13,790 $ 12,980 $ 11,769 $ 11,809 $ $ 0.71 0.71 $ $ 0.67 0.67 $ $ 0.61 0.61 $ $ 0.61 0.61 19,333 19,366 19,333 19,395 19,333 19,387 19,333 19,445 (1) The second quarter included a pre-tax restructuring charge of $8,595 or $0.29 per diluted share after tax. Market for Piper Jaffray Common Stock and Related Shareholder Matters SHAREHOLDERS STOCK PRICE INFORMATION Our common stock is listed on the New York Stock We had 21,300 shareholders of record and an esti- Exchange under the symbol ‘‘PJC.’’ The following ta- mated 112,000 beneﬁcial owners of our common ble contains historical quarterly price information for the years ended December 31, 2005 and 2004. On February 17, 2006, the last reported sale price of our common stock was $47.90. 2005 FISCAL YEAR stock as of February 17, 2006. High Low DIVIDENDS We do not intend to pay cash dividends on our com- mon stock for the foreseeable future. Instead, we cur- rently intend to retain all available funds and any future earnings for use in the operation and expansion of our business. Our board of directors is free to change our dividend policy at any time. 29.00 28.56 Restrictions on our broker dealer subsidiary’s ability to pay dividends are described in Note 21 to the con- solidated ﬁnancial statements. Low $ 47.18 $ 36.59 26.40 37.67 35.00 41.12 High $ 57.63 $ 41.35 55.55 44.70 49.37 45.23 39.20 37.65 First Quarter Second Quarter Third Quarter Fourth Quarter 2004 FISCAL YEAR First Quarter Second Quarter Third Quarter Fourth Quarter 64 Piper Jaffray Annual Report 2005 Corporate Headquarters Piper Jaffray Companies Mail Stop J09N05 800 Nicollet Mall, Suite 800 Minneapolis, MN 55402 612 303-6000 Company Web Site www.piperjaffray.com Stock Transfer Agent and Registrar Mellon Investor Services LLC acts as transfer agent and registrar for Piper Jaffray Companies and maintains all shareholder records for the company. For questions regarding owned Piper Jaffray Companies stock, stock transfers, address corrections or changes, lost stock certiﬁcates or duplicate mailings, please contact Mellon Investor Services by writing or calling: Mellon Investor Services LLC P.O. Box 3315 South Hackensack, NJ 07606 800 872-4409 Street address for overnight deliveries: 480 Washington Blvd. Jersey City, NJ 07310-1900 Web Site Access to Registrar Shareholders may access their investor statements online 24 hours a day, seven days a week with MLinkSM; for more information, go to www.melloninvestor.com/ISD. E-mail Delivery of Shareholder Materials Piper Jaffray invites its shareholders to join in its commitment to being an environmentally responsible corporation by receiving future shareholder materials electronically. Registered shareholders may sign up for electronic delivery of future proxy statements, proxy cards and annual reports by accessing the Web site www.proxyvote.com and following the instructions to vote. After you have voted your proxy, you will be prompted regarding electronic delivery. Electronic delivery will help Piper Jaffray reduce paper waste and minimize printing and postage costs. This book was printed on paper that contains 30 percent post-consumer waste. Independent Accountants Ernst & Young LLP Common Stock Listing New York Stock Exchange (symbol: PJC) Investor Inquiries Shareholders, securities analysts and investors seeking more information about the company should contact Jennifer A. Olson- Goude, director of Investor Relations, at jennifer.a.olson-goude@pjc.com, 612 303-6277, or the corporate headquarters address. Web Site Access to SEC Reports and Corporate Governance Information Piper Jaffray Companies makes available free of charge on its Web site, www.piperjaffray.com, its annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports ﬁled or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act, as well as all other reports ﬁled by Piper Jaffray Companies with the SEC, as soon as reasonably practicable after it electronically ﬁles them with, or furnishes them to, the SEC. Piper Jaffray Companies also makes available free of charge on its Web site the company’s codes of ethics and business conduct, its corporate governance principles and the charters of the audit, compensation, and nominating and governance committees of the board of directors. Printed copies of these materials will be mailed upon request. Dividends Piper Jaffray Companies does not currently pay cash dividends on its common stock. Certiﬁcations The certiﬁcations by the chief executive ofﬁcer and chief ﬁnancial ofﬁcer of Piper Jaffray Companies required under Section 302 of the Sarbanes-Oxley Act of 2002 have been ﬁled as exhibits to its 2004 Annual Report on Form 10-K. The certiﬁcation by the chief executive ofﬁcer of Piper Jaffray Companies required under Section 303A.12(a) of the corporate governance rules of the New York Stock Exchange has been submitted to the New York Stock Exchange.

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