10-Q 1 doc1.txt FORM 10-Q SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 (Mark One) (X) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended: December 31, 2002 ----------------- OR ( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _____ to ______ Commission file number: 1-14897 A.B. Watley Group Inc. ---------------------- (Exact name of registrant as specified in its charter) Delaware 13-3911867 -------- ---------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 40 Wall Street, New York, NY 10005 ---------------------------------- (Address of principal executive offices) (Zip Code) (212) 422-1100 -------------- (Registrant`s telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Common Stock, $0.001 par value (Title of Class) 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 [ ] No [ X ]. The number of shares outstanding of the issuer`s common stock, par value $.001 per share, as of February 21, 2003 was 12,508,852. A.B. Watley Group Inc.

-2- PART I -- FINANCIAL INFORMATION Item 1. Financial Statements A.B. Watley Group Inc. Consolidated Statements of Financial Condition

See notes to consolidated financial statements -3- A.B. Watley Group Inc. Consolidated Statements of Operations (Unaudited)

See notes to consolidated financial statements -4- A.B. Watley Group Inc. Consolidated Statements of Cash Flows (Unaudited)

See notes to consolidated financial statements -5- A.B. Watley Group Inc. Notes to Consolidated Financial Statements (Unaudited) 1. Organization and Business A.B. Watley Group Inc. ("ABWG" or the "Company") is a U.S. public corporation. The Company conducts business primarily through its principal subsidiaries, A.B. Watley, Inc. ("A.B. Watley") and Integrated Clearing Solutions, Inc. ("Integrated"). A.B. Watley and Integrated are registered broker-dealers with the Securities and Exchange Commissions ("SEC"), and are members of the National Association of Securities Dealers, Inc. ("NASD"). A.B. Watley is an introducing broker-dealer, conducting business in electronic trading, information and brokerage services, as well as institutional block trading. Integrated is an introducing broker-dealer conducting sales of mutual funds to institutional clients. A.B. Watley and Integrated clear all transactions through clearing brokers on a fully disclosed basis. Accordingly, A.B. Watley and Integrated are exempt from Rule 15c3-3 of the Securities Exchange Act of 1934. 2. Basis of Presentation The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) and reflect all normal recurring adjustments which are, in the opinion of management, necessary for a fair presentation of the results for the interim periods presented. Pursuant to the rules and regulations of the SEC, certain footnote disclosures, which are normally required under GAAP, have been omitted. It is recommended that these consolidated financial statements be read in conjunction with the audited consolidated financial statements included in the Company`s Annual Report on Form 10-K for the year ended September 30, 2002. The results of operations for any interim period are not necessarily indicative of results for the full year. The consolidated financial statements include the accounts of ABWG and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated. Certain prior period amounts have been reclassified to conform to the current period`s presentation. The preparation of the financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. 3. Liquidity and Capital Resources The Company has significant deficits in both working capital and stockholders` equity. These factors raise substantial doubt about the Company`s ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. 4. Net Capital Requirements A.B. Watley and Integrated are subject to the SEC`s Uniform Net Capital Rule ("Rule 15c3-1"). In accordance with this rule, A.B. Watley is required to maintain defined minimum net capital to the greater of $100,000 or 6-2/3% of aggregate indebtedness as defined. Integrated is required to maintain minimum net capital of $5,000 or 6-2/3% of aggregate indebtedness as defined. As of December 31, 2002, A.B. Watley and Integrated`s net capital in excess of minimum requirements was $81,131 and $13,400, respectively. -6- 5. Financial Instruments with Off Balance Sheet Risk and Concentrations of Credit Risk Pursuant to clearance agreements, the clearing and depository operations for the Company and its customers` securities transactions are provided by clearing broker-dealers. The Company has agreed to indemnify its clearing brokers for losses that the clearing brokers may sustain from the customer accounts introduced by the Company and maintains deposits with such clearing brokers to collateralize such indemnification obligations. Such deposits are reflected on the consolidated statement of financial condition, net of unsecured customer receivables for which the Company is ultimately responsible. The Company, through its clearing brokers, seeks to control the risks associated with these activities by requiring customers to maintain margin collateral in compliance with various regulatory and internal company policy guidelines. The clearing brokers monitor required margin levels daily and, pursuant to such guidelines, request customers to deposit additional collateral or reduce securities positions when necessary. 6. Redeemable Convertible Preferred Stock On November 29, 2001, the Company entered into the Series A Convertible Preferred Stock Purchase Agreement (the "Purchase Agreement") to issue and sell, in a private placement, an aggregate of 630 (690 shares authorized, par value $.01) shares of Series A Redeemable Convertible Preferred Stock ("Preferred Stock"). Each share is convertible into 3,390 shares of the Company`s Common Stock at an exercise price of $2.95. The purchasers of the Preferred Stock were issued warrants, expiring in 5 years from the date of issuance, to purchase an additional 1,629,069 shares of Common Stock at an exercise price of $2.95. Pursuant to the Purchase Agreement and the Registration Rights Agreement (the "Registration Agreement"), the Company was required to file a registration statement (the "Registration Statement") with the Securities and Exchange Commission registering for resale the 2,135,700 shares of Common Stock issueable upon the conversion of the shares of Preferred Stock, and the 1,629,069 shares of Common Stock subject to purchase upon exercise of the warrants. The Company has not yet filed a Registration Statement and will not be able to have the Registration Statement filed and declared effective within the period required. A penalty of 2% of the liquidation preference value of the Preferred Stock for each thirty-day period accrues to each holder of Preferred Stock and is added to the liquidation preference amount until cured. As of December 31, 2002, liquidated damages of approximately $692,594 were accrued to the preferred holders. The Preferred Stock includes a liquidation preference of $10,000 per share and bears a cumulative dividend at an initial 6% annual rate, which increases to a 15% annual rate after eighteen months, payable twice a year in shares of Common Stock. For the three-month periods ended December 31, 2002 and 2001, dividends of $94,500 and $78,750 were accrued for the Preferred Stock. The holders of Preferred Stock may elect to convert their shares into the Company`s Common Stock at any time, just as they may choose to exercise their related warrants at any time. The holders of Preferred Stock also have the right to require the Company to redeem all of the Preferred Stock for cash equal to the greater of the liquidation preference amount plus any accrued but unpaid dividends and penalties or the aggregate of the market value of the shares of the Common Stock into which such shares of the Preferred Stock are then convertible, upon certain triggering events, as defined in the Agreement. Such triggering events have occurred. The holders of the Preferred Stock waived their Redemption Right through September 30, 2002. Although, the waiver has not been amended or extended, to date, no redemption notice has been received by the Company from any of its Preferred Stockholders. The $6,300,000 aggregate purchase price of the Preferred Stock and the warrants was allocated $4,340,383 to the Preferred Stock and the balance of $1,959,617 was attributed to the fair value of the warrants. In connection with this transaction, the Company issued Preferred Stock and received cash proceeds of $3,324,291 (net of issue costs) and exchanged a note payable in the amount of $2,500,000 ("Senior Subordinated Demand Note") for $2,750,000 plus accrued interest. The premium of $250,000 was recorded as an extraordinary loss on the extinguishment of debt in December 2001. The discount associated with the value of the warrants was accreted over a ten-month period through September 30, 2002, the date the redemption waiver expired. Since the holders of the Preferred Stock may require the Company to redeem all of the Preferred Stock, the Company has excluded the Preferred Stock from Stockholders` Deficit in the accompanying consolidated statement of financial condition. The holders are not subject to any limitations on the number of conversions of Preferred Stock or subsequent sales of the corresponding Common Stock that they can effect, other than a prohibition on any holder acquiring a beneficial ownership of more than 4.95% of the outstanding shares of the Company`s Common Stock. -7- 7. Notes and Loans Payable The Company`s outstanding obligation under notes and loans payable as of December 31, 2002 and September 30, 2002 was as follows: December 31, September 30, 2002 2002 ---------- ---------- Borrowings under line of credit $3,082,826 $3,082,826 Notes payable to former officers 700,000 700,000 Loans payable - other 250,000 200,000 ---------- ---------- $4,032,826 $3,982,826 ========== ========== As of December 31, 2002 and September 30, 2002, interest payable on the Company`s borrowing was $373,000 and $275,000, respectively. The Company recognized interest expense of $108,071 and $128,465 for the three month periods ending December 31, 2002 and 2001, respectively. On December 31, 2002, the Company borrowed $250,000 from a third party. The associated promissory note bears interest at 15% per annum and matures on January 14, 2003. In March 2002, one of the holders of the Company`s Preferred Stock led a group that granted a line of credit of $4,200,000 to the Company. Borrowings under the line of credit are payable on demand after June 18, 2002, with interest payable at 10%. The proceeds of the loans were used for working capital. Additionally, one member of the group was granted warrants to purchase 1,000,000 shares of the Company`s Common Stock at an exercise price of $0.918 a share in connection with the loan facility and a consultant retained by a member of the group was also granted warrants to purchase 50,000 shares of the Company`s Common Stock at an exercise price of $0.918 a share. The loan is collateralized by the assets of the Company as defined in the loan agreement. In February 2002, the Company borrowed $200,000 from a former officer of the Company, due on demand. The Company also borrowed $500,000 from the same party in October 2001 with a stated maturity of October 1, 2002. Both notes bear interest at 10% per annum. The loan due in October 2002 has not been repaid. In February 2002, the Company borrowed $200,000 from a third party with interest payable at 10% per annum. The loan matured on October 26, 2002. In August 30, 2001, the Company obtained a $2,500,000 loan (the "Senior Subordinated Demand Note") bearing interest at an annual rate of 6% due on demand. The loan was redeemed and converted to Series A Convertible Preferred Stock (see Note 6) on November 29, 2001. In January 1999, the Company borrowed $400,000 from New York Community Investment Company, L.L.C. ("NYCIC"). At September 30, 2002, the loan of $360,000 was repaid in full. 8. Subordinated Borrowings Subordinated borrowings as of December 31, 2002 and September 30, 2002 are as follows: December 31, 2002 September 30, 2002 Interest Rate Scheduled Maturity ----------------- ------------------ ------------- ------------------ $125,000 $125,000 12% October 31, 2003 $55,000 $55,000 0% October 31, 2003 $200,000 $200,000 15% October 31, 2003 $150,000 $150,000 13% October 31, 2003 ------------------- ----------------- $530,000 $530,000 =================== ================= -8- Subordinated borrowings are covered by agreements approved by the NASD and are included by A.B. Watley for purposes of computing net capital under the Net Capital Rule. To the extent that such subordinated borrowings are required for A.B. Watley`s continued compliance with minimum net capital requirements, they may not be repaid. The subordinated borrowings in the amounts of $125,000 and $55,000 were originally scheduled to mature on October 31, 2002. Such borrowings were renewed with a new maturity date of October 31, 2003. Of the total subordinated borrowings, $180,000 and $350,000 as of December 31, 2002 and September 30, 2002, respectively, are from an officer and stockholder of the Company, respectively. 9. Commitments and Contingencies Late Filings ------------ The Company did not file required reports with the SEC on a timely basis. Specifically, the quarterly reports on Form 10-Q for the quarters ended March 31, 2002, June 30, 2002, and December 31, 2002 and the annual report on Form 10-K for the year ended September 30, 2002 were filed in April of 2003. The Company`s financial statements do not reflect a reserve for any potential fines or penalties that may result from such late filings. Litigation ---------- The Company is a party to various suits alleging breach of contract due to non-payment for services or goods provided, and for the minority interests of the Class B members of the LLC. The Company is defending these suits and has commenced settlement negotiations as to certain of such suits. In addition, a suit has been brought by Akro Investicni Spolecnost, A.S. and Bozena Konvalinkova, as Czech Receiver of Private Investors, as against A.B. Watley. The plaintiffs allege violations of New York common law and federal securities law by A.B. Watley arising from an agreement between Private Investors, a Czech broker-dealer, and A.B. Watley. Plaintiffs seek damages of $31,400,000 (of which approximately $950,000 is alleged to represent the damages with the balance represents punitive damages). The Company believes it has a meritorious defense against this suit and intends to fight it vigorously and although there can be no assurance, the Company believes the majority of the claims if successful, will be substantially less than the amount of the damage claims and will be covered by insurance. In the opinion of management, after consultation with independent counsel, the Company is unable to predict the ultimate outcome of these matters; accordingly, no adjustment has been made in the accompanying consolidated financial statements for any potential losses. 10. Income taxes The Company has net operating loss carryforwards ("NOL`s") for federal income tax purposes approximating $61,643,000 as of December 31, 2002. The NOL`s are scheduled to expire no sooner than September 30, 2013. The ultimate realization of the deferred tax asset is primarily dependent upon the generation of future taxable income prior to the expiration of the NOL`s. In assessing the realizability of deferred tax assets resulting from such NOL`s, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. Management has established a 100% valuation allowance for such deferred tax asset, since the Company has not yet generated taxable net income. 11. Subsequent Events On January 15, 2003, A.B. Watley entered into a secured demand note agreement for $5,000,000 with a maturity date of June 30, 2004. The loan bears an interest rate of 7% per annum, payable monthly. In connection with the agreement, the Company issued warrants to purchase 500,000 shares of Common Stock at $0.75 per share. The warrants are immediately exercisable and will expire in January 2008. The loan has been approved by the NASD and is included for the purposes of computing net capital under Rule 15c3-1. The holder of the secured demand note has the option to convert all of the collateral into Common Stock of the Company within five business days after February 15, 2004, at a discount of 5% of the average price per share based on the 10-day period prior to conversion. The holder may also elect to convert the collateral within five business days after June 30, 2004 at $1.80. In no event shall the conversion result in the holder of the secured demand note owning more than 15% of the Company`s Common Stock. In January 2003, the Company entered into two leases for office space requiring security deposits of approximately $21,000 and aggregate minimum monthly rents of $15,173. The leases expire in 2004. -9- Item 2. Management`s Discussion and Analysis of Financial Condition and Results of Operations The following discussion of the financial condition and results of operations of the Company should be read in conjunction with the consolidated financial statements and notes thereto included in the Company`s Annual Report on Form 10-K. The results of operations for interim periods are not necessarily indicative of the results for the entire fiscal year. Results of Operations Three Months Ended December 31, 2002 Compared to the Three months Ended December 31, 2001 Revenues. Total revenues for the quarter ended December 31, 2002 were $4,179,700 - a decrease of 50%, as compared to revenues of $8,288,701 for the quarter ended December 31, 2001. Commissions. For the three-month period ending December 31, 2002, we earned commission revenues of $1,477,976, representing a 79% decrease as compared to commission revenues of $6,963,713 for the corresponding period in 2001. This $5,485,737 decrease in commission revenues resulted from both significant reductions in overall trading volume and the loss of the On-Site customers from our direct access business that was acquired in October 2001. Data Service Fees. Our revenues from data service fees for the three-month period ending December 31, 2002 also dropped substantially as compared to the corresponding period in 2001. The $16,897 of current period revenues represents an 88% decrease from the three-month period ending December 31, 2001. This decrease was caused by the loss of customers and the migration of remaining customers from third party software to the UltimateTrader II software for which no fees are charged. Revenues from Principal Transactions. Revenues from proprietary security transactions increased by 430%. We earned $1,945,306 from such transactions during the three-month period ending December 31, 2002 as compared to $367,360 for the three-month period ending December 31, 2001. Interest Income. Interest and for the three-month period ending December 31, 2002 was $35,698 representing a 94% decrease as compared to $582,894 for the three-month period ending December 31, 2001. The decrease was primarily due the loss of additional accounts acquired from the On-Site retail accounts acquired in October 2001 that had generated margin interest income. Other Income. Other income of $703,823 for the three-month period ending December 31, 2002 represents a $465,422 increase as compared to the three months ended December 31, 2001.Such increase primarily relates to settlements with vendors for which the Company was the beneficiary. Interest Expense. Interest expense decreased from $1,016,710 for the three-months ending December 31, 2001 to $146,893 for the three-months ended December 31, 2002. The value of the warrants issued in August 2001 in connection with the $2,500,000 borrowing under the Senior Subordinated Demand Note was recognized as interest expense prior to the Note`s conversion to Preferred Stock in November 2001. During the three-month period ending December 31, 2001, $552,000 of such interest expense was recognized. Also contributing to the decrease in interest expense was the conversion of debt to equity. Net Revenues. As a result of the foregoing, net revenues decreased by $3,239,184 or 45%, from $7,271,991 for the quarter ended December 31, 2001, to $4,032,807 for the quarter ended December 31, 2002. Customers in the United States generated the majority of revenues and no single customer or group of customers accounted for 10% or more of our revenues. Expenses. Total expenses for the quarter ended December 31, 2002 were $5,707,634 - a 57% decrease as compared to total expenses of $13,426,980 for the three-month period ending December 31, 2001. Commissions, Floor Brokerage and Clearing Charges: For the three-month period ending December 31, 2002, we incurred $1,015,216 of Commissions, Floor Brokerage and Clearing Charges - a 77% decrease as compared to the corresponding three-month period in 2001. These costs represent payments to our clearing and floor brokers who facilitate security transactions for both our customers and our own proprietary accounts. This decrease is largely due to the June 2002 closing of the On-Site business which had been acquired in October 2001. In addition, our institutional sale division had lower volumes as compared to the previous period. -10- Employee Compensation and Related Costs. Our Employee Compensation and Related Costs of $1,807,785 for the three-month period ending December 31, 2002 reflect a 46% decrease as compared to $3,376,391 incurred for such costs during the three-month period ending December 31, 2001. This decrease is attributable to both the reduction in the number of employees and to lower compensation paid to the institutional sales division as a result of declining profits. Communications. Communications expense for the three-month period ending December 31, 2002 amounted to $282,448, a 67% decrease as compared to $847,499 for the corresponding period in 2001. This decrease is largely due to the June 2002 closing of the On-Site business. Business Development. As a result of our substantial curtailment of promotional expenditures, our Business Development costs decreased 92% from $262,343 for the three months ending December 31, 2002 to $21,699 for the three months ending December 31, 2001. Professional Services. Professional Services primarily consists of legal and accounting costs in addition to the cost of external software consultants. For the three-month period ending December 31, 2002, our professional services amounted to $399,024 as compared to $454,913 for the three-month period ending December 31, 2001 - a decrease of 12%. Occupancy and Equipment. Occupancy and Equipment decreased $687,834 or 39% from $1,779,373 for the three-month period ending December 31, 2001 to $1,091,539 for the three-month period ending December 31, 2002. Such costs, primarily consisting of lease costs for both office space and equipment, dropped due to our August 2002 surrender and termination of the 25th and 28th floor office leases at 40 Wall Street. These leases were terminated as part of our overall cost cutting initiatives. In addition, as part of the closing of the On-Site business in June 2002, we no longer have the branch offices in Great Neck, New York and Boca Raton, Florida. Depreciation and Amortization. Depreciation and Amortization decreased by $1,719,572 or 77% when comparing the $2,218,979 for the three-months ending December 31, 2002 to the $499,407 for the three-month period ending December 31, 2002, primarily due to the disposal or surrender of assets subject to such depreciation and amortization. We had sold software to an affiliate of our clearing broker and had written off intangible assets recognized as a result of the On-Site acquisition. In addition, we had surrendered leasehold improvements at our 40 Wall Street office and at former offices in Great Neck and Boca Raton Other Expenses. For the three-month period ending December 31, 2002, we incurred $506,229 of Other Expenses, as compared to $540,707 for the three month-period ending December 31, 2001. Other expenses decreased as part of our overall cost cutting initiatives. Loss before Income Taxes and Extraordinary Item. As a result of the aforementioned factors, our Loss before Income Taxes and Extraordinary Item decreased from $6,154,989 for the three-month period ending December 31, 2001 to $1,674,827 for the three-month period ending December 31, 2002. Liquidity and Capital Resources As indicated by the accompanying unaudited consolidated financial statements, the Company has significant deficits in both working capital and stockholders` equity. These factors raise substantial doubt about the Company`s ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. Trading volume has significantly decreased and the Company has lost customers in its direct access business. To respond to its liquidity and capital resource needs management has implemented various cost cutting initiatives including renegotiating its clearing agreements at more favorable rates, the restructuring of its software license with E*Trade Group, Inc. and the sale of its software programs known as Ultimate Trader II and Watley Trader. The Company is also looking into more traditional lines of business such as fixed income and equity capital markets, as well as, the feasibility of expanding its existing business to attract active traders and hedge funds. As a further fund raising alternative the management of ABWG may seek to raise additional capital from time to time to fund operations through private placements of equity or debt instruments. There can be no assurance that any of these alternatives will be successful. -11- Cash provided by operating activities during the three months ended December 31, 2002 was $566,748, as compared to cash utilized by operating activities of $3,969,647 for the three months ended December 31, 2001. Cash was principally provided by decrease in securities owned of $2,143,466. Cash was principally used to fund the net loss of $1,293,720 net of non-cash items including depreciation and amortization of $499,408 and non-cash compensation/service costs of $9,334. In addition, cash was used to lower liabilities for accounts payable, accrued liabilities, and lease obligations by $767,288. No cash was provided by investing activities during the three months ended December 31, 2002, compared to cash used in investing activities of $115,419 during the three months ended December 31, 2001. Cash provided by financing activities was $49,962 during the three months ended December 31, 2002 compared to $3,905,933 during the three months ended December 31, 2001. Cash provided by financing activities during the three months ended December 31, 2002, principally consisted of a net increase in outstanding notes payable. Net Operating Loss Carryforwards The Company`s net operating loss carryforwards are scheduled to expire beginning in the year 2013. The issuance of additional equity securities, together with the Company`s recent financing and public offering, could be deemed to result in an ownership change and thus could limit our use of the Company`s net operating losses. If the Company achieves profitable operations, any significant limitation on the utilization of our net operating losses would have the effect of increasing our tax liability and reducing net income and available cash reserves. We are unable to determine the availability of these net operating losses since this availability is dependent upon profitable operations, which we have not achieved in recent periods. Relevant Accounting Standards The following pronouncements have been issued by the Financial Accounting Standards Board ("FASB"). SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" supercedes SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of." This statement principally addresses implementation issues of SFAS No. 121, including developing a single accounting model for long-lived assets to be disposed of by sale. The provisions of this Statement are effective for financial statements issued for fiscal years beginning after December 15, 2001, and interim periods within those fiscal years, with early application encouraged. The provisions of this Statement generally are to be applied prospectively. SFAS No. 145, "Rescission of FASB Statement Nos. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections as of April 2002" primarily provides guidance for reporting gains and losses from extinguishment of debt and sale-leaseback transactions. The provisions of this Statement are effective for financial statements issued for fiscal years beginning after May 15, 2002 with early adoption encouraged. SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities". This standard required companies to recognize costs associates with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. SFAS No. 146 replaces the existing guidance provided by EITF Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs incurred in a Restructuring)." SFAS No. 146 is to be applied prospectively to exit or disposal activities initiated after December 31, 2002. SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure - an amendment of FASB Statement No. 123" provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. The provisions of this Statement are effective for fiscal years beginning after December 15, 2003. Management does not believe that the adoption of any of these pronouncements had, or will have, a material effect on the Company`s consolidated financial statements. -12- Forward Looking Statements Certain statements contained in this report, including statements regarding the development of services and markets and future demand for services and other statements regarding matters that are not historical facts, discuss future expectations or other forward-looking information. Those statements are subject to known and unknown risks, uncertainties and other factors that could cause our actual results to differ materially from those contemplated by the statements. Factors that might cause a difference include, but are not limited to, customer trading activity, loss of one or more significant customers, changes in technology, shifts in competitive patterns, ability to manage growth effectively, risks associated with acquisitions including integration risks, risks associated with strategic partnerships, various project-associated risks, substantial competition, general economic and securities markets conditions, risks associated with intellectual property rights, risks associated with international operations and other risk factors listed from time to time in the Company`s filings and reports with the Securities and Exchange Commission. Item 3. Quantitative and Qualitative Disclosures about Market Risk. Our primary financial instruments are cash in banks and money market instruments. We do not believe that these instruments are subject to material potential near-term losses in future earnings from reasonably possible near-term changes in market rates or prices. We do not have derivative financial instruments for speculative or trading purposes. In the normal course of business, our customers enter into transactions where the risk of potential loss due to market fluctuations or failure to perform exceeds the amount reported for the transaction. We have established policies, procedures and internal processes governing our management of market risk in the normal course of our business operations. We, along with our clearing brokers, continuously monitor our exposure to market and counter party risk through the use of a variety of financial, position and credit exposure reporting and control procedures. In addition, we review the creditworthiness of each customer and/or other counter party with which we conduct business. We are not currently exposed to any material currency exchange risk because the risk is borne by international customers and our international partners, and we do not hold any assets or incur any liabilities denominated in foreign currency. Investment Considerations and Risk Factors The following factors and other information in this Form 10-K should carefully be considered when evaluating the Company and its stock. o If we are unable to continue cost cutting and revenue generation initiatives, enter into a strategic business combination or obtain additional funding sources at acceptable terms, our ability to operate our business will be significantly diminished. We are implementing cost cutting and revenue generation initiatives, and exploring strategic business combinations. We also will need to find additional funding sources at rates and terms acceptable to us to meet our capital and liquidity needs for the remainder of the year. To the extent that capital is raised through the sale of equity or convertible debt securities, the issuance of these securities could result in dilution to our stockholders. If we are unable to obtain such financing, make sufficient improvement in our operating results or find a strategic partner our ability to operate our business will be significantly diminished. o Periods of declining securities prices, decreasing trade volumes, or uncertainty in the public equity markets may adversely affect our revenues. Our future revenues are likely to be lower during periods of declining securities prices or reduced securities market activity The public markets have historically experienced significant volatility not only in the number and size of share offerings, but also in the secondary market trading volume and prices of newly issued securities. Activity in the private equity markets frequently reflects the trends in the public markets. As a result, our revenues from brokerage activities may also be adversely affected during periods of declining prices or reduced activity in the public markets. o We may not be able to adapt with rapid technological change in a cost effective manner. Traditional and online financial services industries are characterized by rapid technological change, changes in customer requirements, frequent new service and product introductions and enhancements and evolving industry standards. Our future success will depend on our ability to enhance our existing services and products. We must also develop new services and products that address the increasingly sophisticated and varied needs of our customers and prospective customers. We must respond to technological -13- advances and evolving industry standards and practices on a timely and cost-effective basis. The development and enhancement of services and products entails significant technical and financial risks. We may fail to o use new technologies effectively; o adapt services and products to evolving industry standards; or o develop, introduce and market service and product enhancements or new services and products. In addition, we may experience difficulties that could delay or prevent the successful development, introduction or marketing of our services and products, and our new service and product enhancements may not achieve market acceptance. If we encounter these problems, our business, financial condition and operating results may be materially adversely affected. o Operational risks may disrupt our business or limit our growth. Like other securities and securities-related businesses, we are highly dependent on information processing and telecommunications systems. We face operational risks arising from potential mistakes made in the confirmation or settlement of transactions or from the failure to properly record, evaluate or account for transactions. Our business is highly dependent on our ability, and the ability of our clearing firms, to process, on a daily basis, a large and growing number of transactions across numerous and diverse markets. Consequently, we and our clearing firms rely heavily on our respective financial, accounting, telecommunications and other data processing systems. If any of these systems were to not operate properly or become unavailable due to problems with our physical infrastructure, we could suffer financial loss, a disruption of our business, liability to clients, regulatory intervention or reputational damage. In addition, we are aware that other companies in our industry have had problems due to high volume of telephone and e-mail customer inquiries that has at times strained the capacity of their telecommunications systems and customer service staffs, and has also led to temporary disruptions in website service. Thus, any inability of systems used to accommodate an increasing volume of transactions and customer inquiries could also constrain our ability to expand our businesses and could damage our reputation. o Employee misconduct could harm us and is difficult to detect and deter. There have been a number of highly publicized cases involving fraud or other misconduct by employees in the financial services industry in recent years, and we run the risk that employee misconduct could occur. Misconduct by employees could bind us to transactions that exceed authorized limits or present unacceptable risks, or hide from us unauthorized or unsuccessful activities. In either case, this type of conduct could result in unknown and unmanaged risks or losses. Employee misconduct could also involve the improper use of confidential information, which could result in regulatory sanctions and serious reputational harm. It is not always possible to deter employee misconduct, and the precautions we take to prevent and detect this activity may not be effective in all cases. o The securities industry in which we will operate is heavily regulated by the Securities and Exchange Commission ("SEC"), state regulators, and the National Association of Securities Dealers ("NASD"). If we fail to comply with applicable laws and regulations, we may face penalties or other sanctions that may be detrimental to our business. The securities industry in the United States is subject to extensive regulation under both federal and state laws. Broker-dealers are subject to regulations covering all aspects of the securities business, including: o sales methods; o trade practices among broker-dealers; o use and safekeeping of customers` funds and securities; o capital structure; o record keeping; o conduct of directors, officers, and employees; and o supervision of employees, particularly those in branch offices. The principal purpose of regulation and discipline of broker-dealers is the protection of customers and the securities markets, rather than protection of creditors and stockholders of broker-dealers. Uncertainty regarding the application of these laws and other regulations to our business may adversely affect the viability and profitability of our business. The SEC, the NASD, other self-regulatory organizations and state securities commissions can censure, fine, issue cease-and-desist orders, or suspend or expel a broker-dealer or any of its officers or employees. Our ability to comply with all applicable laws and rules is largely dependent on our establishment and maintenance of a compliance system to ensure such compliance, as well as our ability to attract and retain qualified compliance personnel. We could be subject to disciplinary or other actions due to claimed noncompliance in the future, and the imposition of any material penalties or orders on us could have a material adverse effect on our business, operating results and financial condition. In addition, it is possible that noncompliance could subject us to future civil lawsuits, the outcome of which could harm our business. -14- In addition, our mode of operation and profitability may be directly affected by: o additional legislation; o changes in rules promulgated by the SEC, state regulators, the NASD, and other regulatory and self-regulatory organizations; and o changes in the interpretation or enforcement of existing laws and rules. o The failure to remain in compliance with the Net Capital Rule would adversely affect our ability to continue to operate as a broker-dealer. The SEC, the NASD and various other regulatory agencies have stringent rules with respect to the maintenance of specific levels of net capital by securities brokers, including the SEC`s Uniform Net Capital Rule (the "Net Capital Rule"). Net capital is the net worth of a broker or dealer (assets minus liabilities), less certain deductions that result from excluding assets that are not readily convertible into cash and from conservatively valuing certain other assets. Failure to maintain the required net capital may subject a firm to suspension or revocation of registration by the SEC and suspension or expulsion by the NASD and other regulatory bodies and ultimately could require the firm`s liquidation. In addition, a change in the net capital rules, the imposition of new rules or any unusually large charge against net capital could limit those aspects of our contemplated operations that require the intensive use of capital, such as trading activities and the financing of customer account balances. A significant operating loss or any unusually large charge against net capital could adversely affect our ability to operate and/or expand, which could have a material adverse effect on our business, financial condition and operating results. As of February 28, 2002, March 31, 2002, and April 30, 2002, the Company had a net capital deficit as defined, of $520,836, $1,487,966, and $637,141, respectively, in violation of the Net Capital Rule. In addition, as of September 30, 2002, the Company had a net capital deficit of $301,523. These deficiencies were cured through additional funding and through funds generated from operations. While the Company is presently in compliance with net capital requirements, there can be no assurance that we will not fall below minimum net capital requirements in the future. o The failure of brokerage customers to meet their margin requirements could result in significant liabilities. The brokerage business, by its nature, is subject to risks related to defaults by our customers in paying for securities they have agreed to purchase and delivering securities they have agreed to sell. Our clearing firm may make margin loans to our customers in connection with their securities transactions. We are required by contract to indemnify that firm for, among other things, any loss or expense incurred due to defaults by our customers in failing to repay margin loans or to maintain adequate collateral for those loans. We will be subject to risks inherent in extending credit, especially during periods of volatile markets or in connection with the purchase of highly volatile stocks which could lead to a higher risk of customer defaults. o We may be obligated to redeem our Series A Preferred Stock at a point in the future. The holders of our Series A Preferred Stock have the right to have their shares redeemed for cash equal to the greater of (i) the price we received when we sold them the stock ($10,000 per share) plus any accrued and unpaid dividend payments and (ii) the aggregate value of the shares of Common Stock into which such shares of Series A Preferred Stock are then convertible (based upon the closing bid price), in any of the following situations: o if our Common Stock is not tradable on the NYSE, the AMEX, the NASDAQ National Market or the NASDAQ SmallCap market for a period of five consecutive days. o if we fail to register with the Securities and Exchange Commission (or maintain such registration of) the Common Stock into which the Series A Preferred Stock converts. o if we fail to honor requests for conversion, or if we notify any holder of Series A Preferred Stock of our intention not to honor future requests for conversion. o if the holders of more than 30 percent of the outstanding shares of our Common Stock sell or exchange their stock. o if we commit a material breach under, or otherwise materially violate the terms of, the transaction documents entered into in connection with the issuance of the Series A Preferred Stock and the warrants. In April of 2002, our Common Stock was delisted from the NASDAQ Stock Market. In addition, we have not registered the Common Stock into which the Series A Preferred Stock converts. We have not received a redemption notice from any of the holders of our Series A Preferred Stock. Redemption of the Series A Preferred Stock in any event described above would require us to expend a significant amount of cash that likely will exceed our ability to make such payment or raise additional capital. -15- o Our stockholders could experience substantial dilution as a result of the issuance of and terms of our Series A Preferred Stock and the related warrants. The 630 shares of Series A Preferred Stock that were sold in the private placement are initially convertible into approximately 2,135,700 shares of Common Stock. The warrants granted in connection with the sale of Series A Preferred Stock are initially exercisable for 1,629,069 shares of Common Stock, at an exercise price of $2.95 per share. Under the terms of the Series A Preferred Stock, we are also obligated to issue additional shares of Common Stock every six months to the holders of the Series A Preferred Stock as preferred stock dividends. Initially, these dividends will be payable at the rate of six percent for the first 18 months following issuance of the Series A Preferred Stock and fifteen percent after that initial 18 month period. The number of shares of Common Stock will be determined by dividing the dividend payment by the market price for our Common Stock on the day before such dividend is payable. Because these shares are issueable as a dividend, we will receive no additional consideration in connection with their issuance. o We may also be required to issue shares of Common Stock without additional consideration in the event that we fail to redeem any shares of Series A Preferred Stock when required. All of the foregoing issuances of Common Stock are likely to be substantially dilutive to the outstanding shares of Common Stock, especially where, as described above, the shares of Common Stock are issued without additional consideration. Moreover, any increase in the number of shares of Common Stock we are required to issue resulting from anti-dilution protection, penalties or other adjustments to the conversion or exercise prices of the Series A Preferred Stock and/or the warrants described above will further increase the anticipated dilution to the outstanding holders of our Common Stock. We cannot predict whether or how many additional shares of our Common Stock will become issuable due to these provisions. Any such dilution, potential dilution, or increase in dilution or potential dilution, may result in a decrease in the value of the outstanding shares of our Common Stock. Such a decrease in value, the risk of dilution, any actual dilution, or any increase in potential dilution may cause our stockholders to sell their shares, which would contribute to a downward movement in the price of our Common Stock. This could prevent us from sustaining a per share price sufficient to enable us to maintain an active trading market on the NASDAQ National Market or SmallCap Market if our stock is re-listed. In addition, any downward pressure on the trading price of our Common Stock could encourage investors to engage in short sales, which would further contribute to a downward pricing of our Common Stock. o We may be required to obtain the consent of the holders of Series A Preferred Stock before taking corporate actions, which could harm our business. Our charter documents require us to obtain the consent of the holders of the Series A Preferred Stock before we may issue securities that have senior or equal rights as the Series A Preferred Stock or take other actions with respect to the Series A Preferred Stock or securities that have fewer rights than the Series A Preferred Stock. We are also required to obtain the consent of the holders of the Series A Preferred Stock before we amend or modify our certificate of incorporation or bylaws, whether by merger, consolidation or otherwise to change any of the rights of the holders of Series A Preferred Stock. While these obligations may deter a potential acquirer from completing a transaction with us, they may also prevent us from taking corporate actions that would be beneficial to the holders of our Common Stock and the Company, such as raising capital to operate our business or maintain our capitalization or per share price in attempts to maximize stockholder volume and liquidity. o We may be unable to obtain critical goods or services from our suppliers We obtain financial information from a number of third-party suppliers of software and information services. We believe we have available to us at comparable cost a number of alternative sources of supply of these items of software and information services, to provide adequate replacements on a timely basis, if arrangements with any of our current suppliers are abrogated. We have established a number of relationships with third-party suppliers of software and information services. There can be no assurance that such relationships will continue or that timely replacement of such services will be available in the future. -16- Item 4. Controls and Procedures During the quarter, an evaluation was performed under the supervision and with the participation of the Company`s management, including the Principal Executive Officer and the Principal Financial Officer, of the effectiveness of the design and operation of the Company`s disclosure controls and procedures. Based on that evaluation, the Company`s management, including the Principal Executive Officer and the Principal Financial Officer, concluded that the Company`s disclosure controls and procedures were effective as of December 31, 2002. There have been no significant changes in the Company`s internal controls or in other factors that could significantly affect internal controls subsequent to December 31, 2002. Part II - OTHER INFORMATION Item 1. Legal Proceedings Our business involves substantial risks of liability, including exposure to liability under federal and state securities laws in connection with claims by dissatisfied clients for fraud, unauthorized trading, churning, mismanagement, and breach of fiduciary duty, as well as in connection with the underwriting or distribution of securities. In recent years, there has been an increasing incidence of litigation involving the securities industry, including class actions which generally seek rescission and substantial damages. In the ordinary course of business, we and our principals are, and may become, a party to legal proceedings or arbitration. Except as described below, the Company is not a party to any material legal proceedings or arbitrations. The Company is a party to various suits alleging breach of contract (i) due to non-payment for services or goods provided, and (ii) for the minority interest of the Class B members of the LLC. The Company is defending these suits and has commenced settlement negotiations as to certain of such suits. In addition, a suit has been brought by Akro Investicni Spolecnost, A.S. and Bozena Konvalinkova, as Czech Receiver of Private Investors, as against A.B. Watley. The plaintiffs allege violations of New York common law and federal securities law by A.B. Watley arising from an agreement between Private Investors, a Czech broker-dealer, and A.B. Watley. Plaintiffs seek damages of $31,400,000 (of which approximately $950,000 is alleged to represent the damages) plus punitive damages. The Company believes it has a meritorious defense against this suit and intends to fight it vigorously and although there can be no assurance, the Company believes the majority of the claims if successful, will be substantially less than the amount of the damage claims and will be covered by insurance. We are a defendant in four actions relating to the lease of equipment in which the plaintiffs have asserted breach of contract and damages in the aggregate amount of approximately $683,000. Three of such actions are pending before the Supreme Court of New York, New York, and the remaining action is pending before the District Court, 4th Judicial District, Hennepin County, Minnesota. We are a defendant in an action pending before the American Arbitration Association ("AAA") in which the plaintiffs have asserted breach of fiduciary duties. The plaintiff in this action seeks an accounting and unspecified damages. We are a defendant in an action pending before the AAA in connection with our failure to maintain a registration statement in which the plaintiffs have asserted breach of contract and damages in the amount of approximately $84,000. We are a defendant in a breach of contract action pending before the Supreme Court, Nassau County, New York arising out of an employment dispute. The plaintiff in this action is seeking compensatory damages of $93,000, as well as liquidated damages, under New York`s Labor Law, in the amount of 25% of the compensatory damages. We are a defendant in an action pending before the Supreme Court of New York, New York in connection with a construction contract in which the plaintiffs have asserted breach of contract and damages in the aggregate amount of approximately $234,000. -17- We are a defendant in an action pending before the Supreme Court of New York, New York in connection with an advertising contract in which the plaintiffs have asserted breach of contract and damages in the aggregate amount of approximately $29,000. We are a defendant in an action pending before the National Association of Securities Dealers ("NASD") in which the claimants have asserted breach of contract and damages in the aggregate amount of approximately $147,000. There is one action that relates to collection of an existing account payable in which a judgment has been entered against the Company totaling approximately $24,000. In addition to the foregoing, in the ordinary course of business, we and our principals are, and may become, a party to legal or regulatory proceedings commenced by the NASD, the SEC or state securities regulators relating to compliance, trading and administrative problems that are detected during periodic audits and inspections or reported by dissatisfied customers. Such matters, if pursued by such entities, could rise to the level of disciplinary action. The Company is not currently involved in any proceeding by a governmental agency or self-regulatory organization, the outcome of which is expected to have a material adverse effect on our business. There can be no assurance that one or more future disciplinary actions, if decided adversely to the Company, would not have a material adverse effect on the Company`s business, financial condition and results of operations. Item 2. Changes in Securities None. Item 3. Default upon Senior Securities On November 29, 2001, the Company entered into a Series A Convertible Preferred Purchase Agreement whereby it issued 630 shares of Series A Convertible Preferred Stock, par value $.01 ("Preferred Stock") in a private placement. Each share is convertible into 3,390 shares of the Company`s Common Stock at an exercise price of $2.95. The purchasers of the Preferred Stock were issued warrants, expiring in 5 years from the date of issuance, to purchase an additional 1,629,069 shares of Common Stock at an exercise price of $2.95. Pursuant to the Purchase Agreement and the Registration Rights Agreement (the "Registration Agreement"), the Company was required to file a registration statement (the "Registration Statement") with the Securities and Exchange Commission registering for resale the shares of Common Stock issuable upon the conversion of the shares of Preferred Stock in the amount of 2,135,700 shares, and upon the exercise of warrants to purchase shares of Common Stock in the amount of 1,629,069. As of the date hereof, the Company has not filed a Registration Statement and will not be able to have the Registration Statement filed and declared effective within the period required. As a result, the Company is in default of the Purchase Agreement and the Registration Agreement. A penalty of 2% of the liquidation preference value of the Preferred Stock for each thirty-day period accrues to each holder of Preferred Stock and is added to the liquidation preference amount until cured. As of December 31, 2002, liquidated damages of approximately $692,594 has been accrued to the preferred holders. Item 4. Submission of Matters to a Vote of Security Holders None. Item 5. Other Information None. -18- Item 6. Exhibits and Reports on Form 8-K. (a) Exhibits 99.1 Certification by John J. Amore, Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 99.2 Certification by Robert Malin, Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (b) Reports None. -19- 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. Date: April 15, 2003 A.B. WATLEY GROUP INC. (Registrant) By: /s/ John J. Amore -------------------------------- John J. Amore Chief Executive Officer By: /s/ Robert Malin -------------------------------- Robert Malin Vice-Chairman -20- CERTIFICATION I, John J. Amore, the Chief Executive Officer, certify that: 1. I have reviewed this quarterly report on Form 10-Q of A.B. Watley Group Inc. 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; and 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report. 4. The registrant`s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant`s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date. 5. The registrant`s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant`s auditors and the audit committee of registrant`s board of directors (or persons performing the equivalent functions): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant`s ability to record, process, summarize and report financial data and have identified for the registrant`s auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant`s internal controls; and 6. The registrant`s other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. /s/ Steven Malin ---------------------------------- Chief Executive Officer Date: April 15, 2003 -21- CERTIFICATION I, Robert Malin, the Principal Financial Officer, certify that: 1. I have reviewed this quarterly report on Form 10-Q of A.B. Watley Group Inc. 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; and 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report. 4. The registrant`s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant`s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date. 5. The registrant`s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant`s auditors and the audit committee of registrant`s board of directors (or persons performing the equivalent functions): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant`s ability to record, process, summarize and report financial data and have identified for the registrant`s auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant`s internal controls; and 6. The registrant`s other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. /s/ Robert Malin ---------------------------------- Robert Malin Principal Financial Officer Date: April 15, 2003 -22-

WATLEY A B GROUP INC 10-Q