-------------------------------------------------------------------------------- -------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2003 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM TO COMMISSION FILE NUMBER: 1-10024 BKF CAPITAL GROUP, INC. (Exact name of registrant as specified in its charter) DELAWARE 36-0767530 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) ONE ROCKEFELLER PLAZA, 10020 NEW YORK, NEW YORK (Zip Code) (Address of principal executive offices) (212) 332-8400 (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes [X] No [ ] As of July 31, 2003, 6,654,672 shares of the registrant's common stock, $1.00 par value, were outstanding. -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS BKF CAPITAL GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF FINANCIAL CONDITION (DOLLAR AMOUNTS IN THOUSANDS) JUNE 30, DECEMBER 31, 2003 2002 ----------- ------------ (UNAUDITED) (UNAUDITED) ASSETS Cash and cash equivalents................................... $ 43,008 $ 39,150 Investment advisory and incentive fees receivable........... 21,897 24,146 Investments in securities, at value (cost $304 and $1,304, respectively)............................................. 368 1,047 Investments in affiliated partnerships...................... 10,825 9,382 Prepaid expenses and other assets........................... 3,114 2,120 Fixed assets (net of accumulated depreciation of $4,023 and $3,747, respectively)..................................... 4,632 3,689 Deferred tax asset.......................................... 7,666 5,682 Goodwill (net of accumulated amortization of $8,566)........ 14,796 14,796 Investment advisory contracts (net of accumulated amortization of $49,062 and $45,558, respectively)........ 21,027 24,531 Consolidated affiliated partnerships: Due from broker........................................... -- 31,746 Investments in securities, at value (cost $8,634 and $17,797 respectively).................................. 8,896 17,810 Investments in unaffiliated partnerships.................. 5,221 4,275 -------- -------- Total assets........................................... $141,450 $178,374 ======== ======== LIABILITIES, MINORITY INTEREST AND STOCKHOLDERS' EQUITY Accrued expenses............................................ $ 3,553 $ 5,209 Accrued bonuses............................................. 21,196 31,509 Accrued incentive compensation.............................. 5,757 2,312 Income taxes payable........................................ 2,387 532 Consolidated affiliated partnerships: Securities sold short, at value (proceeds of $0 and $9,450, respectively).................................. -- 9,395 Partner contributions received in advance................. -- 1,150 -------- -------- Total liabilities...................................... 32,893 50,107 -------- -------- Minority interest in consolidated affiliated partnerships... 9,041 26,529 -------- -------- STOCKHOLDERS' EQUITY Common stock, $1 par value, authorized -- 15,000,000 shares, issued and outstanding -- 6,646,602 and 6,641,738 shares, respectively.............................................. 6,647 6,642 Additional paid-in capital.................................. 64,798 64,662 Retained earnings........................................... 28,071 30,434 -------- -------- Total stockholders' equity............................. 99,516 101,738 -------- -------- Total liabilities, minority interest and stockholders' equity.................................................... $141,450 $178,374 ======== ======== See accompanying notes 1 BKF CAPITAL GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (DOLLAR AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED) THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, JUNE 30, ----------------------- ----------------------- 2003 2002 2003 2002 ---------- ---------- ---------- ---------- REVENUES: Investment advisory fees..................... $ 14,421 $ 16,450 $ 28,251 $ 33,394 Incentive fees and allocations............... 8,697 5,644 15,563 9,041 Commission income -- net..................... 496 629 989 1,409 Net realized and unrealized gain (loss) on investments................................ 405 (194) 506 (110) Interest and dividend income................. 145 164 229 316 From consolidated affiliated partnerships: Net realized and unrealized gain (loss) on investments............................. 861 (3,558) 1,165 (3,704) Interest and dividend income............... 82 299 214 528 ---------- ---------- ---------- ---------- Total revenues.......................... 25,107 19,434 46,917 40,874 ---------- ---------- ---------- ---------- EXPENSES: Employee compensation and benefits........... 18,521 15,358 34,493 29,841 Occupancy & equipment rental................. 1,534 1,482 3,178 2,903 Other operating expenses..................... 3,155 4,043 6,188 7,142 Other operating expenses from consolidated affiliated partnerships.................... 37 89 107 171 Amortization of intangibles.................. 1,752 1,752 3,504 3,504 ---------- ---------- ---------- ---------- Total expenses.......................... 24,999 22,724 47,470 43,561 ---------- ---------- ---------- ---------- Operating income (loss)...................... 108 (3,290) (553) (2,687) Minority interest in consolidated affiliated partnerships............................... (585) 2,949 (822) 2,980 ---------- ---------- ---------- ---------- Income (loss) before taxes................... (477) (341) (1,375) 293 ---------- ---------- ---------- ---------- Income tax expense........................... 597 654 988 1,704 ---------- ---------- ---------- ---------- NET (LOSS)................................... $ (1,074) $ (995) $ (2,363) $ (1,411) ========== ========== ========== ========== Earnings (loss) per share: Basic and Diluted.......................... $ (0.16) $ (0.15) $ (0.36) $ (0.21) ========== ========== ========== ========== Weighted average shares outstanding Basic and Diluted.......................... 6,646,055 6,618,731 6,644,992 6,615,566 ========== ========== ========== ========== See accompanying notes 2 BKF CAPITAL GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (DOLLAR AMOUNTS IN THOUSANDS) (UNAUDITED) SIX MONTHS ENDED JUNE 30, ----------------- 2003 2002 ------- ------- CASH FLOWS FROM OPERATING ACTIVITIES Net (loss).................................................. $(2,363) $(1,411) Adjustments to reconcile net (loss) to net cash provided by (used in) operations: Depreciation and amortization............................. 4,192 4,022 Compensation expense for vesting of restricted stock units.................................................. 3,636 660 Tax benefit related to employee compensation plans........ -- 218 Unrealized (gain) loss on investments in securities....... (320) 397 Changes in operating assets and liabilities: Decrease in investment advisory and incentive fees receivable............................................ 2,249 10,212 (Increase) decrease in prepaid expenses and other assets................................................ (996) 558 Decrease in investments in affiliated investment partnerships.......................................... 4,150 12,805 Decrease in investments in securities.................. 999 1,174 (Increase) in deferred tax asset....................... (1,984) (1,236) (Decrease) in accrued expenses......................... (1,619) (344) (Decrease) in accrued bonuses.......................... (10,313) (19,145) Increase (decrease) in income taxes payable............ 1,855 (1,187) Changes in operating assets and liabilities from consolidated affiliated partnerships: Minority interest in income (loss)..................... 823 (2,991) Decrease in due from broker............................ 15,118 -- (Increase) decrease in securities...................... 3,549 (64,204) (Increase) in investments in unaffiliated partnerships.......................................... (946) (4,740) Increase (decrease) in securities sold short........... (3,076) 7,701 Minority interest in previously unconsolidated affiliated partnerships............................... -- 38,208 ------- ------- Net cash provided by (used in) operating activities......... 14,954 (19,303) ------- ------- CASH FLOWS FROM INVESTING ACTIVITIES Fixed asset additions....................................... (1,631) (720) ------- ------- Net cash (used in) investing activities..................... (1,631) (720) ------- ------- CASH FLOWS FROM FINANCING ACTIVITIES Payment of loan principal................................... -- (186) Issuance of common stock.................................... (50) 226 Consolidated affiliated partnerships: Partner subscriptions..................................... 2,785 18,003 Partner redemptions....................................... (12,200) (6,098) ------- ------- Net cash provided by (used in) financing activities......... (9,465) 11,945 ------- ------- Net increase (decrease) in cash and cash equivalents........ 3,858 (8,078) Cash and cash equivalents at the beginning of the period.... 39,150 41,827 ------- ------- Cash and cash equivalents at the end of the period.......... $43,008 $33,749 ======= ======= SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION Cash paid for interest...................................... $ -- $ 5 ======= ======= Cash paid for taxes......................................... $ 1,597 $ 3,946 ======= ======= See accompanying notes 3 BKF CAPITAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ORGANIZATION AND BASIS OF PRESENTATION The consolidated interim financial statements of BKF Capital Group, Inc. (formerly Baker, Fentress & Company, hereto referred to as "BKF" or the "Company") and its subsidiaries included herein have been prepared in accordance with generally accepted accounting principles for interim financial information and Rule 10-01 of Regulation S-X. Accordingly, they do not include all the information and footnotes required by generally accepted accounting principles for complete financial statements. These consolidated financial statements are unaudited and should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2002. The Company follows the same accounting policies in the preparation of interim reports. In the opinion of management, the consolidated financial statements reflect all adjustments, which are of a normal recurring nature, necessary for a fair presentation of the financial condition, results of operations and cash flows of the Company for the interim periods presented and are not necessarily indicative of a full year's results. In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the amounts reported in the financial statements. Actual results could differ from those estimates. The Company operates through a wholly-owned subsidiary, Levin Management Co., Inc. and its subsidiaries, all of which are referred to as "Levco". The Company trades on the New York Stock Exchange, Inc. ("NYSE") under the symbol "BKF". The Consolidated Financial Statements of Levco include its wholly-owned subsidiary, John A. Levin & Co., Inc. ("JALCO"), JALCO's two wholly-owned subsidiaries, Levco GP Inc. ("Levco GP") and LEVCO Securities, Inc. ("LEVCO Securities") and certain affiliated investment partnerships for which the Company is deemed to have controlling interest of the applicable partnership. Two investment partnerships were consolidated at June 30, 2003 and five were consolidated at December 31, 2002. In addition, the operations of two investment partnerships (which were terminated in March 2003) were included in the consolidated statements of operations and cash flows for the six month period ended June 30, 2003. The operations of one additional investment partnership (which was terminated in September 2002) was included in the consolidated statement of operations and cash flows for the six months ended June 30, 2002. All intercompany transactions have been eliminated in consolidation. JALCO is an investment advisor registered under the Investment Advisers Act of 1940, as amended, which provides investment advisory services to its clients which include U.S. and foreign corporations, mutual funds, limited partnerships, universities, pension and profit sharing plans, individuals, trusts, not-for-profit organizations and foundations. JALCO also participates in broker consulting programs (Wrap Accounts) with several nationally recognized financial institutions. LEVCO Securities is registered with the SEC as a broker-dealer and is a member of the National Association of Securities Dealers, Inc. Levco GP acts as the managing general partner of several affiliated investment partnerships and is registered with the Commodities Futures Trading Commission as a commodity pool operator. REVENUE RECOGNITION Generally, investment advisory fees are billed quarterly, in arrears, and are based upon a percentage of the market value of each account at the end of the quarter. Wrap account fees are billed quarterly based upon a percentage of the market value of each account as of the previous quarter end. Incentive fees, general partner incentive allocations earned from affiliated investment partnerships, and incentive fees from other accounts are accrued on a quarterly basis and are billed quarterly or at the end of their respective contract year, as 4 BKF CAPITAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (UNAUDITED) applicable. Such accruals may be reversed as the result of subsequent investment performance prior to the conclusion of the applicable contract year. Commissions earned on securities transactions executed by LEVCO Securities and related expenses are recorded on a trade-date basis. REVENUE RECOGNITION POLICIES FROM CONSOLIDATED AFFILIATED PARTNERSHIPS ("CAP") Marketable securities owned and securities sold short, are valued at independent market prices with the resultant unrealized gains and losses included in operations. Security transactions are recorded on a trade date basis. Interest income and expense are accrued as earned or incurred. Dividend income and expense are recorded on the ex-dividend date. COMPREHENSIVE INCOME The Company has not presented consolidated statements of comprehensive income in accordance with SFAS No. 130 "Reporting Comprehensive Income," because it does not have any items of "other comprehensive income". INVESTMENTS IN AFFILIATED INVESTMENT PARTNERSHIPS Levco GP serves as the managing general partner for several affiliated investment partnerships ("AIP"), which primarily engage in the trading of publicly traded equity securities. The financial condition and results of operations of the AIP are not included in the Company's consolidated statements of financial condition with the exception of Levco GP's equity ownership and certain partnerships whereby Levco GP is deemed to have a controlling interest in the partnership (see note 4). The limited partners of the AIP have the right to redeem their partnership interests at least quarterly. Additionally, the unaffiliated limited partners of the AIP may terminate Levco GP as the general partner of the AIP at any time. Levco GP does not maintain control over the unconsolidated AIP, has not guaranteed any of the AIP obligations, nor does it have any contractual commitments associated with them. Investments in unconsolidated AIP held through Levco GP, are recorded based upon the equity method of accounting. This investment amount in the unconsolidated AIP equals the sum total of Levco GP's capital accounts, including incentive allocations, in the AIP. Each AIP values their underlying investments in accordance with policies as described in each of their audited financial statements and underlying offering memoranda. It is the Company's general practice to withdraw the incentive allocations earned from the AIP within three months after the fiscal year end. Levco GP has general partner liability with respect to its interest in each of the AIP and has no assets in the AIP other than its interest in these partnerships. INCOME TAXES The Company accounts for income taxes under the liability method prescribed by Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes." Deferred tax assets and liabilities are recognized for the future tax consequences attributable to the differences between the financial statement carrying amount of existing assets and liabilities and their respective tax basis. Future tax benefits are recognized only to the extent that realization of such benefits is more likely than not to occur. 5 BKF CAPITAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (UNAUDITED) INTANGIBLE ASSETS The cost in excess of net assets of Levco acquired by BKF in June 1996 is reflected as goodwill, investment advisory contracts, and employment contracts (which have been fully amortized) in the Consolidated Statements of Financial Condition. Through December 31, 2001, goodwill was amortized straight line over 15 years. Effective January 1, 2002 the Company adopted SFAS No. 142, "Goodwill and Other Intangible Assets". Under the new rules, goodwill is no longer amortized but is subject to an impairment test at least annually or when indicators of potential impairment exist in accordance with SFAS No. 142. Other intangible assets with finite lives are amortized over their useful lives. EARNINGS PER SHARE Basic (loss) per share is calculated by dividing net (loss) by the weighted average number of common shares outstanding during the period. Diluted (loss) per share is computed by dividing net (loss) by the total of the weighted average number of shares of common stock outstanding and common stock equivalents. Diluted (loss) per share is computed using the treasury stock method. The following table sets forth the computation of basic and diluted (loss) per share (in thousands, except per share data). THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, JUNE 30, ----------------------- ----------------------- 2003 2002 2003 2002 ---------- ---------- ---------- ---------- Net (loss)........................... $ (1,074) $ (995) $ (2,363) $ (1,411) ========== ========== ========== ========== Basic and Diluted weighted-average shares outstanding................. 6,646,055 6,618,731 6,644,992 6,615,566 ========== ========== ========== ========== Basic and diluted (loss) per share:............................. $ (0.16) $ (0.15) $ (0.36) $ (0.21) ========== ========== ========== ========== In calculating diluted (loss) per share for the three and six months ended June 30, 2003 and 2002, common stock equivalents of 2,231,136 and 1,480,922, respectively, were excluded due to their anti-dilutive effect on the calculations. STOCK-BASED COMPENSATION The Company follows SFAS No. 123, "Accounting for Stock-Based Compensation," and has adopted the intrinsic value method under APB Opinion No. 25, "Accounting for Stock Issued to Employees," for all arrangements under which employees receive shares of stock or other equity instruments of the Company, or if the Company incurs liabilities to employees in amounts based on the price of its stock. Under APB Opinion No. 25, no compensation costs were recognized relating to the option grants because the exercise prices of the options awarded were equal to the fair market price of the common stock on the dates of the grants. In December 2002, the Financial Accounting Standards Board ("FASB") Issued SFAS No. 148, "Accounting for Stock-Based Compensation-Transition and Disclosure, an amendment of FASB Statement No. 123." SFAS No. 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation and amends the disclosure requirements of SFAS No. 123 to require prominent disclosures about the method of accounting for stock-based compensation. The Company has elected to apply the disclosure provisions of SFAS No. 123. See note 6 for 2003 RSU activity. 6 BKF CAPITAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (UNAUDITED) The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123 (dollar amounts in thousands, except per share amounts): THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, JUNE 30, ------------------- ----------------- 2003 2002 2003 2002 -------- -------- ------- ------- Net (loss), as reported........................ $(1,074) $ (995) $(2,363) $(1,411) Add: Stock-based employee compensation expense included in reported net (loss), net of related tax effects.......................... 1,142 210 1,948 365 Deduct: Total stock-based employee compensation expense determined under the fair value based method for all awards, net of related tax effects...................................... (1,162) (414) (2,007) (786) ------- ------- ------- ------- Pro forma net (loss)........................... $(1,094) $(1,199) $(2,422) $(1,832) ======= ======= ======= ======= Earnings per share: Basic and diluted -- as reported............. $ (0.16) $ (0.15) $ (0.36) $ (0.21) ======= ======= ======= ======= Basic and diluted -- pro forma............... $ (0.16) $ (0.18) $ (0.36) $ (0.28) ======= ======= ======= ======= SIGNIFICANT ACCOUNTING POLICIES OF CONSOLIDATED AFFILIATED PARTNERSHIPS ("CAP") Securities sold short represent obligations to deliver the underlying securities sold at prevailing market prices and option contracts written represent obligations to purchase or deliver the specified security at the contract price. The future satisfaction of these obligations may be at amounts that are greater or less than that recorded on the consolidated statements of financial condition. The CAP monitors their positions continuously to reduce the risk of potential loss due to changes in market value or failure of counterparties to perform. Investments in Unaffiliated Investment Partnerships The Company's investments in unaffiliated investment partnerships result from the consolidation of an affiliated investment partnership that invests in unaffiliated investment partnerships. Investments in unaffiliated investment partnerships are recorded at fair value, which generally is equal to the CAP pro rata interest in the net assets of each unaffiliated investment partnership (based upon the net asset values reported by the unaffiliated investment partnerships). Minority Interest Minority interests in the accompanying consolidated statements of financial condition represent the minority owners' share of the equity of consolidated investment partnerships as of the consolidated statements of financial condition dates. Minority interest in the accompanying consolidated statements of operations represents the minority owners' share of the income or loss of consolidated investment partnerships. Partner contributions and withdrawals Typically, Partner contributions are accepted monthly and withdrawals are made quarterly with the required notification period having been met. The notification period ranges from thirty to sixty days. 7 BKF CAPITAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (UNAUDITED) RECLASSIFICATIONS Certain prior period amounts reflect reclassifications to conform to current period presentation. RECENT ACCOUNTING DEVELOPMENTS In April 2003, the FASB issued SFAS No. 149 "Amendment of Statement 133 on Derivative Instruments and Hedging Activities." SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003, and hedging relationships designated after June 30, 2003. The Company does not believe that the adoption of this statement would have a material impact on the Company's financial statements. In May 2003, the FASB issued SFAS No. 150 "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity." SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period after June 15, 2003. Under SFAS No. 150 certain financial instruments shall be classified as a liability on the issuer's financials statements. The Company does not believe that the adoption of this statement would have a material impact on the Company's financial statements. 2. OFF-BALANCE SHEET RISK LEVCO Securities acts as an introducing broker and all transactions for its customers are cleared through and carried by a major U.S. securities firm on a fully disclosed basis. LEVCO Securities has agreed to indemnify its clearing broker for losses that the clearing broker may sustain from the customer accounts introduced by LEVCO Securities. In the ordinary course of its business, LEVCO Securities does not accept orders with respect to client accounts if the funds required for the client to meet its obligations are not on deposit in the client account at the time the order is placed. In the event a customer is unable to fulfill its contractual obligation to the clearing broker, LEVCO Securities may be exposed to off-balance sheet risk. In the normal course of business, the consolidated affiliated investment partnerships enter into transactions in various financial instruments, including derivatives, for trading purposes, in order to reduce their exposure to market risk. These transactions include option contracts and securities sold short. Substantially all of the CAP cash and securities positions are deposited with one clearing broker for safekeeping purposes. The broker is a member of major securities exchanges. 3. INVESTMENT ADVISORY AND INCENTIVE FEES RECEIVABLE Included in investment advisory and incentive fees receivable are approximately $12.3 million and $2.9 million of accrued incentive fees as of June 30, 2003 and December 31, 2002, respectively, for which the full contract measurement period has not been reached. The Company has provided for the applicable expenses relating to this revenue. If the accrued incentive fees are not ultimately realized, a substantial portion of the related accrued expenses will be reversed. 4. CONSOLIDATION OF CAP In January 2003, the FASB issued FIN No. 46, "Consolidation of Variable Interest Entities." FIN No. 46 addresses the application of Accounting Research Bulletin No. 51, "Consolidated Financial Statements," to variable interest entities ("VIE"). The interpretation provides a framework for determining whether an entity should be evaluated for consolidation based on voting interests or significant financial support provided to the entity ("variable interests"). FIN 46 generally would require that the assets, liabilities and results of operations of a VIE be consolidated into the financial statements of the enterprise that is the primary beneficiary. 8 BKF CAPITAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (UNAUDITED) An entity is classified as a VIE if (a) total equity is not sufficient to permit the entity to finance its activities without additional subordinated financial support or (b) its equity investors lack (i) the direct or indirect ability to make decisions about an entity's activities through voting rights or absorb the expected losses of the entity if they occur or (ii) the right to receive the expected residual returns of the entity if they occur. Once an entity is determined to be a VIE, its assets, liabilities and results of operations should be consolidated with those of its primary beneficiary. The primary beneficiary of a VIE is the entity which either will absorb a majority of the VIE's expected losses or has the right to receive a majority of the VIE's expected residual returns. The expected losses and residual returns of a VIE include expected variability in its net income or loss, fees to decision makers and fees to guarantors of substantially all VIE assets or liabilities. A public enterprise with a variable interest in a VIE created before January 31, 2003, shall apply FIN No. 46 to that VIE as of the beginning of the first interim or annual reporting period beginning after June 15, 2003. The Company has elected to adopt FIN No. 46 for the applicable periods presented. In the context of making determinations pursuant to FIN No. 46, BKF has also decided to consolidate certain affiliated investment partnerships in which it may be deemed to have a controlling interest. As of June 30, 2003 and December 31, 2002, the Company is deemed to have control of two and five affiliated limited partnerships, respectively. The assets, liabilities and related operations of these partnerships and related minority interests have been reflected in the consolidated financial statements for the periods the Company was deemed to have control. The consolidation of these partnerships does not impact the Company's equity or net income. Levco GP has general partner liability with respect to its interest in each of the CAP. 9 BKF CAPITAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (UNAUDITED) The following tables represent the consolidation of the CAP with BKF as of June 30, 2003 and December 31, 2002 (dollar amounts in thousands): JUNE 30, 2003 ------------------------------------------------------- BKF CAP ELIMINATIONS CONSOLIDATED ----------- ----------- ------------ ------------ (UNAUDITED) (UNAUDITED) (UNAUDITED) ASSETS Cash and cash equivalents........................ $ 42,935 $ 73 $ -- $ 43,008 Investment advisory and incentive fees receivable..................................... 21,908 -- (11) 21,897 Investments in securities, at value (cost $304).......................................... 368 -- -- 368 Investments in affiliated partnerships........... 15,948 -- (5,123) 10,825 Prepaid expenses and other assets................ 3,057 57 -- 3,114 Fixed assets (net of accumulated depreciation of $4,023)........................................ 4,632 -- -- 4,632 Deferred tax asset............................... 7,666 -- -- 7,666 Goodwill (net of accumulated amortization of $8,566)........................................ 14,796 -- -- 14,796 Investment advisory contracts (net of accumulated amortization of $49,062)....................... 21,027 -- -- 21,027 Consolidated affiliated partnerships: Investments in securities, at value (cost $8,634)..................................... -- 8,896 -- 8,896 Investments in unaffiliated partnerships....... -- 5,221 -- 5,221 -------- ------- -------- -------- Total assets................................... $132,337 $14,247 $ (5,134) $141,450 ======== ======= ======== ======== Liabilities, Minority Interest and Stockholders' Equity Accrued expenses................................. $ 3,481 $ 83 $ (11) $ 3,553 Accrued bonuses.................................. 21,196 -- -- 21,196 Accrued incentive compensation................... 5,757 -- -- 5,757 Income taxes payable............................. 2,387 -- -- 2,387 -------- ------- -------- -------- Total liabilities.............................. 32,821 83 (11) 32,893 -------- ------- -------- -------- Minority interest in consolidated affiliated partnerships................................... -- -- 9,041 9,041 -------- ------- -------- -------- STOCKHOLDERS' EQUITY Common stock, $1 par value, authorized -- 15,000,000 shares, issued and outstanding -- 6,646,602....................... 6,647 -- -- 6,647 Additional paid-in capital....................... 64,798 -- -- 64,798 Retained earnings................................ 28,071 -- -- 28,071 Capital from consolidated affiliated partnerships................................... -- 14,164 (14,164) -- -------- ------- -------- -------- Total stockholders' equity..................... 99,516 14,164 (14,164) 99,516 -------- ------- -------- -------- Total liabilities, minority interest and stockholders' equity........................... $132,337 $14,247 $ (5,134) $141,450 ======== ======= ======== ======== 10 BKF CAPITAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (UNAUDITED) DECEMBER 31, 2002 ----------------------------------------------------- BKF CAP ELIMINATIONS CONSOLIDATED --------- ----------- ------------ ------------ (AUDITED) (UNAUDITED) (UNAUDITED) ASSETS Cash and cash equivalents........................ $ 39,100 $ 50 $ -- $ 39,150 Investment advisory and incentive fees receivable..................................... 24,177 -- (31) 24,146 Investments in securities, at value (cost $1,304)........................................ 1,047 -- -- 1,047 Investments in affiliated partnerships........... 26,148 -- (16,766) 9,382 Prepaid expenses and other assets................ 2,008 112 -- 2,120 Fixed assets (net of accumulated depreciation $3,747)........................................ 3,689 -- -- 3,689 Deferred tax asset............................... 5,682 -- -- 5,682 Goodwill (net of accumulated amortization of $8,566)........................................ 14,796 -- -- 14,796 Investment advisory contracts (net of accumulated amortization of $45,558)....................... 24,531 -- -- 24,531 Consolidated affiliated partnerships: Due from broker................................ -- 31,746 -- 31,746 Investments in securities at value (cost $17,797).................................... -- 17,810 -- 17,810 Investments in unaffiliated partnerships....... -- 4,275 -- 4,275 -------- ------- -------- -------- Total assets................................ $141,178 $53,993 $(16,797) $178,374 ======== ======= ======== ======== LIABILITIES, MINORITY INTEREST AND STOCKHOLDERS' EQUITY Accrued expenses................................. $ 5,087 $ 153 $ (31) $ 5,209 Accrued bonuses.................................. 31,509 -- -- 31,509 Accrued incentive compensation................... 2,312 -- -- 2,312 Income taxes payable............................. 532 -- -- 532 Consolidated affiliated partnerships: Securities sold short from, at value (proceeds of $9,450)........................................ -- 9,395 -- 9,395 Partner contributions received in advance........ -- 1,150 -- 1,150 -------- ------- -------- -------- Total liabilities........................... 39,440 10,698 (31) 50,107 -------- ------- -------- -------- Minority interest in consolidated affiliated partnerships................................... -- -- 26,529 26,529 -------- ------- -------- -------- STOCKHOLDERS' EQUITY Common stock, $1 par value, authorized -- 15,000,000 shares, issued and outstanding -- 6,646,602 and 6,641,738 shares, respectively................................... 6,642 -- -- 6,642 Additional paid-in capital....................... 64,662 -- -- 64,662 Retained earnings................................ 30,434 -- -- 30,434 Capital from consolidated affiliated partnerships................................... -- 43,295 (43,295) -- -------- ------- -------- -------- Total stockholders' equity.................. 101,738 43,295 (43,295) 101,738 -------- ------- -------- -------- Total liabilities, minority interest and stockholders' equity........................... $141,178 $53,993 $(16,797) $178,374 ======== ======= ======== ======== 11 BKF CAPITAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (UNAUDITED) 5. INVESTMENTS IN AFFILIATED INVESTMENT PARTNERSHIPS AND RELATED REVENUE Summary financial information, including the Company's carrying value and income from the non-consolidated AIP is as follows (dollar amounts in thousands): JUNE 30, 2003 --------- Total AIP assets............................................ $ 919,058 Total AIP liabilities....................................... (244,016) Total AIP equity balance.................................... 675,042 AIP net earnings............................................ 12,119 Company's carrying value (including incentive fees)......... 10,825 Company's income on invested capital (excluding accrued incentive fees)........................................... 420 Included in investments in AIP at June 30, 2003 are accrued but unearned incentive allocations approximating $4.2 million and $7.4 million of earned incentive allocations at December 31, 2002. Included in the Company's incentive fees and general partner incentive allocations are approximately $1.8 million and $1.6 million payable directly to employee owned and controlled entities ("Employee Entities") for the three months ended June 30, 2003 and 2002, and $3.4 million and $2.4 million for the six moths ended June 30,2003 and 2002, respectively. These amounts are included in the Company's carrying value of the AIP at the end of the applicable period. These Employee Entities, which serve as non-managing general partners of several AIP, also bear the liability for all compensation expense relating to the allocated revenue, amounting to approximately $1.8 million and $1.6 million for the three months ended June 30, 2003 and 2002, and $3.4 million and $2.4 million for the six months ended June 30, 2003 and 2002,respectively. These amounts are included in the Consolidated Statement of Operations. The Company recorded investment advisory fees and incentive allocations/fees from affiliated domestic investment partnerships and affiliated offshore investment vehicles of approximately $13.4 million and $9.7 million for the three months ended June 30, 2003, and 2002, and $ 24.4 million and $15.2 million for the six months ended June 30, 2003 and 2002, respectively. Included in investment advisory and incentive fees receivable at June 30, 2003 and December 31, 2002 are $2.4 million and $2.7 million, respectively, of advisory fees from AIP and sponsored offshore vehicles. Also included in investment advisory and incentive fees receivable are $12.1 million and $13.1 million of incentive fees from sponsored offshore investment vehicles (similar to several domestic AIP) at June 30, 2003 and December 31, 2002, respectively. 6. INCOME TAXES The Company's provision for income taxes differs from the amount of income tax determined by applying the applicable U.S. federal statutory income tax rate principally due to state and local taxes and non-deductible amortization. The Company has determined that the amortization expense on intangible assets is non-deductible since the purchase method of accounting has been applied retroactive to June 1996. Deferred tax assets arise from the future tax benefit on deferred and non-cash compensation, unrealized losses on investments, depreciation and utilization of capital losses. Deferred tax liabilities arise from deferred revenues, unrealized gains on investments, and state and local taxes. 12 BKF CAPITAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (UNAUDITED) 7. NON-CASH TRANSACTIONS (INCLUDING RESTRICTED STICK UNITS ("RSU") ACTIVITY) On December 11, 2002 the Company issued a tender offer to exchange 333,308 outstanding options for RSU, on a three for one exchange basis. As of January 10, 2003 the tender offer was complete, with a total of 111,105 RSU being granted in exchange for the options tendered. The RSU will vest in two annual installments with fifty percent (50%) vesting on December 31, 2003 and fifty percent (50%) vesting on December 31, 2004. The Company will recognize $2.0 million of compensation expense related to the RSU over the two-year vesting period. In January 2003, the Company granted 10,500 RSU to non-employee directors of the Company with a value of approximately $192,000. This amount will be used to reduce cash payments for Board of Directors and Committee meetings. In addition, certain executive officers of the Company, who are subject to performance based criteria with regard to their 2002 compensation, and several employees were granted 347,365 RSU as of March 2003 with a value of approximately $5.7 million. In May 2003, the Company granted 165,700 RSU to several employees with a value of approximately $2.7 million. In May 2003, the Company granted 1,125 RSU to a newly elected non-employee director of the Company with a value of approximately $18,000. This amount will be used to reduce cash payments for Board of Directors and Committee meetings. After giving effect for the 2003 RSU activity, the Company has approximately 225,000 shares available for future grants under the Incentive Compensation plan as of June 30, 2003. In addition, the Company has the authority to buy back up to 700,000 shares of BKF stock in the open market which may be used as compensation under the Incentive Compensation plan (subject to Board approval). In November 2003, 643,257 RSU are due to be delivered of which 449,929 were elected to be deferred until November 2004 under the Company's employee compensation plan. In January 2002, the Company granted a total of 168,213 RSU to employees with a value of approximately $4.7 million. 13 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS INTRODUCTION BKF Capital Group, Inc. ("BKF") operates entirely through John A. Levin & Co., Inc., an investment adviser registered with the U.S. Securities and Exchange Commission. The investment adviser is a wholly owned subsidiary of Levin Management Co., Inc., which in turn is a wholly owned subsidiary of BKF. Levin Management Co., Inc. and its subsidiaries are referred to collectively as "Levco." Levco specializes in managing equity portfolios for institutional and individual investors. Most accounts are managed pursuant to value equity strategies; Levco also offers a range of alternative investment products as well as other more specialized investment programs. Most clients are based in the United States, though a significant portion of investors in the alternative investment products are located outside the United States. Levco acts as the managing general partner of several investment partnerships and also acts as an adviser to private investment vehicles organized outside the United States. With respect to accounts managed pursuant to its value equity strategies, Levco generally receives advisory fees based on a percentage of the market value of assets under management, including market appreciation or depreciation and client contributions and withdrawals. In some cases, Levco receives performance-based fees from accounts pursuing value equity strategies. With respect to private investment vehicles and separate accounts managed pursuant to similar strategies, Levco is generally entitled to receive both a fixed management fee based on a percentage of the assets under management and a share of net profits. Levco obtains some of its clients for its large cap value products through wrap fee programs sponsored by major financial services companies. In these programs, clients pay the sponsoring broker an asset-based fee that covers brokerage commissions, advisory services, custodial fees, and other reporting and administrative services. Investors are able to select Levco from among a limited number of managers participating in the program, and Levco receives a portion of the asset-based fee paid by the clients who select Levco to manage their accounts through the program. At June 30, 2003, assets under management were $11.56 billion, down from $13.02 billion a year earlier. Following is a comparison of assets under management (in millions) as defined by product and client type: JUNE 30, MARCH 31, DECEMBER 31, SEPTEMBER 30, JUNE 30, 2003 2003 2002 2002 2002 -------- --------- ------------ ------------- -------- VALUE EQUITY ACCOUNTS: Institutional................. $ 2,704 $ 2,372 $ 2,562 $ 2,526 $ 3,063 Sub-Advisory.................. 1,991 1,771 1,861 1,730 2,049 Non-institutional............. 1,508 1,385 1,489 1,464 1,819 Wrap.......................... 2,532 2,537 2,982 2,955 3,943 ALTERNATIVE STRATEGIES: Event Driven.................. 2,138 1,979 1,849 1,756 1,677 Short-Biased.................. 409 452 452 443 359 Other Private Investment Funds....................... 273 150 90 95 107 ------- ------- ------- ------- ------- TOTAL......................... $11,555 $10,646 $11,285 $10,969 $13,017 ======= ======= ======= ======= ======= Levco also has a wholly-owned broker-dealer subsidiary that clears through Correspondent Services Corporation, a subsidiary of National Financial Services, LLC, on a fully disclosed basis. Generally, the customers of the broker-dealer subsidiary are advisory clients of Levco, and the trades executed through the broker-dealer are generally placed by Levco in its capacity as investment adviser. RISK FACTORS The following risks, among others, sometimes have affected, and in the future could affect, BKF's business, financial condition or results of operations. The risks described below are not the only ones facing 14 BKF. Additional risks not presently known to BKF or that BKF currently deems immaterial may also impact its business. LEVCO IS DEPENDENT ON KEY PERSONNEL Levco is largely dependent on the efforts of its senior investment professionals managing the value equity strategies and the event driven and short-biased products. Levco is also dependent on the efforts of Mr. John A. Levin, the chairman and chief executive officer of BKF. The loss of the services of key investment personnel, including Mr. Levin, could have a material adverse effect on Levco because it could jeopardize its relationships with clients and result in the loss of those accounts. Levco's key investment personnel, including Mr. Levin, are not subject to employment contracts. Levco's future success depends on its ability to retain and attract qualified personnel to conduct its investment management business. To the extent that Levco further diversifies its products and strategies, BKF anticipates that it will be necessary for Levco to add portfolio managers and investment analysts. No assurance can be given that Levco will succeed in its efforts to recruit and retain the required personnel. Because of its relatively smaller size, Levco may have relatively fewer resources with which to recruit and retain personnel. The loss of key personnel or the inability to recruit and retain qualified portfolio managers, business and marketing personnel could have a material adverse effect on Levco's business. In December 1998, BKF adopted an incentive compensation plan to give Levco the ability to attract and retain talented professionals with equity-based and cash compensation. Determinations with regard to the implementation of this plan, as amended, are made by the Compensation Committee of the board of directors of BKF on a regular basis. Because BKF is a relatively small public company, the value of the equity awards that may be offered to professionals may be limited relative to what competitors may offer. If the price of BKF stock decreases, no assurance can be given that the equity-based compensation will serve its purpose to attract and retain talented professionals. LEVCO IS DEPENDENT ON A LIMITED NUMBER OF INVESTMENT PRODUCTS Levco currently derives most of its revenues from three particular investment products -- a large cap value strategy, an event-driven alternative investment product and a short-biased alternative investment product. While the large cap value strategy and the short-biased alternative investment products may often perform differently in a given investment environment, adverse developments with regard to any of these products could have a material adverse effect on Levco's business. A DECLINE IN THE PERFORMANCE OF THE SECURITIES MARKETS COULD HAVE AN ADVERSE EFFECT ON LEVCO'S REVENUES Levco's operations are affected by many economic factors, including the performance of the securities markets. Declines in the securities markets, in general, and the equity markets, in particular, would likely reduce Levco's assets under management and consequently reduce its revenues. In addition, any continuing decline in the equity markets, failure of these markets to sustain their prior rates of growth, or continued volatility in these markets could result in investors' withdrawing from the equity markets or decreasing their rate of investment, either of which would likely adversely affect Levco. Levco's rates of growth in assets under management and revenues have varied from year to year, and there can be no assurance that the growth rates sustained in the past will continue. Levco is generally a "value" manager, and a general decline in the performance of "value" securities could have an adverse effect on Levco's revenues. POOR INVESTMENT PERFORMANCE COULD ADVERSELY AFFECT LEVCO'S FINANCIAL CONDITION Success in the investment management industry depends largely on investment performance. Good performance generally stimulates sales of services and investment products and tends to keep withdrawals and redemptions low. This generates higher management fees, which are based on the amount of assets under management and sometimes on investment performance. If Levco experiences poor performance, this will likely result in decreased sales, decreased assets under management and the loss of accounts, with corresponding decreases in revenue. 15 Levco also offers event-driven and short-biased products and other alternative investment strategies. The failure to implement these strategies effectively could likewise impact Levco's revenues. ADVERSE DEVELOPMENTS WITH REGARD TO SIGNIFICANT CUSTOMERS OR RELATIONSHIPS COULD ADVERSELY AFFECT LEVCO'S REVENUES As of June 30, 2003, Levco had approximately 290 customers (counting as single customers each wrap fee program and related family and institutional accounts and excluding proprietary pooled investment vehicles and other accounts following alternative investment strategies), of which the ten largest customers generated approximately $9.1 million of revenues for Levco in the first half of 2003 (including incentive fees), or approximately 20% of BKF's total revenues. The five largest customers (excluding proprietary pooled investment vehicles and other accounts following alternative investment strategies) accounted for approximately 43% of all asset-based investment advisory fees earned in the first half of 2003. The loss of any of these customers could have an adverse effect on BKF's revenues. In the institutional marketplace, consultants play a key role in selecting investment managers for their clients. In the event that a consultant advising current clients of Levco takes a negative view of Levco, Levco could lose a number of accounts related to that consultant. A DECREASE IN LEVCO'S MANAGEMENT FEES, THE CANCELLATION OF INVESTMENT MANAGEMENT AGREEMENTS OR POOR INVESTMENT PERFORMANCE BY THE LEVCO PRIVATE INVESTMENT FUNDS COULD ADVERSELY AFFECT LEVCO'S PROFITS Management Fees. Some segments of the investment management industry have experienced a trend toward lower management fees. Levco must maintain a level of investment returns and service that is acceptable to clients given the fees they pay. No assurance can be given that Levco will be able to maintain its current fee structure or client base. Reduction of the fees for new or existing clients could have an adverse impact on Levco's profits. Cancellation of Investment Management Agreements. It is expected that Levco will derive almost all of its revenue from investment management agreements. For registered investment companies, a majority of the disinterested members of each fund's board must approve these agreements at least annually and the agreements are terminable without penalty on 60 days' notice. The agreements with Levco's separately-managed account clients generally are subject to termination by the client without penalty and with little or no notice. Any failure to renew, or termination of, a significant number of these agreements could have an adverse effect on Levco. Poor Investment Performance of the Private Investment Funds. BKF derives revenue from incentive fees and general partner incentive allocations earned with respect to its proprietary unregistered investment funds. Stronger positive performance by these funds generates higher incentive fees and incentive allocations because those fees and allocations are based on the performance of the assets under management. On the other hand, relatively poor performance will result in lower or no incentive fees or allocations, and will tend to lead to decreased assets under management and the loss of accounts, with corresponding decreases in revenue. LEVCO IS A RELATIVELY SMALL PUBLIC COMPANY IN A HIGHLY COMPETITIVE BUSINESS Levco competes with a large number of domestic and foreign investment management firms, commercial banks, insurance companies, broker-dealers and other firms offering comparable investment services. Many of the financial services companies with which Levco competes have greater resources and assets under management than Levco does and offer a broader array of investment products and services. Management believes that the most important factors affecting Levco's ability to attract and retain clients are the abilities, performance records and reputations of its portfolio managers, the ability to hire and retain key investment personnel, the attractiveness of investment strategies to potential investors and competitive fees and investor service. Levco's ability to increase and retain client assets could be adversely affected if client accounts underperform client expectations or their relevant benchmarks or if key investment personnel leave 16 Levco. Levco's ability to compete with other investment management firms also depends, in part, on the relative attractiveness of its investment philosophies and methods under prevailing market conditions. The absence of significant barriers to entry by new investment management firms in the institutional managed accounts business increases competitive pressure. Since Levco is a relatively smaller asset management company, changes in customers, personnel and products and other business developments may have a greater impact on Levco than they would have on larger, more diversified asset management companies. LEVCO IS DEPENDENT ON INFORMATION SYSTEMS AND ADMINISTRATIVE, BACK-OFFICE AND TRADE EXECUTION FUNCTIONS Levco is highly dependent on information systems and technology and depends, to a great extent, on third parties who are responsible for managing, maintaining and updating these systems. No assurance can be given that Levco's current systems will continue to be able to accommodate its growth or that the costs of its outsourcing arrangements will not increase. The failure to accommodate growth or an increase in costs could have an adverse effect on Levco. Success in the investment management industry also depends on the ability of an investment manager, and third parties with whom the investment manager contracts, to successfully perform administrative, back-office and trade execution functions. A failure by Levco or a third party contracted by Levco to perform such functions could adversely impact Levco's revenues. CONFLICTS OF INTEREST MAY ARISE AND ADVERSELY AFFECT LEVCO From time to time, Levco's officers, directors and employees may own securities which one or more of its clients also own. Although Levco maintains internal policies regarding individual investments by its officers, directors and employees which require them to report securities transactions and restrict certain transactions so as to minimize possible conflicts of interest, possible conflicts of interest may arise that could have adverse effects on Levco. Similarly, conflicting investment positions may develop among various investment strategies managed by Levco. Although Levco has internal policies in place to address such situations, such conflicts could have adverse effects on Levco. GOVERNMENT REGULATIONS MAY ADVERSELY AFFECT LEVCO'S BUSINESS Virtually all aspects of Levco's business are subject to various federal and state laws and regulations. Levco is registered with the Securities and Exchange Commission under the Investment Advisers Act of 1940, as amended. The Investment Advisers Act imposes numerous obligations on registered investment advisers, including fiduciary, recordkeeping, operational and disclosure obligations. John A. Levin & Co. is also registered with the Commodity Futures Trading Commission as a commodity trading advisor and a commodity pool operator, and Levco GP, Inc. is registered with that agency as a commodity pool operator. John A. Levin & Co. and Levco GP are members of the National Futures Association. LEVCO Securities, Inc. is registered as a broker-dealer under the Securities Exchange Act of 1934, is a member of the National Association of Securities Dealers, Inc. and is a member of the Municipal Securities Rulemaking Board. In addition, Levco is subject to the Employee Retirement Income Security Act of 1974 and its regulations insofar as it is a "fiduciary" with respect to certain clients. These laws and regulations generally grant supervisory agencies and bodies broad administrative powers, including the power to limit or restrict Levco from conducting its business if it fails to comply with these laws and regulations. If Levco fails to comply with these laws and regulations, these agencies may impose sanctions, including the suspension of individual employees, limitations on business activities for specified periods of time, revocation of registration, and other censures and fines. Even if in compliance with all laws and regulations, changes in these laws or regulations could adversely affect Levco's profitability and operations and its ability to conduct certain businesses in which it is currently engaged. 17 TERRORIST ATTACKS COULD ADVERSELY AFFECT OUR COMPANY Terrorist attacks, including biological or chemical weapons attacks, and the response to such terrorist attacks, could have a significant impact on New York City, the local economy, the United States economy, the global economy, and global financial markets. It is possible that the above factors could have a material adverse effect on our business, especially given the fact that all operations are conducted from a single location in New York City and BKF has incurred lease obligations with regard to this location through September 2011. BKF does have a business continuity facility in Stamford, Connecticut encompassing approximately 5,000 square feet. Certain statements under this caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" constitute "forward-looking statements" under the Private Securities Litigation Reform Act of 1995 (the "Reform Act"). See "Part II -- Other Information." RESULTS OF OPERATIONS The following discussion and analysis of the results of operations is based on the Consolidated Statements of Financial Condition and Consolidated Statements of Operations for BKF Capital Group, Inc. and Subsidiaries. In January 2003, the Financial Accounting Standards Board issued Financial Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN 46"). FIN 46 addresses the application of Accounting Research Bulletin No. 51, "Consolidated Financial Statements," to variable interest entities ("VIE"). A public enterprise with a variable interest in a VIE created before January 31, 2003, is required to apply FIN 46 to that VIE as of the beginning of the first interim or annual reporting period beginning after June 15, 2003. BKF has elected to adopt FIN 46 for the periods reflected in the Consolidated Statements of Financial Condition and the Consolidated Statements of Operations included in this Quarterly Report on Form 10-Q. In the context of making determinations pursuant to FIN 46, BKF has also decided to consolidate certain affiliated investment partnerships in which it may be deemed to have a controlling interest. It should be noted that the number and identity of the partnerships being consolidated may change over time as the interest held by BKF and its affiliates in affiliated partnerships changes. The assets, liabilities and related operations of these partnerships and related minority interest have been reflected in the consolidated financial statements for the three and six month periods ended June 30, 2003 and June 30, 2002, respectively. The consolidation of the partnerships does not impact BKF's stockholders' equity or net income. The general partner liability with respect to the consolidated partnerships is limited to Levco GP, Inc., which has no assets other than its interests in affiliated limited partnerships. THREE MONTHS ENDED JUNE 30, 2003 AS COMPARED TO THREE MONTHS ENDED JUNE 30, 2002 Revenues Total revenues for the second quarter of 2003 were $25.11 million, reflecting an increase of 29.2% from $19.43 million in revenues in the same period in 2002. This increase was primarily attributable to (i) a 54.1% increase in incentive fees and general partner incentive allocations to $8.70 million in the second quarter of 2003 from $5.64 million in the same period in 2002 and (ii) a net realized and unrealized gain on investments from consolidated investment partnerships of $861,000 in the second quarter of 2003 as compared to a loss of $3.56 million in the same period in 2002. The gains/losses on investments in consolidated investment partnerships include minority interest, i.e., the portion of the gains or losses generated by the partnerships allocable to all partners other than Levco GP, Inc., which is separately identified on the consolidated statements of operations. Incentive fees and general partner allocations are accrued on a quarterly basis but are primarily determined and billed or allocated, as the case may be, at the end of the applicable contract year or upon investor withdrawal. Such accruals may be reversed prior to being earned or allocated as the result of investment performance. The increase in incentive fees and general partner incentive allocations was primarily attributable to an increase in the performance of, and net capital contributions to, certain accounts following event-driven investment strategies and net capital contributions to a long/short equity strategy, which gains were partially offset by the reversal of an accrual made in 2002 with regard to an investment vehicle following 18 a short-biased strategy. The increase in incentive fees and general partner incentive allocations was in large part offset by a 12.3% decrease in asset-based investment advisory fees to $14.42 million in the second quarter of 2003 from $16.45 million in the same period in 2002. This decrease in asset-based advisory fees is primarily attributable to the decrease in assets managed (as the result of net withdrawals and negative investment performance) for value equity accounts, which was partly offset by an increase in assets under management in alternative investment strategies (as the result of net contributions and positive investment performance). Management believes that with regard to the value equity strategies, their underperformance relative to their benchmarks in 2002 may adversely affect BKF's ability to retain existing accounts and attract new accounts in 2003 with respect to its value equity products. In April 2003, Levco was notified that as of June 20, 2003 it would no longer be able to participate in a wrap fee program. As a result, Levco lost approximately $175 million in wrap program assets from such program in May and June 2003. The impact of the loss of such accounts will be felt most strongly beginning in the third quarter. In addition, in June 2003, the wrap program through which Levco managed approximately 85% of its wrap program assets as of June 30, 2003 changed the status of Levco so that Levco may continue to accept additional contributions from existing accounts but may not open new accounts in the program. The duration of this change in status is indefinite. Net commission income generated by the broker-dealer business declined 21.1% to $496,000 in the second quarter of 2003 from $629,000 in the second quarter of 2002, primarily as the result of a decrease in the number of accounts at the broker-dealer and a decrease in commission rates. In the second quarter of 2003, BKF had a net realized and unrealized gain on investments of $405,000 primarily derived from its seed capital investments in non-consolidated investment vehicles pursuing alternative investment strategies. In the second quarter of 2002, BKF had a net realized and unrealized loss of $194,000 on investments in various long only and alternative investment strategies (excluding investments in consolidated investment partnerships). Interest and dividend income in the second quarter of 2003 (excluding consolidated investment partnerships) was $145,000, reflecting a 11.6% decrease from $164,000 in the same period in 2002. This decrease is primarily attributable to a decrease in interest rates. Interest and dividend income from consolidated investment partnerships in the second quarter of 2003 was $82,000, reflecting a 72.6% decrease from $299,000 in the same period in 2002. This decrease is primarily attributable to the decrease in the number, and the corresponding decrease in the assets under management, of the affiliated partnerships being consolidated. Expenses Total expenses for the second quarter of 2003 were $25.00 million, reflecting an increase of 10.0% from $22.72 million in expenses in the same period in 2002. Total expenses excluding amortization of finite life intangibles were $23.25 million in the second quarter of 2003, reflecting an increase of 10.8% from $20.97 million for the second quarter of 2002. Compensation expense was $18.52 million in the second quarter of 2003, reflecting an increase of 20.6% from $15.36 million in the same period in 2002. This increase in compensation expense is primarily attributable to restricted stock units granted in 2002 and 2003 (including restricted stock units granted in exchange for options), an increase in the percentage of revenues attributable to alternative investment strategies, and the expansion of the investment teams involved in managing alternative investment strategies. Compensation with regard to alternative investment products is determined on a different basis than compensation with regard to value equity products. Compensation expense accruals were made in accordance with compensation guidelines most recently approved by the board of directors in 2001, but in view of current market and business conditions, it is anticipated that such compensation guidelines will be reviewed. Such review could result in changes in the manner in which bonus compensation is determined in 2003. Occupancy and equipment rental was $1.53 million in the second quarter of 2003, reflecting a 3.5% increase from $1.48 million in the same period in 2002. This increase is attributable to (i) escalations in the lease for the facilities at One Rockefeller Plaza, (ii) real estate tax increases, and (iii) the lease for a business 19 continuity facility in Stamford, Connecticut that commenced in September 2002. In order to reduce operating expenses, BKF is currently considering subleasing, or otherwise reducing its obligations with respect to, a portion of its facilities at One Rockefeller Plaza. Based on the difference between current rental obligations and current market rates, BKF may incur a significant charge based on the difference between current rental obligations and the total value to be received by BKF. Other operating expenses were $3.16 million in the second quarter of 2003, reflecting a 22.0% decrease from $4.04 million in the same period in 2002. The decrease was primarily attributable to (i) a decrease in fees to third party marketers as the result of a reversal in an accrued performance fee relating to a vehicle following a short-biased investment strategy and (ii) decreases in technology and other consulting fees. These decreases were offset by increased insurance premiums. Other operating expenses from consolidated limited partnerships were $37,000 in the second quarter of 2003, reflecting a 58.4% decrease from $89,000 in the same period in 2002. These expenses are primarily comprised of auditing, tax preparation and legal fees borne directly by the consolidated investment partnerships, and the decrease in such expenses primarily reflects the decrease in the number of partnerships being consolidated during the respective periods. Operating Income (Loss) Operating income for the second quarter of 2003 was $108,000, as compared to an operating loss of $3.29 million in the same period in 2002. Excluding (i) net realized and unrealized gain (loss) on investments and interest and dividend income (including the portions attributable to consolidated investment partnerships), and (ii) the amortization of finite life intangibles, operating income in the second quarter of 2003 was $367,000, reflecting a 79.0% decrease from $1.75 million in the same period in 2002, primarily as the result of the increase in compensation expense attributable to restricted stock unit grants. Income Taxes Total income tax expense was $597,000 in the second quarter of 2003, reflecting a decrease of 8.7% from $654,000 for the same period in 2002. This decrease primarily reflects the decrease in income before taxes (as determined without a deduction for the amortization of intangibles). An effective tax rate of 46.9% (before amortization) was used to make the determination with respect to the provision for taxes at June 30, 2003, while an effective tax rate of 46.4% (before amortization) was used to calculate the provision for taxes at June 30, 2002. The differential in tax rates is primarily due to differences in state allocations. SIX MONTHS ENDED JUNE 30, 2003 AS COMPARED TO SIX MONTHS ENDED JUNE 30, 2002 Revenues Total revenues for the six months ended June 30, 2003 were $46.92 million, reflecting an increase of 14.8% from $40.87 million in revenues in the same period in 2002. This increase was primarily attributable to (i) a 72.1% increase in incentive fees and general partner incentive allocations to $15.56 million in the first six months of 2003 from $9.04 million in the same period in 2002 and (ii) a net realized and unrealized gain on investments from consolidated investment partnerships of $1.17 million in the six months ended June 30, 2003 as compared to a loss of $3.70 million in the same period in 2002. The gains/losses on investments in consolidated investment partnerships include minority interest, i.e., the portion of the gains or losses generated by the partnerships allocable to all partners other than Levco GP, Inc., which is separately identified on the consolidated statements of operations. Incentive fees and general partner allocations are accrued on a quarterly basis but are primarily determined and billed or allocated, as the case may be, at the end of the applicable contract year or upon investor withdrawal. Such accruals may be reversed prior to being earned or allocated as the result of investment performance. The increase in incentive fees and general partner incentive allocations was primarily attributable to an increase in the performance of, and net capital contributions to, certain accounts following event-driven investment strategies and net capital contributions to a long/short equity strategy, which gains 20 were partially offset by the reversal of an accrual made in 2002 with regard to an investment vehicle following a short-biased strategy. The increase in incentive fees and general partner incentive allocations was in large part offset by a 15.4% decrease in asset-based investment advisory fees to $28.25 million in the first six months of 2003 from $33.39 million in the same period in 2002. This decrease in asset-based advisory fees is primarily attributable to the decrease in assets managed (as the result of net withdrawals of approximately $1.15 billion) for value equity accounts. Net commission income generated by the broker-dealer business declined 29.8% to $989,000 for the six months ended June 30, 2003 from $1.41 million in the same period in 2002, primarily as the result of a decrease in the number of accounts at the broker-dealer and a decrease in commission rates. In the six months ended June 30, 2003, BKF had a net realized and unrealized gain on investments of $506,000 primarily derived from its seed capital investments in non-consolidated investment vehicles pursuing alternative investment strategies. In the six months ended June 30, 2002, BKF had a net realized and unrealized loss of $110,000 on investments in various long only and alternative investment strategies (excluding investments in consolidated investment partnerships). Interest and dividend income in the six months ended June 30, 2003 (excluding consolidated investment partnerships) was $229,000, reflecting a 27.5% decrease from $316,000 in the same period in 2002. This decrease is primarily attributable to a decrease in interest rates. Interest and dividend income from consolidated investment partnerships in the six months ended June 30, 2003 was $214,000, reflecting a 59.5% decrease from $528,000 in the same period in 2002. This decrease is primarily attributable to the decrease in the number, and the corresponding decrease in the assets under management, of the affiliated partnerships being consolidated. Expenses Total expenses for the six months ended June 30, 2003 were $47.47 million, reflecting an increase of 9.0% from $43.56 million in expenses in the same period in 2002. Total expenses excluding amortization of finite life intangibles were $43.97 million in the first six months of 2003, reflecting an increase of 9.8% from $40.06 million for the same period in 2002. Compensation expense was $34.49 million for the six months ended June 30, 2003, reflecting an increase of 15.6% from $29.84 million in the same period in 2002. This increase in compensation expense is primarily attributable to restricted stock units granted in 2002 and 2003 (including restricted stock units granted in exchange for options), an increase in the percentage of revenues attributable to alternative investment strategies, and the expansion of the investment teams involved in managing alternative investment strategies. Compensation with regard to alternative investment products is determined on a different basis than compensation with regard to value equity products. Occupancy and equipment rental was $3.18 million in the first six months of 2003, reflecting a 9.5% increase from $2.90 million in the same period in 2002. This increase is attributable to (i) escalations in the lease for the facilities at One Rockefeller Plaza, (ii) real estate tax increases, and (iii) the lease for a business continuity facility in Stamford, Connecticut that commenced in September 2002. Other operating expenses were $6.19 million in the first six months of 2003, reflecting a 13.4% decrease from $7.14 million in the same period in 2002. The decrease was primarily attributable to (i) a decrease in fees to third party marketers as the result of a reversal in an accrued performance fee relating to a vehicle following a short-biased investment strategy and (ii) decreases in technology and other consulting fees. These decreases were offset by increased insurance premiums. 21 Other operating expenses from consolidated limited partnerships were $107,000 in the six months ended June 30, 2003, reflecting a 37.4% decrease from $171,000 in the same period in 2002. These expenses are primarily comprised of auditing, tax preparation and legal fees expenses borne directly by the consolidated investment partnerships. Operating Loss Operating loss for the six months ended June 30, 2003 was $553,000, as compared to an operating loss of $2.69 million in the same period in 2002. Excluding (i) net realized and unrealized gain on investments and interest and dividend income (including the portions attributable to consolidated investment partnerships), and (ii) the amortization of finite life intangibles, operating income in the second quarter of 2003 was $837,000, reflecting a 77.9% decrease from $3.79 million in the same period in 2002, primarily as the result of the increase in compensation expense attributable to restricted stock unit grants. Income Taxes Income tax expense was $988,000 for the six months ended June 30, 2003, reflecting a decrease of 42.0% from $1.70 million for the same period in 2002. This decrease primarily reflects the decrease in income before taxes (as determined without a deduction for the amortization of intangibles). An effective tax rate of 46.4% (before amortization) was used to make the determination with respect to the provision for taxes at June 30, 2003, while an effective tax rate of 44.8% (before amortization) was used to calculate the provision for taxes at June 30, 2002. The differential in tax rates is due to state allocations. LIQUIDITY AND CAPITAL RESOURCES BKF's current assets as of June 30, 2003 consist primarily of cash, short term investments and investment advisory and incentive fees receivable. While BKF's daily business operations are not generally capital intensive, BKF utilizes capital to develop and seed new investment products. The development of new products is an important element in BKF's business plan, and such seed capital investments may require substantial financial resources. Due to its relatively small size, BKF may consider a number of options to obtain such seed capital. BKF has historically met its cash and liquidity needs through cash generated by operating activities. At June 30, 2003, BKF had cash and cash equivalents of $43.01 million, compared to $39.15 million at December 31, 2002. This increase primarily reflects the withdrawal of seed capital from affiliated investment partnerships, the collection of receivables and the annual withdrawal of general partner incentive allocations from affiliated investment partnerships, which were partly offset by payment of cash bonuses in 2003 which were accrued in 2002. The decrease in investment advisory and incentive fees receivable from $24.15 million at December 31, 2002 to $21.90 million at June 30, 2003 primarily reflects the receipt in 2003 of incentive fees earned in 2002. The decrease in investments in securities from $1.05 million at December 31, 2002 to $368,000 at June 30, 2003 reflects the return of capital relating to the liquidation of the Van Eck Levin Mid Cap Value Fund during the second quarter, as BKF ceased the development of its mid cap value effort. The decrease in investments in securities from consolidated limited partnerships from $17.81 million at December 31, 2002 to $8.90 million at June 30, 2003, and the decrease in due from broker from consolidated limited partnerships from $31.75 million at December 31, 2002 to zero at June 30, 2003 reflects (i) the liquidation in the first quarter of 2003 of two investment partnerships and (ii) the de-consolidation of an investment partnership as of January 1, 2003. The increase in prepaid expenses and other assets to $3.11 million at June 30, 2003 from $2.12 million at December 31, 2002 primarily reflects the prepayment of insurance policies. The increase in investments in affiliated investment partnerships from $9.38 million at December 31, 2002 to $10.83 million at June 30, 2003 primarily reflects the de-consolidation of an affiliated investment partnership and the accrual of incentive allocations for the six months ended June 30, 2003, which was partly offset by the withdrawal of general partner incentive allocations from the unconsolidated, affiliated investment partnerships earned with respect to 2002. Incentive allocations typically are withdrawn within three months following the end of the calendar year to pay compensation and other expenses. In July 2003, BKF invested $5.3 million dollars in affiliated, unconsolidated limited partnerships utilizing alternative investment strategies. Investments in 22 unaffiliated partnerships from consolidated limited partnerships, which rose from $4.28 million at December 31, 2002 to $5.22 million at June 30, 2003 reflects investments made by a consolidated multi-manager, multi-strategy investment partnership. Accrued expenses were $3.55 million at June 30, 2003, as compared to $5.21 million at December 31, 2002. The largest component of such expenses was the accrual for third party marketing fees. Such fees are based on a percentage of accrued revenue, and such accruals may be reversed based on the subsequent investment performance of the relevant accounts through the end of the applicable performance measurement period. Expenses accrued during the six months ended June 30, 2003 were offset primarily by the payment of accrued third party marketing fees. Accrued bonuses were $21.20 million at June 30, 2003, as compared to $31.51 million at December 31, 2002, reflecting the payment of 2002 bonuses and the accrual for 2003 bonuses. The decrease in securities sold short from consolidated limited partnerships from $9.40 million at December 31, 2002 to zero at June 30, 2003 reflects (i) the liquidation in the first quarter of 2003 of two investment partnerships and (ii) the de-consolidation of an investment partnership as of January 1, 2003. The increase in accrued incentive compensation to $5.76 million at June 30, 2003 from $2.31 million at December 31, 2002 reflects the granting of restricted stock units during the period. Based upon BKF's current level of operations and anticipated growth, BKF expects that cash flows from operating activities will be sufficient to finance its working capital needs for the foreseeable future. Except for its lease commitments, which are discussed in Note 9 in the Notes to Consolidated Financial Statements in BKF's Annual Report on Form 10-K for the year ended December 31, 2002, BKF has no material commitments for capital expenditures. BKF expects to spend approximately $3.0 million in connection with improving its facilities currently under lease, which expenditures will be amortized over the life of the lease. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Since BKF's revenues are largely driven by the market value of Levco's assets under management, these revenues are exposed to fluctuations in the equity markets. Management fees for most accounts are determined based on the market value of the account on the last day of the quarter, so any significant increases or decreases in market value occurring on or shortly before the last day of a quarter may materially impact revenues of the current quarter or the following quarter (with regard to wrap program accounts). Furthermore, since Levco manages most of its assets in a large cap value style, a general decline in the performance of value stocks could have an adverse impact on Levco's revenues. Similarly, a lack of opportunity to implement, or a failure to successfully implement, Levco's event-driven and short-biased strategies could reduce performance based incentive fees and allocations and thereby negatively impact BKF's revenues. Because BKF is primarily in the asset management business and manages equity portfolios, changes in interest rates, foreign currency exchange rates, commodity prices or other market rates or prices impact BKF only to the extent they are reflected in the equity markets. ITEM 4. DISCLOSURE CONTROLS AND PROCEDURES An evaluation was performed under the supervision and with the participation of BKF's management, including the CEO and CFO, of the effectiveness of the design and operation of BKF's disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended). Based on that evaluation, BKF's management, including the CEO and CFO, concluded that BKF's disclosure controls and procedures were effective as of the end of the period covered by this report. There have been no significant changes in BKF's internal controls or in other factors that could significantly affect internal controls since the date of their evaluation. It should be noted that any system of controls, however well designed and operated, can provide only reasonable, and not absolute, assurance that the objectives of the system are met. In addition, the design of any control system is based in part upon certain assumptions about the likelihood of future events. Because of 23 these and other inherent limitations of control systems, there is only reasonable assurance that BKF's controls will succeed in achieving their stated goals under all potential future conditions. PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS None ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS None ITEM 3. DEFAULTS UPON SENIOR SECURITIES None ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS On May 21, 2003, BKF held its Annual Meeting of Stockholders. At the Annual Meeting, David D. Grumhaus, James S. Tisch and Barton M. Biggs were elected to serve as directors of BKF. Anson M. Beard, Jr., J. Barton Goodwin, John A. Levin, Burton G. Malkiel, Peter J. Solomon and Dean J. Takahashi continued as directors following the Annual Meeting. At the Annual Meeting, the stockholders also approved proposal 2, ratifying the appointment of Ernst & Young LLP as BKF's independent auditors, and proposal 3, a shareholder proposal requesting that the board of directors redeem the Common Share Purchase Rights issued pursuant to the Rights Agreement dated June 8, 2001 (the "Plan"), unless the holders of a majority of the outstanding shares approve the issuance at a meeting of stockholders held as soon as practical. The board of directors recognizes the stockholder vote in favor of proposal 3 and continues to believe that the Plan supports the objectives of preserving and maximizing the Company's value for all stockholders. The voting on the above matters is set forth below: Proposal 1 NOMINEE VOTES FOR VOTES WITHHELD ------- --------- -------------- David D. Grumhaus........................................... 4,761,383 1,335,595 James S. Tisch.............................................. 4,805,258 1,291,720 Barton M. Biggs............................................. 4,801,275 1,295,703 Proposal 2 -- There were 5,349,004 votes for, 94,165 votes against, and 653,805 abstentions. Proposal 3 -- There were 3,327,924 votes for, 996,890 votes against, and 27,405 abstentions. ITEM 5. OTHER INFORMATION This Quarterly Report on Form 10-Q contains certain statements that are not historical facts, including, most importantly, information concerning possible or assumed future results of operations of BKF and statements preceded by, followed by or that include the words "may," "believes," "expects," "anticipates," or the negation thereof, or similar expressions, which constitute "forward-looking statements" within the meaning of the Reform Act. For those statements, BKF claims the protection of the safe harbor for forward-looking statements contained in the Reform Act. These forward-looking statements are based on BKF's current expectations and are susceptible to a number of risks, uncertainties and other factors, including the risks specifically enumerated in "Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations," and BKF's actual results, performance and achievements may differ materially from any future results, performance or achievements expressed or implied by such forward-looking statements. Such factors include the following: retention and ability of qualified personnel; the performance of the securities markets and of value stocks in particular; the investment performance of client accounts; the 24 retention of significant client and/or distribution relationships; competition; the existence or absence of adverse publicity; changes in business strategy; quality of management; availability, terms and deployment of capital; business abilities and judgment of personnel; labor and employee benefit costs; changes in, or failure to comply with, government regulations; the costs and other effects of legal and administrative proceedings; and other risks and uncertainties referred to in this document and in BKF's other current and periodic filings with the Securities and Exchange Commission, all of which are difficult or impossible to predict accurately and many of which are beyond BKF's control. BKF will not undertake and specifically declines any obligation to publicly release the result of any revisions which may be made to any forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events. In addition, it is BKF's policy generally not to make any specific projections as to future earnings, and BKF does not endorse any projections regarding future performance that may be made by third parties. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits 31.1 Section 302 Certification of Chief Executive Officer 31.2 Section 302 Certification of Chief Financial Officer 32.1 Section 906 Certification of Chief Executive Officer 32.2 Section 906 Certification of Chief Financial Officer (b) Reports on Form 8-K None. 25 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. BKF CAPITAL GROUP, INC. By /s/ JOHN A. LEVIN ------------------------------------ John A. Levin Chairman, Chief Executive Officer and President By: /s/ GLENN A. AIGEN ------------------------------------ Glenn A. Aigen Senior Vice President and Chief Financial Officer Date: August 14, 2003 26