Knight Capital avoids collapse with $400M lifeline

A Knight Capital trader works on the floor of the New York Stock Exchange during morning trading on August 6, 2012, in New York. (Spencer Platt/Getty Images)

(AP) NEW YORK - Knight Capital Group (KCG) survived a near-death experience on Monday, lining up Wall Street firms to lend it badly needed cash after the brokerage lost $440 million last week when a malfunction in its trading system flooded the market with erroneous trades.

But the rescue, which came down to the wire, had a steep price: control of the firm. And it's still not certain that Knight will make it through the episode intact.

Knight's new investors will gain a 73 percent stake in the company and three board seats. The value of current shareholders' stake will also be heavily diluted. And Knight, which has removed the problem software and is still completing its own investigation of what went wrong, faces a difficult task of rebuilding trust with clients and persuading regulators that Wednesday's disaster was an anomaly. Its stock has plunged 70 percent since last Tuesday, before the glitch happened.

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"This is an isolated situation," Knight's CEO Thomas Joyce said on CNBC Monday morning. "We screwed up. We paid the price."

All weekend, speculators wondered if Knight would be able to open for business Monday. The technical glitch briefly sent dozens of shares swinging wildly last week and left Knight responsible for many of the stocks that its computers accidentally ordered. The company had to drain its capital to cover the erroneous trades.

The trading disaster Knight caused has revived a thorny debate about how heavily stock trading has come to rely on massive computer systems. Stocks can now be traded in fractions of a second, often by automated programs.

Recent technical problems have eroded shareholders' confidence that they can trust the system - a point punctuated again Monday, when a technical problem shut down markets in Madrid for five hours.

Early Monday morning, before the stock market opened at 9:30 a.m., it still wasn't clear whether Knight was OK.

Just after 7 a.m., Knight made a regulatory filing saying it had secured a $400 million lifeline but that the deal wasn't yet sealed.

An hour later, the New York Stock Exchange threw another twist into the story, announcing it had temporarily reassigned some of Knight's trading responsibilities to a rival firm.

At 9:22 a.m., Knight announced that the deal was completed, but didn't say who the investors were. At 9:24 a.m., it did.

Once trading opened, Knight's stock moved sharply lower in heavy trading. It ended the day down 98 cents, or 24 percent, at $3.07. That's far below its closing price of $10.33 on Tuesday, the day before the debacle occurred.

Knight Capital is a trading firm that takes orders from big brokers like TD Ameritrade (AMTD) and E-Trade (et). It then routes them to the exchanges where stocks are traded, like the New York Stock Exchange.

One of the roles Knight plays in the stock market is that of a "designated market maker." Those firms are responsible for keeping trading of the stocks they oversee orderly. They are viewed as particularly important during the open and close of trading, as well as during times when there is a lot of volatility in the market. Knight is responsible for the trading of 524 NYSE-listed stocks, a sizable chunk of the roughly 2,300 total corporate issuers.

Being on the defensive is a humbling position for Knight, which is considered a respected and top-tier trading firm. That, some observers say, makes its blunder all the more troubling: If it can happen at Knight, it can happen anywhere.

Manoj Narang, CEO of Tradeworx, a high-frequency trading firm, said the market would still function fine without Knight, if it has to.

"Markets are a battleground; it's survival of the fittest," Narang said. He compared the activities of Knight and other equity brokerages to driving a car: Sometimes there are accidents, but "that doesn't mean we should all stop using automobiles."

A decade ago, CEO Joyce was the architect of another rescue for Knight. That's when he was brought on to turn around a company mired in losses and sinking revenue. A Merrill Lynch veteran and an athlete during his days at Harvard, Joyce has been praised for being straightforward in his company's latest crisis.

The CEO, 57, had knee surgery last Tuesday and hobbled back to work the next day to the chaos emanating from the firm he leads. Knight, headquartered across the Hudson River from Wall Street in Jersey City, N.J., was founded in 1995 and has about 1,400 employees across the U.S. and internationally.

Over the weekend, Knight tried, unsuccessfully, to lighten its burden. It asked the Securities and Exchange Commission for an exemption so it wouldn't have to buy back so many of the mistaken trades, a development first reported by The Wall Street Journal.

The SEC does allow trading firms to cancel some trades made in error, but it has gotten stricter about what qualifies ever since the notorious "flash crash" of May 2010, when another technical problem sent the Dow Jones industrial average plunging nearly 600 points in five minutes.

On CNBC, Joyce said he respected the SEC's decision but added: "This was an error, by any definition this was an error, so we would have liked to see more flexibility."

Knight's cash infusion comes from a group of financial firms led by the Jefferies Group (JEF), as well as Blackstone (BX), the trading firm Getco, Stephens, Stifel Financial (SF) and TD Ameritrade. They're essentially paying $1.50 per share, a bargain-basement price.

Even with the cash infusion, it's not yet clear that Knight will regain the trust of other key players in the stock market to carry on and survive as a firm. Some of Knight's trading partners last week suspended routing trades through Knight, though some have come back.

E-trade on Monday announced it had resumed routing trades through Knight. Online brokerage Ditto Trade said it still wasn't sending trades through Knight but expected to soon.

When a public company sells such a big portion of itself, as Knight did Monday, it's usually required to ask shareholders for their permission first. But Knight got an exception after telling the New York Stock Exchange that its financial viability was at stake.

Problems such as the one Knight caused last week have been occurring more regularly as the stock market's trading systems come under increasing pressure from traders using huge computer systems.

In May the highly anticipated market debut of Facebook was marred when technical problems at the Nasdaq stock exchange delayed the opening of Facebook's trading and kept many investors from knowing if their trades had gone through. Some were left holding unwanted shares.

In an irony that now dogs Joyce, he was one of the most vocal critics at the time of Nasdaq's botching of Facebook's stock market debut.

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